Accounting Exam 1

Define: Trial Balance

A listing of the accounts and their ending debit or credit balances at a point in time.

Define: Net Income

A measure of financial performance resulting from the aggregation of revenues, expenses, gains, and losses that are not items of other comprehensive income.

What is the group think bias?

A phenomenon that occurs in situations where members of a group, to avoid conflict, reach a consensus decision without considering all of the alternatives.

Define: Permanent Accounts

Accounts with cumulative balances carried forward period after period.

What are the general line items in the single-step income statement?

All Revenues and Gains - All Expenses and Losses = Income from Continuing Operations + Discontinued Operations = Net Income

Define: Temporary Accounts

All income statement accounts and dividends that must be reduced to a zero balance in order to report net income and dividends for the next accounting period.

What companies have to follow the GAAP and which follow IFRS?

All public companies in the United States are subject to GAAP whereas IFRS are standards that the rest of the publicly traded companies around the world are subject to.

Define: Unadjusted Trial Balance

An initial listing of all accounts and their debt or credit balances.

What are the 9 steps in the accounting cycle?

Analyze the transaction, journalize the transaction, post it to the general ledger, prepare the unadjusted trial balance, prepared adjusting journal entries, prepare adjusted trial balance, prepare financial statements, close temporary accounts (income statement), prepare post-closing trial balances.

Elements of Financial Reporting: Three Point-in-Time Elements

Assets represent the probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. Liabilities are the probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events. Equity is the net assets or residual interest in the assets of an entity that remains after deducting its liabilities

What are techniques to mitigate cognitive biases?

Be organized and methodical in the decision making process, generate alternatives, document your rational about the alternatives, and delay your judgement until you have gathered all of the facts/info and have time to consider alternatives.

Qualitative: Cost Constraint

Because providing all relevant and faithful information is costly, the conceptual framework stipulates that standard setters should compare the cost of requiring information to be presented to the benefits derived from the information.

What are big baths?

Big baths are an earnings management technique involving increasing a net loss to allow the firm to show increased net income in the future.

What is the single-step approach to the income statement?

Combines all revenues and gains, and all expenses and losses into single categories. The drawback from this approach is that it combines revenues, gains, expenses, and losses without classification, it doesn't separate the operating and non-operating items, and it does not identify key performance measures.

Define Comprehensive Income and what are the key line items in the financial statements?

Comprehensive income can be presented only on the statement of comprehensive income or in two consecutive statements, the statement of net income and the statement of comprehensive income. The key line items for comprehensive income are unrealized gains/losses from the available-for-sale portfolio of investments securities, foreign currency translation, and/or unrecognized pensions costs from adjustments. Comprehensive net income = net income + other comprehensive income

Define: Other Comprehensive Income

Comprised of revenues, expenses, gains, and losses that are explicitly excluded from net income specific accounting standards such as, unrealized gains/losses on an available-for-sale investment, unrealized gains/losses on cash flow hedges, foreign currency translation adjustments, and pension adjustments.

What is the conceptual framework and what are the key aspects of the framework?

Conceptual framework sets for theory, concept, and principles to ensure that accounting standards are coherent and uniform. The components of the conceptual framework are the objective of financial reporting, the characteristics associated with high-quality accounting standards, the elements of the financial reporting system, and recognition and reporting criteria.

Define: Post-Closing Trial Balance

Contains only permanent balance sheet accounts because all temporary accounts were closed out and have zero balances.

How to Find: Temporary Revenue Accounts

Debit: all revenue and gain accounts Credit: income summary for total

How to Find: Temporary Income Summary Account

Debit: income summary account Credit: retained earnings

How to Find: Temporary Expense Accounts

Debit: income summary for total Credit: all expenses/losses accounts

What is presented in the discontinued operations portion of the income statement and how?

Discontinued operations are the portions of the business that a company has disposed of or is in the process of disposing of.

What is EPS, what does it measure, and where is it presented on the income statement?

EPS stands for earnings per share and measures the net income that the company reported in the specified period for each outstanding share of a company's common stock. The EPS is reported for a company's continuing operations, discontinued operations, and net income on the income statement below net income. EPS for net income is equal to the sum of the continuing and discontinued operations EPS.

What are the motivations of management to bias their estimates and impede the use of good judgement?

Earnings management occurs when managers manipulate financial information and misrepresent the firm's financial position and performance. They do this because manager's are pressured to beat benchmarks from previous quarters, to avoid reporting a loss, to present a firm's earnings on a smooth upward trend, and to increase their own compensation.

Define: Adjusting Journal Entries

Entries made to ensure all revenues are recognized in the period earned and expenses are recognized in the period incurred.

Qualitative: Fundamental Characterisitcs

Fundamental characteristics of financial reporting are relevance and faithful representations. Relevance is whether or not it can make a difference in decision making by exhibiting predictive value, confirmatory value, or materiality. Faithful representation indicates whether financial information depicts the substance of an economic even in a manner that is complete, neutral, and free from error.

What is GAAP / IFRS? What is their purpose and focus?

GAAP stands for general accepted accounting principles and represents the standards for financial reporting for companies in the U.S. These standards are set by the financial accounting standards board (FASB) in order to create a congruent reporting environment. Similar guidelines called the international financial reporting standards (IFRS) are accounting rules and guidelines that international public companies must adhere to. These rules and regulations are set by the international accounting standards board (IASB) and serve the same purpose as the FASB.

What are general purpose financial statements and what are some limitations of such financial statements?

General purpose financial statements provide information to a wide spectrum of user groups and is provided to satisfy users with limited ability or authority to obtain additional information. The four basic financial statements are the balance sheet, income statement, statement of cash flows, and the statement of stockholders' equity.

What are the revenue recognition principles?

In order to recognize revenue, it must meet the definition of one of the elements of the financial statements, it must be measurable, reliable, and relevant. This means that the company has exchanged a good or service for cash or claims to cash and that the revenue is only considered earned when a company has accomplished what it must do to be entitled the revenues.

What is income from continued operations and how is it presented on the income statement?

Income from continued operations is income from portions of the business that are expected to continue into the future. The value is the sum of operating income, non-operating income items, and income tax provision. Operating income can be found by subtracting sg&a expenses from gross profit.

What is the usefulness of comprehensive net income?

It can be used to evaluate past performance, predict future performance, and to assess risk or uncertainties of achieving future cash flows.

What are some limitations of the income statement?

It excludes certain items, depends on the accounting method selected, and requires extensive judgement and estimation.

What is judgement and why is it relevant in financial reporting?

Judgement is the process by which an accountant or manager reaches a decision in situations in which there are multiple alternatives. Accounting standards allow financial statement preparers to use judgement to report the substance of a transaction in the financial statements within certain boundaries, in the manner that best reflects reality. Accountants use their judgement to estimate and record economic events as accurately as possible. For example, PP&E are depreciated using a particular method which is decided on by management.

What are non-controlling interests and how are such interests presented on the income statement?

Non-controlling interests are when one company controls another company, but owns less than 100% of its voting shares.The controlling company adds all of the subsidiary income to its own, however, the controlling company must identify the amount that is attributable to non-controlling owners. The Non-Controlling Interest Line Item on the income statement represents the income attributable to the portion of subsidiary owned by others.

Define: Accrued Revenues

Occurs when a company has earned revenues but has not yet received cash. Ex Debit: Accounts Receivable Credit: Service Revenue Debit: Service Revenue Credit: Accounts Receivable

Define: Accrued Expenses

Occurs when a company has incurred expenses but has not paid cash or been issued an invoice. Ex Debit: Wages Expense Credit: Wages Payable Debit: Wages Payable Credit: Cash

Define: Deferred Expenses

Occurs when a company makes a cash payment before incurring an expense under accrual basis accounting (prepaid expense). Recorded as assets until they are used or consumed in operations. Ex Debit: Prepaid Rent Credit: Cash Debit: Rent Expense Credit: Prepaid Rent

Define: Deferred Revenues

Occurs when a company receives cash before earning revenue and recognizes it on the financial statements under accrual basis accounting (unearned revenues or advanced collections). Recorded as liabilities until they are earned. Ex Debit: Cash Credit: Unearned Revenue Debit: Unearned Revenue Credit: Service Revenue

Permanent vs Transitionary Components of Earnings

Permanent components of earnings are likely to continue into the future whereas transitionary components of earnings are unlikely to continue into the future.

What is the multi-step approach to the income statement?

Reports several critical subtotals before computing income from continuing operations and net income. This allows financial statement users to view clearly separated key performance measures.

Define: Materiality Threshold

Requires that an item be recognized in the financial statements of its omission or misstatement would significantly influence the judgement of a reasonably informed statement user.

What are cookie jar reserves?

Reserves created by managers that are used in future periods to increase earnings as needed, possibly to exceed analysts' forecasts. This is done by taking earnings in excess of what was expected and putting them into a reserve account for a rainy day.

What are the general line items in the multi-step income statement?

Sales - COGS = Gross Profit - Opex = Operating Income + Other Revenues and Gains - Other Expenses and Losses = Income from Continuing Operations before Tax - Income Tax Expense = Income from Continuing Operations + Discontinued Operations = Net Income

Describe the differences between the asset/liability approach vs income statement approach to developing accounting standards.

The asset/liability approach involves basing decisions on whether an economic resource is received and it meets the definition of an asset, such as an account receivable. The income statement approach involves basing decisions on revenue recognition criteria. Reporting standards are beginning to trend towards the asset/liability approach.

Define: Comprehensive Net Income

The change in a company's equity during a period of time resulting from transactions, events, and circumstances other than transactions with owners.

What is earnings quality?

The degree to which reported income provides financial statement users with useful information for predicting earnings quality. Depends on the amount of permanent vs transitionary earnings components.

What is the body responsible for promulgating U.S. GAAP?

The financial accounting standards board (FASB)

What are the key differences between GAAP and IFRS?

The first key difference is that GAAP is used strictly in the U.S. where IFRS is used by the rest of the world. The international accounting standards board (IASB) sets the international financial reporting standards (IFRS) - much like how the financial accounting standards board (FASB) sets U.S. GAAP - but they also conduct a post-implementation review after an IFRS is issued. Finally, we tend to view GAAP as more rules based compared to IFRS as more principles based, but neither is completely rules or principles based.

What are some assumptions that are made in financial reporting?

The going concern concept, the business or economic entity concept, the monetary unit assumption, and the periodicity assumption. Accountants are required to state the details of the accounting policies that the company uses in one of the first footnotes to the financial statements.

Define: Adjusted Trial Balance

The listing of all accounts and their ending debit or credit balances after making the adjusting journal entries.

What are the five common sections of the multi-step income statement?

The operation section, the non-operating section, the income tax provision, the discontinued operations, and net income and earnings per share.

What is the definition of the accounting cycle?

The process by which a company records business transactions and ultimately aggregates and summarizes them in financial statements.

What is financial accounting?

The process of identifying, measuring, and communicating financial information about an economic entity to various user groups within the legal, economic, political and social environment. It provides information that enables users to evaluate economic entities and make efficient resource allocation decisions based on the risks and returns of a particular investment.

What are the qualitative characteristics of financial reporting?

The qualitative characteristics of financial reporting are encompassed by fundamental characteristics, the enhancing characteristics, and the cost constraint on providing information. Fundamental characteristics are those basic characteristics that distinguish useful financial information from information that is not useful. Enhancing characteristics help determine when information is relevant and representationally faithful. The cost constraint compares the benefits received from presenting the information to the cost required in order to provide the information.

What is the FASB codification and what purpose does it serve?

The structure that the accounting rules are presented that summarize all the current standards by topic. Topics, subtopics, sections, paragraphs.

What are the three main types of income of discontinued operations?

The three main types of income are the income/loss from operations of discontinued unit (net of tax), the gain/loss on re-measurement of net assets held for sale to fair value less disposal costs (net of tax), and the gain/loss on disposal of assets constituting the discontinued operations (net of tax).

What are the elements of financial reporting?

The two elements of financial reporting are the three point-in-time elements as well as the seven-period-of-time elements.

Qualitative: Enhancing Characteristics

There are four main enhancing characteristics. Compatibility allows financial statements users to identify and understand similarities and differences among several entities. Verifiability means that a group of reasonably informed financial statement users can reach a consensus decision that reported information is a faithful representation of an underlying economic event. Timeliness refers to information being available to financial statement users early enough to make a difference in decision making. And finally, understandability is when financial statements classify, characterize, and clearly present all the information.

What are the expense recognition principles?

These are principles used to determine the period when a company reports an expense on the income statement. This means that the entity's economic benefits are consumed in the process of producing or delivering goods or rendering services, or when an asset has experienced a reduced (or eliminated) future benefit, or when a liability has been incurred or increased without an associated economic benefit.

Elements of Financial Reporting: Seven Period-of-Time Elements

These elements represent the results of events and circumstances that affect an entity during a period of time and appear on the income statement, statement of comprehensive income, or statement of shareholders' equity. These elements include: investment by owners (buying common stock), distributed to owners (dividends), revenues (sales, fees, takings), gains (profit from selling long-term assets), expenses (rent, wages, COGS), losses (loss from selling long-term assets), and comprehensive net income (change in equity in one year from nonowner sources).

What is the going concern assumption and under what circumstances is this assumption not followed?

This is the assumption that accountants will record transactions and prepare financial statements as if the entity will continue to operate into perpetuity, unless there is evidence to the contrary. This concept justifies accounting practices such as the long/short-term classifications on the balance sheet, depreciation, etc. If a business is in jeopardy of failing (bankruptcy), then the going concern assumption would not be valid.

What is Accrual-Basis Accounting?

This type of accounting is GAAP required and is when firms recognize revenues according to the revenue recognition principle and recognize expenses according to the expense recognition principle. Both of which are essentially recognized when the revenues or expenses are earned or incurred respectively.

What is the objective of financial reporting?

To provide information about the reporting entiy that is useful to existing and potential investors, lenders, and other creditors in making decisions about providing resources to the entity

What are the unusual gains and losses on the income statement and how are they presented?

Unusual gains and losses reported by companies as non-operating income items on the income statement. They occur infrequently by nature and are typically unrelated/remotely related to the company's ordinary activities. Examples of these line items include restructuring charges, losses on asset impairment, gains/losses on the disposal of certain assets, and/or losses due to natural disaster such as an earthquake or hurricane.

What is the anchoring bias?

When decision makers focus on one piece of information.

What is the confirmatory bias?

When decision makers under-weight information that is not consistent with their initial beliefs.

What is Cash-Basis Accounting?

When firms only recognize revenues when they receive cash and only recognize expenses when they pay cash. Measures cash receipts and disbursements. It does not accurately measure the economic actively of underlying cash receipts and payments.

Working Capital

current assets - current liabilities

Current Ratio

current assets/current liabilities

Debt to Equity Ratio

debt/shareholders equity

Return on Equity

net income/shareholders equity

Return on Assets

net income/total assets

What is the overconfidence bias?

the tendency to be more confident than your abilities and experience level would objectively warrant.

What is the availability bias?

the tendency to use the data that is most readily available or most easily recalled.