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Key Things to Know Self Test
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Accounting Concepts, Assumptions, Principles, Elements

Key Things to Know

Objectives of Financial Reporting:

            1. Provide useful information to investors and creditors for decision making

           (assume users have a “reasonable understanding” of business).

            2.  Provide information to access the amounts, timing, and uncertainty of cash
                        inflows and outflows.

            3.  Provide information about resources (assets) and claims to resources


Recognition:  An item should be recognized in the financial statements when
                          it meets all 4 of the following criteria:

                                    1.  Definition:  meets the definition of an element
                                    2.  Measurability:  measurable with sufficient reliability
                                    3.  Relevance: makes a difference in the decision
                                    4.  Reliability – representationally faithful, verifiable, neutral


Accounting Underlying Assumptions - Basis for Generally Accepted Accounting   
  Principles (GAAP)


            Entity Assumption - each business is its own “accounting” entity.


            Periodicity Assumption - divide economic activities into time periods
                        for reporting.


            Going Concern Assumption - the company will remain in business and will                         carry out existing commitments.  Assets will be used to bring future benefit                         and liabilities will be paid.

            Monetary Assumption -  assume the dollar is stable over time.
                        No adjustments are made for inflation or deflation.          


Accounting Principles:


            Historical Cost  -  Assets and Liabilities are recorded at cost.
                  Cost is the best estimate of fair value at the time the transaction occurs.
                  Historical cost is very reliable and not often relevant in the future.



            Realization / Revenue Recognition:  2 criteria must be met to record                         revenues:

                         1.  The earnings process is judged to be complete or virtually complete

                               (“earned” - you do not owe the customer anything else)

                         2.  There is reasonable certainty as to the collectibility of the asset to be
                               received, usually cash (you believe you will be paid)


            Full Disclosure - all relevant accounting information must be disclosed to users
                        1) the “notes to the financial statements” are required
                        2) the “notes to the financial statements” discuss details that are not
                             shown on the financial statements

                        Accomplished by using:
                                    1.  parenthetical comments on the face of financial statements
                                    2.  disclosure notes (footnotes)
                                    3.  supplemental financial statements reporting more detailed info


            Matching - expenses incurred should be matched (reported) with revenues
                        earned in the same period.

                        Revenue is recognized according to the “Realization Principle”

                        Expenses can be recognized based on:

                          1.  Exact cause and effect relationship between revenue and expense
                          2.  Associating an expense with revenue in a specific time period
                          3.  Systematic and rational allocation to specific time periods
                          4.  In the period incurred, without regard to related revenues


Accounting Constraints:


            Conservatism  -  when estimating, present the lowest asset value, the highest
                        liability amount, and the lowest net income position

                           Do not mislead with a low or a high estimate
                            A practical justification for an accounting choice
                                    1) recognize losses as soon as you know about them
                                    2) recognize gains when you collect the cash

            Materiality - the amount is big enough to make a difference in the decision of
                                      a reasonable person using the financial statements.

            Cost/Benefit (Cost Effectiveness) - the benefit must exceed the cost when
                                  gathering and presenting financial information.



Primary Qualitative Characteristics of Financial Information:


            Relevance  - capable of making a difference in a decision
                        1) helps the user predict the future (predictive)
                        2) helps the user evaluate past decisions (feedback)
                        3) current and available when making a decision (timeliness)


            Reliability – a user can rely on it and have confidence in the information
                        1) represents the economic position as it really is
                               (representational faithfulness)
                        2) several individuals would reach the same conclusion (verifiable)
                        3) doesn’t sway the users opinion, objective (neutrality)


Secondary Qualitative Characteristics of Financial Information:


            Consistency - use the same accounting policies and procedures from
                                         one period to the next  

                        Permits valid comparisons between different periods of time


            Comparability -  allows users to identify similarities and differences
                        1) one year to the next                      2) one company to another



Elements of Financial Statements:

                        SFAC 6 defines 10 elements of the financial statements


Asset:     The company’s economic resources used to operate the business        
                            (What the company HAS)

                      1)  Probable future economic benefit
                      2) Owned or controlled by the company
                      3) Resulting from a past transaction, something that has already occurred

                        The economic benefit is using the asset to generate future cash flows
                        or the asset itself will convert to cash


Liability:  The company’s debts and obligations        (What the company OWES)

                      1) Probable sacrifice of a future economic benefit (an asset)
                      2) Present obligation to transfer assets or provide services
                      3) Resulting from a past transaction

                        You will give up an asset to pay what you owe


Equity:  Residual interest in the assets after deducting liabilities
                        From two sources:  Paid in Capital and Retained Earnings


Investments by Owners:  Transfer of resources to the company in exchange
                                                for ownership


Distributions to Owners:  Decreases in equity from transfers to owners (dividends)


Revenues:  Inflows from providing goods or services in exchange for an asset.
                      This is the amount the customer is expected to pay for the goods
                         or services they received

                        A revenue occurs when the good/service is provided to the customer
                        regardless of whether the customer has paid or not


Expenses:   Outflows or using an asset of the company to provide goods or services
                          Incurred in the process of generating revenues

                         What it costs the company to provide the goods or services
                         to the customer.

                        A service or good is provided to the company that the company
                        will have to pay for.  The expense occurs when the company
                         receives the service or the asset is used up, not when the
                         company pays for the goods or service


Gains:  Increases in equity from peripheral (incidental) transactions – not part of
                day to day primary business activities  (sell an asset for more than cost)


Losses:  Decreases in equity from peripheral (incidental) transactions – not part of
                day to day primary business activities (sell an asset for less than cost)


Comprehensive Income:  Change in equity from transactions and non owner sources

                        Includes all changes in equity except investments from and distributions
                           to owners


                        Net Income often does not equal comprehensive income due to items
                           that are reported directly to owner’s equity as comprehensive income
                           that are not reported on the income statement          

                             Net income = Revenues + Gains – Expenses - Losses




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