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Lecture 4

Lecture 4-6 - WEEK 2 (Sept 16) - COMM 2AA3

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McMaster University
Aadil Merali Juma

COMM 2AA3 Chapter 2: Investing and Financing Decisions and the Statement of Financial Position September 16, 2013 The Conceptual Framework  Framework that informs accounting practice; issue at a business, consult conceptual framework for solution  Objective of Financial Reporting – to provide useful economic information to external users for decision making and for assessing future cash flow o Major users of financial information (shareholders (investors) and creditors) can only get return when businesses generate future cash flows o The objective of financial reporting with regard to future cash flows is to assess their timing, amount and uncertainty o Riskier the cash flows; less valuable they are  Eg/ Future cash flows $50 million; but risk/uncertainty is that this cash high (probability 1/1 million (like the lottery)) – high uncertainty, cannot plan future on this future cash flow o Eg/ Next paycheck  Timing – Friday  Uncertainty – low; can depend on receiving it o Eg/ Proceeds from the sale of house  Timing – 90% of houses sell within the first 3 months of listing  Amount – a 10% range around the asking price  Uncertainty – not so low  Qualitative Characteristics – what are the qualities that accounting must have to be useful  Elements of Statements – what accountants measure; what information it provides  Recognition and Measurement Criteria – o Eg/ Business buys a car; Recognize as an asset? (Recognition; yes); How much should they put in the books? (Measure; however much they paid) Qualitative Characteristics of Accounting Information 1. Fundamental Qualitative Characteristics a. Relevance – in order to be relevant, it must be:  Predictive value  Eg/ Past sales can be predictive of future sales – thus it is relevant  Confirmatory value – allows you to verify past predictions; reexamine predictions b. Faithful Representation  Complete  Neutral – free from bias; useful to all stakeholders, not some in particular  Free from Error  iClicker – which of the following statements is not an objective of financial reporting? a. Provide information that is useful to users in making resource allocation decisions b. Provide information about an entity’s economic resources, obligations and equity/net assets c. Provide information on the liquidation value of an enterprise d. Provide information about changes in an entity’s economic resources, obligations and equity/net assets 2. Enhancing Qualitative Characteristics a. Comparability – accomplished by i. Uniformity (everyone using same valuation basis, accounting methods, units of measure) 1 COMM 2AA3 ii. Provide sufficient disclosure – different valuation basis and accounting methods; but people can gain sufficient information b. Verifiability – verified by objective evidence c. Timeliness d. Understandability – use language that investors and potential users can understand; someone with reasonable business background and some knowledge of accounting should be able to understand Elements of Financial Statements  Assets – economic resources controlled by an entity as a result of past transactions or events and from which future economic benefits may be obtained o What you own as a result of past transaction that is of value to you – must benefit you in the future  Liabilities – obligations of an entity arising from past transactions or events, the settlement of which may result in the transfer or use of assets, provision of services or other yielding of economic benefits in the future o Business not liable for future transactions – only past transactions o Has to cost you something; to settle a liability, you have to give up something  Shareholders’ Equity – the ownership interest in the assets of a profit-oriented enterprise after deducting its liabilities o Whatever is leftover from your assets when you pay off your liabilities  Revenues – increases in assets or settlements of liabilities from ongoing operations  Expenses – decreases in assets or increases in liabilities from ongoing operations  Gains – increases in assets or settlements of liabilities from peripheral transaction  Losses – decreases in assets or increases in liabilities from peripheral transaction  Difference between Revenues and Gains o Revenue – what you generate from your business on an ongoing basis; predictive value o Gain – not from ongoing operations; not a stream of income you can count on, not reliable stream of cash flows; no predictive value  Eg/ Someone damages the business; sue and file for insurance, cover costs and you end up making money  Gains; not revenue because it is not ongoing operations  Difference between Expenses and Losses o Expense – has predictive value o Losses  Eg/ Flood in business and not insured – have to pay for repairs  Loss; not going to happen again, not from ongoing operations, but decrease in asset/increase in liability Recognition and Measurement Criteria  Assumptions o Unit of measurement – must be measured in dollars (currency); cannot recognize an item that is not measured in currency o Separate entity – businesses and owners are separate for accounting purposes o Periodicity – business operates indefinitely, but break down business into time periods o Going concern  Principles o Historical cost – measurement principle; when reporting assets, recognize them at original acquisition cost (what you paid for it)  Eg/ Paid $200, even though market value is $1000, report as $200 o Full disclosure – providing sufficient information; investors can do calculations and make decisions on own  Eg/ If you are sued, adverse effects of products etc o Revenue recognition o Matching – recognize expenses when you generate revenue  Constraints o Cost-benefits – costly to produce information; benefit must outweigh cost o Materiality – differentiate between assets and expense; some things don’t make a difference (eg/ remote clicker vs. computer)  Asset = long-term; help to obtain revenue in year or more  Expense = short-term; use now  Eg/ Office Supplies  Can be abused and manipulated; especially when thresholds are close to being met  iClicker – The economic equity assumption states that economic events a) Of different entities can be combined if all the entities are corporations b) Must be reported o the office of the Superintendent of Financial Institutions c) Of a proprietorship cannot be distinguished from personal economic events of its owners 2 COMM 2AA3 d) Of every entity can be separately identified and accounted for Statement of Financial Position  Assets o Recognition (Identification)  Future benefits  R&D (research and development) expensing – exception; not recognized as an asset because it has high degree of uncertainty about these benefits  Err on the side of understating assets, overstating liabilities  Rights to future benefits -  Human capital – exception; company does not own employee; cannot recognize as an asset  Eg/ Star Wars – sold at $4 billion; George Lucas could not recog
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