Environment and
Theoretical Structure of
Financial Accounting
Chapter 1
(SELF-STUDY)
Learning Objectives
1. Describe the function and primary focus of financial
accounting. Pg. 4.
2. Explain the difference between cash and accrual accounting.
Pg. 6.
3. Define generally accepted accounting principles (GAAP)
and discuss the historical development of accounting
standards. Pg. 8.
4. Explain why the establishment of accounting standards
is characterized as a political process. Pg. 13.
5. Explain factors that encourage high quality financial
reporting. Pg. 15.
6. Explain the purpose of the FASB’s conceptual framework.
Pg. 19.
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Learning Objectives
7. Identify the objective and qualitative characteristics
of financial reporting information, and the elements
of financial statements. Pg. 21.
8. Describe the four basic assumptions underlying GAAP.
Pg. 25.
9. Describe the Recognition, Measurement and Disclosure
Concepts that guide accounting practice. Pg. 27.
10. Contrast a revenue/expense and an asset/liability
approach to standard setting. Pg. 33.
11. Describe the primary differences between US GAAP and
IFRS with respect to the development of Accounting
standards. Pg. 15 and 21.
Financial Accounting Environment
Providers of
Financial
Information
Profit-oriented
companies
Not-for-profit
entities
Households
External
User Groups
Relevant
Financial
Information
Investors
Creditors
Employees
Labor unions
Customers
Suppliers
Government
agencies
Financial
intermediaries
Financial Accounting Environment
Relevant financial information is provided primarily through financial
statements and related disclosure notes. The following financial
statements are the most frequently provided.
1. Balance Sheet
2. Income Statement
3. Statement of Cash Flows
4. Statement of Shareholders’ Equity
Starting in 2012, companies must either provide a Statement of
Other Comprehensive Income immediately following the
Income Statement, or present a Combined Statement of
Comprehensive Income that includes the information
normally contained in both the Income Statement and the
Statement of Other Comprehensive Income.
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 corporation is owned
by shareholders.
A highly-developed system
communicates financial
information from a
corporation to its many
shareholders.
Investment-Credit Decisions ─ A Cash
Flow Perspective
Shareholders
Receive
Cash
1. Dividends
2. Sale of Stock
Creditors
Receive
Cash
1. Interest
2. Repayment of
Principle
Accounting information should help investors
and creditors evaluate the amount, timing, and
uncertainty of the enterprise’s future cash
flows.
Cash versus Accrual Accounting
Cash Basis Accounting
Revenue is recognized when cash is received.
Expenses are recognized when cash is paid.
O
R
O
OR
R
O
R
Accrual Accounting
Revenue is recognized when earned.
Expenses are recognized when incurred.
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.
Cash versus Accrual Accounting
Cash Basis Accounting
Sales (on credit)
Year 1
$ 100,000
Cash receipts from
customers
$
50,000
Summary of Cash Flows
Year 2
Year 3
$ 100,000
$ 100,000
Total
$ 300,000
$ 125,000
$ 300,000
$ 125,000
Payment of 3
years' rent
(60,000)
-
-
(60,000)
Salaries to
employees
(50,000)
(50,000)
(50,000)
(150,000)
(5,000)
$ (65,000)
(15,000)
$ 60,000
(10,000)
$ 65,000
(30,000)
$ 60,000
Payments for
utilities
Net cash flow
Cash versus Accrual Accounting
Cash Basis Accounting
Sales (on credit)
Year 1
$ 100,000
Cash receipts from
customers
$
Payment of 3
years' rent
50,000
(60,000)
Summary of Cash Flows
Year 2
Year 3
$ 100,000
$ 100,000
Total
$ 300,000
$ 125,000
$ 300,000
-
$ 125,000
-
Salaries to Cash flows in any one year may not
employees be a predictor
(50,000) of (50,000)
future cash(50,000)
flows.
Payments for
utilities
Net cash flow
(5,000)
$ (65,000)
(15,000)
$ 60,000
(10,000)
$ 65,000
(60,000)
(150,000)
(30,000)
$ 60,000
Cash versus Accrual Accounting
Accrual Basis Accounting
Year 1
Revenue
Summary of Operations
Year 2
Year 3
Total
$ 100,000
$ 100,000
$ 100,000
$ 300,000
Rent Expense
(20,000)
(20,000)
(20,000)
(60,000)
Salaries Expense
(50,000)
(50,000)
(50,000)
(150,000)
Utilities Expense
(10,000)
(10,000)
(10,000)
(30,000)
Net Income
$
20,000
$
20,000
$
20,000
$
60,000
Cash versus Accrual Accounting
Accrual Basis Accounting
Year 1
Revenue
Summary of Operations
Year 2
Year 3
Total
$ 100,000
$ 100,000
$ 100,000
$ 300,000
(20,000)
(20,000)
(20,000)
(60,000)
Rent Expense
Salaries Expense
(50,000)
Net Income(50,000)
is considered
a better(50,000)
indicator (150,000)
of future cash flows.
Utilities Expense
Net Income
(10,000)
$
20,000
(10,000)
$
20,000
(10,000)
$
20,000
(30,000)
$
60,000
The Development of Financial
Accounting and Reporting Standards
Concepts,
principles, and
procedures
developed to meet the
needs of external
users (GAAP).
Historical Perspective and Standards
Current U. S. Standard Setting
Financial Accounting
Standards Board
 Supported by the Financial Accounting
Foundation
 Seven full-time, independent voting members
 Members not required to be CPAs
FASB Accounting Standards Codification
The codification project integrates and organizes all
relevant accounting pronouncements into a searchable,
online database.
International Standard Setting
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.
Comparison of Organizations of U.S.
and International Standard-Setters
U.S. GAAP
Regulatory oversight
provided by:
Securities Exchange
Commission (SEC)
Foundation providing
oversight, appointing
members, raising funds:
Financial Accounting
Foundation (FAF): 20 trustees
Standard-setting board:
Financial Accounting Standards
Board (FASB): 7 full-time
members
Advisory council providing
input on agenda and
projects:
Group to deal with
emerging issues:
IFRS
International Organization of
Securities Commissions
(IOSCO)
International Accounting
Standards Committee
Foundation (IASCF): 22
trustees
International Accounting
Standards Board (IASB): 14
members (12 full-time; 2 parttime)
Financial Accounting Standards
Standards Advisory Council
Advisory Council (FASAC): 30(SAC): 30-40 members
40 members
International Financial
Emerging Issues Task Force
Reporting Interpretations
(EITF): 15 members
Committee (IFRIC): 14
members
Efforts to Converge U.S. and
International Standards
Issues and Concerns:
Desire for a single set of global standards
 Need for standards that are customized to fit stringent legal and
regulatory requirements of U.S.
 Possible differences in implementation and enforcement

Progress:
September 2002: FASB and IASB sign Norwalk Agreement.
 November 2008: SEC issues a Roadmap with milestones.
 May 2011: SEC issues discussion paper describing a
“condorsement” approach.
 November 2011: SEC issues two studies comparing U.S. GAAP to
IFRS and analyzing how IFRS are applied globally.
 December 2011: SEC postpones final determination until 2012.

FASB’s Standard-Setting Process







Board receives recommendations for projects.
FASB Chairman decides whether to add a 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.
Role of the Auditor
Auditors serve as independent
intermediaries to help ensure that
management has appropriately applied U.S.
GAAP in preparing the company’s financial
statements.
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.
A Move Away from
Rules-Based Standards?
Rules-based accounting standards
vs.
Objectives-oriented approach
Objectives-oriented
(principles-based) approach
stresses professional
judgment
Ethics in Accounting
Code of Ethics:
Provides guidance and rules to help
accounting professionals perform their
professional responsibilities in an ethical
manner.
Analytical 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.
The Conceptual Framework
The Conceptual Framework has been described as
an “Accounting Constitution.” It provides the
underlying foundation for accounting standards.
FASB Conceptual Framework
(Statements of Financial Accounting Concepts)
Objectives of Financial Reporting (SFAC 1, replaced by SFAC 8)
Qualitative Characteristics (SFAC 2, replaced by SFAC 8)
Elements of Financial Statements (SFAC 3, replaced by SFAC 6)
Recognition and Measurement (SFAC 5 and SFAC 7)
The Conceptual Framework
Objective
To provide financial information
that is useful to capital providers.
Qualitative
Characteristics
Elements
Constraints
Financial
Statements
Recognition and
Measurement
Concepts
Qualitative Characteristics of
Accounting Information
Decision usefulness
Relevance
Predictive
value
Confirmatory
value
Comparability
(Consistency)
Faithful representation
Materiality
Verifiability
Completeness
Timeliness
Neutrality
Free from
error
Understandability
Key Constraint
Cost
Effectiveness
Benefits
Costs
Elements of Financial Statements
Elements of Financial Statements
Underlying Assumptions
Recognition, Measurement and
Disclosure Concepts
Recognition
Process of admitting information
into the basic financial statements
Measurement
Process of associating numerical
amounts with the elements.
Disclosure
Process of including additional
supplemental information.
Criteria:
1. Definition
2. Measurability
3. Relevance
4. Reliability
Measurement Attributes:
1. Historical cost
2. Net realizable value
3. Current cost
4. Present value of
future cash flows
5. Fair value
Examples:
1. Parenthetical
amounts
2. Notes to FS
3. Supplemental FS
Revenue Recognition: Realization
Two Criteria:
1. Earnings process is complete or virtually
complete.
2. Reasonable certainty as to the collectability of the
asset to be received (usually cash).
Expense Recognition: Matching
The matching principle requires that all
expenses incurred in generating revenue for a
period also be recognized in the same period.
1.
2.
3.
4.
Four Approaches
Based on exact cause-and-effect relationships.
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
revenues.
Fair Value Hierarchy
U.S. GAAP gives companies the option to report some or all of
their financial assets and liabilities at fair value.
Evolving U.S. GAAP
U.S. GAAP has been evolving from an emphasis on revenues
and expenses to an emphasis on assets and liabilities.
Revenue/Expense Approach: Emphasize principles for recognizing
revenues and expenses, with some assets and liabilities recognized
as necessary to make the balance sheet reconcile with the income
statement.
Asset/Liability Approach: Emphasize principles for recognizing
assets and liabilities first, and then recognize and measure the
revenues, expenses, gains, and losses needed to account
for the changes in assets and
liabilities from the previous measurement date.
Where We’re Headed:
The Conceptual Framework
FASB and IASB Joint Conceptual Framework Project
Eight Phases:
A. Objective and Qualitative Characteristics (Completed)
B. Elements and Recognition (In progress)
C. Measurement (In progress)
D. Reporting Entity (In progress)
E. Presentation and Disclosure
F. Framework for a GAAP Hierarchy
G.Applicability to the Not-For-Profit Sector
H. Remaining Issues
End of Chapter 1