1 01 Generally Accepted Accounting Principles Accounting Constraints

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1. 01 Generally Accepted Accounting Principles – Accounting Constraints, Concepts, Assumptions, and Principles GAAP

1. 01 Generally Accepted Accounting Principles – Accounting Constraints, Concepts, Assumptions, and Principles GAAP Power. Point #3

Hierarchy of Qualitative Information Cost/Benefit Understandability Discussed in PPT #2 Decision Usefulness Relevance Reliability

Hierarchy of Qualitative Information Cost/Benefit Understandability Discussed in PPT #2 Decision Usefulness Relevance Reliability Verifiability Timeliness Feedback Value Neutrality Representational Faithfulness Predictive Value Comparability and Consistency Materiality www. fasb. org

Constraints �A constraint is a limit, regulation, or confinement within prescribed bounds. � This

Constraints �A constraint is a limit, regulation, or confinement within prescribed bounds. � This term refers to the accounting guidelines that border the Hierarchy of Qualitative Information � They consist of: ◦ Cost Effectiveness ◦ Materiality ◦ Conservatism

Cost Effectiveness Constraint � Also called Cost Benefit Constraint � The cost of providing

Cost Effectiveness Constraint � Also called Cost Benefit Constraint � The cost of providing accounting information should not exceed the benefit of the information it is reporting. � Example: Your checkbook register and bank statement differs by $0. 10. Rather than waste time to find the $0. 10, the accountant should record the amount as miscellaneous expense or income.

Materiality Constraint � Material means big enough to make a difference in the user’s

Materiality Constraint � Material means big enough to make a difference in the user’s decision-making process. � States that the requirements of any accounting principle may be ignored when there is no effect on the decisions of the user of financial information. � Example: A company purchases a Trashcan for $10. Per GAAP, this amount should be capitalized as an asset and depreciated. Because the amount is immaterial, the $10 can be recorded as an expense.

Conservatism Constraint � Accountants use their judgment to record transactions that require estimation. �

Conservatism Constraint � Accountants use their judgment to record transactions that require estimation. � Conservatism helps the accountant choose between 2 equally likely alternatives. � Requires the accountant to record the transaction using the less optimistic choice. � Example: There is the potential for a customer to sue the company. Although, the customer may choose not to sue, the accountant will disclose this potential lawsuit to investors.

Concepts � Concepts are the ground rules of accounting that should be followed when

Concepts � Concepts are the ground rules of accounting that should be followed when preparing financial statements. � These are: ◦ Recognition Concept ◦ Measurement Concept

Recognition Concept � States that an item should be recognized (recorded) in the financial

Recognition Concept � States that an item should be recognized (recorded) in the financial statements when: ◦ It can be defined by GAAP assumptions and principles ◦ It can be measured ◦ It is relevant to decision-making by users ◦ It is reliable

Measurement Concept � States that every transaction is measured by the stated unit of

Measurement Concept � States that every transaction is measured by the stated unit of measurement, such as the dollar � The stated procedure of valuing assets, liabilities, equity, revenue, and expenses as defined by GAAP

Assumptions � Assumptions are agreed upon rules of accounting, and are basic, understood beliefs.

Assumptions � Assumptions are agreed upon rules of accounting, and are basic, understood beliefs. � There are Four Basic Assumptions of Accounting: ◦ ◦ Economic Business Entity Going Concern Monetary Unit Time Period

Economic Business Entity Assumption � All of the business transactions should be separate from

Economic Business Entity Assumption � All of the business transactions should be separate from the business owner’s personal transactions � There should be no co-mingling of personal funds with business funds.

Going Concern Assumption � Financial statements are prepared under the assumption that the company

Going Concern Assumption � Financial statements are prepared under the assumption that the company will remain in business indefinitely unless there is sufficient evidence otherwise. � If there is evidence that a company may possibly have a going concern issue, this must be disclosed in the financial statements.

Monetary Unit Assumption � Assumes a stable currency is going to be the unit

Monetary Unit Assumption � Assumes a stable currency is going to be the unit of record. � FASB accepts the nominal value of the US Dollar as the monetary unit of record unadjusted for inflation.

Time Period Assumption � The entity’s activities are separated into periods of time such

Time Period Assumption � The entity’s activities are separated into periods of time such as months, quarters or years. � Transactions must be accounted for within the time period they occur regardless of when cash is exchanged.

Principles of Accounting � Principles are accounting rules used to prepare, present, and report

Principles of Accounting � Principles are accounting rules used to prepare, present, and report financial statements. � Principles dictate how events should be recorded and reported.

Cost Principle � Assets are recorded at historical cost, not fair market value. �

Cost Principle � Assets are recorded at historical cost, not fair market value. � For example, if a company purchases a building for $500, 000 it should be recorded as such, and should remain on the books for that amount until disposed of. � If the building appreciates to $700, 000 in the next few years, no adjustment should be made.

Full Disclosure Principle � All information pertaining to the operations and financial position of

Full Disclosure Principle � All information pertaining to the operations and financial position of the entity must be reported within the period of time in question. � Circumstances and events that make a difference to financial statement users should be disclosed.

Revenue Recognition Principle � Revenue is earned and recognized upon product delivery or service

Revenue Recognition Principle � Revenue is earned and recognized upon product delivery or service completion, without regard to when cash is actually received. � Also called accrual basis accounting � Example: A customer purchases inventory from a company on credit. Even though no cash has yet been received, the sale is recorded.

Matching Principle � The costs of doing business are recorded in the same period

Matching Principle � The costs of doing business are recorded in the same period as the revenue they help generate, regardless of when the money is actually paid. � Also called accrual basis accounting � Example: A company orders merchandise on credit and has 30 days in which to pay. This purchase is recorded immediately, even though no cash has been paid.

Questions for Understanding/Discussion � Explain what is meant by “The benefits of accounting information

Questions for Understanding/Discussion � Explain what is meant by “The benefits of accounting information must exceed the costs. ” � What is meant by the term materiality in financial reporting? � What is meant by the term conservatism in financial reporting? � Explain the Going Concern assumption. � Explain the Time Period assumption. � Explain the accounting principles that guide accounting practice.