Financial Accounting, 3e
Weygandt, Kieso, & Kimmel
Prepared by
Gregory K. Lowry
Mercer University
Marianne Bradford
The University of Tennessee
John Wiley & Sons, Inc.
CHAPTER 7
ACCOUNTING PRINCIPLES
After studying this chapter, you should be able to:
1 Explain the meaning of generally accepted
accounting principles and identify the key
items of the conceptual framework.
2 Describe the basic objectives of financial
reporting.
3 Discuss the qualitative characteristics of
accounting information and elements of
financial statements.
CHAPTER 7
ACCOUNTING PRINCIPLES
After studying this chapter, you should be able to:
4 Identify the basics assumptions used by
accountants.
5 Identify the basic principles of accounting.
6 Identify the two constraints in accounting.
7 Understand and analyze classified financial
statements.
8 Explain the accounting principles used in
international operations.
PREVIEW OF CHAPTER 7
ACCOUNTING
PRINCIPLES
The Conceptual
Framework of
Accounting
 Objectives
of
reporting
 Qualitative
characteristics
 Elements
of
financial
statements

Operating
guidelines
Assumptions
 Monetary
unit
 Economic
entity
 Time
period
 Going
concern
Principles
 Revenue
recognition
 Matching
 Full
 Cost
disclosure
Constraints in
Accounting
 Materiality
 Conservatism
 Summary
of
conceptual
framework
Financial Statement
Presentation and
Analysis
 Classified
balance
sheet
 Classified
income
statement
 Analyzing
financial
statements
 An
international
perspective
THE CONCEPTUAL FRAMEWORK
OF ACCOUNTING
 Generally accepted accounting principles are a set of
rules and practices that are recognized as a general
guide for financial reporting purposes.
 Generally accepted means that these principles must
have substantial authoritative support.
 This support usually comes from the Financial
Accounting Standards Board (FASB) and Securities
and Exchange Commission (SEC).
 The FASB has the responsibility for developing
accounting principles in the United States.
THE CONCEPTUAL FRAMEWORK
OF ACCOUNTING
 The conceptual framework developed by the
FASB serves as the basis for resolving accounting
and reporting problems.
 The conceptual framework consists of:
1 objectives of financial reporting;
2 qualitative characteristics of
accounting information;
3 elements of financial statements; and
4 Operating guidelines (assumptions,
principles, and constraints).
OBJECTIVES OF
FINANCIAL REPORTING
The FASB concluded that the objectives of financial
reporting are to provide information that:
1 Is useful to those making investment and credit
decisions.
2 Is helpful in assessing future cash flows.
3 Identifies the economic resources (assets), the claims
to those resources (liabilities), and the changes in
those resources and claims.
QUALITATIVE CHARACTERISTICS
OF ACCOUNTING INFORMATION
 The FASB concluded that the overriding criterion by
which accounting choices should be judged is
decision usefulness.
 To be useful, information should possess the
following qualitative characteristics:
1 relevance,
2 reliability, and
3 comparability and consistency.
RELEVANCE
 Accounting information is relevant if it
makes a difference in a decision.
 Relevant information helps users forecast
future events (predictive value),
or
it confirms or corrects prior expectations
(feedback value).
 Information must be available
to decision makers before it
loses its capacity to influence
their decisions (timeliness).
RELIABILITY
 Reliability of information means that
the information is free of error and
bias; it can be depended on.
 To be reliable, accounting information
must be verifiable – we must be able to
prove that it is free of error and bias.
 The information must be a faithful
representation of what it purports to
be – it must be factual.
COMPARABILITY AND
CONSISTENCY
 Comparability means that the information
should be comparable with accounting
information about other enterprises.
 Consistency means that the same accounting
principles and methods should be used from
year to year within a company.
1999
2000
2001
ILLUSTRATION 7-1
QUALITATIVE CHARACTERISTICS
OF ACCOUNTING INFORMATION
Useful
Financial
Information has:
Relevance
Reliability
1 Predictive value
1 Verifiable
2 Feedback value
2 Faithful representation
3 Timely
3 Neutral
Comparability
and
Consistency
ILLUSTRATION 7-2
THE OPERATING GUIDELINES OF
ACCOUNTING
 Operating guidelines are classified as assumptions,
principles, and constraints.
 Assumptions provide a foundation for the accounting
process.
 Principles indicate how transactions and other economic
events should be recorded.
 Constraints permit a company to modify generally accepted
accounting principles without reducing the usefulness of the
reported information.
Assumptions
Monetary unit
Economic entity
Time period
Going concern
Principals
Revenue recognition
Matching
Full disclosure
Cost
Constraints
Materiality
Conservatism
ASSUMPTIONS
1 The monetary unit assumption states that only
transaction data capable of being expressed in terms
of money should be included in the accounting
records of the economic entity.
Example: employee satisfaction and percent of
international employees are not
transactions that should be included in
the financial records.
Customer Satisfaction
Percentage of
International Employees
Should be included
in accounting records
Salaries paid
ASSUMPTIONS
2 The economic entity assumption states that
economic events can be identified with a
particular unit of accountability.
Example: BMW activities
can be distinguished from
those of other car
manufacturers such as Mercedes.
ASSUMPTIONS
3 The time period assumption states that
the economic life of a business can be
divided into artificial time periods.
Example: months, quarters, and years
1997
QTR 1
QTR 2
QTR 3
QTR 4
1998
JAN
APR
JUL
OCT
FEB
MAY
AUG
NOV
1999
MAR
JUN
SEPT
DEC
ASSUMPTIONS
4 The going concern assumption assumes that the
enterprise will continue in operation long enough
to carry out its existing objectives.
Implications: depreciation and amortization are
used, plant assets recorded at cost instead of
liquidation value, items are labeled as fixed or
long-term.
PRINCIPLES
REVENUE RECOGNITION
 The revenue recognition
principle dictates that revenue
should be recognized in the
accounting period in which
it is earned.
 When a sale is involved,
revenue is recognized at
the point of sale.
PRINCIPLES
MATCHING (EXPENSE RECOGNITION)
 Expense recognition is traditionally tied to revenue
recognition.
 This practice – referred to as the matching principle
– dictates that expenses be matched with revenues in the
period in which efforts are expended to generate
revenues.
 To understand the various approaches for matching
expenses and revenues on the income statement, it is
necessary to examine the nature of expenses.
1 Expired costs are costs that will generate revenues only
in the current period and are therefore reported as
operating expenses on the income statement.
2 Unexpired costs are costs that will generate revenues in
future accounting periods and are recognized as assets.
PRINCIPLES
MATCHING (EXPENSE RECOGNITION)
Unexpired costs become expenses in 2 ways:
1 Cost of goods sold – Costs carried as
merchandise inventory are expensed as cost
of goods sold in the period in which the sale
occurs – so there is a direct matching of
expenses with revenues.
2 Operating expenses – Unexpired costs
become operating expenses through use or
consumption or through the passage of
time.
ILLUSTRATION 7-4
EXPENSE RECOGNITION PATTERN
Operating expenses contribute to the revenues
of the period but their association with revenues
is less direct than for cost of goods sold.
Provides Future Benefits
(Unexpired Cost)
Asset
Cost
Incurred
Benefits Decrease
Provides No Apparent
Future Benefit
(Expired Cost)
Expense
PRINCIPLES
FULL DISCLOSURE
 The full disclosure principle requires that
circumstances and events that make a
difference to financial statement users be
disclosed.
 Compliance with the full disclosure principle
is accomplished through
1 the data in the financial statements and
2 the notes that accompany the statements.
 A summary of significant accounting policies
is usually the first note to the financial
statements.
PRINCIPLES
COST
 The cost principle dictates that assets are
recorded at their cost.
 Cost is used because it is both relevant and
reliable.
1 Cost is relevant because if represents a) the
price paid, b) the assets sacrificed, or c) the
commitment made at the date of
acquisition.
2 Cost is reliable because it is a) objectively
measurable, b) factual, and c) verifiable.
ILLUSTRATION 7-5
EXAMPLE OF CHANGING PRICES
Consider the data below in which 1980 prices are
compared with 2000 expected prices, assuming
average price increases of 6% and 12% per year.
1980
Assumed price increase
Public college, yearly average cost
Average taxi ride, New York City (before tip)
Slice of pizza
First-class postage stamp
Run-of-the-mill suburban house, New York City
McDonald’s milk shake
2000
6%
12%
$ 3,350.00 $ 8,510.00 $ 20,537.00
2.95
7.49
18.08
.65
1.65
3.98
.15
.38
.92
150,000.00
381,052.00
919,559.00
.75
1.91
4.60
CONSTRAINTS IN
ACCOUNTING
 Constraints permit a company to modify
generally accepted accounting principles without
reducing the usefulness of the reported
information.
 The constraints are materiality and conservatism.
1 Materiality relates to an item’s impact on a
firm’s overall financial condition and
operations.
2 Conservatism in accounting means that, when
in doubt, the accountant chooses the method
that will be the least likely to overstate assets
and income.
ILLUSTRATION 7-8
CONCEPTUAL FRAMEWORK
CONSTRAINTS
Objectives of Financial Reporting
Qualitative
Characteristics of
Accounting Information
Elements of
Financial Statements
Operating Guidelines
Assumptions
Principles
CONSTRAINTS
ILLUSTRATION 7-9
STANDARD CLASSIFICATION OF BALANCE SHEET
 The balance sheet is composed of 3 major elements:
1 assets,
2 liabilities, and
3 stockholders’ equity.
 Additional segregation within these groups is
considered useful to financial statement readers.
 The following classification breakdown is usually
found:
Assets
Current assets
Long-term investments
Property, plant, and equipment
Intangible assets
Liabilities and Stockholders’ Equity
Current liabilities
Long-term liabilities
Stockholders’ equity
ILLUSTRATION 7-10
PROPRIETORSHIP BALANCE SHEET
 If the form of organization is a proprietorship, the term owner’s
equity is used instead of stockholders’ equity to describe that
section of the balance sheet.
 The Capital account 1 represents the owner’s investment in the
business and 2 is reported in the owner’s equity section of the
balance sheet for a proprietorship.
 Assume that Sally Field invests $90,000 on July 10 to start up
Med/Waste Company.
 The company’s balance sheet immediately after the investment is
shown below.
MED/WASTE COMPANY
Balance Sheet
July 10, 2000
Cash
$ 90,000
Sally Field, Capital
$ 90,000
ILLUSTRATION 6-11
PARTNERSHIP BALANCE SHEET
 If the form of organization is a partnership, each partner has a
separate capital account and the owner’s equity section shows the
capital accounts of all partners.
 Assume that A. Roy and B. Siegfried form a partnership on
December 11, 2001 by each investing $60,000.
 The company’s balance sheet immediately after their investments
is shown below.
ROY AND SEIGFRIED
Balance Sheet
December 11, 2001
Cash
$ 120,000
$ 120,000
A. Roy, Capital
B. Siegfried, Capital
$ 60,000
60,000
$ 120,000
FINANCIAL STATEMENT
PRESENTATION AND ANALYSIS
The multiple-step income statement for Highpoint Electronic,
Inc. in Chapter 5 included the following:
1 Sales revenue section – Presents the sales, discounts,
allowances, and other related information to arrive at the
net amount of sales revenue.
2 Cost of goods sold – Indicates the cost of goods sold to
produce sales.
3 Operating expenses – Provides information on both selling
and administrative expenses.
4 Other revenues and gains – Indicates revenues earned or
gains resulting from nonoperating transactions.
5 Other expenses and losses – Indicates expenses or losses
incurred from nonoperating transactions.
INCOME TAX EXPENSE
 Income taxes must be paid and reported for
a corporation since a corporation is a legal
entity that is separate and distinct from its
owners.
 Corporate income taxes (or income tax
expense) are reported in a separate section
of the income statement before net income.
NET INCOME
INCOME TAX
ILLUSTRATION 6-12
INCOME STATEMENT WITH INCOME TAXES
Note
that
income
before
income
taxes is
reported
before
income
tax
expense.
LEADS INC.
Income Statement
For the Year Ended December 31, 2001
Sales
Cost of goods sold
Gross profit
Operating expenses
Income from operations
Other revenues and gains
Other expenses and losses
Income before income taxes
Income tax expense
Net income
$ 800,000
600,000
200,000
50,000
150,000
10,000
4,000
156,000
46,800
$ 109,200
RECORDING INCOME TAXES
Income tax expense and the related liability for
income taxes payable are recorded as part of the
adjusting process preceding financial statement
preparation. Using the previous data for Leads
Inc., the adjusting entry for income tax expense at
December 31, 2001, would be as follows:
Date
Dec. 31
Account Titles and Explanation
Income Tax Expense
Income Taxes Payable
(To record income taxes for 1996)
Debit
46,800
46,800
Credit
ILLUSTRATION 7-13
EARNINGS PER SHARE FORMULA NO CHANGE IN OUTSTANDING SHARES
 Earnings per share (EPS) indicates the net
income earned by each share of common stock.
 Thus, earnings per share is only reported for
common stock.
 The formula for computing earnings per share
when there has been no change in outstanding
shares during the year is as follows:
Net
Income
÷
Number of
Shares
Outstanding
=
Earnings
per
Share
ILLUSTRATION 7-14
BASIC EARNINGS PER SHARE DISCLOSURE
 Due to its importance, EPS is required to be reported
on the face of the income statement.
 This amount is usually simply reported below net
income on the statement.
 Leads, Inc. has net income of $109,200.
 Assuming that it has 54,600 shares of common stock
outstanding for the year, EPS is $2.00 ($109,200 ÷
54,600), and is presented as follows:
Net income
$ 109,200
Earnings per Share
$
2.00
ILLUSTRATION 7-15
FINANCIAL STATEMENTS – GENLYTE INC.
In analyzing and interpreting financial statement
information, 3 major characteristics are generally evaluated:
1 liquidity,
2 profitability, and
3 solvency.
GENLYTE INC.
Balance Sheet
December 31, 2001
Assets
Current assets
Plant and equipment (net)
Intangible assets
Total assets
$ 156,000
74,000
14,000
Liabilities and Stockholders’ Equity
Current liabilities
Long-term liabilities
Stockholders’ equity
$ 70,000
114,000
60,000
$ 244,000
Total liabilities and stockholders’ equity
$ 244,000
ILLUSTRATION 7-15
FINANCIAL STATEMENTS – GENLYTE INC.
GENLYTE INC.
Income Statement
For the Year Ended December 31, 2001
Net sales
Cost of goods sales
Gross profit
Selling and administrative expenses
Income from operations
Other expenses and losses
Income before income taxes
Income tax expense
Net income
Earnings per share
$ 430,000
295,000
135,000
109,000
26,000
5,000
21,000
7,000
$ 14,000
$
0.35
ILLUSTRATION 7-16
CURRENT RATIO FORMULA AND COMPUTATION
 The current ratio is current assets
divided by current liabilities.
 With its 2.23:1 ratio, Genlyte’s
short-term debt-paying ability appears
to be very favorable compared to
reasonable performance standards.
Current
Assets
$156,000
÷
Current
Liabilities
=
÷
$70,000
=
Current
Ratio
2.23:1
ILLUSTRATION 7-17
WORKING CAPITAL FORMULA AND COMPUTATION
 The excess of current assets over current
liabilities is called working capital.
 For Genlyte Inc., working capital is
$86,000, as shown below.
Current
Assets
$156,000
-
Current
Liabilities
=
-
$70,000
=
Working
Capital
$86,000
ILLUSTRATION 7-18
PROFIT MARGIN FORMULA AND COMPUTATION
 The profit margin percentage measures the
percentage of each dollar of sales that results in
net income and is calculated by dividing net
income by net sales for the period.
 Genlyte Inc’s profit margin percentage is 3.3%
which seems too low compared to reasonable
performance standards.
Net
Income
$14,000
÷
Net
Sales
=
÷
$430,000
=
Profit
Margin
Percentage
3.3%
ILLUSTRATION 7-19
RETURN ON ASSETS FORMULA AND COMPUTATION
 Rate of return on assets is an overall measure of
profitability that is calculated by dividing net
income by total assets.
 Genlyte Inc’s rate of return on assets is relatively
low at 5.7% – compared to reasonable
performance standards – which suggests that
Genlyte may not be using its assets effectively.
Net
Income
$14,000
÷
Total
Assets
=
÷
$244,000
=
Return on
Assets
5.7%
ILLUSTRATION 7-20
RETURN ON COMMON STOCKHOLDERS’
EQUITY FORMULA AND COMPUTATION
 Return on common stockholders’ equity is a
measure of profitability that is calculated by
dividing net income by common stockholders’
equity.
 Genlyte Inc’s return on common stockholders’
equity is quite good at 23.3% compared to
reasonable performance standards.
Net
Income
$14,000
÷
Common
Equity
=
÷
$60,000
=
Return on
Common
Stockholders’
Equity
23.3%
ILLUSTRATION 7-21
DEBT TO TOTAL ASSETS
FORMULA AND COMPUTATION
 Debt to total assets ratio is a measure of
solvency that is calculated by dividing total
debt (liabilities) by total assets.
 Genlyte Inc’s debt to total assets ratio is 75.4%
which means that Genlyte’s creditors have
provided about 3/4 of its total assets.
Total
Debt
$184,000
÷
÷
Total
Assets
$244,000
=
=
Debt to Total
Assets Ratio
75.4%
ILLUSTRATION 7-22
FOREIGN SALES AND
TYPE OF PRODUCT
Firms that conduct their operations in more than one country through
subsidiaries, divisions, or branches in foreign countries are referred to as
multinational corporations. The table below illustrates the magnitude of foreign
sales and type of product sold by U.S. companies.
Company
Caterpillar
Coca-Cola
Eastman Kodak
E.I duPont de Nemours
Exxon
Ford Motor
General Motors
Hewlett-Packard
IBM
Philip Morris Cos.
Foreign Sales
as a % of Total
22.6
68.3
52.5
42.1
77.4
29.6
28.4
54.1
62.3
30.4
Product
Heavy machinery, engines, turbines
Beverages
Photographic equipment and supplies
Specialty chemicals
Petroleum, chemicals
Motor vehicles and parts
Motor vehicles and parts
Computers, electronics
Computers and related equipment
Tobacco, beverages, food products
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CHAPTER 7
ACCOUNTING PRINCIPLES