1. Objective 4
Accounting principles

2. How to Do Accounting: Principles
Accountants follow professional guidelines.
The rules that govern accounting are called GAAP
(generally accepted accounting principles).

3. Accounting principles
Accounting entity principle
 Business transactions of the accounting entity should
be separated from personal transactions.
Historical cost principle
 Assets recorded at the cost paid to have them.
Going concern principle
 The assumption that an entity will continue in
business.
Reporting period principle
 Artificial segment on the calendar used as the basis for
preparing the financial statements

4. Accounting principles
Matching principle
 Revenue for a period shall match with expenses over the same
period of time to calculate profit.
Monetary unit principle
 The measurement unit used is the currency of the country in
which the report is being prepared.
Conservatism principle
 Losses would be allowed for when expected to occur, while
gains would only be recognized if certain to happen.
Consistency principle
 Accounting methods used are applied consistently from one
reporting period to another.

5. Accounting principles
Accrual Principles
Entity should prepare the financial statements on the basis that
transactions are recorded in them, not as cash is paid or received, but
as revenue or expense are earned or incurred in the accounting period
to which they relate.

6. The Entity Concept Example
Assume that John decides to open up a gas
station and coffee shop.
The gas station made $250,000 in profits,
while the coffee shop lost $50,000.

7. The Entity Concept Example
How much money did John make?
At a first glance, we would assume that
John made $200,000.
However, by applying the entity concept we
realize that the gas station made $250,000
while the coffee shop lost $50,000.

8. Going concern
A retailer commence business on 1 Jan and buy
inventory of 20 washing machines, each costing
$100. During the year, he sells 17 machines at
$150/each. How should the remaining machines
be valued at 31 Dec. in the following
circumstances:
(b) He is forced to close down his business at the
end of the year and the remaining machines be
valued at 31 Dec. only $60 each in forced sale.
(c) He intends to continue his business into the next
year.

9. The Going Concern Concept
The entity will continue
to operate in the future.

10. Accounting Period
Managers adopt an
artificial period of time
to evaluate performance.

11. Interim Period Statements
Monthly
Quarterly
Semi-annually

12. The Matching Principle
What is the matching principle?
It is the basis for recording expenses.
Expenses are the costs of assets and the
increase in liabilities incurred in the earning
of revenues.
Expenses are recognized when the benefit
from the expense is received.

13. Matching principle
Emma buys 20 T-shirts in her first month
of trading (May) at a cost of $5 each.
(b) Emma sells all of them for $10 each.
Profit= Revenue – Cost
$100= 20*10-20*5
(b) Emma only sells 18 T-shirts
Profit= 18*10-18*5=$90

14. Matching Expenses with
Revenues Example
Parker Floor sells a wood floor for $15,000
on the last day of May.
The wood was purchased from the
manufacturer for $8,000 in March of the
same year.
The floor is installed in June.
When is income recognized?

15. Matching Expenses with
Revenues Example
May
Revenues $15,000
Cost of goods sold 8,000
Net income $ 7,000

16. The Monetary-Unit principle
The dollar’s purchasing
power is relatively
stable.

17. Accrual principles
Distinguish accrual
accounting from
cash-basis
accounting.

18. The Two Bases of Accounting:
Accrual-basis:
Cash-basis:
Transactions are
Transactions are
recorded
recorded when
when revenues are
cash is paid or
earned or expenses
cash is received.
are incurred.

19. Accrual Versus Cash Example
In January 2002, Prensa Insurance sells
a three-year health insurance policy to a
business client.
The contract specifies that the client had
to pay $150,000 in advance.
Yearly expenses amount to $20,000.
What is the income or loss?

20. Accrual Versus Cash Example
Accrual-Basis Accounting
(000 omitted) 2002 2003 2004
Revenues $50 $50 $50
Expenses 20 20 20
Net income (loss) $30 $30 $30

21. Accrual Versus Cash Example
Cash-Basis Accounting
(000 omitted) 2002 2003 2004
Cash inflows $150 $ 0 $ 0
Cash outflows 20 20 20
Net income (loss) $130 ($20) ($20)

22. Objective 5
Requirements for Accounting
information

23. Requirements for Accounting
information
y Relevance –all accounting information is
presented in general purpose financial
report (personal transaction are omitted)
y Reliability - information must be free of
error and bias
y Comparability - ability to compare
information of different companies because
they use the same accounting principles

24. Requirements for Accounting
information
y Materiality- all significant items must be
reported in accounting report.
y Understandability – Reports being
prepared in such s way that general users
are able to comprehend their meaning.

25. Characteristics of Useful Information