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 1-2 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 1-3 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. 1-4 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. 1-5 Slide 6 Cash Versus Accrual Accounting Cash Basis Accounting Revenue is recognized when cash is received. Expenses are recognized when cash is paid. 1-6 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. 1-7 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 1-8 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. 1-9 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. 1-10 Slide 11 The Development of Financial Accounting and Reporting Standards Concepts, principles, and procedures were developed to meet the needs of external users (GAAP). 1-11 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) 1-12 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. 1-13 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. 1-14 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. 1-18 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. 1-21 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 1-24 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.