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 ID: 803688
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Slide1
FA2Module 1. Financial reporting/accounting concepts
What is accounting?
Objectives of financial reporting
Accounting choice process
Accounting concepts
The accounting cycle
Closing entries
Adjusting entries
Slide2Who 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:
Cameron.Morrill@ad
.um
anitoba.ca
Tel: (204) 474-8435
Office hours: Wednesdays 9:30 AM – 11:30 AM
Slide31. What is accounting?
Accounting involves:
the recognition, measurement, and disclosure of financial information about
economic entities to
interested persons.
Slide4What 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.
Slide5Financial 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
Slide6What do users do with financial statement information?
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.
Slide7What 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.
Slide8GAAP in Canada in 2012
Different standards for different organizations, but underlying principles are the same
Publicly accountable enterprises (PAE) – IFRS (
CICA Handbook Part I
)
Private enterprises –
IFRS (like PAEs)
Canadian accounting standards for private enterprises or
ASPE
(
CICA Handbook Pt II
)
Disclosed basis of accounting
Slide9GAAP in Canada in 2012
Not-for-profit (NFP) Organizations – (
CICA Handbook Part III
)
Pension Plans – (
CICA Handbook Part IV
)
Public Sector – (
Public Sector Accounting Standards)
Slide102. 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
Slide11Objectives 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
Slide12Objectives of financial reporting
External users (continued)
Income tax minimization/deferral
Contract compliance (debt covenants)
Stewardship
Slide13Objectives of financial reporting
Preparers
Earnings management
Maximize earnings
Accounting-based performance measures
Market-based performance measures
Minimize earnings
Minimum disclosure (proprietary information)
Expanded disclosures
Slide143. 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)
Slide154. Accounting concepts
Accounting concepts (conceptual framework) provide criteria to guide accounting choices and, hopefully, achieve financial reporting objectives. Concepts are:
Underlying assumptions
Qualitative criteria
Measurement methods
Elements of financial statements
Slide16I. Underlying assumptions (universal)
Time period
: meaningful information can be reported for a time period less than the entity’s life span
Separate entity
: entity can be reported independently of its owners
Unit of measure
: entity results can meaningfully be measured in monetary terms
Slide17I. Underlying assumptions (entity-specific)
Continuity
: enterprise will continue in operation for reasonable future period
Proprietary approach
: entity results should be reported from point of view of its owners
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
Slide18II. Qualitative criteria
Relevance
Faithful representation
Comparability
Verifiability
Timeliness
Understandability
Materiality constraint
Cost constraint
Slide19RELEVANCE
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
Slide20REPRESENTATIONAL 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
Slide21Comparability
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.
Slide22Verifiability
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
Slide23Timeliness
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).
Slide24Understandability
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
Slide25Materiality
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.
Slide26Cost (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).
Slide27III. 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
Slide28Measurement 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
Quoted prices in active markets for identical assets
Quoted prices in active markets for similar assets
Valuation techniques (e. g., PV)
Slide29Measurement 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
.
Slide30Measurement methods
Revenue recognition
Revenue is recognized when
performance achieved (seller has performed all significant acts required and risks and reward of ownership are transferred to, and accepted by, buyer) and
proceeds are measurable and collectibility assured
Slide31Measurement 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
Slide32Measurement methods
Expense recognition
(continued)
If there is no clear event that causes a decrease in net assets, then
Use some arbitrary cost allocation rule (e. g., depreciation), and/or
Check regularly for asset impairment (e. g., goodwill)
Slide33Measurement 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
Slide34A2-8, 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
Slide35IV. 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)
Slide36Elements 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
Slide37Elements 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
Slide385. 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
double-entry bookkeeping system
(debits and credits).
Assets = Liabilities + Owners’ Equity
Debits = Credits
Slide39Steps 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)
Slide40Steps 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
Slide41Debits, 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)
Slide42A-20: Journal entries
a.
Dr. Cash 60,000
Dr. Accounts receivable 30,000
Cr. Sales revenue 90,000
Dr. Cost of goods sold 58,500
Cr. Inventory 58,500
Slide43A-20: Journal entries
b
Dr. Cash 51,000
Cr. Accounts receivable 51,000
c
Dr. Income taxes payable 12,000
Cr. Cash 12,000
Slide44A-20: Journal entries
d
Dr. Inventory 120,000
Cr. Accounts payable 24,000
Cr. Cash 96,000
e
Dr. Accounts payable 18,000
Cr. Cash 18,000
Slide45A-20: Journal entries
f
Dr. Cash 216,000
Cr. Sales revenue 216,000
Dr. Cost of goods sold 140,400
Cr. Inventory 140,400
g
Dr. Operating expenses 57,000
Cr. Cash 57,000
Slide46A-20: Journal entries
h
Dr. Cash 3,000
Cr. Common shares 3,000
i
Dr. Inventory 300,000
Cr. Cash 219,000
Cr. Accounts payable 81,000
Slide47A-20: Journal entries
j
Dr. Cash 204,000
Dr. Accounts receivable 90,000
Cr. Sales revenue 294,000
Dr. Cost of goods sold 191,100
Cr. Inventory 191,100
k
Dr. Cash 78,000
Cr. Accounts receivable 78,000
Slide48A-20: Journal entries
l
Dr. Accounts payable 84,000
Cr. Cash 84,000
m
Dr. Operating expenses 54,000
Cr. Cash 54,000
Slide496. 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
Slide506. 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
Slide517. Adjusting Entries: A-7