Accounting II  © John Petroff; contributors: Luis Carlos Bonilla Posada, Mayowa Adeyemi, Luiz Fernando Noronha Bogado et al. Source: PEOI

 

Chapter 1:

CONCEPTS & PRINCIPLES

 

THE DEVELOPMENT OF CONCEPTS AND PRINCIPLES
The development of accounting concepts and principles is closely related to the economic growth of the United States, as businesses grew in size, and outsiders increased their demand for financial information. Accounting principles focus on the users of accounting information. Principles have developed over a long period of time, and are continuously subject to revision as information needs change. It is the responsibility of accounting professionals, teachers and accounting organizations to keep accounting principles up-to-date, relevant and useful.

FINANCIAL ACCOUNTING STANDARDS BOARD
The FASB was set up with the purpose of developing accounting principles in 1973. Today it is the most influential accounting organization. The FASB is involved in solving reporting problems and developing solutions. When Statements of Financial Accounting Standards are released by the FASB, they quickly become gerenally accepted accounting principles (GAAP) pertaining to standards, assumptions, conventions or concepts. When it is difficult to understand accounting principles, interpretations are released which have the same authority as the standards.

INFLUENTIAL ACCOUNTING ORGANIZATIONS
The FASB is the most influential accounting organization, but many other organizations exist that affect accounting practices. The Securities and Exchange Commission is the most influential government agency that regulates financial statement reporting. The IRS is involved in regulations related to income tax. IRS regulations often conflict with accounting principles, and as a result many businesses maintain two sets of records. Other organizations affecting accounting principles have less importance, and tend to specialize in a certain area of accounting.

 

BUSINESS ENTITY CONCEPT
The business entity concept states that each business entity is a legal entity on its own. That's a business is different from the owner, the promoter or the investors. A business should have its own separate Account statement from the owner of the business. Basically,a business financial statement has the following major heading , Assets, Liabilities, and Owner's Equity which should be reported at as a specific date or period. It should be noted, however, that in some circumstances the investors or owners of a business are legally liable for debts or damages arising from the day to day operation of the business. This liability depends upon the legal form of the business. In the event an individual owns more than one unrelated business, each business must also be treated as a separate entity.

GOING CONCERN CONCEPT
The going concern concept is based on the belief that a business will operate indefinitely. Assets purchased for long-term use,should be recorded at historical cost even if the market value is above or below the original cost. When expenses are prepaid, they should be listed as assets. In the event a business is near the end of its life, this information should be disclosed in the financial statements of a company. Accounting procedures should change to reflect the special needs of a business in liquidation.

OBJECTIVITY
All information must be maintained objectively, which means that it is free of bias and subject to verification. Objectivity is closely tied to reliability. Objective evidence consists of anything that can be physically verified such as a bill, check, invoice, or bank statement. In the event something cannot be supported objectively, a number of subjective methods are used to develop an estimate. The determination of items such as depreciation expense and allowance for doubtful accounts are based on subjective factors. Still even subjective factors are influenced by objective evidence such as past experience.

STABLE-DOLLAR UNIT OF MEASUREMENT
All accounting transactions are recorded in terms of monetary value. The use of a monetary value makes it easy to compare financial data, and it is the common factor of all business transactions. During changing price levels, monetary value does not always properly reflect true economic conditions. The use of current cost data or constant cost data can be used to adjust price levels to a current price range. This data is reported as supplementary information and the financial statements are prepared with the assumption of a stable dollar.

ACCOUNTING PERIOD
Financial reports should be issued by businesses at least yearly. Most corporations issue reports quarterly, as well. Timely information provided by financial reports is essential for investors, creditors, industry analysts, management and government agencies. Periodic income is difficult to determine because of the many adjustments that are necessary. The accuracy of financial reports depends on subjective factors such as an estimation of depreciation and inventory costing.

MATCHING REVENUES AND EXPENSES
For most businesses, recognition of revenue is based on when the revenue has been realized, that is, when a price has been agreed with the purchaser and the seller has completed all obligations. Few businesses rely on collection or receipt of payment. For some businesses, revenue recognition is spread over time as in the installment or time-of-completion method. All costs directly associated with a given revenue must be matched with that revenue. Some expenses are not associated with specific revenue items but with a given time period. Expenditures, for instance for plant asset, must be allocated over their useful life and remain as unexpired cost or assets.

ADEQUATE DISCLOSURE
All relevant and material facts which affect the reliability and comparability of financial statements must be disclosed. This usually relates to
1) accounting methods used,
2) changes in accounting estimates,
3) contingent liabilities,
4) performance of business segments, and
5) any significant event subsequent to the end of the financial period.

CONSISTENCY CONCEPT
The purpose of the consistency concept is to assure that financial statements can be easily compared period to period, and therefore to encourage that the same accounting principles be used from year to year. When changes in accounting methods are necessary, such changes should be disclosed and the reasoning explained in notes to financial statements. If businesses were allowed to change accounting principles whenever they wished, the amount of net income reported could continuously be manipulated. Different accounting methods may be used for different business segments.

 

MATERIALITY CONCEPT
The materiality concept proposes paying attention to important events and ignoring insignificant accounting items. The extra effort required to process insignificant items is not cost effective. The concept of materiality also suggests that small asset purchases or improvements should be initially written off as an expense. Definitive rules exist on whether an accounting element is significant or insignificant. Therefore decisions are based on both objective and subjective criteria.

CONSERVATISM
Conservatism proposes that the information in financial statements should not foster undue optimistic expectations and bends toward being prepared for the worst situation. When a policy of conservatism is followed, assets and income tend to be understated. For instance, depreciation expenses are often accelerated causing lower book values for plant assets.

REVIEW OF CONCEPTS AND PRINCIPLES
The following concepts and principles have been covered:
1) business entity,
2) going concern,
3) objective evidence,
4) unit of measurement,
5) accounting period,
6) matching revenues and expenses,
7) adequate disclosure,
8) materiality,
9) consistency, and
10) conservatism.

MATCHING REVENUES AND EXPENSES
Recording revenue upon receipt of payment is used in cash basis accounting and does not conform to generally accepted accounting principles.It has the advantage of not requiring an estimate of allowance for doubtful accounts. Professional services such as consultants, doctors, dentists and lawyers use this method.

INSTALLMENT METHOD
The installment method is used when collection of payments (in excess of the downpayment) extends over several years and is uncertain. It offers a saving from income tax postponement. Depending on the contract, the seller or the buyer has title to the goods.

1) A gross profit percentage is determined on the entire contract by subtracting the cost of goods sold from the sale price, and dividing by the sale price.

2) Each year the gross profit recognized is calculated by multiplying the amount collected by the gross profit percentage.

PERCENTAGE-OF-COMPLETION METHOD
The percentage-of-completion method is recommended for businesses involved in long-term projects or contracts, such as construction firms. In such circumstances, revenue is recognized periodically throughout the life of the project.

1) An initial profit is estimated based on the contract price and anticipated future costs.

2) The total revenue is spread evenly over the years or in proportion to the annual estimated costs. The actual costs incurred during each time period are subtracted from revenue.

3) In the final year the actual remaining profit is recognized.

For example, a person sold a $500,000 machine with an upfront payment of $100,000 and payments of $80,000 over 5 years. The accounting would be as follows:

 

GENERAL JOURNAL YEAR X1
Date Title and Account explanation Debit Credit
Jan 01 ACCOUNTS RECEIVABLE   $500,000  
Jan 01 INSTALLMENT SALES   $500,000
Jan 01 COST OF MACHINE SOLD $300,000  
Jan 01 INVENTORY   $300,000
    (To record machine sale)    

 

 

GENERAL JOURNAL YEAR X1
Date Title and Account explanation Debit Credit
Jan 15 ACCOUNTS RECEIVABLE   $180,000
Jan 15 CASH $180,000  
         
         
    (To record upfront and 1st payment of machine)    

 

 

GENERAL JOURNAL YEAR X1
Date Title and Account explanation Debit Credit
Dec 31 INSTALLMENT SALES $500,000  
Dec 31 COST OF MACHINE SOLD   $300,000
Dec 31 DEFERRED GROSS PROFIT   $200,000
         
    (To record gross profit in year X1)    

 

 

GENERAL JOURNAL YEAR X1
Date Title and Account explanation Debit Credit
Dec 31 DEFERRED GROSS PROFIT $72,000  
Dec 31 NET GROSS PROFIT   $72,000
         
         
    (To record Net profit in year X1)    

-Gross profit percent: (INSTALLMENT SALES-COSTS)/INSTALLMENT SALES. (500,000-300,000)/500,000 = 0,4. 

-Net profit: AMOUNT COLLECTED*GROSS PROFIT PERCENT. $180,000 ($100,000 upfront payment + $80,000 1st payment) * 0,4 (gross profit percent) = $72,000.

 

GENERAL JOURNAL YEARS X2 TO X5
Date Title and Account explanation Debit Credit
Dec 31 DEFERRED GROSS PROFIT $32,000  
Dec 31 NET GROSS PROFIT   $32,000
         
         
    (To record Net profit in years X2 to X5)    

For years X2 to X5, the same method is applied to remaining payments.

The accounting of a $100,000 construction contract under percentage-of-completion method, would be like this.

 

GENERAL JOURNAL YEAR X1
Date Title and Account explanation Debit Credit
Dec 31 CONSTRUCTION IN PROGRESS $35,000  
Dec 31 ACCOUNTS PAYABLE   $35,000
         
         
    (To record expenses in year X1)    

 

GENERAL JOURNAL YEAR X1
Date Title and Account explanation Debit Credit
Dec 31 ACCOUNTS RECEIVABLE $55,000  
Dec 31 PROGRESS BILLINGS   $55,000
         
         
    (To record earnings in year X1)    

 

 

GENERAL JOURNAL YEAR X2
Date Title and Account explanation Debit Credit
Dec 31 CONSTRUCTION IN PROGRESS $20,000  
Dec 31 ACCOUNTS PAYABLE   $20,000
         
         
    (To record expenses in year X2)    

 

GENERAL JOURNAL YEAR X2
Date Title and Account explanation Debit Credit
Dec 31 ACCOUNTS RECEIVABLE $45,000  
Dec 31 PROGRESS BILLINGS   $45,000
         
         
    (To record earnings in year X2)    

 

The revenues are recorded according to the job percent of completion. In this example, the $100,000 contract was completed in two time periods: 55% in year X1 and 45% in year X2. The cost incurred during each time period must be recorded and subtracted from revenues in order to get the Net profit (or loss) for the period.

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