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Chapter 1-6

BU387 Chapter 1-6 + 2A full midterm notes w/ charts, tables, pictures

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Leigh Sherry

Chapter 1 - Accounting is best defined by its 3 characteristics: o (1) identification, measurement, and communication of financial information (2) about economic entities (3)to interested persons - Financial accounting is the process for preparing financial statements for both internal and external parties - Managerial accounting is the process of identifying, measuring, analyzing and communicating financial information to internal decision makers - Objective of financial reporting is to provide financial information about the reporting entity that is useful to present and potential equity investors, lenders and other creditors in making decisions as capacity providers (referred to as decision-usefulness approach) o An entity perspective is adopted, as companies are viewed as separate and distinct from owners. Because of the same reason, a proprietary perspective (focusing on shareholder’s needs) is inappropriate - Adverse Selection: where information asymmetry exists, the wrong company is attracted to the market (since companies with most to gain from not disclosing information would want this), whereas those that fully disclose information would not enter as their share prices would fall - Moral Hazard: refers to human nature that people will shirk responsibilities if they believe no one is looking (i.e. not disclosing stewardship responsibilities such as polluting environment if they can get away with it instead of sacrificing share price [aka management bias]), or downplaying negatives and focusing on positives (aggressive accounting) (i.e. overstated assets) Chapter 2 - Conceptual framework - a coherent system of interrelated objectives and fundamentals that can lead to consistent standards and that prescribes the nature, function, and limits of financial accounting and financial statements - Accounting information is useful for decision-making if two fundamental qualities are present: 1. Relevance: makes a difference to a decision, by having predictive value (helps make predictions of final outcome based on past, present, and future events) and feedback/confirmatory value (confirm/correct previous decisions). Materiality (how important a piece of info is) is also referred to when discussing relevance 2. Representational faithfulness: info is faithful to the extent that it reflects underlying economic substance of an event/transaction (reason beneath numbers), completeness (including all info to portray underlying event/transaction), and neutrality (info cannot be selected to favour one set of interested parties over another) - Qualitative characteristics can be enhanced by factors such as: o Comparability: measured and reported in similar/consistent way yearly so it can be considered comparable, enabling users to find real similarities/differences in economic phenomena o Verifiability: similar results will be achieved if any particular transaction reoccurs, thus verifiable o Timeliness: info is available to decision-makers before losing its ability to influence decisions o Understandability: info has sufficient quality/clarity for informed users to see significance - Assets have 3 essential characteristics: 1. There is some economic benefit to the entity 2. Entity has control over that benefit* 3. Benefits result from a past transaction/event *assets gained through contractual or other rights (i.e. leases) still give rights (thus control) to use the asset despite fact that company does not have legal title - Liabilities have 3 essential characteristics: 1. They represent a present duty/responsibility 2. Duty/responsibility obligates entity, leaving it little to no discretion to avoid it 3. Transaction/event results from a past transaction/event - Liabilities arise from contractual obligations (i.e. owing an employee wages) or statutory requirements (i.e. polluting illegally), as well as constructive and equitable obligations o Constructive Obligations: obligations that arise through past/present practices that signals that the company acknowledges potential economic burden  Ie. Entity makes statement that it stands behind its products, thus in a situation of a defective product, they exchange it despite terms of sales contract o Equitable obligations: arises due to moral/ethical considerations  I.e. retraining employee who is being downsized - Comprehensive income: includes net income and other comprehensive income (made up of revenues, expenses, gains, and losses). The following is included in other comprehensive income in the comprehensive income statement: o Unrealized holding gains/losses on certain securities and property, plant, and equipment (revaluation method) o Certain gains/losses related to foreign exchange instruments, foreign operations, and certain types of hedges o Certain gains/losses related to re-measurement of defined benefit plans and liabilities measured at fair value - Recognition/Derecognition: act of including/removing something in entity’s statement of financial position or income o Elements of financial statements are recognized when they:  Meet the definition of an element (i.e. liability)  they are probable  they are reliably measurable Basic foundational principles - Economic entity assumption: allows us to identify an economic activity with a particular unit of accountability (i.e. company, division, individual). Concept aids in determining what to include/recognize and what not to in a particular set of statements - Revenue Recognition and Realization: outlines when revenue should be recognized, generally when the following 3 conditions have been met: 1. Risks and rewards have passed and/or earnings process is substantially complete (significant acts have been performed and there is no continuing involvement) 2. Revenue is measurable 3. Revenue is collectible (realized or realizable) - Matching Principle: matches expenses/costs to revenues to illustrate a cause-effect relationship between money spent to earn revenues and revenues themselves. Operating expenditures incurred are often classified to 2 groups: o Product costs – material, labour, overhead to product (portion can be carried to later periods if inventory isn’t sold) o Period costs – officer’s salaries, administrative expenses, etc (not seen as part of production process despite benefits associated occurring in future). General expense faced to run the business, opposed to the inventory production process - Measurement: process of converting economic events into numbers for interpretation. Elements that cannot be measured are not recognized, thus accountants must determine an acceptable level of uncertainty, use measurement tools to help deal with uncertainty, and disclose enough information to signal the uncertainty - Periodicity Assumption: implies that an enterprise’s economic activities can be divided into artificial time periods (the shorter, the more difficult to determine proper net income accurately), so users are informed about performance/economic status on a timely basis for evaluation and comparison of firms - Monetary unit assumption: assumption that money is common denominator of economic activity, and appropriate basis for accounting measurement/analysis as it is the most effective way of expressing changes in capital and exchanges of goods/services to interested parties - Going Concern Assumption: assumption that business will continue to operate into foreseeable future (not forced to end its operations, will last long enough to fulfill commitments) o Does not apply if there is intent to liquidate company’s assets and cease operations, cease trading company shares, or company has no realistic alternative but to liquidate or cease operations - Historic cost principle: transactions are initially measured at amount of cash/cash equivalents that was paid/received or fair value that was associated to transaction. Has 3 assumptions: 1. Represents a value at a point in time 2. Results from a reciprocal exchange (in other words, a 2-way exchange) 3. Exchange includes an outside arm’s length party - Initial recognition: for non-financial assets, value includes any laid-down costs (incurred to get asset ready for sale or generating income). Transactions with some or all of the following characteristics are more challenging; 1. Nonmonetary or barter transactions; no cash/monetary consideration is exchanged, thus difficult to determine value of assets exchanged 2. Nonmonetary, nonreciprocal transactions; no exchange happens (i.e. donations) 3. Related party transactions; parties to transaction are not acting at arm’s length (in other words, no outside party), thus exchange price doesn’t reflect true value o Subsequent remeasurement: historic cost has an advantage over other valuation methods as it generally comes from an arm’s-length transaction/exchange, thus representing a fairly arrived-at value at a specific point in time. It may become irrelevant in terms of predictive value over time. Later measurements also have limitations, such as measurement uncertainty and subjective value changes - Fair value principle: fair value, defined under IFRS as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction, in other words the exit price. Fair value is a market- based measure, opposed to an entity- specific measure, meant to be more objective o Which value is better? Entity-specific value may be more relevant for operating assets that entity plans to keep/use to produce revenues, but subjective. Market-based view is more objective and verifiable, thus fair value calls upon market-based view under IFRS - Full disclosure principle: all info relevant to decisions should be included in the financial statements. Trade-offs aim for information that is detailed enough to disclose matters that make a difference to users, but condensed enough to make info understandable and appropriate in terms of cost of preparing/using it. Information overload refers to too much info that users cant digest or process it o Notes to financial statements generally amplify or explain presented items in statement. Examples of notes are descriptions of accounting policies/methods used in measuring elements, explanations of uncertainties/contingencies, details too voluminous for statements o Supplementary information include details/amounts that present a different perspective from what appears in financial statements - Financial engineering: process of legally structuring business arrangement/transaction so it meets company’s financial reporting objective (i.e. maximize earnings, minimize debt-equity ratio), often done by creating complex legal arrangements and financial instruments, in order to meet objective within GAAP standards - Market pressure to allow fraudulent financial reporting include: o Economic or business environment: drops in revenue or market share can pressure a company to “prop up” its revenues by recognizing unearned revenues or deferring recognition of some expense o Other pressures: budgets, reliance of bonuses and wages depending on objectives can cause negative influences. Chances of fraud can be lessened by establishing control and a solid governance structure, including:  Vigilant/knowledge top management, independent audit committee, internal audit functions, and other internal controls at lower levels - Obligations may be conditional, unconditional, or both o Unconditional obligations (can be referred to as stand-ready obligations) is when obligor stand ready to do what is required under terms of contract, agreement or law  i.e. insurance contracts, where insurer pays out amount equal to loss on occurrence.  Obligation where entity agrees to provide future service/deliver something in future is often referred to as performance obligation o Conditional obligations may exist for potential breakings of a law/regulation, since if violated the company has an economic burden (obligation enforceable under law) Chapter 2A - In order to measure fair value, entity must determine: o Item being measured (consider specific nature, condition, location of asset) o How item would be/could be used by market participants  Asset is valued based on highest and best use in market regardless of how entity is using asset o Market that item was bought/sold in  Principle Market: measurement would consider value based on market that entity normally buys/sells in  Would usually be most advantageous market, market in which price would be highest o If a model is being used to measure fair value, what model  Market price in liquid market for item measured best represents fair value. If pure market values not used, then value is essentially estimated using a model  Estimating fair value means measurement uncertainty, which we offset by using solid input information, classified into 3 categories based on quality (level 1, 2, 3) with level 1 being the highest quality to produce best estimates (the lower the output, the higher the required disclosures) - Valuation models are roughly categorized into 3 groups: 1. Market models: uses prices/other info generated from market transactions for identical/similar transactions (i.e. earnings multiples model; company is valued under publicly available earnings number for similar companies, etc) 2. Income models: convert future amounts (i.e. cash flows to be generated by asset) to current amount s(adjusted for time value of money); examples included discounted cash flow/options pricing models 3. Cost models: attempts to reflect amount that would be required to replace asset’s service capacity. Model is used for older non-financial assets where item being valued is no longer bought/sold; perhaps it is obsolete. Value is benchmarked against similar items (that are currently sold), focusing for instance on capacity - Discounted cash flow model: very robust, widely accepted tool for dealing with uncertainty/time value of money. Two approaches generally accepted: o Traditional approach: discount rate reflects all risk in cashs flow but cash flow assumed to be certain o Expected cash flow approach: risk-free discount rate used to discount cash flows that has been adjusted for uncertainty [Chapter 3] BASIC TERMINOLOGY - Event: Something of consequence that happens. An event generally is the source or cause of changes in assets, liabilities, and equity. Events can be external or internal. Transaction. An external event involving a transfer or exchange between two ormore entities or parties. - Account: A systematic arrangement that accumulates transactions and other events. A separate account is kept for each asset, liability, revenue, and expense, and for gains, losses, and capital (owners' equity). - Permanent and temporary accounts. Permanent (real) accounts are asset, liability, and equity accounts; they appear on the statement of financial position. Temporary (nominal) accounts are revenue, expense, and dividend accounts; except for dividends, they appear on the statement of comprehensive income. Temporary accounts are closed at the end of each fiscal year; permanent accounts are left open. Ledger.1 The book (or electronic database) containing the accounts. Each account usually has a separate page. A general ledger is a collection of all the asset, liability, owners' equity, revenue, and expense accounts. A subsidiary ledger contains the details of a specific general ledger account. - Journal: The book of original entry where transactions and other selected events are first recorded. Various amounts are transferred to the ledger from the book of original entry, the journal. - Posting: The process of transferring the essential facts and figures from the book of original entry to the ledger accounts. - Trial balance: A list of all open accounts in the ledger and their balances. A trial balance that is taken immediately after all adjustments have been posted is called an adjusted trial balance. A trial balance taken immediately after closing entries have been posted is known as a post-closing or after-closing trial balance. A trial balance can be prepared at any time. - Adjusting entries: Entries that are made at the end of an accounting period to bring all accounts up to date on an accrual accounting basis so that correct financial statements can be prepared. - Financial statements: Statements that reflect the collecting, tabulating, and final summarizing of the accounting data. Four financial statements are involved: (1) the statement of financial position (or balance sheet under ASPE), which shows the enterprise's financial condition at the end of a period; (2) the statement of comprehensive income (or income statement under ASPE), which measures the results of operations during the period; (3) the statement of cash flows, which reports the cash provided and used by operating, investing, and financing activities during the period; and (4) the statement of changes in shareholders' equity (or statement of retained earnings under ASPE), which reconciles the balance of the retained earnings and other equity accounts from the beginning to the end of the period. - Closing entries: The formal process for reducing temporary accounts to zero and then determining net income or net loss and transferring it to an owners' equity account. Using closing entries is also known as "closing the ledger," "closing the books," or merely "closing." - Reversing entries: Entries made to reverse some of the adjusting entries prior to recording the next period's transactions. These entries are optional (as discussed in Appendix 3A). Chapter 3 - 1. The first step in the accounting cycle is to determine what to record. Generally, you record any transaction regardless of value, whereas changes in personnel, managerial policies, etc are not recorded. An item should be recognized if it meets the definition of element (asset/liability) and is measurable o If there is uncertainty of a future event occurring/ is not measurable, entity must use all available information to make neutral decision whether asset/liability exists or not - 2. Since its inconvenient to first record directly in a general ledger (with t-accounts being in different pages), its general practice to first chronologically list all transactions/events as debits/credits to particular accounts in a general journal o Each journal entry has 4 parts: accounts/amounts to be debited, to be credited, a date, and an explanation - 3. Items in general journal must be transferred to general ledger, a collection of all accounts (in T-account form). This procedure is called posting, and there are generally reference numbers in the general journal to refer to the general ledger accounts to which items are posted - 4. A trial balance is a list of all general ledger accounts/balances at a specific time, with the main opurpose of proving mathematical equality of debits/credits after posting. Doing this helps uncover errors in journalizing/posting o Errors can still occur when:  A transaction isn’t journalized  Incorrect entry posted  Entry posted twice  Incorrect accounts used in journalizing/posting  Offsetting errors made in recording transaction amount - 5. Adjusting entries are made at end of accounting period to record revenues in period they are earned, recognize expenses in period incurred to list accurate accounts on financial statements at statement date. This is to offset reasons such as:  Some events are not journalized daily (i.e. consumption of supplies, wages)  Costs not journalized at accounting period because costs expire with time rather than through recurring transactions (i.e. depreciation, prepaid rent/insurance)  Some items may be unrecorded (i.e. utility bill not received until next period) o Adjusting entries are required every time financial statements are prepared. Adjusting entries are classified into 3 groups: Prepayments, accruals, and estimated items - at the end of eacn period, an estimate is made of fair value of investments held in fair value through net income (FV-NI) and fair value through other comprehensive income (FV-OCI) categories o FV-NI includes equity investments or investments in debt securities, FV-OCI excludes debt securities under IFRS - ^ if a FV-OCI investments, it would be the same entry but FV-OCI investments debited, unrealized holding gain/loss – OCI credited - 6. Following the adjusting entries preparation and posting, an adjusted trial balance is prepared. - 7. The adjusted trial balance helps the preparation of the other financial statements. o Assets and liabilities reported on SFP, often grouped into current and non- current classifications o Common shares, retained earnings, and accumulated OCI reported in shareholder’s equity section of SFP o Dividends reported on statement of changes in shareholder’s equity o Revenues/expenses reported on statement of comprehensive income o Revenues/expenses eventually transferred to retained earnings at end of period, OCI income transferred to accumulated other comprehensive income - 8. Closing entries are prepared, reducing the balance of temporary accounts to 0 to prepare accounts for next period’s transactions. In the closing process, all revenues and expenses account balances are transferred to a clearing account; Income Summary, used only at year end. o Net result of income summary is the net income/loss for period, transferred to an owners equity account (retained earnings for a corporation), or AOCI account for OCI items o Dividends declared and distributed during year are directly closed to retained earnings - The previous closing procedure is assuming that a perpetual inventory system is being used, where purchases/sales are recorded directly in inventory accounts as they occur. Thus, balance in inventory represents ending inventory, not requiring adjusting entries to update it. o When inventory items are sold, cost is credited to inventory and debited to COGS - In a periodic inventory system, purchase accounts are used, and inventory is unchanged during the period (thus representing beg. Inventory throughout period), and adjusted by closing out beg. Inventory by recording ending inventory amount (determined by physical count) o COGS = beginning inventory + purchases – ending inventory - 9. A post-closing trial balance may be taken after closing entries, consisting of only the asset, liability, and owner’s equity accounts (permanent accounts) - 10. After statements are prepared and books are closed, it is often helpful to reverse some adjusting entries before recording next period’s regular transactions, i.e. reversing entries. o Reversing entries are made at beginning of next accounting period, and is exact opposite of the related adjusting entry made in previous period; it’s an optional step - To make end-of-period accounting and reporting process easier, a work sheet is often used; a speadsheet used to adjust account balances and prepare statements on a timelier basis o The 10-column worksheet has columns for the first trial balance, adjustments, adjusted trial balance, statement of comprehensive income, and statement of financial position o Worksheet does not replace financial statements, it is an informal device for accumulating and sorting information needed for statements. Completing worksheets adds certainty that all details of end-of-period accounting and statement preparation have been brought together properly Chapter 4 - Basic business model is broken down to 3 types of activities: o Financing – obtaining cash funding (often by borrowing, issuing shares, retaining profit), as well as repayment of debt/repurchase of shares o Investing – using funding to buy assets and invest in people, including divestitures o Operating – using assets to earn profits - Risk Management: area of study devoted to managing risks with money o Risk/return trade-off: market demands greater return when there is greater risk - Information from the income statement can be used to: o Evaluate enterprise’s past performance and profitability  Examining revenues, expenses, gains, and losses, users can see company performance compared to competitors o Provide basis for predicting future performance  Info about business risk/past performance can aid determining important trends that may provide info about future performance o Help assess risk of not achieving future net cash flows  Info on various components of income highlights relationshiop among them and can help assess risk of not achieving particular level of cash flow in future (i.e. segregating company’s recurring operating income (continuing ops.) from non-recurring income (discontinued ops.)) - Statement of income/comprehensive income has following limitations: o Items that cannot be reliably measured are not reported in statement  i.e. contingent gains are not recorded in income due to uncertainty o Income numbers are affected by accounting method used o Income measu
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