ACC 101 Introductory accounting 1
Financial
Accounting: Introductory Section Pretest Introduction Welcome to the
pre-assessment test for the Financial Accounting Online Course: Introductory
Section. This test will allow you to assess your knowledge of basic and
advanced financial accounting. All questions must be answered for your exam to
be scored.
Navigation:
To advance from one question to the next, select one of the answer choices or, if applicable, complete with your own choice and click the “Submit” button. After submitting your answer, you will not be able to change it, so make sure you are satisfied with your selection before you submit each answer. You may also skip a question by pressing the forward advance arrow. Please note that you can return to “skipped” questions using the “Jump to unanswered question” selection menu or the navigational arrows at any time. Although you can skip a question, you must navigate back to it and answer it - all questions must be answered for the exam to be scored. Your results will be displayed immediately upon completion of the exam. After completion, you can review your answers at any time by returning to the exam. Good Luck! Welcome to Financial Accounting
You are about to begin an interactive experience that will introduce you to financial accounting, the language of business. Successful completion of this course will enable you to understand how accounting systems are used to record the day-to- day economic activities of a business and to generate reports about its financial health and performance. Using the Tutorial
The structure of the HBS Financial Accounting Tutorial and its navigational tools are easy to master. If you're reading this text, you must have clicked on the navigation item labeled "Using the Tutorial" on the left. Please click on the Help icon in the upper right corner of the tutorial to view a clickable animation on how to use this tutorial. The Setting
This HBS Financial Accounting Tutorial uses a business context to help you learn the fundamentals of financial accounting. You are setting up a store called Global Grocer. It will carry gourmet foods and condiments, unusual spices and specialty kitchen implements from all over the world. Global Grocer is a franchise business - it will pay a franchising company, Global Grocer International, a franchise fee for the use of the name and for marketing support. You are planning to have a grand store opening in early September, with a big sale on items related to various fall and harvest celebrations around the world. You have a limited amount of cash available to start up the business, but you hope to obtain bank loans and also raise capital from outside investors. You will be keeping the accounts (or bookkeeping) for the Global Grocer store. Completing this tutorial will prepare you for that role. The Accounting Process
This tutorial is based on a model of the accounting process in a small business. Financial accounting is a financial information system that tracks and records an organization's business transactions and aggregates them into reports for decision makers both inside and outside the business. A transaction is an event that has consequences for a business' financial condition. The event could be either external or internal to the business.
(1) In the running of a business, various decisions are made and implemented as business transactions. For example, in a typical business, managers will raise capital from investors and banks, rent or buy equipment, and purchase and sell merchandise and services. Each business transaction is related to one of three types of activities: operating, investing and financing activities. (2) Even the most simple organizations have numerous business transactions that have to be tracked and recorded. Transactions are formally recorded in a database called a journal, and then organized by accounts into a ledger. (3) Report preparation requires the aggregation of accounting transactions into statements or reports that describe the financial status of the business and its performance. The most common financial accounting reports are the balance sheet, the income statement and the statement of cash flows. (4) Financial statements are used by decision makers inside and outside the business. For example, managers use them to decide whether the firm is making a profit, whether customer incentives are working, or whether to take a loan and expand the business. If a business raises capital from outside investors, the investors will examine the company's financial statements to judge whether the funds they have invested have been used wisely. (5) Financial reporting concepts and principles tell us when and how to measure, record and classify business transactions and aggregate them into financial reports. By following these concepts and principles, financial reporting systems provide information that is consistent over time and across different businesses, and accounting becomes a language that is widely understood. (6) Auditors are independent parties who periodically examine a company's financial statements and the systems, internal controls and records used to produce the statements. Since a company's managers prodice their own report cards, i.e., the company's financial statements, auditors play an important role as a control mechanism. They attest that the financial statements conform to generally accepted accounting principles and they provide assurance that the company's accounts are presented fairly. (7) Based on their analyses of financial statements, financial statement users take actions, which in turn, affect the future operating, investing and financing decisions made by the organization. Hence, the financial reporting system is an information feedback loop between users of financial statements and the decision makers within the organization. Module Overview
In each chapter of this tutorial, you will learn new financial accounting terms and concepts and how to use this knowledge within the context of the Global Grocer setting. You will also be given exercises to practice and test what you have learned at several points in each chapter. The "Terms and Concepts" chapter introduces key financial accounting terms and five fundamental financial accounting concepts. It provides a brief overview of the three most important financial statements. The chapters labeled "The Balance Sheet," "The Income Statement," and "The Statement of Cash Flows" explain relevant new financial accounting concepts and use the concepts to construct a financial statement. You will see how Global Grocer's financial statements are affected by its business transactions during the first month of operations. In the "Accounting Records" chapter you will learn how to formally record Global Grocer's business transactions into its journal and ledger and how to use these records to prepare its financial statements. In doing so, you will revisit and record all the events that occurred at Global Grocer during the first month; only, this time, you will use the formal bookkeeping structures used in financial accounting systems. Module Overview (continued)
As you will learn, accounting practices in the United States are governed by a set of accounting rules referred to as Generally Accepted Accounting Principles (GAAP) These rules and their applications are covered in depth in this tutorial. Because there is a distinct possibility these rules may be replaced by another set of similar rules referred to as International Financial Reporting Standards (IFRS) in 2014, the tutorial, where appropriate, refers to IFRS as well as its GAAP counterpart. Exercise 1.1
Financial accounting is an information system that:
Choose the word that best completes the following sentence: In financial accounting, an organization's business
transactions are classified into operating activities, _________ activities and financing activities. Since auditors have to attest to the validity of a company's financial statements, what is an important characteristic for an auditor from the following choices? Terms and Concepts
In this chapter, you will explore the three main financial statements in some detail, and you will be introduced to five basic financial accounting concepts: entity, money measurement, going concern, consistency and materiality. You will also learn about two important qualities of financial accounting information--relevance and reliability--and how the use of accrual accounting and generally accepted accounting principles aid accountants in their quest for these qualities. Overview of Financial Reports
In this section, you will be introduced to the three main financial reports or statements. Each statement will be covered in more detail in the following chapters. Balance Sheet
A balance sheet, also called a statement of financial position, is a report of the organization's financial situation at a particular point in time. It lists the entity's assets, liabilities and owners' equity. It is called a balance sheet because it reports the balance or amount in each asset, liability and owners' equity account. This is Global Grocer's balance sheet one month after it opens for business. We will use it to explain key balance sheet-related terms. The chapter labeled "The Balance Sheet" covers the balance sheet in more detail. (1) At top of each financial statement is the name of the organization or entity for which the statement has been prepared. The term entity is used to indicate the separate economic unit for which financial records are being kept and financial statements prepared. Common types of accounting entities are businesses, political and charitable organizations, city governments, universities...any organization that needs to record and communicate its financial activities. (2) A balance sheet, also called a statement of financial position, is a report of the organization's financial situation at a particular point in time. It lists the entity's assets, liabilities and owners' equity. It is called a balance sheet because it reports the balance or amount in each asset, liability and owners' equity account. Chapter 3 covers the balance sheet in greater detail. (3) Each balance sheet is prepared as of a specific date, which is recorded at the top of the statement. In the next chapter, you will prepare this opening balance sheet for Global Grocer, dated August 31, 2004. (4) Assets are economic resources acquired in a business transaction that are obtained or controlled by an entity, and are expected to produce future economic benefits. For example, this balance sheet shows that on September 30, 2004, among other assets, Global Grocer had a cash asset recorded at $95,500 and a warehouse property (building and land) recorded at $69,700. (5) A liability is an obligation to transfer economic resources to entities outside the business. Liabilities represent the capital provided to the business by creditors. For example, a loan from a bank is a liability, such as the one listed on Global Grocer's Spetember 30, 2004 balance sheet as short-term debt. Under the loan contract, Global Grocer has an obligation to repay the bank from which it obtained the loan. (6) Owners' Equity, also known as stockholders' or shareholders' equity, represents the residual interest of the owners in the business. The owners' interest is what's left over after deducting liabilities from assets. The common stock listed on Global Grocer's Spetember 30, 2004 balance sheet indicates that its owners have contributed capital to the company, and in return, have received common stock certificates establishing their ownership interest. Income Statement
The income statement details the entity's operating performance during a specific period of time, known as the accounting period, displayed at the top of the statement. In this income statement for Global Grocer, the accounting period is the month of September 2004. The income statement lists the revenues earned and expenses incurred during the period; subtracting expenses from revenues results in the measurement of net income for the period.
The chapter labeled "The Income Statement" covers the income statement in greater detail. (1) Just as in the balance sheet, the income statement contains the name of the entity at the top. (2) The income statement details the entity's operating performance during a specific period of time known as the accounting period. The income statement lists the revenues earned and expenses incurred during the period; subtracting expenses from revenues results in the measurement of net income for the period. Chapter 4 covers the income statement in greater detail. (3) The date is displayed at the top of the statement. In this example income statement for Global Grocer, the accounting period is the month of September 2004. (4) Sales, sometimes denoted as Sales revenue or Revenues, is the sum of the economic benefits the entity has earned during the accounting period in exchange for the goods and services it has provided to its customers. The economic benefits may be increases in assets or decreases in liabilities. (5) Expenses are the assets used or liabilities incurred by the entity during an accounting period to provide the goods and services that generated revenue during the period. (6) Net income or profit, or net profit, is the difference between the sales and expenses of the accounting period. Because it appears as the last line of the income statement, it is often referred to as the bottom line. Statement of Cash Flows
The statement of cash flows details the sources and uses of cash by the entity over an accounting period. For the convenience of financial statement users, the statement of cash flows is organized by type of business activity: operating, investing and financing. The chapter labeled "The Statement of Cash Flows" covers the statement of cash flows in greater detail. (1) Just as in the balance sheet and the income statement, the statement of cash flows indicates the name of the entity at the top. (2) The statement of cash flows details the sources and uses of cash by the entity over an accounting period. For the convenience of financial statement users, the statement of cash flows is organized by type of business activity: operating, investing and financing. Chapter 6 covers the statement of cash flows in greater detail. (3) The date is displayed at the top of the statement. In this statement of cash flows for Global Grocer, the accounting period is the month of September 2004. (4) Operating activities are those activities that are related to the delivery of goods and services. The cash impact of such activities is recorded in the operating activities section of the statement of cash flows. At Global Grocer, this section of the statement of cash flows would, for example, report cash collected from customers, cash paid to suppliers and cash paid to employees as part of its daily business activities. (5) Investing activities are those activities that are related to the purchase and sale of long-lived assets. The impact of such activities on the cash account is recorded in the investing activities section of the statement of cash flows. At Global Grocer, this section of the statement of cash flows would, for example, report the cash used to purchase a van. (6) Financing activities relate to borrowing or retiring debt and to increasing or decreasing owners' equity in the firm. The impact of such activities on the cash account is recorded in the financing activities section of the statement of cash flows. At Global Grocer, cash from bank loans and amounts received from owners are reported in this section of the statement of cash flows. Exercise 2.1
Navigation:
To advance from one question to the next, select one of the answer choices or, if applicable, complete with your own choice and click the “Submit” button. After submitting your answer, you will not be able to change it, so make sure you are satisfied with your selection before you submit each answer. You may also skip a question by pressing the forward advance arrow. Please note that you can return to “skipped” questions using the “Jump to unanswered question” selection menu or the navigational arrows at any time. Although you can skip a question, you must navigate back to it and answer it - all questions must be answered for the exam to be scored. Your results will be displayed immediately upon completion of the exam. After completion, you can review your answers at any time by returning to the exam. Good Luck! Welcome to Financial Accounting
You are about to begin an interactive experience that will introduce you to financial accounting, the language of business. Successful completion of this course will enable you to understand how accounting systems are used to record the day-to- day economic activities of a business and to generate reports about its financial health and performance. Using the Tutorial
The structure of the HBS Financial Accounting Tutorial and its navigational tools are easy to master. If you're reading this text, you must have clicked on the navigation item labeled "Using the Tutorial" on the left. Please click on the Help icon in the upper right corner of the tutorial to view a clickable animation on how to use this tutorial. The Setting
This HBS Financial Accounting Tutorial uses a business context to help you learn the fundamentals of financial accounting. You are setting up a store called Global Grocer. It will carry gourmet foods and condiments, unusual spices and specialty kitchen implements from all over the world. Global Grocer is a franchise business - it will pay a franchising company, Global Grocer International, a franchise fee for the use of the name and for marketing support. You are planning to have a grand store opening in early September, with a big sale on items related to various fall and harvest celebrations around the world. You have a limited amount of cash available to start up the business, but you hope to obtain bank loans and also raise capital from outside investors. You will be keeping the accounts (or bookkeeping) for the Global Grocer store. Completing this tutorial will prepare you for that role. The Accounting Process
This tutorial is based on a model of the accounting process in a small business. Financial accounting is a financial information system that tracks and records an organization's business transactions and aggregates them into reports for decision makers both inside and outside the business. A transaction is an event that has consequences for a business' financial condition. The event could be either external or internal to the business.
(1) In the running of a business, various decisions are made and implemented as business transactions. For example, in a typical business, managers will raise capital from investors and banks, rent or buy equipment, and purchase and sell merchandise and services. Each business transaction is related to one of three types of activities: operating, investing and financing activities. (2) Even the most simple organizations have numerous business transactions that have to be tracked and recorded. Transactions are formally recorded in a database called a journal, and then organized by accounts into a ledger. (3) Report preparation requires the aggregation of accounting transactions into statements or reports that describe the financial status of the business and its performance. The most common financial accounting reports are the balance sheet, the income statement and the statement of cash flows. (4) Financial statements are used by decision makers inside and outside the business. For example, managers use them to decide whether the firm is making a profit, whether customer incentives are working, or whether to take a loan and expand the business. If a business raises capital from outside investors, the investors will examine the company's financial statements to judge whether the funds they have invested have been used wisely. (5) Financial reporting concepts and principles tell us when and how to measure, record and classify business transactions and aggregate them into financial reports. By following these concepts and principles, financial reporting systems provide information that is consistent over time and across different businesses, and accounting becomes a language that is widely understood. (6) Auditors are independent parties who periodically examine a company's financial statements and the systems, internal controls and records used to produce the statements. Since a company's managers prodice their own report cards, i.e., the company's financial statements, auditors play an important role as a control mechanism. They attest that the financial statements conform to generally accepted accounting principles and they provide assurance that the company's accounts are presented fairly. (7) Based on their analyses of financial statements, financial statement users take actions, which in turn, affect the future operating, investing and financing decisions made by the organization. Hence, the financial reporting system is an information feedback loop between users of financial statements and the decision makers within the organization. Module Overview
In each chapter of this tutorial, you will learn new financial accounting terms and concepts and how to use this knowledge within the context of the Global Grocer setting. You will also be given exercises to practice and test what you have learned at several points in each chapter. The "Terms and Concepts" chapter introduces key financial accounting terms and five fundamental financial accounting concepts. It provides a brief overview of the three most important financial statements. The chapters labeled "The Balance Sheet," "The Income Statement," and "The Statement of Cash Flows" explain relevant new financial accounting concepts and use the concepts to construct a financial statement. You will see how Global Grocer's financial statements are affected by its business transactions during the first month of operations. In the "Accounting Records" chapter you will learn how to formally record Global Grocer's business transactions into its journal and ledger and how to use these records to prepare its financial statements. In doing so, you will revisit and record all the events that occurred at Global Grocer during the first month; only, this time, you will use the formal bookkeeping structures used in financial accounting systems. Module Overview (continued)
As you will learn, accounting practices in the United States are governed by a set of accounting rules referred to as Generally Accepted Accounting Principles (GAAP) These rules and their applications are covered in depth in this tutorial. Because there is a distinct possibility these rules may be replaced by another set of similar rules referred to as International Financial Reporting Standards (IFRS) in 2014, the tutorial, where appropriate, refers to IFRS as well as its GAAP counterpart. Exercise 1.1
Financial accounting is an information system that:
Choose the word that best completes the following sentence: In financial accounting, an organization's business
transactions are classified into operating activities, _________ activities and financing activities. Since auditors have to attest to the validity of a company's financial statements, what is an important characteristic for an auditor from the following choices? Terms and Concepts
In this chapter, you will explore the three main financial statements in some detail, and you will be introduced to five basic financial accounting concepts: entity, money measurement, going concern, consistency and materiality. You will also learn about two important qualities of financial accounting information--relevance and reliability--and how the use of accrual accounting and generally accepted accounting principles aid accountants in their quest for these qualities. Overview of Financial Reports
In this section, you will be introduced to the three main financial reports or statements. Each statement will be covered in more detail in the following chapters. Balance Sheet
A balance sheet, also called a statement of financial position, is a report of the organization's financial situation at a particular point in time. It lists the entity's assets, liabilities and owners' equity. It is called a balance sheet because it reports the balance or amount in each asset, liability and owners' equity account. This is Global Grocer's balance sheet one month after it opens for business. We will use it to explain key balance sheet-related terms. The chapter labeled "The Balance Sheet" covers the balance sheet in more detail. (1) At top of each financial statement is the name of the organization or entity for which the statement has been prepared. The term entity is used to indicate the separate economic unit for which financial records are being kept and financial statements prepared. Common types of accounting entities are businesses, political and charitable organizations, city governments, universities...any organization that needs to record and communicate its financial activities. (2) A balance sheet, also called a statement of financial position, is a report of the organization's financial situation at a particular point in time. It lists the entity's assets, liabilities and owners' equity. It is called a balance sheet because it reports the balance or amount in each asset, liability and owners' equity account. Chapter 3 covers the balance sheet in greater detail. (3) Each balance sheet is prepared as of a specific date, which is recorded at the top of the statement. In the next chapter, you will prepare this opening balance sheet for Global Grocer, dated August 31, 2004. (4) Assets are economic resources acquired in a business transaction that are obtained or controlled by an entity, and are expected to produce future economic benefits. For example, this balance sheet shows that on September 30, 2004, among other assets, Global Grocer had a cash asset recorded at $95,500 and a warehouse property (building and land) recorded at $69,700. (5) A liability is an obligation to transfer economic resources to entities outside the business. Liabilities represent the capital provided to the business by creditors. For example, a loan from a bank is a liability, such as the one listed on Global Grocer's Spetember 30, 2004 balance sheet as short-term debt. Under the loan contract, Global Grocer has an obligation to repay the bank from which it obtained the loan. (6) Owners' Equity, also known as stockholders' or shareholders' equity, represents the residual interest of the owners in the business. The owners' interest is what's left over after deducting liabilities from assets. The common stock listed on Global Grocer's Spetember 30, 2004 balance sheet indicates that its owners have contributed capital to the company, and in return, have received common stock certificates establishing their ownership interest. Income Statement
The income statement details the entity's operating performance during a specific period of time, known as the accounting period, displayed at the top of the statement. In this income statement for Global Grocer, the accounting period is the month of September 2004. The income statement lists the revenues earned and expenses incurred during the period; subtracting expenses from revenues results in the measurement of net income for the period.
The chapter labeled "The Income Statement" covers the income statement in greater detail. (1) Just as in the balance sheet, the income statement contains the name of the entity at the top. (2) The income statement details the entity's operating performance during a specific period of time known as the accounting period. The income statement lists the revenues earned and expenses incurred during the period; subtracting expenses from revenues results in the measurement of net income for the period. Chapter 4 covers the income statement in greater detail. (3) The date is displayed at the top of the statement. In this example income statement for Global Grocer, the accounting period is the month of September 2004. (4) Sales, sometimes denoted as Sales revenue or Revenues, is the sum of the economic benefits the entity has earned during the accounting period in exchange for the goods and services it has provided to its customers. The economic benefits may be increases in assets or decreases in liabilities. (5) Expenses are the assets used or liabilities incurred by the entity during an accounting period to provide the goods and services that generated revenue during the period. (6) Net income or profit, or net profit, is the difference between the sales and expenses of the accounting period. Because it appears as the last line of the income statement, it is often referred to as the bottom line. Statement of Cash Flows
The statement of cash flows details the sources and uses of cash by the entity over an accounting period. For the convenience of financial statement users, the statement of cash flows is organized by type of business activity: operating, investing and financing. The chapter labeled "The Statement of Cash Flows" covers the statement of cash flows in greater detail. (1) Just as in the balance sheet and the income statement, the statement of cash flows indicates the name of the entity at the top. (2) The statement of cash flows details the sources and uses of cash by the entity over an accounting period. For the convenience of financial statement users, the statement of cash flows is organized by type of business activity: operating, investing and financing. Chapter 6 covers the statement of cash flows in greater detail. (3) The date is displayed at the top of the statement. In this statement of cash flows for Global Grocer, the accounting period is the month of September 2004. (4) Operating activities are those activities that are related to the delivery of goods and services. The cash impact of such activities is recorded in the operating activities section of the statement of cash flows. At Global Grocer, this section of the statement of cash flows would, for example, report cash collected from customers, cash paid to suppliers and cash paid to employees as part of its daily business activities. (5) Investing activities are those activities that are related to the purchase and sale of long-lived assets. The impact of such activities on the cash account is recorded in the investing activities section of the statement of cash flows. At Global Grocer, this section of the statement of cash flows would, for example, report the cash used to purchase a van. (6) Financing activities relate to borrowing or retiring debt and to increasing or decreasing owners' equity in the firm. The impact of such activities on the cash account is recorded in the financing activities section of the statement of cash flows. At Global Grocer, cash from bank loans and amounts received from owners are reported in this section of the statement of cash flows. Exercise 2.1
please read topic:
Econ 1101 Microeconomics 1
Econ 200 Principles of Business Economics
The Balance Sheet is so named because:
A balance sheet is prepared _________.
An income statement is prepared __________.
A statement of cash flows is prepared _________.
Choose the pair of words that best completes the following sentence: Cash held by a business would best be listed as _________ on the balance sheet; a bank loan taken by the business would be listed as _________.
Classify the following as Operating, Investing or Financing activities: Purchase or sale of building Raising cash from investors
Selling products and services
Introduction to Concepts
Financial Accounting concepts form the foundation on which the financial accounting system and reports are built. Entities and the nature of their economic activities change and evolve over time. Accounting must be able to accommodate and reflect those changes. Accounting concepts provide guidance to resolve accounting issues that may arise today or in the future. In the United States, the Financial Accounting Standards Board (FASB) sets accounting standards. It has adopted a set of essential accounting concepts. They form the basis of a large number of accounting standards that provide guidance to accountants on how to account for specific types of transactions. These standards and the details on how to apply them, if printed in hard copy, would number in the thousands of pages. Five broad accounting concepts - entity, money measurement, going concern, consistency and materiality - will be discussed in this section. Other concepts will be discussed in subsequent chapters. Entity Concept
The entity concept is the most basic accounting concept. It states that accounts are kept for an entity as distinct from the people who own, run or do business with the entity. The entity concept is simple but powerful. It allows the accountant to draw a virtual boundary around the entity and hence limit the activities that need to be tracked and recorded. Money Measurement Concept
The money measurement concept states that financial accounting deals only with things that can be represented in monetary terms. This concept is so intuitive that it is usually taken for granted. But, since it is so important, it is stated as a basic accounting concept. Going Concern Concept
Going concern is accounting's way of saying that an entity is expected to remain in operation for the indefinite future. The going concern concept directs the accountant to explicitly make this assumption in the absence of evidence to the contrary. The significance of the going concern concept can be understood by considering the alternative: that the entity is about to go out of business. If this was the case, all its resources should be valued at their current worth to potential buyers. The going concern concept directs the accountant, under the normal course of business, to ignore this doomsday scenario. Consistency Concept
The consistency concept states that an entity should use the same accounting methods and procedures from period to period unless it has a sound reason to change methods. The consistency concept needs to be explicitly stated because some accounting standards allow a fair degree of variation in how transactions are recorded. The consistency concept reduces the likelihood of opportunistic or whimsical changes in accounting procedures by an entity. Note that the consistency concept does not forbid a switch in accounting procedures. If an entity does make a procedural accounting change, its management and auditors are required to note the change in their discussion of the entity's accounts. Note also that in the context of accounting concepts, consistency means consistency over time.
Materiality Concept
The materiality concept states that an entity need only apply proper accounting to items that are material, i.e., significant to potential users of the financial statements. This concept allows the accountant to be practical in choosing the appropriate degree of precision in the accounts. Just what is material and not material is not made specific in accounting. The general rule is that, "An item is material if its disclosure would impact the decisions of the users of the accounts." The application of this rule requires accountants to judge what users of financial statements would consider significant to their decisions. As in most matters requiring judgments, reasonable people can differ. Determining materiality is no exception. Exercise 2.2
A non-profit agency cannot be a financial accounting entity. Global Grocer is the entity for which you will keep the books. Which of the following events will affect Global Grocer's accounts? Which of the following will not be recorded on Global Grocer's books because it violates the Money Measurement concept: "Accounting does not report what the assets of a business could be sold for if the business ceased to exist". This is a result of the: Quality Attributes
In any financial accounting system, there are a number of decisions to be made: whether to record a transaction, when to record it and how to record it. Also, there are different ways to aggregate the account balances in financial reports. Any such system must have a set of criteria or guidelines to help make those decisions. This section addresses some of those issues. It discusses desired financial accounting quality attributes and some of the guidance that flows from these attributes. Relevance and Reliability
In financial accounting, the quality of the output depends on the relevance and reliability of the data presented. Relevance refers to the timeliness and usefulness of the information to its users. Reliability refers to the objectivity and verifiability of the information. Different ways of recognizing, measuring and recording an event may yield more or less reliable or more or less relevant account balances. Often, judgment has to be used to make the trade-off between relevance and reliability, i.e., there isn't a way to record a transaction that will maximize both these desirable properties. In such cases, reliability is generally given precedence over relevance.
A balance sheet is prepared _________.
An income statement is prepared __________.
A statement of cash flows is prepared _________.
Choose the pair of words that best completes the following sentence: Cash held by a business would best be listed as _________ on the balance sheet; a bank loan taken by the business would be listed as _________.
Classify the following as Operating, Investing or Financing activities: Purchase or sale of building Raising cash from investors
Selling products and services
Introduction to Concepts
Financial Accounting concepts form the foundation on which the financial accounting system and reports are built. Entities and the nature of their economic activities change and evolve over time. Accounting must be able to accommodate and reflect those changes. Accounting concepts provide guidance to resolve accounting issues that may arise today or in the future. In the United States, the Financial Accounting Standards Board (FASB) sets accounting standards. It has adopted a set of essential accounting concepts. They form the basis of a large number of accounting standards that provide guidance to accountants on how to account for specific types of transactions. These standards and the details on how to apply them, if printed in hard copy, would number in the thousands of pages. Five broad accounting concepts - entity, money measurement, going concern, consistency and materiality - will be discussed in this section. Other concepts will be discussed in subsequent chapters. Entity Concept
The entity concept is the most basic accounting concept. It states that accounts are kept for an entity as distinct from the people who own, run or do business with the entity. The entity concept is simple but powerful. It allows the accountant to draw a virtual boundary around the entity and hence limit the activities that need to be tracked and recorded. Money Measurement Concept
The money measurement concept states that financial accounting deals only with things that can be represented in monetary terms. This concept is so intuitive that it is usually taken for granted. But, since it is so important, it is stated as a basic accounting concept. Going Concern Concept
Going concern is accounting's way of saying that an entity is expected to remain in operation for the indefinite future. The going concern concept directs the accountant to explicitly make this assumption in the absence of evidence to the contrary. The significance of the going concern concept can be understood by considering the alternative: that the entity is about to go out of business. If this was the case, all its resources should be valued at their current worth to potential buyers. The going concern concept directs the accountant, under the normal course of business, to ignore this doomsday scenario. Consistency Concept
The consistency concept states that an entity should use the same accounting methods and procedures from period to period unless it has a sound reason to change methods. The consistency concept needs to be explicitly stated because some accounting standards allow a fair degree of variation in how transactions are recorded. The consistency concept reduces the likelihood of opportunistic or whimsical changes in accounting procedures by an entity. Note that the consistency concept does not forbid a switch in accounting procedures. If an entity does make a procedural accounting change, its management and auditors are required to note the change in their discussion of the entity's accounts. Note also that in the context of accounting concepts, consistency means consistency over time.
Materiality Concept
The materiality concept states that an entity need only apply proper accounting to items that are material, i.e., significant to potential users of the financial statements. This concept allows the accountant to be practical in choosing the appropriate degree of precision in the accounts. Just what is material and not material is not made specific in accounting. The general rule is that, "An item is material if its disclosure would impact the decisions of the users of the accounts." The application of this rule requires accountants to judge what users of financial statements would consider significant to their decisions. As in most matters requiring judgments, reasonable people can differ. Determining materiality is no exception. Exercise 2.2
A non-profit agency cannot be a financial accounting entity. Global Grocer is the entity for which you will keep the books. Which of the following events will affect Global Grocer's accounts? Which of the following will not be recorded on Global Grocer's books because it violates the Money Measurement concept: "Accounting does not report what the assets of a business could be sold for if the business ceased to exist". This is a result of the: Quality Attributes
In any financial accounting system, there are a number of decisions to be made: whether to record a transaction, when to record it and how to record it. Also, there are different ways to aggregate the account balances in financial reports. Any such system must have a set of criteria or guidelines to help make those decisions. This section addresses some of those issues. It discusses desired financial accounting quality attributes and some of the guidance that flows from these attributes. Relevance and Reliability
In financial accounting, the quality of the output depends on the relevance and reliability of the data presented. Relevance refers to the timeliness and usefulness of the information to its users. Reliability refers to the objectivity and verifiability of the information. Different ways of recognizing, measuring and recording an event may yield more or less reliable or more or less relevant account balances. Often, judgment has to be used to make the trade-off between relevance and reliability, i.e., there isn't a way to record a transaction that will maximize both these desirable properties. In such cases, reliability is generally given precedence over relevance.
Exercise
2.3
Choose the pair of words that best completes the following sentence: Since financial accounting reports are used to make decisions that affect the entity, financial accounting strives to present information about the entity that is __________ and _________. Choose the pair of words that best completes the following sentence: Relevance of financial information refers to its ___________ and ___________. Which of the following pairs of attributes best contributes to the reliability of financial data: When relevance and reliability are in conflict, financial accounting will favor relevance. Accrual Accounting
Accrual accounting is an important tool in the quest for relevance in accounting reports. This method of accounting provides information about a company's assets, liabilities and owners' equity that cannot be obtained by accounting for only cash receipts and outlays. Accrual accounting focuses on the economic characteristics of transactions rather than their cash flows. Accrual vs. Cash-Basis
Accrual accounting attempts to record the financial effects on a business of transactions that have economic consequences for the business in the accounting period when the transaction occurs rather than only in the periods when cash is received or paid by the company. At this stage, some simple examples will help give meaning to the term accrual accounting as contrasted with cash-basis accounting. When applied consistently, accrual accounting is a means of enhancing the relevance of financial statements. Cash- basis accounting results in inadequate and misleading financial statements for all but the most simple of businesses. As a result, accrual accounting is the accounting system of choice throughout the world today. Accrual accounting attempts to record the financial effects on a business of transactions that have economic consequences for the business in the accounting period when the transaction occurs rather than only in the periods when cash is received or paid by the company. At this stage, some simple examples will help give meaning to the term accrual accounting as contrasted with cash-basis accounting. When applied consistently, accrual accounting is a means of enhancing the relevance of financial statements. Cash- basis accounting results in inadequate and misleading financial statements for all but the most simple of businesses. As a result, accrual accounting is the accounting system of choice throughout the world today. GAAP
Financial accounting reports are used by investors, regulators, employees, customers and a number of other external parties. So that this diverse list of users can understand an entity's financial statements, accountants must follow certain guidelines or standards when preparing financial accounting reports. These principles, more numerous than the accounting concepts, are explicit rules that are used to improve the reliability and comparability of financial reports. Generally Accepted Accounting Principles (GAAP) are guidelines that accountants, managers and auditors must follow while preparing and auditing accounting information for external reporting purposes. For example, GAAP requires the use of accrual accounting. The application of GAAP rules results in reasonably reliable financial information, while also permitting each entity to reasonably describe its own business strategy and performance through relevant accounting information. In this tutorial, you will use GAAP to record Global Grocer's business transactions. However, you will not need to actually look up or refer to the Generally Accepted Accounting Principles each time. Instead, this tutorial will simply show you how to record Global Grocer's transactions according to GAAP. The Financial Accounting Standards Board (FASB) determines GAAP in the United States. There also exists an International Accounting Standards Board (IASB), which, among other activities, has undertaken a major effort to harmonize accounting standards around the world. IFRS
Convergence Project
The International Accounting Standards Board (IASB) publishes International Financial Reporting Standards (IFRS). The FASB and the IASB have a major project underway to bring about a convergence of GAAP and IFRS. As a result of this project, users of this tutorial can assume, unless noted otherwise, that the accounting for a particular transaction described in the tutorial is essentially the same under both GAAP and IFRS. As noted earlier, IFRS could replace GAAP as early as 2014. Principles vs Rules
Principles Based versus Rules Based
IFRS tends to be stated as in the form of broad principles. In contrast, much of GAAP tends to be stated in the form of bright-line rules. For example, as you will learn later along with various accounting rules, under GAAP if a term of a lease is equal to 75 percent of the economic life of the leased property, the lease will be accounted for as a capital lease. On the other hand, if the lease item is equal to 74 percent or less of the leased property's economic life, the lease will be accounted for as an operating lease. IFRS takes a different approach. It makes the distinction between a capital and an operating lease based on which party - the lessor or the lessee - substantially bears the risk and reward of ownership. The distinction between the principle based and rule based accounting standards is important. Under a principle standards model, the accounting for transactions is more likely to reflect the substance of the transaction. Under a rule based standards model, the accounting for a transaction is more likely to reflect the form of the transaction. As GAAP and IFRS converge, it is anticipated that GAAP will become more principle based. Recap
In this chapter, you have
briefly explored three fundamental accounting statements,
learned about the entity concept, the money measurement concept, the going concern concept, the consistency concept and the materiality concept, started to appreciate the inherent conflict between relevance and reliability that accountants must resolve in setting standards and preparing financial reports, been introduced to accrual accounting and GAAP and their use in financial accounting practice, and learned that in the near future GAAP may be replaced by IFRS. The Balance Sheet
In this chapter, you will learn how a balance sheet is organized and about its main organizing principle, the accounting equation. Two concepts that are important for the preparation of the balance sheet, dual aspect and historical cost, will be explained. They will be used to record the operating, investing and financing activities you have undertaken to get Global Grocer ready for business. Finally, two financial ratios that can be computed from the balance sheet--current ratio and total debt to equity ratio--will be discussed. Layout
The balance sheet, also known as a statement of financial position, is a snapshot at a specific point in time, of the resources controlled by an entity (assets), the claims against those resources (liabilities), and the owners' residual interest in the entity (owners' equity). In the side-by-side format shown, assets are listed on the left side of the balance sheet; liabilities and owners' equity are listed on the right. Here is Global Grocer's balance sheet as it will appear at the end of business on September 30, after a month of operations. (1) Global Grocer, Inc.—is named at the top, and the balance sheet date is indicated. This is Global Grocer's balance sheet as it will appear at the end of business on September 30, 2004, after a month of operations. (2) In the side-by-side format shown, the entity's assets are listed on the left; its liabilities and owners' equity are listed on the right. Note that total assets equals total liabilities plus owners' equity. Exercise 3.1
Which one of the following best describes a balance sheet?
Assets
Let's now look at the left-hand side of the balance sheet. It lists the asset accounts, which represent the economic resources of the firm. To be recorded as an asset, an economic resource must meet four requirements: Acquired at measurable cost
Obtained or controlled by the entity
Expected to produce future economic benefits Arises from a past transaction or event Asset Examples
Here are three assets that you will record on Global Grocer's August 31,2004 balance sheet.(not shown) Each satisfies all four criteria for being recorded as an asset.
Not Assets
Here are some items that Global Grocer will not list as assets on its balance sheet. Each fails to satisfy at least one of the four criteria for being recorded as an asset. Tangibility
An item can be an asset whether or not it has physical substance, i.e., whether or not it can be touched and felt. Assets like computers and buildings having physical substance are tangible assets. Other assets, like licenses and prepaid expenses that lack physical substance, are intangible assets. Liquidity
On the balance sheet, assets are organized into two categories: current and non-current. Current assets include cash and those assets that are expected to be converted into cash or consumed within 12 months of the balance sheet date. Non-current assets are assets that are expected to provide economic benefits for periods longer than a year. The first current asset on Global Grocer's September 30, 2004 balance sheet is cash. It is followed by three other assets whose economic benefits turn into cash or are expected to expire during the 12 months following the balance sheet date. They are accounts receivable (money owed to Global Grocer by customers), merchandise inventory (goods available for sale) and prepaid expenses (rent paid in advance for the store). The end of September balance sheet also includes several non-current assets: land, a warehouse, some store fixtures for display purposes, and a franchise fee asset. These assets are expected to provide economic benefits for more than one year from the balance sheet date. Some tangible, non-current assets with limited lives, such as the warehouse building, have an associated contra-asset account, called accumulated depreciation, that reduces the recorded value of the asset. In the U.S., assets are reported in a standard order on the balance sheet. Current assets are listed first, starting with cash, and following in order of liquidity i.e., availability to meet current obligations. For example, cash is Exercise 3.2
more readily available than accounts receivable to pay creditor claims. Prepaid expenses, the last item listed as a current asset, is probably not available at all. Non-current assets are listed next, typically starting with land, Consider each item listed in the left column of the table below. Use the drop down menus provided to indicate plant and equipment, followed by intangible assets, such as the franchise fee. whether the item meets each of the four asset criteria. Items that meet all four criteria are assets. Exercise 3.3
Which one of the following best describes an asset that is expected to provide economic benefits for three years and does not have physical substance?
Liabilities
Now we shift our attention to the right side of the balance sheet, starting with liabilities. A liability represents an obligations of the entity to other parties. To be recorded as a liability, an obligation must meet three requirements: It involves a probable future sacrifice of economic resources by the entity The economic resource transfer is to another entity
The future sacrifice is a present obligation, arising from a past transaction or event Examples
Consider three liabilities that you will record on Global Grocer's August 31, 2004 balance sheet.(not shown) Each satisfies all three criteria for being a liability.
Not Liabilities
Here are some items that you will not record as liabilities on Global Grocer's balance sheet. Each fails to satisfy at least one of the three criteria for being recorded as a liability. Liability Types
Liabilities are organized into two categories: current and non-current. Current liabilities are obligations that are expected to become due within 12 months of the balance sheet date. Non-current liabilities are obligations that are expected to become due more than 12 months past the balance sheet date. There are three current liabilities on Global Grocer's September 30, 2004, balance sheet: accounts payable (money owed by Global Grocer to its suppliers who will be paid during the coming year), taxes payable (money potentially owed to the tax authorities) and a short-term debt (a loan to Global Grocer that it must pay back within a year of the balance sheet date). Global Grocer has one non-current liability on its September 30, 2004, balance sheet: a mortgage payable. The mortgage is a long-term loan. It represents money owed by Global Grocer to a bank, with payments to be made for more than 12 months from the balance sheet date. Exercise 3.4
Consider the items listed in the left column of the table below. Use the drop down menus provided to indicate whether the item meets each of the three liability criteria. Items meeting all three criteria are liabilities. Owners' Equity
Owners' Equity is the residual interest of the entity's owners in the company's assets. It is the amount remaining after liabilities are deducted from assets. (1) Given the way it is defined, Owners' Equity is also known as net assets (meaning net of liabilities). Other names for it are stockholders equity or shareholders equity, or, just equity. (2) Global Grocer's September 30 balance sheet has two owners' equity accounts: common stock and retained earnings. Common stock represents the amount invested in the entity by shareholders. It is sometimes called Paid-in capital. Retained earnings represent the cumulative earnings of the entity to date, less any distribution of earnings to owners of the entity. Exercise 3.5
On June 30, 2004, Ardel company has total assets of $12,500,000. It has total liabilities of $10,500,000. What is the amount of Ardel's owners' equity on June 30, 2004? The Accounting Equation
A simple relationship connects assets, liabilities and owners' equity. The key feature of a balance sheet is that total assets is always equal to total liabilities plus owners' equity. This relationship between assets and liabilities plus owners' equity is known as the fundamental accounting equation. The left side of the accounting equation--total assets--represents all of an entity's resources that have probable future economic benefits that the entity has obtained or controls as a result of past transactions or events. The right side of the equation--total liabilities plus owners' equity--represents the sources for those resources. Therefore, the two sides must be equal at all times. Exercise 3.6
Which one of the following best describes the fundamental accounting equation? Concepts In this section we will introduce two more accounting concepts, namely the dual-aspect and historical cost concepts. They are particularly relevant to the balance sheet. These two concepts provide guidance on the valuation of assets, liabilities and owners' equity. Dual Aspect
BUSN 3002 AuditingChoose the pair of words that best completes the following sentence: Since financial accounting reports are used to make decisions that affect the entity, financial accounting strives to present information about the entity that is __________ and _________. Choose the pair of words that best completes the following sentence: Relevance of financial information refers to its ___________ and ___________. Which of the following pairs of attributes best contributes to the reliability of financial data: When relevance and reliability are in conflict, financial accounting will favor relevance. Accrual Accounting
Accrual accounting is an important tool in the quest for relevance in accounting reports. This method of accounting provides information about a company's assets, liabilities and owners' equity that cannot be obtained by accounting for only cash receipts and outlays. Accrual accounting focuses on the economic characteristics of transactions rather than their cash flows. Accrual vs. Cash-Basis
Accrual accounting attempts to record the financial effects on a business of transactions that have economic consequences for the business in the accounting period when the transaction occurs rather than only in the periods when cash is received or paid by the company. At this stage, some simple examples will help give meaning to the term accrual accounting as contrasted with cash-basis accounting. When applied consistently, accrual accounting is a means of enhancing the relevance of financial statements. Cash- basis accounting results in inadequate and misleading financial statements for all but the most simple of businesses. As a result, accrual accounting is the accounting system of choice throughout the world today. Accrual accounting attempts to record the financial effects on a business of transactions that have economic consequences for the business in the accounting period when the transaction occurs rather than only in the periods when cash is received or paid by the company. At this stage, some simple examples will help give meaning to the term accrual accounting as contrasted with cash-basis accounting. When applied consistently, accrual accounting is a means of enhancing the relevance of financial statements. Cash- basis accounting results in inadequate and misleading financial statements for all but the most simple of businesses. As a result, accrual accounting is the accounting system of choice throughout the world today. GAAP
Financial accounting reports are used by investors, regulators, employees, customers and a number of other external parties. So that this diverse list of users can understand an entity's financial statements, accountants must follow certain guidelines or standards when preparing financial accounting reports. These principles, more numerous than the accounting concepts, are explicit rules that are used to improve the reliability and comparability of financial reports. Generally Accepted Accounting Principles (GAAP) are guidelines that accountants, managers and auditors must follow while preparing and auditing accounting information for external reporting purposes. For example, GAAP requires the use of accrual accounting. The application of GAAP rules results in reasonably reliable financial information, while also permitting each entity to reasonably describe its own business strategy and performance through relevant accounting information. In this tutorial, you will use GAAP to record Global Grocer's business transactions. However, you will not need to actually look up or refer to the Generally Accepted Accounting Principles each time. Instead, this tutorial will simply show you how to record Global Grocer's transactions according to GAAP. The Financial Accounting Standards Board (FASB) determines GAAP in the United States. There also exists an International Accounting Standards Board (IASB), which, among other activities, has undertaken a major effort to harmonize accounting standards around the world. IFRS
Convergence Project
The International Accounting Standards Board (IASB) publishes International Financial Reporting Standards (IFRS). The FASB and the IASB have a major project underway to bring about a convergence of GAAP and IFRS. As a result of this project, users of this tutorial can assume, unless noted otherwise, that the accounting for a particular transaction described in the tutorial is essentially the same under both GAAP and IFRS. As noted earlier, IFRS could replace GAAP as early as 2014. Principles vs Rules
Principles Based versus Rules Based
IFRS tends to be stated as in the form of broad principles. In contrast, much of GAAP tends to be stated in the form of bright-line rules. For example, as you will learn later along with various accounting rules, under GAAP if a term of a lease is equal to 75 percent of the economic life of the leased property, the lease will be accounted for as a capital lease. On the other hand, if the lease item is equal to 74 percent or less of the leased property's economic life, the lease will be accounted for as an operating lease. IFRS takes a different approach. It makes the distinction between a capital and an operating lease based on which party - the lessor or the lessee - substantially bears the risk and reward of ownership. The distinction between the principle based and rule based accounting standards is important. Under a principle standards model, the accounting for transactions is more likely to reflect the substance of the transaction. Under a rule based standards model, the accounting for a transaction is more likely to reflect the form of the transaction. As GAAP and IFRS converge, it is anticipated that GAAP will become more principle based. Recap
In this chapter, you have
briefly explored three fundamental accounting statements,
learned about the entity concept, the money measurement concept, the going concern concept, the consistency concept and the materiality concept, started to appreciate the inherent conflict between relevance and reliability that accountants must resolve in setting standards and preparing financial reports, been introduced to accrual accounting and GAAP and their use in financial accounting practice, and learned that in the near future GAAP may be replaced by IFRS. The Balance Sheet
In this chapter, you will learn how a balance sheet is organized and about its main organizing principle, the accounting equation. Two concepts that are important for the preparation of the balance sheet, dual aspect and historical cost, will be explained. They will be used to record the operating, investing and financing activities you have undertaken to get Global Grocer ready for business. Finally, two financial ratios that can be computed from the balance sheet--current ratio and total debt to equity ratio--will be discussed. Layout
The balance sheet, also known as a statement of financial position, is a snapshot at a specific point in time, of the resources controlled by an entity (assets), the claims against those resources (liabilities), and the owners' residual interest in the entity (owners' equity). In the side-by-side format shown, assets are listed on the left side of the balance sheet; liabilities and owners' equity are listed on the right. Here is Global Grocer's balance sheet as it will appear at the end of business on September 30, after a month of operations. (1) Global Grocer, Inc.—is named at the top, and the balance sheet date is indicated. This is Global Grocer's balance sheet as it will appear at the end of business on September 30, 2004, after a month of operations. (2) In the side-by-side format shown, the entity's assets are listed on the left; its liabilities and owners' equity are listed on the right. Note that total assets equals total liabilities plus owners' equity. Exercise 3.1
Which one of the following best describes a balance sheet?
Assets
Let's now look at the left-hand side of the balance sheet. It lists the asset accounts, which represent the economic resources of the firm. To be recorded as an asset, an economic resource must meet four requirements: Acquired at measurable cost
Obtained or controlled by the entity
Expected to produce future economic benefits Arises from a past transaction or event Asset Examples
Here are three assets that you will record on Global Grocer's August 31,2004 balance sheet.(not shown) Each satisfies all four criteria for being recorded as an asset.
Not Assets
Here are some items that Global Grocer will not list as assets on its balance sheet. Each fails to satisfy at least one of the four criteria for being recorded as an asset. Tangibility
An item can be an asset whether or not it has physical substance, i.e., whether or not it can be touched and felt. Assets like computers and buildings having physical substance are tangible assets. Other assets, like licenses and prepaid expenses that lack physical substance, are intangible assets. Liquidity
On the balance sheet, assets are organized into two categories: current and non-current. Current assets include cash and those assets that are expected to be converted into cash or consumed within 12 months of the balance sheet date. Non-current assets are assets that are expected to provide economic benefits for periods longer than a year. The first current asset on Global Grocer's September 30, 2004 balance sheet is cash. It is followed by three other assets whose economic benefits turn into cash or are expected to expire during the 12 months following the balance sheet date. They are accounts receivable (money owed to Global Grocer by customers), merchandise inventory (goods available for sale) and prepaid expenses (rent paid in advance for the store). The end of September balance sheet also includes several non-current assets: land, a warehouse, some store fixtures for display purposes, and a franchise fee asset. These assets are expected to provide economic benefits for more than one year from the balance sheet date. Some tangible, non-current assets with limited lives, such as the warehouse building, have an associated contra-asset account, called accumulated depreciation, that reduces the recorded value of the asset. In the U.S., assets are reported in a standard order on the balance sheet. Current assets are listed first, starting with cash, and following in order of liquidity i.e., availability to meet current obligations. For example, cash is Exercise 3.2
more readily available than accounts receivable to pay creditor claims. Prepaid expenses, the last item listed as a current asset, is probably not available at all. Non-current assets are listed next, typically starting with land, Consider each item listed in the left column of the table below. Use the drop down menus provided to indicate plant and equipment, followed by intangible assets, such as the franchise fee. whether the item meets each of the four asset criteria. Items that meet all four criteria are assets. Exercise 3.3
Which one of the following best describes an asset that is expected to provide economic benefits for three years and does not have physical substance?
Liabilities
Now we shift our attention to the right side of the balance sheet, starting with liabilities. A liability represents an obligations of the entity to other parties. To be recorded as a liability, an obligation must meet three requirements: It involves a probable future sacrifice of economic resources by the entity The economic resource transfer is to another entity
The future sacrifice is a present obligation, arising from a past transaction or event Examples
Consider three liabilities that you will record on Global Grocer's August 31, 2004 balance sheet.(not shown) Each satisfies all three criteria for being a liability.
Not Liabilities
Here are some items that you will not record as liabilities on Global Grocer's balance sheet. Each fails to satisfy at least one of the three criteria for being recorded as a liability. Liability Types
Liabilities are organized into two categories: current and non-current. Current liabilities are obligations that are expected to become due within 12 months of the balance sheet date. Non-current liabilities are obligations that are expected to become due more than 12 months past the balance sheet date. There are three current liabilities on Global Grocer's September 30, 2004, balance sheet: accounts payable (money owed by Global Grocer to its suppliers who will be paid during the coming year), taxes payable (money potentially owed to the tax authorities) and a short-term debt (a loan to Global Grocer that it must pay back within a year of the balance sheet date). Global Grocer has one non-current liability on its September 30, 2004, balance sheet: a mortgage payable. The mortgage is a long-term loan. It represents money owed by Global Grocer to a bank, with payments to be made for more than 12 months from the balance sheet date. Exercise 3.4
Consider the items listed in the left column of the table below. Use the drop down menus provided to indicate whether the item meets each of the three liability criteria. Items meeting all three criteria are liabilities. Owners' Equity
Owners' Equity is the residual interest of the entity's owners in the company's assets. It is the amount remaining after liabilities are deducted from assets. (1) Given the way it is defined, Owners' Equity is also known as net assets (meaning net of liabilities). Other names for it are stockholders equity or shareholders equity, or, just equity. (2) Global Grocer's September 30 balance sheet has two owners' equity accounts: common stock and retained earnings. Common stock represents the amount invested in the entity by shareholders. It is sometimes called Paid-in capital. Retained earnings represent the cumulative earnings of the entity to date, less any distribution of earnings to owners of the entity. Exercise 3.5
On June 30, 2004, Ardel company has total assets of $12,500,000. It has total liabilities of $10,500,000. What is the amount of Ardel's owners' equity on June 30, 2004? The Accounting Equation
A simple relationship connects assets, liabilities and owners' equity. The key feature of a balance sheet is that total assets is always equal to total liabilities plus owners' equity. This relationship between assets and liabilities plus owners' equity is known as the fundamental accounting equation. The left side of the accounting equation--total assets--represents all of an entity's resources that have probable future economic benefits that the entity has obtained or controls as a result of past transactions or events. The right side of the equation--total liabilities plus owners' equity--represents the sources for those resources. Therefore, the two sides must be equal at all times. Exercise 3.6
Which one of the following best describes the fundamental accounting equation? Concepts In this section we will introduce two more accounting concepts, namely the dual-aspect and historical cost concepts. They are particularly relevant to the balance sheet. These two concepts provide guidance on the valuation of assets, liabilities and owners' equity. Dual Aspect
The dual-aspect concept formalizes the idea that there are two sides to every
accounting transaction. Recording both sides of each transaction is known as
double-entry bookkeeping. The dual-aspect concept has a very important
implication: after both sides of each accounting transaction are recorded on
the entity's books, the basic accounting equation should remain balanced.
Exercise 3.7
The dual-aspect concept tells us that
Historical Cost
The historical cost concept, also known as the cost concept, provides guidance as to the amount at which a transaction should be reported initially in the entity's accounts. It requires that transactions be recorded in terms of their actual price or cost at the time the transaction occurred. Global Grocer is planning to buy a warehouse property. The historical cost concept directs you to record the warehouse property at its acquisition cost of $70,000. Others may think the warehouse property is worth more or less than the amount Global Grocer paid, but their views are irrelevant. The accounting records will record the warehouse transaction initially at the amount actually paid for it. Relevance/Reliability
The historical cost concept provides a degree of reliability in the entity's accounts. It allows the accountant to ignore opinion and hearsay about the monetary value of items, and to report amounts based on actual transactions. But, the use of the historical cost concept also means that some amounts on an entity's balance sheet are based on historical values, determined at the time of purchase, which could predate the current balance sheet date by years. Consequently, it is unlikely that the asset amounts on the balance sheet reflect the value that the assets would fetch if they were sold today. In this sense, the financial statements may be 'less relevant' for the purposes of users of the entity's balance sheets, than if current market prices were reported. As noted earlier, when relevance and reliability have to be traded off, financial reporting practice tends to favor reliability. Hence reliance on the historical cost concept may sometimes yield more reliable but less relevant financial information. However, accountants are not blind to the relevance issue. As you will learn in more advanced accounting classes, many monetary assets are recorded initially at their cost, and subsequently measured and reported in the balance sheet at their market value. Monetary assets are items such as marketable securities. Their market value can generally be estimated reasonably reliably. In addition, you will learn how accountants enhance relevance by recording some transactions to reflect their substance rather than their form. While IFRS favors the historical cost model, it does present as an acceptable alternative treatment the revaluation of land and buildings to their market value, if their value can be measured reliably subsequent to their initial recognition at cost. Exercise 3.8
Sun Electronics purchases a stamping machine for $10,000. Almost immediately, a trade embargo restricts the number of stamping machines that can be imported into the U.S. Based on want ads in the commercial section of the newspaper, stamping machines like Sun's are now selling for $15,000. Sun Electronics should immediately Exercise 3.9
To users of an entity's financial statements, which of the following is a potential limitation of the historical cost concept: Review
The exercises in this section cover all the material you have learned about the balance sheet up to this point. Take a few moments to test your understanding of this material. Exercise 3.10
Choose the pair of words that best completes the fundamental accounting equation: _________________ = Liabilities + ________________
Exercise 3.11
Which one of the following is not a requirement for an item to be an asset: Exercise 3.12
Global Grocer has purchased a warehouse building with an expected useful life of 10 years for $40,000. Which of the following is the best description of this new asset? Exercise 3.13
A liability on the balance sheet represents _________________ of the entity. Exercise 3.14
On January 1, 2004, Scott Manufacturing has assets of $1,600,000 and liabilities of $900,000. Its owners' equity is Let's Get Global Grocer Started
You have spent much of August raising financing and making the necessary investments and pre-operating decisions to get Global Grocer ready to open its doors on September 1. Although the transactions took place during August, for simplicity, you will record them all together on August 31st before the store opens. Of course, you start with an empty balance sheet. Common Stock Short-Term Debt Franchise Fee Prepaid Rent Warehouse Property Mortgage Store Fixtures Merchandise Inventory Hiring
Exercise 3.15
Suppose Barnum and Sons obtains a 5-year, $100,000 bank loan, payable at maturity. Which one of the following describes the effect of this transaction on its balance sheet? Transaction Exercises
The exercises in this section describe various transactions and ask you how they affect the balance sheet. Take a few moments to test your understanding of this material. Exercise 3.16 Exercise 3.17
On June 2, 2004, Mansfield purchases a computer system for $22,000 from Infostore Systems. Mansfield pays $10,000 in cash and promises to pay Infostore the rest in equal installments over the rest of the year. The computer system is expected to last 4 years. Which of the following would you do in this situation? Exercise 3.18
Exercise 3.19 Ratios
Users of financial statements use a technique known as financial ratio analysis to assess the financial position and performance of an entity. Financial ratios are ratios based on the amounts in the financial statements. Two simple balance-sheet-based ratios are introduced in this section. They are the current ratio and the long-term-debt-to-equity ratio. Current Ratio
An entity's ability to meet its current obligations - those due within the coming year - is an important measure of its financial health. These short-term obligations are usually repaid in the normal course of business, as the entity's current assets are converted to cash. For example, cash is generated when merchandise inventory is sold for cash, or when accounts receivables are collected in cash from customers. This cash can then be used to pay accounts payable. The current ratio, or, ratio of current assets to current liabilities is a measure of an entity's ability to meet its maturing short-term obligations. In the current ratio, the numerator, current assets, represents the resources of the entity that are either cash or expected to soon be converted into cash. Cash and these asset conversions to cash can be used to satisfy the immediate claims of short-term creditors. The denominator, current liabilities, represents the current claims of creditors that must be extinguished in the near-term. Current Ratio = Current Assets Current Liabilities
Interpretation
While there is no single ideal current ratio, financial statement users often employ the rule-of-thumb that a healthy business will have a minimum current ratio of 2. Because the appropriate current ratio varies by industries, financial statement users tend to focus on an entity's current ratio relative to those of other, similar businesses. In the U.S., the pharmaceutical industry has had an average current ratio of 1.8 over the past decade; the software industry, on the other hand, has had a 2.9 average current ratio over the same time period. Software companies, with their limited need for fixed assets, traditionally hold a much larger proportion of their assets in cash and monetary current assets, and this is reflected in their significantly higher current ratios. If financial statement users notice that an entity has a current ratio that significantly higher than that of its peers, they may be concerned that the entity holds more cash or inventory than a business needs. This may signal that it is locking up potentially productive capital. If, on the other hand, an entity has current ratio that is significantly lower than that of its peers, financial statement users may question its ability to satisfy its current obligations in a timely manner. Exercise 3.20
Farrah Company's December 31, 2004 balance sheet shows current assets of $250,000 and current liabilities of $100,000. Its current ratio is Total Debt to Equity Ratio
The composition of a company's long-term capital structure - primarily its total interest-bearing debt and owners' equity - is of interest to financial statement users seeking to assess the long-term financial viability of an entity. Of particular interest is the ratio of total debt (capital that accrues interest and has to be repaid to lenders) to equity capital (capital that does not demand interest and does not have to be repaid). The total debt to equity ratio is useful for judging an entity's long-term financial viability. As the name suggests, it is the ratio of all interest bearing debt on the balance sheet, to total equity. This ratio measures financial leverage or the degree of the entity's indebtedness relative to its equity funding. Debt and equity are very different kinds of capital. When an entity assumes debt, i.e., accepts a loan, it has to pay interest and also repay the loan to the debt holder over an agreed-upon period of time. If the entity runs into hard times and fails to pay its maturing financial obligations to its debt holders, they can force the entity into bankruptcy. Equity capital, on the other hand, is a residual claim on the entity's assets. If a company becomes insolvent, equity holders get what remains after debt-holders have been satisfied. So, the larger the size of an entity's debt obligations relative to equity, i.e., the larger its total debt to equity ratio, the greater is the implied strain on the entity to make regular payments to debt holders, and the higher is the risk of bankruptcy. Total Debt to Equity Ratio = Total Debt Total Equity
Busn 2015 Company AccountingThe dual-aspect concept tells us that
Historical Cost
The historical cost concept, also known as the cost concept, provides guidance as to the amount at which a transaction should be reported initially in the entity's accounts. It requires that transactions be recorded in terms of their actual price or cost at the time the transaction occurred. Global Grocer is planning to buy a warehouse property. The historical cost concept directs you to record the warehouse property at its acquisition cost of $70,000. Others may think the warehouse property is worth more or less than the amount Global Grocer paid, but their views are irrelevant. The accounting records will record the warehouse transaction initially at the amount actually paid for it. Relevance/Reliability
The historical cost concept provides a degree of reliability in the entity's accounts. It allows the accountant to ignore opinion and hearsay about the monetary value of items, and to report amounts based on actual transactions. But, the use of the historical cost concept also means that some amounts on an entity's balance sheet are based on historical values, determined at the time of purchase, which could predate the current balance sheet date by years. Consequently, it is unlikely that the asset amounts on the balance sheet reflect the value that the assets would fetch if they were sold today. In this sense, the financial statements may be 'less relevant' for the purposes of users of the entity's balance sheets, than if current market prices were reported. As noted earlier, when relevance and reliability have to be traded off, financial reporting practice tends to favor reliability. Hence reliance on the historical cost concept may sometimes yield more reliable but less relevant financial information. However, accountants are not blind to the relevance issue. As you will learn in more advanced accounting classes, many monetary assets are recorded initially at their cost, and subsequently measured and reported in the balance sheet at their market value. Monetary assets are items such as marketable securities. Their market value can generally be estimated reasonably reliably. In addition, you will learn how accountants enhance relevance by recording some transactions to reflect their substance rather than their form. While IFRS favors the historical cost model, it does present as an acceptable alternative treatment the revaluation of land and buildings to their market value, if their value can be measured reliably subsequent to their initial recognition at cost. Exercise 3.8
Sun Electronics purchases a stamping machine for $10,000. Almost immediately, a trade embargo restricts the number of stamping machines that can be imported into the U.S. Based on want ads in the commercial section of the newspaper, stamping machines like Sun's are now selling for $15,000. Sun Electronics should immediately Exercise 3.9
To users of an entity's financial statements, which of the following is a potential limitation of the historical cost concept: Review
The exercises in this section cover all the material you have learned about the balance sheet up to this point. Take a few moments to test your understanding of this material. Exercise 3.10
Choose the pair of words that best completes the fundamental accounting equation: _________________ = Liabilities + ________________
Exercise 3.11
Which one of the following is not a requirement for an item to be an asset: Exercise 3.12
Global Grocer has purchased a warehouse building with an expected useful life of 10 years for $40,000. Which of the following is the best description of this new asset? Exercise 3.13
A liability on the balance sheet represents _________________ of the entity. Exercise 3.14
On January 1, 2004, Scott Manufacturing has assets of $1,600,000 and liabilities of $900,000. Its owners' equity is Let's Get Global Grocer Started
You have spent much of August raising financing and making the necessary investments and pre-operating decisions to get Global Grocer ready to open its doors on September 1. Although the transactions took place during August, for simplicity, you will record them all together on August 31st before the store opens. Of course, you start with an empty balance sheet. Common Stock Short-Term Debt Franchise Fee Prepaid Rent Warehouse Property Mortgage Store Fixtures Merchandise Inventory Hiring
Exercise 3.15
Suppose Barnum and Sons obtains a 5-year, $100,000 bank loan, payable at maturity. Which one of the following describes the effect of this transaction on its balance sheet? Transaction Exercises
The exercises in this section describe various transactions and ask you how they affect the balance sheet. Take a few moments to test your understanding of this material. Exercise 3.16 Exercise 3.17
On June 2, 2004, Mansfield purchases a computer system for $22,000 from Infostore Systems. Mansfield pays $10,000 in cash and promises to pay Infostore the rest in equal installments over the rest of the year. The computer system is expected to last 4 years. Which of the following would you do in this situation? Exercise 3.18
Exercise 3.19 Ratios
Users of financial statements use a technique known as financial ratio analysis to assess the financial position and performance of an entity. Financial ratios are ratios based on the amounts in the financial statements. Two simple balance-sheet-based ratios are introduced in this section. They are the current ratio and the long-term-debt-to-equity ratio. Current Ratio
An entity's ability to meet its current obligations - those due within the coming year - is an important measure of its financial health. These short-term obligations are usually repaid in the normal course of business, as the entity's current assets are converted to cash. For example, cash is generated when merchandise inventory is sold for cash, or when accounts receivables are collected in cash from customers. This cash can then be used to pay accounts payable. The current ratio, or, ratio of current assets to current liabilities is a measure of an entity's ability to meet its maturing short-term obligations. In the current ratio, the numerator, current assets, represents the resources of the entity that are either cash or expected to soon be converted into cash. Cash and these asset conversions to cash can be used to satisfy the immediate claims of short-term creditors. The denominator, current liabilities, represents the current claims of creditors that must be extinguished in the near-term. Current Ratio = Current Assets Current Liabilities
Interpretation
While there is no single ideal current ratio, financial statement users often employ the rule-of-thumb that a healthy business will have a minimum current ratio of 2. Because the appropriate current ratio varies by industries, financial statement users tend to focus on an entity's current ratio relative to those of other, similar businesses. In the U.S., the pharmaceutical industry has had an average current ratio of 1.8 over the past decade; the software industry, on the other hand, has had a 2.9 average current ratio over the same time period. Software companies, with their limited need for fixed assets, traditionally hold a much larger proportion of their assets in cash and monetary current assets, and this is reflected in their significantly higher current ratios. If financial statement users notice that an entity has a current ratio that significantly higher than that of its peers, they may be concerned that the entity holds more cash or inventory than a business needs. This may signal that it is locking up potentially productive capital. If, on the other hand, an entity has current ratio that is significantly lower than that of its peers, financial statement users may question its ability to satisfy its current obligations in a timely manner. Exercise 3.20
Farrah Company's December 31, 2004 balance sheet shows current assets of $250,000 and current liabilities of $100,000. Its current ratio is Total Debt to Equity Ratio
The composition of a company's long-term capital structure - primarily its total interest-bearing debt and owners' equity - is of interest to financial statement users seeking to assess the long-term financial viability of an entity. Of particular interest is the ratio of total debt (capital that accrues interest and has to be repaid to lenders) to equity capital (capital that does not demand interest and does not have to be repaid). The total debt to equity ratio is useful for judging an entity's long-term financial viability. As the name suggests, it is the ratio of all interest bearing debt on the balance sheet, to total equity. This ratio measures financial leverage or the degree of the entity's indebtedness relative to its equity funding. Debt and equity are very different kinds of capital. When an entity assumes debt, i.e., accepts a loan, it has to pay interest and also repay the loan to the debt holder over an agreed-upon period of time. If the entity runs into hard times and fails to pay its maturing financial obligations to its debt holders, they can force the entity into bankruptcy. Equity capital, on the other hand, is a residual claim on the entity's assets. If a company becomes insolvent, equity holders get what remains after debt-holders have been satisfied. So, the larger the size of an entity's debt obligations relative to equity, i.e., the larger its total debt to equity ratio, the greater is the implied strain on the entity to make regular payments to debt holders, and the higher is the risk of bankruptcy. Total Debt to Equity Ratio = Total Debt Total Equity
Interpretation
There is no single ideal total debt to equity ratio. Over the past couple of decades, in the U.S., the average total debt to equity ratio for public companies has ranged from 0.5 to 1.0. However, it can vary considerably from one industry to another. Businesses in stable industries with tangible assets that make good collateral tend to borrow heavily to finance those investments, so they tend to have high total debt to equity ratios. In contrast, volatile businesses with few tangible assets tend to have low total debt to equity ratios. In the U.S., the software industry, which traditionally holds very little debt, has had a 0.10 average total debt to equity ratio over the past decade. On the other hand, financial firms, which traditionally are very highly leveraged, have had a total debt to equity ratio of 3.3 over the same time period. If a company has a total debt to equity ratio that is significantly higher than that of its peers, financial statement users may be concerned about its ability to make the required payments to its debt holders and the company's long-term solvency may be questioned. If, on the other hand, a company has a total debt to equity ratio that is significantly lower than that of its peers, financial statement users may question whether the company is being aggressive enough in pursuing profitable growth opportunities by raising debt when necessary to finance those opportunities. As with other financial ratios, there is no single perfect total debt to equity ratio for any business. What is important is a company's total debt to equity ratio relative to those of other, similar businesses, and also how the ratio changes over time. Exercise 3.21
Which one of the following choices best completes this sentence: The total debt to equity ratio is useful for judging ___________________.
Ratio Exercises
The exercises in this section test your understanding of the two simple balance sheet-based ratios: current ratio and total debt to equity ratio. Please take a moment to complete these exercises. Exercise 3.22
Exercise 3.23 Recap
In this chapter you learned:
How a balance sheet is organized.
Assets, liabilities and owners' equity were defined.
The key relationship linking assets, liabilities and owners' equity - the fundamental accounting equation - was explained. The dual aspect and historical cost concepts were introduced and used to record all of Global Grocer's business transactions in August. How to compute and use two simple but important balance sheet ratios - the current ratio and the total debt to equity ratio. The Income Statement
In this chapter, you will learn more about the income statement and how it is organized. You will also be introduced to three new accounting concepts--the realization, matching and conservatism concepts--as well as how to apply them to record the results of Global Grocer's business operations during the month of September. Finally, you will learn about two ratios that are important measures of operating performance: the gross margin and return on sales percentages. Layout
In this section, you will learn how the income statement is organized. An income statement is a financial description of an entity's operating performance during an accounting period. It reports the entity's sales, expenses and net income or loss for the period. The income statement's basic equation is Sales minus Expenses equals Net Income. Here is a sample income statement for Global Grocer for its first accounting period, the month of September. (1) The income statement heading lists the name of the entity, Global Grocer. (2)The next line indicates the accounting period covered by the income statement; in this case, the month of September 2004. (3) Sales are increases in assets or decreases in liabilities during a period resulting from delivering goods, rendering services or other activities constituting the entity's central operations. (4) From sales, we subtract the expenses associated with generating the sales of the period. Expenses are decreases in assets or increases in liabilities during a period resulting from a delivery of goods, rendering of services, or other activities constituting the entity's central operations. Gross Margin
The first segment of the income statement shows the company's sales, the cost of those sales and the difference, which is known as gross margin. We calculated gross margin by subtracting from sales the cost of goods sold ("COGS"). Next we subtract the entity's other expenses of running the business to determine net income. The first segment of the income statement shows the company's sales, the cost of those sales and the difference, which is known as gross margin. We calculated gross margin by subtracting from sales the cost of goods sold ("COGS"). Next we subtract the entity's other expenses of running the business to determine net income. (1) From Sales, we subtract the cost of the goods sold during the accounting period. (2) The excess of the sales amount over the cost of goods sold amount—or, sales minus cost of goods sold—is referred to as the gross margin or gross profit. It is called gross profit because operating expenses have not yet been accounted for. Other Line Items
You will notice on Global Grocer's income statement that the expenses of running the business listed below the gross margin are displayed in three categories: operating expenses, interest expense and income tax expense. (1) For Global Grocer, expenses listed below the gross margin are operating expenses, interest expense and income tax expense. (2) Operating expenses, as their name implies, relate to the operations of the business. These include the marketing, selling and administrative expenses incurred in running a business. They are often reported as a single account, selling, general and administrative (SG&A) expenses. (3) Gross margin minus operating expenses yields operating income (also known as operating profit). It is a measure of the profit generated from the day-to-day running of the business. (4) Interest expense is the cost of debt financing for the accounting period. If Global Grocer had invested any excess cash during this accounting period, interest income, in any, would be reported in this section of the income statement. Operating profit minus interest expense yields income before income taxes. (5) Income before income taxes minus the tax expense yields net income. Since taxes will not be due until next year, the tax expense is an estimate of the taxes that might have to be paid on the profit when Global Grocer's 2004 tax return is filed. (6) The net income for a period, i.e., the earnings of the entity, net of all expenses, is often called profit or net profit when it is positive (i.e., sales have been greater than total expenses), or loss or net loss when it is negative (i.e., sales have been less than total expenses). Link to Balance Sheet
The balance sheets at the beginning and end of an accounting period are linked, by the income statement for the period, through the retained earnings account in the owners' equity section of the balance sheets. Retained Earnings
The retained earnings account is the sum of the company's net income to date, less dividends, if any, paid to the owners. The net income for the period is added to the retained earnings amount reported on the period's beginning balance sheet to determine the period's ending retained earnings, before any dividend payments. Dividends
Dividends are distributions of earnings to owners, usually in the form of cash. The payment of a dividend reduces the Retained Earnings account. Summary
In summary, two events change the retained earnings account during an accounting period. First, the Net Income (loss) earned by the entity during the period increases (decreases) the retained earnings account. Second, any dividends paid (distributions made to investors) during the period reduce the retained earnings account. The payment of dividends is not an expense; it is a distribution of equity capital to investors. Hence, the payment of dividends is not recorded on the income statement; instead, it directly reduces the retained earnings account. Exercise 4.1
During the month of April 2005, Mansfield Company records sales of $5,000, and total expenses of $3,000. What is Mansfield's net income for April 2005? Exercise 4.2
Suppose Mansfield has a retained earnings balance of $20,000 on April 1, 2005. During the month of April, it earns a net income of $2,000 and also pays a dividend of $500 to its investors. What is its retained earnings balance at the end of April 2005? Concepts
In this section, we will introduce three more accounting concepts: the
realization, matching and conservatism concepts. They are particularly relevant
to the income statement. These three concepts provide guidance as to the timing
of the recognition and amounts of sales and expenses to be recorded by the
entity. Like the other financial reporting concepts, when properly applied,
they reflect a balance between relevance and reliability in the reported
amounts. Realization Concept
Realization is the process of converting assets, such as merchandise for sale, into cash, cash equivalents, or good accounts receivable. Realization plays an important role in determining when revenue is recognized. Two conditions must be satisfied. First, the revenue must be earned, which typically means that the customer has received the good or service. Second, the revenue must have been realized or realizable, implying that the customer has paid or is expected to pay for the merchandise. Realization is the process of converting assets, such as merchandise for sale, into cash, cash equivalents, or good accounts receivable. Realization plays an important role in determining when revenue is recognized. Two conditions must be satisfied. First, the revenue must be earned, which typically means that the customer has received the good or service. Second, the revenue must have been realized or realizable, implying that the customer has paid or is expected to pay for the merchandise. IFRS
The IFRS and GAAP revenue recognition rules differ in their wording and underlying theory. IFRS recognizes revenue when the "risks and rewards of ownership are transferred." In contrast, GAAP, among other requirements, recognizes revenue when it is "earned." Despite these differences, in most cases the accounting for revenue transactions will be the same under either concept. IFRS recognizes revenue when all the following conditions have been satisfied: The seller has transferred to the buyer the significant risks and rewards of ownership of the goods; The seller retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the good sold; The amount of revenue can be measured reliably;
It is probable that the economic benefits associated with the transaction will flow to the seller; and The costs incurred or to be incurred in respect of the transaction can be measured reliably. Exercise 4.3
Following GAAP, consider each situation described below and indicate whether revenue has been earned and whether it is realized or realizable by choosing the appropriate entries in each cell. Matching Concept
The GAAP and IFRS revenue recognition criteria tells us when to recognize revenue. The Matching concept indicates what expenses should be recognized when revenue is recorded. The timing of expense recognition is important since revenue less expenses equals net income. The Matching Concept stipulates that expenses should be recognized in the same period as the relevant revenues are recognized. Costs related to this period's activities but which are not directly related to products and services sold, are expensed this period. The Realization concept tells us when to recognize revenue. The Matching concept indicates what expenses should be recognized when revenue is recorded. The timing of expense recognition is important since revenue less expenses equals net income. The Matching Concept stipulates that expenses should be recognized in the same period as the relevant revenues are recognized. Costs related to this period's activities but which are not directly related to products and services sold, are expensed this period. The Realization concept tells us when to recognize revenue. The Matching concept indicates what expenses should be recognized when revenue is recorded. The timing of expense recognition is important since revenue less expenses equals net income. The Matching Concept stipulates that expenses should be recognized in the same period as the relevant revenues are recognized. Costs related to this period's activities but which are not directly related to products and services sold, are expensed this period. The Realization concept tells us when to recognize revenue. The Matching concept indicates what expenses should be recognized when revenue is recorded. The timing of expense recognition is important since revenue less expenses equals net income. The Matching Concept states that expenses should be recognized in the same period as the relevant revenues are recognized. Costs related to this period's activities but which are not directly related to products and services sold, are expensed this period. Conservatism Concept
The Realization Concept and its associated "earned" requirements provide guidance as to when to recognize revenues and the Matching Concept provides guidance as to when to recognize expenses. The Conservatism Concept goes one step further by recommending that prudence be exercised in recording revenues and expenses. It says that revenues should be recognized only when reasonably certain, but expenses should be recognized as soon as reasonably possible. Conservatism in financial accounting means that an entity should recognize only those revenues for which there is a high degree of confidence that they will be earned and realized. Expenses, on the other hand, should be recorded as soon as they seem likely to be incurred. If the entity is uncertain whether to recognize an expense or about the amount of an expense, the conservatism concept encourages it to pro- actively estimate the cost and record the expense. The conservatism concept also applies to the balance sheet. It suggests prudence in the recording of assets (record when reasonably certain) and in the recording of liabilities (record as soon as reasonably possible). Further, if two different estimates of a balance sheet amount were equally acceptable, the conservatism concept would guide accountant to record the smaller amount when measuring assets and the larger amount for liabilities. Care must be taken when applying the conservatism concept. Otherwise, it can lead to bias in financial statements by understating profits in one period only to be followed by overstatement in a subsequent period. Let's Get Going
It is September 1 and this is Global Grocer's balance sheet. During August, you raised capital for Global Grocer, paid a franchise fee, bought store fixtures, purchased a warehouse property, rented a store and stocked up merchandise inventory. You also hired two experienced employees who will start work today. (1) The current asset, accounts receivable, and the owners' equity account retained earnings, which have zero balances at present, will be affected by the operations that commence today. The First Few Sales
The store opens on Wednesday, September 1, and as expected, the first few days of store operations are slow. Several people stop by to browse, pick up brochures and taste the free samples. The store makes three sales by the end of its first day of operations. The dollar amount of each sale, the cash received, credit provided to customers and recorded as accounts receivable and the cost to Global Grocer of the goods sold (COGS) are shown in this table. In each of these sales, goods have been delivered to the customer and cash has either been collected or is expected be collected by Global Grocer. The revenues have been earned and are realized or realizable.
Realization is the process of converting assets, such as merchandise for sale, into cash, cash equivalents, or good accounts receivable. Realization plays an important role in determining when revenue is recognized. Two conditions must be satisfied. First, the revenue must be earned, which typically means that the customer has received the good or service. Second, the revenue must have been realized or realizable, implying that the customer has paid or is expected to pay for the merchandise. Realization is the process of converting assets, such as merchandise for sale, into cash, cash equivalents, or good accounts receivable. Realization plays an important role in determining when revenue is recognized. Two conditions must be satisfied. First, the revenue must be earned, which typically means that the customer has received the good or service. Second, the revenue must have been realized or realizable, implying that the customer has paid or is expected to pay for the merchandise. IFRS
The IFRS and GAAP revenue recognition rules differ in their wording and underlying theory. IFRS recognizes revenue when the "risks and rewards of ownership are transferred." In contrast, GAAP, among other requirements, recognizes revenue when it is "earned." Despite these differences, in most cases the accounting for revenue transactions will be the same under either concept. IFRS recognizes revenue when all the following conditions have been satisfied: The seller has transferred to the buyer the significant risks and rewards of ownership of the goods; The seller retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the good sold; The amount of revenue can be measured reliably;
It is probable that the economic benefits associated with the transaction will flow to the seller; and The costs incurred or to be incurred in respect of the transaction can be measured reliably. Exercise 4.3
Following GAAP, consider each situation described below and indicate whether revenue has been earned and whether it is realized or realizable by choosing the appropriate entries in each cell. Matching Concept
The GAAP and IFRS revenue recognition criteria tells us when to recognize revenue. The Matching concept indicates what expenses should be recognized when revenue is recorded. The timing of expense recognition is important since revenue less expenses equals net income. The Matching Concept stipulates that expenses should be recognized in the same period as the relevant revenues are recognized. Costs related to this period's activities but which are not directly related to products and services sold, are expensed this period. The Realization concept tells us when to recognize revenue. The Matching concept indicates what expenses should be recognized when revenue is recorded. The timing of expense recognition is important since revenue less expenses equals net income. The Matching Concept stipulates that expenses should be recognized in the same period as the relevant revenues are recognized. Costs related to this period's activities but which are not directly related to products and services sold, are expensed this period. The Realization concept tells us when to recognize revenue. The Matching concept indicates what expenses should be recognized when revenue is recorded. The timing of expense recognition is important since revenue less expenses equals net income. The Matching Concept stipulates that expenses should be recognized in the same period as the relevant revenues are recognized. Costs related to this period's activities but which are not directly related to products and services sold, are expensed this period. The Realization concept tells us when to recognize revenue. The Matching concept indicates what expenses should be recognized when revenue is recorded. The timing of expense recognition is important since revenue less expenses equals net income. The Matching Concept states that expenses should be recognized in the same period as the relevant revenues are recognized. Costs related to this period's activities but which are not directly related to products and services sold, are expensed this period. Conservatism Concept
The Realization Concept and its associated "earned" requirements provide guidance as to when to recognize revenues and the Matching Concept provides guidance as to when to recognize expenses. The Conservatism Concept goes one step further by recommending that prudence be exercised in recording revenues and expenses. It says that revenues should be recognized only when reasonably certain, but expenses should be recognized as soon as reasonably possible. Conservatism in financial accounting means that an entity should recognize only those revenues for which there is a high degree of confidence that they will be earned and realized. Expenses, on the other hand, should be recorded as soon as they seem likely to be incurred. If the entity is uncertain whether to recognize an expense or about the amount of an expense, the conservatism concept encourages it to pro- actively estimate the cost and record the expense. The conservatism concept also applies to the balance sheet. It suggests prudence in the recording of assets (record when reasonably certain) and in the recording of liabilities (record as soon as reasonably possible). Further, if two different estimates of a balance sheet amount were equally acceptable, the conservatism concept would guide accountant to record the smaller amount when measuring assets and the larger amount for liabilities. Care must be taken when applying the conservatism concept. Otherwise, it can lead to bias in financial statements by understating profits in one period only to be followed by overstatement in a subsequent period. Let's Get Going
It is September 1 and this is Global Grocer's balance sheet. During August, you raised capital for Global Grocer, paid a franchise fee, bought store fixtures, purchased a warehouse property, rented a store and stocked up merchandise inventory. You also hired two experienced employees who will start work today. (1) The current asset, accounts receivable, and the owners' equity account retained earnings, which have zero balances at present, will be affected by the operations that commence today. The First Few Sales
The store opens on Wednesday, September 1, and as expected, the first few days of store operations are slow. Several people stop by to browse, pick up brochures and taste the free samples. The store makes three sales by the end of its first day of operations. The dollar amount of each sale, the cash received, credit provided to customers and recorded as accounts receivable and the cost to Global Grocer of the goods sold (COGS) are shown in this table. In each of these sales, goods have been delivered to the customer and cash has either been collected or is expected be collected by Global Grocer. The revenues have been earned and are realized or realizable.
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ACC 103 Economics for Management
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