2. 1 Chapter 15 Accounting Principles ACCT 100

3. 2 Objectives of the Chapter 1. Define the generally accepted accounting principles (GAAP). 2. Study the conceptual framework underlying financial reports. 3. Study the accounting standard compliance system in the United States. 4. Discuss the need for a set of global accounting standards.

4. 3 Objectives of the Chapter (contd.) 5.Multiple-step income statement vs. single-step income statement. 6.Analyzing Financial Statements

5. Environment and Theoretical Structure of Financial Acounting4 1. General Accepted Accounting Principles (GAAP) n Accounting methods having “substantial authoritative support” and used by business entities in preparing financial statements. n The support is from the Securities and Exchange Commission (SEC). n The SEC is a government agency which was created by the Securities Exchange Act of 1934. n

6. The Authorities Prescribe the Accounting Standards  Prior to 1973, two committees under the AICPA (American Institute of Certified Public Accountants) were the authorities in the private sector to be in charge of prescribing accounting standards.  Since 1973, the financial accounting standards board (FASB) became the authority in the private sector to prescribe accounting standards. i5

7. Environment and Theoretical Structure of Financial Accounting6 1934Congress SECRegulation S-X ASR and FRR Staff Accounting Bulletins 1938Accounting Profession AICPA 1938-1959CAP ………ARBs (51) 1959-1973APB ………APB Opinions (31) 1973FASB …….1. Statement of Financial Accounting Standards 2. Interpretations 3. Concepts of Financial Accounting 4. Technique Bulletins 5. Statements issued by EITF YearAuthorityOfficial Release 6

8. Problems Associated with Accounting Standards Developed Prior to 1973  Under CAP (Committees on Accounting Procedures) and APB (Accounting Principles Board), accounting standards were developed on a problem-by- problem basis.  Accounting rule-making bodies (i.e., CAP and APB) solved specific problems. 7

9. Problems Associated with Accounting Standards Developed Prior to 1973 (Contd.)  The problem-by-problem approach resulted in inconsistent accounting standards.  The FASB developed a conceptual framework to serve as the foundation to develop accounting standards. 8

10. Environment and Theoretical Structure of Financial Accounting9 2. Conceptual Framework of Financial Reporting n Conceptual Framework of Financial Reporting: a system of interactive objectives and fundamentals which can lead to a set of consistent standards in preparing financial reports. n The current accounting standard setting authority (FASB) relies on this framework to prescribe a set of consistent accounting standards.

11. Environment and Theoretical Structure of Financial Accounting10 Financial Reporting: A Theoretical Structure A Conceptual Framework for Financial Reporting Assumptions Entity Going- Concern Monetary unit Periodicity Constraints Cost/Benefit Materiality Industry Practice Conservatism Objectives Qualitative Characteristic of Accounting Information Elements (SFAC No. 6) Recognition and Measurement Concepts Principles Historical Cost Revenue Matching Full Disclosure SFAC N0. 1 SFAC No. 8 SFAC No.5 First Level Second Level Third level 10

12. 11 SFAC No. 1 (Level One of the Conceptual Framework) n Objectives of financial reporting: Providing information 1. useful in making investment and credit decisions; 2. useful in assessing future cash flows; 3. about entity resources, claims to the resources and changes of these resources.

13. 12 SFAC No. 8 (Chapter 3 : Qualitative Characteristics of Useful Financial Information ) (Level Two of The Framework) n Qualitative Characteristics of Accounting Information I. Primary Qualities 1) Relevance a) Predictive value b) Confirmatory value c) Materiality 2 ) Faithful Representation a) Complete b) Neutral c) Free from error

14. 13 SFAC No. 8 (contd.) II. Enhancing Qualitative Characteristics 1) Comparability (including consistency) 2) Verifiability 3) Timeliness 4) Understandability

15. 14 SFAC No. 5 (Operating Guidelines) (Level Three of The Conceptual Framework) n Measurement and Recognition Concepts I.Assumptions 1) Economic Entity 2) Going-concern (continuity) 3) Monetary unit 4) Periodicity (Period of time)

16. 15 SFAC No. 5 (contd.) II.Principles 1) Historical cost (exception: LCM of inventory) 2) Revenue recognition (exceptions: 3) Matching 4) Full Disclosure (footnote disclosure) III.Constraints 1) Cost-Benefit 2) Materiality 3) Industry Practice 4) Conservatism

17. 16 3. The Accounting Standard Compliance System in the US n The interrelationship of the SEC and the FASB: FASB: the current rule making body. SEC: the enforcing agency of securities laws and accounting standards; regulating the stock market.

18. 17 4. The Need for International Accounting Standards n Companies doing business in more than one nations found that it is hard to comply with more than one set of accounting standards established by authorities in different nations. n In response to this problem, International Accounting Standards Committee (IASC) was formed in 1973 to develop a single set of global accounting standards.

19. The Popularity of the International Accounting Standards  IASC created International Accounting Standards Board (IASB) in 2001 to be in charge of prescribing the standards.  Since 2005, over 7,000 companies listed in the European Union used IASB standards.  Many other countries now also use IASB standards. 18

20. 19 The Convergence of the U.S. Accounting Standards and the International Accounting Standards n To increase the international comparability and the quality of US accounting standards, the FASB has been engaged in activities to increase the convergence of the accounting standards. n The FASB is working closely with the IASB toward the convergence of accounting standards (i.e., to develop a single set of global standards).

21. 20 Short-Term International Convergence (source: FASB Project Updates) n The IASB and the FASB acknowledged that convergence of IASB standards and U.S. GAAP is a primary objective of both Boards. n To achieve this objective and to improve the financial reporting in the US, the FASB started a short term project, conducted jointly with the IASB, to eliminate narrow differences between US GAAP and IASB standards in 2002.

22. 21 Current Compliances in the US n The U.S. firms filing reports with the SEC must use U.S. GAAP. n Foreign issuers filing reports with the SEC can use U.S. GAAP or the international standards. n The SEC abolished a requirement that non-US companies with US listings reconcile their financial reports to US GAAP in 2007.

23. Accrual Accounting and the Financial Statements22 5. Income Statement Formats n Multiple -Step Income Statement (see illustration 5-11 of textbook for an Example) : 22

24. Income Statement Formats (contd.) Single-Step Income Statement (See Illus.5-12 of textbook) Revenues: Net sales $150,000 Interest revenue 2,000 Gain on sale of equipment 3,000 Total revenue $155,000 Expenses: Cost of goods sold 80.000 Selling, administrative and depr. 40,000 Interest expense 9,000 Income tax expense 10,000 Total expenses 139,000 Net Income $ 16,000 Accounting for Merchandising Operations23

25. Income Statement Formats (Contd.)  CGS=Beg. Inv.+Net Pur. – End. Inv.  Net Pur. =Pur. –PR –PD + Freight-In  Selling expenses include: salaries expense (sales related), advertising expense, freight-out.  Administrative expenses include: salaries expense (administration related), utility expense, insurance expense. Accounting for Merchandising Operations24

26. Financial Statement Analysis25 6. Analyzing Financial Statements n Liquidity n Measuring a company’s ability to pay current liabilities.  Current ratio = Current Assets Current Liabilities  Working Capital = Current assets –Current Liabilities

27. Financial Statement Analysis26 Solvency Ratio n Indicators of long-run solvency and stability of a company.  Debt ratio = Total Liabilities Total Assets u This ratio indicates the percentage of assets financed with debt.

28. Financial Statement Analysis27 Profitability n Indicators of how effective a company has been in meeting its overall profit objectives, particularly in relation to the resources invested.

29. Financial Statement Analysis28 Profitability (contd.)  a. Profit margin percentage (rate of return on sales) = Net Income Net Sales  b. Return on assets = Net Income Average Total Assets  c. Return on comm. stockholders’ equity = Net Income - Preferred Dividends Average Stockholders’ Equity