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Financial Reporting

Chapter 1

S t I c e | S t I c e | S k o u s e n

Intermediate Accounting

16E

Learning Objectives

1. Describe the purpose of financial reporting and identify the primary financial statements.

2. Explain the function of accounting standards and describe the role of the FASB in setting those standards in the United States.

3. Recognize the importance of the SEC, AICPA, AAA and IRS to financial reporting.

Learning Objectives (cont.)

4. Realize the growing importance and relevance of international accounting issues to the practice of accounting in the United States and understand the role of the IASB in international accounting standard setting.

5. Understand the significance of the FASB’s conceptual framework in outlining the qualities of good accounting information, defining terms such as asset and revenue, and providing guidance about appropriate recognition, measurement, and reporting.

6. Identify career opportunities related to accounting and financial reporting and understand the importance of personal ethics in the practice of accounting.

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, p. 8)

Key Features

• Provides a vital service in today’s business environment.

• Uses quantitative financial information in conjunction with qualitative evaluations to help make decisions.

• Helps in decision making for scarce resources.

• Impacts economic decisions about the future by analyzing past information.

Accounting:

Users of Accounting Information

• Stakeholders are all parties interested in the financial health of a company.

• Internal users make decisions that directly affect the internal operations of the company.

• External users make decisions concerning their relationship to the enterprise.

Users of Financial Information

InvestorsCommunity

Board of DirectorsManagement

EmployeesSuppliers

Employees

CreditorsCustomers

Analysts

Government

Internal UsersExternal Users

Branches of Accounting

• Management accounting deals with financial reporting for internal users- especially management.

• Financial accounting focuses on creating and communicating financial information for external users.

Financial Reporting

The balance sheet reports, as of a certain point in time, the resources of a company (the assets), the company’s obligations (the liabilities), and the equity of the owners.

The balance sheet reports, as of a certain point in time, the resources of a company (the assets), the company’s obligations (the liabilities), and the equity of the owners.

The income statement reports, for a specified interval, the net assets generated through business operations (revenues), the net assets consumed (the expenses), and the net income.

The income statement reports, for a specified interval, the net assets generated through business operations (revenues), the net assets consumed (the expenses), and the net income.

The statement of cash flows reports, for a specified time period, the amount of cash generated and consumed by a company through operating, financing, and investing activities.

The statement of cash flows reports, for a specified time period, the amount of cash generated and consumed by a company through operating, financing, and investing activities.

Accounting estimates and judgments are outlined in the notes to financial statements.

Stop & Think

In addition to the financial statements, the

management of a company has a variety of

other methods of communicating financial information to external users. Which ONE of

the following is NOT one of those methods?

Auditor’s Role

• Auditors working independently of a company’s management and internal accountants examine the financial statements

• They issue an auditor’s opinion about the fairness of the statements and their adherence to proper accounting principles.

Types of Audit Opinions

• Unqualified opinion - the financial statements are presented in accordance with GAAP.

• Qualified opinion- except for the effects of the qualified item, the financial statements are presented in conformity with GAAP.

• No opinion – no opinion is expressed about the financial statements.

• Adverse opinion- the financial statements do not present information in conformity with GAAP.

IAPCGASAC FASAC FASB

FAF SEC

AcSEC

AICPA

IASC

Other

EITF

GASB U.S. Gov't

Accounting Standards Setting Organizations

Securities Exchange Commission (SEC)

• 1929 stock market crash blamed on nonstandard accounting.

• 1933 Securities Act established SEC to standardize accounting.

• Created to protect the interests of investors by ensuring full and fair disclosure.

• Granted legal authority to dictate GAAP.• Has tended to defer setting GAAP to the

accounting profession.

Securities Exchange Commission (SEC)

• Financial Reporting Releases – official statements which are accounting interpretations and policies the SEC uses in evaluating firms’ disclosure policies.

• Other Authoritative Literature:• Staff Accounting Bulletins• Accounting and Auditing Enforcement Releases• Accounting Series Releases

IAPCGASAC FASAC FASB

FAF SEC

AcSEC

AICPA

IASC

Other

EITF

GASB U.S. Gov't

Accounting Standards Setting Organizations

Financial Accounting Standards Board (FASB)

• A private sector body responsible for the US accounting standards (also known as GAAP).

• Seven full-time members comprise this independent body.

• Issues Statements of Financial Accounting Standards.

• Determines GAAP by “due process.”• Works within the Conceptual Framework.

FASB “Due Process”

1. Topic or project added to agenda.2. Task force assembled to study topic.3. Research and analysis performed by

FASB technical staff.4. Discussion Memorandum (DM) drafted

and released.5. Public hearing, usually 60 days later, is

held.6. Board analyzes and evaluates public

response.

FASB “Due Process” (cont.)

7. Exposure Draft (ED) prepared and released.

8. Sixty-day exposure period allows for public comment.

9. Committee studies public response to exposure draft and prepares final draft.

10.Board votes on final draft leads to either the issuance of a Statement of Financial Accounting Standard, a revised Exposure Draft, or abandonment of the project.

In an effort to overcome the slow process of standard setting, in 1984 the FASB established the Emerging Issues Task Force (EITF) to assist the FASB in identifying the emerging

issues that affect financial reporting.

In an effort to overcome the slow process of standard setting, in 1984 the FASB established the Emerging Issues Task Force (EITF) to assist the FASB in identifying the emerging

issues that affect financial reporting.

Emerging Issue Task Force

Statement PreparersStatement Preparers• Financial ExecutivesFinancial Executives

InstituteInstitute• IMAIMA• Individual CorpsIndividual Corps

FASB

Gov’t RegulatorsGov’t Regulators• SECSEC• State Boards State Boards

of Public Acct.of Public Acct.

• American Acct.American Acct.InstructorsInstructors

AssociationAssociation

AuditorsAuditors• AICPAAICPA• State societies of State societies of

CPAsCPAs• Major audit firmsMajor audit firms

FASB Authority Sources

Congress SEC

FASB

Registrant

Companies

FASB Authority Sources- SEC

American Institute of Certified Public Accountants (AICPA)

• Professional organization of practicing CPAs in the United States

• Responsibilities include:– certification– continuing education– quality control– standard setting

Internal Revenue Service

• The Internal Revenue Service (IRS) has the primary goal of equitable collecting revenue.

• Although not the same, there are many areas where tax and financial accounting are related.

What is GAAP?

• With so many different bodies creating authoritative literature, what is GAAP?

International Accounting Standards Board (IASB)

• Formed in 1973 to harmonize conflicting worldwide standards.

• Similar to FASB, IASB develops pronouncements after feedback sessions.

• Board members are representatives from the US, UK, France, Germany, Sweden, Canada, Australia, South Africa and Japan.

• IASB standards are called International Financial Reporting Standards (IFRSs).

Stop & Think

Consider these four organizations:

FASB, AICPA, SEC, and IASB.

Which one do you think will be making U.S. GAAP 20 years from

now?

Conceptual Framework

• Concepts guide the field in developing new accounting policies for a changing business world.

• When accountants face issues not covered by GAAP, they are to look to the conceptual framework as a guide.

• This framework can be traced to early AAA publications in 1936.

Concepts Statements

• In 2000, FASB issued Statements of Financial Accounting Concepts which 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?

4. Recognition, measurement, and reporting: How should the objectives, qualities and elements definitions be implemented?

Conceptual Framework of Accounting

Objectivesof FinancialReporting

QualitativeCharacteristicsof Information

Accounting

Elementsof FinancialStatements

Recognition and Measurement Concepts

Assumptions ConstraintsPrinciples

Objectives of Financial Reporting

• Usefulness.• Understandability.• Target audience: investors and

creditors.• Assessing future cash flows.• Evaluating economic resources.• Primary focus on earnings.


UsefulnessUsefulnessUsefulnessUsefulnessFinancial reporting should provide information that is

useful to present and potential investors and creditors and

other users in making rational investment, credit, and similar

decisions.


UnderstandabilityUnderstandabilityUnderstandabilityUnderstandability

Financial reporting should provide information that is understandable

to one who has a reasonable knowledge of accounting and business and who is willing to

study and analyze the information presented.


Target AudienceTarget AudienceTarget AudienceTarget Audience

While there are many potential users of

financial reports, the objectives are directed

primarily toward investors and creditors.


Assessing Future Cash FlowsAssessing Future Cash FlowsAssessing Future Cash FlowsAssessing Future Cash Flows

Financial reporting should provide information that is

useful in assessing amounts, timing, and uncertainty (risk) of

prospective cash flows.


Evaluating Economic ResourcesEvaluating Economic ResourcesEvaluating Economic ResourcesEvaluating Economic ResourcesFinancial reporting should also provide information about an enterprise’s assets, liabilities,

and owners’ equity to help investors, creditors, and others evaluate the financial strengths

and weaknesses of the enterprise and its liquidity and

solvency.


Primary Focus on EarningsPrimary Focus on EarningsPrimary Focus on EarningsPrimary Focus on EarningsInformation about enterprise

earnings, measured by accrual accounting, generally provides a

better basis for forecasting future performance than does information about current cash

receipts and disbursements.

Qualitative Characteristics of Accounting Information

• Benefits greater than cost

• Relevance• Reliability• Comparability• Materiality



Benefits Greater Than CostsBenefits Greater Than CostsBenefits Greater Than CostsBenefits Greater Than Costs

The information must be worth the time and

research required to gather and interpret the

information.


RelevanceRelevanceRelevanceRelevance

The information must “make a difference”. It

must carry the qualities of:

•Feedback value

•Predictive value

•Timeliness.


ReliabilityReliabilityReliabilityReliability

The information must be relatively free from error and represent what

it claims to represent. It must have:

•Verifiability

•Representational faithfulness

•Neutrality.


ComparabilityComparabilityComparabilityComparability

The information must be relatable to a benchmark or

standard. Similar events must be accounted for in the same

manner on the financial statements for different

companies and for different periods.


MaterialityMaterialityMaterialityMateriality

Is the item large enough to influence the decision of a

user of information? This can never be summarized to a

simple numerical benchmark so the accountant must make

a judgment based on the company or industry data.


ConservatismConservatismConservatismConservatism

The concept of conservatism can be summarized as follows: When in doubt, recognize all

losses but don’t recognize any gains.

Elements of Financial Statements

Recognition

• Recognition- Taking all the estimates and judgments into one number and using that number to make a journal entry.

• Recognition Criteria- For an item to be formally recognized, it must meet one of the definitions of the elements of the financial statements.– For example, revenue must meet the definition

of revenue to be recorded and reported on the income statement.

• Disclosure- Skipping the journal entry and just relying on the note to convey the information to users.

Measurement

• Five attributes of measurement:1. Historical cost2. Current replacement cost3. Current market value4. Net realizable value5. Present (or discounted) value

Reporting

• To meet the objectives of financial reporting, a full set of financial statements should include:

1. Financial position at the end of the period2. Earnings (net income) for the period3. Cash flows during the period4. Investments by and distributions to

owners during the period5. Comprehensive income for the period

Traditional Assumptions

• Underlying assumptions not addressed in the framework:

1. Economic entity2. Going concern3. Arm’s-length transactions4. Stable monetary unit5. Accounting period

Careers in Financial Accounting

1. Public Accounting

2. Corporate Accounting

3. User (analyst, banker, consultant

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