Chapter 1 - Intermediate Accounting
Example calculation of rate of return: Assume an investor provides a company with $10,000 cash by purchasing stock at the end of 2020, receives $400 in dividends from the company during 2021, and sells the ownership interest (shares) at the end of 2021 for $10,600.
$400 dividends + $600 share in price appreciation / $10,000 initial investment = 10%
Practice Problem: Creecher purchased $200,000 worth of Troman stock , received four quarterly dividends of $1,000 each, and sold the Troman shares for $206,000 after one year. What is Creecher's rate of return?
(4 x $1,000) dividends + $6,000 share in price appreciation / $200,000 investment = 5%
Expense recognition is implemented by which of the following ways?
1. Associating expenses and revenues in a specific period of time. 2. Cause-and-effect relationship. 3. Systematic and rational allocation. 4. In the period incurred.
General Recognition Criteria
1. Definition 2. Measurability 3. Relevance 4. Reliability
Measurement five attributes
1. Historical Cost 2. Net realizable value. 3. Current Cost 4. Present Value 5. Fair Value
Four basic assumptions underlie GAAP
1. The economic entity assumption presumes that economic events can be identified specifically with an economic entity. 2. The going concern assumption anticipates that a business entity will continue to operate indefinitely. 3. The periodicity assumption allows the life of a company to be divided into artificial time periods to provide timely information. 4. The monetary unit used in U.S. financial statements is the U.S. Dollar.
What information regarding an entity's future cash flows are investors and lenders interested in?
1. Uncertainty 2. Timing 3. Amount
Which of the following are among the basic assumptions underlying U.S. GAAP?
1. going concern 2. monetary unit 3. economic entity 4. periodicity
On January 1, Jennifer purchased common stock of Gamma Corporation for $100,000. During the year, Gamma Corporation stock pays a dividend of $3,000. At the end of the year, Jennifer sells the Gamma stock for $104,000. What is the return on investment of the Gamma stock?
7%
Which of the following models is best in helping predict future cash flows?
Accrual Accounting
What accounting model best meets the primary goal of users of financial reporting?
Accrual Basis
Elements of Financial Statements
Assets, liabilities, equity, investments by owners, distributions to owners, comprehensive income, revenues, expenses, gains, losses
What accounting model produces a measure called net operating cash flow?
Cash Basis
What basis of accounting measures the difference between cash receipts and cash payments from transactions related to providing goods and services to customers during a reporting period?
Cash Basis
Faithful Representation includes:
Completeness Neutrality Free from error
Which of the following forms of business provide shares of stock as an ownership interest?
Corporation
What bases its measurements on the price that would be received in an orderly market transaction.
Fair Value
Generally Accepted Accounting Principles (GAAP)
GAAP is a dynamic set of both broad & specific guidelines that companies should follow when measuring & reporting the information in their financial statements & related notes. GAAP facilitates decision making by investors & creditors by allowing them to compare financial information among companies.
Revenue
Inflows of assets or settlements of liabilities resulting from providing a product or service to a customer.
Corporations acquire capital from:
Investors in exchange for ownership interest. Creditors by borrowing - Either through individual loans or publicly traded debt such as bonds
Users of financial Information
Investors, creditors, employees, labor unions, customers, suppliers, government regulatory agencies, financial intermediaries
Expense Recognition Principle
Match expenses with revenues in the period when the company makes efforts to generate those revenues
Cash Basis Accounting:
Measurements of cash receipts and cash payments from transactions related to providing goods and services. Difference is net operating cash flow.
Accrual Basis Accounting:
Measurements of revenues and expenses, regardless of when cash is received or paid. Difference is net income or net loss.
What type of measurement model does U.S. GAAP currently employ?
Mixed Attribute
Cash flows from operations
Net Income - noncash items in net income (e.g., depreciation expense)
Comprehensive income is the change in equity of a business enterprise during a period from transactions and other events and circumstances from what type of sources?
Nonowner
FASB Accounting Standards Codification
Only source of authoritative nongovernmental U.S. GAAP -Organize the thousands of U.S GAAP pronouncements into roughly 90 accounting topics. -Also includes portions of SEC accounting guidance.
Relevance representation includes:
Predictive Value Confirmatory Value Materiality
Primary objective of financial accounting:
Provided information should be useful for decision making. Information should help investors & creditors evaluate the following characteristics of the enterprise's future cash receipts and disbursements: -Amounts -Timing -Uncertainty
Key variables in investment decision
Rate of Return Uncertainty of Risk
Revenue Recognition Principle
Record revenue in the period in which it's earned
Net Realizable Value (NRV)
The amount of cash into which an asset is expected to be converted in the ordinary course of business
What does it mean if information is cost effective?
The benefits of providing financial information exceed the costs of doing so.
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 rate.
Why do investors and creditors provide capital?
They want to earn a fair return on the resources they provide Shareholders receive cash from: Sale of the ownership shares of stock Periodic dividends
What is not a component of faithful representation as defined in the FASB's conceptual framework?
Understandability
The discounted cash flow valuation model
VE0 = CF1/(1+i) + CF2/(1+i)2+ CF3/(1+i)3... CFn/(1+i)n - VD0 where: VE0 = the value of common equity (per shares/stock) of the firm VD0 = the value of the net debt of the firm CFt = free cash flow of period t i = interest rate (reflects risk) t = time in years before the cash flow occurs It helps forecast cash flow from operations.
Recognition refers to the process of
admitting information into the financial statements
Measurement is the process of
associating numerical amounts with the elements
Financial Statements Include:
balance sheet, income statement, statement of cash flows, statement of shareholder's equity
The primary purpose of financial reporting is to provide useful information for decision making to providers of
capital
The qualitative characteristic of using the same accounting method each period over time refers to the concept of
comparability
Before they can be recognized, favorable items tend to require more verification than unfavorable items. Accountants refer to this as
conservatism
Suffered Corporation changed its inventory valuation method. Which characteristic is jeopardized by this change?
consistency
Cost effectiveness is a(n) on the accounting choices a company makes.
constraint
Which approach to measuring fair value determines fair value by estimating the amount that would be required to buy or construct an asset of similar quality and condition?
cost approach
The full disclosure principle requires that any information useful to decision makers be provided in the financial statements, subject to the
cost effectiveness constraint.
To enhance timeliness, how frequently does the SEC require its registrants to submit their financial information?
daily
The overriding objective in the hierarchy of qualitative characteristics of financial reporting information is
decision usefulness
Decreases in equity of a particular enterprise resulting from transfers to owners are called
disbursements to owners
Investors & creditors like to invest in stocks or bonds that provide a high
expected rate of return.
Under the accrual accounting model, the measure of resources sacrificed is called
expense
Financial information is conveyed through
financial statements and related disclosure notes
The FASB recently issued a standard that requires companies recognize revenue
for the amount the company expects to be entitled to receive at a point in time or over a period of time when goods or services are transferred to customers
What is not a component of relevance as defined in the FASB's conceptual framework?
free from error
Reporting assets at net realizable value helps predict:
future cash flows
Disclosure refers to the process
including additional pertinent information in the financial statements and accompanying notes.
Increases in equity of a particular business enterprise resulting from transfers to it from other entities of something of value to obtain or increase ownership interests is a(n)
investment by owners.
The application of conservatism leads to:
losses being recognized later than gains
Another term for equity is
net assets
Which of the following are acceptable measurement attributes for certain financial statement items?
net realizable value fair value historical cost present value of future cash flows
Historical Cost
original transaction value adjusted for depreciation and amortization
The measurement attribute based on future cash flows and the objective of approximating fair value in valuing an asset or liability is
present value
Accounting provides useful information about economic activity to help
produce good decisions and foster a prosper society
Providers of Financial Information
profit-oriented companies, not-for-profit entities, households
Capital Markets
provide a mechanism to help the economy allocate resources efficiently.
Investors and creditors are willing to provide capital to a corporation only if they expect to
receive more cash in return at some time in the future.
The hierarchy of qualitative characteristics of financial information require that, in order to be useful for decision making, information should possess the fundamental characteristics of
relevance and faithful representation
The accrual accounting model's measure of resources provided by business operations is called
revenues
Current Cost
the cost that would be incurred to purchase or reproduce the asset
Present Value
the current value of future cash flows, calculated by applying the time value of money
Outflows or other using up of assets or incurrences of liabilities during a period from delivering or producing goods, rendering services, or other activities that constitute
the entity's ongoing major or central operations are referred to as expenses
The fair value approach that uses current information from recent transactions or exchanges in active trading on stock exchanges is
the market approach
Financial reporting refers to
the process of providing financial information to external users.
The previous requirement for revenue recognition, which dictated that the earnings process must be virtually complete and the collectability of the related assets reasonably assured was referred to as
the realization principle
Risk refers to
the uncertainty of an investment
Four different competent accountants independently agree on the amount and method of reporting on economic events. The concept demonstrated is:
verifiability