Unit 1: External Financial Statements and Revenue Recognition Flashcards
Objective of General-Purpose Financial Reporting
- To report financial information that is useful in making decisions to the reporting entity
- Information about economic resources and claims to evaluate liquidity, solvency, financing needs, and the probability of obtaining financing
- Information about entity’s performance
- Return on economic resources, its variability, and its components
- Evaluating management
- Predicting future returns
Users of Financial Statements
Users with direct interests usually invest in or manage the business, and users with indirect interests advise, influence, or represent users with direct interests.
- Users with direct interests include: - Investors or potential investors - Suppliers and creditors - Employees - Management
- Users having indirect interests include: - Financial advisors and analysts - Stock markets or exchanges - Regulatory authorities
Features of Financial Statements
Financial statements are the primary means of communicating financial information to external parties. The notes are considered an integral part of Financial statements and they should not be used to correct improper presentation.
Full set of financial statements includes:
- Statement of financial position (balance sheet)
- Income statement
- Statement of comprehensive income
- Statement of changes in equity
- Statement of cash flows
To enhance the usefulness, the information should be comparable with similar information for (1) other entities and (2) the same entity for another period or date. Thus, “comparability” allows users to understand similarities and differences.
Financial statements are prepared under the going-concern assumption, which means that the entity is assumed to continue operating indefinitely.
Accrual Basis of Accounting
Financial statements are prepared under the accrual basis of accounting. Accrual accounting records the financial effects of transactions and other events when they occur rather than when their associated cash is paid or received.
- Revenues are recognized in the period in which they were earned even if the cash will be received in a future period.
- Expenses are recognized in the period in which they were incurred even if the cash will be paid in a future period.
NOTE: Under GAAP, financial statements cannot be prepared under the cash basis of accounting.
Statement of Financial Position
(Balance Sheet)
- Balance sheet reports the amounts of assets, liabilities, equity “at a moment” in time, such as at the end of the fiscal year.
- It helps users to assess liquidity, financial flexibility, and risk.
- The “basic accounting equation” presents a perfect balance between the entity’s resources and its capital structure.
- The entity’s resources consist of the assets the entity deploys in its attempts to earn a return.
- The capital structure consists of the amounts contributed by outsiders (liabilities) and insiders (equity).
Assets = Liabilities + Equity
Current and Noncurrent Assets
- An asset is classified as ‘current’ on the statement of financial position if it is expected to be realized in cash or sold or consumed within the entity’s operating cycle or 1 year, whichever is longer.
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Noncurrent assets are those not qualifying as current. e.g.
- Investments in securities made to control or influence another entity and other noncurrent securities.
- Funds restricted as to withdrawal or use for other than current operations, for example, to retire long-term debt, satisfy pension obligations, or pay for the acquisition or construction of noncurrent assets.
- PPE include Land and natural resources subject to depletion, e.g., oil and gas.
Intangible assets are nonfinancial assets without physical substance. Examples are patents and goodwill.
Current and Noncurrent Liabilities
- Current liabilities are expected to be settled or liquidated in the ordinary course of business during the longer of the next year or the operating cycle.
- Following are the major categories of current liabilities:
- Trade payables for items entering into the operating cycle, e.g., for materials and supplies.
- Other payables arising from operations, such as accrued wages, salaries, rentals, royalties, and taxes.
- Unearned revenues arising from collections in advance e.g., ticket sales revenue.
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Other obligations expected to be liquidated in the ordinary course of business. These include:
- Short-term notes given to acquire capital assets;
- Long-term obligations that are or will become callable by the creditor because of the debtor’s violation of a provision of the debt agreement at the balance sheet date.
- Current liabilities do not include short-term debt if an entity
- Intends to refinance them on a noncurrent basis and
- Demonstrates an ability to do so. (The ability to refinance may be demonstrated by entering into a refinancing agreement before the balance sheet is issued.)
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Noncurrent liabilities are those not qualifying as current.
- Noncurrent notes and bonds
- Liabilities under capital leases
- Most postretirement benefit obligations
- Deferred tax liabilities arising from interperiod tax allocation
- Obligations under product or service warranty agreements
- Advances for noncurrent commitments to provide goods or services
- Deferred revenue
Equity
- Any recognized transaction that does not have equal and offsetting effects on total assets and total liabilities changes equity.
- The following are the major items of equity:
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Capital contributions by owners (par value of common and preferred stock issued and additional paid-in capital).
- Additional paid-in (contributed) capital is the amount received in excess of par value at the time stock was sold.
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Retained earnings are the accumulated net income not yet distributed to owners. Retained earnings can be restricted or unrestricted depending on the board of directors’ intent.
- Restriction of retained earnings indicates their unavailability for disbursement as dividends.
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Treasury stock is the firm’s own stock that has been repurchased.
- Treasury stock is reported either at cost (as a deduction from total equity) or at par (as a direct reduction of the relevant contributed capital account).
- Treasury stock is reported as a reduction of equity.
- Accumulated other comprehensive income items not included in net income.
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Capital contributions by owners (par value of common and preferred stock issued and additional paid-in capital).
Limitations of Balance Sheet
- The balance sheet shows a company’s financial position at a single point in time; accounts may vary significantly a few days before or after the publication of the balance sheet.
- Many balance sheet items, such as fixed assets, are valued at historical costs, which may bear no resemblance to the current value of those items. Even those assets reported at their current fair values may not always faithfully represent what a company could sell those items for on an open market.
Income Statement
- The income statement reports the results of an entity’s operations over a period of time, such as a year.
- The following are the elements of income statement:
- Revenues are inflows or other enhancements of assets or settlements of liabilities from activities that qualify as ongoing central operations.
- Gains are increases in equity (or net assets) other than from revenues or investments by owners.
- Expenses are outflows or other usage of assets or incurrences of liabilities from activities that qualify as ongoing central operations.
- Losses are decreases in equity (or net assets) other than from expenses or distributions to owners.
- All transactions affecting the net change in equity during the period are included in income except
- Transactions with owners
- Prior-period adjustments (such as error correction or a change in accounting principle)
- Items reported initially in other comprehensive income
- Transfers to and from appropriated retained earnings
- income or loss for the period (a nominal or temporary account) is closed to retained earnings (a real account) at the end of the reporting period.
Expense Recognition Principles
(Matching Principle)
The expense recognition principles are:
- associating cause and effect
- systematic and rational allocation
- immediate recognition.
Matching is essentially synonymous with associating cause and effect. Such a direct relationship is found when the cost of goods sold is recognized in the same period as the revenue from the sale of the goods.
Cost of Goods Sold
(For a retailer)
Cost of Goods Sold
(For a manufacturer)
Reporting Irregular Items
- When an entity reports a discontinued operation or an extraordinary item, it must be presented in a separate section after income from continuing operations.
- Because these items are reported after the presentation of income taxes, they must be shown net of tax.
- The term “continuing operations” is used only when a discontinued operation is reported.
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Discontinued operations, if reported, may have two components:
- Income or loss from operations of the component that has been disposed of or is classified as held for sale from the first day of the reporting period until the date of disposal (or the end of the reporting period if it is classified as held for sale)
- Gain or loss on the disposal of this component
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Extraordinary items are income statement items that meet the following two criteria:
- Unusual in nature and
- Infrequent in occurrence in the environment in which the entity operates
- If an item meets only one of the criteria, it should be presented separately as a component of income from continuing operations.
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IFRS Difference:
No items are classified as extraordinary, either on the statement of comprehensive income or in the notes.
Reporting Irregular Items
(Example)