SAMHAIN 2022 ritual music Medival Celtic music for Halloween Wiccan paga...

Accounting: The Language of Business - Vol. 2 (Intermediate: Part 17)

Nature is an expert in cost-benefit analysis,' she says. 'Although she does her accounting a little differently. As for debts, she always collects in the long run.

Margaret Atwood

Judgment and Applied Financial Accounting Research (Part B)

by 

Charles Lamson

The Role of Assumptions and Estimates

After a manager or accountant determines that a firm should report a business event in the financial statements, he or she often uses assumptions and estimates to answer the questions related to when to recognize the transaction, what accounting method to use, and what amount to record.

Assumptions and Estimates in the Financial Statements

Many amounts reported on the financial statements are based upon assumptions. For example:

1. Property, plant, and equipment are deprecated using a particular method [such as straight-line depreciation (Straight-line depreciation is the simplest method for calculating depreciation over time. Under this method, the same amount of depreciation is deducted from the value of an asset for every year of its useful life.) See part 58 of vol. 1.] that requires managers and accountants to make assumptions about the pattern of use.

2. Investments in another company are accounted for differently depending on how long management intends to hold the investment. Thus, managers and accountants must make assumptions about the duration of the investment.

Many of the balances reported on financial statements are estimates. Consider these two specific examples:

1. The value reported for plant, property, and equipment is net of accumulated depreciation. Depreciation is based upon estimates of the life and pattern of use of the depreciable assets.

2. Accounts receivable are reported on the balance sheet net of an allowance for those receivables that are not likely to be collected. However, the balance in the allowance account is an estimate as to how much of the accounts receivable balance might not be paid by customers.

It is important for financial statement preparers and users to understand the extensive use of assumptions and judgment in the financial statement preparation process.

Judgement-Related Disclosures

How does a financial statement user know where managers used judgment in the financial reporting process? Financial statement disclosures---specifically, the accounting policies footnote provide this information. Generally Accepted Accounting Principles (U.S. GAAP or GAAP) require companies to disclose their significant accounting policies.

Accounting Policies Footnote. The accounting policies footnote outlining the portfolio of accounting choices is typically one of the first notes to the financial statements. In Johnson & Johnson's 2015 annual report, it listed accounting policy choices for 14 different areas: cash equivalents; investments; property, plant, and equipment depreciation; revenue recognition; shipping and handling; inventories; intangible assets and goodwill; financial instruments; product liability; concentration of credit risk; research and development; advertising; income taxes; and net earnings per share. For example, Johnson & Johnson indicated that it reported inventory at the lower of cost or market and valued inventory using the first-in, first-out method ( an easy-to-understand inventory valuation method that assumes that goods purchased or produced first are sold first). As another example, Johnson & Johnson disclosed that it reports property, plant, and equipment at cost, depreciating these assets using the straight-line method [Straight line basis is a method of calculating depreciation and amortization, the process of expensing an asset over a longer period of time than when it was purchased. It is calculated by dividing the difference between an asset's cost and its expected salvage value by the number of years it is expected to be used (Investopedia).], and it also disclosed the lives that it uses to depreciate various groupings of assets. Toward the end of the disclosure, Johnson & Johnson also indicated that it uses estimates extensively in the preparation of financial information.

Industry Comparisons. Financial statement users rely on accounting policies footnote information to compare Johnson & Johnson to other firms in the industry. Johnson & Johnson's competitors include healthcare and pharmaceutical companies such as Pfizer Inc., GlaxoSmithKline plc, and AstraZeneca plc. Exhibit 3.1 illustrates the different methods, estimates, and assumptions that Johnson & Johnson and its competitors use in accounting for common items such as inventory and long-lived tangible assets. Notice that two of the companies Johnson & Johnson and Pfizer---are U.S. GAAP reporters and that two report under IFRS---GlaxoSmithKline and AstraZeneca. Next, two of the four companies use the first-in, first-out (FIFO) inventory cost flow assumption (Johnson & Johnson and GlaxoSmithKline), one uses average cost (Pfizer), and one uses a combination of FIFO and average cost (AstraZeneca). Or depreciation of long-lived tangible assets, all four companies use the straight-line method. However, the asset categories and useful lives vary considerably among the companies and are influenced by management judgment. For example, all four companies have a different range of useful lives for their buildings (Analysts and other financial statement users also employ various statement analysis techniques to understand a company's financial position and performance and compare it to other companies. We will discuss some of these techniques in upcoming posts and apply them where appropriate throughout this text.).

In addition, the accounting policies footnote enables users to determine whether a company employs income-increasing or income-reducing accounting policies or methods. For example, a company using FIFO in a period of inflation will typically report lower cost of sales and higher gross profit than a company using LIFO.

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 57-58*

end

C Root Chakra Muladhara Nature -: 1 Hour :- New Mix

Day 403 of Training for Trek across Missouri via the Katy Trail in a Whe...

Accounting: The Language of Business - Vol. 2 (Intermediate: Part 16)

There are two kinds of discontented in this world, the discontented that works and the discontented that wrings its hands. The first gets what it wants and the second loses what it has. There is no cure for the first but success and there is no cure at all for the second. The very worst of my vices and bad habits will abate of themselves if they are brought to an accounting every day.

Og Mandino

Judgment and Applied Financial Accounting Research (Part A)

by

Charles Lamson

Introduction

Accountants use judgment almost every day in their work when they evaluate facts to make a decision. For example, analyzing a business event and determining whether to record it or deciding whether to record a liability for pending litigation involves a great deal of judgment. Selecting and applying accounting methods such as the choice of a cost flow assumption (e.g., LIFO versus FIFO, see part 52 of Vol. 1) in inventory valuation---and using assumptions and estimates in financial reporting also require judgment. Determining the provision for bad debts relies on the use of estimates. Financial statement preparers use the best information available to make these judgments, knowing business activities could change and there could be new information in the future.

Managers use judgement in preparing financial statements, making the best estimates at that time. Consider Activision Blizzard, a leading provider of interactive game services. Activision Blizzard users play games for free yet, within these games, they can purchase virtual currency to obtain virtual goods to enhance their game playing experience. For example a Candy Crush player may purchase "gold bars." How does Activision Blizzard determine when the virtual goods are used and when to record revenues? Initially, Activision Blizzard records on earned revenue when players buy the virtual currency and virtual goods. Activision Blizzard recognizes revenue as the players use their virtual goods. Some virtual goods are consumable and used within days whereas others are durable and used over long periods of time. Activision Blizzard relies on historical data and making judgments about when the virtual goods are used and when to record revenues. However, assumptions based on historical data can change rapidly in young, growing, and dynamic markets such as social game services. If Activision Blizzard revises assumptions based on new data, changes its product mix due to new game introductions, or modifies estimates used such as average playing periods, the amount of revenue recognized may differ significantly from one period to the next.

In the next several posts, we identify areas in financial reporting that require judgment. We explore the assumptions and estimates disclosed in financial reports and highlight key judgement areas found in practice. We then discuss some obstacles to the use of good judgment and ways to overcome them. Because accountants are required to make judgments based on accounting standards and other authoritative literature, the authoritative literature in use for both U.S. GAAP and IFRS will be explained. We then outline the six steps used in the applied financial accounting research process. While the accounting standards differ, the use of judgment in the applied financial accounting research process are similar under U.S. GAAP and IFRS.

The Importance and Prevalence of Judgement in Financial Reporting 

When first studying accounting, most people expect to encounter clear cut methods and rules. In practice, accountants frequently use judgment to prepare and audit financial statements. Judgment is the process by which an accountant or manager reaches a decision in situations in which there are multiple alternatives.

Judgment and the Accountant

Accountants use judgment in several aspects of accounting and financial reporting, including researching and interpreting standards. Here, accountants seek answers to questions such as:

1. Should the company report a business event and, if so, when? For example, at times there are complexities involved in deciding when to recognize revenue. Specifically, should the company recognize revenue this year or deferred until future periods?

2.  If the company decides to report a business event in the current period, then what is the appropriate financial reporting treatment? For example, there are multiple methods for reporting an investment in the equity of another company. Thus, when a company acquires that investment, accountants must decide which accounting method is most appropriate.

3.  What amount(s) should the company report in the financial statements related to this business event? For example, when a company purchases inventory, there may be costs (such as freight costs) associated with that purchase other than the cost of the inventory itself. Accountants must determine what costs to include in the amount recorded as inventory.

Activision Blizzard, the social game service company, faced these types of questions when it started its business. In the new social media field, Activation Blizzard, needed to grapple with how to apply revenue recognition rules developed years earlier to the way it delivers its virtual products.

Judgment: Use and Abuse

Accounting standards allow financial statement preparers to use judgment to report the substance of a transaction in the financial statements, within certain boundaries, in the manner that best reflects economic reality. The ability to apply judgement enhances the usefulness of the financial statements. Of course, management might also use this latitude to engage in earnings management behavior. Earnings management occurs when managers manipulate financial information and misrepresent the firm's financial position and performance. We will discuss earnings management in more depth in a later post.

Judgment and Financial Statement Comparisons

Accounting standards afford management discretion in selecting accounting methods, applying these methods, and changing methods or estimates. This latitude can be problematic for users comparing the financial information reported by two firms in the same industry when each firm uses a different set of accounting methods or estimation techniques. In addition, the same firm may change its methods or estimation techniques over time. However, the flexibility afforded in the selection and application of accounting standards permits managers to choose those methods and assumptions that best reflect the economic reality of their transactions. Therefore, the financial information provided and user decisions based on that information may be enhanced by not requiring all companies to use the same accounting methods.

For example, consider two firms in the same industry: one uses the average-cost inventory method and the other uses the first-in, first-out (FIFO) inventory costing method (for a brief review of these methods, see part 52 of Vol. 1). The different inventory costing methods mean that the firm's financial statements will reflect different measurement bases for inventory. To compare the inventory balances as well as the cost of goods sold of these two firms, the investor will need to "undo" the effects of the inventory costing method choice. That is, a reasonably informed financial statement user would understand that ending inventory would be higher under FIFO than under average cost in a period of rising prices. Knowledge of the direction of the bias in the reported inventory valuation enables the financial statement user to interpret the results with ratio analysis and other financial statistics.

Accountants use their judgment to estimate and record economic events as accurately as possible.

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 55-56*

end

Accounting: The Language of Business - Vol. 2 (Intermediate: Part 15)

The first year, I didn't have much capital so I did everything myself. I had to keep my overhead low by learning everything about running a business, from accounting to fixing the gears of my equipment. I really started from scratch.

Li Ka-shing

Financial Reporting Theory (Part I)

by

Charles Lamson

Assumptions in Financial Reporting

We will now examine a number of underlying assumptions that are integral to the financial reporting process. The assumptions we discuss are:

• Going concern concept

• Business or economic entity concept

• The monetary unit assumption

• Periodicity assumption

U.S. GAAP does not directly state these four items as assumptions in the conceptual framework. [Another assumption, the full disclosure principle, states that accountants must report and disclose all information that can significantly affect the judgment of a reasonably informed financial statement user. The revisions to the conceptual framework (The Conceptual Framework is a body of interrelated objectives and fundamentals. The objectives identify the goals and purposes of financial reporting and the fundamentals are the underlying concepts that help achieve those objectives.) added that financial information must be complete to be a faithful representation. Completeness, then, makes explicit the prior assumption of full disclosure.] Yet, they are implicit in determining financial reporting standards.

Going Concern Concept

Many assumptions in the financial statements are based on long-term periods. How can a manager assert with certainty that a business will be valuable in, say, twenty-five years? The going concern concept indicates that accountants will record transactions and prepare financial statements as if the entity will continue to operate for an indefinite period of time unless there is evidence to the contrary. That is, the entity will exist for a period of time long enough to carry out contemplated operations, utilize existing productive capacity, and liquidate outstanding obligations. This concept justifies accounting practices such as the long-term/short-term classifications on the balance sheet and the depreciation of buildings for as long as 40 years.

The going concern concept is also tied to the use of historical cost. A business planning to operate for an indefinite period of time will now sell productive assets. Consequently, market values are less relevant. If a business is in jeopardy of failing (e.g., bankruptcy), then the going concern assumption would not be valid. If the assumption is not applicable, accountants would measure assets and liabilities at the amount at which they expect to dispose of them, their liquidation values.

Business or Economic Entity Concept

The business or economic entity concept states that all transactions and events relate to the reporting entity and must be kept separate from the personal affairs of the owner, related businesses, and the owners outside business interests. For example, Kyle Perry owns and operates several sporting goods shops called Perry's Sports. Perry's Sports is an economic entity separate from Kyle Perry. Perry's Sports owns its store buildings and reports them in the company's financial statements. Kyle Perry owns his house. The house is an asset of Kyle Perry and is not reported in the financial statements of Perry's Sports. Financial reporting for different entities must be separate and include disclosures describing transactions among related entities.

Monetary Unit Assumption

The monetary unit assumption stipulates that an entity measure and report its economic activities in dollars (or some other monetary unit).These dollars are assumed to remain relatively stable over time in terms of purchasing power. This assumption ignores any inflation or deflation experienced in the economy in which the entity operates. This assumption justifies adding dollars of different purchasing power on the balance sheet. For example, a company would add land purchased in the current period to the balance of land acquired in 1969.

Periodicity Assumption

The periodicity assumption specifies that an economic entity can divide its life into artificial time periods for the purpose of providing periodic reports on its economic activities. The periodicity assumption results in the need for accrual accounting because revenue and expenses must be reported in a given period under this assumption. In addition, the time period used will vary depending on the demands of financial statement users. For example, the SEC currently requires quarterly financial statements for publicly traded firms. These statements use significant estimates and may be less representationally faithful than the annual report. However, quarterly statements are more timely (an enhancing characteristic) than reporting on an annual basis because timely information is more useful (relevant) in decision making.

Assumptions in Financial Reporting: International Financial Reportng Standards (IFRS)

IFRS explicitly addresses the going concern assumption. The other assumptions are implicit in the standard-setting process. 

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 42-43*

end

Accounting: The Language of Business - Vol. 2 (Intermediate: Part 14)

I think about photographs as being full, or empty. You picture something in a frame and it's got lots of accounting going on in it-stones and buildings and trees and air - but that's not what fills up a frame. You fill up the frame with feelings, energy, discovery, and risk, and leave room enough for someone else to get in there.

Joel Meyerowitz

Financial Reporting Theory (Part H)

by

Charles Lamson

Recognition and Measurement: International Financial Reporting Standards (IFRS)

In this section, we discuss major differences in recognition and measurement between Generally Accepted Accounting Principles (GAAP or US GAAP) and IFRS.

General Recognition Principles. Recall from part 12 that, according to U.S. GAAP, Recognition is the process of reporting an economic event in the financial statements. Recognized events are included in a line item on the financial statements as opposed to in the notes to the statements [FASB, Statement of Financial Accounting Concept No. 5, "Recognition and Measurement in Financial Statements of Business Enterprises" (Stamford CT: FASB, 1984), Paragraph 6.]

Again, according to U.S. GAAP, companies should recognize items when (and only when) they have met the following four criteria.

1. The item meets the definition of one of the elements (the building blocks of the financial statement, see part 10) of the financial statements. For example, before a company records an asset, the item must meet the definition of an asset.

2.  The item is measurable. Events that are relevant to decision making are recognizable only if the firm can measure them. Consider an entity that has been sued. In the early stages of the lawsuit, it may not be possible to reliably estimate the amount of the potential obligation. Therefore, it does not report a liability on the balance sheet.

3.  The item must be reliable. This notion is similar to the faithful representation characteristic discussed earlier in that reliable financial information depicts the substance of an economic event in a manner that is complete, neutral, and free from error.

4.  The item is relevant. That is, it must allow financial statement users to make rational economic decisions.

IFRS also has four recognition criteria. Notice that the first three recognition criteria are similar to U.S. GAAP:

1. The item meets the definition of one of the elements.

2. The item is measurable.

3. The measurement of the item must be reliable.

4. It is probable that future economic benefits will flow to or from the company.

To illustrate the fourth criterion, assume management determines it is probable that the company will collect an estimated amount of receivables, resulting in an economic benefit to the company. Management should not include any receivables unlikely to be collected as assets by establishing an allowance for noncollectable accounts. The fourth criterion is used instead of relevance under U.S. GAAP.

The IFRS cost-benefit constraint and materiality constraint are similar to U.S. GAAP. We summarize the US GAAP and IFRS recognition criteria in Exhibit 2.11. 

Revenue and Expense Recognition. Under the current IFRS conceptual framework, firms recognize revenue when they meet both of the following criteria:

1. An increase in future economic benefits related to an increase in an asset or decrease of a liability has occurred.

2. The revenue can be measured reliably (IASB, Conceptual Framework for Financial Reporting, Paragraph 4.47.)

Similar to U.S. GAAP, the IASB recently adopted new revenue standards not completely aligned with the IFRS conceptual framework (The conceptual framework defines the objective of financial reporting as providing financial information that is useful in making decisions about resource allocation. It identifies characteristics associated with high-quality financial information. The conceptual framework also defines the elements of the financial reporting system, such as assets and liabilities, and specifies the recognition and measurement criteria to be used in practice. Therefore, when investors and creditors analyze financial statements of companies such as Facebook or Johnson & Johnson, they understand how the financial statements were prepared, what each financial statement contains, and what each line item on the statement represents.) The IASB adopted the same new revenue standard in the FASB, applying the notion of the transfer of control of the goods or services for revenue recognition. The IASB is expected to align the conceptual framework, with the new standard when it rewrites the framework.

Firms recognize expenses in the income statement when both of the following criteria are met:

1. A decrease in future economic benefits related to a decrease in an asset or an increase of a liability has occurred.

2. The expense can be measured reliably. (IASB, International Financial Reporting Standard 15, "Revenues from Contracts with Customers" (London, UK: International Accounting Standards Board, 2014).

Firms recognize expenses simultaneously with an increase in liabilities or a decrease in assets. For example, salaries payable is increased when a company recognizes salary expense. Unlike U.S. GAAP, IFRS does not use the matching approach [The matching principle (or approach) requires that a business records expenses alongside revenues earned. Ideally, they both fall within the same period of time for the clearest tracking. This principle recognizes that businesses must incur expenses to earn revenues (freshbooks.com).} for expense recognition.

Bases of Measurement. IFRS includes four of the five measurement bases used under U.S. GAAP. The four IFRS measurement bases are:

1. Historical cost

2. Current cost

3. Net realizable value

4. Present value of future cash flows 

IFRS does not include current market value as a separate measurement basis. Rather, The view under IFRS is that current cost, net reliable value, and the present value of future cash flows are all current market value measures.

Cash versus Accrual Accounting

U.S. GAAP is based on accrual accounting. It follows U.S. GAAP does not allow a cash basis system. [In U.S. GAAP the mandate for accrual accounting is in the FASB's Statement of Financial Accounting Concepts No. 6, "Elements of Financial Statements" (Norwalk, CT: FASB, 1985), Paragraph 134. IFRS discusses accrual accounting in IASB. Conceptual Framework for Financial Reporting, Paragraphs OB17-19.)]. To highlight the advantages of accrual accounting, we will begin by reviewing the cash-basis system.

Cash-Basis Accounting. Under the cash basis, firms recognize revenues only when they receive cash and recognize expenses only when they pay cash. Consequently, the cash basis measures cash receipts and disbursements but does not measure economic activity. Further, the cash basis enables firms to manipulate net income with the timing of cash flows. For example, a company using the cash basis could report higher net income by delaying payment of expenses until the next accounting period. Alternatively, to reduce reported earnings, a company could delay billing its customers until the next account. To ensure that it would not receive cash revenues in the current period. 

Accrual Accounting. Under the accrual basis, firms recognize revenues and expenses according to the principles we discussed in part 12. Accrual accounting is a financial accounting method that allows a company to record revenue before receiving payment for goods or services sold and record expenses as they are incurred (investopedia.com).

In other words, the revenue earned and expenses incurred are entered into the company's journals regardless of when money changes hands. When the firm receives or pays cash does not matter.

In summary, the accrual basis of accounting recognizes revenues when control of a good or service passes to the customer and expenses when incurred. As a result the major difference between cash and accrual accounting is the timing of revenue and expense recognition.

Example: The Cash versus the Accrual Basis of Accounting

PROBLEM: Yards, Inc. mows lawns at a fee of $100 per month. In the current year, 200 customers prepaid for the four months in the summer, beginning on May 1. Yards received $80,000 of cash receipts ($100 per month * 200 customers * 4 months) in May. Yards, Inc. provided the required service for 4 months by mowing lawns throughout May, June, July, and August. During those months the company incurred expenses of $10,000, $13,000, $12,000, and $10,000, respectively, and paid these expenses during the same month it consumed the economic benefit. Determine Yards Inc.'s net income for each month from May through August under both the cash and the accrual basis of accounting.

SOLUTION: Because Yards Inc. paid for the expenses in the same months it consumed the benefits, there is no difference in expense recognition between the cash basis and the accrual basis. However, there is a difference in revenue recognition.

Under cash-basis accounting, Yards would recognize revenue of $80,000 in May because that is when it received cash. However, under the accrual basis, it would recognize revenue of $20,000 ($100 per yard x 200 yards) in each of the four months.

Thus, under both systems Yards will ultimately recognize $80,000 revenue, $45,000 in expenses and $35,000 in net income. However, the timing of the revenue recognition differs, as illustrated in the following table. 

            

Note that the cash basis reports only cash receipts and disbursements but does not properly measure economic activity. Yards' cash-basis net income is overstated in May and understated in June, July, and August. 

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 40-42*

end