CHAPTER 11

Agenda Learning goals Conceptual framework of accounting Characteristics of accounting information Accounting principle assumptions Accounting Principles Constraints in Accounting

Learning goals Describe the conceptual framework of accounting Identify and apply the basic assumption used by accountants Identify and apply the basic principles of accounting Identify and apply the constraints in accounting

CONCEPTUAL FRAMEWORK OF ACCOUNTING Generally accepted accounting principles are a set of rules and practices that are recognized as a general guide for financial reporting purposes. Generally accepted means that these principles must have substantial authoritative support. The Canadian Institute of Chartered Accountants (CICA) is responsible for developing accounting principles in Canada.

CICA’S CONCEPTUAL FRAMEWORK The conceptual framework consists of: –objective of financial reporting, –qualitative characteristics of accounting information, –elements of financial statements, and –recognition and measurement criteria (assumptions, principles, and constraints).

OBJECTIVE OF FINANCIAL REPORTING The objective of financial reporting is to provide information that is useful for decision-making

QUALITATIVE CHARACTERISTICS OF ACCOUNTING INFORMATION The accounting alternative selected should be one that generates the most useful financial information for decision making. To be useful, information should possess the following qualitative characteristics: 1. understandability 2. relevance 3. reliability 4.comparability and consistency

UNDERSTANDABILITYUNDERSTANDABILITY Information must be understandable by its users. Main two external users are investors and creditors Users are assumed to have a reasonable comprehension of, and ability to study, the accounting, business, and economic concepts needed to understand the information.

RELEVANCERELEVANCE Accounting information is relevant 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).

RELIABILITYRELIABILITY Reliability of information means that the information is free of error and bias – it can be depended on. To be reliable, accounting information must be verifiable – there must be proof that it is free of error and bias. The information must be a faithful representation of what it purports to be – it must be factual. Verifiable, faithful and representation are called objectivity

RELIABILITY Objectivity means that two individuals, each working independently, can review the same information and reach the same results or similar conclusions. Conservatism in accounting means that when making financial statements, companies need to choose a method that is less likely to overstate the assets and income

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.

Assumptions Going concern Monetary unit Economic entity Time period Principles Revenue recognition Matching Full disclosure Cost Constraint s Cost - benefit Materiality Recognition and measurement criteria used by accountants to solve practical problems include assumptions, principles, and constraints. Assumptions provide a foundation for the accounting process. Principles indicate how economic events should be reported in the accounting process. Constraints permit a company to modify generally accepted accounting principles without reducing the usefulness of the reported information. RECOGNITION AND MEASUREMENT CRITERIA

GOING CONCERN ASSUMPTION The going concern assumption assumes that the enterprise will continue to operate in the foreseeable future. Implications: capital assets are recorded at cost instead of liquidation value, amortization is used, items are labeled as current or non-current.

The monetary unit assumption states that only transaction data capable of being expressed in terms of money should be included in the accounting records of the economic entity. Also assumes unit of measure ($) remains sufficiently stable over time. Ignores inflationary and deflationary effects. MONETARY UNIT ASSUMPTION Customer satisfaction Percentage of international employees Salaries paid Should be included in accounting records Should not be included in accounting records

ECONOMIC ENTITY ASSUMPTION The economic entity assumption activities of a unit or organization in society are kept separate and distinct from other entities and owner Example: Mineral Water activities can be distinguished from those of the parent company Coca Cola.

TIME PERIOD ASSUMPTION 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

Revenue Recognition Principle Revenue should be recognized in the accounting period in which it is earned Specifically, revenue should be recognized when all of these guidelines are met: –Evidence of arrangement between two parties –Delivery occurred or services provided –Seller’s price is fixed or can be determined –Cash collection is reasonably certain

Revenue can be recognized: 1.At point of sale 2. During production 3.At completion of production 4.Upon collection of cash REVENUE RECOGNITION

POINT OF SALE When the customer pays the cash and takes the merchandise. Cash XXXX Sales Revenue XXX When the customer bought the product on credit Accounts Receivable XXXX Sales Revenue XXXX

DURING PRODUCTION In certain cases, revenue can be recognized before delivery has occurred or the service has been fully provided. For example law or accounting firm that provides services for a client over serval months-how do they recognize revenue? Answer: The client is billed monthly for service provided

Revenue Recognition: During Production Percentage-of-completion method recognizes revenue on long-term projects based on periodic estimates of the progress to completion Progress to completion is determining by comparing the costs incurred to date to total cost: Costs Incurred (Current Period) Total Estimated Cost Percent Complete (Current Period) Total Revenue Revenue Recognized (Current Period) ÷ = = x

Revenue Recognition During Production: Revision of Estimate Costs Incurred (To Date) Total Estimated Cost Percent Complete (To Date) Total Revenue Revised Revenue ÷ = = x Revenue Recognized Previously Revenue Recognized (Current Period) = _ Revised Revenue When estimated project costs are revised, the percentage complete is also revised by using costs incurred to date rather than per period A revised revenue to date is then calculated and previously recognized revenue subtracted to determine the revenue for the current period

REVENUE RECOGNITION COLLECTION OF CASH The cash basis is generally used only when it is difficult to determine the revenue amount at thetime of a credit sale because collection is so uncertain. The instalment method, which uses the cash basis, is a popular approach to revenue recognition. Under the instalment method gross profit is recognized in the period in which the cash is collected.

ILLUSTRATION 12-8 GROSS PROFIT FORMULA- INSTALMENT METHOD Under the instalment method, each cash collection from a customer consists of 1. a partial recovery of the cost of goods sold, and 2. a partial gross profit from the sale. The formula to recognize gross profit is shown below. Sales Revenue Gross Profit Margin Gross Profit Gross Profit Margin Cash Collections from Customer Gross Profit Recognized during the period   = =

Example YearCash Collections from Customers Gross Profit Margin Gross Profit 2013$280,00030%$84, ,00030%60, ,00030%36,000 Total$600,000$180,000 Saskatchewan farm machinery dealer has instalment sales of $600,000, and collection is uncertain. The dealer’s cost of goods sold on these instalment sales is $420,000. total gross profit is $180,000 = $600,000-$420,000. $180,000/$600,000 = 30% gross profit margin Instalment sales are: 1 st year $280,000, 2 nd $200,000, 3 rd $120,000.

Revenue Recognition: Completion of Production Revenue, expenses and gross profit not recognized until completion of project –Used when costs cannot be reliably estimated More reliable results than percentage-of- completion method –As costs are known instead of estimated Information is not as relevant or timely –Not reported until end of contract –Earnings are distorted over life of project

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 those expenses helped to generate revenue. MATCHING PRINCIPLE (Expense Recognition)

Expired costs are costs that will generate revenuesonly in the current period and are therefore reported as operating expenses on the income statement. Or a direct relationship to revenue is hard to prove –Salaries Unexpired costs are costs that will generate revenues in future accounting periods and are recognized as assets. –Such as machinery –Are depreciated over the life of the asset MATCHING PRINCIPLE MATCHING PRINCIPLE

FULL DISCLOSURE PRINCIPLE 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.

Cost Principle Requires assets to be recorded at cost Cost is used because it is: –Relevant: represents the price paid, assets sacrificed or the commitment made at the date of acquisition –Reliable: objectively measurable, factual and verifiable CICA has moved to a modified cost model for some assets –Certain securities: at market value –Merchandise inventory: lower of cost or market –Long-lived assets: Market if permanent decline in value

CONSTRAINTS IN ACCOUNTING Constraints permit a company to modify generally accepted accounting principles without reducing the usefulness of the reported information. The constraints are cost-benefit and materiality. 1. Cost-benefit means that the value of information should be greater than the cost of providing it. Giving more information increases costs, and the benefits of giving this information may be less than the cost sin some cases. 2. Materiality relates to an item’s impact on a firm’s overall financial condition and operations If an item will not make a difference in decision- making, it is immaterial and GAAP does not have to be followed

Classwork/Homework P588 #1-10 BE11-2, 11-4, 11-5