Copyright © 2014 Pearson Education, Inc publishing as Prentice Hall 15 - Chapter 15 Basic Accounting: Concepts, Techniques, and Conventions Copyright © 2014 Pearson Education, Inc publishing as Prentice Hall 15 - Chapter 15 Learning Objectives Read and interpret basic financial statements Analyze typical business transactions using the balance sheet equation Distinguish between the accrual basis of accounting and the cash basis of accounting Make adjustments to the accounts under accrual accounting Explain the nature of dividends and retained earnings Select relevant items from a set of data and assemble them into a balance sheet and an income statement Copyright © 2014 Pearson Education, Inc publishing as Prentice Hall 15 - Chapter 15 Learning Objectives Distinguish between the reporting of corporate owners’ equity and the reporting of owners’ equity for partnerships and sole proprietorships Explain the role of auditors in financial reporting and how accounting standards are set Identify how the measurement principles of recognition, matching and cost recovery, and stable monetary unit affect financial reporting 10 Define continuity, relevance, faithful representation, materiality, conservatism, and cost benefit (Appendix 15A) 11 Use T-accounts, debits, and credits to record transactions (Appendix 15B) Copyright © 2014 Pearson Education, Inc publishing as Prentice Hall 15 - The Need for Accounting Accounting information can be used to assess past financial performance of a company and help predict its future performance All kinds of organizations— government agencies, nonprofit organizations, and others —rely on accounting to gauge their progress The accounting process begins with a transaction A transaction is any event that affects the financial position of an organization and requires recording Copyright © 2014 Pearson Education, Inc publishing as Prentice Hall 15 - The Need for Accounting Many concepts, conventions, and rules determine what events a company records as accounting transactions and how accountants measure the financial impact of each transaction Financial statements are used to summarize the recorded accounting transactions Copyright © 2014 Pearson Education, Inc publishing as Prentice Hall 15 - The Need for Accounting Managers, investors, and other internal groups want the answers to two important questions: How well did the organization perform? Where does the organization stand? Copyright © 2014 Pearson Education, Inc publishing as Prentice Hall 15 - Learning Objective The Need for Accounting Accountants answer these questions with three major financial statements: Balance sheet Income statement Statement of cash flows Copyright © 2014 Pearson Education, Inc publishing as Prentice Hall 15 - Balance Sheet The balance sheet (also called statement of financial position or statement of financial condition) is a snapshot of the financial status of an organization at a point in time The balance sheet has two sections (1) assets and (2) liabilities plus owners’ (stockholders’) equity Copyright © 2014 Pearson Education, Inc publishing as Prentice Hall 15 - Balance Sheet Assets are economic resources that are expected to benefit future activities of the organization Liabilities are the entity’s economic obligations to nonowners Owners’ equity is the excess of the assets over the liabilities Copyright © 2014 Pearson Education, Inc publishing as Prentice Hall 15 - 10 Comparison of Owners’ Equity Reporting Unlike corporations, sole proprietorships and partnerships not distinguish between paid-in capital (i.e., amounts invested by owners) and retained earnings Instead, they typically accumulate a single amount for each owner’s original investment, subsequent investments, share of net income, and withdrawals Copyright © 2014 Pearson Education, Inc publishing as Prentice Hall 15 - 45 Learning Objective Generally Accepted Accounting Principles (GAAP) Accounting is more an art than a science It is commonly misunderstood as being a precise discipline that produces exact measurements of a company’s financial position and performance Accounting is based on a set of principles on which there is general agreement, not on rules that can be “proved.” The principles and procedures that together make up accepted accounting practice at any given time are known as generally accepted accounting principles (GAAP) Copyright © 2014 Pearson Education, Inc publishing as Prentice Hall 15 - 46 Audit An audit is an “examination” or in-depth inspection of financial statements and companies’ records that is made in accordance with generally accepted auditing standards Auditing standards are approved by the Public Company Accounting Oversight Board (PCAOB) which is a part of the Securities and Exchange Commission (SEC), a government agency that regulates the financial markets in the U.S including financial reporting Copyright © 2014 Pearson Education, Inc publishing as Prentice Hall 15 - 47 Accounting Standard Setters The Financial Accounting Standards Board (FASB) is the primary regulatory body over accounting principles and practices in the U.S The FASB consists of seven full-time members plus a staff of nearly 60 members, and it is an independent creation of the private sector The IASB is a similar independent organization whose pronouncements, called International Financial Reporting Standards (IFRS) define GAAP in more than 100 other countries Copyright © 2014 Pearson Education, Inc publishing as Prentice Hall 15 - 48 Accounting Standard Setters In 2008 the SEC started accepting financial statements based on IFRS for non-U.S Companies whose stock is traded in U.S capital markets It defined a “road-map” for eventual adoption of IFRS by U.S companies as well the FASB and IASB are currently working on converging their separate standards into one set of world-wide standards Copyright © 2014 Pearson Education, Inc publishing as Prentice Hall 15 - 49 Accounting Standard Setters The public sector–private sector relationship: The SEC has the ultimate responsibility for specifying GAAP for U.S companies with publicly traded stock The SEC has informally delegated much rule-making power to the FASB If and when the pending move to international Standards occurs, such power will also be delegated to the IASB Copyright © 2014 Pearson Education, Inc publishing as Prentice Hall 15 - 50 Ethics The public sector–private sector relationship: Confidence in financial information is important to the smooth functioning of the world’s capital markets, and confidence in financial statements depends on the competence and integrity of accountants and auditors A hallmark of the accounting profession has been its ethics and integrity Most accountants and auditors are highly ethical and truthfully report their financial results in accordance with GAAP Copyright © 2014 Pearson Education, Inc publishing as Prentice Hall 15 - 51 Learning Objective Three Measurement Conventions U S GAAP is based on a conceptual framework that contains three broad measurement or valuation conventions (principles) that underlie accrual accounting: Recognition Matching and cost recovery Stable monetary unit Copyright © 2014 Pearson Education, Inc publishing as Prentice Hall 15 - 52 Recognition Principle The recognition principle specifies when a company should record revenue in the accounting records Generally, companies recognize revenue when it is both earned and realized or realizable In some industries revenue recognition is not so straightforward These judgment issues require company accountants together with its auditor to decide when earning and realization are sufficiently complete to recognize the revenue Copyright © 2014 Pearson Education, Inc publishing as Prentice Hall 15 - 53 Matching and Cost Recovery The timing of revenue recognition is important because it leads to the recording of expenses through the concept of matching—the linking of revenues with expenses incurred to generate them Accountants apply matching as follows: Identify the revenue recognized during the period Record expenses that relate directly to the recognized revenue Record expenses that are costs of operations during a specific time period that have no measurable benefit for a future period and must be linked to the current period’s revenues Copyright © 2014 Pearson Education, Inc publishing as Prentice Hall 15 - 54 Matching and Cost Recovery The heart of recognizing expense is the cost recovery concept Companies carry forward as assets such items as inventories, prepayments, and equipment because they expect to recover the costs of these assets in the form of cash inflows (or reduced cash outflows) in future periods At the end of each period, accountants examine evidence to assure themselves that they should not write off these assets—the unexpired costs—as an expense of the current period Copyright © 2014 Pearson Education, Inc publishing as Prentice Hall 15 - 55 Stable Monetary Unit The monetary unit (for example, the dollar in the United States, the yen in Japan, or the euro in the European Union) is the principal means for measuring assets, liabilities, and stockholders’ equity This measurement assumes that the monetary unit— the dollar, for example—is an unchanging yardstick Yet, a 2010 dollar does not have the same purchasing power as a 2000 or 1990 dollar Therefore, users of accounting statements that include dollars from different years must recognize the limitations of the basic measurement unit Copyright © 2014 Pearson Education, Inc publishing as Prentice Hall 15 - 56 Learning Objective 10 Appendix 15A: Additional Accounting Concepts Concepts that are prominent parts of the body of GAAP: Continuity (going concern) Relevance Predictive value Confirmatory value Faithful representation Comparability Consistency Verifiability Timeliness Understandable Materiality Conservatism Cost-benefit Copyright © 2014 Pearson Education, Inc publishing as Prentice Hall 15 - 57 Learning Objective 11 Appendix 15B: Using Ledger Accounts Some techniques that accountants use to record transactions T-Accounts Ledger Accounts Double-Entry System Debits and Credits Copyright © 2014 Pearson Education, Inc publishing as Prentice Hall 15 - 58 All rights reserved No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher Printed in the United States of America Copyright © 2014 Pearson Education, Inc publishing as Prentice Hall 15 - 59