Download FA2 Module 1. Financial reporting/accounting concepts

FA2
Module 1. Financial reporting/accounting concepts
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What is accounting?
Objectives of financial reporting
Accounting choice process
Accounting concepts
The accounting cycle
Closing entries
Adjusting entries
Who is your instructor?
Cameron Morrill, PhD, CGA
Associate Professor of Accounting
I. H. Asper School of Business
University of Manitoba
www.umanitoba.ca/asper/faculty/cam.morrill/fa2/
E-mail: [email protected]
Tel: (204) 474-8435
Office hours: Wednesdays 9:30 AM – 11:30 AM
1. What is accounting?
Accounting involves:
• the recognition, measurement, and disclosure
of financial information about
• economic entities to
• interested persons.
What is financial accounting?
Financial accounting is concerned with the
classification, recording, analysis, and
interpretation of the overall financial position
and operating results of an organization and
providing such information to owners,
managers and third parties.
It includes the processes and decisions that
culminate in the preparation of financial
statements.
Financial statements and business reporting
Financial statements are an important source of
information about economic organizations
(required by Canadian corporations legislation
and securities commissions), but are only one of
several, which include:
•Other information in the annual report
•Reports required by securities commissions
•Reports/releases issued voluntarily
What do users do with financial statement
information?
1. Contracting
Accounting information plays a key role in
debt agreements, executive compensation
and turnover, etc.
Emphasis on accounting as it helps to explain
past performance.
What do users do with financial statement
information?
2. Investment/resource allocation
Accounting information plays a key role in
investing (buying and selling shares and
other equity instruments) and credit (lending
money) decisions.
Emphasis on accounting as it helps to predict
future performance, especially future cash
flows.
GAAP in Canada in 2012
Different standards for different organizations,
but underlying principles are the same
1. Publicly accountable enterprises (PAE) –
IFRS (CICA Handbook Part I)
2. Private enterprises –
a. IFRS (like PAEs)
b. Canadian accounting standards for private
enterprises or ASPE (CICA Handbook Pt II)
c. Disclosed basis of accounting
GAAP in Canada in 2012
3. Not-for-profit (NFP) Organizations – (CICA
Handbook Part III)
4. Pension Plans – (CICA Handbook Part IV)
5. Public Sector – (Public Sector Accounting
Standards)
2. Objectives of financial reporting
. . . to provide information about the financial
position, performance and changes in
financial position of an entity that is useful to
a wide range of users in making economic
decisions. (IASB)
Users? Target is investors (equity and
debtholders) – hopefully, what is good for
investors will also work for most everyone
else
Objectives of financial reporting
External users
Assessing (performance appraisal) and
predicting (investment decisions) cash flows
Why cash flows?
Generate return, pay debts
Why accrual accounting?
Cash flows are volatile, often independent of
economic performance of entity; accrual
accounting provides better long-run view
Objectives of financial reporting
External users (continued)
• Income tax minimization/deferral
• Contract compliance (debt covenants)
• Stewardship
Objectives of financial reporting
Preparers
• Earnings management
– Maximize earnings
• Accounting-based performance measures
• Market-based performance measures
– Minimize earnings
• Minimum disclosure (proprietary
information)
• Expanded disclosures
3. Accounting choice process
To make accounting choices, must identify
financial reporting objectives which are a
function of:
• Preparer/user needs and motivations
• Organizational facts (public or private, debt
covenants, legal/economic environment)
• Constraints (GAAP, audit, regulatory
requirements)
4. Accounting concepts
Accounting concepts (conceptual framework)
provide criteria to guide accounting choices
and, hopefully, achieve financial reporting
objectives. Concepts are:
I. Underlying assumptions
II. Qualitative criteria
III. Measurement methods
IV. Elements of financial statements
I. Underlying assumptions (universal)
i. Time period: meaningful information can be
reported for a time period less than the
entity’s life span
ii. Separate entity: entity can be reported
independently of its owners
iii. Unit of measure: entity results can
meaningfully be measured in monetary terms
I. Underlying assumptions (entity-specific)
iv. Continuity: enterprise will continue in
operation for reasonable future period
v. Proprietary approach: entity results should
be reported from point of view of its owners
vi. Stable currency: value of measurement
currency does not change from year to year
(no inflation or exchange rate fluctuation);
profit occurs if revenues are higher than
historical cost of resources used
II. Qualitative criteria
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Relevance
Faithful representation
Comparability
Verifiability
Timeliness
Understandability
Materiality constraint
Cost constraint
RELEVANCE
Information is relevant when it can influence the
decisions of users.
• Predictive value: helps predict future events
(especially cash flows)
• Confirmatory (feedback) value: confirms or
corrects prior expectations
REPRESENTATIONAL
FAITHFULNESS
Information is a sufficiently accurate measure
of what it purports to measure (economic
substance over form).
• Completeness
• Neutrality (free from bias)
• Free from material error
Comparability
Two pieces of information are comparable if
they are consistent and/or uniform
• Uniformity
Information measured and reported in a similar
manner for different entities in a given year
• Consistency
Information is measured and reported in the
same way for a given entity, from period to
period. Changes occur only if justified.
Verifiability
Knowledgeable and independent observers can
measure an economic event and arrive at the
same result
• Accounting measure is a reasonable measure
of economic event (related to representational
faithfulness)
• Independent observers, using the same
measurement methods, would reach the same
result
Timeliness
Information should be available to users in time
to make a difference in their decisions.
Note potential conflict between timeliness and
some aspects of representational faithfulness (but
not verifiability).
Understandability
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Information must be understandable to be
helpful to users
Assumes that users have reasonable
understanding of business and economic
activity and of accounting; or get advice
from people who have such understanding
Assumes that users will study information
with reasonable diligence
Materiality
Significance of an item – an item is material if its
omission or misstatement would probably
influence or change a decision.
• Size: e. g., 5% of income
• Nature: something small might still be
indicative of a larger potential problem (e. g.,
small fine for environmental legislation
violation)
Also implies occasional deviation from
theoretically correct treatment, e. g., expense $5
stapler rather than capitalize and depreciate.
Cost (Cost vs. Benefit)
The cost of an accounting measurement or
disclosure should not exceed the benefit of such
measurement/disclosure to the user (e. g.,
ASPE).
III. Measurement methods
Recognition
Inclusion of an item in one or more of the
financial statements (not just note disclosure)
Measurement
The process of determining the amount at
which an item is recognized in the financial
statements
Measurement methods
Historical cost: Transactions/events recorded at
amount of cash or equivalent received or given
up at the time the event took place
Alternatives to historical cost: Fair value
1. Quoted prices in active markets for identical
assets
2. Quoted prices in active markets for similar
assets
3. Valuation techniques (e. g., PV)
Measurement methods
Revenue recognition
Revenue is increases in economic resources
(increase in assets and/or settlement of liabilities)
of an entity resulting from delivering or
producing goods, rendering service or performing
other activities that constitute a company’s
ongoing business operation.
Measurement methods
Revenue recognition
Revenue is recognized when
(1)performance achieved (seller has performed all
significant acts required and risks and reward
of ownership are transferred to, and accepted
by, buyer) and
(2) proceeds are measurable and collectibility
assured
Measurement methods
Expense recognition
An expense is recognized when an event that
is part of ongoing operating activities of entity
occurs which results in a decrease in an asset
or an increase in a liability. For example, sale
of a car creates:
Cost of goods sold: decrease in inventory
Warranty expense: increase in warranty
liability
Measurement methods
Expense recognition (continued)
If there is no clear event that causes a
decrease in net assets, then
1. Use some arbitrary cost allocation rule (e.
g., depreciation), and/or
2. Check regularly for asset impairment (e.
g., goodwill)
Measurement methods
Full disclosure
Financial statements should report all relevant
information, i. e., all information that might be
expected to have an impact on user decisions.
Prudence
Under uncertainty, should be careful not to
overstate net assets or income. Does not mean
that net assets/income should be systematically
understated.
Examples: A2-8, A2-20
A2-8, A2-20
Time Period
Separate entity
Unit of measure
Continuity
Proprietary approach
Stable currency
Relevance
Faithful representation
Comparability
Verifiability
Timeliness
Materiality
Cost (Cost/benefit)
Historical cost
Revenue recognition
Expense recognition
Full disclosure
Prudence
IV. Elements of financial statements and
recognition
Recognition
An element is recognized and included in the
accounts when it meets the definition of an
element; can be measured with reasonable
precision; and, for assets and liabilities, it is
probable that the economic benefits will be
received or given up (realized)
Elements of financial statements
• Assets: economic resources controlled by
entity by virtue of past transaction or event and
from which future economic benefits may be
obtained
• Liabilities: obligations arising from past
transactions or events which will result in
future transfer or use of assets, services or
other economic benefits
• Owners equity: ownership interest in entity
assets after deducting liabilities
Elements of financial statements (continued)
• Income (Revenues/gains): increases in
economic resources resulting from ordinary
activities of entity
• Expenses/losses: decreases in economic
resources resulting from income-generating
activities of entity
• Other comprehensive income: increases and
decreases in net assets that are excluded from
income by IFRS and do not reflect transactions
with owners in their capacity as owners
5. The accounting cycle
The accounting cycle refers to the process of
recognizing and recording economic events
up to the production of financial statements.
The accounting cycle is based on the doubleentry bookkeeping system (debits and credits).
Assets = Liabilities + Owners’ Equity
Debits = Credits
Steps of the accounting cycle
1. Journal entries to record transactions and events
2. Post journal entries to ledger
3. Prepare unadjusted trial balance to ensure that
debits = credits
4. Prepare and post adjusting entries to update
accounts, e. g.
 proportion of assets consumed (insurance,
equipment)
 expenses incurred but not yet invoiced (interest,
purchases, salaries, etc.)
 revenues earned but not yet recorded (interest,
investment)
Steps of the accounting cycle (cont’d)
5. Prepare adjusted trial balance
6. Prepare income statement from income statement
accounts
7. Prepare statement of retained earnings/statement of
changes in equity
8. Prepare closing entries
9. Prepare postclosing trial balance
10. Prepare balance sheet and cash flow statement
Debits, credits and the accounting equation
Debit (Dr.)
Increases assets and expenses
Decreases liabilities, owners’ equity and revenues
Credit (Cr.)
Decreases assets and expenses
Increases liabilities, owners’ equity and revenues
Under double-entry bookkeeping, any event that
affects the financial position of the firm is recorded
by (at least) one debit and (at least) one credit; the
total value of the debits must equal the total value
of the credits.
Example: A-20 (p. 673)
A-20: Journal entries
a.
Dr. Cash
Dr. Accounts receivable
Cr. Sales revenue
60,000
30,000
90,000
Dr. Cost of goods sold
Cr. Inventory
58,500
58,500
A-20: Journal entries
b
Dr. Cash
Cr. Accounts receivable
51,000
51,000
c
Dr. Income taxes payable
Cr. Cash
12,000
12,000
A-20: Journal entries
d
Dr. Inventory
Cr. Accounts payable
Cr. Cash
120,000
24,000
96,000
e
Dr. Accounts payable
Cr. Cash
18,000
18,000
A-20: Journal entries
f
Dr. Cash
Cr. Sales revenue
Dr. Cost of goods sold
Cr. Inventory
g
Dr. Operating expenses
Cr. Cash
216,000
216,000
140,400
140,400
57,000
57,000
A-20: Journal entries
h
Dr. Cash
Cr. Common shares
3,000
3,000
i
Dr. Inventory
Cr. Cash
Cr. Accounts payable
300,000
219,000
81,000
A-20: Journal entries
j
Dr. Cash
Dr. Accounts receivable
Cr. Sales revenue
Dr. Cost of goods sold
Cr. Inventory
k
Dr. Cash
Cr. Accounts receivable
204,000
90,000
294,000
191,100
191,100
78,000
78,000
A-20: Journal entries
l
Dr. Accounts payable
Cr. Cash
84,000
84,000
m
Dr. Operating expenses
Cr. Cash
54,000
54,000
6. Closing entries
Closing entries are recorded at the end of each period
to “close” income statement and dividend accounts
to retained earnings, in order to
 transfer balances in revenue, expense and
dividend accounts (which are really owners’
equity sub-accounts) to retained earnings; and
 reset these balances to zero for the next period
Closing entry steps
1. Close revenue accounts to income summary
Dr. Revenue
Cr. Income summary
6. Closing entries (continued)
2. Close expense accounts to income summary
Dr. Income summary
Cr. COGS, Salaries expense, etc.
3. Close income summary account to retained earnings
Dr. Income summary
net income
Cr. Retained earnings
net income
OR
Dr. Retained earnings
loss
Cr. Income summary
loss
4. Close dividend accounts to retained earnings
Dr. Retained earnings
Cr. Dividends
7. Adjusting Entries: A-7