PRINCIPLES OF ACCOUNTING

Lecture 1

Topic 1: Introduction and Subject Overview

Teaching Details

Lecturer in Charge:

Dr. Md. Hamid U Bhuiyan

Associate Professor

Department of Accounting & Information Systems

University of Dhaka

Email: hubhuiyan72@gmail.com

Text Book

Accounting Principles, Weygandt, Kimmel, and Kieso 10th Edition

Intermediate Accounting, Kieso, Weygandt, Warfield 15th Edition

Everyone should have the access to this textbook, class Test questions are set from it

Assessment Assessment includes:

Mid-semester exam (15*2) 30% Class test (best two out of three) 20% Assignment & presentation 10% Final examination (2-hours) 40%

Assessment components Mid-semester exam 1 will comprise multiple-choice questions and

be of 90 minutes duration in Week 5 Mid-semester exam 2 will comprise problem solving questions and

be of 90 minutes duration in Week 10 Class test process will comprise 3 tests in week 3, 7, and 11. Your

best 2 will be counted towards the 20% of the total assessment Final examination will be a 2-hour exam Final exam will be divided into 3 sections: Section 1 – Multiple choice, Section 2 – Short questions & Problem

Solving, and Section 3 – Critical and detail problem solving

How to Succeed This Subject? Regularly attend lectures Be prepared before lectures

read the relevant chapters of the textbook before a lecture

complete assigned class exercises independently

Balance work and study Resolve study difficulties and problems

immediately, by consulting the lecturer, and never accumulate problems to the end of the semester

Subject Content

Mixture of theory and practical topics

Lectures emphasis the important materials and both theoretical element, application and practical problems

Use of real company examples to support theory concepts as much as possible

What is Accounting?

The primary function of accounting is to provide useful financial

information to users who are external to the business enterprise,

particularly investors and creditors

Accounting as a special “language” used to communicate financial

information about a business to those who wish to use the

information to make decisions

Accounting Consists Three Basic Activities:

1. identify, record, and communicate the economic events of an

2. organization to

3. interested users

The Activities in the Accounting Process

An Example of Accounting Process

Examples of economic events are sale of Motor Car, Payment of

Wages, and Manufacturing of Motor Car by Ford Motor

Corporation

Once Ford Motor identifies economic events, it records those events in order

to provide a history of its financial activities. Recording consists of keeping a

systematic, chronological diary of events, measured in monetary terms

In recording, Ford Motor also classifies and summarizes economic events

Finally, Ford Motor communicates the collected information to

interested users by means of accounting reports (known as

Financial Statements)

An Example of Accounting Process

To make the reported financial information meaningful, Ford

Motor reports the recorded data in a standardized way. It

accumulates information resulting from similar transactions

For example, Ford accumulates all sales transactions over a

certain period of time and reports the data as one amount in the

company’s financial statements.

By presenting the recorded data in the aggregate, the accounting

process simplifies a multitude of transactions and makes a series

of activities understandable and meaningful

Users of Accounting Information

Internal Users: Management Human Resources

Dept. Marketing Dept. Finance Dept.

External Users: Existing Investors Potential Investors Creditors and Lenders Regulatory Agencies Financial Intermediaries Labor Unions Customers Govt. Organizations

Illustration – Users of Accounting Information Can we afford to give our employees a pay

raise?

Did the company earn a satisfactory income?

Do we need to borrow in the near future?

Is cash sufficient to pay dividends to the stockholders?

What price for our product will maximize net income?

Will the company be able to pay its short-term debts?

Human Resources

Investors

Management

Finance

Marketing

Creditors

Generally Accepted Accounting Principles

GAAP: A set of rules and practices, having substantial

authoritative support, that the accounting profession recognizes

as a general guide for financial reporting purposes and are

generally accepted and universally practiced

Standard-setting bodies determine these guidelines:

► Securities and Exchange Commission (SEC)

► Financial Accounting Standards Board (FASB)

► International Accounting Standards Board (IASB)

An Interview

Conceptual Framework for Accounting

The conceptual framework has been described as an “Accounting Constitution” because it provides the underlying foundation for accounting standards

  It is a logical system of interrelated objectives and fundamentals

that are intended to lead to consistent standards

The fundamentals are the underlying concepts of accounting that guide the selection of events to be accounted for, the measurement of those events, and the means of summarizing and communicating them to interested parties

Overview of Conceptual Framework

Objective of Financial Reporting

The objective of general-purpose financial reporting is to provide financial information about the reporting entity that is useful to present and potential equity investors, lenders, and other creditors in making decisions about providing resources to the entity

Those decisions involve buying, selling, or holding equity and debt instruments, and providing or settling loans and other forms of credit

Information that is decision-useful to capital providers may

also be useful to other users of financial reporting, who are not capital providers

General-Purpose Financial Statements General-purpose financial statements provide financial

reporting information to a wide variety of users

These statements help shareholders, creditors, suppliers, employees, and regulators to better understand its financial position and related performance.

To be cost effective in providing this information, general-purpose financial statements are most appropriate.

In other words, general-purpose financial statements provide at the least cost the most useful information possible

General-Purpose Financial StatementsThe primary means of conveying financial information to investors,

creditors, and other external users is through financial statements and

related disclosure notes

The financial statements most frequently provided are:

1. The balance sheet, also called the statement of financial position

2. The income statement, also called the statement of operations

3. The statement of cash flows, and

4. The statement of shareholders’ equity

Also, starting in 2012, companies must either provide a statement of

other comprehensive income immediately following the income

statement, or present a combined statement of comprehensive income

that includes the information normally contained in both the income

statement and the statement of other comprehensive income

Qualitative Characteristics of Accounting Information

How does a company choose an acceptable accounting method, the

amount and types of information to disclose, and the format in which

to present it? The answer:

By determining which alternative provides the most useful information

for decision making purposes (decision-usefulness)

The FASB (Financial Accounting Standard Board) identified the

qualitative characteristics of accounting information that distinguish

better (more useful) information from inferior (less useful) information

for decision-making purposes

Hierarchy of Accounting Qualities

To be relevant, accounting information must be capable of

making a difference in a decision

Fundamental Quality - Relevance

Financial information has predictive value if it has value as an

input to predictive processes used by investors to form their own

expectations about the future. For example, Current-period net

income has predictive value if it helps users predict a company’s

future cash flows

Relevance – Ingredients

Relevant information also helps users confirm or correct prior expectations. For example, It has confirmatory value if it helps investors confirm or change their prior assessments regarding a company’s cash-flow generating ability.

Relevance – Ingredients

Information is material if omitting it or misstating it could influence decisions that users make on the basis of the reported financial information. The threshold for materiality often depends on the relative dollar amount of the transactionFor example, $10,000 in total anticipated bad debts for a multibillion dollar company like Dell would not be considered material. This same $10,000 amount, however, might easily be material for a neighborhood pizza parlor

Relevance – Ingredients

Faithful representation means that the numbers and descriptions match what really existed or happened

For example, assume that the term inventory in the balance sheet of a retail company is understood by external users to represent items that are intended for sale in the ordinary course of business. If inventory includes, say, machines used to produce inventory, then it lacks faithful representation

Fundamental Quality – Faithful Representation

Completeness means that all the information that is necessary for faithful representation is provided.

A representation of an economic occurrence is complete if it includes all the information necessary for faithful representation of the economic phenomenon that it significance to represent. Omitting a portion of that information can cause it to be false or misleading and thus not helpful.

Faithful Representation – Ingredients

Neutrality means that a company cannot select information to favor

one set of interested parties over another. Accounting information

should be free from bias.Accounting standards should be established with the goal of providing high-quality information, and should try not to achieve particular social outcomes or favor particular groups or companies

Faithful Representation – Ingredients

An information item that is free from error will be a more accurate

(faithful) representation of a financial item.Accounting estimates are common, and some inaccuracy is likely. An estimate is represented faithfully if it is described clearly and accurately as being an estimate, and financial statement users are given enough information to understand the potential for inaccuracy that exists

Faithful Representation – Ingredients

Information that is measured and reported in a similar manner for

different companies is considered comparable.Comparability ensures investors and creditors being able to compare information among companies to make their resource allocation decisions. Closely related to comparability is the notion that consistency of accounting practices over time permits valid comparisons among different reporting periods.

Enhancing Qualities - Comparability

Verifiability occurs when independent measurers, using the same methods, obtain similar results. Verifiability implies that different knowledgeable and independent measurers would reach consensus regarding whether information is a faithful representation of what it is intended to depict. Direct verification involves observing the item being depicted. For example, the historical cost of a piece of land to be reported in a company’s balance sheet usually is highly verifiable, however, the fair value of the piece of land is much more difficult to verify.

Enhancing Qualities – Verifiability

Timeliness means having information available to decision-makers

before it loses its capacity to influence decisions.Information is timely when it’s available to users early enough to allow them to use it in their decision process. The need for timely information requires that companies provide information on a periodic basis. To enhance timeliness, the SEC requires its registrants to submit financial statement information on a quarterly as well as on an annual basis for each fiscal year.

Enhancing Qualities – Timeliness

Understandability is the quality of information that lets reasonably informed users see its significance.

Understandability means that users must be able to comprehend the information within the context of the decision being made. This is a user-specific quality because users will differ in their ability to comprehend any set of information.

Enhancing Qualities – Understandability

Key Constraint

Information is cost effective only if the benefit of increased decision usefulness exceeds the costs of providing that information.

The benefits of endowing financial information with all the

qualitative characteristics we’ve discussed must exceed the costs

of doing so. The costs of providing financial information include

those of gathering, processing, and disseminating information.

There also are costs to users when interpreting information.

In addition, costs include possible adverse economic consequences

of implementing accounting standards

Elements of Financial Statements

Ten interrelated elements that relate to measuring the performance and financial status of a business enterprise.

“Moment in Time”

Assets Liabilities Equity

“Period of Time”

Investment by owners Distribution to owners Comprehensive income Revenue Expenses Gains Losses

Basic Assumptions

Four basic assumptions underlie GAAP:

1. The economic entity assumption

2. The going concern assumption

3. The periodicity assumption

4. The monetary unit assumption

These assumptions identify the entity that is being

reported on, the assumption that the entity will continue to exist, and the frequency and denomination in which reports occur

Basic Assumptions Economic Entity – company keeps its activity separate from its

owners and other businesses.

For example, if you were considering buying some ownership

stock in Google , you would want information on the various

operating units that constitute Google.

Going Concern - company to last long enough to fulfill objectives

and commitments.

In absence of this assumption assets and liabilities assets and

liabilities would be measured in their current liquation value

Basic Assumptions Periodicity - company can divide its economic activities into time

periods. The accounting profession and the SEC advocate that companies adopt a fiscal

year that corresponds to their natural business year. A natural business year is the 12-month period that ends when the business activities of a company reach their lowest point in the annual cycle.

For example, many retailers, Wall-Mart have a fiscal year ending on January 31; Dell company’s fiscal year ends at the end of January; The Campbell Soup Company ’s fiscal year ends in July; Clorox’s in June; and Monsanto’s in August.

Monetary Unit - money is the common denominator.

In the United States, the U.S. dollar is the monetary unit used in financial statements. In the EU, the euro is the monetary unit. Other countries use other currencies as their monetary units.

One problem is that the purchasing power of currencies are not stable. However, in Accounting it is presumed that the monetary unit is stable over time

Basic Assumptions - Illustration(a) The economic activities of KC Corporation are divided into

12-month periods for the purpose of issuing annual reports.

PERIODICITY

(b) Solectron Corporation, Inc. does not adjust amounts in its financial statements for the effects of inflation.

MONETARY UNIT

(c) Walgreen Co. reports current and noncurrent classifications in its balance sheet.

GOING CONCERN

(d) The economic activities of General Electric and its subsidiaries are merged for accounting and reporting purposes.

ECONOMIC ENTITY

Basic Principles Measurement Principle – The most commonly used

measurements are based on historical cost and fair value.

Issues:

Historical cost provides a reliable benchmark for measuring historical trends.

Fair value information may be more useful.

Recently the FASB has taken the step of giving companies the option to use fair value as the basis for measurement of financial assets and financial liabilities.

Reporting of fair value information is increasing.

Basic Principles Revenue Recognition - requires that companies recognize

revenue in the accounting period in which the performance obligation is satisfied

Expense Recognition - “Let the expense follow the revenues.”

Basic Principles

Full Disclosure – providing information that is of

sufficient importance to influence the judgment

and decisions of an informed user.

Provided through:

Financial Statements

Notes to the Financial Statements

Supplementary information

Illustration KC Corporation reports revenue in its income statement when it is

earned instead of when the cash is collected

Revenue Recognition

Yahoo, Inc. recognizes depreciation expense for a machine over the 2-year period during which that machine helps the company earn revenue

Expense Recognition

Oracle Corporation reports information about pending lawsuits in the notes to its financial statements

Full Disclosure

Eastman Kodak Company reports land on its balance sheet at the amount paid to acquire it, even though the estimated fair market value is greater

Measurement

Constraint

Cost Constraint – cost of providing information must be weighed

against the benefits that can be derived from using it

Illustration: The following two situations represent

applications of the cost constraint.

Rafael Corporation discloses fair value information on its loans because it already gathers this information internally

Willis Company does not disclose any information in the notes to the financial statements unless the value of the information to users exceeds the expense of gathering it