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Chapter 2

MGAB01H3 Chapter Notes - Chapter 2: Financial Statement, Accounting, Money Market Fund

Financial Accounting
Course Code
G.Quan Fun

of 3
Tuesday, September 15, 2009
TN: Chapter 2 [MGTB05]
Conceptual Framework of Accounting
Conceptual Framework of Accounting: The elements that guides the development & application of
accounting principles that maintain consistent standards. “Consistent set of standards
1. Ensures that existing standards are clear & consistent
2. Makes it possible to respond quickly to new issues
3. Increases the relevance, faithful representation, comparability, and understandability of financial
reporting results
New standards can easily be build on the same foundations
1. The Objective of Financial Reporting
Used to provide information that is useful to those who are making investment and credit decisions
F.R. should provide financial information and managers explanations about financial activities
2. Qualitative Characteristics of Accounting Information: Characteristics for useful information
I. Relevance: The ability to make a difference in users decisions
a) Relevant information allows to make predictions (predictive value), confirm/correct their
previous expectations (feedback value), and influence decisions on time (timely)
II. Faithful Representation: The quality of describing information that shows economic reality
A. Verifiable: people reviewing the information should reach similar conclusions
B. Neutral: information cannot be presented to favour one set of users over another
C. Complete: information needed to represent economic reality must be included
III. Comparability: Describing accounting information to allow comparison between other companies
A. Comparability: allows to see differences and similarities between companies
B. Consistency: the act of using the same accounting treatment for similar events year to year
IV.Understandability: providing information that is understandable to users (some accounting needed)
3. Elements of Financial Statements
Definitions of basic terms in accounting
4. Recognition and Measurement Criteria: Assumptions, Principles and Constrains
I. Assumptions: guide when to include and how to measure economic activities
A. Monetary Unit Assumption: only items that can be expressed in money be included in accounting
records and that units of measure remain stable over time
a) Inflation/deflation are ignored, or in some countries adjusted (if too high)
B. Economic Entity Assumption: economic activity of a company are separate from shareholders
C. Time Period Assumption: life of a business can be divided into artificial time periods
a) Interim periods: reporting periods less than a one year
b) The shorter the periods the more difficult to create a faithful accounting report
D. Going Concern Assumption: business will remain in operation for the foreseeable future.
a) If business has history of profitable operations & access to financial resources, its
assumed that it will operating to carry out its existing obligations & commitments
b) If going concern is not assumed , assets are stated in liquidation value
c) Assumption should not be used when liquidation of business is likely
II. Accounting Principles: how economic events should be reported
A. Cost Principal: assets be recorded at their cost at the time of acquisition (but some revalued)
a) Value of land will remain the same because its more relevant, since the land is intended
for business not for resale, until either it is sold/the going concern assumption is not valid
b) Argue that over time fair value is different from original cost value, but others say that for
faithful representation the principal should be used because it can be verified & is neutral
B. Full Disclosure Principal: events that make a difference to F.S. users be disclosed (in notes)
III. Constraints In Accounting: allow to make changes to GAAP as long as the information is still useful
A. Maturity: F.S. items impact on a company’s overall financial condition & operation
a) Material item: including it, or leaving it, will influence the decisions of external users
b) Immaterial item: including or not will have no affect on decisions of external users
B. Cost Benefit: the value of the information is greater than the cost to provide it
a) For completeness all financial events should be disclosed, however that is too expensive
Classified Balance Sheet
I. Assets: are the resources that the company owns that will provide future economic benefits
A. Current Assets: assets expected to be converted into cash/sold/used up within 1 year
a) Cash, ST investments (debt or equity securities), accounts receivable (converted
to cash as the amounts are collected), inventory (sold and converted to cash or
accounts receivable), supplies, and prepaid expenses
b) Cash equivalents are near cash items (ex:money market funds) are included
B. Non-current Assets: resources those benefit will be recognized over more than 1 year
1. Long-term Investment: multi-year investments in debt (mortgage) and equity (shares)
of other corporations “Business invest in other corporations?”
2. P.P.E.: assets with long live that are currently used in operating the business
a) Examples: land, buildings, equipment & furniture (listed in order of permanency)
b) Depreciation happens. Carrying amount=Cost-Accumulated Amortization
3. Intangible Assets: assets with no physical substance held by the company
a) Examples: goodwill, patents, copyrights, trademarks, trade names & licenses
b) Group (1) indefinite lives, Group (2) definite lives are amortized
II. Liabilities: obligations that result from past transactions
A. Current Liabilities: obligations that must be paid in the coming year from current assets
a) Examples: accounts payable, unearned revenue, current maturities of LT debt
b) Liabilities that are to be paid first are listed first
B. Long-Term Liabilities: obligations that will be payed after 1 year
a) Examples: Mortgages payable, future income tax payable
III. Shareholders Equity: the amount by which a company is financed
A. Share Capital: total amount of shares issued (aka Common Shares)
B. Retained Earnings: cumulative earnings that remained for use in the company
Using the Financial Statement
1. Intracompany comparisons covering 2 years for the same company
2. Inter-company comparisons based on comparisons with a competitor of same industry
3. Industry average comparisons based on average ratios for particular industries
Using the Statement of Earnings
I. Profitability Ratio: measures the earnings of a company for a specific period of time
A. Earnings Per Share: measures the net earnings for each share (only for common shares)
Earnings Per Share = Net Earnings ÷ Weighted Average Number of Common Shares
a) Disadvantage: ?
B. Price-Earnings Ratio: shows what investors expect of a company’s future earnings
Price-Earnings Ratio = Market Price Per Share ÷ Earnings Per Share
a) P-E ratio high if investors current earnings will increase, lower if earnings decline
b) No P-E ratio can be calculated for if price per share is negative
Using the Balance Sheet
I. Liquidity Ratio: measures the ST ability to pay maturing obligations & have resources for