Environment and Theoretical Structure of Financial Accounting | ACCT 4111, Study notes of Financial Accounting

Download Environment and Theoretical Structure of Financial Accounting | ACCT 4111 and more Study notes Financial Accounting in PDF only on Docsity! Chapter 01 - Environment and Theoretical Structure of Financial Accounting Question 1-1 Financial accounting is concerned with providing relevant financial information about various kinds of organizations to different types of external users. The primary focus of financial accounting is on the financial information provided by profit-oriented companies to their present and potential investors and creditors. Question 1-2 Resources are efficiently allocated if they are given to enterprises that will use them to provide goods and services desired by society and not to enterprises that will waste them. The capital markets are the mechanism that fosters this efficient allocation of resources. Question 1-3 Two extremely important variables that must be considered in any investment decision are the expected rate of return and the uncertainty or risk of that expected return. Question 1-4 In the long run, a company will be able to provide investors and creditors with a rate of return only if it can generate a profit. That is, it must be able to use the resources provided to it to generate cash receipts from selling a product or service that exceeds the cash disbursements necessary to provide that product or service. Question 1-5 The primary objective of financial accounting is to provide investors and creditors with information that will help them make investment and credit decisions. Question 1-6 Net operating cash flows are the difference between cash receipts and cash disbursements during a period of time from transactions related to providing goods and services to customers. Net operating cash flows may not be a good indicator of future cash flows because, by ignoring uncompleted transactions, they may not match the accomplishments and sacrifices of the period. 1-1 Chapter 1 Environment and Theoretical Structure of Financial Accounting QUESTIONS FOR REVIEW OF KEY TOPICS Chapter 01 - Environment and Theoretical Structure of Financial Accounting Answers to Questions (continued) Question 1-7 GAAP (generally accepted accounting principles) are a dynamic set of both broad and specific guidelines that a company should follow in measuring and reporting the information in their financial statements and related notes. It is important that all companies follow GAAP so that investors can compare financial information across companies to make their resource allocation decisions. Question 1-8 In 1934, Congress created the SEC and gave it the job of setting accounting and reporting standards for companies whose securities are publicly traded. The SEC has retained the power, but has delegated the task to private sector bodies. The current private sector body responsible for setting accounting standards is the FASB. Question 1-9 Auditors are independent, professional accountants who examine financial statements to express an opinion. The opinion reflects the auditors’ assessment of the statements' fairness, which is determined by the extent to which they are prepared in compliance with GAAP. The auditor adds credibility to the financial statements, which increases the confidence of capital market participants relying on that information. Question 1-10 On July 30, 2002, President Bush signed into law the Sarbanes-Oxley Act of 2002. The most dramatic change to federal securities laws since the 1930s, the Act radically redesigns federal regulation of public company corporate governance and reporting obligations. It also significantly tightens accountability standards for directors and officers, auditors, securities analysts and legal counsel. Student opinions as to the relative importance of the key provisions of the act will vary. Key provisions in the order of presentation in the text are:  Creation of an Oversight Board  Corporate executive accountability  Non-audit services  Retention of work papers  Auditor rotation  Conflicts of interest  Hiring of auditor  Internal control 1-2 Chapter 01 - Environment and Theoretical Structure of Financial Accounting Answers to Questions (continued) Question 1-21 The periodicity assumption relates to needs of external users to receive timely financial information. This assumption requires that the economic life of a company be divided into artificial periods for financial reporting. Companies usually report to external users at least once a year. Question 1-22 The four key broad accounting principles that guide accounting practice are (1) the historical cost or original transaction value principle, (2) the realization or revenue recognition principle, (3) the matching principle, and (4) the full disclosure principle. Question 1-23 Two important reasons to base valuation on historical cost are (1) historical cost provides important cash flow information since it represents the cash or cash equivalent paid for an asset or received in exchange for the assumption of a liability, and (2) historical cost valuation is the result of an exchange transaction between two independent parties and the agreed upon exchange value is, therefore, objective and possesses a high degree of verifiability. Question 1-24 The realization principle requires that two criteria be satisfied before revenue can be recognized: 1. The earnings process is judged to be complete or virtually complete, and, 2. There is reasonable certainty as to the collectibility of the asset to be received (usually cash). 1-5 Chapter 01 - Environment and Theoretical Structure of Financial Accounting Answers to Questions (concluded) Question 1-25 The four different approaches to implementing the matching principle are: 1. Recognizing an expense based on an exact cause-and-effect relationship between a revenue and expense event. Cost of goods sold is an example of an expense recognized by this approach. 2. Recognizing an expense by identifying the expense with the revenues recognized in a specific time period. Office salaries is an example of an expense recognized by this approach. 3. Recognizing an expense by a systematic and rational allocation to specific time periods. Depreciation is an example of an expense recognized by this approach. 4. Recognizing expenses in the period incurred, without regard to related revenues. Advertising is an example of an expense recognized by this approach. Question 1-26 In addition to the financial statement elements arrayed in the basic financial statements, information is disclosed by means of parenthetical or modifying comments, notes, and supplemental financial statements. Question 1-27 GAAP prioritizes the inputs companies should use when determining fair value. The highest and most desirable inputs, Level 1, are quoted market prices in active markets for identical assets or liabilities. Level 2 inputs are other than quoted prices that are observable including quoted prices for similar assets or liabilities in active or inactive markets and inputs that are derived principally from observable related market data. Level 3 inputs, the least desirable, are inputs that reflect the entity’s own assumptions about the assumptions market participants would use in pricing the asset or liability developed based on the best information available in the circumstances. 1-6 Chapter 01 - Environment and Theoretical Structure of Financial Accounting BRIEF EXERCISES Revenues ($340,000 + 60,000)$400,000 Expenses: Rent ($40,000  2) (20,000) Salaries (120,000) Utilities ($50,000 + 2,000) (52,000) Net income $208,000 (1) Liabilities (2) Assets (3) Revenues (4) Losses 1. The periodicity assumption 2. The economic entity assumption 3. The realization (revenue recognition) principle 4. The matching principle 1. The matching principle 2. The historical cost (original transaction value) principle 3. The economic entity assumption 1. Disagree — The full disclosure principle 2. Agree — The periodicity assumption 3. Disagree — The matching principle 4. Agree — The realization (revenue recognition) principle 1-7 Brief Exercise 1-1 Brief Exercise 1-2 Brief Exercise 1-3 Brief Exercise 1-4 Brief Exercise 1-5 Chapter 01 - Environment and Theoretical Structure of Financial Accounting Requirement 2 The specific citation that describes the information that companies must disclose about the use of fair value to measure assets and liabilities for recurring measurements is FASB ASC 820–10–50–2: “Fair Value Measurements and Disclosures-Overall- Disclosures.” Requirement 3 The disclosure requirements are: a. The fair value measurements at the reporting date 1-10 Chapter 01 - Environment and Theoretical Structure of Financial Accounting b. The level within the fair value hierarchy in which the fair value measurements in their entirety fall, segregating fair value measurements using any of the following: 1. Quoted market prices in active markets for identical assets or liabilities (Level 1). 2. Significant other observable inputs (Level 2). 3. Significant unobservable inputs (Level 3). c. For fair value measurements using significant unobservable inputs (Level 3), a reconciliation of the beginning and ending balances, separately presenting changes during the period attributable to any of the following: 1. Total gains and losses for the period (realized and unrealized), segregating those gains or losses included in earnings (or changes in net assets) are reported in the statement of income (or activities). 2. Purchases, sales, issuances, and settlements (net). 3. Transfers in and/or out of Level 3 (for example, transfers due to changes in the observability of significant inputs). d. The amount of the total gains or losses for the period in (c)(1) included in earnings (or changes in net assets) that are attributable to the change in unrealized gains and losses relating to those assets and liabilities still held at the reporting date and a description of where those unrealized gains and losses are reported in the statement of income (or activities). e. In annual periods only, the valuation technique(s) used to measure fair value and a discussion of changes in valuation techniques, if any, during the period. The FASB Accounting Standards Codification represents the single source of authoritative U.S. generally accepted accounting principles. The specific citation for each of the following items is: 1. The topic number for business combinations: FASB ASC 805: “Business Combinations.” 2. The topic number for related party disclosures: 1-11 Exercise 1-4 Chapter 01 - Environment and Theoretical Structure of Financial Accounting FASB ASC 850: “Related Party Disclosures.” 3. The topic, subtopic, and section number for the initial measurement of internal-use software: FASB ASC 350–40–30: “Intangibles–Goodwill and Other–Internal–Use Software–Initial Measurement.” 4. The topic, subtopic, and section number for the subsequent measurement of asset retirement obligations: FASB ASC 410–20–35: “Asset Retirement and Environmental Obligations–Asset Retirement Obligations–Subsequent Measurement.” 5. The topic, subtopic, and section number for the recognition of stock compensation: FASB ASC 718–10–25: “Compensation–Stock Compensation–Overall– Recognition.” Organization Group 1. Securities and Exchange Commission Users 2. Financial Executives International Preparers 3. American Institute of Certified Public Accountants Auditors 4. Institute of Management Accountants Preparers 5. Association of Investment Management and Research Users 1. Liability 2. Distribution to owners 3. Revenue 4. Assets, liabilities and equity 5. Comprehensive income 6. Gain 7. Loss 8. Equity 1-12 Exercise 1-5 Exercise 1-6 Chapter 01 - Environment and Theoretical Structure of Financial Accounting 2. Disagree — Full disclosure principle 3. Agree — The matching principle 4. Disagree — Historical cost (original transaction value) principle 5. Agree — Realization (revenue recognition) principle 6. Agree — Materiality 7. Disagree — Periodicity assumption 1. Disagree — This is a violation of the historical cost (original transaction value) principle. 2. Disagree — This is a violation of the economic entity assumption. 3. Disagree — This is a violation of the realization (revenue recognition) principle. 4. Agree — The company is conforming to the matching principle. 5. Agree — The company is conforming to the full disclosure principle. 6. Disagree — This is a violation of the periodicity assumption. Statement Assumption, Principle, Constraint 1. f. Realization principle 2. h. Full-disclosure principle 3. g. Matching principle 4. e. Historical cost principle 5. c. Periodicity assumption 6. a. Economic entity assumption 7. i. Cost effectiveness 8. j. Materiality 9. k. Conservatism 10. b. Going concern assumption 11. d. Monetary unit assumption 1. b 2. d 3. c 4. d 5. b 6. b 1-15 Exercise 1-13 Exercise 1-14 Exercise 1-15 Chapter 01 - Environment and Theoretical Structure of Financial Accounting CPA Exam Questions 1. a. Auditor independence is not a qualitative characteristic. 2. b. Neutrality is an attribute of faithful representation. 3. b. The FASB is a private body, though the SEC has the ultimate authority to set accounting standards. The FASB does not set auditing standards nor does it consist entirely of the members of the American Institute of CPAs. 4. a. Confirmatory value is an ingredient of the primary quality of relevance. 5. d. Predictive value is an ingredient of relevance. 6. b. Completeness is an ingredient of faithful representation. 7. b. The objective of financial reporting is to provide information that is useful to present and potential investors and creditors and other users in making rational investment, credit and other similar decisions. 8. d. Comprehensive income excludes only owner transactions. 1-16 CPA / CMA REVIEW QUESTIONS Chapter 01 - Environment and Theoretical Structure of Financial Accounting CMA Exam Questions 1. b. Accounting standards in the United States for nongovernmental entities are set primarily by private sector. The principle standard setters are the FASB and the AICPA’s AcSEC. 2. c. Verifiability implies a consensus among different measurers. 3. c. The four fundamental recognition criteria are: 1) the item meets the definition of an element of financial statements, 2) the item has an attribute measurable with sufficient reliability, 3) the information is relevant, and 4) the information is reliable. In addition, revenue should be recognized when it is realized or realizable and earned. 1-17 Chapter 01 - Environment and Theoretical Structure of Financial Accounting Requirement 3 The answers to this question will vary depending on the date the research is conducted. In 2009, the chairman of the IASB was Sir David Tweedie. Requirement 4 London, United Kingdom Requirement 2 In 1978, China’s enterprise reform program was initiated. Prior to 1978, all business enterprises were state owned and run. Now, China’s companies exhibit a considerable range of ownership structures. For example, the Contract Responsibility System was introduced to provide financial incentives to both workers and managers of state-owned enterprises. In addition, many state-owned enterprises were converted into companies with limited liabilities similar to corporations in the United States. Requirement 3 The author feels that the accounting environment in China differs considerably from what is typically presumed by IAS. In particular, the lack of independent/professional auditing in China implies that the proposed detailed IAS- based standards may be counterproductive in China. 1-20 Research Case 1-5 Chapter 01 - Environment and Theoretical Structure of Financial Accounting In the long run, a company will be able to provide investors with a return only if it can generate a profit. That is, it must be able to use the resources provided by investors and creditors to generate cash receipts from selling a product or service that exceed the cash disbursements necessary to provide that product or service. If this excess cash can be generated, the marketplace is implicitly saying that society’s resources have been efficiently allocated. The marketplace is assigning a value to the product or service that exceeds the value assigned to the resources used to produce that product or service. Pollution costs to society should be borne by the company/individual causing the costs to be incurred. If they are, and the pollution- causing company can still generate a profit, then society’s resources are still being allocated efficiently. From this perspective, it appears that information on pollution costs is relevant information to financial statement users. However, even though this information might be relevant, it would not possess faithful representation. For example, how could we objectively measure the costs to society of dumping hazardous waste into a river? Fish and other river-life will die, drinking water will contain more pollutants, and the river will be a less desirable place for recreation. Some of these costs can be quantified (estimated), but others can’t. It is important that each student actively participate in the process of arriving at a solution. Domination by one or two individuals should be discouraged. Students should be encouraged to contribute to the group discussion by (a) offering information on relevant issues, and (b) clarifying or modifying ideas already expressed, or (c) suggesting alternative direction. 1-21 Communication Case 1-6 Chapter 01 - Environment and Theoretical Structure of Financial Accounting Suggested Grading Concepts and Grading Scheme: Content (70%) _______ 30 Briefly outlines the standard setting process. ______ Role of FASB, SEC. ______ The process. _______ 20 Explains the meaning of economic consequences. _______ 20 Discusses the need to balance accounting considerations and economic consequences. ______ _______ 70 points Writing (30%) _______ 6 Terminology and tone appropriate to the audience of a business journal. _______ 12 Organization permits ease of understanding. ______ Introduction that states purpose. ______ Paragraphs that separate main points. _______ 12 English ______ Sentences grammatically clear and well organized, concise. ______ Word selection. ______ Spelling. ______ Grammar and punctuation. ______ _______ 30 points Discussion should include these elements. Auditors' Role in Examining Financial Statements: 1-22 Communication Case 1-7 Ethics Case 1-8 Chapter 01 - Environment and Theoretical Structure of Financial Accounting Requirement 1 The desired benefit is that the new standard will provide a better set of information to external users. This will then increase the efficiency of the resource allocation process. Better is defined by the FASB in terms of an appropriate combination of relevance and faithful representation. Requirement 2 The costs could include increased information-gathering, processing and dissemination costs to the companies affected, increased interpreting costs to users, and adverse economic consequences to the companies, their investors, creditors, employees, other interest groups as well as to society as a whole. Requirement 3 The FASB undertakes a series of elaborate information gathering steps before issuing a substantive accounting standard. These steps include open hearings, deliberations, and requests for written comments. These steps provide information to the FASB as to the possible benefits and costs of the new standard. Requirement 1 The realization principle requires that two criteria be satisfied before revenue can be recognized: 1. The earnings process is judged to be complete or virtually complete. 2. There is reasonable certainty as to the collectibility of the asset to be received (which is usually cash). Requirement 2 Disagree. The second criterion necessary for revenue recognition has been satisfied. However, the earnings process is not complete. Revenue should be recognized over the rental period, not at the beginning of the period. Requirement 1 The term matched with revenues means that an attempt is made to recognize expenses in the same period as the related revenues. Implicit in this definition is a cause-and-effect relationship between revenue and expense. However, difficulties arise in trying to identify cause-and-effect relationships. Many expenses are not directly incurred because of a revenue event. Requirement 2 The four different approaches to implementing the matching principle are: 1-25 Judgment Case 1-11 Judgment Case 1-12 Analysis Case 1-13 Chapter 01 - Environment and Theoretical Structure of Financial Accounting 1. Recognizing an expense based on an exact cause-and-effect relationship between a revenue and expense event. Cost of goods sold is an example of an expense recognized by this approach. 2. Recognizing an expense by identifying the expense with the revenues recognized in a specific time period. Office salaries is an example of an expense recognized by this approach. 3. Recognizing an expense by a systematic and rational allocation to specific time periods. Depreciation is an example of an expense recognized by this approach. 4. Recognizing expenses in the period incurred, without regard to related revenues. Advertising is an example of an expense recognized by this approach. 1-26 Chapter 01 - Environment and Theoretical Structure of Financial Accounting Analysis Case 1-13 (concluded) Requirement 3 a. The cost of producing a product - 1. b. The cost of advertising - 4. c. The cost of monthly rent on the office building - 2. d. The salary of an office employee - 2. e. Depreciation on an office building - 3. Requirement 1 The key factor is whether or not the expenditure creates a benefit beyond the current period. If it does, then the expenditure should be capitalized and expensed in future periods when the benefits from that asset are realized. For example, if the expenditure is for the purchase of a machine that will be used for five years to produce products, the expenditure creates future benefits and should be capitalized. On the other hand, if the expenditure is for this month’s rent, no benefits beyond the current period are created and the expenditure should be expensed now. Requirement 2 The key accounting principle related to this decision is the matching principle, which states that expenses are recognized in the same period as the related revenues. Requirement 3 Yes, the materiality constraint. If an expenditure creates a benefit beyond the current period but the amount is below the materiality threshold, companies often expense rather than capitalize. 1-27 Judgment Case 1-14