Question

1.  What information does the Income Statement, Balance Sheet and Cash Flow Statement provide to various users? Why is the Income Statement constructed first and the Cash Flow Statement contructed last? What type of accounts are in each statement?

2. What is the difference between an accrual basis and cash basis of accounting? What type of companies might use each basis and why? What is GAAP and who determines GAAP? What is IFERs and what impact might it have in the future towards U.S. GAAP?

3. What is the accounting cycle? What types of accounting records are needed within this accounting cycle? How might an accounting system be expanded beyond the basic accounting records? What types of accounting checks are available to make sure we are constructing the statements accurately?

4. Identify and explain five theoritical concepts, assumptions and/or constraints that might be within an accrual basis of accounting, (i.e. matching concept). Give an example of an account affected by each theory you mention. What are some differences with U.S. GAAP and IFERs in certain financail accounting areas?

5. Identify five different accounts that might be affected by different accounting treatments, (i.e. inventory could be accounted for by the LIFO or FIFO cost flow assumptions).

6. How does the type of company, (service, merchandise or manufacturing) affect the accounting records?

7. How does the ownership of a company, (sole proprietorship, partnership or corporation affect the accounting records?

8. What limitations are present in the financial statements for various users? Be as specific as possible.

Answer 1

1The income statement, balance sheet and cash flow statement are all interrelated. The income statement describes how the assets and liabilities were used in the stated accounting period. The cash flow statement explains cash inflows and outflows, and it will ultimately reveal the amount of cash the company has on hand, which is also reported in the balance sheet. By themselves, each financial statement only provides a portion of the story of a company's financial condition; together, they provide a more complete picture.

The first of these is your income statement. You may have heard this also referred to as a profit and loss statement, or simply the P & L. Income statements show your revenues (the money your business has earned or gross profits), your expenses (the cost of goods sold and other expenses of running your business), and what is left after the expenses are paid (revenues minus expenses or your net profits

A balance sheet is another number that should be checked monthly. Even with high profits, your company can be losing ground in its value.

The final statement that should be checked monthly is the cash flow statement. The cash flow statement takes the net profit from income statement and accounts for changes in the amount of equity in the business shown on the balance sheet. This lets you know what cash you have available for paying bills, payroll, and debt payments.

2.The main difference between accrual and cash basis accounting lies in the timing of when revenue and expenses are recognized. ... The revenue is recorded even ifcash has not been received or if expenses have been incurred but no cash has been paid. Accrual accounting is the most common method used by businesses.

The standards that govern financial reporting and accounting vary from country to country. In the United States, financial reporting practices are set forth by the Financial Accounting Standards Board, or FASB, and organized within the framework of the generally accepted accounting principles, or GAAP. More than 100 countries around the world have adopted the international financial reporting standards, or IFRS, which aim to establish a common global language for company accounting affairs. While the Securities and Exchange Commission, or SEC, has openly expressed a desire to switch from GAAP to IFRS, development has been slow.

Some accountants consider methodology to be the primary difference between the two systems; GAAP is rules-based and IFRS is principles-based. This disconnect manifests itself in specific details and interpretations; IFRS guidelines provide much less overall detail than GAAP. Consequently, the theoretical framework and principles of the IFRS leave more room for interpretation and may often require lengthy disclosures on financial statements. On the other hand, the consistent and intuitive principles of IFRS are more logically sound and may possibly better represent the economics of business transactions.

Perhaps the most notable specific difference between GAAP and IFRS involves their inventory treatments. IFRS rules ban the use of last-in, first-out, or LIFO, inventory accounting methods. GAAP rules allow for LIFO. Both systems allow for the first-in, first-out method, or FIFO, and the weighted average cost method. GAAP does not allow for inventory reversals, while IFRS permits them under certain conditions.

Another key reporting difference is that GAAP requires financial statements to include a statement of comprehensive income. IFRS does not consider comprehensive income to be a major element of performance and therefore does not include it. This leaves some room for mixing owner and nonowner activity within the financial statements.

3.The accounting cycle is the name given to the collective process of recording and processing the accounting events of a company. The series of steps begin when a transaction occurs and end with its inclusion in the financial statements. Additional accounting records used during the accounting cycle include the general ledger and trial balance.

4.

Assumption#1. Accounting Entity

A company is considered a separate “living” enterprise, apart from its owners. In other words, a corporation is a “fictional” being:

• It has a name.
• It has a birthdate and birthplace (referred to as incorporation date and place, respectively).
• It is engaged in clearly defined activities.
• It regularly reports its financial health (through financial reports) to the general public.
• It pays taxes.
• It can file lawsuits.

Why Assume “Accounting Entity”?

• It Provides Context. The accounting entity assumption enables users of financial reports to tell whose financials they are reviewing and therefore places those financials into context.
• It Promotes Ownership. The assumption of a company as a separate economic entity promotes ownership in the business, since its current and future owners know that their financial liability is limited to the value of their investment while they are legally shielded from any potential lawsuits brought against the company.

Assumption#2. Going Concern

A company is considered viable and a “going concern” for the foreseeable future. In other words, a corporation is assumed to remain in existence for an indefinitely long time. Exxon Mobil, for example, has existed since 1882, and General Electric has been around since 1892; both of these companies are expected to continue to operate in the future. To assume that an entity will continue to remain in business is fundamental to accounting for publicly held companies.

Why Assume “Going Concern”?

The going concern assumption essentially says that a company expects to continue operating indefinitely; that is, it expects to realize its assets at the recorded amounts and to extinguish its liabilities in the normal course of business.

If this assumption is incorrect or untenable for a particular company (think of a liquidation or a fire sale), then the methods prescribed by Generally Accepted Accounting Principles (GAAP) for accounting for various transactions would need to be adjusted, with consequences to revenues, expenses, and equity.

Assumption#3. Measurement and Units of Measure

Financial statements have limitations; they show only measurable activities of a corporation such as its quantifiable resources, its liabilities (money owed by it), amount of taxes facing it, and so forth. For example, financial statements exclude:

• Internally developed trademarks and patents (think of Coke, Microsoft, General Electric)—the value of these brands cannot be quantified or recorded.
• Employee and customer loyalty—their value is undeterminable. Since financial statements show only measurable activities of a company, they must be reported in the national monetary unit: U.S. financial statements are reported in U.S. dollars (Exhibit 2.2); European financial statements now use the euro as a standard monetary unit.

5.

When you are recording entries, they are always going to fall into one of the 5 main types of accounts:

• Asset
• Liability
• Equity
• Revenue
• Expense

Its not always straightforward which account to use, even for seasoned business owners. Something that a business considers an expense, like a $1,000 computer may be considered a $1,000 asset by an accountant or the tax man (ok fine, we’re PC here, so tax person). So don't be discouraged if you don't quite know which account to use when recording an entry. If you don't know, ask a professional to help you out, someone who knows the local laws and regulations for your type of business.In the next lesson we'll go over giving credit to customers and getting credit from vendors, which is a good introduction to accrual accounting.

6.

Similarities

The accounting cycle for service companies and merchandising companies includes similar processes. For example, the accounting cycle for both companies follows the same basic structure of recording transactions and reporting financial results. The accountants in both types of companies review the account balances and identify any necessary adjustments. Adjustments refer to transactions that occurred during the month but did not create an entry in the financial records. The adjusting entry records the entry.

Differences

Several differences exist in the accounting cycle between service companies and merchandising companies. These include recognition of revenue and the format of the financial statements. Service companies recognize revenue when the company performs the service for the customer. In most cases, the company bills the customer on a future date to request payment. Merchandising companies generally collect payment from customers when the customer takes the merchandise from the store. The merchandising company recognizes revenue on the date of sale. The income statement formats vary between service companies and merchandising companies. The income statement for the service company subtracts the operating expenses from the revenues to arrive at net income. The merchandising company subtracts the cost of merchandising from the revenue to arrive at gross profit. It then subtracts all other operating expenses to arrive at net income.

7.

Filing Taxes

Partnerships and sole proprietorships are referred to as pass-through entities. This is because sole proprietors and partners in a partnership report their share of company profits and losses directly on their personal income tax return. Sole proprietorships and partnerships are not required to file business taxes with the Internal Revenue Service. Corporations are subject to double taxation. This occurs when the corporation pays taxes on the company's profits at the business level, and shareholders pay taxes on income received from the corporation on their personal tax return.

Setting Up

Corporations have a structure consisting of shareholders, directors, officers and employees. Every corporation must select at least one person to serve on its board of directors. The board of directors is responsible for allocating the company's resources and increasing the shareholders' profits. Officers are required to manage the day-to-day activities of the company and implement the decisions made by the company's shareholders and directors. Sole proprietorships and partnerships have a more informal structure that does not require the selection of officers and directors. Sole proprietors have full control over every aspect of their business, whereas partnerships and corporations have to vote on important company issues.

8.

The following are all limitations of financial statements:

• Dependence on historical costs. Transactions are initially recorded at their cost. This is a concern when reviewing the balance sheet, where the values of assets and liabilities may change over time. Some items, such as marketable securities, are altered to match changes in their market values, but other items, such as fixed assets, do not change. Thus, the balance sheet could be misleading if a large part of the amount presented is based on historical costs.
• Inflationary effects. If the inflation rate is relatively high, the amounts associated with assets and liabilities in the balance sheet will appear inordinately low, since they are not being adjusted for inflation. This mostly applies to long-term assets.
• Intangible assets not recorded. Many intangible assets are not recorded as assets. Instead, any expenditures made to create an intangible asset are immediately charged to expense. This policy can drastically underestimate the value of a business, especially one that has spent a large amount to build up a brand image or to develop new products. It is a particular problem for startup companies that have created intellectual property, but which have so far generated minimal sales.
• Based on specific time period. A user of financial statements can gain an incorrect view of the financial results or cash flows of a business by only looking at one reporting period. Any one period may vary from the normal operating results of a business, perhaps due to a sudden spike in sales or seasonality effects. It is better to view a large number of consecutive financial statements to gain a better view of ongoing results.
• Not always comparable across companies. If a user wants to compare the results of different companies, their financial statements are not always comparable, because the entities use different accounting practices. These issues can be located by examining the disclosures that accompany the financial statements.
• Subject to fraud. The management team of a company may deliberately skew the results presented. This situation can arise when there is undue pressure to report excellent results, such as when a bonus plan calls for payouts only if the reported sales level increases. One might suspect the presence of this issue when the reported results spike to a level exceeding the industry norm.
• No discussion of non-financial issues. The financial statements do not address non-financial issues, such as the environmental attentiveness of a company's operations, or how well it works with the local community. A business reporting excellent financial results might be a failure in these other areas.
• Not verified. If the financial statements have not been audited, this means that no one has examined the accounting policies, practices, and controls of the issuer to ensure that it has created accurate financial statements. An audit opinion that accompanies the financial statements is evidence of such a review.
• No predictive value. The information in a set of financial statements provides information about either historical results or the financial status of a business as of a specific date. The statements do not necessarily provide any value in predicting what will happen in the future. For example, a business could report excellent results in one month, and no sales at all in the next month, because a contract on which it was relying has ended.

Financial statements are normally quite useful documents, but it can pay to be aware of the preceding issues before relying on them too much.