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
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.
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. (T1-1)
1-2 Intermediate Accounting, 8/e
2. Income statement or statement of operations
3. Statement of cash flows
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
III. The Development of Financial Accounting and Reporting Standards
A. Historical perspective and U.S. standards (T1-4)
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
(T1-5)
B. International standard setting
1. The International Accounting Standards Committee (IASC) was formed in 1973 to
develop global accounting standards. The IASC reorganized itself and created a new
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
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.
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.
IV. Encouraging high-quality financial reporting
A. Auditors offer credibility to financial statements by verifying that they are presented fairly
in conformity with GAAP.
1-4 Intermediate Accounting, 8/e
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 if corporate executives,
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
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.
II. Objective of Financial Reporting (T1-10)
A. To provide financial information that is useful to capital providers.
III. Fundamental Qualitative Characteristics of Accounting Information (T1-11)
A. Overriding objective is decision usefulness.
B. Primary qualities of useful information are relevance and faithful representation.
C. Components of relevance are:
IV. Elements of Financial Statements (T1-12)
A. Balance sheet elements:
1. Assets
5. Distributions to owners
B. Income statement elements:
1. Revenues
V. Underlying Assumptions (T1-13)
A. Economic entity 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. (T1-14)
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,
3. Expense recognition typically occurs in the period in which expenses are incurred to
produce revenue.
B. Measurement (T1-15)
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
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C. Disclosure (T1-17)
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.
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.
PowerPoint Slides
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Teaching Transparency Masters
The following can be reproduced on transparency film as they appear here, or
FINANCIAL INFORMATION SUPPLIER GROUPS AND EXTERNAL USER GROUPS
PROVIDERS OF
FINANCIAL
EXTERNAL USER
INFORMATION
GROUPS
Profit-oriented
Investors
companies
Creditors
(banks, bondholders, other
lenders)
Employees
Customers
Illustration 1-1
T1-1
1-8 Intermediate Accounting, 8/e
FINANCIAL STATEMENTS
➢ The primary means of conveying financial information to
➢ The financial statements most frequently provided are:
1. The balance sheet or statement of financial position
5. Either
a) a statement of other comprehensive income
immediately following the income statement, or
CASH VERSUS ACCRUAL ACCOUNTING
Carter Company — 3 Years of Operating Transactions
Year 1
Year 2
Year 3
Sales (on credit)
$100,000
$100,000
$100,000
Net Operating Cash Flows:
Cash receipts from customers
$ 50,000
$125,000
$125,000
Cash disbursements
Prepayment of three years’ rent
Salaries to employees
Utilities
$ 60,000
$ 65,000
T1-3
1-10 Intermediate Accounting, 8/e
➢ Measuring the same activities by the accrual accounting
model provides a more accurate prediction of future operating
cash flows.
Carter Company — Income Statements
Year 1
Year 2
Year 3
Revenues
$100,000
$100,000
$100,000
Expenses:
Rent
Salaries
Utilities
10,000
Net Income
$ 20,000
$ 20,000
$ 20,000
Illustration 1-3
T1-3 (Continued)
ACCOUNTING STANDARD SETTING
HIERARCHY OF STANDARD-SETTING AUTHORITY
Congress
Illustration 1-4
T1-4
1-12 Intermediate Accounting, 8/e
FASB Accounting Standards Codification Topics
Topic
Numbered
General Principles
100-199
Presentation
200-299
Assets
300-399
Liabilities
400-499
Revenues
600-699
Expenses
700-799
800-899
Illustration 1-5
THE FASB’s STANDARD-SETTING PROCESS
U.S. GAAP
IFRS
Regulatory oversight
provided by:
Securities Exchange
Commission (SEC)
International Organization of
Securities Commissions
(IOSCO)*
Standard-setting
Financial Accounting
Standards Board
International Accounting
Standards Board (IASB): 16
Advisory council
providing input on
agenda and projects:
Financial Accounting
Standards Advisory
Council (FASAC):
30-40 members
Standards Advisory Council
(SAC): 30-40 members
emerging issues:
Task Force (EITF):
15 members
Reporting Interpretations
Committee (IFRIC): 14
members
Illustration 1-6
T1-6
1-14 Intermediate Accounting, 8/e
THE FASB’s STANDARD-SETTING PROCESS
STEP
EXPLANATION
1.
The Board deliberates at one or more public meetings the various
The Board identifies financial reporting issues based on
requests/recommendations from stakeholders or through other
means.
4.
The Board issues an Exposure Draft. (In some projects, a
Discussion Paper may be issued to obtain input at an early stage
that is used to develop an Exposure Draft.)
5.
The Board holds a public roundtable meeting on the Exposure
Draft, if necessary.
Illustration 1-7
THE SARBANES-OXLEY ACT
Key Provisions of the Act:
• Oversight board. The five-member (two accountants) Public Company Accounting Oversight
Board has the authority to establish standards dealing with auditing, quality control, ethics,
• Non-audit services. The law makes it unlawful for the auditors of public companies to perform
a variety of non-audit services for audit clients. Prohibited services include bookkeeping,
internal audit outsourcing, appraisal or valuation services, and various other consulting services.
Other non-audit services, including tax services, require pre-approval by the audit committee of
the company being audited.
preceding year.
• Hiring of auditor. Audit firms are hired by the audit committee of the board of directors of the
company, not by company management.
• Internal Control. Section 404 of the Act requires that company management document and
Illustration 1-5
T1-8
1-16 Intermediate Accounting, 8/e
ANALYTICAL MODEL FOR ETHICAL DECISIONS
Step 1. Determine the facts of the situation. This involves
determining the who, what, where, when, and how.
Step 4. Specify the alternative courses of action.
Step 5. Evaluate the courses of action specified in step 4 in terms
of their consistency with the values identified in step 3.
This step may or may not lead to a suggested course of
action.
T1-9
THE CONCEPTUAL FRAMEWORK
Objective
To provide financial information that is useful to capital
providers.
Phase A
Qualitative
Characteristics
Recognition and
Measurement Concepts
(including consistency)
Primary
Relevance
Predictive value
Faithful Representation
Completeness
Enhancing
Comparability
Elements
Equity
Investments by owners
Distributions to owners
Losses
Comprehensive income
Assumptions
Periodicity
Monetary unit
Mixed attribute
measurement
Financial Statements
Constraint
• Balance sheet
• Income statement
Illustration 1-9