Guided Readings for Financial Accounting, Lesson 2.2– Mastery Level

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1

Read the third section of Chapter Two (Section 2.3, “The Need for Accounting Standards”). As you read, ask yourself why the existence of official accounting standards is so vitally important? How do these standards help decision makers understand the financial information they are receiving? What are these standards called? Who creates these accounting standards? How do these standards change over time?

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(2Q13) – When a financial accountant says that information is presented fairly (it contains no material misstatements), that judgment must be based on a set of standards. What standards are used to determine how financial information should be reported in order to be viewed as presented fairly?

(2A13) – In the United States, a highly structured system known as Generally Accepted Accounting Principles (or U.S. GAAP) provides the rules and standards by which financial information is reported. In most of the world outside the United States, International Financial Reporting Standards (or IFRS) are used. These two reporting systems are identical for many topics but do differ in a number of key areas.

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(2Q14) – Who produces U. S. GAAP? Who produces IFRS?

(2A14) – Accounting standards are only created after a long period of study and discussion. U. S. GAAP is produced by the Financial Accounting Standards Board (FASB) which is located in Connecticut. The accumulation of all U.S. GAAP is known as the Accounting Standards Codification. IFRS is produced by the International Accounting Standards Board (IASB) which is based in London.

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(2Q15) – Why is having a standard set of accounting rules (such as U. S. GAAP and IFRS) so important for both reporting companies and decision makers?

(2A15) – Around the world, most organizations follow either U.S. GAAP or IFRS in their financial reporting. Organizations cannot simply prepare information as they see fit. Officials might be biased or not use proper methods. They might report information that could not be understood. For clear communications, organizations must follow official rules. Such standards enable decision makers to better understand the reported information and make better decisions. Consequently, worthy organizations are more likely to get the funding needed for growth and prosperity.

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The following statement is from the end of chapter material in the textbook. It is false. Explain why it is false. Most countries require companies that operate within their borders to follow U.S. GAAP in preparing their financial statements.

As indicated, this statement is false. U.S. GAAP is primarily used in the United States and also in a few other countries. In most of the rest of the world, IFRS accounting rules are required.

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(2Q16) – How often do U.S. GAAP (or IFRS) rules change? Do they stay the same forever or do they change frequently?

(2A16) – Some basic accounting rules have been around for hundreds of years but most accounting rules that comprise U.S. GAAP only began to be developed within the last 80-100 years. The process sped up in 1973 when FASB was created. By now, a tightly structured system has developed. Some rules have changed little over the last 50-60 years but many change every 10-30 years as both business operations and accounting theory evolve. IFRS has a somewhat complicated history but its rules also tend to change over time.

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(2Q17) – What would be the likely outcome if accounting standards such as U.S. GAAP or IFRS did not exist?

(2A17) – Without accounting standards, investors and creditors would be less likely to trust financial information and, therefore, less willing to provide money to enable businesses and other organizations to grow. They would be less likely to provide financing for deserving operations. Innovation would not flourish. Businesses would be smaller and the economy weaker with fewer jobs and less prosperity. Money could well flow to less deserving organizations, creating an inefficient allocation of resources. Accounting rules help to create economic wealth.

8

The following statement is from the end of chapter material in the textbook. It is false. Explain why it is false. Creation of U.S. GAAP is primarily done by the U.S. government.

As indicated, this statement is False. U.S. GAAP is created and managed by the Financial Accounting Standards Board (FASB). FASB is a private organization that is independent of the federal government (and any state governments). By being independent, the group’s decisions can hopefully be made in a purely theoretical manner.

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Work the Test Yourself question in Section 2.3 of Chapter Two (“An investor is studying a set of financial statements…”). This question is included to ensure that you have a proper understanding of the term U.S. GAAP. Three of these answers are incorrect. They are myths or misunderstandings about U.S. GAAP. Choose your answer and then study the explanation carefully.

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10

Near “The Evolution of Accounting Standards” in Section 2.3, watch the video titled, Who creates accounting rules and why are accounting rules important? This video looks at the role played by accounting standards in the world of modern commerce.

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11

Read the fourth section of Chapter Two (“Four Essential Terms Encountered in Financial Accounting”). Notice that the course changes here. Until now, the program has studied financial information and accounting rules in general. Now, for the first time, we look at specific pieces of information reported by an organization. It begins with four of the most basic terms in all of accounting: assets, liabilities, revenues, and expenses. In any understanding of this course, the importance of these four cannot be overstated.

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(2Q18) – What is an asset? What are common examples of assets that an organization might report?

(2A18) – An asset is a future economic benefit that an organization owns or controls. For example, a business like McDonald’s that has numerous restaurants would report many assets such as: land, buildings, refrigerators, stoves, cash, inventory (merchandise to be sold), and accounts receivable (amounts owed to the company). Each of these is a future economic benefit that the company owns or controls. This is not a complicated concept. You can do this.

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(2Q19) – What is the definition of a liability? What are examples of common liabilities?

(2A19) – A liability is a debt that an organization owes. More formally, a liability is a probable future sacrifice of economic benefits arising from present obligations. For example, money owed to employees is a liability (salary payable) as is money owed to a bank on a loan (a note payable). The amount of a company’s debts is always information of interest to a decision maker.

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(2Q20) – What is meant by the term “net assets?”

(2A20) – An organization’s net asset total is found by subtracting its liabilities from its assets. The amount of net assets is one important measure of the size of an organization. As assets grow or liabilities shrink, a company’s net asset total gets larger. A successful company like Coca-Cola or McDonald’s has been able to increase its net assets rapidly over a great many years.

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(2Q21) – At the end of the current year, a company reports that it earned revenues of $700,000 during this period of time. What information is being conveyed by this revenue figure?

(2A21) – Revenue reflects an increase in net assets that comes from selling a good or service. Therefore, this organization’s net assets grew by $700,000 because it sold goods or services for that amount during the current year. In simple terms, if a grocery store sells a pound of carrots for $3.00, it reports that it has earned revenue of $3.00.

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(2Q22) – An organization reports that it incurred total expenses of $400,000 during the current year. What is the meaning of that information? What is an expense?

(2A22) – Expenses are reductions (or outflows) of an organization’s net assets incurred in an attempt to generate revenue. Examples include rent expense, salary expense, and advertising expense. In each case, the cost is incurred because it is needed by the organization to earn revenue.

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(2Q23) – In general, what are the two ways that an organization can bring in more net assets, thus increasing the size of the organization? Remember that net assets is the figure found by subtracting liabilities from assets.

(2A23) – An organization increases the amount of its net assets by earning revenue (the sale of a good or service) or by issuing its ownership shares to owners in exchange for assets. This second inflow is referred to as contributed capital (or as capital stock). Therefore, an organization that wants to grow must earn revenues and/or receive contributed capital.

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(2Q24) - In general, what are the two ways that reductions occur in the net asset balance reported by an organization, thus decreasing the size of that organization?

(2A24) – The net assets of an organization are reduced if (a) an expense is incurred or (b) a dividend is distributed to the owners. Both events create decreases or outflows of net assets which make the organization smaller. A third possibility is that the organization can buy back an owner’s capital stock (known as a treasury stock transaction). The reporting of this event will be discussed later in the textbook.

19

(2Q25) – Revenues and contributed capital increase an organization’s net assets whereas expenses and dividends decrease net assets. What if an organization borrows $1 million? Does that transaction increase net assets? The company certainly has more cash, but what is the effect on net assets?

(2A25) – Borrowing money on a loan does NOT increase net assets. It does not make the company larger. Assets (cash) do go up by $1 million but liabilities (notes payable) also go up by the same $1 million. As a result the net asset figure (assets minus liabilities) stays the same. The two increases offset each other.

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(2Q26) – Revenues and contributed capital increase an organization’s net assets whereas expenses and dividends decrease net assets. You are learning to gauge the impact of a transaction. What if a company pays $1 million in cash to buy a new building? Does that transaction increase net assets? The company certainly has obtained a large new building.

(2A26) – Acquiring a new building for cash does not change an organization’s net assets. It does not cause the company to become larger. One asset (building) increases by $1 million. At the same time, another asset (cash) goes down by $1 million. The total asset figure has not changed and net assets remain the same. One asset has been exchanged for another. The increase and the decrease offset each other.

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Near the end of the section “Definition of the Term 'Expense',” you will find a video titled, What do these five important accounting terms mean? Watch this video to make sure you have developed a strong understanding of these essential terms found in accounting and in the world of business.

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22

In Section Four of Chapter Two (“Four Essential Terms Encountered in Financial Accounting”), you will find numerous Test Yourself questions that provide you with the opportunity to practice using these essential terms (assets, liabilities, revenues, and expenses). In accounting, practice always helps. Work each one and then carefully read the explanations especially if you were not sure of an answer.

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23

There is a lot of interesting terminology in this chapter: presents fairly, material misstatements, U.S. GAAP, IFRS, FASB, uncertainty, asset, liability, net assets, revenue, and expense. For review purposes, make a list of the five things in the chapter that you felt were most important. Then, go to the end of Chapter Two and watch the video titled, “The Most Important Elements of Chapter Two.”

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