Intermediate Accounting Chapter 1 & 2

Basic Assumptions Underlying GAAP

• Generally Accepted Accounting Principles (GAAP): The standardized framework of accounting guidelines, rules, and procedures used to record and report financial information.
• Economic Entity Assumption:
  • Presumes that all economic events can be identified with a specific economic entity, such as a corporation or an LLC.
  • Example: An investor considering stock in Alphabet (the parent company of Google) requires financial information separated by operating units, such as distinguishing United States operations from European operations.
  • Ensures that transactions are attributed strictly to the corresponding corporate entity.
• Going Concern Assumption:
  • Presumes that, unless contrary information is present, a business entity will continue to operate indefinitely.
  • Financial statements prepared at period-end (e.g., December 31) carry forward balance sheet balances to the beginning of the next period (e.g., January 1) based on expected operational continuity.
  • Long-Term Depreciation Context: Physical structures (buildings) are depreciated over lengthy timeframes (e.g., $30$ to $40$ years). Depreciation tables presume long-term operational existence.
  • Basis and Valuation Adjustments: Real estate fair market values may appreciate, but GAAP permits tax deductions for depreciation, which reduces the asset's adjusted tax basis. The adjusted basis determines gain or loss upon sale.
  • Basis Example: Purchasing a building for $500,000$ and taking $100,000$ in accumulated depreciation yields an adjusted basis of $400,000$. Selling the building recoups prior write-offs relative to this basis.
  • External Influences on Value: Externalities (e.g., unmaintained neighbor properties or uncontained livestock like horses and sheep) can lower fair market property value, even though tax depreciation calculations follow formal basis rules.
• Periodicity Assumption:
  • Allows the economic life of a company to be divided into artificial time periods to deliver timely financial information.
  • Reporting Intervals: Companies generate weekly, monthly, quarterly, or annual financial statements.
  • Nature of "Artificial" Periods: Business operations are continuous (e.g., work performed on August 31 continues into September 1), requiring artificial cutoff points to make adjustments, accrue liabilities, and report performance.
  • Entity Size and Seasonality: Enterprise scale dictates reporting frequency. Large corporations monitor performance using daily reports, whereas smaller or seasonal businesses evaluate weekly or monthly trends (e.g., seasonal probate businesses adjusting operational hours between summer and winter).
• Monetary Unit Assumption:
  • Requires financial statement elements to be measured in nominal units of currency without adjustments for purchasing power changes or inflation.
  • Currency Standards: Measured in the US Dollar ($\text{USD}$) within the United States, and in the Euro ($\text{EUR}$) within the European Union.

Measurement Bases in GAAP

• Overview of Measurement Attributes: Financial items are measured using five distinct attributes under GAAP framework rules.
• Historical Cost:
  • Definition: The original exchange price given or received in an initial transaction.
  • Balance Sheet Retention: Assets remain recorded at historical cost regardless of market appreciation or depreciation.
  • Example: Purchasing land for $100,000$ requires debiting land and crediting cash or liabilities for $100,000$. Even if fair market value rises to $150,000$, the asset remains on the books at its historical cost of $100,000$.
• Net Realizable Value (NRV):
  • Definition: The estimated selling price in the ordinary course of business minus reasonably predictable costs of completion, disposal, and transportation.
  • Disclosure Context: Disclosed in financial statement notes for inventory valuation methods like First-In, First-Out (FIFO).
  • Example: An inventory holding can be sold for $10,000$, but incurs $2,000$ in completion and transportation costs. The calculated Net Realizable Value is:     $\text{Net Realizable Value} = \u002410,000 - \u00242,000 = \u00248,000$
• Current Cost:
  • Definition: The cost required currently to purchase or reproduce an identical asset.
  • Application: Evaluates changes in price levels and inflationary replacement costs over multi-year periods.
• Present Value:
  • Definition: Measurements based on estimated future cash flows discounted using the time value of money.
  • Application: Employs present value interest tables and explicit discount rates to quantify long-term investments, receivables, and obligations.
• Fair Value:
  • Definition: 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.
  • Application: Utilized when evaluating asset impairment and marking adjustments.

Full Disclosure Principle and Financial Reporting

• Principle Definition: Mandates that financial reports include any information capable of impacting decisions made by external users.
• Methods of Disclosure: Information is presented through parenthetical balance sheet entries, structured disclosure notes, and supplementary financial tables.
• Risk and Litigation Disclosures: Publicly traded companies are legally required to disclose material contingencies, such as potential payout liabilities from pending lawsuits, to protect investors and avoid litigation.

Cash Basis vs. Accrual Basis Accounting

• Cash Basis Accounting:
  • Revenue Recognition: Recorded only when cash is received.
  • Expense Recognition: Recorded only when cash is disbursed.
  • Limitation: Excludes earned uncollected revenues and incurred unpaid obligations from period results.
• Accrual Basis Accounting:
  • Revenue Recognition: Recorded when earned (e.g., services rendered and billed to accounts receivable), regardless of cash receipt timing.
  • Expense Recognition: Recorded when incurred (e.g., accrued liabilities and accounts payable), matching costs against related revenues.
  • Accrued Revenue Entry: Debit Accounts Receivable, Credit Revenue.
  • Accrued Expense Entry: Debit Expense, Credit Payable.

Detailed Accounting Exercises and Numerical Solutions

• Brief Exercise 1-1: Accrual Net Income Calculation:

  • Operating Data Provided:
  • Cash collected from customers = $340,000$
  • Cash paid for rent (covers a 2-year period) = $40,000$
  • Cash paid to employees for services = $120,000$
  • Cash paid for utilities = $50,000$
  • Year-end customer Accounts Receivable = $60,000$ (no bad debts anticipated)
  • Year-end utility liability owed = $2,000$
  • Revenue Calculation:     $\text{Accrual Revenue} = \text{Cash Collected} + \text{Accounts Receivable} = \u0024340,000 + \u002460,000 = \u0024400,000$
  • Expense Calculations:
  • Rent Expense (2-year prepaid allocation):       $\text{Rent Expense} = \frac{\u002440,000}{2} = \u002420,000$
  • Salaries Expense (full incurred compensation):       $\text{Salaries Expense} = \u0024120,000$
  • Utilities Expense (cash paid plus unpaid liability):       $\text{Utilities Expense} = \u002450,000 + \u00242,000 = \u002452,000$
  • Total Accrual Net Income Summary:     $\text{Accrual Net Income} = \u0024400,000 - \u002420,000 - \u0024120,000 - \u002452,000 = \u0024208,000$
  • Accounting Practice Standard: A double underline beneath the final figure ($\u0024208,000$) indicates that the financial statement calculation is complete.

• Exercise 1-1: Perez Associates (Operating Cash Flow vs. Accrual Analysis):

  • Operational Data Provided:
  • Amounts billed to clients: Year 1 = $170,000$; Year 2 = $220,000$
  • Cash collected from clients: Year 1 = $160,000$; Year 2 = $190,000$
  • Salaries paid: Year 1 = $90,000$; Year 2 = $100,000$
  • Utilities cash paid: Year 1 = $30,000$; Year 2 = $40,000$
  • Total utilities incurred over two years = $70,000$ (Year 1 incurred = $35,000$; Year 2 incurred = $35,000$)
  • Insurance policy purchase (paid Year 1, 3-year term) = $60,000$
  • Part 1: Operating Cash Flow (Cash Basis):
  • Year 1 Operating Cash Flow:       $\text{Cash Collected} - \text{Salaries} - \text{Utilities} - \text{Insurance} = \u0024160,000 - \u002490,000 - \u002430,000 - \u002460,000 = -\u002420,000$
  • Year 2 Operating Cash Flow:       $\text{Cash Collected} - \text{Salaries} - \text{Utilities} - \text{Insurance} = \u0024190,000 - \u0024100,000 - \u002440,000 - \u00240 = \u002450,000$
  • Part 2: Accrual Net Income:
  • Revenues (Amounts Billed): Year 1 = $170,000$; Year 2 = $220,000$
  • Salaries Expense: Year 1 = $90,000$; Year 2 = $100,000$
  • Utilities Expense: Year 1 = $35,000$; Year 2 = $35,000$
  • Insurance Expense (3-year allocation):       $\text{Annual Insurance Expense} = \frac{\u002460,000}{3} = \u002420,000$
  • Year 1 Accrual Net Income Calculation:       $\text{Net Income (Year 1)} = \u0024170,000 - \u002490,000 - \u002435,000 - \u002420,000 = \u002425,000$
  • Year 2 Accrual Net Income Calculation:       $\text{Net Income (Year 2)} = \u0024220,000 - \u0024100,000 - \u002435,000 - \u002420,000 = \u002465,000$
  • Part 3: Balance Sheet Accounts Receivable Calculations:
  • Year 1 Ending Accounts Receivable:       $\text{Beginning AR} + \text{Amounts Billed} - \text{Cash Collected} = \u00240 + \u0024170,000 - \u0024160,000 = \u002410,000$
  • Year 2 Ending Accounts Receivable:       $\text{Beginning AR} + \text{Amounts Billed} - \text{Cash Collected} = \u002410,000 + \u0024220,000 - \u0024190,000 = \u002440,000$

• Exercise 1-2: Accrual Net Income & Advertising Breakdown:

  • Operational Data Provided:
  • Amounts billed to clients (Year 2) = $350,000$
  • Rent payment covering 2-year period = $80,000$
  • Salaries paid: Year 2 = $140,000$; Year 3 = $160,000$
  • Advertising Details: Owed at end of Year 1 = $5,000$; Incurred in Year 2 = $25,000$; Paid in Year 2 = $15,000$; Ending liability Year 2 = $15,000$; Paid in Year 3 = $35,000$; Total advertising cash disbursements across periods = $50,000$
  • Expense Calculations:
  • Annual Rent Expense:       $\text{Rent Expense} = \frac{\u002480,000}{2} = \u002440,000$
  • Year 2 Advertising Expense Derivation:       $\text{Year 2 Advertising Expense} = \u002420,000$
  • Final Accrual Net Income Output:
  • Year 2 Accrual Net Income = $115,000$
  • Year 3 Accrual Net Income = $109,000$

The Accounting Equation and Components of Shareholders' Equity

• The Expanded Accounting Equation:   $\text{Assets} = \text{Liabilities} + \text{Shareholders' Equity}$
  • Assets: Economic resources controlled by the corporation.
  • Liabilities: External creditor claims against corporate resources.
  • Shareholders' Equity: Owner claims against corporate resources.
• Sources of Shareholders' Equity:
  • Paid-in Capital: Amounts contributed directly to the corporation by shareholders purchasing equity shares.
  • Retained Earnings: Accumulated net income earned by the corporation on behalf of shareholders that is retained in the business rather than distributed.     $\text{Retained Earnings} = \text{Net Income} - \text{Distributions to Shareholders}$
• Sub-Components of Retained Earnings:
  • Revenues and Gains: Increase Retained Earnings.
  • Expenses and Losses: Decrease Retained Earnings.
  • Dividends: Represent distributions of corporate assets to owners.
• Accounting Rules Governing Dividends:
  • Non-Deductibility: Dividends are asset distributions to owners, not operating expenses, and are not tax-deductible.
  • Net Income Impact: Dividends do not impact net income.
  • Equity Impact: Paid dividends reduce Retained Earnings directly, resulting in a net decrease to total Shareholders' Equity in the accounting equation.