Chapter 2: Analyzing Transactions Flashcards
Do All Canadian Companies Use the Same Accounting Standards?
NO
All Canadian public companies (which are companies whose shares trade on a Canadian public stock exchange) are required to prepare their financial statements using
International Financial Reporting Standards (IFRS)
public = IFRS
Private companies generally follow
Accounting Standards for Private Enterprises (ASPE) (but have the option of using IFRS)
Why were common standards of reporting invented?
to minimize the differences in financial reporting across countries and to reduce the need for companies to generate different sets of financial information in each country in which they operate or raise funds.
dual-listed companies
Company listed on another public stock exchange (outside of canada perhaps, Toronto-New York)
Both IFRS and ASPE focus on the needs of _____ (current and potential) and _____ in determining the financial information that would be useful.
shareholders
creditors
Who Sets the Accounting Standards Used in Canada?
The Canadian Accounting Standards Board (AcSB) is the body responsible for developing and establishing the accounting standards used by Canadian companies.
-Both public and private
Conceptual framework
an underlying set of objectives and concepts that guide accounting standard- setting bodies in justifying new standards and revising old ones.
Useful financial information must be both ______ and ______
Relevant
Representationally faithful
Fundamental qualitative characteristics.
Relevance and representational faithfulness (That means that they are essential if financial information is to be considered useful and, without them, the information is useless.)
The IASB identified four other qualitative characteristics
enhancing qualitative characteristics
1) comparability,
2) verifiability,
3) timeliness, and
4) understandability.
In other words, on their own they cannot make useless information useful, but they can enhance the usefulness of useful information.
Predictive information (Predictive Value)
Information that users can use as the basis for developing expectations about the company’s future.
For example, based on the changes in sales this year, what might next year’s sales be?
Confirmatory Information (confirmatory value)
It provides feedback to users on their previous assessments of the company.
For example, analysts may have projected that a company would achieve a certain revenue target, and the actual revenues for that period allow them to assess this.
materiality / material
Information is considered to be material if it, or its absence, would impact the decisions of a financial statement user.
Material vs immaterial
Material: Information that is critical to user decision-making
Imaterial: information that would not affect the user’s decisions
(Normally, the greater the dollar value of an item, the more material it is considered to be,)
To be representationally faithful information, 3 things must occur
it must be complete, neutral, and free from error.
Complete
related to providing users with all of the information needed to understand what is being presented in the financial statements, including any necessary explanations
Neutral
is unbiased: it is neither optimistic nor overly conservative.
Free from error
if it has been determined based on the best information available, using the correct process and with an adequate explanation provided.
Comparability
the need for users to be able to compare the financial information of two companies, especially if they are in the same industry, or the need to be able to compare financial information for the same company across multiple periods.
Verifiability
achieved if a third party, with sufficient understanding, would arrive at a similar result to that used by the company.
Cost Constraint
It recognizes that capturing and reporting financial information is costly for companies.
-the benefits of reporting financial information must exceed the costs of doing so.
Two types of qualitative characteristics
Fundamental
Enhancing
Accounting standard setters have concluded that the financial information that results from ______ accounting is more useful to users than the information that results from the cash basis.
accrual
Accrual basis of accounting.
Under the accrual basis of accounting, transactions are recorded in the period in which they occur, regardless of when the cash related to these transactions flowed into or out of the company.
- the recognition of revenues and expenses is not a function of when the related cash was received or paid. Instead, revenues are recorded when they have been earned, regardless of whether the related cash was received by the company.
- companies should recognize revenues when they have been earned (that is, when the company has satisfied its performance obligations in the contract by providing the goods or services to its customers). Expenses are incurred when there has been a decrease in economic resources, such as a decrease in assets or an increase in liabilities, for the purpose of generating revenues.
Cash basis of accounting
Under the cash basis of accounting, transactions are recorded only when the cash is actually received or paid by the company.
- transactions are recorded only when cash flows into or out of the company.
- In other words, revenues would be recorded only when the customer or client pays for the goods or services. Expenses, on the other hand, are recorded only when they are paid for by the company.
- E.G the university would recognize a portion of your tuition payment as revenue in each month of the semester in which it is delivering your courses to you.
template approach / synoptic approach
Initially, we will use the accounting equation as the framework for our transaction analysis and recording.
-the most basic of accounting systems
Accounting Equation
Assets=Liabilities+Shareholders’ Equity
Types of assets
A/R: Accounts receivable
Inv: Invententory
Prepaid ins: prepaid insurance
Equip: Equipment
Types of liabilities
A/P: accounts payable
Interest payable
Bank Loan Payable
Shareholders Equity (S/H equity)
Common shares
Retained earnings
Three basic rules When recording transactions within the template,
- Every transaction must affect at least two accounts.
- The accounting equation must remain in balance with each transaction; that is, assets must constantly equal the sum of liabilities and shareholders’ equity.
- Nothing can be recorded in the Retained Earnings account without an explanation of the nature of that transaction being recorded in the final column, stating whether it is due to a revenue, an expense, or a dividend declared.
Retained Earnings account is a “bridge” between the financial statements.
“R” for revenues (which will increase retained earnings)
“E” for expenses (which will decrease retained earnings)
“DD” for dividends declared (which also decrease retained earnings)
Incorporation
The process of organizing a business as a separate legal entity having ownership divided into transferable shares held by shareholders
purchasing on account (also known as a credit purchase)
Pay at a later date
Cost of goods sold
the inventory that has been provided to the client and has become an expense
When analyzing transactions involving the sale of goods
Part 1 accounts for the sales revenue and cash/accounts receivable.
Part 2 accounts for the inventory that has become cost of goods sold.
To depreciate property, plant, and equipment, we need to know four things:
- the pattern in which the asset’s economic benefits will be consumed
- the asset’s cost
- the asset’s estimated residual value
- the asset’s estimated useful life
depreciation
The allocation of the cost of capital to expense over their estimated useful life
estimated residual value
The amount the company estimates it may be able to recover from the disposal of the asset when the company is finished using it
estimated useful life.
The period of time a company estimates an asset will be used to help generate revenue
straight-line depreciation
A method of calculating depreciation in which the amount of expense for each period is found by dividing an assets depreciable amount (equal to cost less estimated residual value) by its estimated useful life
Straight line depreciation formula
Original cost-Estimated residual Value / estimated useful life
What Are the Limitations of the Accounting Equation Template Approach?
-One of the main limitations of the template method is the number of columns that can be included within the template.
-Another significant limitation of the template method is the lack of specific revenue, expense, and dividends declared accounts.
-
Classified statement of financial position.
A classified balance sheet is a financial statement that reports asset, liability, and equity accounts in meaningful subcategories for readers’ ease of use. In other words, it breaks down each of the balance sheet accounts into smaller categories to create a more useful and meaningful report.
carrying amount is also known as the net book value
It represents the portion of the equipment’s cost that has yet to be expensed.
Operating activities
normally expected to result in a net inflow of cash (and therefore have a positive effect on cash) because companies would be expected to collect more cash from customers than they spend to generate these sales. This may not be the case for new businesses.
Investing activities
normally expected to result in a net outflow of cash (and therefore have a negative effect on cash) because companies would be expected to spend more purchasing new property, plant, and equipment than they would receive from selling the property, plant, and equipment that they have finished using.
Financing activities
normally expected to result in a net inflow of cash (and therefore have a positive effect on cash) for new companies because they are generally borrowing and issuing shares to finance their growth. Mature companies may not fit this pattern because they are often able to finance new assets through operating activities, while returning some profits to shareholders as dividends or repaying debt.
Ratio analysis uses
can be used to assess things such as profitability, the effectiveness of management, and the company’s ability to meet debt obligations.
profitability ratios.
Profitability ratios are usually constructed by comparing some measure of the company’s profit (net income or earnings) with the amount invested, or by comparing the profit with the company’s revenues.
Net income / revenue
profit margin ratio
calculated by dividing the company’s profit (or net income) by the revenues that produced the profit.
(Profit Margin=Net Income/Sales Revenue)
EX: 7,400/34,000=0.217or 21.7%
Return on equity ratio
compares the profit (or net income) earned relative to the amount invested by the shareholders (represented by the total shareholders’ equity)
(Return on Equity=Net Income/Average Total Shareholders’ Equity)
EX: 7,400/257,000* =0.0288 or 2.88%
This measure shows that in the month of January, SCL’s shareholders earned a 2.88% return on their investment in the company. It also means that during its first month of operations, the company earned profit at the rate of $0.0288 for each $1.00 that was invested by the owners.
Return on assets
It is calculated by dividing the company’s profit (or net income) by its average total assets.
(Return on Assets=Net Income/Average Total Assets)
Simple terms: Cash basis
Revenues recorded when cash is received
Expenses recorded when cash is paid
Simple terms; Accrual basis
Revenues recorded when they are earned (i.e service is performed)
Expenses recorded when they are incurred (phone bill came in december, did not pay until January)
