McGraw-Hill /Irwin© 2009 The McGraw-Hill Companies, Inc. ENVIRONMENT AND THEORETICAL STRUCTURE OF FINANCIAL ACCOUNTING Chapter 1

Slide 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

Slide 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

Slide 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.

Slide 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. Accounting information should help investors evaluate the amount, timing, and uncertainty of the enterprise’s future cash flows.

Slide Cash Versus Accrual Accounting Cash Basis Accounting Revenue is recognized when cash is received. Expenses are recognized when cash is paid.

Slide 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. Let’s look at the cash flows.

Slide Cash Versus Accrual Accounting Cash Basis Accounting Cash flows in any one year may not be a predictor of future cash flows.

Slide Cash Versus Accrual Accounting Accrual Accounting Revenue is recognized when earned. Expenses are recognized when incurred. Let’s reconsider the Carter Company information.

Slide Accrual Accounting ◦ Revenue is recognized when earned. ◦ Expenses are recognized when incurred. ◦ Let’s reconsider the Carter Company information. Cash Versus Accrual Accounting

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

Slide Historical Perspective and Standards Securities and Exchange Commission (SEC)  1934 – present Evolution of Standard-Setting Process  1938 – 1959:  Committee on Accounting Procedure (CAP)  1959 – 1973:  Accounting Principles Board (APB)

Slide 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.

Slide Hierarchy of GAAP FASB Statements of Financial Accounting Standards, FASB Interpretations, SEC rules and interpretive releases, 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 widely recognized general or industry practices. Most Authoritative Least Authoritative An FASB Accounting Standards Codification, expected in 2009, will integrate, topically organize, and effectively eliminate this hierarchy.

Slide 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

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

Slide International Accounting Standards Board (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.

Slide Role of the Auditor Independent intermediary to help insure that management has appropriately applied GAAP.

Slide 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.

Slide 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.

Slide 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.

Slide Maintain consistency among standards. Resolve new accounting problems. Provide user benefits. The Conceptual Framework

Slide The Conceptual Framework Recognition and Measurement Criteria (SFAC No. 5 and SFAC No. 7) 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)

Slide 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

Slide 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

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

Slide Practical Constraints to Achieving Desired Qualitative Characteristics Cost Effectiveness Materiality Conservatism

Slide Elements of Financial Statements

Slide Elements of Financial Statements

Slide Recognition and Measurement Concepts

Slide The Asset/Liability Approach The focus on assets and liabilities has lead to increased interest on fair value measurement  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.

Slide 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

Slide Fair Value Hierarchy SFAS No. 159 gives companies the option to report some or all of their financial assets and liabilities at fair value.

Slide 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

Slide 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

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

Slide 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

Slide Question 5 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

Slide Question 6 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

McGraw-Hill /Irwin© 2009 The McGraw-Hill Companies, Inc. End of Chapter 1