Chapter 1

ENVIRONMENT AND
THEORETICAL STRUCTURE OF
FINANCIAL ACCOUNTING

© 2013 The McGraw-Hill Companies, Inc.

 Slide 2

Financial Accounting Environment

Providers of
Financial External
Information User Groups
Investors
Creditors
Profit-oriented Relevant Employees
companies Labor unions
Not-for-profit Customers
entities Financial Suppliers
Information Government
Households agencies
Financial
intermediaries
 Slide 3

Financial Accounting Environment

Relevant financial information is provided

primarily through financial statements
and related disclosure notes.
 Statement of Financial Position
 Statement of Comprehensive Income
 Statement of Cash Flows
 Statement of Changes in Equity
 Slide 4

The Economic Environment

and Financial Reporting
A sole proprietorship A corporation is owned
is owned by a by shareholders,
single individual. frequently numbering
in the tens of thousands
in large corporations.
A partnership is
owned by two or
more individuals.

A highly-developed system of financial

reporting is necessary to communicate
financial information from a corporation
to its many shareholders.
Investment-Credit Decisions ─
Slide 5

A Cash Flow Perspective

Corporate shareholders receive cash
from their investments through . . .
• Periodic dividend distributions from the
corporation.
• The ultimate sale of the ownership shares.

Accounting information should help investors

evaluate the amount, timing, and uncertainty
of the enterprise’s future cash flows.
 Slide 6

Cash Versus Accrual Accounting

Cash Basis Accounting

Revenue is recognized when cash is received.

Expenses are recognized when cash is paid.

 Slide 7

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.

 Slide 8

Cash Versus Accrual Accounting

Cash Basis Accounting
Summary of Cash Flows
Year 1 Year 2 Year 3 Total
Sales (on credit) $ 100,000 $ 100,000 $ 100,000 $ 300,000

Cash receipts from

customers $ 50,000 $ 125,000 $ 125,000 $ 300,000
Payment of 3
years' rent (60,000) - - (60,000)
Salaries toCash flows in any one year may not
employeesbe a predictor
(50,000) of (50,000)
future cash(50,000)
flows. (150,000)
Payments for
utilities (5,000) (15,000) (10,000) (30,000)
Net cash flow $ (65,000) $ 60,000 $ 65,000 $ 60,000
 Slide 9

Cash Versus Accrual Accounting

Accrual Accounting
Revenue is recognized when earned.

Expenses are recognized when incurred.

Let’s reconsider the Carter

Company information.
 Slide 10

Cash Versus Accrual Accounting

Accrual Accounting
◦ Revenue is recognized when earned.

◦ Expenses are recognized when incurred.

◦
Let’s reconsider the Carter
Company information.
 Slide 11

The Development of Financial Accounting

and Reporting Standards

Two major sets

of accounting
Concepts, standards –
principles, and •IFRS
procedures were
developed to meet the •U.S. GAAP
needs of external
users.
 Slide 12

Historical Perspective and Standards

International Standard Setting

▪ Standards set by private-sector
▪ Standards set by governmental body
International Financial Reporting Standards
▪ IASC formed in 1973
 Members from countries such as France, Germany, Japan,
U.K., and U.S.
▪ IASC reorganized to IASB in 2001.
 Slide 13

International Accounting Standards Board (IASB)

and supporting organizations
 IASB members include accounting profession,
analysts, academics, regulators, and government.
 IFRS Foundation selects members, oversees, and
ensures adequate funding.
 IFRS Advisory Council advises on agenda and work
priorities.
 IFRS Interpretations Committee seeks to resolve
accounting issues and interpret existing IFRS.
 International Organization of Securities Commissions
(IOSCO) provides regulatory oversight of IASB.
 IASB is a private and non-governmental body with no
authority to enforce the use of IFRS.
 Slide 14

Structure of IASB
 Slide 15

Establishment of Accounting Standards

Due Process
▪ Understand the nuances of the economic
transactions the standards address and the
views of key constituents concerning how
accounting would best capture that
economic reality
▪ Steps include open hearings, deliberations,
and requests for written comments from
interested parties
 Slide 16

Role of the Auditor

Independent intermediary to help

ensure that management has
appropriately applied accounting
standards.
 Slide 17

Financial Reporting Reform in U.S.

As a result of numerous financial scandals,

the U.S. Congress passed the Public
Company Accounting Reform and Investor
Protection Act of 2002, commonly referred to
as the Sarbanes-Oxley Act for the two
congressmen who sponsored the bill.
 Slide 18

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.
 Slide 19

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.
 Slide 20

The Conceptual Framework

 IASB conceptual framework provides

structure and direction to financial
accounting and reporting
 IASB and FASB are working together to
develop a common conceptual framework
through 8 phases
 Slide 21

The Conceptual Framework

Objectives of Financial Reporting

(Phase A)

Qualitative Characteristics Elements of

of Accounting Information Financial Statements
(Phase A)

Underlying Assumptions
Recognition of Elements
Measurement of Elements
Capital and Capital Maintenance
 Slide 22

Conceptual Framework

Objectives
To provide financial information that is useful to
capital providers

Underlying Assumptions
Recognition of Elements
Qualitative
Elements Measurement of Elements
Characteristics Capital and
Capital Maintenance

Financial
Constraints Statements
Continued
 Slide 23
Objective of financial reporting
Underlying Assumptions
Qualitative Going concern
Characteristics Elements Recognition of Elements
Probability of future
Understandability economic benefits
Financial Position Reliability of
Fundamental
Assets measurement
Relevance
Liabilities
Faithful representation Equity
Measurement of Elements
Basis of measurement
Enhancing
Comparability Performance Capital and Capital
Maintenance
Verifiability Income Concepts of capital
Timeliness Expenses Concepts of capital
Understandability maintenance and
determination of profit

Financial Statements
Statement of financial position
Constraints Income statement
Cost effectiveness Statement of comprehensive income
Statement of cash flows
Statement of changes in shareholder’s equity
Notes and supplementary disclosures
 Slide 24

Qualitative Characteristics of Financial

Reporting Information
 Slide 25

Key Constraint

Cost
Effectiveness
 Slide 26

Elements of Financial Statements

© 2013 The McGraw-Hill Companies, Inc.

 Slide 27

Recognition and Measurement Concepts

 Slide 28

Measurement of Elements of Financial Statements

Measurement attributes in IFRS:

1.Historical cost
2.Net realizable value
3.Current cost
4.Present value of future cash flow
5.Fair value

The attribute chosen to measure a particular item

should be the one that maximizes the combination of
relevance and representational faithfulness.

© 2013 The McGraw-Hill Companies, Inc.

 Slide 29

The Move Toward Fair Value

Fair value is the price that would be received

to sell an asset or paid to transfer a liability in
an orderly transaction between market
participants at a measurement date.

Market Income
Approaches Approaches

Cost
Approaches
© 2013 The McGraw-Hill Companies, Inc.
 Slide 30

Fair Value Hierarchy

IFRS gives a company the option to value financial assets

and liabilities at fair value
© 2013 The McGraw-Hill Companies, Inc.
End of Chapter 1

© 2013 The McGraw-Hill Companies, Inc.