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Teal Mc Ateer

Investing and Financing Decision and the Balance Sheet Learning Objectives 1. Describe the conceptual framework of accounting. 2. Identify the qualities that make accounting information useful. 3. Identify the elements of financial statements. 4. Understand recognition and measurement criteria. 5. Describe and define the balance sheet and its major elements. 6. Explain the asset Recognition Criteria. 7. Understand alternative methods of measuring the value of assets. 8. Understand the Disclosure rules of assets in the balance sheet. 9. Explain the liabilities Recognition Criteria. 10. Understand alternative methods of measuring the value of liabilities. 11. Understand the Disclosure rules of liabilities in the balance sheet. 12. Explain the Owners’ Equity Recognition Criteria. 13. Identify and calculate ratios for analyzing a company’s profitability. 14. Identify and calculate ratios for analyzing a company’s liquidity and solvency. Conceptual Framework of Accounting and Qualitative Characteristics 1 The conceptual framework of accounting is a set of objectives, principles, and guidelines that help CICA develop GAAP. The objective of a conceptual framework is to facilitate the consistent and logical formulation of standards and provide a basis for the use of judgment in resolving 2 accounting issues. The conceptual framework is organized in a hierarchal order at three levels. The highest level of the conceptual framework is the objective of financial reporting. The objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to existi ng and potential investors, lenders and other creditors in making decisions about providing resources to the entity. Those decisions involve buying, selling or holding equity and de bt instruments, and providing or settling loans and other forms of credit. Users of financial reports need to be able to use financial information to help them predict future cash flows related to investing and financing. At an operational level, financial reporting should provide information that is useful to investors and creditors in assessing the amount, timing, and uncertainty of expected future cash flows of the business. The second level of the conceptual framework consists of two elements: Qualitative Characteristics of Accounting Information and Elements of Financial Statements. Qualitative Characteristics of Accounting Information These are the characteristics of accounting information that make them useful for the objective of financial reporting. Fundamental qualitative characteristics The fundamental qualitative characteristics are relevance and faithful representation. Relevance Relevant financial information is capable of making a difference in the decisions made by users. Financialinformationiscapableof making a difference in decisions if it has predictive value, confirmatory value or both. Financial information haspredictive value if it can be used as an input to processes employed by users to predict future outcomes. Financial information need not be a prediction or forecast to have predictive value. Financial information with predictive value is employed by users in making their own predictions. Financial information has confirmatory value if it provides feedback about (confirms or changes) previous evaluations. Faithful representation To be a perfectly faithful representation, a depiction would have three characteristics. It would be complete, neutral and free from error. Of course, perfection is seldom, if ever, achievable. A complete depiction includes all information necessary for a user to understand the phenomenon being depicted, including all necessary descriptions and explanations. Aneutral depiction is without bias in the se lection or presentation of financial information. A neutral depiction is not slanted, weighted, emphasized, de-emphasized or otherwise manipulated to increase the probability that financial information will be received favorably or unfavorably by users.Neutral information does not mean information with no purpose or no influence on behavior. On the contrary, relevant financial information is, by definition, capable of making a difference in users' decisions. Free from error means there are no errors or omissions inthe description of the phenomenon, and the process used to produce the reported information has been selected and applied with no errors in the process. In this context, free from error does not mean perfectly accurate in all respects. Enhancing qualitative characteristics Comparability, verifiability, timeliness and understandability are qualitative characteristics that enhance the usefulness of information that is relevant and faithfully represented. The enhancing qualitative characteristics may also help determine which of two ways should be used to depict a phenomenon if both are considered equally relevant and faithfully represented. Comparability Comparability is the qualitative characteristic that enables users to identify and understand similarities in, and differences among, items. Unlike the other qualitative characteristics, comparability does not relate to a single item. A comparison requires at least two items. Consistency, although related to comparability, is not the same. Consistency refers to the use of the same methods for the same items, either from period to period within a reporting entity or in a single period across entities. Comparability is the goal; consistency helps to achieve that goal. Verifiability Verifiability helps assure users that information faithfully represents the economic phenomena it purports to represent. Verifiability means that different knowledgeable and independent observers could reach consensus, although not necessarily complete agreement, that a particular depiction is a faithful representation. Quantified information need not be a single point estimate to be verifiable. A range of possible amounts and the related probabilities can also be verified. Timeliness Timeliness means having information available todecision-makers in time to be capable of influencing their decisions. Generally, the older the information is the less useful it is. However, some information may continue to be timely long after the end of a reporting period because, for example, some users may need to identify and assess trends. Understandability Classifying, characterizing and presenting information clearly and concisely make it understandable. Some phenomena are inherently complex and cannot be made easy to understand. Excluding information about those phenomena from financial reports might make the information in those financial reportseasier to understand. However, those reports would be incomplete and therefore potentially misleading. Financial reports are prepared for users who have a reasonable knowledge of business and economic activities and who review and analyze the information diligently. At times, even well-informed and diligent users may need to seek the aid of an adviser to understand information about complex economic phenomena. 1 2 Most of the discussion in this chapter is from Section 1000 of the CICA Handbook. CICA Handbook, Section 1000.12 (This citation means that I am quoting from paragraph 12 of section 1000 of the CICA Handbook). 3 ibid 5 E LEMENTS OF FINANCIAL S TATEMENTS • Assets: economic resources controlled by an entity as a result of past transactions or events and from which future economic benefits may be obtained. • Liabilities: are 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. • Shareholders’ Equity: the ownership interest in the assets of a profit-oriented enterprise after deducting its liabilities. While equity of a profit-oriented enterprise in total is a residual, it includes specific categories of items. Alternatively, equity can be described as financing provided by owners and operations • 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 transactions • Losses: decreases in assets or increases in liabilities from peripheral transactions Notice that although both revenues and gains are increases in assets or reductions in liabilities, they differ in the source of these changes. Revenues result from ongoing operations, and gains resul t from incidental operation. That distinction is important in light of the objective of financial reporting. The same goes for the distinction between expenses and losses. 5 These definitions are from Section 1000, Paragraphs 24-35 of the CICA Handbook. These elements will be discussed in greater details below. M EASUREMENT AND R ECOGNITION C RITERIA The third, and the lowest, level of the conceptual framework is the measurement and recognition criteria. It is broken down into Assumptions, Principles, and Constraints. Assumptions 1. Separate - entity assumption: "business" transactions are separate from “owner” transactions. 2. Unit-of-measure assumption: accounting information will be measdred an reported in the national monetary unit of that company. 3. Continuity (going-concern) assumption: a business is expected to continue operations in the foreseeable future without forced liquidation. 4. Time period assumption: the life of the business is a broken down into artificial time periods (e.g., monthly, quarterly, and annual) for which financial reports are prepared. Principles 1 Historical cost principle: amounts shown on the Statement of Financial Position represent the cash-equivalent cost at the date of acquisition. 2 Full disclosure: all information deemed important for users of financial reports should be disclosed. 3 Revenue recognition: revenues are recognized when the earnings process is complete is nearly complete, an exchange has taken place, and collection is reasonably assured. 4 Matching: expenses are recorded when incurred in earning revenues. Constraints 1 Cost versus benefit: the benefit of providing financial information should outweigh the cost of producing this information. 2 Materiality: minor items that would not influence the decisions of financial statements users are to be treated in the easiest and most convenient manner. Statement of Financial Position The balance sheet is a snapshot of the financial position (co ndition, health) of a business entity at a particular point in time. It describes what th e entity owns, to whom it has obligations, and what is left over to the owners after satisfying the obligations to creditors. When preparing financial statements, accoun tants must deal with the following three issues: Recognition, Measurement, and Disclosure. 1. Recognition is related to the question whether a financial statement element should be recognized in the financial statement, and if so, which statement. 2. Measurement follows recognition. Accountants must decide on a valuation for the financial statement element in question. 3. Disclosure follows measurement, where the accountant must decide on which section of the financial report to place the financial statement element. A SSETS A SSET RECOGNITION C RITERIA : A firm will recognize a resource as an asset if all the following criteria are satisfied: (1) The asset has the potential for providing the firm with future benefits, (2) The firm has acquired the rights to its use in theANDture, (3) The firm can measure or quantify the future benefits with a reasonable degree of precision. Example 1 Miller Corporation sold merchandise and receiveda note from the customer who agreed to pay $2,000 within four months . This note receivable will recognized an asset of Mille r Corporation because Miller has a right to receive a definite amount of cash in the futurf as a result o the previous sale of merchandise. Example 2 Miller Corporation acquired manufacturing equipment costing $40,000 and agreed to pay the seller over three years. After the final payment, but not until then, legal title to the equipment will transfer to Miller Corporation. Even though Miller Corporation will not possess legal title for three years, the equipment is Miller’s asset because Miller has the rights and responsibilities of ownership and can maintaithose rights as long as it makes payments on schedule. Example 3 Miller Corporation has developed agood reputation with its employees, customers, and citizens of the community. Management expects this good reputation to provide benefits to the firm in its future business activities. A good reputation, however, is generally not an accounting asset. Although Miller Corporation has made various expenditures in the past to develop the reputation, the future benefits are too difficult toquantify with a sufficient degree of precision to allow Miller to recognize an asset. Example 4 Miller Corporation plans to acquire a fleet of newtrucks next year to replace those that are wearing out. These new trucks are not as sets now because Miller Corporation has made no exchange with a supplier and, therefore, has not established a right to the future use of the trucks. 1.2 ASSETV ALUATION M ETHODS (MEASUREMENT ): Accounting must assign a monetary amount to each asset in the Statement of Financial Position. There are four approaches (methods) of computing this amount. A CQUISITION (HISTORICAL ) COST ▯ The acquisition (historical) cost of an asset includes all costs incurred in order to acquire the asset and make it ready for use. ▯ The acquisition cost is typically supported by verifiable evidence such as contracts, invoices, and canceled checks related to the acquisition of the asset. ▯ We can safely assume that that the firm expects to receive from the acquired asset future benefits at least as large as the acquisition cost. Thus, historical cost sets the lower limit on the value of the asset’s future benefits to the firm at the time of acquisition. C URRENT M ARKET V ALUE Current Replacement Cost (Entry Value) ▯ Current replacement cost represents the amount the company would pay to replace an existing asset with another similar asset that provides the same future benefits. ▯ For assets purchased more frequently, suchas merchandise inventory, the accountant can often calculate current replacement cost by consulting suppliers’ catalogs or pricelists. But fo r assets purchased less frequently—such as land, buildings, and equipment— it is very difficult to measure replacement cost. ▯ With technological improvements and quality changes, it becomes very difficult to find similarasset. ▯ This approach requires subjectivity in identifying assets with equivalent service potential and may open the door for management to manipulate accounting information. Current Net Realizable Value (Exit Value) ▯ The net amount of cash (selling price less selling costs) that a firm would receive currentlyfi it sells each asset separateMeasuring net realizable value entails difficulties similar to those encountered in measuring current replacement cost. ▯ Without well-organized secondhand markets for used equipment, the accountant cannot readily measure net realizable value, particularly for equipment specially designed for a firm’s needs. In this case, the current selling price of the asset (value in exchange) will generally be less than the value of the future benefits to the firm from using the asset (value in use). PRESENT VALUE OF F UTURE C ASH FLOWS ▯ An asset is a resource that provides future benefits in the form of either to generate future net cash receipts or to reduce future cash expenditures. For example, a building that the firm owns reduces future cash outflows for rental payments. ▯ Because cash can earn interest over time, today’s value of a stream of future cash flows, called the present value, is worth less than the sum of the cash amounts that a firm will receive or save over time. ASSETV ALUATION BASESU NDERGAAP Monetary assets: include cash and other assets that are expected to be collected in the future in terms of fixed number of cash such as accounts receivable and notes receivable. ▯ Long-term monetary assets appear on the balance sheet at their net present value. ▯ Short-term Monetary assets (e.g., accounts receivable) appear at the amount of cash the firm expects to collect in the future. Accounting ignores the discounting process on the basis of a lack of materiality. Non-monetary assets, such as merchandise inventory, land, buildings, and equipment, generally appear at historical cost, in some cases adjusted downward to reflect the assets’ services that have been consumed and to recognize some declines in market value. 1.3. ASSET CLASSIFICATION (D ISCLOSURE ): Assets are classified on the balance sheet into four groups: (1) current assets, (2) investments, (3) property, plant and equipment, and (4) intangible assets. C URRENT A SSETS ▯ Current Assets includash and other assets that a firm expects to realize in cash or to sell or consume during the operating cycle or within one year, whichever is longer. ▯ The operating cycle refers to the period of time during which a given firm converts cash into salable goods and services, sells those goods and services to customers, and receives cash from customers in payment for their purchases (i.e., cash-to-cash cycle). ▯ Since the operating cycle for most businesses is less than one year, conventional accounting practice uses one year as the dividing line between current assets and non-curren t assets. The construction industry is an example where the operating cycle is greater than one year, since most construction contracts take more than one year to complete. In that case, one year is not used as the dividing line between current assets and non-current assets. ▯ Examples of current assets include cash, ma rketable securities held for the short term, accounts and notes receivable, inventories (such merchandise, supplies, raw materials, work in process, and finished goods), and prepaid operating costs(such as prepaid insurance ind prepad rent). INVESTMENTS ▯ Investments include long-term (non-current) investments in securities of other firms. PROPERTY , PLANT ,AND EQUIPMENT (FIXED A SSETS) ▯ Fixed assets include tangible, long-lived assets acquired to be used in a firm’s operations over a period of years and generally not acquired for resale. This category includes land, buildings, machinery, automobiles, furniture, fixtures, computers, and other equipment. ▯ The balance sheet shows these items (except land) at acquisition cost reduced by the cumulative (accumulated) depreciation since the firm acquired the assets. INTANGIBLE ASSETS ▯ Intangible Assetinclude assets such items as patents, trademarks, franchises, and goodwill. 2. L IABILITIES 2.1 LIABILITY R ECOGNITION C RITERIA A firm will recognize a liability only if all the following criteria are satisfied: 1 The firm has received certain benefits from an outsider, 2 The firm has promised the provider of these befits to pay back certain benefits in the future, 3 The firm can measure or quantify the future payment with a reasonable degree of precision,AND 4 The due date is known either definitely or approximately. Example 1 Miller Corporation borrowed $4 million by issuing long-term bonds. On December 31 of each yea r it must make annual interest payments of 10 percent of the amount borrowed, and it must repay the $4 million principal in 20 years. This obligati on is a liability because MillerCorporation received the cash and must repay the debt in a definite amount at a definite future time. Example 2 Miller Corporation purchased merchandise inventory and agreed to pay the supplier $8,000 within 30 days. This obligation is a liability because Miller Corporation received the goods and must pay a definite amount at a reasonably definite future time. Example 3 Miller Corporation provides a three-year warranty on its products. The obligation to maintain the products under warranty plans creates a liability. The selling price for its products implicitly includes a charge for future warranty services. As customers pay t
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