Environment and Theoretical Structure of Financial Accounting Chapter 1
Relevant Financial Information Financial Accounting Environment Providers of Financial Information External User Groups Profit-oriented companies Not-for-profit entities Households Investors Creditors Employees Labor unions Customers Suppliers Governmentagencies Financialintermediaries
Relevant financial information is provided primarily through financial statements and related disclosure notes. The following financial statements are the most frequently provided. Balance Sheet Income Statement Statement of Cash Flows Statement of Shareholders’ Equity Starting in 2012, companies must either provide a Statement of Other Comprehensive Income immediately following the Income Statement, or present a Combined Statement of Comprehensive Income that includes the information normally contained in both the Income Statement and the Statement of Other Comprehensive Income. Financial Accounting Environment
A highly-developed system communicates financial information from a corporation to its many shareholders. The Economic Environment and Financial Reporting A sole proprietorshipis owned by asingle individual. A partnership isowned by two ormore individuals. A corporation is ownedby shareholders.
Investment-Credit Decisions ─ A Cash Flow Perspective Shareholders Receive Cash Creditors Receive Cash Dividends Sale of Stock Interest Repayment of Principle Accounting information should help investors and creditors evaluate theamount, timing, and uncertainty of the enterprise’s future cash flows.
Cash versus Accrual Accounting Cash Basis AccountingRevenue is recognized when cash is received. Expenses are recognized when cash is paid. OROROR OR Accrual Accounting Revenue is recognized when earned.Expenses are recognized whenincurred.
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.
Cash versus Accrual Accounting Cash Basis Accounting
Cash versus Accrual Accounting Cash Basis Accounting Cash flows in any one year may notbe a predictor of future cash flows.
Cash versus Accrual Accounting Accrual Basis Accounting
Cash versus Accrual Accounting Accrual Basis Accounting Net Income is considered a better indicator of future cash flows.
The Development of Financial Accounting and Reporting Standards Concepts, principles, and procedures developed to meet the needs of external users (GAAP).
Supported by the Financial Accounting Foundation Seven full-time, independent voting members Members not required to be CPAs Current U. S. Standard Setting Financial Accounting Standards Board
FASB Accounting Standards Codification The codification project integrates and organizes all relevant accounting pronouncements into a searchable, online database.
International Standard Setting The main objective of the International Accounting Standards Board (IASB) is to develop a single set of high quality, understandable, and enforceable global accounting standards to help participants in the world’s capital markets and other users make economic decisions.
Comparison of Organizations of U.S. and International Standard-Setters
Efforts to Converge U.S. and International Standards Issues and Concerns: • Desire for a single set of global standards • Need for standards that are customized to fit stringent legal and regulatory requirements of U.S. • Possible differences in implementation and enforcement Progress: • September 2002: FASB and IASB sign Norwalk Agreement. • November 2008: SEC issues a Roadmap with milestones. • May 2011: SEC issues discussion paper describing a “condorsement” approach. • November 2011: SEC issues two studies comparing U.S. GAAP to IFRS and analyzing how IFRS are applied globally. • December 2011: SEC postpones final determination until 2012.
FASB’s Standard-Setting Process • Board receives recommendations for projects. • FASB Chairman decides whether to add a project to its agenda. • Board deliberates the issues at a series of public meetings. • Board issues an Exposure Draft (ED). • Board holds a public roundtable meeting on the ED. • Staff analyzes feedback and the Board re-deliberates the proposed revisions at public meetings . • Board issues a Standards Update describing amendments to the Codification.
Role of the Auditor Auditors serve as independent intermediaries to help ensure that management has appropriately applied U.S. GAAP in preparing the company’s financial statements.
Financial Reporting Reform As a result of numerous financial scandals, Congress passed the Public Company Accounting Reform and Investor Protection Act of 2002, (Sarbanes-Oxley Act). The goal was to restore credibility and investor confidence in the financial reporting process.
A Move Away from Rules-Based Standards? Rules-based accounting standards vs. Objectives-oriented approach • Objectives-oriented (principles-based) approach stresses professional judgment
Ethics in Accounting Code of Ethics: Provides guidance and rules to help accounting professionals perform their professional responsibilities in an ethical manner.
Analytical 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.
The Conceptual Framework The Conceptual Framework has been described as an “Accounting Constitution.” It provides the underlying foundation for accounting standards. FASB Conceptual Framework (Statements of Financial Accounting Concepts) Objectives of Financial Reporting (SFAC 1, replaced by SFAC 8) Qualitative Characteristics (SFAC 2, replaced by SFAC 8) Elements of Financial Statements (SFAC 3, replaced by SFAC 6) Recognition and Measurement (SFAC 5 and SFAC 7)
The Conceptual Framework Objective To provide financial information that is useful to capital providers. Qualitative Characteristics Recognition andMeasurementConcepts Elements FinancialStatements Constraints
Qualitative Characteristics ofAccounting Information Decision usefulness Relevance Faithful representation Confirmatory value Predictivevalue Materiality Completeness Neutrality Free from error Comparability (Consistency) Verifiability Timeliness Understandability
Key Constraint CostEffectiveness Benefits Costs
Recognition, Measurement and Disclosure Concepts Criteria: Definition Measurability Relevance Reliability Recognition Process of admitting information into the basic financial statements Measurement Attributes: Historical cost Net realizable value Current cost Present value of future cash flows Fair value Measurement Process of associating numerical amounts with the elements. Examples: Parenthetical amounts Notes to FS Supplemental FS Disclosure Process of including additional supplemental information.
Revenue Recognition: Realization Two Criteria: Earnings process is complete or virtually complete. Reasonable certainty as to the collectability of the asset to be received (usually cash).
Expense Recognition: Matching The matching principle requires that all expenses incurred in generating revenue for a period also be recognized in the same period. Four Approaches Based on exact cause-and-effect relationships. By associating an expense with the revenues recognized in a specific time period. By a systematic and rational allocation to specific time periods. In the period incurred, without regard to related revenues.
Fair Value Hierarchy U.S. GAAP gives companies the option to report some or all of their financial assets and liabilities at fair value.
Evolving U.S. GAAP U.S. GAAP has been evolving from an emphasis on revenues and expenses to an emphasis on assets and liabilities. Revenue/Expense Approach: Emphasize principles for recognizing revenues and expenses, with some assets and liabilities recognized as necessary to make the balance sheet reconcile with the income statement. Asset/Liability Approach: Emphasize principles for recognizing assets and liabilities first, and then recognize and measure the revenues, expenses, gains, and losses needed to account for the changes in assets and liabilities from the previous measurement date.
Where We’re Headed:The Conceptual Framework FASB and IASB Joint Conceptual Framework Project • Eight Phases: • Objective and Qualitative Characteristics (Completed) • Elements and Recognition (In progress) • Measurement (In progress) • Reporting Entity (In progress) • Presentation and Disclosure • Framework for a GAAP Hierarchy • Applicability to the Not-For-Profit Sector • Remaining Issues