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Ch. 1 Environment and Theoretical Structure of Financial Accounting
I. General Info
A. Definitions of accounting
1. Accounting is used to identify, measure, and communicate financial information about economic entities
(businesses) to interested parties.
2. Accounting is an information system that measures business activity, processes the information into reports,
and communicates the results to decision makers.
3. Accounting is the “language of business.”
2. Managerial accounting
a. Managerial accounting is the process of identifying, measuring, analyzing, and communicating financial
information needed by management to plan, control, and evaluate a company's operations.
b. Internal use: It is concerned with providing information to managers—that is, people inside an organization
who direct and control a firm’s operations.
c. May or may not follow GAAP- b/c only the management is using it
d. Taught in Intro to Fin Acct (Mgmt 1B), and Management/Cost Acct (Mgmt 122)
3. Other types of accounting include tax accounting, governmental accounting, etc.
C. Financial statements
1. A company communicates its financial information to those outside of the company primarily through
financial statements.
2. Provides information about a company in monetary terms.
3. 5 Key Financial Statements
a. Balance Sheet (aka Statement of Financial Position)
b. Income Statement (aka Profit and Loss Statement or Statement of Operations)
c. Statement of Cash Flows
d. Statement of Owners' Equity or Statement of Stockholders' Equity (aka Statement of Stockholders' Equity)
e. Statement of Comprehensive Income
4. Note some financial information is disclosed outside of the formal financial statements. Examples include…
a. President's letter or supplementary schedules in the corporate annual report
b. Prospectuses
c. Reports filed with government agencies
d. News releases
e. Management's forecasts
f. Social or environmental impact statements
B. Note
Although the focus is on providing info for primary users (investors and creditors), this information may also be
helpful to other users of financial reporting such as government agencies, management, unions, etc.
6. From 1939-1959, the APB issued 31 APB Opinions. APB Opinions are pronouncements (statements,
standards, interpretations and other financial reporting guidelines) that were intended to be based mainly on
research studies and supported by reasons and analysis.
7. The APB was dissolved in 1973 because it:
a. Lacked of productivity and failed to act promptly to accounting abuses
b. Faced opposition from industry and CPA firms when it tackled thorny accounting issues
c. Occasionally ran into governmental interference
8. In 1971, the accounting profession's leaders appointed a Study Group on Establishment of Accounting
Principles (known as the Wheat Committee) to examine the APB and determine the necessary changes to attain
better results. As a result, the APB was replaced with the Financial Accounting Standards Board (FASB) in
1973. More specifically, this resulted in the creation of 3 organizations to set standards.
a. Financial Accounting Foundation (FAF)- Private Sector
i. Selects the members of the FASB and the Advisory Council
ii. Funds their activities
iii. Oversee the FASB's activities.
b. Financial Accounting Standards Advisory Council (FASAC)- Private Sector
i. Consults with the FASB on major policy and technical issues.
ii. Helps select task force members for FASB.
c. Financial Accounting Standards Board (FASB)- which replaced the APB.
2. Consists of
a. Reps from CPA firms
b. Financial statement preparers
c. Observers from the SEC and AICPA also attend task force meetings
3. Its purpose was to reach a quick consensus on how to account for new and unusual financial transactions that
may potentially create differing financial reporting practices (i.e. accounting for pension plan termination,
revenue from barter transactions from Internet companies, excessive amounts paid to takeover specialists,
reporting of losses from the 9/11 terrorist attack, etc.)
5. FASB tends to work on long-term accounting problems while the EITF deals with short-term emerging
issues.
6. The EITF was designed to minimize the need for the FASB to spend time and effort addressing narrow
implementation, application, or other emerging issues that can be analyzed within existing GAAP.
8. The SEC views all consensus solutions as preferred accounting. It requires persuasive justification for
departing from them.
IV. Sarbanes-Oxley Act
A. In 2002, the Sarbanes-Oxley Act was passed by Congress as a result of the various accounting scandals at
companies like Enron, Cendant, Sunbeam, Rite-Aid, Xerox, and WorldCom.
B. This law
1. Increased the resources to the SEC to combat fraud and poor reporting practices.
2. Changed new auditor independence rules and materiality guidelines for financial reporting.
3. Affected the institutional structure of the accounting profession.
2. Implemented stronger independence rules for auditors. For example, audit partners are required to rotate
every 5 years, and auditors are prohibited from offering certain types of consulting services to corporate clients.
3. Requires CEO’s and CFO’s to personally certify that financial statements and disclosures are accurate and
compete
4. Requires CEO’s and CFO’s to forfeit bonuses and profits when there is an accounting restatement.
5. Requires audit committees to be made of independent members and member with financial expertise.
C. 4 out the 7 board members need to vote in favor of new FASB guidance/pronouncements before it is passed
of in the form of an Accounting Standards Update.
E. All ARBs and APB Opinions implemented prior to the formation of FASB continue to be in effect until it is
amended or superseded by FASB pronouncements.
2. As you can see, these documents that made up GAAP varied in format, completeness, and structure. In some
cases, these documents were inconsistent and difficult to interpret. As a result, financial statement preparers
sometimes were not sure whether they had the right GAAP. Determining what was authoritative and what was
not became difficult.
Subtopics Go to FASB ASC 310-10 to access the Overall Subtopic of the Topic 310.
Sections Go to FASB ASC 310-10-35 to access the Subsequent Measurement Section of the Subtopic 310-10.
Go to FASB ASC 310-10-35-47 to access the Loans and Trade Receivables not Held for Sale paragraph of
Paragraph
Section 310-10-35.
C. Note:
1. U.S. companies that list overseas are still permitted to use GAAP, and foreign companies listed on U.S.
exchanges are permitted to use IFRS.
2. There are many similarities between GAAP and IFRS.
B. People often encounter ethical dilemmas in accounting. Unfortunately, technical competence is not enough
when encountering ethical decisions, and there is no comprehensive ethical system to provide guidelines. Time,
job, client, personal, and peer pressures can complicate the process of ethical decision making.
1. Companies that concentrate on “maximizing the bottom line,” “facing the challenges of competition,” and
“stressing short-term results” place accountants in an environment of conflict and pressure.
2. Questions such as, “Is this way of communicating financial information good or bad?” “Is it right or
wrong?” and “What should I do in this circumstance?” cannot always be answered by simply following GAAP
or the rules of the profession.
3. Doing the right thing is not always easy or obvious. The pressures “to bend the rules,” “to play the game,” or
“to just ignore it” can be considerable. For example, “Will my decision affect my job performance negatively?”
“Will my superiors be upset?” and “Will my colleagues be unhappy with me?” are often questions business
people face in making a tough ethical decision.
Conceptual Framework
I. General Info
A. In 1976, the FASB began to develop a conceptual framework that would be a basis for setting accounting
rules and for resolving financial reporting controversies.
B. This is the foundation of the conceptual framework as it identifies the purpose of financial reporting.
The 2nd level of the conceptual framework are fundamental concepts that consists of 2 parts qualitative
characteristics AND elements. It bridges the why of accounting (the objective) with the how of accounting
(recognition, measurement, and disclosure concepts).
II. Qualitative Characteristics
A. General Info
1. Qualitative characteristics are meant to enhance decision-usefulness
a. States the characteristics that make accounting information useful
b. Helps distinguish better (more useful) information from inferior (less useful) information for decision-
making purposes.
c. Note
Providing useful financial information is limited by a cost constraint on financial reporting. Basically, cost
should not exceed the benefits of a reporting practice.
2. Depending on how they affect the decision usefulness of information, qualitative characteristics are either
a. Fundamental qualities OR
b. Enhancing qualities
5. The hierarchy of qualitative characteristics.
B. Fundamental Qualities (that make accounting info useful for decision making)
1. Relevance- info must make a difference in decision making. Financial information is capable of making a
difference when it has the following 3 ingredients.
a. Predictive value- info must help users predict future events
Example:
If potential investors are interested in purchasing stocks in United Parcel Service, they may analyze its balance
sheet, its dividend payments, and its income statement to predict the amount, timing, and uncertainty of the
company future cash flows.
b. Confirmatory value- info must help users confirm or change past (or present) expectations.
For Company A, it appears to be immaterial because the amount is only 2% (20,000/1,000,000) of its income
from operations. On the other hand, Company B had an unusual loss of only $5,000. However, it is relatively
much more significant because $5,000 amounts to 50% (5,000/10,000) of its income from operations.
b. Neutrality- info must be unbiased, cannot have info that shows favoritism.
Example: R.J. Reynolds (a tobacco company) should not suppress information in the notes to financial
statements about the numerous lawsuits that have been filed because of tobacco-related health concerns—even
though such disclosure is damaging to the company.
Conservatism
i. In cases of uncertainty, many accountants practice conservatism in accounting treatments. This means that
accountants require greater verification before recognizing good news than bad news.
ii. As a result losses are reflected in net income more quickly than are gains AND net assets tend to be
understated instead of overstated.
iii. Example: The lower-of-cost-or-market method is used for measuring inventory.
iv. Note the conceptual framework does not include conservatism because it is biased and inconsistent with
neutrality (undermining representational faithfulness). Even so, it is likely to continue as an important
consideration.
C. Enhancing Qualities (qualities that make accounting info even more useful)
1. Comparability
a. Info would be better if it were measured and reported in a similar manner. Users could then compare it with
similar info from another company.
b. Another type of comparability is consistency. This is when companies consistently use the same accounting
standards from period to period.
c. Example: The accounting for pensions in Japan differed historically from that in the U.S. In Japan,
companies generally recorded little or no charge to income for these costs. U.S. companies recorded pension
cost as incurred. As a result, it is difficult to compare and evaluate the financial results of Toyota or Honda to
General Motors or Ford. Investors can only make valid evaluations if comparable information is available.
2. Verifiability- independent measurers, using the same methods, can obtain similar conclusions on the info.
Example: Two auditors count PepsiCo's inventory and arrive at the same physical quantity amount for
inventory.
3. Timeliness- info must be useful to users before it loses its value in the decision-making process.
Example: If Dell waited to report its interim results until 9 months after the period, the information would be
much less useful for decision-making purposes.
4. Understandability
a. Info must be presented clearly to users so that they can see its significance.
b. Note users of financial reports are assumed to have a reasonable knowledge of business and economic
activities.
B. Assumptions
1. Economic Entity Assumption (aka Separate Entity Assumption or Business Entity Concept)
a. The concept that an organization or a section of an organization that, for accounting purposes, stands apart
from other organizations, and individuals as a separate entity
b. Assumes a company keeps its activity separate from its owners and other business units
c. Example
Assume when Bill Gates started Microsoft on his own, he borrowed $100,000 from Wells Fargo. Following the
economic entity assumption, Bill would account for the $100,000 separately from his personal assets (his house,
his clothes, his car, etc.) To mix the $100,000 of Microsoft cash with his personal assets would make it difficult
to measure the financial position of Microsoft.
C. Principles of Accounting
1. Measurement Principle
a. GAAP has 5 measurement attributes
- Historical cost
- Fair value (aka fair market value or market value).
- Net realizable value
- Current cost
- Present (or discounted) value of future cash flows
The 2 most commonly used are historical cost and fair value, which we will discuss further below.
Example #2
Boeing Corporation signs a contract to sell airplanes to Delta Air Lines for $100 million. To determine when to
recognize revenue, Boeing uses the 5 steps shown below.
The 5 Steps of Revenue Recognition