ACC 301 Ch. 2 PP Slides
Transcript of ACC 301 Ch. 2 PP Slides
Financial Reporting: Its Conceptual
Framework
Chapter2
An electronic presentation by Norman Sunderman Angelo State University
An electronic presentation by Norman Sunderman Angelo State University
COPYRIGHT © 2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.
Intermediate AccountingIntermediate Accounting 10th edition 10th edition
Nikolai Bazley JonesNikolai Bazley Jones
2
1. Explain the FASB conceptual framework.
2. Understand the relationship among the objectives of financial reporting.
3. Identify the general objective of financial reporting.
4. Describe the three specific objectives of financial reporting.
ContinuedContinuedContinuedContinued
Objectives
3
5. Discuss the types of useful information for investment and credit decision making.
6. Explain the qualities of useful accounting information.
7. Understand the accounting assumptions and conventions that influence GAAP.
8. Define the elements of financial statements.
Objectives
4
Objectives Oriented Principles
The SEC has recommended that future accounting standards should not follow a rules-base or principles based only approach, but should be objectives-oriented.
Should be built on an improved and consistently improved conceptual framework
Clearly state the accounting objectiveMinimize exceptionsAvoid the use of bright-line (percentage) tests
5
To develop a conceptual
framework of accounting theory.
Charges Given to the FASB
6
To establish standards (GAAP)
for financial accounting practices.
Charges Given to the FASB
7
To guide the FASB in establishing accounting standards.
To provide a frame of reference for resolving accounting questions in situations where a standard does not exist.
To determine the bounds for judgment in the preparation of financial statements.
To increase users’ understanding of and confidence in financial reporting.
To enhance comparability.
FASB Conceptual Framework- serves as a conceptual underpinning that provides a unified and consistent structure and direction to financial
accounting and reporting
8
Relationship of Conceptual Framework and Standard-Setting
Process
9
Conceptual Framework Projects for Financial Accounting and Reporting
10
Objectives of Financial Reporting—TO PROVIDE INFORMATION THAT SATISFIES THE
FOLLOWING OBJECTIVESGeneral Objective
• Useful
Derived External User Objective– assess their (THE USER) prospective cash receiptsDerived Company Objective– assess the net cash inflows to the companySpecific Objectives – provide information about a
company’s– economic resources, obligations, owners’ eq.– comprehensive income and its components– cash flows
11
General ObjectiveProvide information that is
useful to present and potential investors, creditors, and other users in making their rational investment,
credit, and similar decisions.
Objectives of Financial Reporting
12
Derived External User Objective (relates to external users’ needs) (they made this investment to increase their cash
inflows)Provide information that is useful to present and potential
investors creditors, and other users in assessing the amounts, timing, and uncertainty of
prospective cash receipts from dividends and interest, and the proceeds from the
sale, redemption, or maturity of securities or loans.(investors need financial information to help set their expectations of their future cash receipts….they are
interested in not only the return of their investment, but also, a return on their investment.)
Objectives of Financial Reporting
13
Derived Company ObjectiveProvide information to help investors, creditors, and
others in assessing the amounts, timing, and uncertainty of prospective
net cash inflows to related company.(In reality, the investor’s cash receipts are affected by
the cash flows of the company)
Objectives of Financial Reporting
14
Specific Objectives---RELATE TO THE TYPES OF INFORMATION THAT A COMPANY
SHOULD PROVIDE IN ITS FINANCIAL REPORTS
Provide information about a company’s economic
resources, obligations, and owners’ equity.
Provide information about a company’s economic
resources, obligations, and owners’ equity.
Provide information about a company’s comprehensive
income and its components.
Provide information about a company’s comprehensive
income and its components.
Provide information about a company’s
cash flows.
Provide information about a company’s
cash flows.
Objectives of Financial Reporting
15
Accrual Accounting
The measurement of comprehensive income should relate or match the costs or sacrifices of a com.’s operations to the benefits from its operations.
Under accrual accounting, the financial effects of a com.’s transactions having cash consequences are related to the period in which they occur instead of to when the cash receipt or cash payment takes place.
16
First, financial reporting should provide information
about how the management of a company has dischargeddischarged its stewardshipstewardship responsibilitiesresponsibilities.
First, financial reporting should provide information
about how the management of a company has dischargeddischarged its stewardshipstewardship responsibilitiesresponsibilities.
Other Issues – the FASB raised these other issues in Other Issues – the FASB raised these other issues in its SFAC#1its SFAC#1
17
Second, financial statements and other means of financial reporting should include explanationsexplanations and
interpretationsinterpretations of management to help external users understand
the financial information provided. (KNOWN AS FULL
DISCLOSURE)
Second, financial statements and other means of financial reporting should include explanationsexplanations and
interpretationsinterpretations of management to help external users understand
the financial information provided. (KNOWN AS FULL
DISCLOSURE)
Other Issues
18
The FASB first step in developing its conceptual framework was to
establish the objectives of financial reporting. These objectives will be guidelines for providing financial information for investment and
credit decisions. These guidelines will help in the efficient operation of the capital markets and in promoting
the efficient allocation of scarce resources.
19
Types of Useful Information A company’s financial reports should provide information to help
external users asses the amounts, timing, and uncertainty about
its future net cash inflows. The FASB has identified five
types of information as being useful in meeting this specific objective.
1. Return on investment 2. Risk 3. Financial flexibility 4. Liquidity 5. Operating capability
20
Return on Investment
Provides a measure of overall company performance e.g. the comprehensive income….
21
Risk
The uncertainty or unpredictability of the future results of a company.
The greater the risk of an investment, the higher the rate of return expected by investors or the higher rate of interest charged by creditors.
22
Financial Flexibility
The ability of a company to use its financial
resources to adapt to change.Important because it enhances a company
to respond to unexpected needs and opportunities.
Reduces the risk of failure in the
event of a shortage in net cash flows from operations.
23
Liquidity
Refers to how quickly a company can convert its assets into cash to pay its bills.
Liquidity reflects an asset’s nearness to cash.An indication of a company’s ability to meet its obligations
when they come due.A more liquid company is likely to have a superior
ability to adapt to unexpected needs and opportunities.
A more liquid company is likely to have a lower risk of failure.
Liquid assets often offer lower rates of return than nonliquid assets.
24
Operating Capability
Refers to the ability of a company to maintain a given physical level of operations.
This level of operating capability may be indicated by– The quantity of goods & services produced
– The physical capacity of the fixed assetsOperating capability helps users to understand a
company’s past performance and predict its future performance.
25
Financial Reports
Return on Investment
Risk
Financial Flexibility
Liquidity
Operating Capability
•Buy•Hold• Sell
• Extend Credit
• Continue Credit
• Deny Credit
Communication Documents
Types of Useful InformationExternal Decision Making
Interrelationship of Final Reports, Useful Information and
Decision Making
26
Qualitative Characteristics of Useful Accounting Information
SFAC #2 is to specify the qualitative characteristics or “ingredients” that accounting information should have.
Hierarchy of qualitative characteristics is bounded by two constraints
• Benefits > costs• The dollar amount of the info. Must be material (large enough to
make a difference in decision making)
Hierarchy is not designed to assign priorities among the qualitative characteristics…accounting info. Must have each of the qualitative characteristics to a minimum degree
27
Understandability
Accounting information should be understandable to users who have
• A reasonable knowledge of business and economic activities
• Are willing to study the information carefully
28
Decision Usefulness
The overall qualitative characteristic to be used in judging the quality of accounting information.
Decision Usefulness can be separated into the primary qualities of
• Relevance
• Reliability
29
Relevance
Accounting information is relevant if it can make a difference in a decision
Can the accounting information help the users • Predict the outcome past, present, and future events
• Confirm or correct prior expectations
To be relevant, accounting information should have either
– Predictive value- help forecast
– Feedback value-help to confirm or correct prior expectations
– Be timely- available before it loses its ability to influence decisions
30
Reliability
Information is free from error and bias, and faithfully represents what it is intended to represent
To be reliable, information must be• Verifiable – measurement results can be duplicated by
different measurers (accountants)
• Neutral- accounting info., is neutral when it is not biased to attain a predetermined result. In other words, accounting information is not to be influenced in a predetermined direction.
• Possess representational faithfulness- there is a relationship b/w the reported accounting measurements and the economic resources, obligations, and transactions
31
Consistency and Comparability
Information about a company is more useful if it can be compared with similar information from other companies or with similar information from past periods within the company
• Intercompany comparison
• Intracompany comparison
Consistency- conformity from period to period, with accounting policies and procedures remaining unchanged
32
Constraints to the Hierarchy Benefits greater than costs –
• Accounting information is a commodity• Cost are passed onto consumers• The FASB must have reasonable assurance that the costs of implementing a
standard will not exceed the benefits
Materiality– A quantitative threshold constraint– Refers to the magnitude of an omission or misstatement of accounting info.
–would the judgment of a reasonable person relying on the information have been influenced by the omission or misstatement…..is the amount large enough to make a difference
– No quantitative guidelines for materiality
• Materiality involves judgment• Consider the nature of the item (did this item arise from abnormal
circumstances)
• Consider the relative size of the item, rather than the absolute size– Some co. establish a percentage threshold of 5% of NI and 5% of total assets
33
Primary Decision-Specific QualitiesPrimary Decision-Specific Qualities
RelevanceRelevance ReliabilityReliability
Accounting Information
Benefits>CostsBenefits>Costs
UnderstandabilityUnderstandability
Decision Usefulness
Pervasive Pervasive ConstraintConstraint
Pervasive Pervasive ConstraintConstraint
ContinuedContinuedContinuedContinued
Hierarchy of Qualitative Characteristics
User-User-Specific Specific QualityQuality
User-User-Specific Specific QualityQualityOverall Overall QualityQuality
Overall Overall QualityQuality
34
Ingredients of Primary QualitiesIngredients of Primary Qualities
RelevanceRelevance ReliabilityReliability
Predictive Value
Predictive Value
Feedback Value
Timeli-ness
Verifi-ability
Representa-tional
faithfulness
Neu-trality
Secondary and
Interactive Qualities
MaterialityMateriality
Comparability (including Consistency
Threshold for
Recognition
Threshold for
Recognition
Hierarchy of Qualitative Characteristics
35
Accounting information is relevant if it can make a difference in a decision.
Accounting information is relevant if it can make a difference in a decision.
Hierarchy of Qualitative Characteristics
36
Accounting information is reliable when it is reasonably free from error and bias, and faithfully represents what it
is intended to represent.
Accounting information is reliable when it is reasonably free from error and bias, and faithfully represents what it
is intended to represent.
Hierarchy of Qualitative Characteristics
37
Comparability of accounting information enables users to
identify and explain similarities and differences between two or
more sets of economic facts.
Comparability of accounting information enables users to
identify and explain similarities and differences between two or
more sets of economic facts.
Hierarchy of Qualitative Characteristics
38
Are benefits greater
than costs?
Constraints to the Hierarchy
39
The nature of the item.The relative size rather
than absolute size of an item.
The nature of the item.The relative size rather
than absolute size of an item.
Materiality
Constraints to the Hierarchy
40
EntityEntity
The entity assumption assumes that a proprietorship, partnership, or corporation’s
financial activities are distinguished from other financial organizations in keeping its own
financial records and reports. Each organization is distinguished from its owners. The personal
transactions are kept separate from those of the business enterprise.
The entity assumption assumes that a proprietorship, partnership, or corporation’s
financial activities are distinguished from other financial organizations in keeping its own
financial records and reports. Each organization is distinguished from its owners. The personal
transactions are kept separate from those of the business enterprise.
Assumptions and Conventions
41
ContinuityContinuity
This assumption assumes that the company will continue to operate in the near future, unless substantial evidence to the contrary exists. This assumption is also known as the going-concern assumption. The continuity assumption is necessary for many of the accounting procedures used. Example: If a company is not regarded as a going concern, it should not depreciate its fixed assets over their expected useful lives nor should it record its inventory at its cost, b/c the receipt of future economic benefits from these items is uncertain. (continued)
This assumption assumes that the company will continue to operate in the near future, unless substantial evidence to the contrary exists. This assumption is also known as the going-concern assumption. The continuity assumption is necessary for many of the accounting procedures used. Example: If a company is not regarded as a going concern, it should not depreciate its fixed assets over their expected useful lives nor should it record its inventory at its cost, b/c the receipt of future economic benefits from these items is uncertain. (continued)
Assumptions and Conventions
42
Continuity (cont)
-does not imply permanence-implies that a co. will operate long enough
to carry out its existing commitments-if a co. appears to be going bankrupt, it
must report its financial statements on a liquidation basis
• All assets and liabilities valued at the amounts estimated to be collected or paid when they are sold or liquidated
43
Period of TimePeriod of Time
In accordance with the period-of-time assumption, a company prepares financial statements at the end of each year and includes them its annual report. The period-of-time assumption is the basis for the
adjusting entry process at period-end. If the co. did not prepare FS on a certain time basis, there would be no reason to determine the time frame affected
by particular transactions.
In accordance with the period-of-time assumption, a company prepares financial statements at the end of each year and includes them its annual report. The period-of-time assumption is the basis for the
adjusting entry process at period-end. If the co. did not prepare FS on a certain time basis, there would be no reason to determine the time frame affected
by particular transactions.
Assumptions and Conventions
44
Historical Cost The exchange price at the time each transaction occurs. -a company delays recording gains//losses resulting from value
changes of assets or liabilities until another exchange occurs. -historical cost is reliable -source documents are available to confirm the recorded amount -HC information may not be completely relevant for all decisions, but
it does have reliability -in certain situations, the use of valuation methods other than
historical cost to report the fair value of selected items in FS is required b/c they provide more relevant information for the decision
-concerns for measurement problems in alternative valuation methods -fasb encourages companies to disclose supplemental current value
information in their annual reports
45
Market Value
$13,500
Market Value
$13,500Cost
$16,000
Cost$16,000
Replacement Cost
$13,000
Replacement Cost
$13,000
Historical CostHistorical Cost
Usually, the exchange price is retained in the accounting records as the value of an item until it is removed from the records.
Usually, the exchange price is retained in the accounting records as the value of an item until it is removed from the records.
Assumptions and Conventions
46
Historical CostHistorical Cost
Which amount Which amount should be used?should be used?Which amount Which amount should be used?should be used?
Cost$16,000
Cost$16,000
Assumptions and Conventions
47
Monetary UnitMonetary Unit
This assumption states that there must be some basis for measuring exchange of goods
or services. Currently the dollar is considered to be a stable monetary unit for preparing a
company’s financial statements.
This assumption states that there must be some basis for measuring exchange of goods
or services. Currently the dollar is considered to be a stable monetary unit for preparing a
company’s financial statements.
The FASB encourages companies to prepare supplemental disclosures about the impact of
changing prices.
The FASB encourages companies to prepare supplemental disclosures about the impact of
changing prices.
Assumptions and Conventions
48
Monetary Unit (cont.)
- used to be gold that was accepted in exchange for goods & services
-monetary unit is different for almost every nation-accountants generally adopt the national
currency of the reporting company and the unit of measure in FS
-the dollar is considered to be a stable monetary unit for preparing a company’s FS
49
Realization and RecognitionRealization and Recognition
Realization is the process of converting noncash resources and rights into cash or rights to cash.
Recognition is the process of formally recording and reporting
an item in the financial statements of a company.
Realization is the process of converting noncash resources and rights into cash or rights to cash.
Recognition is the process of formally recording and reporting
an item in the financial statements of a company.
Assumptions and Conventions
50
Recognition
-shown in both words and numbersTo be recognized, an item must
• Meet the definition of an element
• Be measurable• Be relevant• Be reliable
Revenues should be recognized when
1. realization has taken place
2. they have been earned
51
Realization
-the process of converting noncash resources and rights Into Cash or rights to cash
-fasb suggests that revenues are considered to be earned when a co. has substantially completed what it must do to be entitled to the benefits (assets) generated by the revenues---this is usually the point of sale
52
Recognizing revenue
-at times a co. may not recognize (record) revenue at the same time as realization
--a co. may recognize revenue• DURING PRODUCTION
– PERCENTAGE OF COMPLETION METHOD– PROPORTIONAL PERFORMANCE
• AT THE END OF PRODUCTION– A FIXED SELLING PRICE AND THERE IS NO LIMIT ON THE
AMOUNT THAT IT CAN SELL
• AFTER THE SALE– IF THE ULTIMATE COLLECTIBILITY IS UNCERTAIN
» USE THE INSTALLMENT MEHTOD» USE THE COST RECOVERY METHOD
53
Accrual accounting is the process of relating the financial effects of
transactions, events, and circumstances having cash consequences to the period in which they occur rather than to when the
cash receipt or payment occurs.
Accrual accounting is the process of relating the financial effects of
transactions, events, and circumstances having cash consequences to the period in which they occur rather than to when the
cash receipt or payment occurs.
The matching principle states that to determine the income of a company for an accounting period, the company computes the total expense involved in obtaining the revenues of the period and relates these total expenses to the total revenues recorded
in the period. INTENT IS TO MATCH THE
SACRIFICES AGAINST THE BENEFITS, OR THE
EFFORTS AGAINST THE ACCOMPLISHMENTS
The matching principle states that to determine the income of a company for an accounting period, the company computes the total expense involved in obtaining the revenues of the period and relates these total expenses to the total revenues recorded
in the period. INTENT IS TO MATCH THE
SACRIFICES AGAINST THE BENEFITS, OR THE
EFFORTS AGAINST THE ACCOMPLISHMENTS
Matching and Accrual AccountingMatching and Accrual Accounting
Assumptions and Conventions
54
MATCH EXPENSES AGAINST REVENUES ON THE BASIS OF THREE PRINCIPLES
1. ASSOCIATION OF CASUE & EFFECT• Sales commissions• Product cost included in CGS
2. SYSTEMATIC AND RATIONAL ALLOCATION
• Depreciation• amortization
3. IMMEDIATE RECOGNITION• Period costs
– salaries
55
ConservatismConservatism
The conservatism convention states that when alternative accounting valuations are
equally possible, the accountant should select the one that is least likely to
overstate assets and income in the current period.
The conservatism convention states that when alternative accounting valuations are
equally possible, the accountant should select the one that is least likely to
overstate assets and income in the current period.
Assumptions and Conventions
56
Financial Statement
Fasb has identified sources from which users might obtain information for decision making
Fasb has identified four specific FS and the elements of each
Page 52 –Sources of Information Used in External Decision Making
57
A balance sheet is a financial statement that
summarizes the financial position of a company on
a particular date.
A balance sheet is a financial statement that
summarizes the financial position of a company on
a particular date.
It also is called a statement of
financial position.
It also is called a statement of
financial position.
Balance Sheet
58
Assets are the probable future economic benefits obtained and controlled by a company as a result of past transactions or events. ECONOMIC RESOURCES
Liabilities are the probable future sacrifices of economic benefits arising from present obligations of a company to transfer assets or provide services in the future as a result of past transactions or events. ECONOMIC OBLIGATIONS
Equity is the owners’ residual interest in the net assets of a company.
Elements of a balance sheet:
Balance Sheet
59
An income statement is a financial statement that summarizes the results
of a company’s operations. A company’s operations are called the earnings process which include its
purchasing, producing, selling, delivering, servicing, and administrating activities.
An income statement is a financial statement that summarizes the results
of a company’s operations. A company’s operations are called the earnings process which include its
purchasing, producing, selling, delivering, servicing, and administrating activities.
Income Statement
60
1. Revenues are inflows or other enhancements of assets of a company or settlement of its liabilities during a period from delivering or producing goods, rendering services, or other activities that are the company’s ongoing major operation. Revenues increase the equity of a company.
ContinuedContinuedContinuedContinued
The four elements of the income statement are:
Income Statement
61
2. Expenses are outflows or other using up of assets of a company or incurrences of liabilities during a period from delivering or producing goods, rendering services, or carrying out other activities that are the company’s ongoing major operation. Expenses decrease the equity of a company.
ContinuedContinuedContinuedContinued
The elements of the income statement are:
Income Statement
62
3. Gains are increases in the equity of a company from peripheral or incidental transactions and from all other transactions and other events and circumstances affecting the company, except those that result from revenues or investments by owners. Gains increase the equity of a company.
ContinuedContinuedContinuedContinued
The elements of the income statement are:
Income Statement
63
4. Losses are decreases in the equity of a company, from peripheral or incidental transactions except those that result from expenses or distribution to owners. Losses decrease the equity of a company.
The elements of the income statement are:
Income Statement
64
Expenses decrease the equity of the
company. May be thought of as
measures of the efforts to achieve
the revenues
Income Statement
Revenues increase the equity of the company. May be thought
of as measures of the accomplishments of a co. during
its accounting period.
65
Gains/Losses
-gains are similar to revenues-gains relate to a company’s secondary
activities, not to its primary operations-losses are similar to expenses-losses relate to a company’s secondary
activities
66
A statement of cash flows is a financial statement that
summarizes the cash inflows and outflows of a company for a
period.
A statement of cash flows is a financial statement that
summarizes the cash inflows and outflows of a company for a
period.
Statement of Cash Flows
67
Operating cash flows are the flows of cash from acquiring, selling, and delivering goods for sale, as well as providing services.
Investing cash flows are the flows of cash from acquiring and selling investments, property, plant, and equipment, as well as from lending money and collecting on loans.
Financing cash flows are the flows of cash to and from the owners and long-term creditors.
The elements of a statement of cash flows are:
Statement of Cash Flows
68
A statement of changes in equity summarizes the changes in a company’s
equity for a period.
A statement of changes in equity summarizes the changes in a company’s
equity for a period.
Statement of Changes in Equity
69
Investments by owners are increases in equity resulting from transfers of something valuable to the company from other entities in order to obtain or increase ownership interest.
Distribution to owners are decreases in equity of a company caused by transferring assets, rendering services, or incurring liabilities to owners.
A statement of changes in equity contains two elements:
Statement of Changes in Equity
70
1. Financial and nonfinancial data.1. FS and related disclosures2. High level operating data and performance measures
2. Management’s analysis of the financial and nonfinancial data.1. Reasons for changes2. The identity and past effect of key trends
3. Forward-looking information.1. Assessment of opportunities and risks2. Management plans3. Comparison of actual business performance to plans
4. Information about management and shareholders.1. Directors, management, compensation, major shareholders2. Transactions and relationship among related parties
5. Background about the company.1. Broad objectives and strategies2. Scope of business3. Industry structure
Framework of the Model – 5 categories
Model of Business Reporting—the information that a company provides to help users with capital allocation
decision about the company…goal of the model is provide a foundation for future improvement in business reporting—a
recommendation by AICPA
71
IASB Framework
In 2004, the FASB and the IASB added to their respective agendas a project to develop a common conceptual framework.
Promote harmonization of future accounting standards that are principles based
72
Question 1
The conceptual framework, which is intended to provide a theoretical foundation for consistent accounting standards, has been essentially completed, with seven Statements of Financial Accounting Concepts issued.
73
SFACs
Statement No. 1 "Objectives of Financial Reporting by Business Enterprises,"
Statement No. 2 "Qualitative Characteristics of Accounting Information,"
Statement No. 3 "Elements of Financial Statements of Business Enterprises," (replaced by Statement No. 6 "Elements of Financial Statements"),
Statement No. 4 "Objectives of Financial Reporting by Nonbusiness Organizations,"
Statement No. 5 "Recognition and Measurement in Financial Statements of Business Enterprises,” and Statement No. 7 “Using Cash Flow Information and Present Value in Accounting Measurements.”
74
Question 2
The most general objective is that financial reporting should provide useful information for present and potential investors, creditors, and other external users in making rational investment, credit, and similar decisions.
Investors include both equity security holders (stockholders) and debt security holders (bondholders), while creditors include suppliers, customers and employees with claims, individual lenders, and lending institutions.
75
question 3The "derived external user objective" is to provide
information that is useful to external users in assessing the amounts, timing, and uncertainty of prospective cash receipts. This objective is important because individuals and institutions make cash outflows for investing and lending activities primarily to increase their cash inflows. Financial information is needed to help establish expectations about the timing and amount of prospective cash receipts (e.g., dividends, interest, proceeds from resale or repayment) and assess the risk involved.
76
Question 4
The "derived company objective" is to provide information to help investors, creditors, and others in assessing the amounts, timing, and uncertainty of prospective net cash inflows to the related company. Information about (1) a company's economic resources, obligations, and owners' equity; (2) a company's comprehensive income and its components; and (3) a company's cash flows should be reported to satisfy the "derived company objective.“
77
Question 5 Information about the "economic resources and claims to
those resources" of a company is useful to external users for four reasons:
1. To identify the company's financial strengths and weaknesses and to assess its liquidity;
2. To provide a basis to evaluate information about the company's performance during a period;
3. To provide direct indications of the cash flow potentials of some resources and the cash needed to satisfy obligations; and
4. To indicate the potential cash flows that are the joint result of combining various resources in the company's operations.
78
Question 5 cont.
Information about the "comprehensive income and its components" of a company is useful to external users in:
1. Evaluating management's performance;2. Estimating the "earning power" or other
amounts that are representative of its long-term income producing ability;
3. Predicting future income; and4. Assessing the risk of investing in or lending
to the company.
79
Question 5 cont.
Information about the cash flows of a company is useful to external users:
1. To help understand its operations;2. To evaluate its financing and investing
activities;3. To assess its liquidity; andTo interpret the comprehensive income
information provided.
80
Question 6
The terms are defined as follows: (a) return on investment provides a measure of overall company performance, (b) risk is the uncertainty or unpredictability of the future results of a company, (c) financial flexibility is the ability of a company to use its financial resources to adapt to change, (d) liquidity refers to how quickly a company can convert its assets into cash to pay its bills, and (e) operating capability refers to the ability of a company to maintain a given physical level of operations.
81
Question 7
Decision usefulness is the overall qualitative characteristic of useful accounting information. The two primary qualities of decision usefulness are relevance and reliability.
82
Question 8
information is relevant if it can make a difference in a decision by helping users predict the outcomes of past, present, and future events or confirm or correct prior expectations. To be relevant, accounting information must be timely and must have either predictive value or feedback value, or both. Predictive value is present when the information helps decision makers forecast the outcome of past or present events more accurately. Feedback value is present when the accounting information enables decision makers to confirm or correct prior expectations. Timeliness is having information available to decision makers before it loses its capacity to influence decisions.
83
Question 9
Accounting information is reliable if it is reasonably free from error and bias and faithfully represents what it purports to represent. To be reliable the information must be verifiable, neutral, and possess representational faithfulness. Verifiability is the ability of accountants to agree that the selected method has been used without error or bias. Representational faithfulness is the degree of correspondence between the reported accounting measurements and the economic resources, obligations, and the transactions and events causing changes in these items. Neutrality is present when information is not biased to influence behavior in a particular direction. Neutrality also implies a completeness of information.
84
Question 10
The secondary quality of useful accounting information is comparability. Comparability of accounting information enables users to identify and explain similarities and differences between two (or more) sets of economic phenomena. Comparability is enhanced by consistency. Consistency means conformity from period to period with unchanging accounting policies and procedures. Without consistency, it would be difficult to determine whether differences in results were caused by economic differences or simply differences in accounting methods.
85
Question 11
Materiality refers to the magnitude of an omission or misstatement of accounting information that makes it likely the judgment of a reasonable person relying on the information would have been influenced by the omission or misstatement. Materiality is closely linked to relevance. Both characteristics are defined in terms of the influences that affect a decision maker. However, relevance deals with the need that the users may have for that information, while materiality occurs because the amount is large enough to make a difference.
86
Question 12
The continuity assumption (or going-concern assumption) is the assumption that a company will continue to operate in the near future, unless substantial evidence to the contrary exists. This assumption is important in financial accounting because it is necessary for many of the accounting procedures used by the company. For example, its assets which are depreciated and its method of recording inventory may be affected if the future economic benefits from these items are uncertain.
87
Question 13
The period-of-time assumption is the assumption that a company has adopted the year, either calendar or fiscal, as the reporting period. This assumption is important to financial accounting because it is the basis for the adjusting entry process in accounting. If a company's financial statements were not prepared on a yearly (or shorter time) basis, there would be no reason to determine the time frame affected by particular transactions.
88
Question 14
Historical cost is the exchange price that is retained in the accounting records as the value of an economic resource. Reliability provides the rationale behind the use of historical cost; it possesses representational faithfulness, neutrality, and verifiability (i.e., source documents are usually available to substantiate the recorded amount).
89
Question 15
Recognition the process of formally recording and reporting an item in the financial statements of a company. Realization is the process of converting noncash resources and rights into cash or rights to cash. Two factors provide guidance for revenue recognition. Revenues should be recognized when: (1) realization has taken place, and (2) the revenues have been earned. Revenues are considered to be earned when a company has substantially completed what it must do to be entitled to the benefits generated by the revenues. Thus, revenue is usually recognized at the point of sale.
90
Question 16
Accrual accounting is the process of relating the financial effects of transactions, events, and circumstances having cash consequences to the period in which they occur instead of when the cash receipt or payment occurs. This process is related to the matching principle, which states that to determine the income of a company for an accounting period the company computes the total expenses involved in obtaining the revenues of the period and relates these total expenses to (matches them against) the total revenues recorded in the period.
91
Question 17
The three principles for matching expenses against revenues are:
1. Associating cause and effect;2. Systematic and rational allocation;
and3. Immediate recognition.
92
Question 18
Conservatism states that when alternative accounting valuations are equally possible, the accountant should select the alternative which is least likely to overstate the company’s assets and income in the current period. Conservatism, however, can conflict with neutrality. Conservative financial statements may be unfair to present stockholders and biased in favor of future stockholders because the net valuation of the company may not fully include future expectations. The result may be a relatively lower current market price of the company's common stock.
93
Question 19
A balance sheet (or statement of financial position) is a financial statement that shows the financial position of a company on a particular date (usually the end of the accounting period). There are three elements of a balance sheet: (a) assets, (b) liabilities, and (c) equity.
94
Question 20
An income statement is a financial statement that shows the results of a company's operations (i.e., net income) for a period of time (generally a one-year or one-quarter accounting period). There are four elements of an income statement: (a) revenues, (b) expenses, (c) gains, and (d) losses.
95
Question 21
A statement of cash flows is a financial statement that shows the cash inflows and outflows of a company for a period of time (generally one year or one-quarter). There are three elements of a statement of cash flows: (a) operating cash flows, (b) investing cash flows, and (c) financing cash flows.
96
Question 22
statement of changes in equity shows the changes in a company's equity for a period of time (generally one year or one-quarter). There are two elements of a statement of changes in equity: (a) investments by owners, and (b) distributions to owners.
97
question 23 The IASB Framework states that the objective of financial
statements is to provide information about the financial position, performance, and changes in financial position of a company that is useful to a wide range of users in making economic decisions. The Framework has two underlying assumptions; that a company is a going concern and uses accrual accounting. It identifies four qualitative characteristics of financial statements–understandability, relevance (including materiality), reliability ( including faithful presentation, substance over form, neutrality, prudence, and completeness), and comparability. Three constraints on relevant and reliable information are identified; they include timeliness, balance between benefit and cost, and balance between the qualitative characteristics. The Framework calls for financial statements that present a true and fair view of the company and a fair presentation of the company’s activities.
98
Chapter2
Task Force Image Gallery clip art included in this electronic presentation is used with the permission of NVTech Inc.