1 f inancial r eporting chapter 1. 2 learning objectives 1.describe the purpose of financial...

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FFINANCIAL INANCIAL

RREPORTINGEPORTING

chapter chapter 11

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Learning Objectives

1. Describe the purpose of financial reporting and identify the primary financial statements.

2. Explain the function of accounting standards and describe the role of the FASB in setting these standards in the United States.

3. Recognize the importance to financial reporting of the SEC, AICPA, AAA, and IRS.

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Learning Objectives

4. See the growing importance and relevance of international accounting issues to the practice of accounting in the United States and understand the role of the ISAC in international accounting standard setting.

5. Understand the significance of the FASB’s conceptual framework in outlining the qualities of good accounting information, defining terms such as asset and revenue, and providing guidance about appropriate recognition, measurement, and reporting.

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Learning Objectives

6. Identify career opportunities related to accounting and financial reporting in the fields of public accounting, corporate accounting, financial analysis, banking, and consulting.

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Definition for Accounting

“Accounting is a service activity. Its function is to provide quantitative information, primarily financial in nature, about economic entities that is intended to be useful in making economic decisions—in making reasoned choices among alternative courses of action.” (Statement of the Accounting Principles Board No. 4, p. 40)

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• Accounting provides a vital service in today’s business environment.

• Accounting is concerned primarily with quantitative financial information that is used in conjunction with qualitative evaluations in making judgments.


Key features of this definition:

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• Accounting information is used in making decisions about how to allocate scarce resources.



Economists and environmentalists

remind us constantly that we live in a world with limited resources.

Economists and environmentalists

remind us constantly that we live in a world with limited resources.

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• Although accountants place much emphasis on reporting what has already occurred, this past information is intended to be useful in making economic decisions about the future.



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Users of Accounting Information

All parties interested in the financial health of a

company are called stakeholders.

All parties interested in the financial health of a

company are called stakeholders.

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Users of Accounting Information

Internal users, Internal users, who who make decisions make decisions

directly affecting the directly affecting the internal operations internal operations of the enterprise.of the enterprise.

Internal users, Internal users, who who make decisions make decisions

directly affecting the directly affecting the internal operations internal operations of the enterprise.of the enterprise.

External users, External users, who make decisions who make decisions

concerning their concerning their relationship to the relationship to the

enterprise.enterprise.

External users, External users, who make decisions who make decisions

concerning their concerning their relationship to the relationship to the

enterprise.enterprise.

Two major classifications of stakeholders

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InvestorsCommunity

Board of DirectorsManagement

EmployeesSuppliers

Employees

CreditorsCustomers

Analysts

Government

Major Internal and External Stakeholder Groups

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Financial Reporting

The balance sheet reports, as of a certain

point in time, the resources of a

company (the assets), the company’s obligations (the

liabilities), and the equity of the owners.

The balance sheet reports, as of a certain

point in time, the resources of a

company (the assets), the company’s obligations (the

liabilities), and the equity of the owners.

The income statement reports, for a specified interval, the net assets

generated through business operations (revenues), the net

assets consumed (the expenses), and the net

income.

The income statement reports, for a specified interval, the net assets

generated through business operations (revenues), the net

assets consumed (the expenses), and the net

income.

The statement of cash flows reports, for a

specified time period, the amount of cash generated

and consumed by a company through

operating, financing, and investing activities.

The statement of cash flows reports, for a

specified time period, the amount of cash generated

and consumed by a company through

operating, financing, and investing activities.

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Accounting estimates and judgments are

outlined in the notes to financial statements.

Accounting estimates and judgments are

outlined in the notes to financial statements.

Financial Reporting

14Financial Statement Relationships

Balance Sheet 12/31/04

Cash $ 80,000Other 4,550,000Total $4,630,000

Liabilities $2,970,000Stock 900,000R/E 760,000Total $4,630,000

Statement of Cash Flows 2005

Cash From Op $ 973,000Cash From Inv (1,188,000)Cash From Fin 245,000Net Increase $ 30,000Beg. Cash 80,000End. Cash $ 110,000

Statement ofRetained Earnings

R/E 12/31/04 $ 760,000Net Income 864,600Dividends (400,000)R/E 12/31/05 $1,224,600

Revenues $12,443,000Expenses 11,578,400Net Income $ 864,600

Income Statement

Cash $ 110,000Other 4,975,000Total $5,085,000

Liabilities $2,860,400Stock 1,000,000R/E 1,224,600Total $5,085,000

Balance Sheet 12/31/05

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Auditors

Auditors working independently of

a company’s management and

internal accountants examine the

financial statements.

Auditors working independently of

a company’s management and

internal accountants examine the

financial statements.

Auditors issue an auditor’s opinion about the fairness of the statements

and their adherence to

proper accounting principles.

Auditors issue an auditor’s opinion about the fairness of the statements

and their adherence to

proper accounting principles.

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Auditor’s Opinion Unqualified opinion—In the opinion of the auditor, the

financial statements are presented in accordance with GAAP.

Qualified opinion—In the opinion of the auditor, except for the effects of the qualified item, the financial statement are presented in conformity with GAAP.

No opinion—The auditor does not express an opinion about the financial statements.

Adverse—In the opinion of the auditor, the financial statements do not present information in conformity with GAAP.

17Relative Frequency of Audit Opinions (2000)

Companies

Unqualified 5,651

Unqualified With Explanatory Language 1,506

Qualified 4

No opinion 2

Adverse 1

TotalTotal 7,1647,164

18Accounting Standard–Setting Organizations

FASAC FASB

FAF SEC

AcSEC

AICPA

IASC

IAPC

Other

EITF

GASAC GASB U.S. Gov't

19 Financial Accounting Standards Board

Committee on Accounting Procedures

(CAP)Born: 1939Died: 1959

Pronouncements: Accounting Research Bulletins

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Accounting Principles

Board(APB)

Born: 1959Died: 1973

Pronouncements: APB Opinions

Financial Accounting Standards Board

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Financial Accounting

Standards Board(FASB)

Born: 1973Died:

Pronouncements: Statements of Financial Accounting Standards


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1) Seven full-time members comprise this independent body.

2) Issues Statements of Financial Accounting Standards.3) Determines GAAP by “due process.”4) Works within the Conceptual Framework.


Statement PreparersStatement Preparers• Financial ExecutivesFinancial Executives

InstituteInstitute• IMAIMA• Individual CorpsIndividual Corps

FASB

FASB Authority Sources—Overview

Gov’t RegulatorsGov’t Regulators• SECSEC• State Boards State Boards

of Public Acct.of Public Acct.

• American Acct.American Acct.InstructorsInstructors

AssociationAssociation

AuditorsAuditors• AICPAAICPA• State societies of State societies of

CPAsCPAs• Major audit firmsMajor audit firms

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Congress

FASB Authority Sources—SEC

SEC

FASB

Registrant Companies

25FASB Authority Sources -- AICPA

Provides authority to the FASB through its Code of Professional Conduct Rule 203.

AICPA members must show that client financial statements comply with FASB pronouncements (GAAP).

AICPA grants continuing membership to its members who comply with Rule 203.

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FASB “Due Process”

1) Topic or project added to agenda.2) Task force assembled to study topic.3) Research and analysis performed by FASB

technical staff.4) Discussion Memorandum (DM) drafted and

released.5) Public hearing, usually 60 days later, is held.

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6) Board analyzes and evaluates public response.

7) Exposure Draft (ED) prepared and released. 8) Sixty-day exposure period allows for public

comment. 9) Committee studies public response to

exposure draft and prepares final draft.


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10) Board votes on final draft leads to either the issuance of a Statement of Financial Accounting Standard, a revised Exposure Draft, or abandonment of the project.


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Emerging Issue Task Force

In an effort to overcome the slow process of standard setting, in 1984 the FASB established the Emerging Issues Task Force (EITF) to assist the FASB in identifying the emerging

issues that affect financial reporting.

In an effort to overcome the slow process of standard setting, in 1984 the FASB established the Emerging Issues Task Force (EITF) to assist the FASB in identifying the emerging

issues that affect financial reporting.

30Accounting Standard–Setting Organizations

FASAC FASB

FAF SEC

AcSEC

AICPA

IASC

IAPC

Other

EITF

GASAC GASB U.S. Gov't

31Securities Exchange Commission (1933-present)

1929 stock market crash blamed on nonstandard accounting.

1933 Securities Act established SEC to standardize accounting.

Created to protect the interests of investors by ensuring full and fair disclosure.

Granted legal authority to dictate GAAP.Has tended to defer setting GAAP to the

accounting profession.

32Securities and Exchange Commission

SEC official statements are referred to as Financial Reporting Releases

which are accounting interpretations and policies the SEC uses in

evaluating firms’ disclosure policies.

SEC official statements are referred to as Financial Reporting Releases

which are accounting interpretations and policies the SEC uses in

evaluating firms’ disclosure policies.

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Staff Accounting Bulletins Accounting and Auditing

Enforcement Releases Accounting Series Releases

Securities and Exchange Commission

Other Authoritative LiteratureOther Authoritative LiteratureOther Authoritative LiteratureOther Authoritative Literature

34American Institute of Certified Public Accountants

The American Institute of Certified Public Accountants

(AICPA) is the professional

organization of practicing CPAs in the

United States.

35American Accounting Association

What are assets ?

The American Accounting

Association (AAA) is primarily an

organization for accounting professors.

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Internal Revenue Service

The Internal Revenue Service (IRS) has the

primary goal of equitable collecting

revenue.

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What is GAAP?

A B C D

Higher Authority

Lower Authority

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What is GAAP?

– FASB Statements and Interpretations

– APB Opinions

– CAP Accounting Research Bulletins

AHighest AuthorityHighest AuthorityHighest AuthorityHighest Authority

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What is GAAP?

– FASB Technical Bulletins

– AICPA Industry Audit and Accounting Guides

– AICPA Statements of Position

B

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What is GAAP?

– Consensus Positions of EITF

– AICPA Practice Bulletins C

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What is GAAP?

– AICPA Accounting Interpretations

– FASB “Question and Answer” guides

– Other widely recognized industry practices

DLowest AuthorityLowest AuthorityLowest AuthorityLowest Authority

42International Accounting Standards Committee

The International Accounting Standards Committee (ISAC) was formed in 1973 to develop

worldwide accounting standards.

The International Accounting Standards Committee (ISAC) was formed in 1973 to develop

worldwide accounting standards.

The accounting standards produced by the International

Accounting Standards Committee are referred to as International Accounting Standards or IAS.

The accounting standards produced by the International

Accounting Standards Committee are referred to as International Accounting Standards or IAS.

43Conceptual Framework of Accounting

Objectivesof FinancialReporting

QualitativeCharacteristicsof Information

Accounting

Elementsof FinancialStatements

Recognition and Measurement Concepts

Assumptions Principles Constraints

44Objectives of Financial Reporting

The overall objective of financial reporting is to

provide information useful for decision making.

The overall objective of financial reporting is to

provide information useful for decision making.

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Usefulness.

Understandability.

Target audience: investors and creditors.

Assessing future cash flows.

Evaluating economic resources.

Primary focus on earnings.

Objectives of Financial Reporting


UsefulnessUsefulnessUsefulnessUsefulness

Financial reporting should provide information that is useful to present and

potential investors and creditors and other users in making rational

investment, credit, and similar decisions.


UnderstandabilityUnderstandabilityUnderstandabilityUnderstandability

Financial reporting should provide information that is understandable to one

who has a reasonable knowledge of accounting and business and who is

willing to study and analyze the information presented.


Target AudienceTarget AudienceTarget AudienceTarget Audience

While there are many potential users of financial reports, the objectives are directed

primarily toward investors and creditors.


Assessing Future Cash FlowsAssessing Future Cash FlowsAssessing Future Cash FlowsAssessing Future Cash Flows

Financial reporting should provide information that is useful in assessing

amounts, timing, and uncertainty (risk) of prospective cash flows.


Evaluating Economic ResourcesEvaluating Economic ResourcesEvaluating Economic ResourcesEvaluating Economic Resources

Financial reporting should also provide information about an enterprise’s assets,

liabilities, and owners’ equity to help investors, creditors, and others evaluate the financial strengths and weaknesses of the enterprise and its liquidity and solvency.


Primary Focus on EarningsPrimary Focus on EarningsPrimary Focus on EarningsPrimary Focus on Earnings

Information about enterprise earnings, measured by accrual accounting, generally

provides a better basis for forecasting future performance than does information

about current cash receipts and disbursements.

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PredictiveValue

FeedbackValue

Timeliness

Relevance

Verifiability

Neutrality

RepresentationalFaithfulness

Reliability

DecisionUsefulness

Understandability

Decision Makers

Qualitative Characteristics of Accounting Information

Materiality

Benefits > Cost

Comparability (including

Consistency)

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What About Conservatism?

The concept of conservatism can be summarized as follows: When in doubt, recognize all losses but

don’t recognize any gains.

The concept of conservatism can be summarized as follows: When in doubt, recognize all losses but

don’t recognize any gains.

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Elements of Financial Statements

• Assets• Liabilities• Equity, or Net Assets• Investments by Owners• Distributions to Owners• Comprehensive Income• Revenues• Expenses• Gains• Losses

55 Recognition, Measurement, and Reporting

Boiling down all the estimates and judgments into one number and then using that one number to make a journal entry is called recognition.


Skipping the journal entry and just relying on the note to

convey the information to users is called disclosure.

Skipping the journal entry and just relying on the note to

convey the information to users is called disclosure.


MeasurementMeasurementMeasurementMeasurement

1. Historical cost

2. Current replacement cost

3. Current market value

4. Net realizable value

5. Present (or discounted) value


ReportingReportingReportingReporting

Financial position at the end of the period Earnings (net income) for the period Cash flows during the period Investments by and distributions to owners

during the period Comprehensive income for the period

59Traditional Assumptions of the Accounting Model

• Economic entity.

• Going concern.

• Arm’s-length transactions.

• Stable monetary unit.

• Accounting period.

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• Public accounting.

• Company accounting.

• User (analyst, banker, consultant).

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