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Accounting - Chapter 1-4 Notes.docx

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Emad Mohammad

CHAPTER ONE: FINANCIAL STATEMENTS AND BUSINESS DECISIONS The Basic Objective of Accounting  Accounting is about providing useful information for decision making  Objective is to identify and measure the activities of a business entity in order to evaluate its performance and to assess its financial health  Then communicate results to stakeholders through set of accounting reports  Reports help stakeholders make rational economic decisions  Have to know the stakeholders and what they need  Two groups of primary users of financial statements: 1) Managers: interpret information in financial statements to make business decisions 2) Investors/creditors: analyze financial statements to determine resource allocation of funds (if they want to invest in company) External Users  Financial accounting: periodic financial statements and related disclosures (for external users)  Managerial accounting: detailed plans and continuous performance reports (for internal users)  External users and internal users need different information  External users do not need to know about employee records but internal users do Owners  There is a legal separation between the entity and the owners  Owners are external; management is internal  Business owners (investors/shareholders) look for two sources of possible gain: 1. Sell ownership interest in the future for more than they paid 2. Dividends: Receive a portion of the company’s earnings in cash  Capital gain: sale price of the stock is greater than the purchase price Creditors  Creditors lend money to company for specific amount of time  Gain profit by charging interest on the money loaned  Give money to the business but are not considered owners  Creditors are guaranteed to be paid back Other Groups  Government (tax purposes, regulations)  Financial analysts: o Work for investment bankers o Evaluate info contained in financial statements and issue forecasts  Customers  Suppliers  Employees and labour unions Communication  Financial statements: o Primary means of communicating financial info to parties outside of business o Summarize financial activities of business  Cannot always communicate to outside parties one-on-one  Companies prepare financial statements at: o End of the month (good because can see changes right away; bad because require estimates and businesses can be successful at different times of the year) o End of the quarter o End of the year Generally Accepted Accounting Principles (GAAP)  GAAP: o Set of accounting standards/principles o Law for accountants o Developed by private sector  Financial statements prepared according to GAAP  In Canada GAAP is developed by Accounting Standards Board (ASB) of the Canadian Institute of Chartered Accountants (CICA)  Conceptual framework: set of objectives, principles, guidelines that help CICA develop GAAP  GAAP was replaced by International Financial Reporting Standards (IFRS) in Canada in 2011 Financial Statements Income Statement  Measures financial success  Financial success is measured by ability to increase financial assets year by year  Financial health is how much wealth has been accumulated  Can be successful but be cash poor  Net Income = Revenues – Expenses  Revenues: o Earnings from sale of goods/services o Recognized when service is performed or goods delivered (ex. in the month the sale was made) o Has nothing to do with cash  Expenses: o Dollar amount of resources used by entity to earn revenues during a period o Salaries expense: expense form using resources from employees o Rent expense: expense from using the property o Interest expense: the expense of using the lender’s money o Income tax expense: expense is not proportionate to goods/services used (wealthier people pay more but use less resources)  Pre-payments: paid before use resource (ex. rent, insurance, tuition)  Post-payments (deferrals): pay after service (ex. utilities, salaries)  Depreciation: the expense of using a long-term asset (car, house, etc.)  Cannot put items that belong on balance sheet on income statement Statement of Changes in Equity  Shows the change in wealth/net worth  Same as the statement of retained earnings  Retained earnings: accumulated earnings since the start of the business less dividends paid out to owners  Ending RE = Beginning RE + Net Income – Dividends  Net Income: increases the account balance  Dividends: decrease the account balance  Dividends are a distribution of income (not used to generate revenue so are not expenses)  Account Receivable (A/R): represent what customers owe the business  Ending A/R = Beginning A/R + Credit Sales – Collections from Customers  A/R increases with credit sales to customers  A/R decreases when customers pay  Write off: happens when an asset becomes worthless Statement of Financial Position  Assets: o Economic resources controlled by entity as result of past transactions from which future economic benefits may be obtained o What the business owns  Liabilities: o Debts/obligations of entity resulting from past transactions o What the business owes  Shareholder’s Equity (Net Worth): o Amount of financing provided by owners of corporation and from earnings o Difference between (assets – liabilities)  E = A – L  Snapshot of the business at a point in time  Assets sorted in order of liquidity: o Cash o Accounts receivable (A/R) o Inventory o Prepaid expense: assets because gives the business the right to a future benefit (ex. pay rent and have the right to use building) o Long-term investments: more than a year o Property, plant, equipment: least liquid cause lasts for a long time o Intangible assets  Liabilities sorted in order of maturity (due date): o Accounts payable (A/P) o Short-term notes payable (N/P): short-term bank loans (less than a year) o Accrued liabilities: expense that are not paid yet (salaries payable, income tax payable, interest payable) o Long-term liabilities  Shareholder’s Equity: o Share capital: amounts invested in business by owners o Retained earnings: past earnings NOT distributed to owners o Accumulation of losses will result in negative equity Statement of Cash Flows  Shows sources and uses of cash during a period  Organized around business activities  Accrual basis: o Revenues do not always equal cash collected o Expenses do not always equal cash paid o Net income is usually not equal to changes in cash  Ending balances of given year are opening balances of new year Notes  Provide supplemental info about financial condition of a company  Three types: o Describe accounting rules applied o Present additional detail about an item on the financial statements o Provide additional info about an item not on the financial statements Business Activities  Investing activities: purchases and sales of assets  Financing activities: related to liabilities and shareholder’s equity  Operating activities: profit-generating activities  Debt financing: getting loan from the bank (have full control but is high risk)  Equity financing: using own money or inviting others to own the business CHAPTER TWO: INVESTING AND FINANCIAL DECISIONS AND THE STATEMENT OF FINANCIAL POSITION The Conceptual Framework  Framework that informs accounting practice  Says what qualities information must possess to make it useful for financial accounting  Objective Financial Reporting: what we report and what makes this useful for financial reporting  Recognition Criteria: should it be recognized as a loss or a gain  Measurement Criteria: by how much The Objective of Financial Reporting  Objective of financial reporting is to provide useful economic information to external users for decisions making and for assessing future cash flows  Two groups: investors and creditors  Borrow cash from someone: they care about whether or not you have access to future cashflows to pay them back  Three things that matter: 1. The amount (how much will be generated in future cashflows) 2. The timing (when is that money coming) 3. Uncertainty (what are the chances of making that cashflow)  Financial reporting provides info to investors and creditors to help them assess timing, amount and uncertainty of future cashflows Qualitative Characteristics of Accounting Information  What qualities accounting information must have in order to be useful for the objective of financial reporting  Fundamental Qualitative Characteristics: o Relevance: information that has predictive value (can be used to make predictions about the future) o Faithful representation: must be complete, neutral and free from error  Enhancing Qualitative Characteristics: o Comparability: accounting information must be comparable across businesses and consistent over time o Verifiability: have objective evidence to verify that accounting information (ex. with a receipt, by looking at comparable assets in marketplace) o Timeliness: information is useful only when it is timely (ex. need to know traffic before getting in a traffic jam so it can be avoided) o Understandability: has to be presented in a way that an intelligent person with some business background can understand it Elements of Financial Statements  Assets: economic resources controlled by an entity as a result of past transactions or events from which future economic benefits may be obtained  Liabilities: o Obligations of an entity arising from past transactions or events o Settlement of liabilities may result in the transfer or use of assets, provision of services or other yielding of economic benefits in the future o Will be paid off with assets or with work o Only liable once service has been performed  Shareholders’ Equity: the ownership interest in the assets of a profit-oriented enterprise after deducting its 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 transactions  Losses: decreases in assets or increases in liabilities from peripheral transactions  Revenues vs. Gains: o Revenues are ongoing (ex. selling products in the store) o Peripheral (ex. someone ruins products in store and insurance pays for it) o Revenues have predictive value; gains do not Recognition and Measurement Criteria  Must recognize as an asset, liability, etc.  Must decide how much goes on either side Assumptions  Unit of Measurement: o Accounting does not account for inflation  Separate Entity o For accounting purposes, business is separate from it’s owners o Must decide if assets belong to owners or business o Ex. sole proprietorship: owner and business are the same entity but for accounting purposes they are separated  Periodicity: o Breaking the business life into artificial time periods o Ex. four quarters in a year  Going Concern: o Assume that businesses are eternal o Cannot compare performance over 12 months with performance over 17 months Principles  Historical Cost: o Assets are measured at their original acquisition cost o Do not account for change in price because of comparability and verifiability (do not have objective evidence for market values)  Full Disclosure: o Must provide sufficient information that is useful o Ex. must disclose threats of any type – being sued, losing big customer, etc. o Investors want to know breakdown of assets  Revenue Recognition: o Principle that says when to recognize revenues o When in doubt do not recognize gains and assets until their realization is certain o Accountants are conservative  Matching: o Principle that says when to recognize losses Constraints  Cost-Benefit: o See if something is worth it o Do not need to provide all information to investors o Some info would cost a lot to produce and is not relevant  Materiality: o Immaterial items can become material at the margin o Immaterial: does not make a difference to the bottom line whether it is classified as an expense or as an asset o Does not matter if recognize immaterial item as an asset or as an expense o Classify as asset if expenditure provides future benefits o Classify as expense otherwise Statement of Financial Position Assets: Recognition  Future benefits: o Anything with future benefits can potentially be an asset o R&D: has future benefits in life but not in accounting (cannot be realized because future benefits is highly uncertain)  Rights to future benefits: o Just because something has future benefits does not make it an asset o Must have the rights to the benefit o Cannot include human capital because do not control employees  Quantifiable: o The ability to measure the asset o Sometimes have an asset that cannot be measured (ex. reputation) o Intangible assets: cannot be measured (not verifiable because cannot be measured in dollars) Assets: Measurement  Historical Cost: o Acquisition cost plus all other costs to make the asset ready for use o Objective evidence (verifiable): wait until the asset is sold or the appreciation in the asset value is realized through higher future revenues o Conservatism (prudence): when in doubt, defer the recognition of assets/gains and recognize liabilities immediately o Better to be wrong on the side of losses  Market Value: o Replacement cost (entry value): cost to replace an existing asset with similar asset that has same future benefits o Net realizable value (exit value): net amount of cash that firm would receive currently if sold the asset (need an appraisal) o Hard to find value if specially made for one customer because no one else will want it  Present Value of Future Cash Flows: o Monetary assets: future benefits are realized in fixed amounts of cash (ex. accounts receivable) o Non-monetary assets: measured at historical cost (ex. do not know exactly how much inventory will be sold for) Assets: Disclosure  Sorted in order of liquidity  Current assets: o Assets that will be used or turned into cash within one year o Cash, short-term investment, A/R, inventory, prepaid expenses o Short-term investment: happens when a firm has excess cash; businesses prefer to invest cash because there is no return otherwise  Non-current assets: o Turned into cash over a period longer than the next year o Long-term investments: difference is what management intends to do with it (intend to keep it in bank for a long time not just sell it when they need cash) o Property, Plant and Equipment o Intangible Assets: intellectual property rights acquired by business (ex. copyright, trademark)  Depreciation: the expense of using a long-term asset  Accumulated depreciation: the sum of annual depreciation expenses since the acquisition of the asset Liabilities: Recognition  Past transactions  Promise of payment: o Promise can be implied o Have to pay for products if you sign for them  Quantifiable: o Warrantee liability has three uncertainties: (1) if it will happen, (2) when will it happen, (3) what will it cost o Do not know if product will break o Do not know how much damage will cost  Known date: o Does not have to be stated – can be implied (like promise to pay) o Need to know date t
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