S1 (13E) - C01 - Introduction To Financial Reporting

© 2013 Cengage Learning. All Rights Reserved.
May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or
otherwise on a password-protected website for classroom use.
Chapter
1
Introduction to Financial
Reporting
© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for
use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for
classroom use.
Development of GAAP in the United
States
• Generally Accepted Accounting Principles
(GAAP)
– Have substantial authoritative support
• Major parties involved in development of GAAP
– The Securities and Exchange Commission (SEC)
– The American Institute of Certified Public Accountants
(AICPA)
– The Financial Accounting Standards Board (FASB)
© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain
product or service or otherwise on a password-protected website for classroom use.
Statutory Financial Reports
Form 10-K (Annual Report)
10-Q (Quarterly Report)
20-F (Registration Statement/ Annual Report

[Foreign])
8-K (Current Report)
14-A (Proxy Statement/Prospectus)
Other SEC Filings
Development of GAAP in the United
States—Continued
• Securities Act of 1933
– To regulate the initial offerings and sale of securities
in interstate commerce
• Securities Exchange Act of 1934
– Regulate securities traded on national exchanges
– Created the Securities and Exchange Commission
(SEC)
• SEC has the authority to determine GAAP
• SEC issues Regulation S-X, which describes disclosure
requirements for companies
Securities and Exchange Commission
(SEC)
• Has the authority to determine GAAP and to
regulate the accounting profession
• Issues Regulation S-X, which describes
disclosure requirements for companies
• Issues Financial Reporting Releases (FRRs)
that pertain to financial reporting requirements
American Institute of Certified Public
Accountants (AICPA)
• Is a professional accounting organization whose
members are certified public accountants
(CPAs)
• Established two standing committees in 1939
– Committee on Accounting Procedures
– Committee on Accounting Terminology
• AICPA replaced the two committees in 1959
with:
– Accounting Principles Board (APB)
– Accounting Research Division
AICPA’s Role in GAAP
Organization(s) Period Issued
Committee on
51 Accounting
Accounting Procedures
1939–1959 Research Bulletins
& Committee on
(ARBs)
Accounting Terminology
31 Opinions
Accounting Principles
1959–1973 (APBOs) and 4
Board (APB)
Statements (APBSs)
Accounting Research 14 Accounting
1959–1973
Division Research Studies
Financial Accounting Standards Board
(FASB)
• Issues four types of pronouncements
– Statements of Financial Accounting Standards
(SFASs)
– Interpretations of SFASs, APBOs, and ARBs
– Technical Bulletins
– Statement of Financial Accounting Concepts (SFACs)
• Output of the FASB’s Conceptual Framework project
• Not a part of GAAP
Exhibit 1-1—Structure of The FASB
Operating Procedure for SFAS
• Topic is added to the technical agenda
• Public comments solicited
– Discussion Memorandum
– Invitation to Comment
– Holds hearing to review comments
• Issues Exposure Draft (ED)
FASB Conceptual Framework
• A system of interrelated objectives and
underlying concepts
• Serves as the basis for evaluating existing
standards of financial accounting and reporting
• Statements of Financial Accounting Concepts
(SFACs)
– Provide the Board with common foundation for
considering merits of alternative accounting principles
• FASB intends to evaluate current principles in
terms of the concepts established
SFAC 1: Objectives of Financial
Reporting
• Provide information useful in making business
and economic decisions
• Information is comprehensible to those having a
reasonable understanding of business and
economic activities
• Helps users to assess future cash flows
• Primary focus is on earnings and its components
• Information is provided about economic
resources and the claims against those
resources
Exhibit 1-2—A Hierarchy of Accounting
Qualities
SFAC 6: Elements of Financial
Statements
• Assets
– Probable future economic benefits obtained or
controlled as a result of past business transactions
• Liabilities
– Obligations to transfer assets or provide services in
the future as a result of past business transactions
• Equity
– The residual interest in the assets after deducting
liabilities
Statements—Continued
• Investments by owners
– Increases in the equity due to transfers of value to
obtain or increase ownership interests (or equity) in it
• Distribution to owners
– Decrease in equity resulting from transferring assets,
rendering services, or incurrence of liabilities by the
enterprise to owners
• Comprehensive income
– The change in equity during a period due to
transactions, events, and circumstances from
nonowner sources
• Revenues
– Inflows and other enhancements of assets or
settlements of liabilities from delivering or providing
goods, rendering services, or carrying out other
activities related to the central operations
• Expenses
– Outflows or consumption of assets or incurrence of
liabilities from delivering or providing goods, rendering
services, or carrying out other activities related to the
central operations
• Gains
– Increases in equity from peripheral or incidental
transactions of an entity
• Losses
– Decreases in equity from peripheral or incidental
transactions of an entity
SFAC 5: Recognition and Measurement
• To be recognized, an item should meet the

following criteria
– Fits in to a definition of elements
– Measurable with sufficient reliability
– Information should be relevant
– Information should be reliable
—Continued
• The five different measurement attributes used
are
– Historical cost (historical proceeds)
– Current cost
– Current market value
– Net realizable (settlement) value
– Present (or discounted) value of future cash flows
—Continued
• A full set of financial statements for a period
should show the following
– Financial position at the end of the period
– Earnings (net income)
– Comprehensive income (total nonowner change in
equity)
– Cash flows during the period
– Investments by and distributions to owners during the
period
Additional Input from AICPA
• Accounting Standards Executive Committee
(AcSEC) serves as the official voice of the
AICPA
• Accounting Standards Division published
numerous documents
– Industry Audit Guides
– Industry Accounting Guides Sources of GAAP
– Statements of Position (SOPs)
Emerging Issues Task Force (EITF)
• Established by the FASB in July 1984
• Identifies
– Emerging issues affecting reporting
– Problems in implementing authoritative
pronouncements
• Capable of reviewing a number of issues within
a relatively short time
• Issues statements that are part of GAAP
A New Reality
• Major financial frauds
– Enron
– WorldCom
• Such frauds led to the legislation called
Sarbanes-Oxley Act of 2002
– Section 404 requires companies to document
adequate internal controls and procedures
– Must be able to assess the effectiveness of the
internal controls and financial reporting
Annual Report on Internal Control
Systems
• Required by the SEC to include the following:
– A statement of management’s responsibilities for
establishing and maintaining an adequate system
– Identification of the framework used to evaluate the
internal controls
– A statement as to whether or not the internal control
system is effective as of year-end
– The disclosure of any material weaknesses
– A statement that the company’s auditors have issued
an audit report on management’s assessment
The Public Company Accounting
Oversight Board (PCAOB)
• Created by the Sarbanes-Oxley Act
• Consists of 5 members—2 CPAs, 3 non-CPAs
• Promulgates auditing standards for companies
subject to the Sarbanes-Oxley Act
– Impact on the AICPA’s role in setting auditing
standards
• Fee-based financial support
• CEOs and CFOs must certify the financial
statement disclosures
FASB Accounting Standards
Codification™
• Provides a single source of authoritative U.S.
GAAP
• 2009 Codification is organized in a tiered
structure
– Organized into eight areas from industry-specific to
general financial statement matters
– Provides electronic real time updates
Traditional Assumptions
of the Accounting Model
• Business Entity • Matching
• Going Concern or • Consistency
Continuity • Full Disclosure
• Time Period • Materiality
• Monetary Unit • Industry Practices
• Historical Cost • Transaction Approach
• Conservatism • Cash Basis
• Realization • Accrual Basis
Business Entity
• The business entity is separate and distinct from
the owners of the entity
• The entity is an economic unit that stands on its
own
Going Concern or Continuity
• The entity will remain in business for an
indefinite period of time
• Disregards possibility of bankruptcy or
liquidation
• Impacts how assets and liabilities are measured
and reported
• In case of a threat of liquidation or bankruptcy,
financial statements must disclose that the
presumption of continuity is not applicable
Time Period
• Finite reporting periods applied to the presumed
indefinite life of a business
– Natural business year
– Calendar year
– Fiscal year
• Allows measurement of the results of operations
prior to the liquidation of a business entity’s life
Monetary Unit
• Standard of measure for financial transactions
• U.S. dollar for domestic entities
• Inflation: The loss in value of money
• For countries with significant inflation, financial
statements are adjusted by an inflation factor
Historical Cost
• Often used because it is objective and
determinable
• Acceptable deviations
– When it becomes apparent that the historical cost
cannot be recovered (justified by the conservatism
concept)
– Where specific standards call for another
measurement attribute such as current market value,
net realizable value, or present value
Conservatism
• Select from various measures of value, each
having reasonable support
• Conservatism guides selection of the alternative
that has the
– Least favorable impact on net income and financial
position
Realization
• In general, the point of recognition of revenue
should be the point in time when revenue can be
reasonably and objectively determined
• Point of sale
– Earning process is virtually complete, and the
exchange value is determined
• End of production
– Recognition of revenue is acceptable when the price
of item is known and a ready market exists
Realization—Continued
• Receipt of cash
– It is used when collection cannot be reasonably
estimated
• During production
– Revenue is recognized proportional to effort
• Cost recovery
– Acceptable for highly speculative transactions
• There are many other acceptable methods of
recognizing revenue that are usually industry-
specific
Matching
• Match revenue recognized with costs associated
• Direct association (i.e., inventory sales and cost
of the inventory)
• Costs that have no direct connection with
revenue
– Systematic recognition, usually in the period incurred
Consistency
• Same accounting treatment should be given to
comparable transactions from period to period
• Helps make financial reports comparable
• Supports trend analysis
• If a change is made
– Justification of change is disclosed
– Impact of the change on the financial must be
explained
Full Disclosure
• Accounting reports must disclose all the facts
that may influence the judgment of an informed
reader
• Methods of disclosure
– Parenthetical explanations
– Supporting schedules
– Cross-references
– Notes
• Reasonable summarization of significant
financial information is required
Materiality
• Considers the relative size and importance of an
item to the business entity
• Immaterial items not subject to concepts and
principles
– Handle in most economical and expedient manner
• Does the information influence an informed
reader of the financial statements?
– Yes, if it is material
– No, if it is immaterial
Industry Practices
• Industry-specific reports
• Do not conform to general accounting guidelines
– Government regulation
– Unique needs or peculiarities of an industry
• Effort to minimize but will probably never be
completely eliminated
Transaction Approach
• Record transactions that
– Affect the financial position of the entity
– Can be reasonably determined in monetary terms
• Many transactions are nonmonetary in nature
– Not recorded
– May be disclosed in compliance with “full disclosure”
assumption
Cash Basis
• Recognize revenue when cash is received
• Recognize expense when cash is paid
• Usually does not provide reasonable information
about the earning capability of the entity in the
short run
• Acceptability
– Usually not accepted by GAAP
– May be used if difference between cash basis and
accrual basis is not material
Accrual Basis
• Revenue recognized when realized (realization
concept)
• Expenses recognized when incurred (matching
concept)
• Numerous year-end adjustments required
• More complex than cash basis
• Result is more representational of financial
condition
• Supports the time period assumption
Accrual vs. Cash Basis Accounting
(Example)
• Sold inventory for $25,000 on credit, which cost
$12,500
• Purchase inventory of $30,000 on credit
• Paid suppliers $18,000 for inventory this year
• Collected $15,000 from previous sales
Accrual Basis Cash Basis

Sales $ 25,000 Receipts $ 15,000
Cost of Sales (12,500) Expenditures (18,000)
Income $ 12,500 Loss $ (3,000)
• Accruals-The Cornerstone
• Accruals and Cash Flows - Myths
o Myth: Since company value depends on future cash
flows, only current cash flows are relevant for
valuation.
o Myth: All cash flows are value relevant.
o Myth: All accrual accounting adjustments are value
irrelevant.
o Myth: Cash flows cannot be manipulated.
o Myth: All income is manipulated.
o Myth: It is impossible to consistently manage
income upward in the long run.
Accruals-The Cornerstone
• Accruals and Cash Flows - Truths
o Truth: Accrual accounting (income) is more

relevant than cash flow.
o Truth: Cash flows are more reliable than
accruals.
o Truth: Accrual accounting numbers are subject
to accounting distortions.
o Truth: Company value can be determined by
using accrual accounting numbers.
Harmonization of International
Accounting Standards
• Domestic accounting standards have developed
to meet the needs of domestic environments
• Increased interest in the harmonization due to
expansion of international business and global
capital markets
Organizations Involved in
Harmonization
• The United Nations (UN) appointed a group to
study harmonization in 1973
– To facilitate development of standards
• Other organizations
– FASB
– European Economic Community (EEC)
– Organization for Economic Cooperation and
Development (OECD)
– International Federation of Accountants (IFAC)
– International Accounting Standards Committee (IASC)
International Accounting Standards
Committee (IASC)
• Formed in 1973
• Issued International Accounting Standards (IAS)
from 1973 to 2000
• Objectives include
– Developing international accounting standards and
disclosure
– Developing standards to meet the needs of
developing and newly industrialized countries
– Working toward increased comparability between
national and international accounting standards
International Accounting Standards
Board (IASB)
• Replaced the IASC in 2001
• Standards have been adopted in whole or in part
by approximately 100 countries
– But does not have authority to enforce its standards
• Issues International Financial Reporting
Standards (IFRSs)
– IFRSs now refers to the entire body of international
standards
• Employs a due-process procedure similar to that
of the FASB to issue standards
Convergence
• The FASB and the IASB met jointly in Norwalk,
Connecticut, 2002
– Commit to the development of high-quality,
compatible accounting standards
• Other joint meetings reaffirmed their
commitment and agreed to the convergence of
U.S. GAAP and IFRS
• 2007 agreement between US and European
Union allowed companies to drop US GAAP if
financial statements were prepared by IFRS
Financial Reporting Standards for
SMEs
• IASB published an IFRS for Small and Medium-
Sized Entities (SMEs) in 2009
• A blue ribbon panel on Private Company
Financial Reporting was appointed in 2010
– The panel made recommendations to the Financial
Accounting Foundation (FAF)
• For a new, separate board with standard setting authority
under the oversight of the FAF
• Changes and modifications to GAAP recognizing the unique
needs of users of private company financial statements

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© 2013 Cengage Learning. All Rights Reserved.

20-F (Registration Statement/ Annual Report

8-K (Current Report)

14-A (Proxy Statement/Prospectus)

Other SEC Filings

• To be recognized, an item should meet the

Accrual Basis Cash Basis

o Truth: Accrual accounting (income) is more

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