mcgraw-hill /irwin© 2009 the mcgraw-hill companies, inc. environment and theoretical structure of...

McGraw-Hill /Irwin © 2009 The McGraw-Hill Companies, Inc.

ENVIRONMENT AND ENVIRONMENT AND THEORETICAL STRUCTURE THEORETICAL STRUCTURE OF FINANCIAL OF FINANCIAL ACCOUNTINGACCOUNTING

Chapter 1

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Financial Accounting EnvironmentFinancial Accounting Environment

Profit-orientedcompanies

Not-for-profitentities

Households

Providers ofFinancial

InformationExternal

User Groups

Investors

Creditors

Employees

Labor unions

Customers

Suppliers

Governmentagencies

Financialintermediaries

Relevant

FinancialInformation

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Financial Accounting EnvironmentFinancial 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

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The Economic EnvironmentThe Economic Environment and Financial Reporting and Financial Reporting

A sole proprietorshipis owned by a

single individual.

A sole proprietorshipis owned by a

single individual.

A partnership isowned by two ormore individuals.

A partnership isowned by two ormore individuals.

A corporation is ownedby stockholders,

frequently numberingin the tens of thousands

in large corporations.

A corporation is ownedby stockholders,

frequently numberingin the tens of thousands

in large corporations.

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

to its many shareholders.

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

to its many shareholders.

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Investment-Credit Decisions ─ Investment-Credit Decisions ─ A Cash Flow PerspectiveA Cash Flow Perspective

Corporate shareholders receive cash from their investments through . . .• Periodic dividend distributions from the

corporation.• The ultimate sale of the ownership shares of

stock.

Accounting information should help investors evaluate the amount, timing, and uncertainty

of the enterprise’s future cash flows.

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Cash Versus Accrual AccountingCash 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 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.

Let’s look at the cash flows.

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Cash Basis Accounting

Cash flows in any one year may notbe a predictor of future cash flows.

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Accrual AccountingRevenue is recognized when earned.

Expenses are recognized when incurred.

Let’s reconsider the CarterCompany information.

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Accrual Accounting◦Revenue is recognized when earned.

◦Expenses are recognized when incurred.◦

Let’s reconsider the CarterCompany information.


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The Development of Financial AccountingThe Development of Financial Accountingand Reporting Standardsand Reporting Standards

Concepts, principles, and

procedures weredeveloped to meet the

needs of external users (GAAP).

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Historical Perspective and StandardsHistorical Perspective and Standards

Securities and Exchange Commission (SEC) 1934 – present

Evolution of Standard-Setting Process 1938 – 1959:

Committee on Accounting Procedure (CAP) 1959 – 1973:

Accounting Principles Board (APB)

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Current Standard Setting - FASBCurrent Standard Setting - FASBwww.fasb.orgwww.fasb.org

Supported by the Financial Accounting Foundation.

Seven full-time, independent voting members serving for 10 years.

Answerable only to the Financial Accounting Foundation.

Members not required to be CPAs.

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Hierarchy of GAAPHierarchy of GAAPFASB Statements of Financial Accounting Standards,

FASB Interpretations, SEC rules and interpretivereleases, AICPA Accounting Research Bulletins,

Accounting Principles Board Opinions

FASB Technical Bulletins, AICPA Industry Audit and Accounting Guides and Statements of Position

AICPA Accounting Standards Executive Committee Practice Bulletins

FASB Implementation Guides, AICPA Accounting Interpretations, AICPA Industry Audit and Accounting

Guides and Statements of Position, and widelyrecognized general or industry practices.

Most Authoritative

Least Authoritative

An FASB Accounting Standards Codification, expected in 2009, willintegrate, topically organize, and effectively eliminate this hierarchy.

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Establishment of Accounting StandardsEstablishment of Accounting StandardsA Political ProcessA Political Process

GAAP

Internal RevenueServicewww.irs.gov

American Instituteof CPAswww.aicpa.org

Securities andExchangeCommissionwww.sec.gov

AmericanAccountingAssociation www.aaa-edu.org

GovernmentalAccountingStandards Boardwww.gasb.org

Financial ExecutivesInternationalwww.fei.org

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FASB’s Standard-Setting ProcessFASB’s Standard-Setting Process

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

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International Accounting StandardsInternational Accounting StandardsBoard (IASB)Board (IASB)

Established in 2001 with the following objectives: Develop a single set of high quality, understandable and enforceable global accounting standards that require transparent and comparable information in general purpose financial statements.

Cooperate with national accounting standard setters to achieve convergence in accounting standards around the world.

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Role of the AuditorRole of the Auditor

Independent intermediary to helpinsure that management has appropriately applied GAAP.

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Financial Reporting ReformFinancial Reporting Reform

As a result of numerous financial scandals, Congress passed the Public Company Public Company

Accounting Reform and Investor Protection Accounting Reform and Investor Protection Act of 2002Act of 2002, commonly referred to as the

Sarbanes-Oxley Act for the two congressmen who sponsored the bill.

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Ethics in AccountingEthics in Accounting

To be useful, accounting information must be objective and reliable.

Management may be under pressure to report desired results and ignore or bend existing rules.

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Model for Ethical DecisionsModel 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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Maintain consistency among standards.Resolve new accounting problems.Provide user benefits.

The Conceptual FrameworkThe Conceptual Framework

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The Conceptual FrameworkThe Conceptual Framework

Recognition and Measurement Criteria(SFAC No. 5 and SFAC No. 7)

Environment Implementation Implementationassumptions principles constraints

Objectives of Financial Reporting(SFAC No. 1)

Qualitative Characteristicsof Accounting Information

(SFAC No. 2)

Elements ofFinancial Statements

(SFAC No. 6)

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ObjectivesTo 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.

ElementsRecognition and

MeasurementConcepts

Constraints

Conceptual Framework

QualitativeCharacteristics

FinancialStatements

Continued

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ElementsAssets

LiabilitiesEquity

Investments by OwnersDistributions to owners

RevenuesExpenses

GainsLosses

Comprehensive Income

Recognition andMeasurement

Concepts

AssumptionsEconomic entityGoing concern

PeriodicityMonetary unit

PrinciplesHistorical cost

RealizationMatching

Full Disclosure

Objectives

Financial StatementsBalance sheet

Income statementStatement of cash flows

Statement of shareholders’ equityRelated disclosures

ConstraintsCost effectiveness

MaterialityConservatism

QualitativeCharacteristics

Understandability

PrimaryRelevanceReliability

SecondaryComparabilityConsistency

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Relevance Reliability

PredictiveValue

FeedbackValue

Timeliness NeutralityVerifiabilityRepresentational

Faithfulness

Comparability Consistency

Qualitative Characteristics ofQualitative Characteristics ofAccounting InformationAccounting Information

Decision Usefulness

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Practical Constraints to Achieving Practical Constraints to Achieving Desired Qualitative CharacteristicsDesired Qualitative Characteristics

CostEffectiveness

CostEffectiveness MaterialityMateriality

ConservatismConservatism

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Elements of Financial StatementsElements of Financial Statements

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Elements of Financial StatementsElements of Financial Statements

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Recognition and Measurement ConceptsRecognition and Measurement Concepts

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The Asset/Liability ApproachThe Asset/Liability Approach

The focus on assets and liabilities has lead toincreased interest on fair value measurement

Measure assets and liabilities that exist at a balance sheet date.

Recognize revenues, expenses, gains, and losses needed to account for the changes in assets and liabilities from the previous balance sheet date.

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The Move Toward Fair ValueThe Move Toward Fair Value

Fair value is 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.

Market Approaches

Income Approaches

CostApproaches

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Fair Value HierarchyFair Value Hierarchy

SFAS No. 159 gives companies the option to report some or all of their financial assets and liabilities at fair value.

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Question 1Question 1

The function of financial accounting is to identify, measure and communicate financial information about economic entities to interested parties.

a. Trueb. False

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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. Trueb. False

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The primary objective of accrual basis accounting is the measurement of income.

a. Trueb. False

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

a. Trueb. False

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The major financial accounting standard setting body is the

a. Accounting Principles Boardb. Securities and Exchange

Commissionc. Financial Accounting Standards

Boardd. American Institute of CPAs

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The FASB issues which of the following types of pronouncements?

a. Standardsb. Interpretationsc. Financial Accounting Conceptsd. Technical Bulletinse. All of the above

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