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Unit 6
Accounting Concepts and Principles

Accounting Principles
Introduction to Accounting Principles

There are general rules and concepts that govern the field of accounting. These
general rules–referred to as basic accounting principles and guidelines–form the
groundwork on which more detailed, complicated, and legalistic accounting rules
are based. For example, the Financial Accounting Standards Board (FASB) uses
the basic accounting principles and guidelines as a basis for their own detailed and
comprehensive set of accounting rules and standards.

The phrase "generally accepted accounting principles" (or "GAAP") consists of

three important sets of rules: (1) the basic accounting principles and guidelines,
(2) the detailed rules and standards issued by FASB and its predecessor the
Accounting Principles Board (APB), and (3) the generally accepted industry
practices.

If a company distributes its financial statements to the public, it is required to follow

generally accepted accounting principles in the preparation of those statements.
Further, if a company's stock is publicly traded, federal law requires the company's
financial statements be audited by independent public accountants. Both the
company's management and the independent accountants must certify that the

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financial statements and the related notes to the financial statements have been
prepared in accordance with GAAP.

GAAP is exceedingly useful because it attempts to standardize and regulate

accounting definitions, assumptions, and methods. Because of generally accepted
accounting principles we are able to assume that there is consistency from year to
year in the methods used to prepare a company's financial statements. And
although variations may exist, we can make reasonably confident conclusions
when comparing one company to another, or comparing one company's financial
statistics to the statistics for its industry. Over the years the generally accepted
accounting principles have become more complex because financial transactions
have become more complex.

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.

Business entity principle – a business enterprise is separate and distinct from

its owner or investor.

Examples :

o If the owner has a barber shop, the cash of the barber shop should be
reported separately from personal cash.
o The owner had a business meeting with a prospective client. The
expenses that come with that meeting should be part of the company’s
expenses. If the owner paid for gas for his personal use, it should not be
included as part of the company’s expenses.

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

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effect of inflation on recorded amounts. For example, dollars from a 1960

transaction are combined (or shown) with dollars from a 2017 transaction.

Monetary unit principle – amounts are stated into a single monetary unit

Example :
o Jollibee should report financial statements in pesos even if they have a
store in the United States.
o IHOP should report financial statements in dollars even if they have a
branch here in the Philippines

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, 2017, or the 5 weeks ended May 1, 2017. 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, 2016, the amount is known; but for the income statement for the three months
ended March 31, 2017, 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, 2017 the month ended December 31, 2017 the three months ended
December 31, 2017 or the year ended December 31, 2017.

Time period principle – financial statements are to be divided into specific time
intervals.

Example:
o Philippine companies are required to report financial statements annually.
o the salary expenses from January to December 2015 should only be reported in
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.

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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.

Cost principle – accounts should be recorded initially at cost.

Example :
o When Jollibee buys a cash register, it should record the cash register at
its price when they bought it.
o When a company purchases a laptop, it should be recorded at the price it
was purchased.

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.

Disclosure principle – all relevant and material information should be reported.

Example:
The company should report all relevant information.

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

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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.

Going concern principle – business is expected to continue indefinitely.

Example: When preparing financial statements, you should assume that the entity
will continue indefinitely.

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 2017 revenues as a
bonus on January 15, 2018, the company should report the bonus as an expense
in 2017 and the amount unpaid at December 31, 2017 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.

Matching principle – cost should be matched with the revenue generated.

Example:
When you provide tutorial services to a customer and there is a transportation cost
incurred related to the tutorial services, it should be recorded as an expense for
that period.

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 P20,000
of revenue in its first month of operation but receive P0 in actual cash in that month.

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For example, if ABC Consulting completes its service at an agreed price of P1,000,
ABC should recognize P1,000 of revenue as soon as its work is done—it does not
matter whether the client pays the P1,000 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 P150 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 P150 in the year it is
purchased. The justification is that no one would consider it misleading if P150 is
expensed in the first year instead of P30 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.

Materiality principle – in case of assets that are immaterial to make a difference

in the financial statements, the company should instead record it as an expense.

Example:
A school purchased an eraser with an estimated useful life of three years. Since
an eraser is immaterial relative to assets, it should be recorded as an expense.

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.

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Conservatism principle – also known as prudence. In case of doubt, assets and

income should not be overstated while liabilities and expenses should not be
understated.

Example: In case of doubt, expenses should be recorded at a higher amount.

Revenue should be recorded at a lower amount.

11. Objectivity principle – financial statements must be presented with

supporting evidence.

Example:
o When the customer paid Jollibee for their order, Jollibee should have a
copy of the receipt to represent as evidence.

When a company incurred a transportation expense, a voucher should be

prepared as evidence.

12. Accrual Accounting Principle – revenue should be recognized when earned

regardless of collection and expenses should be recognized when incurred
regardless of payment. On the other hand, the cash basis principle in which
revenue is recorded when collected and expenses should be recorded when paid.
Cash basis is not the generally accepted principle today.

Example:
When a barber finishes performing his services, he should record it as revenue.
When the barber shop receives an electricity bill, it should record it as an expense
even if it is unpaid.

Other Characteristics of Accounting Information

When financial reports are generated by professional accountants, we have certain

expectations of the information they present to us:

 We expect the accounting information to be reliable, verifiable, and

objective.
 We expect consistency in the accounting information.
 We expect comparability in the accounting information.

1. Reliable, Verifiable, and Objective

In addition to the basic accounting principles and guidelines listed in Part 1,

accounting information should be reliable, verifiable, and objective. For example,
showing land at its original cost of P10,000 (when it was purchased 50 years ago)
is considered to be more reliable, verifiable, and objective than showing it at its

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current market value of P250,000. Eight different accountants will wholly agree that
the original cost of the land was P10,000—they can read the offer and acceptance
for P10,000, see a transfer tax based on P10,000, and review documents that
confirm the cost was P10,000. If you ask the same eight accountants to give you
the land's current value, you will likely receive eight different estimates. Because
the current value amount is less reliable, less verifiable, and less objective than
the original cost, the original cost is used.

The accounting profession has been willing to move away from the cost principle if
there are reliable, verifiable, and objective amounts involved. For example, if a
company has an investment in stock that is actively traded on a stock exchange,
the company may be required to show the current value of the stock instead of its
original cost.

2. Consistency

Accountants are expected to be consistent when applying accounting principles,

procedures, and practices. For example, if a company has a history of using
the FIFO cost flow assumption, readers of the company's most current financial
statements have every reason to expect that the company is continuing to use the
FIFO cost flow assumption. If the company changes this practice and begins using
the LIFO cost flow assumption, that change must be clearly disclosed.

3. Comparability

Investors, lenders, and other users of financial statements expect that financial
statements of one company can be compared to the financial statements of
another company in the same industry. Generally accepted accounting
principles may provide for comparability between the financial statements of
different companies. For example, the FASB requires that expenses related to
research and development (R&D) be expensed when incurred. Prior to its rule,
some companies expensed R&D when incurred while other companies deferred
R&D to the balance sheet and expensed them at a later date.

How Principles and Guidelines Affect Financial Statements

The basic accounting principles and guidelines directly affect the way financial
statements are prepared and interpreted. Let's look below at how accounting
principles and guidelines influence the (1) balance sheet, (2) income statement,
and (3) the notes to the financial statements.

1. Balance Sheet

Let's see how the basic accounting principles and guidelines affect the balance
sheet of Mary's Design Service, a sole proprietorship owned by Mary Smith. (To

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learn more about the balance sheet go to Explanation of Balance Sheet and Quiz
for Balance Sheet.)

A balance sheet is a snapshot of a company's assets, liabilities, and owner's equity

at one point in time. (In this case, that point in time is after all of the transactions
through September 30, 2017 have been recorded.) Because of the economic entity
assumption, only the assets, liabilities, and owner's equity specifically identified
with Mary's Design Service are shown—the personal assets of the owner, Mary
Smith, are not included on the company's balance sheet.

Mary’s Design Service

Balance Sheet
September 30, 2017
ASSETS LIABILITIES
Cash 300 Notes Payable
Accounts Receivable 1,000 Accounts Payable
Supplies 160 Wages Payable
Prepaid Insurance 90 Unearned revenues
Land 10,000 Total Liabilities
OWNER’S EQUITY
M. Smith, Capital
Total Assets 11,550 Total Liabilities and Owner’s 11,550
Equity

The assets listed on the balance sheet have a cost that can be measured and each
amount shown is the original cost of each asset. For example, let's assume that a
tract of land was purchased in 1956 for P10,000. Mary's Design Service still owns
the land, and the land is now appraised at P250,000. The cost principle requires
that the land be shown in the asset account Land at its original cost of P10,000
rather than at the recently appraised amount of P250,000.

If Mary's Design Service were to purchase a second piece of land, the monetary
unit assumption dictates that the purchase price of the land bought today would
simply be added to the purchase price of the land bought in 1956, and the sum of
the two purchase prices would be reported as the total cost of land.

The Supplies account shows the cost of supplies (if material in amount) that were
obtained by Mary's Design Service but have not yet been used. As the supplies
are consumed, their cost will be moved to the Supplies Expense account on the
income statement. This complies with the matching principle which requires
expenses to be matched either with revenues or with the time period when they
are used. The cost of the unused supplies remains on the balance sheet in the
asset account Supplies.

The Prepaid Insurance account represents the cost of insurance that has not yet
expired. As the insurance expires, the expired cost is moved to Insurance

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Expense on the income statement as required by the matching principle. The cost
of the insurance that has not yet expired remains on Mary's Design Service's
balance sheet (is "deferred" to the balance sheet) in the asset account Prepaid
Insurance. Deferring insurance expense to the balance sheet is possible because
of another basic accounting principle, the going concern assumption.

The cost principle and monetary unit assumption prevent some very valuable
assets from ever appearing on a company's balance sheet. For example,
companies that sell consumer products with high profile brand names, trade
names, trademarks, and logos are not reported on their balance sheets because
they were not purchased. For example, Coca-Cola's logo and Nike's logo are
probably the most valuable assets of such companies, yet they are not listed as
assets on the company balance sheet. Similarly, a company might have an
excellent reputation and a very skilled management team, but because these were
not purchased for a specific cost and we cannot objectively measure them in
dollars, they are not reported as assets on the balance sheet. If a company actually
purchases the trademark of another company for a significant cost, the amount
paid for the trademark will be reported as an asset on the balance sheet of the
company that bought the trademark.

2. Income Statement

Let's see how the basic accounting principles and guidelines might affect the
income statement of Mary's Design Service.

An income statement covers a period of time (or time interval), such as a year,
quarter, month, or four weeks. It is imperative to indicate the period of time in the
heading of the income statement such as "For the Nine Months Ended September
30, 2017". (This means for the period of January 1 through September 30, 2017.)
If prepared under the accrual basis of accounting, an income statement will show
how profitable a company was during the stated time interval.

Mary’s Design Service

Income Statement
For the Months Ending September 30, 2017
Revenue and gains Php 10,000
Revenues 5,000
Gain on sale of land 15,000
Total revenues and gains
Expenses and losses
Expenses Php 8,000
Loss on sale of computer 350
Total expenses and losses 8,350
Net Income Php 6,650

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Revenues are the fees that were earned during the period of time shown in the
heading. Recognizing revenues when they are earned instead of when the cash is
actually received follows the revenue recognition principle and the matching
principle. (The matching principle is what steers accountants toward using the
accrual basis of accounting rather than the cash basis. Small business owners
should discuss these two methods with their tax advisors.)

Gains are a net amount related to transactions that are not considered part of the
company's main operations. For example, Mary's Design Service is in the business
of designing, not in the land development business. If the company should sell
some land for P30,000 (land that is shown in the company's accounting records at
P25,000) Mary's Design Service will report a Gain on Sale of Land of P5,000. The
P30,000 selling price will not be reported as part of the company's revenues.

Expenses are costs used up by the company in performing its main operations.
The matching principle requires that expenses be reported on the income
statement when the related sales are made or when the costs are used up (rather
than in the period when they are paid).

Losses are a net amount related to transactions that are not considered part of the
company's main operating activities. For example, let's say a retail clothing
company owns an old computer that is carried on its accounting records at P650.
If the company sells that computer for P300, the company receives an asset (cash
of P300) but it must also remove P650 of asset amounts from its accounting
records. The result is a Loss on Sale of Computer of P350. The P300 selling price
will not be included in the company's sales or revenues.

3. The Notes To Financial Statements

Another basic accounting principle, the full disclosure principle, requires that a
company's financial statements include disclosure notes. These notes include
information that helps readers of the financial statements make investment and
credit decisions. The notes to the financial statements are considered to be an
integral part of the financial statements.

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Test
Multiple choice: Write the word/s of the correct answer:

1. The accounting guideline that requires financial statement information to be

supported by independent, unbiased evidence other than someone's belief or
opinion is the:
 Business entity principle
 Monetary unit principle
 Going-concern principle
 Cost principle
 Objectivity principle

2. The principle that requires every business to be accounted for separately and
distinctly from its owner or owners is known as the:
 Objectivity principle
 Business entity principle
 Going-concern principle
 Revenue recognition principle
 Cost principle

3. The rule that requires financial statements to reflect the assumption that the
business will continue operating instead of being closed or sold, unless evidence
shows that it will not continue, is the:
 Going-concern principle
 Business entity principle
 Objectivity principle
 Cost Principle
 Monetary unit principle

4. To include the personal assets and transactions of a business's owner in the

records and reports of the business would be in conflict with the:
 Objectivity principle
 Realization principle
 Business entity principle
 Going-concern principle
 Revenue recognition principle

5. The objectivity principle:

 means that information is supported by independent, unbiased evidence
 means that information can be based on what the preparer thinks is true
 means that financial statements should contain information that is optimistic
 means that a business may not re-organize revenue until cash is received
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6. Marian Mosely is the owner of Mosely Accounting Services. Which accounting

principle requires Marian to keep her personal financial information separate from
the financial information of Mosely Accounting Services?
 Monetary unit principle
 Going-concern principle
 Cost principle
 Business entity principle

7. Which of the following accounting principles would require that all goods and
services purchased be recorded at cost?
 Going-concern principle
 Continuing-concern principle
 Cost principle
 Business entity principle

8. The personal assets of the owner of a company will not appear on the
company's balance sheet because of which principle/guideline?
 Cost
 Economic Entity
 Monetary Unit

9. Which principle/guideline requires a company's balance sheet to report its land

at the amount the company paid to acquire the land, even if the land could be
sold today at a significantly higher amount?
 Cost
 Economic Entity
 Monetary Unit

10. Which principle/guideline allows a company to ignore the change in the

purchasing power of the dollar over time?
 Cost
 Economic Entity
 Monetary Unit

11. Which principle/guideline requires the company's financial statements to have

footnotes containing information that is important to users of the financial
statements?
 Conservatism
 Economic Entity
 Full Disclosure

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12. Which principle/guideline justifies a company violating an accounting principle

because the amounts are immaterial?
 Conservatism
 Full Disclosure
 Materiality

13. Which principle/guideline is associated with the assumption that the company
will continue on long enough to carry out its objectives and commitments?
 Economic Entity
 Going Concern
 Time Period

14. A very large corporation's financial statements have the dollar amounts
rounded to the nearest P1,000. Which accounting principle/guideline justifies
not reporting the amounts to the penny?
 Full Disclosure
 Materiality
 Monetary Unit

15. Accountants might recognize losses but not gains in certain situations. For
example, the company might write-down the cost of inventory, but will not write-
up the cost of inventory. Which principle/guideline is associated with this
action?
 Conservatism
 Materiality
 Monetary Unit

16. Which principle/guideline directs a company to show all the expenses related
to its revenues of a specified period even if the expenses were not paid in that
period?
 Cost
 Matching
 Monetary Unit

17. When the accountant has to choose between two acceptable alternatives, the
accountant should select the alternative that will report less profit, less asset
amount, or a greater liability amount. This is based upon which
principle/guideline?
 Conservatism
 Cost
 Materiality

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18. Public utilities' balance sheets list the plant assets before the current assets.
This is acceptable under which accounting principle/guideline?
 Conservatism
 Cost
 Industry Practices

19. A large company purchases a P250 digital camera and expenses it

immediately instead of recording it as an asset and depreciating it over its
useful life. This practice may be acceptable because of which
principle/guideline?
 Cost
 Matching
 Materiality

20. A corporation pays its annual property tax bill of approximately P12,000 in one
payment each December 28. During the year, the corporation's monthly income
statements report Property Tax Expense of P1,000. This is an example of
which accounting principle/guideline?
 Conservatism
 Matching
 Monetary Unit

21. A company sold merchandise of P8,000 to a customer in December. The

company's sales terms require the customer to pay the company in 30 days.
The company's income statement reported the sale in December. This is proper
under which accounting principle/guideline?
 Full Disclosure
 Monetary Unit
 Revenue Recognition

22. Accrual accounting is based on this principle/guideline.

 Cost
 Full Disclosure
 Matching

16.The creative chief executive of a corporation who is personally responsible for

numerous inventions and innovations is not reported as an asset on the
corporation's balance sheet. The accounting principle/guideline that prevents the
corporation for reporting this person as an asset is
 Conservatism
 Cost
 Going Concerns

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17.An asset with a cost of P120,000 is depreciated over its useful life of 10 years
rather than expensing the entire amount when it is purchased. This complies with
which principle/guideline?
 Cost
 Full Disclosure
 Matching

18.Near the end of the current year, a company required a customer to pay
P200,000 as a deposit for work that is to begin in the following year. At the end of
the current year the company reported the P200,000 as a liability on its balance
sheet. Which accounting principle/guideline prevented the company from reporting
the P200,000 on its income statement for the current year?
 Going Concern
 Materiality
 Revenue Recognition

19.A retailer wishes to report its merchandise inventory on its balance sheet at its
retail value. This would violate which accounting principle/guideline?
 Cost
 Full Disclosure
 Monetary Unit

20.A company borrowed P100,000 in December and will make its only payment
for interest when the note comes due six months later. The total interest for the six
months will be P3,600. On the December income statement the accountant
reported Interest Expense of P600. This action was the result of which accounting
principle/guideline?
 Cost
 Matching
 Revenue Recognition

B. IDENTIFICATION. Write the word of the cored answer. Accounting

principles. Indicate which principles are violated. (Business entity /
Monetary unit / Time period / Business entity / Materiality / Objectivity)

1. The owner-manager bought a computer for personal use. The invoice was given
to the accountant who recorded it as an asset of the business.

2. The statement of financial position of a company included an equipment

purchased from Japan for 350,000 yen. It was reported at that amount in the
statement of financial position while all the other assets were reported in Philippine
pesos.

3. No financial statements were prepared by Michael Go for his business. He

explained that he will prepare the statements when he closes the business, which
he predicts to take place after 20 years.
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4. Aside from owning a shoe store, Albert operates a canteen. The assets of the
canteen are reported in the statement of financial position of the shoe store.

5. Purchased a hammer at a cost of PHP500. This was recorded as an asset and

expense to decrease its value by PHP50 per year for 10 years.

6. A food company ordered a machine needed in the assembly line of its production
department. Upon order, the machine was immediately listed as one of its assets.

C. Matching. Match the following words with their definition:

Column A Column B
a. All relevant information should be included in the  Going concern
financial reports principle
b. In case of doubt, assets and income should not  Objectivity principle
be overstated.
c. Assume that the company will continue  Matching principle
indefinitely.
d. All transactions should be supported by  Materiality principle
unbiased evidence.
e. Expenses should be recorded in the period when  Time period principle
the revenue is generated.
f. Minimal costs incurred should be recorded as an  Cost principle
expense.
g. A Philippine company should report financial  Disclosure principle
statements in pesos.
h. A barber who performs services for a client  Monetary unit
should record revenue. principle
i. Statement of Financial position should be  Accrual accounting
recorded as of December 31, 2015. principle

j. A company that purchases furniture should  Conservatism

record it at its acquisition price. principle

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