Lecture 6 - Accounting Conventions

Review of the Accounting Cycle
In the last step of the cycle, prepare the financial statements.
Prepare Income Statement first, Statement of Retained Earnings and finally the Balance Sheet.
We’ll cover the Statement of Cash Flows at the end of the course.

Accounting Conventions
Comparability
Financial statements should be comparable from one period to the next and between different companies. Must go out of your way to disclose ways in which they are not comparable – in footnotes and in Auditors’ Opinion.
Financial statements should facilitate comparisons among firms and period to periods comparisons of the same firm.
Consistency
Use the same methods to become comparable. Financial statements should be prepared on a consistent basis to facilitate comparisons. Inconsistencies in the method of preparation should be highlighted.
Materiality
Is it worth our time, effort and money to get the data right down to the last cent? Historically, if it has less than 5% effect on net income, it was considered immaterial. However, lately, this has become insufficient. Enron was an example where several immaterial dollar amounts added up to something that would effect investors and creditors.
In deciding the level of detail to examine and disclose, accountants should take into account whether the detail is likely to affect decision makers.
Conservatism
When in doubt, accountants tend to choose Underestimate income and underestimate net carry value of assets.
Germany is ultra-conservative in this regard due to smaller capital markets and funding being provided primarily by banks.
Full Disclosure
Accountants should attempt to fully disclose all information needed to understand the financial statements.
Cost-Benefit

Balance Sheet Categories
Current Assets
There’s a sub-total called “current assets”. Then all other assets are listed, but not subtotaled and then a grand total of all assets is listed.
Current assets: Cash and assets that are expected to be converted into cash, sold or consumed during the next year or operating cycle, whichever is longer. Typically, a year is longer.

What is the Operating Cycle?
Cash -> Inventory -> Receivables -> back to Cash

Typical current assets:
Cash, account and notes receivables (including installment payments – even if no payments are to be received for more than a year), some investments, inventory, prepayments (usually consumed within the next year)

Investments
Property held as an investment, as opposed to used in the trade or business. Parking lot next door is not an investment.

Property, Plant and Expenses
These are long-lived assets, except for land.
On books at cost and depreciated over their typical life.
Use the Accumulated Depreciation account.
Land is put on the books at cost and not depreciated.

Intangibles
These are long-lived assets without a traditional physical existence, such as patents, franchises, trademarks, etc.

Liabilities

Current liabilities – those that will be satisfied within the next year or operating cycle, whichever is longer.

Long-Term Liabilities
Ex: a long term note which is paid off over more than a year. The portion that will be paid within the current year goes into Current Liabilities.

Owners’ Equity
Contributed capital: Common Stock, Excess over Par, Preferred Stock
Earned capital: Retained Earnings.

Income Statement Categories
Can be either single-step or multi-step statement.
Usually says margin, not “profit”. Groceries stores still use the term profit.
Multi-step:
Sales-COGS = Gross Profit
Gross Profit – Operating Expenses = Net Operating Income
Net Operating Income – Non-Operating Items = Net Income before taxes
Single Step:
List and total all revenues and then list and total all expenses. Net Income before taxes = Revenue – Expenses