COURSE 2

ACCOUNTING CONCEPTUAL FRAMEWORK

GENERAL ACCEPTED ACCOUNTING PRINCIPLES (GAAP)

Over the years, the accounting profession evolved without a defined set of guiding principles.
Confusion often arose as different firms used varying methods to correct similar problems. This made
comparison of financial reports between companies and over time difficult, as information was
interpreted in different ways by different people. For these reason, c conceptual framework, in the
form of a number of concept statement, is being developed to provide a set of guiding principles for
the accounting profession.
Accountants themselves have developed traditional ways of doing things. This is reflected in
the Accounting Conventions, which are generally accepted accounting principles which have been
used for many years. These conventions (or accepted practices) include those described below.

The entity concept (business – entity concept). Under the business entity concept, for
accounting purposes, every business is conceived to be and is treated as a separate entity, separate and
distinct from its owner or owners and from every other business. Businesses are so conceived and
treated because, in as far as a specific business is concerned, the purpose of accounting is to record its
financial position and profitability. Consequently, the records and periodically report its financial
position and should not include either the transactions or assets of another business or the personal
assets and transactions of its owner or owners. To include either distorts the financial position and
profitability of the business. For example, the personally owed automobile of a business owner should
not be included among the assets of the owner's business. Likewise, its gas, oil and repairs should not
be treated as an expense of the business, for to do so distort the reported financial position and
profitability of the business.
It should be also made a clear distinction between accounting and legal entities. In some cases
the two coincide. For example, corporations, trusts and governmental agencies are both accounting and
legal entities.
The proprietorship is an accounting entity, as indicated by the fact that all assets and liabilities
of the business unit are included in its financial statements. The business proprietorship is not a legal
entity (is not legally separated from its proprietor). He is legally liable both for his personal obligations
and for those incurred in his business. For accounting purposes, the proprietor as an individual and his
business enterprise are separate entities. A corporation is a legal entity (the shareholders are not
responsible from the legal point of view for the company's debts or obligation), separate from the
persons who own it.
As a general rule, we may say that any legal or economic unit which controls economic
resources and is accountable for those resources is an accounting entity.

The substance over form principle

When assets are recorded, it is respected first the economic – financial point of view and after this, the
juridical interfierence.

The going – concern assumption (continuity of activity convention). An underlying

assumption in accounting is that an accounting entity will continue in operation for a period of time
sufficient to carry out its existing commitments.
The assumption of continuity leads to the concept of the going – concern. In general, the going
concern assumption justifies ignoring immediate liquidating values in presenting assets and liabilities

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in the balance sheet. The going – concern principle assumes an indefinite life for most accounting
entities.

Accrual convention (the independence of financial year principle). This principle states that
any transaction should be registrated in the moment when it happens and not in the moment of paying
or receiving the money.
For example, a company sells merchandises in its total value of $400, on January, the 2nd 2002
and will receive the money later on a certain maturity date, which is March, 3 rd 2003. The accrual
convention says that the company should registrate the transaction in the moment it was generated (on
January, the 2nd 2002) and not in the moment it will receive the money (Accounts Receivable) which is
March, 3rd 2003.

Consistency. The same procedures used to collect accounting information should be used each
fiscal period; in the absence of this standard it is not possible to make decisions and comparisons.

Periodicity (the time period principle). Statements of the operation's financial condition must
be reported periodically. So, this principle assures the requirement to measure operating progress and
changes in economic position at relatively short time intervals during the indefinite life of the business
entity. The intervals are called "accounting period of time" or just "accounting year".
In each accounting period (usually a year, but the reports may be made quarterly or even often)
it is necessary to present the beginning financial position (though the beginning balance sheet) and a
final financial position (determined at the end of the period) though the ended balance sheet.
Dividing the life of the enterprise into time segments and measuring changes in financial
position for these short periods is a difficult process. The tentative nature of periodic measurements of
net income should be understood by those who rely on periodic accounting information. The need for
frequent measurements creates many of the accounting most serious problems.
The most common reporting is the financial year, which in our country and in Europe could be
the same with the calendaristic year (Jan 1st – Dec 31st) and in UK lasts from April the 1st to March 31st
.

Prudence (conservatism). This standard requires that all losses are to be shown in financial
records if there is a reasonable change that such problems will occur; gains and related financial
benefits, however should not be reflected in records until really occur. Further on, in accounting will
registrate elements for the minimum value between book value and inventory value.
This principle is important since many accounting decisions do not have a single “right”
answer. Therefore, a choice between alternative assumptions is necessary. This concept guides the
accountant faced with alternate measurement to select the option with the least favorable impact upon
the net income and financial position within the current accounting period.

The money measurement concept. This principle means that money is used as the basic
measuring unit for financial reporting.
Money is the common denominator in which accounting measurements are made and
summarized. The USD, or any other monetary unit (ROL) represents a unit of value. Implicit in the
use of money as a measuring unit is the assumption that the USD (ROL) is not a stable unit of value.
The prices of goods and services in economy changes over time. When the general price level (the
average of all prices) increases, the value of money (that is, its ability to command goods and services)
decreases.
According to the stable USD (ROL) concept, subsequent changes in the purchasing power of
money do not affect the amount used for the evaluation of the event when it was recorded in the
accounts.
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 The cost (historical cost) concept. A fundamental concept of accounting, closely related to the
going concern principle, is that an asset is commonly entered in the accounting records at the price
paid to acquire it. This price is called acquisition cost because it means resources used in order to bring
the assets in the patrimony. This cost is the basis for all subsequent accounting records related to the
asset aquired.
For example, if a business pays $50,000 for land to be used in carrying on its operations, the
purchase should be recorded at $50,000. It makes no difference if the buyer and several competent
outside appraisers think the land “worth” at least $60,000. Its cost $50,000 should appear on the
balance sheet at that amount. Furthermore, if five years later, due to the booming real estate prices, the
land’s market value has doubled, this makes no difference either. The land cost $50,000 and should
continue to appear on the balance sheet at $50,000 even though its estimated market value is twice
that. The real value of an asset may change in time, during the revaluation procedure. The accounting
records do not necessarily reflect all the changes in the asset value.
In accounting assets are initially recorded at their cost. This is also referred to as an asset’s
historical cost. This amount is ordinarily unaffected by subsequent changes in the value of the asset. In
ordinary usage by contrast, the value of an asset usually means the amount for which it currently be
sold.
Thus, the amounts at which assets are shown in an entity’s account do not indicate the sale
values of the assets. If the asset is sold at a price above or below historical cost, in the accounting
books must be recorded three types of information:
1) the historical cost written off from the books;
2) the market value or the price obtained by selling the asset;
3) the proceeds (differences) between historical cost and market value as an increase in
revenues or expenses.
The most common mistake made by persons who read accounting reports is that of
believing there is a close correspondence between the amounts at which an asset appears in these
reports and the actual value of the asset.
To emphasize the distinction between the accounting concept and the ordinary measuring of
value, the term “book value” is used for the historical cost amounts as shown in the accounting records
and the term “market value” for the actual value of the asset as reflected in the market place.

Double entry. This principle is based on the fundamental accounting equation:

ASSETS = LIABILITIES + OWNER’S EQUITY
Each transaction supposes at the same time at least two changes in the patrimony substance.
That means that minimum two accounts are going to be used in connection, in order to reflect a
business transaction (because for each item is used one account to reflect its existence and its changes).
The accounts used should be affected in different ways, because they reflect two images of the same
patrimony (assets and equity or assets and liabilities etc.).
Double entry applied for the accounts, used as a concept, can be summarized in the
correspondence existing between:
DEBIT ---------------------------------- CREDIT
Anyway, each phenomenon that occurs should be first analyzed from two points of view : what
is it? and where does it come from? And then registered with the inherent changes that produces on
the fundamental accounting equation.

Materiality. The term materiality refers to the relative importance of an item or event.
Disclosure of relevant information is closely related to the concept of materiality; what is material is
likely to be relevant.
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 We must recognize that the materiality of an item is a relative matter, what is materiality of an
item is a relative matter, what is material for one business may not be material for another. Materiality
of an item may depend not only on its amount but also on its nature. In summary, it can be stated the
following rule: an item is material if there is a reasonable expectation that knowledge of it would
influence the decision of prudent users of financial statements.

The full – disclosure principle. Adequate disclosure means that all materials and relevant
facts concerning financial position and the results of operations are communicated to the users. This
can be accomplished either in the financial statements or in the notes accompanying the statements.
Such disclosure should make the financial statements more useful and less subject to misinterpretation.
The following information generally should be disclosed:
1. terms of major borrowing arrangements and existence of large contingent liabilities.
2. contractual provisions relating to leasing arrangements, employee pension and major
proposed asset acquisition.
3. accounting methods used in preparing the financial statements.
4. changes in accounting methods made during the latest period.
5. other significant events affecting financial position, including major new contracts for sale
of goods or services, laborer strikes, shortages of raw materials.

The matching principle. This is a fundamental principle for determining the net
income of a company and preparing an income statement.
Revenue, the gross increase in net assets resulting from the production or sale
of goods and services, is offset by expenses incurred in bringing the firm’s output to the point of sale.
So, incurred expenses must be matched with, and deducted from, revenues generated.
The recognition of revenue, accordingly to the realization principle is made
“when it is earned”. In a manufacturing business, the earning process involves: (a) acquisition of raw
materials, (b) production of finished goods, (c) sale of the finished goods and (d) collection of cash
from credit customers.
In cash accounting revenue is considered realized only when cash is collected
from customers.
In accrual accounting revenue should be recognized at the time of the sale of
the goods or the rendering of services.
The measurement of expenses occurs in two stages:
1) measuring the cost of goods and services that will be consumed or expire in
generating revenue and
2) determining when the goods and services acquired, have contributed to revenue and
their cost thus become an expense.

The second aspect of the measurement process is often referred to as “matching

costs and revenues” and is fundamental to the accrual basis of accounting.
Costs are matched with revenues in two major ways:
1. In relation to the product sold or service rendered.
If goods and services can be related to the product or service that constitutes the output
of the enterprise, its costs become an expense when the product is sold or the service
rendered to customers. The cost of goods sold in merchandising firms is a good
example of this type of expense.

2. In relation to the time period during which revenue is earned.

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 Some costs incurred by business cannot be directly related to the product or service
output of the firm. These “period costs” are considered expense in that period when
they contribute to revenue.

The realization principle (recognition principle). The realization principle is the

accounting rule that defines a revenue as an inflow of assets, not necessarily cash, in the exchange for
goods and services and requires the revenue to be recognized at the same time, but not before it is
earned. The principle also requires that the amount of revenue recognized be measured by the cash
received plus the cash equivalent (fair value) of any other asset or assets received.

The objectivity principle. This principle is the accounting rule that wherever possible the
amounts used in recording transactions be based on objective evidence rather than on subjective
judgments.
The objectivity principle supplies the reason transactions are recorded at cost, since it requires
that transaction amounts be objectively established. Whims and fancies plus, for example, something
like an opinion of management that an asset is “worth more than it cost” have no place in accounting.
To be fully useful, accounting information must be based on objective data. As a rule, costs are
objective, since they normally are established by buyers and sellers, each striking the best possible
bargain for himself or herself.

Considering its procedures or instruments used in the accounting practice, the method
of accounting science represents an assembly of general, common and specific procedures. Some of
the general procedures are: observation, classification, analysis and synthesizing. Common procedures
are: documentation, evaluation, calculus and physical counts for inventory, while the specific
procedures are: balance sheet, account and trial balance. The accounting information processing cycle
includes these procedures with their interaction.