Objective 4

Accounting principles
 How to Do Accounting: Principles

Accountants
Accountants follow
follow professional
professional guidelines.
guidelines.

The
The rules
rules that
that govern
govern accounting
accounting are
are called
called GAAP
GAAP
(generally
(generally accepted
accepted accounting
accounting principles).
principles).
Accounting principles

 Accounting entity principle

 Business transactions of the accounting entity should
be separated from personal transactions.
 Historical cost principle
 Assets recorded at the cost paid to have them.
 Going concern principle
 The assumption that an entity will continue in
business.
 Reporting period principle
 Artificial segment on the calendar used as the basis for
preparing the financial statements
Accounting principles
 Matching principle
 Revenue for a period shall match with expenses over the same
period of time to calculate profit.
 Monetary unit principle
 The measurement unit used is the currency of the country in
which the report is being prepared.
 Conservatism principle
 Losses would be allowed for when expected to occur, while
gains would only be recognized if certain to happen.
 Consistency principle
 Accounting methods used are applied consistently from one
reporting period to another.
Accounting principles
 Accrual Principles
 Entity should prepare the financial statements on the basis that
transactions are recorded in them, not as cash is paid or received, but
as revenue or expense are earned or incurred in the accounting period
to which they relate.
The Entity Concept Example
 Assume that John decides to open up a gas
station and coffee shop.
 The gas station made $250,000 in profits,
while the coffee shop lost $50,000.
The Entity Concept Example
 How much money did John make?
 At a first glance, we would assume that
John made $200,000.
 However, by applying the entity concept we
realize that the gas station made $250,000
while the coffee shop lost $50,000.
Going concern
 A retailer commence business on 1 Jan and buy
inventory of 20 washing machines, each costing
$100. During the year, he sells 17 machines at
$150/each. How should the remaining machines
be valued at 31 Dec. in the following
circumstances:
(a) He is forced to close down his business at the
end of the year and the remaining machines be
valued at 31 Dec. only $60 each in forced sale.
(b) He intends to continue his business into the next
year.
The Going Concern Concept

The entity will continue

to operate in the future.
Accounting Period

Managers adopt an
artificial period of time
to evaluate performance.
Interim Period Statements

Monthly

Quarterly

Semi-annually
The Matching Principle
 What is the matching principle?
 It is the basis for recording expenses.
 Expenses are the costs of assets and the
increase in liabilities incurred in the earning
of revenues.
 Expenses are recognized when the benefit
from the expense is received.
Matching principle
 Emma buys 20 T-shirts in her first month
of trading (May) at a cost of $5 each.
(a) Emma sells all of them for $10 each.
Profit= Revenue – Cost
$100= 20*10-20*5
(b) Emma only sells 18 T-shirts
Profit= 18*10-18*5=$90
Matching Expenses with
Revenues Example
 Parker Floor sells a wood floor for $15,000
on the last day of May.
 The wood was purchased from the
manufacturer for $8,000 in March of the
same year.
 The floor is installed in June.
 When is income recognized?
Matching Expenses with
Revenues Example

May

Revenues $15,000
Cost of goods sold 8,000
Net income $ 7,000
The Monetary-Unit principle

The dollar’s purchasing

power is relatively
stable.
Accrual principles

Distinguish accrual
accounting from
cash-basis accounting.
The Two Bases of Accounting:

Accrual-basis:
Cash-basis:
Transactions are
Transactions are
recorded
recorded when
when revenues are
cash is paid or
earned or expenses
cash is received.
are incurred.
Accrual Versus Cash Example
 In January 2002, Prensa Insurance sells
a three-year health insurance policy to a
business client.
 The contract specifies that the client had
to pay $150,000 in advance.
 Yearly expenses amount to $20,000.
 What is the income or loss?
 Accrual Versus Cash Example

Accrual-Basis Accounting
(000 omitted) 2002 2003 2004

Revenues $50 $50 $50

Expenses 20 20 20
Net income (loss) $30 $30 $30
Accrual Versus Cash Example

Cash-Basis Accounting
(000 omitted) 2002 2003 2004

Cash inflows $150 $ 0 $ 0

Cash outflows 20 20 20
Net income (loss) $130 ($20) ($20)
Objective 5

Requirements for Accounting

information
Requirements for Accounting
information
 Relevance –all accounting information is
presented in general purpose financial
report (personal transaction are omitted)
 Reliability - information must be free of
error and bias
 Comparability - ability to compare
information of different companies because
they use the same accounting principles
Requirements for Accounting
information
 Materiality- all significant items must be
reported in accounting report.

 Understandability – Reports being

prepared in such s way that general users
are able to comprehend their meaning.
Characteristics of Useful Information