Intermediate Accounting O ctober 5 th , 2010

1. Intermediate AccountingOctober 5th, 2010 • DO NOT Turn in Discussion Questions (Kapnick & Wyatt) • General Course Questions • Review Take-Home Quiz Chapter 3: Accounting Mechanics • Introduce Chapter 2: The Accounting Conceptual Framework • Discuss Kapnick and Wyatt articles and discussion questions • Assignments for Thursday, October 7th: A. Quiz 1: Chapters 1-3 and readings B. Readings: Ethical Framework for Decision Making B. Discussion Questions Ethics Case

2. Chapter 2 Learning Objectives • Understand the “Objectives of Financial Reporting” and the usefulness of a conceptual framework. • Identify the qualitative characteristics of accounting information. • Define the basic elements of financial statements. • Use GAAP assumptions, principles and constraints to determine proper financial reporting (proper recognition, measurement and classification in the financial statements).

3. Objectives of Financial Accounting To provide information that is: • Useful in investment and credit decisions (useful to present and potential investors and creditors and other users in making rational investment, credit, and similar decisions) • Useful in assessing cash flow prospects (helps present & potential investors & creditors & other users in assessing the amounts, timing, and uncertainty of prospective cash receipts) • About company resources, claims to those resources and changes in them (portrays the economic resources of an enterprise, the claims to those resources, and the effects of transactions, events, and circumstances that change its resources and claims to those resources) 3

4. The Need for a Conceptual Framework • To develop a coherent set of standards and rules • Help stockholders and creditors: • 1) make wise investment choices with their limited resources by requiring companies to report comparable information using the same rules (GAAP) • 2) increase the users’ understanding and confidence in • financial reports. • To solve new and emerging practical problems • Help the FASB: • 1) issue more useful and consistent standards • 2) solve new issues quicker by referring to an existing framework of basic theory • See Chapter 2 question 1

5. ASSUMPTIONS • Economic entity • Going concern • Monetary unit • Periodicity • PRINCIPLES • Measurement • Revenue recognition • Expense recognition • Full disclosure • CONSTRAINTS • Cost-benefit • Materiality • Industry practice • Conservatism Third level HOW? QUALITATIVE CHARACTERISTICS Relevance Reliability Comparability Consistency ELEMENTS Assets, Liabilities, and Equity Investments by owners Distribution to owners Comprehensive income Revenues and Expenses Gains and Losses Second level Bridges Level 1 & 3 Conceptual Framework for Financial Reporting in the U.S. OBJECTIVES 1. Useful in investment and credit decisions 2. Useful in assessing future cash flows 3. About enterprise resources, claims to resources, and changes in them First level: Why?

6. Qualitative Characteristics Qualitative Characteristics 1. Primary qualities (Decision Usefullness) A. Relevance (1) Predictive value (2) Feedback value (3) Timeliness B. Reliability (1) Representational faithfulness (2) Verifiability (3) Neutrality 2. Secondary qualities A. Comparability B. Consistency

7. Relevance • Information is relevant if it pertains to the particular decision that is at hand. • Relevant information must possess at least two characteristics: • #1 - Timeliness - information must be available in time to influence the decision. • #2 - Either (or both) of the following: • Predictive Value - the information contains features that allow the decision maker to make predictions about the amount and timing of cash flows. • Feedback Value - the information contains features that allow the decision maker to assess the progress or outcome of the decisions already made.

8. Reliability • Information is reliable if it is reasonably accurate. To be reliable, accounting information must have three qualities: • #1 - Verifiability - information is verifiable if different informed individuals, working independently, would arrive at approximately the same conclusions. • #2 - Representational Faithfulness - the accounting information must be based on what really happened. • #3 -Neutrality - accounting information must be free from bias. It should not be slanted one way or another in an attempt to influence the decision maker. • Accounting information need not be perfectly accurate to be • reliable. Accuracy is often difficult to determine or dependent • on the instrument used for measurement purposes.

9. Comparability & Consistency • Comparabilityof accounting information means that the financial reports of one entity can be reasonably compared to the financial reports of another entity. • Consistency of accounting information means that the financial reports of one entity can be reasonably compared to the financial reports of the previous and successive periods. = • Comparing last year’s results with this year’s results would be futile if different methods were used in the two years. • Chapter 2 question #6, BE #1

10. U.S. Conceptual Framework Level 2: Hierarchy of Qualitative Characteristics

11. Define the Basic Elements of Financial Statements Concepts Statement No. 6defines ten interrelated elements that relate to measuring the performance and financial status of a business enterprise. “Moment in Time” “Period of Time” • Assets • Liabilities • Equity • Investment by owners • Distribution to owners • Comprehensive income • Revenue • Expenses • Gains • Losses Chapter 3 question 23

12. Element Definitions (E2-3) • (a) Arises from peripheral or incidental transactions. • (b) Obligation to transfer resources arising from a past transaction. • (c) Increases ownership interest. • (d) Declares and pays cash dividends to owners. • (e) Increases in net assets in a period from non-owner sources. • (f) Items characterized by future economic benefit. • (g) Equals increase in net assets during the year, after adding distributions to owners and subtracting investments by owners. • (h) Arises from income statement activities that constitute the entity’s ongoing major or central operations. • (i) Residual interest in the net assets of the enterprise. • (j) Increases assets through sale of product. • (k) Decreases assets by purchasing the company’s own stock. • Changes in equity during the period, except those from investments by owners and distributions to owners.

13. Basic Elements Exercise 2-3: Identify the element or elements associated with items below. Elements • Assets • Liabilities • Equity • Investment by owners • Distribution to owners • Comprehensive income • Revenue • Expenses • Gains • Losses • (a) Arises from peripheral or incidental transactions. • (b) Obligation to transfer resources arising from a past transaction. • (c) Increases ownership interest. • (d) Declares and pays cash dividends to owners. • (e) Increases in net assets in a period from non-owner sources. (b) (c) (d) (e) (c) (a) (a)

14. Basic Elements Exercise 2-3: Identify the element or elements associated with items below. Elements • Assets • Liabilities • Equity • Investment by owners • Distribution to owners • Comprehensive income • Revenue • Expenses • Gains • Losses (f) • (f)Items characterized by future economic benefit. • (g) Equals increase in net assets during the year, after adding distributions to owners and subtracting investments by owners. • (h) Arises from income statement activities that constitute the entity’s ongoing major or central operations. (b) (c) (d) (g) (e) (c) (h) (h) (a) (a)

15. Basic Elements Exercise 2-3: Identify the element or elements associated with items below. Elements • Assets • Liabilities • Equity • Investment by owners • Distribution to owners • Comprehensive income • Revenue • Expenses • Gains • Losses • (i) Residual interest in the net assets of the enterprise. • (j) Increases assets through sale of product. • (k) Decreases assets by purchasing the company’s own stock. • (l) Changes in equity during the period, except those from investments by owners and distributions to owners. (f) (b) (i) (c) (k) (d) (l) (g) (e) (c) (j) (h) (h) (a) (a)

16. Playing by the GAAP Rules Use GAAP assumptions, principles and constraints to determine proper financial reporting (proper recognition, measurement and classification in the financial stmts.) • Help stockholders and creditors make wise investment choices with their limited resources by requiring companies to report comparable information using the same rules (GAAP). • Apply "Conservatism" to avoid misleading investors • Understand when GAAP allows us to report Revenue • Determine when Expenses need to be reported • Use “Full Disclosure” to report everything that is important • Weigh the advantages and disadvantages of using“Historical Cost” on the Financial Statements • Determine when Expenses need to be reported • Review the 4 assumptions underlying Financial Reports • Use "Industry Practices" when there are no reporting guidelines

17. When do we get to record REVENUE? Remember where Revenue is? • The first number, and hopefully the largestnumber on the Income Statement. • The larger this number, the more work we have done for our customers, and the stronger our performance. (Revenue – Expenses = Net Income • The larger our Revenue the larger our potential Net Income. • Other names for Revenue are Sales or Service Fees.

18. Revenue should be recognized when • Cash is collected • in the period you want to report higher income • When you have done the work • When you know you will be paid • Both c & d

19. GAAP’s Two Requirements for Reporting Revenue • The Work has been done – we have earned this much money from our customer. Revenue is typically recognized when goods are delivered or services rendered. • Payment has been made (the revenue is realized) or we have confidence our customer will pay (realizable).

20. Timing of Revenue Recognition Revenue Recognition - generally occurs (1) when realized or realizable and (2) when earned. Exceptions: Chapter 2 question 20

21. Conservatism – Don’t Overstate or “Puff up” _____ & ______ on the Financial Statements Balance Sheet Assets Liabilities Stockholders’ Equity Income Statement Revenue Expenses Net Income Chapter 2 question 29

22. Conservatism - Don't Overstate or "Puff up" what on the Financial Statements? A. Assets and Expenses B. Assets and Income C. Liabilities and Revenue

23. Expense Recognition Matching: “Let the expense follow the revenues.” • It is easy to know when to record expenses if there is adirect cause and effect between expenses and revenues. - examples • If there is NO direct cause and effect between expenses and revenues: Try to allocate the expense rationally (to the time periods that are benefited) • examples: • If that is not possible or reasonable, then: Immediately recognize the expense if: a) there is no identifiable future benefit, or b) if the future benefit cannot be reasonably measured - example:

24. Example: How could a biotech firm’s $1,000,000 expenditure on research and development be recorded? DR R&D Expense? or DR R&D Asset? CR Cash For each alternative consider: What is the relevance/reliability tradeoff? How can the treatment be theoretically supported? How is your answer justified by the U.S. GAAP conceptual framework? Relevance and Reliability – Tradeoff Example

25. What value should be used to record assets? ASSETS Receivables Inventory Investments (in other company’s stock) Property Plant & equipment Goodwill Historical Cost (Price paid when acquired) Fair Market Value (Value today if sold) Chapter 2 question 13

26. Exceptions to Historical Cost for: • Conservatism • Full Disclosure • Cost/Benefit • Materiality • Going Concern

27. Full Disclosure Tell financial statement users everything they need to know to make good decisions. • Disclosure Techniques: • Parenthetical Explanations • NOTES • Cross References • Contra Items • Supporting Schedules Chapter 2 question 25

28. Moving from Historical Cost to a Conservative Fair Market Value(FMV) ASSET Recorded Value Receivables ___________________ Inventory ___________________ Property ___________________ Plant & Equip. ___________________ Goodwill ___________________ Foreign Currency & Investments in Marketable securities________________________

29. Receivables should be reported at: • Total amount your customers owe the company • The Fair Market Value (what you could get if you sold them for someone else to collect) • Net Realizable Value (amount you expect to be paid = total amount owed minus the uncollectable amounts)

30. Inventory should be reported at: • Cost - amount paid to acquire or manufacture it • Fair Market Value - amount it is worth today C. Lower of Cost or Market

31. Property (Land) should be reported at: • Cost • Fair Market Value • Cost less Depreciation

32. Plant & Equipment should be reported at: • Cost • Fair Market Value • Cost less Depreciation • Lower of Cost or Market

33. Goodwill should be reported at: • Cost • Fair Market Value of future earnings due to location, brand, employees, etc. • Cost less Amortization • Lower of Cost or Market based upon future earnings potential

34. Foreign Currency and Trading Securities should be reported at: • Cost • Fair Market Value • Lower of Cost or Market Chapter 3 question 15, BE #6

35. Moving from Historical Cost to a Conservative Fair Market Value(FMV) ASSET Recorded Value Receivables Net realizable value Inventory Lower of cost/market Property Historical Cost Plant & Equip. Cost less depreciation Goodwill Cost less impairments Foreign Currency & FMV (gain or loss recorded Investments in in Stockholders’ Equity as Marketable securities “Other Comprehensive Income”)

36. GAAP Assumptions Economic Entity– the company keeps its activity separate from its owners and other businesses. Going Concern – the company is expected to survive (last long enough to fulfill objectives and commitments). Monetary Unit - money is the common denominator. Periodicity - company can divide its economic activities into time periods. Cost-Benefit– weigh the costs of providing the in- formation against the benefit derived from using it Chapter 2 BE #8 & 9

37. Four GAAP Assumptions • Economic Entity: Should Gert Boyle record the motorcycle she uses personally on Columbia Sportswear’s financial statements? • Going Concern: What value should be used for the • store display equipment of Mom & Pop Grocery if they know • they need to file bankruptcy? • Monetary Unit: How should the Euros that Columbia Sportswear anticipates receiving from a customer in Italy be reflected on their Portland Financial Statements? • Periodicity:How frequently do Columbia Sportswear’s stockholders’ and creditors need to receive financial statements? • chapter 2 question 11

38. What do you do if there are no GAAP rules to guide you? When determining how to report financial information the guideline to use “Generally Accepted” principles may require or allow companies to rely upon widely recognized and prevalent “INDUSTRY PRACTICES” if: • There are NO authoritative guidelines published by standard setters or in the accounting literature. • The peculiar nature of a business or industry requires departure from basic theory.

39. HOUSE OF GAAP GAAP’s Objective is to provide Financial Information that is: • Useful in investment & credit decisions • Useful in assessing future cash flows • About the enterprise resources, claims to resources, and changes in them (chapter 2 ex 5, 7 & 8) add’l practice ex 4 Qualitative Characteristics A. Relevance 1) Predictive or Feedback Value 2) Timeliness B. Reliability C. Comparability D. Consistency Elements Assets Liabilities Stockholders’ Equity Other Comprehensive Income Revenues Expenses Assumptions Economic Entity Going Concern Monetary Unit Periodicity Principles Historical Cost Revenue Recognition Matching Full Disclosure Constraints Cost/Benefit Materiality Industry Practice Conservatism

40. Challenges Facing the Accounting Profession • Nonfinancial Measurements • Forward-looking Information • Soft Assets • Timeliness • An Expectations gap 40

41. Trust • Trust drives the accounting profession • SOX, PCAOB, and class action lawsuits are a result of a breach of trust • From a broad perspective, we pay a heavy price for low trust: • Waits at airports, audit fees • Implications for personal conduct (Ethics, Character and Integrity) 41

42. Issues in Financial Reporting Ethics in the Environment of Financial Accounting In accounting, we frequently encounter ethical dilemmas. • GAAP does not always provide an answer • Doing the right thing is not always easy or obvious 42

43. AICPA Principles of Professional Conduct Exercise sensitive professional and moral judgments in all activities Accept the obligation to act in a way that will serve the public interest, honor the public trust and demonstrate commitment to professionalism Perform all professional responsibilities with the highest sense of integrity to maintain and broaden public confidence. Maintain objectivity, be free of conflicts of interest, be independent in fact and appearance. Observe the profession’s technical and ethical standards, strive continually to improve confidence and quality of services and discharge professional responsibility to the best of one’s ability. Observe the Principles of the Code of Professional Conduct, section 52-57, in determining the services provided to the public. 43

44. STANDARDS OF ETHICAL CONDUCT FOR MANAGEMENT ACCOUNTANTS (adapted from IMA) • 1. COMPETENCE • Maintain professional competence. • Follow laws, regulations, and standards • Prepare complete and clear reports and recommendations after appropriate analysis. • 2. CONFIDENTIALITY • Don't disclose confidential information. • Ensure that subordinates do not disclose confidential information. • Do not use confidential information for personal gain or advantage • See next slide for items 3 & 4 44

45. STANDARDS OF ETHICAL CONDUCT FOR MANAGEMENT ACCOUNTANTS (adapted from IMA) continued • 3. INTEGRITY • Avoid actual or apparent conflicts of interest. • Refuse gifts, favors, or hospitality that might influence objectivity. • Refrain from subverting the organization's legitimate objectives. • Recognize and communicate personal limitations. • Communicate unfavorable as well as favorable information and opinions. • Refrain from actions that discredit the profession. • 4. OBJECTIVITY • Communicate information fairly and objectively. • Fully disclose all information that could be expected to influence a user's understanding. 45

46. Common Features of Criminal and Ethical Misconduct • Secret Problem • Opportunity • Rationalization

47. Resolving Ethical Dilemmas • Identify the Ethical Issues involved • Identify the Stakeholders involved (persons or organizations affected by the outcome of the dilemma) • Identify the alternative courses of action that can be taken • Decide on the best course of action consistent with the principles of honesty, integrity, and fairness and also consistent with any existing code of ethical conduct.. 47

48. Resolving Ethical Dilemmas Follow the organization’s established policies for conflict resolution. If the ethical conflict is not resolved, consider the following course of action: Discuss the problem with the immediate superior except whet it appears that the superior is involved, in which case the problems should be presented initially to the next higher managerial level. If satisfactory resolutions cannot be achieved when the problem is initially presented, submit the issues to the next higher managerial level. If the immediate superior is the chief executive officer, or equivalent, the acceptable reviewing authority may be a group such as the audit committee, executive committee, board of directors, board of trustees, or owners. Contact with levels above the immediate superior should be initiated only with the superior’s knowledge, assuming the superior is not involved Continued on next slide….. 48

49. Resolving Ethical Dilemmas, continued • Clarify relevant concepts by confidential discussion with an objective advisor to obtain an understanding of possible courses of action. • If the ethical conflict still exists after exhausting all levels of internal review, the management accountant may have no other recourse on significant matters than to resign from the organization and to submit an informative memorandum to an appropriate representative of the organization. • Except where legally prescribed, communication of such problems to authorities or individuals not employed or engaged by the organization is not considered appropriate. • *Institute of Management Accountants, Formerly National Association of Accountants, Statements on Management Accounting: Objectives of Management Accounting. Statement No. 1B, New York, NY., June 17, 1982. 49

50. Summary of Reversing Entries Reversing entries do not have to be used. Therefore, some accountants avoid them entirely. • All accruals can be reversed. • All deferrals for which a company debited or credited the original cash transaction to an expense or revenue account can be reversed. • Adjusting entries for depreciation and bad debts are not reversed.