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Copyright 2007 by The McGraw-Hill Compan ies, Inc. Al l rights reserved.

Environmental andTheoretical Structure

of FinancialAccounting

1Insert Book Cover

Picture

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Learning Objectives

Describe the function and primaryfocus of financial accounting.

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Financial Accounting Environment

Profit-orientedcompanies

Not-for-profitentities

Households

Providers ofFinancial Information

ExternalUser Groups

Investors

Creditors

Employees

Labor unions

Customers

Suppliers

Governmentagencies

Financialintermediaries

Relevant

Financial

Information


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Financial Accounting Environment

Relevant financial information is provided

primarily through financial statements andrelated disclosure notes.

Balance Sheet

Income Statement

Statement of Cash Flows

Statement of Shareholders Equity

1-5The Economic Environment andFinancial Reporting

A sole proprietorshipis owned by a

single individual.

A partnership isowned by two ormore individuals.

A corporation is ownedby stockholders,

frequently numberingin the tens of thousands

in large corporations.

A highly-developed system of financialreporting is necessary to communicatefinancial information from a corporation

to its many shareholders.

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Investment-Credit DecisionsA Cash Flow Perspective

Corporate shareholders receive cash from

their investments through . . .

Periodic dividend distributions from thecorporation.

The ultimate sale of the ownership shares ofstock.


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Accounting information should help

investors evaluate the amount, timing,and uncertainty of the enterprises

future cash flows.

Investment-Credit DecisionsA Cash Flow Perspective

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Learning Objectives

Explain the difference betweencash and accrual accounting.

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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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Cash Basis AccountingCarter 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 secondand third years. The company prepaid $60,000 for

three years rent in the first year. Utilities are $10,000per year, but in the first year only $5,000 was paid.

Payments to employees are $50,000 per year.

Lets look at the cash flows.

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Year 1 Year 2 Year 3 Total

Cash receipts from

customers 50,000$ 125,000$ 125,000$ 300,000$

Payment of 3

years' rent (60,000) - - (60,000)Salaries to

employees (50,000) (50,000) (50,000) (150,000)

Payments for

utilities (5,000) (15,000) (10,000) (30,000)

Net cash flow (65,000)$ 60,000$ 65,000$ 60,000$

Summary of Cash Flows

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Year 1 Year 2 Year 3 Total

Cash receipts from

customers 50,000$ 125,000$ 125,000$ 300,000$

Payment of 3

years' rent (60,000) - - (60,000)

Salaries to

employees (50,000) (50,000) (50,000) (150,000)

Payments for

utilities (5,000) (15,000) (10,000) (30,000)

Net cash flow (65,000)$ 60,000$ 65,000$ 60,000$

Summary of Cash Flows


Cash flows i n any one year may not be a

predictor of future cash flows.



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Accrual AccountingRevenue is recognized when earned.

Expenses are recognized when incurred.

Lets reconsider the CarterCompany information.

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Accrual Accounting

Revenue is recognized when earned.

Expenses are recognized when incurred.

Lets reconsider the CarterCompany information.


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Learning Objectives

Define generally accepted accountingprinciples (GAAP) and discuss the historical

development of accounting standards.


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The Development of Financial Accountingand Reporting Standards

Concepts,

principles, andprocedures were

developed to meet the

needs of external

users (GAAP).

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Historical Perspective and Standards

Securities and Exchange Commission

1934 present

Evolution of Standard-Setting Process

1938 1959:

Committee on Accounting Procedures (CAP)

1959 1973:

Accounting Principles Board (APB)

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Current Standard Setting - FASBwww.fasb.org

pSupported by the Financial AccountingFoundation.

pSeven full-time, independent voting membersserving for 10 years.

pAnswerable only to the Financial AccountingFoundation.

pMembers not required to be CPAs.


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Learning Objectives

Explain why the establishment ofaccounting standards is characterized

as a political process.

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Establishment of Accounting StandardsA Political Process

GAAP

Internal RevenueService

www.irs.gov

American Instituteof CPAs

www.aicpa.org

Securities andExchange

Commissionwww.sec.gov

AmericanAccountingAssociation

www.aaa-edu.org

GovernmentalAccounting

Standards Board

www.gasb.org

Financial ExecutivesInternationalwww.fei.org

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FASBs Standard-Setting Process

Identification of problem.

The task force.

Research and analysis.

Discussion memorandum.

Public response.

Exposure draft.

Public response.

Statement issued.


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International Accounting StandardsBoard (IASB)

pEstablished in 1973 to narrow the

range of differences in accountingstandards.

p Increase in international trade hasmotivated the IASB to attempt toeliminate alternative accountingtreatments.

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Role of the Auditor

Independent intermediary to help insure thatmanagement has in fact appropriately

applied GAAP.

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Financial Reporting Reform

As a result of numerous financial scandals,Congress passed the Public CompanyPublic Company

Accounting Reform and Investor ProtectionAccounting Reform and Investor Protection

Act of 2002Act of 2002, commonly referred to as theSarbanes-Oxley Act for the two congressmen

who sponsored the bill.


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Learning Objectives

Explain the purpose of theFASBs conceptual framework.

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The Conceptual Framework

pMaintain consistency among standards.

pResolve new accounting problems.

pProvide user benefits.

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Learning Objectives

Identify the objectives of financial reporting, thequalitative characteristics of accounting

information, and the elements of f inancialstatements.

Describe the four basicassumptions underlying GAAP

Describe the four basic accountingprinciples that guide accounting practice.


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The Conceptual Framework

Recognition and Measurement Criteria(SFAC No. 5)

Environment Implementation Implementationassumptions princi ples constraints

Objectives of Financial Reporting(SFAC No. 1)

Qualitative Characteristicsof Accounting Information

(SFAC No. 2)

Elements ofFinancial Statements

(SFAC No. 6)

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ObjectivesTo 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.

ElementsRecognition and

Measurement

Concepts

Constraints

Conceptual Framework

Qualitative

Characteristics

Financial

StatementsContinued

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ElementsAssets

LiabilitiesEquity

Investments by OwnersDistributions to owners

RevenuesExpenses

GainsLosses

Comprehensive Income

Recognition andMeasurement

Concepts

AssumptionsEconomic entityGoing concern

PeriodicityMonetary u nit

PrinciplesHistorical cost

RealizationMatching

Full Disclosure

Objectives

Financi al StatementsBalance sheet

Income statementStatement of cash flows

Statement of shareholders equityRelated disclosures

ConstraintsCost effectiveness

MaterialityConservatism

QualitativeCharacteristics

Understandability

Primary

RelevanceReliability

Secondary

Comparability

Consistency


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Relevance Reliability

PredictiveValue

FeedbackValue

Timeliness NeutralityVerifiabilityRepresentational

Faithfulness

Comparability Consistency

Qualitative Characteristics ofAccounting Information

Decision Usefulness

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Practical Constraints to AchievingDesired Qualitative Characteristics

Cost

Effectiveness Materiality

Conservatism

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SFAC No. 6Assets and Liabilities

Assets are probable future economic benefitsobtained or controlled by a particular entity as aresult of past transactions or events.

Liabilities are probable future sacrifices ofeconomic benefits arising from presentobligations of a particular entity to transfer orprovide services to other entities in the future asa result of past transactions or events.


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SFAC No. 6Equity

Equity, or net assets, called shareholdersequity or stockholders equity for acorporation, is the residual interest in the

assets of an entity that remains afterdeducting liabilities.

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SFAC No. 6Investments and Distributions

Investments by owners are increases in

equity resulting from transfers of resources(usually cash) to a company in exchangefor ownership interest.

Distributions to owners are decreases in

equity resulting from transfers to theowners.

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SFAC No. 6Revenues

Revenues are inflows or otherenhancements of assets or settlements of

liabilities from delivering or producinggoods, rendering services, or otheractivities that constitute the entitys

ongoing major, or central, operations.


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SFAC No. 6Expenses

Expenses are outflows or other using up ofassets or incurrences of liabilities during aperiod from delivering or producing goods,rendering services, or other activities thatconstitute the entitys ongoing major, or

central, operations.

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SFAC No. 6Gains and Losses

Gains are increases in equity peripheral, orincidental, transactions of an entity.

Losses represent decreases in equity arising

from peripheral, or incidental, transactionsof an entity.

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SFAC No. 6Comprehensive Income

Comprehensive income is the change in equityof a business enterprise during a period from

transactions and other events andcircumstances from nonowner sources. It

includes all changes in equity during a periodexcept those resulting from investments from

owners and distributions to owners.


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Recognition and Measurement Concepts

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Question

The function of financial accounting is toidentify, measure and communicatefinancial information about economicentities to interested parties.

a. True

b. False

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Question

The function of financial accounting is to

identify, measure and communicatefinancial information about economicentities to interested parties.

a. True

b. False


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Question

Accrual accounting provides a better

indication of ability to generate cash flowsthan does information limited to thefinancial effects of cash receipts and cashpayments.

a. True

b. False

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Question

Accrual accounting provides a betterindication of ability to generate cash flowsthan does information limited to thefinancial effects of cash receipts and cashpayments.

a. Trueb. False

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Question

The primary objective of accrual basis

accounting is the measurement of income.

a. True

b. False


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Question

The primary objective of accrual basis

accounting is the measurement of income.

a. True

b. False

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Question

Generally accepted accounting principlesinclude both standards set by various rulemaking bodies and certain accountingpractices that have evolved over time.

a. True

b. False

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Question

Generally accepted accounting principles

include both standards set by various rulemaking bodies and certain accountingpractices that have evolved over time.

a. True

b. False


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Question

The major financial accounting standard

setting body is the

a. Accounting Principles Board

b. Securities and Exchange Commission

c. Financial Accounting Standards Board

d. American Institute of CPAs

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Question

The major financial accounting standardsetting body is the

a. Accounting Principles Board

b. Securities and Exchange Commission

c. Financial Accounting Standards Board

d. American Institute of CPAs

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Question

The FASB issues which of the following

types of pronouncements?

a. Standards

b. Interpretations

c. Financial Accounting Concepts

d. Technical Bulletins

e. All of the above


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Question

The FASB issues which of the following

types of pronouncements?

a. Standards

b. Interpretations

c. Financial Accounting Concepts

d. Technical Bulletins

e. All of the above

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Question

The Financial Accounting StandardsBoard develops accounting and reportingstandards independent of public, businessand political pressures.

a. True

b. False

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Question

The Financial Accounting Standards

Board develops accounting and reportingstandards independent of public, businessand political pressures.

a. True

b. False


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Ethics in Accounting

p

To be useful, accounting information must beobjective and reliable.

pManagement may be under pressure to reportdesired results and ignore or bend existing rules.

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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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End of Chapter 1

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