lOMoARcPSD|6699752 Accounting - Chapter 2 pt 2 Intermediate Accounting (Wilfrid Laurier University) StuDocu is not sponsored or endorsed by any college or university Downloaded by Richard Ma (canadarichardma@gmail.com) lOMoARcPSD|6699752 Qualitative Characteristics of Useful Information Choosing an acceptable accounting method, the amount and types of information to be disclosed, and the format in which information should be presented involves determining which alternatives gives the most useful information for decision-making purposes. A) Fundamental Qualitative Characteristics 1. Relevance – accounting info must be capable of making a difference in a decision - helps users confirm or correct their previous expectations; has feedback/confirmatory value 2. Representational Faithfulness – reflects the underlying economic substance of an event/transaction - info that is representationally faithful is complete, neutral and free from material error or bias Completeness – statements should include all necessary information to portray underlying events Neutrality – information cannot be selected to favour one set of stakeholders over another - standard setters must also choose the best standards regardless of economic consequences Freedom from material error/bias – information must be reliable B) Enhancing Qualitative Characteristics 1. Comparability – information that has been measured and reported in a similar way is considered comparable (company to company or year-to-year) - comparability enables users to identify the real similarities and differences in economic phenomena 2. Verifiability – knowledgeable, independent users achieve similar results or reach consensus regarding the accounting for a particular transaction 3. Timeliness – information must be available to decision makers before it loses its ability to influence their decisions 4. Understandability – users need to have reasonable knowledge of business and financial accounting matters in order to understand the information in financial statements but this information must also be of sufficient quality and clarity that is allows reasonably informed users to see its significance Materiality – info is material if including it or leaving it out would influence the judgement of a reasonable person (qualitative factors must be considered in determining materiality as well) Cost vs. Benefit – the costs of providing the information must be weighed against the benefits that can be had from using the information - costs may be from auditing, processing, collecting info, distributing, analysis etc. Elements of Financial Statements - there are many elements that users expect to find on the financial statements, including assets, liabilities, equity, revenues, expenses, gains, and losses - there are also subcategories such as noncurrent assets, cash, inventory etc. Downloaded by Richard Ma (canadarichardma@gmail.com) lOMoARcPSD|6699752 Assets 1. They involve present economic resources 2. The entity has a right or access to these resources where others do not In order for something to be an asset, the entity must provide evidence that it represents an economic resource and then link itself to that resource. In other words, the entity must first prove that the item has economic value and then that the entity may lay claim to or access that value. Economic resources are defined to thing that are scarce and capable of producing cash flows where teh right to access is an enforceable right. Using the example of land: a) Present economic resource: the land and plant represent a present resource; the entity may sell or use the property now and the property is not freely available to all so it has economic value (someone would pay to acquire the property) b) Right or access that others do not have: the entity has sole ownership of the property since it holds legal title. It therefore is connected to this specific economic resource and may lay claim to it Liabilities 1. They represent an economic burden or obligation 2. The entity has a present obligation (which is enforceable) Constructive Obligations are obligations that arise through past or present practice that signals that the company acknowledges a potential economic burden (warranty for defective products). Equity/Net Assets is a residual interest in the assets of an entity that remains after deducting its liabilities Revenues are increases in economic resources, either by inflows or other enhancements of an entity’s assets or by settlement of its liabilities Expenses are decreases in economic resources, either by outflows or reductions of assets of by the incurrence of liabilities Gains are increases in equity from an entity’s peripheral or incidental transactions Losses are decreases in equity from an entity’s peripheral or incidental transactions Comprehensive Income includes net income and all other changes in equity except for owners’ investments/distributions. In the new comprehensive income statement, the following would be included as “other comprehensive income”: - unrealized holding gains and losses on certain securities - certain gains and losses related to foreign exchange instruments - gains and losses related to certain types of hedges - other Downloaded by Richard Ma (canadarichardma@gmail.com) lOMoARcPSD|6699752 Foundational Principles Recognition/Derecognition 1. Economic entity 2. Control 3. Revenue recognition and realization 4. Matching Measurement 5. Periodicity 6. Monetary unit 7. Going concern 8. Historical cost 9. Fair value Presentation and Disclosure 10. Full disclosure Recognition/Derecognition Recognition deals with the act of including something on the entity’s balance sheet / income statement. Elements of financial statements have historically been recognized when: 1. they meet the definition of an element (ex. liability) 2. they are probable 3. They are reliably measurable Derecognition deals with the act of taking something off the balance sheet / income statement. 1. Economic Entity Assumption This assumption allows us to identify an economic activity with a particular unit of accountability. This helps accountants determine what to include or recognize in a particular set of financial statements. The consolidated financial statements are prepared from the perspective of the economic entity which allows the company to recognize and group together the assets, liabilities, and other financial statement elements that are under the parent’s control into one set of statements. 2. Control Control is important in determining which entities to consolidate and include in the financial statements. 1. There is power to direct the entity’s activities. In order to include the entity in the consolidated financial statements, the reporting entity must be able to make strategic decisions for the entity. 2. Only one entity has the power to direct the activities of the entity in question. Control prevents the sharing of power. 3. Power need not be exercised or absolute. 4. The reporting entity should have access to the benefits from the entity. Downloaded by Richard Ma (canadarichardma@gmail.com) lOMoARcPSD|6699752 3. Revenue Recognition and Realization 1. Risks and rewards have passed or the earnings process is substantially complete 2. Measurability is reasonably certain 3. Collectibility is reasonably assured 4. Matching Accounting attempts to match costs with the revenues that they produce. GAAP requires that a rational and systematic allocation policy be used to establish exactly how much of a contribution is made to each period. The cost of a long term asset must be allocated over all accounting periods during which the asset is used because the asset contributes to revenue generation throughout its useful life. Costs are often classified into product costs and period costs. Product costs such as material, labour, and overhead attach to the product and are carried into future periods as inventory (if not sold) since inventory meets the definition of an asset. Period costs such as officers’ salaries and other administrative expenses are recognized immediately, even though the benefits associated with these costs occur in the future, because the costs do not meet the definition of an asset. Measurement Elements are recognized in the financial statements if they meet the definition of elements and are measurable (amounts may be reasonably estimated). 5. Periodicity Assumption This assumption implies that an enterprise’s economic activities can be divided into artificial time periods. These time periods vary, but the most common are one month, one quarter or one year. The shorter the time period, the more difficult it becomes to determine the proper net income for the period. 6. Monetary Unit Assumption This assumptions means that money is the common denominator of economic activity and is an appropriate basis for accounting measurement and analysis. It implies that the monetary unit is the most effective way of expressing to interested parties changes in capital and exchanges of goods and services. 7. Going Concern Assumption This is the assumption that a business enterprise will continue to operate for the foreseeable future. The only time when the assumption does not apply is when there is intent to liquidate the company’s net assets and cease operations or cease trading in the company’s shares or when the company has no realistic alternative but to liquidate or cease operations. Downloaded by Richard Ma (canadarichardma@gmail.com) lOMoARcPSD|6699752 8. Historical Cost Principle Transactions are initially measured at the amount of cash that was paid or received. 1. It represents a value at a point in time 2. It results from a reciprocal exchange (2-way exchange) 3. The exchange includes an outside party 9. Fair Value Principle GAAP has increasingly called for the use of standardized fair value measurements in the financial statements. Fair value is an exit price (a price to sell/transfer). If an entity has a manufacturing facility that is integrated into its other facilities, the entity might successfully argue that the facility has synergistic value and is worth more to the specific entity. However, the market would generally value the facility based on what it was worth without the entityspecific synergies. Someone buying the facility would not have access to these entity-specific synergies and so would not attribute any excess value to them. Presentation and Disclosure 10. Full Disclosure Principle Anything that is relevant to decisions should be included in the financial statements. The principle recognizes that the nature and amount of information included in financial reports reflects a series of judgemental trade-offs. The trade-offs aim for information that is detailed enough to disclose matters that make a difference to users, but also condensed enough to make the information understandable. Five Elements to be Included in MD&As: 1. The company’s vision, core businesses, and strategy 2. Key performance drivers 3. Capabilities (capital/other resources) to achieve the desired results 4. Results (historical and prospective) 5. Risks that may shape and/or affect the achievement of results Financial Engineering – the process of legally structuring a business arrangement or transaction so that it meets the company’s financial reporting objective Downloaded by Richard Ma (canadarichardma@gmail.com)
