Accounting Concepts, Assumptions, Principles, Elements
Key Things to Know
Objectives of Financial Reporting:
1. Provide useful information to investors and creditors for decision making
(assume users have a “reasonable understanding” of business).
2. Provide information to access the amounts, timing, and uncertainty of cash
inflows and outflows.
3. Provide information about resources (assets) and claims to resources
(liabilities).
Recognition: An item should be recognized in the financial statements when
it meets all 4 of the following criteria:
1. Definition: meets the definition of an element
2. Measurability: measurable with sufficient reliability
3. Relevance: makes a difference in the decision
4. Reliability – representationally faithful, verifiable, neutral
Accounting Underlying Assumptions - Basis for Generally Accepted Accounting
Principles (GAAP)
Entity Assumption - each business is its own “accounting” entity.
Periodicity Assumption - divide economic activities into time periods
for reporting.
Going Concern Assumption - the company will remain in business and will carry out existing commitments. Assets will be used to bring future benefit and liabilities will be paid.
Monetary Assumption - assume the dollar is stable over time.
No adjustments are made for inflation or deflation.
Accounting Principles:
Historical Cost - Assets and Liabilities are recorded at cost.
Cost is the best estimate of fair value at the time the transaction occurs.
Historical cost is very reliable and not often relevant in the future.
Realization / Revenue Recognition: 2 criteria must be met to record revenues:
1. The earnings process is judged to be complete or virtually complete
(“earned” - you do not owe the customer anything else)
2. There is reasonable certainty as to the collectibility of the asset to be
received, usually cash (you believe you will be paid)
Full Disclosure - all relevant accounting information must be disclosed to users
1) the “notes to the financial statements” are required
2) the “notes to the financial statements” discuss details that are not
shown on the financial statements
Accomplished by using:
1. parenthetical comments on the face of financial statements
2. disclosure notes (footnotes)
3. supplemental financial statements reporting more detailed info
Matching - expenses incurred should be matched (reported) with revenues
earned in the same period.
Revenue is recognized according to the “Realization Principle”
Expenses can be recognized based on:
1. Exact cause and effect relationship between revenue and expense
2. Associating an expense with revenue in a specific time period
3. Systematic and rational allocation to specific time periods
4. In the period incurred, without regard to related revenues
Accounting Constraints:
Conservatism - when estimating, present the lowest asset value, the highest
liability amount, and the lowest net income position
Do not mislead with a low or a high estimate
A practical justification for an accounting choice
1) recognize losses as soon as you know about them
2) recognize gains when you collect the cash
Materiality - the amount is big enough to make a difference in the decision of
a reasonable person using the financial statements.
Cost/Benefit (Cost Effectiveness) - the benefit must exceed the cost when
gathering and presenting financial information.
Primary Qualitative Characteristics of Financial Information:
Relevance - capable of making a difference in a decision
1) helps the user predict the future (predictive)
2) helps the user evaluate past decisions (feedback)
3) current and available when making a decision (timeliness)
Reliability – a user can rely on it and have confidence in the information
1) represents the economic position as it really is
(representational faithfulness)
2) several individuals would reach the same conclusion (verifiable)
3) doesn’t sway the users opinion, objective (neutrality)
Secondary Qualitative Characteristics of Financial Information:
Consistency - use the same accounting policies and procedures from
one period to the next
Permits valid comparisons between different periods of time
Comparability - allows users to identify similarities and differences
1) one year to the next 2) one company to another
Elements of Financial Statements:
SFAC 6 defines 10 elements of the financial statements
Asset: The company’s economic resources used to operate the business
(What the company HAS)
1) Probable future economic benefit
2) Owned or controlled by the company
3) Resulting from a past transaction, something that has already occurred
The economic benefit is using the asset to generate future cash flows
or the asset itself will convert to cash
Liability: The company’s debts and obligations (What the company OWES)
1) Probable sacrifice of a future economic benefit (an asset)
2) Present obligation to transfer assets or provide services
3) Resulting from a past transaction
You will give up an asset to pay what you owe
Equity: Residual interest in the assets after deducting liabilities
From two sources: Paid in Capital and Retained Earnings
Investments by Owners: Transfer of resources to the company in exchange
for ownership
Distributions to Owners: Decreases in equity from transfers to owners (dividends)
Revenues: Inflows from providing goods or services in exchange for an asset.
This is the amount the customer is expected to pay for the goods
or services they received
A revenue occurs when the good/service is provided to the customer
regardless of whether the customer has paid or not
Expenses: Outflows or using an asset of the company to provide goods or services
Incurred in the process of generating revenues
What it costs the company to provide the goods or services
to the customer.
A service or good is provided to the company that the company
will have to pay for. The expense occurs when the company
receives the service or the asset is used up, not when the
company pays for the goods or service
Gains: Increases in equity from peripheral (incidental) transactions – not part of
day to day primary business activities (sell an asset for more than cost)
Losses: Decreases in equity from peripheral (incidental) transactions – not part of
day to day primary business activities (sell an asset for less than cost)
Comprehensive Income: Change in equity from transactions and non owner sources
Includes all changes in equity except investments from and distributions
to owners
Net Income often does not equal comprehensive income due to items
that are reported directly to owner’s equity as comprehensive income
that are not reported on the income statement
Net income = Revenues + Gains – Expenses - Losses
