I. the Formulation of Accounting Theory: Two Crucial Questions

I. The Formulation of Accounting Theory: two crucial questions

A.

B.

II. The Financial Accounting Standards Board

A. Structure of the FASB

FAF

|

| ------|

FASB Financial Accounting Advisory Council

7 members (minimum 20 members)

B. Process

1. task force

2. discussion memo

3. public hearings

4. staff analysis of 2 and 3

5. board meeting

6. preliminary views

7. exposure draft

8. issuance of standards

C. Objectives of FASB

1. improve usefulness of financial statements (F/S)

2. provide up-to-date standards

3. consider problems promptly

4. improve understandability of what F/S represent

III. Guidelines for FASB

A. neutral information

B. listen to constituents

C. weigh cost/benefits

D. minimize disruption of continuity

E. review past decisions

IV. Politicization of Accounting

A. Accounting information affects economic behavior

1.

2.

3.

B. Examples of 1, 2, & 3

1. Postretirement Benefits

2. Research and Development

3. Stock-based compensation

V. Statement of Financial Accounting Concept #1: "Objectives of Financial Accounting by Business Enterprises"

A. Purpose of financial reporting

1. provide useful information

2. recognize that accounting is not immutable

3. limitations and qualifications

a. uses approximate measures

b. report on historical events

c. one of many other sources of information

d. costly

B. Objectives of financial reporting: provide information to investors and creditors on the amount, timing, and uncertainty, of future cash flows and

1. economic resources

2. claims on those resources

3. changes in 1 and 2

VI. SFAC #2: "Qualitative Characteristics of Accounting Information":

Cost/Benefit

USEFULNESS

Understandability

RelevantReliable

Timely Predictive Feedback Verifiable Neutral Rep. Faithful

value value

ComparableConsistent

Materiality

MC. Reporting inventory at the lower of cost or market is a departure from the accounting principle of

a. Historical cost.

b. Consistency.

c. Conservatism.

d. Full disclosure.

VII. Cash versus Accrual Accounting: Cash basis accounting measures income as difference between cash in and cash out. Accrual basis accounting measures revenues when earned and matches expenses with the revenues they generate (e.g., depreciation). For example, Mr. Bart S. owns a hardware store:

1. Bart contributes $10,000 in cash and borrows $10,000 more at 12% interest

2. Bart prepays 2 months rent at $1,000 month

3. Bart prepays 1 year's insurance of $1,200

4. Bart buys $20,000 of inventory for $13,000 in cash and a $7,000 A/P.

5. Bart sells inventory that cost him $16,000 for $25,000 ($17,000 in cash and $8,000 in A/R)

6. Bart owes his employees $2,500

Monthly Cash Income Statement

Cash Receipts from Sales$17,000

Cash paid:

Inventory 13,000

Rent2,000

Insurance1,200 16,200

Net Income 800

Monthly Accrual Basis Income Statement

Sales $25,000

Cost of goods sold 16,000

Gross Margin9,000

Operating expenses

Salaries2,500

Rent*1,000

Insurance** 100 3,600

Income from operations 5,400

Other revenues/expenses

Interest*** 100

Net Income5,300

*$2,000/2 months

**$1,200/12 months

***$10,000 x 12% x 1/12

MC. For $50 a month, Rawl Co. visits its customers' premises and performs insect control services. If customers experience problems between regularly scheduled visits, Rawl makes service calls at no additional charge. Instead of paying monthly, customers may pay an annual fee of $540 in advance. For a customer who pays the annual fee in advance, Rawl should recognize the related revenue

a. When the cash is collected.

b. At the end of the fiscal year.

c. At the end of the contract year after all of the services have been performed.

d. Evenly over the contract year as the services are performed.

MC. Compared with the accrual basis of accounting, the cash basis of accounting understates income by the net decrease during the accounting period of

Accounts

Receivable Accrued Expenses

a.Yes Yes

b. Yes No

c. No No

d. No Yes

Accrual Basis

Receivables?

Accrual Basis

Cash Basis

Before 1991, Adroit Co. used the cash basis of accounting. As of December 31, 1991, Adroit changed to the accrual-basis. Adroit cannot determine the beginning balance of supplies inventory. What is the effect of Adroit's inability to determine beginning supplies inventory on its 1991 accrual-basis net income and December 31, 1991 accrual-basis owners' equity?

1991 Net Income 12/31/91 Owners' Equity

a. No effect No effect

b. No effect Overstated

c.Overstated No effect

d.Overstated Overstated

VIII. Real versus Nominal Accounts

A. Real accounts: Balance carries over from 1 accounting period to the next

1.

2.

3.

B. Nominal accounts: temporary accounts used to measure net income for the current accounting period. Nominal accounts are "closed" to a zero balance at the end of each period.

Example: We earn $100 in revenue on December 26 for accounting services for and incur $20 in cost.

Entries:

12/26/01

(a)A/R 100

Revenue100

(b)Expense 20

A/P 20

12/31/01

(c)Revenue100

Income Summary100

(d)Income Summary 20

Expense 20

(e)Income Summary 80

Capital 80

A/R A/P Revenue

(a) 100|| 20 (b) |100 (a)

|| (c)100|

|||

I/S Capital Expense

|100 (c)| (b) 20|

(d) 20|| 80 (e)| 20 (d)

(e) 80|| |

MC. The changes in account balances of the Vel Corporation during 1995 are presented below:

Increase

Assets $356,000

Liabilities $108,000

Capital stock $240,000

Additional paid-in capital $ 24,000

Assuming there are no charges to retained earnings other than for a dividend payment of $52,000, the net income for 1995 should be

a. $16,000

b. $36,000

c. $52,000

d. $68,000

If the other owners’ equity accounts increased by $264,000, then retained earnings must have decreased by $16,000 net.

Retained Earnings

dividends52,000|36,000net income

IX. 3 major considerations in determining net income

A. Going concern (continuity): firm will continue to exist indefinitely.

B. Annual accounting period (periodicity): users of accounting want information for an arbitrary period

C. Historical cost: Assets and liabilities are recorded and presented on the financial statements at the original acquisition cost.

MC. On December 31, 1994, KMM Co. decided to end operations and dispose of its assets within 3 months. At December 31, 1994, the net realizable value of the equipment was below historical cost. What is the appropriate measurement basis for equipment included in KMM's December 31, 1994 balance sheet?

a. Historical cost.

b. Current reproduction cost.

c. Net realizable value.

d. Current replacement cost.

X. Accrual accounting: Revenue recognized when earned (i.e., sale of goods or performance of services) and expenses matched (allocated to time period) revenues earned.

How? 4 types of adjusting entries

1. Revenues recorded, not yet earned (deferred)

2. Revenues earned, not yet recorded (accrued)

3. Expenses recorded, not yet incurred (deferred)

4. Expenses incurred, not yet recorded (accrued)

Examples:

1. On Jan. 1, we collect 2 months rent in advance at $600 a month ($1,200 total).

Entries

Cash R.C.I.A. Revenue

1,200||| 1200

| | 600600|

| | |

2. We are owed $600 rent for January but are not paid until Feb. 2

Entries

3. We owe 1 month's rent for January but prepay 2 months' rent on Jan. 1

Entries

4. We owe one month's rent on Jan. 31 but do not pay until Feb. 2.

XI. Preparing an Adjusted Trial Balance (ATB)

A. Accounting Cycle

1. Journalize in the general and 4 special purpose journals

2. Post to the ledger

3. Prepare a trial balance

4. Make adjusting entries

5. Prepare an ATB

6. Close all nominal accounts

7. Prepare a post-closing Trial Balance.

8. Reverse

B. Example of an ATB: Assume the following information has been provided: ABC Corp. has $10,000 in cash, $5,000 in accounts receivable, $2,400 in Prepaid Insurance (a three year policy), $50,000 in Equipment, $20,000 in Accounts Payable, $10,000 in Unearned Revenue, and $37,400 in Capital.

C. Prepare a Trial Balance.

D. Assume the following additional data:

1. ABC owes $3,000 in salaries

2. The equipment has an estimated life of 10 years, no salvage value, and is depreciated using the straight-line method.

3. One-third of the insurance has expired.

4. $9,000 of the unearned revenue has been earned.

E. Prepare the necessary adjusting entries

(1)

Salary expense3,000

Salary payable3,000

(2)

Depreciation expense5,000

Accumulated depreciation5,000

(3)

Insurance Expense800

Prepaid Insurance800

(4)

Unearned Revenue9,000

Revenue9,000

F. Prepare an ATB