Video Transcript: The Major Accounting Principles part 1

Hello and welcome back now we're going to discuss the major accounting  principles, generally accepted accounting principles, otherwise known as GAP  set for standards or methods for presenting financial accounting information, a  standardized presentation format enables users to compare the financial  information of different companies more easily. Generally Accepted Accounting  Principles have been either developed through accounting practice or  established by authorities of organizations. Organizations that have contributed  to the development of the principles are the American Institute of Certified Public Accountants, the Financial Accounting Standards Board, the Security and  Exchange Commission, the American Accounting Association, the financial  Executive Institute and the Institute of Management Accounting. This section  explains the following major principles, the exchange price or the cost principle,  the revenue recognition principle, the matching principle, gain and loss  recognition principle and full disclosure principle. Whenever resources are  transferred between two parties, such as buying merchandise on account, the  accountant must follow the exchange price or the cost principle in presenting  that information. The Exchange price principle requires an accountant to record  transfers of resources at prices agreed on by the parties to exchange at the time of the exchange, the principle set forth what goes into the accounting system,  transaction data, when it is recorded at the time of the exchange, and the  amounts, exchange prices at which assets, liabilities, stockholders, equity,  revenue and expenses are recorded as applied to most assets. The principal is  often called the cost principle. It dictates, dictates that purchased or self  constructed assets are initially recorded as historical cost. Historical cost is the  amount paid or the fair market value of the liability incurred or other resources  surrendered to acquire an asset and place it in a condition and position for its  intended use. For instance, when the cost of a plant asset, such as a machine,  is recorded, its cost includes the net purchase price plus any cost of  reconditioning, testing, transporting and placing the asset in the location for its  intended use. Accountants prefer the term exchange price principal to cost  principal because it seems inappropriate to refer to liabilities, stockholders'  equity and such assets as cash and accounts receivable, as being measured in  terms of cost. Current assets are cash and other assets that a business can  convert to cash or use up in a relatively short period, one year or one operating  cycle. Whichever is longer, an operating cycle is the is the time it takes to start  with cash by necessary items to produce revenues, sell services or goods and  receive cash by collecting the resulting receivables. More recently, the FASB  and SFAS 157 has moved definitely towards fair market value accounting, or  mark to market which records the value of an asset or liability at its current  market value, rather than its book value. The SFAS 157 defines fair value as the price that would be received to sell an asset or pay to transfer liability in an  orderly transaction between market participants at the measurement date. It is 

also defined as an exit price from the perspective of a market participant that  holds the asset or owns a liability, whether or not the business plans to hold the  asset liability for investment or sell it. Cash includes deposits in the bank  available for current operations at the balance sheet date, plus cash on hand,  consisting of currency undeposited checks, drafts and money orders. Cash is  the first current asset to appear on the balance sheet. The term cash normally  includes cash equivalents, the fair value accounting standard SFAS 157 applies  to financial assets of all publicly traded companies in the US. As of 2007  November 15. It also applies to non financial assets and liabilities that are  recognized or disclosed at fair value on a reoccurring basis, beginning in 2009  the standard will apply to other non financial assets. SFAS 157 applies to items  for which other accounting pronouncements require or permit fair value  measurements, except share based payment transactions such as stock option  compensation. The SFAS 157 provides a hierarchy of three levels of input data  for determining the fair value of an asset or liability this hierarchy, this hierarchy  ranks the quality and the reliability of information used to determine fair values,  with level one inputs being the most reliable, and level three inputs being the  least reliable. Level one is quoted prices for identical items in active, liquid and  visible markets, such as stock exchanges. Level two is observable information  for similar items in active or inactive markets, such as two similar situated  buildings in a downtown real estate market. Level three are unobservable inputs to be used in situations where markets do not exist or are illiquid, such as the  present credit crisis. At this point, fair market valuation becomes highly  subjective. Fair value accounting has been a continuous topic since it was  introduced. For example, banks and investment banks have had to reduce the  value of the mortgage and mortgage backed securities to reflect current prices.  Those prices declined severely with the collapse of credit markets and mortgage defaults escalated in the financial crisis of 2008 and 2009 despite debate over  the proper implementation of fair market value accounting International Financial Reporting Standards, utilizes the approach much more than the generally  accepted accounting principles of the United States, revenue is not difficult to  determine or measure. It is the inflow of assets from the sale of goods and  services to customers, measured by the cash expected to be received from  customers. However, the crucial question for the accountant is when to record a  revenue under the revenue recognition principle. Revenues should be earned  and realized when they are recognized. All economic activities undertake  undertaken by a company to create revenues are part of the earning process.  Many activities may may have preceded the actual receipt of cash from a  customer, including placing advertisements, calling on the customer several  times, submitting samples, acquiring or manufacturing goods and selling and  delivering goods. For these activities, the company incurs cost, although  revenue was actually being earned by these activities, accountants do not 

recognize revenue until the time of sale, because of the requirement that  revenue be substantially earned before it is recognized. This requirement is the  earnings principle. Under the realization principle, the accountant does not  recognize revenue until the seller acquires the right to receive payment from the  buyer. The seller acquires this right from the buyer at the time of sale for  merchandise transactions, or when services have been performed in service  transactions, legally, a sale of merchandise occurs when title to the goods  passes to the buyer. The time at which title passes, normally depends on the  shipping terms, FOB freight on board, shipping point or FOB destination, and  we'll discuss this in chapter six as a practical matter. Accountants generally  record revenue when goods are delivered. The advantages of recognizing  revenue at the time of sell are the actual transaction. Delivery of goods is an  observable event. Revenue is easily measured, and risk of loss due to price  decline or destruction of the goods has passed to the buyer. Revenue has been  earned or substantially So, and because the revenue has been earned,  expenses and net income can be determined, as discussed later. The  disadvantage of recognizing revenue at the time of sale is that the revenue  might not be recorded in the period during which most of the activity creating it  occurred exceptions to the realization principle. The following examples are  instances when practical considerations may cause accountants to vary the  point of revenue recognition from the time of sale. These examples illustrate the  effect that the business environment has on the development of accounting  principles and standards. Cash collection as point of revenue recognition. Some  small companies record revenues and expenses at the time of cash collection  and payment, which would not occur at the time of sale. This procedure is the  cash basis of accounting. The cash basis is acceptable primarily in service and  enterprises that do not have substantial credit transactions or investments, such  as business entities of doctors or dentists when collecting the selling price of  goods sold in monthly or annual installments, a considerable doubt exists as to  the collectibility the company may use the installment basis of accounting  companies make these sales in spite of the doubtful collectibility of The account, because their margin of profit is high and the goods can be repossessed if the  payments are not received under the installment basis, the percentage of total  gross margin the selling price of goods minus its cost recognized in a period, is  equal to the percentage of total cash from a sale that is received in that period.  Thus, the gross margin recognized in a period is equal to the cash received  times the gross margin percentage. The formula to recognize gross profit on  cash collections made on installment sales of a certain year is as follows. So as  you can see, you have your cash collections times your gross margin  percentage, which would equal your gross margin recognized. To be more  precise, you can expand it into the following formula. So your cash collections  for the year resulting from installment sales made in a certain year times the 

gross margin percentage for the year of the sale. That will equal your gross  margin recognized this year on cash collections this year from installment sales  made in the certain year, Okay, to illustrate that point, assume, assume a  company sold a stereo set. The facts of the sell are the day of the sale, the  selling price, the cost. So you go your gross margin is your $200 so your gross  margin percentage is your gross margin divided by your selling price, which will  give you 40, I'm sorry, 40% the buyer makes 10 equal monthly installment  payments of $50 to pay for this. For the set, if the company receives three  monthly payments in 2010 the total amount of cash received in 2010 is $150 the gross margin to recognize in 2010 is you can take Your $150 times your 40%  and your gross margin is $60 the US dollars, the company collects the other  installments when due. So it receives a total of $350 in 2011 from 2010  installment sales, the gross margin to recognize in 2010 11 on these cash  collections, as it follows. So you have your 2011 cash collections that came from 2010 they will equal to $350 and your gross margin percentage is your 40% so  you're going to just multiply that times the your installments that were are being  made in 2011 and you're going to get your your gross margin recognized is $140 in summary, the total receipts and gross margin recognized in the two years are  as follows. So in 2010 your cash recognized was $150 and then in 2011 your  $350 so you recognize 30% in 2010 and 70% in 2011 which gives you your  100% and then your gross margin recognized is $60 which is your 30% $140 in  2011 which is your 70% for a total of $200 with 100% margin recognized  because the installment basis delays some revenue recognized beyond the time of sale. It is acceptable for accounting purposes only when considerable doubt  exists as to collectibility of the installment companies recognize revenue from a  long term construction project under two different methods, the first method the  completed contract method, and the second is the percentage of completion  method. The completed contract method does not recognize any revenue until  the project is completed. In that period, they recognize all revenue, even though  the contract may have required three years to complete. Thus, the completed  contract method recognizes revenue at the time of sale, as is true for most sales transactions, companies carry costs incurred on the project forward in an  inventory account construction in progress, and charge them to expense in the  period in which the revenue is recognized.