3.4. Final accounts

The principles and ethics of accounting practice

Basic Accounting Principles and Guidelines

Since GAAP is founded on the basic accounting principles and guidelines, we can better understand GAAP if we understand those accounting principles. The following is a list of the ten main accounting principles and guidelines together with a highly condensed explanation of each.

1. Economic Entity Assumption

The accountant keeps all of the business transactions of a sole proprietorship separate from the business owner's personal transactions. For legal purposes, a sole proprietorship and its owner are considered to be one entity, but for accounting purposes they are considered to be two separate entities.

2. Monetary Unit Assumption

Economic activity is measured in U.S. dollars, and only transactions that can be expressed in U.S. dollars are recorded.

Because of this basic accounting principle, it is assumed that the dollar's purchasing power has not changed over time. As a result, accountants ignore the effect of inflation on recorded amounts. For example, dollars from a 1960 transaction are combined (or shown) with dollars from a 2015 transaction.

3. Time Period Assumption

This accounting principle assumes that it is possible to report the complex and ongoing activities of a business in relatively short, distinct time intervals such as the five months ended May 31, 2015, or the 5 weeks ended May 1, 2015. The shorter the time interval, the more likely the need for the accountant to estimate amounts relevant to that period. For example, the property tax bill is received on December 15 of each year. On the income statement for the year ended December 31, 2014, the amount is known; but for the income statement for the three months ended March 31, 2015, the amount was not known and an estimate had to be used.

It is imperative that the time interval (or period of time) be shown in the heading of each income statement, statement of stockholders' equity, and statement of cash flows. Labeling one of these financial statements with "December 31" is not good enough–the reader needs to know if the statement covers the one week ended December 31, 2015 the month ended December 31, 2015 the three months ended December 31, 2015 or the year ended December 31, 2015.

4. Cost Principle

From an accountant's point of view, the term "cost" refers to the amount spent (cash or the cash equivalent) when an item was originally obtained, whether that purchase happened last year or thirty years ago. For this reason, the amounts shown on financial statements are referred to as historical cost amounts.

Because of this accounting principle asset amounts are not adjusted upward for inflation. In fact, as a general rule, asset amounts are not adjusted to reflect any type of increase in value. Hence, an asset amount does not reflect the amount of money a company would receive if it were to sell the asset at today's market value. (An exception is certain investments in stocks and bonds that are actively traded on a stock exchange.) If you want to know the current value of a company's long-term assets, you will not get this information from a company's financial statements–you need to look elsewhere, perhaps to a third-party appraiser.

5. Full Disclosure Principle

If certain information is important to an investor or lender using the financial statements, that information should be disclosed within the statement or in the notes to the statement. It is because of this basic accounting principle that numerous pages of "footnotes" are often attached to financial statements.

As an example, let's say a company is named in a lawsuit that demands a significant amount of money. When the financial statements are prepared it is not clear whether the company will be able to defend itself or whether it might lose the lawsuit. As a result of these conditions and because of the full disclosure principle the lawsuit will be described in the notes to the financial statements.

A company usually lists its significant accounting policies as the first note to its financial statements.

6. Going Concern Principle

This accounting principle assumes that a company will continue to exist long enough to carry out its objectives and commitments and will not liquidate in the foreseeable future. If the company's financial situation is such that the accountant believes the company will not be able to continue on, the accountant is required to disclose this assessment.

The going concern principle allows the company to defer some of its prepaid expenses until future accounting periods.

7. Matching Principle

This accounting principle requires companies to use the accrual basis of accounting. The matching principle requires that expenses be matched with revenues. For example, sales commissions expense should be reported in the period when the sales were made (and not reported in the period when the commissions were paid). Wages to employees are reported as an expense in the week when the employees worked and not in the week when the employees are paid. If a company agrees to give its employees 1% of its 2015 revenues as a bonus on January 15, 2016, the company should report the bonus as an expense in 2015 and the amount unpaid at December 31, 2015 as a liability. (The expense is occurring as the sales are occurring.)

Because we cannot measure the future economic benefit of things such as advertisements (and thereby we cannot match the ad expense with related future revenues), the accountant charges the ad amount to expense in the period that the ad is run.

8. Revenue Recognition Principle

Under the accrual basis of accounting (as opposed to the cash basis of accounting), revenues are recognized as soon as a product has been sold or a service has been performed, regardless of when the money is actually received. Under this basic accounting principle, a company could earn and report $20,000 of revenue in its first month of operation but receive $0 in actual cash in that month.

For example, if ABC Consulting completes its service at an agreed price of $1,000, ABC should recognize $1,000 of revenue as soon as its work is done—it does not matter whether the client pays the $1,000 immediately or in 30 days. Do not confuse revenue with a cash receipt.

9. Materiality

Because of this basic accounting principle or guideline, an accountant might be allowed to violate another accounting principle if an amount is insignificant. Professional judgement is needed to decide whether an amount is insignificant or immaterial.

An example of an obviously immaterial item is the purchase of a $150 printer by a highly profitable multi-million dollar company. Because the printer will be used for five years, the matching principle directs the accountant to expense the cost over the five-year period. The materiality guideline allows this company to violate the matching principle and to expense the entire cost of $150 in the year it is purchased. The justification is that no one would consider it misleading if $150 is expensed in the first year instead of $30 being expensed in each of the five years that it is used.

Because of materiality, financial statements usually show amounts rounded to the nearest dollar, to the nearest thousand, or to the nearest million dollars depending on the size of the company.

10. Conservatism

If a situation arises where there are two acceptable alternatives for reporting an item, conservatism directs the accountant to choose the alternative that will result in less net income and/or less asset amount. Conservatism helps the accountant to "break a tie." It does not direct accountants to be conservative. Accountants are expected to be unbiased and objective.

The basic accounting principle of conservatism leads accountants to anticipate or disclose losses, but it does not allow a similar action for gains. For example, potential losses from lawsuits will be reported on the financial statements or in the notes, but potential gains will not be reported. Also, an accountant may write inventory down to an amount that is lower than the original cost, but will not write inventory up to an amount higher than the original cost.

Source - http://www.accountingcoach.com/accounting-principles/explanation

Task 1: Take the accounting principles test - https://www.accountingcoach.com/accounting-principles/quiz

Fundamental principles of accounting

The five fundamental principles are in the following tables

Trading Account

Balance Sheet

A balance sheet (also known as a statement of financial position) is a formal document that follows a standard accounting format showing the same categories of assets and liabilities regardless of the size or nature of the business. The balance sheet you prepare will be in the same format as IBM’s or General Motors’.

A balance sheet provides a snapshot of a business’ health at a point in time. It is a summary of what the business owns (assets) and owes (liabilities). Balance sheets are usually prepared at the close of an accounting period such as month-end, quarter-end, or year-end. New business owners should not wait until the end of 12 months or the end of an operating cycle to complete a balance sheet. Savvy business owners see a balance sheet as an important decision-making tool.

Over time, a comparison of balance sheets can give a good picture of the financial health of a business. In conjunction with other financial statements, it forms the basis for more sophisticated analysis of the business. The balance sheet is also a tool to evaluate a company’s flexibility and liquidity.

How to prepare a balance sheet

A balance sheet is a statement of a firm’s assets, liabilities and net worth. The key to understanding a balance sheet is the simple formula:

Assets = Liabilities + Net Worth

Assets

All balance sheets show the same categories of assets: current, long-term (fixed) assets, and other assets. Assets are arranged in order of how quickly they can be turned into cash. Turning assets into cash is called liquidity.

Fixed Assets

Fixed Assets are also known as long-term assets. Fixed assets are the assets that produce revenues. They are distinguished from current assets by their longevity. They are not for resale. Many small businesses may not own a large amount of fixed assets. This is because most small businesses are started with a minimum of capital. Of course, fixed assets will vary considerably and depend on the business type (such as service or manufacturing), size and market.

Fixed assets include furniture and fixtures, motor vehicles, buildings, land, building improvements (or leasehold improvements, if you rent), production machinery, equipment and any other items with an expected business life that can be measured in years.

All fixed assets (except land) are shown on the balance sheet at original (or historic) cost less any depreciation. Subtracting depreciation is a conservative accounting practice to reduce the possibility of overvaluation. Depreciation subtracts a specified amount from the original purchase price for the wear and tear on the asset.

This section concentrates on the categories of fixed assets common to most small businesses: furniture and fixtures, motor vehicles, and machinery and equipment.

• Furniture and fixtures is a line item that includes office furniture, display shelves, counters, work tables, storage bins and other similar items. On the balance sheet, these items are listed at cost (plus related expenses) minus depreciation.

• Motor vehicles is a line item to list the original value (less depreciation) of any motor vehicle, such as a delivery truck, that is owned by your business.

• Machinery and equipment are vital to many businesses. If you are a manufacturing firm, this could be your largest fixed asset. Like the other fixed assets on the balance sheet, machinery and equipment will be valued at the original cost minus depreciation.

• Other assets is a fourth category of fixed assets. Other assets are generally intangible assets such as patents, royalty arrangements and copyrights.

Current Assets

Current assets include cash, stocks and bonds, accounts receivable, inventory, prepaid expenses and anything else that can be converted into cash within one year or during the normal course of business. These are the categories you will use to group your current assets.

· Cash is relatively easy to figure out. It includes cash on hand, in the bank and in petty cash.

· Accounts receivable is what you are owed by customers. The easy availability of this information is important. Fast action on slow paying accounts may be the difference between success and failure for a small business.

· Inventory may be your largest current asset. On a balance sheet, the value of inventory is the cost to replace it. If your inventory were destroyed, lost or damaged, how much would it cost you to replace or reproduce it? Inventory includes goods ready for sale, as well as raw material and partially completed products that will be for sale when they are completed.

· Prepaid expenses are listed as a current asset because they represent an item or service that has been paid for but has not been used or consumed. An example of a prepaid expense is the last month of rent of a lease that you may have prepaid as a security deposit. It will be carried as an asset until it is used. Prepaid insurance premiums are another example of a prepaid expense.

On a balance sheet, current assets are totalled and this total is shown as the line item: Total Current Assets.

Liabilities

There are two types of liabilities: current liabilities and long-term liabilities. Liabilities are arranged on the balance sheet in order of how soon they must be repaid. For example, accounts payable will appear first as they are generally paid within 30 days. Notes payable are generally due within 90 days and are the second liability to appear on the balance sheet.

Current liabilities are accounts payable, notes payable to banks (or others), accrued expenses (such as wages and salaries), taxes payable, the current due

within one-year portion of long-term debt and any other obligations to creditors due within one year from the date of the balance sheet. The current liabilities of most small businesses include accounts payable, notes payable to banks and accrued payroll taxes.

• Accounts payable is the amount you may owe any suppliers or other creditors for services or goods that you have received but not yet paid for.

• Short-term borrowing refers to any money due on a loan during the next 12 months.

• Accrued wages would be any compensation to employees who have worked, but have not been paid, at the time the balance sheet is created.

Long-term Liabilities

Long-term liabilities are any debts that must be repaid by your business more than one year from the date of the balance sheet. This may include startup financing from relatives, banks, finance companies or others.

Source https://www.zionsbank.com/pdfs/biz_resources_book-2.pdf

Capital Employed

The last section of the balance sheet is capital employed. Capital employed represents the necessary investments required for the business to operate. Capital employed consists of three main categories:

1. Share Capital: The investment of the shareholders in the company. This has nothing to do with the stock market as there is no additional capital in stock investments.

2. Loan Capital: Long term liabilities such as debentures. Loan capital represents the financing needed for the firm.

3. Retained Profit: The profit that has been previously been earned and instead of given out in dividends, is retained by the firm.

Now that you understand the main categories of the balance sheet, you need to understand how they relate.

• Net Assets = Total Assets - Current liabilities
• Net Assets = Capital Employed (this is how you know whether you made the balance sheet correctly)
• Working Capital (net current assets) = Current Assets - Current Liabilities

Net Worth

The formula that defines the balance sheet is:

Assets = Liabilities + Net Worth

The formula can be transposed to yield a definition of net worth:

Net Worth = Assets - Liabilities

Net worth is what is left over after liabilities have been subtracted from the assets of the business.

In a sole proprietorship, it is also known as owner’s equity. This equity is the investment by the owner plus any profits or minus any losses that have accumulated in the business.

Depreciation (HL Only)

Over time fixed assets depreciate which means their value gradually decreases. This decrease in value needs to be shown on the balance sheet, otherwise the net worth of the company would not be accurate. In order to do this there are a few different depreciation methods that can be applied.

Straight Line Method

The straight line method is the simplest way to depreciate an asset, though this simplicity makes it not the most accurate method as it is unrealistic an asset will depreciate by the same value every year.

Annual Depreciation = Cost of fixed asset - Residual value Life span of fixed assets

• Cost of fixed asset: Purchase price of the asset
• Lifespan: Expected amount of time the firm will use the fixed asset before it needs to be replaced.
• Residual value: Expected selling value of the asset at the end of the life of the lifespan of the asset (aka scrap value)