Chapter One

Development of Accounting Principles and Professional Practice

1.1 The Environment Of Accounting
The Business world is experiencing unprecedented changes, such as globalization, deregulation,
and computerization. Fair presentation is the essence of accounting theory and practice. With the
increasing size and complexity of the business enterprises and the increasing economic role of
business enterprises and government, the responsibility placed on accountants is greater today
than ever before. If accountants are to meet this challenge, they must have the logical and
consistent body of accounting theory to guide them.
Financial statements and reports prepared by the accountants are the principal means through
which financial information is communicated to those inside and outside the enterprise. They are
vital to the successful working of the society. These statements provide the firm’s history in
quantitative terms. Economists, investors, business executives, labor leaders, bankers, and
government agencies rely on these financial statements and reports as fair and meaningful
summaries of day-to-day business transaction.
Accounting communicates financial information about an economic entity to interested persons.
As economic entities continued to increase in size and complexity, the interested person’s
increased so greatly in number and diversity.
The financial statements are expected to present fairly, clearly, and completely the economic
facts of the existence and operations of the enterprise. In preparing the financial statements,
accountants are confronted with the potential dangers of bias, misinterpretation, inexactness and
ambiguity. In order to minimize these dangers, the accounting profession has attempted to
develop a set of standards that is generally accepted and universally practiced. Without
standards, each enterprise would have to develop its own standards and readers of financial
statements have to familiarize themselves with every company’s accounting and reporting
practice.
Organizations and laws affecting financial accounting
Certain professional organizations and laws have been externally influential in the development
of current accounting and reporting standards. Among the most important of these have been the
American Institute of Certified public Accountant (AICPA), the Financial Accounting Standards

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 Board (FASB), the American Accounting Association (AAA), and the Securities and Exchange
Commission (SEC).
1.2 Conceptual Frame Work For Financial Accounting And Reporting
One of the important tasks of FASB was the development of broad conceptual framework for financial
accounting and financial reporting.

Needs for conceptual framework:

 It enables the FASB to issue more useful and consistent pronouncements overtime.
 The profession should be able to more solve emerging practical problems in referring to
an existing framework.

Recognition and measurement concepts

Assumptions Constraints
Principles
Qualitative Characteristics Elements of Financial Statements

Objectives of Financial Statements

1.3 Objectives Of Financial Reporting

Financial reporting should provide information that:

1. Is useful to present and potential investors, creditors and other users in making rational
investment, credit, and other decisions.
2. Helps assess the amounts, timing, and uncertainty of prospective cash receipts.
3. Clearly portrays the economic resources of an enterprise, and claims to those resources.
1.4 Qualitative Characteristics Of Accounting Information
1. Primary qualities:

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 i. Relevance: To be relevant accounting information must be capable of making a difference
in decision. (Must be useful for decision making.)
 Predictive value: relevant information helps users predict the ultimate outcome of past,
present, and future events.
 Feedback value: relevant information help users confirm or correct prior expectations.
(Interim report is relevant because it provides a basis for forecasting annual earnings and
feedback on past performance).
 Timeliness: relevant information is available to decision makers before it loses its capacity
to influence their decision.
ii. Reliability: Accounting information is trustworthy to the extent that is verifiable, is a faithful
representation, and is reasonably free of errors and biases.
 Verifiability: It occurs when independent measures using the same methods, obtain similar
results.
 Representational faithfulness: It means the numbers and the description match what really
existed or happened.
 Neutrality: A company should not select information to favor one set of interested parties
over other.
2. Secondary qualities:
i. Comparability and consistency: consistent application of accounting principles for a
business enterprise from one accounting period to the next is needed in order that the
financial statements of successive periods will be comparable. If the financial statements
for the current accounting period show larger earnings than for the preceding period, the
user assume that operations have been more profitable. However, if a material change in
an accounting principle has occurred, the reported increase in earnings could have been
resulted solely by the accounting change, rather than by any improvement in the
underlying business activity.

1.5 Elements Of Financial Statements Of Business Enterprise

1. Assets: are probable future economic benefits obtained or controlled by a particular entity as
a result of past transactions or events.

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2. Liabilities: are probable future scarifies 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.
3. Equity: is the residual interest in the assets of an entity that remains after deducting its
liabilities.
4. Investment by owners: are increases in net assets of a particular enterprise resulting from
transfers to it from another entities of something value to obtain or increase ownership
interests (equity) in it.
5. Distribution to owners: are decreases in net assets of a particular enterprise resulting from
transfers of assets, rendering services, or incurring liabilities by the enterprise to owners.
6. Comprehensive income: is a change in equity (net assets) of an entity 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 investment by owners and
distribution to owners.
7. Revenues: are inflows or other enhancements of assets of an entity or settlement of its
liabilities (or a combination of both) during a period from delivering or producing, rendering
services, or other activities that constitute the entity’s ongoing major or central operations.
8. Expenses: are outflows or using up of assets or incurrence of liabilities (or a combination of
both) during a period from delivering or producing, rendering services, or other activities that
constitute the entity’s ongoing major or central operations.
9. 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
during a period except those that result from revenues or investments by owners.
10. 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
during a period except those that result from expenses or distributions to owners.

1.6 Generally Accepted Accounting Principles (GAAP)

 Business Entity principle: Regardless of the form of organization, the business affairs of
the entity are distinguished from those of its owners.

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  Going concern principle (continuity): Accountants assume that a business entity will
continue to exist indefinitely.
 Revenue realization principle: It indicates that assets such as inventories be carried at
cost until appreciation in value is realized through sale.
 Valuation principle: Monetary assets should be valued at their current value whereas;
productive assets should be valued at their historical cost.
 Matching principle: It states that after the revenue for an accounting period has been
determined, the costs associated with this revenue must be deducted from revenue to
measure the net income.
 Monetary principle: Accountants assume that money to be used a useful standard
measuring unit for reporting the effects business transactions. Money is used as the
common denominator throughout the accounting process.
 Disclosure principle: Financial statement must be complete in the sense of including all
information necessary to users of the statements.

1.7 Cash Flows and Income Measurement

Accountants assume that a business enterprise has continuous existence. Therefore, they record
the prospect of future cash inflows as an increase in assets and as revenue whenever they have
reliable evidence of the amount of the future cash receipts. Cash inflows often occur before an
enterprise has performed its part of a contract. In this case, an increase in assets is recorded, but a
liability is recognized instead of revenue. The liability indicates an obligation on the part of the
enterprise to perform in accordance with the contract. When performance is completed, the
revenue is recognized. Thus, cash inflows are closely related to revenue realization; however, the
assumptions underlying the timing of revenue realization do not always permit cash inflows and
revenue to be recorded in the same accounting period.

Similarly, cash out flows are closely related to expenses of a business enterprise; however, cash
outflows and expenses may not be recorded in the same accounting period. For example,
enterprises frequently acquire for cash in one period asset that will be productive over several
future periods, and assets that are productive only during the current period often are acquired in
exchange for a promise to pay cash in a future period.

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Income Measurement Approaches

1. Accrual Basis of Accounting

The accrual basis of accounting assumes revenue is recognized when realized and expenses are
recognized when incurred, without regard to the timing of cash receipt or payment. The focus of
the accrual basis of accounting is on the realization of revenue, the incurrence of costs, and the
matching of revenue realized with costs expired (expenses).

2. Cash Basis of Accounting

Under cash basis of accounting, revenue is recorded only when cash is received and expenses are
recorded only when cash is paid. The determination of income thus rests on the collection of
revenue and the payment of expenses. Use of the cash basis of accounting is not compatible
with the matching principle and consequently, financial statements prepared under the cash basis
of accounting do not present the financial position or operating results of an enterprise in
conformity with generally accepted accounting principles (GAAP).

3. Modified Cash Basis Accounting

Under the modified cash basis of accounting, which is mostly used for income tax purpose, the
entire cost of property having an economic life of more than one year may not be deduced in the
year of acquisition. It must be treated as an asset to be depreciated over its economic life.
Expenses such as rent or advertising paid in advance also are regarded as assets and are
deductible only in the year or years to which they apply. Expenses paid after the year in which
incurred are deductible only in the year paid. Revenue is reported in the year received.

However, in any business enterprise on which the purchase, production, or sale of merchandise is
a significant factor, these transactions must be reported on the accrual basis (in the period earned
or incurred). Thus for a merchandising enterprise the revenue from sale, the cost of goods sold,
and the gross profit on sales will be the same under the accrual basis of accounting as under the
modified cash basis of accounting.

Illustrative Example 1: Assume that a Contractor signs an agreement to construct a garage

for $22,000. In January, the contractor begins construction, incurs costs of $18,000 on credit, and

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by the end of January delivers a finished garage to the buyer. In February, the contractor collects
$22,000 cash from the customer. In March, the contractor pays the $18,000 due the creditors.
Required: prepare an income statement under cash basis and accrual basis of accounting for the
months.
Conversion from Cash Basis to Accrual Basis

Not infrequently, companies want to convert a cash basis or a modified cash basis set of financial
statements to the accrual basis for presentation to investors and creditors.
 Service Revenue Computation
To convert the amount of cash received from patients to service revenue on an accrual basis, we
must consider changes in accounts receivable and unearned service revenue during the year.
Accounts receivable at the beginning of the year represents revenues earned last year that are
collected this year. Ending accounts receivable indicates revenues earned this year that are not
yet collected. Therefore, to compute revenue on an accrual basis, we subtract beginning accounts
receivable and add ending accounts receivable.

Cash Receipts from Customers + Ending accounts receivable – Beginning Accounts

receivable = Revenue on an Accrual Basis

Similarly, beginning unearned service revenue represents cash received last year for revenues
earned this year. Ending unearned service revenue results from collections this year that will be
recognized as revenue next year. Therefore, to compute revenue on an accrual basis, we add
beginning unearned service revenue and subtract ending unearned service revenue.
Cash Receipts from Customers + Beginning unearned revenue – Ending unearned revenue
= Revenue on an Accrual Basis

 Operating Expense Computation

To convert cash paid for operating expenses during the year to operating expenses on an accrual
basis, we must consider changes in prepaid expenses and accrued liabilities.
First, we need to recognize as this year’s expenses the amount of beginning prepaid expenses.
(The cash payment for these occurred last year.) Therefore, to arrive at operating expense on an
accrual basis, we add the beginning prepaid expenses balance to cash paid for operating
expenses.

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Conversely, ending prepaid expenses result from cash payments made this year for expenses to
be reported next year. To convert these cash payments to operating expenses on an accrual basis,
we deduct ending prepaid expenses from cash paid for expenses.
Cash paid for operating Expenses + Beginning prepaid expenses – Ending prepaid
expenses = operating Expenses on an Accrual basis

Similarly, beginning accrued liabilities result from expenses recognized last year that require
cash payments this year. Ending accrued liabilities relate to expenses recognized this year that
have not been paid. To arrive at expense on an accrual basis, we deduct beginning accrued
liabilities and add ending accrued liabilities to cash paid for expenses.
Cash paid for operating Expenses + Ending accrued liabilities – Beginning accrued
liabilities = operating Expenses on an Accrual basis