FA2Module 1. Financial reporting/accounting concepts

1. What is accounting?

2. Objectives of financial reporting

3. Accounting choice process

4. Accounting concepts

5. The accounting cycle

6. Closing entries

7. Adjusting entries

Who 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.umanitoba.ca

Tel: (204) 474-8435

Office hours: Wednesdays 9:30 AM – 11:30 AM

1. What is accounting?

Accounting involves:• the recognition, measurement, and disclosure

of financial information about• economic entities to• interested persons.

What 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.

Financial 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

What do users do with financial statement information?

1. 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.

What do users do with financial statement information?

2. Investment/resource allocationAccounting 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.

GAAP in Canada in 2012

Different standards for different organizations, but underlying principles are the same1. Publicly accountable enterprises (PAE) –

IFRS (CICA Handbook Part I)2. Private enterprises –

a. IFRS (like PAEs)b. Canadian accounting standards for private

enterprises or ASPE (CICA Handbook Pt II)c. Disclosed basis of accounting

GAAP in Canada in 2012

3. Not-for-profit (NFP) Organizations – (CICA Handbook Part III)

4. Pension Plans – (CICA Handbook Part IV)5. Public Sector – (Public Sector Accounting

Standards)

2. 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

Objectives of financial reportingExternal usersAssessing (performance appraisal) and predicting (investment decisions) cash flowsWhy cash flows?Generate return, pay debtsWhy accrual accounting?Cash flows are volatile, often independent of economic performance of entity; accrual accounting provides better long-run view

Objectives of financial reportingExternal users (continued)• Income tax minimization/deferral• Contract compliance (debt covenants)• Stewardship

Objectives of financial reportingPreparers• Earnings management

–Maximize earnings• Accounting-based performance measures• Market-based performance measures

–Minimize earnings• Minimum disclosure (proprietary

information)• Expanded disclosures

3. 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)

4. Accounting concepts

Accounting concepts (conceptual framework) provide criteria to guide accounting choices and, hopefully, achieve financial reporting objectives. Concepts are:

I. Underlying assumptions

II. Qualitative criteria

III. Measurement methods

IV. Elements of financial statements

I. Underlying assumptions (universal)

i. Time period: meaningful information can be reported for a time period less than the entity’s life span

ii. Separate entity: entity can be reported independently of its owners

iii. Unit of measure: entity results can meaningfully be measured in monetary terms

I. Underlying assumptions (entity-specific)

iv. Continuity: enterprise will continue in operation for reasonable future period

v. Proprietary approach: entity results should be reported from point of view of its owners

vi. 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

II. Qualitative criteria

• Relevance• Faithful representation• Comparability• Verifiability• Timeliness• Understandability• Materiality constraint• Cost constraint

RELEVANCE

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

REPRESENTATIONAL 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

Comparability

Two pieces of information are comparable if they are consistent and/or uniform

• UniformityInformation measured and reported in a similar manner for different entities in a given year

• ConsistencyInformation is measured and reported in the same way for a given entity, from period to period. Changes occur only if justified.

VerifiabilityKnowledgeable 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

Timeliness

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).

Understandability

• 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

MaterialitySignificance 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.

Cost (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).

III. Measurement methods

RecognitionInclusion of an item in one or more of the financial statements (not just note disclosure)

MeasurementThe process of determining the amount at which an item is recognized in the financial statements

Measurement 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

1. Quoted prices in active markets for identical assets

2. Quoted prices in active markets for similar assets

3. Valuation techniques (e. g., PV)

Measurement 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.

Measurement methods

Revenue recognition

Revenue is recognized when

(1)performance achieved (seller has performed all significant acts required and risks and reward of ownership are transferred to, and accepted by, buyer) and

(2)proceeds are measurable and collectibility assured

Measurement 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

Measurement methods

Expense recognition (continued)

If there is no clear event that causes a decrease in net assets, then

1. Use some arbitrary cost allocation rule (e. g., depreciation), and/or

2. Check regularly for asset impairment (e. g., goodwill)

Measurement 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

A2-8, A2-20Time PeriodSeparate entityUnit of measureContinuityProprietary approachStable currencyRelevanceFaithful representationComparabilityVerifiability

TimelinessMaterialityCost (Cost/benefit)Historical costRevenue recognitionExpense recognitionFull disclosurePrudence

IV. 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)

Elements 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

Elements 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

5. 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

Steps of the accounting cycle1. Journal entries to record transactions and events2. Post journal entries to ledger3. Prepare unadjusted trial balance to ensure that

debits = credits4. 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)

Steps 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

Debits, credits and the accounting equationDebit (Dr.)

Increases assets and expensesDecreases liabilities, owners’ equity and revenues

Credit (Cr.)Decreases assets and expensesIncreases 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)

A-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

A-20: Journal entries

b

Dr. Cash 51,000

Cr. Accounts receivable 51,000

c

Dr. Income taxes payable 12,000

Cr. Cash 12,000

A-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

A-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

A-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

A-20: Journal entries

jDr. Cash 204,000Dr. Accounts receivable 90,000

Cr. Sales revenue 294,000Dr. Cost of goods sold 191,100

Cr. Inventory 191,100kDr. Cash 78,000

Cr. Accounts receivable 78,000

A-20: Journal entries

l

Dr. Accounts payable 84,000

Cr. Cash 84,000

m

Dr. Operating expenses 54,000

Cr. Cash 54,000

6. Closing entriesClosing 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 periodClosing entry steps1. Close revenue accounts to income summaryDr. Revenue

Cr. Income summary

6. Closing entries (continued)2. Close expense accounts to income summaryDr. Income summary

Cr. COGS, Salaries expense, etc.3. Close income summary account to retained earningsDr. Income summary net income

Cr. Retained earnings net incomeORDr. Retained earnings loss

Cr. Income summary loss4. Close dividend accounts to retained earningsDr. Retained earnings

Cr. Dividends

7. Adjusting Entries: A-7