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.
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?