Environmental and Theoretical Structure of Financial Accounting

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Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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Learning Objectives

Describe the function and primary focus of financial accounting.

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Financial Accounting Environment

Providers of Financial Information External User Groups

Profit-oriented companies Not-for-profit entities Households

Relevant

Financial Information

Investors Creditors Employees Labor unions Customers Suppliers Government agencies Financial intermediaries

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Financial Accounting Environment

Relevant financial information is provided primarily through financial statements and related disclosure notes.
Balance Sheet Income Statement Statement of Cash Flows Statement of Shareholders Equity

The Economic Environment and Financial Reporting

A sole proprietorship is owned by a single individual. A partnership is owned by two or more individuals. A corporation is owned by stockholders, frequently numbering in the tens of thousands in large corporations.

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A highly-developed system of financial reporting is necessary to communicate financial information from a corporation to its many shareholders.

Investment-Credit Decisions
A Cash Flow Perspective

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Corporate shareholders receive cash from their investments through . . .

Periodic dividend distributions from the corporation. The ultimate sale of the ownership shares of stock.

Investment-Credit Decisions
A Cash Flow Perspective

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Accounting information should help investors evaluate the amount, timing, and uncertainty of the enterprises future cash flows.

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Learning Objectives

Explain the difference between cash and accrual accounting.

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Cash Versus Accrual Accounting

Cash Basis Accounting
Revenue is recognized when cash is received. Expenses are recognized when cash is paid.

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Cash Versus Accrual Accounting

Cash Basis Accounting
Carter Company has sales on account totaling $100,000 per year for three years. Carter collected $50,000 in the first year and $125,000 in the second and third years. The company prepaid $60,000 for three years rent in the first year. Utilities are $10,000 per year, but in the first year only $5,000 was paid. Payments to employees are $50,000 per year. Lets look at the cash flows.

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Cash Versus Accrual Accounting

Cash Basis Accounting
Year 1 Cash receipts from customers $ 50,000 Payment of 3 years' rent Salaries to employees Payments for utilities Net cash flow (60,000) (50,000) (5,000) $ (65,000) Summary of Cash Flows Year 2 Year 3 $ 125,000 (50,000) (15,000) $ 60,000 $ 125,000 (50,000) (10,000) $ 65,000 Total $ 300,000 (60,000) (150,000) (30,000) $ 60,000

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Cash Versus Accrual Accounting

Cash Basis Accounting
Year 1 Cash receipts from customers $ 50,000 Payment of 3 years' rent (60,000) Summary of Cash Flows Year 2 Year 3 $ 125,000 $ 125,000 Total $ 300,000 (60,000)

Salaries to Cash flows in any one year may not be a (150,000) employees (50,000) (50,000) (50,000) Payments for utilities Net cash flow

predictor of future cash flows.

(5,000) $ (65,000) (15,000) $ 60,000 (10,000) $ 65,000 (30,000) $ 60,000

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Cash Versus Accrual Accounting

Accrual Accounting
Revenue is recognized when earned. Expenses are recognized when incurred. Lets reconsider the Carter Company information.

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Cash Versus Accrual Accounting

Accrual Accounting
Revenue is recognized when earned. Expenses are recognized when incurred. Lets reconsider the Carter Company information.

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Learning Objectives

Define generally accepted accounting principles (GAAP) and discuss the historical development of accounting standards.

The Development of Financial Accounting and Reporting Standards

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Concepts, principles, and procedures were developed to meet the needs of external users (GAAP).

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Historical Perspective and Standards

Securities and Exchange Commission
1934 present

Evolution of Standard-Setting Process

1938 1959:
Committee on Accounting Procedures (CAP)

1959 1973:
Accounting Principles Board (APB)

Current Standard Setting - FASB

www.fasb.org
p Supported by the Financial Accounting

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Foundation.
p Seven full-time, independent voting members

serving for 10 years.

p Answerable only to the Financial Accounting

Foundation.
p Members not required to be CPAs.

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Learning Objectives

Explain why the establishment of accounting standards is characterized as a political process.

Establishment of Accounting Standards

A Political Process

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Internal Revenue Service www.irs.gov American Institute of CPAs www.aicpa.org Securities and Exchange Commission www.sec.gov

Financial Executives International www.fei.org Governmental Accounting Standards Board www.gasb.org American Accounting Association www.aaa-edu.org

GAAP

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FASBs Standard-Setting Process

Identification of problem. The task force. Research and analysis. Discussion memorandum. Public response. Exposure draft. Public response. Statement issued.

International Accounting Standards Board (IASB)

p Established in 1973 to narrow the

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range of differences in accounting standards. p Increase in international trade has motivated the IASB to attempt to eliminate alternative accounting treatments.

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Role of the Auditor

Independent intermediary to help insure that management has in fact appropriately applied GAAP.

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Financial Reporting Reform

As a result of numerous financial scandals, Congress passed the Public Company Accounting Reform and Investor Protection Act of 2002, commonly referred to as the 2002 Sarbanes-Oxley Act for the two congressmen who sponsored the bill.

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Learning Objectives

Explain the purpose of the FASBs conceptual framework.

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The Conceptual Framework

p Maintain consistency among standards. p Resolve new accounting problems. p Provide user benefits.

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Learning Objectives
Identify the objectives of financial reporting, the qualitative characteristics of accounting information, and the elements of financial statements.

Describe the four basic assumptions underlying GAAP

Describe the four basic accounting principles that guide accounting practice.

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The Conceptual Framework

Objectives of Financial Reporting

(SFAC No. 1)

Qualitative Characteristics of Accounting Information

(SFAC No. 2)

Elements of Financial Statements

(SFAC No. 6)

Recognition and Measurement Criteria

(SFAC No. 5)

Environment assumptions

Implementation principles

Implementation constraints

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Conceptual Framework Objectives To provide information: Useful for investor and creditor decisions. That helps predict cash flows. About economic resources, claims to resources, and changes in resources and claims.

Qualitative Characteristics

Elements

Recognition and Measurement Concepts

Constraints

Financial Statements

Continued

Objectives
Qualitative Characteristics
Understandability Primary Relevance Reliability Secondary Comparability Consistency

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Elements
Assets Liabilities Equity Investments by Owners Distributions to owners Revenues Expenses Gains Losses Comprehensive Income

Recognition and Measurement Concepts

Assumptions Economic entity Going concern Periodicity Monetary unit Principles Historical cost Realization Matching Full Disclosure

Financial Statements Constraints

Cost effectiveness Materiality Conservatism Balance sheet Income statement Statement of cash flows Statement of shareholders equity Related disclosures

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Qualitative Characteristics of Accounting Information

Decision Usefulness

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Relevance

Reliability

Predictive Value

Feedback Value

Timeliness

Verifiability

Neutrality

Representational Faithfulness

Comparability

Consistency

Practical Constraints to Achieving Desired Qualitative Characteristics

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Conservatism

Cost Effectiveness

Materiality

SFAC No. 6
Assets and Liabilities Assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. Liabilities are probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer or provide services to other entities in the future as a result of past transactions or events.

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SFAC No. 6
Equity

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Equity, or net assets, called shareholders equity or stockholders equity for a corporation, is the residual interest in the assets of an entity that remains after deducting liabilities.

SFAC No. 6
Investments and Distributions

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Investments by owners are increases in equity resulting from transfers of resources (usually cash) to a company in exchange for ownership interest. Distributions to owners are decreases in equity resulting from transfers to the owners.

SFAC No. 6
Revenues

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Revenues are inflows or other enhancements of assets or settlements of liabilities from delivering or producing goods, rendering services, or other activities that constitute the entitys ongoing major, or central, operations.

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SFAC No. 6
Expenses

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Expenses are outflows or other using up of assets or incurrences of liabilities during a period from delivering or producing goods, rendering services, or other activities that constitute the entitys ongoing major, or central, operations.

SFAC No. 6
Gains and Losses

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Gains are increases in equity peripheral, or incidental, transactions of an entity. Losses represent decreases in equity arising from peripheral, or incidental, transactions of an entity.

SFAC No. 6
Comprehensive Income Comprehensive income is the change in equity of a business enterprise during a period from transactions and other events and circumstances from nonowner sources. It includes all changes in equity during a period except those resulting from investments from owners and distributions to owners.

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Recognition and Measurement Concepts

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Question
The function of financial accounting is to identify, measure and communicate financial information about economic entities to interested parties. a. True b. False

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Question
The function of financial accounting is to identify, measure and communicate financial information about economic entities to interested parties. a. True b. False

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Question
Accrual accounting provides a better indication of ability to generate cash flows than does information limited to the financial effects of cash receipts and cash payments. a. True b. False

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Question
Accrual accounting provides a better indication of ability to generate cash flows than does information limited to the financial effects of cash receipts and cash payments. a. True b. False

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Question
The primary objective of accrual basis accounting is the measurement of income. a. True b. False

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Question
The primary objective of accrual basis accounting is the measurement of income. a. True b. False

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Question
Generally accepted accounting principles include both standards set by various rule making bodies and certain accounting practices that have evolved over time. a. True b. False

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Question
Generally accepted accounting principles include both standards set by various rule making bodies and certain accounting practices that have evolved over time. a. True b. False

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Question
The major financial accounting standard setting body is the a. b. c. d. Accounting Principles Board Securities and Exchange Commission Financial Accounting Standards Board American Institute of CPAs

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Question
The major financial accounting standard setting body is the a. b. c. d. Accounting Principles Board Securities and Exchange Commission Financial Accounting Standards Board American Institute of CPAs

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Question
The FASB issues which of the following types of pronouncements? a. b. c. d. e. Standards Interpretations Financial Accounting Concepts Technical Bulletins All of the above

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Question
The FASB issues which of the following types of pronouncements? a. b. c. d. e. Standards Interpretations Financial Accounting Concepts Technical Bulletins All of the above

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Question
The Financial Accounting Standards Board develops accounting and reporting standards independent of public, business and political pressures. a. True b. False

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Question
The Financial Accounting Standards Board develops accounting and reporting standards independent of public, business and political pressures. a. True b. False

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Ethics in Accounting
p To be useful, accounting information must be

objective and reliable.

p Management may be under pressure to report

desired results and ignore or bend existing rules.

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Model for Ethical Decisions

Determine the facts of the situation. Identify the ethical issue and the stakeholders. Identify the values related to the situation. Specify the alternative courses of action. Evaluate the courses of action. Identify the consequences of each course of action. Make your decision and take any indicated action.

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End of Chapter 1

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