Financial Accounting Fundamentals and Analysis in Practice

Theoretical Structure of Financial Accounting INTERMEDIATE ACCOUNTING I CHAPTER 1

Financial Accounting Environment The primary focus of financial accounting is on the information needs of investors and creditors (capital providers). Financial statements convey financial information to external users. Investors Creditors Employees Customers Suppliers Government

Financial Statements The primary means of conveying financial information to investors, creditors, and other external users is through financial statements and related notes. The financial statements most frequently provided are: 1. Balance sheet or statement of financial position 2. Income statement or statement of operations 3. Statement of cash flows 4. Statement of shareholders' equity 5. Either a) a statement of other comprehensive income immediately following the income statement, or b) a statement of comprehensive income (including information on the income statement as well as on the statement of other comprehensive income).

Cash vs Accrual Basis of Accounting Two primary methods of measuring income exist Cash basis income and expenses are only recognized when received or paid in cash Accrual basis income is recognized when earned regardless of whether or not cash has been received

Net Operating Cash Flow vs Net Income Cash Basis - Net operating cash flow is the difference between cash receipts and cash disbursements from providing goods and services. Income is recognized when received in cash Expenses are recognized when paid in cash Accrual Basis - Net income is the difference between revenues and expenses. Income is recognized when a good or service has been provided Expenses are recognized when incurred Cash basis net operating cash flow can be converted to accrual net income. Measuring the same activities by the accrual accounting model provides a more accurate prediction of future operating cash flows.

Exercise 1-1, page 38 (adjusted) Listed below are several transactions that took place during the first two years of operations for the law firm of Pete, Pete, and Roy. In addition, you learn that the company incurred utility costs of $35,000 in year 1, that there were no liabilities at the end of year 2, no anticipated bad debts on receivables, and the insurance policy covers a three-year period. a) Determine the amount of net income to be recognized each year using accrual basis accounting. b) Determine the amount receivables due from customers in Year 2. Year 1 Year 2 Amounts billed to customers for services rendered $170,000 $220,000 Cash collected from customers 160,000 190,000 Cash disbursements Salaries paid to employees for services rendered during the year 90,000 100,000 Utilities 30,000 40,000 Purchase of insurance policy 60,000 -0- Net Operating Cash Flow (20,000) 50,000

Exercise 1-1, page 38 (adjusted) - Solution Part a Part b Year 1 Amount billed to customers Less: Cash collected Ending Accounts Receivable $170,000 (160,000) Pete, Pete, and Roy Comparative Income Statements $10,000 Year 1 $170,000 Year 2 $220,000 Year 2 Beginning Accounts Receivable Plus: Amounts billed to customers Less: Cash collected Ending Accounts Receivable $10,000 220,000 (190,000) Revenues Expenses: Salaries Utilities Insurance (90,000) (35,000) (20,000) $ 25,000 (100,000) (35,000) (20,000) $ 65,000 $40,000 Net Income Explanation of Utilities Expense: $35,000 of utilities were incurred in Year 1 and should therefore be recognized in Year 1. Since only $30,000 of the $35,000 of utilities were paid in Year 1, $5,000 of utilities payable were carried into Year 2. Therefore, $5,000 of the $40,000 paid in Year 2 was actually incurred in Year 1 leaving $35,000 of utilities actually incurred, and therefore recognized, in Year 2.

Financial Accounting and Reporting Standards Generally accepted accounting principles (GAAP) are a set of guidelines companies follow in measuring and reporting financial information. The Financial Accounting Standards Board (FASB) currently sets accounting standards. The Securities and Exchange Commission (SEC) has the authority to set accounting standards for companies, but always has delegated the task to the accounting profession.

The Conceptual Framework A coherent system of interrelated objectives and fundamentals that is intended to lead to consistent standards and that prescribes the nature, function, and limits of financial accounting and reporting. Underlying foundation for accounting standards Underlying concepts of accounting that guide the selection of events to be accounted for, the measurement of those events, and the means of summarizing and communicating them to interested parties Does not set GAAP Provides structure and direction to financial accounting and reporting Conveyed by the FASB through Statements of Financial Accounting Concepts (SFACs) See Conceptual Framework, Intermediate Accounting text, page 20

Qualitative Characteristics of Accounting Information To be useful for decision making, accounting information should possess the primary characteristics of relevance and faithful representation. FUNDAMENTAL QUALITATIVE CHARACTERISTICS Relevance Predictive value helps to predict a future condition Confirmatory value assists users in validating or changing a prior assessment of a company s condition Materiality (enhancing aspect) has an effect on decisions Faithful representation Completeness All information that is necessary for faithful representation. Neutrality Accounting standards should be set with overall societal goals and specific objectives in mind, and should try not to favor particular groups or companies. Free from error

Financial Accounting and Reporting Standards ENHANCING QUALITATIVE CHARACTERISTICS Comparability - Ability to help users see similarities and differences among events and conditions (also includes consistency). Verifiability - Consensus among different measurers. Timeliness - Available to users before a decision is made. Understandability - Users must understand the information.

Financial Accounting and Reporting Standards CONSTRAINT Cost Effectiveness The benefits received should exceed the cost to generate the benefits

ELEMENTS OF FINANCIAL STATEMENTS ELEMENTS OF FINANCIAL STATEMENTS Probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. Probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events. the residual interest in the assets of an entity that remains after deducting its liabilities. Called shareholders equity or stockholders equity for a corporation. Increases in equity of a particular business enterprise resulting from transfers to it from other entities of something of value to obtain or increase ownership interests in it. Decreases in equity of a particular enterprise resulting from transfers to owners. The change in equity of a business enterprise during a period from transactions and other events and circumstances from nonowner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners. Inflows or other enhancements of assets of an entity or settlements of its liabilities during a period from delivering or producing goods, rendering services, or other activities that constitute the entity s ongoing major or central operations. Outflows or other using up of assets or incurrences of liabilities during a period from delivering or producing goods, rendering services, or other activities that constitute the entity s ongoing major, or central, operations. Increases in equity from peripheral or incidental transactions of an entity. Represent decreases in equity arising from peripheral or incidental transactions of an entity. Assets Liabilities Equity (or net assets) Investments by owners Distributions to owners Comprehensive income Revenues Expenses Gains Losses

Recognition, Measurement and Disclosure Concepts It is important to accurately determine when the financial elements should be recorded and how they should be measured and disclosed.

Underlying Assumptions Economic Entity Assumption All economic events can be identified with a particular economic entity. Going Concern Assumption In the absence of information to the contrary, it is anticipated that a business entity will continue to operate indefinitely. Periodicity Assumption The life of a company can be divided into artificial time periods to provide timely information to external users. Monetary Unit Assumption Financial statement elements should be measured in terms of the United States dollar.

General Recognition Criteria An item should be recognized in the basic financial statements when it meets the following criteria: (SFAC 5) Definition the item meets the definition of an element of financial statements. Measurability the item has a relevant attribute measurable with sufficient reliability. Relevance the information about it is capable of making a difference in user decisions. Reliability the information is representationally faithful, verifiable, and neutral.

Recognition Revenue Recognition Principle Revenue should be recognized when goods or services are transferred to customers for the amount the company expects to be entitled to receive in exchange for the goods or services. Expense Recognition Principle Expenses are typically recognized in the same period as the related revenues. Mixed-attribute Measurement The attribute chosen to measure a particular item should be the one that maximizes the combination of relevance and representational faithfulness. Full Disclosure Principle Any information useful to decision makers must be provided in the financial statements (subject to the cost effectiveness constraint).

MEASUREMENT MEASUREMENT Measurement Associating numerical amounts to the elements. GAAP uses a mixedattribute model including Historical Cost measurement is based on the amount given or received in the exchange transaction Net Realizable Value measurement is based on the amount of cash into which the asset or liability could be converted in the ordinary course of business Current Cost measurement is based on the current replacement cost Present Value of Future Cash Flows measurement is based on future cash flows discounted for the time value of money Fair Value measurement is based on the price that would be received to sell assets or transfer liabilities in an orderly market transaction

Full-disclosure Principle The full-disclosure principle means that the financial reports should include any information that could affect the decisions made by external users, subject to the cost effectiveness constraint. Supplemental information is disclosed in a variety of ways including Parenthetical or modifying comments placed on the face of the financial statements. Disclosure notes conveying additional insights about company operations, accounting principles, contractual agreements, and pending litigation. Supplemental financial statements that report more detailed information than is shown in the primary financial statements.

Theoretical Structure of Financial Accounting INTERMEDIATE ACCOUNTING I CHAPTER 1 END OF PRESENTATION