Theoretical Structure of
Financial Accounting
I N T ERMEDIATE ACCOU N T I NG I
CHA PT ER 1
Financial Accounting Environment
 The primary focus of financial accounting is on the information needs
of investors and creditors.
 Financial statements convey financial information to external users.
Financial Statements
 The primary means of conveying financial information to investors, creditors,
and other external users is through financial statements and related notes.
The financial statements most frequently provided are:
1.
2.
3.
4.
5.
Balance sheet or statement of financial position
Income statement or statement of operations
Statement of cash flows
Statement of shareholders' equity
Either
a) a statement of other comprehensive income immediately following
the income statement, or
b) a statement of comprehensive income (including information on the
income statement as well as on the statement of other comprehensive
income).
Cash vs Accrual Basis of Accounting
 Two primary methods of measuring income exist
 Cash basis – income is only recognized when received in cash
 Accrual basis – income is recognized when earned regardless of
whether or not cash has been received
 Measuring the same activities by the accrual accounting model provides a
more accurate prediction of future operating cash flows.
Cash vs Accrual Basis of Accounting
 Two primary methods of measuring income exist
 Cash basis – income is only recognized when received in cash
 Accrual basis – income is recognized when earned regardless of
whether or not cash has been received
 Measuring the same activities by the accrual accounting model provides a
more accurate prediction of future operating cash flows.
Exercise 1-1, page 38 (adjusted)
Listed below are several transactions that took place during the first two years of operations for
the law firm of Pete, Pete, and Roy. In addition, you learn that the company incurred utility
costs of $35,000 in year 1, that there were no liabilities at the end of year 2, no anticipated bad
debts on receivables, and the insurance policy covers a three-year period. Determine the
amount of net income to be recognized each year using accrual basis accounting.
Exercise 1-1, page 38 (adjusted)
Solution
Pete, Pete, and Roy
Income Statements
Revenues
Expenses:
Salaries
Utilities
Insurance
Net Income
Year 1
$170,000
Year 2
$220,000
(90,000)
(35,000)
(20,000)
$ 25,000
(100,000)
(35,000)
(20,000)
$ 65,000
Explanation of Utilities Expense: $35,000 of utilities were incurred in Year 1 and should therefore be
recognized in Year 1. Since only $30,000 of the $35,000 of utilities were paid in Year 1, $5,000 of utilities
payable were carried into Year 2. Therefore, $5,000 of the $40,000 paid in Year 2 was actually incurred in
Year 1 leaving $35,000 of utilities actually incurred, and therefore recognized, in Year 2.
The Conceptual Framework
A coherent system of interrelated objectives and fundamentals that
is intended to lead to consistent standards and that prescribes the
nature, function, and limits of financial accounting and reporting.
 Underlying foundation for accounting standards
 Underlying concepts of accounting that guide the selection of
events to be accounted for, the measurement of those events, and
the means of summarizing and communicating them to interested
parties
 Provides structure and direction to financial accounting and
reporting
 Does not set GAAP
 See Conceptual Framework, Intermediate Accounting text, page 20
Financial Accounting and Reporting Standards
 Generally accepted accounting principles (GAAP) are a set of
guidelines companies follow in measuring and reporting financial
information.
 The Securities and Exchange Commission (SEC) has the authority to
set accounting standards for companies, but always has delegated the
task to the accounting profession.
 The Financial Accounting Standards Board (FASB) currently sets
accounting standards.
Qualitative Characteristics of
Accounting Information
To be useful for decision making, accounting information should possess the primary characteristics
of relevance and faithful representation.
PRIMARY QUALITATIVE CHARACTERISTICS

Relevance




Predictive value – helps to predict a future condition
Confirmatory value – assists users in validating or changing a prior assessment of a
company’s condition
Materiality (enhancing aspect) – has an effect on decisions
Faithful representation



Completeness – All information that is necessary for faithful representation.
Neutrality – Accounting standards should be set with overall societal goals and specific
objectives in mind, and should try not to favor particular groups or companies.
Free from error
Financial Accounting and Reporting Standards
ENHANCING QUALITATIVE CHARACTERISTICS
 Comparability - Ability to help users see similarities and differences
among events and conditions (also includes consistency).
 Verifiability - Consensus among different measurers.
 Timeliness - Available to users before a decision is made.
 Understandability - Users must understand the information.
Financial Accounting and Reporting Standards
CONSTRAINT
 Cost Effectiveness – The benefits received should exceed the cost to
generate the benefits
Underlying Assumptions

Economic Entity Assumption
All economic events can be identified with a particular economic entity.

Going Concern Assumption
In the absence of information to the contrary, it is anticipated that a business entity will
continue to operate indefinitely.

Periodicity Assumption
The life of a company can be divided into artificial time periods to provide timely
information to external users.

Monetary Unit Assumption
Financial statement elements should be measured in terms of the United States dollar.
Recognition, Measurement and
Disclosure Concepts
It is important to accurately determine when the
financial elements should be recorded and how
they should be measured and disclosed.
General Recognition Criteria
An item should be recognized in the basic financial statements when it
meets the following criteria:
 Definition — the item meets the definition of an element of financial
statements.
 Measurability — the item has a relevant attribute measurable with
sufficient reliability.
 Relevance — the information about it is capable of making a difference in
user decisions.
 Reliability — the information is representationally faithful, verifiable, and
neutral.
Revenue Recognition:
Realization and Matching Principles
 Realization Principle

Revenue should be recognized only after the earnings process is virtually
complete and there is reasonable certainty of collecting the asset.

Revenue should be recognized in the period it is earned, not necessarily
in the period in which cash is received.
 Matching Principle

Expenses are recognized in the same period as the related revenues.
T1-14
MEASUREMENT
Measurement — Associating numerical amounts to the elements.
 GAAP uses a “mixed attribute” model including
 Historical Cost – measurement is based on the amount given or
received in the exchange transaction
 Net Realizable Value – measurement is based on the amount of
cash into which the asset or liability could be converted in the
ordinary course of business
 Current Cost – measurement is based on the current replacement
cost
 Present Value of Future Cash Flows – measurement is based on
future cash flows discounted for the time value of money
 Fair Value – measurement is based on the price that would be
received to sell assets or transfer liabilities in an orderly market
transaction
Theoretical Structure of
Financial Accounting
I N T ERMEDIATE ACCOU N T I NG I – CHA PT ER 1
E N D OF P R ESENTATION