978-1259722660 Chapter 1 Lecture Note Part 1

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CHAPTER 1

ENVIRONMENT AND THEORETICAL STRUCTURE OF FINANCIAL

ACCOUNTING

Overview

The primary function of financial accounting is to provide useful financial information to users

external to the business enterprise. The focus of financial accounting is on the information needs of

investors and creditors. These users make critical resource allocation decisions that affect the

nation’s economy. The primary means of conveying financial information to investors, creditors, and

other external users is through financial statements and related notes.

In this chapter you explore important topics, such as the FASB’s conceptual framework, that serve

as a foundation for a more detailed study of financial statements, the way the elements of these

statements are measured, and the concepts underlying these measurements and related disclosures.

Learning Objectives

LO1–1 Describe the function and primary focus of financial accounting.

LO1–2 Explain the difference between cash and accrual accounting.

LO1–3 Define generally accepted accounting principles (GAAP) and discuss the historical

development of accounting standards, including convergence between U.S. and

international standards.

LO1–4 Explain why establishing accounting standards is characterized as a political process.

LO1–5 Explain factors that encourage high-quality financial reporting.

LO1–6 Explain the purpose of the conceptual framework.

LO1–7 Identify the objective and qualitative characteristics of financial reporting information and

the elements of financial statements.

LO1–8 Describe the four basic assumptions underlying GAAP.

LO1–9 Describe the recognition, measurement, and disclosure concepts that guide accounting

practice.

LO1–10 Contrast a revenue/expense approach and an asset/liability approach to accounting

standard setting.

LO1–11 Discuss the primary differences between U.S. GAAP and IFRS with respect to the

development of accounting standards and the conceptual framework underlying

accounting standards.

Lecture Outline

Part A: Financial Accounting Environment

I. The Function and Primary Purpose of Financial Accounting

A. There are a number of financial information supplier groups as well as several external

user groups.

B. The primary focus of financial accounting is on the information needs of investors and

creditors.

C. Financial statements convey financial information to external users.

1. Balance sheet or statement of financial position

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2. Income statement or statement of operations

3. Statement of cash flows

4. Statement of shareholders’ equity

5. Either

a) a statement of other comprehensive income immediately following the income

statement, or

b) a statement of comprehensive income (including information on the income

statement as well as on the statement of other comprehensive income)

II. The Economic Environment and Financial Reporting

A. The capital markets provide a mechanism to help our economy allocate resources

efficiently.

B. Corporations, the dominant form of business organization in the United States in terms of

the ownership of productive resources, acquire capital from investors in exchange for

ownership interest and by borrowing from creditors.

C. The investment-credit decision—a cash flow perspective

1. A company will be able to provide a return to investors and creditors only if it can

generate cash receipts from selling a product or service that exceed the cash

disbursements necessary to provide that product or service.

2. The objective of financial accounting is to provide information to investors and

creditors to help them predict future cash flows.

D. Cash versus accrual accounting

1. Over short periods of time, operating cash flow may not be an accurate predictor of

future operating cash flows.

2. The accrual accounting model provides a measure of periodic performance called net

income.

3. Net income is considered a better indicator of future operating cash flows than is

current net operating cash flows.

III. The Development of Financial Accounting and Reporting Standards

A. Historical perspective and U.S. standards

1. Generally accepted accounting principles (GAAP) are a set of guidelines companies

follow in measuring and reporting financial information.

2. The Securities and Exchange Commission (SEC) has the authority to set accounting

standards for companies, but has always delegated the task to the accounting

profession.

3. The Financial Accounting Standards Board (FASB) currently sets accounting

standards.

4. The FASB Accounting Standards Codification became effective on July 1, 2009 and

now represents the single source of authoritative nongovernmental U.S. GAAP, except

for rules and interpretive release of the SEC, which remain also as sources of

authoritative GAAP.

5. The Codification is organized into nine main topics and approximately 90 subtopics.

B. International standard setting

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1. The International Accounting Standards Committee (IASC) was formed in 1973 to

develop global accounting standards. The IASC reorganized itself and created a new

standard-setting body called the International Accounting Standards Board (IASB).

2. The IASC acts as an umbrella organization similar to the Financial Accounting

Foundation in the United States. The International Accounting Standards Board

(IASB) has responsibility for developing International Financial Reporting Standards

(IFRSs).

3. The organizations involved in setting IFRSs parallel those involved in setting U.S.

GAAP.

2. IASB standards are used in some form in approximately 120 jurisdictions, including

the companies in the European Union.

C. Convergence between FASB and IASB standards

1. In 2002 the FASB and IASB signed the Norwalk Agreement, pledging to remove

existing differences between standards. Since then, both boards have been working

towards convergence.

2. In November 2008, the SEC proposed a Roadmap for the potential use of financial

statements prepared in accordance with IFRS. The Roadmap sets forth several

milestones that, if achieved, could lead to the required use of IFRS by publicly-traded

U.S. companies.

3. In July 2012, the SEC staff issues its Final Staff Report in which it concludes that it is

not feasible for the U.S. to simply adopt IFRS, given (1) a need for the U.S. to have

strong influence on the standard-setting process and ensure that standards meet U.S.

needs, (2) the high costs to companies of converting to IFRS, and (3) the fact that

many laws, regulations, and private contracts reference U.S. GAAP. Therefore, the

staff recommends that the SEC consider other approaches, such as developing a

mechanism to consider endorsing individual IFRS standards for incorporation into

U.S. GAAP, or to just maintain the current approach in which the FASB and IASB

work together to converge standards.

4. As of the date this text was written, the SEC still had not made an announcement about

whether it would adopt or incorporate IFRS into U.S. GAAP.

D. The establishment of accounting standards—a political process

1. A standard setter must consider potential economic consequences of accounting

standards.

2. The FASB undertakes a series of information gathering steps before issuing a

substantive accounting standard.

3. In the past, various interest groups have successfully lobbied standard setters for

changes in standards involving such topics as accounting for stock-based

compensation, business combinations, and other-than-temporary impairments of

investments.

4. Political pressures on IASB standard setting are severe, with important groups like the

EU threatening to “carve out” aspects of standards that they view as undesirable.

IV. Encouraging high-quality financial reporting

A. Auditors offer credibility to financial statements by verifying that they are presented fairly

in conformity with GAAP.

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B. The Public Company Accounting Reform and Investor Protection Act of 2002, commonly

referred to as the Sarbanes-Oxley Act, provides for the regulation of auditors and the types

of services they furnish to clients, increases accountability of corporate executives,

addresses conflicts of interest for securities analysts, and provides for stiff criminal

penalties for violators.

IV. Ethics in Accounting

A. Recent accounting scandals have rekindled the debate over principles-based, or more

recently termed, objectives-oriented, versus rules-based accounting standards. A

principles-based approach to standard setting stresses professional judgment, as opposed to

following a list of rules.

B. Ethical judgment is critical in accounting, particularly if decisions are not specified by

rules.

1. Ethics deal with the ability to distinguish right from wrong.

2. Many professions have articulated ethical standards in a code of ethics.

3. There are a number of steps that provide a framework for analyzing ethical issues.

Part B: The Conceptual Framework

I. Purpose of the Conceptual Framework

A. The conceptual framework does not prescribe GAAP.

B. It provides an underlying foundation for accounting standards.

C. The FASB and IASB are working together to develop a common and improved conceptual

framework. The project consists of eight phases, and only Phase A has been completed.

D. The framework consists of a financial reporting objective, qualitative characteristics of

information, financial statement elements, recognition and measurement concepts, and

constraints.

II. Objective of Financial Reporting

A. To provide financial information that is useful to capital providers.

III. Fundamental Qualitative Characteristics of Accounting Information

A. Overriding objective is decision usefulness.

B. Primary qualities of useful information are relevance and faithful representation.

C. Components of relevance are:

1. Predictive value

2. Confirmatory value

3. Materiality—an aspect of information that enhances relevance

D. Components of faithful representation are:

1. Completeness

2. Neutrality

3. Free from error

E. Enhancing qualities are comparability (including consistency), verifiability, timeliness and

understandability.

F. A key constraints is cost effectiveness.

IV. Elements of Financial Statements

A. Balance sheet elements:

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1. Assets

2. Liabilities

3. Equity

4. Investments by owners

5. Distributions to owners

B. Income statement elements:

1. Revenues

2. Gains

3. Expenses

4. Losses

5. Comprehensive income

V. Underlying Assumptions

A. Economic entity assumption

B. Going concern assumption

C. Periodicity assumption

D. Monetary unit assumption

VI. Recognition, Measurement, and Disclosure Concepts

A. Recognition

1. An item should be recognized in the basic financial statements when it meets certain

criteria.

2. Revenue recognition recently changed due to issuance of ASU 2014-09. It requires that

revenue be recognized when the seller transfers goods and services to customers, but

does not allow revenue recognition if it is not probable that the seller will receive the

cash it is entitled to receive. That has some similarities to the realization principle used

in prior GAAP, which required that the earnings process be virtually complete and

there be reasonable certainty as to the collectivity of assets to be received.

3. Expense recognition typically occurs in the period in which expenses are incurred to

produce revenue.

B. Measurement

1. GAAP uses a “mixed attribute” model, in which different attributes are used to

measure different financial statement elements.

2. The five measurement attributes commonly employed in GAAP are:

a. Historical cost

b. Net realizable value

c. Current cost

d. Present value

e. Fair value

1) The FASB has provided a framework for measuring fair value whenever fair

value is called for in applying GAAP.

2) GAAP gives a company the option to report some or all of its financial assets

and liabilities at fair value.

C. Disclosure

1. Financial reports should include any information that could affect users’ decisions.

2. Techniques for providing full disclosure include parenthetical comments, disclosure

notes and supplemental schedules and tables.

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VII. Evolution of Accounting Principles

A. Two competing approaches for the recognition of revenues and expense are (1) the

revenue/expense approach and (2) the asset/liability approach.

B. Under the revenue/expense approach, principles for recognizing revenues and expenses

are emphasized, with assets and liabilities recognized as necessary to make the balance

sheet reconcile with the income.

C. Under the asset/liability approach, principles for asset and liability measurement are

emphasized, and revenues, expenses, gains and losses are recognized as necessary to make

the balance sheet reconcile with the income statement.

PowerPoint Slides

Three PowerPoint presentations of the chapter are available in the Connect Library:

1. With “Concept Checks” useful for classroom presentation, permitting the

instructor to intersperse in the presentation short exercises students can be asked

to solve individually or in small groups before the solution is “revealed” by the

instructor. {These are available only within Instructor Resources.}

2. Without the “Concept Checks” so students don’t have the solutions before being

asked to solve individually or in small groups.

3. Accessible PowerPoint Presentations. Accessibility is becoming even more

important in the education marketplace. Students and instructors with

disabilities use many different assistive technologies, and McGraw-Hill

Education is working to increase compatibility and access that will not only

help those with disabilities achieve better learning outcomes, but also serve the

institutions that are teaching these students. Accessible PowerPoint allows slide

content to be read by a screen reader and provides alternative text descriptions

for any image files used that enrich the learning experience. Accessible

PowerPoint is also designed with high-contrast color palettes and uses texture

when possible, instead of color to denote different aspects of the imagery used

within the slide.

Note: The slides are intended to provide comprehensive coverage of the chapter, but

they can be easily edited to allow instructors to change numbers and content in

illustrations or to delete slides pertaining to topics they choose to omit or

deemphasize. (Using your students’ names for company names in the Concept

Checks or Illustrations can be fun.)

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Suggestions for Class Activities

1. Real World Scenario

America Online (AOL) is a leader in the Internet access provider industry. In 1996, the company

changed a controversial accounting method involving the treatment of the cost of advertising and

free trials. The following is an excerpt from a May 15, 2000, CNET News.com article:

America Online will pay a civil penalty of $3.5 million as part of a settlement

with the Securities and Exchange Commission over the accounting of

advertising costs. According to the SEC, the Internet and media giant

improperly reported most of the costs of acquiring new subscribers—such as

the expense of sending computer disks to potential customers—as an asset. As

a result, the SEC said AOL posted a profit for six of eight quarters in 1995 and

1996 but would have recorded a loss if the company followed recommended

accounting practices.

AOL, backed by its auditor, defended the accounting method of capitalizing these costs arguing that

spreading the costs over two years was a justifiable way to match expenses against revenue flows

that would emerge later. In 1996, AOL switched to expensing these costs in the period incurred.

Suggestions:

Have the class consider the general treatment of advertising and promotion costs. Why are these

costs normally expensed in the period incurred even though they are incurred with the intention of

generating future revenues? Why did they expense these costs over a two-year period? Then discuss

the possible reasons why AOL chose a different approach followed by a discussion of the possible

reasons why the company decided to change its method. Another interesting discussion is the civil

penalty of $3.5 million leveled by the SEC four years after AOL changed its method. This could lead

to a general discussion of the SEC’s role in the financial reporting process.

Points to note:

Perhaps an important factor prompting the switch was the increased competition in the industry

and the loss of customers that prompted AOL to implement a new pricing scheme. The loss of

customers creates significant uncertainty with respect to the realization of deferred advertising and

promotion costs. Another reason is pressure exerted by the SEC to make the switch and another is

that AOL’s competitors all expensed these costs.

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2. Target Analysis

Have students, individually or in groups, go to the most recent Target annual report using EDGAR

which can be located at: ww.sec.gov. Ask them to:

1. Compare revenues, total costs and expenses, net income, total assets, and total shareholders’

equity with those in the 2015 report in Appendix B of the text. Are there any discernible

trends? How might they be interpreted?

2. Use EDGAR to locate the most recent annual report information for Walmart, one of Target’s

chief competitors. Using the most recent annual report information for both companies,

compare:

a. growth rates in revenues and net income, and

b. the relationship between revenues and net income (profit margin).

What could account for any differences you identify?

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