Midterm #1 Flashcards
Why does accounting matter?
- The language of business
- Economic systems depend on reliable and accurate financial reporting
- Records the economic events and communicates to interested users
Two types of users of accounting?
External and internal
What are internal users?
- People who work for or manage for-profit, non-profit or government organizations
- People within the company itself to use financial reporting to make decisions (business opportunities, pricing) and assist them in managing and operating the company
What are external users?
- People who are making financial decisions outside of businesses which companies they should allocate their money to
- They do not have access to accounting information other than what’s already available to the public
What is ethical behaviour?
- Companies have a rules of conduct
- For accounting information to have value, preparers must have high ethical standards (actions must be legal and responsive)
What are the different forms of business organizations?
Proprietorship, Partnership, Corporation
What is a proprietorship?
Type of business organization that is owned by one person
What are some true characteristics of a proprietorship?
- Owned by one person
- Easy to set up
- Owner has control over business
- Unlimited liability (responsible for it all)
- Income is included in individual owners tax return (business income is added to personal tax return)
What is a partnership?
Type of business organization owned by 2 or more people
What are some key characteristics of a partnership?
- Somewhat easy to set up
- Formalized in written agreement (how things are going to be shared)
- Each partner has unlimited liability
- Tax on each partner’s personal income tax return
Key characteristics of a corporation?
- Limited liability for shareholders
- One owner or tons of people
- Indefinite life
- May be public or private → depending on whether shares are publicly traded
- The corporation has its own tax return
What are the different types of businesses?
Manufacturing, Merchandising, Service
What is a manufacturing business?
- Uses raw materials, parts, and components to assemble finished goods
- Makes stuff
What is a merchandising business?
- Sells goods to consumers
- Sells stuff
What is a service business?
- Performs tasks for the benefit of its customers
- Does stuff
What are the 3 types of business activities?
Financing, Investing, Operating
What are financing activities?
- Obtaining and repaying funds to finance the operation of the business
- How does a company find money to find their business?
* Ex. Borrowing money or paying loans (debt)
* Ex. Selling or repurchasing shares (equity) - Shares in exchange for cash
What are examples of inflows from financing activities?
Issuing shares, taking out a loan
What are some examples of outflows from financing activities?
Paying dividends, repurchasing shares, repaying loans
What are investing activities?
- Obtaining the resources or assets needed to operate the business for long term
- Buying long term assets that will help your company in the long run
- Ex. Purchase or sale of investments
- Ex. Purchase or sale of long lived assets (property, equipment, intangible assets)
What are some examples of inflows from investing activities?
Proceeds from selling long-lived assets and shares of other companies
What are some examples of outflows from investing activities?
Buying long-lived assets, buying shares of other companies
What are operating activities?
- The main day-to-day activities of the business
- Ex. Revenues (income coming from increase in asset or decrease in liability), expenses
What are some examples of inflows from operating activities?
Revenues, collection of receivables, sale of services or goods
What are some examples of outflows from investing activities?
Expenses, payments of payables, purchase of inventory and supplies
What are dividends?
- Payments that distribute a portion of income to share holders
What is goodwill?
- When a company acquires another company, paying a price that is higher than the value of the purchased company’s net identifiable assets
Why are financial statements important?
- They show you the performance over time
- The business documents that companies use to report the results of their activities to various other groups
What are the four types of financial statements (ASPE)?
Income Statements, Statement of Retained Earnings, Balance Sheet, Cash Flow Statement
What are the four types of financial statements (IFRS)?
Statement of Income, Statement of Changes in Equity, Statement of Financial Position, Statement of Cash Flow
What is a statement of income useful for?
- Report the results of operations for a specific period of time
- Revenue minus expenses
What are revenues?
- They arise from the sale of a product or service from ordinary activities
What are expenses?
- Costs of assets consumed or services used to generate revenues
- Decrease in economic resources
What are gains and losses?
- Extra income or expenses arising from one time (or unusual) events that are not in the regular course of operations
- Ex. Cupcake shop buying real estate
What is the equation for statement of income?
(Revenue + gains) - (expenses - loss) = net income
Why do we use Statement of Changes in Equity?
It shows the changes in each component of shareholders equity for the period
What is the equation for Statement of Changes in Equity (retained earnings)?
Beginning balance of retained earnings (start of the period) +/- net income (revenues-expenses) - dividends = ending balance of retained earnings
What is share capital?
- Amounts contributed by shareholders
- May have common and preferred classes
What is deficit?
More money being spent than earning
What is the equation for Statement of Financial Position? (balance sheet)
Assets = Liabilities + Shareholder’s Equity
What is shareholder’s equity?
Share capital and retained earnings
What is a Statement of Cash Flow useful for?
Report cash receipts and payments for a specific period of time
(They are categorized as operating, financing and investing)
What does GAAP stand for?
Generally Accepted Accounting Principles
What is GAAP used for?
- Rules for how financial statements should be prepared
Publicly-traded corporations use International Financial Reporting Standards (IFRS)
Private corporations may use IFRS or Accounting Standards for Private Enterprises (ASPE)
What does the financial reporting framework look like?
Level 1 - Objectives of financial reporting (the why)
Level 2 - Qualitative Characteristics of accounting information
Elements of financial statements
Level 3 - Foundational Principles and Conventions (the how)
Why is a conceptual framework useful?
- Aids in creation of standards for the accounting profession
- Increases financial statement users’ understanding of and confidence in financial reporting
- Enhances comparability of financial statements of different companies
- Foundation for solving new emerging problems more quickly
What is conservatism?
The principle that net assets and net income should not be overstated
What is prudence?
Using caution when exercising judgment to make estimates in case of uncertainty
What is the moral hazard issue?
Where certain stakeholders such as accountants and owner-managers have expert knowledge that the rest of the capital marketplace does not.
What is the Objective of Financial Reporting?
Level 1
The overall objective of financial reporting is to provide/communicate information that is:
* useful to users (e.g. Investors, creditors)
* decision relevant (resource allocation)
Resource allocation decisions are assumed to include assessment of how well management is using entity resources to create and sustain value
What are the Fundamental Qualitative Characteristics that support usefulness of information?
Relevance and Representational Faithfulness (Reliable)
What is Relevance in the context of Fundamental Qualitative Characteristics?
- Has predictive and feedback/confirmatory value
- Includes information that makes a difference in decision making
What is materiality?
How important a piece of information is (compare to other pieces of financial statements to determine if it is material/will make a difference)
What is Representational Faithfulness in the context of Fundamental Qualitative Characteristics?
How faithful does it reflect/represent the underlying economic substance of an event or transaction (accuracy)
Transparency, completeness, neutrality, free from material error, substance over form
What are the 4 Enhancing Qualitative Characteristics ?
Comparability, Verifiability, Timeliness, Understandability
What is comparability?
- Information measured and reported in similar way (company to company, and year to year)
- Allows users to identify real economic similarities and differences
What is verifiability?
- Being able to achieved similar results if same methods are used (consensus)
- How much money you have in the bank = easy, account receivable (money customers owe us… some customers won’t pay us back = hard)
What is timeliness?
Want info to stay relevant and have it when you need it (quarterly reporting provides info on a more timely basis)
What is understandability?
- Allows reasonably informed users to see the significance of the information
- Provides “enough” information so that it is clear
What are trade-offs?
When characteristics are temporarily sacrificed for better information in the future
Assets have three key characteristics…
- They involve some economic benefit to the entity (if there is a future economic benefit)
- Entity has a control over that benefit
- Results from a past transaction or event
Liabilities have three key characteristics…
- They represent a present duty or responsibility
- Entity is obligated to give money and cannot avoid the duty or responsibility
- Obligation results from a past transaction or event
What does equity represent?
What’s left over of our assets after the liabilities are paid
What is recognition vs. derecognition?
Recognition is including an item on the financial statements (FS)
Derecognition is removing something from the FS (for assets its when control is given up and for liabilities its when the obligation is extinguished)
What are the 4 principles of Recognition/Derecognition?
- Economic Entity Assumption
- Control
- Revenue recognition
- Matching principle
What is the economic entity assumption?
A business activity is separate from the owner’s personal activity.
(Ex. going to dinner with a client)
What is control?
If two corporations are controlled by the same person/party, then their FS are consolidated (report their statements together)
What is Revenue Recognition?
Revenue realized when earned & when risks/rewards have passed to purchaser
(Ex. I should report revenue when the job is done, and the cash is received afterwords)
What is Matching Principle?
Matching principle- Expenses are matched/recorded in the same period as the revenues they help produce, cause and effect relationship
(Ex. the timing of expenses should be matched/recorded at the same time as revenues… I payed utility bill for the month of Jan in Feb, and it relates to Jan revenue)
What is depreciation?
Allocate cost of a fixed asset over its useful life (not just using a delivery asset for this year, but using it for the next 10 years, so I will pay it off over the next 10 years)
Cost of asset/# of years
What are the 5 measurement principles?
- Periodicity assumption
- Monetary unit
- Going concern
- Historical cost
- Fair value
What is Periodicity assumption?
Economic activity of a business can be divided into artificial time periods (month, quarter, year)
What is Monetary Unit?
Use money to measure economic transactions. Assume currency is stable year over year (in CAN & USD- ignore inflation)
What is Going Concern?
Assume a business will continue to operate in the foreseeable future
What is Historical Cost?
Record certain elements of the FS at their cost when bought (i.e. property, plant & equipment)
What is Fair Value?
Record certain elements of the FS at their estimate price (Accounts receivable, short term investments)
What is Accrual Accounting?
Records cash transaction + noncash transactions, only once the cash is given
What is Full Disclosure Principle?
- Anything that is relevant to users’ decisions should be included in financial statements
Disclosure may be made:
* Within the main body of the financial statements
* As notes to the financial statements
* As supplementary information, including Management Discussion and Analysis
What are the 3 Profitability Ratio?
Earnings per share (how much profit for single share)
Price earnings ratio (how much you’re willing to pay per dollar of earnings)
Gross Profit (revenue - inventory costs = gross profit)
How do we calculate Earnings per share?
Net profit after tax / number of issued common shares
How do we calculate Price Earnings ratio?
Market price per share / earnings per share
How do we calculate Gross Profit?
Revenue - inventory costs = gross profit
How to measure liquidity?
Current Ratio = Current Assets / Current Liabilities
What is liquidity?
Measure the short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash
What is solvency?
Measuring a company’s ability to survive over the long term by having enough assets to settle its liabilities as they fall due
Assets - liabilities
How do we calculate Debt/Total Assets ratio?
Total liabilities / Total Assets
What is an operating cycle?
The average period of time it takes a business to pay cash to obtain products or services and then receive cash from customers for these products or services.
In a service business, this is the time it takes a business to perform services for customers on account, pay the employees performing the services, and then collect the cash from customers
What makes up Shareholder’s Equity?
Share capital and retained earnings
What makes up liabilities?
Current and long-term liabilities
What are some examples of current assets?
Cash, Trading Investments, Accounts Receivable, Notes Receivable, Inventory, Supplies, Prepaid Expenses
What is a trading investment?
Investment in debt securities that are bought with the intention of reselling them after a short period of time in order to earn income from fluctuations in their price
What is accounts receivable?
Amounts owed to a company by its customers who purchased products or services on credit “on account”, sale invoices
What is notes receivable?
Amounts owed to a company by customers or others supported by a written promise to repay, loans
What is Property, Plant, and Equipment?
- Tangible assets with relatively long useful lives
- Assets used in operating the business
Ex. Land, building, machinery, delivery equipment, furniture and fixtures
What is the carrying amount of an asset?
The difference between the cost of the asset and its accumulated depreciation.
What are some types of assets that aren’t depreciated? (have an indefinite life)
Land, goodwill, assets under construction
What is notes payable?
Written promises to repay/written documents
What is interest payable?
When you owe interest
What is salaries payable?
When you have to pay your workers (the time when you haven’t paid your workers)
Accrued liabilities
Expenses that I am using up, but haven’t pay for yet
Ex. Utility bill
What is deferred revenue/unearned revenue?
Revenue we collect in advance but in advance of performing the service (owing someone a service)
What is shareholder’s equity?
- Investment of cash (or other assets) in the business by the shareholders in exchange for preferred or common shares
- Money that people have paid of our shares to us
Retained earnings
Earnings kept for use in the business
(Not paid out as dividends)
What type of economic events must be recorded on financial statements?
Only those that change assets, liabilities or shareholders’ equity
What happens when theres an increase in common shares or revenue?
Increase shareholder’s equity
What happens when there’s an increase in expenses or dividends?
Decrease shareholder’s equity
What is on the left of the T-account?
Debit
What is on the right of the T-account?
Credit
What does it mean when an account has a debit balance?
When totalled, the debits exceed the credits (greater sum on left side)
What does it mean when an account has a credit balance?
When totalled, the credits exceed the debits (greater sum on right side)
Do assets have a credit normal or debit normal balance?
Debit normal
Do liabilities and shareholder’s equity have a credit normal or debit normal balance?
Credit normal
Are expenses and dividends credit or debit normal balance?
Debit
Are common shares, retained earnings and revenues credit or debit normal?
Credit
What are the accounting cycle steps?
- Analyze business transactions
- Journalize the transactions
- Post to general ledger accounts
- Prepare a trial balance
What is Step 1 of the accounting cycle?
- Analyze each transaction to determine its effect on accounts (if any)
- Evidence comes from a source document
What is Step 2 of the accounting cycle?
- Record transaction as a journal entry in the general journal
- Accounting record where the transactions are recorded in chronological order
- General journal is most common
What is Step 3 of the accounting cycle?
Transfer information to appropriate accounts in the general ledger (Entire group of accounts maintained by a company)
Contains all the asset, liability, and shareholders’ equity accounts
Posting is the process of transferring information from the general journal to the general ledger accounts (increase and decreases in account in date order)
Who are the primary types of users of financial statements?
Creditors or investors
What is Step 4 of the accounting cycle?
Trial Balance
List of all the accounts and their balances at a specific time
Serves to prove the mathematical equality of debits and credits after posting
