ACCOUNTING 301 LECTURE NOTES

Autumn 2013 Paul Febry, CPA

(Some of the materials contained in these notes have been reprinted from Professor Dawn Matsumotos lecture notes with her kind permission)

THE ROLE OF ACCOUNTING IN BUSINESS What is accounting?

Who are the primary users of financial accounting?

Others?

Why do they need this information?

Example: Should I buy this stock?

Theoretical value of the firm:

What are the benefits to entities to supply this information?

What are the costs?

STANDARD SETTING Why do we need standards?

Who sets the standards in the U.S.? SEC (Securities and Exchange Commission)

FASB (Financial Accounting Standards Board)

Before FASB: Committee On Accounting Procedures (CAP) Accounting Research Bulletins (ARBs) Accounting Principles Board (APB) APB Opinions (APBOs) Currently: Accounting Standards Codification (ASC)

What about SOX?

How are standards set?

Advantages:

Disadvantages:

How do we know standards are followed?

International Financial Reporting Standards (IFRS) Reason for global accounting standards:

Difficulties/Drawbacks:

Current Status:

CONCEPTUAL FRAMEWORK Purpose: To set forth fundamentals on which financial reporting standards are based
The FASB and the IASB are currently working on a joint project to revise the conceptual framework where it is incomplete and inconsistent. SFAC No. 8 Chapters 1 and 3 have been completed to date.

SFAC #8, Ch. 1 Objective of General Purpose Financial Reporting Provide financial information about the reporting entity that is useful to existing and potential equity investors, lenders, and other creditors in making decisions in their capacity as capital providers. SFAC #8, Ch. 3 Qualitative Characteristics of Useful Financial Information Fundamental Qualitative Characteristics: Relevance: capable of making a difference in a decision made by users

Faithful Representation: depicts the economic phenomena it purports to represent

Enhancing Qualitative Characteristics: Comparability (and consistency)

Verifiability

Timeliness

Understandability

Constraints: Cost Effectiveness

Materiality

What about Conservatism?

SFAC #6 Elements of Financial Statements Assets probable future economic benefit obtained or controlled by a particular entity as a result of past transactions Liabilities probable future sacrifices of economic benefit resulting from a present obligation of a particular entity as a result of past transactions Equity residual ownership interest (assets less liabilities) o Transactions with owners

o Comprehensive Income Comp Inc. = NI + Other Comp. Income

Revenue Expenses + Gains - Losses o Revenues: Gains:

o Expenses:

Losses:

SFAC #5 Recognition and Measurement in Financial Statements Recognition: The process of recording an item in the financial statements What is the alternative to recognition?

Criteria for recognition: Definitions the item meets the definition of an element of financial statements Measurability the item has an attribute you can measure Five different attributes currently used in practice: 1. Historical cost 2. Current cost 3. Market Value 4. Net Realizable Value 5. Present value of future cash flows Relevance the attribute is relevant Reliability the attribute is reliably measured Which measurement is the most common for recognition? Why?

Recent Trends: Fair Value Accounting An irrevocable option to value some or all financial instruments at fair value What is fair value?

Measuring fair value: FASBs Hierarchy (ASC 820-10-35): Level 1: Most desirable: quoted market prices in active markets for identical assets or liabilities Level 2: Inputs other than quoted prices that are observable for the asset or liability. Comparison to similar assets or liabilities in active or inactive markets; inputs derived from observable related market data Level 3: Least desirable: Unobservable inputs that reflect entitys own assumptions; based on best information available in the circumstances What are the benefits of fair value accounting?

What are the shortcomings?

Movement to balance-sheet approach

THE ACCOUNTING PROCESS Illustration 2-4 (p. 56 in the Text) provides an overview of the accounting cycle. We will not focus on all the steps in the process the main steps are:
Journalization Posting Adjustments Statement Preparation Closing

Journalization In order to maintain the equality of the equation, accountants have developed a simple method of representing transactions the journal entry There are three components to a journal entry: 1) 2) 3) The direction of the effect on an account is represented by debits and credits. What does debit and credit mean? DEBIT ASSETS CREDIT LIABILITIES + S/E

To increase the assets (left-hand side) we need to debit these accounts. To increase the liabilities and S/E (right-hand side) we need to credit these accounts.

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Likewise, to decrease assets we credit these accounts and to decrease liabilities and S/E we debit these accounts. So, as long as debits = credits, the accounting equation will remain in balance. So, for all journal entries debits must equal credits! What about revenues and expenses?

Adjustments Some events that need to be recorded are not the result of transactions with external parties. These events require adjusting entries at the end of the reporting. Prepayments (deferrals):

Accruals:

Estimated items:

Periodic inventory:

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Practice Problem (continued): Analyze the following items and determine if an adjusting entry is necessary. 1) At month end, a physical count determined the cost of beer, wine, and spirits remaining on hand to be $2,000. Paul also counted his other supplies (limes, napkins, coasters, etc.) and found that he had about $200 worth of supplies remaining.

2) Interest on the bank loan is payable annually on Dec. 31.

3) The bar furniture and beer tabs are expected to last 5 years (assume that the salvage value is zero).

4) The company sold certain beers at a discount to its Mug Club members throughout the month.

5) The company has been leasing the building for a month since starting operations.

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Financial Statements and Closing Entries The financial statements can now be prepared from the ending balances in each T-account. Recall however that revenues and expenses DO NOT appear on the balance sheet but do affect the balance sheet through their effect on retained earnings. In order to prepare the balance sheet, we need to transfer the revenues and expenses to the retained earnings account. This method of transferring the revenues and expenses to retained earnings is known as the closing process. Closing process: 1. Close revenues and expenses to income summary account 2. Close income summary account to retained earnings 3. Close dividends to retained earnings What does it mean to close an account?

How is this accomplished?

Practice Problem (continued) Prepare the closing entries for Duchess for the month of September.

Prepare the income statement, balance sheet, and statement of shareholders equity for Duchess.

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Duchess Income Statement For the month ended September 30, 2013

Duchess Statement of Shareholders Equity For the month ended September 30, 2013

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Duchess Balance Sheet September 30, 2013

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To prepare the cash flow statement, we must return to the Cash Taccount and examine the transactions that affected the account throughout the period. First, classify each transaction as operating, investing, or financing, and then prepare the statement of cash flows (using the direct method). Duchess Statement of Cash Flows For the month ended September 30, 2013

Notice that Cash from Operations DOES NOT equal Net Income.
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