Account, his aims and basic principles

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Who makes these decisions and informed judgments? Users of accounting information include the management of the entity or organization, the owners of the organization (who are frequently not involved in the management process), potential investors in and creditors of the organization, employees, and various federal, state, and local governmental agencies that are concerned with regulatory and tax matters. Exhibit 1-1 illustrates some of the users and uses of accounting information. Pause, and try to think of at least one other decision or informed judgment that each of these users might make from the economic information that could be communicated about an entity.


What Is Accounting?
Why Accounting?

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Account, his aims and basic principles



The student of a 1 course of a group







Table of contents:


What Is Accounting?

Why Accounting?





















What Is Accounting?


In a broad sense, accounting is the process of identifying, measuring, and communicating economic information about an organization for the purpose of making decisions and informed judgments. (Accountants frequently use the term entity instead of organization because it is more inclusive.)

Who makes these decisions and informed judgments? Users of accounting information include the management of the entity or organization, the owners of the organization (who are frequently not involved in the management process), potential investors in and creditors of the organization, employees, and various federal, state, and local governmental agencies that are concerned with regulatory and tax matters. Exhibit 1-1 illustrates some of the users and uses of accounting information. Pause, and try to think of at least one other decision or informed judgment that each of these users might make from the economic information that could be communicated about an entity.

Accounting information must be provided for just about every kind of organization. Accounting for business firms is what many people initially think of, but not-for-profit social service organizations, governmental units, educational institutions, social clubs, political committees, and other groups all require accounting for their economic activities.

Accounting is frequently perceived as something that others do, rather than as the process of providing information that supports decisions and informed judgments. Relatively few people actually become accountants, but almost all people use accounting information. The principal objective of this text is to help you become an informed user of accounting information, rather than to prepare you to become an accountant. However, the essence of this user orientation provides a solid foundation for those students who choose to become accounting majors.

If you haven't already experienced the lack of understanding or confusion that results from looking at one or more financial statements, you have been spared one of life's frustrations. Certainly during the course of your formal business education and early during your employment experience, you will be presented with financial data. Being an informed user means knowing how to use those data as information.

The following sections introduce the major areas of practice within the accounting discipline and help you to understand the types of work done by professional accountants within each of these broad categories. The Business in Practice discussion on page 6 highlights career opportunities in accounting.

Why Accounting?


An accounting course is like a course in English or history—it provides general knowledge that will make it easier for you to understand the world when you graduate from college. After taking this course, you should be able to use accounting software programs for your business and understand the impact of accounting transactions. On a more personal level, you should be able to gain insights and skills in handling your own business decisions. And you should be able to read an annual report so that you can be an intelligent consumer of various companies' stocks.

By taking this course, you may be embarking on the first of many accounting courses leading up to the certified public accountant (CPA) exam, the certified management accountant (CMA) exam, or other professional exams. You may use your accounting background as a lawyer, an engineer, a management consultant, a real estate broker, a hospital administrator, a professional athlete, a doctor, an entrepreneur, or someone with a financial responsibility of some kind. A larger dose of accounting is required for bankers and stockbrokers. The banker needs to be able to read financial statements with a critical eye to make sure that it is prudent to loan a company money. The stockbroker has to be able to read a company's financial statements to decide whether the company would be a wise investment. Are sales growing? Are profits growing? The answers to these and many other financial questions are provided by the accounting function.



On the of these fundamental assumptions of accounting, the accounting profession has devoloped prinsiples that dictate how transactions end other economic events should be recorded and reported. In earlier chapters we discussed the cost prinsiple and the revenue recognition and matching prinsiples. We now examine a number of reporting issues related to these prinsiples. In aditions, another prinsiples, the full disclosure prinsiple, is discussed.

Revenue Recognition Principle

The revenue recognition principle dictates that revenue should be recognized in the accounting period in which it is earned. Applying this general principle in practice, however, can be difficult. For example, it was reported that Automatic Inc. was improperly recognizing revenue on goods that had not been shipped to customers. Similarly, many questioned the revenue recognition practices of the savings and loan industry, which until recently recorded a large portion of its fees for granting a loan as revenue immediately rather than spreading those fees over the life of the loan.

When a sale is involved, revenue is recognized at the point of sale. The sales basis involves an exchange transaction between the seller and buyer, and the sales price provides an objective measure of the amount of revenue realized. There are, however, two exceptions to the sales basis for revenue recognition that have become generally accepted.

Percentage-of-CompIetion Method

In long-term construction contracts, recognition of revenue is usually required before the contract is completed. For example, assume that Warrior Construction Co. had a contract to build a dam for the U.S. Bureau of the Interior for $400 million. Construction is estimated to take 3 years (starting in 1994) at a construction cost of $360 million. If Warrior applies the point-of-sale basis, it will report no revenues and no profit in the first two years. But, in 1996 when compl^1011 and sale take place, Warrior will report $400 million in revenues, costs of $360 million, and the entire profit of $40 million. Was Warrior really producing n° revenues and earning no profit in 1994 and 1995? Obviously not. The dam will be as good as sold when Warrior completes the project according to specifications. Although technically an exchange transaction (transfer of ownership) has not occurred until completion of the dam, the earning process is considered substantially completed at various stages as construction progresses.

In recognizing revenue, Warrior can apply the percentage-of-completion method. This method recognizes revenue and income over the life of a long-term project on the basis of reasonable estimates of the project's progress toward completion. Progress toward completion is measured by comparing the costs incurred in a year to the total estimated costs for the entire project. That percentage is multiplied by the total revenue for the project; the result is then recognized as revenue for the period. The formulas for this method are as follows:

Сosts incurred (current period) / Total Estimated Costs = PersentComplete  (Current Period)

PersentComplete  (Current Period) * Total Revenue = Revenue Recognized (Current Period)

The costs incurred in the current period are then subtracted from the revenue recognized during the current period to arrive at the gross profit.

Let's look at an illustration of the percentage-of-completion method. Assume that Warrior Construction Co. incurs costs of $54 million in 1994, $180 million in 1995, and $126 million in 1996 on the dam project. The portion of the $400 million of revenue recognized in each of the 3 years is shown in Illustration 12-5.

Mote that no estimate is made of the percentage of work completed during tne final period. In the final period, all remaining revenue is recognized. In this example, the company's cost estimates have been very accurate; the costs incurred in the third year were 35% of the total estimated cost ($126,000 /360,000).

Application of the percentage-of-completion method involves some subjectivity. As a result, there is the possibility of error in determining the amount of revenue recognized and net income reported. Yet to wait until completion would seriously distort each period's financial statements. Naturally, if it is not possible to obtain dependable estimates of costs and progress, then the revenue should be recognized at the completion date and not by the percentage-of-completion method.

Installment Method

Another basis for revenue recognition is the receipt of cash. The cash basis is generally used only when it is difficult to determine the revenue amount at the time of a credit sale because collection is so uncertain. One popular approach to the recognition of revenue using the cash basis is the installment method.

Under the installment method, each cash collection from a customer consists of (1) a partial recovery of the cost of the goods sold, and (2) partial gross profit from the sale. For example, if the gross profit rate at date of sale is 40%, each subsequent receipt consists of 60% recovery of cost of goods sold and 40% gross profit. The formula to recognize gross profit is as follows:

Cash Collections from Customers * Gross Profit Percentage = Gross Profit Recognised during the Period 

To illustrate, assume that an Iowa farm machinery dealer in the first year of operations had installment sales of $600,000 and a cost of goods sold on installment of $420,000. Total gross profit is, therefore, $180,000 ($600,000 - $420,000), and the gross profit percentage is 30% ($180,000 -f- $600,000). The collections on the installment sales were as follows: First year, $280,000 (down payment plus monthly payments); second year, $200,000; and, third year, $120,000. The collections of cash and recognition of the gross profit are summarized in Illustration 12-8 (interest charges are ignored in this illustration)

Under the installment method of accounting, gross profit is therefore recognized in the period in which the cash is collected.

As indicated earlier, use of the installment method is justified when the risk of not collecting an account receivable may be such that the sale is not sufficient evidence for revenue to be recognized.

Matching Principle (Expense Recognition)

Expense recognition is traditionally tied to revenue recognition: "Let the expense follow the revenue." This practice is referred to as the matching principle: it dictates that expenses be matched with revenues in the period in which efforts are expended to generate revenues. Expenses are not recognized when cash is paid, or when the work is performed, or when the product is produced; they are recognized when the labor (service) or the product actually makes its contribution to revenue.

The problem is that it is sometimes difficult to determine the accounting period in which the expense contributed to the generation of revenues. Several approaches have therefore been devised for matching expenses and revenues on the income statement.

To understand these approaches, it is necessary to examine the nature of expenses. Costs that will generate revenues only in the current accounting period are expensed immediately. They are reported as operating expenses in the income statement. Examples include such costs as advertising, sales salaries, and repairs. These expenses are often called expired costs.

Costs that will generate revenues in future accounting periods are recognized as assets. For example, this is the basis on which America Online accounts for its subscription-acquisition costs. Other examples include merchandise inventory, prepaid expenses, and plant assets. These costs represent unexpired costs. Unexpired costs become expenses in two ways:

1. Cost of goods sold. Costs carried as merchandise inventory are expensed as cost of goods sold in the period when the sale occurs. Thus, there is a direct matching of expenses with revenues.

2 Operating expenses. Unexpired costs become operating expenses through use or consumption (as in the case of store supplies) or through the passage of time (as in the case of prepaid insurance and prepaid rent). The cost of plant assets and other long-lived productive resources is expensed through rational and systematic allocation methods which result in periodic depredation and amortization. Operating expenses contribute to the revenues of the period but their association with revenues is less direct than for cost of goods sold.

Full Disclosure Principle

The full disclosure principle requires that circumstances and events that make a difference to financial statement users be disclosed. For example, most accountants would agree that Manville Corporation should have disclosed the 52,000 asbestos liability suits (totaling $2 billion) pending against it so that interested parties were made aware of this contingent loss. Similarly, it is generally agreed that companies should disclose the major provisions of employee pension plans and long-term lease contracts.

Compliance with the full disclosure principle occurs through the data contained in the financial statements and the information in the notes that accompany the statements. The first note in most cases is a summary of significant accounting policies. The summary includes, among others, the methods used by the company for inventory costing, depreciation of plant assets, and amortization of intangible assets.

Deciding how much disclosure is enough can be difficult. Accountants could disclose every financial event that occurs and every contingency that exists. However, accounting  information must be condensed and combined to make it understandable. Providing additional information entails a cost, and the benen's of providing this information in some cases may be less than the costs. Many companies complain of an accounting standards overload. In addition, they object to requirements that force them to disclose confidential information. Deter' mining where to draw the line on disclosure is not easy.

One thing is certain: financial statements were much simpler years ago, when many companies provided little additional information regarding the financial statements. In 1930, General Electric had no notes to the financial statements; today it has over 10 pages of notes! Why this change? A major reason is that the objectives of financial statements have changed. In the past, information was generally presented on what the business had done. Today the objectives of financial reporting are more future-oriented; accounting is trying to provide information that makes it possible to predict the amount, timing, and uncertainty of future cash flows.

Cost Principle

As you lenow, the cost principle dictates that assets are 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. Cost is reliable because it is objectively measurable, factual, and verifiable. It is the result of an exchange transaction. Cost is the basis used in preparing financial statements.

The cost principle, however, has come under much criticism. It is criticized by some as irrelevant. Subsequent to acquisition, the argument goes, cost is not equivalent to market value or current value. For that matter, as the purchasing power of the dollar changes, so also does the meaning associated with the dollar that is used as the basis of measurement. Consider the classic story about the individual who went to sleep and woke up 10 years later. Hurrying to a telephone, he got through to his broker and asked what his formerly modest stock portfolio was worth. He was told that he was a multi-millionaire—his General Motors stock was worth $5 million and his AT&T stock was up to $10 million. Elated, he was about to inquire about his other holdings, when the telephone operator cut in with "Your time is up. Please deposit $100,000 for the next 3 minutes."3

This story demonstrates that prices can and do change over a period of time, and that one is not necessarily better off when they do. Although the numbers in the story are extreme, consider some more realistic data that compare prices m 1980 with what is expected in 1996, assuming average price increases of 6% and 12% per year.

Despite the inevitability of changing prices during a period of inflation, the accounting profession still follows the stable monetary unit assumption in preparing a company's primary financial statements. While admitting that some changes in prices do occur, the profession believes the unit of measure—the dollar—has remained sufficiently constant over time to provide meaningful financial information.

If presented, the disclosure of price-level adjusted data is in the form of supplemental information presented with financial statements. The two most widely used approaches to show the effects of changing prices on a company's financial statements are (1) constant dollar accounting and (2) current cost accounting.

Constant Dollar Accounting

The real value of the dollar is determined by the goods or services for which it can be exchanged. This real value is commonly called purchasing power. As the economy experiences inflation (rising price levels) or deflation (falling price levels), the amount of goods or services for which a dollar can be exchanged changes; that is, the purchasing power of the dollar changes from one period to the next. These changes are referred to as general price level changes.

Constant dollar accounting restates financial statement items into dollars that have equal purchasing power. As one executive from Shell Oil Company explained, "Constant dollar accounting is a restatement of the traditional financial information into a common unit of measurement." In other words, constant dollar accounting changes the unit of measurement; it does not, however, change the underlying accounting principles used to report cost amounts. Constant dollar accounting is cost based.

Current Cost Accounting

The price of a specific item may be affected not only by a change in the general price level, but also by individual market forces. For example, during a recent 6-year period, certain items changed more or less than the general price level. To illustrate, during this period of time, the cost of a local telephone call increased 150%, guaranteed overnight mail delivery increased 4,575%, a gallon of gasoline decreased over 30%, and a flawless one-carat diamond decreased over 70%. Thus, changes in the specific price of items may be very different from the change in the general price level. These changes are referred to as specific price level changes.


























  1. Introductionm to Accounting An integrated Approach Penne Ainsworth, 1997, p. 16
  2. Accounting Principles Weygant J. J. , 1996, p. 499-506
  3. Accounting What the number  mean David H. Marshal, Wayne W Mc Manus – 4th ed 1999, p. 3

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