Environmental and
Theoretical Structure
of Financial
Accounting
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Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
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Learning Objectives
Describe the function and primary
focus of financial accounting.
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Financial Accounting Environment
Providers of
Financial Information
Profit-oriented
companies
Not-for-profit
entities
Households
External
User Groups
Relevant
Financial
Information
Investors
Creditors
Employees
Labor unions
Customers
Suppliers
Government
agencies
Financial
intermediaries
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Financial Accounting Environment
Relevant financial information is provided
primarily through financial statements and
related disclosure notes.
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


Balance Sheet
Income Statement
Statement of Cash Flows
Statement of Shareholders’ Equity
The Economic Environment and
Financial Reporting
A sole proprietorship
is owned by a
single individual.
A partnership is
owned by two or
more individuals.
A corporation is owned
by stockholders,
frequently numbering
in the tens of thousands
in large corporations.
A highly-developed system of financial
reporting is necessary to communicate
financial information from a corporation
to its many shareholders.
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Investment-Credit Decisions
A Cash Flow Perspective
Corporate shareholders receive cash from
their investments through . . .
 Periodic dividend distributions from the
corporation.
 The ultimate sale of the ownership shares of
stock.
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Investment-Credit Decisions
A Cash Flow Perspective
Accounting information should help
investors evaluate the amount, timing,
and uncertainty of the enterprise’s
future cash flows.
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Learning Objectives
Explain the difference between
cash and accrual accounting.
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Cash Versus Accrual Accounting
Cash Basis Accounting
Revenue is recognized when cash is received.
Expenses are recognized when cash is paid.
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Cash Versus Accrual Accounting
Cash Basis Accounting
Carter Company has sales on account totaling
$100,000 per year for three years. Carter collected
$50,000 in the first year and $125,000 in the second
and third years. The company prepaid $60,000 for
three years’ rent in the first year. Utilities are $10,000
per year, but in the first year only $5,000 was paid.
Payments to employees are $50,000 per year.
Let’s look at the cash flows.
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Cash Versus Accrual Accounting
Cash Basis Accounting
Year 1
Cash receipts from
customers
$ 50,000
Summary of Cash Flows
Year 2
Year 3
$ 125,000
$ 125,000
Total
$ 300,000
Payment of 3
years' rent
(60,000)
-
-
(60,000)
Salaries to
employees
(50,000)
(50,000)
(50,000)
(150,000)
(5,000)
$ (65,000)
(15,000)
$ 60,000
(10,000)
$ 65,000
(30,000)
$ 60,000
Payments for
utilities
Net cash flow
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Cash Versus Accrual Accounting
Cash Basis Accounting
Year 1
Cash receipts from
customers
$ 50,000
Payment of 3
years' rent
(60,000)
Summary of Cash Flows
Year 2
Year 3
$ 125,000
-
$ 125,000
-
Total
$ 300,000
(60,000)
Salaries to
Cash flows
in any one
year may(50,000)
not be a (150,000)
employees
(50,000)
(50,000)
Payments for
utilities
Net cash flow
predictor of future cash flows.
(5,000)
$ (65,000)
(15,000)
$ 60,000
(10,000)
$ 65,000
(30,000)
$ 60,000
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Cash Versus Accrual Accounting
Accrual Accounting
Revenue is recognized when earned.
Expenses are recognized when incurred.
Let’s reconsider the Carter
Company information.
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Cash Versus Accrual Accounting
Accrual Accounting
Revenue is recognized when earned.
Expenses are recognized when incurred.
Let’s reconsider the Carter
Company information.
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Learning Objectives
Define generally accepted accounting
principles (GAAP) and discuss the historical
development of accounting standards.
The Development of Financial Accounting
and Reporting Standards
Concepts,
principles, and
procedures were
developed to meet the
needs of external
users (GAAP).
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Historical Perspective and Standards
Securities and Exchange Commission
 1934 – present
Evolution of Standard-Setting Process
 1938 – 1959:
Committee on Accounting Procedures (CAP)
 1959 – 1973:
Accounting Principles Board (APB)
Current Standard Setting - FASB
www.fasb.org
 Supported by the Financial Accounting
Foundation.
 Seven full-time, independent voting members
serving for 10 years.
 Answerable only to the Financial Accounting
Foundation.
 Members not required to be CPAs.
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Learning Objectives
Explain why the establishment of
accounting standards is characterized
as a political process.
Establishment of Accounting Standards
A Political Process
Internal Revenue
Service
www.irs.gov
American Institute
of CPAs
www.aicpa.org
Securities and
Exchange
Commission
www.sec.gov
Financial Executives
International
www.fei.org
GAAP
Governmental
Accounting
Standards Board
www.gasb.org
American
Accounting
Association
www.aaa-edu.org
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FASB’s Standard-Setting Process
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


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

Identification of problem.
The task force.
Research and analysis.
Discussion memorandum.
Public response.
Exposure draft.
Public response.
Statement issued.
International Accounting Standards
Board (IASB)
 Established in 1973 to narrow the
range of differences in accounting
standards.
 Increase in international trade has
motivated the IASB to attempt to
eliminate alternative accounting
treatments.
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Role of the Auditor
Independent intermediary to help insure that
management has in fact appropriately
applied GAAP.
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Financial Reporting Reform
As a result of numerous financial scandals,
Congress passed the Public Company
Accounting Reform and Investor Protection
Act of 2002, commonly referred to as the
Sarbanes-Oxley Act for the two congressmen
who sponsored the bill.
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Learning Objectives
Explain the purpose of the
FASB’s conceptual framework.
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The Conceptual Framework
 Maintain consistency among standards.
 Resolve new accounting problems.
 Provide user benefits.
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Learning Objectives
Identify the objectives of financial reporting, the
qualitative characteristics of accounting
information, and the elements of financial
statements.
Describe the four basic
assumptions underlying GAAP
Describe the four basic accounting
principles that guide accounting practice.
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The Conceptual Framework
Objectives of Financial Reporting
(SFAC No. 1)
Qualitative Characteristics
of Accounting Information
Elements of
Financial Statements
(SFAC No. 2)
(SFAC No. 6)
Recognition and Measurement Criteria
(SFAC No. 5)
Environment
assumptions
Implementation
principles
Implementation
constraints
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Conceptual Framework
Objectives
To provide information:
Useful for investor and creditor decisions.
That helps predict cash flows.
About economic resources, claims to resources,
and changes in resources and claims.
Qualitative
Characteristics
Constraints
Elements
Financial
Statements
Recognition and
Measurement
Concepts
Continued
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Objectives
Qualitative
Characteristics
Understandability
Primary
Relevance
Reliability
Secondary
Comparability
Consistency
Elements
Assets
Liabilities
Equity
Investments by Owners
Distributions to owners
Revenues
Expenses
Gains
Losses
Comprehensive Income
Financial Statements
Constraints
Cost effectiveness
Materiality
Conservatism
Balance sheet
Income statement
Statement of cash flows
Statement of shareholders’ equity
Related disclosures
Recognition and
Measurement
Concepts
Assumptions
Economic entity
Going concern
Periodicity
Monetary unit
Principles
Historical cost
Realization
Matching
Full Disclosure
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Qualitative Characteristics of
Accounting Information
Decision Usefulness
Relevance
Predictive
Value
Feedback
Value
Comparability
Reliability
Timeliness
Verifiability
Neutrality
Consistency
Representational
Faithfulness
Practical Constraints to Achieving
Desired Qualitative Characteristics
Conservatism
Cost
Effectiveness
Materiality
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SFAC No. 6
Assets and Liabilities
Assets are probable future economic benefits
obtained or controlled by a particular entity as a
result of past transactions or events.
Liabilities are probable future sacrifices of
economic benefits arising from present
obligations of a particular entity to transfer or
provide services to other entities in the future as
a result of past transactions or events.
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SFAC No. 6
Equity
Equity, or net assets, called shareholders’
equity or stockholders’ equity for a
corporation, is the residual interest in the
assets of an entity that remains after
deducting liabilities.
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SFAC No. 6
Investments and Distributions
Investments by owners are increases in
equity resulting from transfers of resources
(usually cash) to a company in exchange
for ownership interest.
Distributions to owners are decreases in
equity resulting from transfers to the
owners.
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SFAC No. 6
Revenues
Revenues are inflows or other
enhancements of assets or settlements of
liabilities from delivering or producing
goods, rendering services, or other
activities that constitute the entity’s
ongoing major, or central, operations.
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SFAC No. 6
Expenses
Expenses are outflows or other using up of
assets or incurrences of liabilities during a
period from delivering or producing goods,
rendering services, or other activities that
constitute the entity’s ongoing major, or
central, operations.
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SFAC No. 6
Gains and Losses
Gains are increases in equity peripheral, or
incidental, transactions of an entity.
Losses represent decreases in equity arising
from peripheral, or incidental, transactions
of an entity.
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SFAC No. 6
Comprehensive Income
Comprehensive income is the change in equity
of a business enterprise during a period from
transactions and other events and
circumstances from nonowner sources. It
includes all changes in equity during a period
except those resulting from investments from
owners and distributions to owners.
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Recognition and Measurement Concepts
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Question
The function of financial accounting is to
identify, measure and communicate
financial information about economic
entities to interested parties.
a. True
b. False
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Question
The function of financial accounting is to
identify, measure and communicate
financial information about economic
entities to interested parties.
a. True
b. False
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Question
Accrual accounting provides a better
indication of ability to generate cash flows
than does information limited to the
financial effects of cash receipts and cash
payments.
a. True
b. False
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Question
Accrual accounting provides a better
indication of ability to generate cash flows
than does information limited to the
financial effects of cash receipts and cash
payments.
a. True
b. False
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Question
The primary objective of accrual basis
accounting is the measurement of income.
a. True
b. False
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Question
The primary objective of accrual basis
accounting is the measurement of income.
a. True
b. False
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Question
Generally accepted accounting principles
include both standards set by various rule
making bodies and certain accounting
practices that have evolved over time.
a. True
b. False
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Question
Generally accepted accounting principles
include both standards set by various rule
making bodies and certain accounting
practices that have evolved over time.
a. True
b. False
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Question
The major financial accounting standard
setting body is the
a. Accounting Principles Board
b. Securities and Exchange Commission
c. Financial Accounting Standards Board
d. American Institute of CPAs
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Question
The major financial accounting standard
setting body is the
a. Accounting Principles Board
b. Securities and Exchange Commission
c. Financial Accounting Standards Board
d. American Institute of CPAs
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Question
The FASB issues which of the following
types of pronouncements?
a.
b.
c.
d.
e.
Standards
Interpretations
Financial Accounting Concepts
Technical Bulletins
All of the above
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Question
The FASB issues which of the following
types of pronouncements?
a.
b.
c.
d.
e.
Standards
Interpretations
Financial Accounting Concepts
Technical Bulletins
All of the above
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Question
The Financial Accounting Standards Board
develops accounting and reporting
standards independent of public, business
and political pressures.
a. True
b. False
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Question
The Financial Accounting Standards Board
develops accounting and reporting
standards independent of public, business
and political pressures.
a. True
b. False
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Ethics in Accounting
 To be useful, accounting information must be
objective and reliable.
 Management may be under pressure to report
desired results and ignore or bend existing rules.
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Model for Ethical Decisions
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
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


Determine the facts of the situation.
Identify the ethical issue and the stakeholders.
Identify the values related to the situation.
Specify the alternative courses of action.
Evaluate the courses of action.
Identify the consequences of each course of action.
Make your decision and take any indicated action.
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End of Chapter 1