Lecture#2:

Financial Accounting Conceptual

Framework

Prepared & Delivered by: Babar Akhtar

Lecture Outline
Types of Business Activity
Accounting Systems
Methods and Approaches
GAAP/GAAS
Key terms

Types of Business
1) On the basis of ownership:
Sole Proprietorship A business in which there is only one
owner who has an unlimited liability and carries on business on
his own risk.
Partnership A business in which there are 2 to 19 owners
having unlimited liability, who carry on business together.
Joint Stock Company A business which has an unlimited
number of owners, having limited liability equal to their
respective investment. They contribute their capital and start
a business on a large scale. The minimum number of owners is
seven, however there is no maximum limit of owners.

Types of Business
2) On the basis of activities.
Manufacturing Business A business which produces
goods and sells them to its customers.
Trading/Merchandizing Business A business which
purchases ready-made goods and sells them to its
customers.
Servicing Business A business which does not sell any
tangible goods, but provide services and earns income.

Accounting Systems
The cash basis of accounting recognizes sales
revenue inflows when cash is received and
operating expense outflows to generate sales
revenue when cash is paid. Simply put, the cash
basis recognizes sales revenue and operating
expenses only when cash changes hands.
The accrual basis of accounting recognizes
inflows of sales revenue when earned and operating
expense outflows to produce sales revenues when
incurred; it does not matter when cash is received
or paid.

Accounting Methods and

Approaches
Conservative accounting methods: These accounting
methods delay the recording of revenue and accelerate
the recording of expenses. Profit is reported slowly.
Liberal accounting methods: These accounting
methods accelerate the recording of revenue and delay
the recording of expenses. Profit is reported quickly.
Summing up, conservative accounting methods are
pessimistic, and liberal methods are optimistic. The choice
of accounting methods also affects the values reported for
assets, liabilities, and owners equities in the balance
sheet.

GAAP Assumptions, Principles

and Constraints
Assumptions provide
accounting process.

foundation

for

the

On the basis of the fundamental assumptions of

accounting,
the
accounting
profession
has
developed principles that dictate how economic
events should be recorded and reported.
Constraints permit a company to modify
generally accepted accounting principles
without reducing the usefulness of the reported
information.

Who Develops
GAAP/GAAS???
The Financial Accounting Standards Board (FASB) is
a private, not-for-profit organization whose primary
purpose is to develop generally accepted
accounting principles (GAAP) within the United
States.
The Securities and Exchange Commission (SEC) is a
federal agency which holds primary responsibility
for enforcing the federal securities laws and
regulating the securities industry, the nation's
stock and options exchanges, and to facilitate FASB
in development of GAAP.

GAAP Vs GAAS
GAAP (Generally Accepted Accounting Principles)is a set of
rules meant for companies to help and assist in preparing
financial statements that are followed in all parts of the
world. These are accounting principles, standards and
procedures that are adhered by companies while preparing
financial statements.
GAAS (Generally Accepted Auditing Standards)is a set of
guidelines for auditors that are meant to help them in the
audit of companies in such a way that these audits are
accurate, are consistent, and are verifiable. These guidelines
ensure that auditors do not miss on any material information.

GAAP
Assumptions/Convention
s
The monetary unit assumption states that only transaction
data that can be expressed in terms of money be included in
the accounting records. For example, the value of a company
president is not reported in a companys financial records
because it cannot be expressed easily in dollars. An important
corollary to the monetary unit assumption is the assumption that
the unit of measure remains relatively constant over time.

The economic entity assumption states that the

activities of the entity be kept separate and distinct
from the activities of the owners and of all other economic
entities. For example, it is assumed that the activities of
Coke can be distinguished from those of other companies
such as PEPSI, Gourmet, etc

Contd

The time period assumption states that the economic

life of a business can be divided into artificial time
periods. Thus, it is assumed that the activities of business
enterprises such as PSO, Lever Brothers, Carlson
Hospitality, or any enterprise can be subdivided into
months, quarters, or a year for meaningful financial
reporting purposes.

The going concern assumption assumes that the

enterprise will continue in operation long enough to
carry out its existing objectives. In spite of numerous
business failures, companies have a fairly high continuance
rate. It has proved useful to adopt a going concern
assumption for accounting purposes.

Contd

The
Revenue
Recognition/Realization
principle
dictates that revenue should be recognized in the
accounting period in which it is earned.

The Matching principle dictates that expenses be

matched with revenues in the period in which efforts
are made to generate revenues. Expenses are not
recognized when cash is paid, or when the work is
performed, or when the product is produced. Rather, they
are recognized when the labor (service) or the product
actually makes its contribution to revenue. Expense
recognition is traditionally tied to revenue recognition: Let
the expense follow the revenue.

The
full
disclosure
principle
requires
that
circumstances and events that make a difference to
financial statement users be disclosed. Compliance with the

Contd

The cost principle dictates that assets be recorded at

their cost. Cost is used because it is both relevant and
reliable. Cost is relevant because it represents the
price paid, the assets sacrificed, or the commitment made
at date of acquisition.

The Materiality relates to an items impact on a

firms overall financial condition and operations. An
item is material when it is likely to influence the
decision of a reasonably prudent investor or creditor. It
is immaterial if its inclusion or omission has no impact on a
decision maker.

Accounting-- Key Terms

Merchandize/Goods The items or objects which
are traded in a business to earn revenue.
Purchases The purchase of merchandize/goods
only.
Sales The sale of merchandize/goods only.
Cost/Prepaid The payments for which respective
benefit is yet to be derived in full.
Expense The payments for which respective
benefit has been derived in full.

Accounting-- Key Terms

Revenue That part of business earnings, from which expenses
have not been deducted yet.
Income/Profit That part of earnings, from which all expenses
have been deducted. (Profit/Income = Revenue Expenses)
Accounts Receivable Parties, by whom payments have not
been received yet.
Accounts Payable Parties, to whom payments have not been
paid yet.
Drawings That part of capital which is withdrawn by the
owner for his personal use

Accounting-- Key Terms

Discount The reduction or price cut, offered by the
seller to the purchaser/customer.
Trade Discount Reduction in list price of goods. In
case of trade discount, cash is not involved.
Cash Discount Reduction in price, paid by the seller
to the purchaser in terms of cash.
Discount Allowed Discount, which is paid by the seller.
Discount Received Discount, which is received by the customer.