1.01 Generally Accepted Accounting Principles –

Accounting Constraints, Concepts, Assumptions,

and PrinciplesGAAP PowerPoint #3

Understandability

Decision Usefulness

Relevance

Predictive Value

Feedback Value

Timeliness

Reliability

Verifiability

Neutrality

Representational Faithfulness

Comparability and Consistency

Hierarchy of Qualitative Information

Cost/Benefit

Materiality

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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

Constraints

Also called Cost Benefit Constraint The cost of providing accounting

information should not exceed the benefit of the information it is reporting.

Example: A company purchases pencils and pens to use in its business. Rather than inventory these items, they are included as supplies and are expensed periodically because of the minor cost of the items.

Cost Effectiveness 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.

Materiality 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.

Conservatism Constraint

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

These are:◦Recognition Concept◦Measurement Concept

Concepts

States that an item should be recognized (recorded) in the financial statements when:◦ It can be defined by GAAP assumptions and

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

Recognition 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

Measurement Concept

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

There are Four Basic Assumptions of Accounting:◦ Economic Business Entity◦ Going Concern◦ Monetary Unit◦ Time Period

Assumptions

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.

Economic Business Entity 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.

Going Concern 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.

Monetary Unit 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.

Time Period Assumption

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

Principles dictate how events should be recorded and reported.

Principles of Accounting

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.

Cost 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.

Full Disclosure 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.

Revenue Recognition 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.

Matching Principle

Explain what is meant by “The benefits of accounting information must exceed 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.

Questions for Understanding/Discussion