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Chapter 1 Environment and Theoretical Structure of Financial Accounting Primary Focus of Financial Accounting Providing financial information to various external users Investors Creditors Other external users Investors & creditors To predict the future risk and potential return of investments or loans Before supplying capital to businesses Use different kinds of information LO1-1 Financial information is a key component of that information set Financial Accounting Financial information is conveyed through financial statements and related disclosure notes Balance sheet Income statement Statement of cash flows Statement of shareholders equity Financial Reporting Refers to the process of providing financial information to external users LO1-1 Financial Information Providers and External User Groups LO1-1 The Economic Environment and Financial Reporting Capital markets provide a mechanism to help the economy allocate resources efficiently Initial market transactions involve issuance of stocks and bonds by the corporation Corporations receive new cash Secondary market transactions involve the transfer of stocks and bonds between individuals and institutions Corporations receive no new cash Corporations acquire capital from investors in exchange for ownership interest and from creditors by borrowing LO1-1 The Investment-Credit Decision A Cash Flow Perspective Why do investors and creditors provide capital? They want to earn a fair return on the resources they provide Shareholders receive cash from: Sale of the ownership shares of stock Periodic dividends Key variables in investment decision Rate of return Uncertainty or risk LO1-1 The Investment-Credit Decision A Cash Flow Perspective Example calculation of rate of return: If an investor provides a company with $10,000 cash by purchasing stock at the end of 2015, receives $400 in dividends from the company during 2016, and sells the ownership interest (shares) at the end of 2016 for $10,600. Investors and creditors like to invest in stocks or bonds that provide a high expected rate of return $400 dividends + $600 share price appreciation $10,000 initial investment 10% LO1-1 = Concept Check Creecher purchased $200,000 worth of Troman stock, received four quarterly dividends of $1,000 each, and sold the Troman shares for $206,000 after one year. What is Creechers rate of return? a.1%. b.2.5%. c.5%. d.10%. ((4 x $1,000) + ($206,000 - $200,000)) $200,000 = 5% The Investment-Credit Decision A Cash Flow Perspective Example of uncertainty (risk): consider the following two investment options. Which would you pick? Investing $10,000 in a savings account insured by the U.S. government that will generate a 5% rate of return Investing $10,000 in a profit-oriented company Risk/Return tradeoff: Most investors would invest in the profit-oriented company only if the potential return is high enough. LO1-1 The Investment-Credit Decision A Cash Flow Perspective Primary objective of financial accounting Provided information should be useful for decision making Information should help investors and creditors evaluate Amounts Timing Uncertainty LO1-1 Cash versus Accrual Accounting Cash Basis Accounting Measurement of cash receipts and cash payments from transactions related to providing goods and service Difference is net operating cash flow Accrual Basis Accounting Measurement of revenues and expenses, regardless of when cash is received or paid Difference is net income or net loss LO1-2 Example of Cash Basis Accounting LO1-2 Example of Accrual Accounting Concept Check Which of the following is not an advantage of accrual accounting? a.Spreads out the influence of one-time events that affect multiple reporting periods. b.Highlights cash effects of operations. c.Captures long-run performance. d.Recognizes assets and liabilities associated with receivables and payables. Cash-based accounting focuses on cash in and cash out, and so highlights the cash effects of ongoing operations. The Development of Financial Accounting and Reporting Standards LO1-3 Generally Accepted Accounting Principles (GAAP) GAAP is a set of both broad and specific guidelines that companies should follow when measuring and reporting the information in their financial statements and related notes GAAP is set by standard setters but also emerges from practice GAAP facilitates decision making by investors and creditors by helping them understand information and enhancing the comparability of that information among companies Accounting Standard Setting LO1-3 Congress SEC Private Sector CAPAPBFASB 1938 Present HIERARCHY OF STANDARD-SETTING AUTHORITY Historical Perspective and Standards Securities and Exchange Commission (SEC) Created by Congress in response to the stock market crash of 1929 Goal: To restore investor confidence 1933 Securities Act Applies to initial offerings of securities (stocks and bonds) 1934 Securities Exchange Act Applies to secondary market transactions Mandates reporting requirements for companies whose securities are publicly traded LO1-3 Early U.S. Standard Setting Committee on Accounting Procedure (CAP) (1938 to 1959) First private sector standard-setting body Committee of the American Institute of Accountants(AIA) AIA: National professional organization for certified professional public accountants AIA: Renamed as American Institute of Certified Public Accountants (AICPA) Issued 51 Accounting Research Bulletins (ARBs) Accounting Principles Board (APB) (1959 to 1973) Issued 31 Accounting Principles Board Opinions (APBOs), various Interpretations, and four Statements Replaced by Financial Accounting Standards Board (FASB) LO1-3 Financial Accounting Standards Board (FASB) FASB created in 1973 Established to set U.S. accounting standards Supported by Financial Accounting Foundation (FAF) Seven full-time members Emerging Issues Task Force (EITF) created in 1984 Identifies financial reporting issues and attempts to resolve them without involving the FASB primarily addresses implementation issues speeding up the standard-setting process EITF rulings are ratified by the FASB and are considered part of GAAP Government Accounting Standards Board (GASB): develop accounting standards for governmental units such as states and cities. LO1-3 Concept Check Accounting standards in the United States are currently set by: a.The FASB. b.The AICPA. c.The EITF. d.The NCAA. Since 1973, the FASB has been the primary standard-setting body in the United States. Codification FASB Accounting Standards Codification Only source of authoritative nongovernmental U.S. GAAP Organizes the thousands of U.S. GAAP pronouncements into roughly 90 accounting topics Also includes portions of SEC accounting guidance Accounting Standards Update (ASU): any new standard issued by FASB LO1-3 (www.fasb.org) FASB Accounting Standards Codification Topics LO1-3 International Standard Setting International Accounting Standards Committee (IASC) Formed in 1973 to develop global accounting standards Created a new standard-setting body called the International Accounting Standards Board (IASB) (2001) IASB: To develop a single set of high-quality, understandable, and enforceable global accounting standards Issued and endorsed 41 International Accounting Standards (IASs) Issued new standards of its owncalled International Financial Reporting Standards (IFRSs) LO1-3 Comparison of Organizations of U.S. and International Standard Setters LO1-3 Efforts to Converge U.S. And International Standards LO1-3 U.S. GAAP IFRS Converged Standards Efforts to Converge U.S. And International Standards LO1-3 September 2002: FASB and IASB signed the Norwalk Agreement pledging to remove existing differences between their standards and to coordinate their future standard-setting agendas December 2007: The SEC signalled its view that IFRS are of high quality by removing reconciliation requirements April 2008: FASB and IASB agreed to accelerate the convergence process and focus on a subset of key convergence projects Efforts to Converge U.S. And International Standards LO1-3 November 2008: SEC issued a Roadmap that listed necessary conditions to be achieved before the U.S. will shift to requiring use of IFRS by public companies November 2011: The SEC issued two studies identified key differences between U.S. GAAP and IFRS and analyzed how IFRS are applied globally July 2012: The SEC staff issued its Final Staff Report Concluded it is not feasible for the U.S. to adopt IFRS due to: need for the U.S. to have stronger influence on the standard-setting process high costs to companies of converting to IFRS the fact that many laws, regulations and private contracts reference U.S. GAAP The FASBs Standard-Setting Process LO1-4 Examples of Politics in Standard Setting LO1-4 Mid-1990saccounting for employee stock options Accounting for business combinations Implementation of the fair value accounting standard issued in 2007 Encouraging High-Quality Financial Reporting LO1-5 Role of an Auditor Offer credibility to financial statements Express an opinion on the compliance of financial statements with GAAP Licensed by states to provide audit services Certified public accountants (CPAs) Financial Reporting Reform LO1-5 EnronWorldComXeroxMerck Adelphia Communications Accounting scandals Sarbanes-Oxley Act Increased the pressure on lawmakers to pass measures that would restore credibility and investor confidence in the financial reporting process Sarbanes-Oxley Act LO1-5 Oversight board Corporate executive accountability Nonaudit services Retention of work papers Auditor rotation Conflicts of interest Hiring of auditor Internal control A principles-based, or objectives-oriented, approach to standard-setting stresses professional judgment, as opposed to following a list of rules Regardless, poor ethical values on the part of management are at the heart of accounting abuses and scandals A Move Away from Rules-Based Standards? vs.Principles-based Rules-based Objectives-oriented LO1-5 Ethics and Professionalism LO1-5 Ethics deals with the ability to distinguish right from wrong Codes of ethics are provided by: American Institute of Certified Public Accountants (AICPA) Institute of Management Accountants (IMA) Institute of Internal Auditors (IIA) Analytical Model for Ethical Decisions LO1-5 Step 1. Determine the facts of the situation Step 2. Identify the ethical issue and the stakeholders Step 3. Identify the values related to the situation Step 4. Specify the alternative courses of action Step 5. Evaluate the courses of action specified in step 4 in terms of their consistency with the values identified in step 3 Step 6. Identify the consequences of each possible course of action Step 7. Make your decision and take any indicated action Concept Check Which of the following is not one of the ways in which high-quality accounting is encouraged by the U.S. financial reporting system? a.Accounting standards encourage comparability. b.Auditors assess whether financial statements are materially misstated. c.Sarbanes-Oxley instituted reforms designed to improve the quality of financial reporting. d.Managers are required to use frameworks for ethical decision making when deciding how to account for transactions. Ethical frameworks can be very useful, but managers are not required to use them. The Conceptual Framework LO1-6 Described as an Accounting Constitution Provides an underlying foundation for accounting standards Guide the selection of events to be accounted for Measurement of those events Means of summarizing and communicating them to interested parties Provides structure and direction to financial accounting and reporting Disseminated by FASB through Statements of Financial Accounting Concepts (SFACs) The Conceptual Framework Elements Recognition and Measurement Concepts Constraints Qualitative Characteristics Financial Statements Objective The Conceptual Framework Elements Recognition and Measurement Concepts Constraints Qualitative Characteristics Financial Statements Objective Hierarchy of Qualitative Characteristics of Financial Information LO1-7 Decision usefulness RelevanceFaithful Representation Predictive Value Confirmatory value Materiality CompletenessNeutrality Free from error Comparability (Consistency) VerifiabilityTimelinessUnderstandability Cost effectiveness constraint (benefits exceed costs) Concept Check Which of the following is not a component of relevance as defined in the FASBs conceptual framework? a.Free from error. b.Materiality. c.Predictive value. d.Confirmatory value. Free from error is a component of faithful representation. Concept Check Which of the following is not a component of faithful representation as defined in the FASBs conceptual framework? a.Free from error. b.Neutrality. c.Understandability. d.Completeness. Understandability is an enhancing characteristic of decision usefulness. The Conceptual Framework Elements Recognition and Measurement Concepts Constraints Qualitative Characteristics Financial Statements Objective Elements of Financial Statements Assets Liabilities Equity (or net assets) Investments by owners Distributions to owners Comprehensive income Revenues Expenses Gains Losses LO1-7 Underlying Assumptions LO1-8 The economic entity assumption presumes that economic events can be identified specifically with an economic entity. The going concern assumption anticipates that a business entity will continue to operate indefinitely. The periodicity assumption allows the life of a company to be divided into artificial time periods to provide timely information. The monetary unit used in U.S. financial statements is the U.S. dollar. The Conceptual Framework Elements Recognition and Measurement Concepts Constraints Qualitative Characteristics Financial Statements Objective Recognition, Measurement, and Disclosure Concepts LO1-9 Recognition refers to the process of admitting information into the financial statements Measurement is the process of associating numerical amounts with the elements Disclosure refers to the process of including additional pertinent information in the financial statements and accompanying notes General Recognition Criteria Definition, Measurability, Relevance, and Reliability Revenue Recognition LO1-9 Revenue: Inflows of assets or settlements of liabilities resulting from providing a product or service to a customer FASB recently issued ASU No , which requires that we recognize revenue when goods or services are transferred to customers for the amount the company expects to be entitled to receive in exchange for those goods or services. Previously, revenue recognition was guided by the realization principle (two criteria) Earnings process is judged to be complete or virtually complete Reasonable certainty as to the collectibility of the asset to be received (usually cash) Expense Recognition LO1-9 Often matches revenues and expenses that arise from the same transactions or other events Four approaches: Based on an exact cause-and-effect relationship By associating an expense with the revenues recognized in a specific time period By a systematic and rational allocation to specific time periods In the period incurred, without regard to related revenue Measurement LO1-9 GAAP currently employs a mixed attribute measurement model. The five measurement attributes are: Historical cost: original transaction value adjusted for depreciation and amortization. Net realizable value: the amount of cash into which an asset is expected to be converted in the ordinary course of business Current cost: the cost that would be incurred to purchase or reproduce the asset. Present (or discounted) value: calculated by removing the time value of money from future cash flows Fair value: the price that would be received to sell assets or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Measurement LO1-9 Historical Cost: Original transaction value Bases measurements on the amount given or received in the exchange transactions For assets: Value of what is given in exchange (usually cash) for the asset at its initial acquisition For liabilities: Current cash equivalent received in exchange for assuming the liability Long-lived, revenue-producing assets (equipment): Adjusted subsequent to its initial measurement by recognizing depreciation or amortization Measurement LO1-9 Net Realizable Value Bases measurements on the amount of cash into which the asset or liability will be converted in the ordinary course of business Provides useful information to aid in the prediction of future cash flows Current Cost Some inventories are reported at their current replacement cost Present Value (SFAC 7) Bases measurement on future cash flows discounted for the time value of money Measurement LO1-9 Fair Value (called current market value originally in SFAC 5 ) Bases measurements on the price that would be received to sell assets or transfer liabilities in an orderly market transaction Fair value can be measured using: 1.Market approach: Valuation based on market information 2.Income approach: Estimates future amounts and then mathematically converts those amounts to a single present value 3.Cost approach: Estimates the amount that would be required to buy or construct an asset of similar quality and condition Concept Check Which of the following is not a measurement attribute defined in the FASBs conceptual framework? a.Net realizable value. b.Historical cost. c.List price. d.Fair value. List price is not a measurement attribute. Rather, it is whatever sales price a seller indicates (which might be negotiable or subject to discounts). Fair Value Hierarchy LO1-9 Concept Check Which of the following is not true? a.The fair value hierarchy reflects the subjectivity of inputs used to compute fair values. b.Level 1 of the fair value hierarchy refers to quoted market prices that can be directly observed. c.Level 3 of the fair value hierarchy refers to inputs that are not directly observable, and so must be based on the entitys own assumptions. d.Level 3 inputs are preferred to Level 2, which are preferred to Level 1. Level 1 inputs are most preferable because they are the least subjective. Level 3 inputs are the least preferable because they are based on the entitys own assumptions. Measurement LO1-9 Fair Value Option GAAP gives a company the option to report some financial assets and liabilities at fair value Provides companies a way to reduce volatility in reported earnings without having to comply with complex hedge accounting standards Helps to converge with international accounting standards Disclosure LO1-9 Full-disclosure principle: requires that the financial reports should include any information that could affect the decisions made by external users Such information can be disclosed in a variety of ways: Parenthetical comments or modifying comments Placed on the face of the financial statements Disclosure notes Convey additional insights Supplemental schedules and tables Report more detailed information than is shown in the primary financial statements Summary of Recognition, Measurement, and Disclosure Concepts LO1-9 Evolving GAAP Revenue/Expense Approach Emphasize principles for recognizing revenues and expenses, which determines amount and timing of recognition of assets and liabilities Asset/Liability Approach Recognize and measure the assets and liabilities that exist at a balance sheet date Recognize and measure the revenues, expenses, gains and losses needed to account for the changes in these assets and liabilities from the previous measurement date LO1-10 International Financial Reporting Standards LO1-11 Emphasizes that financial statements should provide a true and fair representation of the company Role of the conceptual framework IFRSU.S GAAP Primarily provides guidance to standard setters to help them develop high-quality standards Guides standard setting, but in addition it is supposed to provide a basis for practitioners to make accounting judgments Does not include an explicit requirement, but U.S. auditing standards require this consideration End of Chapter 1