Chapter 1
ENVIRONMENT AND
THEORETICAL STRUCTURE
OF FINANCIAL
ACCOUNTING
McGraw-Hill /Irwin
© 2009 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
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Slide 3
Financial Accounting Environment
Relevant financial information is provided
primarily through financial statements
and related disclosure notes.




Balance Sheet
Income Statement
Statement of Cash Flows
Statement of Shareholders’ Equity
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The Economic Environment
and Financial Reporting
A sole proprietorship
is owned by a
single individual.
A partnership is
owned by two or
more individuals.
Slide 4
A corporation is owned
by stockholders,
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.
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Investment-Credit Decisions ─
A Cash Flow Perspective
Slide 5
Corporate shareholders receive cash
from their investments through . . .
• Periodic dividend distributions from the
corporation.
• The ultimate sale of the ownership shares of
stock.
Accounting information should help investors
evaluate the amount, timing, and uncertainty
of the enterprise’s future cash flows.
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Slide 6
Cash Versus Accrual Accounting
Cash Basis Accounting
Revenue is recognized when cash is received.
Expenses are recognized when cash is paid.
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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.
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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
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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.
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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.
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Slide 11
The Development of Financial Accounting
and Reporting Standards
Concepts,
principles, and
procedures were
developed to meet the
needs of external
users (GAAP).
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Slide 12
Historical Perspective and Standards
Securities and Exchange Commission (SEC)
 1934 – present
Evolution of Standard-Setting Process
 1938 – 1959:
 Committee on Accounting Procedure (CAP)
 1959 – 1973:
 Accounting Principles Board (APB)
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Current Standard Setting - FASB
www.fasb.org
Slide 13
 Supported by the Financial Accounting
Foundation.
 Seven full-time, independent voting members
serving for 10 years.
 Answerable only to the Financial Accounting
Foundation.
 Members not required to be CPAs.
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Slide 14
Hierarchy of GAAP
FASB Statements of Financial Accounting Standards,
FASB Interpretations, SEC rules and interpretive
releases, AICPA Accounting Research Bulletins,
Accounting Principles Board Opinions
Most
Authoritative
FASB Technical Bulletins, AICPA Industry Audit and
Accounting Guides and Statements of Position
AICPA Accounting Standards Executive
Committee Practice Bulletins
FASB Implementation Guides, AICPA Accounting
Interpretations, AICPA Industry Audit and Accounting
Guides and Statements of Position, and widely
recognized general or industry practices.
Least
Authoritative
An FASB Accounting Standards Codification, expected in 2009, will
integrate, topically organize, and effectively eliminate this hierarchy.
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Slide 15
Establishment of Accounting Standards
A Political Process
Internal Revenue
Service
www.irs.gov
American Institute
of CPAs
www.aicpa.org
Securities and
Exchange
Commission
www.sec.gov
Financial Executives
International
www.fei.org
GAAP
Governmental
Accounting
Standards Board
www.gasb.org
American
Accounting
Association
www.aaa-edu.org
1-15
Slide 16
FASB’s Standard-Setting Process
 Identification of problem.
 The task force.
 Research and analysis.
 Discussion memorandum.
 Public response.
 Exposure draft.
 Public response.
 Statement issued.
1-16
Slide 17
International Accounting Standards
Board (IASB)
Established in 2001 with the following objectives:
 Develop a single set of high quality, understandable
and enforceable global accounting standards that
require transparent and comparable information in
general purpose financial statements.
 Cooperate with national accounting standard setters
to achieve convergence in accounting standards
around the world.
1-17
Slide 18
Role of the Auditor
Independent intermediary to help
insure that management has
appropriately applied GAAP.
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Slide 19
Financial Reporting Reform
As a result of numerous financial scandals,
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.
1-19
Slide 20
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.
1-20
Slide 21
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.
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Slide 22
The Conceptual Framework
 Maintain consistency among standards.
 Resolve new accounting problems.
 Provide user benefits.
1-22
Slide 23
The Conceptual Framework
Objectives of Financial Reporting
(SFAC No. 1)
Qualitative Characteristics
of Accounting Information
Elements of
Financial Statements
(SFAC No. 2)
(SFAC No. 6)
Recognition and Measurement Criteria
(SFAC No. 5 and SFAC No. 7)
Environment
assumptions
Implementation
principles
Implementation
constraints
1-23
Slide 24
Conceptual Framework
Objectives
To provide information:
Useful for investor and creditor decisions.
That helps predict cash flows.
About economic resources, claims to resources,
and changes in resources and claims.
Qualitative
Characteristics
Constraints
Elements
Financial
Statements
Recognition and
Measurement
Concepts
Continued
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Slide 25
Objectives
Qualitative
Characteristics
Understandability
Primary
Relevance
Reliability
Secondary
Comparability
Consistency
Elements
Assets
Liabilities
Equity
Investments by Owners
Distributions to owners
Revenues
Expenses
Gains
Losses
Comprehensive Income
Recognition and
Measurement
Concepts
Assumptions
Economic entity
Going concern
Periodicity
Monetary unit
Principles
Historical cost
Realization
Matching
Full Disclosure
Financial Statements
Constraints
Cost effectiveness
Materiality
Conservatism
Balance sheet
Income statement
Statement of cash flows
Statement of shareholders’ equity
Related disclosures
1-25
Qualitative Characteristics of
Accounting Information
Slide 26
Decision Usefulness
Relevance
Predictive
Value
Feedback
Value
Comparability
Reliability
Timeliness
Verifiability
Neutrality
Representational
Faithfulness
Consistency
1-26
Slide 27
Practical Constraints to Achieving
Desired Qualitative Characteristics
Conservatism
Cost
Effectiveness
Materiality
1-27
Slide 28
Elements of Financial Statements
1-28
Slide 29
Elements of Financial Statements
1-29
Slide 30
Recognition and Measurement Concepts
1-30
Slide 31
The Asset/Liability Approach
 Measure assets and liabilities that
exist at a balance sheet date.
 Recognize revenues, expenses,
gains, and losses needed to account
for the changes in assets and
liabilities from the previous balance
sheet date.
The focus on assets and liabilities has lead to
increased interest on fair value measurement
1-31
Slide 32
The Move Toward Fair Value
Fair value is 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.
Market
Approaches
Income
Approaches
Cost
Approaches
1-32
Slide 33
Fair Value Hierarchy
SFAS No. 159 gives companies the option to report some
or all of their financial assets and liabilities at fair value.
1-33
Slide 34
Question 1
The function of financial accounting is to
identify, measure and communicate
financial information about economic
entities to interested parties.
a. True
b. False
1-34
Slide 35
Question 2
Accrual accounting provides a better
indication of ability to generate cash flows
than does information limited to the
financial effects of cash receipts and cash
payments.
a. True
b. False
1-35
Slide 36
Question 3
The primary objective of accrual basis
accounting is the measurement of
income.
a. True
b. False
1-36
Slide 37
Question 4
Generally accepted accounting principles
include both standards set by various rule
making bodies and certain accounting
practices that have evolved over time.
a. True
b. False
1-37
Slide 38
Question 5
The major financial accounting standard
setting body is the
a.
b.
c.
d.
Accounting Principles Board
Securities and Exchange Commission
Financial Accounting Standards Board
American Institute of CPAs
1-38
Slide 39
Question 6
The FASB issues which of the following
types of pronouncements?
a.
b.
c.
d.
e.
Standards
Interpretations
Financial Accounting Concepts
Technical Bulletins
All of the above
1-39
End of Chapter 1
McGraw-Hill /Irwin
© 2009 The McGraw-Hill Companies, Inc.