FINANCIAL ACCOUNTING CORE CONCEPTS
Financial statements, who can use them? • Mangers • Enterpreneurs • Investors • Lenders • Suppliers • Customers • Tax authorithies • Employees • Goverments • Competitors
Conceptual framework • Main users of financial statements are investors • Investors’ objective is to make economic decisions • Prediction of future cash flows • SO, financial reporting should be understandable, relevant, reliable and comparable.
Buisness entity • Buisness and its owner are considered seperately. • Each entity can have its own balance sheet. Assets Equity Liabilities total total Equity – amount of wealth invested in the entity by the owner or amount of money obtained from the owner or amount of money entity „owes” to the owner We can only look at this that way with our 1st assumption: Buisness =/= Owner
Accounting period • Profit occurs over time • We cannot speak about profit if we dont specify the lenght of peroid • Maximum lenght : 1 year • Some companies do reports internally and externally with different peroids
Overall Objective • Fair Concept • Accurals – Going Concern • Relevance • Realiability
UnderlyingassumptionAccrualsincludingmatching • The essence of the accruals convention is that transactions should be recognized when they occur, not by reference to the date of the receipt or payment of cashAlso, the process of profit calculation consists of relating together (matching) therevenues with the expenses; it is not concerned with relating together cash receipt and cash paymentsThe balance sheet and the income statement are based on the accruals convention, but the cash flow statement is not.
Underlyingassumptions • Accruals, includingmatching • Figure 3.2 Effects of accruals(1)
Underlyingassumptions • Accruals, includingmatching • Figure 3.3 Effects of accruals (2)
Underlyingassumptions • Accruals, includingmatching • Figure 3.4 Effects of accruals (3) • Goingconcern
Relevance • Comparability, includingconsistency • Timeliness • Understandability, includingmateriality
Realibility • Faithful representation • Economic substance • Neutrality • Prudenceorconservatism • Completeness • Whyitmatters
Basic Accounting Concepts • Correctness of concepts • Concept as solution of accounting problem
Money Measurement Concept • Monetary units expressing value • Another values which cannot be expressed using money • Value over the time
Entity Concept • Division of entities • Difficulties in division – home bussiness • Entities in corporations • Enitity as part of larger entity
The Going-concern concept Accounting assumes that the entity will continue to operate for an indefinitely long period in the future; Going-concern assumes that the resources available will be used in future operations; In case of liquidation, accounting would try to measure the entity’s resources for potencial buyers;
The Cost concept • Means that an asset is ordinarily entered in the accounting records at the price paid to acquire it at its cost. This cost is the basis for all subsequent accounting for the asset; • The real value of an asset may change with time, but the accounting measure not because it’s only measured when adquired; • “Historical cost”(example of the land); • But extraordinarily the cost of the asset can change if it’s a really old asset with a considerable depreciation;
The Cost concept • “Goodwill” ( Philip Morris example); • Book value Historical cost; • Market value Actual value; • The basic criteria of Cost concept:
THE DUAL-ASPECT CONCEPT • The economic resources of an entity are called assets. The claims of various parties against these assets are called equities. • There are two types of equities: • 1 LIABILITIES, which are the claims of creditors (that is, everyone other than the owners of the business) • 2 OWNER´S EQUITY, which is the claims of the owners of the business. (Owners' equity for an incorporated business is commonly called shareholders' equity.) ASSETS = LIABILITIES • This is the fundamental accounting equation, which is the formal expression of the dual-aspect concept . As we shall see, all accounting procedures are derived from this equation. To reflect the two types of liabilities, the equation is. ASSETS = OWNERS' EQUITY + OTHER LIABILITIES • Events that affect the numbers in an entity's accounting records are called transactions. Although it is certainly not self-evident to someone just beginning to study accounting, every transaction has a dual impact on the accounting records. Accounting systems are set up so as to record both of these aspects of a transaction; this is why accounting is called a double-entry system.
EXAMPLE • Mr Ramón starts a business and that he opens a bank account in which he deposits $40,000 of his own money. • Now Ramón has an asset, cash, of $40,000, and also the owner, has a claim, $40,000, against this asset. Assets (cash), $40,000 = Equities (owner's), $40,000 • If as its next transaction, the business borrowed $15,000 from a bank, the business's accounting records would change in two ways: (1) $15,000 increase in cash, making the amount $55,000, • (2) they would show a new claim against the assets, the bank's claim, in the amount of $15,000. the accounting records of the business would show the following: • Assets (cash), $55,000 = Equities (owner's), $40,000 + bank's claim (other liabilities), $15,000
Accounting period. • An accounting period is the time interval reflected by the data in a financial statement. • Income or loss of a business can be analysed and determined on the basis of suitable accounting period instead of wait for a long period,i.e, until it is liquidated. • The accounting period is normally adopted for one year. At the end of the each accounting period an income statement and balance sheet are prepared. This concept is simply intended for a periodical ascertainment and reporting the true and fair financial position of the concern as a whole. • An accounting period is a discrete and uniform length of time which serves as a basis for reporting and analyzing companies' financial performance. The uniformity of accounting periods also allows for comparative analysis between companies.
Example • Firms prepare financial statements for publication and tax reporting based on an accounting period. Financial statements comprise data generated by a company's operations during the accounting period. • The accounting period for publishing financial statements is usually a quarter (e.g. January 1st, 2009 through March 31st, 2009), while the accounting period for tax reporting is usually a year (e.g. January 1st, 2009 – December 31st, 2009).
CONSERVATISM • “Prudent reporting based on a healthy scepticism builds confidence in the results and, in the long run, best serves all of the divergent interests (of financial statement users).“ • This concept is often articulated as a preference for understatement rather than overstatement of net income and net assets.
CONSERVATISM Recognize expenses (decreases in retained earnings) as soon as they are reasonably possible. • Recognize revenues (increases in retained earnings) only when they are reasonably certain.
Example • In December 1993 Lynn Jones agrees to buy an automobile from Varsity Motors, Inc., for delivery in January 1994. Although this is good news to Varsity Motors, it is possible that something will go wrong and the sale will not be consummated. Therefore, the conservatism concept requires that the revenue not be recorded, that is, recognized, until the automobile is actually delivered. Thus, Varsity Motors does not recognize revenue from this transaction in 1993 because the revenue is not reasonably certain in 1993, even though it is reasonably possible. Rather, if the automobile is actually delivered in 1994, revenue is recognized in 1994
REALIZATION • Realization refers to inflows of cash or claims to cash (e.g., accounts receivable) arising from the sale of goods or services. • The realization concept, indicates the amount of revenue that should be recognized from a given sale. • The realization concept states that the amount recognized as revenue is the amount that is reasonably certain to be realized-that is, that customers are reasonably certain to pay.
REALIZATION • Of course, there is room for differences in judgment as to how certain "reasonably certain" is. • Sale of merchandise at a discount-at an amount less than its normal selling price Revenue is recorded at the lower amount, not the normal price • Sale of merchandise on credit The amount of sales made on credit should be reduced by the estimated amount of credit sales that will never be realized (that is, by the estimated amount of bad debts).
Example • In many instances, the sale of a new car is made at a negotiated price that is lower than the manufacturer's list ("sticker") price for the automobile. In these circumstances, revenue is the amount at which the sale is made, rather than the list price. If the list price is $25,000 and the car is actually sold for $23,500, then the revenue is $23,500. • If a store makes credit sales of $100,000 during a period and if experience indicates that 3 % of credit sales will eventually become bad debts, the amount of revenue for the period is $97,000, not $100,000.
THE MATCHING CONCEPT The Matching Concept: • A significant relationship exists between revenue andexpenses. • Expenses are incurred for the purpose of producing revenue. • Inmeasuring net income for a period, revenue should be offset by all the expensesincurred in producing that revenue. • This concept of offsetting expenses againstrevenue on the basis of "causes and effect" is called the Matching Concept. • Theterm 'matching' means appropriate association of related revenues and expenses. • In matching expenses against revenue the question when the payment was made orreceived is 'irrelevant'.
ReportingRevenueandExpenses • Cash Basis of Accounting • AccrualBasis of Accounting
Accrual Basis of Accounting • Revenue reported when earned • Expense reported when incurred • Properly matches revenues and expenses in determining net income • Requires adjusting entries at end of period
Thematchingconceptsupportsreportingrevenuesandrelatedexpenses in thesameperiod.
Example • If a salesman is paid commission inJanuary 2014, for sale made by him in December 2013. • According to this conceptcommission expense should be offset against sales of December 2013because thisexpense is incurred for producing revenue in December 2013. • On account of thisconcept, adjustments are made for all outstanding expenses, accrued revenues, prepaid expenses and unearned revenues, while preparing the final accountsat the end of the accounting period.
THE CONSISTENCY CONCEPT • Concept: Once anentity has decidedononemethod, itshoulduse thesamemethodforallsubsequentevents of thesamecharacterunlessit has a soundreasontochangeit. • Reason: Comparability. Itenablesinvestors and otherusers of financialstatementstoeasily and correctly compare thefinancialstatements of a company.
THE CONSISTENCY CONCEPT • Procedure: When a company changes its accounting method, outside auditors include the change in their opinion letter. 7 • Narrow meaning of consistency: the treatment of different categories of transactions must be consistent with one another, but only that transactions in a given category must be treated consistently from one accounting period to the next.
Example • Company A has been using declining balance depreciation method for its IT equipment. According to consistency concept it should continue to use declining balance depreciation method in respect of its IT equipment in the following periods. If the company wants to change it to another depreciation method, say for example the straight line method, it must provide in its financial report, the reason(s) for the change, the nature of the change and the effects of the change on items such as accumulated depreciation.
THE MATERIALITY CONCEPT • Concept: Not record events so insignificantthatthework of recordingthemisnotjustifiedbytheusefulness of theresults. • Problem: No agreement as totheexact line separatingmaterial eventsfrominmmaterialevents. Thedecisiondependsonjugdement and commonsense. Someoppinionssaysthatmaterialitymightbebasedon a percentage of 0.5% of sales oron total assets. (http://accountingexplained.com/financial/principles/materiality)
THE MATERIALITY CONCEPT • Importance of materiality concept: Isimportant in theprocess of determiningthe expenses and revenuefor a givenaccountingperiod. • Anothersenseof materiality in accounting: Insignificanteventsmaybedisregarded, buttheremustbe full disclosure of allimportantinformation.
THE MATERIALITY CONCEPT. • Examples: • The government of the country in which the company operates in working on a new legislation which would seriously impair the company's operations in future. Although there are no figures involved but the impact is so large that disclosure is imminent. • The remuneration paid to the executives and the directors is material. • The accounting policies are material because they help the users understand the figures.