ACC 310 Chapter 2
What is recognition in accounting?
Recognition is the process of formally recording and reporting an item in the financial statements of a company. The FASB has identified four fundamental recognition criteria: 1. meet the definition of an element (ex: asset) 2. be measurable 3. be relevant 4. be representationally faithful
Compare and contrast comparability and consistency.
Comparability of accounting info enables users to identify and explain similarities and differences between two or more sets of economic facts. Although related to comparability, consistency means that accounting methods and procedures are applied in the same manner from period to period. Consistency is a quality of the accounting process rather than a quality of the accounts and amounts themselves. Consistency helps to achieve the goal of comparability across periods, but only if the underlying phenomena being reported remain the same.
What are the two primary qualities of useful accounting information?
Decision usefulness is the ultimate objective of accounting information. This overall goal of decision usefulness can be achieved if the accounting information has a sufficient degree of the fundamental characteristics of (1) relevance and (2) faithful representation.
Why should financial reporting provide useful information about the stewardship of company management?
Financial reporting should provide info about how efficiently and effectively the company's management and governing board have discharged their responsibilities to use the company's resources. This is commonly referred to as management's stewardship responsibility. Management is responsible to the owners for the custody and safekeeping of the resources, their efficient and profitable use, and their protection against unfavorable economic impacts, technological developments, and social changes.
Describe the financial reporting model within the FASB Conceptual Framework.
It includes all of the financial statements, Notes to the statements, supplementary information, other means of financial reporting (ex: MD&A), and other information.
What is materiality, and how does it relate to relevance?
Materiality is an entity-specific aspect of relevance. Materiality refers to the nature and magnitude of an omission or misstatement of accounting information that would influence the judgment of a reasonable person relying on that information. Because materiality depends on entity-specific circumstances, the FASB did not set quantitative guidelines for materiality in the Statements of Concepts. Instead, materiality requires judgment to determine whether an item would influence users' decisions. To assist in the evaluation of materiality, the FASB suggested that companies should consider: 1. the nature of the item 2. the relative size rather than absolute size of an item
What are the primary sources of useful information identified in the model?
The primary sources of useful information identified in the model are the 5 financial statements (including comprehensive income statement), the Notes, and supplementary info.
Identify the enhancing characteristics of useful accounting information. Why is each one important, and how do they enhance information usefulness?
1. COMPARABILITY - Information about a company is more useful if it can be compared with similar info from other companies (intercompany comparison) of from past periods within the company (intracompany comparison). It is an interactive quality between two or more items of information. Comparability of accounting information enables users to identify and explain similarities and differences between two or more sets of economic facts. 2. VERIFIABILITY - Accounting info is verifiable when different knowledgeable and independent observers can reach consensus that a particular representation is faithful. Verification means that other accountants would agree that the words to describe an account or an activity represent fairly what they purport to represent and that the amount or value used to depict that account or activity is measured without error or bias. 3. TIMELINESS - Accounting info is timely when it is available to decision makers in time to influence their decisions. If information is not available when it is needed, it lacks relevance and is not useful. *The SEC has established minimum requirements for timeliness, requiring that corporations file a Form 10-K annual report within 60 days of its fiscal year-end and a Form 10-Q within 40 days of the end of each quarter. 4. UNDERSTANDABILITY - Understandability means that accounting info should be comprehensible to users who have a reasonable knowledge of business and economic activities and who are willing to study the information carefully.
Define return on investment, risk, financial flexibility, liquidity, and operating capability.
1. return on investment - provides a measure of overall company performance for equity shareholders 2. risk - the uncertainty or unpredictability of the future profitability of a company. *The greater the variability and uncertainty in a company's future financial performance, the greater the risk of an investment in or extension of credit to the company *The greater the risk of a particular company, the higher the rate of return expected by investors and lenders 3. Financial flexibility - the ability of a company to use its financial resources to adapt to change and to take advantage of opportunities when they arise *Greater financial flexibility reduces the risk of failure in the event of an unexpected shortage in net cash flows from operations. 4. Liquidity - refers to how quickly a company can convert its assets into cash to meet short-term obligations and cover operating costs *Liquidity is positively related to financial flexibility but negatively related to both risk and return on investment. A more liquid company is likely to have a lower risk of failure as well as a superior ability to adapt to unexpected opportunities and meet obligations as they become due. On the other hand, liquid assets often generate lower rates of return than illiquid assets. 5. Operating capability - refers to the ability of a company to efficiently produce goods and services for customers
List the reasons why external stakeholders use information about a company's (a) economic resources and claims to these resources, (b) comprehensive income and its components, and (C) cash flows.
A) This information is useful to external users for the following reasons: *to identify the company's resources, obligations, financial strengths and weaknesses, and to assess its liquidity and solvency * to specify the types of resources in which the company has invested, as well as the types of claims on the company *to indicate the potential future cash flows from the company's resources and the ability of the resources to satisfy the claims on the company B) This information is useful to external users in: *evaluating management's performance *estimating the company's "earning power" *predicting future income and net cash inflows *assessing the risk of investing in or lending to the company C) The company's ability to generate net cash inflows determines both it's ability to pay dividends and interest and the market prices of securities.
What is relevant accounting information? Identify and define the characteristics of relevant accounting information.
Accounting information has relevance if it is capable of making a difference in decisions made by financial statement users. Info can make a difference if it helps users predict future outcomes and/or confirm or correct prior expectations, and if it is material in nature and amount. To have predictive value, accounting info should help users form expectations about the future. Financial information has predictive value if it can be used as an input to a process to predict future outcomes (such as an analyst's forecast). Financial information has confirmatory value if it provides feedback to confirm or correct prior predictions and expectations. Materiality is the third aspect of relevance and is discussed on the next card.
What is faithfully represented accounting information? Identify and define the characteristics of faithful representation of accounting information.
Accounting information is a faithful representation of the underlying economic transactions, events, and arrangements when the words and numbers accurately depict the economic substance of what they purport to represent. To be a faithful representation, the information must be complete, neutral, and free from error. *A complete representation provides a user with full disclosure of all the info necessary to understand the information being reported, with all necessary facts, descriptions, and explanations. *A neutral representation is not biased, slanted, emphasized, or otherwise manipulated to achieve a predetermined result or to influence users' behavior in a particular direction. *Free from error means the info is measured and described as accurately as possible, a process that reflects the best available inputs. Free from error does not imply certainty or precision because often times numbers are estimates. However, these amounts must be described as estimates so that the information is faithfully represented.
How do accounting concepts, principles, standards, and rules differ?
Accounting principles are fundamental theories, truths, and propositions that serve as the practical foundation for financial accounting and financial reporting. The most fundamental statements of these principles comes from the FASB's Concepts Statements. Concepts Statements and principles form the basis and objectives of GAAP. GAAP lays out the standards and rules. As a general rule: Concepts Statements and principles are broad and definitional. Standards are authoritative statements that comprise GAAP and are applications of concepts and principles to different types of transactions, events, and arrangements. Rules are specific implementation procedures within accounting standards.
Describe accrual accounting. What are the objectives of accrual accounting?
Accrual accounting is the process of measuring and reporting the economic effects of transactions, events, and arrangements on a company's economic resources and claims in the period when those effects occur, even though the cash flows may occur in a different period. The objectives of accrual accounting are to appropriately measure financial position and financial performance each period. accruals - cash flow occurs after performance obligation (ex: accrued liability for wages) deferrals - cash flow occurs before performance obligation (ex: prepaid rent)
What do the FASB's Concepts Statements establish?
Concepts Statements establish: *fundamental principles of accounting *objectives of financial reporting *qualities of useful financial accounting info *definitions of basic elements like assets and liabilities *types of economic transactions, events, and arrangements to be recognized in financial statements *measurement attributes to use to measure and report these transactions, events, and arrangements] *how transactions, events, and arrangements should be presented and classified in financial statements
What is conservatism? Why do accountants sometimes find it necessary to be conservative in financial reporting?
Conservatism is an approach that accountants use to avoid overstating net assets and net income when these amounts are uncertain. When accounting valuations are uncertain and alternative accounting valuations for assets or liabilities are equally possible, the accountant should select the one that is least likely to overstate the company's assets and income in the current period. Conservatism is not desirable, nor is it a principle of accounting; instead, it is a practical approach accountants take to avoid misleading investors, lenders, and other creditors when valuations are uncertain. Conservatism is sometimes described as "prudence."
What is the period-of-time assumption, and why is it important in financial reporting?
In accordance with the period-of-time assumption, companies prepare and report financial statements at the end of each year and include them in an annual report and in annual filings with the SEC. The annual reporting period is sometimes called the accounting period (or fiscal year). Most companies adopt the calendar year as the accounting period. However, many companies choose a fiscal year that more closely approximates their annual business cycle, which is the yearly period from lowest sales through highest sales and back to lowest sales.
Why does financial reporting utilize a mixed set of measurement attributes?
In order to provide financial statement users with the most relevant and representationally faithful measures, accounting uses a mixture of measurement attributes. The mixed attribute measurement model seeks to measure assets, liabilities, revenues, expenses, etc. with the most relevant and faithful measurement available. The types of measurement attributes used include historical costs, allocated historical costs, fair values, present values, net realizable values, and others.
What is the purpose of the FASB's Conceptual Framework?
The Conceptual Framework is intended to: *guide the FASB in establishing accounting standards *establish objects and concepts to guide financial statement preparers and auditors to resolve questions and make appropriate judgements in the preparation of financial statements, even in situations where a standard does not exist *increase users' understanding of and confidence in financial reporting *enhance financial statement comparability across companies and over time
What is the Conceptual Framework of the FASB?
The FASB Conceptual Framework is a theoretical foundation of interrelated objectives, concepts, principles, and definitions that enable the establishment and application of consistent financial accounting standards. It provides a logical structure to guide standard setters, financial statement preparers, auditors, and financial statement users. To establish the Conceptual Framework, the FASB has issued a number of Concepts Statements.
Discuss the relationship among historical cost, relevance, and faithful representation.
The economic activities and resources of a company initially are measured using the exchange price at the time each transaction occurs. At the time of most transactions, the historical cost (exchange price) is the most relevant and faithful representation of the value of the exchange. Accountants understand that historical cost info can lose relevance for financial decisions if the economic value of the resource or obligation has changed since the time of the original transaction. For certain types of assets and liabilities, accounting standards require the use of valuation methods other than historical cost so that reported values are more relevant.
What drives expense recognition? When should expenses be recognized?
The expense recognition principle determines the appropriate period in which a company has consumed economic resources in conducting business operations. Companies typically recognize expenses in a particular period on the basis of three methods, all of which apply accrual accounting principles: 1. cause and effect (matching principle) - matches the expense to the period in which the economic benefits are consumed by generating revenues 2. immediate consumption 3. systematic and rational allocation over time
What is the going-concern assumption, and why is it important in financial reporting?
The going concern assumption (continuity assumption) is that the company will continue to operate in the foreseeable future. It does not imply permanence. It simply indicates that the company can be reasonably expected to operate long enough to realize economic benefits from its assets and satisfy its existing obligations. *if a company appears to be going bankrupt, it doesn't meet the going concern assumption
What is the most general objective of financial reporting? Who are investors, lenders, and other creditors?
The primary objective of financial reporting is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders, and other creditors in making decisions about providing resources to the entity. Investors are the equity security holders (shareholders), equity fund managers, analysts, and others. Lenders include banks, lending institutions, debt security holders (bondholders), and credit rating agencies. Creditors include suppliers, customers, and employees, and other parties with claims on the firm.
What is the reporting entity assumption? How does it affect the scope of financial reporting?
The reporting entity assumption (economic entity assumption) states that a business enterprise is a legally and economically distinct entity, so that financial statements can be prepared and reported specifically for that entity. In accounting, we assume the reporting entity is distinct from its owners. Each separate reporting entity prepares its own financial records and reports.
What drives the timing of revenue recognition? When should revenue be recognized?
The revenue recognition principle determines the appropriate period in which a company creates economic benefits and can recognize revenues in income. Revenue should be recorded when a company satisfies its' performance obligations.
What is the cost constraint, and how does it affect financial reporting?
To identify what financial information should be disclosed in financial reports, the qualitative characteristics are bounded by a single, pervasive constraint - the cost constraint. While accounting information is very beneficial to decision makers, it is also costly to prepare and use. The benefits of the info are enjoyed by a diverse group of investors and creditors and by the company itself because, by providing the information, it can compete for and attract scarce economic resources. To be reported, accounting info not only must be relevant and faithfully represented but it also must pass an economic test by satisfying the benefit/cost constraint.