Accounting Theory

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 Disney Company.

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 entries. 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 users.

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 income.

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 discussed next.

Exhibit 27: The underlying assumptions or concepts

The major principles

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 be material.

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. 

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:

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 properly.

The second objective of financial reporting is to:

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:

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.

Qualitative characteristics

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 decision maker.

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 method bias.

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: http://www.fasb.org 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 statements.

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 these items

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.

Accounting changes

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.

Revenue recognition

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.

Merchandise inventories

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 adjusted accordingly.

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.

Other assets

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 than trading.

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) articulation. 
  
• 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 financial reporting. 
  
• 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 statements. 
  
• To a large extent, accounting theory determines the nature of those policies.
  

Demonstration problem

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 closed.

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:
  

• 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.