FA2 Module 1. Financial reporting/accounting concepts. What is accounting? Objectives of financial reporting Accounting choice process Accounting concepts The accounting cycle Closing entries Adjusting entries. Who is your instructor?. Cameron Morrill, PhD, CGA
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Cameron Morrill, PhD, CGA
Associate Professor of Accounting
I. H. Asper School of Business
University of Manitoba
Tel: (204) 474-8435
Office hours: Wednesdays 9:30 AM – 11:30 AM
Financial accounting is concerned with the classification, recording, analysis, and interpretation of the overall financial position and operating results of an organization and providing such information to owners, managers and third parties.
It includes the processes and decisions that culminate in the preparation of financial statements.
Financial statements are an important source of information about economic organizations (required by Canadian corporations legislation and securities commissions), but are only one of several, which include:
Accounting information plays a key role in debt agreements, executive compensation and turnover, etc.
Emphasis on accounting as it helps to explain past performance.
2. Investment/resource allocation
Accounting information plays a key role in investing (buying and selling shares and other equity instruments) and credit (lending money) decisions.
Emphasis on accounting as it helps to predict future performance, especially future cash flows.
Different standards for different organizations, but underlying principles are the same
. . . to provide information about the financial position, performance and changes in financial position of an entity that is useful to a wide range of users in making economic decisions. (IASB)
Users? Target is investors (equity and debtholders) – hopefully, what is good for investors will also work for most everyone else
Assessing (performance appraisal) and predicting (investment decisions) cash flows
Why cash flows?
Generate return, pay debts
Why accrual accounting?
Cash flows are volatile, often independent of economic performance of entity; accrual accounting provides better long-run view
External users (continued)
To make accounting choices, must identify financial reporting objectives which are a function of:
Accounting concepts (conceptual framework) provide criteria to guide accounting choices and, hopefully, achieve financial reporting objectives. Concepts are:
Information is relevant when it can influence the decisions of users.
Information is a sufficiently accurate measure of what it purports to measure (economic substance over form).
Two pieces of information are comparable if they are consistent and/or uniform
Information measured and reported in a similar manner for different entities in a given year
Information is measured and reported in the same way for a given entity, from period to period. Changes occur only if justified.
Knowledgeable and independent observers can measure an economic event and arrive at the same result
Information should be available to users in time to make a difference in their decisions.
Note potential conflict between timeliness and some aspects of representational faithfulness (but not verifiability).
Significance of an item – an item is material if its omission or misstatement would probably influence or change a decision.
Also implies occasional deviation from theoretically correct treatment, e. g., expense $5 stapler rather than capitalize and depreciate.
The cost of an accounting measurement or disclosure should not exceed the benefit of such measurement/disclosure to the user (e. g., ASPE).
Inclusion of an item in one or more of the financial statements (not just note disclosure)
The process of determining the amount at which an item is recognized in the financial statements
Historical cost: Transactions/events recorded at amount of cash or equivalent received or given up at the time the event took place
Alternatives to historical cost: Fair value
Revenue is increases in economic resources (increase in assets and/or settlement of liabilities) of an entity resulting from delivering or producing goods, rendering service or performing other activities that constitute a company’s ongoing business operation.
Revenue is recognized when
An expense is recognized when an event that is part of ongoing operating activities of entity occurs which results in a decrease in an asset or an increase in a liability. For example, sale of a car creates:
Cost of goods sold: decrease in inventory
Warranty expense: increase in warranty liability
Expense recognition (continued)
If there is no clear event that causes a decrease in net assets, then
Financial statements should report all relevant information, i. e., all information that might be expected to have an impact on user decisions.
Under uncertainty, should be careful not to overstate net assets or income. Does not mean that net assets/income should be systematically understated.
Examples: A2-8, A2-20
An element is recognized and included in the accounts when it meets the definition of an element; can be measured with reasonable precision; and, for assets and liabilities, it is probable that the economic benefits will be received or given up (realized)
The accounting cycle refers to the process of recognizing and recording economic events up to the production of financial statements. The accounting cycle is based on the double-entry bookkeeping system (debits and credits).
Assets = Liabilities + Owners’ Equity
Debits = Credits
1. Journal entries to record transactions and events
2. Post journal entries to ledger
3. Prepare unadjusted trial balance to ensure that debits = credits
4. Prepare and post adjusting entries to update accounts, e. g.
5. Prepare adjusted trial balance
6. Prepare income statement from income statement accounts
7. Prepare statement of retained earnings/statement of changes in equity
8. Prepare closing entries
9. Prepare postclosing trial balance
10. Prepare balance sheet and cash flow statement
Increases assets and expenses
Decreases liabilities, owners’ equity and revenues
Decreases assets and expenses
Increases liabilities, owners’ equity and revenues
Under double-entry bookkeeping, any event that affects the financial position of the firm is recorded by (at least) one debit and (at least) one credit; the total value of the debits must equal the total value of the credits.
Example: A-20 (p. 673)
Dr. Cash 60,000
Dr. Accounts receivable 30,000
Cr. Sales revenue 90,000
Dr. Cost of goods sold 58,500
Cr. Inventory 58,500
Dr. Cash 51,000
Cr. Accounts receivable 51,000
Dr. Income taxes payable 12,000
Cr. Cash 12,000
Dr. Inventory 120,000
Cr. Accounts payable 24,000
Cr. Cash 96,000
Dr. Accounts payable 18,000
Cr. Cash 18,000
Dr. Cash 216,000
Cr. Sales revenue 216,000
Dr. Cost of goods sold 140,400
Cr. Inventory 140,400
Dr. Operating expenses 57,000
Cr. Cash 57,000
Dr. Cash 3,000
Cr. Common shares 3,000
Dr. Inventory 300,000
Cr. Cash 219,000
Cr. Accounts payable 81,000
Dr. Cash 204,000
Dr. Accounts receivable 90,000
Cr. Sales revenue 294,000
Dr. Cost of goods sold 191,100
Cr. Inventory 191,100
Dr. Cash 78,000
Cr. Accounts receivable 78,000
Dr. Accounts payable 84,000
Cr. Cash 84,000
Dr. Operating expenses 54,000
Cr. Cash 54,000
Closing entries are recorded at the end of each period to “close” income statement and dividend accounts to retained earnings, in order to
Closing entry steps
1. Close revenue accounts to income summary
Cr. Income summary
2. Close expense accounts to income summary
Dr. Income summary
Cr. COGS, Salaries expense, etc.
3. Close income summary account to retained earnings
Dr. Income summary net income
Cr. Retained earnings net income
Dr. Retained earnings loss
Cr. Income summary loss
4. Close dividend accounts to retained earnings
Dr. Retained earnings