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A CCOUNTING T HEORY U NDERLYING F INANCIAL A CCOUNTING.

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1 A CCOUNTING T HEORY U NDERLYING F INANCIAL A CCOUNTING

2 Introduction to Accounting Theory What is Accounting Theory What is Accounting Theory Accounting Theory & Policy Making Accounting Theory & Policy Making Measurement Measurement

3 Accounting Theory is defined as the basic the basic assumptions assumptions definitions definitions principles and principles and concepts that underlie the rule making by a legislative body concepts that underlie the rule making by a legislative body the reporting of accounting and financial information applicable to financial accounting, not to governmental or managerial

4 Accounting Theory includes Conceptual Frameworks Conceptual Frameworks Accounting Legislation Accounting Legislation Concepts Concepts Valuation Models Valuation Models Hypotheses and Theories Hypotheses and Theories

5 Accounting Theory Defined 173

6 Accounting theory provides a logical framework for accounting practice. Structure of Accounting Theory Formal Approach

7 Development of Accounting Standards

8 History.. History.. Prior to Securities act of 1933 and 1934 little financial reporting was required. Prior to Securities act of 1933 and 1934 little financial reporting was required. The securities acts assigned the power of accounting role making for publicly held companies to SEC The securities acts assigned the power of accounting role making for publicly held companies to SEC They also required most publicly held companies to be audited by independent CPAs They also required most publicly held companies to be audited by independent CPAs

9 The (SEC) in turn delegated rule making to American Institute of Certified Public Accountants (AICPA). The (SEC) in turn delegated rule making to American Institute of Certified Public Accountants (AICPA). The Committee on Accounting Procedures (CAP) was formed by (AICPA) in and issued 51 Accounting Research Bulletins (ARBs). The Committee on Accounting Procedures (CAP) was formed by (AICPA) in and issued 51 Accounting Research Bulletins (ARBs). Accounting Principles Board (APB) issued 31 Opinions from Accounting Principles Board (APB) issued 31 Opinions from The financial Accounting Foundation (FAF) was created by (AICPA) in 1973 and oversees 2 other bodies: The financial Accounting Foundation (FAF) was created by (AICPA) in 1973 and oversees 2 other bodies: Financial Accounting Standards Board (FASB) has issued over 140 Statements (SFASs)from1973-present Financial Accounting Standards Board (FASB) has issued over 140 Statements (SFASs)from1973-present Governmental Accounting Standards Board (GASB) Governmental Accounting Standards Board (GASB) The Standard Setting Process: Parties Involved

10 The International Accounting Standards Committee (IASC) was formed in The International Accounting Standards Committee (IASC) was formed in The objective was to narrow divergence in international financial reporting. The objective was to narrow divergence in international financial reporting. There are many similarities between U.S. and International accounting standards. There are many similarities between U.S. and International accounting standards. The concern is that international standards may not be as rigorous as U.S. standards. The concern is that international standards may not be as rigorous as U.S. standards. International Accounting Standards

11 History 1973International Accounting Standards Committee (IASC) founded by 10 national accountancy organisations. national accountancy organisations. 1981All members of IFAC became members of IASC countries. Structure reviewed. 2001International Accounting Standards Board (IASB) began operations. 2005Europe, Australia, 90+ countries adopting IFRS

12 Board (14) (approves IAS [IFRS], ED, SIC [IFRIC]) 7 Liaison Members Intnl. Financial Reporting Interpretations Committee (12+1) (publishes draft Interpretations and prepares draft of final Interpretations) Standards Advisory Council (SAC) (advises Board) Trustees (19) (appoint Board, IFRIC and SAC) (6 North America, 6 Europe, 4 Asia/Pacific, 3 Other) National standard setters (Australia/NZ, Canada, France, Germany, Japan, UK, US.) IASB Structure Structure

13 IASC Foundation 19 trustees: 19 trustees: 6 from North America 6 from North America 6 from Europe 6 from Europe 4 from Asia Pacific 4 from Asia Pacific 3 from any area 3 from any area Appoint IASB members, SAC and IFRIC Appoint IASB members, SAC and IFRIC Monitor IASB’s effectiveness, raise funds, approve budget, responsible for constitution Monitor IASB’s effectiveness, raise funds, approve budget, responsible for constitution

14 Standards Advisory Council (SAC) About 50 members from throughout the world. About 50 members from throughout the world. Meets three times each year Meets three times each year Provides advice to IASB on priorities Provides advice to IASB on priorities Informs IASB of implications of proposed standards Informs IASB of implications of proposed standards

15 IASB Has the sole responsibility for setting standards. Has the sole responsibility for setting standards. Approves principles-based standards, – does not issue detailed application guidelines. Approves principles-based standards, – does not issue detailed application guidelines. Addresses business ventures – not public sector, government or not-for-profit activities. Addresses business ventures – not public sector, government or not-for-profit activities.

16 International Financial Reporting Interpretations Committee (IFRIC) 12 voting members and a non-voting chairman 12 voting members and a non-voting chairman Provide guidance on reporting issues not specifically addressed in IASB’s standards, or where unsatisfactory or conflicting interpretations have developed. Provide guidance on reporting issues not specifically addressed in IASB’s standards, or where unsatisfactory or conflicting interpretations have developed.

17 IASB … is committed to developing, in the public interest, a single set of high quality, global accounting standards that require transparent and comparable information in financial statements …

18 IASB Has an agreement with FASB to achieve convergence of standards. Has an agreement with FASB to achieve convergence of standards. Works in close co-operation with other national standard setters. Works in close co-operation with other national standard setters. Board members have liaison responsibilities with a large number of countries and international organisations. Board members have liaison responsibilities with a large number of countries and international organisations.

19 Process Comment period for each document Comment period for each document Decisions made in open, public meetings Decisions made in open, public meetings Explain basis for conclusions in each standard Explain basis for conclusions in each standard Voting – approval by 8 of 14 members Voting – approval by 8 of 14 members Dissenting views published Dissenting views published

20 Process Research Research Discussion Paper Discussion Paper Exposure Draft Exposure Draft Standard Standard Implementation Implementation

21 Objectives of the Conceptual Framework The Framework is to be the foundation for building a set of coherent accounting standards and rules. The Framework is to be the foundation for building a set of coherent accounting standards and rules. The Framework is to be a reference of basic accounting theory for solving emerging practical problems of reporting. The Framework is to be a reference of basic accounting theory for solving emerging practical problems of reporting.

22 FASB’S CONCEPTUAL FRAMEWORK  The conceptual framework developed by the FASB serves as the basis for resolving accounting and reporting problems.  The Framework was to be the foundation for building a set of coherent accounting standards and rules.  The conceptual framework consists of: 1 objectives of financial reporting; 2 qualitative characteristics of accounting information; 3 elements of financial statements; & 4 Operating guidelines (assumptions, principles, and constraints). principles, and constraints).

23 Conceptual Framework for Financial Reporting

24 OBJECTIVES OF FINANCIAL REPORTING The FASB concluded that the objectives of financial reporting are to provide information that: 1 Is useful to those making investment and credit decisions. and credit decisions. 2 Is helpful in assessing future cash flows. 3 Identifies the economic resources (assets), the claims to those resources (liabilities), the claims to those resources (liabilities), and the changes in those resources and and the changes in those resources and claims. claims.

25 Hierarchy of Accounting Qualities

26 External Financial Statements First: Users and their needs: Side of economic interest Side of economic interest Users with direct Interest. Users with direct Interest. Users with indirect Interest. Users with indirect Interest. Side of the relation of business Side of the relation of business Internal users Internal users External Users External Users

27 USERS AND USES OF ACCOUNTING Marketing managers Production supervisors Finance directors Company officers Investors Creditors Tax authorities Regulatory agencies Customers Labor unions Internal Users External Users

28 QUESTIONS ASKED BY INTERNAL USERS Is cash sufficient to pay bills?What is the cost of manufacturing each unit of product? Can we afford to give employee pay raises this year? Which product line is the most profitable?

29 QUALITATIVE CHARACTERISTICS OF ACCOUNTING INFORMATION  The FASB concluded that the overriding criterion for accounting choices is decision usefulness.  To be useful, information should possess the following qualitative characteristics: 1 Relevance 2 Reliability 3 Comparability 4 Consistency 4 Consistency

30 Qualitative Characteristics of Accounting Information Primary qualities of accounting information are relevance and reliability. Primary qualities of accounting information are relevance and reliability. Secondary qualities are comparability and consistency of reported information. Secondary qualities are comparability and consistency of reported information.

31 RELEVANCERELEVANCE  Accounting information has relevance if it makes a difference in a decision.  Relevant information helps users forecast future events (predictive value), or it confirms or corrects prior expectations (feedback value).  Information must be available to decision makers before it loses its capacity to influence their decisions (timeliness). influence their decisions (timeliness).

32 RELIABILITYRELIABILITY  Reliability of information means that the information is free of error and bias. In short, it can be depended on. Information is verifiable, when, given the same information, independent users can arrive at similar conclusions. Information is verifiable, when, given the same information, independent users can arrive at similar conclusions. Information is faithful, when it represents what really existed or happened. Information is faithful, when it represents what really existed or happened. Information is neutral, when it is free from bias. Information is neutral, when it is free from bias.

33 COMPARABILITY AND CONSISTENCY  Comparability means that the information should be comparable with accounting information about other enterprises.  Consistency means that the same accounting principles and methods should be used from year to year within a company.

34 Secondary Characteristics Secondary characteristics are: comparability and consistency of reported information. Secondary characteristics are: comparability and consistency of reported information. For information to be comparable, it must be : For information to be comparable, it must be : measured and reported in a similar manner for different enterprises. measured and reported in a similar manner for different enterprises. useful in the allocation of resources to the areas of greatest benefit. useful in the allocation of resources to the areas of greatest benefit. useful to users in identifying real differences between enterprises. useful to users in identifying real differences between enterprises.

35 Secondary Characteristics Accounting information is consistent, if the same accounting principles are applied in a similar manner from one period to the next. Accounting information is consistent, if the same accounting principles are applied in a similar manner from one period to the next. Accounting principles may be changed, if the change results in better reporting. Accounting principles may be changed, if the change results in better reporting. If principles are changed, the justification for, and the nature and effect of the change, must be disclosed. If principles are changed, the justification for, and the nature and effect of the change, must be disclosed.

36 Relevance 1 Predictive value 2 Feedback value 3 Timely Reliability 1 Verifiable 2 Faithful representation 3 Neutral Comparability Useful Financial Information has: QUALITATIVE CHARACTERISTICS OF ACCOUNTING INFORMATION Consistency

37 External Financial Statements Second: Basic Financial Statements Balance Sheet Balance Sheet Income Statement Income Statement Statement of Cash Flows Statement of Cash Flows Statement of Stockholders’ Equity Statement of Stockholders’ Equity

38 FINANCIAL STATEMENTS After transactions are identified, recorded, and summarized, 4 financial statements are prepared from the summarized accounting data: 1 A balance sheet reports the assets, liabilities, and owner’s equity at a specific date. 2 An income statement presents the revenues and expenses and resulting net income or net loss for a specific period of time. 3 A statement of cash flows summarizes information about the cash inflows (receipts) and outflows (payments) for a specific period of time. 4 An owner’s equity statement summarizes the changes in owner’s equity for a specific period of time.

39 The Balance Sheet Summarizes a firms assets, liabilities, and owner’s equity at a moment in time Summarizes a firms assets, liabilities, and owner’s equity at a moment in time Amounts measured at historical values and historical exchange rates Amounts measured at historical values and historical exchange rates Prepared according to IFRS, International Financial Reporting Standards Prepared according to IFRS, International Financial Reporting Standards

40 The balance sheet provides information for evaluating: The balance sheet provides information for evaluating: Capital structure Capital structure Rates of return Rates of return Analyzing an enterprise’s: Analyzing an enterprise’s: Liquidity Liquidity Solvency Solvency Financial flexibility Financial flexibility Balance Sheet: Usefulness

41 Basic Elements of Financial Statements Assets: Probable future economic benefits resulting from past transactions Assets: Probable future economic benefits resulting from past transactions Liabilities: Probable future sacrifices of economic benefits resulting from past transactions Liabilities: Probable future sacrifices of economic benefits resulting from past transactions Equity: Residual or ownership interest Equity: Residual or ownership interest Investment by Owners: Increases in net assets Investment by Owners: Increases in net assets Distributions to Owners: Decreases in net assets Distributions to Owners: Decreases in net assets Comprehensive Income: All changes in equity from non-owner sources Revenues: Inflows from entity’s ongoing operations Expenses: Outflows from entity’s ongoing operations Gains: Increases in equity from incidental transactions Losses: Decreases in equity from incidental transactions Balance Sheet IncomeStatement Income Statement

42 The Annual Report Usually Contains... – financial statements. – notes to the financial statements. – a summary of accounting methods used. – management discussion and analysis of the financial statements. – an auditor’s report. – comparative financial data for 5 to 10 years.

43 Balance Sheet Assets: probable future economic benefits Assets: probable future economic benefits Liabilities: probable future economic sacrifices Liabilities: probable future economic sacrifices Stockholders’ Equity: residual interest, representing ownership interest (also called net assets) Stockholders’ Equity: residual interest, representing ownership interest (also called net assets)

44 THE BASIC ACCOUNTING EQUATION Assets Liabilities Stockholders’ Equity Stockholders’ Equity =+ resources owned by a business claims against those assets owners’ residual claim on total assets

45 AssetsAssets Current Assets :cash & cash equivalents, short-term marketable securities, accounts receivable, inventory, other) Current Assets :cash & cash equivalents, short-term marketable securities, accounts receivable, inventory, other) Non Current Assets: Property, plant & equipment, Long-term Non Current Assets: Property, plant & equipment, Long-term investments, investments, and Other assets and Other assets

46 LiabilitiesLiabilities Current Liabilities (accounts payable, accrued & other current liabilities) Current Liabilities (accounts payable, accrued & other current liabilities) Long-term debt Long-term debt Bonds Bonds

47 Stockholders’ Equity Preferred stock Preferred stock Common stock Common stock Other paid-in capital Other paid-in capital Retained earnings Retained earnings Treasury stock Treasury stock Other comprehensive income Other comprehensive income Other equity items Other equity items

48  Operating guidelines are classified as assumptions, principles, and constraints.  Assumptions provide a foundation for the accounting process.  Principles indicate how transactions and other economic events should be recorded.  Constraints on the accounting process allow for a relaxation of the principles under certain circumstances. THE OPERATING GUIDELINES OF ACCOUNTING

49 Basic Assumptions 1. Economic entity 2. Going concern 3. Monetary unit 4. Periodicity Principles 1. Historical cost 2. Revenue recognition 3. Matching 4. Full disclosure Constraints 1. Cost benefit 2. Materiality 3. Industry practices 4. Conservatism Recognition and Measurement Criteria

50 Most assets and liabilities are stated at historical cost. Most assets and liabilities are stated at historical cost. Judgments and estimates are used in determining many of the items. Judgments and estimates are used in determining many of the items. The balance sheet does not report items that can not be objectively determined. The balance sheet does not report items that can not be objectively determined. It does not report information regarding off- balance sheet financing. It does not report information regarding off- balance sheet financing. Balance Sheet: Limitations

51 Income Statement Revenues: inflows from major operations Revenues: inflows from major operations Expenses: outflows from major operations Expenses: outflows from major operations Gains & Losses: changes in equity from peripheral activities Gains & Losses: changes in equity from peripheral activities Net income: bottom line all operating activities recorded on the income statement Net income: bottom line all operating activities recorded on the income statement Comprehensive income: Changes in equity from all non-owner sources Comprehensive income: Changes in equity from all non-owner sources

52 Evaluate the past performance of the enterprise. Evaluate the past performance of the enterprise. Provide a basis for predicting future performance. Provide a basis for predicting future performance. Help assess the risk or uncertainty of achieving future cash flows. Help assess the risk or uncertainty of achieving future cash flows. Usefulness of Income Statement

53 Items that cannot be measured reliably are not reported in the income statement. Items that cannot be measured reliably are not reported in the income statement. Income numbers are affected by the accounting methods employed. Income numbers are affected by the accounting methods employed. Income measurement involves judgment. Income measurement involves judgment. Limitations of the Income Statement

54 Comprehensive Income All changes in equity during a period, except those resulting from investments by or distributions to owners.

55 Must be displayed as: Must be displayed as: A separate statement of comprehensive income OR A separate statement of comprehensive income OR Combined income statement and comprehensive income statement OR Combined income statement and comprehensive income statement OR Part of statement of stockholders’ equity Part of statement of stockholders’ equity Other Comprehensive Income

56 1 The Monetary unit assumption states that only transaction data that can be expressed in terms of money be included in the accounting records. Example: employee satisfaction and percent of international employees are not transactions that should be included in the financial records. Example: employee satisfaction and percent of international employees are not transactions that should be included in the financial records. ASSUMPTIONSASSUMPTIONS Customer Satisfaction Percentage of International Employees Salaries paid Should be included in accounting records

57 ASSUMPTIONSASSUMPTIONS 2 The Economic Entity Assumption states that the activities of the entity be kept separate and distinct from the activities of the owner of all other economic entities. Example: BMW activities can be distinguished from those of other car manufacturers such as as Mercedes. Mercedes.

58 ASSUMPTIONSASSUMPTIONS 3 The Time period assumption states that the economic life of a business can be divided into artificial time periods. Example: months, quarters, and years QTR 1 QTR 2 QTR 3 QTR JAN FEB MAR APR MAY JUN JUL AUG SEPT OCT NOV DEC

59 4 The Going concern assumption assumes that the enterprise will continue in operation long enough to carry out its existing objectives. Implications: depreciation and amortization are used, plant assets recorded at cost instead of liquidation value, items are labeled as fixed or long-term. ASSUMPTIONSASSUMPTIONS

60  The Revenue Recognition principle dictates that revenue should be recognized in the accounting period in which it is earned.  When a sale is involved, revenue is recognized at revenue is recognized at the point of sale. the point of sale. PRINCIPLES REVENUE RECOGNITION

61 PERCENTAGE-OF-COMPLETION METHOD OF REVENUE RECOGNITION  In long-term construction contracts, revenue recognition is usually required before the contract is completed.  The percentage-of-completion method recognizes revenue on the basis of reasonable estimates of progress toward completion.  A project’s progress toward completion is measured by comparing the costs incurred in a year to total estimated costs of the entire project.

62 FORMULA TO RECOGNIZE REVENUE IN THE PERCENTAGE-OF-COMPLETION METHOD Costs Incurred (Current Period) ÷ = Total Estimated Cost Percent Complete (Current Period) Total Revenue X = Revenue Recognized (Current Period) Percent Complete (Current Period)

63 FORMULA TO COMPUTE GROSS PROFIT IN CURRENT PERIOD Cost Incurred (Current Period) _ = Gross Profit Recognized (Current Period) Revenue Recognized (Current Period) The costs incurred in the current period are then subtracted from the revenue recognized during the current period to arrive at the gross profit.

64 Warrior Construction Co. has a contract to build a dam for $400 million. It will take 3 years (starting in 2000) at a construction cost of $360 million. Assume that Warrior incurs $54 million in 2000, $180 million in 2001, and $126 million in 2002 on the dam project. The portion of the $400 million of revenue recognized in each of the 3 years is shown below: REVENUE RECOGNIZED PERCENTAGE-OF-COMPLETION METHOD

65 The gross profit recognized each period for Warrior Construction Co. is as shown below. Use of the percentage-of-completion method involves some subjectivity. As a result, errors are possible in determining the amount of revenue recognized. To wait until completion would seriously distort the financial statements. If it is not possible to obtain dependable estimates of costs and progress, then the revenue should be recognized at the completion date and not by the percentage-of-completion method. GROSS PROFIT RECOGNIZED PERCENTAGE-OF- COMPLETION METHOD

66

67 INSTALLMENT METHOD OF REVENUE RECOGNITION  Another basis for revenue recognition is the receipt of cash.  The cash basis is generally used only when it is difficult to determine the revenue amount at the time of a credit sale because collection is uncertain.  The installment method, which uses the cash basis, is a popular approach to revenue recognition.  Under the installment method gross profit is recognized in the period in which the cash is collected.

68 Cash Collections from Customers Gross Profit Percentage x = Gross Profit Recognized during the Period GROSS PROFIT FORMULA- INSTALLMENT METHOD  Under installment method, each cash collection from a customer consists of 1 a partial recovery of the cost of goods sold and 2 partial gross profit from the sale.  The formula to recognize gross profit is shown below.  Under installment method, each cash collection from a customer consists of 1 a partial recovery of the cost of goods sold and 2 partial gross profit from the sale.  The formula to recognize gross profit is shown below.

69 An Iowa farm machinery dealer had installment sales in its first year of operations of $600,000 and a cost of goods sold on installment of $420,000. Therefore, total gross profit is $180,000 ($600,000 - $420,000), and the gross profit percentage is 30% ($180,000 ÷ $600,000). The collections on the installment sales were: First year, $280,000 (down payments plus monthly payments), second year, $200,000, and third year, $120,000. The collections of cash and recognition of the gross profit are summarized below (ignoring interest charges). GROSS PROFIT RECOGNIZED INSTALLMENT METHOD

70  Expense recognition is traditionally tied to revenue recognition.  This practice – referred to as the matching principle – dictates that expenses be matched with revenues in the period in which efforts are made to generate revenues.  To understand the various approaches for matching expenses and revenues on the income statement, it is necessary to examine the nature of expenses. 1 Expired costs are costs that will generate revenues only in the current period and are therefore reported as operating expenses on the income statement. 2 Unexpired costs are costs that will generate revenues in future accounting periods and are recognized as assets. PRINCIPLES MATCHING (EXPENSE RECOGNITION)

71 Unexpired costs become expenses in 2 ways: 1) Cost of goods sold – Costs carried as merchandise inventory become expensed when the inventory is sold. They are expensed as cost of goods sold in the period in which the sale occurs – so there is a direct matching of expenses with revenues. 2) Operating expenses – Other unexpired costs become operating expenses through use or consumption or through the passage of time. PRINCIPLES MATCHING (EXPENSE RECOGNITION)

72 Cost Incurred AssetExpense EXPENSE RECOGNITION PATTERN Operating expenses contribute to the revenues of the period but their association with revenues is less direct than for cost of goods sold. Benefits Decrease Provides Future Benefit Provides No Apparent Future Benefits

73 The practice of expense recognition is referred to as the matching principle. The practice of expense recognition is referred to as the matching principle. The matching principle dictates that efforts (expenses) be matched with accomplishments (revenues). The matching principle dictates that efforts (expenses) be matched with accomplishments (revenues). Revenues earned this month are offset against.... expenses incurred in earning the revenue MATCHING PRINCIPLE

74 Time-Period Assumption Economic life of business can be divided into artificial time periods Revenue-Recognition Principle Revenue recognized in the accounting period in which it is earned Matching Principle Expenses matched with revenues in the same period when efforts are expended to generate revenues GAAP RELATIONSHIPS IN REVENUE & EXPENSE RECOGNITION GAAP RELATIONSHIPS IN REVENUE & EXPENSE RECOGNITION

75 Adjusting entries are needed to ensure that revenue recognition and matching principles are followed 1 Revenues are recorded in the period earned, and Expenses are recognized in the period incurred. WHY ADJUSTING ENTRIES ARE NECESSARY

76 PRINCIPLES FULL DISCLOSURE PRINCIPLES  The full disclosure principle requires that circumstances and events that make a difference to financial statement users be disclosed.  Compliance with the full disclosure principle is accomplished through 1 the data in the financial statements and 2 the notes that accompany the statements.  A summary of significant accounting policies is usually the first note to the financial statements.

77 PRINCIPLESCOSTPRINCIPLESCOST  The cost principle dictates that assets be recorded at their cost.  Cost is used because it is both relevant and reliable. 1 Cost is relevant because it represents a) the price paid, b) the assets sacrificed, or c) the commitment made at the date of acquisition. 2 Cost is reliable because it is a) objectively measurable, b) factual, and c) verifiable.

78 BASIC PRINCIPLES USED IN ACCOUNTING Revenue Recognition During production At end of production At point of sale At time cash received Revenue should be recognized in the accounting period in which it is earned (generally at point of sale). Matching Advertising Utilities Delivery Costs Matching Sales Revenue Materials Labor Operating Expenses Expenses should be matched with revenues CEMENT Cost Assets should be recorded at cost. Full Disclosure Circumstances and events that make a difference to financial statement users should be disclosed. * Financial Statements * Balance Sheet * Income Statement * Retained Earnings Statement * Cash Flow Statement

79 CONSTRAINTS IN ACCOUNTING  Constraints permit a company to modify generally accepted accounting principles without reducing the usefulness of the reported information.

80 Constraints: The Cost Benefit Rule Cost-Benefit Relationship The cost of providing information should not outweigh the benefit derived. The cost of providing information should not outweigh the benefit derived. Costs and benefits are not always obvious or measurable. Costs and benefits are not always obvious or measurable. Sound judgment must be used in providing information. Sound judgment must be used in providing information.

81 Constraints: Materiality Materiality refers to an item’s importance to a firm’s overall financial operations. An item must make a difference to be material and be disclosed. An item must make a difference to be material and be disclosed. It is a matter of the relative significance of the element. It is a matter of the relative significance of the element. Both quantitative and qualitative factors are to be considered in determining relative significance. Both quantitative and qualitative factors are to be considered in determining relative significance.

82 Constraints: Industry Practices Industry Practices The nature of some industries sometimes require departures from basic accounting theory. The nature of some industries sometimes require departures from basic accounting theory. If application of accounting theory results in statements that are not comparable or consistent, then industry practices must be examined for possible explanations. If application of accounting theory results in statements that are not comparable or consistent, then industry practices must be examined for possible explanations.

83 Constraints: Conservatism Conservatism suggests that the preparer, when in doubt, choose a conservative solution. Conservatism suggests that the preparer, when in doubt, choose a conservative solution. This solution will be least likely to overstate assets and income. This solution will be least likely to overstate assets and income. Conservatism does not suggest that net assets or net income be deliberately understated. Conservatism does not suggest that net assets or net income be deliberately understated.

84 CONSTRAINTS IN ACCOUNTING Materiality $ $ $ $ $ $ $ $ $ If dollar amounts of costs are small, GAAP does not have to be followed. Conservatism When in doubt, choose the solution that will be least likely to overstate assets and income.


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