Chapter 1 - Environment and Theoretical Structure of Financial Accounting Flashcards
LO1–1 Describe the function and primary focus of financial accounting. (p. 4)
Financial accounting is chiefly concerned with providing financial information to various external users.
The primary focus of financial accounting is on the information needs of investors and creditors.
We use the term financial reporting to refer to the process of providing this information to external users.
The capital markets provide a mechanism to help our economy allocate resources efficiently. Corporations acquire capital from investors in exchange for ownership interest and from creditors by borrowing.
Initial market transactions involve issuance of stocks and bonds by the corporation.
Secondary market transactions involve the transfer of stocks and bonds between individuals and institutions.
Investors and creditors are interested in earning a fair return on the resources they provide.
The expected rate of return and the uncertainty, or risk, of that return are key variables in the investment decision.
A company will be able to provide a return to investors and creditors only if it can generate a profit from selling its products or services.
The objective of financial accounting is to provide investors and creditors with useful information for decision making.
LO1–2 Explain the difference between cash and accrual accounting. (p. 6)
CASH BASIS ACCOUNTING. Cash basis accounting produces a measure called NET OPERATING CASH FLOW. This measure is the difference between cash receipts and cash payments from transactions related to providing goods and services to customers during a reporting period.
Net operating cash flow is the difference between cash receipts and cash disbursements from providing goods and services.
Over short periods of time, operating cash flow may not be an accurate predictor of future operating cash flows.
Over short periods of time, operating cash flow may not be an accurate predictor of future operating cash flows.
ACCRUAL ACCOUNTING. The ACCRUAL ACCOUNTING MODEL doesn’t focus only on cash flows. Instead, it also reflects other resources provided and consumed by operations during a period.
The accrual accounting model’s measure of resources provided by business operations is called revenues, and the measure of resources sacrificed to produce revenues is called expenses.
The difference between revenues and expenses is net income, or net loss if expenses are greater than revenues.
Net income is the difference between revenues and expenses. Net income also includes gains and losses, which are discussed later in the chapter.
Net income is considered a better indicator of future operating cash flows than is current net operating cash flow.
The accrual accounting model provides a measure of periodic performance called net income, the difference between revenues and expenses.
LO1–3 Define generally accepted accounting principles (GAAP) and discuss the historical development of accounting standards, including convergence between U.S. and international standards. (p. 8)
GAAP is a dynamic set of both broad and specific guidelines that companies should follow when measuring and reporting the information in their financial statements and related notes.
The Securities and Exchange Commission (SEC) was created by Congress with the 1934 Securities Exchange Act. The SEC has the authority to set accounting standards for companies, but has delegated the task to the private sector.
The Accounting Principles Board (APB) followed the CAP.
The FASB was established to set U.S. accounting standards.
The Emerging Issues Task Force (EITF) identifies financial reporting issues and attempts to resolve them without involving the FASB.
The FASB Accounting Standards Codification is now the only source of authoritative U.S. GAAP, other than rules and interpretive releases of the SEC.
FASB Accounting Standards Codification Topics: General Principles 100–199 Presentation 200–299 Assets 300–399 Liabilities 400–499 Equity 500–599 Revenues 600–699 Expenses 700–799 Broad Transactions 800–899 Industry 900–999
The International Accounting Standards Board (IASB) is dedicated to developing a single set of global accounting standards.
International Financial Reporting Standards are gaining support around the globe.
See Page 13
LO1–4 Explain why establishing accounting standards is characterized as a political process. (p. 13)
The Standard-Setting Process:
DUE PROCESS. When developing accounting standards, a standard setter must understand the nuances of the economic transactions the standards address and the views of key constituents concerning how accounting would best capture that economic reality. Therefore, the FASB undertakes a series of elaborate information-gathering steps before issuing an Accounting Standards Update.
POLITICS IN STANDARD SETTING. A change in accounting standards can result in a substantial redistribution of wealth within our economy. Therefore, it is no surprise that the FASB has had to deal with intense political pressure over controversial accounting standards, and sometimes has changed standards in response to that pressure.
In 2012, the Financial Accounting Foundation responded to this concern by establishing the Private Company Council (PCC). The ten-member PCC determines whether changes to existing GAAP are necessary to meet the needs of users of private company financial statements.
LO1–5 Explain factors that encourage high-quality financial reporting. (p. 16)
It is the responsibility of management to apply GAAP appropriately. Another group, AUDITORS, serves as an independent intermediary to help ensure that management has in fact appropriately applied GAAP in preparing the company’s financial statements.
Auditors offer credibility to financial statements. Auditors express an opinion on the compliance of financial statements with GAAP.
Certified public accountants (CPAs) are licensed by states to provide audit services.
Sarbanes-Oxley Act: Public Company Accounting Reform and Investor Protection Act of 2002
Section 404 is perhaps the most controversial provision of SOX. It requires that company management document internal controls and report on their adequacy. Auditors also must express an opinion on whether the company has maintained effective control over financial reporting.
A principles-based, or objectives-oriented, approach to standard setting stresses professional judgment, as opposed to following a list of rules.
Ethics deals with the ability to distinguish right from wrong. See Page 19
LO1–6 Explain the purpose of the conceptual framework. (p. 20)
The CONCEPTUAL FRAMEWORK has been described as an “Accounting Constitution” because it provides the underlying foundation for U.S. accounting standards.
The conceptual framework does not prescribe GAAP. It provides an underlying foundation for accounting standards.
Role of the conceptual framework. The conceptual frameworks in U.S. GAAP and IFRS are very similar, and are converging even more with ongoing efforts by the FASB and IASB. However, in U.S. GAAP, the conceptual framework primarily provides guidance to standard setters to help them develop high-quality standards. In IFRS the conceptual framework guides standard setting, but in addition it provides a basis for practitioners to make accounting judgments when another IFRS standard does not apply. Also, IFRS emphasizes the overarching concept of the financial statements providing a “true and fair representation” of the company. U.S. GAAP does not include a similar requirement, but U.S. auditing standards require this consideration.
LO1–7 Identify the objective and qualitative characteristics of financial reporting information, and the elements of financial statements. (p. 21)
OBJECTIVE To provide financial information that is useful to capital providers.
To be useful for decision making, information should possess the qualities of RELEVANCE and FAITHFUL REPRESENTATION. Information is MATERIAL if it has an effect on decisions.
Professional judgment determines what amount is material in each situation.
Faithful representation means agreement between a measure and a real-world phenomenon that the measure is supposed to represent.
A depiction is complete if it includes all information necessary for faithful representation.
Neutrality implies freedom from bias. Representational faithfulness is enhanced if information is free from error.
Conservatism is inconsistent with neutrality.
Accounting information should be comparable across different companies and over different time periods.
Accounting information is consistent if it is measured and reported the same way in each time period.
Information is verifiable if different measurers would reach consensus about whether it is representationally faithful.
Information is timely if it is available to users before a decision is made. Information is understandable if users can comprehend it.
Information is cost effective only if the benefit of increased decision usefulness exceeds the costs of providing that information.
The costs of providing financial information include any possible adverse economic consequences of accounting standards.
The 10 elements of financial statements defined in SFAC 6 describe financial position and periodic performance. SEE PAGE 25
LO1–8 Describe the four basic assumptions underlying GAAP. (p. 26)
Economic entity assumption: All economic events can be identified with a particular economic entity.
Going concern assumption: In the absence of information to the contrary, it is anticipated that a business entity will continue to operate indefinitely.
Periodicity assumption: The life of a company can be divided into artificial time periods to provide timely information to external users.
Monetary unit assumption: In the United States, financial statement elements should be measured in terms of the U.S. dollar.
LO1–9 Describe the recognition, measurement and disclosure concepts that guide accounting practice. (p. 27)
GENERAL RECOGNITION CRITERIA.
According to SFAC 5, an item should be recognized in the basic financial statements when it meets the following four criteria, subject to a cost effectiveness constraint and materiality threshold:
- Definition. The item meets the definition of an element of financial statements.
- Measurability. The item has a relevant attribute measurable with sufficient reliability.
- Relevance. The information about it is capable of making a difference in user decisions.
- Reliability. The information is representationally faithful, verifiable, and neutral.
Historical cost bases measurements on the amount given or received in the exchange transaction.
Net realizable value bases measurements on the amount of cash into which the asset or liability will be converted in the ordinary course of business.
Present value bases measurement on future cash flows discounted for the time value of money.
Fair value bases measurements on the price that would be received to sell assets or transfer liabilities in an orderly market transaction.
Fair value can be measured using:
- Market approaches.
- Income approaches.
- Cost approaches.
GAAP gives a company the option to value financial assets and liabilities at fair value.
The full-disclosure principle requires that any information useful to decision makers be provided in the financial statements, subject to the cost effectiveness constraint.
LO1–10 Contrast a revenue/expense approach and an asset/liability approach to accounting standard setting. (p. 34)
With the revenue/ expense approach, recognition and measurement of revenues and expenses are emphasized.
With the asset/liability approach, recognition and measurement of assets and liabilities drives revenue and expense recognition.
Spiceland, J. David. Intermediate Accounting (Page 34). McGraw-Hill Higher Education. Kindle Edition.
Spiceland, J. David. Intermediate Accounting (Page 34). McGraw-Hill Higher Education. Kindle Edition.
LO1–11 Discuss the primary differences between U.S. GAAP and IFRS with respect to the development of accounting standards and the conceptual framework underlying accounting standards. (pp. 15 and 20)
IFRS and U.S. GAAP are similar in the organizations that support standard setting and in the presence of ongoing political pressures on the standard-setting process. U.S. GAAP and IFRS also have similar conceptual frameworks, although the role of the conceptual framework in IFRS is to provide guidance to preparers as well as to standard setters, while the role of the conceptual framework in U.S. GAAP is more to provide guidance to standard setters. (pp. 15 and 20)
