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Chapter 1. accounting overview4

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Chapter 1. accounting overview4

  1. 1. Objective 4Accounting principles
  2. 2. How to Do Accounting: Principles Accountants follow professional guidelines.The rules that govern accounting are called GAAP (generally accepted accounting principles).
  3. 3. Accounting principles Accounting entity principle  Business transactions of the accounting entity should be separated from personal transactions. Historical cost principle  Assets recorded at the cost paid to have them. Going concern principle  The assumption that an entity will continue in business. Reporting period principle  Artificial segment on the calendar used as the basis for preparing the financial statements
  4. 4. Accounting principles Matching principle  Revenue for a period shall match with expenses over the same period of time to calculate profit. Monetary unit principle  The measurement unit used is the currency of the country in which the report is being prepared. Conservatism principle  Losses would be allowed for when expected to occur, while gains would only be recognized if certain to happen. Consistency principle  Accounting methods used are applied consistently from one reporting period to another.
  5. 5. Accounting principles Accrual Principles Entity should prepare the financial statements on the basis that transactions are recorded in them, not as cash is paid or received, but as revenue or expense are earned or incurred in the accounting period to which they relate.
  6. 6. The Entity Concept Example Assume that John decides to open up a gas station and coffee shop. The gas station made $250,000 in profits, while the coffee shop lost $50,000.
  7. 7. The Entity Concept Example How much money did John make? At a first glance, we would assume that John made $200,000. However, by applying the entity concept we realize that the gas station made $250,000 while the coffee shop lost $50,000.
  8. 8. Going concern A retailer commence business on 1 Jan and buy inventory of 20 washing machines, each costing $100. During the year, he sells 17 machines at $150/each. How should the remaining machines be valued at 31 Dec. in the following circumstances:(b) He is forced to close down his business at the end of the year and the remaining machines be valued at 31 Dec. only $60 each in forced sale.(c) He intends to continue his business into the next year.
  9. 9. The Going Concern Concept The entity will continue to operate in the future.
  10. 10. Accounting Period Managers adopt an artificial period of time to evaluate performance.
  11. 11. Interim Period Statements Monthly Quarterly Semi-annually
  12. 12. The Matching Principle What is the matching principle? It is the basis for recording expenses. Expenses are the costs of assets and the increase in liabilities incurred in the earning of revenues. Expenses are recognized when the benefit from the expense is received.
  13. 13. Matching principle Emma buys 20 T-shirts in her first month of trading (May) at a cost of $5 each.(b) Emma sells all of them for $10 each.Profit= Revenue – Cost$100= 20*10-20*5(b) Emma only sells 18 T-shirtsProfit= 18*10-18*5=$90
  14. 14. Matching Expenses withRevenues Example Parker Floor sells a wood floor for $15,000 on the last day of May. The wood was purchased from the manufacturer for $8,000 in March of the same year. The floor is installed in June. When is income recognized?
  15. 15. Matching Expenses withRevenues Example May Revenues $15,000 Cost of goods sold 8,000 Net income $ 7,000
  16. 16. The Monetary-Unit principle The dollar’s purchasing power is relatively stable.
  17. 17. Accrual principles Distinguish accrual accounting from cash-basis accounting.
  18. 18. The Two Bases of Accounting: Accrual-basis: Cash-basis: Transactions are Transactions are recorded recorded when when revenues are cash is paid or earned or expenses cash is received. are incurred.
  19. 19. Accrual Versus Cash Example In January 2002, Prensa Insurance sells a three-year health insurance policy to a business client. The contract specifies that the client had to pay $150,000 in advance. Yearly expenses amount to $20,000. What is the income or loss?
  20. 20. Accrual Versus Cash Example Accrual-Basis Accounting(000 omitted) 2002 2003 2004Revenues $50 $50 $50 Expenses 20 20 20 Net income (loss) $30 $30 $30
  21. 21. Accrual Versus Cash Example Cash-Basis Accounting(000 omitted) 2002 2003 2004Cash inflows $150 $ 0 $ 0 Cash outflows 20 20 20 Net income (loss) $130 ($20) ($20)
  22. 22. Objective 5Requirements for Accounting information
  23. 23. Requirements for Accountinginformationy Relevance –all accounting information is presented in general purpose financial report (personal transaction are omitted)y Reliability - information must be free of error and biasy Comparability - ability to compare information of different companies because they use the same accounting principles
  24. 24. Requirements for Accountinginformation y Materiality- all significant items must be reported in accounting report. y Understandability – Reports being prepared in such s way that general users are able to comprehend their meaning.
  25. 25. Characteristics of Useful Information

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