FA2
Module 1. Financial reporting/accounting concepts
1.
2.
3.
4.
5.
6.
7.
What is accounting?
Generally accepted accounting principles
The accounting cycle
Closing entries
Adjusting entries
A conceptual framework
Financial statement concepts: Section 1000
Who is your instructor?
Cameron Morrill, PhD, CGA
Associate Professor of Accounting
I. H. Asper School of Business
University of Manitoba
http://www.umanitoba.ca/asper/faculty/cam.morrill/
E-mail: Cameron_Morrill@UManitoba.CA
Tel: (204) 474-8435
Office hours: Mon/Wed 2:30 PM – 3:45 PM
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 stock exchanges
•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 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.
2. Generally accepted accounting principles
(GAAP)
GAAP form the basis on which financial
statements are normally prepared. They
consist of:
1. Conceptual framework (CICA Handbook)
2. Specific policies, practices, procedures
and rules (CICA Handbook)
3. Other sources: International (esp. US)
standards, professional and academic
publications
Hierarchy of standards
Primary sources (descending order of authority)
Materials issued by AcSB
1. CICA Handbook sections (+ appendices);
italicized and non-italicized equally important
2. Accounting Guidelines (+ appendices)
3. EIC abstracts
4. Background info/bases for conclusions
5. Illustrative material for above sources
6. Implementation guides
Hierarchy of standards (continued)
Secondary sources (no particular order)
1. FASB standards (US)
2. International accounting standards
3. Implementation guides not issued by AcSB
4. Draft materials for primary sources
5. Research reports and studies (CICA and other)
6. Accounting textbooks, journals, articles
7. Established practice
Differential reporting (section 1300)
Under GAAP, qualifying corporations can choose
not to apply certain CICA recommendations (e.
g., income tax accounting, goodwill).
Corporations qualify if:
• It has no shares or other securities that are
publicly traded
• The company is not publicly accountable in
some other respect(e. g., utility or financial
institution)
• Shareholders agree unanimously to use
differential reporting options
Future of Canadian Accounting
CICA goal: Full convergence with International
Financial Reporting Standards (IFRS) by 2011.
Implications:
Phased adoption: Most CICA Handbook sections
are already “substantively converged” with IFRS;
new revisions are all consistent with IFRS
No differential reporting options: IFRS is for listed
companies only; International Acctg Stds Board
(IASB) has released exposure draft of GAAP for
small and medium-sized enterprises, and CICA has
introduced possibility of Framework for OwnerManaged Enterprises (FOME)
3. 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 doubleentry bookkeeping system (debits and credits).
Assets = Liabilities + Owners’ Equity
Debits = Credits
Steps 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)
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
8. Prepare closing entries
9. Prepare postclosing trial balance
10. Prepare balance sheet and cash flow statement
Debits, 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-19
A-19: Journal entries
a.
Dr. Cash
Dr. Accounts receivable
Cr. Sales revenue
20,000
10,000
30,000
Dr. Cost of goods sold
Cr. Inventory
19,500
19,500
A-19: Journal entries
b
Dr. Cash
Cr. Accounts receivable
17,000
17,000
c
Dr. Income taxes payable
Cr. Cash
4,000
4,000
A-19: Journal entries
d
Dr. Inventory
Cr. Accounts payable
Cr. Cash
40,000
8,000
32,000
e
Dr. Accounts payable
Cr. Cash
6,000
6,000
A-19: Journal entries
f
Dr. Cash
Cr. Sales revenue
Dr. Cost of goods sold
Cr. Inventory
g
Dr. Operating expenses
Cr. Cash
72,000
72,000
46,800
46,800
19,000
19,000
A-19: Journal entries
h
Dr. Cash
Cr. Common shares
1,000
1,000
i
Dr. Inventory
Cr. Cash
Cr. Accounts payable
100,000
73,000
27,000
A-19: Journal entries
j
Dr. Cash
Dr. Accounts receivable
Cr. Sales revenue
Dr. Cost of goods sold
Cr. Inventory
k
Dr. Cash
Cr. Accounts receivable
68,000
30,000
98,000
63,700
63,700
26,000
26,000
A-19: Journal entries
l
Dr. Accounts payable
Cr. Cash
28,000
28,000
m
Dr. Operating expenses
Cr. Cash
18,000
18,000
4. 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
4. 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
5. Adjusting Entries: A-8
6. A conceptual framework
What is a conceptual framework?
A conceptual framework is “a coherent
system of interrelated objectives and
fundamentals that can lead to consistent
standards and that prescribes the nature,
function, and limits of financial accounting
and financial statements.”
- a “constitution” for accounting
6. A conceptual framework (cont’d)
Why a conceptual framework?
i. Enable development of a coherent set of
standards
ii. Better handle new and emerging problems
iii. Increase users’ understanding of and
confidence in financial reporting
iv. Enhance comparability among different
companies’ financial statements
7. Financial statement concepts: Section 1000
I.
II.
III.
IV.
V.
Objectives of financial reporting
Underlying assumptions
Qualitative criteria
Implementation constraints
Elements of financial statements and
recognition
VI. Measurement methods
I. Objectives of financial reporting
To provide information that is:
• Useful for making investment, credit and
other decisions;
• Helpful for assessing the amounts, timing
and risk associated with future cash flows;
• About enterprise resources, claims to those
resources, and changes in them.
II. Underlying assumptions
i. Time-period assumption: meaningful
information can be reported for a time period
less than the entity’s life span
ii. Separate-entity assumption: entity can be
reported independently of its owners
iii. Continuity assumption: entity will continue
in operation for a reasonable future period
II. Underlying assumptions
iv. Proprietary assumption: entity results should
be reported from point of view of its owners
v. Unit-of-measure assumption: entity results
can meaningfully be measured in monetary
terms
vi. Nominal dollar capital maintenance
assumption: profit occurs if revenues are
higher than historical cost of resources used
III. Qualitative criteria
•
•
•
•
•
•
Relevance
Reliability
Understandability
Comparability
Objectivity
Conservatism
RELEVANCE
Information is relevant when it can influence the
decisions of users.
• Predictive value: helps predict future events
(especially cash flows)
• Feedback value: confirms or corrects prior
expectations
• Timeliness: information must be available in
time to make a difference to users
RELIABILITY
Information is reliable if it is:
• In agreement with actual events and
transactions (representational faithfulness);
economic substance over legal form
• Is capable of independent verification
(verifiable)
• Free from bias (neutrality)
Understandability
•
•
•
Information must be understandable to be
helpful to users
Assumes that users have reasonable
understanding of business and economic
activity and of accounting
Assumes that users will study information
with reasonable diligence
Comparability
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.
Objectivity
Not in CICA Handbook, but part of Beechy
• Quantifiability: ability to attach a number to an
event or transaction
• Verifiability: independent experts would agree
(part of reliability)
• Freedom from bias: neutrality (part of
reliability)
• Non-arbitrariness: accounting measurements
are based on observable values
Criteria used by the FASB to make decisions
Conceptual Framework, augmented by Jonas and Blanchet
(Accounting Horizons, September 2000)
Decision usefulness
Clarity
Comparability (Consistency)
Relevance
Reliability

Timeliness
Neutrality
Feedback value
Verifiability
Predictive value
Disaggregated
Earnings
Persistence
Representational
Measurement
faithfulness
uncertainty
Information
Completeness
Conservatism
When two or more accounting methods are
equally acceptable, choose the one that has least
favourable effect on income and net assets (does
not mean deliberate misstatement).
Conservatism is controversial as it seems to
contradict the neutrality quality. Proponents of
conservatism say that it is good to be prudent,
but opponents disagree. Preliminary
recommendations from a FASB/IASB
conceptual framework task group include
dropping Conservatism.
IV. Implementation Constraints
Cost/benefit trade-off
The cost of an accounting measurement or
disclosure should not exceed the benefit of such
measurement/disclosure to the user (e. g.,
differential reporting).
Materiality
The principle is that it can be desirable to deviate
from the preferred accounting treatment if the
amounts in question are relatively insignificant,
i. e., if deviating from the preferred treatment in
favour of an easier treatment would not affect a
decision-maker.
For example, a $5 stapler, with five-year useful
life, is charged as an expense of the period rather
than amortized over its five-year useful life.
V. 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)
• Revenues: increases in economic resources
resulting from ordinary activities of entity
• Expenses: decreases in economic resources
resulting from ordinary revenue-generating
activities of entity
• Gains: increases in net assets from peripheral
or incidental transactions; not revenues
• Losses: decreases in net assets from peripheral
or incidental transactions; not expenses
VI. 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
Measurement methods
• Historical cost: Transactions/events recorded
at amount of cash or equivalent received or
given up at the time the event took place
• Revenue recognition: Revenue recognized
when (1) performance achieved (seller has
performed all significant acts required and risks
and reward of ownership are transferred to
buyer) and (2) proceeds are measurable and
collectibility assured
Measurement methods
Matching: When to recognize expenses (when
does a cost become an expense?)
– If there is a clear cause-and-effect link to
revenue, expense is recorded in the same period
as the revenue
– If there is no clear link, then either allocate cost
to periods in which benefit is received (e. g.,
long-lived assets); or expense immediately if no
future benefit is foreseeable
Measurement methods
• Full disclosure: Any information that might
be relevant to an investor or creditor should be
disclosed, either in the body of the financial
statements or in the notes attached thereto.
This entails a trade-off between:
– Sufficient detail so that all relevant information is
presented; and
– Sufficient condensation so that the information is
understandable
Examples: A2-13, A2-22
A2-22
Comparability
Conservatism
Continuity
Cost/benefit effectiveness
Full disclosure
Historical cost
Matching
Nominal dollar capital
maintenance
Proprietary
Relevance
Reliability
Revenue recognition
Separate entity
Time period
Unit of measure