© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Intermediate Accounting

Spiceland / Sepe / Tomassini

Third Edition

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Chapter 1

Environment and Theoretical Structure of Financial Accounting

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Financial Accounting Environment

Profit-orientedcompanies

Not-for-profitentities

Households

Providers ofFinancial Information

ExternalUser Groups

InvestorsCreditors

EmployeesLabor unionsCustomersSuppliers

GovernmentagenciesFinancial

intermediaries

Relevant

FinancialInformation

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Financial Accounting Environment

Relevant financial information is provided primarily through financial statements and

related disclosure notes. Balance Sheet Income Statement Statement of Cash Flows Statement of Shareholders’ Equity

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Investment-Credit DecisionsA Cash Flow Perspective

Corporate shareholders will receive cash from their investments through . . .

Periodic dividend distributions from the corporation.

The ultimate sale of the ownership shares of stock.

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Investment-Credit DecisionsA Cash Flow Perspective

Accounting information should help investors evaluate the amount, timing, and

uncertainty of the enterprise’s future cash flows.

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Cash Versus Accrual Accounting

Cash Basis Accounting Revenue is recognized when cash is received. Expenses are recognized when cash is paid.

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Cash Versus Accrual Accounting

Cash Basis Accounting Carter Company has sales on account totaling $100,000 per year, and collected as shown on the

following slide. The company prepaid $60,000 for three years’ rent in the first year. Utilities are

$10,000 per year, but in the first year only $5,000 was paid. Payments to employees are $50,000 per

year.

Let’s look at the cash flows.

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Cash Versus Accrual Accounting

Cash Basis Accounting

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Cash Basis Accounting

Cash Versus Accrual Accounting

Cash flows in any one year may not be apredictor of future cash flows.

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Cash Versus Accrual Accounting

Accrual AccountingRevenue is recognized when earned.Expenses are recognized when incurred.

Let’s reconsider the Carter Company information.

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Accrual AccountingRevenue is recognized when earned.Expenses are recognized when incurred.

Let’s reconsider the Carter Company information.

Cash Versus Accrual Accounting

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The Development of Financial Accounting and Reporting Standards

Concepts, principles, and

procedures weredeveloped to meet the

needs of external users (GAAP).

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Early Standard Setting

Evolution of Standard-Setting Process1938 - 1959:

Committee on Accounting Procedures (CAP)

1959 - 1973:Accounting Principles Board (APB)

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Current Standard Setting - FASBwww.fasb.org

Supported by the Financial Accounting Foundation. Seven full-time, independent voting members serving

for 10 years. Answerable only to the Financial Accounting

Foundation. Members not required to be CPAs.

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Establishment of Accounting StandardsA Political Process

GAAP

Internal RevenueService

www.irs.gov

American Instituteof CPAs

www.aicpa.org

Securities andExchange

Commissionwww.sec.gov

AmericanAccountingAssociation

www.aaa-edu.org

GovernmentalAccounting

Standards Boardwww.gasb.org

Financial ExecutivesInstitute

www.fei.org

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FASB’s Standard-Setting Process

Identification of problem. The task force. Research and Analysis. Discussion memorandum. Public response. Exposure draft. Public response. Statement issued.

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International Accounting Standards Committee (IASC)

Established in 1973 to narrow the range of differences in accounting standards.

Increase in international trade has motivated the IASC to attempt to eliminate alternative accounting treatments.

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Role of the Auditor

Independent intermediary to help insure that management has in fact appropriately

applied GAAP.

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The Conceptual Framework

Maintain consistency among standards.Resolve new accounting problems.Provide user benefits.

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The Conceptual Framework

Recognition and Measurement Criteria (SFAC No. 5)

Environment Implementation Implementationassumptions principles constraints

Objectives of Financial Reporting(SFAC No. 1)

Qualitative Characteristicsof Accounting Information

(SFAC No. 2)

Elements ofFinancial Statements

(SFAC No. 6)

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To provide information:Useful for decisions.That helps predict cash flows.About economic resources, claims to resources, and changes in resources and claims.

ElementsRecognition and

MeasurementConcepts

Constraints

Conceptual Framework Objectives

QualitativeCharacteristics

FinancialStatements

Continued

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ElementsAssets

LiabilitiesEquity

Investments by OwnersDistributions to owners

RevenuesExpenses

GainsLosses

Comprehensive Income

Recognition andMeasurement

Concepts

AssumptionsEconomic entityGoing concern

PeriodicityMonetary unit

PrinciplesHistorical cost

RealizationMatching

Full Disclosure

Objectives

Financial StatementsBalance sheet

Income statementStatement of cash flows

Statement of shareholders’ equityRelated disclosures

ConstraintsCost effectiveness

MaterialityConservatism

QualitativeCharacteristics

Understandability

PrimaryRelevanceReliability

SecondaryComparabilityConsistency

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Relevance Reliability

PredictiveValue

FeedbackValue

Timeliness NeutralityVerifiabilityRepresentational

Faithfulness

Comparability Consistency

Qualitative Characteristics - Understandability

Decision Usefulness

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Slide1-25 Practical Constraints to Achieving

Desired Qualitative Characteristics

CostEffectiveness

CostEffectiveness MaterialityMateriality

ConservatismConservatism

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SFAC No. 6Revenues

“Inflows of assets or settlements of liabilities during a particular accounting period. Such inflows or settlements stem from delivery or

production of goods or rendering of services.”

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SFAC No. 6Expenses

“Outflows of assets or incurrences of liabilities during a particular accounting period. Such outflows are necessary for

delivery or production of goods or rendering of services.”

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SFAC No. 6Gains and Losses

Gains: “Increases in equity resulting from incidental transactions not associated with the company’s major business.”

Losses: “Decreases in equity resulting from incidental transactions not associated with the company’s major business.”

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SFAC No. 6Assets and Liabilities

Assets: “Business resources that have probable future economic benefits.”

Liabilities: “Probable future sacrifices of economic benefits.”

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SFAC No. 6Equity

Residual interest in the assets of a business entity is also known as net assets.

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SFAC No. 6Investments and Distributions

Investments by owners: “Increases in equity resulting from asset contribution by other entities (owners/stockholders).”

Distribution to owners: “Decreases in equity resulting from the distribution of assets to other entities.”

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SFAC No. 6Comprehensive Income

“The change in equity resulting from the aggregate of all transactions reported in a particular accounting period, except for

investments by and distributions to owners.”

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Recognition and Measurement ConceptsAssumptions DescriptionEconomic entity All economic events identified with a particular

economic entity.

Going concern Business entity will continue to operate indefinitely.

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

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

PrinciplesHistorical cost Measurement based on exchange transaction amounts.

Realization Revenue recognized when earnings process is complete and reasonable certainty of collection exists.

Matching Expenses recognized in same period as related revenue.

Full disclosure Information that could change user decisions should be included.

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The Realization Principle

ReasonableAssurance of

Collection

SubstantialCompletion ofTransaction

Two conditions must be met if therealization principle is to be satisfied.

Two conditions must be met if therealization principle is to be satisfied.

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Question

The function of financial accounting is to identify, measure and communicate financial information about economic entities to interested parties.

a. True

b. False

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Question

The function of financial accounting is to identify, measure and communicate financial information about economic entities to interested parties.

a. True

b. False

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Question

Accrual accounting provides a better indication of ability to generate cash flows than does information limited to the financial effects of cash receipts and cash payments.

a. True

b. False

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

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Question

Accrual accounting provides a better indication of ability to generate cash flows than does information limited to the financial effects of cash receipts and cash payments.

a. True

b. False

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

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Question

The primary objective of accrual basis accounting is the measurement of income.

a. True

b. False

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Question

The primary objective of accrual basis accounting is the measurement of income.

a. True

b. False

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Question

Generally accepted accounting principles include both standards set by various rule making bodies and certain accounting practices that have evolved over time.

a. True

b. False

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

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Question

Generally accepted accounting principles include both standards set by various rule making bodies and certain accounting practices that have evolved over time.

a. True

b. False

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

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Question

The major financial accounting standard setting body is the

a. Accounting Principles Board

b. Securities and Exchange Commission

c. Financial Accounting Standards Board

d. American Institute of CPAs

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Question

The major financial accounting standard setting body is the

a. Accounting Principles Board

b. Securities and Exchange Commission

c. Financial Accounting Standards Board

d. American Institute of CPAs

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

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Question

The FASB issues which of the following types of pronouncements?

a. Standards

b. Interpretations

c. Financial Accounting Concepts

d. Technical Bulletins

e. All of the above

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

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Question

The FASB issues which of the following types of pronouncements?

a. Standards

b. Interpretations

c. Financial Accounting Concepts

d. Technical Bulletins

e. All of the above

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

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Question

The Financial Accounting Standards Board develops accounting and reporting standards independent of public, business and political pressures.a. True

b. False

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Question

The Financial Accounting Standards Board develops accounting and reporting standards independent of public, business and political pressures.a. True

b. False

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

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Ethics in Accounting

To be useful, accounting information must be objective and reliable.

Management may be under pressure to report desired results and ignore or bend existing rules.

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Model for Ethical Decisions

Determine the facts of the situation. Identify the ethical issue and the stakeholders. Identify the values related to the situation. Specify the alternative courses of action. Evaluate the courses of action. Identify the consequences of each course of action. Make your decision and take any indicated action.

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

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End of Chapter 1