McGraw-Hill/Irwin

Copyright 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

1 Environment and Theoretical Structure of Financial Accounting

PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA

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Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Financial Accounting Environment

Providers of Financial Information External User Groups
Investors Creditors Employees Labor unions Customers Suppliers Government agencies Financial intermediaries

Profit-oriented companies Not-for-profit entities Households

Relevant

Financial Information

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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

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The Economic Environment and Financial Reporting

A sole proprietorship A sole proprietorship is owned by a is owned by a single individual. single individual. A partnership is A partnership is owned by two or owned by two or more individuals. more individuals. A corporation is owned A corporation is owned by shareholders. by shareholders.

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Investment-Credit Decisions A Cash Flow Perspective

Shareholders Receive Cash Creditors Receive Cash

1. Dividends 2. Sale of Stock

1. Interest 2. Loan Repayment

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Accounting information should help investors and creditors evaluate the amount, timing, and uncertainty of the enterprises future cash flows.

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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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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Cash versus Accrual Accounting

Cash Basis Accounting

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

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Cash versus Accrual Accounting

Accrual Basis Accounting

Net Income is considered a better indicator of future cash flows.

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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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Historical Perspective and Standards

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Current Standard Setting

Financial Accounting Standards Board
Supported by the Financial Accounting

Foundation Five full-time, independent voting members Answerable only to the Financial Accounting Foundation Members not required to be CPAs
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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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Establishment of Accounting Standards

A Political Process
Internal Revenue Service www.irs.gov American Institute of CPAs www.aicpa.org
GAAP

Financial Executives International www.fei.org Governmental Accounting Standards Board www.gasb.org

International Accounting Standards Board www.iasb.org Securities and Exchange Commission www.sec.gov
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American Accounting Association www.aaa-edu.org

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).
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Board holds a public roundtable meeting on the ED.

Toward Global Accounting Standards

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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Role of the Auditor

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

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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 2002 was to restore credibility and investor confidence in the financial reporting process.

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A Move Away from Rules-Based Standards?

Rules based accounting standards vs.

objectives-oriented approach Objectives oriented (principles-based) approach stressed professional judgment

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Ethics in Accounting
For financial information to be useful, it

should possess the fundamental decisionspecific qualities of relevance and faithful representation. Management may be under pressure to report desired results and ignore or bend existing rules.

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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.

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The Conceptual Framework

The Conceptual Framework has been described as a constitution, a coherent system of interrelated objectives and fundamental that lead to consistent accounting standards.
FASB Conceptual Framework (Statements of Financial Accounting Concepts) Objectives of Financial Reporting (SFAC No. 1) Qualitative Characteristics (SFAC No. 2) Elements of Financial Statements (SFAC No. 6) Recognition and Measurement (SFAC No. 5 and SFAC No. 7)

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The Conceptual Framework

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

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The Conceptual Framework

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

Elements

Recognition and Measurement Concepts

Constraints
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Financial Statements

Qualitative Characteristics of Accounting Information

Decision usefulness

Relevance

Faithful representation

Predictive value

Confirmatory value

Completeness Neutrality

Free from material error

Comparability (Consistency)
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Verifiability

Timeliness

Understandability

Practical Boundaries (Constraints) to Achieving Desired Qualitative Characteristics

Cost Cost Effectiveness Effectiveness

Materiality Materiality

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Elements of Financial Statements

Assets Probable future economic benefits obtained or controlled by a particular entity as a result of past transactions. Probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions. Shareholders' equity or stockholders' equity for a corporation is the residual interest in the assets of an entity that remains after deducting its liabilities. Increases in equity of a particular business enterprise resulting from transfers to it from other entities of something of value to obtain or increase ownership interests in it. Decreases in equity of a particular enterprise resulting from transfers to owners.

Liabilities

Equity (or net assets) Investments by owners

Distributions to owners
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Elements of Financial Statements

Comprehensive income 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 by owners and distributions to owners. Inflows or other enhancements of assets of an entity or settlements of its liabilities during a period from delivering or producing goods, rendering services, or other activities that constitute the entity's ongoing major or central operations. Outflows or other using up of assets or incurrences of liabilities during a period from delivering goods, rendering services, or other activities that constitute the entity's ongoing major or central operations. Increases in equity from peripheral or incidental transactions of an entity. Decreases in equity arising from peripheral or incidental transactions of an entity.

Revenues

Expenses

Gains Losses
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Recognition and Measurement Concepts

Recognition
Process of admitting information into the basic financial statements 1. 2. 3. 4. Definition Measurability Relevance Reliability

Measurement involves both the choice of a unit of measure and the choice of an attribute to be measured.

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Underlying Assumptions and Accounting Principles

Assumptions Economic entity Going concern Periodicity Monetary unit Principles Historical cost Realization Matching Full disclosure
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Description All economic events identified with a particular economic entity. Business entity will continue to operate indefinitely. Life of company is divided into time periods to provide timely information. Financial statements are measured in U. S. Dollars.

Measurement based on exchange transaction amounts. Revenue recognized when earnings process is complete and reasonable certainty of collection exists. Expenses recognized in same period as related revenue. Information that could change user decisions should be included.

Evolution of Accounting Principles 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 led to increased interest on fair value measurement.
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Evolution of Accounting Principles 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 Cost Approaches
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Income Approaches

Fair Value Hierarchy

Level 1 Most Desirable 1 Inputs Quoted market prices in active markets for identical assets or liabilities Inputs other than quoted prices that are observable for the asset or liability. These inputs include quoted prices for similar assets or liabilities in active or inactive markets and inputs that are derived principally from or corroborated by observable related market data. Unobservable inputs that reflect the entity's own assumptions about the assumptions market participants would use in pricing the asset or liability developed on the best information available on the circumstances.

1 Least Desirable

GAAP gives companies the option to report some or all of their financial assets and liabilities at fair value.
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End of Chapter 1