Professional Documents
Culture Documents
1
Environment and Theoretical Structure of Financial Accounting
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
LO11 Describe the function and primary focus of financial accounting.
LO12 Explain the difference between cash and accrual accounting.
LO13 Define generally accepted accounting principles (GAAP) and discuss the historical
development of accounting standards, including convergence between U.S. and
international standards.
LO14 Explain why the establishment of accounting standards is characterized as a political
process.
LO15 Explain factors that encourage high-quality financial reporting.
LO16 Explain the purpose of the conceptual framework.
LO17 Identify the objective and qualitative characteristics of financial reporting information, and
the elements of financial statements.
LO18 Describe the four basic assumptions underlying GAAP.
LO19 Describe the recognition, measurement and disclosure concepts that guide accounting
practice.
LO110 Contrast a revenue/expense approach and an asset/liability approach to accounting standard
setting.
LO111 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.
CHAPTER HIGHLIGHTS
$385,000
332,000
220,000
40,000
30,000
10,000
In addition, you learn that the company incurred advertising costs of $25,000 in year one, that there
were no liabilities at the end of year one other than the amount owed for advertising, no anticipated
bad debts on receivables, and that the insurance policy purchased covers a three-year period.
Net operating cash flow for year one is determined as follows:
Cash receipts from customers
Cash disbursements:
Salaries
Utilities
Purchase of insurance
Advertising
Net operating cash flow
$332,000
$220,000
40,000
30,000
10,000
300,000
$ 32,000
$385,000
$220,000
40,000
10,000
25,000
295,000
$ 90,000
Ethics in Accounting
Ethics deals with the ability to distinguish right from wrong. Accountants are faced with ethical
dilemmas, just like others operating in the business world. Many accountants belong to
professional organizations that have articulated expected standards of behavior in codes of ethics.
These codes provide guidance and rules to organization members in the performance of their
professional responsibilities.
PART B:
The increasing complexity of business transactions adds to the already difficult task of the FASB of
Student Study Guide
When formulated, this framework will replace the Statements of Financial Accounting Concepts.
The Boards currently are working on the first four phases of the project and only Phase A is
complete. This phase replaces SFAC 1 and SFAC 2. It likely will take several years before the
project is completed.
Faithful
Representation - Exists when there is agreement between a measure or description and the
phenomenon it purports to represent. The ingredients of reliability are:
Completeness - A depiction of an economic phenomenon is complete if it
includes all information that is necessary for faithful representation of the
economic phenomena that it purports to represent.
Neutrality - Assumes the information being relied on does not favor any
particular group of companies nor influence behavior in any specific way.
Free from error We would not expect all measurement to be
error-free. However, the information should be free from material error if it is
to be useful.
Enhancing qualitative characteristics are comparability, consistency, verifiability, timeliness, and
understandability. Comparability is the ability to help users see similarities and differences among
events and conditions, and consistency, the consistent application of accounting principles from
period to period. The ability of investors to compare financial information across companies is
critical to their resource allocation decisions. Consistency enhances the ability of investors and
creditors to compare financial information across time. Verifiability implies a consensus among
different users. Information is timely when it is available to users early enough to allow them to
use it in the decision process. Understandability means that users must understand the information within
the context of the decision being made.
The practical boundary (constraint) to achieving the desired qualitative characteristics is cost
effectiveness. Information is cost effective only if the perceived benefit of increased decision
usefulness exceeds the anticipated costs of providing that information. This is referred to as the
constraint. Conservatism is a frequently cited characteristic of accounting information. It is not,
however, a desired qualitative characteristic but a practical justification for some accounting
choices.
Liabilities
Equity(or net
assets)
Investments by
owners
Distributions to
owners
Comprehensive
income
Revenues
Expenses
Gains
Losses
Underlying Assumptions
The four basic assumptions underlying GAAP are as follows:
Economic Entity Assumption
Going Concern Assumption
Periodicity Assumption
Monetary Unit Assumption
States dollar.
SFAC 5 provides general recognition criteria and essentially confirms existing practice in the area of
measurement. SFAC 5 also confirms some of the more important generally accepted accounting
principles used in practice. These principles are predicated on some important underlying
assumptions.
SFAC 7 provides a framework for using future cash flows in accounting measurements. Present
value measurements have long been associated with accounting valuation. SFAC 7 provides a
framework for using future cash flows as the basis for accounting measurement and also asserts that
the objective in valuing an asset or liability using present value is to approximate the fair value of
that asset or liability.
Disclosure helps ensure that financial reports include any information that could affect users
decisions. Techniques for providing full disclosure include parenthetical comments, disclosure
notes and supplemental schedules and tables.
Evolving GAAP
The realization and matching principles sometimes are described as "income-statement focused,"
because they focus on determining when we recognize revenues and expenses in the income
statement. From this perspective, sometimes referred to as the revenue/expense approach,
principles for recognizing revenues and expenses are emphasized, with assets and liabilities
recognized as necessary to make the balance sheet reconcile with the income statement.
Under the alternative asset/liability approach we first measure the assets and liabilities that exist at
a balance-sheet date and then recognize the revenues, expenses, gains and losses needed to account
for the changes in these assets and liabilities from the previous measurement date. Under this
approach, principles for asset and liability measurement are emphasized, and revenues, expenses,
gains and losses are recognized as necessary to make the balance sheet reconcile with the income
statement. The asset/liability approach encourages standard-setters to focus on accurately
measuring assets and liabilities. It perhaps is not surprising, then, that a focus on assets and
liabilities has led standard-setters to lean more and more toward fair value measurement
2.
The primary means of conveying financial information to investors, creditors, and other
external
users
is
through
and
related
.
3.
The
and
variables in the investment decision.
4.
Even though predicting future cash flows is an important objective, the model best able to
achieve that objective is the
model.
5.
6.
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.
7.
8.
The
body in the United States.
9.
The
FASBs
or
dilemma is to balance
considerations and
considerations resulting from perceived possible adverse economic
consequences.
10. One objective of the
bring about convergence of
11.
International
Accounting
standards and
Standards
Board is
standards.
to
be
relevant,
.
information
must
possess
and/or
The McGraw-Hill Companies, Inc., 2013
1-"
16.
17.
obtained or controlled by a
or other using up of
or incurrences of
during a period from delivering or producing goods, rendering services, or other
activities that constitute the entitys ongoing major or central operations.
22.
23. The
assumption presumes that economic events can be identified
specifically with an economic entity.
24. Another necessary assumption is that, in the absence of information to the contrary, it is
anticipated
that
a
business
entity
will
continue
to
operate
.
25. The realization principle states that revenue should be recognized when the earnings process is
and collection is
.
26.
Answers:
1. profit-oriented, investors, creditors 2. financial statements, disclosure notes
3. expected rate of return, uncertainty, risk 4. accrual accounting 5. net income 6. GAAP 7. SEC
8. Financial Accounting Standards Board 9. accounting, political 10. national accounting,
international accounting 11. Auditors 12. constitution, objectives 13. relevance, faithful
representation 14. predictive value, confirmatory value 15. comparability (including consistency),
verifiability, timeliness, and understandability 16. Faithful representation
Student Study Guide
$655,000
580,000
420,000
55,000
20,000
3,000
The rent on the company offices is $10,000 per year. The $20,000 in payments made in 2013
applies to 2013 and 2014. At the end of the year, $1,000 in supplies were still on hand and
available for future use. Also, in addition to the $55,000 paid for utilities, the company owed
$5,000 for utility cost incurred during 2013 that will not be paid until 2014.
Required:
Calculate the difference between net operating cash flow and net income for 2013.
Solution:
Net operating cash flow for 2013 is determined as follows:
Cash receipts from customers
Cash disbursements:
Salaries
Utilities
Payment of rent
Purchase of supplies
Net operating cash flow
$580,000
$420,000
55,000
20,000
3,000
498,000
$ 82,000
$655,000
$420,000
60,000
10,000
2,000
492,000
163,000
$ 81,000
Exercise 2
Match each of the following characteristics with the phrase most related to that characteristic.
Characteristic
Related Phrase
1. Cost effectiveness
2. Materiality
A. Predictive/confirmatory value.
B. Two accountants independently
measure an asset at the same
3. Relevance
value.
4. Faithful representation
5. Consistency
6. Neutrality
7. Completeness
8. Verifiability
E.
G.
A.
C.
5.
6.
7.
8.
F.
H.
D.
B.
Exercise 3
Match the following concepts with the statement or phrase most closely related to the concept.
Concept
Related Phrase
Answers:
1.
2.
3.
4.
5.
G.
C.
H.
B.
I.
6.
7.
8.
9.
A.
F.
D.
E.
MULTIPLE CHOICE
Enter the letter corresponding to the response that best completes each of the following statements
or questions.
1. The process of providing financial information to external decision makers is referred to
as:
a. Public accounting.
b. Government accounting.
c. Financial accounting.
d. Managerial accounting.
2. Financial statements generally include all of the following except:
a. Income statement.
b. Federal income tax return.
c. Balance sheet.
d. Statement of cash flows.
3. The primary objective of financial reporting is to provide information:
a. About a firm's financing and investing activities.
b. About a firm's management team.
c. About a firm's product lines.
d. Useful in decision making.
4. GAAP includes which of the following pronouncements:
a. Statements of Financial Accounting Standards.
b. Accounting Research Bulletins.
c. Accounting Principles Board Opinions.
d. All of the above.
5. The SEC exerts a continuing influence on the establishment of accounting standards. It
does so primarily by:
a. Monitoring the development of GAAP within the accounting profession and using
its stature to influence that development.
b. Exercising its statutory authority to prescribe external financial reporting
requirements.
c. Allying with the AICPA to lobby the efforts of the FASB.
d. Providing auxiliary funding to the FASB.
6. The documents that set forth fundamental concepts on which financial accounting and
reporting standards will be based are:
a. Statements of Financial Accounting Standards.
b. Statements of Financial Accounting Concepts.
c. Accounting Principles Board Opinions.
d. All of the above.
Student Study Guide
7. The two primary decision-specific qualities that make accounting information useful are:
a. Verifiability and representational faithfulness.
b. Predictive value and feedback value.
c. Cost effectiveness and materiality.
d. Relevance and faithful representation.
8. Relevance requires that information possess predictive and/or:
a. Neutrality.
b. Completeness.
c. Confirmatory value.
d. Freedom from error.
9. The qualitative characteristic that means there is agreement between a measure and a
real-world phenomenon is:
a. Verifiability.
b. Representational faithfulness.
c. Neutrality.
d. Materiality.
10. Which of the following is considered a practical constraint on the qualitative
characteristics?
a. Verifiability.
b. Conservatism.
c. Cost effectiveness.
d. Timeliness.
11. Which of the following characteristics does not describe an asset?
a. Probable future economic benefits.
b. Controlled by an entity.
c. Requires the receipt of cash.
d. Result of a past transaction.
12. Which of the following characteristics does not describe a liability?
a. Result of a past transaction.
b. Probable future sacrifices.
c. Present obligation.
d. Must be legally enforceable.
13. The underlying assumption that presumes a company will continue indefinitely is:
a. Periodicity.
b. Going concern.
c. Economic entity.
d. Monetary unit.
Answers:
1. c.
2. b.
3. d.
4. d.
5. a.
6.
7.
8.
9.
10.
b.
d.
c.
b.
c.
11.
12.
13.
14.
15.
c.
d.
b.
a.
a.
16.
17.
c.
b.