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FINANCIAL ACCOUNTING
Where do the numbers reported in the financial statements come from? BOOKEEPING
- Recorded during the financial year by:
- Focusing on transactions – Understanding their impacts on the entity’s assets, liabilities, and / or equity by means of a peculiar conceptual lens (“accounting equation”)
- Identifying such impacts through “accounts” and “transaction analysis”
- Formalising such impacts through journalising and posting
- Aggregating such impacts in an unadjusted trial balance
- Adjusted at the end of the financial year REQUIRED STEPS IN THE ACCOUNTING CYCLE TRIAL BALANCE
- A list of accounts and their balances at a given time
- Accounts are listed in the order in which they appear in the ledger
- Assets ; Liabilities ; Equity ; Revenues ; Expenses
- Purpose is to prove that debits equal credits
- May also uncover errors in journalizing and posting
- Useful in the preparation of financial statements LIMITATIONS
- The trial balance may balance even when:
- A transaction is not journalized
- A correct journal entry is not posted
- A journal entry is posted twice
- Incorrect accounts are used in journalizing or posting
- Offsetting errors are made in recording the amount of a transaction
ADJUSTING ENTRIES
BASICS
- Ensure that revenue recognition & expense recognition principles are followed
- Delivery & use may not be properly captured during the accounting period
- Use does not involve an exchange with third parties & is often not captured in formal docs
- Applying revenue & matching principles on a daily basis would be costly & time- consuming
- Eg day-by-day depreciation!
- Required every time a company prepares financial statements
- Based on the tools used to analyse & record transactions
- Transaction Analysis – Journal & ledger
- Require additional estimations, assumptions, & judgments
- Values do not stem directly from exchanges with third parties
- Follow unadjusted trial balance & lead to adjusted trial balance
- Include one income statement account and one balance sheet account
- Never include cash REVENUE RECOGNITION PRINCIPLE
- Co’s recognise revenue in the acctg period in which the performance obligation is satisfied, regardless of whether / when cash is received
- Goods delivered – Services rendered
- If cash is received BEFORE the obligation is satisfied: UNEARNED or DEFERRED REVENUES when cash is received
- If cash is received AFTER the obligation is satisfied: A/R when the obligation is satisfied EXPENSE RECOGNITION (MATCHING) PRINCIPLE
- Match expenses with revenues in the period when the company makes efforts to generate those revenues – Regardless of time of purchase – Regardless of time of payment
- “Let the expenses follow the revenues”
- Emphasis on the USE of resources ADJUSTING ENTRIES TYPES DEFERRALS
- PREPAID EXPENSES: Expenses paid in cash and recorded as assets before they are used or consumed
- UNEARNED REVENUES: Cash received before service are performed ACCRUALS
- ACCRUED REVENUES: Revenues for services performed but not yet received in cash or recorded
- ACCRUED EXPENSES: Expenses incurred but not yet paid in cash or recorded
THE ADJUSTED TRIAL BALANCE
- Prepared after all adjusting entries are journalized and posted
- Intended to prove the equality of debit balances and credit balances in the ledger
- Provides the primary basis for the preparation of the financial statements INCOME STATEMENT “HOW SUCCESSFULLY HAS THE ENTITY PERFORMED?”
- Reports revenues and expenses for a specific period of time
- Net income – revenues exceed expenses
- Net loss – expenses exceed revenues
- Past net income provides information for predicting future net income CLASSIFIED INCOME STATEMENT
- OPERATING ACTIVITIES (central focus of the business): can include insurance, repairs, utilities,
fuel expenses. It includes OPERATING REVENUES and OPERATING EXPENSES.
- SUBTOTAL OF OPERATING REVENUES MINUS OPERATING EXPENSES (OPERATING INCOME)
- PERIPHERAL ACTIVITIES (not the main focus of the business, OTHER ITEMS, such as
investment income, interest expense, loss on restaurants sold)
- SUBTOTAL OF ALL REVENUES MINUS EXPENSES EXCEPT TAXES (INCOME BEFORE INCOME
TAXES)
- INCOME TAX EXPENSE
- NET INCOME
STATEMENT OF RETAINED EARNINGS
“HOW MUCH OF PREVIOUS INCOME HAS BEEN DISTRIBUTED AS DIVIDENDS AND HOW MUCH HAS
BEEN REINVESTED IN THE ENTITY?”
- Statement shows amounts and causes of changes in retained earnings during the period.
- Time period is the same as that covered by the income statement.
- Users can evaluate dividend payment practices BALANCE SHEET “WHAT DOES THE ENTITY OWN & OWE?”
- Balance sheet presents a snapshot at a point in time
- Reports assets and claims to assets at a specific point in time
- Assets = Liabilities + Stockholders’ Equity CLASSIFIED BALANCE SHEET
- Balance sheet presents a snapshot at a point in time
- To improve understanding, companies group similar assets and similar liabilities together STANDARD CLASSIFICATION
STATEMENT OF CASH FLOWS
“WHERE WAS CASH OBTAINED & HOW HAS IT BEEN USED?”
Reports inflows and outflows of cash during the accounting period in the categories of operating, investing, and financing Preparing the Statement of Cash Flows:
- Simplified version:
- Classification of entries in the Cash account as operating, investing, or financing cash flows
- Real life: it Requires:
- Balance sheet at end of relevant acctg period
- Balance sheet at beginning of relevant acctg period = Balance sheet at end of previous acctg period
- Income statement for relevant acctg period
- Additional info MORE ON THIS LATER… POST-CLOSING TRIAL BALANCE Purpose is to prove the equality of the permanent account balances after journalizing and posting of closing entries
What are the main standard-setting bodies? At the national level:
- US : the FASB (Financial Accounting Standards Board) issues the GAAP (Generally
Accepted Accounting principles, American accounting standards)
- Other countries: National regulators (e.g. Italy’s civil code & OIC standards,
Organismo italiano di contabilità)
- At the international level: IASB (International Accounting Standards Board).
IASB was formed in 2001 as the successor organisation to the International Accounting Standards Committee, IASC, which had been setting International Accounting Standards, IAS since 1973. It issues the International Financial Reporting Standards ( IFRS ). IFRS can cover or replace topics present in the IAS (e.g., new standards on leasing). Principles of the IFS take precedence if there's contradiction with those of the IAS, and this results in the IAS principles being dropped. So, depending on the topic, companies refer to IAS or IFRS. THE IASB The International Accounting Standards Board is an independent, privately-funded (not by the government) accounting standard setter based in London, UK. It is the standard-setting body of the IFRS Foundation. The Board is committed to developing a single set of global accounting Standards that provide high quality, transparent and comparable information in general purpose financial statements. The IASB conducts extensive public consultations (“due process”, specific steps before issuing new standards, consulting, advices by national boards, accounting standards setter boards, professionals) and seeks the co-operation of international and national bodies around the world. The IASB has 14 full-time members drawn from 12 countries and a variety of professional backgrounds. IASB members are appointed by, and accountable to, the Trustees of the IFRS Foundation, who are required to select the best available combination of technical expertise and diversity of international business and market experience. In their work the Trustees are accountable to a Monitoring Board of public authorities. The IFRS Foundation's three-tier structure The IFRS Foundation has a three-tier governance structure, based on two independent standard-setting boards of experts (International Accounting Standards Board that issues IFRS accounting standards and International Sustainability Standards Board that issues IFRS sustainability disclosure standards), governed and overseen by Trustees from around the
world (IFRS Foundation Trustees) who in turn are accountable to a monitoring board of public authorities (IFRS Foundation Monitoring Board). The “due process” IFRS Standards are developed through an international consultation process, called the "due process", which involves interested individuals and organizations from around the world. The principles of due process are:
- Transparency
- full & fair consultation
- accountability
Changing standards can mean changing business decisions: e.g., change leasing standards changes a lot of business decisions. MAIN COMPONENTS OF A SET OF ACCOUNTING STANDARDS Conceptual framework is chosen by the standard setter body that sets the international accounting standards. In the conceptual framework, starting from declaring what you think as a standard setter body, there is the objective of the financial reporting
FAIR VALUE PRINCIPLE: the actual value of an asset, estimation made by using the value of the market. COST: historical cost, using the invoice of the counterpart, the seller of that asset. It can be either the notary public deed, or whatever… some historical official document, which is extremely trusted by the official authorities. FAIR VALUE: more complicated. It is the value that is normally evident, that results from an ordinary negotiation between us and a thrift party, on a market, for identical items. The listed price for something, the price that comes from a public market. It can be used for raw material, for real estate. The best quality of fair value is the listed price of an asset, regarding liability can it have a listed price? Yes, because it can be still listed on the market. If out asset or liability does not have a public market, its necessary to make estimate, using the market data. It is an ADJUSTED VALUE, if we don’t have a listed value. If the asset is customized, it can have a fair value, especially when it comes to plant, buildings. A fair value can be determined by starting from the most similar asset on the market, but we need more discretion. It is mainly due to the fact that the determination of fair value needs professional judgement, that’s why the quality of fair value can be lower, because we don’t have a precise market value we can look at. !!! The choice between the two option is an accounting policy, the values will be different. For large companies or groups that are listed, even though it can be applied also for non- listed companies. The use of fair value is much wider within the IFRS system, since it is more likely you provide information to investors. The shareholders are very interested to fair value, because it is updated with respect to the historical value, which can be very old. FINANCIAL STATEMENTS LIST, CONTENT AND PURPOSE These five are mandatory in international accounting standards While in Italy, retained earnings statement and comprehensive income statement are not mandatory.
TREATMENTS OF SPECIFIC ITEMS OR TRANSACTIONS
IFRS currently in issue IAS currently in issue Interpretations by IFRIC currently in issue Interpretations by SIC currently in issue
THE EU APPROACH: IFRS STANDARDS ENDORSEMENT
Starting from 2005, the European Regulation 1606/2002 has mandated the adoption of IAS/IFRS in all the member states of the European Union for consolidated accounts of listed groups (listed must prepare individual and consolidated financial accounts); options for single Member States to extend the use of IFRS to individual accounts and non-listed groups. (if a company part of a another company it has to prepare individual and consolidated financial statement/annual report). IFRS/IAS must be ‘endorsed’ in a specific procedure in order to become binding law in the EU. The technical body involved in this procedure is the European Financial Reporting Advisory Group (EFRAG). EFRAG provides technical advice to the European Commission on whether newly issued or revised IFRS meet the criteria in the IAS Regulation for endorsement for use in the EU. EU ENDORSEMENT PROCEDURE EFRAG gives technical advice to EU commission if to accept the new standards; then the decisions go to the commission, followed by the Accounting Regulatory committee vote. After that, European union, the council and parliament will have the last word (legislative power). Then the IFRS become mandatory. THE CONVERGENCE MODEL: FASB VS. IASB The basic recording process is followed worldwide & is unlikely to change in the future
- The double-entry system is the basis of accounting systems worldwide
- Transaction analysis is the same under IFRS and US-GAAP (although different
standards sometimes impact how transactions are recorded)
- The trial balance is the same under IFRS and US-GAAP
- IFRS rely less on historical cost and more on fair value than US-GAAP.
- IFRS are less detailed (more principles-based & less rules-based) than US-GAAP. The
definitions of assets, liabilities, equity, revenues, and expenses may change over time as the IASB and FASB evaluate their overall conceptual framework for establishing accounting standards.
(Usually in the price it is included IVA, not studied in this course) FOB SHIPPING POINT: FREE ON-BOARD SHIPPING POINT/DESTINATION explains the shipping terms: who is responsible for the goods and at which point (who is the owner, recording the loss) 2/10, n/30: CREDIT TERMS, when you have to pay RETURNING POLICY When the accountant receives the invoice, they record the purchase. SHIPPING TERMS : PAYING FREIGHT COSTS ON MERCHANDISE PURCHASED FOB shipping point: inventory cost should include all costs to acquire the inventory, including freight cost. Companies recognize these costs as cost of goods sold when the inventory is sold. When the seller pays the fright charges, the seller will usually establish a higher invoice price for the goods to cover the shipping expense. FREIGHT COSTS a) FOB Shipping Point: Assume upon delivery of the goods on May 6, Sauk Stereo pays Public Freight Company €150 for freight charges, the entry on Sauk Stereo’s books is: b) FOB Destination: Assume the freight terms on the invoice in Illustration 5-6 had required PW Audio Supply to pay the freight charges, the entry by PW Audio Supply (the seller) would have been: (Seller pays for transport)
P URCHASE RETURNS AND ALLOWANCES
Purchaser may be dissatisfied because goods are damaged or defective, of inferior quality, or do not meet specifications. Two options: return or allowance (the seller allows to keep the good and to have a reduction in the price to be paid) a) Assume Sauk Stereo returned goods costing €300 to PW Audio Supply on May 8. b) Suppose instead Sauk Stereo chose to keep the goods after being granted a € 50 allowance (reduction in price). CREDIT TERMS Invoices report “ Credit terms ”. Credit terms of a purchase on account may permit the buyer to claim a cash discount for prompt payment (purchase discount) Credit terms specify the amount of the cash discount and time period in which it is offered and indicate the time period in which the purchaser is expected to pay the full invoice price (from the issuance of the invoice). PURCHASE DISCOUNTS n/30: remaining amount due after subtracting any sales returns and allowances and partial payments. EOM: end of month If not respecting the deadline, the seller will ask to pay the interest.
SALES TRANSACTIONS - PERPETUAL INVENTORY SYSTEM
SALES TRANSACTIONS
In accordance with the revenue recognition principle, companies record sales revenue when the performance obligation is satisfied (when goods are transferred from the seller to the buyer). Sales may be made on credit or for cash and a business document should support every sales transaction.
- Selling merchandise to customers
- Paying freight costs on sales (FOB destination) – see previous section
- Granting sales returns or allowances to customers
- Receiving payment from customers within discount period (sales discounts)
RECORDING SALE OF MERCHANDISE
- Same as invoice to the buyer
- Sales revenue is recorded when the performance obligation is satisfied (revenue recognition principle).
- Performance obligation is satisfied when the goods are transferred from the seller to the buyer.
- Business documents support journal entries (Sales invoice for credit sale, Cash register documents for cash sales)
- the seller makes two entries for each sale. It is an up-to-date information of inventories sold and those still on hand Example PW Audio Supply records the sale of €3,800 on May 4 to Sauk Stereo on account. Assume the merchandise cost PW Audio Supply €2,400.
SALE RETURNS AND ALLOWANCES
“Flip side” of purchase returns (reverse both entries) and allowances (reverse just the first entry). The seller records: Sales returns/allowances: contra revenue account, how many goods are returned, to be disclosed in the income statement, it reduces the value of revenues. SALES DISCOUNTS Sales discounts are based on invoice price less returns and allowances, if any. They are contra revenue accounts Discount for the buyer: decrease in cost of inventory Discount for the seller: if collecting money, decrease in accounts receivable and discount revenue (a contra revenue account)
