Accounting Principles and Standards

Accounting: The Language of Business

Role of Accounting

• Accounting communicates a business's financial and economic information.

• It's a process of analyzing, recording, summarizing, organizing, and reporting business information.

• It's an information system providing useful data about a company's economic activities and condition for decision-making.

Users of Accounting Information

Internal Users

• Employees

• Managers

• Use information for daily operating and strategic decisions (e.g., new equipment, hiring).

External Users

• Investors

• Creditors

• Vendors

• Taxing agencies (IRS, Franchise Tax Board).

• Information is used for investment decisions, lending assessments, and tax compliance.

Reporting Standards

• In the US, publicly traded companies follow Generally Accepted Accounting Principles (GAAP).

• The Financial Accounting Standards Board (FASB) develops these standards.

• Standards are found in the Accounting Standards Codification.

• Internationally, many companies use International Financial Reporting Standards (IFRS).

GAAP Principles and Assumptions

• GAAP is a collection of accounting standards, principles, and assumptions.

Qualitative Characteristics of Useful Information

• Relevance: Information's potential influence on decision-making.

• Faithful Representation: Accuracy in reflecting the entity's economic activity or condition.

• Comparability: Allows users to identify similarities and differences among items (e.g., sales, expenses).

  • Enables comparisons between companies or across multiple periods.

• Verifiability: Information can be directly or indirectly verified or confirmed.

• Timeliness: Financial reports are available in time to influence decisions.

• Understandability: Information is classified, characterized, and presented clearly and concisely.

Financial Accounting Assumptions

• Monetary Unit Assumption: Financial reports are expressed in a single monetary unit of currency (e.g., US dollars).

• Time Period Assumption: Companies report economic activities regularly for specific periods (annually with quarterly reports).

• Business Entity Assumption: Financial reports include only events and transactions directly related to the business, excluding:

  • Unrelated activities of owners.

  • Personal activities and expenses.

  • Activities of creditors or other business entities.

Accounting Principles

Measurement Principles

• Determine the amount at which assets should be recorded and reported.

  • Historical Cost Principle: Assets are recorded at their original cost.

  • Fair Value Principle: Assets are recorded at their current fair value. (market value)

Revenue Recognition Principle

• Determines when revenues should be recorded (when earned, not necessarily when cash is received).

Expense Recognition Principle (Matching Principle)

• Determines when expenses should be recorded (when incurred, not necessarily when cash is paid).

Scenarios Applying the Principles

Scenario 1: Land Purchase

• Business buys land in February for $300,000$.

• Market value increases to $350,000$ during the year.

• According to the historical cost principle, the land is recorded at $300,000$ (historical cost).

Scenario 2: Service Revenue

• Business provides services for $1,500$ in December.

• Payment is received in January.

• Under the revenue recognition principle, the $1,500$ is recorded in December (when earned).

Scenario 3: Labor Costs

• Business incurs $3,300$ in labor costs in December but pays in January.

• Under the matching principle, the $3,300$ expense is recorded in December (when incurred).