Environment and Theoretical Structure of Financial Accounting

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Environment and Theoretical Structure of
Financial Accounting

• Chapter 1

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Financial Accounting Environment
Providers of Financial Information
External User Groups
Profit-oriented companies Not-for-profit entities
Households
Investors Creditors Employees Labor
unions Customers Suppliers Governmentagencies Fin
ancialintermediaries
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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 proprietorshipis owned by asingle
individual.
A corporation is ownedby stockholders,frequently
numberingin the tens of thousandsin large
corporations.
A partnership isowned by two ormore individuals.
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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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Investment-Credit DecisionsA Cash Flow
Perspective

• Accounting information should help investors
  evaluate the amount, timing,and uncertainty of
  the enterprisesfuture cash flows.

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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

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

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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

• 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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Hierarchy of GAAP
Most Authoritative
FASB Statements of Financial Accounting
Standards, FASB Interpretations, SEC rules and
interpretivereleases, AICPA Accounting Research
Bulletins,Accounting Principles Board Opinions
FASB Technical Bulletins, AICPA Industry Audit
and Accounting Guides and Statements of Position
AICPA Accounting Standards Executive Committee
Practice Bulletins
FASB Implementation Guides, AICPA Accounting
Interpretations, AICPA Industry Audit and
Accounting Guides and Statements of Position, and
widelyrecognized general or industry practices.
Least Authoritative
An FASB Accounting Standards Codification,
expected in 2009, willintegrate, topically
organize, and effectively eliminate this
hierarchy.
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Establishment of Accounting StandardsA Political
Process
Internal Revenue Servicewww.irs.gov
Financial Executives Internationalwww.fei.org
GAAP
Governmental Accounting Standards
Boardwww.gasb.org
American Institute of CPAswww.aicpa.org
Securities and Exchange Commissionwww.sec.gov
American Accounting Association www.aaa-edu.org
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FASBs 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 2001 with the following
  objectives? Develop a single set of high
  quality, understandable and enforceable
  global accounting standards that require
  transparent and comparable information in
  general purpose financial statements.
• ? Cooperate with national accounting standard
  setters to achieve convergence in accounting
  standards around the world.

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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 Accounting
Reform and Investor Protection Act of 2002,
commonly referred to as the Sarbanes-Oxley Act
for the two congressmen who sponsored the bill.
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The Conceptual Framework

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

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The Conceptual Framework
Objectives of Financial Reporting (SFAC No. 1)
Qualitative Characteristics of Accounting
Information (SFAC No. 2)
Elements of Financial Statements (SFAC No. 6)
Recognition and Measurement Criteria(SFAC No.
5 and SFAC No. 7) Environment
Implementation Implementation assumptions
principles
constraints
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Conceptual Framework

• Objectives
• To 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.

Recognition andMeasurementConcepts
Elements
QualitativeCharacteristics
FinancialStatements
Constraints
Continued
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Objectives
Recognition andMeasurementConcepts AssumptionsE
conomic entity Going concern Periodicity Monetary
unit Principles Historical cost Realization Matchi
ng Full Disclosure
Elements Assets Liabilities Equity Investments by
Owners Distributions to owners Revenues Expenses G
ains Losses Comprehensive Income
QualitativeCharacteristics Understandability Prim
ary Relevance Reliability Secondary Comparability
Consistency
Financial Statements Balance sheet Income
statement Statement of cash flows Statement of
shareholders equity Related disclosures
Constraints Cost effectiveness Materiality Conserv
atism
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Qualitative Characteristics ofAccounting
Information
Decision Usefulness
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Practical Constraints to Achieving Desired
Qualitative Characteristics
Conservatism
CostEffectiveness
Materiality
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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
  entitys 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 entitys 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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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
toincreased interest on fair value measurement
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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
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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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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