1 01 GAAP powerpoint 3

1.01 Generally Accepted Accounting
Principles – Accounting Constraints,
Concepts, Assumptions, and
Principles
GAAP PowerPoint #3


Hierarchy of Qualitative Information
Cost/Benefit

Understandability
Understandability

in PPT #2

Discussed

Decision
Decision Usefulness
Usefulness

Relevance
Relevance

Reliability
Reliability
Verifiability
Verifiability

Timeliness
Timeliness

Neutrality
Neutrality

Feedback
Feedback Value
Value

Representational
Representational Faithfulness
Faithfulness

Predictive
Predictive Value
Value

Comparability
Comparability and
and Consistency
Consistency

Materiality
www.fasb.org


Constraints
 A constraint is a limit, regulation, or confinement within prescribed bounds.
 This term refers to the accounting guidelines that border the Hierarchy of
Qualitative Information
 They consist of:

Cost Effectiveness
Materiality
Conservatism

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Cost Effectiveness Constraint
 Also called Cost Benefit Constraint
 The cost of providing accounting information should not exceed the benefit of
the information it is reporting.

 Example: Your checkbook register and bank statement differs by $0.10.
Rather than waste time to find the $0.10, the accountant should record the
amount as miscellaneous expense or income.


Materiality Constraint
 Material means big enough to make a difference in the user’s decision-making
process.
 States that the requirements of any accounting principle may be ignored when
there is no effect on the decisions of the user of financial information.
 Example: A company purchases a Trashcan for $10. Per GAAP, this amount
should be capitalized as an asset and depreciated. Because the amount is
immaterial, the $10 can be recorded as an expense.


Conservatism Constraint

 Accountants use their judgment to record transactions that require estimation.
 Conservatism helps the accountant choose between 2 equally likely
alternatives.
 Requires the accountant to record the transaction using the less optimistic
choice.
 Example: There is the potential for a customer to sue the company.
Although, the customer may choose not to sue, the accountant will disclose
this potential lawsuit to investors.


Concepts
 Concepts are the ground rules of accounting that should be followed when
preparing financial statements.

 These are:

◦ Recognition Concept
◦ Measurement Concept


Recognition Concept
 States that an item should be recognized (recorded) in the financial statements
when:

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It can be defined by GAAP assumptions and principles

It can be measured
It is relevant to decision-making by users
It is reliable


Measurement Concept
 States that every transaction is measured by the stated unit of measurement,
such as the dollar

 The stated procedure of valuing assets, liabilities, equity, revenue, and
expenses as defined by GAAP


Assumptions
 Assumptions are agreed upon rules of accounting, and are basic,
understood beliefs.

 There are Four Basic Assumptions of Accounting:

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Economic Business Entity
Going Concern
Monetary Unit
Time Period

Economic Business Entity Assumption
 All of the business transactions should be separate from the business owner’s
personal transactions

 There should be no co-mingling of personal funds with business funds.


Going Concern Assumption
 Financial statements are prepared under the assumption that the company will
remain in business indefinitely unless there is sufficient evidence otherwise.

 If there is evidence that a company may possibly have a going concern issue,
this must be disclosed in the financial statements.


Monetary Unit Assumption
 Assumes a stable currency is going to be the unit of record.
 FASB accepts the nominal value of the US Dollar as the monetary unit of record
unadjusted for inflation.


Time Period Assumption
 The entity’s activities are separated into periods of time such as months,
quarters or years.

 Transactions must be accounted for within the time period they occur
regardless of when cash is exchanged.


Principles of Accounting

 Principles are accounting rules used to prepare, present, and report
financial statements.

 Principles dictate how events should be recorded and reported.


Cost Principle
 Assets are recorded at historical cost, not fair market value.
 For example, if a company purchases a building for $500,000 it should be
recorded as such, and should remain on the books for that amount until
disposed of.

 If the building appreciates to $700,000 in the next few years, no adjustment
should be made.


Full Disclosure Principle
 All information pertaining to the operations and financial position of the entity
must be reported within the period of time in question.

 Circumstances and events that make a difference to financial statement users
should be disclosed.


Revenue Recognition Principle
 Revenue is earned and recognized upon product delivery or service
completion, without regard to when cash is actually received.

 Also called accrual basis accounting
 Example: A customer purchases inventory from a company on credit. Even

though no cash has yet been received, the sale is recorded.


Matching Principle
 The costs of doing business are recorded in the same period as the revenue
they help generate, regardless of when the money is actually paid.

 Also called accrual basis accounting
 Example: A company orders merchandise on credit and has 30 days in which
to pay. This purchase is recorded immediately, even though no cash has been
paid.


Questions for Understanding/Discussion
 Explain what is meant by “The benefits of accounting information must exceed
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the costs.”
What is meant by the term materiality in financial reporting?
What is meant by the term conservatism in financial reporting?
Explain the Going Concern assumption.
Explain the Time Period assumption.
Explain the accounting principles that guide accounting practice.