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.