|Course:||BUS103: Introduction to Financial Accounting|
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|Date:||Tuesday, October 4, 2022, 9:22 PM|
This chapter will introduce you to the fundamental theories and rules that guide the system of accounting. The key tenets of accounting are explained, including: double entry, substance over form, the matching principle, the revenue recognition principle, cost-benefit, materiality, and conservatism, as is their impact on the overall application of GAAP (Generally Accepted Accounting Principles). The underlying intent behind creating financial reports is for the information in the reports to be reliable enough to support sound business decision-making. By the time you finish this chapter, you should have a better understanding of the overall structure of accounting rules and guiding principles.
Table of contents
- Learning objectives
- A career as an accounting professor
- Traditional accounting theory
- Underlying assumptions or concepts
- Other basic concepts
- The measurement process in accounting
- The major principles
- Modifying conventions (or constraints)
- The financial accounting standards board's conceptual framework project
- Objectives of financial reporting
- Qualitative characteristics
- The basic elements of financial statements
- Recognition and measurement in financial statements
- Summary of significant accounting policies
- Significant accounting policies
- Understanding the learning objectives
After studying this chapter, you should be able to:
- Identify and discuss the underlying assumptions or concepts of accounting.
- Identify and discuss the major principles of accounting.
- Identify and discuss the modifying conventions (or constraints) of accounting.
- Describe the conceptual framework project of the Financial Accounting Standards Board.
- Discuss the nature and content of a company's summary of significant accounting policies in
its annual report.
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A career as an accounting professor
Do you enjoy college life? Do you enjoy teaching others? If so, you might want to consider a career
as a college professor. Although a position as a college professor may pay less than some other career
alternatives, the intangible benefits are beyond measure. A college professor can make a real difference
in the lives of hundreds, even thousands, of students over a career. Students come to college with great
potential, but are in need of some additional training and guidance. The work of a college professor is a
valuable investment in our nation's most valuable resource - people.
College faculty generally teach fewer hours each week than elementary and secondary school
teachers. This is because most college faculty have at least two additional important responsibilities:
research and service. The research component represents far more than just summarizing what others
have already learned. It represents arriving at new knowledge by discovering things that previously
were unknown. For instance, accounting research has demonstrated the ways in which accounting
numbers such as earnings and stockholder's equity are related to stock prices. This illustrates the
importance of accounting numbers and has resulted in a large stream of discovery called Capital
Markets research. Besides teaching and research, most faculty have significant service responsibilities
as well. Accounting faculty are involved in service to the university, the accounting profession, and to
the general public. Many college faculty dedicate 10-20 hours or more each week to the service
component of their jobs.
The demand for college professors varies greatly by discipline. In fields such as English, Fine Arts,
Philosophy, and Psychology there is a large supply of candidates with advanced degrees and, thus, the
competition for positions as college professors in these areas is intense. However, in applied fields such
as accounting and engineering, there is a shortage of candidates with advanced degrees. The
opportunities for professors in these applied fields are excellent, and the chance to make a real
difference in the lives of others is exciting.
Chapter 1 briefly introduced the body of theory underlying accounting procedures. In this chapter, we discuss accounting theory in greater depth. Now that you have learned some accounting procedures, you are better able to relate these theoretical concepts to accounting practice. Accounting theory is "a set of basic concepts and assumptions and related principles that explain and guide the accountant's actions in identifying, measuring, and communicating economic information".
To some people, the word theory implies something abstract and out of reach. Understanding the
theory behind the accounting process, however, helps one make decisions in diverse accounting
situations. Accounting theory provides a logical framework for accounting practice.
The first part of the chapter describes underlying accounting assumptions or concepts, the
measurement process, the major principles, and modifying conventions or constraints. Accounting
theory has developed over the years and is contained in authoritative accounting literature and
textbooks. The next part of the chapter describes the development of the Financial Accounting
Standards Board's (FASB) conceptual framework for accounting. This framework builds on accounting
theory developed over time and serves as a basis for formulating accounting standards in the future.
Presenting the traditional body of theory first and the conceptual framework second gives you a sense
of the historical development of accounting theory. Despite some overlap between the two parts of the
chapter, remember that FASB's conceptual framework builds on traditional theory rather than replaces
it. The final part of the chapter discusses significant accounting policies contained in annual reports
issued by companies and illustrates them with an actual example from an annual report of the Walt
Traditional accounting theory
Traditional accounting theory consists of underlying assumptions, rules of measurement, major
principles, and modifying conventions (or constraints). The following sections describe these aspects of
accounting theory that greatly influence accounting practice.
Underlying assumptions or concepts
The major underlying assumptions or concepts of accounting are (1) business entity, (2) going
concern (continuity), (3) money measurement, (4) stable dollar, and (5) periodicity. This section
discusses the effects of these assumptions on the accounting process.
Data gathered in an accounting system must relate to a specific business unit or entity. The
business entity concept assumes that each business has an existence separate from its owners,
creditors, employees, customers, interested parties, and other businesses. For each business (such as a
horse stable or a fitness center), the business, not the business owner, is the accounting entity.
Therefore, financial statements are identified as belonging to a particular business entity. The content
of these financial statements reports only on the activities, resources, and obligations of that entity.
A business entity may be made up of several different legal entities. For instance, a large business
(such as General Motors Corporation) may consist of several separate corporations, each of which is a
separate legal entity. For reporting purposes, however, the corporations may be considered as one
business entity because they have a common ownership. Chapter 14 illustrates this concept.
When accountants record business transactions for an entity, they assume it is a going concern. The
going-concern (continuity) assumption states that an entity will continue to operate indefinitely
unless strong evidence exists that the entity will terminate. The termination of an entity occurs when a
company ceases business operations and sells its assets. The process of termination is called
liquidation. If liquidation appears likely, the going-concern assumption is no longer valid.
Accountants often cite the going-concern assumption to justify using historical costs rather than
market values in measuring assets. Market values are of less significance to an entity using its assets
rather than selling them. On the other hand, if an entity is liquidating, it should use liquidation values
to report assets.
The economic activity of a business is normally recorded and reported in money terms. Money
measurement is the use of a monetary unit such as the dollar instead of physical or other units of
measurement. Using a particular monetary unit provides accountants with a common unit of
measurement to report economic activity. Without a monetary unit, it would be impossible to add such
items as buildings, equipment, and inventory on a balance sheet.
Financial statements identify their unit of measure (such as the dollar in the United States) so the
statement user can make valid comparisons of amounts. For example, it would be difficult to compare
relative asset amounts or profitability of a company reporting in US dollars with a company reporting
in Japanese yen.
In the United States, accountants make another assumption regarding money measurement - the
stable dollar assumption. Under the stable dollar assumption, the dollar is accepted as a
reasonably stable unit of measurement. Thus, accountants make no adjustments for the changing value
of the dollar in the primary financial statements.
Using the stable dollar assumption creates a difficulty in depreciation accounting. Assume, for
example, that a company acquired a building in 1975 and computed the 30-year straight-line
depreciation on the building without adjusting for any changes in the value of the dollar. Thus, the
depreciation deducted in 2008 is the same as the depreciation deducted in 1975. The company makes
no adjustments for the difference between the values of the 1975 dollar and the 2008 dollar. Both
dollars are treated as equal monetary units of measurement despite substantial price inflation over the
30-year period. Accountants and business executives have expressed concern over this inflation
problem, especially during periods of high inflation.
According to the periodicity (time periods) assumption, accountants divide an entity's life
into months or years to report its economic activities. Then, accountants attempt to prepare accurate
reports on the entity's activities for these periods. Although these time-period reports provide useful
and timely financial information for investors and creditors, they may be inaccurate for some of these
time periods because accountants must estimate depreciation expense and certain other adjusting
Accounting reports cover relatively short periods. These time periods are usually of equal length so
that statement users can make valid comparisons of a company's performance from period to period.
The length of the accounting period must be stated in the financial statements. For instance, so far, the
income statements in this text were for either one month or one year. Companies that publish their
financial statements, such as publicly held corporations, generally prepare monthly statements for
internal management and publish financial statements quarterly and annually for external statement
Accrual basis and periodicity Chapter 3 demonstrated that financial statements more
accurately reflect the financial status and operations of a company when prepared under the accrual
basis rather than the cash basis of accounting. Under the cash basis, we record revenues when cash is
received and expenses when cash is paid. Under the accrual basis, however, we record revenues when
services are rendered or products are sold and expenses when incurred.
The periodicity assumption requires preparing adjusting entries under the accrual basis. Without
the periodicity assumption, a business would have only one time period running from its inception to
its termination. Then, the concepts of cash basis and accrual basis accounting would be irrelevant
because all revenues and all expenses would be recorded in that one time period and would not have to
be assigned to artificially short periods of one year or less.
Approximation and judgment because of periodicity To provide periodic financial
information, accountants must often estimate expected uncollectible accounts (see Chapter 9) and the
useful lives of depreciable assets. Uncertainty about future events prevents precise measurement and
makes estimates necessary in accounting. Fortunately, these estimates are often reasonably accurate.
Other basic concepts
Other basic accounting concepts that affect accounting for entities are (1) general-purpose financial
statements, (2) substance over form, (3) consistency, (4) double entry, and (5) articulation. We discuss
these basic accounting concepts next.
Accountants prepare general-purpose financial statements at regular intervals to meet many
of the information needs of external parties and top-level internal managers. In contrast, accountants
can gather special-purpose financial information for a specific decision, usually on a one-time basis.
For example, management may need specific information to decide whether to purchase a new
computer system. Since special-purpose financial information must be specific, this information is best
obtained from the detailed accounting records rather than from the financial statements.
In some business transactions, the economic substance of the transaction conflicts with its legal
form. For example, a contract that is legally a lease may, in fact, be equivalent to a purchase. A
company may have a three-year contract to lease (rent) an automobile at a stated monthly rental fee. At
the end of the lease period, the company receives title to the auto after paying a nominal sum (say, USD
1). The economic substance of this transaction is a purchase rather than a lease of the auto. Thus,
under the substance-over-form concept, the auto is an asset on the balance sheet and is depreciated
instead of showing rent expense on the income statement. Accountants record a transaction's
economic substance rather than its legal form.
Consistency generally requires that a company use the same accounting principles and reporting
practices through time. This concept prohibits indiscriminate switching of accounting principles or
methods, such as changing inventory methods every year. However, consistency does not prohibit a
change in accounting principles if the information needs of financial statement users are better served
by the change. When a company makes a change in accounting principles, it must make the following
disclosures in the financial statements: (1) nature of the change; (2) reasons for the change; (3) effect of
the change on current net income, if significant; and (4) cumulative effect of the change on past
Chapter 2 introduced the basic accounting concept of the double-entry method of recording
transactions. Under the double-entry approach, every transaction has a two-sided effect on each party
engaging in the transaction. Thus, to record a transaction, each party debits at least one account and
credits at least one account. The total debits equal the total credits in each journal entry.
When learning how to prepare work sheets in Chapter 4, you learned that financial statements are
fundamentally related and articulate (interact) with each other. For example, we carry the amount of
net income from the income statement to the statement of retained earnings. Then we carry the ending
balance on the statement of retained earnings to the balance sheet to bring total assets and total
equities into balance.
In Exhibit 27 we summarize the underlying assumptions or concepts. The next section discusses the
measurement process used in accounting.
The measurement process in accounting
Earlier, we defined accounting as "the process of identifying, measuring, and communicating
economic information to permit informed judgments and decisions by the users of the information". 2
In this section, we focus on the measurement process of accounting.
Accountants measure a business entity's assets, liabilities, and stockholders' equity and any changes
that occur in them. By assigning the effects of these changes to particular time periods (periodicity),
they can find the net income or net loss of the accounting entity for those periods.
Accountants measure the various assets of a business in different ways. They measure cash at its
specified amount. Chapter 9 explains how they measure claims to cash, such as accounts receivable, at
their expected cash inflows, taking into consideration possible uncollectibles. They measure
inventories, prepaid expenses, plant assets, and intangibles at their historical costs (actual amounts
paid). After the acquisition date, they carry some items, such as inventory, at the lower-of-cost-or-
market value. After the acquisition date, they carry plant assets and intangibles at original cost less
accumulated depreciation or amortization. They measure liabilities at the amount of cash that will be
paid or the value of services that will be performed to satisfy the liabilities.
Accountants can easily measure some changes in assets and liabilities, such as the acquisition of an
asset on credit and the payment of a liability. Other changes in assets and liabilities, such as those
recorded in adjusting entries, are more difficult to measure because they often involve estimates
and/or calculations. The accountant must determine when a change has taken place and the amount of
the change. These decisions involve matching revenues and expenses and are guided by the principles
|Assumption or Concept
||Each business has an existence separate from its owners, creditors, employees, customers, other interested parties, and
||Defines the scope of the business such as a horse stable or physical fitness center. Identifies which transactions should be recorded on the company's books.|
|Going concern (continuity)
||An entity will continue to operate indefinitely
unless strong evidence exists that the entity
||Allows a company to continue carrying plant assets at their historical costs in spite of a change in their market values.|
||Each business uses a monetary unit of measurement, such as the dollar, instead of physical or other units of measurement.
||Provides accountants with a common unit of measure to report economic activity. This concept permits us to add and subtract items on the financial statements.|
||The dollar is accepted as a reasonably
stable unit of measure.
||Permits us to make no adjustments in the financial statements for the changing value of the dollar. This assumption works fairly well in the United States because of our relatively low rate of inflation.|
|Periodicity (time periods)
||An entity's life can be subdivided into months or years to report its economic activities.||Permits us to prepare financial statements that cover periods shorter than the entire life of a activities. Thus, we know how well a business is performing before it terminates its operations. The need for adjusting entries arises because of this concept and the use of accrual accounting.|
||One set of financial statements serves the needs of all users.
||Allows companies to prepare only one set of financial statements instead of a separate set for each potential type of user of those statements. The financial statements should be free of bias so they do not favor the interests of any one type of user.|
|Substance over form
||Accountants should record the economic substance of a transaction rather than its legal form.
||Encourages the accountant to record the true nature of a transaction rather than its apparent nature. This approach is the accounting equivalent of "tell it like it is". An apparent lease transaction that has all the characteristics of a purchase should be recorded as a purchase.|
||Generally requires that a company use the same accounting principles and reporting
practices every accounting period.
||Prevents a company from changing accounting methods whenever it likes to present a better picture or to manipulate income. The inventory and depreciation chapters (Chapters 7 and 10) both mention the importance of this concept.|
||Every transaction has a two-sided effect on each company or party engaging in the transaction.
||Uses a system of checks and balances to help identify whether or not errors have been made in recording transactions. When the debits do not equal the credits, this inequality immediately signals us to stop and find the error.|
||Financial statements are fundamentally related and articulate (interact) with each other.||Changes in account balances during an accounting period are reflected in financial statements that are related to one another. For instance, earning revenue increases net income on the income statement, retained earnings on the statement of retained earnings, and assets and retained earnings on the balance sheet. The statement of retained earnings ties the income statement and balance sheet together.|
Exhibit 27: The underlying assumptions or concepts
The major principles
Generally accepted accounting principles (GAAP) set forth standards or methods for presenting
financial accounting information. A standardized presentation format enables users to compare the
financial information of different companies more easily. Generally accepted accounting principles
have been either developed through accounting practice or established by authoritative organizations.
Organizations that have contributed to the development of the principles are the American Institute of
Certified Public Accountants (AICPA), the Financial Accounting Standards Board (FASB), the
Securities and Exchange Commission (SEC), the American Accounting Association (AAA), the
Financial Executives Institute (FEI), and the Institute of Management Accounting (IMA). This section
explains the following major principles:
- Exchange-price (or cost) principle
- Revenue recognition principle
- Matching principle
- Gain and loss recognition principle
- Full disclosure principle
Whenever resources are transferred between two parties, such as buying merchandise on account,
the accountant must follow the exchange-price (or cost) principle in presenting that information. The
exchange-price (or cost) principle requires an accountant to record transfers of resources at
prices agreed on by the parties to the exchange at the time of exchange. This principle sets forth (1)
what goes into the accounting system - transaction data; (2) when it is recorded - at the time of
exchange; and (3) the amounts - exchange prices - at which assets, liabilities, stockholders' equity,
revenues, and expenses are recorded.
As applied to most assets, this principle is often called the cost principle. It dictates that
purchased or self-constructed assets are initially recorded at historical cost. Historical cost is the
amount paid, or the fair market value of the liability incurred or other resources surrendered, to
acquire an asset and place it in a condition and position for its intended use. For instance, when the
cost of a plant asset (such as a machine) is recorded, its cost includes the net purchase price plus any
costs of reconditioning, testing, transporting, and placing the asset in the location for its intended use.
Accountants prefer the term exchange-price principle to cost principle because it seems inappropriate
to refer to liabilities, stockholders' equity, and such assets as cash and accounts receivable as being
measured in terms of cost.
More recently, the FASB in SFAS 157 has moved definitively towards fair market value accounting,
or "mark-to-market", which records the value of an asset or liability at its current market value (also
known as a "fair value") rather than its book value.
SFAS 157 defines "fair value" as "the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date".
It is also defined as "an exit price from the perspective of a market participant that holds the asset or owes the liability", whether or not the business plans to hold the asset/liability for investment, or sell it.
"The fair value accounting standard SFAS 157 applies to financial assets of all publicly-traded
companies in the US as of 2007 Nov. 15. It also applies to non-financial assets and liabilities that are
recognized, or disclosed, at fair value on a recurring basis. Beginning in 2009, the standard will apply
to other non-financial assets. SFAS 157 applies to items for which other accounting pronouncements
require or permit fair value measurements except share-based payment transactions, such as stock
"SFAS 157 provides a hierarchy of three levels of input data for determining the fair value of an
asset or liability. This hierarchy ranks the quality and reliability of information used to determine fair
values, with level 1 inputs being the most reliable and level 3 inputs being the least reliable.
- Level 1 is quoted prices for identical items in active, liquid and visible markets such as stock
- Level 2 is observable information for similar items in active or inactive markets, such as two
similarly situated buildings in a downtown real estate market.
- Level 3 are unobservable inputs to be used in situations where markets do not exist or are
illiquid such as the present credit crisis. At this point fair market valuation becomes highly
Fair value accounting has been a contentious topic since it was introduced, For example, "banks and
investment banks have had to reduce the value of the mortgages and mortgage-backed securities to
reflect current prices". Those prices declined severely with the collapse of credit markets as mortgage
defaults escalated in the financial crisis of 2008-2009. Despite debate over the proper implementation
of fair market value accounting, International Financial Reporting Standards utilize this approach
much more than the Generally Accepted Accounting Principles of the United States.
To learn more about fair market value accounting, visit the AICPA site,
(http://www.aicpa.org/MediaCenter/fva_faq.htm), the source used for the explanation of this topic.
An accounting perspective: Business insight
In some European countries, the financial statements contain secret reserves. These secret
reserves arise from a company not reporting all of its profits when it has a very good year.
The justification is that the stockholders vote on the amount of dividends they receive each
year; if all profits were reported, the stockholders might vote to pay the entire amount out as
dividends. By holding back some profits, not only are the creditors more protected but the
company is also more solvent and has more resources to invest in productive assets.
Revenue is not difficult to define or measure; it is the inflow of assets from the sale of goods and
services to customers, measured by the cash expected to be received from customers. However, the
crucial question for the accountant is when to record a revenue. Under the revenue recognition
principle, revenues should be earned and realized before they are recognized (recorded).
Earning of revenue All economic activities undertaken by a company to create revenues are part
of the earning process. Many activities may have preceded the actual receipt of cash from a customer,
including (1) placing advertisements, (2) calling on the customer several times, (3) submitting samples,
(4) acquiring or manufacturing goods, and (5) selling and delivering goods. For these activities, the
company incurs costs. Although revenue was actually being earned by these activities, accountants do
not recognize revenue until the time of sale because of the requirement that revenue be substantially
earned before it is recognized (recorded). This requirement is the earning principle.
Realization of revenue Under the realization principle, the accountant does not recognize
(record) revenue until the seller acquires the right to receive payment from the buyer. The seller
acquires this right from the buyer at the time of sale for merchandise transactions or when services
have been performed in service transactions. Legally, a sale of merchandise occurs when title to the
goods passes to the buyer. The time at which title passes normally depends on the shipping terms -
FOB shipping point or FOB destination (as we discuss in Chapter 6). As a practical matter, accountants
generally record revenue when goods are delivered.
The advantages of recognizing revenue at the time of sale are (1) the actual transaction - delivery of
goods - is an observable event; (2) revenue is easily measured; (3) risk of loss due to price decline or
destruction of the goods has passed to the buyer; (4) revenue has been earned, or substantially so; and
(5) because the revenue has been earned, expenses and net income can be determined. As discussed
later, the disadvantage of recognizing revenue at the time of sale is that the revenue might not be
recorded in the period during which most of the activity creating it occurred.
Exceptions to the realization principle The following examples are instances when practical considerations may cause accountants to vary the point of revenue recognition from the time of sale. These examples illustrate the effect that the business environment has on the development of accounting principles and standards.
Cash collection as point of revenue recognition Some small companies record revenues and
expenses at the time of cash collection and payment, which may not occur at the time of sale. This
procedure is the cash basis of accounting. The cash basis is acceptable primarily in service enterprises
that do not have substantial credit transactions or inventories, such as business entities of doctors or
Installment basis of revenue recognition When collecting the selling price of goods sold in
monthly or annual installments and considerable doubt exists as to collectibility, the company may use
the installment basis of accounting. Companies make these sales in spite of the doubtful collectibility of
the account because their margin of profit is high and the goods can be repossessed if the payments are
not received. Under the installment basis, the percentage of total gross margin (selling price of a
good minus its cost) recognized in a period is equal to the percentage of total cash from a sale that is
received in that period. Thus, the gross margin recognized in a period is equal to the cash received
times the gross margin percentage (gross margin divided by selling price). The formula to recognize
gross profit on cash collections made on installment sales of a certain year is:
Cash collections x Gross margin percentage=Gross margin recognized
To be more precise, we expand the descriptions in the formula as follows:
Cash collections this year resulting
from installment sales made in a
certain year * Gross margin percentage
for the year of sale
= Gross margin recognized this
year on cash collections this
year from installment sales
made in a certain year
To illustrate, assume a company sold a stereo set. The facts of the sale are:
|Date of sale||Selling price||Cost||Gross margin (Selling price – Cost)||Gross margin percentage (Gross margin/Selling price)|
|2010 Oct. 1||USD 500||USD 300||(500-300) – 200||(200/500) = 40 per cent|
The buyer makes 10 equal monthly installment payments of USD 50 to pay for the set (10 X USD 50
= USD 500). If the company receives three monthly payments in 2010, the total amount of cash
received in 2010 is USD 150 (3 X USD 50). The gross margin to recognize in 2010 is:
2010 cash collections from
2010 installment sales * Gross margin percentage
on 2010 installment sales
= 2010 gross margin
recognized on 2010 cash
collections from 2010
USD 150 * 40 per cent = USD 60
The company collects the other installments when due so it receives a total of USD 350 in 2011 from
2010 installment sales. The gross margin to recognize in 2011 on these cash collections is as follows:
2011 cash collections from 2010
installment sales * Gross margin percentage on 2010
= 2011 gross margin recognized on
2011 cash collections from 2010
USD 350 * 40 per cent = USD 140
In summary, the total receipts and gross margin recognized in the two years are as follows:
|Year||Total Amount of Cash Recognized||Gross Margin Recognized|
|2010|| $150 30%
..... 350 70%
| $60 30%
|2011||$500 100%||$200 100%|
Because the installment basis delays some revenue recognition beyond the time of sale, it is acceptable for accounting purposes only when considerable doubt exists as to collectibility of the installments.
Revenue recognition on long-term construction projects Companies recognize revenue
from a long-term construction project under two different methods: (1) the completed-contract method
or (2) the percentage-of-completion method. The completed-contract method does not recognize
any revenue until the project is completed. In that period, they recognize all revenue even though the
contract may have required three years to complete. Thus, the completed-contract method recognizes
revenues at the time of sale, as is true for most sales transactions. Companies carry costs incurred on
the project forward in an inventory account (Construction in Process) and charge them to expense in
the period in which the revenue is recognized.
Some accountants argue that waiting so long to recognize any revenue is unreasonable. They believe
that because revenue-producing activities have been performed during each year of construction,
revenue should be recognized in each year of construction even if estimates are needed. The
percentage-of-completion method recognizes revenue based on the estimated stage of completion
of a long-term project. To measure the stage of completion, firms compare actual costs incurred in a
period with the total estimated costs to be incurred on the project.
To illustrate, assume that a company has a contract to build a dam for USD 44 million. The estimated construction cost is USD 40 million. You calculate the estimated gross margin as follows:
|Sales price of dam||Estimated costs of construct dam||Estimated gross margin (sales price – estimated costs)|
|USD 44 million||USD 40 million||(44 million – 40 million) – 4 million|
The firm recognizes the USD 4 million gross margin in the financial statements by recording the
assigned revenue for the year and then deducting actual costs incurred that year. The formula to
recognize revenue is:
Suppose that by the end of the first year (2010), the company had incurred actual construction costs of USD 30 million. These costs are 75 per cent of the total estimated construction costs (USD 30 million/USD 40 million = 75 per cent). Under the percentage-of-completion method, the firm would use the 75 per cent figure to assign revenue to the first year. In 2011, it incurs another USD 6 million of construction costs. In 2012, it incurs the final USD 4 million of construction costs. The amount of revenue to assign to each year is as follows:
|Year||Ratio of Actual Construction Costs to Total Estimated Construction Costs||×||Agreed Price = of Dam =||Amount of Revenue to Recognize (Assign)|
|2010||($30 million + $40 million = 75%) 75%||×||$44 million =||$33 million|
|2011||($6 million + $40 million = 15%) 15%||×||$44 million =||$6.6 million|
|2012||($4 million + $40 million = 10%) 10%||×||$44 million =|| $4.4 million
The amount of gross margin to recognize in each year is as follows:
- Construction Costs
||Recognized = Gross|
|2010||$33.0 million||- $30.0 million||= $3.0 million|
|2011||6.6||- 6.0||= 0.6|
|2012||4.4||- 4.0||= 0.4
|$44.0 million||$40.0 million||$4.0 million|
|Number of Companies|
|Percentage of completion||78||82||80||71|
|Units of delivery||32||26||21||19|
Exhibit 28: Methods of accounting for long-term contracts
This company would deduct other costs incurred in the accounting period, such as general and
administrative expenses, from gross margin to determine net income. For instance, assuming general
and administrative expenses were USD 100,000 in 2010, net income would be (USD 3,000,000 - USD
100,000) = USD 2,900,000.
Expense recognition is closely related to, and sometimes discussed as part of, the revenue
recognition principle. The matching principle states that expenses should be recognized (recorded)
as they are incurred to produce revenues. An expense is the outflow or using up of assets in the
generation of revenue. Firms voluntarily incur expense to produce revenue. For instance, a television
set delivered by a dealer to a customer in exchange for cash is an asset consumed to produce revenue;
its cost becomes an expense. Similarly, the cost of services such as labor are voluntarily incurred to
The measurement of expense Accountants measure most assets used in operating a business
by their historical costs. Therefore, they measure a depreciation expense resulting from the
consumption of those assets by the historical costs of those assets. They measure other expenses, such
as wages that are paid for currently, at their current costs.
The timing of expense recognition The matching principle implies that a relationship exists
between expenses and revenues. For certain expenses, such as costs of acquiring or producing the
products sold, you can easily see this relationship. However, when a direct relationship cannot be seen,
we charge the costs of assets with limited lives to expense in the periods benefited on a systematic and
rational allocation basis. Depreciation of plant assets is an example.
Product costs are costs incurred in the acquisition or manufacture of goods. As you will see in the
next chapter, included as product costs for purchased goods are invoice, freight, and insurance-in-
transit costs. For manufacturing companies, product costs include all costs of materials, labor, and
factory operations necessary to produce the goods. Product costs attach to the goods purchased or
produced and remain in inventory accounts as long as the goods are on hand. We charge product costs
to expense when the goods are sold. The result is a precise matching of cost of goods sold expense to its
Period costs are costs not traceable to specific products and expensed in the period incurred.
Selling and administrative costs are period costs.
The gain and loss recognition principle states that we record gains only when realized, but
losses when they first become evident. Thus, we recognize losses at an earlier point than gains. This
principle is related to the conservatism concept.
Gains typically result from the sale of long-term assets for more than their book value. Firms
should not recognize gains until they are realized through sale or exchange. Recognizing potential
gains before they are actually realized is not allowed.
Losses consume assets, as do expenses. However, unlike expenses, they do not produce revenues.
Losses are usually involuntary, such as the loss suffered from destruction by fire on an uninsured
building. A loss on the sale of a building may be voluntary when management decides to sell the
building even though incurring a loss.
The full disclosure principle states that information important enough to influence the
decisions of an informed user of the financial statements should be disclosed. Depending on its nature,
companies should disclose this information either in the financial statements, in notes to the financial
statements, or in supplemental statements. In judging whether or not to disclose information, it is
better to err on the side of too much disclosure rather than too little. Many lawsuits against CPAs and
their clients have resulted from inadequate or misleading disclosure of the underlying facts.
We summarize the major principles and describe the importance of each in Exhibit 29.
An accounting perspective: Business insight
The accounting model involves reporting revenues earned and expenses incurred by
the company. Some have argued that social benefits and social costs created by the
company should also be reported. Suppose, for instance, that a company is dumping
toxic waste into a river and this action causes cancer among the citizens downstream.
Should this cost be reported when preparing financial statements showing the
performance of the company? What do you think?
Modifying conventions (or constraints)
In certain instances, companies do not strictly apply accounting principles because of modifying
conventions (or constraints). Modifying conventions are customs emerging from accounting
practice that alter the results obtained from a strict application of accounting principles. Three
modifying conventions are cost-benefit, materiality, and conservatism.
Cost-benefit The cost-benefit consideration involves deciding whether the benefits of including
optional information in financial statements exceed the costs of providing the information. Users tend
to think information is cost free since they incur none of the costs of providing the information.
Preparers realize that providing information is costly. The benefits of using information should exceed
the costs of providing it. The measurement of benefits is inexact, which makes application of this
modifying convention difficult in practice.
Materiality Materiality is a modifying convention that allows accountants to deal with immaterial
(unimportant) items in an expedient but theoretically incorrect manner. The fundamental question
accountants must ask in judging the materiality of an item is whether a knowledgeable user's decisions
would be different if the information were presented in the theoretically correct manner. If not, the
item is immaterial and may be reported in a theoretically incorrect but expedient manner. For
instance, because inexpensive items such as calculators often do not make a difference in a statement
user's decision to invest in the company, they are immaterial (unimportant) and may be expensed
when purchased. However, because expensive items such as mainframe computers usually do make a
difference in such a decision, they are material (important) and should be recorded as assets and
depreciated. Accountants should record all material items in a theoretically correct manner. They may
record immaterial items in a theoretically incorrect manner simply because it is more convenient and
less expensive to do so. For example, they may debit the cost of a wastebasket to an expense account
rather than an asset account even though the wastebasket has an expected useful life of 30 years. It
simply is not worth the cost of recording depreciation expense on such a small item over its life.
The FASB defines materiality as "the magnitude of an omission or misstatement of accounting
information that, in the light of surrounding circumstances, makes it probable that the judgment of a
reasonable person relying on the information would have been changed or influenced by the omission
or misstatement". The term magnitude in this definition suggests that the materiality of an item may
be assessed by looking at its relative size. A USD 10,000 error in an expense in a company with
earnings of USD 30,000 is material. The same error in a company earning USD 30,000,000 may not
Materiality involves more than the relative dollar amounts. Often the nature of the item makes it
material. For example, it may be quite significant to know that a company is paying bribes or making
illegal political contributions, even if the dollar amounts of such items are relatively small.
Conservatism Conservatism means being cautious or prudent and making sure that assets and
net income are not overstated. Such overstatements can mislead potential investors in the company
and creditors making loans to the company. We apply conservatism when the lower-of-cost-or-market
rule is used for inventory (see Chapter 7). Accountants must realize a fine line exists between
conservative and incorrect accounting.
See Exhibit 30 for a summary of the modifying conventions and their importance. The next section of this chapter discusses the conceptual framework project of the Financial Accounting Standards Board. The FASB designed the conceptual framework project to resolve some disagreements about the proper theoretical foundation for accounting. We present only the portions of the project relevant to this text.
||Requires transfers of resources to be
recorded at prices
to the exchange at the time of exchange.
||Tells the accountant to record a transfer of resources at an objectively determinable amount at the time of exchange. Also, self-constructed assets are recorded at their actual cost rather than at some estimate of what they would have cost if they had been purchased.|
||Revenues should be earned and realized
before they are recognized (recorded).
||Informs accountant that revenues generally should be recognized when services are performed or goods are sold. Exceptions are made for items such as installment sales and long-term construction projects.|
||Expenses should be recognized (recorded) as they are incurred to produce revenues.||Indicates that expenses are to be recorded as soon as they are incurred rather than waiting until some future time.|
|Gain and loss
||Gains may be recorded only when realized,
but losses should be recorded when they
first become evident.
||Tells the accountant to be conservative when recognizing gains and losses. Gains can only be recognized when they have been realized through sale or exchange. Losses should be recognized as soon as they become evident. Thus, potential losses can be recorded, but only gains that have actually been realized can be recorded.|
||Information important enough to influence the decisions of an informed user of the financial statements should be disclosed. disclose.||Requires the accountant to disclose everything that is important. A good rule to follow is - if in doubt, disclosed. disclose. Another good rule is - if you are not consistent, disclose all the facts and the effect on income.|
|Cost-benefit||Optional information should be included financial statements only if the benefits providing it exceed its costs.||Lets the accountant know that information that is not required should be made available only if its benefits exceed its costs. An example may be companies going to the expense of providing information on the effects of inflation when the inflation rate is low and/or users do not seem to benefit significantly from the information.|
|Materiality||Only items that would affect a knowledgeable user's decision are material (important) and must be reported in a theoretically correct way.||Allow accountants to treat immaterial (relatively small dollar amount) information in a theoretically incorrect but expedient manner. For instance, a wastebasket can be expensed rather than capitalized and depreciated even though it may last for 30 years.|
|Conservatism||Transactions should be recorded so that assets and net income are not overstated.||Warns accountants that assets and net income are not to be overstated. "Anticipate (and record) all possible losses and do not anticipate (or record) any possible gains" is common advice under this constraint. Also, conservative application of the matching principle involves making sure that adjustments for expenses for such items as uncollectible accounts, warranties, and depreciation are adequate.|
Exhibit 30: Modifying conventions
The financial accounting standards board's conceptual framework project
Experts have debated the exact nature of the basic concepts and related principles composing
accounting theory for years. The debate continues today despite numerous references to generally accepted accounting principles (GAAP). To date, all attempts to present a concise statement of GAAP
have received only limited acceptance.
Due to this limited success, many accountants suggest that the starting point in reaching a concise
statement of GAAP is to seek agreement on the objectives of financial accounting and reporting. The
belief is that if a person (1) carefully studies the environment, (2) knows what objectives are sought, (3)
can identify certain qualitative traits of accounting information, and (4) can define the basic elements
of financial statements, that person can discover the principles and standards leading to the stated
objectives. The FASB completed the first three goals by publishing "Objectives of Financial Reporting
by Business Enterprises" and "Qualitative Characteristics of Accounting Information". Addressing the
fourth goal are concepts statements entitled "Elements of Financial Statements of Business
Enterprises" and "Elements of Financial Statements".
Objectives of financial reporting
Financial reporting objectives are the broad overriding goals sought by accountants engaging
in financial reporting. According to the FASB, the first objective of financial reporting is to:
provide information that is useful to present and potential investors and creditors and
other users in making rational investment, credit, and similar decisions. The
information should be comprehensible to those who have a reasonable understanding of
business and economic activities and are willing to study the information with
Interpreted broadly, the term other users includes employees, security analysts, brokers, and
lawyers. Financial reporting should provide information to all who are willing to learn to use it
The second objective of financial reporting is to:
provide information to help present and potential investors and creditors and other users in assessing the amounts, timing, and uncertainty of prospective cash receipts from dividends [owner withdrawals] or interest and the proceeds from the sale, redemption, or maturity of securities or loans. Since investors' and creditors' cash flows are related to enterprise cash flows, financial reporting should provide information to help investors, creditors, and others assess the amounts, timing, and uncertainty of prospective net cash inflows to the related enterprise.
This objective ties the cash flows of investors (owners) and creditors to the cash flows of the
enterprise, a tie-in that appears entirely logical. Enterprise cash inflows are the source of cash for
dividends, interest, and the redemption of maturing debt.
Third, financial reporting should:
provide information about the economic resources of an enterprise, the claims to those resources (obligations of the enterprise to transfer resources to other entities and owners' equity), and the effects of transactions, events, and circumstances that change its resources and claims to those resources.
We can draw some conclusions from these three objectives and from a study of the environment in
which financial reporting is carried out. For example, financial reporting should:
- Provide information about an enterprise's past performance because such information is a basis
for predicting future enterprise performance.
- Focus on earnings and its components, despite the emphasis in the objectives on cash flows.
(Earnings computed under the accrual basis generally provide a better indicator of ability to
generate favorable cash flows than do statements prepared under the cash basis).
On the other hand, financial reporting does not seek to:
- Measure the value of an enterprise but to provide information useful in determining its value.
- Evaluate management's performance, predict earnings, assess risk, or estimate earning power
but to provide information to persons who wish to make these evaluations.
These conclusions are some of those reached in Statement of Financial Accounting Concepts No. 1.
As the Board stated, these statements "are intended to establish the objectives and concepts that the
Financial Accounting Standards Board will use in developing standards of financial accounting and
reporting". How successful the Board will be in the approach adopted remains to be seen.
Accounting information should possess qualitative characteristics to be useful in decision making. This criterion is difficult to apply. The usefulness of accounting information in a given instance depends not only on information characteristics but also on the capabilities of the decision makers and their professional advisers. Accountants cannot specify who the decision makers are, their characteristics, the decisions to be made, or the methods chosen to make the decisions. Therefore, they direct their attention to the characteristics of accounting information. Note the FASB's graphic summarization of the qualities accountants consider in Exhibit 31.
To have relevance, information must be pertinent to or affect a decision. The information must
make a difference to someone who does not already have it. Relevant information makes a difference in
a decision either by affecting users' predictions of outcomes of past, present, or future events or by
confirming or correcting expectations. Note that information need not be a prediction to be useful in
developing, confirming, or altering expectations. Expectations are commonly based on the present or
past. For example, any attempt to predict future earnings of a company would quite likely start with a
review of present and past earnings. Although information that merely confirms prior expectations
may be less useful, it is still relevant because it reduces uncertainty.
Critics have alleged that certain types of accounting information lack relevance. For example, some
argue that a cost of USD 1 million paid for a tract of land 40 years ago and reported in the current
balance sheet at that amount is irrelevant (except for possible tax implications) to users for decision
making today. Such criticism has encouraged research into the types of information relevant to users.
Some suggest using a different valuation basis, such as current cost, in reporting such assets.
Predictive value and feedback value Since actions taken now can affect only future events,
information is obviously relevant when it possesses predictive value, or improves users' abilities to
predict outcomes of events. Information that reveals the relative success of users in predicting
outcomes possesses feedback value. Feedback reports on past activities and can make a difference in decision making by (1) reducing uncertainty in a situation, (2) refuting or confirming prior
expectations, and (3) providing a basis for further predictions. For example, a report on the first
quarter's earnings of a company reduces the uncertainty surrounding the amount of such earnings,
confirms or refutes the predicted amount of such earnings, and provides a possible basis on which to
predict earnings for the full year. Remember that although accounting information may possess
predictive value, it does not consist of predictions. Making predictions is a function performed by the
Timeliness Timeliness requires accountants to provide accounting information at a time when it
may be considered in reaching a decision. Utility of information decreases with age. To know what the
net income for 2010 was in early 2011 is much more useful than receiving this information a year later.
If information is to be of any value in decision making, it must be available before the decision is made.
If not, the information is of little value. In determining what constitutes timely information,
accountants consider the other qualitative characteristics and the cost of gathering information. For
example, a timely estimate for uncollectible accounts may be more valuable than a later, verified actual
amount. Timeliness alone cannot make information relevant, but potentially relevant information can
be rendered irrelevant by a lack of timeliness.
Exhibit 31: A hierarchy of accounting qualities
In addition to being relevant, information must be reliable to be useful. Information has reliability
when it faithfully depicts for users what it purports to represent. Thus, accounting information is
reliable if users can depend on it to reflect the underlying economic activities of the organization. The
reliability of information depends on its representational faithfulness, verifiability, and neutrality. The
information must also be complete and free of bias.
Representational faithfulness To gain insight into this quality, consider a map. When it shows
roads and bridges where roads and bridges actually exist, a map possesses representational
faithfulness. A correspondence exists between what is on the map and what is present physically.
Similarly, representational faithfulness exists when accounting statements on economic activity
correspond to the actual underlying activity. Where there is no correspondence, the cause may be (1)
bias or (2) lack of completeness.
- Effects of bias. Accounting measurements contain bias if they are consistently too high or too low. Accountants create bias in accounting measurements by choosing the wrong measurement method or introducing bias either deliberately or through lack of skill.
- Completeness. To be free from bias, information must be sufficiently complete to ensure that
it validly represents underlying events and conditions. Completeness means disclosing all
significant information in a way that aids understanding and does not mislead. Firms can reduce
the relevance of information by omitting information that would make a difference to users.
Currently, full disclosure requires presentation of a balance sheet, an income statement, a
statement of cash flows, and necessary notes to the financial statements and supporting schedules.
Also required in annual reports of corporations are statements of changes in stockholders' equity
which contain information included in a statement of retained earnings. Such statements must be
complete, with items properly classified and segregated (such as reporting sales revenue
separately from other revenues). Required disclosures may be made in (1) the body of the financial
statements, (2) the notes to such statements, (3) special communications, and/or (4) the
president's letter or other management reports in the annual report.
Another aspect of completeness is fully disclosing all changes in accounting principles and their
effects. Disclosure should include unusual activities (loans to officers), changes in expectations (losses
on inventory), depreciation expense for the period, long-term obligations entered into that are not
recorded by the accountant (a 20-year lease on a building), new arrangements with certain groups
(pension and profit-sharing plans for employees), and significant events that occur after the date of the
statements (loss of a major customer). Firms must also disclose accounting policies (major principles
and their manner of application) followed in preparing the financial statements. Because of its
emphasis on disclosure, we often call this aspect of reliability the full disclosure principle.
Verifiability Financial information has verifiability when independent measurers can
substantially duplicate it by using the same measurement methods. Verifiability eliminates measurer
bias. The requirement that financial information be based on objective evidence arises from the
demonstrated needs of users for reliable, unbiased financial information. Unbiased information is
especially necessary when parties with opposing interests (credit seekers and credit grantors) rely on
the same information. If the information is verifiable, this enhances the reliability of information.
Financial information is never completely free of subjective opinion and judgment; it always
possesses varying degrees of verifiability. Canceled checks and invoices support some measurements.
Accountants can never verify other measurements, such as periodic depreciation charges, because of
their very nature. Thus, financial information in many instances is verifiable only in that it represents a
consensus of what other accountants would report if they followed the same procedures.
Neutrality Neutrality means that the accounting information should be free of measurement
method bias. The primary concern should be relevance and reliability of the information that results
from application of the principle, not the effect that the principle may have on a particular interest.
Non-neutral accounting information favors one set of interested parties over others. For example, a
particular form of measurement might favor stockholders over creditors, or vice versa. "To be neutral,
accounting information must report economic activity as faithfully as possible, without coloring the
image it communicates for the purpose of influencing behavior in some particular direction".
Accounting standards are not like tax regulations that deliberately foster or restrain certain types of
activity. Verifiability seeks to eliminate measurer bias; neutrality seeks to eliminate measurement
When comparability exists, reported differences and similarities in financial information are real
and not the result of differing accounting treatments. Comparable information reveals relative
strengths and weaknesses in a single company through time and between two or more companies at
the same time.
Consistency requires that a company use the same accounting principles and reporting practices
through time. Consistency leads to comparability of financial information for a single company
through time. Comparability between companies is more difficult because they may account for the
same activities in different ways. For example, Company B may use one method of depreciation, while
Company C accounts for an identical asset in similar circumstances using another method. A high
degree of inter-company comparability in accounting information does not exist unless accountants
are required to account for the same activities in the same manner across companies and through time.
As we show in Exhibit 31, accountants must consider one pervasive constraint and one threshold for
recognition in providing useful information. First, the benefits secured from the information must be
greater than the costs of providing that information. Second, only material items need be disclosed and
accounted for strictly in accordance with generally accepted accounting principles (GAAP). We
discussed cost-benefit and materiality earlier in the chapter.
An accounting perspective: Use of technology
You may want to visit the home page of the Financial Accounting Standards Board at:
You can check out the latest developments at the FASB to see how the rules of
accounting might be changing. You can investigate facts about the FASB, press
releases, exposure drafts, publications, emerging issues, board actions, forthcoming
meetings, and many other topics.
The basic elements of financial statements
Thus far we have discussed objectives of financial reporting and qualitative characteristics of accounting information. A third important task in developing a conceptual framework for any discipline is identifying and defining its basic elements. The FASB identified and defined the basic elements of financial statements in Concepts Statement No. 3. Later, Concepts Statement No. 6 revised some of the definitions. We defined most of the terms earlier in this text in a less technical way; the more technical definitions follow. (These items are not repeated in this chapter's Key terms).
Assets are probable future economic benefits obtained or controlled by a particular entity as a
result of past transactions or events.
Liabilities are probable future sacrifices of economic benefits arising from present obligations of a
particular entity to transfer assets or provide services to other entities in the future as a result of past
transactions or events.
Equity or net assets is the residual interest in the assets of an entity that remains after deducting
its liabilities. In a business enterprise, the equity is the ownership interest. In a not-for-profit
organization, which has no ownership interest in the same sense as a business enterprise, net assets is
divided into three classes based on the presence or absence of donor-imposed restrictions -
permanently restricted, temporarily restricted, and unrestricted net assets.
Comprehensive income is the change in equity of a business enterprise during a period from
transactions and other events and circumstances from non-owner sources. It includes all changes in
equity during a period except those resulting from investments by owners and distributions to owners.
Revenues are inflows or other enhancements of assets of any entity or settlements of its liabilities
(or a combination of both) from delivering or producing goods, rendering services, or other activities
that constitute the entity's ongoing major or central operations.
Expenses are outflows or other using up of assets or incurrences of liabilities (or a combination of
both) from delivering or producing goods, rendering services, or carrying out other activities that
constitute the entity's ongoing major or central operations.
Gains are increases in equity (net assets) from peripheral or incidental transactions of an entity
and from all other transactions and other events and circumstances affecting the entity except those
that result from revenues or investments by owners.
Losses are decreases in equity (net assets) from peripheral or incidental transactions of an entity
and from all other transactions and other events and circumstances affecting the entity except those
that result from expenses or distributions to owners.
Investments by owners are increases in equity of a particular business enterprise resulting from
transfers to it from other entities of something valuable to obtain or increase ownership interests (or
equity) in it. Assets are most commonly received as investments by owners, but that which is received
may also include services or satisfaction or conversion of liabilities of the enterprise.
Distributions to owners are decreases in equity of a particular business enterprise resulting from transferring assets, rendering services, or incurring liabilities by the enterprise to owners. Distributions to owners decrease ownership interest (or equity) in an enterprise.
An accounting perspective: Business insight
Accountants record expenditures on physical resources such as land, buildings, and
equipment that benefit future periods as assets. However, they expense expenditures
on human resources for hiring and training that benefit future periods. Also, when a
computer is dropped and destroyed, accountants record a loss. However, when the
president of the company dies, they record no loss. Should the accounting model be
changed regarding the accounting for human resources?
Recognition and measurement in financial statements
In December 1984, the FASB issued Statement of Financial Accounting Concepts No. 5,
"Recognition and Measurement in Financial Statements of Business Enterprises", describing
recognition criteria and providing guidance for the timing and nature of information included in
financial statements. The recognition criteria established in the Statement are fairly consistent with
those used in current practice. The Statement indicates, however, that when information more useful
than currently reported information is available at a reasonable cost, it should be included in financial
Summary of significant accounting policies
As part of their annual reports, companies include summaries of significant accounting policies.
These policies assist users in interpreting the financial statements. To a large extent, accounting theory
determines the nature of these policies. Companies must follow generally accepted accounting
principles in preparing their financial statements.
The accounting policies of The Walt Disney Company, one of the world's leading entertainment companies, as contained in a recent annual report follow. After each, the chapter of this text where we discuss that particular policy is in parentheses. While a few of the items have already been covered, the remainder offer a preview of the concepts explained in later chapters.
An ethical perspective: Maplehurst company
Maplehurst Company manufactures large spinning machines for the textile industry.
The company had purchased USD 100,000 of small hand tools to use in its business.
The company's accountant recorded the tools in an asset account and was going to
write them off over 20 years. Management wanted to write these tools off as an expense
of this year because revenues this year had been abnormally high and were expected to
be lower in the future. Management's goal was to smooth out income rather than
showing sharp increases and decreases. When told by the accountant that USD
100,000 was a material item that must be accounted for in a theoretically correct
manner, management decided to consider the tools as consisting of 10 groups, each
having a cost of USD 10,000. Since amounts under USD 20,000 are considered
immaterial for this company, all of the tools could then be charged to expense this year.
The accountant is concerned about this treatment. She doubts that she could
successfully defend management's position if the auditors challenge the expensing of
Significant accounting policies
Principles of consolidation
The consolidated financial statements of the Company include the accounts of The Walt Disney
Company and its subsidiaries after elimination of inter-company accounts and transactions.
Investments in affiliated companies are accounted for using the equity method.
The Company changed its method of accounting for pre-opening costs. These changes
had no cash impact.
The pro forma amounts presented in the consolidated statement of income reflect the effect of
retroactive application of expensing pre-opening costs.
Revenues from the theatrical distribution of motion pictures are recognized when motion pictures are exhibited. Television licensing revenues are recorded when the program material is available for telecasting by the licensee and when certain other conditions are met. Revenues from video sales are recognized on the date that video units are made widely available for sale by retailers. Revenues from participants and sponsors at the theme parks are generally recorded over the period of the applicable agreements commencing with the opening of the related attraction.
Cash, cash equivalents and investments
Cash and cash equivalents consist of cash on hand and marketable securities with original
maturities of three months or less.
SFAS 115 requires that certain investments in debt and equity securities be classified into one of
three categories. Debt securities that the Company has the positive intent and ability to hold to
maturity are classified as "held-to-maturity" and reported at amortized cost. Debt securities not
classified as held-to-maturity and marketable equity securities are classified as either "trading" or
"available-for-sale", and are recorded at fair value with unrealized gains and losses included in
earnings or stockholders' equity, respectively.
Carrying amounts of merchandise, materials and supplies inventories are generally determined on a
moving average cost basis and are stated at the lower of cost or market.
Film and television costs
Film and television production and participation costs are expensed based on the ratio of the
current period's gross revenues to estimated total gross revenues from all sources on an individual
production basis. Estimates of total gross revenues are reviewed periodically and amortization is
Television broadcast rights are amortized principally on an accelerated basis over the estimated
useful lives of the programs.
Theme parks, resorts and other property
Theme parks, resorts and other property are carried at cost. Depreciation is computed on the straight-line method based upon estimated useful lives ranging from three to fifty years.
Rights to the name, likeness and portrait of Walt Disney, goodwill and other intangible assets are
amortized over periods ranging from two to forty years.
Risk management contracts
In the normal course of business, the Company employs a variety of off-balance-sheet financial
instruments to manage its exposure to fluctuations in interest and foreign currency exchange rates,
including interest rate and cross-currency swap agreements, forward and option contracts, and interest
rate exchange-traded futures. The company designates interest rate and cross-currency swaps as
hedges of investments and debt, and accrues the differential to be paid or received under the
agreements as interest rates change over the lives of the contracts. Differences paid or received on
swap agreements are recognized as adjustments to interest income or expense over the life of the
swaps, thereby adjusting the effective interest rate on the underlying investment or obligation. Gains
and losses on the termination of swap agreements, prior to the original maturity, are deferred and
amortized to interest income or expense over the original term of the swaps. Gains and losses arising
from interest rate futures, forwards and option contracts, and foreign currency forward and option
contracts are recognized in income or expense as offsets of gains and losses resulting from the
underlying hedged transactions.
Cash flows from interest rate and foreign exchange risk management activities are classified in the
same category as the cash flows from the related investment, borrowing or foreign exchange activity.
The Company classifies its derivative financial instruments as held or issued for purposes other
Earnings per share
Earnings per share amounts are based upon the weighted average number of common and common
equivalent shares outstanding during the year. Common equivalent shares are excluded from the
computation in periods in which they have an antidilutive effect.
As you proceed through the remaining chapters, you can see the accounting theories introduced in
this chapter being applied. In Chapter 6, for instance, we discuss why sales revenue is recognized and
recorded only after goods have been delivered to the customer. So far, we have used service companies
to illustrate accounting techniques. Chapter 6 introduces merchandising operations. Merchandising
companies, such as clothing stores, buy goods in their finished form and sell them to customers.
Understanding the learning objectives
- The major underlying assumptions or concepts of accounting are (1) business entity, (2) going
concern (continuity), (3) money measurement, (4) stable dollar, (5) periodicity, and (6) accrual
basis and periodicity.
- Other basic accounting concepts that affect the accounting for entities are (1) general-purpose
financial statements, (2) substance over form, (3) consistency, (4) double entry, and (5)
- The major principles include exchange-price (or cost), revenue recognition, matching, gain and
loss recognition, and full disclosure. Major exceptions to the realization principle include cash
collection as point of revenue recognition, installment basis of revenue recognition, and the
percentage-of-completion method of recognizing revenue on long-term construction projects.
- Modifying conventions include cost-benefit, materiality, and conservatism.
- The FASB has defined the objectives of financial reporting, qualitative characteristics of
accounting information, and elements of financial statements.
- Financial reporting objectives are the broad overriding goals sought by accountants engaging in
- Qualitative characteristics are those that accounting information should possess to be useful in
decision making. The two primary qualitative characteristics are relevance and reliability. Another
qualitative characteristic is comparability.
- Pervasive constraints include cost-benefit analysis and materiality. The FASB has identified and defined the basic elements of financial statements.
- The FASB has also described revenue recognition criteria and provided guidance as to the timing
and nature of information to be included in financial statements.
- The summary of significant accounting policies aid users in interpreting the financial
- To a large extent, accounting theory determines the nature of those policies.
For each of the following transactions or circumstances and the entries made, state which, if any, of
the assumptions, concepts, principles, or modifying conventions of accounting have been violated. For
each violation, give the entry to correct the improper accounting assuming the books have not been
During the year, Dorsey Company did the following:
- Had its buildings appraised. They were found to have a market value of USD 410,000, although
their book value was only USD 380,000. The accountant debited the Buildings and Accumulated
Depreciation - Buildings accounts for USD 15,000 each and credited Paid-in Capital - From
Appreciation. No separate mention was made of this action in the financial statements.
- Purchased new electric pencil sharpeners for its offices at a total cost of USD 60. These pencil
sharpeners were recorded as assets and are being depreciated over five years.
Solution to demonstration problem
- The cost principle and the modifying convention of conservatism may have been violated. Such
write-ups simply are not looked on with favor in accounting. To correct the situation, the entry
made needs to be reversed:
Accumulated Depreciation - Building 15,000
- Theoretically, no violations occurred, but the cost of compiling insignificant information could
be considered a violation of acceptable accounting practice. As a practical matter, the USD 60
could have been expensed on materiality grounds.