ACCCOB2 Unit 1: Introduction to Financial Accounting PDF

UNIT 1: INTRODUCTION TO FINANCIAL ACCOUNTING Accounting The art of recording, classifying, and summarizing in a significant manner and in terms of money, transactions and events which are, in part at least of financial character, and interpreting the results thereof (AICPA) Financial Accounting Bran...

UNIT 1: INTRODUCTION TO FINANCIAL ACCOUNTING Accounting The art of recording, classifying, and summarizing in a significant manner and in terms of money, transactions and events which are, in part at least of financial character, and interpreting the results thereof (AICPA) Financial Accounting Branch of accounting that deals with the provision of general-purpose financial reports to various users Users of accounting information Primary users (Conceptual Framework 1.5) Investors (Individuals, Businesses, Banks, Insurance companies) o Existing investors – monitor business performance to check return on their investments o Potential investors – monitor business performance to assess risk and reward of future investments Lenders and other creditors o Lenders – ensure that the business is capable of repaying a loan and determine the terms of the loan o Suppliers / Creditors – assess the ability of the business to pay its bills for extending credit and setting credit terms and credit limit Other users Internal users o Owner/s – monitor business performance to check return on their investment o Managers – evaluate the results of the company’s operations to plan and make decisions for the future o Employees – ensure that the business can pay salaries and other benefits External users o Tax authorities – collect taxes (E.g., employee tax, sales tax, property tax, business tax, etc.) o Regulatory agencies – oversee the financial information provided by public companies (E.g., The Securities and Exchange Commission (SEC) enforces security laws and protects against infractions like insider trading, accounting fraud, and companies which provide misleading information about their financial condition) o Customers – check to see if they can rely on continued service or supply of goods o Employee unions – negotiate salary increases, benefits, and profit-sharing o Trade associations – provide summary reports to assess the business and the industry o Financial intermediaries § Financial analysts – provide summary reports to assess the business and the industry for investment purposes § Stock brokers – assess returns of current and future stock investments § Mutual fund companies – monitor business performance to assess risk and reward of current and future investments § Credit-rating agencies – provide summary reports to assess the credit-worthiness of public companies (ability to make timely payments of principal and interests) 1 | ACCCOB2 / AY2023-2024_Term 3 Trinidad, Editha O. Generally accepted accounting principles (GAAP) refer to a common set of rules, procedures, practices and standards followed in the preparation and presentation of financial statements issued by the Financial Accounting Standards Board (FASB). GAAP are rules that accountants follow in recording business transactions and preparing financial statements. Underlying assumptions – assumptions made when preparing financial statements to avoid misunderstanding that refers to expectations and beliefs taken as accurate without proof or concrete evidence. Entity / Business entity / Economic entity / Separate entity o assumes that a business unit is separate and distinct from its owner/s o requires that business’s accounting records should always be kept separate from the owner’s personal accounting records Going concern / Continuity o assumes that a business entity has an indefinite life, that it will continue to operate in the foreseeable future in the absence of any evidence to the contrary Monetary / Money measurement / Monetary unit o assumes that only transactions that can be expressed in monetary terms are recorded o assumes that the peso § is used to record transactions and § that it is relatively free from value fluctuations Time period / Periodicity of income / Time interval o assumes that the indefinite life of a business entity is subdivided into short periods of equal length within which financial statements are prepared to provide users of financial statements with timely information Accrual o revenue should be recognized when earned, regardless of when cash is received, and o expenses should be recognized when incurred, regardless of when cash is paid General principles – guidelines in preparing financial statements Cost / Historical cost o transactions should be recorded at the cost paid by the business and that assets should be shown at their original cost (this will also support the objectivity concept since the assets can be verified with business documents) Revenue recognition o revenue is recorded when it is earned regardless of when cash is received (Exception: goods delivered on ‘sale or return’ basis) § when a sale is made § when a service is provided o revenue is recorded only if it has been earned and realized § realization of revenue occurs at the time new assets are created in the form of - cash - accounts receivable Matching / Expense recognition o revenues earned during an accounting period should be matched (offset) with the expenses incurred in generating this revenue in the same accounting period (cause and effect) Full disclosure / Disclosure o the business entity should provide financial information and other facts that are necessary for the users to properly interpret the financial statements 2 | ACCCOB2 / AY2023-2024_Term 3 Trinidad, Editha O. Modifying constraints – limitations that restrict and practical considerations that modify the accounting choices that an accountant makes in preparing financial statements Materiality o if omitting, misstating, or obscuring an information could reasonably be expected to influence decisions that the primary users of general-purpose financial reports make on the basis of those reports Cost-Benefit Test o the cost of gathering information to fully comply with an accounting principle or rule may be much higher than the benefit received o information is cost effective only if the benefit of increased decision usefulness exceeds the costs of providing that information § For example, depreciating low-value assets such as a stapler Conservatism / Prudence o the exercise of caution when making judgements under conditions of uncertainty o if there are two or more equally acceptable treatments to record a transaction, then the accountant should choose the conservative approach § lower income § lower valued asset o assets and income are not overstated § does not mean that assets or income should be understated o liabilities and expenses are not understated § record all possible expenses or losses § does not mean that liabilities or expenses should be overstated o a business entity should always err on the side of caution Industry Practice o Some industries have unusual tax laws or regulatory requirements and so have developed special accounting principles and procedures for their industry. These practices may not conform completely with GAAP or IFRS Standards and so are not suitable for other industries. Other concepts Objectivity o the business entity should use documents as basis for recording business transactions and so avoids subjectivity when preparing financial statements Substance over form o business transactions should be treated according to the real substance, not the legal position (legal form) 3 | ACCCOB2 / AY2023-2024_Term 3 Trinidad, Editha O. Qualitative characteristics of useful financial information Fundamental qualitative characteristics The fundamental qualitative characteristics are qualities that make accounting information useful for decision making by interested users. If financial information is to be useful, it must be relevant and faithfully represent what it purports to represent. Relevance – Relevant financial information is capable of making a difference in the decisions made by users. o Predictive value – if it can be used as an input to processes employed by users to predict future outcomes o Confirmatory value – if it provides feedback about (confirms or changes) previous evaluations § The predictive value and confirmatory value of financial information are interrelated. § For example, revenue information for the current year, which can be used as the basis for predicting revenues in future years, can also be compared with revenue predictions for the current year that were made in past years. § The results of those comparisons can help a user to correct and improve the processes that were used to make those previous predictions. o Materiality – if omitting, misstating, or obscuring an information could reasonably be expected to influence decisions that the primary users of general-purpose financial reports make on the basis of those reports § A business entity may depart from the generally accepted principles for recording some transactions when an information is not significant enough to affect financial decisions (follows convenience rather than theoretical principles). When is a financial information considered obscured? o vague disclosure, language is unclear o information is scattered o dissimilar items are improperly aggregated o similar items are disaggregated o if material information is hidden o if there are a lot of unnecessary information Faithfully representation – Financial reports represent economic phenomena in words and numbers. To be useful, financial information must also faithfully represent the substance of the phenomena that it purports to represent. o Completeness – includes all information necessary for a user to understand the phenomenon being depicted, including all necessary descriptions and explanations. Omitting a portion of that information can cause it to be false or misleading. For example, § Assets should have description, nature, numerical and depiction. § Explanations of significant facts about the quality and nature of the items, factors and circumstances that might affect their quality and nature, and the process used to determine the numerical depiction. o Neutrality – without bias in the selection or presentation of financial information § Neutrality is supported by the exercise of prudence. Prudence is the exercise of caution when making judgements under conditions of uncertainty. o Free from error – no errors or omissions in the description of the phenomenon, and the process used to produce the reported information has been selected and applied with no errors in the process. § For use of estimates, it should be described clearly and accurately as being an estimate, the nature and limitations of the estimating process are explained, and no errors have been made in selecting and applying an appropriate process for developing the estimate. 4 | ACCCOB2 / AY2023-2024_Term 3 Trinidad, Editha O. Enhancing qualitative characteristics The enhancing qualitative characteristics are attributes that enhance the fundamental qualitative characteristics of financial information. Comparability – enables users to identify and understand similarities in items and differences among items. o Consistency – Consistency refers to the use of the same methods for the same items, either from period to period within a reporting entity or in a single period across entities. o Uniformity – Comparability of financial information is not enhanced by making unlike things look alike any more than it is enhanced by making like things look different. Verifiability – helps assure users that different knowledgeable and independent observers could reach consensus, although not necessarily complete agreement, that a particular depiction is a faithful representation. Timeliness – having information available to decision-makers in time to be capable of influencing their decisions. o Generally, the older the information is, the less useful it is. o Some information may continue to be timely long after the end of a reporting period (E.g., to identify and assess trends) Understandability – classifying, characterising, and presenting information clearly and concisely Financial Statements Definition General purpose reports that provide financial information about the reporting entity’s [business] economic resources [assets], claims against the entity [liabilities and owner’s equity], and changes in those economic resources and claims [revenues, expenses, owner’s capital, owner’s drawings] that is useful to primary users in making decisions relating to providing resources to the entity Objective To provide financial information about the reporting entity’s assets, liabilities, equity, revenues, and expenses that is useful to users of financial statements in assessing the prospects for future net cash inflows to the reporting entity and in assessing management’s stewardship of the entity’s economic resources (includes protecting the company’s assets against price changes and technological changes as well as compliance with laws, regulations, and contracts) Scope Financial information about the reporting entity Reporting Specified period of time period Information about transactions and other events that have occurred after the end of the reporting period is provided if that information is necessary to meet the objective of financial statements Perspective From the perspective of the reporting entity Assumption Going-concern Elements of Financial Statements Conceptual Framework Element Economic resource Asset Claim Changes in economic resources and claims, reflecting financial performance Other changes in economic resources and claims Liability Equity Income Expenses 5 | ACCCOB2 / AY2023-2024_Term 3 - Definition or Description A present economic resource controlled by the entity as a result of past events An economic resource is a right that has the potential to produce economic benefits A present obligation of the entity to transfer an economic resource as a result of past events The residual interest in the assets of the entity after deducting all its liabilities Increases in assets, or decreases in liabilities, that result in increases in equity, other than those relating to contributions from holders of equity claims Decreases in assets, or increases in liabilities, that result in decreases in equity, other than those relating to distributions to holders of equity claims Contributions from holder/s of equity claims, and distributions to them Exchanges of assets or liabilities that do not result in increases or decreases in equity Trinidad, Editha O. Statement of Financial Position [Balance Sheet] Definition A position statement that reports the financial condition (financial standing; financial strength) of an entity at the end of the period and presents an organized list of assets, liabilities, and equity Usefulness Provides information useful to assess the entity’s future cash flows, liquidity, and long-term solvency Limitation - The entity's reported book value (assets minus liabilities) will not directly measure the company’s market value (in a public corporation, this is current market price x number of shares issued) - Many assets are measured at their historical costs rather than their fair values - Many aspects of a company may represent valuable resources but are not recorded as assets o Product knowledge o Experienced management team o Trained employees o Loyal customer relationships Forms Report form Assets Liabilities Owner's equity Account form Liabilities Owner's equity Assets Elements ASSETS A present economic resource controlled by the entity as a result of past events Economic resource – the right that has the potential to produce economic benefits Control – the present ability to direct the use of the economic resource and obtain the economic benefits that may flow from it o no other party controls that asset o the right to deploy that asset in its activities o ability to enforce legal rights on that asset Current assets – assets that are expected to be realized (converted to cash) or intended to be sold or to be consumed within the entity’s normal operating cycle* held primarily for the purpose of trading expected to be realized within twelve months after the reporting period cash or cash equivalent unless the asset is restricted from being exchanged or used to settle a liability for at least twelve months after the reporting period *Operating cycle – time between the acquisition of assets for processing and their realisation in cash or cash equivalents * Where a company has no clearly defined operating cycle, the one-year convention is used. 1 2 3 4 Use cash to acquire inventory ↓ Prepare inventory for sale to customers (Including the production process for manufacturing business) ↓ Deliver inventory to customer ↓ Collect cash from customer ←← ↑ ↑ ↑ →→ Current assets are listed according to its liquidity, its nearness to cash. Non-current assets – residual by definition, an entity shall classify all other assets as non-current. 6 | ACCCOB2 / AY2023-2024_Term 3 Trinidad, Editha O. LIABILITIES A present obligation of the entity to transfer an economic resource as a result of past events Obligation – a duty or responsibility that an entity has no practical ability to avoid and owed to another party/parties o person o another entity o a group of people / a group of entities o society at large Transfer an economic resource o pay cash o deliver goods or provide services o exchange economic resources with another party on unfavourable terms (E.g., Forwards; Options) o transfer an economic resource if a specified uncertain future event occurs o Issue a financial instrument if that financial instrument will oblige the entity to transfer an economic recourse Result of past events o the entity has already obtained economic benefits or taken an action o the entity will or may have to transfer an economic resource that it would not otherwise have had to transfer Current liabilities – liabilities that are expected to be settled in the entity’s normal operating cycle are owed primarily for the purpose of trading are due to be settled within twelve months after the reporting period do not have the right at the end of the reporting period to defer settlement of the liability for at least twelve months after the reporting period Non-Current liabilities – residual by definition, an entity shall classify all other liabilities that are not current as noncurrent 7 | ACCCOB2 / AY2023-2024_Term 3 Trinidad, Editha O. Statement of Profit & Loss [Income Statement; Statement of Operations] Definition A change statement that summarizes the profit-generating transactions that changes the owner’s equity for the period and reports an entity’s financial performance, that is, its net profit or net loss, for the period Usefulness Provides information useful to assess the entity’s profitability, return on owner’s investment, its operations and various functions and predicting future expenses and cash outflows Forms Nature of expense method Classifies expenses within profit or loss according to their nature Function of expense method Classifies expenses by their function within the entity o Cost of sales – cost of providing service / cost of goods sold o Distribution costs – expenses related to selling and distributing the goods to the customers o Administrative costs – expenses related to the general administration of the business o Finance costs – interest expense Elements INCOME Earnings of an entity Inflow of resources resulting from services provided or goods sold to customers Increases in assets, or decreases in liabilities, that result in increases in equity, other than those relating to contributions from holders of equity claims Income encompasses both revenue (from ordinary activities) and gains (not from ordinary activities) EXPENSES Outflow of resources incurred for generating revenues Decreases in assets, or increases in liabilities, that result in decreases in equity, other than those relating to distributions to holders of equity claims Expenses encompasses expenses (used in ordinary activities) and losses (not used in ordinary activities) 8 | ACCCOB2 / AY2023-2024_Term 3 Trinidad, Editha O. Statement of Changes in Owner’s Equity Definition A change statement that discloses the events that caused the owner’s equity to change for the period Usefulness Provides information useful to understand the transactions with owners in their capacity as owners, showing separately contributions by and distributions to owners Items affecting equity Income [revenues] and expenses Contributions [investment] by owner Owner’s capital – financial investment of the owner o Cash o Other assets § Recorded at its fair market value at the time of investment Distributions to [withdrawal by] owner Owner’s drawings – temporary withdrawal of the profit of the business Statement of Cash Flows Definition A change statement disclosing the events that caused cash to change for the period Usefulness Provides information useful to assess the entity’s ability to generate cash and cash equivalents and to utilize those cash flows Notes to Financial Statements The notes shall: present information about the basis of preparation of the financial statements and the specific accounting policies used disclose the information required by IFRSs that is not presented elsewhere in the financial statements provide information that is not presented elsewhere in the financial statements, but is relevant to an understanding of any of them --------------------------------------------------------------------------------------------------------------------------------------------------REFERENCES IFRS Foundation (2018, March). Conceptual Framework for Financial Reporting. IFRS Foundation (2020, July). IAS 1 - Presentation of Financial Statements. Price, J., Haddock, M., & Farina, M., (2021). College Accounting, 16th edition. McGraw-Hill Education. Spiceland, Sepe, Thomas, Tan, Low, Low (2019), Intermediate Accounting Global Edition (2nd Edition), McGraw- Hill Education (Asia). 9 | ACCCOB2 / AY2023-2024_Term 3 Trinidad, Editha O.