Accounting Midterm 1 (Ch. 1 - 5)

Periodicity: third level - basic assumption

also known as time period assumption, implies that a company can divide its economic activities into artificial time periods; common ones are monthly, quarterly, yearly. *the shorter the time period, the harder it is to determine proper net income for the period.

Cost constraint: third level

also referred to as the cost-benefit relationship; companies must weigh the costs of providing information against the benefits that can be derived from using it.

Third level: recognition and measurement concepts

concepts that implement the basic objective of level one and explain how companies should recognize, measure, and report financial elements and events; consists of: BASIC ASSUMPTIONS and BASIC PRINCIPLES and COST CONSTRAINT

Noncontrolling interest on an income statement

consolidated net income xx less: net income attributable to noncontrolling interests xx net income attributable to stockholders' of X company xx

General ledger

contains all the asset, liability, and stockholders equity accounts

A conceptual framework

establishes the concepts that underlie financial reporting; is a coherent system of concepts that flow from an objective which identifies the purpose of financial reporting. The other concepts provide guidance on 1. identifying the boundaries of financial reporting; 2. selecting the transactions, other events, and circumstances to be represented; 3. how they should be recognized and measured; 4. how they should be summarized and reported

Financial reporting issues

failure to provide nonfinancial measurements, forward-looking info, soft assets, real-time financial data (timeliness), lack of understandability

Single step income statement format

revenues - expenses = net income

If a company does not make an adjustment for accruals, then

the revenue account (and the related asset account) or the expense account (and the related liability account) are understated.

Adjusting entries

the type of entries companies make to ensure that revenues be recorded in the period in which services are performed and to ensure that expenses be recognized in the period in which they are incurred; ensures that companies follow the revenue recognition and expense recognition principles

Examples of accrued expenses

-accrued interest -accrued salary and wages -bad debts

Changes in accounting principle

-criteria: change from one GAAP to another -ex: change inventory pricing from FIFO to avg. cost -placement on income st: recast prior years' income statement on the same basis as the newly adopted principle (net of tax)

Corrections of errors

-criteria: mistake, misuse of fact -ex: error in reporting income and expenses -placement on income st: treat as prior period adjustment; restate prior years' income statements to correct for error (net of tax)

Changes in accounting estimates

-criteria: normal, recurring corrections -ex: change in estimated lives of equipment -placement on income st: show change only in the affected accounts in current and future periods (not net of tax)

Increases retained earnings

-net income -change in accounting principle -prior period adjustments

Decreases retained earnings

-net loss -dividends -change in acct. principle -prior period adjustments

Examples of prepaid expenses

-supplies -insurance -depreciation

Uses of the balance sheet

-Computing rates of return. -Evaluating the capital structure. -Assess risk and future cash flows. -Analyze the company's: -Liquidity, solvency, and financial flexibility.

Two statement approach

The two statement approach uses the traditional term income statement for the first statement and the comprehensive income statement for the second statement.

Earnings per share (EPS)

- A significant business indicator. - Measures the dollars earned by each share of common stock. - Must be disclosed on the income statement. (net income - preferred dividends) / weighted average of common shares outstanding

Limitations of the balance sheet

-Most assets and liabilities are reported at historical cost. -Use of judgments and estimates. -Many items of financial value are omitted.

How to display components of other comprehensive income:

1. A single continuous statement (one statement approach) 2. Two separate, but consecutive statements of net income and other comprehensive income (two statement approach). How it looks on income statement: net income xx other comprehensive income unrealized holding gain, net of tax xx comprehensive income

2 major types of pronouncements issued by the FASB

1. Accounting Standards Updates 2. Financial Accounting Concepts

the two sets of rules accepted for international use

1. GAAP 2. IFRS - international financial reporting standards issued by the London-based IASB (international accounting standards board) *US companies that list overseas use GAAP *Foreign companies that list in the US use IFRS

3 organizations that are instrumental in the development of financial accounting standards (GAAP)

1. SEC 2. AICPA 3. FASB

Why do we need a conceptual framework?

1. To be useful, rule-making should build on and relate to an established body of concepts, because this will allow the FASB to issue more useful and consistent pronouncements over time. Without a soundly developed framework, standard-setting ends up being based on individual concepts developed by each member of the standard setting body. 2. To allow the profession to more quickly solve new and emerging practical problems by referring to an already existing framework of basic theory

Financial statements

1. balance sheet - shows the financial condition of the enterprise at the end of a period 2. income statement - measures the results of operations during the period 3. statement of cash flows - reports the cash provided and used by operating, investing, and financing activities during the period 4. statement of retained earnings - reconciles the balance of the retained earnings account from the beginning to the end of the period

Limitations of the income statement

1. companies omit items from the income statement that they cannot measure reliably 2. income numbers are affected by the accounting methods employed 3. income measurement involves judgement

Discontinued operation

1. company eliminates the results of operations of a component of the business 2. the elimination of a component that represents a strategic shift, having a major effect on the company's operations and financial results (a major line of business, a major geographical area, a major equity method investment *reported net of tax *reported after "income from continuing operations"

Uses for the income statement

1. evaluates the performance of the company 2. provides a basis for predicting future performance 3. helps assess the risk or uncertainty of achieving future cash flows

Intermediate components of the (multi-step) income statement

1. operating section - sales or revenue - cost of goods sold - selling expenses (operating x) - administrative or general expenses (operating x) 2. Nonoperating section (unusual and infrequent items) - other revenues and gains - other expenses and losses 3. income tax 4. discontinued operations (unusual and infrequent items) 5. noncontrolling interest (unusual and infrequent items) 6. earnings per share (unusual and infrequent items)

Elements of the income statement

1. revenues 2. expenses 3. gains 4. losses

Essential characteristics of accounting

1. the identification, measurement, and communication of financial information about 2. economic entities to 3. interested parties

APB

Accounting Principles Board - 1. advances the written expression of accounting principles 2. determines appropriate practices 3. narrows the areas of difference and inconsistency in practice

One statement approach

Advantage - does not require the creation of a new financial statement. Disadvantage - net income buried as a subtotal on the statement.

Comprehensive income

All changes in equity during a period except those resulting from investments by owners and distributions to owners: all revenues and gains, expenses and losses reported in net income. *Other comprehensive income: all gains and losses that bypass net income but affect stockholders' equity, such as unrealized gains and losses on available-for-sale securities, translation gains and losses on foreign currency.

AICPA

American Institute of Certified Public Accountants - national private sector professional organization of CPAs with over 400,000 members in 145 countries that set ethical standards for the profession

Assets, Liabilities, Equity: second level - basic elements - moment in time

Assets - probable future economic benefits obtained or controlled by a particular entity as a result of past transactions Liabilities - 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 - residual interest in the assets of an entity that remains after deducting its liabilities (equity = ownership interest)

Accounting equation

Assets = Liabilities + Stockholders' Equity

Classification in the balance sheet

Assets: current assets (presented in order of most liquid to least liquid), long term investments, PP&E, intangible assets, other assets Liabilities & Owners' Equity: current liabilities, long-term debt, stockholders' equity

How does a company choose an acceptable accounting method, the amount and types of information to disclose, and the format in which to present it?

By determining which alternative provides the most useful info for decision making (decision-usefulness)

Owners' Equity

Capital stock, additional paid-in capital, retained earnings, accumulated other comprehensive income, treasury stock, noncontrolling interest, deficit

Current assets

Cash and other assets a company expects to convert into cash, sell, or consume either in one year or in the operating cycle, whichever is longer.

Usefulness of the cash flow statement

Cash flow from operations: High amount - company is able to generate sufficient cash to pay its bills. Low amount - company may have to borrow or issue equity securities to pay bills.

CAP

Committee on Accounting Procedure - first private sector org composed of practicing CPAs that issued 51 accounting research bulletins, but failed; lead to creation of the AICPA

Liabilities

Current liabilities: obligations that a company reasonably expects to liquidate either through the use of current assets or the creation of other current liabilities. LT liabilities: obligations that a company does not reasonably expect to liquidate within the normal operating cycle.

Types of adjusting entries

Deferrals: Prepaid expenses: expenses paid in cash before they are used/consumed Unearned revenues: cash received before services are performed Accruals: Accrued revenues: revenues for services performed but not yet received in cash or recorded Accrued expenses: Expenses incurred but not yet paid in cash or recorded

Inventories

Disclose: Basis of valuation (e.g., lower-of-cost-or-market). Cost flow assumption (e.g., FIFO or LIFO).

FASAC

Financial Accounting Standards Advisory Council - consults with FASB on major policy and technical issues and helps select task force members

FASB

Financial Accounting Standards Board - the designated organization in the private sector for establishing standards of financial acctg and reporting in America; working on convergence project with IASB for less complex, more understandable standards

Preparing a cash flow statement

Four steps: 1. Determine the net cash provided by (or used in) operating activities. 2. Determine the net cash provided by (or used in) investing and financing activities. 3. Determine the change (increase or decrease) in cash during the period. 4. Reconcile the change in cash with the beginning and the ending cash balances.

Cash

Generally any monies available "on demand"; cash equivalents - short-term highly liquid investments that mature within three months or less; restrictions or commitments must be disclosed.

Information from cash flow statement is received from

Information obtained from several sources: comparative balance sheets, the current income statement, and selected transaction data.

IASB

International Accounting Standards Board - the independent standard-setting body of the IFRS foundation

Investments by owners, Distributions to owners, Comprehensive income, Revenues, Expenses, Gains, Losses: second level - basic elements - period of time

Investments by owners - increases in net assets of a particular enterprise resulting from transfers to it from other entities of something of value to obtain or increase ownership interests (or equity) in it. Distributions to owners - Decreases in net assets of a particular enterprise resulting from transferring assets, rendering services, or incurring liabilities by the enterprise to owners; decrease equity in an enterprise. Comprehensive income - change in equity (net assets) of an entity during a period from transactions and other events and circumstances from nonowner sources; includes all changes in equity during a period except those resulting from investments by owners and distribution to owners. Revenues - inflows or other enhancements of assets of an entity or settlement of its liabilities (combo of both) during a period from delivering or producing goods, rendering services, or other activities that constitute the entity's ongoing major or central operations. Expenses - outflows or other using up of assets or incurrences of liabilities (combo of both) during a period from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity's ongoing major or central operations. Gains - increases in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity during a period except those that result from revenues or investment by owners. Losses - decreases in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity during a period except those that result from expenses or distributions to owners.

Other assets

Items vary in practice. Can include only unusual items sufficiently different from assets in the other categories.: Long-term prepaid expenses Non-current receivables Assets in special funds Deferred income taxes Property held for sale Restricted cash or securities

Intangible assets

Lack physical substance and are not financial instruments; limited life intangibles amortized and indefinite-life intangibles tested for impairment. Includes: goodwill, franchises, patents, and trademarks

Receivables

Major categories of receivables should be shown in the balance sheet or the related notes. A company should clearly identify anticipated loss due to uncollectibles, amount and nature of any nontrade receivables, receivables used as collateral.

Current cash debt coverage ratio (measures liquidity)

Net cash provided by operating activities/average current liabilities

Cash debt coverage ratio (measures financial flexibility)

Net cash provided by operating activities/average total liabilities

Three different activities of a cash flow statement

Operating: Cash effects of transactions that enter into the determination of net income. Investing: Making and collecting loans and acquiring and disposing of investments and property, plant, and equipment. Financing: Obtaining resources from owners and providing them with a return on their investment, and borrowing money from creditors and repaying the amounts borrowed.

Prepaid Expenses

Payment of cash, that is recorded as an asset because service or benefit will be received in the future: insurance supplies advertising rent taxes

Real and nominal accounts

Real (permanent) - asset, liability, equity; never closed Nominal (temporary) - revenue, expenses, dividends; periodically closed

Quality of earnings

Refers to the credibility of the earnings number reported. Companies have incentives to manage income to meet or beat Wall Street expectations, so that: market price of stock increases and value of stock options increase.

The balance sheet (statement of financial position)

Reports assets, liabilities, and equity at a specific date; provides information about resources, obligations to creditors, and equity in net resources; helps in predicting amounts, timing, and uncertainty of future cash flows.

Statement of stockholders' equity

Reports the changes in each stockholders' equity account and total equity for the period. Following items are disclosed in the statement: -Contributions (issuances of shares) and distributions (dividends) to owners. -Reconciliation of the carrying amount of each component of stockholders' equity (retained earnings, accumulated other comprehensive income, common stock) from the beginning to the end of the period.

Revenues & expenses vs. gains & losses

Revenues and expenses occur from a variety of different sources, but these sources constitute the entity's ongoing major or central operations, whereas gains and losses also can arise from many different sources, but these sources occur from peripheral or incidental transactions of an entity. The major distinction between revenues and gains (or expenses and losses) depends on the typical activities of the company.

LT investments

Securities (bonds, common stock, or long-term notes). Tangible fixed assets not currently used in operations (land held for speculation). Special funds (sinking fund, pension fund, plant expansion fund, or cash surrender value of life insurance). Nonconsolidated subsidiaries or affiliated companies.

SEC

Securities Exchange Commission - enforces federal securities laws, proposes securities rules, and regulates the securities industry; develops and standardizes financial info presented to stockholders

Significant non-cash activities

Significant financing and investing activities that do not affect cash are reported in either a separate schedule at the bottom of the statement of cash flows or in the notes. Examples include: Issuance of common stock to purchase assets. Conversion of bonds into common stock. Issuance of debt to purchase assets. Exchanges on long-lived assets.

PP&E

Tangible long-lived assets used in the regular operations of the business: -Physical property such as land, buildings, machinery, furniture, tools, and wasting resources (minerals). -With the exception of land, a company either depreciates (e.g., buildings) or depletes (e.g., oil reserves) these assets.

Intraperiod tax allocation

The allocation of tax within a period; helps users understand the impact of income taxes on the various components of net income; is used for: (1) Income from continuing operations, (2) discontinued operations. The general concept is "let the tax follow the income."

Free cash flow

The amount of discretionary cash flow a company has that may be used for purchasing additional investments, retiring its debt, purchasing treasury stock, or simply adding to its liquidity.

Statement of cash flows

The statement of cash flows presents a DETAILED SUMMARY of all the cash inflows and outflows, or the sources and uses of cash during the period.

Transaction approach

The transaction approach focuses on the activities that have occurred during a given period and instead of presenting only a net change, a description of the components that comprise the change is included.

Relevance: second level - fundamental qualitative characteristic

To have relevance, accounting info must be capable of making a difference in a decision; accounting info is capable of making a difference when it has predictive value, confirmatory value, or both. predictive value - has this if it has value as an input to predictive processes used by investors to form their own expectations about the future confirmatory value - has this if it helps users confirm/correct prior expectations materiality - info is material if omitting it or misstating it could influence decisions that users make on the basis of the reported financial information. An individual company determines whether information is material by the nature (qualitative factor) and/or magnitude (quantitative factor) of the item(s) to which the info relates. Info is immaterial (irrelevant) if it would have no impact on a decision-maker. A gain is generally considered immaterial when it is anything under 5% of net income.

Purpose of cash flow statement

To provide relevant information about the cash receipts and cash payments of an enterprise during a period. The statement provides answers to the following questions: Where did the cash come from? What was the cash used for? What was the change in the cash balance?

Unusual and infrequent gains and losses

Unusual - high degree of abnormality and of a type clearly unrelated to, or only incidentally related to, the ordinary and typical activities of the company, taking into account the environment in which it operates Infrequency of occurrences - type of transaction that is not reasonably expected to recur in the foreseeable future, taking into account the environment in which the company operates examples: -losses on write-down (impairment) of receivables, inventories, etc. -restructuring charges -sale/abandonment of property -effects of a strike -extinguishment (redemption) of debt obligations -related to casualties like fires, floods, earthquakes -sale of investment securities

Noncontrolling interest

When a company owns substantial interests (generally greater than 50%) in another company, GAAP generally require that the financial statements of both companies be consolidated together into one set of financials. Noncontrolling interest is the portion of equity (net assets) interest in a subsidiary not attributable to the parent company.

Measurement: third level - basic principle

a "mixed-attribute" system that permits the use of various measurement base; the most commonly used measurements are based on historical cost and fair value. historical cost - GAAP requires that companies account for and report many assets and liabilities on the basis of acquisition and price of which the asset was purchased; historical cost is generally thought to be verifiable, which is an advantage fair value - the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date; a market-based measure; GAAP has increasingly called for use of fair value measurements in financial statements.

If a company does not make an adjustment for deferrals, then

assets and liabilities are overstated, and the related expense and revenue are understated

Order of current assets

cash, accounts receivable, inventories, prepaid items

Accounting information system

collects and processes transaction data and then disseminates the financial info to interested parties

Expense recognition: third level - basic principle

companies recognize expenses not when they pay wages or make a product, but when the work (service or the product) actually contributes to revenue; matching efforts (expenses) with accomplishments (revenues). Product cost: recognize in period of revenue (matching) Period cost: expense as incurred because there is no direct relationship between cost and revenue as there is with a product cost.

Accrued revenue adjusting entry

dr. Accounts receivable cr. Service revenue

Depreciation adjusting entry

dr. Depreciation expense cr. Accumulated depreciation How it looks on the balance sheet: Equipment xx Less: Accumulated depreciation - equipment xx Net book value - equipment xx

Insurance adjusting entry

dr. Insurance expense cr. Prepaid insurance

Supplies adjusting entry

dr. Supplies Expense cr. Supplies *for the difference between the balance in the supplies (asset) account and the cost of supplies on hand represents supplies used (expense).

Unearned revenue adjusting entry

dr. Unearned service revenue cr. Service revenue

Bad debts adjusting entry

dr. bad dept expense cr. allowance for doubtful accounts

Accrued interest adjusting entry

dr. interest expense cr. interest payable

Closing entries order

dr. revenue cr. income summary dr. income summary cr. expenses dr. income summary (dif b/w income summ in 1st entry and income summary in 2nd entry) cr. retained earnings dr. retained earnings cr. dividends Retained earnings balance: dif b/w retained earnings in 3rd entry and retained earnings in 4th entry

Accrued salaries and wages adjusting entry

dr. salaries and wages expense cr. salaries and wages payable

accrual-basis accounting

ensures that a company records events that change its financial statements in the periods in which the events occur, rather than only in the periods in which it receives or pays cash

Expectations gap

gap between what the public thinks accountants should do and what accountants think they can do; gap is difficult to close

Short-term investments

held-to-maturity, trading, available for sale

Discontinued operations (gain) on an income statement

income from continuing operations xx gain on discontinued operations xx less: applicable income tax net income

Discontinued operations (loss) on an income statement

income from continuing operations xx loss from discontinued operations xx less: applicable income tax reduction net income

Comparability: second level - enhancing qualitative characteristic

info that is measured and reported in a similar manner for different companies is considered comparable; enables users to identify the real similarities and differences in economic events between companies consistency: another type of comparability that is present when a company applies the same accounting treatment to similar events, from period to period.

Financial Accounting

is the process that culminates in the preparation of financial reports on the enterprise for use by both internal and external parties. Users of these financial reports include investors, creditors, managers, unions, and government agencies.

Trial balance

list of accounts and their balances at a given time in the order in which they appear in the ledger, with debit balances in the left column and credit balances in the right column

Timeliness: second level - enhancing qualitative characteristic

means having info available to decision-makers before it loses its capacity to influence decisions; having relevant info available sooner can enhance its capacity to influence decisions and vice versa.

Economic entity: third level - basic assumption

means that economic activity can be identified with a particular unit of accountability; a company keeps its activity separate and distinct from its owners and any other business unit; an entity's financial activities are recorded separate from those of its owners and managers.

Monetary unit: third level - basic assumption

means that money is the common denominator of economic activity and provides an appropriate basis for accounting measurement and analysis; the monetary unit is relevant, simple, universally available, understandable, and useful (based on the even more basic assumption that quantitative data are useful in communicating economic info and in making rational economic decisions).

Verifiability: second level - enhancing qualitative characteristic

occurs when independent measurers, using the same methods, obtain similar results

Sarbanes-Oxley Act

passed in response to a string of accounting scandals; increased resources for the SEC to combat fraud and curb poor reporting practices

EPS on an income statement

per share of common stock income from continuing operations xx income from operations of discontinued division, net of tax xx loss on disposal of discontinued operation, net of tax xx net income xx

Financial Statements

principle means through which a company communicates its financial info to those outside of it; main financial statements: balance sheet, income statement, statement of cash flows, statement of stockholders' equity

General-purpose financial statements

provide the most useful financial info possible to a wide variety of users at the least cost; the objective of financial reporting identifies investors and creditors as the primary purpose for these financial statements; are presented fairly, clearly,and completely; leads to the common set of standards and procedures known as GAAP

Second level: fundamental concepts

provides conceptual building blocks that explain the qualitative characteristics of accounting info and define the elements of financial statements - forms a bridge between why (the objective) and how (recognition, measurement, financial stmt presentation) of accounting; consists of: QUALITATIVE CHARACTERISTICS OF ACCTG INFO: 1. fundamental qualitative characteristics 2. enhancing qualitative characteristics and BASIC ELEMENTS OF ACCOUNTING INFO 1. moment in time 2. period of time

Full disclosure: third level - basic principle

recognizes that the nature and amount of information included in financial reports reflects a series of judgmental trade-offs that strive for: 1. sufficient detail to disclose matters that make a difference to users, yet 2. sufficient condensation to make information understandable, keeping in mind costs of preparing and using it.

Closing entries process

reduces the balance of nominal accounts to zero in order to prepare the accounts for the next period's transactions

Going concern: third level - basic assumption

the assumption that the company will have a long life (only where liquidation appears imminent is the assumption inapplicable).

First level: objective of financial reporting

the foundation of the conceptual framework; to provide financial information about the reporting entity that is useful to present and potential equity investors, lenders, and other creditors in making decisions about providing resources to an entity; these decisions involve buying, selling, or holding equity and debt instruments, and providing or settling loans and other forms of credit; the "why" purpose of accounting

Faithful representation: second level - fundamental qualitative characteristic

the numbers and descriptions match what really existed or happened; the three components of FR are: 1. completeness - all the info that is necessary for FR is provided; 2. neutrality - a company cannot select info to favor one set of interested parties over another (unbiased info); 3. free from error: an info item that is free from error will be a more accurate (faithful) representation of a financial item; does not imply total freedom from error because most financial reports involve various estimates (i.e. bad debt x).

Understandability: second level - enhancing qualitative characteristic

the quality of info that lets reasonably informed users see its significance; the connection (linkage) between information users and the decisions they make

objective/purpose of financial reporting?

to provide financial information about the reporting entity that is useful to present and potential equity investors, lenders, and other creditors in decisions about providing resources to the entity (decision-usefulness - investors interested in assessing the company's ability to generate net cash inflows and management's ability to protect and enhance the capital providers' investments)

Posting

transferring journal entries to the ledger accounts

Revenue recognition: third level - basic principle

when a company agrees to perform a service or sell a product to a customer, it has a performance obligation. When the company satisfies this obligation, it recognizes revenue. This principle, therefore, requires that companies recognize revenue in the accounting period in which the performance obligation is satisfied.