Accounting Theory 1 Exam 1

Most common financial statements

1) Balance Sheet (Statement of Financial Position) 2) Income Statement (Statement of Operations)/ Profit and Loss Statement 3) Statement of Cash Flows 4) Statement of Shareholder's Equity

Cost Measurement

1) Historical cost: measure assets and liabilities based on their original transaction value; adjusted by recognizing appreciation or amortization; the value is highly objective and verifiable 2) Net realizable value: the estimated selling price in the oridnary course of business less the reasonably predictable costs of completion, disposal, and transportation 3) Current cost: cost that would be incurred to purchase or reproduce the asset; useful in inflationary economics 4) Present or discounted value of future cash flows: provides a framework for using future cash flows as the basis for the accounting measurement to indicate value 5) Fair value: the price tha twould be received to seel assets or paid to transfer a liability in an orderly transaction between market participants at the measurement date

Estimates

Accountants often must make estimates of future events to comply with the accrural accounting model

Politics in Standard Setting

Accounting for employee stock options; implementation of fair value accounting

Retained Earnings

Accumulated lifetime profits a company has earned for its shareholders but has not yet distributed

Securities and Exchange Commission (SEC)

Also created by the 1934 Act. Congress gave the SEC the authority to set accounting and reporting standards for companies whose securities are publicly traded. However, the SEC, a government appointed body, has delegated the task of setting accounting standards to the private sector. If the SEC does not agree with a particular standard issued by the private sector, it can force a change in the standard.

Enhancing Qualitative Characteristics

Comparability, Consistency, Verifiability, Timeliness, Understandability

Deferred Revenues

Created when a company receives cash from a customer in one period for goods or services that are to be provided in a future period

Financial Accounting Standards Board

Criticism of the APB led to the creation in 1973 of the FInancial Accounting Standards Board (FASB) and its supporting structure. -Seven full time members FASB is suppored by its parent organization Financial Accounting Foundations (FAF) IN 1984, FASB's Emerging Issues Task Force (EITF) was formed to improve financial reporting by resolving narrowly defined financial accounting issues within the framework of existing GAAP.

Recognition Requirements

Definition: the item meets the definition of an element of finanical statements Measurability: the item has a relevant attribute measureable with sufficient reliability Relevance: The information about it is capable of making a difference in user decisions Reliability: The information is representationally faithful, verifiable, and neutral

Management Intent

Determines how an asset is determined, deciding whether it will be sold soon (reported at liquid value) or kept and reported at another value

Rules-Oriented Approach

Detractors (of objectives-oriented) argue the absence of detailed rules opens the door to even more abuse, or reliance on professional judgement might result in different interpretations for similar transactions, raising concerns about comparability. The key is whether management is dedicated to high-quality financial reporting,

Summary of Significant Accounting Policies

Disclosures which note what type of method is being used to calculate depreciation, inventory, which costs are used to record investments, etc

Rate of return for investors

Dividends+Share Price Appreciation/Initial Investment

Accounts Receivable (Trade Receivables)

Due in 30 to 60 days; Notes receivable are considered nontrade receivables

Underlying Assumptions

Economic Entity, Going Concern, Periodicity, Monetary Unit

Objectives-Oriented Approach

Emphasizes using professional judgement as opposed to following a list of rules, when choosing how to account for a transaction; Proponents of an objectives-oriented approach argue that a focus on professional judgement means that there are fewer rules to sidestep

Expense Recognition

Expenses are outflows or other using up of assets or incurrences of liabilities from providing goods or services. Expense recognition matches revenue recognition -Based on an exact cause-and-effect relationship -By associating an expense with the revenues recognized in a specific time period -By a systematic and rational llocation to specific time periods (depreciation) -In the period incurred without regard to related revenues The timing of expense recognition also affects the timing of asset and liability recognition and de-recognition.

Accrued Liabilities

Expenses incurred but not yet paid

Materiality

Financial information is material if omitting it or mistating it could affect users' decisions. Materiality is an aspect of relevance that depends on a company's particular situation The threshold for materiality often depends on the relative dollar bill mount of the transaction

Intangible Assets

Grant an exclusive right to a company to provide a product or servbice Patents copyrights, franchises, and trademarks Intangible assets are generally reported in the balance sheet at their purchase price less accumulated amortization Not all intangible assets are purchased, some are developed internally (research and development) Goodwill

International Accounting Standards Board

IASB's main objective is to develop a single set of high-quality, understandable, and enforceable global accounting standards to help participants in the world's capital markets and other users make economic decisions. IASB has revised many International Accounting Standards (IASs) and has issued new standards of its own, called International Financial Reporting Standards (IFRS).

Accounting Principles Board

In 1959, the Accounting Principles Board (APB) replaced CAP. -suffered from a variety of problems -was never able to establish a conceptual framework for financial accounting and reporting that was broadly accepted -members served on the APB on a voluntary, part-time basis, so it was not able to act quickly enough to keep up with developing issues -perceived lack of independence from the AICPA

Accrued Receivables

Involve situations when the revenue is recognized in a period prior to the cash receipt

Cash Equivalents

It is common practice to classify investments that have a maturity date of three months or less from the date of purchase as cash equivalents

The Statement of Shareholder's Equity

Its purpose is to disclose the sources of changes in the various permanent shareholders equity accounts that occured during the period from investments by owners, distributions to owners, net incomes, and other comprehensive income

Usefulness of the Balance Sheet

Liquidity most often refers to the ability of a company to convert its assets to cash to pay its current obligations. Long-term solvency refers to an assessment of whether a company will be able to pay its long-term debts. Solvency also provides information about financial flexibility - the ability of a company to alter cash flows in order to take advantage of unexpected investment opportunities and needs. The higher percentage of a company's liabilities to its equity, the more difficult it typically will be to borrow additional funds' either to take advantage of a promising investment opportunity or to meet obligations

Faithful Representation

Must be complete, neutral (free from bias), and free from error

Accrurals

Occur when the cash flow comes after either expense or revenue recognition Many accrurals involve external transactions that automatically are recorded from a source document

Prepayments

Occur when the cash flow precedes either expense or revenue recognition; Prepaid Expenses or Deferred Revenue

Fair Value Option

Permits companies to choose whether to report financial assets and liabilities at fair value Provides companies with a way to reduce volatility in reported earnings without having to comply with complex hedge accounting standards

Management's Discussion and Analysis

Precedes financial statements and the auditor's report, management provides its views on significant events, trends, and uncertainties pertaining to operations, liquidity and capital resources

The Statement of Cash Flows

Purpose of the statement of cash flows is to report the events that caused cash to change during the period The statement classifies all transactions affecting cash into one of three categories: operatig, investing, and financing activites Operating activities are inflows and outflows of cash related to transactions entering into the determination of net income Investing activities involve the acquisition and sale of long-term assets used in the business and nonoperating investment assets. Financing activities involve cash inflows and outflows from transactions with creditors and owners

Noteworthy Events and Transactions

Related-party transactions, errors and fraud, and illegal acts The potential problem with related-party transactions is that their economic substance may differ from their legal form, such as borrowing or lending money at a very low interest rate Errors are unintential Fraud is intentional misappropriation of assets or fraudulent financial reporting Illegal acts include bribes, kickbacks, illegal contributions to political candidates, and other violations of the law

Qualitative Characteristics of Financial Reporting Information

Relevance, Faithful Representation, Enhancing Qualitative Characteristics, Key Constraint: Cost Effectiveness

Revenue Recognition

Revenues are inflows of assets or settlements of liabilities resulting form providing a product or service to a customer The timing of revenue recognition is a key lemetn of earnings measurement 1) the earnings process is judged to be complete or virtually complete 2) there is reasonable certainity as to the collectibility of the asset to be received Standard required companies recognize revenue when goods or services are transferred to customers for the amounts the company expects to be entitled to receive in exchange for those goods or services

Temporary Accounts

Revenues, Expenses, Gains and Losses

Section 404 of Sarbanes-Oxley Act

Section 404 is perhaps the most controversial provision of Sarbanes-Oxley Act. It requires that company management document internal controls and report on their adequacy. Research provides evidence that 404 reports affect investors' risk assessments and companies' stock prices, indicating these reports are seen as useful by investors.

Auditor

Serve as an independent intermediary to help ensure management has in fact appropriately applied GAAP in preparing the company's financial statements; Only individuals licensed as certified public accountants can represent that the financial statements have been audited in accordance with generally accepted auditing standards

Analytical Model for Ethical Situations

Step 1. Determine the facts of the situation Step 2. Identify the ethical issue and the stakeholders Step 3. Identify the values related to the situation Step 4. Specify the alternative courses of action Step 5. Evaluate the courses of action specified in step 4 in terms of their consistency with the values identified in step 3 Step 6. Identify the consequences of each possible course of action Step 7. Make your decision and take any indicated action

The Accounting Processing Cycle

Step 1: Obtain information about transactions from source documents Step 2: Analyze the transaction Step 3: Record the transaction in a journal -Journal provides a chronological record of all economic events affecting a firm Step 4: Post form the journal to the general ledger accounts -Ledger is a collection of all of the company's various accounts (T-Accounts) Each accont provides a summary of the effects of all events and transactions on that individual account. -Posting involves transferring the debits and credits recorded in individual journal entries to teh specific accounts affected. Step 5: Prepare an unadjusted trial balance -List of general ledger accoungs along with their balances at a particular date Step 6: Record adjusting entries and post to the ledger accounts Step 7: The adjusted trial balance Step 8: Prepartation of financial statements Step 9: Closing Trial Balance -Close the temporary accounts to retained earnings (at year-end only)

Property, Plant and Equipment

Tangible, long-lived, and used in the operations of business Reported at original cost lesss accumulated depreciation to date Land has an unlimited useful life and is therefore not depreciated

Codification

The FASB has developed a conceptual framework that is not authoritative GAAP but provides an underlying structure for the development of accounting standards -Accounting Standards Updates (ASUs) -Statements of Financial Accounting Standards (SFASs) -Interpreations -Staff Positions -Technical Bulletins -EITF Issue Consensuses The Codification integrates and topically organizes all relevant accounting pronouncements comprising GAAP in a searchable online database.

The Closing Process

The closing process serves a dual purpose: the temporary accounts (revenues, expenses, gains and losses) are reduced to zero balances, ready to measure activity in the upcoming accounting period and these temporary balances are closed (transfered) to retained earnings to reflect the changes that have occured in that account during the period. Often, an intermediate step is to close revenues and expenses to income summary, and then income summary is closed to retained earnings The use of the income summary account is just a bookkeeping convenience that provides a check that all temporary accounts have been properly closed (That is, the balance equals net income or loss)

Limitations

The company's book value, its reported assets minus liabilities as shown on the balance sheet, usually will not directly measure the company's market value. Market value is the amount someone would be willing to pay to own the company. For a company with publicly traded stock, market value can easily be computed as the current stock price times the number of shares outstanding. The two primary reasons that the balance sheet does not portray the company's market value are: 1) Many assets like land and buildings are measured at their historical costs rather than their fair values 2) Many aspects of a company may represent valuable resources that are not recorded as assets in the balance sheet Another limitation of the balance sheet is that many items are heavily reliant on estimates and judgements rather than determinable amounts Even though the balance sheet does not directly measure the market value of an entity, it provides valuable information to help judge market value

Prepaid Expenses

The costs of assets acquired in one period and expenses in a future period Whenever cash is paid and it is not to 1) satisfy a liability or 2) pay a dividend or return capital to owners it must be determined whether or not the payment creates future benefits or whether the payment benefits only the current period

First Accounting Standards Setting Body

The first private sector body to assume the task of setting accounting standards was the Committee on Accounting Procedure (CAP). The CAP was a committee of the American Institute of Accountants (AIA). The AIA was renamed the American Institute of Certified Public Accountants (AICPA).

Proxy Statement

The proxy statement must be reported each year to all shareholders, usually along with the annual report. The statement invites shareholders to the annual meeting to elect board members and to vote on issues, or to vote by proxy. The proxy statement also includes compensation and stock option information for directors and top executives

The Income Statement and Comprehensive Statement of Income

The purpose of the income statement is to summarize the profit-generating activities of a company that occured during a particular period of time. it is a change statement in that it reports the changes in shareholders' equity (retained earnings) that occured during the period as a result of revenues, expenses, gains, and alosses. A common classification scheme is to separate operating items from nonoperating items Gross profit = sales less cost of goods sold The statement of comprehensive income extends the income statement by reporting all changes in shareholders' equity during hte period that were not a result of transactions with owners A few types of gains and losses, called other comprehensive income or loss are excluded from the determination of net income and the income statement, but are included in the broader concept of comprehensive income. Comprehensive income can be reported in one of two ways: in a single, continueous statement of comprehensive income or in two seperate but consecutive statements The statement of comprehensive income begins with net income as the first component followed by OCI items to arrive at comprehensive income In the separate statement approach, we separate the continuous statement into two parts, but the content is the same

Three Types of Fair Value Techniques

Three types of Fair Value techniques: 1) Market approaches base valuation on market information 2) Income appraoches estimate fair value by first estimating future amounts and then mathematically converting those amounts into a single present value 3) Cost appraoches determine value by estimating the amount that would be required to buy or construct an asset of similar quality and condition Must provide detailed disclosures about their use of fair value measurements The use of fair value measurement attribute is increasing both under GAAP and IFRS

Primary objective of financial accounting

To provide investors and creditors with information that will help them make investment and credit decisions. That information should help investors and creditors evaluate the amounts, timing, and uncertainty

Unqualified Auditors Report

Unqualified (clean) opinion when the auditor has undertaken professional care to ensure that the financial statements are presented in conformity with GAAP

Operating Cycle

Way of classifying current assets; The operating cycle for a typical merchandising or manufacturing company refers to the period of time from the initial outlay of cash for the purchase of inventory until the time the company collects cash from a customer from the sale of inventory. For a merchandising company, the initial purchase of inventory often is for a finished good. For a manufacturing company, the initial outlay of cash often involves the purchase of raw materials, which are then converted into a finished product.

Subsequent Events

When an event that has a material effect on the company's financial position occurs after the fiscal year-end but before financial statements are issued

Generally Accepted Accounting Principles (GAAP):

a dynamic set of both broad and specific guidelines that companies should follow when measuring and reporting the information in their financial statements and related notes

Conservatism

accountants require greater verification before recognizing good news than bad news. The result is that losses are reflected in net income more quickly than are gains, and net assets tend to be biased downwards Conservatism is rejected by official standards, but other standards seem to inherently promote it

1934 Securities Exchange Act

applies to secondary market transactions and mandates reporting requirements for companies whose securities are publicly traded on either organized stock exchanges or in over-the-counter markets

Internal Events

directly affect the financial position of the company but don't involve an exchange transaction with another entity (ex: adjusting entries)

Full-disclosure principle

financial reports should include any information that could affec thte decisions made by external users 1) Parenthetical comments or modifying comments 2) Disclosure notes 3) Supplemental schedules and tables

Verifiability

implies different knowledgeable and independent measurers would reach consensus regarding whether information is a faithful representation of what it is intended to depict. Direct verification involves observing the item being depicted, ie historical cost. Appraisal of fair value is an indirect verification because it is an estimate and there are different ways to caluculate such a cost Historical cost is objective, but fair value is subjective

Disclosure

including pertinent information in the financial statements and accompanying notes

External Events

involve an exchange between the company and a separate economic entity

1933 Securities Act

sets forth accounting and disclosure requirements for initial offerings of securities (stocks and bonds).

Unqualified with an explanatory paragraph

the auditor believes the financial statements are in conformity with GAAP, but feels that other important information needs to be emphasize to financial statement users: -Change in accounting principle that affects conformity and comparability -Going concern is doubtful -Emphasis of a matter

Relevance

the information must possess predictive value and/or confirmatory value -central to the conept of "earnings quality," the ability of reported earnings (income) to predict a company's future earnings.

Recognition

the process of admitting information into financial statements

Measurement

the process of associating numerical amounts with the elements

Qualified Opinion

when either the audit process has been limited or there has been a departure from GAAP, but neither is of sufficient seriousness to invalidate the financial statements as a whole

Adverse Opinion

when the auditor has specific knowledge that financial statements or disclosures are seriously misleading

Disclaimer

when the auditor is not able to gather sufficient information that financial statements are in conformity with GAAP