© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Intermediate Accounting Spiceland / Sepe / Tomassini Third Edition

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Chapter 1 Environment and Theoretical Structure of Financial Accounting

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 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

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 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

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 1-5 Investment-Credit Decisions A Cash Flow Perspective Corporate shareholders will receive cash from their investments through... Periodic dividend distributions from the corporation. The ultimate sale of the ownership shares of stock.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 1-6 Investment-Credit Decisions A Cash Flow Perspective Accounting information should help investors evaluate the amount, timing, and uncertainty of the enterprise’s future cash flows.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 1-7 Cash Versus Accrual Accounting Cash Basis Accounting Revenue is recognized when cash is received. Expenses are recognized when cash is paid.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 1-8 Cash Versus Accrual Accounting Cash Basis Accounting Carter Company has sales on account totaling $100,000 per year, and collected as shown on the following slide. 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.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 1-9 Cash Versus Accrual Accounting Cash Basis Accounting

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 1-10 Cash Basis Accounting Cash Versus Accrual Accounting Cash flows in any one year may not be a predictor of future cash flows.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 1-11 Cash Versus Accrual Accounting Accrual Accounting Revenue is recognized when earned. Expenses are recognized when incurred. Let’s reconsider the Carter Company information.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 1-12 Accrual Accounting Revenue is recognized when earned. Expenses are recognized when incurred. Let’s reconsider the Carter Company information. Cash Versus Accrual Accounting

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 1-13 The Development of Financial Accounting and Reporting Standards Concepts, principles, and procedures were developed to meet the needs of external users (GAAP).

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 1-14 Early Standard Setting Evolution of Standard-Setting Process : Committee on Accounting Procedures (CAP) : Accounting Principles Board (APB)

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 1-15 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.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 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 Institute

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 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.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 1-18 International Accounting Standards Committee (IASC) Established in 1973 to narrow the range of differences in accounting standards. Increase in international trade has motivated the IASC to attempt to eliminate alternative accounting treatments.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 1-19 Role of the Auditor Independent intermediary to help insure that management has in fact appropriately applied GAAP.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 1-20 The Conceptual Framework Maintain consistency among standards. Resolve new accounting problems. Provide user benefits.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 1-21 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)

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 1-22 To provide information:  Useful for 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 Objectives Qualitative Characteristics Financial Statements Continued

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 1-23 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

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 1-24 RelevanceReliability Predictive Value Feedback Value TimelinessNeutrality Verifiability Representational Faithfulness ComparabilityConsistency Qualitative Characteristics - Understandability Decision Usefulness

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 1-25 Practical Constraints to Achieving Desired Qualitative Characteristics Cost Effectiveness Materiality Conservatism

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 1-26 SFAC No. 6 Revenues “Inflows of assets or settlements of liabilities during a particular accounting period. Such inflows or settlements stem from delivery or production of goods or rendering of services.”

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 1-27 SFAC No. 6 Expenses “Outflows of assets or incurrences of liabilities during a particular accounting period. Such outflows are necessary for delivery or production of goods or rendering of services.”

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 1-28 SFAC No. 6 Gains and Losses Gains: “Increases in equity resulting from incidental transactions not associated with the company’s major business.” Losses: “Decreases in equity resulting from incidental transactions not associated with the company’s major business.”

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 1-29 SFAC No. 6 Assets and Liabilities Assets: “Business resources that have probable future economic benefits.” Liabilities: “Probable future sacrifices of economic benefits.”

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 1-30 SFAC No. 6 Equity Residual interest in the assets of a business entity is also known as net assets.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 1-31 SFAC No. 6 Investments and Distributions Investments by owners: “Increases in equity resulting from asset contribution by other entities (owners/stockholders).” Distribution to owners: “Decreases in equity resulting from the distribution of assets to other entities.”

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 1-32 SFAC No. 6 Comprehensive Income “The change in equity resulting from the aggregate of all transactions reported in a particular accounting period, except for investments by and distributions to owners.”

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 1-33 Recognition and Measurement Concepts

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 1-34 The Realization Principle Reasonable Assurance of Collection Substantial Completion of Transaction Two conditions must be met if the realization principle is to be satisfied. Two conditions must be met if the realization principle is to be satisfied.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 1-35 Question The function of financial accounting is to identify, measure and communicate financial information about economic entities to interested parties. a. True b. False

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 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

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 1-37 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

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 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

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 1-39 Question The primary objective of accrual basis accounting is the measurement of income. a. True b. False

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 1-40 Question The primary objective of accrual basis accounting is the measurement of income. a. True b. False

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 1-41 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

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 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

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 1-43 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

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 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

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 1-45 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

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 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

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 1-47 Question The Financial Accounting Standards Board develops accounting and reporting standards independent of public, business and political pressures. a. True b. False

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 1-48 Question The Financial Accounting Standards Board develops accounting and reporting standards independent of public, business and political pressures. a. True b. False

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 1-49 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.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 1-50 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.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 1-51 End of Chapter 1