Intermediate Accounting October 5th, 2010 1. DO NOT Turn in Discussion Questions (Kapnick & Wyatt) 2. General Course Questions 3. Review Take-Home Quiz Chapter 3: Accounting Mechanics 3. Introduce Chapter 2: The Accounting Conceptual Framework 4. Discuss Kapnick and Wyatt articles and discussion questions 5. Assignments for Thursday, October 7th: A. Quiz 1: Chapters 1-3 and readings B. Readings: Ethical Framework for Decision Making B. Discussion Questions Ethics Case 1 Chapter 2 Learning Objectives 1. Understand the “Objectives of Financial Reporting” and the usefulness of a conceptual framework. 2. Identify the qualitative characteristics of accounting information. 3. Define the basic elements of financial statements. 4. Use GAAP assumptions, principles and constraints to determine proper financial reporting (proper recognition, measurement and classification in the financial statements). 2 Objectives of Financial Accounting To provide information that is: 1) Useful in investment and credit decisions (useful to present and potential investors and creditors and other users in making rational investment, credit, and similar decisions) 1) Useful in assessing cash flow prospects (helps present & potential investors & creditors & other users in assessing the amounts, timing, and uncertainty of prospective cash receipts) 2) About company resources, claims to those resources and changes in them (portrays the economic resources of an enterprise, the claims to those resources, and the effects of transactions, events, and circumstances 3 that change its resources and claims to those resources) The Need for a Conceptual Framework To develop a coherent set of standards and rules Help stockholders and creditors: 1) make wise investment choices with their limited resources by requiring companies to report comparable information using the same rules (GAAP) 2) increase the users’ understanding and confidence in financial reports. To solve new and emerging practical problems Help the FASB: 1) issue more useful and consistent standards 2) solve new issues quicker by referring to an existing framework of basic theory See Chapter 2 question 1 4 ASSUMPTIONS PRINCIPLES CONSTRAINTS 1. Economic entity 1. Measurement 1. Cost-benefit 2. Going concern 2. Revenue recognition 2. Materiality Third 3. Monetary unit 3. Expense recognition 3. Industry practice level 4. Periodicity 4. Full disclosure 4. Conservatism HOW? QUALITATIVE CHARACTERISTICS ELEMENTS Relevance Assets, Liabilities, and Equity Investments by owners Reliability Distribution to owners Second level Comparability Comprehensive income Revenues and Expenses Bridges Consistency Gains and Losses Level 1 & 3 Conceptual Framework OBJECTIVES 1. Useful in investment for Financial and credit decisions 2. Useful in assessing Reporting in future cash flows First level: the U.S. 3. About enterprise Why? resources, claims to resources, and changes in them 5 Qualitative Characteristics Qualitative Characteristics 1. Primary qualities (Decision Usefullness) A. Relevance (1) Predictive value (2) Feedback value (3) Timeliness B. Reliability (1) Representational faithfulness (2) Verifiability (3) Neutrality 2. Secondary qualities A. Comparability B. Consistency 6 Relevance Information is relevant if it pertains to the particular decision that is at hand. Relevant information must possess at least two characteristics: #1 - Timeliness - information must be available in time to influence the decision. #2 - Either (or both) of the following: Predictive Value - the information contains features that allow the decision maker to make predictions about the amount and timing of cash flows. Feedback Value - the information contains features that allow the decision maker to assess the progress or outcome of the decisions already made. 7 Reliability Information is reliable if it is reasonably accurate. To be reliable, accounting information must have three qualities: #1 - Verifiability - information is verifiable if different informed individuals, working independently, would arrive at approximately the same conclusions. #2 - Representational Faithfulness - the accounting information must be based on what really happened. #3 - Neutrality - accounting information must be free from bias. It should not be slanted one way or another in an attempt to influence the decision maker. Accounting information need not be perfectly accurate to be reliable. Accuracy is often difficult to determine or dependent on the instrument used for measurement purposes . 8 Comparability & Consistency • Comparability of accounting information means that the financial reports of one entity can be reasonably compared = to the financial reports of another entity. • Consistency of accounting information means that the Comparing last year’s results financial reports of one with this year’s results would be futile if different methods were entity can be reasonably used in the two years. compared to the financial reports of the previous and Chapter 2 question #6, BE #1 successive periods. 9 U.S. Conceptual Framework Level 2: Hierarchy of Qualitative Characteristics 10 Define the Basic Elements of Financial Statements Concepts Statement No. 6 defines ten interrelated elements that relate to measuring the performance and financial status of a business enterprise. “Moment in Time” “Period of Time” Assets Investment by owners Distribution to owners Liabilities Comprehensive income Equity Revenue Expenses Gains Losses Chapter 3 question 23 11 Element Definitions (E2-3) (a) Arises from peripheral or incidental (h) Arises from income statement transactions. activities that constitute the (b) Obligation to transfer resources entity’s ongoing major or arising from a past transaction. central operations. (c) Increases ownership interest. (i) Residual interest in the net (d) Declares and pays cash dividends assets of the enterprise. to owners. (j) Increases assets through sale (e) Increases in net assets in a period of product. from non-owner sources. (k) Decreases assets by purchasing (f) Items characterized by future the company’s own stock. economic benefit. (l) Changes in equity during the (g) Equals increase in net assets period, except those from during the year, after adding investments by owners and distributions to owners and distributions to owners. subtracting investments by owners. 12 Basic Elements Exercise 2-3: Identify the element or elements associated with items below. Elements (a) Arises from peripheral or Assets incidental transactions. (b) Liabilities (b) Obligation to transfer resources Equity arising from a past transaction. (c) Investment by owners (c) Increases ownership interest. (d) Distribution to owners (d) Declares and pays cash dividends to owners. (e) (c) Comprehensive income (e) Increases in net assets in a period Revenue from non-owner sources. Expenses (a) Gains (a) Losses 13 Basic Elements Exercise 2-3: Identify the element or elements associated with items below. Elements (f) Assets (f) Items characterized by future economic benefit. (b) Liabilities (g) Equals increase in net assets Equity during the year, after adding (c) Investment by owners distributions to owners and (d) Distribution to owners subtracting investments by owners. (g) (e) (c) Comprehensive income (h) Arises from income statement (h) Revenue activities that constitute the (h) Expenses entity’s ongoing major or (a) Gains central operations. (a) Losses 14 Basic Elements Exercise 2-3: Identify the element or elements associated with items below. Elements (i) Residual interest in the net (f) Assets assets of the enterprise. (b) Liabilities (j) Increases assets through sale of (i) Equity product. (c) Investment by owners (k) Decreases assets by purchasing the company’s own stock. (k) (d) Distribution to owners (l) (l) Changes in equity during the (g) (e) (c) Comprehensive income period, except those from (j) (h) Revenue investments by owners and (h) Expenses distributions to owners. (a) Gains (a) Losses 15 Playing by the GAAP Rules Use GAAP assumptions, principles and constraints to determine proper financial reporting (proper recognition, measurement and classification in the financial stmts.) 1. Help stockholders and creditors make wise investment choices with their limited resources by requiring companies to report comparable information using the same rules (GAAP). 2. Apply "Conservatism" to avoid misleading investors 3. Understand when GAAP allows us to report Revenue 4. Determine when Expenses need to be reported 5. Use “Full Disclosure” to report everything that is important 6. Weigh the advantages and disadvantages of using “Historical Cost” on the Financial Statements 7. Determine when Expenses need to be reported 8. Review the 4 assumptions underlying Financial Reports 9. Use "Industry Practices" when there are no reporting guidelines 16 When do we get to record REVENUE? Remember where Revenue is? • The first number, and hopefully the largest number on the Income Statement. • The larger this number, the more work we have done for our customers, and the stronger our performance. (Revenue – Expenses = Net Income • The larger our Revenue the larger our potential Net Income. • Other names for Revenue are Sales or Service Fees. 17 Revenue should be recognized when A. Cash is collected B. in the period you want to report higher income C. When you have done the work D. When you know you will be paid E. Both c & d 18 GAAP’s Two Requirements for Reporting Revenue 1. The Work has been done – we have earned this much money from our customer. Revenue is typically recognized when goods are delivered or services rendered. 2. Payment has been made (the revenue is realized) or we have confidence our customer will pay (realizable). 19 Timing of Revenue Recognition Revenue Recognition - generally occurs (1) when realized or realizable and (2) when earned. Exceptions: 20 Chapter 2 question 20 Conservatism – Don’t Overstate or “Puff up” _____ & ______ on the Financial Statements Balance Sheet Income Statement Assets Revenue Liabilities Expenses Stockholders’ Equity Net Income Chapter 2 question 29 21 Conservatism - Don't Overstate or "Puff up" what on the Financial Statements? A. Assets and Expenses B. Assets and Income C. Liabilities and Revenue 22 Expense Recognition Matching: “Let the expense follow the revenues.” • It is easy to know when to record expenses if there is a direct cause and effect between expenses and revenues. - examples • If there is NO direct cause and effect between expenses and revenues: Try to allocate the expense rationally (to the time periods that are benefited) – examples: • If that is not possible or reasonable, then: Immediately recognize the expense if: a) there is no identifiable future benefit, or b) if the future benefit cannot be reasonably measured - example: 23 Relevance and Reliability – Tradeoff Example Example: How could a biotech firm’s $1,000,000 expenditure on research and development be recorded? DR R&D Expense? or DR R&D Asset? CR Cash For each alternative consider: What is the relevance/reliability tradeoff? How can the treatment be theoretically supported? How is your answer justified by the U.S. GAAP conceptual framework? 24 What value should be used to record assets? ASSETS Historical Cost (Price paid when acquired) Receivables Inventory Investments (in other company’s stock) Fair Market Value (Value today if sold ) Property Plant & equipment Goodwill Chapter 2 question 13 25 Exceptions to Historical Cost for: A. Conservatism B. Full Disclosure C. Cost/Benefit D. Materiality E. Going Concern 26 Full Disclosure Tell financial statement users everything they need to know to make good decisions. Disclosure Techniques: • Parenthetical Explanations • NOTES • Cross References • Contra Items • Supporting Schedules Chapter 2 question 25 27 Moving from Historical Cost to a Conservative Fair Market Value (FMV) ASSET Recorded Value Receivables ___________________ Inventory ___________________ Property ___________________ Plant & Equip. ___________________ Goodwill ___________________ Foreign Currency & Investments in Marketable securities ________________________ 28 Receivables should be reported at: A. Total amount your customers owe the company B. The Fair Market Value (what you could get if you sold them for someone else to collect) C. Net Realizable Value (amount you expect to be paid = total amount owed minus the uncollectable amounts) 29 Inventory should be reported at: A. Cost - amount paid to acquire or manufacture it B. Fair Market Value - amount it is worth today C. Lower of Cost or Market 30 Property (Land) should be reported at: A. Cost B. Fair Market Value C. Cost less Depreciation 31 Plant & Equipment should be reported at: A. Cost B. Fair Market Value C. Cost less Depreciation D. Lower of Cost or Market 32 Goodwill should be reported at: A. Cost B. Fair Market Value of future earnings due to location, brand, employees, etc. C. Cost less Amortization D. Lower of Cost or Market based upon future earnings potential 33 Foreign Currency and Trading Securities should be reported at: A. Cost B. Fair Market Value C. Lower of Cost or Market Chapter 3 question 15, BE #6 34 Moving from Historical Cost to a Conservative Fair Market Value (FMV) ASSET Recorded Value Receivables Net realizable value Inventory Lower of cost/market Property Historical Cost Plant & Equip. Cost less depreciation Goodwill Cost less impairments Foreign Currency & FMV (gain or loss recorded Investments in in Stockholders’ Equity as Marketable securities “Other Comprehensive Income”) 35 GAAP Assumptions Economic Entity – the company keeps its activity separate from its owners and other businesses. Going Concern – the company is expected to survive (last long enough to fulfill objectives and commitments). Monetary Unit - money is the common denominator. Periodicity - company can divide its economic activities into time periods. Cost-Benefit – weigh the costs of providing the in- formation against the benefit derived from using it 36 Chapter 2 BE #8 & 9 Four GAAP Assumptions 1. Economic Entity: Should Gert Boyle record the motorcycle she uses personally on Columbia Sportswear’s financial statements? 2. Going Concern: What value should be used for the store display equipment of Mom & Pop Grocery if they know they need to file bankruptcy? 3. Monetary Unit: How should the Euros that Columbia Sportswear anticipates receiving from a customer in Italy be reflected on their Portland Financial Statements? 4. Periodicity: How frequently do Columbia Sportswear’s stockholders’ and creditors need to receive financial statements? chapter 2 question 11 37 What do you do if there are no GAAP rules to guide you? When determining how to report financial information the guideline to use “Generally Accepted” principles may require or allow companies to rely upon widely recognized and prevalent “INDUSTRY PRACTICES” if: 1. There are NO authoritative guidelines published by standard setters or in the accounting literature. 2. The peculiar nature of a business or industry requires departure from basic theory. 38 HOUSE OF GAAP GAAP’s Objective is to provide Financial Information that is: 1. Useful in investment & credit decisions 2. Useful in assessing future cash flows 3. About the enterprise resources, claims to resources, and changes in them (chapter 2 ex 5, 7 & 8) add’l practice ex 4 Qualitative Characteristics Elements A. Relevance Assets 1) Predictive or Feedback Value Liabilities 2) Timeliness Stockholders’ Equity B. Reliability Other Comprehensive Income C. Comparability Revenues D. Consistency Expenses Assumptions Principles Constraints Economic Entity Historical Cost Cost/Benefit Going Concern Revenue Recognition Materiality Monetary Unit Matching Industry Practice Periodicity Full Disclosure Conservatism 39 Challenges Facing the Accounting Profession Nonfinancial Measurements Forward-looking Information Soft Assets Timeliness An Expectations gap 40 Trust • Trust drives the accounting profession – SOX, PCAOB, and class action lawsuits are a result of a breach of trust – From a broad perspective, we pay a heavy price for low trust: • Waits at airports, audit fees • Implications for personal conduct (Ethics, Character and Integrity) 41 Issues in Financial Reporting Ethics in the Environment of Financial Accounting In accounting, we frequently encounter ethical dilemmas. GAAP does not always provide an answer Doing the right thing is not always easy or obvious 42 AICPA Principles of Professional Conduct 1. Exercise sensitive professional and moral judgments in all activities 2. Accept the obligation to act in a way that will serve the public interest, honor the public trust and demonstrate commitment to professionalism 3. Perform all professional responsibilities with the highest sense of integrity to maintain and broaden public confidence. 4. Maintain objectivity, be free of conflicts of interest, be independent in fact and appearance. 5. Observe the profession’s technical and ethical standards, strive continually to improve confidence and quality of services and discharge professional responsibility to the best of one’s ability. 6. Observe the Principles of the Code of Professional Conduct, section 52-57, in determining the services provided to the public. 43 STANDARDS OF ETHICAL CONDUCT FOR MANAGEMENT ACCOUNTANTS (adapted from IMA) 1. COMPETENCE • Maintain professional competence. • Follow laws, regulations, and standards • Prepare complete and clear reports and recommendations after appropriate analysis. 2. CONFIDENTIALITY • Don't disclose confidential information. • Ensure that subordinates do not disclose confidential information. • Do not use confidential information for personal gain or advantage See next slide for items 3 & 4 44 STANDARDS OF ETHICAL CONDUCT FOR MANAGEMENT ACCOUNTANTS (adapted from IMA) continued 3. INTEGRITY • Avoid actual or apparent conflicts of interest. • Refuse gifts, favors, or hospitality that might influence objectivity. • Refrain from subverting the organization's legitimate objectives. • Recognize and communicate personal limitations. • Communicate unfavorable as well as favorable information and opinions. • Refrain from actions that discredit the profession. 4. OBJECTIVITY • Communicate information fairly and objectively. • Fully disclose all information that could be expected to 45 influence a user's understanding. Common Features of Criminal and Ethical Misconduct • Secret Problem • Opportunity • Rationalization Resolving Ethical Dilemmas 1. Identify the Ethical Issues involved 2. Identify the Stakeholders involved (persons or organizations affected by the outcome of the dilemma) 3. Identify the alternative courses of action that can be taken 4. Decide on the best course of action consistent with the principles of honesty, integrity, and fairness and also consistent with any existing code of ethical conduct.. 47 Resolving Ethical Dilemmas Follow the organization’s established policies for conflict resolution. If the ethical conflict is not resolved, consider the following course of action: 1. Discuss the problem with the immediate superior except whet it appears that the superior is involved, in which case the problems should be presented initially to the next higher managerial level. If satisfactory resolutions cannot be achieved when the problem is initially presented, submit the issues to the next higher managerial level. 2. If the immediate superior is the chief executive officer, or equivalent, the acceptable reviewing authority may be a group such as the audit committee, executive committee, board of directors, board of trustees, or owners. Contact with levels above the immediate superior should be initiated only with the superior’s knowledge, assuming the superior is not involved Continued on next slide….. 48 Resolving Ethical Dilemmas, continued 3. Clarify relevant concepts by confidential discussion with an objective advisor to obtain an understanding of possible courses of action. 4. If the ethical conflict still exists after exhausting all levels of internal review, the management accountant may have no other recourse on significant matters than to resign from the organization and to submit an informative memorandum to an appropriate representative of the organization. 5. Except where legally prescribed, communication of such problems to authorities or individuals not employed or engaged by the organization is not considered appropriate. *Institute of Management Accountants, Formerly National Association of Accountants, Statements on Management Accounting: Objectives of Management Accounting. Statement No. 1B, New York, NY., June 17, 1982. 49 Summary of Reversing Entries Reversing entries do not have to be used. Therefore, some accountants avoid them entirely. 1. All accruals can be reversed. 2. All deferrals for which a company debited or credited the original cash transaction to an expense or revenue account can be reversed. 3. Adjusting entries for depreciation and bad debts are not reversed. Illustration of Reversing Entries—Accruals After preparing the financial statements and closing the books, a company may reverse some of the adjusting entries before recording the regular transactions of the next period. 52 US GAAP vs. IFRS Objectives of Financial Reporting US GAAP IFRS Per SFAC 1-2, 4-7 Per IASB Framework (April 1989) • Provide information that is useful • The objective of f/s’s is to provide to those making investment & information about the financial credit decisions. position, performance and changes • Helpful to present and potential in financial position of an entity investors, creditor and other that is useful to a wide range of users in assessing the amounts, users in making economic timing and uncertainty of future decisions. cash flows; and • Users are present & potential • About economic resources, the investors, employees, lenders, claims to those resources and the suppliers & other trade creditors, changes in them. customers, gov’ts & their agencies 53 & the general public. US GAAP vs. IFRS Qualitative Characteristics US GAAP IFRS Primary characteristics Understandability • Relevance Relevance – Predictive value • Predictive value – Feedback value – Timeliness • Confirmatory value • Reliability • Materiality – Verifiability Reliability – Representational • Faithful representation faithfulness • Substance over form – Neutrality • Neutrality Secondary Characteristics • Prudence • Comparability • Completeness • Consistency 54 Comparability US GAAP vs. IFRS Qualitative Characteristics con’t US GAAP IFRS Constraints Constraints on relevant & • Cost/Benefit reliable info • Materiality • Timeliness • Industry Practices • Balance between benefit and cost • Conservatism • Balance between qualitative characteristics 55 US GAAP vs. IFRS Elements of Financial Statements US GAAP IFRS Assets Asset Liabilities Liabilities Equity Equity Investment by Owners Distributions to Owners Income Comprehensive Income Expenses Revenues Capital Maintenance Expenses • result from revaluation of assets Gains and liabilities Losses 56 US GAAP vs. IFRS Basic Assumptions, Principles US GAAP IFRS Assumptions Underlying Assumptions • Economic Entity • Accrual Basis • Going concern • Going concern • Monetary Unit • Periodicity Principles Principles • Measurement • Measurement – Historical cost – Historical Cost – Current cost – Fair value – Realizable value • Revenue Recognition – Fair value • Expense Recognition • Revenue Recognition • Full disclosure • Expense Recognition • Full disclosure 57 How to Cheat with Conservatism Scumbag Corp. pays a bonus to the CFO of $10,000 if the company earns net income over $1 million in any given year. – Draft f/s for 2004 show net income of $1.5 million dollars – However, the CFO argues that slowing sales indicate that inventory may be overvalued, and advocates the following journal entry: Dr. Cost of Goods Sold (overvalued goods) 400,000 Cr. Inventory 400,000 – What would this entry do? Cause COGS to be 400K lower in following year • Sometimes this practice is called the “cookie jar” – What if projected net income in 2005 was $800,000 (before 58 this journal entry was made)? Professional Ethics and Principles Based Accounting Readings: “Study Pursuant to Section 108(d) of the Sarbanes-Oxley Act of 2002 on…Principles-Based Accounting System” Kapnick (1974) and Wyatt (2004) Questions: What is meant by principles vs. rules based accounting? Why did Congress want this examined? What are the benefits and concerns with principles based accounting? Are judgment and professional ethics more or less 59 important under principles based accounting?