3. Accounting Principles, Assumptions and Constraint

Accounting is guided by principles. General principles are the...

assumptions, concepts, and guidelines for preparing financial statements

What are the four general accounting principles?

Measurement (cost) principle, Revenue recognition principle, Expense recognition principle (matching principle), Full disclosure principle.

What is the measurement principle (cost principle)?

Accounting information is based on actual cost. Cost is measured on a cash or equal-to-cash basis. This means if cash is given for a service, its cost is measured by the cash paid. If something besides cash is exchanged (such as a car traded for a truck), cost is measured as the cash value of what is given up or received. Information based on cost is considered objective.

What does objectivity mean?

information is supported by independent, unbiased evidence.

What is the revenue recognition principle?

Revenue is recognized

1. when goods or services are provided to customers and

2. at the amount expected to be received from the customer.

To put it simply, revenue is recorded when services are provided.

What is revenue?

Revenue (sales) is the amount received from selling products and services. The amount received is usually in cash, but it can also be a customer's promise to pay at a future date, called credit sales.

What is the expense recognition principle?

Expense is recognized in the same period as the revenue is recognized as a result of that expense. To put it simply, expenses must be recorded in the same accounting period as the revenues they helped generate, not necessarily when the cash is paid.

What is the full disclosure principle?

A company reports the details behind financial statements that would impact users' decisions. Those disclosures are often in notes to the statements.

A lawn service bills a customer $800 on June 1 for two months of mowing (June and July). The customer pays the bill on July 1. When is revenue recorded?

It is recorded over time as it is earned, record $400 revenue for June and $400 for July.

Credit cards are used to pay $200 in gas for a lawn service during June and July. The cards are paid in August. When is expense recorded?

If revenue is earned over time, record $100 expense in June and $100 in July.

What are the four accounting assumptions?

going-concern assumption, monetary unit assumption, time period assumption, and business entity assumption

What is the going concern assumption?

Accounting information presumes that the business will continue operating instead of being closed or sold. This means, for example, that property is reported at cost instead of liquidation value.

What is the monetary unit assumption?

Transactions and events are expressed in monetary, or money, units such as the U.S. dollar and the Mexican peso.

What is the time period assumption?

the life of a company can be divided into time periods, such as months and years, and useful reports can be prepared for those periods.

What is the business entity assumption?

A business is accounted for separately from other business entities, including its owner.

What are four common business entities?

1. Sole Proprietorship

2. Partnership

3. Corporation

4. Limited Liability Company (LLC)

Give the details of a sole proprietorship.

1. one owner

2. No additional business income tax

3. Unlimited liability. Owner is personally liable for proprietorship debts.

4. Not a separate legal entity.

Give the details of a partnership.

1. 2 or more partners.

2. No additional business income tax.

3. Unlimited liability. Partners are jointly liable for partnership debts.

4. Not a separate legal entity.

Give the details of a corporation.

1. 1 or more shareholders; can get many investors by selling stock or shares of corporate ownership.

2. Additional corporate income tax.

3. Limited liability. Owners, called shareholders are not liable for corporate acts and debts.

4. Separate entity with the same rights and responsibilities as a person.

Give the details of an LLC (Limited Liability Company)

1. 1 or more members

2. No additional business income tax.

3. Limited liability. Owners, called members, are not personally liable for LLC debts.

4. A separate entity with the same rights and responsibilities as a person.

What are the two constraints in accounting?

The cost-benefits constraint and materiality.

What is the cost-benefit constraint?

Information disclosed by an entity must have benefits to the user that are greater than the costs of providing it.

What is materiality?

The ability to influence decisions is also sometimes mentioned as a constraint.

Identify the accounting principle or assumption that best reflects each situation.

AAA Painting performs services for a customer. AAA records revenue this period even though the customer is not billed until next period.

Revenue recognition principle.

Identify the accounting principle or assumption that best reflects each situation

Ming Studios purchases camera equipment for $12,000 cash. The owner thinks the equipment is worth $18,000. The equipment is recorded at $12,000.

Measurement principle.

Identify the accounting principle or assumption that best reflects each situation

Alfonso owns Consulting LLC. Alfonso keeps personal expenses separate from LLC expenses.

Business entity assumption.