1. Environmental and Theoretical Structure of Financial Accounting
Insert Book Cover Picture
Environmental and Theoretical Structure of Financial Accounting 1
Chapter 1: Environmental and Theoretical Structure of Financial Accounting.

2. Describe the function and primary focus of financial accounting.
Learning Objectives
Describe the function and primary focus of financial accounting.
LO1
Our first learning objective in Chapter 1 is to describe the function and primary focus of financial accounting.

3. 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 creditors when you seek credit.

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
The primary means 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.

5. The Economic Environment and Financial Reporting
A sole proprietorship is owned by a single individual.
A corporation is owned by stockholders, frequently numbering in the tens of thousands in large corporations.
A partnership is owned by two or more individuals.
A highly-developed system of financial reporting is necessary to communicate 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 stockholders, frequently numbering in the tens of thousands in large corporations. Although sole proprietorships and partnerships out number corporations, corporations are the dominant form or 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.

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.
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 will receive future cash returns in the form of periodic dividends and from the sale of their ownership shares. Creditors will receive future cash returns in the form on interest and repayment of principal.

7. 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.
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.

8. Explain the difference between cash and accrual accounting.
Learning Objectives
Explain the difference between cash and accrual accounting.
LO2
Our second learning objective in Chapter 1 is to explain the difference between cash and accrual accounting.

9. Cash Versus Accrual Accounting
Cash Basis Accounting
Revenue is recognized when cash is received.
Expenses are recognized when cash is paid.
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.
Consider the following example.

10. 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.

11. Cash Versus Accrual Accounting
Cash Basis Accounting
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?

12. Cash Versus Accrual Accounting
Cash Basis Accounting
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.

13. Cash Versus Accrual Accounting
Revenue is recognized when earned.
Expenses are recognized when incurred.
Let’s reconsider the Carter Company information.
Even though predicting future cash flows is the primary objective, accrual accounting achieves that objective better than the cash basis of accounting.
Using accrual accounting, revenue is recognized when it is earned, and expenses are recognized when they are incurred. Let’s reconsider the Carter Company information using accrual accounting to report net income.

14. Cash Versus Accrual Accounting
Revenue is recognized when earned.
Expenses are recognized when incurred.
Let’s reconsider the Carter Company information.
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 income is $20,000 each year. Isn’t this a more reasonable result? After all, if sales revenue is the same amount each year, wouldn’t you expect income to be equal or nearly equal each year?
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?

15. Learning Objectives LO3
Define generally accepted accounting principles (GAAP) and discuss the historical development of accounting standards.
LO3
Our third learning objective in Chapter 1 is to define generally accepted accounting principles and discuss the historical development of accounting standards.

16. 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.

17. 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)
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. In the 1934 Act, Congress gave the Securities and Exchange Commission the power and responsibility for setting 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 responsibility for setting accounting standards to the private sector.
The first private sector standards-setting body was the Committee on Accounting Procedures, in existence from 1938 until In 1959, the Accounting Principles Board replaced the Committee on Accounting Procedures. The Accounting Principles Board lasted until 1973 at which time it was replaced by the current standards-setting body, the Financial Accounting Standards Board.

18. Current Standard Setting - FASB www.fasb.org
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.
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 seven full-time, independent voting members serving for ten years.
Is answerable only to the Financial Accounting Foundation.
Does not require its members to be Certified Public Accountants.

19. Learning Objectives LO4
Explain why the establishment of accounting standards is characterized as a political process.
LO4
Our fourth learning objective in Chapter 1 is to explain why the establishment of accounting standards is characterized as a political process.

20. Establishment of Accounting Standards A Political Process
Internal Revenue
Service
Financial Executives
International
GAAP
Governmental
Accounting
Standards Board
American Institute
of CPAs
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 postretirement benefits, employee stock options, and business combinations.
On occasion, the financial Accounting Standards board has bowed to public pressure, and conceptual merit in the standards setting process has suffered..
Securities and
Exchange
Commission
American
Accounting
Association

21. FASB’s Standard-Setting Process
Identification of problem.
The task force.
Research and analysis.
Discussion memorandum.
Public response.
Exposure draft.
Statement issued.
The Financial Accounting Standards Board goes through an elaborate information-gathering process before issuing standards. First an issue is identified and placed on the Board’s agenda by the Emerging Issues Task Force. Next a task force of knowledgeable persons is appointed to advise the Board on the issue. The Board’s technical staff investigates the issue. A discussion memorandum on the issue is then written and distributed to interested parties. The Board holds public hearings and solicits feedback on the issue. After public hearings, a preliminary draft (called an exposure draft) of a proposed Board statement is issued. Responses to the exposure draft are analyzed and the draft is revised as necessary. Finally, a new standard called a Statement of Financial Accounting Standards is issued.

22. International Accounting Standards Board (IASB)
Established in 1973 to narrow the range of differences in accounting standards.
Increase in international trade has motivated the IASB to attempt to eliminate alternative accounting treatments.
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 Board was formed in The objectives of the Board are to:
 Develop a single set of high quality, understandable global accounting standards.
 Promote the use of those standards.
 Bring about the convergence of national accounting standards and international accounting standards.

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

24. Financial Reporting Reform
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.
As a result of numerous financial scandals, Congress passed the Public Company Accounting Reform and Investor Protection Act of The Act is commonly referred to as the Sarbanes-Oxley Act for the two congressmen who sponsored the bill. You are no doubt familiar with the financial collapses of such large companies as Enron and WorldCom that led Congress to take this action. This new federal law provides for the regulation of auditors and the types of services they furnish to clients, increases accountability of corporate executives, address conflicts of interest for securities analysts, and provides for stiff criminal penalties for violators.

25. Explain the purpose of the FASB’s conceptual framework.
Learning Objectives
Explain the purpose of the FASB’s conceptual framework.
LO5
Our fifth learning objective in Chapter 1 is to explain the purpose of the Financial Accounting Standard Board’s conceptual framework.

26. The Conceptual Framework
Maintain consistency among standards.
Resolve new accounting problems.
Provide user benefits.
The Financial Accounting Standards Board has issued seven Statements of Financial Accounting Concepts that form what we know as the conceptual framework of accounting. The conceptual framework does not prescribe generally accepted accounting principles, but it provides an underlying foundation for the development of accounting standards.. The primary purpose of the conceptual framework is a process leading to cohesive objectives and fundamental concepts on which financial accounting and reporting can be based.

27. Describe the four basic assumptions underlying GAAP
Learning Objectives
Identify the objectives of financial reporting, the qualitative characteristics of accounting information, and the elements of financial statements.
LO6
Describe the four basic assumptions underlying GAAP
LO7
Our sixth, seventh, and eighth learning objectives in Chapter 1 are to:
Identify the objectives of financial reporting, the qualitative characteristics of accounting information, and the elements of financial statements.
Describe the four basic assumptions underlying generally accepted accounting principles.
Describe the four basic accounting principles that guide accounting practice.
Describe the four basic accounting principles that guide accounting practice.
LO8

28. The Conceptual Framework
Objectives of Financial Reporting
(SFAC No. 1)
Qualitative Characteristics
of Accounting Information
(SFAC No. 2)
Elements of
Financial Statements
(SFAC No. 6)
The Financial Accounting Standards Board has issued seven Statements of Financial Accounting Concepts. Statement One provides the objectives of financial accounting and reporting. Statement Two outlines the qualitative characteristics of accounting information. Statement Three has been superceded by Statement Six. Statement Four deals with the objectives of financial reporting for nonprofit organizations. Statement Five addresses recognition and measurement issues. Statement Six defines ten elements of financial statements. Statement Seven provides a framework for using future cash flows in accounting measurements.
We will focus our discussion on Statements One, Two, Five, and Six in this chapter. Statement Seven will be addressed in Chapter 6.
Recognition and Measurement Criteria
(SFAC No. 5)
Environment Implementation Implementation
assumptions principles constraints

29. Qualitative Characteristics Recognition and Measurement Concepts
Conceptual Framework
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.
Qualitative Characteristics
Elements
Recognition and Measurement Concepts
Statement of Financial Accounting Concepts One provides three objectives of financial accounting and reporting. The objectives are to:
Recognize that investors and creditors are the primary users of financial reporting and to provide information useful for their decisions.
Provide specific cash flow information for user needs.
Emphasize the need for information about economic resources, claims to resources, and changes in resources and claims.
Financial Statements
Constraints
Continued

30. Recognition and Measurement Concepts Qualitative Characteristics
Objectives
Recognition and Measurement Concepts
Assumptions Economic entity
Going concern
Periodicity
Monetary unit
Principles
Historical cost
Realization
Matching
Full Disclosure
Elements
Assets
Liabilities
Equity
Investments by Owners
Distributions to owners
Revenues
Expenses
Gains
Losses
Comprehensive Income
Qualitative Characteristics
Understandability
Primary
Relevance
Reliability
Secondary
Comparability
Consistency
The broad objectives in Statement of Financial Accounting Concepts One feed into the more specific issues addressed in Statements Two, Five and Six. On your screen, you see a graphic summary of the conceptual framework with key points of Statements Two, Five and Six.
Financial Statements
Balance sheet
Income statement
Statement of cash flows
Statement of shareholders’ equity
Related disclosures
Constraints
Cost effectiveness
Materiality
Conservatism

31. Qualitative Characteristics of Accounting Information
Decision Usefulness
Comparability
Consistency
Relevance
Reliability
Predictive Value
Feedback
Value
Timeliness
Verifiability
Neutrality
Representational Faithfulness
Part I.
Statements of Financial Accounting Concepts Two outlines the qualitative characteristics of accounting information. Accounting information should be understandable and be useful for decision making. The primary decision specific qualities of accounting information are relevance and reliability. To be relevant, the information must have predictive value and feedback value, and be timely.
Part II.
Reliability is the extent to which the information is verifiable, representationally faithful and neutral.
Part III.
The secondary qualitative characteristics of accounting information are comparability and consistency.

32. Practical Constraints to Achieving Desired Qualitative Characteristics
Conservatism
Cost Effectiveness
Materiality
There are three practical constraints to achieving the desired qualitative characteristics of accounting information:
 Cost effectiveness.
 Materiality.
 Conservatism.

33. 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.
Statements of Financial Accounting Concepts Six defines ten elements of financial statements. Assets and liabilities are defined as follows:
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 assets or provide services to other entities in the future as a result of past transactions or events.

34. 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.
Equity (net assets) is the residual interest in the assets of a business entity. It is also known as stockholders’ equity or shareholders’ equity. For a corporation, equity arises from two sources:
 Amounts invested by stockholders in the corporation.
 Amounts earned by the corporation on behalf of its stockholders.
These two sources are reported as paid-in capital and retained earnings.

35. 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.
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 owners. A cash dividend is the most common form of distribution to owners.

36. 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.
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.

37. 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.
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.

38. 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.
Gains are 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.

39. 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.
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.

40. Recognition and Measurement Concepts
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 the collectibility of 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.

41. Question
The function of financial accounting is to identify, measure and communicate financial information about economic entities to interested parties.
a. True
b. False
At this point, let’s look at a series of questions to help summarize some of the key points of the issues we have been discussing. The first question on your screen deals with the function of financial accounting.

42. Question
The function of financial accounting is to identify, measure and communicate financial information about economic entities to interested parties.
a. True
b. False
The correct answer is true. The function of financial accounting is to identify, measure, and communicate financial information about economic entities to interested parties.

43. 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
The second question asks us about accrual accounting and cash basis accounting.

44. 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
The correct answer is true. 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.

45. Question
The primary objective of accrual basis accounting is the measurement of income.
a. True
b. False
The third question asks us to recall the primary objective of accrual accounting.

46. Question
The primary objective of accrual basis accounting is the measurement of income.
a. True
b. False
The correct answer is true. The primary objective of accrual basis accounting is the measurement of income.

47. 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
The fourth question is concerned with the nature of generally accepted accounting principles.

48. 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
The correct answer is true. Generally accepted accounting principles include both standards set by various rule making bodies and certain accounting practices that have evolved over time.

49. 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
The fifth question asks us to identify the major accounting standard setting body.

50. 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
The correct answer is choice c. The Financial Accounting Standards Board is the major financial accounting standard setting body.

51. 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
The sixth question asks us to identify the types of pronouncements issued by the Financial Accounting Standards Board.

52. 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
The correct answer is choice e. The Financial Accounting Standards Board issues Standards, Interpretations, Financial Accounting Concepts, and Technical Bulletins.

53. Question
The Financial Accounting Standards Board develops accounting and reporting standards independent of public, business and political pressures.
a. True
b. False
The seventh question deals with the environment in which the Financial Accounting Standards Board operates.

54. Question
The Financial Accounting Standards Board develops accounting and reporting standards independent of public, business and political pressures.
a. True
b. False
The correct answer is false. The Financial Accounting Standards Board is subject to public, business, and political pressure.

55. 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.
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.

56. 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.
Here you see seven steps that provide a framework for analyzing ethical issues. Following these seven steps can help you apply your sense of right and wrong in the resolution of ethical issues.
 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.

57. End of Chapter 1
End of Chapter 1.