Exam 1 (Chapters 1-5) Flashcards
Balance sheet equation
Assets = liabilities + equity
Income statement equation
Revenue - expenses = net income
Retained earnings equation
Beg + NI - Dividends = Ending
Debit increases…
DEAD –> Debits, expenses, assets, dividends
Credit increases…
CLRS –> Liabilities, revenues, equity
Purposes of external financial accounting
- Reducing information asymmetry
- Evaluate future cash flows
- Evaluate management (stewardship perspective)
What is accounting?
-Identification, measurement, and communication of financial information about economic entities to interested parties
Interest parties in financial accounting
Investors and creditors (external users)
Objective of financial accounting
Provide information that is USEFUL 1) equity investors and creditors 2) entity perspective 3) decision usefulness
Players in the accounting process
- Management (Preparation, guided by GAAP)
- Auditors (Verification, guided by GAAS)
- Users (Analysis & Decisions, investors, analysts, and lenders)
- SEC (Reporting & Enforcement, SEC Regulations)
- FASB (Standard Setting, determines GAAP)
FASB
- Private entity
- Autonomous from SEC not governmental just oversight from SEC
- No ability to enforce standards
SEC
- Public entity
- Has the power to oversee the whole process and has delegated some authority to FASB
- Can decide if a company can be publicly traded or not
- Faces alot of political pressure and lobbyists
Model used in the United States to develop GAAP
A mixed approach, GAAP is set by private sector bodies whose actions are heavily influenced by the government
- Alot of conflict of interest
- Takes a while to get anything done
Standard setting process
Standards in place to enhance comparability of financial statements, FASB has had primary responsibility since 1973
- Topics identified and placed on board agenda
- Research and analysis conducted, preliminary pro/con
- Public hearing on proposed standard
- Board evaluates research and public response
- Evaluates responses, changes exposure draft
Due process
Used when considering a new standard
- Operates in full view of the public
- Responsive to needs off entire economic community
What is GAAP?
- Principles to follow when collecting and presenting accounting information externally
- Established by FASB with SEC oversight
- Developed in the private sector but subject to political pressures
FASB Codification
- New codification process to simplify GAAP
- No more levels, organized into topics, subtopics, sections, and paragraphs
- Help users gain a better understanding
IFRS
- Published by IASB (based in London)
- International principles growing world-wide
- Focused on objectives and principles, less reliant on rules than GAAP
- Since 2002 efforts have been underway to merge IFRS and GAAP
Benefits of IFRS
- Reduced complexity, transparent, more comparability
- Better comparisons with foreign companies (currently have to be completely different statements)
- Global companies want to prepare statements with one set of standards (reduces cost)
Sarbanes-Oxley Act of 2002
- Huge accounting scandal shook
- Established the PCAOB which regulates financial audits
- Increased auditor independence standards (conflict consulting/auditing services, 5 yr rule)
- Requires CEO and CFO personal signature (more personally responsible) on financial statements
Challenges Facing Accounting
- Accounting for soft assets (Human capital, brand value)
- More forward-looking and timely information (no regulations on projections)
- Ethics
How does accounting information benefit the capital allocation process?
Efficient allocation of capital resources requires knowing where it can be best put to use
Conceptual Framework
- Coherence in rules and standards
- Quick solutions to new and emerging problems through an existing basic theory
- Increased user understanding and confidence
- Enhanced comparability
SFAC No. 5
Recognition and Measurement in Financial Statements of Business Enterprises gives guidance on what information should be formally incorporated into financial statements
SFAC No, 6
Elements of Financial Statements replaces No. 3 and expands its scope to include non-profits
SFAC No. 8
The Obejctive of General Purpose Financial Reporting and Qualitative Characteristics of Useful Financial Information (replaces no 1 &2)
What are the Concepts intended to establish?
Th objectives and concepts for use in developing standards of financial accounting and reporting
First Level of Pyramid: Basic Objective
Provide information about the reporting entity that is useful to present and potential equity investors, lenders, and other creditors in their capacity as capital providers
- The “Why?” of Accounting
- Systems that help us accomplish this objecctive
Second level: Basic elements & characteristics
Bridge between 1 & 3, contains the fundamental and enhancing characteristics and the basic elements of financial statements
Qualitative Characteristics
Broader, theoretical to help distinguish more useful information
Relevance
Must be capable of making a difference in a decision, ingredients are:
- Predictive value
- Confirmatory value (confirm prior expectation)
- Materiality
Faithful Representation
(Reliability), means that the numbers match what really happened. Ingredients are:
- Completeness (nothing left out)
- Neutrality (No bias in information)
- Free from error (accuracy)
Trade-off between Relevance and Faithful Representation
There exists a trade off between producing more reliable financial statements and the timeliness of them
More relevant, less reliable: Goodwill, intangible assets, Forecasts, allowance for doubtful accounts
Less relevant, more reliable: Land (historical cost and fair value accounting)
Enhancing Qualities
Comparability - information reported in a similar way across companies, different from consistency which is similar treatment from one period to another (same firm)
Verifiability - independent measures obtain the same results (trust b/c you can replicate the numbers)
Timeliness - having information available to decision-makers before it loses its capacity to influence decisions
Understandability - quality of information that lets reasonably informed users see significance
Elements
Assets, Liabilities, Equity, Investment by owners, distribution to owners, comprehensive income, revenues, expenses, gains & losses (outside of normal operations, incidental)
**All are Period of Time which reset each period except assets, liabilities, and equity which carry forward
Third Level: Recognition and Measurement
The “how”, implementation
Consists of Assumptions, Principles, and Constraints
These are set forth in Concept No. 5
Assumptions
Economic entity - separate managers from company, subsidiaries all part of one economic entity
Going concern - businesses will have a long enough life to justify the use of accruals and deferrals
Monetary unit - the monetary unit is most effective way to express changes in capital, no inflation assumption
Periodicity - activities of an enterprise can be divided into artificial time periods
Principles
Measurement Principle - most commonly used are based on historical cost and fair value, FASB seems to think that fair value is more useful
Revenue Recognition Principle - Revenue is recognized in the period when performance obligation is satisfied, heart of difference between cash and accrual accounting
Expense Recognition Principle - let the expense follow the revenues (recognize in same period as revenue if tied tot he revenue or in period when expense is incurred)
Full disclosure principle - Financial statements should reveal any facts of sufficient importance to influence the judgment and decisions of an informed user (notes very important)
Constraints
Cost constraint - the benefit derived from requiring accounting information should exceed the cost of providing it (costs 7.8 m on average)
Industry practices - removed from list but still a constraint
Acctg Cycle Step 1: Journalizing
Include: reference date, debits written first, credits indented, total debits and credits must be equal
Acctg Cycle Step 2: Posting to the Ledger
Transfer amounts in the journals to the general ledger, purpose is to summarize the amounts in each account (t accounts for each category)
Acctg Cycle Step 3: Prepare Unadjusted Trial Balance
Lists all ledger accounts and their balances, the trial balance provides an initial check of the mechanical accuracy, have not yet accounted for expenses
**Does NOT necessarily mean it is free from error if debits and credits match up
Acctg Cycle Step 4: Adjusting Entries
Adjusted entries are made at the end of the period to bring accounts up to date and ensure revenue/expense recognition
- Never use cash in an adjusting entry
- Adjusting entries affect at least one real account and one nominal account (balance at the end gets closed out)
- Either accruals or deferrals
Acctg Cycle Step 5: Adjusted Trial Balance
After journalizing and posting the adjusting entries, prepare a second trial balance called the Adjusted Trial Balance
Acctg Cycle Step 6: Prepare Financial Statements
Prepare in this order: Income statement, statement of retained earnings, balance sheet, statement of cash flows
-Order is important because numbers flow form one statement to the next
Acctg Cycle Step 7: Record and Post Closing Entries
Since nominal accounts accumulate data form one period at a time, they must be adjusted at the end of the period
Close out revenue accounts: because revenue is credit normal, you debit to close it, expense accounts debit income summary credit expense
Then, you must close out the income summary account to retained earnings
***If rev>exp, debit inc summary, credit RE; if rev<exp, debit RE and credit income summary
Finally, close out the dividend account (debit RE, credit dividends)
Post-closing trial balance
- Verify that nominal accounts have zero balances
- Verify that debits = credits
Benefits of income statement
Evaluate past performance, predict future cash flows, accrual based
Limitation of income statement
Items that cannot be reliably measured are omitted (changes in human capital)
Accounting methods affect income (FIFO v LIFO)
Estimation methods or judgments may distort income (bad debt expense, useful life of an asset)
Earnings management
- The planned timing of revenues, expenses, gains, and losses to smooth out bumps in earnings
- Incentive to meet Wall Street expectations
- Not necessarily illegal, but you are distorting (gray area)
- Estimating earnings quality abnormal accruals
Multi-step income statement
GAAP permits single or multi, multi separates operating and non-operating and may classify revenues and expenses by function
Research shows investors are more likely to read and consider multistep
What number on the income statement is most important to investors?
Operating income, important predictor for future cash flows
Unusual Gains or Losses
Atypical or infrequent but doesnt have to be both, generally report them in the other revenues
- Do not disclose net of tax
- i.e.: write-downs of inventory, restructuring costs, impairment of goodwill
Items presented below “Income From Continuing Operations”
- Order: Discontinued operations and extraordinary items
- Must be separately disclosed
- Disclosure is net of tax
- After income from continuing operations
Discontinued Operations
- The results of operations and cash flows of a component of a company have been eliminated from the ongoing operations
- No significant continuing involvement
- Required to disclose facts and circumstances leading to the disposal
Extraordinary Items
Both unusual and infrequent, FASB has eliminated these items from the IS
Changes in Principle
- The result of adopting an accounting method that is different from one previously used (LIFO to FIFO)
- Violates consistency
- Restate comparative years presented in current year financial statements
- Adjust beginning retained earnings of earliest comparative year presented for cumulative effect
- DO have to change prior financial statements
Correction of errors
Could be intentional or unintentional
Treated like a change in principle (retroactive adjustments and cumulative adjustments to beginning retained earnings)
Change in estimates
Handled differently, these are normal recurring adjustments that result from periodic revisions in estimates
NOT made retroactively , only account for change in the current period
i.e.–> changes in estimated collectability of receivables
Earnings per share
Calculated as: Net income - Preferred Dividends / Avg shares outstanding, tells us amt of earnings available to give to common shareholders
- dividends to common shareholders not deducted from eps because preferred are like debt
- Separate eps for everything below the continuing operations line
Statement of Retained Earnings
Summarizes changes in the balance of Retained Earnings from the beginning to the end of the period
- Includes net income and dividends
- Prior period adjustments, reported NET OF TAX
Balance Sheet Elements
Summarize what the company owns, who has claims to what the company owns at any point in time
Assets - Probable economic benefits obtained ro controlled by the entity as a result of past transactions
Liabilities - probably future economic sacrifices of economic benefits arising from present obligations of the entity to transfer assets to other entities in the future as a result of past events
Equity - Residual claim on the assets of the company (whatever is left over after satisfying liabilities)
Usefulness of the balance sheet
Used to evaluate risk, evaluate capital structure andd predict future cash flows
Used to assess:
-Liquidity: amount of time until an asset is converted to cash or a liability is paid
-Solvency - the ability to pay debts as they mature
-Financial flexibility - Ability to alter amounts and timing of cash flows to respond to unexpected
Limitations of the Balance Sheet
Many assets and liabilities are reported at historical cost and may lack relevance
Subjective judgments and estimates determine many values
Items might be omitted that cannot be measured objectively
Current assets
Resources the firm expects to be turned to cash or consumed withing a year or the operating cycle Presented in order of liquidity 1) Cash and cash equivalents 2) Short-term investments 3) Receivables 4) Inventory 5) Prepaid assets
Short term investments
1) Held-to-maturity: debt, amortized cost, current or non-current (can never be equity)
2) Trading: Debt or equity, fair value, current (unrealized gains or losses recognized here in NI)
3) Available-for-sale: catch-all for anything else, can be debt or equity, fair value, current or non-current
Non-current assets
Will be converted to cash at some date beyond the operating cycle
Still in order of liquidity (long-term investments,PPE, Intangible Assets)
Intangible assets
- Limited-life intangibles (patents, copyrights)
- Indefinite intangibles (goodwill)
Current liabilities
- Reasonably expected to be liquidated within one year
- Reported in the order they will be paid or liquidated
Long-term liabilities
Obligations that are reasonably expected to be liquidated at some date beyond one year
Stockholder’s equity
Capital stock
-Preferred stock and common stock
-Carried at the par or stated value
Additional Paid-in Capital
-The excess of amounts paid in over the par or stated value
Retained Earnings
-The undistributed earnings of the company over entire life
Other
-Accumulated OCI (other comprehensive income, on BS not IS), treasury stock (buying back shares), minority interest (if another company owns some portion)
Additional Information Reported
There are normally 4 types of information that are supplemental to account titles and balance sheet amounts
- Contingencies (uncertain events)
- Accounting policies (usually Note 1)
- Contractual situations (debt terms)
- Fair values (primarily for financial instruments)
