Introduction
A major part of understanding financial accounting is understanding the
basic concepts and principles on which financial accounting and reporting are
based. Notice that we studying financial accounting and reporting. The
procedures used to prepare the financial statements and financial
information are only a means to an end. The goal is to produce information
that can be used by decision makers (both internal and external).
The first part of the course deals with financial accounting. Financial
accounting is concerned with the way businesses communicate financial
information to the public: the various categories of people who invest in,
lend money to, or do business with an entity.
Listed below are concepts, principles, definitions, and organizations that you
will need to understand in order to prepare financial information:
1.
Financial Accounting Standards Board (FASB)
The FASB is the rule-making body that establishes financial
accounting concepts and standards. The FASB has 7 voting members.
These members devote their full time to their duties at the FASB and
must resign from their prior organizations. Members cannot hold
investments in companies in order to ensure objectivity. Members are
not required to be CPAs (although many are) and have distinguished
themselves as being among the most knowledgeable regarding financial
accounting and reporting and business generally.
The FASB is financed by fees collected from public accounting firms
that audit publicly traded companies. The FASB emphasizes a due
process in which those affected by the rules the FASB promulgates
are allowed express their views regarding the setting of standards of
financial accounting and reporting.
2.
Generally Accepted Accounting Principles (GAAP)
Generally accepted accounting principles are broad guidelines,
conventions, rules, and procedures of financial accounting from two
main sources:
a.
Pronouncements from designated authoritative bodies
(such as FASB) that must be followed in all applicable
cases.
b.
Accounting practices that have been developed by
respected bodies and industries or that have evolved
over time.
3.
Independent Auditors
A professional accountant in public practice who expresses a written
opinion on whether an entity’s financial statements present fairly the
entity’s financial position and results of operations. A professional
accountant must be licensed as a certified public accountant (CPA).
The independent auditor is said to attest to the financial statements,
i.e., provides a reliability check to the users of financial statements.
The independent auditor must be free from any obligation to or
interest in the client, its management, or its owners.
4.
Securities and Exchange Commission (SEC)
The objective of the SEC is to ensure that investors have adequate
information to make investment decisions. A company cannot issue
new securities (stocks, bonds, etc.) unless the company files a
prospectus with the SEC. The prospectus reports information about
the company, its officers, and its financial and operating affairs. The
prospectus includes audited financial statements attested to by
independent CPAs. After the securities have been sold to the public,
the company must file quarterly and annual reports with the SEC in
order to keep investors informed as to the status of the company and
the company’s securities.
Congress delegated to the SEC the authority to establish and enforce
accounting standards for companies over which the SEC has
jurisdiction. The SEC has relied on the accounting profession to
prescribe financial accounting and external reporting requirements
for companies having publicly traded securities. The SEC on occasion
prods the accounting profession to move forward in resolving critical
problems.
5.
The Public Companies Accounting Oversight Board (PCAOB)
The PCAOB is a private-sector, non-profit corporation, created by the
Sarbanes-Oxley Act of 2002 (SOX), to oversee the auditors of public
companies in order to protect the interests of investors and further
the public interest in the preparation of informative, fair, and
independent audit reports. The Securities and Exchange Commission
appoints the chairman and members of the Public Company Accounting
Oversight Board. Section 109 of SOX provides that funds to cover
the Board’s annual budget (less registration and annual fees paid by
public accounting firms) are to be collected from issuers of financial
statements.
6.
The Conceptual Framework of Accounting
The conceptual framework is a theoretical underpinning to support
solutions to accounting and reporting problems. The Conceptual
Framework consists of seven Statements of Financial Accounting
Concepts (SFACs—sometimes referred to as “Concepts Statements”)
that describe and define the conceptual framework. The conceptual
framework provides consistency among accounting standards as well as
a basis for resolving new and unique accounting problems.
A conceptual framework in accounting is important because it can lead
to consistent standards and it prescribes the nature, function, and
limits of financial accounting and financial statements. The benefits its
development will generate can be characterized as follows: (a) it should
be easier to promulgate a coherent set of standards and rules; and (b)
practical problems should be more quickly solved.
The FASB recognized the need for a conceptual framework upon which
a consistent set of financial accounting standards could be based. The
FASB has issued six Statements of Financial Accounting Concepts
(SFAC) that relate to financial reporting. They are listed and described
briefly below:
SFAC No. 1.
"Objectives of Financial Reporting by Business
Enterprises" presents the goals and purposes of accounting.
SFAC No. 2. "Qualitative Characteristics of Accounting Information"
examines the characteristics that make accounting information useful.
SFAC No. 3.
"Elements of Financial Statements of Business
Enterprises" defines the broad classifications of items found in
financial statements.
SFAC No. 4. (This Statement deals with not-for-profit entities,
which are not covered in this course.)
SFAC No. 5. "Recognition and Measurement in Financial Statements of
Business Enterprises" gives guidance on what information should be
formally incorporated into financial statements and when.
SFAC No. 6. "Elements of Financial Statements" replaces SFAC No. 3 and
expands its scope to include not-for-profit organizations.
SFAC No. 7. "Using Cash Flow Information and Present Value in
Accounting Measurements," provides a framework for using expected future
cash flows and present value as a basis for measurement.
SFAC No. 1
Statement of Financial Accounting Concepts No. 1 recognizes the main
user groups of external financial statements as investors and
creditors. Other users are employees, managers and directors of a
company, customers, stock exchanges, taxing authorities, and
regulatory bodies (SEC and other governmental agencies). These
external users lack authority to prescribe the information they want
and must rely on the information management communicates to them.
The information communicated should be:
a.
Useful to current and potential investors and creditors
(and other users) in making rational investment, credit,
and other related decisions.
b.
Helpful to current and potential investors and creditors
(and other users) in assessing the amounts, timing, and
uncertainty of future cash flows such as dividend and
interest payments.
c.
Accurate in reporting the economic resources of the
business, including any claims to those resources held by
other entities (outstanding liabilities), as well as the
effects of any pending transactions, events, and
circumstances that will affect the company’s resources
and claims to those resources.
Although investors and creditors are interested in cash-flow
information, SFAC No. 1 asserts (based on research conducted) that
financial information prepared on the accrual basis is most useful in
helping investors and creditors estimate the amounts, timing, and risk
of future cash flows. The accrual basis recognizes revenues when
earned and expenses when incurred rather than when cash is received
and paid (disbursed).
SFAC No. 2 presents the qualities that make accounting information
useful for decision making. Thos qualities are relevance and reliability.
Primary Qualities
Relevance. Accounting information is relevant if it is capable of making
a difference in a decision. For information to be relevant, it should have
predictive or feedback value, and it must be presented on a timely basis.
Reliability. Accounting information is reliable to the extent that it is
verifiable, is a faithful representation, and is reasonably free of error
and bias. To be reliable, accounting information must possess three key
characteristics: (a) verifiability, (b) representational faithfulness, and
(c) neutrality.
Secondary Qualities
The secondary qualities identified are comparability and consistency.
Comparability. Accounting information that has been measured and
reported in a similar manner for different enterprises is considered
comparable.
Consistency. Accounting information is consistent when an entity
applies the same accounting treatment to similar events from period to
period.
7.
Elements of Financial Statements
Revenues
Inflows of assets or settlements of liabilities (or a combination of
both) during a particular accounting period; such inflows or
settlements stem from the delivery or production of goods or the
rendering of services.
Expenses
Outflows of assets or incurrences of liabilities (or both) during a
particular accounting period; such outflows are necessary to the
delivery or production of goods or rendering of services that
constitute the entity’s ongoing major or central operations. Expenses
are made to benefit the entity.
Gains
Increases to equity (net assets) resulting from peripheral or
incidental transactions not associated with the entity’s major or
central lines of business.
Losses
Decreases to equity (net assets) resulting from peripheral or
incidental transactions not associated with the company’s major or
central lines of business. They provide no benefit to the firm.
Assets
Probable future economic benefits obtained or controlled by a
particular entity as a result of past transaction or events.
Liabilities
Probable future sacrifices of economic benefits arising from present
obligations of a particular entity to transfer assets or provide
services to other entities in the future as a result of past
transactions or events.
Equity
The residual interest in the assets of an entity that remains after
deducting its liabilities. In a business enterprise, the equity is the
ownership interest.
Investments by Owners
Increases in net assets of a particular enterprise resulting from
transfers to it from other entities of something of value to obtain or
increase ownership interests (or equity ) in it.
Distributions to Owners
Decreases in net assets of a particular enterprise resulting from
transferring assets, rendering services, or incurring liabilities by the
enterprise to owners. Distributions to owners decrease ownership
interest (or equity) in an enterprise.
Comprehensive Income
Change in equity (net assets) of an entity during a period from
transactions and other events and circumstances from nonowner
sources. It includes all changes in equity during a period except those
resulting from investments by owners and distributions to owners.
8.
Some Important Assumptions and Principles Underlying Financial
Accounting
Separate Entity Assumption
Under the separate entity assumption, all accounting records and
reports are developed from the viewpoint of a single entity, whether
it is a proprietorship, a partnership, or a corporation. The assumption
is that an individual’s transactions are distinguishable from those of
the business he or she might own.
Continuity (“Going-Concern”) Assumption
The business entity in question is expected not to liquidate but to
continue operations for the foreseeable future. The business is
assumed to stay in existence for the period of time necessary to
carry out contemplated operations, contracts, and commitments.
This assumption provides the basis for the historical cost principle as
well as for various classifications of accounting information (e.g.,
current vs. long term assets and liabilities). If a business is expected
to be liquidated in the near future, assets and liabilities should be
valued at net realizable amounts (liquidation values).
Unit-of-Measure Assumption
Money is the common denominator of economic activity and provides
an appropriate basis for accounting measurement and analysis. In the
United States, accountants have chosen generally to ignore inflation
(changes in the purchasing power of the dollar) by assuming the unit
of measure (the dollar) remains reasonably stable. This assumption
results in 1970 dollars being added to 2001 dollars with no
adjustment.
Periodicity (Time-Period) Assumption
The operating results of a business enterprise cannot be known with
certainty until the company has completed its life span and ceased
business operations. In the meantime, external decision makers
require timely accounting information to analyze and use as a basis for
their decisions. The periodicity assumption requires that changes in a
business’s financial position be reported over a series of shorter time
periods. The periodicity assumption necessitates the use of accrual
and deferral of items in the financial statements (the accrual basis of
accounting).
Cost Principle
The cost principle specifies that actual acquisition cost be used for
initial recognition purposes. The actual acquisition cost is reliable and
objective. The cash-equivalent cost of an asset is used if the asset is
acquired by some means other than cash. The cost principle assumes
that assets are acquired in business transactions conducted at armslength. The cost principle also is applied to liabilities. Liabilities are
issued by a business in exchange for assets upon which an agreed
price has been placed. This price, established by the exchange
transaction, is the “cost” of the liability and provides the figure at
which the liability should be recorded in the accounts and reported in
the financial statements.
Revenue Recognition Principle
Revenue can be defined as inflows of cash or other enhancements of a
business’s assets, settlements of its liabilities, or a combination of the
two. Such inflows must be derived from delivering and producing
goods, rendering service, or performing other activities that
constitute a company’s ongoing business operations over a specific
period of time. Revenue generally is recognized when (1) realized or
realizable and (2) earned. Revenues are realized when products,
goods, services, merchandise, or other assets are exchanged for cash
or claims to cash. Revenues are realizable when assets received or
held are readily convertible into cash or claims to cash. Assets are
readily convertible when they are salable or interchangeable in an
active market at readily determinable prices without significant
additional cost. Revenues are considered earned when the entity has
substantially accomplished what it must do to be entitled to the
benefits represented by the revenues. Recognition at the time of sale
is a common (but not the only) point of revenue recognition.
Matching Principle
The matching principle is based on the accrual basis of accounting and
deals with the recognition of expenses. This principle requires that
all expenses incurred in earning the revenue recognized for a period
should be recognized during the same period. If revenue is deferred,
then so should the related expenses be deferred. Some expenses are
linked to revenue by a direct cause-and-effect relationship. Other
expenses have no direct relationship to revenue and are recognized in
the time period incurred.
Full-Disclosure Principle
The full-disclosure principle requires that the financial statements
report all relevant information bearing on the economic affairs of a
business enterprise. Under the full-disclosure principle, transactions
should be reported to emphasize the economic substance of the
transactions rather than the form of the transaction. The goal is to
provide external users with the accounting information they need to
make informed investment and credit decisions.
Materiality Constraint
Materiality is defined as the magnitude of an omission or
misstatement of accounting that, in the light of surrounding
circumstances, makes it probable that the judgment of a reasonable
person relying on the information would have been changed or
influenced by the omission or misstatement. The assumption is that
the omission or inclusion of immaterial facts is not likely to change or
influence the decision of a rational external user. The item must
make a difference or it need not be disclosed. The materiality
concept provides a threshold for recognition. The inclusion or
exclusion of an item on the basis of materiality is situation specific.
An amount may be considered immaterial in one situation but material
in another. Both qualitative and quantitative factors must be
considered in determining whether an item is material.
Conservatism Constraint
The conservatism constraint holds that when two alternative
accounting methods are acceptable and both equally satisfy the
conceptual and implementation principles set forth by the FASB, the
alternative having the less favorable effect on net income or total
assets is preferable. The reasoning is that investors prefer
information that does not unnecessarily raise expectations. The
conservatism constraint does not urge or require that assets or net
income be understated.