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MGT 220 Chapter 1 & 2
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What is Financial Accounting for?
Accounting identifies, measures, and communicates financial information about economic entities to interested parties such as investors, creditors, unions and governmental agencies.
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What Are the Forms of Financial Reporting?
• Major forms of financial reporting include:– the balance sheet– the income statement– the statement of cash flows– the statement of owners’ (or shareholders’) equity
• Other forms of financial reporting include:– annual report– prospectuses– government reporting– news releases– management forecasts
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How does Information flow through the Financial Statements
Income Statement
Statement of Equity
Balance Sheet
Statement of Cash Flows
Reports Net Income
Ending balance reported
Change in cash as reported displays the change in cash position
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Who Are the Stakeholders in Financial Reporting
• Definition: someone who prepares, relies on, reviews, audits or monitors financial information
• Includes both internal and external parties
• Key stakeholders include:– users of the financial information– both internal and external parties
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Generally Accepted Accounting Principles (GAAP)
• The profession has developed GAAP, which present fairly, clearly and completely the financial operations of the enterprise
• GAAP consist of authoritative pronouncements issued by certain accounting bodies
• CICA Handbook is the foremost source for GAAP
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The GAAP Hierarchy
Primary SourcePrimary SourceAccounting recommendations covered in the CICA Handbook
Secondary SourceSecondary SourcePrinciples generally accepted by a significant number of entities in Canada
Principles consistent with the CICA Handbook and are developed through professional judgement
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What is a Conceptual Framework for Financial Reporting
• A coherent system of interrelated objectives and fundamentals that can lead to consistent standards and that prescribes the nature, function, and limits of financial accounting and financial statements
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Conceptual Framework for Financial Reporting
Recognition and Measurement Recognition and Measurement ConceptsConcepts
3rd Level: Answers the ‘How’ Question
2nd Level: The ‘Bridge’
QualitativQualitativee
ElementsElements
ObjectivesObjectives
1st Level: Answers the ‘Why’ Question
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Conceptual Framework for Financial Reporting
Recognition and Measurement ConceptsRecognition and Measurement Concepts
QualitativeQualitative ElementsElements
ObjectivesObjectives
AssumptionsAssumptionsEconomic EntityGoing concernMonetary unitPeriodicity
PrinciplesPrinciplesHistorical costRevenue recognitionMatchingFull disclosure
ConstraintsConstraintsUncertaintyCost-benefitMaterialityIndustry Practice
AssetsLiabilitiesEquity/Net AssetsRevenuesExpensesGains and Losses
Primary:-Relevance-ReliabilitySecondary:
-Comparability-Consistency
-useful in investment & credit decisions-useful in making resource allocation decisions-useful in assessing management stewardship
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Conceptual Framework – Objectives (level 1)
To provide information:
• useful to investors, creditors and other users in making their resource allocation decisions
• useful in assessing management stewardship
• to individuals who reasonably understand business and economic activities.
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Qualitative Characteristics (level 2)• Information is relevant if
it:– has predictive value– has feedback value– is timely
• Information is reliable if it:– is verifiable; independent
users can arrive at the same conclusion
– is representationally faithful; it represents (reports) what actually happened
– is neutral; is free from bias
• Information is comparable if it:– allows users to identify real
economic similarities and differences
• Information is consistent if:– similar events have the same
accounting treatment from period to period
– if the treatment changes, full disclosure is made
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Basic Elements (level 2)
Balance SheetAssets: probable future economic benefit
Liabilities: probable future sacrifice of economic benefits
Equity/Net Assets: residual interest (Assets – Liabilities)
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Assets: Three essential characteristics
1. They embody a future benefit
2. The entity can control access to this benefit
3. The transaction or event giving the entity access to this benefit has occurred.
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Liabilities: Three essential characteristics
1. They embody a duty or responsibility
2. The entity has little or no discretion to avoid the duty
3. The transaction or event obligating the entity has occurred.
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Basic Elements (level 2)
Income StatementRevenues: increases in economic resources
Expenses: decreases in economic resources
Gains: increases in equity
Losses: decreases in equity
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What Is Comprehensive Income
• Is the sum of net income and all other changes in equity exclusive of owners’ investments and distributions.
• Example of other comprehensive income– Unrealized holding gains and losses on certain
securities
– Certain gains and losses related to foreign exchange instruments
– Gains and losses related to certain hedges
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Economic Entity Assumption– The economic entity can be identified with a particular
unit of accountability– The business activity is separate and distinct from its
owners– The entity’s assets and other financial elements are not
commingled with those of the owners– The economic entity assumption is an accounting
concept, and not a legal construct– Departments or divisions of an entity may be
considered separate entities
Basic Assumptions (level 3)
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Going Concern Assumption– The business is assumed to continue indefinitely unless
terminated by owners– Expectation of continuing long enough to meet their
objectives and commitments– The basis of recording financial elements is historical
accounting– If liquidation of the enterprise is assumed to occur, then
liquidation accounting is more appropriate– Liquidation accounting (net realizable value) is not followed
unless liquidation of the enterprise appears imminent
Basic Assumptions (level 3)
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Monetary Unit– Money is the common unit of measure of economic
transactions
– Use of a monetary unit is relevant, and simple and understandable, universally available, and useful
– The dollar is assumed to remain relatively stable in value (effects of inflation/deflation are ignored
– Monetary unit is relevant only as long as it is assumed that quantitative data is the driving force behind users decision making
Basic Assumptions (level 3)
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Periodicity (Time Period) Assumption– Economic activity of an entity may be artificially
divided into time periods for reporting purposes– Shorter time periods are subject to errors but
may be more timely• Trade-off between relevance and reliability
Basic Assumptions (level 3)
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Historical Cost Principle– Three basic presumptions of historical cost
1. Represents a value at a point in time2. Results from a reciprocal exchange3. Exchange includes an outside party
– Assets and liabilities are recorded at acquisition price
– Financial information is reliable (a primary characteristic of information)
Basic Principles of Accounting (level 3)
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Historical Cost Principle– Recording transactions at other than historical cost
results in a net income materially affected by opinion
– Trend towards a ‘mixed attribute’ system that reports historical cost, fair value, and lower of cost or market values.
Basic Principles of Accounting (level 3)
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Revenue Recognition Principle– Revenue is recognized when:
• Performance is achieved (earned)
• Measurability is reasonably certain
• Collectibility is reasonably assured (realized/realizable)
– Basic presumptions of revenue recognition• Results from a reciprocal exchange
• Exchange includes an outside party
Basic Principles of Accounting (level 3)
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Matching Principle• Expenses in one period are matched to revenues
recognized in the same period
• There should be a logical, rational association of revenues and expenses
• If the expense benefits the current and future periods, it is recorded as an asset
• This asset cost is then systematically and rationally matched to future revenues
Basic Principles of Accounting (level 3)
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Full Disclosure Principle• Financial statements must report any information that could
reasonably be seen to affect the judgement or decision of an informed user
• Disclosure may be made:– within the main body of the financial statements– as notes to those statements– as supplementary information
• Disclosed information should:– provide sufficient detail of the occurrence; and at the same time– be sufficiently brief enough to remain understandable
• Full disclosure should not be seen as a replacement for well-founded accounting practice
Basic Principles of Accounting (level 3)
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Management Discussion and Analysis (MD&A)
• Management’s explanation of the financial information and its significance
• Publicly traded corporations are now required to include MD&A in their annual reports
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Management Discussion and Analysis (MD&A)
Six general principles1. Allows readers to view company through
management eyes2. Complement and supplement financial
statements3. Be reliable, complete, fair, and balanced4. Have a forward-looking perspective5. Focus on management’s strategy for
increasing investor value6. Be written in plain language
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Management Discussion and Analysis (MD&A)
Five key elements to be included1. Company’s vision, core businesses, and
strategy
2. Key performance indicators
3. Resources (capabilities) to reach targets
4. Results
5. Outline of risks
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• Uncertainty– Recognition becomes difficult (or impossible)
when there is uncertainty– Information reported is less likely to be
uncertain if:• Events reported are likely or probably, and
• They are measurable
– Measurement Uncertainty• Difference between the recognized amount and
another reasonably possible amount
Constraints (level 3)
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Cost-Benefit Relationship
–The cost of providing information should not outweigh the benefit derived
–Costs and benefits are not always obvious or quantifiable
–Sound judgment must be used in providing information
Constraints (Level 3)
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Constraints (level 3)Materiality• Refers to an item’s impact on a user’s decision
– An item must make a difference to be material and be disclosed
– It is a matter of the relative significance of the element
– Both quantitative and qualitative factors are to be considered in determining relative significance
• General rule of thumb: if the item is 5% or more of net income it is considered material
• Determination of materiality requires professional judgment and expertise
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Industry Practices• The nature of some industries may sometimes
require departures from basic accounting theory
• If application of accounting theory results in statements that are not comparable or consistent, then industry practices must examined for possible explanations
Constraints (level 3)
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Conceptual Framework for Financial Reporting
Recognition and Measurement ConceptsRecognition and Measurement Concepts
QualitativeQualitative ElementsElements
ObjectivesObjectives
AssumptionsAssumptionsEconomic EntityGoing concernMonetary unitPeriodicity
PrinciplesPrinciplesHistorical costRevenue recognitionMatchingFull disclosure
ConstraintsConstraintsUncertaintyCost-benefitMaterialityIndustry Practice
AssetsLiabilitiesEquity/Net AssetsRevenuesExpensesGains and Losses
Primary:-Relevance-ReliabilitySecondary:
-Comparability-Consistency
-useful in investment & credit decisions-useful in making resource allocation decisions-useful in assessing management stewardship
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Financial Reporting Issue Identification
Recognition—should the element be recorded or not in the general ledger, e.g., revenue recognition or accrual of a liability?
Measurement—if recognized, how much should the element be recorded at; e.g., what is the value?
Presentation—where on the key financial statements should the item be shown, e.g., as debt or equity?
Disclosure—how much detail should be given in the financial reports? Any transactions or balances that affect key numbers or ratios by a material amount become important and significant.
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Ethics are a crucial aspect of accounting
1. Accounting information can influence behaviour (decision making).
2. Accounting information needs to be fair and unbiased.
3. Because estimates and judgements are required and there are significant pressures that may tempt to sway these estimates and judgements into certain directions, accountants must always act ethically in doing their job. Without an ethical focus, the integrity of financial statement information would be nonexistent.
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Recognizing and resolving ethical dilemmas
1. Recognise an ethical situation or ethical dilemma.2. Move toward an ethical resolution by identifying
and analysing the principal elements in the situation.
3. Identify the alternatives and weigh the impact of each alternative on various stakeholders.
4. Select the best or most ethical alternative considering all the circumstances and the consequences.