4.1 A Basic Concepts And Underlying Principles Of Fin Acc

Question 1

Purpose of GAAP

Answer 1

GAAP - generally accepted accounting principles

Reports prepared using these principles allow investors and other stakeholders to compare one company to another.

Question 2

Who is FASB?

Answer 2

Financial Accounting Standards Board
They are the authoritative body having the primary responsibility for developing accounting principles
FASB publishes Statements of Financial Accounting Standards and Interpretations to those Standards.

Question 3

Business Entity Concept

Answer 3

The business entity must be identified so that the accountant can determine which economic data should be analysed, recorded and summarised in reports.
It is important because it limits the economic data in the accounting system to data related directly to the activities of the business.
Business is viewed as an entity separate from its owners, creditors or other stakeholders.

Question 4

Business Entity Concept can be related to which other concepts?

Answer 4

Economic entity assumption
Going-concern assumption
Monetary unit assumption

Question 5

Economic entity assumption

Answer 5

Economic activity can be identified with a particular unit of accountability

Question 6

Going-concern assumption

Answer 6

Accountant assumes that, unless there is evidence to the contrary, the reporting entity will have a life long enough to fulfill its objectives and commitments

Question 7

Monetary unit assumption

Answer 7

All transactions and events can be measured in terms of a common denominator - the dollar

Question 8

Cost Concept

Answer 8

Basis for entering the exchange price or cost of an asset into the accounting records.
Involves two other important concepts: objectivity and unit of measure.
Objectivity - requires that accounting records and reports be based on objective evidence.
Unit of measure - requires that economic data be recorded in dollars.

Question 9

Matching Concept

Answer 9

• Is based on accrual accounting

- Refers to the matching of expenses and revenues for an accounting period.

Question 10

Accrual Basis

Answer 10

Revenues are recognised when sales are made or services are performed, and expenses are recognised as incurred.

Revenues and expenses are recognised in the period in which they occur rather than when cash is received or paid out.

Question 11

Cash Basis

Answer 11

Revenues and expenses are reported in the income statement in the period in which cash is received or paid.

Advantages:

• increased reliability: transactions are not recorded until complete
• simplicity: fewer estimates and judgments are required

Not in accordance with GAAP

Question 12

Materiality Concept

Answer 12

Implies that errors, which could occur during journalising and posting transactions, should be significant enough to affect decision making process.

Question 13

Accounting information should contain 2 qualitative characteristics…

Answer 13

Primary and secondary qualities

Question 14

Primary Qualities that distinguish useful accounting information

Answer 14

Relevance

Reliability

Question 15

Primary Qualities - Relevance

Answer 15

Information must have a bearing on a particular decision situation.
Relevant accounting information possesses at least 2 characteristics: Timeliness and Predictive value or feedback value.
Timeliness - accounting info must be provided in time to influence a particular decision
Predictive value - accounting info can be used to predict the future and timing of cash flows.
Feedback value - accounting function must provide decision makers with information that allows them to assess the progress or economic worth of an investment.

Question 16

Primary Qualities - Reliability

Answer 16

• Reliable accounting information must possess 3 qualities: verifiability, representational faithfulness and neutrality.
• Verifiability - several individuals, working independently, would arrive at similar conclusions using the same data.
• Representational faithfulness - Accounting information must report what actually happened
• Neutrality - accounting information must be free of bias or distortion.

Question 17

Secondary Qualities of accounting information

Answer 17

Does not mean of lesser importance than primary qualities.
If a secondary characteristic is missing, the accounting info is not necessarily useless.
Secondary qualities are comparability and consistency.

Question 18

Secondary quality: comparability

Answer 18

Accounting reports generated for one firm may be easily and usefully compared with accounting reports generated for other firms.

Question 19

Secondary quality: consistency

Answer 19

A firm systematically uses the same accounting methods and procedures from one accounting period to the next accounting period.

Question 20

Additionally to primary and secondary qualities accounting info must be…

Answer 20

Understandable to economic decision makers. The earnings mgt strategy can destroy the primary and secondary qualities of acc information

Question 21

Two factors allow the recording of a transaction:

Answer 21

Evidence: an exchange is an observable event and therefore provides evidence of business activity.
Measurement: The exchange takes place at a set price and thus provides an objective measure of the economic activity.

Question 22

The accounting cycle is one of 4 cycles; name the other 3

Answer 22

Sales
Finance
Production

Question 23

Double entry bookkeeping

Answer 23

Assets = Liabilities + Owners Equity

Total amount of debits must equal total amount of credits

Question 24

Debits:
Assets
Liabilities
Owners equity
Owners drawings
Revenues
Expenses

Answer 24

Increase assets
Decrease liabilities
Decrease Owners Equity
Increase Owners drawings
Decrease Revenues
Increase Expenses

Question 25

Steps in accounting cycle

Answer 25

1) analysis of transactions
2) journalising of transactions
3) posting to ledger
4) trial balance and working papers
5) adjusting journal entries
6) closing journal entries
7) preparing financial statements
8) reversing journal entries

Question 26

Step 1: analysis of transactions

Answer 26

• each transaction must be analysed to determine effect on assets, liabilities and owners equity accounts.

Question 27

Step 2: Journalising of transactions

Answer 27

• transactions are recorded in the accounting journal

Question 28

Step 3: Posting to the ledger

Answer 28

Ledger is the complete collection of all the accounts of an organisation.

Ledger maintain current balance of all the accounts.

Question 29

Step 4: Trial balance and working papers

Answer 29

First step in preparation of working papers is preparation of trial balance.

Trial balance lists all accounts with balances as of the end of accounting period.

Debits will equal credits.

Trial balance does not provide a means of determining whether transactions have been posted to correct accounts or journalised and/or posted to general journal.

Working papers - prepared at end of an accounting period and are for internal use only.

Question 30

Step 5: Adjusting Journal Entries

Answer 30

1) Allocate the cost of assets used in several accounting periods and revenues earned in several accounting periods
2) Accrue revenues and expenses attributable to current period that have not been recorded
3) Make appropriate end-of-period adjustments in the carrying value of certain assets
4) cost of long-term assets must be apportioned to the periods that benefit from their use - apportioned to periods through depreciation, depletion and amortisation (productive assets (building, machinery), wasting assets(minerals), and intangible assets (patents, copyrights)
5) Record portion of unearned revenues earned during the year and portion of prepaid expense that expired during year -1 determine current balance in account, -2 determine appropriate balance for account, -3 make appropriate entry to achieve desired ending balance
6) May be necessary to reduce asset to market value (A/R, inventory, marketable security) - debit expense or loss account and credit contra asset account

Question 31

Step 6: Closing journal entries

Question 32

Step 7: Preparing Financial Statements

Question 33

Step 8: Reversing Journal Entries

Question 34

Real Accounts

Answer 34

Asset, liability and equity accounts
Not closed at end of accounting period
Represent the financial position of an organisation at any point in time

Question 35

Nominal accounts

Answer 35

Revenue and expense accounts
Are closed at end of accounting period
Balances are reduced to zero
Represent the results of operations over a given period of time

Question 36

Subsidiary ledger

Answer 36

Most organisations maintain subsidiary ledgers for AR and AP.
Sum of all subsidiary ledgers should be equal to the master account in general ledger.