FIN400 - Chapter 1: Introduction To Financial Reporting

FIN400 - Chapter 1
Introduction to
Financial Reporting
COPYRIGHT ©2011 South-Western, a part of Cengage Learning.

GAAP
• Generally Accepted Accounting Principles

(GAAP) in United States
• Major Sources of GAAP

– Securities and Exchange Commission (SEC)
– American Institute of Certified Public Accountants
(AICPA)
– Financial Accounting Standards Board (FASB)
Copyright 2011 by South-Western, a part of Cengage Learning. All rights reserved. Chapter 1, Slide #2
Securities and Exchange Commission
• Securities Act of 1933

– Regulates IPOs (initial public offerings)
• Securities Exchange Act of 1934

– Regulates secondary market and national
exchanges
– SEC was created by this Act
• SEC has the authority to determine GAAP
• Regulation S-X describes disclosure requirements
AICPA’s Role in GAAP
Years of
Organization Activity Issued
Accounting
Committees on
Research
Accounting Procedures 1939...1959
Bulletins
& Terminology
(ARBs)
Accounting Principles APB Opinions
1959...1973
Board (APBOs)
The FASB
• Financial Accounting Standards Board

• Electors from AICPA, the Financial Executives
Institute, the Institute of Management
Accountants, the Financial Analysts Federation,
the American Accounting Association, the
Security Industry Association, and three not-for-
profit organizations.
FASB Structure
Exhibit 1-1
The FASB
• Promulgates GAAP
– SFASs: Statements of Financial Accounting
Standards
– Interpretations of SFASs, APBOs, and ARBs
– Technical Bulletins
– Statement of Financial Accounting Concepts
• Conceptual Framework
– Statements of Accounting Concepts (not GAAP)
FASB Operating Procedure
• Topic is added to the technical agenda
• Public comments solicited

– Discussion Memorandum
– Invitation to Comment
– Holds hearing to review comments
• Issues Exposure Draft

• Five out of seven members must approve
• Might take two years for developing a statement
FASB Conceptual Framework
(SFAC 1)
Objectives of Financial Reporting are:

•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 earnings and its components
•Information is provided about economic resources and
the claims against those resources
A Hierarchy of Accounting Qualities (SFAC2)
Exhibit 1-2
Source: “Qualitative Characteristics of

Accounting Information.” Adapted from Figure
1 in FASB Statement of Financial Accounting
Copyright 2011 by South-Western, a part of Cengage Learning. All rights reserved. Concepts No. 2 (Stamford, Conn.:
Chapter 1, Financial
Slide #10
Accounting Standards Board, 1980).
Elements of Financial Statements
(SFAC 6)
• Assets
– Probable future economic benefits obtained or
controlled; the result of past business transactions
• Liabilities
– Obligations to transfer assets or provide services in
the future; the result of past business transactions
• Equity
– The owner’s residual interest in the assets after
deducting liabilities
(SFAC 6) (con’t)
• Investments by owners
– Increases in equity due to transfers of value for the
purpose of obtaining or increasing ownership
• Distribution to owners
– Decrease in equity resulting from transfer of asset,
rendering of service, or incurrence of liabilities by
the entity to owners
• Comprehensive income
– The change in equity during a period due to
nonowner transactions, events, and circumstances
(SFAC 6) (con’t)
• Revenues
– Inflows and other enhancements of revenue or reductions of
liabilities from delivering or providing goods or services related
to the central operations
• Expenses
– Outflows or consumption of assets from delivering or providing
goods or services related to the central operations
• Gains
– Increases in equity from peripheral transactions of the entity
• Losses
– Decreases in equity from peripheral transactions of the entity
Recognition and Measurement (SFAC 5)
• To be recognized an item should be

– One of the defined elements
– Measurable with sufficient reliability
– Based on information that is
• Relevant
• Reliable
• Measurement attributes
– Historical cost/proceeds
– Current cost
– Current market value
– Net realizable (settlement) value
– Present (discounted) value of future cash flows
Recognition and Measurement (SFAC 5)
(cont’d)
• A full set of financial statements for a period should

show
– 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
Annual Report on Internal Control Systems
Required by the SEC to include

1. A statement of management’s responsibilities for
established and maintaining an adequate system
2. Identification of the framework used to evaluate
the internal controls
3. A statement as to whether or not the internal
control system is effective as of year-end
4. The disclosure of any material weaknesses in the
system
5. A statement that the company’s auditors have
issued an audit report on management’s
assessment
Traditional Assumptions
of the Accounting Model
• Business Entity • Matching

• Going Concern (Continuity) • Consistency
• Time Period • Full Disclosure
• Monetary Unit • Materiality
• Historical Cost • Industry Practices
• Conservatism • Transaction Approach
• Realization • Cash Basis
• 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 (Continuity)
• The entity will remain in business for an

indefinite period of time
• Disregards possibility of liquidation or
bankruptcy
• Impacts how assets and liabilities are
measured and reported
• Financial statements must disclose if the
presumption of continuity is not applicable
Time Period
• Finite reporting periods applied to the

presumed indefinite life of a business
– Natural business year (Business is on the low ebb)
– Calendar year (Ends on December 31)
– Fiscal year (ending other than December)
– 52-53 Week 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 business transactions
• U.S. dollar for domestic entities
• Supplementary disclosure of inflation-adjusted

financial data currently not required by U.S.
GAAP
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 of the alternatives must have reasonable

support
• Conservatism guides selection of the

alternative that has the
– Least favorable impact on net income
– Least favorable impact on financial position
Realization of Revenue
• 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
• End of production
– If price of item is known and a ready market exists
• Receipt of cash
– Collection cannot be reasonably estimated
Realization of Revenue (cont’d)
• During production
– Revenue is recognized proportional to effort
• Cost recovery
– Applicable for highly speculative transactions
• There are many other acceptable methods of

recognizing revenue
Matching
• Match costs associated with revenue

recognized
– 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 given to

comparable transactions from period to period
• Entity results from several years are
comparable
• Supports trend analysis
• If a change is made
– Justification of change is discussed
– 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
– Supporting schedules
– Cross-references
– Footnotes
• Reasonable summary of significant financial
information
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: material
– No: 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” principle
Cash Basis
• Recognize revenue when cash is collected

• 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 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
Accrual Basis (cont’d)
• Result is more representational of financial

condition
• Supports the time period assumption
• Modified accrual
– Adjusts for buildings and equipment
– Immaterial items
– Specific standards have allowed the cash basis
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 Cash
Sales $25,000 Receipts $15,000
Cost of Goods Sold -12,500 Expenditures -18,000
Income $12,500 Loss $- 3,000
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COPYRIGHT ©2011 South-Western, a part of Cengage Learning.

• Generally Accepted Accounting Principles

• Major Sources of GAAP

• Securities Act of 1933

• Securities Exchange Act of 1934

• Financial Accounting Standards Board

• Topic is added to the technical agenda

• Public comments solicited

• Issues Exposure Draft

Objectives of Financial Reporting are:

Source: “Qualitative Characteristics of

• To be recognized an item should be

• A full set of financial statements for a period should

Required by the SEC to include

• Business Entity • Matching

• The business entity is separate and distinct

• The entity is an economic unit that stands on

• The entity will remain in business for an

• Finite reporting periods applied to the

• Standard of measure for business transactions

• U.S. dollar for domestic entities

• Supplementary disclosure of inflation-adjusted

• Often used because it is objective and

• Select from various measures of value

• Each of the alternatives must have reasonable

• Conservatism guides selection of the

• In general, the point of recognition of revenue

• There are many other acceptable methods of

• Match costs associated with revenue

• Same accounting treatment given to

• Accounting reports must disclose all the facts

• Considers the relative size and importance of

• Record transactions that

• Recognize revenue when cash is collected

• Revenue recognized when realized

• Result is more representational of financial

• Sold inventory for $25,000 on credit, which

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