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Chapter 1

18th
Edition

Financial
Reporting

Intermediate
Accounting
James D. Stice

Earl K. Stice
PowerPoint presented by Douglas Cloud
Professor Emeritus of Accounting, Pepperdine
University
2012 Cengage Learning

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Definition of Accounting
Accounting is a service activity. Its
function is to provide quantitative
information, primarily financial in nature,
about economic entities that is intended to
be useful in making economic decisions
in making reasoned choices among
alternative courses of action.
Statement of the Accounting Principles Board No. 4, par. 40.
(continued)
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Definition of Accounting
Key features in this definition of accounting:

Accounting information is used in making


decisions about how to allocate scarce
resources.

Although accountants place much emphasis


on reporting what has already occurred, this
past information is intended to be useful in
making economic decisions about the future.

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Users of Accounting Information

Stakeholders are all parties interested in the


financial health of a company.
Internal users are stakeholders who make
decisions that directly affect the internal
operations of the enterprise.
External users are stakeholders who make
decisions concerning their relationship to the
enterprise.

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Users of Accounting Information


1. Management accounting is concerned
primarily with financial reporting for internal
users, especially management.
2. Financial accounting focuses on the
development and communication of
financial information for external users.
a. Helps users in determining whether a
companys operations are profitable
enough to justify additional funding.
(continued)
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Users of Accounting Information


b. Helps users in determining how risky
a companys operations are in order
to determine what rate of return is
necessary to compensate capital
providers for the investment risk.

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External Investors
Creditors
Creditors need
need
information
information about
about the
the
profitability
profitability and
and
stability
stability of
of the
the
company
company to
to decide
decide
whether
whether to
to lend
lend
money
money to
to the
the
company
company and,
and, ifif so,
so,
what
what interest
interest rate
rate to
to
charge.
charge.

Investors
Investors (both
(both
existing
existing stockholders
stockholders
and
and potential
potential
investors)
investors) need
need
information
information
concerning
concerning the
the
safety
safety and
and
profitability
profitability of
of their
their
investment.
investment.
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General-Purpose Financial
Statements
The balance sheet reports, as of a
certain point in time, the resources
of a company (the assets), the
companys obligations (the
liabilities), and the equity of the
owners.

(continued)
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General-Purpose Financial
Statements
The income statement reports, for a
certain interval, the net assets
generated through business
operations (revenues), the net assets
consumed (the expenses), and the
difference, which is called net
income.
(continued)
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General-Purpose Financial
Statements
The statement of cash flows
reports, for a certain interval, the
amount of cash generated and
consumed by a company through
the following three types of
activities: operating, financing, and
investing activities.
(continued)
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General-Purpose Financial
Statements
Accounting estimates and
judgments are outlined in the notes
to financial statements. In
addition, the notes contain
supplemental information as well as
information about items not
included in the financial statements.

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Auditors Role

Auditors, working independently of a


companys management and internal
accountants, examine the financial
statements.

They issue an auditors opinion about


the fairness of the statements and their
adherence to proper accounting
principles.
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The FASB

The Financial Accounting Standards


Board (FASB) sets accounting standards
in the United States.

The FASB is a private-sector body and


has no legal authority.

The issuance of new accounting


standards is preceded by a lengthy public
discussion.
(continued)
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The FASB

The Emerging Issues Task Force


(EITF) works under the direction of the
FASB.

The EITF formulates a timely expert


consensus on how to handle new
issues not yet covered in FASB
pronouncements.
(continued)
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The FASB

The Securities and Exchange

Commission (SEC) was created by the


1933 Securities Act to protect the interests
of investors by ensuring full and fair
disclosure.
It was given specific legal authority to
establish accounting standards for
companies desiring to publicly issue shares
in the United States.
(continued)
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The FASB

The SEC has generally allowed the

private-sector organizations to make the


accounting standards in the United States
(commonly referred to as generally
accepted accounting principles
(GAAP)).

(continued)
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The FASB

The Financial Accounting Standards


Board (FASB) is currently recognized as the
private-sector body responsible for the
establishment of U.S. accounting standards.

The FASB was organized in 1973, replacing

the Accounting Principles Board (APB).


Five full-time members are drawn from a
variety of backgroundsauditing, corporate
accounting, financial services, and academia.
(continued)
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The FASB

Appointment of new Board members is


done by the Financial Accounting
Foundation (FAF).

The FAF serves somewhat like a board of


directors overseeing the FASB.

The FAF is also responsible for selecting


and supporting members of the
Governmental Accounting Standards
Board (GASB).
(continued)
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The FASB

The major functions of the FASB are to


study issues and to establish accounting
standards.

These standards are published as


Accounting Standards Updates.

The FASB has also issued Statements of


Financial Accounting Concepts that
provide a framework within which specific
accounting standards can be developed.
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FASB Due Process


1. FASB staff assembles background information
and the Board holds public meetings before a
decision is made to even add a project to the
FASBs formal agenda.
2. After more study and further hearings, the
Board often issues a report summarizing its
Preliminary Views.
3. Interested parties are invited to comment either
in writing or orally at a public hearing.
(continued)
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FASB Due Process


4. After comments from interested parties have
been evaluated, the Board meets as many
times as necessary to resolve the issues.
5. From these meetings, the Board develops an
Exposure Draft of a statement that includes
specific recommendations for financial
accounting and reporting.
6. After 60 days or longer, if the topic is a major
one, all comments are reviewed by the staff and
the Board.
(continued)
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FASB Due Process


7. Further deliberation of the Board leads to either
the issuance of an Accounting Standards
Update, a revised Exposure Draft, or, in some
cases, abandonment of the project.
8. The final statement not only sets forth the actual
standards but also establishes the effective
date and method of transition.
9. Currently, a simple majority (three out of five) is
required for approval of an Exposure Draft or a
final statement of standards.
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Emerging Issue Task Force

In an effort to overcome the methodical,


sometimes slow, nature of the standard
setting process, in 1984 the FASB
established the Emerging Issues Task
Force (EITF).

The EITF assists the FASB in the early

identification of emerging issues that affect


financial reporting.

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FASB Accounting Standards


Codification

The official source of U.S. GAAP is called


the FASB Accounting Standards
Codification (ASC).

Prior to launching of the FASB ASC in July

2009, finding a specific accounting rule on a


specific topic involved a primitive hunt-andpeck strategy.

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Securities and Exchange


Commission (SEC)
The SEC was created by an act of Congress in

1934.
Its primary role is to regulate the issuance and
trading of securities by corporations to the
general public.
It requires companies to furnish various financial
statements, and other periodic information about
significant events.
The SEC requires companies to have their
external financial statements audited by
independent accountants.
(continued)
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Securities and Exchange


Commission (SEC)

In addition to the SECs rules and interpretive


releases, the SEC staff issues Staff
Accounting Bulletins that represent practices
followed by the staff administering SEC
disclosure requirements.

The auditors of SEC-required financial

information must be registered and periodically


inspected by the Public Company
Accounting Oversight Board (PCAOB).
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American Institute of Certified Public


Accountants (AICPA)
The American Institute of Certified Public

Accountants (AICPA) is the professional


organization of practicing certified public
accountants (CPAs) in the United States.
It publishes the monthly journal, the Journal
of Accountancy.
The AICPA is responsible for preparing and
grading the Uniform CPA Examination.

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American Accounting Association

The American Accounting Association


(AAA) is an organization of accounting
professors.
It sponsors national and regional meetings
where accounting professors discuss
technical research and share innovative
teaching techniques and materials.
It organizes working committees of
professors to study and comment on
accounting standards issues.
(continued)

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American Accounting Association

The AAA publishes a number of academic


journals, including The Accounting
Review and Accounting Horizons.
One of the most significant actions of the
AAA is to motivate and facilitate
curriculum revision to keep pace with the
changes in the accounting profession.

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Internal Revenue Service

The Internal Revenue Service (IRS)


has the primary goal of equitably
collecting revenue.

Although not the same, there are many


areas where tax and financial accounting
are closely related.

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What is GAAP?
Historically, the Auditing Standards Board
of the AICPA has defined Generally
Accepted Accounting Principles (GAAP)
in the context of a phrase included in the
standard auditors opinion:
present fairlyin conformity with generally
accepted accounting principles.

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International Accounting
Standards Board

The international nature of business requires

companies to be able to make their financial


statements understandable to users all over
the world.
In an attempt to harmonize conflicting
standards, the International Accounting
Standards Board (IASB) was formed in 1973
to develop worldwide accounting standards.

(continued)
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International Accounting
Standards Board

Accounting standards issued by the IASB are

referred to as International Financial


Reporting Standards (IFRS) if issued since
2001, and International Accounting
Standards (IAS) if issued prior to 2001.
In 2008 the SEC began allowing non-U.S.
companies with shares trading on U.S. stock
exchanges to issue their financial reports using
IASB standards.
(continued)
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International Accounting
Standards Board

The SEC is considering whether to allow

U.S. companies to use IASB standards,


rather than FASB standards, in the financial
reports that they provide to their U.S.
stockholders.
If this happens, the FASB may cease to
exist.
The SEC work plan does not envision a
U.S. switch to IFRS until 2015 at the earliest.
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Conceptual Framework

A strong theoretical foundation is essential if


accounting practice is to keep pace with a
changing business environment.
The conceptual framework plays a vital role
in the development of new standards and in
the revision of previously issued standards.
The conceptual framework provides a guide
for analyzing and resolving emerging issues.
(continued)
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Concepts Statements
In February 2000, the FASB issued the last of
seven Statements of Financial Accounting
Concepts, which provide the basis for the
conceptual framework.
1) Objectives of Financial Reporting by
Business Enterprises
2) Qualitative Characteristics of Accounting
Information
3) Elements of Financial Statements of
Business Enterprises
(continued)

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Concepts Statements
4) Objectives of Financial Reporting by
Nonbusiness Organizations
5) Recognition and Measurement in
Financial Statements of Business
Enterprises
6) Elements of Financial Statements (a
replacement of No. 3, broadened to
include not-for-profit as well as business
enterprises)
(continued)
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Concepts Statements
7) Using Cash Flow Information and Present
Value in Accounting

(continued)
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Concepts Statements
The seven Concepts Statements addressed
four major areas:
1. Objectives: What are the purposes of
financial reporting?
2. Qualitative characteristics: What are the
qualities of useful financial information?
3. Elements: What is an asset? a liability? a
revenue? an expense?
(continued)
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Conceptual Framework
4. Recognition, measurement, and
reporting: How should the objectives,
qualities, and elements of definitions be
implemented?

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Recognition, Measurement,
and Reporting

RecognitionBoiling down all the

estimates and judgments into one


number and using that number to make a
journal entry.
DisclosureSkipping the journal entry
and just relying on the note to convey the
information to users.

(continued)
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Recognition, Measurement,
and Reporting

Recognition CriteriaFor an item to be


formally recognized, it must meet one of the
definitions of the elements of the financial
statements.
For example, a receivable must meet the
definition of an asset to be recorded and
reported on the balance sheet.
Disclosure is preferable to recognition in
situations in which relevant information cannot
be reliably measured.
(continued)
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Recognition, Measurement,
and Reporting
Five different measurement attributes are
currently used in practice.
1. Historical cost
2. Current replacement cost
3. Fair value
4. Net realizable value
5. Present (or discounted) value

(continued)
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Recognition, Measurement,
and Reporting
ReportingIncluded in the recommended
set of general-purpose financial statements
are reports that show the following:
Financial position at the end of the period
Balance
Sheet

(continued)
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Recognition, Measurement,
and Reporting
ReportingIncluded in the recommended
set of general-purpose financial statements
are reports that show the following:
Financial position at the end of the period
Earnings (net income) for the period
Income
Statement

(continued)
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Recognition, Measurement,
and Reporting
ReportingIncluded in the recommended
set of general-purpose financial statements
are reports that show the following:
Financial position at the end of the period
Earnings (net income) for the period
Cash flows during the period
Statement of
cash flows
(continued)

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Recognition, Measurement,
and Reporting
ReportingIncluded in the recommended
set of general-purpose financial statements
are reportsStatement
that showofthe following:
changes in
position
at the end of the period
Financialowners
equity
Earnings (net income) for the period
Cash flows during the period
Investments by and distributions to
owners during the period

(continued)
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Recognition, Measurement,
and Reporting
ReportingIncluded in the recommended
set of general-purpose financial statements
are reports that show the following:
Financial position at the end of the period
Earnings (net income) for the period
Cash flows during the period
Investments by and distributions to
owners during the period
Comprehensive income (total non-owner
changes in equity) for the period
(continued)
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Recognition, Measurement,
and Reporting

Comprehensive income differs from


earnings in that it includes unrealized
gains and losses not recognized in
the income statement.

In 1998, the FASB required


companies to provide, in at least one
place, information relating to
unrealized gains and losses.
(continued)
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Traditional Assumptions of
the Accounting Model
The FASB conceptual framework is
influenced by five basic assumptions:
1. Economic entity
2. Going concern
3. Arms-length transactions
4. Stable monetary unit
5. Accounting period
(continued)
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Impact of the Conceptual Framework

The conceptual framework provides a


basis for consistent judgments by all
those involved in financial reporting.

Related to the conceptual framework is

the push toward more principles-based


accounting standards.

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Rules vs. Principles


In July 2003, the SEC submitted a report to
Congress recommending that the FASB move
toward objectives-oriented standards which
would have the following characteristics:

Be based on an improved and consistently


applied framework

Clearly state the accounting objective of the


standard
(continued)
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Rules vs. Principles

Provide sufficient detail and structure so that the


standard can be operationalized and applied on
a consistent basis

Minimize exceptions from the standard


Avoid use of percentage tests that allow
financial engineers to achieve technical
compliance with the standard while evading the
intent of the standard

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Careers in Financial Accounting


Public
Public Accounting
Accounting

Pubic accountants do not work for a

single business enterprise. Rather, they


provide a variety of services for many
different individuals and business clients.

The four largest firms are Deloitte &

Touche, Ernst & Young, KPMG, and


PricewaterhouseCoopers.
(continued)
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Careers in Financial Accounting


Corporate
Corporate Accounting
Accounting

A large business enterprise employs


financial accountants who are primarily
concerned with external financial
reporting, management accountants who
are primarily concerned with internal
financial reporting, and tax accountants.
(continued)
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Careers in Financial Accounting


User
User (Analyst,
(Analyst, Banker,
Banker, Consultant)
Consultant)

Credit analysts, investment bankers,


brokers, and business consultants need
a strong working knowledge of
accounting as well as strong skills in
information technology.

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The Importance of
Personal Ethics

The flexibility inherent in the assumptions


underlying the preparation of financial
statements means that an accountant
can intentionally deceive financial
statement users and still be in
compliance with GAAP.

Our financial reporting system is of

limited value if the accountants who


operate the system do not have strong
personal ethics.
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Chapter 1

The
The End
End

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