Ch.1 Financial Reporting - · PDF fileCh.1 Financial Reporting . ... American Institute of Certified Public Accountants ... integrity of the profession through its Code of Professional

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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

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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.

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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.


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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

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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

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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)


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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)


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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.


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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.

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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)

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• 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

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• 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

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• 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

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• 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

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• 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

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(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

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• 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

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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)

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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)


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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.


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• 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

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• 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

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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)

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• 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)

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• 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)

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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.

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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

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• 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

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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.

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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?

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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

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• 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)


Board

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• 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.


Board

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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)


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)


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)


1-53

Evaluating Economic

Resources

Evaluating Economic

Resources


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.


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


Information

Relevant information normally provides

both feedback value and predictive

value at the same time.

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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)


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)


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)


Information

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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)


Information

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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)


Information

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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)


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.


Information

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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)

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(continued)

1-67 1-67

(continued)

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(concluded)

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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)


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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)


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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


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• Earnings (net income) for the period




Income

Statement

(continued)


1-74



• Cash flows during the period




Statement of

cash flows

(continued)


1-75




• Investments by and distributions to owners during the period




(continued)

Statement of

changes in

owners’ equity


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• Investments by and distributions to owners during the period

• Comprehensive income (total non-owner changes in equity) for the period




(continued)


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• 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)


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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.


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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)


Model

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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)


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)


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


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.

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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.

Documents

Ch.1 Financial Reporting - · PDF fileCh.1 Financial Reporting . ... American Institute of Certified Public Accountants ... integrity of the profession through its Code of Professional