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.
The three primary forms of business organization are the sole proprietorship, the partnership, and the corporation. A sole proprietorship is owned by a single individual. A partnership is owned by two or more individuals. A corporation is owned by shareholders, frequently numbering in the tens of thousands in large corporations. Although sole proprietorships and partnerships out number corporations, corporations are the dominant form of business in terms of size and ownership of productive resources. Investors and creditors provide massive amounts of financial resources to corporations. A highly-developed system of financial reporting is necessary to communicate financial information from a corporation to its many shareholders and creditors concerning how the corporation uses these resources.
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.
Generally accepted accounting principles are a dynamic set of both broad and specific guidelines that companies should follow when measuring and reporting information in their financial statements and in the accompanying disclosure notes. These guidelines, concepts, principles, and procedures have been developed over time to meet the needs of external users.
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.
The Financial Accounting Standards Board must consider the potential economic consequences of accounting standards. Many times, financial accounting standards are a compromise between the Board’s position and the wishes of various special interest groups. Especially controversial in recent years has been the efforts to develop accounting standards for employee stock options, business combinations, and the fair value standard. The FASB’s dilemma is to balance accounting considerations and political considerations resulting from perceived economic consequences.
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.
The costs of providing financial information include those of gathering, processing, and disseminating information. There are also costs to the users when interpreting the information. Information is considered to be cost effective only if the perceived benefit of increased decision usefulness exceed the anticipated costs of providing that information. Materiality is another boundary or constraint. Information is material if it has an effect on decisions. Conservatism is a justification for some accounting practices, but it is NOT a desired qualitative characteristic of financial information.
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.
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.
End of chapter 1.
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>
The Economic Environment and Financial Reporting A sole proprietorship is owned by a single individual. A partnership is owned by two or more individuals. A corporation is owned by shareholders.
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>
The Development of Financial Accounting and Reporting Standards Concepts, principles, and procedures were developed to meet the needs of external users (GAAP).
Current Standard Setting <ul><li>Supported by the Financial Accounting Foundation </li></ul><ul><li>Five 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
Establishment of Accounting Standards A Political Process GAAP Internal Revenue Service www.irs.gov American Institute of CPAs www.aicpa.org Securities and Exchange Commission www.sec.gov American Accounting Association www.aaa-edu.org Governmental Accounting Standards Board www.gasb.org Financial Executives International www.fei.org International Accounting Standards Board www.iasb.org
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.