1. 1 F INANCIAL R EPORTING chapter 1

2. 2 Learning Objectives 1.Describe the purpose of financial reporting and identify the primary financial statements. 2.Explain the function of accounting standards and describe the role of the FASB in setting these standards in the United States. 3.Recognize the importance to financial reporting of the SEC, AICPA, AAA, and IRS. Continued

3. 3 Learning Objectives 4.See the growing importance and relevance of international accounting issues to the practice of accounting in the United States and understand the role of the ISAC in international accounting standard setting. 5.Understand the significance of the FASB’s conceptual framework in outlining the qualities of good accounting information, defining terms such as asset and revenue, and providing guidance about appropriate recognition, measurement, and reporting. Continued

4. 4 Learning Objectives 6.Identify career opportunities related to accounting and financial reporting in the fields of public accounting, corporate accounting, financial analysis, banking, and consulting.

5. 5 Definition for Accounting “ Accounting is a service activity. Its function is to provide quantitative information, primarily financial in nature, about economic entities that is intended to be useful in making economic decisions—in making reasoned choices among alternative courses of action.” (Statement of the Accounting Principles Board No. 4, p. 40)

6. 6 Accounting provides a vital service in today’s business environment. Accounting is concerned primarily with quantitative financial information that is used in conjunction with qualitative evaluations in making judgments. Definition for Accounting Key features of this definition: Continued

7. 7 Accounting information is used in making decisions about how to allocate scarce resources. Definition for Accounting Key features of this definition: Economists and environmentalists remind us constantly that we live in a world with limited resources.

8. 8 Although accountants place much emphasis on reporting what has already occurred, this past information is intended to be useful in making economic decisions about the future. Definition for Accounting Key features of this definition:

9. 9 Users of Accounting Information All parties interested in the financial health of a company are called stakeholders.

10. 10 Users of Accounting Information Internal users, who make decisions directly affecting the internal operations of the enterprise. External users, who make decisions concerning their relationship to the enterprise. Two major classifications of stakeholders

11. 11 Investors Community Board of Directors Management Employees Suppliers Employees Creditors Customers Analysts Government Major Internal and External Stakeholder Groups

12. 12 Financial Reporting The balance sheet reports, as of a certain point in time, the resources of a company (the assets), the company’s obligations (the liabilities), and the equity of the owners. The income statement reports, for a specified interval, the net assets generated through business operations (revenues), the net assets consumed (the expenses), and the net income. The statement of cash flows reports, for a specified time period, the amount of cash generated and consumed by a company through operating, financing, and investing activities.

13. 13 Accounting estimates and judgments are outlined in the notes to financial statements. Financial Reporting

14. 14 Financial Statement Relationships Balance Sheet 12/31/04 Cash$ 80,000 Other 4,550,000 Total$4,630,000 Liabilities $2,970,000 Stock 900,000 R/E 760,000 Total $4,630,000 Statement of Cash Flows 2005 Cash From Op $ 973,000 Cash From Inv (1,188,000) Cash From Fin 245,000 Net Increase $ 30,000 Beg. Cash 80,000 End. Cash $ 110,000 Statement of Retained Earnings R/E 12/31/04 $ 760,000 Net Income 864,600 Dividends (400,000) R/E 12/31/05 $1,224,600 Revenues $12,443,000 Expenses 11,578,400 Net Income $ 864,600 Income Statement Cash$ 110,000 Other 4,975,000 Total$5,085,000 Liabilities $2,860,400 Stock 1,000,000 R/E 1,224,600 Total $5,085,000 Balance Sheet 12/31/05

15. 15 Auditors Auditors working independently of a company’s management and internal accountants examine the financial statements. Auditors issue an auditor’s opinion about the fairness of the statements and their adherence to proper accounting principles.

16. 16 Auditor’s Opinion  Unqualified opinion—In the opinion of the auditor, the financial statements are presented in accordance with GAAP.  Qualified opinion—In the opinion of the auditor, except for the effects of the qualified item, the financial statement are presented in conformity with GAAP.  No opinion—The auditor does not express an opinion about the financial statements.  Adverse—In the opinion of the auditor, the financial statements do not present information in conformity with GAAP.

17. 17 Relative Frequency of Audit Opinions (2000) Companies Unqualified5,651 Unqualified With Explanatory Language1,506 Qualified4 No opinion2 Adverse1 Total7,164

18. 18 Accounting Standard–Setting Organizations FASACFASB FAFSEC AcSEC AICPA IASC IAPC Other EITF GASACGASBU.S. Gov't

19. 19 Financial Accounting Standards Board Committee on Accounting Procedures (CAP) Born: 1939 Died: 1959 Pronouncements: Accounting Research Bulletins

20. 20 Accounting Principles Board (APB) Born: 1959 Died:1973 Pronouncements: APB Opinions Financial Accounting Standards Board

21. 21 Financial Accounting Standards Board (FASB) Born: 1973 Died: Pronouncements: Statements of Financial Accounting Standards Financial Accounting Standards Board

22. 22 1)Seven full-time members comprise this independent body. 2)Issues Statements of Financial Accounting Standards. 3)Determines GAAP by “due process.” 4)Works within the Conceptual Framework. Financial Accounting Standards Board

23. Statement Preparers Financial Executives Institute IMA Individual Corps FASB FASB Authority Sources— Overview Gov’t Regulators SEC State Boards of Public Acct. American Acct. Instructors Association Auditors AICPA State societies of CPAs Major audit firms Major audit firms

24. 24 Congress FASB Authority Sources—SEC SEC FASB Registrant Companies

25. 25 FASB Authority Sources -- AICPA  Provides authority to the FASB through its Code of Professional Conduct Rule 203.  AICPA members must show that client financial statements comply with FASB pronouncements (GAAP).  AICPA grants continuing membership to its members who comply with Rule 203.

26. 26 FASB “Due Process” 1)Topic or project added to agenda. 2)Task force assembled to study topic. 3)Research and analysis performed by FASB technical staff. 4)Discussion Memorandum (DM) drafted and released. 5)Public hearing, usually 60 days later, is held. ContinuedContinued

27. 27 6)Board analyzes and evaluates public response. 7)Exposure Draft (ED) prepared and released. 8)Sixty-day exposure period allows for public comment. 9)Committee studies public response to exposure draft and prepares final draft. FASB “Due Process”ContinuedContinued

28. 28 10)Board votes on final draft leads to either the issuance of a Statement of Financial Accounting Standard, a revised Exposure Draft, or abandonment of the project. FASB “Due Process”

29. 29 Emerging Issue Task Force In an effort to overcome the slow process of standard setting, in 1984 the FASB established the Emerging Issues Task Force (EITF) to assist the FASB in identifying the emerging issues that affect financial reporting.

30. 30 Accounting Standard–Setting Organizations FASACFASB FAFSEC AcSEC AICPA IASC IAPC Other EITF GASACGASBU.S. Gov't

31. 31 Securities Exchange Commission (1933-present) 1929 stock market crash blamed on nonstandard accounting. 1933 Securities Act established SEC to standardize accounting. Created to protect the interests of investors by ensuring full and fair disclosure. Granted legal authority to dictate GAAP. Has tended to defer setting GAAP to the accounting profession.

32. 32 Securities and Exchange Commission SEC official statements are referred to as Financial Reporting Releases which are accounting interpretations and policies the SEC uses in evaluating firms’ disclosure policies.

33. 33  Staff Accounting Bulletins  Accounting and Auditing Enforcement Releases  Accounting Series Releases Securities and Exchange Commission Other Authoritative Literature

34. 34 American Institute of Certified Public Accountants The American Institute of Certified Public Accountants (AICPA) is the professional organization of practicing CPAs in the United States.

35. 35 American Accounting Association What are assets ? The American Accounting Association (AAA) is primarily an organization for accounting professors.

36. 36 Internal Revenue Service The Internal Revenue Service (IRS) has the primary goal of equitable collecting revenue.

37. 37 What is GAAP? ABCDABCD Higher Authority Lower Authority

38. 38 What is GAAP? –FASB Statements and Interpretations –APB Opinions –CAP Accounting Research Bulletins A Highest Authority

39. 39 What is GAAP? –FASB Technical Bulletins –AICPA Industry Audit and Accounting Guides –AICPA Statements of Position B

40. 40 What is GAAP? –Consensus Positions of EITF –AICPA Practice Bulletins C

41. 41 What is GAAP? –AICPA Accounting Interpretations –FASB “Question and Answer” guides –Other widely recognized industry practices D Lowest Authority

42. 42 International Accounting Standards Committee The International Accounting Standards Committee (ISAC) was formed in 1973 to develop worldwide accounting standards. The accounting standards produced by the International Accounting Standards Committee are referred to as International Accounting Standards or IAS.

43. 43 Conceptual Framework of Accounting Objectives of Financial Reporting Qualitative Characteristics of Information Accounting Elements of Financial Statements Recognition and Measurement Concepts AssumptionsPrinciplesConstraints

44. 44 Objectives of Financial Reporting The overall objective of financial reporting is to provide information useful for decision making.

45. 45  Usefulness.  Understandability.  Target audience: investors and creditors.  Assessing future cash flows.  Evaluating economic resources.  Primary focus on earnings. Objectives of Financial Reporting

46. 46 Objectives of Financial ReportingUsefulnessUsefulness Financial reporting should provide information that is useful to present and potential investors and creditors and other users in making rational investment, credit, and similar decisions.

47. 47 Objectives of Financial ReportingUnderstandabilityUnderstandability Financial reporting should provide information that is understandable to one who has a reasonable knowledge of accounting and business and who is willing to study and analyze the information presented.

48. 48 Objectives of Financial Reporting Target Audience While there are many potential users of financial reports, the objectives are directed primarily toward investors and creditors.

49. 49 Objectives of Financial Reporting Assessing Future Cash Flows Financial reporting should provide information that is useful in assessing amounts, timing, and uncertainty (risk) of prospective cash flows.

50. 50 Objectives of Financial Reporting Evaluating Economic Resources Financial reporting should also provide information about an enterprise’s assets, liabilities, and owners’ equity to help investors, creditors, and others evaluate the financial strengths and weaknesses of the enterprise and its liquidity and solvency.

51. 51 Objectives of Financial Reporting Primary Focus on Earnings Information about enterprise earnings, measured by accrual accounting, generally provides a better basis for forecasting future performance than does information about current cash receipts and disbursements.

52. 52 Predictive Value Feedback Value Timeliness Relevance Verifiability Neutrality Representational Faithfulness Reliability Decision Usefulness Understandability Decision Makers Qualitative Characteristics of Accounting Information Materiality Benefits > Cost Comparability (including Consistency)

53. 53 What About Conservatism? The concept of conservatism can be summarized as follows: When in doubt, recognize all losses but don’t recognize any gains.

54. 54 Elements of Financial Statements Assets Liabilities Equity, or Net Assets Investments by Owners Distributions to Owners Comprehensive Income Revenues Expenses Gains Losses

55. 55 Recognition, Measurement, and Reporting Boiling down all the estimates and judgments into one number and then using that one number to make a journal entry is called recognition.

56. 56 Recognition, Measurement, and Reporting Skipping the journal entry and just relying on the note to convey the information to users is called disclosure.

57. 57 Recognition, Measurement, and ReportingMeasurementMeasurement 1.Historical cost 2.Current replacement cost 3.Current market value 4.Net realizable value 5.Present (or discounted) value

58. 58 Recognition, Measurement, and ReportingReportingReporting  Financial position at the end of the period  Earnings (net income) for the period  Cash flows during the period  Investments by and distributions to owners during the period  Comprehensive income for the period

59. 59 Traditional Assumptions of the Accounting Model Economic entity. Going concern. Arm’s-length transactions. Stable monetary unit. Accounting period.

60. 60 Public accounting. Company accounting. User (analyst, banker, consultant).