Chapter 1

ENVIRONMENT AND
THEORETICAL STRUCTURE
OF FINANCIAL
ACCOUNTING

McGraw-Hill /Irwin

2009 The McGraw-Hill Companies, Inc.

ACCOUNTING
An information system whose
purpose is to . . .
Identify
Collect
Measure
Communicate
Information about an economic
entity to those with an
interest in the financial affairs
of the entity
McGraw-Hill /Irwin

2009 The McGraw-Hill Companies, Inc.

Preparers, Auditors, and Users of Financial

Information
Preparers
(company)
Published
Published
financial
Published
financial
Published
reports
financial
reports
financial
reports
reports

Auditors
(CPAs)

Users
McGraw-Hill /Irwin

2009 The McGraw-Hill Companies, Inc.

Slide 4

Financial Accounting Environment

Providers of
Financial
Information

Profit-oriented
companies
Not-for-profit
entities
Households

External
User Groups

Relevant

Financial
Information

Investors
Creditors
Employees
Labor unions
Customers
Suppliers
Government
agencies
Financial
intermediaries
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1-5

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.

Slide 6

The Economic Environment

and Financial Reporting
AA sole
sole proprietorship
proprietorship
is
is owned
owned by
by aa
single
single individual.
individual.
AA partnership
partnership is
is
owned
owned by
by two
two or
or
more
more individuals.
individuals.

AA corporation
corporation is
is owned
owned
by
by stockholders,
stockholders,
frequently
frequently numbering
numbering
in
in the
the tens
tens of
of thousands
thousands
in
in large
large corporations.
corporations.

AA highly-developed
highly-developed system
system of
of financial
financial
reporting
reporting is
is necessary
necessary to
to communicate
communicate
financial
financial information
information from
from aa corporation
corporation
to
to its
its many
many shareholders.
shareholders.
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Slide 7

Investment-Credit Decisions A Cash Flow

Perspective
Shareholders
Receive
Cash

1. Dividends
2. Sale of Stock

Creditors
Receive
Cash
1. Interest
2. Loan
Repayment

Accounting information should help investors

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

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Slide 8

Cash versus Accrual Accounting

Cash Basis Accounting
Revenue is recognized when cash is received.
Expenses are recognized when cash is paid.
O
R
O
OR
R
O
R

Accrual Accounting
Revenue is recognized when earned.
Expenses are recognized when incurred.
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Slide 9

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.

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Slide 10

Cash Versus Accrual Accounting

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

Cash Basis Accounting

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Slide 11

Cash Versus Accrual Accounting

Accrual Accounting
Revenue is recognized when earned.
Expenses are recognized when incurred.
Lets reconsider the Carter
Company information.

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Slide 12

Cash Versus Accrual Accounting

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

Lets reconsider the Carter

Company information.

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Slide 13

The Development of Financial Accounting

and Reporting Standards

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

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Slide 14

WHAT IS GAAP?
Pronouncements

by designated authoritative
bodies that must be followed in all applicable
cases

Accounting

practices developed by respected

bodies and industries or that have evolved over
time
GAA
P

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Slide 15

Historical Perspective and Standards

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Slide 16

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

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Slide 17

Where do you find GAAP

Until

2009 there are many sources of GAAP:

FASB Standards, Interpretations and Staff
Opinions, APB Opinions and AICPA Research
Bulletins.
Which source is most authoritative and which is
not?
To provide all authoritative literature to a
particular topic in one single place the FASB
developed Accounting Standard Codification.
Purpose is to integrate and synthesize existing
GAAP and to create one level of authoritative
GAAP.
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Slide 18

Codification Goal
The FASB had three primary goals in developing
the Codification:
1. Simplify user access by codifying all
authoritative US GAAP in one spot.
2. Ensure that the codified content accurately
represented authoritative US GAAP as of
July1, 2009.
3. Create a codification research system that
is up to date for the released results of
standard-setting activity.
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Slide 19

FASB Accounting Standards Codification

The objective of the codification project was to integrate and
organize by topics all relevant accounting pronouncements
into a searchable, online database.

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Slide 20

Benefit of the Codification

The Codification is expected to:
1. Reduce the amount of time and effort required
to solve an accounting research issue
2. Mitigate the risk of noncompliance through
improved usability of the literature
3. Provide accurate information with real-time
updates as Accounting Standards Updates are
released
4. Assist the FASB with the research and
convergence efforts.
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Slide 21

Do I have access to the Codified

Standards?
FIU subscription to FASB Academic
Access for September 1, 2012 to August
31, 2013.
Student

Access
Username - AAA52092
Password - hg6pThV

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Slide 22

Establishment of Accounting Standards

A Political Process
Internal Revenue
Service
www.irs.gov
American Institute
of CPAs
www.aicpa.org
Securities and
Exchange
Commission
www.sec.gov

Financial Executives
International
www.fei.org

GAAP

Governmental
Accounting
Standards Board
www.gasb.org
American
Accounting
Association
www.aaa-edu.org
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Slide 23

FASBs Standard-Setting Process

Board receives recommendations for projects.

Board votes to add the 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.
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Slide 24

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.

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Slide 25

IFRS: International Financial Reporting

Standards
IFRS

are issued by the IASB

More than hundred countries either require or
permit the use of IFRS or IFRS-aligned
standards.
IFRS differ in many respects from the US GAAP
The SEC is in favor of the development of a
single set of high-quality, globally accepted
accounting standards.
SEC has a work plan.
The FASB and IASB have also initiated
convergence efforts.
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Slide 26

Why IFRS is important for US?

The

disparity of different accounting standards in

different parts of the world acts as a barrier for
investors.
International Investors are reluctant to invest in
companies that report their financial statements in a
format that is obscure to them.
International firms
Mergers and Acquisitions
Information Technology
Financial Market
1-26

Slide 27

What are the problems to implement

IFRS?
IFRSs

are not sufficiantly developed for

Globally Accepted
Jurisdictional variants regulatory environments
Problems in consistent application, auditing and
enforcement across countries.
Investors understanding and education
regarding IFRS.
Impact on corporation, changes in contratual
arrangements, corporate governance and
litigation contingencies.
Human resources
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Slide 28

Is IFRS different than US GAAP?

As a general rule, IFRS standards are more broad and principles based with
limited interpretive guidance.

US GAAP contains underlying principles as well but is more specific and rules
based with far more bright lines, comprehensive implementation guidance and
industry interpretations.

Principles based:

Your parents tell you to

do your best to get
good grades and that if
you do not, they will
consider the substance
of your reasons.

Rules based:

Your parents tell you to get

a 3.2 GPA or above and
then provide 15
contingencies that might
justify acceptance of lower
grades.
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Slide 29

International Convergence of Accounting

Standards
What

Does International Convergence of Accounting

Standards Mean?
The phrase international convergence of accounting
standards refers to both a goal and the path taken to reach
it.
The FASB believes that the ultimate goal of convergence
is a single set of high-quality, international accounting
standards that companies worldwide would use for both
domestic and cross-border financial reporting.
Today, the path toward that goal is the collaborative efforts
of the FASB and the IASB to both improve U. S. GAAP and
International Financial Reporting Standards (IFRS) and
eliminate the differences between them.
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Slide 30

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 2011: SEC issues two studies comparing
U.S. GAAP to IFRS and analyzing how IFRS are applied

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Slide 31

Role of the Auditor

Independent intermediary to help
insure that management has
appropriately applied GAAP.

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Slide 32

Financial Reporting Reform

As a result of numerous financial scandals,
Congress passed the Public Company
Accounting Reform and Investor Protection
Act of 2002,
2002 commonly referred to as the
Sarbanes-Oxley Act for the two congressmen
who sponsored the bill.

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Slide 33

Timeline of Major Accounting Scandals (source: Cohen et al.

2005)

October 2001
Enron
November 2001
Arthur Andersen
January 2002
Kmart;
Homestore.com
February 2002
Global Crossing;
Quest
March 2002
Xerox
April 2002
AOL Time Warner
Bristol-Myers
Squibb
Duke Energy

Merck
Mirant
Nicor Energy LLC
May 2002
WorldCom
June 2002
Adelphia
July 2002
CMS Energy
Dynergy
El Paso
Halliburton
Peregrine Systems
Reliant Energy
Tyco

1-33

Slide 34

A Move Away from

Rules-Based Standards?
Rules based accounting standards

vs. objectives-oriented approach

Objectives oriented (principlesbased) approach stressed
professional judgment

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Slide 35

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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Slide 36

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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Slide 37

The Conceptual Framework

Maintain consistency among standards.
Resolve new accounting problems.
Provide user benefits.

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Slide 38

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 Statements (SFAC 3, replaced
by SFAC 6)

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Slide 39

The Conceptual Framework

Objective
To provide financial information
that is useful to capital providers.
Fundamental and
Enhancing
Qualitative
Characteristics

Constraints

Elements

Recognition and
Measurement
Concepts

Financial
Statements
1-39

Slide 40

Qualitative Characteristics of
Accounting Information
Decision usefulness

Relevance

Faithful representation

Predictive Confirmatory
Materiality
value
value

Comparability
(Consistency)

Verifiability

Completeness Neutrality

Timeliness

Free from
error

Understandability
1-40

Slide 41

Practical Boundaries (Constraints) to Achieving

Desired Qualitative Characteristics

Cost
Cost
Effectiveness
Effectiveness

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Slide 42

Elements of Financial Statements

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Slide 43

Elements of Financial Statements

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Slide 44

Recognition and Measurement Concepts

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Slide 45

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
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
Examples:
5.
value
1. Fair
Parenthetical
amounts
2. Notes to FS
3. Supplemental FS
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Slide 46

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).

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Slide 47

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
related revenues.

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Slide 48

The Asset/Liability Approach

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.

The focus on assets and liabilities has lead to

increased interest on fair value measurement
1-48

Slide 49

The 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
Cost
Approaches
1-49

Slide 50

Fair 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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Slide 51

Question 1
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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Slide 52

Question 2
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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Slide 53

Question 3
The primary objective of accrual basis
accounting is the measurement of
income.
a. True
b. False

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Slide 54

Question 4
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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Slide 55

Question 5
The major financial accounting standard
setting body is the
a.
b.
c.
d.

Accounting Principles Board

Securities and Exchange Commission
Financial Accounting Standards Board
American Institute of CPAs

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Slide 56

Question 6
The FASB issues which of the following
types of pronouncements?
a.
b.
c.
d.
e.

Standards
Interpretations
Financial Accounting Concepts
Technical Bulletins
All of the above

1-56

End of Chapter 1

Additional
Materials in
subsequent slides

McGraw-Hill /Irwin

2009 The McGraw-Hill Companies, Inc.