Intermediate Accounting Exam #1 Review

Financial Accounting

The process by which we:

• Identify,

• Measure and

• communicate, financial information, about economic states and transactions, to interested parties.

• Focuses on External Parties

Who uses financial statements?

External users who rely on financial information in order to make economic decisions. Must rely on general-purpose financial statements.

• Shareholders (Investors)

• Lenders (Creditors)

Accounting and the Capital Allocation Process

• Resources are limited, making allocation necessary

• Reliable financial information helps users to make more informed decisions on resource allocation

• Decision makers require information about a company’s economic resources and claims on those resources, and changes in economic resources and claims

Market for Lemons

• Quality is unobservable to buyers which causes asymmetric information between buyers and sellers (seller has more than the buyer). Sellers reduce quality and buyers pay less. As a result, only the lowest quality is provided and buyers become uninterested. Adverse selection: anything being offered isn’t worth having

• Financial accounting bridges the information asymmetry. Founder can credibly provide information to investors so that they can make investment allocation decisions

Who is primarily responsible for establishing US accounting standards?

Financial Accounting Standards Board (FASB)

What is GAAP? Who enforces it for public companies?

• GAAP = generally accepted accounting principles. It is a body of financial accounting concepts, principles, and procedures intended to ensure that external financial statements are relevant and faithfully representative

• The SEC is responsible for enforcing GAAP for public companies

Process for Developing New Accounting Standards

1. Topics identified and placed on Board’s agenda

2. Research and analysis conducted and preliminary pros and cons issued

3. Public hearing on proposed standard

4. Board evaluates research and public response and issues exposure draft

5. Board evaluates responses and changes exposure draft, if necessary

6. Final standard issued

Who has influence over the establishment of GAAP?

The FASB establishes and edits GAAP. They are influenced in their decisions by various business and special interest groups and by circumstances that are not purely accounting. Political influence such as congress and the SEC have large influence since they create/enforce laws and can replace the FASB

How can certain parties exert excessive influence?

Congress has the final say on law, meaning that if they truly wanted to, they could make changes to GAAP.

What is the expectations gap?

• What the public thinks accountants should do vs. what accountants think they can do

• The CEO thinks the accountant created a liability and the accountant thinks the CEO created a liability. The liability was actually created by the business

What is the importance of Conceptual Framework in accounting?

Provides the constitution used by the FASB to guide its deliberations and development of GAAP. Most recent attempt to develop underpinning to support resolutions to accounting and reporting problems. Helps ensure a coherent set of standards and rules. Helps solve new and emerging practical accounting problems. Not considered GAAP.

Fundamental Qualities of Accounting

1. Relevance

2. Faithful Representation

Relevance

Capable of making a difference in the decisions of users.

• Predictive Value

• Confirmatory Value

• Materiality

Faithful Representation

Represents economic phenomena in words and numbers.

1. Completeness

2. Neutrality

3. Free from Error

Predictive Value

Financial information is used as an input to processes employed by users to predict future outcomes.

Confirmatory Value

Financial information provides feedback (confirms or changes) about previous evaluations.

Materiality

• Entity specific

• Probable that the judgement of a reasonable person relying upon the report would have been changed or influenced by the inclusion or correction of the item

Completeness

Includes all information necessary for a user to understand the phenomenon being depicted.

Neutrality

Depiction is without bias.

Free from Error

No errors or omissions in the description of the phenomenon.

Enhancing Qualities of Accounting

1. Comparability

2. Verifiability

3. Timeliness

4. Understandability

Comparability

Can be compared with similar information about other entities and with similar information about the same entity.

Verifiability

Information provided faithfully represents the economic phenomena it purports to represent.

Timeliness

Information is made available to decision-makers in time to be capable of influencing their decisions.

Understandability

Information is reported clearly and concisely.

Basic Elements of the Conceptual Framework

• Assets

• Liabilities

• Equity

• Investments by Owners

• Distributions to Owners

• Comprehensive Income

• Revenue

• Expenses

• Gains

• Losses

Point-In-Time Elements

1. Assets

2. Liabilities

3. Equity

Assets

Present right to an economic benefit.

Liabilities

Present obligation to provide economic benefits to others.

Equity

Residual interests in the assets of an entity.

Period of Time Elements

1. Investments by Owners

2. Distributions to Owners

3. Comprehensive Income

4. Revenue

5. Expenses

6. Gains

7. Losses

Investments by Owners

Increases in equity resulting from transfers to the entity from other entities of something valuable to obtain or increase ownership interests in the entity.

Distributions to Owners

Decreases in equity of an entity resulting from transferring assets, rendering services, or incurring liabilities by the entity to owners.

Comprehensive Income

Change in equity of a business entity during a period from transactions and other events and circumstances from non-owner sources.

Revenue

Inflows or enhancements of assets of an entity or settlements of its liabilities from delivering or producing goods, rendering services, or carrying out other activities.

Expenses

Outflows or other using up of assets of an entity or incurrence of its liabilities from delivering or producing goods, rendering services, or carrying out other activities.

Gains

Increases in equity from transactions and other events and circumstances affecting an entity except for those that result from revenues or investments by owners.

Losses

Decreases in equity from transactions and other events and circumstances affecting an entity except for those that result from revenues or investments by owners.

Accounting Assumptions

1. Economic Entity

2. Going Concern

3. Monetary Unit

4. Periodicity

Economic Entity Assumption

• Specific economic activities are considered an identifiable accounting unit

• Entities are separate from its owners and other entities

Going Concern Assumption

• Entity expected to continue operations for the foreseeable future

• Entity expected to carry out contemplated operations and commitments

Monetary Unit Assumption

• Monetary unit is nominal units of money, unadjusted for inflation or deflation when nominal units of money are relatively stable

• FASB can require adjustments to the U.S. dollar in unstable periods of inflation or deflation

Periodicity Assumption

• Report changes in a company’s financial position over a series of distinct time periods such as months, quarters, or years

• A company’s economic life is divided up into artificial periods for reporting periods

Accounting Principles

1. Measurement

2. Revenue Recognition

3. Expense Recognition

4. Full Disclosure

Measurement Principle

• GAAP is a mixed-attribute measurement model

• Financial statement items are measured using different attributes, depending on the nature of the financial statements and the relevance and reliability of the measurement attributes.

Revenue Recognition Principle

Recognize revenue when seller satisfies a performance obligation.

Expense Recognition Principle

• Simultaneously recognize revenue and expense because expense is directly tied to a particular revenue

• Recognize expense during the period of revenue or by allocation

• Recognize expense in the period in which costs are incurred

Full Disclosure Principle

Financial statements must include all relevant information needed to make informed investmen and credit decisions.

Cost Effectiveness Constraint

Costs are justified by the benefits of reporting that information.

Accounting Cycle

1. Event 

2. Accounting Transaction 

3. Journalize 

4. Post to Account Ledgers 

5. Make Adjusting Entries (for internal transactions) 

6. List totals from each ledger in trial balance 

7. Summarize in format of Financial Statement 

8. Close/zero-out all Nominal Accounts to Real Accounts 

Events During the Collection Period of Accounting Cycle

1. Event 

2. Accounting Transaction 

3. Journalize 

4. Post to Account Ledgers 

Events at Period End Reporting of Accounting Cycle

1. Make Adjusting Entries (for internal transactions) 

2. List totals from each ledger in trial balance 

3. Summarize in format of Financial Statement 

4. Close/zero-out all Nominal Accounts to Real Accounts

Accounting Cycle: Step 1

Event

Accounting Cycle: Step 2

Accounting Transaction

Accounting Cycle: Step 3

Journal Entry

Accounting Cycle: Step 4

Post to Account Ledgers

Accounting Cycle: Step 5

Make Adjusting Entries (for internal transactions)

Accounting Cycle: Step 6

List totals from each ledger in trial balance

Accounting Cycle: Step 7

Summarize in format of Financial Statements

Accounting Cycle: Step 8

Close out all nominal accounts to real accounts

Nominal (Temporary) Accounts

• Inflows/increases are reported on the right(Credit) side

  • Because the new resource gets added to the real account (Debit)

• Outflow/decreases are reported on the left(Debit) side

  • Because the reduction in the resource gets taken away from the real account (Credit)

Real (Permanent) Accounts

• Resources are reported on the left (Debit) side

• Claims on resources are reported on the right (Credit) side

Accounts on a Balance Sheet

• Assets

• Liabilities

• Owner’s Equity

Accounts on an Income Statement

• Revenues

• Expenses

• Operating Income

• Sales

• Cost of Goods Sold

Accounts on Statement of Stockholders’ Equity

• Common Stock

• Retained Earnings

Accrual

• Recognition before cash

  • Revenue: Services are performed, but no cash is received

  • Expenses: Expenses are incurred, but not yet paid in cash

Deferral

• Cash before recognition

  • Prepaid Expenses: Expenses paid in cash before they are used or consumed

  • Unearned Revenues: Cash received before services are performed

Adjusting Entries

• Recording internal transactions

• Ensures:

  • Balance sheet reports the appropriate assets, liabilities, and owner’s equity at the statement date

  • Income statement reports the proper revenues and expenses for the period

    • Revenues are recorded in the period in which the service obligation is performed

    • Expenses are recognized in the same period as the revenues they generate

Closing Entries

• Transfers balances from temporary accounts to permanent accounts (retained earnings)

• Reduces the balance of the nominal account to zero in order to prepare the period accounts for next period’s transactions

Reversing Entries

Reverse out some adjusting entries to simplify future record keeping.

Time Value of Money

A dollar today is worth more than a dollar promised at some time in the future.

When is TVM used in accounting?

Present value based measurements

• Notes

• Leases

• Pensions and other post-retirement benefits

• Share-based compensation

Simple Interest

Interest compounded on principal only.

• Federal law requires disclosure of interest rates on an annual basis

Compound Interest

Computes interest on principal and interest that has not been paid or withdrawn.

Ordinary Annuity

• Rents occur at the end of each period

• No interest during the first period

Annuity Due

• Rents occur at the beginning of each period

• Interest will accumulate during 1st

• One extra interest period