Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Environmental and Theoretical Structure of Financial Accounting 1 Insert Book Cover Picture

1-2 Learning Objectives Describe the function and primary focus of financial accounting.

1-3 Financial Accounting Environment Profit-oriented companies Not-for-profit entities Households Providers of Financial Information External User Groups Investors Creditors Employees Labor unions Customers Suppliers Government agencies Financial intermediaries Relevant Financial Information

1-4 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

1-5 The Economic Environment and Financial Reporting A sole proprietorship is owned by a single individual. A partnership is owned by two or more individuals. A corporation is owned by stockholders, frequently numbering in the tens of thousands in large corporations. A highly-developed system of financial reporting is necessary to communicate financial information from a corporation to its many shareholders.

1-6 Investment-Credit Decisions 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 of stock.

1-7 Accounting information should help investors evaluate the amount, timing, and uncertainty of the enterprise’s future cash flows. Investment-Credit Decisions A Cash Flow Perspective

1-8 Learning Objectives Explain the difference between cash and accrual accounting.

1-9 Cash Versus Accrual Accounting Cash Basis Accounting Revenue is recognized when cash is received. Expenses are recognized when cash is paid.

1-10 Cash Versus Accrual Accounting Accrual Accounting Revenue is recognized when earned. Expenses are recognized when incurred.

1-11 Learning Objectives Define generally accepted accounting principles (GAAP) and discuss the historical development of accounting standards.

1-12 The Development of Financial Accounting and Reporting Standards Concepts, principles, and procedures were developed to meet the needs of external users (GAAP).

1-13 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)

1-14 Current Standard Setting - FASB  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.

1-15 Learning Objectives Explain why the establishment of accounting standards is characterized as a political process.

1-16 Establishment of Accounting Standards A Political Process GAAP Internal Revenue Service American Institute of CPAs Securities and Exchange Commission American Accounting Association Governmental Accounting Standards Board Financial Executives International

1-17 FASB’s Standard-Setting Process  Identification of problem.  The task force.  Research and analysis.  Discussion memorandum.  Public response.  Exposure draft.  Public response.  Statement issued.

1-18 Role of the Auditor Independent intermediary to help insure that management has in fact appropriately applied GAAP.

1-19 Financial Reporting Reform Public Company Accounting Reform and Investor Protection Act of 2002 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.

1-20 Learning Objectives Explain the purpose of the FASB’s conceptual framework.

1-21 The Conceptual Framework  Maintain consistency among standards.  Resolve new accounting problems.  Provide user benefits.

1-22 Learning Objectives Identify the objectives of financial reporting, the qualitative characteristics of accounting information, and the elements of financial statements. Describe the four basic assumptions underlying GAAP Describe the four basic accounting principles that guide accounting practice.

1-23 The Conceptual Framework Recognition and Measurement Criteria (SFAC No. 5) Environment Implementation Implementation assumptions principles constraints Objectives of Financial Reporting (SFAC No. 1) Qualitative Characteristics of Accounting Information (SFAC No. 2) Elements of Financial Statements (SFAC No. 6)

1-24 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. Elements Recognition and Measurement Concepts Constraints Conceptual Framework Qualitative Characteristics Financial Statements Continued

1-25 Elements Assets Liabilities Equity Investments by Owners Distributions to owners Revenues Expenses Gains Losses Comprehensive Income Recognition and Measurement Concepts Assumptions Economic entity Going concern Periodicity Monetary unit Principles Historical cost Realization Matching Full Disclosure Objectives Financial Statements Balance sheet Income statement Statement of cash flows Statement of shareholders’ equity Related disclosures Constraints Cost effectiveness Materiality Conservatism Qualitative Characteristics Understandability Primary Relevance Reliability Secondary Comparability Consistency

1-26 RelevanceReliability Predictive Value Feedback Value TimelinessNeutrality Verifiability Representational Faithfulness ComparabilityConsistency Qualitative Characteristics of Accounting Information Decision Usefulness

1-27 Practical Constraints to Achieving Desired Qualitative Characteristics Cost Effectiveness Materiality Conservatism

1-28 SFAC No. 6 Assets 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.

1-29 SFAC No. 6 Equity 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.

1-30 SFAC No. 6 Investments 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.

1-31 SFAC No. 6 Revenues 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 entity’s ongoing major, or central, operations.

1-32 SFAC No. 6 Expenses 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 entity’s ongoing major, or central, operations.

1-33 SFAC No. 6 Gains 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.

1-34 SFAC No. 6 Comprehensive 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.

1-35 Recognition and Measurement Concepts

1-36 Question The function of financial accounting is to identify, measure and communicate financial information about economic entities to interested parties. a. True b. False

1-37 Question The function of financial accounting is to identify, measure and communicate financial information about economic entities to interested parties. a. True b. False

1-38 Question 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

1-39 Question 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

1-40 Question The primary objective of accrual basis accounting is the measurement of income. a. True b. False

1-41 Question The primary objective of accrual basis accounting is the measurement of income. a. True b. False

1-42 Question 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

1-43 Question 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

1-44 Question The major financial accounting standard setting body is the a. Accounting Principles Board b. Securities and Exchange Commission c.Financial Accounting Standards Board d. American Institute of CPAs

1-45 Question The major financial accounting standard setting body is the a. Accounting Principles Board b. Securities and Exchange Commission c.Financial Accounting Standards Board d. American Institute of CPAs

1-46 Question The FASB issues which of the following types of pronouncements? a. Standards b. Interpretations c. Financial Accounting Concepts d. Technical Bulletins e. All of the above

1-47 Question The FASB issues which of the following types of pronouncements? a. Standards b. Interpretations c. Financial Accounting Concepts d. Technical Bulletins e. All of the above

1-48 Question The Financial Accounting Standards Board develops accounting and reporting standards independent of public, business and political pressures. a. True b. False

1-49 Question The Financial Accounting Standards Board develops accounting and reporting standards independent of public, business and political pressures. a. True b. False

1-50 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.

1-51 End of Chapter 1