1-1
1. The purpose of financial reporting and the primary financial statements
2. Accounting standards and the FASB
3. The importance of the SEC, AICPA, AAA, and IRS to financial reporting
4. The international accounting issues and the
IASB
5. The FASB’s conceptual framework
6. Career opportunities related to accounting and
financial reporting
Ch.1 Financial Reporting
1-2
The overall objective of
accounting is to provide
information that can be used in
making economic decisions.
1. The Purpose of Financial Accounting and
the Primary Financial Statements
1-3
Definition of Accounting
“Accounting is a service activity. Its
function is to provide quantitative
information, primarily financial in nature,
about economic entities that is intended to
be useful in making economic decisions—
in making reasoned choices among
alternative courses of action.” Statement of the Accounting Principles Board No. 4, par. 40.
(continued)
1-4
• Accounting information is used in making
decisions about how to allocate scarce
resources.
• Although accountants place much emphasis
on reporting what has already occurred, this
past information is intended to be useful in
making economic decisions about the future.
Key features in this definition of accounting:
Definition of Accounting
1-5
Users of Accounting Information
• Stakeholders are all parties interested in the
financial health of a company.
• Internal users are stakeholders who make
decisions that directly affect the internal
operations of the enterprise.
• External users are stakeholders who make
decisions concerning their relationship to the
enterprise.
1-6
1-7
Users of Accounting Information
1. Management accounting is concerned
primarily with financial reporting for internal
users, especially management.
2. Financial accounting focuses on the
development and communication of
financial information for external users.
a. Helps users in determining whether a
company’s operations are profitable
enough to justify additional funding.
(continued)
1-8
b. Helps users in determining how risky
a company’s operations are in order
to determine what rate of return is
necessary to compensate capital
providers for the investment risk.
Users of Accounting Information
1-9
Creditors need
information about the
profitability and
stability of the
company to decide
whether to lend
money to the
company and, if so,
what interest rate to
charge.
Creditors need
information about the
profitability and
stability of the
company to decide
whether to lend
money to the
company and, if so,
what interest rate to
charge.
Investors (both
existing stockholders
and potential
investors) need
information
concerning the
safety and
profitability of their
investment.
Investors (both
existing stockholders
and potential
investors) need
information
concerning the
safety and
profitability of their
investment.
External Investors
1-10
The balance sheet reports, as of a
certain point in time, the resources
of a company (the assets), the
company’s obligations (the
liabilities), and the equity of the
owners.
(continued)
General-Purpose Financial Statements
1-11
The income statement reports, for a
certain interval, the net assets
generated through business
operations (revenues), the net assets
consumed (the expenses), and the
difference, which is called net
income.
(continued)
General-Purpose Financial Statements
1-12
The statement of cash flows
reports, for a certain interval, the
amount of cash generated and
consumed by a company through
the following three types of
activities: operating, financing, and
investing activities.
(continued)
General-Purpose Financial Statements
1-13
Accounting estimates and
judgments are outlined in the notes
to financial statements. In
addition, the notes contain
supplemental information as well as
information about items not included
in the financial statements.
General-Purpose Financial Statements
1-14
Auditor’s Role
• Auditors, working independently of a
company’s management and internal
accountants, examine the financial
statements.
• They issue an auditor’s opinion about
the fairness of the statements and their
adherence to proper accounting
principles.
1-15 1-15
1-16
2. The Accounting Standards and the FASB
• The Financial Accounting Standards
Board (FASB) sets accounting standards
in the United States.
• The FASB is a private-sector body and
has no legal authority.
• The issuance of new accounting
standards is preceded by a lengthy public
discussion.
(continued)
1-17
• The Emerging Issues Task Force
(EITF) works under the direction of the
FASB.
• The EITF formulates a timely expert
consensus on how to handle new
issues not yet covered in FASB
pronouncements.
(continued)
The FASB
1-18
• The Securities and Exchange
Commission (SEC) was created by the
1933 Securities Act to protect the interests
of investors by ensuring full and fair
disclosure.
• It was given specific legal authority to
establish accounting standards for
companies desiring to publicly issue shares
in the United States.
(continued)
The FASB
1-19
• The SEC has generally allowed the
private-sector organizations to make the
accounting standards in the United States
(commonly referred to as generally
accepted accounting principles
(GAAP)).
(continued)
The FASB
1-20 1-20
1-21
• The Financial Accounting Standards
Board (FASB) is currently recognized as the
private-sector body responsible for the
establishment of U.S. accounting standards.
• The FASB was organized in 1973, replacing
the Accounting Principles Board (APB).
• Five full-time members are drawn from a
variety of backgrounds—auditing, corporate
accounting, financial services, and academia.
(continued)
The FASB
1-22
• Members are required to sever all
connections with their firms or institutions
prior to assuming membership on the Board.
• Members are appointed for 5-year terms and
are eligible for reappointment to one
additional term.
• When it was initially established, the FASB
was structured to have seven board
members. The number was reduced to five on
July 1, 2008.
(continued)
The FASB
1-23
(continued)
• Appointment of new Board members is
done by the Financial Accounting
Foundation (FAF).
• The FAF serves somewhat like a board of
directors overseeing the FASB.
• The FAF is also responsible for selecting
and supporting members of the
Governmental Accounting Standards
Board (GASB).
The FASB
1-24
• The major functions of the FASB are to
study issues and to establish accounting
standards.
• These standards are published as
Accounting Standards Updates.
• The FASB has also issued Statements of
Financial Accounting Concepts that
provide a framework within which specific
accounting standards can be developed.
The FASB
1-25
FASB “Due Process”
1. FASB staff assembles background information
and the Board holds public meetings before a
decision is made to even add a project to the
FASB’s formal agenda.
2. After more study and further hearings, the
Board often issues a report summarizing its
Preliminary Views.
3. Interested parties are invited to comment either
in writing or orally at a public hearing.
(continued)
1-26
4. After comments from interested parties have
been evaluated, the Board meets as many
times as necessary to resolve the issues.
5. From these meetings, the Board develops an
Exposure Draft of a statement that includes
specific recommendations for financial
accounting and reporting.
6. After 60 days or longer, if the topic is a major
one, all comments are reviewed by the staff and
the Board. (continued)
FASB “Due Process”
1-27
7. Further deliberation of the Board leads to either
the issuance of an Accounting Standards
Update, a revised Exposure Draft, or, in some
cases, abandonment of the project.
8. The final statement not only sets forth the actual
standards but also establishes the effective
date and method of transition.
9. Currently, a simple majority (three out of five) is
required for approval of an Exposure Draft or a
final statement of standards.
FASB “Due Process”
1-28
• In an effort to overcome the methodical,
sometimes slow, nature of the standard
setting process, in 1984 the FASB
established the Emerging Issues Task
Force (EITF).
• The EITF assists the FASB in the early
identification of emerging issues that affect
financial reporting.
Emerging Issue Task Force
1-29
• The official source of U.S. GAAP is called
the FASB Accounting Standards
Codification (ASC).
• Prior to launching of the FASB ASC in July
2009, finding a specific accounting rule on a
specific topic involved a primitive hunt-and-
peck strategy.
FASB Accounting Standards
Codification
1-30 1-30
1-31
3. The importance of the SEC, AICPA, AAA,
and IRS to financial reporting
• The SEC was created by an act of Congress in 1934.
• Its primary role is to regulate the issuance and trading of securities by corporations to the general public.
• It requires companies to furnish various financial statements, and other periodic information about significant events.
• The SEC requires companies to have their external financial statements audited by independent accountants.
(continued)
1-32
• The SEC is vitally interested in financial reporting
and the development of accounting standards.
• It brings to the Board’s attention emerging
problems that need to be addressed and sends
observers to meet with the EITF.
• The SEC has issued statements pertaining to
accounting and auditing issues.
• These statements are authoritative for
companies that are publicly traded in the United
States.
(continued)
Securities and Exchange
Commission (SEC)
1-33
• In addition to the SEC’s rules and interpretive
releases, the SEC staff issues Staff
Accounting Bulletins that represent practices
followed by the staff administering SEC
disclosure requirements.
• The auditors of SEC-required financial
information must be registered and periodically
inspected by the Public Company
Accounting Oversight Board (PCAOB).
Securities and Exchange
Commission (SEC)
1-34
American Institute of Certified Public
Accountants (AICPA)
(continued)
• The American Institute of Certified Public
Accountants (AICPA) is the professional
organization of practicing certified public
accountants (CPAs) in the United States.
• It publishes the monthly journal, the Journal
of Accountancy.
• The AICPA is responsible for preparing and
grading the Uniform CPA Examination.
1-35
American Institute of Certified Public
Accountants (AICPA)
• The AICPA is concerned with maintaining the
integrity of the profession through its Code of
Professional Conduct and through a quality
control program, which includes a process of
peer review of CPA firms conducted by other
CPAs.
• The AICPA continues to influence the
establishment of accounting standards.
• It frequently establishes the specialized
standards that relate to particular industries.
1-36 (continued)
• The American Accounting Association
(AAA) is an organization of accounting
professors.
• It sponsors national and regional meetings
where accounting professors discuss
technical research and share innovative
teaching techniques and materials.
• It organizes working committees of
professors to study and comment on
accounting standards issues.
American Accounting Association
1-37
• One of the most significant actions of the
AAA is to motivate and facilitate
curriculum revision to keep pace with the
changes in the accounting profession.
• The AAA publishes a number of academic
journals, including The Accounting
Review and Accounting Horizons.
American Accounting Association
1-38
Internal Revenue Service
• The Internal Revenue Service (IRS) has
the primary goal of equitably collecting
revenue.
• Although not the same, there are many
areas where tax and financial accounting
are closely related.
1-39
What is GAAP?
Historically, the Auditing Standards Board
of the AICPA has defined Generally
Accepted Accounting Principles (GAAP)
in the context of a phrase included in the
standard auditor’s opinion:
“present fairly…in conformity with generally
accepted accounting principles.”
(continued)
1-40
• The FASB clarified exactly which
accounting rules and statements are
“authoritative” GAAP and which are
merely nonauthoritative suggestions.
• Standards contained in the Codification
itself are “the source of authoritative
generally accepted accounting principles
recognized by the FASB.”
What is GAAP?
1-41
4. International Accounting Issues and the
FASB
• The international nature of business requires
companies to be able to make their financial
statements understandable to users all over
the world.
• In an attempt to harmonize conflicting
standards, the International Accounting
Standards Board (IASB) was formed in
1973 to develop worldwide accounting
standards.
(continued)
1-42
• Similar to FASB, IASB develops proposals,
circulates these among interested
organizations, receives feedback, and then
issues a final pronouncement.
• Board members are representatives from the
United States, the United Kingdom, France,
Sweden, China, Australia, South Africa,
Brazil, and Japan.
(continued)
International Accounting Standards
Board
1-43
• Accounting standards issued by the IASB are
referred to as International Financial
Reporting Standards (IFRS) if issued since
2001, and International Accounting
Standards (IAS) if issued prior to 2001.
• In 2008 the SEC began allowing non-U.S.
companies with shares trading on U.S. stock
exchanges to issue their financial reports using
IASB standards.
(continued)
International Accounting Standards
Board
1-44
• The SEC is considering whether to allow
U.S. companies to use IASB standards,
rather than FASB standards, in the financial
reports that they provide to their U.S.
stockholders.
• If this happens, the FASB may cease to
exist.
• The SEC “work plan” does not envision a
U.S. switch to IFRS until 2015 at the earliest.
International Accounting Standards
Board
1-45
5. Conceptual Framework
• A strong theoretical foundation is essential
if accounting practice is to keep pace with a
changing business environment.
• The conceptual framework plays a vital role
in the development of new standards and in
the revision of previously issued standards.
• The conceptual framework provides a guide
for analyzing and resolving emerging issues.
(continued)
1-46
In February 2000, the FASB issued the last of
seven Statements of Financial Accounting
Concepts, which provide the basis for the
conceptual framework.
1) Objectives of Financial Reporting by
Business Enterprises
2) Qualitative Characteristics of Accounting
Information
3) Elements of Financial Statements of
Business Enterprises (continued)
Concepts Statements
1-47
4) Objectives of Financial Reporting by
Nonbusiness Organizations
5) Recognition and Measurement in Financial
Statements of Business Enterprises
6) Elements of Financial Statements (a
replacement of No. 3, broadened to include not-
for-profit as well as business enterprises)
7) Using Cash Flow Information and Present Value
in Accounting
Concepts Statements
1-48
The seven Concepts Statements addressed four
major areas:
Concepts Statements
1. Objectives: What are the purposes of financial
reporting?
2. Qualitative characteristics: What are the
qualities of useful financial information?
3. Elements: What is an asset? a liability? a
revenue? an expense?
4. Recognition, measurement, and reporting:
How should the objectives, qualities, and
elements of definitions be implemented?
1-49
Usefulness Usefulness
Financial reporting should provide
information that is useful to present and
potential investors and creditors and
other users in making rational
investment, credit, and similar
decisions. Statement of Financial Accounting Concepts No. 1, par. 34.
(continued)
Objectives of Financial Reporting
1-50
The objective of understandability
recognizes a fairly sophisticated user
of financial reports, that is, one who
has a reasonable understanding of
accounting and business and who is
willing to study and analyze the
information presented. Statement of Financial Accounting Concepts No. 1, par. 34.
Understandability Understandability
(continued)
Objectives of Financial Reporting
1-51
Target Audience:
Investors and Creditors
Target Audience:
Investors and Creditors
• While there are many potential users of
financial reports, the objectives are
directed primarily toward investors and
creditors.
• Information useful to investors and
creditors in most cases will be useful to
other external users.
(continued)
Objectives of Financial Reporting
1-52
Financial reporting should provide
information that is useful in assessing
amounts, timing, and uncertainty (risk)
of prospective cash flows.
Assessing Future
Cash Flows
Assessing Future
Cash Flows
(continued)
Objectives of Financial Reporting
1-53
Evaluating Economic
Resources
Evaluating Economic
Resources
Objectives of Financial Reporting
Financial reporting should also provide
information about a company’s assets,
liabilities, and owners’ equity to help
investors, creditors, and others evaluate
the financial strengths and weaknesses
of the enterprise and its liquidity and
solvency.
(continued)
1-54
Primary Focus on
Earnings
Primary Focus on
Earnings
Information about company earnings,
measured by accrual accounting,
generally provides a better basis for
forecasting future performance than
does information about current cash
receipts and disbursements.
Objectives of Financial Reporting
1-55
• Information is like other commodities in
that it must be worth more than the cost
of producing it.
• Benefits are not always evident or
easily measured.
Benefits Greater
Than Cost
Benefits Greater
Than Cost
(continued)
Qualitative Characteristics of Accounting
Information
1-56
Relevance Relevance
The information must “make a
difference.” It must carry the qualities
of:
• Feedback value
• Predictive value
• Timeliness
Qualitative Characteristics of Accounting
Information
Relevant information normally provides
both feedback value and predictive
value at the same time.
1-57 1-57
1-58
Timeliness is essential for
information to “make a difference” because if the information becomes
available after the decision is made,
it isn’t of much use.
Relevance Relevance
(continued)
Qualitative Characteristics of Accounting
Information
1-59
• Information is reliable if it is relatively
free from error and represents what it
claims to represent.
• Reliability does not mean absolute
accuracy.
Reliability Reliability
(continued)
Qualitative Characteristics of Accounting
Information
1-60
• Verifiability implies consensus.
• Representational faithfulness means
that there is agreement between a
measurement and the economic activity
or item that is being measured.
• Neutrality is similar to the all-
encompassing concept of fairness.
Reliability Reliability
(continued)
Qualitative Characteristics of Accounting
Information
1-61
Comparability Comparability
The essence of comparability is that
information becomes much more useful
when it is related to a benchmark or
standard. The comparison may be with
data for other firms or it may be with
similar information for the same firm but
for other periods of time.
(continued)
Qualitative Characteristics of Accounting
Information
1-62
Comparability Comparability
• Comparability of accounting data for the
same company over time is often called
consistency.
• Uniformity is not always the answer to
comparability. Different circumstances
may require different accounting
treatments.
(continued)
Qualitative Characteristics of Accounting
Information
1-63
Materiality Materiality
• Materiality deals with this specific
question: Is the item large enough to
influence the decision of a user of the
information?
• The SEC confirmed that materiality can
never be boiled down to a simple
numerical benchmark.
(continued)
Qualitative Characteristics of Accounting
Information
1-64
Conservatism Conservatism
• The concept of conservatism can be
summarized as follows: When in doubt,
recognize all losses but don’t recognize
any gains.
• In formulating the concept framework,
the FASB did not include conservatism
in the list of qualitative characteristics.
Qualitative Characteristics of Accounting
Information
1-65
Elements of Financial Statements
• The FASB definitions of the ten basic
financial statement elements are listed
in Exhibit 1-6.
• These elements compose the building
blocks upon which financial
statements are constructed.
(continued)
1-66 1-66
(continued)
1-67 1-67
(continued)
1-68 1-68
(concluded)
1-69
Recognition, Measurement, and Reporting
• Recognition—Boiling down all the
estimates and judgments into one
number and using that number to make a
journal entry.
• Disclosure—Skipping the journal entry
and just relying on the note to convey the
information to users.
(continued)
1-70
• Recognition Criteria—For an item to be
formally recognized, it must meet one of the
definitions of the elements of the financial
statements.
For example, a receivable must meet the
definition of an asset to be recorded and
reported on the balance sheet.
• Disclosure is preferable to recognition in
situations in which relevant information cannot
be reliably measured.
(continued)
Recognition, Measurement, and Reporting
1-71
1. Historical cost
2. Current replacement cost
3. Fair value
4. Net realizable value
5. Present (or discounted) value
Five different measurement attributes are
currently used in practice.
(continued)
Recognition, Measurement, and Reporting
1-72
Reporting—Included in the recommended
set of general-purpose financial statements
are reports that show the following:
Balance
Sheet
(continued)
• Financial position at the end of the period
Recognition, Measurement, and Reporting
1-73
• Financial position at the end of the period
• Earnings (net income) for the period
Reporting—Included in the recommended
set of general-purpose financial statements
are reports that show the following:
Income
Statement
(continued)
Recognition, Measurement, and Reporting
1-74
• Financial position at the end of the period
• Earnings (net income) for the period
• Cash flows during the period
Reporting—Included in the recommended
set of general-purpose financial statements
are reports that show the following:
Statement of
cash flows
(continued)
Recognition, Measurement, and Reporting
1-75
• Financial position at the end of the period
• Earnings (net income) for the period
• Cash flows during the period
• Investments by and distributions to owners during the period
Reporting—Included in the recommended
set of general-purpose financial statements
are reports that show the following:
(continued)
Statement of
changes in
owners’ equity
Recognition, Measurement, and Reporting
1-76
• Financial position at the end of the period
• Earnings (net income) for the period
• Cash flows during the period
• Investments by and distributions to owners during the period
• Comprehensive income (total non-owner changes in equity) for the period
Reporting—Included in the recommended
set of general-purpose financial statements
are reports that show the following:
(continued)
Recognition, Measurement, and Reporting
1-77
• Comprehensive income differs from
earnings in that it includes unrealized
gains and losses not recognized in
the income statement.
• In 1998, the FASB required
companies to provide, in at least one
place, information relating to
unrealized gains and losses.
(continued)
Recognition, Measurement, and Reporting
1-78
Full Disclosure Full Disclosure
For financial statement reporting to be
most effective, all relevant information
should be presented in an unbiased,
understandable, and timely manner.
This is sometimes referred to as the
full disclosure principle.
Recognition, Measurement, and Reporting
1-79 1-79
1-80
Traditional Assumptions of the Accounting
Model
1. Economic entity
2. Going concern
3. Arm’s-length transactions
4. Stable monetary unit
5. Accounting period
The FASB conceptual framework is
influenced by five basic assumptions:
(continued)
1-81
Economic Entity Economic Entity
The business enterprise is viewed as
a specific economic entity separate
and distinct from its owners and any
other business unit.
(continued)
Traditional Assumptions of the Accounting
Model
1-82
In the absence of evidence to the
contrary, the entity is viewed as a
going concern. In other words, it is
assumed that the enterprise will last
indefinitely.
Going Concern Going Concern
(continued)
Traditional Assumptions of the
Accounting Model
1-83
Transactions are assumed to occur
between independent parties, each of
which is capable of protecting its own
interests.
Arm’s-Length Transactions Arm’s-Length Transactions
(continued)
Traditional Assumptions of the
Accounting Model
1-84
The stable monetary unit
assumption allows for the ignoring of
changes in the dollar’s purchasing
power resulting from inflation.
Stable Monetary Unit Stable Monetary Unit
(continued)
Traditional Assumptions of the Accounting
Model
1-85
• Because accounting information is
needed on a timely basis, the life of a
business is divided into specific
accounting periods.
• By convention, the year has been
established as the normal period for
reporting, supplemented by interim
quarterly reports.
Accounting Period Accounting Period
Traditional Assumptions of the
Accounting Model
1-86
Impact of the Conceptual Framework
• The conceptual framework provides a
basis for consistent judgments by all
those involved in financial reporting.
• Related to the conceptual framework is
the push toward more “principles-
based” accounting standards.
1-87
Rules vs. Principles
In July 2003, the SEC submitted a report to
Congress recommending that the FASB move
toward “objectives-oriented standards” which
would have the following characteristics:
• Be based on an improved and consistently
applied framework
• Clearly state the accounting objective of the
standard
(continued)
1-88
Rules vs. Principles
• Provide sufficient detail and structure so that the
standard can be operationalized and applied on
a consistent basis
• Minimize exceptions from the standard
• Avoid use of percentage tests that allow
financial engineers to achieve technical
compliance with the standard while evading the
intent of the standard
1-89
• Pubic accountants do not work for a
single business enterprise. Rather, they
provide a variety of services for many
different individuals and business clients.
• The four largest firms are Deloitte &
Touche, Ernst & Young, KPMG, and
PricewaterhouseCoopers.
6. Careers in Financial Accounting and
Personal Ethics
Public Accounting Public Accounting
(continued)
1-90
A large business enterprise employs
financial accountants who are primarily
concerned with external financial
reporting, management accountants who
are primarily concerned with internal
financial reporting, and tax accountants.
Corporate Accounting Corporate Accounting
Careers in Financial Accounting
(continued)
1-91
Credit analysts, investment bankers,
brokers, and business consultants need
a strong working knowledge of
accounting as well as strong skills in
information technology.
User (Analyst, Banker, Consultant) User (Analyst, Banker, Consultant)
Careers in Financial Accounting
1-92
The Importance of Personal Ethics
• The flexibility inherent in the assumptions
underlying the preparation of financial
statements means that an accountant
can intentionally deceive financial
statement users and still be in
compliance with GAAP.
• Our financial reporting system is of
limited value if the accountants who
operate the system do not have strong
personal ethics.