Intermediate financial accounting 1
Process: The method of describing events and transactions and collecting the descriptorsis organized by what is called the accounting process. It is a set of rules and practices,supported by hardware and dedicated software, and coordinated through the activities ofa variety of people, extending well beyond the staff of the accounting department, such asprocurement, payroll, inventory managers, materials handling, etc.
Transactions include such events as the acquisition of resources, selling the firm’s output,securing work space through the signing of lease, payment of the monthly rent, obtaining aloan from a financial institution, etc. Financial accounting only recognizes transactionsthat have or will have monetary implications, i., which will result in a exchange of cash atsome point. However, rules that govern financial accounting create certain exceptions suchas depreciation in which the cash transaction takes place before the recognition of the‘value creation event’.
Materialization of transactions: Each transaction is materialized by a concretedocument (invoice, bank statement, voucher, receipt, secure instructions given byelectronic communication etc.). If a transaction is not documented, the accountant cannotrecognize it and record it.
Analysis of transactions consists in defining the category or class each transactionbelongs to, so they may be aggregated into homogeneous classes. This step in theaccounting process is often manual (with the possibility of human errors andinconsistencies).
Recording is generally carried out on a regular periodic basis (most frequently, daily),and in chronological order. This may explain why the record of these transactions is calledthe journal.
Valuation consists in attaching to the transaction the monetary amount that will berecorded. It is often easy to know the monetary value of a transaction when it is backed byan invoice, but the choice of the amount is, often, a more subjective decision as, forexample, in the case of an exchange of non-cash assets.
Accounting standards are authoritative statements of how particular types oftransactions and other events should be recorded and reflected in financial statements.
Managerial accounting deals with the informational needs of decision makers inside thefirm. It therefore deals with complex issues such as detailed product costs, or business-process cost analysis, or the diffusion of information inside the firm to create amobilization of the energies of all members of personnel and staff. It spans a wide range offields from cost issues to management of performance.
Financial accounting and managerial accounting use the same basic information(economic events occurring with the purpose of creating current or future economicbenefits) for different purposes. They cannot describe events in different ways. Simply put,financial accounting tends to be a ‘recording’ of historical events and reports it in
aggregated ways, while managerial accounting uses the same information, kept at ahigher level of details and structured differently, to forecast future situations through afine modelling of business process.
According to the IASB, the qualitative characteristics of useful financial informationidentify ‘the types of information that are likely to be most useful to the existing andpotential investors, lenders and other creditors for making decisions about the reportingentity on the basis of information in its financial report. The two principal qualitativecharacteristics are relevance and full representation. The usefulness of financialinformation is enhanced if it is comparable, verifiable, timely and understandable. Relevance: Relevant financial information is capable of making a difference in the decision made by users. Financial information is capable of making a difference in decisions if it has predictive value, confirmatory value or both. The relevance of information is affected by its nature and materiality. Information is material if omitting it, or misstating it, could influence decisions that users make on the basis of financial information about a specific reporting entity. Representation: To be a perfectly faithful representation, a depiction would have three characteristics. It would be complete, neutral and free from error. A complete depiction includes all information necessary for a user to understand the phenomenon being depicted, including all necessary descriptions and explanations. A neutral depiction is without bias in the selection or presentation of financial information. Free from error means there are no errors or omissions in the descriptions of the phenomenon.
Enhancement of usefulness: Comparability, verifiability, timeliness, understandability.
An asset is a ‘resource controlled by the entity as a result of past events and from whichfuture economic benefits are expected to flow to the entitity’. Non-current or long-lived asset: Resources not supposed to be sold or potentially consumed in their entirety in the normal operating cycle, or resources not supposed to be realized within 12 months after the reporting period: --- Tangible assets: resources tangible in nature such as plant and equipment. --- Intangible assets: resources intangible in nature such as patents or software. --- Financial assets: shares/bonds of another business or loans/credit to thirds. Current or operating assets: resources related to the normal operating cycle or resources to be sold or potentially consumed in their entirety within 12 months after the reporting period, or cash: inventories, receivables and cash.
A liability is a ‘present obligation of the entity arising from past events, the settlemet ofwhich is expected to result in an outflow from the entity (at an agreed upon date) ofresources embodying economic benefits’.
Equity is a claim, a right or an interest one has over some ‘net worth’. Equity, takenglobally, represents the claim of all shareholders. Equity is defined as ‘the residual interestin the assets of the entity after deducting all its liabilities’. Two components: Share capital is the historical value of the contributions to the firm shareholders have made in the beginning and during the life of the firm by making external
Under objectivity three accounting principles exist: Unit of measurement: financial accounting only records transactions expressed in financial units (euro, dollar, etc.) Basis of valuation: historical cost is the measurement basis most commonly adopted by entities in preparing the financial statements, since it is the one that requires the fewest hypotheses. No offsetting: offsetting of opposite net effects of different transactions could hide some of the richness of the situation accounting is supposed to report on.
Under quality of information also three accounting principles exist: Faithful representation (see chapter 1) Substance over form Materiality and aggregation: An entity shall present separately each material class of similar items. An entity shall present separately items of a dissimilar nature or function unless they are immaterial.
Under prudence also three accounting principles exist: Conservatism Accrual basis: consists in recognizing or recording an event when it occurs and not when the cash transaction it induces has been completed. When there are differences you have to report them under accrued expense, accrued revenue, prepaid expense or prepaid revenue. Matching: the simultaneous or combined recognition of revenues and expenses that result directly and jointly from the same transactions or other events.
Under periodicity also three accounting principles exist: Accounting period Going concern: The ability to accrue revenues and expenses, and therefore income, in the appropriate time periods rests on the assumption that a business entity has a life expectancy that exceeds the accounting reporting period. Consistency
The various (and numerous) users of financial statements need to understand thatfinancial information must be the result of a unique coding of events. For that reason,within each country, local regulations issue ‘generally accepted accounting principels(GAAP)’ that are called accounting standards or financial reporting standards. Accounting standards are authoritative statements of how particular types of transactions and other events should be reflected in financial statements. These standards include specific principles, founding concepts, conventions, rules and practices necessary to prepare the financial statements.
The International Accounting Standards Board (IASB) was established in 2001 as anindependent, private sector regulatory body. It is recognized by those national regulatory
agencies that choose to adopt its statements and mandate businesses in that country tofollow these rules and pronouncements. The IASB is the standard-setting body of the IFRSfoundation.
An entity shall classify an asset as current when: It expects to realize the asset, or intends to sell or consume it, in its normal operating cycle. It holds the asset primarily for the purpose of trading. It expects to realize the asset within 12 months after the reporting period The asset is cash or cash equivalent unless the asset is restricted from being exchanged or used to settle a liability for at least 12 months after the reporting period.
An entity shall classify an liability as current when: It expects to settle the liability in its normal operating cycle. It holds the liability primarily for the purpose of trading The liability is due to be settled within 12 months after the reporting period The entity does not have an unconditional right to defer settlement of the liability for at least 12 months after the reporting period.
Presentation of balance sheetAssets Shareholders Equity and liabilities
Fixed or long-lived assets Shareholders equity
- Accounts receivable
- long-term (non-current)
- short-term (current)
The table above shows us the horizontal balance sheet by term (short term versus longterm): increasing liquidity and maturity. When it is the other way around (decreasingliquidity and maturity) everything is upside down.
Classification of assets and liabilities by nature emphasizes the nature of the assets andliabilities and their role in the operating cycle (intangible versus tangible, and financialversus operatin)
Presentation of income statement Classification by nature: expenses are aggregated in the income statement directly according to their nature. For example: transporation costs, salary expenses Classification by function: expenses are aggregated in the income statement according to their function or purpose. For example: marketing and commercial costs.
Permanent differences are created by revenue and expense items that are recognized foraccounting purposes, but not for tax purposes, such as: penalties.Temporary differences arise when some expenses are recognized immediately forreporting to shareholders and at a later date for tax purposes, or the reverse. I Deferred tax liability: if the tax rules lead to a later recognition of the tax burden than under financial rules. Income tax will be paid later Deferred tax asset: if the tax rules lead to a earlier recognition of the tax burden than under financial rules. Income tax paid in advance
Accounting for net operating losses:Carry-back: used to offset profits made in previous periods (thus calling for a tax refund iftaxes have already been paid)Carry-forward: to be offset against future profits thus reducing future taxable incomeand reducing taxes to be owed on future profit.
Long-term contracts, or construction contracts: two types: Fixed price contract Cost plus contract (includes for example a fixed fee)
Comprehensive income:Total comprehensive income = net income + other (elements of) comprehensive income.Other comprehensive income can include: foreign currency items, actuarial gains andlosses on defined benefit plans and gains and losses on remeasuring available – for – salefinancial assets.
Thee categories of fixed assets: Tangible assets: - buildings, machinery, equipment, furniture and fixtures (depreciation) - land (systematic cost allocation: none) - natural recourses such as oil and gas reserves (depletion) Intangible assets: - with a finite useful life: patents, copyrights, franchises, leaseholds, software (amortization) - with an indefinite useful life: brands, trademarks, goodwill (none) Financial assets: investments (none)
Impairment loss: the amount by which the carrying amount of an tangible asset exceedsits recoverable amount.
Definition of intangibles: Identifiability Lack of physical substance The entity claiming it as an asset must have control over it Existence of defined future economic benefits deriving from controlling that asset.
Main categories of intangibles: Research and development Goodwill Other intangible assets
The term goodwill has been adopted around the world to refer to the difference betweenthe purchase price of an acquired business and the ‘fair value’ of its identifiable assets(minus identifiable liabilities).
Valuation difference is the difference between the fair value of each identifiable asset orliability and their book value.
Examples of other intangible assets: patent, trademark/brand, copyright, franchises,licensing agreements, organization (or set-up) costs, computer software costs, customerlists, soccer player transfer fees and deferred charges (deferred assets). READ AGAIN.
Research is original and planned investigation undertaken with the prospect of gainingnew scientific or technical knowledge and understandingDevelopment is the application of research findings or other knowledge to a plan ordesign for the production of new or substantially improved materials, devices, products,processes, systems or services before the start of commercial production or use.
Allowance method: when the total or partial uncollectibility of the claim is established,an allowance for uncollectibles is recorded as a provision. This method is therefore knownas the allowance method. To be in total conformity with the matching principle, theallowance should be expensed and matched with the revenues which have generated theaccounts receivable.
A financial asset is any asset that is: Cash An equity instrument of another entity (patent etc) A contractual right: - to receive cash or another financial asset from another entity; or - to exchange financial assets or financial liabilities with another entity A contract that will or may be settled in the entity’s own equity instruments.
A financial liability is any liability that: A contractual obligation: - to deliver cash or another financial asset to another entity; or - to exchange financial assets or financial liabilities with another entity