Accounting Exam 1 Study Guide
Chapter 1:
Financial accounting – the process of identifying, measuring, and communicating financial
information about an economic entity to various user groups within the legal, economic,
political, and social environment
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Assists in the efficient allocation of capital
Enables efficient resource allocation decisions based on the risks and returns of a
particular investment
Directs capital flows to their most productive uses, linking the demand for financial
information to the allocation of scarce resources
Four Basic Financial Statements:
1.
2.
3.
4.
Balance sheet (statement of financial position)
Statement of comprehensive income
Statement of cash flows
Statement of shareholder’s equity
Other Financial Information:
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Letter to the shareholders
Formal discussion and analysis of the firm by management
Management report
Auditor’s report
Financial summary
Economic entity – an organization or unit with activities that are separate from those of its
owners and other entities
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Corporations, partnerships, sole proprietorships, or governmental organizations
Financial Statement User Groups:
equity investors – shareholders of the company
creditors – banks and other financial institutions that lend money to the company
financial analysts – use financial information to review and analyze reported results of the
companies they cover and make investment recommendations
employees and labor unions – use financial information during negotiations of new labor
agreements and compensation contracts
suppliers and customers – use financial statements to determine whether to conduct business
or purchase products from a company
government agencies – review the financial statements of publicly traded companies for a
variety of reasons that are in the public interest
competitors – use financial information to determine their market position relative to the
reporting entity and to attempt to identify future strategies of the reporting entity
external auditors – independent of the company and responsible for ensuring that
management prepares and issues financial statements that comply with accounting standards
and fairly present the financial position and economic performance of the company
internal auditors – employees of the company serving in an advisory role to management; they
provide information to management regarding the company’s operations and proper
functioning of its internal controls
regulatory bodies – protect investors and oversee the accounting and auditing standard setting
processes
professional organizations – support accounting professionals throughout their careers by
providing training, professional skills development, and other resources
GAAP – a collection of methods used to process, prepare, and present public accounting
information in the US
Rules vs. Principles Based Standards (pg. 16):
Principles – relies on theories, concepts, and principles of accounting that are linked to a welldeveloped theoretical framework
Rules – contains specific, prescriptive procedures rather than relying on a consistent theoretical
framework
US GAAP is more rules based compared to IFRS
Standard Setting Process:
1. Identification of an issue
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7.
Decision to pursue
Public meetings
Exposure draft
Public roundtables
Re-deliberation
Publication of the final standard
Chapter 2:
Conceptual framework – set of objectives and fundamentals that lead to consistent rules and
prescribes the nature, function, and limits of financial accounting and financial statements
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Ensures accounting standards are coherent, uniform, and guide standard setters
Fundamental vs. Enhancing:
Fundamental – basic characteristics that determine what is useful financial information
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Relevance – capable of making a difference in decision making by showing predictive
value, confirmatory value, and materiality
Faithful representation – financial information depicts the substance of an economic
event in a manner that is complete, neutral, and free from error
Enhancing – help distinguish more useful information from less useful information
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Comparability – compare entities for capital allocation decisions
Verifiability – an amount can be verified
Timeliness – the information is timely enough to be useful for decision making
Understandability – the quality of information that lets reasonably informed users see
its significance
Point-In-Time Elements:
Balance sheet components
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Assets – probable future economic benefits controlled by an entity as a result of a past
transaction
Liabilities – probable future sacrifices of economic benefits arising from a present
obligation as a result of a past transaction
Equity – net assets of the business (assets minus liabilities)
Period-In-Time Elements:
Income statement components
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Investments by owners – buying common stock
Distributions by owners – cash dividends
Revenues – sales, fees, and takings
Gains – profit obtained from selling long-term assets
Expenses – rent expense, wages expense, COGS
Losses – loss obtained from selling long-term assets
Comprehensive income – change in equity in one year from non-owner sources
Accrual – firms recognize revenues according to the revenue recognition principle and
recognize expenses according to the expense recognition concept (financial accounting)
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General recognition, revenue recognition, expense recognition, and bases of
measurement
Cash – recognizes revenues when the cash is received and expenses when the cash is paid
Recognition – the process of reporting and economic event and is included in the financial
statements
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Occurs when the item meets the definition of an element, is measurable, reliable, and
relevant
Revenue is recognized when it is realized or realizable and earned
Expense is recognized when economic benefits are consumed, or an asset has
experienced a reduced future benefit
Five Measurement Bases:
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5.
Historical cost
Current cost
Current market value
Net realizable value
Present value of future cash flows
Going-concern – assumes entity will continue to operate indefinitely
Business or economic entity – owners and business affairs are separated and reported
separately
Monetary unit – all items are valued according to an accepted currency and it is assumed the
currency remains stable over time in terms or purchasing power
Periodicity – entity is to divide its life into artificial time periods for the purpose of providing
periodic reports on its economic activities
Chapter 3:
Financial statement disclosures – (accounting policy footnote) indicate where managers used
judgment in the financial reporting process
Obstacles Faced in Preparing Financial Information:
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Factors may influence management to intentionally bias their estimates (bonuses tied to
income)
Cognitive biases (systematic deviations from rationality)
Complexity of the business environment and transactions (new industries and
environments, complex investment instruments)
Three Reasons Why Accounting Standards May Be Unclear:
1. Judgement is involved because standard setters allow for management discretion
2. Issue is complex that it requires research to determine correct answer
3. No information in the accounting standards that directly provides guidance to resolve a
specific issue
Financial Accounting Standards Board Accounting Standards Codification (ASC):
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Groups and summarizes all current accounting standards by topic
Divided into topics, subtopics, sections, and paragraphs
o 9 major topics
o Subtopics are distinguished by area or scope
o Sections uniform across subtopics
Steps in Accounting Research Process:
1.
2.
3.
4.
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6.
Establish and understand the facts
Identify the issue: what is the research question?
Search the authoritative literature
Evaluate the results of the search
Develop conclusions
Communicate the results of the research
Chapter 4:
Accounting Cycle:
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Analyze the transaction
Journalize the transaction
Post to the general ledger
Prepare the unadjusted trial balance
Prepare adjusting journal entries
Prepare the adjusted trial balance
Prepare financial statements
Close temporary accounts
Prepare post-closing trial balance
Deferrals – occur when a company receives or pays cash before recognizing the revenue or
expense in the financial statements
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Deferred expense – prepaid rent, prepaid insurance
Deferred revenue – unearned revenue, advanced collections
Accruals – occur when the economic event that gives rise to revenue or expenses occurs before
the cash is received or paid
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Accrued revenue – interest revenue, commissions
Accrued expenses – interest, rent, taxes, salaries
Adjusted Trial Balance – the listing of all accounts and their ending debit or credit balances after
making the adjusting journal entries
Close Temporary Accounts:
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Revenue accounts – debit all revenue and gain accounts and credit income summary
Expense accounts – debit income summary and credit all expense and loss account
Income summary account – debit income summary and credit retained earnings for
amount of net income; credit income summary and debit retained earnings in the event
of a net loss
Dividends account – debit retained earnings and credit dividends account
Chapter 5:
Comprehensive income = net income + other comprehensive income
Income Statement:
Useful:
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Provides information that helps investors and creditors predict the amounts, timing, and
uncertainty of future cash flows
Helps evaluate the past performance of the company
Provides a basis for predicting future performance
Allows us to evaluate risks and uncertainty of achieving future cash flows
Limitations:
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Companies omit items that cannot be measured reliably
Income is affected by the accounting methods employed
Income measurement involves judgment and estimation
Earnings is the most forecasted, discussed, and disclosed number
Earnings Quality:
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Reduced if earnings information is less useful for predicting future earnings and cash
flows
Permanence of earnings and earnings management impact earnings quality
Income from continuing operations = operating income + non-operating revenues/gain and
expenses/losses + income tax provision
Operating income = gross profit – all operating expenses
Gross profit = net sales revenue – cost of goods sold
Income before tax = operating income + non-operating income
Net income = income before taxes – income tax provision
Comprehensive income = net income + other comprehensive income
Discontinued Operations:
1. Income or loss from operations of discontinued segment, unit or group, net of tax
2. Gain or loss on re-measurement of net assets held for sale for fair value less disposal
costs, net of tax
3. Gain or loss on disposal of assets or disposal groups constituting the discontinued
operation, net of tax
Chapter 6:
Balance Sheet:
Useful
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Balance sheet is as of a specific point in time
Useful for assessing liquidity, solvency, and financial flexibility
Limitations
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Most assets and liabilities are reported at historical cost
Many valuations involve estimates and judgements
Omits many items that are of financial value
Liquidity – how quickly the firm can convert assets into cash and pay liabilities
Solvency – a measure of a firm’s long-term ability to pay its obligations as they mature
Financial flexibility – ability of company to alter cash flows to take advantage of unexpected
investment opportunities or needs
Working capital = current assets – current liabilities