9A Basic Theory Flashcards
1
Q
What is the basis for financial report?
A
US GAAP, but it does not constitute a cohesive body of accounting theory
2
Q
Why were concept statements issued?
A
Concept statements were issued to provide a theoretical framework for accounting standard development and a basis for financial reporting.
3
Q
What does the ASC do?
A
It replaces all previously issued non-SEC accounting literature. It does not CHANGE GAAP but restructured all existing standard to provide one cohesive set of accounting standards.
4
Q
What does ASC contain?
A
1) GAAP and relevant literature issued by SEC, 2) Accounting Standards Updates (ASUs)
5
Q
What is the purpose of concept statements?
A
- To develop a theoretical framework and to set forth objectives and fundamental concepts that will be the basis for development of financial accounting and reporting guidance.
- To serve as a reference point in formulating standards.
6
Q
Does the SFAC constitute GAAP?
A
No, the SFAC do not constitute authoritative GAAP and therefore are not part of the Codification
7
Q
Per SFAC 8, what is the objective of financial reporting?
A
To provide financial information about the reporting entity that is useful to existing and potential investors, lenders, and other creditors in making decisions about providing resources to the entity.
8
Q
Per SFAC 5, what are the components of the conceptual framework for financial accounting and reporting?
A
Include objectives, qualitative characteristics, elements, recognition, measurement, financial statements, earnings, fund flow, and liquidity.
9
Q
What are the elements of financial statements?
A
Include assets, liabilities, equity, investments by owners, distribution to owners, comprehensive income, revenues, expenses, gains and losses.
10
Q
Who are the users of financial statements?
A
The primary users are investors, lenders, and other creditors.
11
Q
Who are not considered primary users of financial statements?
A
Management because they can get information internally and regulators and members of the public
12
Q
What is the objective of financial reporting?
A
Provide:
1) information to primary users,
2) information about economic resources and claims,
3) changes in economic resources and claims,
4) financial performance through accrual accounting,
5) financial performance by past cash flow, and
6) changes in economic resources and claims not resulting from financial performance.
13
Q
What do qualitative characeristics do in the conceptual framework?
A
Establish criteria for selecting and evaluating accounting alternatives which will meet the objectives.
14
Q
What are the constraints as noted in the conceptual framework?
A
Cost-benefit constraint: Information is expensive. The costs of providing the information must not out-weigh the benefits that can be derived from using the information.
and materiality threshold: An item is material if its inclusion or omission would influence or change the judgment of a reasonable person.
15
Q
Conservatism
A
When in doubt, choose the solution that will be least likely to overstate assets and income.
16
Q
What are the two fundamental qualitative characteristics of accounting information?
A
Relevance and faithful representation
17
Q
What is relevance?
A
Relevant information is capable of making a difference in the user’s decision. It has predictive value, confirmatory value, or both.
18
Q
What is predictive value?
A
It requires that information be used to predict future outcomes. It is a characteristic of relevant information.
19
Q
What is confirmatory value?
A
Information that either confirms or changes prior evaluations. It is a characteristic of relevant information.
20
Q
How does materiality relate to relevant information?
A
An item is material if omitting it or misstating it could influence a user’s decision. Therefore, the materiality threshold relates to the qualititative characteristic of relevance.
21
Q
What is faithful representation?
A
Information that depicts what it purports to represent. It should be complete, neutral and free from error.
22
Q
What is completeness?
A
Information is presented or depicted in a way that users can understand the item being depicted. It is related to faithful representation.
23
Q
What is neutrality?
A
Item is depicted without bias either favorably or unfavorably to users. It is related to faithful representation.
24
Q
What is free from error?
A
Free from error means that there are no errors or omissions in the information reported. It is related to faithful representation.
25
What are the enhancing qualitative characteristics of accounting formation?
Comparability, verifiability, timeliness and understandability
26
What is comparability?
- Enhancing qualitative characteristic.
- Comparability enables users to identify and understand similarities and differences between items.
- Consistency refers to the user of the same accounting methods in different periods.
- Consistency therefore helps achieve comparability because it helps the user make comparisons across different time periods.
27
What is verifiability?
Enhancing qualititative characteristic. When different sources reach consensus or agreement on an amount of representation of an item.
28
What is timeliness?
Enhancing qualitative characteristic. Information is available to a deicsion maker when it is useful to make the decision.
29
What is understandability?
Enhancing qualitative characteristic. Classifying, characterizing and presenting information clearly and concisely. Assumes user has reasonable knowledge to understand financial statements.
30
Per SFAC 6, what are the basic elements of financial statements?
```
There are 10:
assets,
liabilities,
equity,
revenues,
expenses,
gains (losses),
investments by owners,
distribution to owners,
and comprehensive income.
```
31
What is the objective of the definition of elements per SFAC 6?
They are intended to assure that users will receive decision-useful information about enterprise resources (assets), claims to those resources (liablities and equity), and changes therein (the other seven elements).
32
In order to be included in the statements?.
an item must qualify as an element, meet the recognition criteria and be measurable.
33
SFAC 6: asset
1) obtain it or control it today,
2) will provide benefits in the future,
3) occurred as a result of a past transaction
34
SFAC 6: liability
1) owe it as of today,
2) you will sacrifice something in the future,
3) occurred as a result of a past transaction.
35
SFAC 6: equity
Owner's residual interest in the assets of an entity after deducting liabilities:
1) source of distributions by enterprise to its owners,
2) no unconditional right to receive future transfer of assets; depends on future profitability,
3) affected by enterprise's operations and circumstances
36
Per SFAC 6, what changes owner's equity?
Revenue, expenses, gains, losses, investments by owners, distributions to owners, changes within owner's equity
37
SFAC 6: net assets (equity)
Not for profit org:
1) absence of ownership,
2) operating purposes not centered on profit,
3) significant receipt of contributions, many involving donor-imposed restrictions.
38
SFAC 6: Permanently Restricted Assets
- Assets of a not-for-profit organization that come with certain restrictions.
- Permanently restricted assets are any assets that are given to a not-for-profit by an outside individual or agency with restrictions on their use or purpose.
- Donations of such assets are not uncommon, as individuals or organizations making the donations may have certain preferences as to how the assets donated are used by the not-for-profit.
- A common type of permanently restricted asset is the donation of real estate.
- For example, an individual or organization may donate a large chunk of real estate to a not-for-profit, such as a public university, with restrictions on the land to be only used for biological research rather than have the property resold for a capital gain at the university's discretion.
39
SFAC6: Temporarily Restricted Assets
- Funds whose use is restricted by outside parties until some event occurs.
- For example, a not-for-profit organization may have received donated assets that are restricted by the donor until some time period has elapsed.
40
SFAC 6: Unrestricted Assets
- A group of items owned by the government with commercial or exchange value that have no external restrictions regarding their use or function.
- Unrestricted net assets appear in government accounting and are government-owned assets that can be utilized for any decided-upon purpose.
- This is in contrast to restricted net assets that are assigned to specific purposes.
41
SFAC 6: Revenues
Increases in assets or decreases in liabilities:
1) accomplishments of the earning process,
2) actual or expected cash inflows from central operations,
3) inflows reported gross
42
SFAC 6: Expenses
Decreases in assets or increases in liabilities:
1) sacrifices involved in carrying the earnings process,
2) actual or expected cash outflows from central operations,
3) outflows reported gross
43
Gains (losses
Increases (decreases) in equity:
1) from peripheral transactions and circumstances beyond control,
2) may b e classified according to sources or as operating and non-operating,
3) change in equity reported net
44
Transaction
external event involving transfer of something of value between two or more entitites
45
Event
happening of consequence of an entity (internal or external)
46
Circumstances
set of conditions developed from events which may occur imperceptibly and create possibly unanticipated situations
47
Accrual accounting
recording "cash consequence" transactions as they occur rather trhan with movement of cash; deals with process of cash movement isntead of beginning or end of process
48
Accrual accounting
recognizing revenues and related asset increases and expenses and related liability increases as they occur; expected future cash receipt or payment follows recognition of revenue (expense)
49
Deferral
recognizing liability for cash receipt with expected future revenue or recognizing asset for cash payment with expected future expense; cash receipt (payment) precedes recognition of revenues (expenses)
50
Allocation
process of assigning or distributing an amount according to a plan or formula
51
Amortization
process of systematically reducing an amount by period payments or write downs
52
Realization
process of converting noncash resources and rights into money; refers to sales of assets for cash or claims to cash
53
Recognition
process of formally recording an item in financial statements
54
Matching
simultanteous recognition of revenues with expenses which are related directly or jointly to the same transaction or events
55
Investments by owners
Exclusive to business owners, increases in net assets resulting from transfers by other entities of something of value to obtain ownership; investments by owners are usually assets but could also include providing services to the entity or conversion of the entity's liabilities
56
Distributions to owners
Exclusive to business enterprise, decreases in net assets resulting from transferring assets, rendering services, or incurring liabilities by the enterprise to owners; usually assets but could also include providing services to the owner or conversion of the owner's liabilities.
57
Comprehensive income
Exclusive to business enterprise, change in equity of an an entity during a period from transactions and other events of non-owner sources (i.e. all equity amount changes except investment and distributions).
58
Financial capital maintenance
- maintain purchasing power.
- Capital is measured by the amount of cash invested by owners.
- Earnings may not be recognized until the dollar investment in net assets, measured in units of money or purchasing power, is returned.
- Traditional view reflected in most financial statements.
59
Physical capital maintenance
- maintain operating power.
- Capital to be maintained is the physical productivity of the enterprise.
- Earnings may not be recognized until the current replacement costs of assets with the same productive capabilities of the assets used up are returned. It supports current cost accounting and ay be measured in nominal or constant dollars.
60
What are the four basic assumptions?
Economic Entity Assumption,
Going concern Assumption,
Monetary Unit Assumption,
Periodicity Assumption
61
Economic Entity Assumption
Economic activity can be identified with a particular unit of accountability. Note: However, you can define the entity at a higher level (e.g., Parent) or a lower level (e.g., Subsidiary).
62
Going Concern Assumption:
- The business enterprise will have a long life.
- The going concern assumption does not apply if liquidation of the business appears imminent.
- Note: The fair value of an asset irrelevant if we are a going concern and we need this asset in our operations; this is another reason to use historical cost instead of fair value.
63
Monetary Unit Assumption:
Money (the U.S. dollar) is the common denominator of economic activity and provides an appropriate basis for accounting measurement and analysis. Note: We learned this is FC currency transaction and translation.
64
Periodicity Assumption:
The economic activities of an enterprise can be divided into artificial time periods. We report financial information periodically to apprise users of performance and economic status. Note: We learned this in interim reporting.
65
Basic Principles of Accounting
Historical cost principle, revenue recognition principle, matching principle, and full disclosure principle
66
Historical Cost Principle:
GAAP requires that most assets and liabilities be accounted for and reported on the basis of acquisition price because it is the most reliable valuation. Note: There are exceptions (e.g., impairments, lower-of-cost-or-market).
67
Revenue Recognition Principle:
- Revenue is generally recognized when (1) realized or realizable and (2) earned.
- Revenues are realizable when assets received or held are readily convertible into cash or claims to cash.
- Revenues are considered earned when the entity has substantially accomplished what it must do to be entitled to the benefits represented by the revenues.
- Recognition at the time of sale provides a reasonable test.
- Exceptions to this rule are recognition
(1) during production (e.g., percentage of completion accounting for construction) and
(2) upon receipt of cash (installment sales method or cost-recovery method of accounting);
additional exceptions are (3) multiple-deliverable revenue arrangements and (4) milestone method of recognition on research and development contracts.
68
Matching Principle
Expenses are to be matched to the revenues whenever it is reasonable and practicable to do so.
69
Full Disclosure Principle:
- Accountants use their judgment in deciding what gets reported on the financial statements.
- If something does not appear on the statements, then it may appear in the footnotes or in supplementary information.
- The footnotes generally amplify or explain the items in the main body of the statements.
- Supplementary information contains other information that may be highly relevant, but less reliable.
- Note: Segment reporting is a good example of footnote disclosure.
70
Historical cost
- PPE and most inventories are reported at historical cost, amount paid to acquire an asset, commonly adjusted after acquisition for amortization or other allocations.
- Liabilities generally also reported at historical cost commonly adjusted after acquisition for amortization or other allocation.
71
Current cost
- some inventories are reported at their current (replacement) cost which is the amount of cash or equivalent that would have to be paid if the same or an equivalent asset were acquired currently
72
Current market value
- Some investments in marketable securities are reported at their current market value, which is the amount of cash or its equivalent, that could be obtained by selling an asset in orderly liquidation.
- Also used for assets expected to be sold at prices lower than previous carrying amounts.
- Some liabilities that involve marketable commodities and securities, for e.g. obligations of writers of options or sellers of common shares who do not own the underlying commodities or securities, are reported at current market value.
73
Net realizable (settlement) value
- Short-term receivables and some inventories are reported at this, which is the non-discounted amount of cash, or its equivalent, into which an asset is expected to be converted in due course of business less direct costs, if any, necessary to make that conversion.
- liabilities that involve known or estimated amounts of money payable at known future dates, for e.g., trade payables or warranty obligations, generally are reported at their net settlement value, which is the non-discounted amount of cash, or its equivalent, expected to be paid to liquidate an obligation in the due course of business, including direct costs, if any, necessary, to make that payments.
74
Present or discounted value of future cash flows
LT receivables are reported at this, which is the PV of future cash inflows into which an asset is expected to be less PV of cash outlfows necessary to obtain those inflows. Long term payables are similarly reported.
75
When are cash flows measured?
Cash flows are used when observable market place amounts (current costs) which are generally more reliable, are not available.
76
What is SFAC 7?
- Provides a framework for using future cash flows as the basis of an accounting measurement.
- It addresses measurement issues, not recognition questions.
- It only applies to measurements at initial recognition, fresh-start measurements, and amortization techniques based on future cash flows.
- It does not apply to measurements based on the amounts of cash or other assets paid or received or on observation of fair values in the marketplace.
- Does not specify when fresh start measurements are appropriate.
- Fresh-start measurements are defined by the FASB as measurements in periods following initial recognition that establish a new carrying amount unrelated to previous amounts and accounting conventions.
77
Present value formula
- Tool used to incorporate TV of money in measurement, useful when item is being measured using future cash flows,
- objective is to capture the economic difference between sets of future cash flows,
- assets with the same cash flows are distinguished from one another by the timing and uncertainty of those cash flows.
78
What is PV's objective?
The only objective when used in accounting measurements at initial recognition and fresh-start measurements, is to estimate fair value
79
Fair value
the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date under market conditions.
80
What if there is nothing observable for fair value?
Attempt to capture the elements that taken together would comprise a market price, if one existed.
81
Marketplace
- An entity is required to pay the market's price regardless of the intentions or expectations of the entity's management.
- Therefore, for measurements at initial recognition or for fresh start measurements, fair value provides the most complete and representational faithful measurement of the economic characteristics of an asset or a liability.
82
Discount rate adjustment approach
- Assumes that a single interest rate convention can reflect all of the expectations about future cash flows and the appropriate and the appropriate risk premium.
- While the traditional approach may be adequate for some simple measurements, the FASB found that it does not provide the tools needed to address more complex problems.
83
Expected cash flow approach
- found to be more affective approach than discount rate adjustment approach in many situations.
- It uses all expectations about possible cash flows instead of the single most-likely cash flow.
- The expected cash flow approach focuses on direct analysis of the cash flows in question and on explicit assumptions about the range of possible estimated cash flows and their respective probabilities.
84
Risk adjustment
- price that marketplace participants are able to receive for bearing the uncertainties in cash flows.
- This assumes that the amount is identifiable, measurement, and significant
85
Uncertainty
- cash flows used in a present value measurement are estimates, rather than known amounts.
- Uncertainty has accounting implications because it has economic consequences.
- Business and individuals routinely enter into transactions based on expectations about uncertain future events.
- The outcome of those events will place the entity in a financial position that may be better or worse than expected, but until the uncertainties are resolved, the entity is at risk
86
Risk
any exposure to uncertainty in that the exposure has negative consequences
87
Risk adverse
Marketplace participants who prefer situations with less uncertainty relative to an expected outcome.
88
Risk premium
Seek compensation for accepting uncertainty, demand more compensation to assume a liability with expected cash flows that are uncertain than to assume a liability with cash flows of the same expected amount but no uncertainty.
89
Primary objective of accounting
To measure income. Income is a measure of management's efficiency in combining the factors of production into desired goods and services.
90
Product costs
- costs which can be associated with particular sales.
- Attach to a unit of product and become an expense only when the unit to which they attach is sold.
- This is known as associating "cause and effect."
91
Period costs
not attached to a product, they become expensed due to the passage of time by
1) immediate recognition if future benefit cannot be measured,
2) systematic and rational allocation if benefits are produced in certain future periods.
92
Cash basis accounting
- recognizes income when cash is received and expenses when cash is disbursed.
- It is subject to manipulation (i.e. cash receipts and expenses can be switched from one year to another by management).
- Another reason for adopting accrual basis accounting is that economic transactions have become more involved and multi-period.
- An expenditure for a fixed asset may produce revenue for years and years.
93
Installment sales
- Revenue is recognized as cash is collected, so it occurs at point of cash collection rather than the point of sale.
- Can only be used where "collection is not reasonably assured."
- Gross profit is deferred so future periods and recognized proportionately to collection of the receivables.
- Installment receivables and deferred gross profit accounts must be kept separate by year, because the gross profit rate usually varies from year to year.
94
Cost Recovery method
- Gross profit is deferred when cumulative receipts exceed the cost of the assets sold.
- If interest revenue was to be earned, it would likewise be deferred until the entire cost was recovered, it is used when uncertainty of collection is so great that even use of the installment method is precluded.
95
Franchise Agreements
- Initial franchise fee can be recognized as revenue by the franchiser only upon substantial performance of their initial service obligation.
- The amount and timing of revenue recognized depends upon whether the contract contains bargain purchase agreements, tangible property, and whether the continuing franchise fees are reasonable in relation to future service obligations.
- Direct franchise costs are deferred until the related revenue is recognized.
96
Real estate transactions
profit can be recognized in full, provided profit is determinable and the earnings process is virtually complete.
97
What are the criteria for real estate for profit to be recognized?
1) Sale is consummated,
2) Buyer's initial and continuing investments are adequate to demonstrate a commitment to pay for the property.
3) seller's receivable is not subject to future subordination,
4) seller has transferred to the buyer the usual risks and rewards of ownership in a transaction that is in substance, a sale and does not have a substantial continuing involvement in the property.
98
Multiple deliverable revenue arragnement
Revenue generating activities to provide multiple products or services at different times, the arrangement should be evaluated to determine if there are separate units being delivered.
99
What are the conditions that must be met for an item to be considered a separate unit of accounting?
1) deliverable item has value on a stand-alone basis,
2) if arrangement includes a right of return for the delivered item, the undelivered item must be substantially in control of the vendor,
3) if it meets both requirements, the revenue arrangement is divided into separate units based on the relative selling prices.
100
Milestone method
used for research and development arrangements in which revenue (payments) to the vendor is contingent on achieving one or more milestones related to deliverables or units of accounting
101
Substantive milestone
uncertain event that can only be achieved based on the vendor's performance, relates to past perofrmance, is reasonable relative to all of the deliverables and payment terms.
102
What should financial statemtent notes say regarding milestone basis?
Notes should disclose accounting policy for recognition of milestone payments, in addition,
1) description of overall arrangement,
2) description of each milestone and related contingent consideration,
3) determination of whether each milestone is considered substantive,
4) factors considered in determining whether the milestones are substantive,
4) amount of consideration recognized during the period for the milestone or milestones.
103
What is IFRS?
International Financial Reporting Standards (IFRS) are overseen by the IASB. Considered to be "principles based approach" and focuses on a "true and fair view"
104
What is IASB framework?
- Establishes the underlying concepts for preparing fs.
- Addresses the objectives of fs, underlying assumptions, qualitative characteristics of fs information, definitions, recognition, measurement, and capital maintenance concepts.
- It is not considered a standard and therefore does not override any IAS or IFRS.
- It is there to help in the development of future international standards and to assist prepares in accounting for topics that do not have guidance in an existing standard.
105
What are the IASB elements?
Asset, liability, equity, income, expense
106
IASB asset
Resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity
107
IASB liability
present obligation of the entity arising from past events, the settlement of which is expecte dto result in an outflow from the entity of resoruces embodying economic benefits.
108
IASB equity
residual interest in the assets of the entity after deducting all its liablities
109
IASB income
increases in economic benefits during the accounting period in the form of inflows or enhancement of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants
110
IASB expenses
decreases in economic benefits during the accounting period in the form of outflows or depletion of assets or incurrence of liabilities that result in decreases in equity, other than those relating to distributions to equity participants
111
Important difference bewteen IASB revenue and GAAP revenue
- For IASB, gains are increases like revenue, therefore, they are not treated as a separate element on the Framework.
- Framework treats losses in the same way.
112
Capital maintenance adjustments- IASB framework
When assets or liabilities are revalued or restated, and there is a corresponding increase or decrease to equity, the definition of income or expense may not be met. Therefore, certain items maybe included in equity as revaluation reserves.
113
Recognition per IASB framework
Process of incorporating into the balance sheet or income statement an item that meets the definition of an element and satisfies criteria for recognition
114
IASB recognition criteria
1) Probable that a future economic benefit,
| 2) item has a cost or value that can be measured reliably
115
What does IFRS not permit?
Completed contract method is NOT allowed
116
IFRS revenue recognition
1) Significant risks and rewards of ownership passed to buyer,
2) No management involvement or control over goods by seller,
3) Revenue measured reliably,
4) economic benefits are probable,
5) costs can be measured reliably
117
IFRS first time adoption date of transition
- Beginning of the earliest period for which an entity presents full comparative information under IFRSs in its first IFRS financial statements.
- The first IFRS reporting period is defined as the latest reporting period covered by an entity's first IFRS financial statements.
118
IFRS business combinations
First-time adopter can retrospectively adopt IFRS 3 for all periods presented or adjust assets and liabilities through retained earnings in the period of adoption.
119
PPE IFRS
- Unless fair value measurement is chosen, life to date depreciation and amortization of any PPE And intangibles will need to be recalculated.
- Or entity can use many methods to determine the fair value of the assets and use those amounts as the deemed cost at the time of adoption.
- IFRS would then be used going forward. Fair value election can be applied on an individual item basis.
120
GP%=
Net sales – Cost of Sales
121
Net Sales=
Sales- Cost – Discount
122
Deferred gross profit=
Ending A/R x GP %
