Prepared by: Jan Hájek Accounting Lecture no 2

OBJECTIVE OF FINANCIAL REPORTING The objective of financial reporting is to provide information that is useful for decision-making The consistency of information and values of the assets and liabilities is ensured by legislation and accounting principles

QUALITATIVE CHARACTERISTICS OF ACC. INFORMATION The accounting alternative selected should be one that generates the most useful financial information for decision making. To be useful, information should possess the following qualitative characteristics: 1. understandability 2. relevance 3. reliability 4.comparability and consistency

UNDERSTANDABILITYUNDERSTANDABILITY Information must be understandable by its users. Users are assumed to have a reasonable comprehension of, and ability to study, the accounting, business, and economic concepts needed to understand the information.

RELEVANCERELEVANCE  Accounting information is relevant if it makes a difference in a decision.  Relevant information helps users forecast future events (predictive value), or it confirms or corrects prior expectations (feedback value).  Information must be available to decision makers before it loses its capacity to influence their decisions (timeliness).

RELIABILITYRELIABILITY  Reliability of information means that the information is free of error and bias – it can be depended on.  To be reliable, accounting information must be verifiable – there must be proof that it is free of error and bias.  The information must be a faithful representation of what it purports to be – it must be factual.

COMPARABILITY AND CONSISTENCY  Comparability means that the information should be comparable with accounting information about other enterprises.  Consistency means that the same accounting principles and methods should be used from year to year within a company.

Assumptions Going concern Monetary unit Economic entity Time period Principles Revenue recognition Matching Full disclosure Cost Constraint s Cost - benefit Materiality  Recognition and measurement criteria used by accountants to solve practical problems include assumptions, principles, and constraints.  Assumptions provide a foundation for the accounting process.  Principles indicate how economic events should be reported in the accounting process.  Constraints permit a company to modify generally accepted accounting principles without reducing the usefulness of the reported information. RECOGNITION AND MEASUREMENT CRITERIA

GOING CONCERN ASSUMPTION The going concern assumption assumes that the enterprise will continue to operate in the foreseeable future. Implications: capital assets are recorded at cost instead of liquidation value, amortization is used, items are labeled as current or non- current.

 The monetary unit assumption states that only transaction data capable of being expressed in terms of money should be included in the accounting records of the economic entity.  Also assumes unit of measure ($) remains sufficiently stable over time. Ignores inflationary and deflationary effects. MONETARY UNIT ASSUMPTION Customer satisfaction Percentage of international employees Salaries paid Should be included in accounting records Should not be included in accounting records

ECONOMIC ENTITY ASSUMPTION The economic entity assumption states that economic events can be identified with a particular unit of accountability. Example: Harvey’s activities can be distinguished from those of other food services such as Swiss Chalet.

TIME PERIOD ASSUMPTION The time period assumption states that the economic life of a business can be divided into artificial time periods. Example: months, quarters, and years QTR 1 QTR 2 QTR 3 QTR JAN FEB MAR APR MAY JUN JUL AUG SEPT OCT NOV DEC

 The revenue recognition principle says that revenue should be recognized in the accounting period in which it is earned. Production/sales essentially complete Revenues measurable Collection reasonably assured Expenses determinable REVENUE RECOGNITION PRINCIPLE

 Revenue can be recognized: 1.At point of sale 2. During production 3.At completion of production 4.Upon collection of cash REVENUE RECOGNITION

 Expense recognition is traditionally tied to revenue recognition.  This practice – referred to as the matching principle – dictates that expenses be matched with revenues in the period in which efforts are expended to generate revenues. MATCHING PRINCIPLE

 Expired costs are costs that will generate revenuesonly in the current period and are therefore reported as operating expenses on the income statement.  Unexpired costs are costs that will generate revenues in future accounting periods and are recognized as assets. MATCHING PRINCIPLE MATCHING PRINCIPLE

Unexpired costs become expenses through: 1.Cost of goods sold – Costs carried as merchandise inventory are expensed as cost of goods sold in the period when the sale occurs – so there is a direct matching of expenses with revenues. 2.Operating expenses – Unexpired costs become operating expenses through use or consumption or through the passageof time. MATCHING PRINCIPLE

FULL DISCLOSURE PRINCIPLE  The full disclosure principle requires that circumstances and events that make a difference to financial statement users be disclosed.  Compliance with the full disclosure principle is accomplished through 1. the data in the financial statements and 2. the notes that accompany the statements.  A summary of significant accounting policies is usually the first note to the financial statements.

COST PRINCIPLE  The cost principle dictates that assets are recorded at their historic cost.  Cost is used because it is both relevant and reliable. 1. Cost is relevant because it represents the price paid, the assets sacrificed, or the commitment made at the date of acquisition. 2.Cost is reliable because it is objectively measurable, factual, and verifiable.

DUAL ASPECT CONVENTION  The accounting entry is always captured on credit and debit side of the account

CONSTRAINTS IN ACCOUNTING  Constraints permit a company to modify generally accepted accounting principles without reducing the usefulness of the reported information.  The constraints are cost-benefit and materiality. 1. Cost-benefit means that the value of information should be greater than the cost of providing it. 2. Materiality relates to an item’s impact on a firm’s overall financial condition and operations.

CONCEPTUAL FRAMEWORK -SUMMARY Objectives of Financial Reporting Qualitative Characteristics of Accounting Information Elements of Financial Statements Recognition and Measurement Criteria AssumptionsPrinciplesConstraints

FINANCIAL STATEMENTS After transactions are identified, recorded, and summarized, four financial statements are prepared from the summarized accounting data: 1.An income statement presents the revenues and expenses and resulting net income or net loss of a company for a specific period of time. 2. A statement of owner’s equity summarizes the changes in owner’s equity for a specific period of time.

FINANCIAL STATEMENTS In addition to the income statement and statement of owner’s equity, two additional statements are prepared: 3. A balance sheet reports the assets, liabilities, and owner’s equity of a business enterprise at a specific date. (Statement of financial position) 4. A cash flow statement summarizes information concerning the cash inflows (receipts) and outflows (payments) for a specific period of time. The notes are an integral part of the financial statements.

Introduction to Financial Statements Describes where the enterprise stands at a specific date. Income Statement Balance Sheet Statement of Cash Flows

Introduction to Financial Statements Depicts the revenue and expenses for a designated period of time. Income Statement Balance Sheet Statement of Cash Flows

Introduction to Financial Statements Net income (or net loss) is simply the difference between revenues and expenses. Income Statement Balance Sheet Statement of Cash Flows

Introduction to Financial Statements Depicts the ways cash has changed during a designated period of time. Income Statement Balance Sheet Statement of Cash Flows

The Need for Adequate Disclosure Notes to the financial statements often provide facts necessary for the proper interpretation of the statements. Income Statement Balance Sheet Statement of Cash Flows

Relationship between the statement of financial position, the income statement and the statement of cash flows Income statement Statement of cash flows Balance sheet Statement of cash flows Time Period 2 Period 1 Income statement

Brie Manufacturing Statement of financial position as at 31 December 2011 £000 ASSETS Non-current assets Property45 Plant and equipment30 Motor vans19 94 Current assets Inventories23 Trade receivables18 Cash at bank12 53 Total assets 147

Brie Manufacturing Statement of financial position as at 31 December 2011 (continued) £000 EQUITY AND LIABILITIES Equity60 Non-current liabilities Long-term borrowings50 Current liabilities Trade payables37 Total equity and liabilities 147

Better-Price Stores Income statement for the year ended 31 October 2011 £ Sales revenue232,000 Cost of sales154,000 Gross profit78,000 Salaries and wages(24,500) Rent and rates(14,200) Heat and light(7,500) Telephone and postage(1,200) Insurance(1,000) Motor vehicle running expenses(3,400) Depreciation – fixtures and fittings(1,000) Depreciation – motor van (600) Operating profit24,600 Interest received from investments2,000 Interest on borrowings (1,100) Profit for the year 25,500

Miro plc Statement of changes in equity for the year ended 31 Dec 2011 Share capital Share premium Revaluat. reserve Translat. reserve Retained earnings Total £m Balance as at 1 January _ Changes in equity for 2011 Issue of ordinary shares 5020___70 Dividends____(27) Total comprehensive income for the year (10)42152 Balance at 31 December

Tesco plc Summarised statement of cash flows for the year ended 26 Feb 2011 £m Cash generated from operations 5,366 Interest paid(614) Corporation tax paid(760) Net cash from operating activities 3,992 Net cash used in investing activities (1,859) Cash flows from financing activities Dividends paid to equity owners (1,081) Other net cash flows from financing activities(1,955) Net cash from financing activities(3,036) Net decrease in cash and cash equivalents(903) Source: Tesco annual review 2011, p. 35,

Let’s analyze some transactions for JJ’s Lawn Care Service.

On May 1, 2003, Jill Jones and her family invested $8,000 in JJ’s Lawn Care Service and received 800 shares of stock.

On May 2, JJ’s purchased a riding lawn mower for $2,500 cash.

On May 8, JJ’s purchased a $15,000 truck. JJ’s paid $2,000 down in cash and issued a note payable for the remaining $13,000.

On May 11, JJ’s purchased some repair parts for $300 on account.

Jill realized she had purchased more repair parts than needed. On May 18, JJ’s was able to sell half of the repair parts to ABC Lawns for $150, a price equal to JJ’s cost. JJ’s will receive the cash within 30 days.

On May 25, ABC Lawns pays JJ’s $75 as a partial settlement of its accounts receivable.

On May 28, JJ’s pays $150 of its accounts payable.

On May 29, JJ’s recorded lawn care services provided during May of $750. All clients paid in cash.

Now, let’s review how JJ’s transactions affected the accounting equation. On May 31, JJ’s purchased gasoline for the lawn mower and the truck for $50 cash.

These transactions impact the Statement of Cash Flows. These transactions impact the Income Statement. Let’s prepare the Income Statement and Statement of Cash Flows for JJ’s Lawn Care Service for the month ending May 31, 2003.

Investments by and payments to the owners are not included on the Income Statement.

Operating activities include the cash effects of revenue and expense transactions.

Investing activities include the cash effects of purchasing and selling assets.

Financing activities include the cash effects of transactions with the owners and creditors.