1. Financial Accounting A Decision-Making Approach, 2nd Edition King, Lembke, and Smith John Wiley & Sons, Inc. Prepared by Dr. Denise English, Boise State University *

2. After reading Chapter 4, you should be able to: 1. Understand the main objectives of financial reporting. 2. Describe the qualities of useful accounting information and explain why each is important. 3. Explain the basic concepts that underlie financial accounting, and briefly discuss the implications of each. 4. Describe the role of recognition and measurement in accounting, and how both impact financial statement information. 5. Relate the matching concept to accounting and the usefulness of accounting information. 6. Explain how a basic understanding of the financial reporting model is important to financial statement users. CHAPTER FOUR ACCRUAL ACCOUNTING AND FINANCIAL REPORTING

3. Objectives of Financial Reporting  Meet the needs of investors and creditors (primary) and other external parties (secondary).  Meet the needs of those unable to acquire information from other sources.  Provide comprehensive information to informed and responsible users.  Provide information to assess cash flows.  Provide information about economic resources and claims to those resources.  Provide information about periodic earnings.  Provide information about management’s performance.

4. Qualities of Accounting Information Information should be useful, but what does that mean? The two primary qualities of useful information are: 1) Relevance--the information must pertain to the decision at hand. That suggests it will have predictive and feedback value and should be timely. 2) Reliability--the information must reasonably reflect the real-world situation that it represents. To do so, it must be free of bias and verifiable.

5. Other Qualities of Useful Information Understandability--the information must be understood to be useful. Users are assumed to have a general knowledge of business and a very basic knowledge of accounting. Comparability--the information must be reported so that comparisons between similar entities can be made. Consistency--the same accounting methods must be used from period to period to evaluate results over time.

6. A Hierarchy of Accounting Qualities Exhibit 4-1 Decision makers Benefits > Costs Understandability Decision Usefulness RelevanceReliability Feedback value Verifiability Neutrality Representational faithfulness Timeliness Comparability and Consistency Materiality Users of accounting information Overall constraint User-specific qualities Primary decision- specific qualities Ingredients of primary qualities Secondary and interactive qualities Predictive value Threshold for recognition

7. Constraints on Accounting Information  An overall constraint is that the benefits derived from accounting information should be greater than the cost to provide it.  Materiality is related to the cost-benefit constraint, and evaluates whether the information is important enough to influence a decision. Immaterial items need not be disclosed.

8. The Financial Accounting Information Model Income Statement -------------------- ----------------- Transactions and events Supporting Documents JournalLedger Financial statements Accounting links real-world transactions and events with information presented in financial statements through an organized system of recording, classifying, accumulating, summarizing, and reporting. The elements of this system fit together as follows:

9. Financial Records Supporting documents--evidence of financial transactions existing in many forms, such as invoices, remittance advices, and receipts. Records (Books) of Original Entry--transactions are first recorded in the journal, a chronological record of an entity’s activities. Accounts for Classification, Accumulation, and Summarization--information about individual financial statement items is summarized in ledger accounts, such as sales, sales returns, and cash received from sales. -----

10. 1) Income Statement 2) Statement of Financial Position (Balance Sheet) 3) Statement of Cash Flows 4) Statement of Changes in Owners’ Equity (or Statement of Changes in Retained Earnings) The Four Basic Financial Statements

11. Additional Financial Statement Information In addition to the basic financial statements, companies usually include the following in their financial reports: 1) Notes to financial statements--detailed and supplemental information necessary to use the statements effectively, including a summary of accounting methods used. 2) Other financial information--additional information, summaries, or supplemental schedules to make the statements more informative or expand on them. INCOME STATEMENT -------------------- ----------------- NOTES -------------------- ----------------- OTHER INFO -------------------- ----------------- + +

12. Elements of the Financial Statements (1) Elements Related to Financial Position: Assets - probable future economic benefits controlled by a particular entity as a result of past transactions or events. Liabilities - probable future sacrifices of economic benefits arising from present obligations of a particular entity as a result of past transactions or events. Equity - the residual interest in the assets of an entity that remains after deducting its liabilities; equal to net assets (assets minus liabilities). BALANCE SHEET -------------------- -----------------

13. Elements of the Financial Statements (2) Elements Related to Changes in Financial Position: Revenues - inflows of assets from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations. Expenses - outflows or using up of assets or incurrences of liabilities from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major or central operations. INCOME STATEMENT -------------------- -----------------

14. Elements of the Financial Statements (2) Elements Related to Changes in Financial Position (continued): Gains - increases in equity (net assets) from peripheral or incidental transactions and events. Losses - decreases in equity (net assets) from peripheral or incidental transactions and events. Net Income - the change in equity of a business enterprise during a period from transactions and other events and circumstances, excluding those related to prior periods and other than investments by or distributions to owners. INCOME STATEMENT -------------------- -----------------

15. Elements of the Financial Statements (3) Changes Resulting from Transactions with Owner(s): Investments by Owner(s) - increases in equity of a particular business enterprise resulting from transfers to it of something valuable to obtain or increase ownership interests in it. Distributions to Owner(s) - decreases in equity of a particular business enterprise resulting from transferring assets or incurring liabilities by the enterprise to the owner(s). STATEMENT OF CHANGES IN OWNER’S EQUITY

16. The Accounting Entity Each business enterprise is considered to be a separate accounting entity. The accounting entity is not always the same as the legal entity (unincorporated businesses are not legally separate from their owners). A parent company may have subsidiaries whose financial statements will be combined to provide a single set of consolidated financial statements.

17. The Accounting Entity Exhibit 4-5 (partial) OwnersBusiness Proprietorship or Partnership Legal entity Accounting entity

18. Owners Corporation Legal and accounting entity Corporation The Accounting Entity Exhibit 4-5 (in part) Single Corporation Parent’s owners Parent corporation Subsidiary corporation Accounting entity Legal entity Related Corporations

19. Basic Concepts of Financial Accounting Objectivity--information appearing in financial statements should be reliable and subject to verification. Objectivity is why many assets are valued at historical cost. Going Concern--financial statements are prepared under the assumption that the entity will continue to operate indefinitely. Periodicity--Financial statements are prepared that show the results of the entity’s activities for each period and its position at the end of the period. This is necessary to provide timely, and thus, relevant information.

20. Basic Concepts of Financial Accounting Disclosure--dictates that external accounting reports must include any additional information needed to ensure that the financial statements are not misleading. Conservatism--helps to offset the natural optimism of management by suggesting that accounting procedures state assets and revenues at the lower of acceptable values, while stating expenses, liabilities and losses at the higher of acceptable values.

21. Basic Concepts of Financial Accounting Recognition and Measurement--Recognition is the process of recording an item in the financial statements as an asset, liability, revenue, expense, or the like. An item should be recognized when it meets the definition of an element of the financial statements, is relevant to a decision, and can be measured reliably. Measurement Methods--The method used to value each financial statement element depends on which provides the most relevant and reliable method.

22. Matching Costs and Benefits Under accrual accounting, the amount of revenues, expenses, and net income reported during a period is based on the recognition criteria and measurement methods previously discussed, rather than just cash inflows and outflows.

23. The Matching Concept Matching compares the cost of a business’s activities with the benefits they provide. The process of matching involves the following: 1. Determining the amount of a specific cost incurred. 2. Identifying the benefits expected from having incurred that cost. 3. Determining when the benefits are received. 4. Reporting the cost as an expense in the period in which the benefits are received.

24. The Matching Concept applies to virtually all of the costs incurred by a business enterprise. Some examples are: Cost:Report as expense: interest on 2-year bankover the 2-year period of the loan loan premiums on 3-yearover the 3-year period of insurance policy coverage cost of delivery truckover estimated useful life of truck commissions earned byat time of sales sales staff The Matching Concept

25. Classifying Costs Unexpired costs--those costs expected to result in future benefits for the entity. Expired costs--those costs not expected to result in future benefits for the entity. 1/1/1999 3-year Insurance Policy 1/1/9912/31/9912/31/0012/31/01 Today Expired costUnexpired cost Insurance expensePrepaid Insurance (asset)

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