Chapter 2 - Financial Statements for Decision Making

Question 1

What are the types of Business Entities?

Answer 1

• Single Proprietorship or Sole Trader
• Partnership
• Company or Corporation

Question 2

Explain what a Single Proprietorship or Sole Trader is

Answer 2

• Owned by one person
• Simple to set up
• Common form of business structure
• Separate accounting entity, not separate legal entity

Question 3

Explain what a Partnership is

Answer 3

• Owned by two or more partners
• Simple to set up
• Separate accounting entity, not separate legal entity

Question 4

Explain what a Company or Corporation is

Answer 4

• Owned by shareholders
• Separate accounting entity
• Separate legal entity
• Limited liability
  
  • Protection for owners

Question 5

What are the Management Functions of Decision Making?

Answer 5

• Planning
  
  • What to do
  • How to do it
• Organizing
  
  • Developing the organizational structure
• Directions
  
  • Performing according to plan
• Controlling
  
  • Evaluating actual VS planned performance

Question 6

What are the Basic Financial Statements?

Answer 6

• Accounting is an information system
  
  • Designed to communicate financial information
  • To interested users
  • For making economic decisions
• Financial statements
  
  • Are the outcome of the accounting process
  • Are a primary information source for users
  • Are useful for many decisions

Question 7

The 3 Primary Information Types

What information do users want/need?

Answer 7

• Financial Performance: Income Statement
• Financial Position: Statement of Financial Position (Balance Sheet)
• Cash Movements: Cash Flow Statement

Question 8

What is the Financial Performance: Income Statement?

Answer 8

• The ability of the entity to utilise its assets effectively and efficiently.
• What are the business goals (i.e. profit/nor for profit)?
• Reports financial performance over a specific time period (e.g. month, year, etc)
• Shows income and expenses
  
  • Income > Expenses = Profit
  • Income < Expenses = Loss

Question 9

What is the Financial Position: Statement of Financial Position (Balance Sheet)/

Answer 9

• The financial resources controlled by the entity
• Financial structure
• Measure of liquidity and solvency

Question 10

What is the Cash Movements: Cash Flow Statement?

Answer 10

• The ability of the entity to generate cash flow, focussing on three areas:
  • Operating Activities
    The provision of and payment for goods and services
  • Investing Activities
    The acquisition and disposal of long term assets
  • Financing Activities
    The raising of funds for an entity to carry out its operating and investing activities.
• The income statement reports in income earned and expenses incurred – NOT on cash flows
• A statement of cash flow is therefore necessary to report on the cash inflows and outflows of the entity
• This allows users to assess the sources and application of cash
• Also the ability of the entity to remain solvent

Question 11

What is the Statement of financial Position?

The balance sheet

Answer 11

• It reports financial position of an entity at a specific point in time
• Shows assets, liabilities and equity of the entity
• Represents the Accounting Equation
  Assets = Liabilities + Equity
• Alternative Formatives include;
  
  • Account Format
  • Narrative Format

Question 12

What does Income do?

Answer 12

• Increases in economic benefits in the form of inflows or enhancements of assets or decreases of liabilities that results in equity, other than those relating to equity participants

Question 13

What do Expenses do?

Answer 13

• Decreases in economic benefits in the form of outflows or incurrences of liabilities that result in decreases in equity, other than those relating to equity participants

Question 14

What is the process of the Statement Of Changes In Equity?

Answer 14

1) Balance sheet at the beginning of the year
A1 - L1 = E1

2) Income statement for the period
Income - Expenses = Profit

3) Statement of Owner’s Equity for the period
E1 + Profit - Drawing = E2

4) Balance sheet at the beginning of the year
A2 - L2 = E2

Question 15

What are the 4 Underlying Assumptions of Financial Statements?

Answer 15

• Accounting Entity Assumption
  
  • Identify clearly the boundaries of the entity being accounted for
  • Personal transactions of the owner must remain separate from the transactions of the entity
• Accrual Basis Assumption
  
  • Accounting is an “event” driven process
  • The effects of transactions are recognized when they occur, not when the cash is received/paid
• Going Concern Assumption
  
  • Unless we have evidence to the contrary, we assume an entity will continue to operate in the future
• Period Assumption
  
  • The life of the entity can be “broken up” into equal time intervals
  • Profit is determined for particular periods of time in order to be comparable

Question 16

What are the 7 Qualitative Characteristics of Financial Statements

Answer 16

• Relevance
  
  • Information is useful for decision making
  • Can influence economic decision by users
• Faithful Representation
  
  • Information presented faithfully, without bias or undue error
  • Economic Substance over form
• Comparability and Consistency
  
  • Users can identify similarities and differences between two sets of economic Data
• Verifiability
  
  • Different, independent observers can reach consensus that information faithfully represents what it claims to
• Understandability
  
  • Expect a reasonable knowledge of business and economic activity and financial accounting
  • Study the information with reasonable diligence
• Materiality
  
  • The extent to which omission or misstatement would be misleading to users
• Benefits and costs
  
  • Benefits of providing information must justify cost of providing

Question 17

Why is the Rationale for Conceptual Frameworks important?

Answer 17

• To develop the practice of financial reporting logically and consistently we need to address and agree upon such issues as;
  
  • What we mean by ‘financial reporting’ and what should be its scope;
  • Which organisational characteristics indicate that an entity should produce financial reports;
  • Definition of the users of financial statements (and assumptions of their accounting knowledge)
  • The ‘objective’ of financial reporting;
  • Qualitative characteristics financial information should possess for it to be ‘useful’;
  • What are the elements of financial reporting; and
  • What measurement rule(s) should be employed.

Question 18

What does the Qualitative Characteristics of Financial Information Ensure?

Answer 18

• To ensure financial information is useful for economic decision making, we need to consider the attributes or qualities that financial information should have
• The ISAB Conceptual Framework identifies:
  ~ Fundamental Qualitative characteristics
  • Relevance
  • Faithful representation
  ~ Enhancing Qualitative Characteristics
  • Comparability
  • Verifiability
  • Timeliness
  • Understandability

Question 19

Explain the Fundamental Qualities Characteristics (Relevance)

Answer 19

• Something is relevant if it influences decisions on the allocation of scarce resources
  
  • If it is capable of making a difference in a decision
• For information to be relevant it should have:
  
  • Predictive value
  • Feedback (or confirmatory) value

Question 20

Explain the Fundamental Qualities Characteristics (Faithful Representation)

Answer 20

• The previous Conceptual Framework referred to reliability rather than faithful representation
• According to paragraph QC12:

~ To be a perfectly faithful representation, a depiction would have three characteristics. It would be complete, neutral and free from error. Of course, perfection is seldom, if ever, achievable. The Board’s objective is to maximize those qualities to the extent possible.~

Question 21

What the 2 types of Measurement Criteria ?

Answer 21

• Historical Cost

- Current Market Value