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Chapter 1: Financial Accounting Environment

The primary focus of financial accounting is to provide information to

external users (investors and creditors)
This is done with financial reporting primarily through financial
statements and related disclosure notes
o Balance Sheet (Statement of Financial Position)
o Income Statement (Statement of Operations)
o Statement of Cash Flows
o Statement of Shareholders Equity
o Statement of Other Comprehensive Income
Economic Environment & Financial Reporting
Capital Markets: provide a mechanism to help our economy
allocate resources efficiently
Sole proprietorships and partnerships outnumber corporations but
corporations are the dominant form of business organization
Corporation: acquire capital from investors in exchange for
ownership interest and from creditors form borrowing
Initial Market Transactions: issuance of stocks and bonds
between individuals and institutions
Secondary Market Transactions: transfer of stocks and bonds
between individuals and organizations
Corporations should provide information to investors/creditors that
evaluates the amounts, timing, and uncertainty of future cash
receipts and disburstments
o Rate of Return: (dividends + share price appreciation)/initial
Cash Accounting: revenue is recognized when its received and
expenses are recognized when cash is paid
o Net Operating Cash Flow
o Short-run operating cash flows might not be indicative of longrun cash-generating ability
Accrual Accounting: revenue is recognized when earned and
expenses are recognized when incurred
o Net Income/Loss
o Used by most profit-oriented companies & many nonprofits
The Development of Financial Accounting & Reporting Standards
Generally Accepted Accounting Principles (GAAP): set of
guidelines companies follow when measuring and reporting the
information in financial statements and related notes
The Securities & Exchange Commission (SEC) was created by
congress to set accounting and reporting standards for publicly
traded companiesthey gave it off to the private sector
The first body to assume the task was the committee on accounting
procedure (CAP)

The Accounting Principles Board (APB) replaced CAP

In 1973 the Financial Accounting Standards Board (FASB) was
o 7 full time members from various constituencies
o Supported by Financial Accounting Foundation (FAF)
o The Emerging Issues Task Force was created to improve
financial reporting by defining issues within GAAP
o The Codification created a conceptual framework for the
underlying accounting standards. Has over 160 accounting
standards (Statements of Financial Accounting Standards)
International Accounting Standards Board (IASB): dedicated
to developing a single set of global accounting standards
o International Financial Reporting Standards (IFRSs)
o Has been working with FASB set a path to convergence
o Sept 2002: sign the Norwalk Agreement
o Nov 2008: SEC issues roadmap with milestones
o May 2011: SEC issues discussion paper condorsemnt
o Now 2011: SEC issues 2 studies comparing GAAP & IFRS
There is an elaborate process when developing accounting
o Boards receives requests for projects and reconsideration of
standards from various sources
o FASB Chairman decides to add to technical agenda or not
o Board deliberates at public meetings
o Board issues an Exposure Draft
o Board holds a public round table meeting on Exposure Draft
o Staff analyzes comments and suggestions, discussed provisions
at public meetings
o Board issues Accounting Standards Update describing
amendments to the Accounting Standards Codification
Encouraging High-Quality Financial Reporting
Auditors: independent intermediary to help ensure management
appropriately applied GAAP in preparing financial statements
o Adds credibility to financial statements
Certified Public Accountants (CPAs): licensed by states to
provide audit services
The Public Company Accounting Reform & Investor Protection Act of
2002 (Sarbanse-Oxley Act): applies to public securities-issuing
entities. Provides regulation of auditors increasing accountability of
corporate executives and provides stiff criminal penalties
o Oversight Board
o Unlawful for auditors to provide nonaudit services
o Must keep work papers for 7 years
o Auitor rotation

o Cannot have conflict of interest

o Audiors must be hired by board not company management
o Section 404: requires management document internal
controls and report on their adequacy
A Move Away from Rules-Based Standards
There has been a debate to move to Principles based objectives
over Rules basedstressed professional judgment instead of
following a list of rules
Ethics: code or moral system that provides criteria from
evaluating right or wrong
o Expected for professionals to engage in
The Conceptual Framework
Conceptual framework: Accounting Constitution provides the
underlying foundation for US accounting standards
Shown in FASBs Statements of Financial Accounting Concepts
Objectives of Financial Reporting (SFAC 1, replaced by SFAC 8)
o Provide financial reporting to companies that is useful for
capital providers in decision making
Qualitative Characteristics (SFAC 2, replaced by SFAC 8)
o Decision Usefulness: main purpose; subdivided into
o Relevance
Predictive Value/Confirmatory Value: ability of
reported earning to predict a companys future earnings
Material: if omitting/misstating could affect users
o Faithful Representation: agreement between a measure
and the phenomenon it purports to represent
Free from Error
Many accountants employ conservatism
o Enhancing Qualitative Characteristics
Consistency: among different reporting periods
Understandability: if users can comprehend it
o Key constraint is cost effectiveness: the benefits of financial
knowledge must exceed the cost of getting it
Elements of Financial Statements (SFAC 3, replaced by SFAC 6)
o Assets: probable future economic benefits

o Liabilities: probable future sacrifices of economic benefits

arising from present obligations
o Equity: shareholders/stockholders equity; residual interest in
the assets of an entity after deducting its liabilities
o Investments by owners: increased in equity
o Distributions to owners: decreases in equity; transfer to
o Comprehensive income: change in equity during a period
o Revenues: inflows of assets/settlements of liabilities
o Expenses: outflows/using up of assets
o Gains: increases in equity from transactions of an entity
o Losses: decreases in equity from transactions of an entity
Financial Reporting for Nonprofit Organizations (SFAC 4)
Recognition & Measurement (SFAC 5 & SFAC 7)
o Recognition: the process of admitting information into the
financial statements
Definition: item meets definition of element in financial
Measurability: item has relevant attribute measurable
with sufficient reliability
Relevance: information is capable of making a
difference in decisions
Reliability: information represented faithful, verifiable, &
Realization principle: 2 criteria must be met before
revenue can be recognized: earning process is judged to
be completed & there is reasonable certainty to the
collectability of the asset
Allow for accrual accounting
Point-of-sale: triggers recognition of revenue
Matching Principle: expenses should be recognized in
the period in which they produced revenues: based on
cause&effect relationship OR associating an expense
with revenues recognized OR a systematic & rational
allocation OR in period incurred, regardless of related
o Measurement: process of association numerical amounts
with the elements
Historical Cost: original transaction value
Net Realizable Value: bases measurements on the
amount of cash into which the element will be
converted in the ordinary course of business
Current Cost: current replacement cost
Fair Value: current market value

GAAP gives a company the option to value

financial assets/liabilities at their fair value
Fair Value Hierarchy: 1(most desirable) quoted market
prices; 2 Inputs other than quoted prices are
observable; 3 unobservable inputs reflecting the entitys
own assumptions
o Disclosure: process of including additional pertinent
Full Disclosure Principle: requires all information
useful to decision makers be provided in the financial
Parenthetical comments, disclosure notes, supplemental
schedules and tables
Underlying Assumptions
o Economic Entity: all economic events can be identified
specifically with an economic entity
o Going Concern Assumption: an entity will continue to
operate indefinitely (through the next fiscal year)
o Periodicity Assumption: allows the life of a company to be
divided into artificial time periods to provided timely
o Monetary Unit Assumption: measurement is done in
nominal units
Evolving GAAP
Revenue/expense approach: emphasize principles for
recognizing revenues and expenses
o Emphasis is going towards this!
Asset/liability approach: recognition & measurement of
assets/liabilities drives revenues and expense recognition
Chapter 2: Review of the Accounting Process
The Basic Model
Economic Events: cause changes in the financial position of the
External Events: involve an exchange between the company and
another entity
Internal Events: do not involve an exchange transaction but do
affect the companys financial position
The Accounting Equation: Assets=Liabilities+ Owners
o Portrays equality between the total economic resources of an
entity and its total claims
o Each event (transaction) will have a dual effect because
resources must always equal the claims

Assets =









Permanent Accounts: represents basic financial position elements

of the accounting equation (assets, liabilities, & shareholders
Temporary Accounts: represents changes in the retained earnings
component of shareholders equity (revenue, expenses, gain and
The Accounting Processing Cycle
1. Obtain information about transactions from source documents
2. Analyze the transaction (transaction analysis)
3. Record the transactions in the journal
4. Post from the journal to the general ledger accounts (posting)
I. Perpetual Inventory System: cost of merchandise is
recorded in the inventory and when inventory is sold the
inventory account is decreased by the cost of the item sold
II. Periodic Inventory System: Cost of merchandise is
recorded in a temporary Purchases account. Cost of goods
sold is determined at the end of the period and inventory
account is then adjusted (beginning inventory + purchases
ending inventory = cost of goods sold)



i. COGS xx
Inventory x
Purchases xxx
Prepare an unadjusted trial balance
Record adjusting entries
I. Prepayments: cash flows proceed either expense or revenue
Depreciation Expense
Accumulated Depreciation
Unearned Rent Revenue
Rent Revenue
II. Accruals: occur when the cash flow comes after either
expense or revenue recognition
salaries expense
salaries payable
III. Estimates
Prepare an Adjusted Trial Balance
Preparation of Financial Statements

I. Income Statement: a change statement that summarizes

the profit generating transactions that caused stockholders
equity to change during the period (Revenues-Expenses=Net
II. Statement of Comprehensive Income: reports the
changes in stockholders equity that were not a result of
transactions with owners
III. The Balance Sheet: a position statement that presents an
organized list of assets, liabilities, and equity at a particular
point in time
i. Current assets/liabilities: can be converted into
cash/will be satisfied within 1 year or the operating
cycle (whichever is longer)
IV. The Statement of Cash Flows: a change statement that
summarizes the transactions that caused cash to change
during the period
i. Operating Activities: inflows and outflows of cash
related to transactions entering into the determination
of net income
ii. Investing Activities: involve the acquisition & sale of
long-term assets used and nonoperation investments
iii. Financing Activities: financing activities involving
cash inflows and outflows from transactions with
creditors and owners
V. The Statement of Shareholders Equity: a change
statement that discloses the sources of changes in the
permanent shareholders equity accounts
i. Add paid-in capital, deduct dividends
9. Close the Temporary Accounts to Income Summary and then into
Retained Earnings
Sales Revenue
Income Summary
Income Summary
Expense Accounts
Income Summary
Retained Earnings
10. Post-Closing Trial Balance (at year end only)