1. BUS 120: Financial Accounting
Chapter 7: Accounting Principles
Dr. Al Taccone

2. Chapter 7: What you should learn
The conceptual Framework of accounting
* Qualitative characteristics
* Elements of financial statements
* Operating guidelines
Assumptions
Principles
Constraints
Financial statement presentation

3. THE 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.
This support usually comes from the Financial Accounting Standards Board (FASB) and Securities and Exchange Commission (SEC).
The FASB has the responsibility for developing accounting principles in the United States. 2

4. QUALITATIVE CHARACTERISTICS OF ACCOUNTING INFORMATION
The FASB concluded that the overriding criterion by which accounting choices should be judged is decision usefulness.
To be useful, information should possess the following qualitative characteristics:
1 relevance,
2 reliability, and
3 comparability and consistency. 5

5. THE OPERATING GUIDELINES OF ACCOUNTING
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 permit a company to modify generally accepted accounting principles without reducing the usefulness of the reported information.
Assumptions
Monetary unit Economic entity Time period Going concern
Principals
Revenue recognition Matching
Full disclosure
Cost
Constraints
Materiality Conservatism 17

6. ASSUMPTIONS Monetary unit
Only transaction data that can be expressed in terms of money should be included in the accounting records of a company.
Economic entity
Economic events can be identified with a particular unit of accountability and are separate from actual owner’s financial data.
Going concern
Assumes a business will continue in operation long enough to carry out existing objectives.
Time Period
The economic life of a business can be divided into artificial time periods.

7. PRINCIPLES Revenue recognition
Revenue should be recognized in the accounting period in which it is earned.
Matching
Expenses should be matched with revenues in the period in which the revenues are earned. (i.e. the need for prepaid expenses)
Full disclosure
Circumstances and events that make a difference to financial statement users be disclosed.
Cost
Asset must always be recorded at their cost and remain at their cost.

8. CONSTRAINTS Materiality
Relates to an item’s impact on a firm’s overall financial condition and operations.
Conservatism
When in doubt, the accountant chooses the method that will be the least likely to overstate assets and income. In other words, use the method that will result in the conservative reporting of assets and income.

9. STANDARD CLASSIFICATION OF BALANCE SHEET
The balance sheet is composed of 3 major elements:
1 assets,
2 liabilities, and
3 stockholders’ equity.
Additional segregation within these groups is considered useful to financial statement readers.
The following classification breakdown is usually found: 15

10. FINANCIAL STATEMENT RATIO ANALYSIS
Expresses the relationship among selected items of financial statement data. Ratios measures:
Liquidity—short term ability to pay maturing obligations.
Profitability—the income or operating success of a business for a given period of time.
Solvency—the ability of a business to survive over a long period of time.

11. Financial Ratios
Earnings per share—income earned by each share of common stock (profitability ratio)
Net income ÷ Number of shares outstanding
Current ratio—short-term debt-paying ability
(liquidity)
Current assets ÷ Current liabilities

12. Financial Ratios (continued)
Working capital—excess of current assets
over current liabilities (liquidity).
Current assets - Current liabilities
Profit margin—percentage of each dollar of sales that results in net income (profitability).
Net income ÷ Net sales

13. Financial Ratios (continued)
Return on assets—overall measure of return on investment on assets (profitability).
Net income ÷ Total assets
Return on common stockholder’s equity—measure return on equity (profitability)
Net income ÷ Common equity

14. Financial Ratios (continued)
Debt to total assets—measures ability of business to survive over long periods of time (solvency).
Total debt ÷ Total assets

15. FINANCIAL STATEMENT PRESENTATION
The multiple-step income statement for Sellers Electronix, Inc. in Chapter 5 included the following:
1 Sales revenue section – Presents the sales, discounts, allowances, and other related information to arrive at the net amount of sales revenue.
2 Cost of goods sold – Indicates the cost of goods sold to produce sales.
3 Operating expenses – Provides information on both selling and administrative expenses.
4 Other revenues and gains – Indicates revenues earned or gains resulting from non-operating transactions.
5 Other expenses and losses – Indicates expenses or losses incurred from non-operating transactions.

16. INCOME STATEMENT WITH INCOME TAXES
Note that income before income taxes is reported before income tax expense.
LEADS INC.
Income Statement
For the Year Ended December 31, 2002
Sales
$ 800,000
Cost of goods sold
600,000
Gross profit
200,000
Operating expenses
50,000
Income from operations
150,000
Other revenues and gains
10,000
Other expenses and losses
4,000
Income before income taxes
156,000
Income tax expense
46,800
Net income
$ 109,200