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KARACHI, PAKISTAN.The historical development of accounting practice has been closely related to the economic development of the country. In the earlier stages of the American economy, a business enterprise was very often managed by its owner, and the accounting records and reports were used mainly by the owner manager in conducting the business. Bankers and other lenders often relied on their personal relationship with the owner rather than on financial statements as the basis for making loans for business purposes. If a large amount was owed to a bank or supplier, the creditor often participated in management decisions,
As business organizations grew in size and complexity, "management" and "outsiders" became more-clearly differentiated. From the latter group, which includes owners (stockholders), creditors, government, labor unions, customers, and the general public, came the demand for accurate financial information for use in judging the performance of management. In addition, as the size and complexity of the business unit increased, the accounting problems involved in the issuance of financial statements became more and more complex, With these developments came an awareness of the need for a framework of concepts and generally accepted accounting principles to serve as guidelines for the preparation of the basic financial statements.
DEVELOPMENT OF CONCEPTS AND PRINCIPLES
The word "principle" as used in the context of generally accepted accounting principles does not have the same authoritativeness as universal principles or natural laws relating to the study of astronomy, physics, or other physical sciences. Accounting principles have been developed by individuals to help make accounting data more useful in an ever changing society. They represent the best possible guides, based on reason, observation, and experimentation, to the achievement of the desired results. The selection of the best method from among many alternatives has come about gradually, and in some subject matter areas a clear consensus is still lacking. These principles continually are reexamined and revised to keep pace with the increasing complexity of business operations. General acceptance among the members of the accounting profession is the criterion for determining an accounting principle.
Responsibility for the development of accounting principles has rested primarily on practicing accountants and accounting educators, working both independently and under the sponsorship of various accounting organizations. These principles also are influenced by business practices and customs, ideas and beliefs of the users of the financial statements, governmental agencies, stock exchanges, and other business groups.
Financial Accounting Standards Board
In 1973, the Financial Accounting standards Board (FASB) was appointed by the Financial Accounting Foundation (FAF). The FAF is an independent, nonprofit organization that was created in 1972 to oversee the standard setting process, to appoint members of standard setting boards (the FASB and the Governmental Accounting Standards Board) and advisory councils, and to raise funds for the operation of the standard setting process.
The FASB replaced the Accounting Principles Board (APB), which provided much of the leadership in the development of generally accepted accounting principles from 1959 to 1973. The APB was composed of eighteen accountants who were members of the American Institute of Certified Public Accountants and who served without pay and continued their affiliations with their firms or institutions. The FASB, which is presently the dominant body in the development of generally accepted accounting principles, is composed of seven members, four of whom must be CPAs drawn from public practice. These seven members serve full time, receive a salary, and must resign from the firm or institution with which they have been affiliated. The FASB is assisted by an advisory council of approximately forty members, whose major responsibilities include the recommendation of priorities and agenda and the review of FASB plans, activities, and statements proposed for issuance, The FASB employs a full time research staff and administrative staff as well as task forces to study specific matters from time to time.
As problems in financial reporting are identified, the FASB conducts extensive research to identify the principal issues involved and the possible solutions. Generally, after issuing discussion memoranda and preliminary proposals and evaluating comments from interested parties, the Board issues Statements of Financial Accounting Standards, which become part of generally accepted accounting principles. To explain, clarify, or elaborate on existing pronouncements, the Board also issues Interpretations, which have the same authority as the standards.
Presently, the Board is in the process of developing a broad conceptual framework for financial accounting. This project, which is expected to take many years to complete, is an attempt to develop a 1~ constitution" that can be used to evaluate current standards and can serve as the basis for future standards. The results of the completed portion of this project have been published as six Statements of Financial Accounting Concepts, which are briefly described as follows
Objectives of Financial Reporting by Business Enterprises (No. 1) Sets forth three broad objectives of
Financial reporting:
I To provide financial information that is useful in making rational investment, credit, and similar decisions;
2. To provide financial information to enable users to predict cash flows to the business and subsequently
to themselves,.
3. To provide financial information about business resources (assets), claims to these resources (liabilities
and owner's equity), and changes in these resources and claims.
Qualitative Characteristics of Accounting Information (No. 2) Identifies the essential qualities of the accounting information included in financial reports as follows: usefulness, understandability, relevance, reliability verifiability, timeliness, neutrality, completeness, and comparability.
Elements of Financial Statements of Business Enterprises (No. 3) Replaced by Statement No. 6.
Objectives of Financial Reporting by Nonbusiness Organizations (No. 4) Sets forth the objectives that guide the preparation of the financial statements for nonbusiness organizations.
Recognition and Measurement in Financial Statements of Business Enterprises (No. 5) Identifies the financial statements that should be prepared to meet the objectives of financial reporting for business enterprises.
Elements of Financial Statements (No. 6)
Replaces Statement No. 3 and defines the interrelated elements of financial statements that are directly related
to measuring the performance and status of businesses and nonprofit organizations,
Governmental Accounting Standards Board
The Governmental Accounting Standards Board was formed in 1984 as an arm of the Financial Accounting Foundation. The GASB has a full time chairperson and four part time members who have responsibility for establishing the accounting standards to be followed by state and municipal governments. The GASB employs a full time research staff and administrative staff. An advisory council of approximately 20 members assists the GASB and also has fund raising responsibilities.
Accounting Organizations
Among the oldest and most influential organizations of accountants are the American Institute of Certified Public Accountants (AICPA) and the American Accounting Association (AAA). Each organization publishes monthly or quarterly periodicals and, from time to time, issues other publications in the form of research studies, technical opinions, and monographs. There are also other national accounting organizations as well as many state societies and local chapters of the national and state organizations. These groups provide forums for the interchange of ideas and discussion of accounting principles.
Government Organizations
Of the various governmental agencies with an interest in the development of accounting principles, the Securities and Exchange Commission has been the most influential. Established by an act of Congress in 1934, the SEC issues regulations that must be observed in the preparation of financial statements and other reports filed with the Commission.
The Internal Revenue Service (IRS) issues regulations that govern the determination of income for purposes of federal income taxation. Because these regulations sometimes conflict with financial accounting principles, many enterprises maintain two sets of accounts to satisfy both reporting requirements, To avoid this increased record keeping, there have been times when firms have adopted practices that are acceptable for tax purposes as generally accepted accounting principles.'
Other regulatory agencies exercise a dominant influence on the accounting principles of the industries under their jurisdiction. In rare situations, Congress may also enact legislation that dictates accounting principles. These situations usually involve controversial issues on which no clear consensus has been reached within the profession.
Other Influential Organizations
The Financial Executives Institute (FEI) has influenced the development of accounting principles by encouraging and sponsoring accounting research. The FEI also comments on proposed pronouncement s of the FASB, the SEC, and other organizations.
The Institute of Management Accountants (IMA) is one of the largest organizations of accountants. It is primarily concerned with management's use of accounting information in directing business operations. Since management is responsible for the preparation of the basic financial statements, however, the IMA communicates its recommendations on generally accepted accounting principles to appropriate organizations.
Although the organizations mentioned above traditionally have had the most influence upon the establishment of accounting principles, other organizations representing users of accounting reports are increasingly making their views known. Prominent in this group are the Financial Analysts Federation (investors and investment advisors) and the Securities Industry Associates (investment bankers). Many accounting principles have been introduced and integrated with discussions in earlier chapters. The remainder of this chapter is devoted to the underlying assumptions, concepts, and principles of the greatest importance and widest applicability. Attention also will be directed to applications of principles to specific situations in order to facilitate better understanding of accounting practices.
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KARACHI, PAKISTAN.BUSINESS ENTITY
The business entity concept assumes that a business enterprise is separate and distinct from the persons who supply its assets, This distinction exists regardless of the legal form of the business organization. The accounting equation, Assets = Equities, or Assets = Liabilities + Owner's Equity, is an expression of the entity concept; i.e., the business owns the assets and owes the various claimants. Thus, the accounting process primarily is concerned with the enterprise as a productive economic unit and only secondarily is concerned with the investor as a claimant to the assets of the business.
The business entity concept used in accounting for a sole proprietorship is distinct from the legal concept of a sole proprietorship. The nonbusiness assets, liabilities, revenues, and expenses of a sole proprietor are excluded from the business accounts. If a sole proprietor owns two or more dissimilar enterprises, each one is treated as a separate business entity for accounting purposes. Legally, however, a sole proprietor is personally, liable for all business debts and may be required to use nonbusiness assets to satisfy the business creditors. Conversely, business assets are not immune from the claims of the sole proprietor's personal creditors.
Differences between the business entity concept and the legal nature of other forms of business organization will be considered in later chapters. For accounting purposes, however, revenues and expenses of any enterprise are viewed as affecting the business assets and liabilities, not the investors' assets and liabilities.
GOING CONCERN
Only in rare cases is a business organized with the expectation of operating for only a certain period of time. In most cases, it is not possible to determine in advance the length of life of an enterprise, and so an assumption must be made. The nature of the assumption will affect the manner of recording some of the business transactions, which in turn will affect the data reported in the financial statements.
It is customary to assume that a business entity has a reasonable expectation of continuing in business at a profit for an indefinite period of time. This provides much of the justification for recording plant assets at acquisition cost and depreciating them in an orderly manner without reference to their current realizable values. If there is no immediate expectation of selling them, plant assets should not be reported on the balance sheet at their estimated realizable values regardless of whether their current market value is less than their book value or greater than their book value. If the firm continues to use the assets,, the change in market value causes no gain or loss, nor does it increase or decrease the usefulness of the assets. Thus, if the going concern assumption is a valid concept, the investment in plant assets will serve the purpose for which it was made the investment in the assets will be recovered even though they may be individually marketable only at a loss.
The going concern assumption similarly supports the treatment of prepaid expenses as assets, even though they may not be salable. To illustrate, assume that On the last day of its fiscal year, a wholesale firm receives from a printer a $20,000 order of sales catalogs. If there were no assumption that the firm is to continue in business, the catalogs would be merely scrap paper and the value reported for them on the balance sheet would be small.
When there is conclusive evidence that a business entity has a limited life, the accounting procedures should be appropriate to the expected terminal date of the entity. Changes in the application of normal accounting procedures may be needed for business organizations in receivership or bankruptcy, for example. In such cases, the financial statements should clearly disclose the limited life of the enterprise and should be prepared from the "quitting concern" or liquidation point of view, rather than from a "going concern" point of view.
OBJECTIVE EVIDENCE
Entries in the accounting records and data reported on financial statements must be based on objectively determined evidence. If this principle is not followed, the confidence of the many users of the financial statements could not be maintained. For example, objective evidence such as invoices and vouchers for purchases, bank statements for the amount of cash in bank, and physical counts for merchandise on hand supports much of accounting. Such evidence is completely objective and can be verified.
Evidence is not always conclusively objective, for there are many cases in accounting in which judgments, estimates, and other subjective factors must be taken into account. In such situations, the most objective evidence available should be used. For example, the provision for doubtful accounts is an estimate of the losses expected from failure to collect sales made on account. The estimation of this amount should be based on such objective factors as past experience in collecting accounts receivable and reliable forecasts of future business activities. To provide accounting reports that can be accepted with confidence, evidence should be developed that will minimize the possibility of error, intentional bias, or fraud.
UNIT OF MEASUREMENT
All business transactions are recorded in terms of money. Other pertinent information of a nonfinancial nature may also be recorded, such as the description of assets acquired, the terms of purchase and sale contracts, and the purpose, amount, and term of insurance policies. But it is only through the record of dollar amounts that the diverse transactions and activities of a business may be measured, reported, and periodically compared. Money is both the common factor of all business transactions and the only feasible unit of measurement that can be used to achieve uniform financial data.
The generally accepted use of the monetary unit for accounting for and reporting the activities of an enterprise has two major limitations: (1) it limits the scope of accounting reports and (2) it assumes a stability of the measurement unit.
Scope of Accounting Reports
Many factors affecting the activities and the future prospects of an enterprise cannot be expressed in monetary terms. In general, accounting does not attempt to report such factors. For example, information regarding the capabilities of the management, the state of repair of the plant assets, the effectiveness of the employee welfare program, the attitude of the labor union, the effectiveness of antipollution measures, and the relative strengths and weaknesses of the firm's competitors cannot be expressed in monetary terms. Although such matters are important to those concerned with enterprise operations, at the present time, accountancy does not assume responsibility for reporting information of this kind.
Changes in Price Levels
As a unit of measurement, the dollar differs from such quantitative standards as the kilogram, liter, or meter, which have not changed for centuries. The instability of the purchasing power of the dollar is well known, and the disruptive effect of the declining value of the dollar is acknowledged by accountants. In the past, however, this declining value generally has not been given recognition in the accounts or in conventional financial statements.
To indicate the nature of the problem, assume that the plant assets acquired by an enterprise for $ 100,000 twenty years ago are now to be replaced with similar assets which will cost $200,000 at present price levels. Assume further that during the twenty year period the plant assets had been fully depreciated and the net income of the enterprise had amounted to $300,000. Although the initial outlay of $100,000 for the plant assets was recovered through depreciation charges, the amount represents only half of the cost of replacing the assets. Instead of considering the current value of the new assets to have increased to double the value of two decades earlier, the dollars recovered can be said to have declined to one half of their earlier value. From either point of view, the firm has suffered a loss in purchasing power, which is the same as a loss of capital. In addition, $100,000 of the net income reported during the period might be said to be illusory, since it must be used to replace the assets.
The use of a monetary unit that is assumed to be stable insures objectivity. In spite of the inflationary trend
in the United States, historical dollar financial statements are considered to be better than statements based on
movements of the general price level. There are, however, two widely discussed recommendations for
supplementing conventional statements and thus resolving financial reporting problems created by increasing
price levels: (1) supplemental financial data based on current costs and (2) supplemental financial data based
on constant dollars. The discussion in the following sections is confined to the basic concepts and problems of
these recommendations.
Current Cost Data. Current cost is the amount of cash that would have to be paid currently to acquire assets
of the same age and in the same condition as existing assets. When current costs are used as the basis for
financial reporting, assets, liabilities, and owner's equity are stated at current values, and expenses are stated at
the current cost of doing business. The use of current costs permits the identification of gains and losses that
result from holding assets during periods of changes in price levels. To illustrate, assume that a firm acquired
land at the beginning of the fiscal year for $50,000 and that at the end of the year its current cost (value) is
$60,000. The land could be reported at its current cost of $60,000, and the $ 10,000 increase in value could be
reported as an unrealized gain from holding the land.
The major disadvantage in the use of current costs is the absence of established standards and procedures for determining such costs. However, many accountants believe that adequate standards and procedures will evolve through experimentation with actual applications.
Constant Dollar Data. Constant dollar data, also known as general price level data, are historical costs that have been converted to constant dollars through the use of a price level index. In this manner, financial statement elements are reported in dollars, each of which has the same (that is, constant) general purchasing power.
A price level index is the ratio of the total cost of a group of commodities prevailing at a particular time to the total cost of the same group of commodities at an earlier base time. The total cost of the commodities at the base time is assigned a value of 100 and the price level indexes for all later times are expressed as a ratio to 100. For example, assume that the cost of a selected group of commodities amounted to S12,000 at a particular time and $13,200 today. The price index for the earlier, or base, time becomes 100 and the current price index is 110 [(13,200 + 12,000) x 1001.
Current Annual Reporting Requirements for Price Level Changes. In 1979, the Financial Accounting Standards Board undertook an experimental program for reporting the effects of changing prices by requiring approximately 1,300 large, publicly held enterprises to disclose certain current cost information and constant dollar information annually as supplemental data. In 1984, after reviewing the experiences with these 1979 disclosure requirements, the FASB concluded that current cost information was more useful than constant dollar information as a supplement to the basic financial statements. In 1986, the FASB eliminated the requirement to disclose the effects of changing prices, but encouraged it companies to disclose such information voluntarily. The information that is now being disclosed includes elements of both current cost and constant dollar data, as shown in the following footnote from the annual report of The Pillsbury Company:
Information on effects (?f changing prices and inflation
Financial statements, prepared using historical costs as required by generally accepted accounting principles. may not reflect the full impact of current costs and general inflation.
The following supplementary disclosures attempt to remeasure certain historical financial information to recognize the effects of changes in current costs using specific price indices. 7 he current cost information is then expressed in average Fiscal 1986 dollars to reflect the effects of general inflation based on the U. S. Consumer Price Index....
ACCOUNTING PERIOD
A complete and accurate picture of an enterprise's success or failure cannot be obtained until it discontinues operations, converts its assets into cash, and pays off its debts. Then, and only then, is it possible to determine its true net income, But many decisions regarding the business must be made by management and interested outsiders during its existence. It is therefore necessary to prepare periodic reports on operations, financial position, and cash flows.
Reports may be prepared when a certain job or project is completed, but more often they are prepared at specified time intervals. For a number of reasons, including custom and various legal requirements, the longest interval between reports is one year.
This element of periodicity creates many of the problems of accountancy. The basic problem is the determination of periodic net income. For example, the need for adjusting entries discussed in earlier chapters is directly attributable to the division of the life of an enterprise into arbitrary time periods. Problems of inventory costing, of recognizing the uncollectibility of receivables, and of selecting depreciation methods are also directly related to the periodic measurement process. Furthermore, the amounts of the assets and the equities reported on the balance sheet also will be affected by the methods used in determining net income. For example, the cost flow assumption used in determining the cost of merchandise sold during the accounting period will have a direct effect on the amount of cost assigned to the remaining inventory,
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KARACHI, PAKISTAN.MATCHING REVENUE AND EXPIRED COSTS
During the early stages of accounting development, accountants viewed the balance sheet as the principal financial statement. Over the years, the emphasis has shifted to the income statement as the users of financial statements have become more concerned with the results of business operations than with financial position. The determination of periodic net income is a two fold problem involving (1) the revenue recognized during the period and (2) the expired costs to be allocated to the period. It is thus a problem of matching revenue and expired costs, the residual amount being the net income or net loss for the period.
Recognition of Revenue
Revenue is measured by the amount charged to customers for merchandise delivered or services rendered to them. The problem created by periodicity is one of timing; that is, at what point is the revenue realized? For any particular accounting period, the question is whether revenue items should be recognized and reported as such in the current period or whether their recognition should be delayed to a future period.
Various criteria are acceptable for determining when revenue is realized. In any case, the criteria used should reasonably agree with the terms of the contractual arrangements with the customer and be based, insofar as possible, on objective evidence. The criteria most often used are described in the remaining paragraphs of this section.
Point of Sale. Revenue from the sale of merchandise usually is determined by the point of sale method under which revenue is realized at the time title passes to the buyer. At point of sale, the sale price has been agreed upon, the buyer acquires the right of ownership in the merchandise, and the seller has a legal claim against the buyer. The realization of revenue from the sale of services may be determined in a like manner, although there is often a time lag between the time of the initial agreement and the completion of the service. For example, assume that a contract provides that certain repair services be performed, either for a specified price or on a time and materials basis. The price or terms agreed upon in the initial contract do not become revenue until the work has been performed.
Theoretically, revenue from the production and sale of merchandise and services emerges continuously as effort is expended. As a practical matter, however, it is usually not possible to make an objective determination until both (1) the contract price has been agreed upon and (2) the seller's portion of the contract has been completed.
Receipt of Payment. The recognition of revenue may be delayed until payment is received. When this criterion is used, revenue is considered to be realized at the time the cash is collected, regardless of when the sale was made. The cash basis is widely used by physicians, attorneys, and other enterprises in which professional services are the source of revenue. It has little theoretical justification but has the practical advantage of simplicity of operation and avoidance of the problem of estimating losses from uncollectible accounts. Its acceptability as a fair method of timing the recognition of revenue from personal services is influenced somewhat by the fact that it may be used in determining income subject to the federal income tax. It is not an appropriate method of measuring revenue from the sale of merchandise.
Installment Method. In some businesses, especially in the retail field, it is common to make sales on the installment plan. In the typical installment sale, the buyer makes a down payment and agrees to pay the remainder in specified amounts at stated intervals over a period of time. The seller may retain technical title to the goods or may take other means to make repossession easier in the event that the buyer defaults on the payments. Despite such provisions, installment sales ordinarily should be treated in the same manner as any other sale on account, in which case the revenue is considered to be realized at the point of sale.
In some exceptional cases, the circumstances are such that the collection of receivables is not reasonably assured. In these cases, the installment method of deter mining revenue may be used. Under this method, each receipt of cash is considered to be revenue and to be composed of partial amounts of (1) the cost of merchandise sold and (2) gross profit on the sale.
As a basis for illustration, assume that in the first year of operations, a dealer in household appliances had total installment sales of $300,000, and the cost of the merchandise sold amounted to $180,000. Assume also that collections of the installment accounts receivable were spread over three years as follows: 1st year, $140,000; 2nd year, $100,000; 3rd year, $60,000. According to the point of sale method, all of the revenue would be recognized in the first year, and the gross profit realized in that year would be determined as follows:
Installment sales $300,000
Cost of merchandise sold 180,000
Gross profit $120,000
Percentage of Completion. Enterprises engaged in large construction projects may devote several years to the completion of a particular contract, To illustrate, assume that a contractor engages in a project that will require three years to complete, for a contract price of $50,000,000. Further assume that the total cost to be incurred, which will also be spread over the three year period, is estimated at $44,000,000. According to the point of sale criterion, neither the revenue nor the related costs would be recognized until the project is completed. Therefore, using the completed contract method of determining revenue, the entire net income from the contract would be reported in the third year.
Whenever the total cost of a long term contract and the extent of the project's progress reasonably can be estimated, it is preferable to consider the revenue as being realized over the entire life of the contract. The amount of revenue to be recognized in any particular period is then determined on the basis of the estimated percentage of the contract that has been completed during the period. The estimated percentage of completion can be developed by comparing the incurred costs with the most recent estimates of total costs or by estimates by engineers, architects, or other qualified personnel of the progress of the work performed. To continue with the illustration, assume that by the end of the first fiscal year the contract is estimated to be one fourth completed and the costs incurred during the year were $11,200,000. According to the percentage of -completion method, the revenue to be recognized and the income for the year would be determined as follows:
Revenue ($50,000,000 x 25%) $12,500,000
Costs incurred 11,200,000
Income (Year 1) $ 1,300,000
The costs actually incurred during the year (rather than one fourth of the original cost estimate of $44,000,000 or $11,000,000) are deducted from the revenue recognized.
The 1988 edition of Accounting Trends & Techniques indicated that 94% of the surveyed companies with long term contracts used the percentage of completion method. Although the use of this method involves some subjectivity, and hence possible error, in the determination of the amount of reported revenue, the financial statements may be more informative and more useful than they would be if none of the revenue was recognized until completion of the contract.
The method used to recognize revenue on a long term contract should be noted in the financial statements, as indicated in the following excerpt taken from a note to the financial statements of Martin Marietta Corporation:
Revenue Recognition. Sales under long term contracts generally are recognized under the percentage of completion method, and include a proportion of the earnings expected to he realized on the contract... Other sales are recorded upon shipment of products or performance of services.
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KARACHI, PAKISTAN.Allocation of Costs
Properties and services acquired by an enterprise generally are recorded at cost. "Cost" is the amount of cash or equivalent given to acquire the property or the service. If property other than cash is given to acquire properties or services, the cost is the cash equivalent of the property given. When the properties or the services acquired are sold or used, the costs are deducted from the related revenue to determine the amount of net income or net loss. The costs of properties or services acquired and on hand at any particular time represent assets. Such costs may also be called "unexpired costs." As the assets are sold or used, they became "expired costs" or "expenses."
The techniques of determining and recording cost expirations have been described and illustrated in earlier chapters. In general, there are two approaches to cost allocations: (1) compute the amount of the expired cost or (2) compute the amount of the unexpired cost. For example, it is customary to determine the portion of plant assets that have expired. After the depreciation for the period has been recorded, the balances of the plant asset accounts minus the balances of the related accumulated depreciation accounts represent the unexpired cost of the assets. The alternative approach must be used for merchandise and supplies, unless perpetual inventory records are maintained. If the cost of the merchandise or supplies on hand at the end of the period is determined by taking a physical inventory, the remaining costs in the related accounts are assumed to have expired. It might appear that the first approach emphasizes expired costs and the second emphasizes unexpired costs. This is not the case, however, since the selection of the method is based merely on convenience or practicality.
Many of the costs allocable to a period are treated as an expense at the time of incurrence because they will be wholly expired at the end of the period. For example, when a monthly rent is paid at the beginning of a month, the cost incurred is unexpired and hence it is an asset; but, since the cost incurred will be wholly expired at the end of the month, the rental is usually charged directly to the appropriate expense account. This process makes subsequent adjusting entry unnecessary. The proper allocation of costs among periods is the most important consideration. Any one of many accounting techniques may be used in achieving this objective.
ADEQUATE DISCLOSURE
Financial statements and their accompanying footnotes or other explanatory materials should contain all of the pertinent data believed essential to the reader's understanding of the enterprise's financial status. Criteria for adequate disclosure, or full disclosure, often must be based on value judgments rather than on objective facts.
Financial statements are made more useful by the use of headings and subheadings and by merging items in significant categories. Although all essential data should be disclosed within these categories, judgment must be exercised by excluding nonessential information to avoid clutter, For example, detailed information as to the amount of cash in various special and general funds, the amount on deposit in each of several banks, and the amount invested in various marketable government securities is not needed by the reader of financial statements, Such information displayed on the balance sheet would hinder rather than aid understanding.
In most cases, all of the pertinent data needed by the reader cannot be presented in the financial statements themselves. The statements therefore normally include essential or explanatory information in accompanying notes.
Accounting Methods Employed
When there are several acceptable alternative methods that could have a significant effect on amounts reported on the statements, the particular method used should be disclosed. Examples include inventory cost flow and pricing methods, depreciation methods, and various criteria of revenue recognition. There is considerable variation in the format used to disclose accounting methods employed. One form of disclosure is to present "Significant Accounting Policies" as the initial note.
Changes in Accounting Estimates
There are many cases in accounting in which the use of estimates is necessary, These estimates should be revised when additional information or subsequent developments permit better insight or improved judgment upon which to base the estimates. If the effect of such a change on net income is material, it should be disclosed in the financial statements for the year in which the change is adopted.
Contingent Liabilities
As discussed previously, contingent liabilities are potential obligations that will materialize only if certain events occur in the future. If the liability is probable and the amount of the liability can be reasonably estimated, it should be recorded in the accounts. Such liabilities discussed in preceding chapters include vacation pay payable and product warranty payable. Although the vacation pay liability is dependent on employees taking vacations, the liability is probable and is reasonably estimated. Likewise, although the product warranty liability is dependent upon customers presenting products for repair, the product warranty liability is probable and is reasonably estimated. If the amount of the potential obligation cannot be reasonably estimated, the details of the contingency should be disclosed., The most common contingent liabilities disclosed in notes to the financial statements stem from litigation, guarantees, and discounting receivables.
Segment of a Business
Many companies diversify their operations; that is, they are involved in more than one type of business activity. These companies may also operate in foreign markets. The individual segments of such diversified
companies ordinarily experience differing rates of profitability, degrees of risk, and opportunities for growth. To help financial statement users in assessing past performance and future potential of diversified companies, financial statements should disclose such information as the enterprise's operations in different industries, its foreign markets, and its major customers. The required information for each significant reporting segment includes the following: revenue, income from operations, and identifiable assets associated with the segment.
Events Subsequent to Date of Statements
Events occurring or becoming known after the close of the period may have a significant effect on the financial statements and should be disclosed. For example, if an enterprise should suffer a crippling loss from a fire or other catastrophe between the end of the year and the issuance of the statements, the facts should be disclosed. Similarly, such occurrences as the issuance of long term debt or capital stock, or the purchase of another business enterprise after the close of the period should be made known.
CONSISTENCY
A number of accepted alternative principles affecting the determination of income statement and balance sheet amounts have been presented in various sections of the text. Recognizing that different methods may be used under varying circumstances and that the comparison of an enterprise's current financial statements with those of the preceding year is common practice, some guide or standard is needed to assure that the enterprise's periodic financial statements can be compared.
The amount and the direction of change in net income and financial position from period to period is very important to readers and may greatly influence their decisions. Therefore, interested persons should be able to assume that successive financial statements of an enterprise are based consistently on the same generally accepted accounting principles. If the principles are not applied consistently, the trends indicated could be the result of changes in the principles used rather than the result of changes in business conditions or managerial effectiveness.
The concept of consistency does not completely prohibit changes in the accounting principles used. Changes are permissible when it is believed that the use of a different principle will more fairly state net income and financial position. Examples of changes in accounting principles include a change in the method of inventory pricing, a change in depreciation method for previously recorded assets, and a change in the method of accounting for long term construction contracts. Consideration of changes in accounting principles must be accompanied by consideration of the general rule for disclosure of such changes, which is as follows:
The nature of and justification for a change in accounting principle and its effect on income should be disclosed in the financial statements of the period in which the change is made. The justification for the change should explain clearly why the newly adopted accounting principle is preferable.
There are various methods of reporting the effect of a change in accounting principle on net income. The cumulative effect of the change on net income may be reported on the income statement of the period in which the change is adopted. In some cases, the effect of the change could be applied retroactively to past periods by presenting revised income statements for the earlier years affected. The application of the consistency concept does not require that a specific accounting method be used uniformly throughout an enterprise.
MATERIALITY
In following generally accepted accounting principles, the accountant must consider the relative importance of any event, accounting procedure, or change in procedure that affects items on the financial statements. Absolute accuracy in accounting and full disclosure in reporting are not ends in themselves, and there is no need to exceed the limits of practicality. The determination of what is significant and what is not requires the exercise of judgment, Precise criteria cannot be formulated.
To determine materiality, the size of an item and its nature must be considered in relationship to the size and the nature of other items. The erroneous classification of a $10,000 asset on a balance sheet exhibiting total assets of $10,000,000 would probably be immaterial. If the assets totaled only $100,000, however, it certainly would be material, If the $10,000 represented a note receivable from an officer of the enterprise, it might well be material even in the first assumption. If the loan was increased to $ 100,000 between the close of the period and the issuance of the statements, both the nature of the item at the balance sheet date and the subsequent increase in amount would require disclosure.
The concept of materiality may be applied to procedures used in recording transactions. As was stated in an earlier chapter, small expenditures for plant assets may be treated as an expense of the period rather than as an asset. The saving in clerical costs is justified if the practice does not materially affect the financial statements. In establishing a dollar amount as the dividing line between a revenue expenditure and a capital expenditure, consideration would need to be given to such factors as (1) amount of total plant assets, (2) amount of plant assets in relationship to other assets, (3) frequency of occurrence of expenditures for plant assets, (4) nature and expected life of plant assets, and (5) probable effect on the amount of periodic net income reported.
Custom and practicality also influence criteria of materiality. Corporate financial statements seldom report the cents amounts or even the hundreds of dollars. A common practice is to round to the nearest thousand.
For large corporations, there is an increasing tendency to report the financial data in terms of millions, carrying figures to one decimal.
A technique known as "whole dollar" accounting, which is used by some businesses, eliminates the cents amounts from accounting entries at the earliest possible point in the accounting sequence. There are some accounts, such as those with customers and creditors, in which it is not feasible to round to the nearest dollar. Nevertheless, the technique yields savings in office costs and improved productivity. The errors introduced into other accounts by rounding the amounts of individual entries at the time of recording tend to be compensating in nature, and the amount of the final error is not material. It should not be inferred from the foregoing that whole dollar accounting encourages or condones errors. The unrecorded cents are not lost; they are merely reported in a manner that reduces recording costs without materially affecting the accuracy of accounting data.
CONSERVATISM
Periodic statements are affected to a great degree by the selection of accounting procedures and other value judgments. Historically, accountants have tended to be conservative, and in selecting among alternatives they have often favored the method or the procedure that yielded the lesser amount of net income or of asset value. This attitude of conservatism often was expressed in the statement to "anticipate no profits and provide for all losses," For example, it is acceptable to price merchandise inventory at lower of cost or market. If market price is higher than cost, the higher amount is ignored in the accounts and, if presented in the financial statements, is presented parenthetically. Such an attitude of pessimism has been due in part to the need for an offset to the optimism of business management. It could also be argued that potential future losses to an enterprise from poor management decisions would be lessened if net income and assets were understated.
Current accounting thought has shifted somewhat from this philosophy of conservatism. Conservatism is no longer considered to be a dominant factor in selecting among alternatives. Revenue should be recognized when realized, and expired costs should be matched against revenue according to the principles based on reason and logic. The element of conservatism may be considered only when other factors affecting a choice or alternatives are neutral. The concepts of objectivity, consistency, disclosure, and materiality are more important than conservatism, and the latter should be a factor only when the others do not play a significant role.
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