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Accounting Concepts
Characteristics
Relevance – the quality of information that indicates the information makes a difference in a decision.
Reliability – the quality of information that gives assurance that it is free of error and bias. Accounting records
must be based on the most reliable data available (verifiable by independent source).
Comparability – Ability to compare the accounting information of different companies because they use the
same accounting principles.
Consistency – Use of the same accounting principles and methods from year to year within a company.
Assumptions
Monetary Unit – Only items that can be expressed in money are included in the accounting records.
Economic Entity – Every economic entity can be separately identified and accounted for. An organization
stands apart from other organizations as a separate economic unit. Economic events can be identified with a
particular unit of accountability.
Time Period – The life of a business can be divided into artificial time periods so businesses can report
information at regular intervals.
Going Concern – Entity will continue to operate long enough to recover cost of its assets (business will remain
in operation for the foreseeable future).
Principles
Revenue Recognition – Revenue should be recognized (recorded) in the period in which it is earned. Revenue
is earned when the business has completed rendering services and/or ownership of products has transferred.
Amount to record as revenue is equal to the cash value of services and/or goods.
Matching – expenses are matched with related revenues in same accounting period (Let the expenses follow the
revenue).
Full Disclosure Principle – all circumstance and events that would make a difference to financial statement
users will be disclosed (included in financial statements and notes).
Cost Principle – Assets/services acquired are recorded at actual, historical cost.
Constraints
Materiality – whether an item is large enough to likely influence the decision of an investor or creditor.
Conservatism – the approach of choosing an accounting method that will least likely overstate assets and net
income.
Accrual accounting – transactions are recorded in the periods in which the events occur rather than in the
periods in which the entity receives or pays cash. Accrual accounting is required for financial statements that
are prepared using generally accepted accounting principles.
Balance sheet – reports the assets, liabilities and equity at a specific point in time.
Assets = Liabilities + Equity
The balance sheet may also be referred to as the statement of financial position. It is a snapshot of a company's financial
position at a point in time.
Equity – Owners’ claim on total assets. Equity represents the difference between assets and liabilities.
Stockholders' equity is divided into two parts: common stock and retained earnings.
Common stock - Investment of assets into the business by the stockholders – recorded at the amount paid in by
stockholders. “Common stock” is reported at the par or stated value of the stock and any excess paid in is reported in
“Paid In Capital In Excess Of Par” (also may be called “Additional Paid In Capital”).
Retained earnings - income retained for use in the business – is the sum of all net income from inception of the
company less dividends (distributions) paid to the stockholders.
Note: Total assets on the balance sheet must equal total liabilities and stockholders’ equity.
Also, retained earnings on the balance sheet must equal retained earnings end of period on the statement
of retained earnings.
Balance Sheet Example
DSU Corporation
Balance sheet
As of December 31, 2006
ASSETS
Current assets
Cash $ 6,600
Short-term investments 2,000
Account Receivable 7,000
Inventories 4,000
Supplies 2,100
Prepaid Insurance 400
Total current assets $ 22,100
Long-term investments
Investment in stock of Wall Corp. 5,200
Investment in stock of Fancy Corp 2,000
7,200
Intangible assets
Patents 3,100
Long-term liabilities
Mortgage payable 10,000
Notes payable 1,300
Total long-term liabilities 11,300
Stockholders' equity
Common Stock 14,000
Retained earnings 20,050
Total stockholders' equity 34,050
Income Statement – reports the revenues and expenses of an entity for a period of time.
Income Statement Example
DSU Corporation
Income Statement
For the year ended December 31, 2006
Operating Expenses
Selling 80,000
Adminstrative 30,000
Total Operating Expenses 110,000
Income from operations 40,000
Other Revenues
Gain on sale of investment in XYZ 20,000
Other Expenses
Loss on sale of investment in ABC 10,000 10,000
Income from continuing operations before taxes 50,000
Income tax expense 5,000
Statement of Retained Earnings – reports the changes in retained earnings for a period of time.
Example:
DSU Corporation
Statement of Retained Earnings
For the year ended December 31, 2006
Note: Net income (loss) presented on the statement of retained earnings must equal the net income (loss)
presented on the income statement.
Statement of Cash Flows – provides information about the receipts (sources) and disbursements (uses) of a
company’s cash.
Reported based on the three primary business activities: operating, investing and financing. Noncash investing
and financing activities must be reported in a separate schedule.
DSU Corporation
Statement of Cash Flows
For the year ended December 31, 2006
Note: Cash and equivalents at year-end on the statement of cash flows must equal cash presented on the
balance sheet.
This ratio provides a more severe test of immediate solvency by eliminating inventories and prepaid
expenses (current assets that are not more quickly converted into cash).
Indicates the number of times inventory was acquired and sold (or used in production) during the period.
It can be used to detect inventory obsolescence or pricing problems. Average inventory is generally
determined by adding the beginning and ending inventories and dividing by two.
Indicates the number of days inventory is held before it is sold. Average daily cost of goods sold is
determined by dividing cost of goods sold by the number of business days in the year.
This ratio provides an indication of the efficiency of credit policies and collection procedures, and of the
quality of the receivables. Average net receivables include trade notes receivable. Average net
receivables is generally determined by adding the beginning and ending net receivables balances and
dividing by two.
Solvency Ratios – measures the ability of the enterprise to survive over a long period of time. Long-term
creditors and stockholders are interested in a company’s long-run solvency.
Measures total assets provided by creditors. The higher the percentage, the greater the risk the company
may not be able to meet maturing obligations.
Measures the ability of the company to meet its interest payments. Income taxes are added back to net
income because the ability to pay interest is not dependent on the amount of income taxes to be paid
since interest is tax deductible.
Profitability Ratios – measures the income or operating success of an enterprise for a given period of time.
Measures the ability to pay dividends to common stockholders by measuring profit earned per share of
common stock.
A measure of whether a stock is relatively cheap or relatively expensive based on its present earnings.
This ratio provides a measure of the degree of efficiency with which resources (total assets) are used to
generate earnings.
Measures the rate of earnings on resources provided by common stockholders. (In other words, shows
how many dollars of net income were earned for each dollar invested by owners). Average common
stockholders’ equity is generally determined by adding beginning and ending common stockholders’
equity and dividing by two.
Financial leverage – assessment of cost of money borrowed to rate of return earned on assets acquired
with borrowed funds. Successful use of leverage is where a company earns more by the use of
borrowed money than it costs to use the borrowed funds. When compared to the return on total assets,
the return on common stockholders’ equity measures the extent to which leverage is being employed for
or against the common stockholders. When the return on common stockholders’ equity is greater than
the return on total assets, leverage is positive and common stockholders benefit.
Cost of capital – Rate of return that management expects to pay on all borrowed and equity funds.
Cash Budgeting
Cash budget shows anticipated cash flows, usually over a one- to two-year period. The cash budget contributes
to more effective cash management. It contains three sections: cash receipts, cash disbursements, and
financing. Also contains beginning and ending cash balances.
Variable Costs – vary in total directly and proportionately with changes in activity level (ex. Direct Materials)
Fixed Costs – remain the same in total regardless of change in activity level (ex. Rent)
Contribution margin is the amount of revenue remaining after deducting variable costs.
Contribution Margin Per Unit = Unit Selling Price – Unit Variable Price
Break-Even Point – net profits at breakeven point are equal to zero. Profits = costs.
Break-even point in units = fixed costs divided by contribution margin per unit