1. Environment and Theoretical Structure of Financial Accounting1
Environment and Theoretical Structure of Financial Accounting
Chapter 1: Environment and Theoretical Structure of Financial Accounting
The primary function of financial accounting is to provide useful financial information to users external to the business enterprise. The focus of financial accounting is on the information needs of investors and creditors. These users make critical resource allocation decisions that affect the nation’s economy. The principal means of conveying financial information to external users is through financial statements and related notes.

2. 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
Government agencies
Financial intermediaries
Relevant
Financial
Information
Several types of entities provide financial information to a variety of external users. Our primary focus in this book is on the financial information that profit-oriented companies provide to present and potential investors and to creditors. These profit-oriented companies also provide financial information that is used by financial intermediaries such as financial analysts, stockbrokers, mutual fund managers, and credit rating agencies.
Not-for-profit organizations also provide financial information to external users such as citizen groups and donors.
As an individual, you provide financial information to the internal revenue service and to creditors when you seek a loan.

3. 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
Accounting is often thought of as the “language” used to communicate financial information about a business. The primary method that profit-oriented companies use to provide financial information to investors, creditors and other external parties is through financial statements and their accompanying disclosure notes. The four financial statements used most frequently for this purpose are the:
Balance Sheet.
Income Statement.
Statement of Cash Flows.
Statement of Shareholders’ Equity.

4. 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 highly-developed system communicates financial information from a corporation to its many shareholders.
The three primary forms of business organization are the sole proprietorship, the partnership, and the corporation. A sole proprietorship is owned by a single individual. A partnership is owned by two or more individuals. A corporation is owned by shareholders, frequently numbering in the tens of thousands in large corporations. Although sole proprietorships and partnerships out number corporations, corporations are the dominant form of business in terms of size and ownership of productive resources.
Investors and creditors provide massive amounts of financial resources to corporations. A highly-developed system of financial reporting is necessary to communicate financial information from a corporation to its many shareholders and creditors concerning how the corporation uses these resources.
A corporation is owned by shareholders.

5. Investment-Credit Decisions ─ A Cash Flow Perspective
Shareholders Receive
Cash
Creditors
Receive
Cash
Dividends
Sale of Stock
Interest
Loan Repayment
Part I.
Investors and creditors are both concerned with providing resources, usually cash, to companies with the expectation of receiving more cash in return at some future time. Investors may receive future cash returns in the form of periodic dividends and from the sale of their ownership shares. Creditors may receive future cash returns in the form on interest and repayment of principal.
Part II.
The primary objective of financial accounting is to provide investors and creditors with financial information that will help them make investment and credit decisions. The information should help investors and creditors evaluate the amounts, timing, and uncertainty of the company’s future cash receipts and payments. With better financial information, investors and creditors will be able to make better resource allocation decisions.
Accounting information should help investors and creditors evaluate the amount, timing, and uncertainty of the enterprise’s future cash flows.

6. Cash versus Accrual Accounting
Cash Basis Accounting Revenue is recognized when cash is received. Expenses are recognized when cash is paid.
OROROR OR
Using cash basis accounting, revenue is recognized when cash is received, and expenses are recognized when cash is paid. This net cash flow measure of income is easily understood, and all information to measure cash flows is factual. However, there is a major shortcoming to using current net cash flow to predict future periods’ cash flows.
Using accrual accounting, revenue is recognized when it is earned, and expenses are recognized when they are incurred.
Accrual Accounting
Revenue is recognized when earned. Expenses are recognized when incurred.

7. 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.
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.

8. Cash versus Accrual Accounting
Cash Basis Accounting
Part I.
Because sales are made on account, sales in one year may not be collected until the next year. For example, even though sales for each year are $100,000, collections in the first year are only $50,000. Also notice the large rent prepayment in the first year that provides for all three years. The combination of cash receipts lagging sales and the large rent prepayment account for the majority of the negative net cash flow for year one. The pattern of cash payments for utilities actually improves the net cash flow for the first year at the expense of the second year. Can you see how the timing of cash flows and management’s ability to influence the timing for many cash flows can reduce the usefulness of net cash flow as an operating performance measure?
Part II.
For the entire three-year period, the total net cash flow is a good operating performance measure, but for any one year, it is a poor operating performance measure.
Cash flows in any one year may not be a predictor of future cash flows.

9. Cash versus Accrual Accounting
Accrual Basis Accounting
Part I.
Revenue is recognized when the sale is made, not when the cash is received, resulting in the same amount of revenue each year. Rent expense is recognized evenly as the rented space is used over the three years, not when the cash is paid in the first year. Utility expense is recognized when incurred, not when paid. The resulting net income is $20,000 each year. Isn’t this a more reasonable result?
Looking at the cash basis results and the accrual accounting results for Carter Company, which method would you want to use if you were asked to make predictions about future years’ operating performance?
Part II.
By comparing the cash basis results and the accrual basis accounting results for Carter Company, you see that the accrual basis may be a better indicator of future operating cash flows than is current net operating cash flow.
Net Income is considered a better indicator
of future cash flows.

10. The Development of Financial Accounting and Reporting Standards
Concepts,
principles, and
procedures were
developed to meet the
needs of external
users (GAAP).
Generally accepted accounting principles are a dynamic set of both broad and specific guidelines that companies should follow when measuring and reporting information in their financial statements and in the accompanying disclosure notes. These guidelines, concepts, principles, and procedures have been developed over time to meet the needs of external users.

11. Historical Perspective and Standards
As a result of the stock market crash of 1929, Congress passed the 1933 Securities Act and the 1934 Securities and Exchange Act, the latter creating the Securities and Exchange Commission (SEC). In the 1934 Act, Congress gave the Securities and Exchange Commission the authority to set accounting and reporting standards for publicly traded companies. However, even though the Securities and Exchange Commission does issue its own standards, called Financial Reporting Releases, it has delegated the primary task for setting accounting standards to the private sector.
The first private sector standards-setting body was the Committee on Accounting Procedure, in existence from 1938 until In 1959, the Accounting Principles Board replaced the Committee on Accounting Procedure. The Accounting Principles Board lasted until 1973 at which time it was replaced by the current standards-setting body, the Financial Accounting Standards Board.

12. Current Standard Setting
Financial Accounting Standards Board
Supported by the Financial Accounting Foundation
Five full-time, independent voting members
Answerable only to the Financial Accounting Foundation
Members not required to be CPAs
Criticisms of the Accounting Principles Board, primarily lack of independence and its unwieldy actions, led to its demise in 1973 and to its replacement by the Financial Accounting Standards Board, the current standards-setting body. The Financial Accounting Standards Board:
Is supported by the Financial Accounting Foundation.
Consists of five full-time, independent voting members who serve for a five year term, which may be extended by reappointment to one additional five year term.
Is answerable only to the Financial Accounting Foundation.
Does not require its members to be Certified Public Accountants.

13. FASB Accounting Standards Codification
The objective of the codification project was to integrate and organize by topics all relevant accounting pronouncements into a searchable, online database.
In 2007, the FASB launched its FASB Accounting Standards Codification project. The objective of the project was to integrate and organize by topics all relevant accounting pronouncements into a searchable, online database. The codification became effective on July 1, 2009, and now represents the single source of authoritative U.S. GAAP, except for rules and interpretive releases by the SEC (which are also authoritative GAAP). The codification is organized into nine main topic areas and approximately 90 subtopics.

14. Establishment of Accounting Standards A Political Process
Internal Revenue
Service
Financial Executives
International
American Institute
of CPAs
GAAP
Governmental
Accounting
Standards Board
International Accounting Standards Board
The Financial Accounting Standards Board must consider the potential economic consequences of accounting standards. Many times, financial accounting standards are a compromise between the Board’s position and the wishes of various special interest groups. Especially controversial in recent years has been the efforts to develop accounting standards for employee stock options, business combinations, and the fair value standard.
The FASB’s dilemma is to balance accounting considerations and political considerations resulting from perceived economic consequences.
American
Accounting
Association
Securities and
Exchange
Commission

15. FASB’s Standard-Setting Process
Board receives recommendations for projects.
Board votes to add the project to its agenda .
Board deliberates the issues at a series of public
meetings.
Board issues an Exposure Draft (ED).
Board holds a public roundtable meeting on the ED.
Staff analyzes feedback and the Board re-deliberates
the proposed revisions at public meetings .
Board issues a Standards Update describing
amendments to the Codification.
The Financial Accounting Standards Board goes through an elaborate process before issuing standards.
First, the Board receives requests/recommendations for possible projects and reconsideration of existing standards from various sources.
Second, the FASB Chairman decides whether to add a project to the technical agenda, subject to oversight by the Foundation's Board of Trustees and after appropriate consultation with FASB Members and others.
Third, the Board deliberates at one or more public meetings the various issues identified and analyzed by the staff.
Fourth, the Board issues an Exposure Draft (ED). (In some projects, a Discussion Paper may be issued to obtain input at an early stage that is used to develop an Exposure Draft.)
Fifth, the Board holds a public roundtable meeting on the Exposure Draft, if necessary.
Sixth, the staff analyzes comment letters, public roundtable discussion, and any other information, and the Board re-deliberates the proposed provisions at public meetings.
And lastly, the Board issues Board issues an Accounting Standards Update describing amendments to the Accounting Standards Codification.

16. Toward Global Accounting Standards
The main objective of the International Accounting Standards Board (IASB) is to develop a single set of high quality, understandable and enforceable global accounting standards to help participants in the world’s capital markets and other users make economic decisions.
The increase in international trade and the presence of large multinational companies in many countries in the world has led to problems where different accounting standards govern financial reporting in different countries. In response to this problem, the International Accounting Standards Committee (IASC) was formed in The IASC reorganized itself in 2001 and created a new standards setting body called the International Accounting Standards Board (IASB). The main objective of the IASB is to develop a single set of high quality, understandable and enforceable global accounting standards to help participants in the world’s capital markets and other users make economic decisions. The IASB issues standards called International Financial Reporting Standards or IFRSs which are gaining support around the globe. According to the SEC Roadmap, IFRS may be required by U.S. companies in 2014.

17. Role of the Auditor
Auditors serve as independent intermediaries to help insure that management has appropriately applied GAAP in preparing the company’s financial statements.
Management prepares a company’s financial statements. Auditors serve as independent intermediaries to help insure that management has appropriately applied generally accepted accounting principles in preparing the company’s financial statements. Auditors express an opinion on the compliance of the financial statements with generally accepted accounting principles. The auditor’s opinion adds credibility to the financial statements. Audits are conducted by a Certified Public Accountants (CPAs) who are licensed by states to provide audit services.

18. Financial Reporting Reform
As a result of numerous financial scandals, Congress passed the Public Company Accounting Reform and Investor Protection Act of 2002, (Sarbanes-Oxley Act). The goal was to restore credibility and investor confidence in the financial reporting process.
The collapse of Enron in 2001, followed by other accounting scandals in companies like WorldCom, caused Congress to pass the Public Company Accounting Reform and Investor Protection Act of The Act is commonly referred to as the Sarbanes-Oxley Act named for the two congressmen who sponsored the bill. The goal was to restore credibility and investor confidence in the financial reporting process. This federal law provides for the regulation of auditors of public securities issuing entities and the types of services they furnish to clients, increases accountability of corporate executives, addresses conflicts of interest for securities analysts, and provides for stiff criminal penalties for violators.

19. A Move Away from Rules-Based Standards?
Rules based accounting standards vs. objectives-oriented approach
Objectives oriented (principles-based) approach stressed professional judgment
Investors and creditors rely on financial accounting information to make resource allocation decisions. The information must be objective and reliable to be of maximum usefulness. A high standard of ethical behavior is expected of the accounting profession throughout the financial accounting and reporting process.

20. Ethics in Accounting
For financial information to be useful, it should possess the fundamental decision-specific qualities of relevance and faithful representation.
Management may be under pressure to report desired results and ignore or bend existing rules.
Investors and creditors rely on financial accounting information to make resource allocation decisions. The information must possess the fundamental decision-specific qualities of relevance and faithful representation to be of maximum usefulness. A high standard of ethical behavior is expected of the accounting profession throughout the financial accounting and reporting process.

21. Underlying Assumptions and Accounting Principles
The four basic assumptions underlying generally accepted accounting principles are:
 All economic events can be identified with a particular economic entity.
 In the absence of information to the contrary, it is assumed that the business entity will continue to operate indefinitely.
 The life of a business is divided into time periods to provide timely information.
All measurements are in United States dollars.
There are four accounting principles that provide guidance for accounting practice:
 Measurement is based on the original transaction amount.
 Revenue is recognized when the earnings process is complete, and when there is reasonable certainty of collecting the asset to be received.
 Expenses are recognized in the same period as the related revenue.
Financial statements should include any information that could affect the decisions made by external users.

22. Evolution of Accounting Principles 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
GAAP defines fair value as 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.
There are three types of valuation techniques that can be used to measure fair value.
 Market approaches base valuation on market information.
 Income approaches estimate value by determining the present value of estimated future earnings or cash flows.
 Cost approaches base valuation on estimates of amounts required to buy or construct an asset of similar quality and condition.
Cost
Approaches

23. Fair Value Hierarchy
To increase consistency and comparability, the FASB provides a hierarchy that prioritizes the inputs that companies should use when determining fair value. The priority is based on the three broad preference levels shown on your screen. The higher the level (Level 1 is the highest), the more preferable the input.
GAAP gives companies the option to report some or all of their financial assets and liabilities at fair value. A description of the inputs used to measure fair value must be disclosed in the notes to the financial statements so that financial statement readers can understand how the fair value was determined. This makes the information more useful to them.
GAAP gives companies the option to report some or all of their financial assets and liabilities at fair value.