Intermediate Accounting Spiceland, Sepe, Nelson Sixth Edition
Chapter 1: Environment and Theoretical Structure of Financial Accounting 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 principal means of conveying financial information to external users is through financial statements and related notes.
Several types of entities provide financial information to a variety of external users. Our primary focus in this book is on the financial information that profit-oriented companies provide to present and potential investors and to creditors. These profit-oriented companies also provide financial information that is used by financial intermediaries such as financial analysts, stockbrokers, mutual fund managers, and credit rating agencies. Not-for-profit organizations also provide financial information to external users such as citizen groups and donors. As an individual, you provide financial information to the internal revenue service and to creditors when you seek a loan.
Accounting is often thought of as the “language” used to communicate financial information about a business. The primary method that profit-oriented companies use to provide financial information to investors, creditors and other external parties is through financial statements and their accompanying disclosure notes. The four financial statements used most frequently for this purpose are the: Balance Sheet. Income Statement. Statement of Cash Flows. Statement of Shareholders’ Equity.
Part I. Investors and creditors are both concerned with providing resources, usually cash, to companies with the expectation of receiving more cash in return at some future time. Investors may receive future cash returns in the form of periodic dividends and from the sale of their ownership shares. Creditors may receive future cash returns in the form on interest and repayment of principal. Part II. The primary objective of financial accounting is to provide investors and creditors with financial information that will help them make investment and credit decisions. The information should help investors and creditors evaluate the amounts, timing, and uncertainty of the company’s future cash receipts and payments. With better financial information, investors and creditors will be able to make better resource allocation decisions.
Using cash basis accounting, revenue is recognized when cash is received, and expenses are recognized when cash is paid. This net cash flow measure of income is easily understood, and all information to measure cash flows is factual. However, there is a major shortcoming to using current net cash flow to predict future periods’ cash flows. Using accrual accounting, revenue is recognized when it is earned, and expenses are recognized when they are incurred.
Carter Company has sales on account totaling $100,000 per year for three years. Carter collected $50,000 in the first year and $125,000 in the second and third years. 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.
Part I. Because sales are made on account, sales in one year may not be collected until the next year. For example, even though sales for each year are $100,000, collections in the first year are only $50,000. Also notice the large rent prepayment in the first year that provides for all three years. The combination of cash receipts lagging sales and the large rent prepayment account for the majority of the negative net cash flow for year one. The pattern of cash payments for utilities actually improves the net cash flow for the first year at the expense of the second year. Can you see how the timing of cash flows and management’s ability to influence the timing for many cash flows can reduce the usefulness of net cash flow as an operating performance measure? Part II. For the entire three-year period, the total net cash flow is a good operating performance measure, but for any one year, it is a poor operating performance measure.
Part I. Revenue is recognized when the sale is made, not when the cash is received, resulting in the same amount of revenue each year. Rent expense is recognized evenly as the rented space is used over the three years, not when the cash is paid in the first year. Utility expense is recognized when incurred, not when paid. The resulting net income is $20,000 each year. Isn’t this a more reasonable result? Looking at the cash basis results and the accrual accounting results for Carter Company, which method would you want to use if you were asked to make predictions about future years’ operating performance? Part II. By comparing the cash basis results and the accrual basis accounting results for Carter Company, you see that the accrual basis may be a better indicator of future operating cash flows than is current net operating cash flow.
As a result of the stock market crash of 1929, Congress passed the 1933 Securities Act and the 1934 Securities and Exchange Act, the latter creating the Securities and Exchange Commission (SEC). In the 1934 Act, Congress gave the Securities and Exchange Commission the authority to set accounting and reporting standards for publicly traded companies. However, even though the Securities and Exchange Commission does issue its own standards, called Financial Reporting Releases, it has delegated the primary task for setting accounting standards to the private sector. The first private sector standards-setting body was the Committee on Accounting Procedure, in existence from 1938 until 1959. In 1959, the Accounting Principles Board replaced the Committee on Accounting Procedure. The Accounting Principles Board lasted until 1973 at which time it was replaced by the current standards-setting body, the Financial Accounting Standards Board.
Criticisms of the Accounting Principles Board, primarily lack of independence and its unwieldy actions, led to its demise in 1973 and to its replacement by the Financial Accounting Standards Board, the current standards-setting body. The Financial Accounting Standards Board: Is supported by the Financial Accounting Foundation. Consists of five full-time, independent voting members who serve for a five year term, which may be extended by reappointment to one additional five year term. Is answerable only to the Financial Accounting Foundation. Does not require its members to be Certified Public Accountants.
In 2007, the FASB launched its FASB Accounting Standards Codification project. The objective of the project was to integrate and organize by topics all relevant accounting pronouncements into a searchable, online database. The codification became effective on July 1, 2009, and now represents the single source of authoritative U.S. GAAP, except for rules and interpretive releases by the SEC (which are also authoritative GAAP). The codification is organized into nine main topic areas and approximately 90 subtopics.
The increase in international trade and the presence of large multinational companies in many countries in the world has led to problems where different accounting standards govern financial reporting in different countries. In response to this problem, the International Accounting Standards Committee (IASC) was formed in 1973. The IASC reorganized itself in 2001 and created a new standards setting body called the International Accounting Standards Board (IASB). The main objective of the IASB is to develop a single set of high quality, understandable and enforceable global accounting standards to help participants in the world’s capital markets and other users make economic decisions. The IASB issues standards called International Financial Reporting Standards or IFRSs which are gaining support around the globe. According to the SEC Roadmap, IFRS may be required by U.S. companies in 2014.
Management prepares a company’s financial statements. Auditors serve as independent intermediaries to help insure that management has appropriately applied generally accepted accounting principles in preparing the company’s financial statements. Auditors express an opinion on the compliance of the financial statements with generally accepted accounting principles. The auditor’s opinion adds credibility to the financial statements. Audits are conducted by a Certified Public Accountants (CPAs) who are licensed by states to provide audit services.
The collapse of Enron in 2001, followed by other accounting scandals in companies like WorldCom, caused Congress to pass the Public Company Accounting Reform and Investor Protection Act of 2002 . The Act is commonly referred to as the Sarbanes-Oxley Act named for the two congressmen who sponsored the bill. The goal was to restore credibility and investor confidence in the financial reporting process. This federal law provides for the regulation of auditors of public securities issuing entities 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.
Investors and creditors rely on financial accounting information to make resource allocation decisions. The information must possess the fundamental decision-specific qualities of relevance and faithful representation to be of maximum usefulness. A high standard of ethical behavior is expected of the accounting profession throughout the financial accounting and reporting process.
The Conceptual Framework has been described as a constitution, a coherent system of interrelated objectives and fundamental that lead to consistent accounting standards. The conceptual framework does not prescribe generally accepted accounting principles, but it provides an underlying foundation for the development of accounting standards. The Financial Accounting Standards Board issued Statements of Financial Accounting Concepts to disseminate their conceptual framework. Objectives of financial accounting and reporting were addressed in SFAC 1. SFAC outlined the qualitative characteristics of accounting information. The elements of financial statements were described in SFAC 3, and which was superseded by SFAC 6. SFAC 4 deals with the objectives of financial reporting for nonprofit organizations, which are not covered in this text. Recognition and measurement issues were addressed in SFAC 5 and SFAC 7. As part of the ongoing efforts to converge U.S. GAAP and International Financial Reporting Standards, the FASB and the IASB are now working on a joint conceptual framework project.
The primary objective of financial reporting is to provide useful information to capital providers. The joint boards stated that their mandate is to assist in the efficient allocation of resources in capital markets. In Phase A of the joint conceptual framework project the boards addressed the objective, fundamental and enhancing qualitative characteristics, and constraints.
Part I. To be useful, information must make a difference in the decision process. Thus, decision usefulness is identified as the overriding objective in this hierarchy. To be useful, information should possess the fundamental qualities of relevance and faithful representation. Both are critical. Part II. Relevance means that the information must possess predictive value and/or confirmatory value, and typically both. Faithful representation exists when there is agreement between a measure and a real-world phenomenon that the measure is supposed to represent. It requires that information be complete, neutral, and free from material error. Part III. There are also four enhancing qualitative characteristics, comparability (consistency), verifiability, timeliness, and understandability.
Statements of Financial Accounting Concepts 6 defines 10 elements of financial statements. Assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. Liabilities are probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events. Equity (net assets) is the residual interest in the assets of a business entity. It is also known as stockholders’ equity or shareholders’ equity for corporations. 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 owners. A cash dividend is the most common form of distribution to owners.
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. Revenues are inflows or other enhancements of assets or settlements of liabilities from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major, or central, operations. Expenses are outflows or other using up of assets or incurrences of liabilities during a period from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major, or central, operations. Gains are increases in equity from peripheral, or incidental, transactions of an entity. Losses represent decreases in equity arising from peripheral, or incidental, transactions of an entity.
Now that various elements have been identified, the issues of recognition and measurement need to be addressed. Recognition is the process of admitting information into the basic financial statements. The four criteria for recognition are definition, measurability, relevance, and reliability. Phase A of the joint FASB and IASB conceptual framework project has replaced reliability with faithful representation. The other issue is measurement, which involves both the choice of a unit of measure and the choice of an attribute to be measured. SFAC No. 7 provides a framework for using the present value of future cash flows in accounting measurements.
The four basic assumptions underlying generally accepted accounting principles are: All economic events can be identified with a particular economic entity. In the absence of information to the contrary, it is assumed that the business entity will continue to operate indefinitely. The life of a business is divided into time periods to provide timely information. All measurements are in United States dollars. There are four accounting principles that provide guidance for accounting practice: Measurement is based on the original transaction amount. Revenue is recognized when the earnings process is complete, and when there is reasonable certainty of collecting the asset to be received. Expenses are recognized in the same period as the related revenue. Financial statements should include any information that could affect the decisions made by external users.
GAAP defines fair value as 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. There are three types of valuation techniques that can be used to measure fair value. 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.
Environment and Theoretical Structure of Financial Accounting 1
Financial Accounting Environment Profit-oriented companies Not-for-profit entities Households Providers of Financial Information External User Groups Investors Creditors Employees Labor unions Customers Suppliers Government agencies Financial intermediaries Relevant Financial Information
Financial Accounting Environment <ul><li>Relevant financial information is provided primarily through financial statements and related disclosure notes. </li></ul><ul><ul><li>Balance Sheet </li></ul></ul><ul><ul><li>Income Statement </li></ul></ul><ul><ul><li>Statement of Cash Flows </li></ul></ul><ul><ul><li>Statement of Shareholders’ Equity </li></ul></ul>
Investment-Credit Decisions ─ A Cash Flow Perspective Shareholders Receive Cash <ul><li>Dividends </li></ul><ul><li>Sale of Stock </li></ul>Creditors Receive Cash <ul><li>Interest </li></ul><ul><li>Loan Repayment </li></ul>Accounting information should help investors and creditors evaluate the amount, timing , and uncertainty of the enterprise’s future cash flows.
Cash versus Accrual Accounting <ul><li>Cash Basis Accounting Revenue is recognized when cash is received . Expenses are recognized when cash is paid . </li></ul>OROROR OR <ul><li>Accrual Accounting </li></ul><ul><ul><li>Revenue is recognized when earned . Expenses are recognized when incurred . </li></ul></ul>
Cash versus Accrual Accounting <ul><li>Cash Basis Accounting </li></ul><ul><ul><li>Carter Company has sales on account totaling $100,000 per year for three years. </li></ul></ul><ul><ul><li>Carter collected $50,000 in the first year and $125,000 in the second and third years. </li></ul></ul><ul><ul><li>Carter prepaid $60,000 for three years’ rent in the first year. </li></ul></ul><ul><ul><li>Utilities are $10,000 per year, but in the first year only $5,000 was paid. </li></ul></ul><ul><ul><li>Payments to employees are $50,000 per year. Let’s look at the cash flows. </li></ul></ul>
Cash versus Accrual (page 7) <ul><li>Cash Basis Accounting </li></ul>Cash flows in any one year may not be a predictor of future cash flows.
Accrual Accounting (page 8) Net Income is considered a better indicator of future cash flows.
Current Standard Setting <ul><li>Supported by the Financial Accounting Foundation </li></ul><ul><li>How many full-time, independent voting members? </li></ul><ul><li>Answerable only to the Financial Accounting Foundation </li></ul><ul><li>Members not required to be CPAs </li></ul>Financial Accounting Standards Board
FASB Accounting Standards Codification The objective of the codification project was to integrate and organize by topics all relevant accounting pronouncements into a searchable, online database.
Toward Global Accounting Standards The main objective of the International Accounting Standards Board (IASB) is to develop a single set of high quality, understandable and enforceable global accounting standards to help participants in the world’s capital markets and other users make economic decisions.
Role of the Auditor <ul><li>Auditors serve as independent intermediaries to help insure that management has appropriately applied GAAP in preparing the company’s financial statements. </li></ul>
Financial Reporting Reform As a result of numerous financial scandals, Congress passed the Public Company Accounting Reform and Investor Protection Act of 2002 , ( Sarbanes-Oxley Act ). The goal was to restore credibility and investor confidence in the financial reporting process.
Ethics in Accounting <ul><li>For financial information to be useful, it should possess the fundamental decision-specific qualities of relevance and faithful representation . </li></ul><ul><li>Management may be under pressure to report desired results and ignore or bend existing rules. </li></ul>
The Conceptual Framework The Conceptual Framework has been described as a constitution, a coherent system of interrelated objectives and fundamental that lead to consistent accounting standards. FASB Conceptual Framework (Statements of Financial Accounting Concepts) Objectives of Financial Reporting (SFAC No. 1) Qualitative Characteristics (SFAC No. 2) Elements of Financial Statements (SFAC No. 6) Recognition and Measurement (SFAC No. 5 and SFAC No. 7)
The Conceptual Framework Objective To provide financial information that is useful to capital providers. (2) Elements (3) Recognition & Measurement Concepts ( 4) Constraints Financial Statements (1) Qualitative Characteristics
(1) Qualitative Characteristics of Accounting Information (page 23) Relevance Faithful representation Decision usefulness Predictive value Confirmatory value Neutrality Completeness Free from material error Comparability (Consistency) Understandability Verifiability Timeliness
(2a) Elements of Financial Statements (page 27)
(2b) Elements of Financial Statements (page 27)
(3a) Recognition & Measurement Concepts Recognition Process of admitting information into the basic financial statements <ul><li>Definition </li></ul><ul><li>Measurability </li></ul><ul><li>Relevance </li></ul><ul><li>Reliability </li></ul>Measurement involves both the choice of a unit of measure and the choice of an attribute to be measured.
Evolution of Accounting Principles The Move Toward Fair Value Fair value is 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. Market Approaches Income Approaches Cost Approaches