CHAPTER 1

ENVIRONMENT AND THEORETICAL STRUCTURE OF FINANCIAL

ACCOUNTING

Accounting is a system that collects and processes (analyzes, measures, and records) financial
information about an organization and reports that information to decision makers.

Financial accounting conveys financial information to external users.

Providers of External
Financial Information User Groups
Relevant
Financial
Information  Investors
 Profit-oriented
 Creditors
companies
 Employees
 Labor unions
 Not-for-profit
 Customers
entities
 Suppliers
 Government
 Households
agencies

Information
intermediaries:
 Financial
analysts
 Stockbrokers
 Mutual fund
managers
 Credit rating
organizations

Managerial accounting reports detailed information to internal users (managers).

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Relevant financial information is provided primarily through financial statements and related
disclosure notes.
 Balance Sheet (Statement of Financial Position)
 Income Statement (Statement of Earnings / Statement of Operations)
 Statement of Cash Flows
 Statement of Shareholders’ Equity

Types of Business Organizations

1. Corporation: a business incorporated under the laws of a particular state.

A corporation acquires capital from investors in exchange for ownership interest and by
borrowing from creditors.

2. Partnership: unincorporated business owned by two or more persons known as partners.

3. Sole proprietorship: unincorporated business owned by one person.

Information Needs of Investors and Creditors

1. Investors look for two sources of possible cash flow:

 Periodic dividend distributions from the corporation.

 The ultimate sale of the ownership shares of stock.

Example: An investor purchased 100 shares of ABC Mirror, Inc for $10,000 in 2015. At the end
of 2015 the investors received $500 dividends from ABC Mirror, and the investor sold the 100
shares during 2016 for $12,000.

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2. Creditors lend money to a company for a specific length of time. They hope to gain by
charging interest on the money they lend.

Example: A bank lent $10,000 to ABC Mirror, Inc for one year at an interest rate of 15%.

Accounting information should help investors and creditors evaluate the amount, timing, and
uncertainty of the enterprise’s future cash flows.

Cash versus Accrual Accounting

Example:

Carter Company made sales totaling $100,000 per year for two years. Carter collected $50,000 in
the first year and $150,000 in the second year. The company paid $40,000 for two years’ rent in
the first year. Payments to employees are $50,000 per year.

Cash Basis Accounting:

 Revenue is recognized when cash is received.

 Expenses are recognized when cash is paid.

Summary of Cash Flows

Year 1 Year 2 Total
Cash receipts
from customers
Payment of 2
years’ rent
Salaries to
employees
Net cash flow

Drawback: Over short periods of time, operating cash flow may not be an accurate predictor of
future operating cash flows.

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Accrual Accounting:

 Revenue is recognized when earned.

 Expenses are recognized when incurred.

Summary of Operations
Year 1 Year 2 Total

Revenue

Rent expense

Salary expense
Net income

Accrual based net income is considered a better indicator of future operating cash flows than is
current net operating cash flows. The accrual accounting model is required by GAAP.

Development of Accounting Standards

Generally accepted accounting principles (GAAP) are a set of guidelines companies follow in
measuring and reporting financial information.

Parties involved in the standard setting process:

 Securities and Exchange Commission (SEC): SEC has the authority to set accounting
standards for companies, but always has delegated the responsibility to the accounting
profession.

 Financial Accounting Standards Board (FASB): the private sector body given the primary
responsibility to work out the detailed rules that become GAAP.
 Supported by the Financial Accounting Foundation (FAF).
 Answerable only to the Financial Accounting Foundation.
 Seven full-time, independent voting members serving for 10 years.
 Members not required to be CPAs.

 American Institute of Certified Public Accountants (AICPA): a national professional

organization that sets professional requirements for CPAs.

Auditor’s role: Auditors offer credibility to financial statements by verifying that they are
presented fairly in conformity with GAAP.

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  Governmental Accounting Standards Board (GASB): to develop accounting standards for
governmental units.

 International Accounting Standard Committee/Board (IASB): a private organization

dedicated to developing a single set of global accounting standards

Establishment of accounting standards is a political process

How Does GAAP Come Out? –

STEP EXPLANATION

1. The Board receives requests/recommendations for possible projects and

reconsideration of existing standards from various sources.

2. The FASB Chairman decides whether to add a project to the technical agenda,
subject to oversight by the Foundation’s Board of Trustees and after appropriate
consultation with FASB Members and others.

3. The Board deliberates at one or more public meetings the various issues
identified and analyzed by the staff.

4. The Board issues an Exposure Draft.

5. The Board holds a public roundtable meeting on the Exposure Draft, if

necessary.

6. The staff analyzes comment letters, public roundtable discussion, and any other
information. The Board redeliberates the proposed provisions at public meetings.

7. The Board issues an Accounting Standards Update describing amendments to the

Accounting Standards Codification.

International Financial Reporting Standards (IFRS): a set of global accounting standards

issued by IASB.

 Compliance is voluntary. The enforcement authority lies with the local securities
regulator.
 Over 100 jurisdictions accept IFRS (European Union, Australia, China, etc.).
 US is accelerating the convergence of US GAAP and IFRS. IFRS may replace US GAAP
in the middle of next decade.

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The Conceptual Framework

 The Framework was to be the foundation for building a set of coherent accounting
standards and rules.
 The Framework is to be a reference of basic accounting theory for solving emerging
practical problems of reporting.

1. The objectives are specified in Phase A.

 To provide financial information about the reporting entity that is useful to present and
potential equity investors, lenders, and other creditors in making decisions in their
capacity as capital providers.

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2. Hierarchy of Accounting Qualities of Financial INformation

Primary qualities:

 Relevance of information means information capable of making a difference in a

decision context.

 Predictive value
 Confirmatory value
 Materiality: the magnitude of an omission or misstatement of accounting that, in the
light of surrounding circumstances, makes it probable that the judgment of a
reasonable person relying on the information would have been influenced by the
omission or misstatement.

Example:

GMAS’ net income confirms investor expectations about future cash-generating ability. Which
qualitative characteristic of accounting information is described?

GMAS’ investors use 2015 Q1 earnings to predict the earnings in 2016 Q1. Which qualitative
characteristic of accounting information is described?

Washington Power recently completed an office building at a cost of $7.3 million. Office lamps
with a total cost of $1,000 were expensed in the current period, even thought the office lamps
can be used for five years. Which qualitative characteristic of accounting information is
described?

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  Faithful representation means agreement between a measure and a real-world
phenomenon that measure is supposed to represent.

 Completeness
 Neutrality
 Free from error

Example:

DEP Company reported Property, Plant & Equipment (net) as a line item on balance sheet but
omitted the details of composition and depreciation methods in its financial statements. Which
qualitative characteristics of accounting information is violated?

Billy Company has attempted to determine the replacement cost of its machinery. Three different
appraisers arrive at substantially different amounts for the replacement cost. The CFO of Billy
Company decides to use the highest appraisal value for external reporting purposes. Which
qualitative characteristic of accounting information is violated?

Yellowstone Corp misclassified machines used to produce inventory as inventory. Which

qualitative characteristic of accounting information is violated?

Note: SFAC 8 explicitly rejects conservatism as a desirable characteristic of accounting

information.

Conservatism: when two alternative accounting methods are acceptable and both equally satisfy
the conceptual and implementation principles set out by the FASB, the alternative having the less
favorable effect on net income or total assets is preferable.

Example: Small Pen filed a lawsuit against Big Pen. Small Pen has already recorded a gain on
income statement for the possible amount it feels it might win.

Example: Cracker Farms, Inc. uses lower of cost or net realizable value for its inventory
valuation.

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Enhancing qualities:

 Comparability (Consistency): the similar measurement and reporting for different

enterprises (application of the same accounting treatment to similar events by an
enterprise period to period).

 Verifiability

 Timeliness

 Understandability

Example:

The annual financial statements of August Corp are audited by Ernst & Young. Which
qualitative characteristic of accounting information is followed?

Owens Corp is using FIFO as inventory valuation method, while all other companies in its
industry are using LIFO. Which qualitative characteristic of accounting information may not be
followed?

Benjamin Balls, Inc. switches from accelerated depreciation of its plant assets to straight-line
depreciation to depreciation based on units of activity over a two-year period. Which qualitative
characteristic of accounting information is not followed?

Spartan company does not issue its first-quarter report until after the second quarter’s results are
reported. Which qualitative characteristic of accounting information is violated?

3. Key Constraint

Cost effectiveness: the benefits derived by external users of financial statements should
outweigh the costs incurred by the preparers of the information; difficult to quantify. Commented [AM1]: Benefits > cost  basic economic principle

Example: New East Co. does not disclose its contract details in the notes to its financial
statements, because such disclosure would reveal important information to its competitors.
Which constraint on accounting information is described?

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4. Ten basic elements of financial statements are defined in Statement of Financial Accounting
Concepts No. 6:

Source: Kieso, Weygandt, and Warfield, Intermediate Accounting, 11th Edition

Assets are probable future economic benefits obtained or controlled by a particular entity as a
result of past transactions or events.
Commented [AM2]: Can be current or non-current (fixed/long
term assets)
Usually on the left side of the balance sheet and have a debit account
Listed in most liquid to least liquid  cash being the most liquid

Liabilities are probable future sacrifices of economic benefits arising from present obligations of
a particular entity to transfer or provide services to other entities in the future as a result of past
transactions or events. Commented [AM3]: Owe something to someone  accounts
payable when you buy something on account and agree to pay it
later on

Equity, or net assets, called shareholders’ equity or stockholders’ equity for a corporation, is the
residual interest in the assets of an entity that remains after deducting liabilities. Commented [AM4]: Composed of common stock and retained
earnings
R/E = (Revenue – Expenses) - Dividends

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Investments by owners are increases in equity resulting from transfers of resources (usually
cash) to a company in exchange for ownership interest.

Distributions to owners are decreases in equity resulting from transfers to the owners.

Revenues are inflows of assets or settlements of liabilities from the entity’s ongoing major
operations.

Expenses are outflows or other using up of assets or increases of liabilities during a period from
the entity’s ongoing major operations.

Gains are increases in equity peripheral transactions of an entity.

Losses represent decreases in equity arising from peripheral transactions of an entity.

Comprehensive income is the change in equity of a business enterprise during a period from
transactions and other events and circumstances from nonowner sources. It includes all changes
in equity during a period except those resulting from investments from owners and distributions
to owners.

5. Basic Assumptions

Economic entity: All economic events identified with a particular economic entity.

Example: Robert Smith, owner of Smith Bookstore, Inc., bought a computer for his own use. He
paid for the computer by writing a check on the bookstore checking account and charged the
“Office Equipment” account. Which accounting assumption is violated?

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Going concern: Business entity will continue to operate indefinitely.

Example: Watson Brewer, Inc. classifies current and noncurrent assets and liabilities in its
balance sheet. Which accounting assumption is applied?

Periodicity: Life of company is divided into time periods to provide timely information.

Example: The economic activities of Rosemary Company are reported every quarter by issuing
quarterly reports to external decision makers. Which accounting assumption is applied?

Monetary unit: Financial statements are measured in U. S. Dollars.

Example: April Flowers Moving, Inc. measures its economic activities in US dollars and does
not adjust amounts in its financial statements for the effects of inflation. Which accounting
assumption is applied?

6. Principles

1) Recognition

Revenue Recognition: Companies recognize revenue when goods or services are transferred to
customers for the amount the company expects to be entitled to receive in exchange for those
goods or services. Commented [AM5]: Accrual basis

Example: Spartan Company sold the 2016 football game tickets in December 2015 and
recognized revenue for year 2015. Which accounting principle is violated?

Expense Recognition - Matching: all expenses incurred in earning the revenue recognized for a
period must be recognized during the same period. Commented [AM6]: Expenses and revenue have to match at all
times  need to recognize expenses whenever the revenue is
received and vice versa
Example: Vermont Enterprise recognizes depreciation expense for a machine over the five-year
period during which that machine helps the company earn revenue. Which accounting principle
is applied?

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2) Measurement

Historical Cost: the original transaction value Commented [AM7]: Book value of a product

Example: Sandy Creek Corp reports it land on its balance sheet as $500,000, which is the amount
it paid to acquire it. The current fair market value of the land is $5,000,000.

Net Realizable Value: the amount of cash into which an asset is expected to be converted in the
ordinary course of business

Example: Sandy Creek Corp sold on credit for $20,000 in 2016 and anticipated bad debts to be
10% of the credit sale.

Current Cost: the cost that would be incurred to purchase or reproduce the goods Commented [AM8]: Market value  may not be a market
sometimes to call it a market value

Example: Sandy Creek Corp purchased inventory at a cost of $6,000. At the end of 2016, the
replacement cost of its inventory is $5,000.

Present Value of future cash flows

Example: Sandy Creek Corp bought an equipment from a vendor signing a note in which it
promises to pay $20,000 at the end of the year and a total of ten such year-end payments. If they
assume an interest rate of 12%, what is the cost of the equipment?

Fair Value: the price that would be received to sell assets or paid to transfer a liability in an
orderly transaction between market participants at the measurement date.

The Move toward Fair Value:

Fair value: the price that would be received to sell assets or paid to transfer a liability in an
orderly transaction between market participants at the measurement date.

 The FASB established a framework for measuring fair value whenever fair value is called
for in applying GAAP.

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  Market approaches base valuation on market information.
 Income approaches estimate value by determining the present value of estimated
future earnings or cash flows.
 Cost approaches base valuation on estimates of amounts required to buy or
construct an asset of similar quality and condition.

 GAAP gives a company the option to report some or all of its financial assets and
liabilities at fair value.

3) Disclosure

Full-Disclosure Principle: all relevant information bearing on the economic affairs of a business
must be reported.
 Parenthetical comments
 Disclosure notes
 Supplemental schedules and tables

Example: Sam’s Salmon, Inc. decided that, for the sake of brevity, only total assets, liabilities,
and owners’ equity are reported on balance sheet. Details as to cash, inventory, accounts payable,
and other asset and liability items were omitted. Which accounting principle is violated?

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