1st Midterm Review.docx

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Western University
Management and Organizational Studies
Management and Organizational Studies 1023A/B
Maria Ferraro

Page 1-28 Users and Uses of Accounting Accounting – the information system that identifies and records the economic events of an organization and then communicates them to a wide variety of interested users Users of accounting information:  Internal users plan, organize, and run companies – they work for the company (includes finance directors, marketing managers, human resource personnel, production supervisors, and company officers) o Accounting provides a variety of internal reports o Use accounting information to buy, hold, or share ownership interests  External users (investors, lenders, and other creditors) use accounting to see the risk of lending money, and decide whether or not to grant credit o Taxing authorities (ex. Canada Revenue Agency) want to know whether the company respects the tax laws o Regulatory agencies (ex. Provincial securities commissions that regulate companies that sell shares to the public) want to know whether the company is operating within prescribed rules Ethics in accounting is of the upmost importance to accountants and decision makers who rely on the financial information they produce Forms of Business Organization Three common forms of business organization: proprietorships, partnerships, and corporations Reporting entity concept – requires that the economic activity that can be identified with a particular company be kept separate and distinct from the activities of the owner(s) and of all other economic entities – applies to all three business organizations Proprietorships: A proprietorship is a business owned by one person  The owner receives any profits, suffers, and losses and is personally liable for all debts of the business (unlimited liability)  Taxed on the owner’s personal income tax return Partnerships A partnership is a business owned by more than one person  Unlimited liability means that any of the partners can be forced to give up his or her personal assets in order to repay the partnership  Taxed on each partner’s personal income tax return Corporations Corporation – a business organized as a separate legal entity by shareholders  Its life is indefinite – it continues on regardless of who owns it shares  Most shareholders enjoy limited liability since they only risk losing the amount they have invested in the company’s shares  Pay income tax as separate legal entities on any corporate profits  Public corporations distribute their financial statements to investors, lenders, and other creditors, other interested parties, and the general public  Consolidated financial statements - the financial results not only include the company but all the companies it owns and controls (financial statements also produced for each individual company as well) Private corporations – issue shares, but they do not make them available to the general public nor are they traded on public stock shares Generally accepted accounting principles (GAAP) include broad policies and practices as well as rules and procedures that have substantive authoritative support and agreement about how to report economic events  Publicly traded corporations must use International Financial Reporting Standards (IFRS) – a set of global accounting standards developed by the International Accounting Standards Board  Private corporations have a choice between using IFRS or Accounting Standards for Private Enterprises (ASPE) – developed by the Canadian Accounting Standards Board  Proprietorships and partnerships do not have to choose between IFRS and ASPE as their statements are generally prepared only for internal use of the owners Business Activities All business are involved in three types of activity: financing, investing, and operating Financing Activities Borrowing money from lenders by issuing debt, or using cash to repay debt. Cash can also be raised from shareholders by issuing shares, or paid to shareholders by repurchasing shares or distributing dividends  Liabilities – amounts owed to lenders and creditors in the form of debt and other obligations o Bank indebtedness – a liability resulted from when a company uses its operating line of credit to cover shortfalls and overdraws its bank account  Loan payable  Long-term debt (can include mortgages payable, bonds payable, finance lease obligations, etc.) securities borrowed for longer periods of time  Common shares – the amount paid by investors for shares of ownership in a company  Lenders loan money to a company and specify a repayment schedule – interest normally added to amount due or overdue  Creditors have a legal right to be paid at the agreed time – in the event of nonpayment, you may force the company to sell assets to pay its debts  Shareholders – if you buy a company’s shares instead of loaning it money, you have no legal right to expect any payments until all of its lenders and creditors are paid o Dividends – payments to shareholders Investing Activities Purchasing and disposing of long-lived assets such as property, plant, and equipment and purchasing and selling long-term investments  Assets – resources that a company owns or controls – every asset is capable of providing future economic benefits that can be short or long lived o Property, plan, and equipment o Cash  Investments – if a company has excess cash that it does not need for a while, it might choose to invest it in debt securities (e.g., bonds) or equity (e.g., shares) of other corporations or organizations Operating Activities Result from day-to-day operations and include revenues and expenses and related accounts such as receivable, supplies, inventory, and payables  Revenues – increases in economic benefit (normally an increase in an asset but could also be a decrease in a liability) that results from the sale of a product or service o Sources of revenue: sales revenue (sales), service revenue, interest revenue, and rent revenue  Account receivable – the right to receive money in the future  Inventory – an asset once it is ready for future sale to customers  Expenses – the cost of assets that are consumed or services that are used in the process of generating revenues o Cost of goods sold – the cost of the inventory sold  Accounts payable – the obligations to pay for goods  Interest payable – the outstanding amounts owed to various lenders  Dividends payable – to shareholders  Salaries payable – to employees  Property tax payable – to the provincial government  Sales tax payable – to the provincial and federal government  Income tax payable – payable to the government Communicating with Users Arrange a company’s assets, liabilities, shareholder’s equity, revenues, and expenses in four different financial statements that are the backbone of financial reporting (must be presented in this order): 1. Income statement – reports revenues and expenses to show how successfully a company performed during a period of time 2. Statement of changes in equity – shows the changes in each component of shareholder’s equity, as well as total equity, during a period of time  Private corporations prepare a statement of retained earnings instead of a statement of changes in equity 3. Statement of financial position – a statement of financial position presents a picture of what a company owns (its assets), what it owes (its liabilities), and its net worth (its shareholders’ equity) at a specific point in time 4. Statement of cash flows – shows where a company obtained cash during a period of time and how that cash was used  Additional information is reported in notes to the financial statements.  Financial statements are produced annually, quarterly, or monthly depending on the nature and purpose of the company. Publicly traded companies must make their financial statements available to shareholders both quarterly and annually. An accounting time period that is one year is a fiscal year. Income Statement  Lists revenues first and then expenses  Amounts received from issuing shares are not revenues, and amounts paid out as dividends are not expenses Statement of Changes in Equity  Shareholders’ equity – the ownership interest in a company – includes share capital and retained earnings o Share capital – represents amounts contributed by the shareholders in exchange for shares of ownership o Retained earnings – represent the cumulative profit that has been retained in the corporation – it is the profit that has not been paid out to shareholders that has accumulated since the company’s date of incorporation  Deficit – if retained earning are negative – more losses than profits  Shows the amounts and causes of changes in retained earnings  Allows users to monitor a company’s dividend payment practices Statement of Financial Position (Balance Sheet)  Claims to assets are subdivided into two categories: claims of lenders and other creditors (liabilities) and claims of shareholders  Accounting equation: assets = liabilities + shareholders’ equity  Lenders and creditors analyze a company’s statement of financial position to determine the likelihood that they will be paid  Managers use the statement of financial position to determine whether inventory is adequate to support future sales and whether cash on hand is sufficient for immediate cash needs Statement of Cash Flows  Reports the effects on cash of a company’s operating activities, investing activities, and financing activities during the period of time  Operating activities are normally presented first in the statement of cash flows, followed by investing or financing activities  The statement shows the net increase or decrease in cash during the period, and the cash amount at the end of the period  Positive number indicate cash inflows; parentheses indicate cash outflows Relationships between the Statements  The statement of changes in equity depends partly on the results of the income statement  The statement of financial position and statement of changes in equity are interrelated because the ending balances of each component of shareholder’s equity  Statement of cash flows shows how the cash account changed during the period by stating the amount of cash at the beginning of the period, the sources and uses of cash during the period, and the amount of cash at the end of the period Elements of Annual Report Annual report – a document that includes useful nonfinancial information about the company, as well as financial information  Nonfinancial may include the company’s mission, goals, and objectives, products, and people  Financial information normally includes a management discussion and analysis (MD&A), a statement of management responsibility for the financial statements, an auditor’s report, the financial statement from earlier (comparative statements – must last 2 years), notes to the financial statements, and a historical summary of key financial ratios and indicators  Publicly traded companies must produce an annual report each year Page 28-53 Conceptual Framework Conceptual Framework – a coherent system of interrelated objectives and fundamentals that can lead to consistent standards that prescribes the nature, function, and limits of financial accounting and financial statements Rationale for Conceptual Framework  Having a good conceptual framework as starting point, standard setters are then able to issue additional useful and consistent standards over time  A framework should increase financial statement users’ understanding of and confidence in financial reporting and it should enhance the comparability of different companies’ financial statements  By having a framework it is possible to solve new and emerging practical problems more quickly Development of the Conceptual Framework  1976 – FASB made “Conceptual Framework for Financial Accounting and Reporting: Elements of Financial Statements and Their Measurement” o Based on this, six Statements of Financial Accounting Concepts were published and a seventh added in 2000  AcSB and IASB followed and issued their own frameworks  First level: goals and purposes – the conceptual framework’s building blocks  Second level: qualitative characteristics – make accounting information useful and the elements of financial statements (assets, liabilities, equity, revenues, expenses, gains and losses)  Third level: foundational principles – establishing and applying accounting standards Information Asymmetry Revisited  Information in the capital marketplace is not always evenly accessible to investors and creditors, a conceptual framework based on sound principles may help address information asymmetry concerns Objective of Financial Reporting Objective of financial reporting – communicate information that is useful to investors, creditors, and other users  Financial information is useful in making decision about how to allocate resources (including assessing management stewardship)  Companies should provide information about their financial position, changes in financial position, and performance and should also show how efficiently and effectively management and the board of directors have discharged their responsibilities to use the entity’s resources  Companies provide this information through general-purpose financial statements – basic financial statements that give information that meets the needs of key users – intended to provide the most useful information possible in a manner whereby benefits exceed costs to the different kinds of users Qualitative Characteristics of Useful Information  Decision usefulness – determining which alternative gives the most useful information for decision-making purposes in choosing an acceptable accounting method, amount and types of information to be disclose, and the format in which information should be presented Fundamental Qualitative Characteristics  Relevance – making a difference in a decision o Has predictive value – helps make predictions about the financial outcome of past, present, and future events o Feedback/confirmatory value – confirm or correct their previous expectations o Materiality – how important a piece of information is – if it would make a difference to the decision-maker – all material information should be included o Both quantitative and qualitative factors must be considered in determining whether an item is material  Representational faithfulness – information that is complete, neutral, and free from material error o Reflects the underlying economic substance of an event or transaction o Economic reality – transparency o Completeness – the fact that the statements should include all information necessary to portray the underlying events and transactions o Neutrality – information cannot be selected to favour one set of interested parties over another o Management best estimate – assumptions are unbiased, and involve management making diligent efforts to obtain and use all information that it has access to in order to come up with the best quality information o Freedom from material error – the information must be reliable  The task of converting economic events to numbers in a set of financial statements is complex so management must make estimates and use judgment in determining how to portray events and transactions Enhancing Qualitative Characteristics Include comparability, verifiability, timeliness, and understandability  Comparability – information that has been measure and reported in a similar way (both company to company and year to year) o Enables users to identify the real similarities and differences in economic phenomena  FASB allows the use of last-in, first-out (LIFO) accounting and IFRS does not – companies using LIFO will have net income lower than companies that do not o Resource allocation decisions involve evaluations of alternatives – easier to make a valid evaluation is comparable info is available  Verifiability – when knowledgeable, independent users achieve similar results or reach consensus regarding the accounting for a particular transaction  Timeliness – information should be available to decision-makers before it loses its ability to influence their decisions  Understandability – users need to have reasonable knowledge of business and financial accounting matters in order to understand the information in financial statements. Also must be of sufficient quality and clarity that it allows reasonable informed users to see its significance  Trade-offs – not always possible for financial information to have all the enhancing qualities of useful information so trade-offs may exist o Ex. In the interest of providing more relevant information, a new standard may be applied prospectively. In this case, comparability is temporarily sacrificed for better information in the future  Cost Versus Benefits – the costs of providing the information must be weighed against the benefits that can be had from using the information – benefits must outweigh the costs Elements of Financial Statements Basic Elements:  Assets – have 3 essential characteristics: o There is some economic benefit to the entity o The entity has control over that benefit o The benefits result from a past transaction or event  Liabilities o Have 3 essential characteristics:  They represent a present duty or responsibility  The duty or responsibility obligates the entity, leaving it little or no discretion to avoid it  The transaction or event results from a past transaction or event o Has negative economic value and requires that the entity give up economic resources to settle the obligation. o Constructive obligations – obligations that arise through past or present practice that signals that the company acknowledges a potential economic burden (ex. If a company stands behind its products) o Equitable obligations – arise due to moral or ethical considerations  Equity – a residual interest in an entity that remains after deducting its liabilities from its assets (net worth)  Revenues – increases in economic resources, either by inflows or other enhancements of an entity’s assets or by settlement of its liabilities, which result from an entity’s ordinary activities  Expenses – decreases in economic resource, either by outflows or reductions of assets or by the incurrence of liabilities that result from an entity’s ordinary revenue-generating activities  Gains/Losses o Gains – increase in equity (net assets) from an entity’s peripheral or incidental transactions and from all other transactions and other events and circumstances affecting the entity during a period, except those that result from revenues or investment by owners o Losses – decreases in equity from an entity’s peripheral or incidental transactions and from all other transactions and other events and circumstances affecting the entity during a period, except those that result from expenses or distributions to owners o Comprehensive income – a relatively new income concept – includes net income and other comprehensive income (all other changes in equity except for owners’ investments and distributions) Foundational Principles Conceptual framework’s third level consists of foundational principles – implement the basic objectives of the first level – help explain which, when, and how financial elements and events should be recognized, measure, and presented/disclosed by the accounting system. Act as guidelines for developing rational responses to controversial financial reporting issues. It is the substance of the concept and how it provides a solid foundation for accounting standard setting that is important. Recognition/Derecognition  Recognition – deals with the act of including something on the entity’s statement of financial position or income statement o Macro level: decisions need to be made whether to consolidate investments in other entities o Micro level: decisions needs to made whether and when to include assets, liabilities, revenues, expenses, gains an losses in the financial statement o Once recognized, decisions need to be made when to derecognize these elements o Elements of financial statement have been recognized when:  They meet the definition of an element  They are probable  They are reliably measurable  Derecognition – the act of taking something off the statement of financial position or income statement Economic Entity: Assumption and Control  Economic entity assumption – allows us to identify an economic activity with a particular unit of accountability  IASB new standard dealing with consolidation that defines control: o Power over the investee o Exposure or rights to variable returns from its involvement with the investee o The ability to use its power over the investee to affect the amount of investors’ returns  Under ASPE, control is define as the continuing power to determine strategic decisions without the cooperation of others: o Whether the entity in question can be unilaterally dissolved by the company o Whether others have more than a 10% ownership interest  Special purpose entities (SPEs) – variable interest entities or structured entities (many times separate legal entities set up for specific reasons) Revenue Recognition and Realization Principles Revenue recognition principle – revenue recognized if following are met:  Risks and rewards have passed and/or the earnings process is substantially complete (significant acts have been performed and there is no continuing involvement)  The revenue is measurable  The revenue is collectable (realized or realizable) o Revenues are realized when products, merchandise, or other assets are exchanged for cash or claims to cash o Revenues are realizable if the assets received or held can be readily converted into cash or claims to cash o Balance sheet approach – recognizes a transaction has occurred when the entity enters into a contract o Collectable revenues are recognized when performance obligations are settled Matching Principle Matching – dictates that effort (expenditures) be matched with accomplishment (revenues) whenever reasonable and can be done – cause and effect relationship  Operating expenditures classified into 2 groups: o Product costs – (material, labour, and overhead) attach to the product and are carried into future periods as inventory if not sold since they are seen to be part of the inventory production process and because inventory is an asset o Period costs – (officers’ salaries and other administrative expenses) recognized immediately – seen as ongoing expense of running the business instead of inventory costs Measurement  Elements cannot be recognized in the financial statements if they cannot be measured  Measurement uncertainty – when there is a variance between the recognized amount and another reasonably possible amount Periodicity Assumption Periodicity assumption – an enterprise’s economic activities can be divided into artificial time periods – the shorter the time period the harder it becomes to determine the proper net income for the period – investors wants info that has been quickly processed but the quicker it is the more likely it is to have errors Monetary Unit Assumption Monetary unit assumption – money is the common denominator of economic activity and is an appropriate basis for accounting measurement an analysis – most effective way of expressing changes in capital and exchanges of goods and
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