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Midterm

FALL 2013 ADMS 3585 Intermediate Accounting Midterm Review

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Department
Administrative Studies
Course
ADMS 3585
Professor
Liona Lai
Semester
Fall

Description
FALL 2013 ADMS 3585 MIDTERM Chapter 1: The Canadian Financial Reporting Environment Financial Statements and Financial Reporting - Financial Accounting: Process that closes in the preparation of financial reports that covers all of the business activities used by both internal and external parties. - Users: creditors, investors, shareholders, governments, etc. - Managerial Accounting: process of identifying, measuring, analyzing and communicating financial information to internal decision-makers. - Financial Statements: principal way of communication financial information to external parties. Balance Sheet, Income Statement, Cash Flow Statement, Statement of Retained Earnings, Note Disclosures are part of each Cannot be expressed in the financial Statements: President’s Letter, Supplementary Schedules, Annual Report, Management Forecasts, News Releases, etc.  Accounting and Capital Allocation - Sources are limited therefore use them effectively - Accounting: Identification, measurement and communication of financial information about economic entities to interested persons. - Markets, free enterprise and competition determines whether a business will succeed - Information provided enables investors to compare income and assets of companies where they can assess risks and returns and channel their resources- invest in them. - Debt and Equity Markets, Banks: primary exchange mechanisms for allocation resources- stock markets - Efficient capital markets promote productivity, encourage innovation and provide platform for buying and selling credit - Unreliable and irrelevant information can lead to poor capital allocation which hurts securities and economic growth  Stakeholders - parties who have something at risk in the financial reporting environment- their salary, job, investment reputation - Standard Setters set GAAP for direction on accounting - Securities commissions and stock exchanges monitor financial statements to ensure full and plain disclosure of material information and to determine whether companies may continue to list their shares. Stakeholder What is at Stake?  Investors and Creditors  Investment/Loan  Management  Job, bonus, salary increase, access to capital markets  Securities commissions and stock exchanges  Reputations, effective and efficient capital marketplace  Analysts and Credit Rating Agencies  Reputation and profit  Auditors  Reputation and profits (companies as their clients)  Standard Setter  Reputation  Objective of Financial Reporting - To provide information that is decision-useful - Provide information about: entity’s economic resources and claims to those resources, and changes to them - Management stewardship: assume to include in resource allocation. Management is accountable to investors for the safekeeping of the company’s economic resources. - General purpose financial statement: provide financial reporting information to a wide variety of users - Proprietary perspective: financial reporting focused only on the need of the shareholders - Accrual-basis accounting: determine the net income means that a company recognizes revenue when it provides the good and services rather than when it receives cash. Likewise, recognizes expenses when it incurs rather than when it pays them. Recognized revenue when it makes sales  Information Symmetry and Asymmetry - Symmetry: All stakeholders having equal access to relevant information. But management may feel this may hurt the company’s competitive advantage. - Asymmetry: Managers might have more access information than shareholders for the sake of capital markets (stocks exchange) and management only showing the positive side of the company. Problems:  Adverse selection- knowing that there is information asymmetry, capital markets might attract wrong kinds of companies  Moral Hazard: individual may act their own best interest at the expense of others - Possible Motivations for management bias  Evaluation of management performance- evidence to investors  Compensation structures- payments may base on financial statements  Access to capital markets and meeting analyst expectations- strong desire to meet financial analyst’s expectation as it may affect cot capital  Meeting contractual obligations- lending agreements and contract Standard Setting  Need for standards - Help reduce information asymmetry problems in financial reporting. Standards are intended to be generally accepted and universally practised. They are not rules, regulations or laws.  Parties Involve Canadian Accounting Standard Board (AcSB)  responsible for setting GAAP for Canadian private Accounting Standards for Private Enterprises (ASPE) effective enterprises (ASPE), not-to-profit enterprises and beginning on or after January 1, 2011 pensions plans  Two premises for development standard 1. Be responsive 2. Operate in full public view  Objectives: 1. Establish standards that improves quality of information 2. Simplify capital allocation 3. participate with other standard setters 4. support operation International Accounting Standards Board (IASP)  Major international setting body International Financial reporting Standards (IFRS) effective  Mission: beginning on or after January 1, 2011 1. develop a single set of high quality, understandable and international reporting standard (IFRS) 2. promote use application 3. take account of financial reporting needs of emerging and small and medium companies 4. bring union of national accounting  Must be used by public companies in Canada  Private companies have an option of using IFRS Financial Accounting Standard Board (FASB) and Securities and  Major in the U.S. Exchange Commissions (SEC)  SEC has authority over accounting standards in the U.S Provincial Securities Commission  To oversee and monitor capital marketplace  Ensure strict loyalty to securities law Generally Accepted Accounting Principles (GAAP)  GAAP Hierarchy Under ASPE GAAP consists of: Both Under IFRS GAAP consists of: 1. Primary Sources: CICA Handbook  Provide guidance to “what is GAAP”  IFRS Sec 1400-3870 and accounting  Rank sources  International Accounting Standards guidelines  Grounded in the conceptual (IAS) 2. Other Sources: Background framework  Interpretations (IFRIC or SIC) documents and implementation  Establish value and expect use of  If other do not apply, other sources: guidelines issued by AcSB professional judgement - Pronouncements of other standard setting bodies - Accepted industry practices  Professional judgement Challenges and Opportunities for the Accounting Profession  Oversight in the capital marketplace - To establish auditing, quality control and independence standards and rules – Public Company Accounting Oversight Board (PCAOB) - Stronger independence rules  Centrally in ethics - Go beyond applying GAAP or rules of the profession - Self- interest must be balance with the interest of others- ethical sensitivity  Standard of setting in a political environment - Political action can have significant impact on accounting standards - Funding should be: 1. Broad base: rely on one or few sources 2. Compelling 3. Open-ended: not dependent 4. Country-specific: shared by economies  Principles vs. Rules - Principles based standards (ASPE or IFRS) are more dependent on professional judgement  Impact of technology - Increase ability to produce and access timely information - New ways of communication financial information  Integrated Reporting - Reporting to extend beyond financial information, broader business reporting Chapter 2: Conceptual Framework Underlying Financial Reporting Conceptual Framework - Like a constitution “a coherent system of interrelated objectives” - Foundation for building a set of accounting concepts and objectives  Rationale: Aids in creation of standards for accounting profession. Able to issue additional useful and consistent standards over time. Able to solve new problems more quickly. - By using universally accepted conceptual framework, accountants will be able to decide against certain alternatives quickly and focus on a logical treatment.  Development: Need for a generally accepted framework - FASB issued a 3-part discussion memo that states major issues that would need to be addressed in stabling a conceptual framework for setting accounting standards. - AcSB and IASB followed examples and their own perspectives on frameworks - STEPS: 1. Objectives identity accounting’s goals and purposes 2. Qualitative characteristics that makes it useful and the elements of financial statements – assets, liabilities, equity, revenues, expenses, gains and losses 3. Foundations principles used in establishing and applying accounting standards Objective - To communicate information that is useful to investors, creditors and other users - Useful in making decision about how to allocate resources (management stewardship)  Qualitative characteristics of useful information - Fundamental Qualitative Characteristics Relevance Representational Faithfulness Must be capable of making a difference in a decision. To the extent that it reflects the underlying economic substances  Care should be taken of an event- transparency  Helps predictions about final outcome of past, present  Completeness: statements should include all information and future events – predictive value necessary to portray the underlying events and transaction.  Help users confirm or correct previous expectations- - Care must be taken since it is possible to misinterpret feedback/confirmatory value - Ex. selling land but some assets included are leased  Materiality: how important a piece of information is.  Neutrality: information cannot be selected to favour one - If it would make a difference to the decision maker. set on interested parties over another. - Should not be manipulated – factual, truthful, unbiased - Management needs to use many assumptions because of uncertainty in financial reporting- accrual accounting - Ex. revenues recorded when earned not when cash is received. Companies must estimate the amount of revenue that will be realized. - Neutrality in standard setting: must be free from bias or will no longer have credible financial statements.  Freedom from material error: information must be reliable - Task of converting economic events which are always changing to numbers in a set of financial statements - Enhancing Qualitative Characteristics Comparability Information that has been measured and reported in a similar way Enables users to identify the real similarities and differences in economic phenomena Ex. accounting inventories are different under IFRS and FASB (LIFO) Verifiability Exists when knowledgeable, independent users achieve similar results regarding the accounting for a particular transaction. Ex. Cash can be verified at the bank Hard numbers- easy to verify Soft numbers- those who have more measurement uncertainty such as liability Timeliness Information should be available before it loses its ability to influence decisions. Quarterly provides information on a more timely basis other than annually Understandability Users need to have a reasonable knowledge in order to understand the information in financial statements Information must also be of sufficient quality and clarity Job of financial statements’ preparer (clear legalities) and users - Trade-Offs: preparers of financial statements should identify all relevant information then consider how best to ensure that the financial statements are presented- representational faithfulness. Not all have enhancing qualities therefore there’s trade-offs.  A new standard may be applied prospectively. Comparability or consistency year to year is temporarily sacrificed for better information in the future. - Costs vs. Benefits: users assume that information is a cost-free commodity.  The cost of providing information must be weighed against the benefits But .benefits are not usually measureable  Costs: collecting and processing, distributing, auditing, analysis and interpretation, disclosure of information  AsCB has taken some steps to reduce cost of providing information by developing separate standards for private entities. Follow a simplified version of GAAO. Shareholders and creditors of private entities have more access to information and business model are not so complicated- less complex accounting standards.  Elements of Financial Statements - Assets: economic benefit, control over benefit, benefit result from a past transaction or event. - Liabilities: present a duty or responsibility, obligates the entity, leaving little or no discretion to avoid it, transaction results from past transaction or event. - Equity: residual interest in an entity that remains after deducting its liabilities from assets. Consist of common or ordinary shares, preferred shares, retained earnings, and, under IFRS, accumulated other comprehensive income. - Revenues: increases in economic resources, by inflows or other enhancements of an entity’s assets or settlements of liabilities. - Expenses: decreased economic resources by outflows or reductions of assets or by incurrence of liabilities- ordinary revenue-generating activities. - Gains: increases in equity from incidental transactions. - Losses: decreases in equity from incidental transactions - Financial statements include: 1. Income Statement or Statement of Comprehensive Income (IFRS) 2. Balance Sheet 3. Statement of Retained Earnings or Changes in shareholder’s Equity (IFRS) 4. Statement of Cash Flow  Comprehensive Income: new income concept and includes more than the traditional notion of net income. Includes, net income and other comprehensive net income/. - Unrealized holding gains and losses on certain securities and PPE - Certain gains and losses to foreign exchange - Certain gains and losses to measurement of defined benefit plans and liabilities at FV Foundational Principle - Implement basic objectives of first level. Help explain which, when and how financial elements should be recognized, measured and presented.  Recognition/Derecognition - Recognition: deals with the act of including something on the entity’s F/S position or income statement. Elements of F/S have been recognized when: they meet the definition of an element, they are probable and reliably measurable. IFRS: more likely than not. ASPE: likely. - Derecognition: act of taking something off the income statement. Economic Entity Assumption Allows us to identify economic activity with a particular unit of accountability. Helps accountants determine what to include or recognize in a particular set of F/S GAAP: broader definition- parent and subsidiaries are separate legal entities but merging activities for accounting and reporting purposes gives more information. Control IASB issued Standard notes that an investor has control over an investee when it has power over the investee, exposure or rights to variable returns from its involvement with the investee and the ability to use its power over the investee to affect the amount of the investor’s returns ASPE: defined as continuing power strategic decisions without co-operation of others. Focuses more on whether the investee is demonstrably distinct from the company. Revenue Recognition & realization principles Recognized when: 1. Risks and rewards have passed and/or the earnings process is substantially complete 2. Revenue is measurable 3. Revenue is collectable (realized) - products are exchanged for cash. Assets are received IFRS: contract-based approach to revenue recognition being developed- balance sheet approach- recognizes that a transaction has occurred when entity enters a contract. Collectable revenues recognized when performance obligations are settled Matching Principle Expenses match revenues GAAP: rational and systematic allocation policy- making assumptions about the benefits that are being received as well the costs which should be allocated over all accounting periods  Measurement - Elements cannot be recognized if they cannot be measured - Key is to determine level of uncertainty, use measurement tools and disclose enough information Periodicity Assumption Accurate way is to do measurement at the time if the enterprise’s eventual liquidation since there is complete certainty Implies that activities can be divided into artificial time periods. Shorter time period, the more difficult to determine proper net income. A month is less reliable than quarter Real-time financial information- ensure all relevant information are available Monetary Unit Assumption Money is the common denominator of economic activity. It is relevant, simple, universally available, understandable and useful. Going concern Assumption Assumption that a business enterprise will continue to operate for the foreseeable future, it will not be forced to end operations. Experience indicates that companies do have a high continuous rate. Management must assess the company's ability to continue as a going concern- take into account all available information at least 12 months from the date of B/S Asset are better stated at NRV (sale-cost of disposal= npv) Historical Cost Principle 3 assumptions: represents value at a point in time, results from reciprocal exchange, exchange includes an outside arm’s length party. Initial Recognition- non-financial costs include laid-down costs (any cost incurred to get the asset ready) Ex. inventory may include material, labour, etc. Subsequent Measurement: comes from arm’s length transaction, represents bargained at a point in time. First recognized, cost represents fair value. Fair Value Principle IFRS: called for use of standardized fair value measurement- “price received to sell an asset or paid transfer a liability in an orderly transaction between market participation at the measurement date”- an exit price. More useful than historical cost such as mutual funds.  Presentation and disclosure Full Disclosure Principle Anything that is relevant to decisions. Recognizes that the nature and amount of information included reflects a series if judgemental trade-offs which aim for, detailed enough to disclose matters that makes a difference, but condensed enough to make it understandable More information is not always better, it may result to user unable to digest information- information overload Financial Reporting Issues  Principles-based approach - IFRS and ASPE are principal based- based on few foundational principles and concepts. - Benefits are that all decision should be consistent if they start from the same foundational reasoning. As well, principle –based GAAP are flexible. Care should be taken for it not abused. - An entity should adopt accounting policies that are consistent with specific GAAP guidance and developed though exercising professional judgement and applying the framework  Financial engineering - Process of legally structuring a business arrangement so that it meets the company’s financial reporting. - Structured Financing: financial instrument s to meet equity than debt.  Fraudulent financial reporting - Good financial reporting = well-reasoned and supported analysis grounded by framework. - Economic or business Environment- pressure to recognize revenues before they should be recognized - Economic downturns as a clean up IFRS/ASPE Comparison  Looking Ahead - Proposed Financial Statements Elements Definitions- attempts to redefine major elements such as assets and liabilities. - Asset: Present economic resource (scarce of producing cash flow) + right to access to by entity (restricted and enforceable) - Liabilities: Present economic obligation (requires outflow) + entity is the obligor (enforceable) Appendix 2A- Fair Value Measurements - Income Models for measuring fair value - Valuation models include discounted cash flow and options pricing models - Fair value estimates arrived at by using discounted cash flow models incorporates one or more of the following components. 1. Estimates of cash flows: Management makes its best estimates of expected cash flows incorporating contractual cash flows as well as estimated cash flows. 2. Time value of money: An interest rate is used to discount the cash flows. This rate may be the risk-free rate or it may be a risk-adjusted rate 3. Uncertainty or risk: Since not all cash flows are the same in terms of amount, timing, and riskiness, discounted cash flow models reflect the risk or uncertainty by adjusting either the cash flows or the discount rate. Uncertainty may be reflected in the numerator by applying probabilities to various cash flow scenarios. It may be incorporated in the discount rate by applying a risk premium such that the rate exceeds the risk-free rate. Chapter 3: The Accounting information System Accounting Information Accounting cycle and the Adjusting Entries Financial Statements for System recordings process  For prepayments Ownership and Structure  Basic terminology  Identifying and  For accruals  Debits and credits recording  For estimated items  Accounting equations transactions and other events  Journalizing  Posting  Trial balance Closing Process Using a Work Sheet Appendix 3A- using Revising  Preparing closing  Adjustments entered Entries entries  Work sheet columns  Accruals  Revising entries  Financial statements  Prepayments  The accounting cycle to a work sheet  Summary of revising summarized  Closing entries entries  Monthly statements, yearly closing Chapter 4: Reporting Financial Performance Performance  Business models and industries Consists of getting cash, investing it in resources and use them to generate profits. Three activities: Financing: obtaining funding by borrowing, issuing shares or retaining profits. Investing: use funding to buy assets and invest in people Operating: using assets to earn profits. Risk Management: identifying risks, deciding if and how to manage and monitor risks. Risk/Return trade-off: greater return when there is greater risk.  Communicating information about performance - A useful statement of income has both feedback and predictive value, which helps investors, creditors, and other users make decisions about stewardship and resource allocation. - Investors and creditors can use the information in the income statement to:  Evaluate the enterprise’s past performance and profitability- examine revenues, expenses, gains and losses.  Provide a basis for predicting future performances- business risk and past performance.  Help asses risk of not achieving future net cash inflow- information on examine revenues, expenses, gains and losses, highlighting relationships among them to assess risk.  Quality of earnings/information - How solid earnings numbers are - Two main aspects to consider: Content- Integrity of information. Sustainability of earnings Presentation- Earnings presentation is clear and concise. Easy to use and understandable - Characteristics of high quality earnings: 1. Nature of Content  Unbiased and determined objectively  Represents economic reality  Reflects earnings from on-going core activities  Can be correlated with cash flows from operations  Based on sound business strategy/model 2. Presentation  Does not disguise or mislead (transparent)  Understandable  Also, information is clear and concise - Earnings management decreases quality of earnings Statement of Income/Comprehensive Income  Measurements - IFRS generally supports the all-inclusive approach to measuring income  These results in “comprehensive income”which includes any non-shareholder transactions that causes a change in equity. Ex. unrealized gains/losses on revaluation of property, plant, and equipment under the revaluation model  Comprehensive Income = Net Income +/- Other Comprehensive Income (OCI)  OCI is closed to a balance sheet account called Accumulated Other Comprehensive Income (AOCI) - ASPE continues to focus on net income as the measure of income  Discontinued operations - Business Components under ASPE and IFRS ASPE IFRS  Operating segment have their performance review by  Separate major line of business management  Business that meets the criteria to be accounted for as  Reporting unit divined in CICA Handbook part II Sec held for sale upon acquisition. 3064, deals with goodwill and intangible assets  Subsidiary separate legal entity  Asset group has cash flows that are largely independent - Component generates its own cash flows and has its own distinct operations - Held for Sale: Criteria  Authorized plan to sell exists  Asset available for immediate sale  Active search for a buyer  Sale is probable within a year  Asset is reasonably priced and marketed  Unlikely that plan to sell will change - Measurement and Presentation  Depreciation is not recognized for held for sale assets  Remeasured at lower of carrying value and fair value net of cost to sell  Once asset is written down, subsequent gains can be recognized only up to the amount of original loss  Presented separately on balance sheet Under ASPE, held for sale asset retains original classification as current or non-current Under IFRS, held for sale assets generally classified as current - Statement of Discontinuing Operations Income from continuing operations (net of tax) $xx,xxx Discontinued Operations: Income (Loss) from operations (net of tax) $xx,xxx Gain (Loss) on disposal (net of tax) xx,xxx xx,xxx Net Income $xx,xxx Earnings per share from continuing operations $ x Earnings per share from discontinued operations x Earnings per share on net income $ x  Presentation - Under IFRS, the statement of comprehensive income can be presented either a single combined statement, or two separate statements - Companies can present income using either single-step income statement, or multiple-step income statement - Comprehensive Income Statement: Sales 800,000 Cost of goods sold 600,000 Gross profit 200,000 Operating expenses 90,000 Net income 110,000 Other comprehensive income Unrealized holding gain, net of tax 30,000 Comprehensive income 140,000 - Single- Step Income Statement:  Presents only two groupings before Income before Discontinued Operations: Revenues (includes gains) and Expenses (includes losses)  Income tax expense often reported separate from expenses as the last line item in determining net income  Advantages: Simplicity and eliminates classification problems for revenues and expenses  Disadvantage: Oversimplification and less
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