Chapter 6 Time Value of Money Co

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Chapter 6 Time Value of Money Co Powered By Docstoc
					         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

     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).

     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
    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?

                   CHARACTERISTICS                   ELEMENTS
                          Relevance                  Assets, Liabilities, and Equity
                                                     Investments by owners
                          Reliability                Distribution to owners              Second level
                          Comparability              Comprehensive income
                                                     Revenues and Expenses
                          Consistency                Gains and Losses                     Level 1 & 3
 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
                                           resources, claims to
                                           resources, and
                                           changes in them
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
Information is relevant if it pertains to the
particular decision that is at hand.
Relevant information must possess at least two
#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.

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 .

    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.
 U.S. Conceptual Framework Level 2:
Hierarchy of Qualitative Characteristics

           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
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
     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
                                          (c) Investment by owners
 (k) Decreases assets by purchasing
     the company’s own stock.         (k) (d) Distribution to owners
 (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
       When do we get to record
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
• Other names for Revenue are Sales or Service Fees.

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

  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
2. Payment has been made (the revenue is
   realized) or we have confidence our
   customer will pay (realizable).
         Timing of Revenue Recognition
Revenue Recognition - generally occurs (1) when
realized or realizable and (2) when earned.

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

         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
   - 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?
                                    Historical Cost
                                  (Price paid when acquired)
 (in other company’s stock)
                                  Fair Market Value
                                    (Value today if sold )
 Plant & equipment
                              Chapter 2 question 13
Exceptions to Historical Cost for:

A.   Conservatism
B.   Full Disclosure
C.   Cost/Benefit
D.   Materiality
E.   Going Concern

                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   ________________________

Receivables should be reported at:
A. Total amount your customers owe the
B. The Fair Market Value (what you could
   get if you sold them for someone else to
C. Net Realizable Value (amount you
   expect to be paid = total amount owed
   minus the uncollectable amounts)
Inventory should be reported at:

A. Cost - amount paid to acquire or
   manufacture it
B. Fair Market Value - amount it is worth
C. Lower of Cost or Market

   Property (Land) should be
         reported at:
A. Cost
B. Fair Market Value
C. Cost less Depreciation

Plant & Equipment should be
        reported at:
A. Cost
B. Fair Market Value
C. Cost less Depreciation
D. Lower of Cost or Market

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

 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

  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”)

         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

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
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
   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
2. The peculiar nature of a business or industry
   requires departure from basic theory.

                       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


An Expectations gap

• 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)

Issues in Financial Reporting
Ethics in the Environment of Financial Accounting

  In accounting, we frequently
  encounter ethical dilemmas.
    GAAP does not always provide an
    Doing the right thing is not always
    easy or obvious
     AICPA Principles of Professional Conduct
1.    Exercise sensitive professional and moral judgments in all
2.    Accept the obligation to act in a way that will serve the public
      interest, honor the public trust and demonstrate commitment to
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.

 •    Maintain professional competence.
 •    Follow laws, regulations, and standards
 •    Prepare complete and clear reports and recommendations
      after appropriate analysis.
 •   Don't disclose confidential information.
 •   Ensure that subordinates do not disclose confidential
 •   Do not use confidential information for personal gain or
 See next slide for items 3 & 4
         (adapted from IMA) continued
•   Avoid actual or apparent conflicts of interest.
•   Refuse gifts, favors, or hospitality that might influence
•   Refrain from subverting the organization's legitimate
•   Recognize and communicate personal limitations.
•   Communicate unfavorable as well as favorable information
    and opinions.
•   Refrain from actions that discredit the profession.
•   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
Continued on next slide…..
       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.

            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.
              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
                                          & 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
                            •   Substance over form
   – Neutrality
                            •   Neutrality
Secondary Characteristics
                            •   Prudence
• Comparability
                            •   Completeness
• Consistency                                             54
                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

            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
              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
       “Study Pursuant to Section 108(d) of the Sarbanes-Oxley
        Act of 2002 on…Principles-Based Accounting System”
       Kapnick (1974) and Wyatt (2004)
       What is meant by principles vs. rules based accounting?
       Why did Congress want this examined?
       What are the benefits and concerns with principles based
       Are judgment and professional ethics more or less
        important under principles based accounting?

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