Accounting 327 Test 1 Larkin

what is accounting?

identifying, measuring, communicating financial info about economic entities to interested parties

purpose of external financial reporting

financial accountability

reduce information asymmetry

valuation

what is the primary objective of financial accounting?

to provide useful information about the reporting entity to present and potential investors in their decision for allocating capital

when making a decision, investors assess...

ability to generate cash inflow

manager ability to protect/enhance investments

GAAP is developed by which parties?

SEC

FASB

AICPA

SEC

Stock market crash of 1929 led to this

public (gov't) organization

requires adherence to GAAP

oversees other parties (FASB, AICPA)

Congress passes Securities Exchange Acts of 1933 and 1934 and created this

has authority to publish standards BUT has NOT used this authority

Public v private

-Public means you sell stock publicly (IRS, SEC, Disney)

-Private means your financial statements are private and you DON'T HAVE TO FOLLOW GAAP (ex: Hobby Lobby)

FASB

-private

-establish & improve financial accounting & reporting for guidance & education of users, issuers, and auditors

-develop accounting standards

-pronouncements considered GAAP

-NOT a gov't agency

-still writes GAAP today

-gets authority from SEC

-funding is mandatory

-NOT publicly traded

FASB podcast discussed:

FASB's Due Process system in action (illustrating a current Exposure Draft)

Coordination between FASB and IASB

FASB interaction with and request for feedback from the public

due process

used in considering new standards

lengthy process

-topic, research & analysis, public hearing, board evaluates research, board evaluates responses, standard issued

EITF

-emerging issues task force

-rapid response to new issues and problems, before FASB addresses them with due process

AICPA

develops auditing standards; writes GAAP

SEC gave authority to do so

AICPA was too slow writing GAAP so in 1973 FASB was created

Codification

single source of US GAAP

reduced "levels" of GAAP

helps users gain better understanding/access to GAAP

1973

what year did FASB begin setting accounting standards?

what is the most powerful force influencing the development of GAAP?

user groups

(CPAs, academicians, investors, government, industry...)

Sarbanes Oxley Act (SOX)

-GAAP didn't used to require internal controls (policies set internally to make sure numbers are right and accurate for debits and credits; separation of duties) so eventually SOX was created

-very controversial at the time due to the amount of time/effort needed to implement internal controls

key provisions from SOX

-establish PCAOB

-increases auditor independence standards

-requires CEO/CFO to personally certify accuracy of financial statement, increased personal responsibility

-requires audit committee members to be independent and have financial expertise

-requires internal controls for managers

SOX Activity

Auditors are independent- don't want them to be an employee, to be invested in the company, related to people in company

How to prove they are independent- in fact=no financial interest, in appearance= can't look like you're biased

Role of Audit partner- owner of CPA firm that signs off an opinion

Rotate every 5 yrs

PCAOB

oversees AUDITORS and enforces audits and independency standards and requires internal controls

what are some issues with current financial reporting practices?

-fail to include non-financial measures

-fail to provide forward-looking information

-accounting for soft assets (intangibles... ex. brand)

-timeliness/understandability

-convergence with IFRS

-ethics

non financial measures

measures not included in the financial statements under US GAAP and the conceptual framework, but still valuable in determining the value of a company

ex. foot traffic, customer satisfaction

IFRS

International Financial Reporting Standards

-principles-based

-published by London's IASB-finding for IASB is voluntary

-focused on objectives and principles, less reliant on detailed rules than US GAAP; broad

-effort to converge with US GAAP

-popular in Europe

-will become more rules-based over time, a regulator will write a rule about a specific item when people are deceptive

GAAP

-US uses

-rules-based

-companies manage around it

-companies like enron would look at rules and would "game: system to present things a certain way

-FASB's authoritative language

what happened in November 2007?

-SEC eliminated the requirement for foreign companies listing on US exchanges to reconcile IFRS to US GAAP (only required ONE set of financial statements)

key benefits of IFRS

-increased comparability among international companies

-allows US companies to raise capital abroad more easily

-reduce costs

FASB staff

-7 members

-full time membership

-autonomous

-increased independence (sever all ties)

-broad representation

-fully compensated

why do we need a conceptual framework?

-increase user understanding

-increase user confidence

-comparability

-quickly solve new and emerging problems by referencing existing theory

-coherent standards

1976

FASB began developing a conceptual framework

in order to be recognized in the financial statements, items must meet what criteria?

-relevance

-measurability

-definition (asset, liability, etc)

-faithful representation

who are the primary users of financial statements?

investors and creditors

cost constraint

the benefits of information provided on financial statements must outweigh the costs of providing said information

ex: company complains about the amount of additional work SOX required of them

"We've been performing internal controls for years but documenting them is so tedious"

what are the fundamental qualities of useful accounting information?

relevance

faithful representation

relevance

capable of making a difference in a decision

-predictive value

-confirmatory value

-materiality

predictive value

item's ability to provide value to investors in forming EXPECTATIONS about the future

ex. analyzing past income performance to predict future cash flows, classifying assets as current when owning < 1 yr and LT when > 1 yr

ex: including "forward looking info"

confirmatory value

items that confirm or correct prior expectations

ex. adjustments at the end of the period t reconcile the differences between what was predicted and what actually happened

faithful representation

information describes what actually existed or happened

-complete

-neutral

-free from error

material

-impacts decision

-open to interpretation based on size and scale of the business

-generally, anything under 5% income is immaterial

-quantitative and qualitative factors

ex: error of $1 when making $1 B in revenue

ex: ABC, a large publicly-traded company, decided to expense the cost of copy paper when it is acquired

complete

all necessary information is provided, involving numbers (amounts of debt)

ex: disclose something to the public

what are the enhancing qualities of useful accounting information?

comparability

verifiability

timeliness

understandability

neutrality

company cannot select information to favor one set of interested parties over another; unbiased

conservatism

worst case scenario, playing it safe

free from error

all information is accurate

ex: review financial statements numerous times before releasing

Fair Value

more relevant, the price someone is willing to pay today is the reports asset amount

ex: adjusted value of investment from purchase price to current market price

timeliness

information provided to users before it loses its capacity to influence decisions

-we want relevant information sooner!!

To value an asset at FMV you must use 1 of the 3 levels of FMV

1. confirmable quoted prices for identical assets in active markets (most reliable)

2. confirmable inputs other than quoted prices for the identical asset; such as quotes prices for similar assets in active markets

3. unconformable inputs, such as your own assumptions about the current value of the asset (Least reliable)

Fair Market Value

FMV must be used over historical cost in situations where the BV of asset is higher than the FMV of asset

3rd level of FMV is most subjective

FMV, if used, gives external users a more relevant picture of assets

Historical Cost

more reliable

comparability

allows users to compare among different companies

the existence of 2 sets of accounting standards in todays global competitive markets a negative implication for this conceptual framework quality

consistency

allows users to compare events within a company overtime

ex: using same inventory method since inception of company

verifiability

independent measures or methods obtain similar results

ex:using 2 lawyers to get answer

what are the elements of financial statements?

assets

liabilities

equity

revenues

expenses

gains

losses

comprehensive income

distributions to owners (dividends)

investments by owners (retained earnings)

understandability

the quality of information allows reasonably informed users to see significance

ex: editing to make statements more transparent

revenues

inflows or enhancements of assets or settlements of liabilities resulting from the entity's major ongoing or central operations

define asset

probable future economic benefit obtained or controlled by an entity as a result of past transactions or events

ex:

which elements describe resources and claims to resources at a moment in time?

assets, liabilities, equity

the other elements describe transactions during a period of time

permanent or REAL, B/S accounts

Income statement Accounts

-Revenues/ Expenses, Gains/Losses

-temporary or NOMINAL

expenses

outflows or using up of assets or incurrences of liabilities resulting from the entity's major ongoing or central operations

gains

increases in net assets (equity) resulting from peripheral or incidental transactions

losses

decreases in equity from peripheral or incidental transactions

what are the basic assumptions underlying the financial accounting framework?

periodicity

economic entity

going concern

monetary unit

going concern

assumes the company will have a long life

(why we record depreciation and amortization)

economic entity principal

financial activities are assumed to be separate from owners and other business units

ex: owner purchased truck with his own money, not company money so it wasn't on the books

what are the basic principles of accounting to record and report transactions?

measurement

revenue recognition

expense recognition

full disclosure

monetary unit assumption

assumes money as the common denominator of exchanges ($ remains relatively stable)

ex: reflect financial statements in US dollars

periodicity

assumes a company can divide economic activities into periods

ex: breaking up financial statements by month

measurement principle

based on historical cost and fair value

pros/cons of historical cost valuation

pro: high on faithful representation (verifiable)

con: low on relevance (not useful for future decisions)

what is an example of an account that is high on relevance but low on faithful representation?

allowance for doubtful accounts:

-relevant because tied to future cash flows

-does not represent an event that actually happened

what is the only item on the balance sheet reported at historical cost?

land

what are the steps in the revenue recognition process?

1. identify contract

2. identify performance obligations

3. determine price

4. allocate price to performance obligations

5. recognize revenue when satisfy obligation

revenue recognition principle

revenue is recognized in the period that the company satisfies a performance obligation

-connects balance sheet to income statement

(difference between cash-basis & accrual accounting)

ex: phone support, computers at TAMU

Key differences between cash-basis and accrual-basis accounting

1. cash basis accounting will never have a payable account recorded on the balance sheet

2. in cash basis accounting, one side of every journal entry is cash and the other side of the JE would either be revenue, expense, or owner's equity

When switching from cash basis to accrual basis accounting

cash basis income- cash in=revenue; cash out=expense (add all years of cash received in that year for rev and add all cash paid in that year for expense THEN subtract the two to get income)

accrual basis income= cash received in that year will be a reduction to A/R for previous years, cash paid will be reduction to payable from previous years THEN subtract the two to get income

the compare both cash and accrual basis accounting to see effect

ABC Tutoring provides service to a student and at the end of the session the student admits he won't be able to pay

Considering the revenue recognition principal ABC should NOT RECORD revenue bc ABC knows the transaction price will not be received for the performance obligation

employees work 12/29-31 and earn 1000 per day. what is recording on 1/2 when wages are paid

debit wages payable for 3000

remember to increase cash credit to add the next 2 days of work after pay period

what are some exceptions to the "time of sale" revenue recognition principle rule of thumb?

-during production (long term construction)

-end of production (commodities)

expense recognition: direct association

when expense and revenue are directly associated, expense is recorded in the period when the revenues are recognized

realization

cash changing hands

recognition

timing of putting revenues or expenses on income statement

expense recognition principle (MATCHING)

-expenses often matched with revenues

**not an expense until probable future economic benefit is gone (then recorded)

ex: salaries recorded this year even though they won't be paid until next year

justifies inventory not being expensed until revenue has been earned

expense recognition: association difficult to identify

when the association between expenses and revenues is hard to identify, we allocate costs rationally over the periods benefitted (ex. depreciation)

expense recognition: little association

when the association between expenses and revenues doesn't exist, expense immediately (ex. period costs)

what are the requirements for an item to be recognized in the main body of the financial statements?

-definition of a basic element

-measurable

-relevant

-reliable

full disclosure principle

"give investors what they need"

-relevant, understandable

found in notes, main body, or supplementary information

ex: CEO terminally ill, release info to public

what is section 404?

internal audit controls

expensive to implement

what is the industry practice restraint?

the peculiar nature of an industry may result in varied financial reporting

(ex. utilities sector lists PP&E first on balance sheet, rather than assets)

event

happening of consequence

source of a change in assets, liabilities, or equity

external or internal

transactions

external event

transfer between two entities

account

systematic arrangement showing the effect of transactions and events on a specific element

real account

carries over into the next period

not closed out at the end of the period

balance sheet

asset, liability, equity

nominal account

temporary

closed out to R/E at the end of the period

income statement

do not carry over into the next period

revenue, expenses, dividends

ledger

contains accounts

collection of assets, liabilities, equity, expense, revenue throughout the period

journal

initial recording of transactions and events

information is then transferred to the ledger

posting

transferring from journal to ledger

trial balance

list of open accounts in the ledger and their balances

post adjustment or post closing

adjusting entries

entries at the end of the period

affect one real (BS) & one nominal account (IS)

never use cash

financial statements

-balance sheet (financial condition at the end of the period)

-income statement (measures results of operations from the period)

-statement of R/E (reconciles balance from beginning to end)

-statement of cash flows (reports cash used by operating, financing, investing activities during period)

closing entries

reduce all nominal accounts to zero

if a trial balance balances, does it prove that the company recorded all transactions correctly?

no.

failure to journal a transaction, omitted, double posting, incorrect accounts, etc.

deferrals

prepaid expenses (payed before consumed)

unearned revenue (payed before earned)