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Chapter 1

Environmentand Theoretical

Structure of FinancialAccounting

Primary Focus of Financial Accounting

• Providing financial information to various external users– Investors– Creditors– Other external users

Investors &

creditors

To predict the future risk and potential return of investments or loans

Before supplying capital to businesses

Use different kinds of information

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Financial information is a key component of that information set

Objectives of Financial Accounting

Financial reporting should provide information that: Financial reporting should provide information that:

(a) is useful to present and potential investors and creditors and other users in making rational investment, credit, and similar decisions.

(a) is useful to present and potential investors and creditors and other users in making rational investment, credit, and similar decisions.

(b) helps present and potential investors and creditors and other users in assessing the amounts, timing, and uncertainty of prospective cash receipts.

(b) helps present and potential investors and creditors and other users in assessing the amounts, timing, and uncertainty of prospective cash receipts.

(c) clearly portrays the economic resources of an enterprise, the claims to those resources, and the effects of transactions, events, and circumstances that change its resources and claims to those resources.

(c) clearly portrays the economic resources of an enterprise, the claims to those resources, and the effects of transactions, events, and circumstances that change its resources and claims to those resources.

Financial Accounting

• Financial information is conveyed through financial statements and related disclosure notes– Balance sheet– Income statement– Statement of Comprehensive Income– Statement of cash flows– Statement of shareholders’ equity

Financial Reporting• Refers to the process of providing financial information

to external users

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Financial Information Providers and External User Groups

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The Economic Environment and Financial ReportingCapital markets provide a mechanism to help the economy allocate resources efficiently

Initial market transactions involve issuance of stocks and bonds by the corporation– Corporations receive new cash

Secondary market transactions involve the transfer of stocks and bonds between individuals and institutions– Corporations receive no new cash

Corporations acquire capital from investors in exchange for ownership interest and from creditors by borrowing

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The Investment-Credit Decision—A Cash Flow PerspectivePrimary objective of financial accounting• Provided information should be useful for decision

making• Information should help investors and creditors

evaluate– Amounts– Timing– Uncertainty

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The Development of Financial Accountingand Reporting Standards

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Generally Accepted Accounting Principles (GAAP)• GAAP is a set of both broad and specific guidelines that

companies should follow when measuring and reporting the information in their financial statements and related notes

• GAAP is set by standard setters but also emerges from practice

• GAAP facilitates decision making by investors and creditors by helping them understand information and enhancing the comparability of that information among companies

Accounting Standard Setting

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Congress

SEC

Private Sector

CAP APB FASB

1938–1959 1959–1973 1973–Present

HIERARCHY OF STANDARD-SETTING AUTHORITY

Current U.S. Standard Setting

• Supported by the Financial Accounting Foundation• Seven full-time, independent voting members• Members not required to be CPAs• Established to set U.S. accounting standards

Financial Accounting Standards Board

FASB Accounting Standards Codification Only source of authoritative nongovernmental U.S. GAAP• Integrates and organizes all relevant accounting

pronouncements comprising GAAP in a searchable, online database.

• Also includes portions of SEC accounting guidance• Accounting Standards Update (ASU): any new standard

issued by FASB

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(www.fasb.org)

International Standard Setting

International Accounting Standards Committee (IASC)• Formed in 1973 to develop global accounting standards• Created a new standard-setting body called the

International Accounting Standards Board (IASB) (2001)

IASB:

• To develop a single set of high-quality, understandable, and enforceable global accounting standards• Issued new standards of its own—called International

Financial Reporting Standards (IFRSs)

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Comparison of Organizations of U.S. and International Standard Setters

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Efforts to Converge U.S. And International Standards

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U.S. GAAP

IFRS

ConvergedStandards

Efforts to Converge U.S. And International Standards

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• September 2002: FASB and IASB signed the Norwalk Agreement.

• December 2007: The SEC signalled its view that IFRS are of high quality by removing reconciliation requirements

• April 2008: FASB and IASB agreed to accelerate the convergence process and focus on a subset of key convergence projects

• November 2008: SEC issued a Roadmap that listed necessary conditions to be achieved before the U.S. will shift to requiring use of IFRS by public companies

• November 2011: The SEC issued two studies —identified key differences between U.S. GAAP and IFRS and analyzed how IFRS are applied globally

• July 2012: The SEC staff issued its Final Staff Report

• Concluded it is not feasible for the U.S. to adopt IFRS due to:

– need for the U.S. to have stronger influence on the standard-setting process

– high costs to companies of converting to IFRS

– the fact that many laws, regulations and private contracts reference U.S. GAAP

Encouraging High-Quality Financial Reporting

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Role of an Auditor

• Offer credibility to financial statements as an independent party

• Express an opinion on the compliance of financial statements with GAAP

• Licensed by states to provide audit services — Certified public accountants (CPAs)

Financial Reporting Reform

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Enron WorldCom Xerox Merck

Adelphia Communications

Accounting scandals

Sarbanes-Oxley Act

Increased the pressure on lawmakers to pass measures that would restore credibility and investor confidence in

the financial reporting process

Sarbanes-Oxley Act

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• Oversight board

• Corporate executive accountability

• Nonaudit services

• Retention of work papers

• Auditor rotation

• Conflicts of interest

• Hiring of auditor

• Internal control

• A principles-based, or objectives-oriented, approach to standard-setting stresses professional judgment, as opposed to following a list of rules

• Regardless, poor ethical values on the part of management are at the heart of accounting abuses and scandals

A Move Away from Rules-Based Standards?

vs.Principles-based Rules-based

Objectives-oriented

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Ethics and Professionalism

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Ethics deals with the ability to distinguish right from wrong

Codes of ethics are provided by:

• American Institute of Certified Public Accountants (AICPA)

• Institute of Management Accountants (IMA)

• Institute of Internal Auditors (IIA)

The Conceptual Framework

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• Described as an “Accounting Constitution”• Provides an underlying foundation for accounting

standards– Guide the selection of events to be accounted for– Measurement of those events– Means of summarizing and communicating them to

interested parties• Provides structure and direction to financial accounting

and reporting • Disseminated by FASB through Statements of Financial

Accounting Concepts (SFACs)

The Conceptual Framework

ElementsRecognition andMeasurement

Concepts

Constraints

QualitativeCharacteristics

FinancialStatements

Objective

Hierarchy of Qualitative Characteristics of Financial Information

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Decision usefulness

Relevance Faithful Representation

Predictive Value

Confirmatory value Materiality Completeness Neutrality Free from

error

Comparability(Consistency)

Verifiability Timeliness Understandability

Cost effectiveness constraint(benefits exceed costs)

The Conceptual Framework

ElementsRecognition andMeasurement

Concepts

Constraints

QualitativeCharacteristics

FinancialStatements

Objective

Elements of Financial Statements• Assets: Probable future economic benefits obtained or controlled by a particular

entity as a result of past transactions or events.

• Liabilities: 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 or events.

• Equity (or net assets): Called shareholders’ equity or stockholders’ equity for a corporation, it is the residual interest in the assets of an entity that remains after deducting its liabilities.

• Investments by owners: 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.

• Distributions to owners: Decreases in equity of a particular enterprise resulting from transfers 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.

• Revenues: 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.

• Expenses: 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.

• Gains: Increases in equity from 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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Underlying Assumptions

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Assumption DescriptionEconomic entity Presumes that economic events

can be identified specifically with an economic entity.

Going concern Anticipates that a business entity will continue to operate indefinitely.

Periodicity Life of a company to be divided into artificial time periods to provide timely information.

Monetary unit Financial statements are measured in a particular monetary unit (like the U.S. dollar).

The Conceptual Framework

ElementsRecognition andMeasurement

Concepts

Constraints

QualitativeCharacteristics

FinancialStatements

Objective

Recognition, Measurement, and Disclosure Concepts

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• Recognition refers to the process of admitting information into the financial statements

• Measurement is the process of associating numerical amounts with the elements

• Disclosure refers to the process of including additional pertinent information in the financial statements and accompanying notes

• General Recognition Criteria– Definition, Measurability, Relevance, and Reliability

Revenue Recognition

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Revenue: Inflows of assets or settlements of liabilities resulting from providing a product or service to a customer

FASB recently issued ASU No. 2014-09, which requires that we recognize revenue when goods or services are transferred to customers for the amount the company expects to be entitled to receive in exchange for those goods or services.

Previously, revenue recognition was guided by the realization principle (two criteria)

– Earnings process is judged to be complete or virtually complete

– Reasonable certainty as to the collectibility of the asset to be received (usually cash)

Expense Recognition

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Often matches revenues and expenses that arise from the same transactions or other eventsFour approaches:

• Based on an exact cause-and-effect relationship

• By associating an expense with the revenues recognized in a specific time period

• By a systematic and rational allocation to specific time periods

• In the period incurred, without regard to related revenue

Measurement

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GAAP currently employs a “mixed attribute” measurement model. The five measurement attributes are: Historical cost: original transaction value adjusted for

depreciation and amortization. Net realizable value: the amount of cash into which an asset

is expected to be converted in the ordinary course of business Current cost: the cost that would be incurred to purchase or

reproduce the asset. Present (or discounted) value: calculated by removing the

time value of money from future cash flows Fair value: 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.

Measurement

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Fair Value (called current market value originally in SFAC 5 )• Bases measurements on the price that would be received

to sell assets or transfer liabilities in an orderly market transaction

Fair value can be measured using:1. Market approach: Valuation based on market information2. Income approach: Estimates future amounts and then

mathematically converts those amounts to a single present value

3. Cost approach: Estimates the amount that would be required to buy or construct an asset of similar quality and condition

Fair Value Hierarchy

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Measurement

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Fair Value Option• GAAP gives a company the option to report some

financial assets and liabilities at fair value

– Provides companies a way to reduce volatility in reported earnings without having to comply with complex hedge accounting standards

– Helps to converge with international accounting standards

Summary of Recognition, Measurement, and Disclosure Concepts

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Evolving GAAP

• Revenue/Expense Approach– Emphasize principles for recognizing revenues and

expenses, which determines amount and timing of recognition of assets and liabilities

• Asset/Liability Approach– Recognize and measure the assets and liabilities that

exist at a balance sheet date – Recognize and measure the revenues, expenses, gains

and losses needed to account for the changes in these assets and liabilities from the previous measurement date

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Project: Professional Resume

• 5 = 50 points (good resume with a few modifications)

• 3 = 40 points (okay resume but needs some work)

• 1 = 30 points (not very good; seems as if instructions were not followed)

• Students who received a 1 or 3 may re-submit their resumes with substantial improvement for a higher score. Students who received a 3 may get a 5 and who received a 1 may get a 3 to improve their initial score.

End of Chapter 1