Environment and Theoretical

Structure of Financial Accounting

Chapter 1

Intermediate Financial Accounting

Financial Accounting
Environment
Providers of
External
User Groups

Financial
Information

Profit-oriented
companies
Not-for-profit
entities
Households

Investors
Creditors
Relevant
Employees
Labor unions
Customers
Financial Suppliers
Information Government
agencies
Financial
intermediaries

Intermediate Financial Accounting

Financial Accounting
Environment
Relevant financial information is provided primarily through
financial statements and related disclosure notes. The following
financial statements are the most frequently provided.
1. Balance Sheet
2. Income Statement
3. Statement of Cash Flows
4. Statement of Shareholders Equity
Starting in 2012, companies must either provide a Statement of
Other Comprehensive Income immediately following the Income
Statement, or present a Combined Statement of Comprehensive
Income that includes the information normally contained in both
the Income Statement and the Statement of Other
Comprehensive Income.
Intermediate Financial Accounting

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 shareholders.
Intermediate Financial Accounting

A highly-developed
system
communicates
financial information
from a corporation to
its many
shareholders.

Investment-Credit Decisions A
Cash Flow Perspective
Shareholders
Receive
Cash

1.
2.

Dividends
Sale of Stock

Creditors
Receive
Cash
1.
2.

Interest
Repayment of
Principle

Accounting information should help

investors and creditors evaluate the
amount, timing, and uncertainty of
the enterprises future cash flows.

Intermediate Financial Accounting

Cash versus Accrual Accounting

Cash Basis Accounting

Revenue is recognized when cash is

received.
O
Expenses are recognized
when
cash
is
R
paid.
O
OR
R
O
R

Accrual Accounting
Revenue is recognized when earned.
Expenses are recognized when incurred.
Intermediate Financial Accounting

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.

Intermediate Financial Accounting

Cash versus Accrual Accounting

Cash Basis Accounting

Intermediate Financial Accounting

Cash versus Accrual Accounting

Cash Basis Accounting

Cash flows in any one year may not

be a predictor of future cash flows.

Intermediate Financial Accounting

Cash versus Accrual Accounting

Accrual Basis Accounting

Intermediate Financial Accounting

Cash versus Accrual Accounting

Accrual Basis Accounting

Net Income is considered a better indicator

of future cash flows.

Intermediate Financial Accounting

The Development of Financial

Accounting and Reporting Standards

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

Intermediate Financial Accounting

Historical Perspective and Standards

Intermediate Financial Accounting

Current U. S. Standard Setting

Financial Accounting
Standards Board
Supported by the Financial Accounting

Foundation
Seven full-time, independent voting
members
Members not required to be CPAs
Intermediate Financial Accounting

FASB Accounting Standards Codification

The codification project integrates and organizes all
relevant accounting pronouncements into a searchable,
online database.

Intermediate Financial Accounting

International Standard

Setting

The main objective of the International

Accounting Standards Board (IASB) is to
develop a single set of high quality,
understandable, and enforceable global
accounting standards to help participants in
the worlds capital markets and other users
make economic decisions.
Intermediate Financial Accounting

Comparison of Organizations of
U.S. and International StandardSetters
U.S. GAAP
IFRS
International
Organization of
Securities Commissions
(IOSCO)
International Accounting
Standards Committee
Foundation (IASCF): 22
trustees
International Accounting
Standards Board (IASB):
14 members (12 fulltime; 2 part-time)

Regulatory oversight
provided by:

Securities Exchange
Commission (SEC)

Foundation providing
oversight, appointing
members, raising
funds:

Financial Accounting
Foundation (FAF): 20
trustees

Standard-setting
board:

Financial Accounting
Standards Board (FASB):
7 full-time members

Advisory council
providing input on
agenda and projects:

Financial Accounting
Standards Advisory
Council (FASAC): 30-40
members

Standards Advisory
Council (SAC): 30-40
members

Group to deal with

emerging issues:

Emerging Issues Task

Force (EITF): 15
members

International Financial
Reporting Interpretations
Committee (IFRIC): 14
members

Intermediate Financial Accounting

Efforts to Converge U.S. and

International Standards
Issues and Concerns:

Desire for a single set of global standards

Need for standards that are customized to fit
stringent legal and regulatory requirements of U.S.
Possible differences in implementation and
enforcement

Progress:

September 2002: FASB and IASB sign Norwalk

Agreement.
November 2008: SEC issues a Roadmap with
milestones.
May 2011: SEC issues discussion paper describing a
condorsement approach.
November
Intermediate
Financial
Accounting
2011:
SEC issues two studies comparing
U.S. GAAP to IFRS and analyzing how IFRS are

FASBs Standard-Setting
Process

Board receives recommendations for projects.

FASB Chairman decides whether to add a project to
its agenda.
Board deliberates the issues at a series of public
meetings.
Board issues an Exposure Draft (ED).
Board holds a public roundtable meeting on the ED.
Staff analyzes feedback and the Board re-deliberates
the proposed revisions at public meetings .
Board issues a Standards Update describing
amendments to the Codification.
Intermediate Financial Accounting

Role of the Auditor

Auditors serve as independent
intermediaries to help ensure that
management has appropriately
applied U.S. GAAP in preparing the
companys financial statements.

Intermediate Financial Accounting

Financial Reporting Reform

As a result of numerous financial
scandals, Congress passed the Public
Company Accounting Reform and
Investor Protection Act of 2002,
(Sarbanes-Oxley Act). The goal was to
restore credibility and investor
confidence in the financial reporting
process.
Intermediate Financial Accounting

A Move Away from

Rules-Based Standards?
Rules-based accounting standards
vs.
Objectives-oriented approach
Objectives-oriented
(principles-based)
approach stresses
professional judgment
Intermediate Financial Accounting

Ethics in Accounting
Code of Ethics:
Provides guidance and rules to help
accounting professionals perform
their professional responsibilities in
an ethical manner.

Intermediate Financial Accounting

Analytical 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.

Intermediate Financial Accounting

The Conceptual Framework

The Conceptual Framework has been described as
an Accounting Constitution. It provides the
underlying foundation for accounting standards.

FASB Conceptual Framework

(Statements of Financial Accounting Concepts)
Objectives of Financial Reporting (SFAC 1, replaced
by SFAC 8)
Qualitative Characteristics (SFAC 2, replaced by
SFAC 8)
Elements
of Financial
Intermediate
Financial
AccountingStatements (SFAC 3, replaced
by SFAC 6)

The Conceptual Framework

Objective
To provide financial information
that is useful to capital providers.

Qualitative
Characteristics

Elements

Constraints

Financial
Statements

Intermediate Financial Accounting

Recognition and
Measurement
Concepts

Qualitative Characteristics of
Accounting Information
Decision usefulness

Relevance

Predictive Confirmatory
value
value

Faithful representation

Materiality

Comparability
Verifiability
(Consistency)
Intermediate Financial Accounting

Completeness Neutrality

Timeliness

Free from
error

Understandability

Key Constraint
Cost
Effectiveness

Benefits
Costs

Intermediate Financial Accounting

Elements of Financial
Statements

Intermediate Financial Accounting

Elements of Financial
Statements

Intermediate Financial Accounting

Underlying Assumptions

Intermediate Financial Accounting

Recognition, Measurement and

Disclosure Concepts
Recognition

Process of admitting information

into the basic financial statements

Measurement

Process of associating
numerical amounts with the
elements.

Disclosure

Process of including
additional
supplemental
Intermediate
Financial
Accounting
information.

Criteria:
1. Definition
2. Measurability
3. Relevance
4. Reliability
Measurement
Attributes:
1. Historical cost
2. Net realizable
value
3. Current cost
4. Present value of
future cash flows
5.
Fair value
Examples:
1. Parenthetical
amounts
2. Notes to FS
3. Supplemental FS

Revenue Recognition:
Realization
Two Criteria:
1. Earnings process is complete or virtually
complete.
2. Reasonable certainty as to the
collectability of the asset to be received
(usually cash).

Intermediate Financial Accounting

Expense Recognition:
Matching

The matching principle requires that all

expenses incurred in generating revenue for a
period also be recognized in the same period.

Four Approaches
1. Based on exact cause-and-effect
relationships.
2. By associating an expense with the revenues
recognized in a specific time period.
3. By a systematic and rational allocation to
specific time periods.
4. In the
period
incurred, without regard to
Intermediate
Financial
Accounting
related revenues.

Fair Value Hierarchy

U.S. GAAP gives companies the option to report

some or
all of Accounting
their financial assets and liabilities at
Intermediate
Financial
fair value.

Evolving U.S. GAAP

U.S. GAAP has been evolving from an emphasis
on revenues and expenses to an emphasis on
assets and liabilities.
Revenue/Expense Approach: Emphasize
principles for recognizing revenues and expenses,
with some assets and liabilities recognized as
necessary to make the balance sheet reconcile with
the income statement.
Asset/Liability Approach: Emphasize principles
for recognizing assets and liabilities first, and then
recognize and measure the revenues, expenses,
gains, and losses needed to account
for the changes in assets and
liabilities from the previous measurement date.

Intermediate Financial Accounting

Where Were Headed:

The Conceptual Framework
FASB and IASB Joint Conceptual Framework Project
Eight Phases:
A. Objective and Qualitative Characteristics (Completed)
B. Elements and Recognition (In progress)
C. Measurement (In progress)
D. Reporting Entity (In progress)
E. Presentation and Disclosure
F. Framework for a GAAP Hierarchy
G. Applicability to the Not-For-Profit Sector
H. Remaining Issues

Intermediate Financial Accounting

End of Chapter 1

Intermediate Financial Accounting