Intermediate Accounting Exam 1

The objectives of financial reporting are to provide information that is _______.

Decision useful

Relevance

To be relevant, accounting information must be capable of making a difference in a decision

Predictive Value

relevant information helps users confirm or correct prior expectations

Materiality

information is material if omitting it or misstating it could influence decisions that users make on the basis of the reported financial information

Faithful Representation

Accounting numbers and descriptions match what really happened.

Completeness

all information necessary for faithful representation is provided

Neutrality

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

Free from error

accurate

Comparability and consistency

Allows users to identify the real similarities and differences in economic events between companies. And it allows users to compare information for the same company over time because companies apply the same accounting treatment to similar events from period to period so that users can compare results for the same company over time.

Verifiability

Independent measures, using the same methods, obtain similar results

Timeliness

Relevant information is available to decision makers before it has lost its capacity to influence their decisions

Understandability

For information to be useful, there must be a connection between the users and the decisions they make.

Assets

Probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.

Liabilities

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

Equity

Residual interest in the assets of an entity that remains after deducting its liabilities

Investments by Owners

Increases in net assets resulting from transfers to it from other entities of something of value to obtain or increase ownership interests (equity).

Distributions to Owners

Decreases in net assets resulting from transferring assets, rendering services, or incurring liabilities by the enterprise to owners

Comprehensive Income

Change in equity (net assets) of an entity 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.

Primary Qualitative Characteristics

Relevance & Faithful Representation

Relevance consists of:

Predictive value, Confirmatory value, & Materiality

Faithful Representation consists of:

Completeness, Neutrality, Free from error

Enhancing qualities are:

Comparability and consistency, Verifiability, Timeliness, & Understandability

Revenues

Inflows or other enhancements of assets of an entity or settlement of its liabilities (or both) during a period from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major or central operations

Expenses

Outflows or other using up of assets or incurrences of liabilities (or both) during a period from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major or central operations

Actually cleaning carpet is considering a _____

Revenue

Carpet cleaning supplies being used up is considered a _____

Expense

Gains

Increases in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity during a period except those that result from revenues or investment by owners

A carpet cleaning company selling their vacuum for more than its book value is an example of a ______

gain

Losses

Decreases in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity during a period except those that result from expenses or distributions to owners

A carpet cleaning company selling their vacuum for less than its book value is an example of a ______

Loss

Assumptions

Economic entity, going concern, monetary unit, periodicity

Economic entity

Economic activity can be identified with a particular unit of accountability (keep activity separate and distinct from owners and any other business enterprise).

Going concern

Assumes company will have a long life. Except when we see evidence to the contrary we assume the company will be around long enough to fulfill objectives and commitments. 1) historical cost 2) depreciation

Monetary unit

Assumes $ is stable

Periodicity

We can’t wait until the company liquidates to provide results (timeliness). 1) Assumes we can divide the economic activity of the business into artificial time periods 2) Tradeoff of relevance vs. reliability

Basic Principles of Accounting

Measurement Principle, Revenue Recognition Principle, Expense Recognition Principle, Full Disclosure Principle

Measurement Principles

Historical cost principle & Fair value

Historical Cost Principle

Most assets and liabilities are accounted for and reported at the acquisition price. Historical cost is very reliable because it is an objective measure.

Fair Value

The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. (short-term)

Revenue recognition principle

Recognize when rev is earned, not necessarily when cash is received

Five-step process for revenue recognition

a) identify contract with customers b) identify the separate performance obligations in the contract c) determine transaction price d) allocate the transaction price to the separate performance obligations e) recognize revenue when each performance obligation is satisfied

Exceptions of revenue recognition principle

a) during production (like a long-term construction project) b) at the end of production (like mineral mining and certain agricultural products) c) upon receipt of cash (only when collection is uncertain at the time of the sale, installment method only)

Expense recognition principle

Recognition of expenses is related to net change in assets and earning revenue. In practice we let the expense follow the revenues. That is, expenses are matched with revenues. Some costs are difficult to match so we often use “rational and systemic” allocation that approximates the matching principle (e.g. depreciation) (aka matching principle)

Capitalized

Recorded as an asset on balance sheet instead of an expense, usually because of future economic benefit to a company

FOH

rent, utilities, dep on equip, IL, & IM

Two parts of expense recognition principle

product costs & period costs

Product costs

(material, labor, and overhead) - attach to the product and are inventoriable until the related product is sold

Period costs

(officers’ salaries and other administrative costs) - attach to the period and are expensed immediately because companies cannot determine a direct relationship between period costs and revenue

Amoritzed

to gradually pay off a debt

Accrual accounting

records revenue when earned & expenses when incurred regardless of when cash changes hands

Parts of full disclosure principle

Financial statements, notes to the financial statements, supplementary information

Full disclosure principle

the amount of information included in the financial reports balances the tradeoff between providing sufficient detail to disclose matters that make a difference to users, and providing the information in a sufficiently condensed format that it is understandable

Notes to the financial statements

amplify or explain the items in the main body of the financial statements

Supplementary information

Include details or amounts that present a different perspective for that adopted in the financial statements. This information may be high in relevance but low in reliability. Includes management’s explanation of the financial information and its discussion of the significance of that information.

Constraints

Cost constraints, Industry practices

Cost constraint

Information is NOT free. Companies must weigh the costs of providing information against the benefits that can be derived from using it.

Industry practices

The peculiar nature of some industries sometimes requires departures from basic theory. (e.g. utilities report non-current assets first on the B/S and agricultural companies report crop inventories at FMV because cost is hard to determine.)

Allowance for Doubtful Accounts

Estimate of A/R that won'‘t be collected. Helps companies know uncollectible amounts. Reduces A/R on B/S.

Contra-Asset

reduces the balance of a related asset account

Liquidation Value

Amount of $$ a company would get when shutting down. (FV-Liab)

Depreciation

Spreading an asset’s cost over its useful life

Par Value

Nominal amount assigned to a stock or bond when it is issued.