Intermediate Accounting 1
ACC 3000
Spring 2022
Chapter 1. Environment and Theoretical
Structure of Financial Accounting
LO1-1
Primary Focus of Financial Accounting
Healy and Palepu (2001)
LO1-1
The Economic Environment and Financial
Reporting
Capital markets provide a mechanism to help the economy allocate
resources efficiently
Corporations acquire capital from:
• Investors in exchange for ownership interest and;
• Creditors by borrowing
• Either through individual loans or publicly traded debt such as
bonds
01-03
LO1-1
Primary Focus of Financial Accounting
• Providing financial information to various external users
• Investors
• Creditors
• Other external users
Investors
and
creditors
Use different kinds of information ➢ To predict the
Financial information is a
key component of that
information set
future risk and
potential return
of investments
or loans
➢ Before supplying
capital to
businesses
01-04
LO1-1
Financial Accounting
• Financial information is conveyed through financial statements
and related disclosure notes
• Balance sheet
• Income statement (and the statement of comprehensive
income)
• Statement of cash flows
• Statement of shareholders’ equity
• Financial Reporting
• Refers to the process of providing financial information to
external users
01-05
LO1-1
Annual report
• Who has to file with the SEC?
• What forms are filed?
• EDGAR:
https://www.sec.gov/edgar/searchedgar/companysearch.html
01-06
LO1-5
Encouraging High-Quality Financial Reporting
• Role of an Auditor
• Offer credibility to financial statements
• Express an opinion on the compliance of financial statements with GAAP
• Licensed by states to provide audit services—certified public accountants
(CPAs)
01-7
LO1-2
Cash versus Accrual Accounting
Cash Basis Accounting
• Measurement of cash receipts and cash payments from
transactions related to providing goods and services
• Difference is net operating cash flow
Accrual Basis Accounting
• Measurement of revenues and expenses, regardless of
when cash is received or paid
• Difference is net income or net loss
01-8
LO1-2
Cash Basis Example
• Carter Company paid $60,000 for 3 years’ rent at the beginning
of year 1
• Under cash basis accounting, the rent payment is shown
when paid
Year 1
Year 2
Year 3
Total
$100,000
$100,000
$100,000
$300,000
$ 50,000
$125,000
$125,000
$300,000
Prepayment of three years’ rent
(60,000)
–0–
–0–
(60,000)
Salaries to employees
(50,000)
(50,000)
(50,000)
(150,000)
(5,000)
(15,000)
(10,000)
(30,000)
$ (65,000)
$ 60,000
$ 65,000
$ 60,000
Sales (on credit)
Net Operating Cash Flows
Cash receipts from customers
Cash disbursements:
Utilities
Net operating cash flow
01-9
LO1-2
Accrual Basis Example
• Carter Company paid $60,000 for 3 years’ rent at the beginning
of year 1
• Under accrual basis accounting, rent is recognized as an
expense all three years even though it was paid in year 1
CARTER COMPANY
Income Statements
Year 1
Year 2
Year 3
Total
$100,000
$100,000
$100,000
$300,000
Rent
20,000
20,000
20,000
60,000
Salaries
50,000
50,000
50,000
150,000
Utilities
10,000
10,000
10,000
30,000
80,000
80,000
80,000
240,000
$ 20,000
$ 20,000
$ 20,000
$ 60,000
Revenues
Expenses:
Total expenses
Net Income
01-10
LO1-2
Cash versus Accrual Accounting
• Over the life of the company, the sum total of operating cash flows
equals the sum total of accrual-based income.
• For a specific period, however, the amounts will generally differ.
• Over short periods of time, operating cash flow may not be an accurate
predictor of future operating cash flows.
• Accrual-based net income is considered a better indicator of future
operating cash flows than is current net operating cash flows. The
accrual accounting model is required by US GAAP.
01-11
LO1-2
Concept Check: Accrual Accounting
Which of the following is not an advantage of accrual accounting?
a.
b.
c.
d.
Spreads out the influence of one-time events that affect multiple
reporting periods
Highlights cash effects of operations
Captures long-run performance
Recognizes assets and liabilities associated with receivables and
payables
01-12
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education.
LO1-3
The Development of Financial Accounting and
Reporting Standards
• Generally Accepted Accounting Principles (GAAP)
• GAAP is a dynamic set of both broad and specific guidelines
that companies should follow when measuring and reporting
the information in their financial statements and related
notes
• GAAP facilitates decision making by investors and creditors
by allowing them to compare financial information among
companies
• Set by FASB (Financial Accounting Standards Board)
01-13
LO1-3
International Standard Setting
• IASB (Financial Accounting Standards Board):
• To develop a single set of high-quality, understandable, and
enforceable global accounting standards
• Issued new standards of its own—called International
Financial Reporting Standards (IFRS)
• More and more countries are basing their national
accounting standards on IFRS
• By 2018, more than 120 jurisdictions, including Hong Kong,
Egypt, Canada, Australia, and the countries in the European
Union (EU), require or permit the use of IFRS or a local
variant of IFRS
01-14
LO1-3
Efforts to Converge U.S. and International
Standards
U.S. GAAP
Converged
Standards
IFRS
• FASB and IASB have been working for many years to converge
to one global set of accounting standards, however, recent
events suggest that full convergence will not be achieved in
the foreseeable future
• While it appears likely that the FASB and IASB will continue to
work together to converge where possible, some differences
between IFRS and U.S. GAAP will remain
01-15
LO1-6
The Conceptual Framework
01-16
LO1-8
Underlying Assumptions
Four basic assumptions underlie GAAP
• The economic entity assumption presumes that
economic events can be identified specifically with an
economic entity
• The going concern assumption anticipates that a
business entity will continue to operate indefinitely
• The periodicity assumption allows the life of a
company to be divided into artificial time periods to
provide timely information
• The monetary unit used in U.S. financial statements is
the U.S. dollar
01-17
LO1-9
Revenue Recognition
• Revenue: Inflows of assets or settlements of liabilities
resulting from providing a product or service to a customer
• Revenue recognition used to be guided by the realization
principle (two criteria)
• Earnings process is judged to be complete or virtually complete
• Reasonable certainty as to the collectability of the asset to be
received (usually cash)
• FASB issued ASU No. 2014-09, which requires that we
recognize revenue when goods or services are transferred
to customers for the amount the company expects to be
entitled to receive in exchange for those goods or services
01-18
LO1-9
Expense Recognition
Often matches revenues and expenses that arise from
the same transactions or other events
Four approaches:
•
•
•
•
Based on an exact cause-and-effect relationship
By associating an expense with the revenues
recognized in a specific time period
By a systematic and rational allocation to specific
time periods
In the period incurred, without regard to related
revenue
01-19
LO1-9
Measurement
• GAAP currently employs a “mixed attribute” measurement model.
• The five attributes are:
1. Historical cost: original transaction value adjusted for
depreciation and amortization (e.g. land)
2. Net realizable value: the amount of cash into which an asset is
expected to be converted in the ordinary course of business
(e.g. inventory)
3. Current cost: the cost that would be incurred to purchase or
reproduce the asset
4. Present value: the current value of future cash flows,
calculated by applying the time value of money
5. Fair value: 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 (e.g.
investment)
01-20
LO1-9
Disclosure
• Full-disclosure principle: requires that the financial reports
should include any information that could affect the decisions
made by external users
• Such information can be disclosed in a variety of ways:
• Parenthetical comments or modifying comments
• Placed on the face of the financial statements
• Disclosure notes
• Convey additional insights
• Supplemental schedules and tables
• Report more detailed information than is shown in the
primary financial statements
01-21
A detour: Time Value of Money (Chapter 5)
• Money has time value which implies the need for a
procedure to compare dollar amounts at different points in
time.
• A dollar today is not equivalent to a dollar received a year
from now.
• How to decide if X dollars right now (time 0) is preferred to Y
dollars t periods in the future?
FUTURE VALUE
Let:
t = number of periods
r = rate of interest
D = initial deposit
Then the future value, FV, of an initial deposit of D
left to accumulate interest at rate r per period for t
periods is given by
FV = D*(1+r)t
FUTURE VALUE
Interest is the charge (price paid) for the
ability to transfer cash across time
periods
i.e., it is the charge levied to postpone the payment
or receipt of funds
PRESENT VALUE
If the future value is given by
FV = D*(1+r)t
When the interest rate is r per period and t is the number of periods,
then
D = FV/(1+r)t
Where D is the initial deposit (the Present Value or PV)
PV and FV
FV = PV * (1+i)n = PV * FV_factor (i%, n)
$83.96
+ $83.96 * 6%
= $89.00
T=0
T=1
$89.00/1.06
= $83.96
=0.83962* $100
$94.34/1.06
= $89.00
+ $89.00 * 6%
= $94.34
T=2
$100/1.06
= $94.34
PV = FV / (1+i)n = FV * PV_factor (i%, n)
+ $94.34 * 6%
= $100
= 1.19102* $83.96
T=3
$100
Interest Factor Tables
Rate
Periods
1
2
3
4
5
6
7
8
9
10
1%
1.01000
1.02010
1.03030
1.04060
1.05101
1.06152
1.07214
1.08286
1.09369
1.10462
2%
1.02000
1.04040
1.06121
1.08243
1.10408
1.12616
1.14869
1.17166
1.19509
1.21899
3%
1.03000
1.06090
1.09273
1.12551
1.15927
1.19405
1.22987
1.26677
1.30477
1.34392
4%
1.04000
1.08160
1.12486
1.16986
1.21665
1.26532
1.31593
1.36857
1.42331
1.48024
5%
1.05000
1.10250
1.15763
1.21551
1.27628
1.34010
1.40710
1.47746
1.55133
1.62889
6%
1.06000
1.12360
1.19102
1.26248
1.33823
1.41852
1.50363
1.59385
1.68948
1.79085
7%
1.07000
1.14490
1.22504
1.31080
1.40255
1.50073
1.60578
1.71819
1.83846
1.96715
D = 83.96
r = 6%
FV = D*(1+r)t = D * Factor = 83.96 * 1.19102 = 100
8%
1.08000
1.16640
1.25971
1.36049
1.46933
1.58687
1.71382
1.85093
1.99900
2.15892
9%
1.09000
1.18810
1.29503
1.41158
1.53862
1.67710
1.82804
1.99256
2.17189
2.36736
10%
1.10000
1.21000
1.33100
1.46410
1.61051
1.77156
1.94872
2.14359
2.35795
2.59374
LO5-5
Concept Check: Valuing a Note
Turp and Tyne Distillery is considering investing in a two-year
project. The company’s required rate of return is 10%. The
present value of $1 for one period at 10% is .909 and .826 for
two periods at 10%. The project is expected to create cash
flows, net of taxes, of $240,000 in the first year, and $300,000
in the second year. The distillery should invest in the project if
the project’s cost is less than or equal to:
a.
b.
c.
d.
$540,000
$490,860
$465,960
$446,040
05-28
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education.