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

Environmental and Theoretical Structure

of Financial Accounting

1Insert Book Cover

Picture

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Learning Objectives

Describe the function and primaryfocus of financial accounting.

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Financial Accounting Environment

Profit-orientedcompanies

Not-for-profitentities

Households

Providers ofFinancial Information

ExternalUser Groups

Investors

Creditors

Employees

Labor unions

Customers

Suppliers

Governmentagencies

Financialintermediaries

Relevant

FinancialInformation

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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

1-5The Economic Environment 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 DecisionsA 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.

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Accounting information should help investors evaluate the amount, timing,

and uncertainty of the enterprise’sfuture cash flows.

Investment-Credit DecisionsA Cash Flow Perspective

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Learning Objectives

Explain the difference betweencash 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.

Let’s look at the cash flows.

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Cash Versus Accrual Accounting

Cash Basis Accounting

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Cash Versus Accrual Accounting

Cash flows in any one year may not be apredictor of future cash flows.

Cash Basis Accounting

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Cash Versus Accrual Accounting

Accrual AccountingRevenue is recognized when earned.

Expenses are recognized when incurred.

Let’s reconsider the CarterCompany information.

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Accrual AccountingRevenue is recognized when earned.

Expenses are recognized when incurred.

Let’s reconsider the CarterCompany information.

Cash Versus Accrual Accounting

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Learning Objectives

Define generally accepted accounting principles (GAAP) and discuss the historical

development of accounting standards.

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The Development of Financial Accounting and Reporting Standards

Concepts, principles, and

procedures weredeveloped 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)

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Current Standard Setting - FASBwww.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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Learning Objectives

Explain why the establishment ofaccounting standards is characterized

as a political process.

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Establishment of Accounting StandardsA Political Process

GAAP

Internal RevenueService

www.irs.gov

American Instituteof CPAs

www.aicpa.org

Securities andExchange

Commissionwww.sec.gov

AmericanAccountingAssociation

www.aaa-edu.org

GovernmentalAccounting

Standards Boardwww.gasb.org

Financial ExecutivesInternationalwww.fei.org

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FASB’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 StandardsBoard (IASB) Established in 1973 to narrow the

range of differences in accounting standards.

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 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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Learning Objectives

Explain the purpose of theFASB’s conceptual framework.

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The Conceptual Framework

Maintain consistency among standards. Resolve new accounting problems. 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 basicassumptions underlying GAAP

Describe the four basic accountingprinciples that guide accounting practice.

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The Conceptual Framework

Recognition and Measurement Criteria (SFAC No. 5)

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 ofAccounting Information

Decision Usefulness

1-32Practical Constraints to Achieving Desired Qualitative Characteristics

CostEffectiveness

CostEffectiveness MaterialityMateriality

ConservatismConservatism

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SFAC No. 6Assets 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. 6Equity

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.

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SFAC No. 6Investments and Distributions

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.

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SFAC No. 6Revenues

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 entity’s

ongoing major, or central, operations.

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SFAC No. 6Expenses

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 entity’s ongoing major, or

central, operations.

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SFAC No. 6Gains and Losses

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.

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SFAC No. 6Comprehensive 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. Accounting Principles Board

b. Securities and Exchange Commission

c. Financial Accounting Standards Board

d. American Institute of CPAs

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Question

The major financial accounting standard setting body is the

a. Accounting Principles Board

b. Securities and Exchange Commission

c. Financial Accounting Standards Board

d. American Institute of CPAs

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Question

The FASB issues which of the following types of pronouncements?

a. Standards

b. Interpretations

c. Financial Accounting Concepts

d. Technical Bulletins

e. All of the above

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Question

The FASB issues which of the following types of pronouncements?

a. Standards

b. Interpretations

c. Financial Accounting Concepts

d. Technical Bulletins

e. 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

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 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