Chapter 1 ENVIRONMENT AND THEORETICAL STRUCTURE OF FINANCIAL ACCOUNTING © 2013 The McGraw-Hill Companies, Inc. Slide 2 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 Slide 3 Financial Accounting Environment Relevant financial information is provided primarily through financial statements and related disclosure notes. Statement of Financial Position Statement of Comprehensive Income Statement of Cash Flows Statement of Changes in Equity 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, frequently numbering in the tens of thousands in large corporations. A highly-developed system of financial reporting is necessary to communicate financial information from a corporation to its many shareholders. Slide 4 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. Accounting information should help investors evaluate the amount, timing, and uncertainty of the enterprise’s future cash flows. Slide 5 Slide 6 Cash Versus Accrual Accounting Cash Basis Accounting Revenue is recognized when cash is received. Expenses are recognized when cash is paid. Slide 7 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. Slide 8 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 toCash flows in any one year may not employeesbe 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 Slide 9 Cash Versus Accrual Accounting Accrual Accounting Revenue is recognized when earned. Expenses are recognized when incurred. Let’s reconsider the Carter Company information. Slide 10 Cash Versus Accrual Accounting Accrual Accounting ◦ Revenue is recognized when earned. ◦ Expenses are recognized when incurred. ◦ Let’s reconsider the Carter Company information. Slide 11 The Development of Financial Accounting and Reporting Standards Concepts, principles, and procedures were developed to meet the needs of external users. Two major sets of accounting standards – •IFRS •U.S. GAAP Slide 12 Historical Perspective and Standards International Standard Setting Standards set by private-sector Standards set by governmental body International Financial Reporting Standards IASC formed in 1973 Members from countries such as France, Germany, Japan, U.K., and U.S. IASC reorganized to IASB in 2001. Slide 13 International Accounting Standards Board (IASB) and supporting organizations IASB members include accounting profession, analysts, academics, regulators, and government. IFRS Foundation selects members, oversees, and ensures adequate funding. IFRS Advisory Council advises on agenda and work priorities. IFRS Interpretations Committee seeks to resolve accounting issues and interpret existing IFRS. International Organization of Securities Commissions (IOSCO) provides regulatory oversight of IASB. IASB is a private and non-governmental body with no authority to enforce the use of IFRS. Slide 14 Structure of IASB Slide 15 Establishment of Accounting Standards Due Process Understand the nuances of the economic transactions the standards address and the views of key constituents concerning how accounting would best capture that economic reality Steps include open hearings, deliberations, and requests for written comments from interested parties Slide 16 Role of the Auditor Independent intermediary to help ensure that management has appropriately applied accounting standards. Slide 17 Financial Reporting Reform in U.S. As a result of numerous financial scandals, the U.S. 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. Slide 18 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. Slide 19 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. Slide 20 The Conceptual Framework IASB conceptual framework provides structure and direction to financial accounting and reporting IASB and FASB are working together to develop a common conceptual framework through 8 phases Slide 21 The Conceptual Framework Objectives of Financial Reporting (Phase A) Qualitative Characteristics of Accounting Information (Phase A) Elements of Financial Statements Underlying Assumptions Recognition of Elements Measurement of Elements Capital and Capital Maintenance Slide 22 Conceptual Framework Objectives To provide financial information that is useful to capital providers Qualitative Characteristics Constraints Elements Financial Statements Underlying Assumptions Recognition of Elements Measurement of Elements Capital and Capital Maintenance Continued Slide 23 Objective of financial reporting Qualitative Characteristics Underlying Assumptions Going concern Elements Understandability Fundamental Relevance Faithful representation Financial Position Assets Liabilities Equity Enhancing Comparability Verifiability Timeliness Understandability Performance Income Expenses Recognition of Elements Probability of future economic benefits Reliability of measurement Measurement of Elements Basis of measurement Capital and Capital Maintenance Concepts of capital Concepts of capital maintenance and determination of profit Financial Statements Constraints Cost effectiveness Statement of financial position Income statement Statement of comprehensive income Statement of cash flows Statement of changes in shareholder’s equity Notes and supplementary disclosures Qualitative Characteristics of Financial Reporting Information Slide 24 Slide 25 Key Constraint Cost Effectiveness Slide 26 Elements of Financial Statements © 2013 The McGraw-Hill Companies, Inc. Slide 27 Recognition and Measurement Concepts Slide 28 Measurement of Elements of Financial Statements Measurement attributes in IFRS: 1.Historical cost 2.Net realizable value 3.Current cost 4.Present value of future cash flow 5.Fair value The attribute chosen to measure a particular item should be the one that maximizes the combination of relevance and representational faithfulness. © 2013 The McGraw-Hill Companies, Inc. Slide 29 The Move Toward Fair Value Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at a measurement date. Market Approaches Income Approaches Cost Approaches © 2013 The McGraw-Hill Companies, Inc. Slide 30 Fair Value Hierarchy IFRS gives a company the option to value financial assets and liabilities at fair value © 2013 The McGraw-Hill Companies, Inc. End of Chapter 1 © 2013 The McGraw-Hill Companies, Inc.
