Chapter 1

Environment
and Theoretical
Structure of Financial
Accounting

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education.
 LO1-1

Visualize the Important Role of Accounting

• Accounting provides useful information about economic

activity to help:
– Produce good decisions
– Foster a prosperous society

01-02
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education.
 LO1-1

The Economic Environment and Financial

Reporting
Capital markets provide a mechanism to help the economy
allocate resources efficiently

Corporations acquire capital from:

• Investors in exchange for ownership interest and;
• Creditors by borrowing
– Either through individual loans or publicly traded debt such
as bonds

01-03
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education.
 LO1-1

Objective of Financial Accounting

• Primary objective of financial accounting

– Provided information should be useful for decision making
– Information should help investors and creditors evaluate
the following characteristics of the enterprise’s future cash
receipts and disbursements:
1. Amounts
2. Timing
3. Uncertainty

01-4
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education.
 LO1-2

Cash versus Accrual Accounting

Cash Basis Accounting

• Measurement of cash receipts and cash payments from
transactions related to providing goods and services
• Difference is net operating cash flow
Accrual Basis Accounting
• Measurement of revenues and expenses, regardless of when
cash is received or paid
• Difference is net income or net loss

01-5
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education.
 LO1-3

The Development of Financial Accounting and

Reporting Standards

• Generally Accepted Accounting Principles (GAAP)

– GAAP 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
– GAAP facilitates decision making by investors and creditors
by allowing them to compare financial information among
companies

01-6
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education.
 LO1-3

Accounting Standard Setting

HIERARCHY OF STANDARD-SETTING AUTHORITY

Congress

SEC

Private Sector

CAP APB FASB

1938–1959 1959–1973 1973–Present

01-7
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education.
 LO1-3

Codification

• FASB Accounting Standards Codification

– Only source of authoritative nongovernmental U.S. GAAP
• Organizes the thousands of U.S. GAAP pronouncements into
roughly 90 accounting topics
• Also includes portions of SEC accounting guidance
• Accounting Standards Update (ASU): any new
standard issued by FASB
• Located at the FASB website

01-8
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education.
 LO1-3

FASB Accounting Standards Codification

Topics

FASB Accounting Standards Codification Topics

Topic Numbered
General Principles  100–199
Presentation 200–299
Assets 300–399
Liabilities 400–499
Equity 500–599
Revenues 600–699
Expenses 700–799
Broad Transactions 800–899
Industry 900–999

01-9
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education.
 LO1-3

International Standard Setting

• International Accounting Standards Committee
(IASC)
– Formed in 1973 to develop global accounting standards
– Created a new standard-setting body called the
International Accounting Standards Board (IASB) (2001)

•IASB:
– To develop a single set of high-quality, understandable, and
enforceable global accounting standards
– Endorsed 41 International Accounting Standards (IASs)
– Issued new standards of its own—called International
Financial Reporting Standards (IFRS)
01-10
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education.
 LO1-11

Comparison of Organizations of U.S. and

International Standard Setters
U.S. GAAP IFRS

Regulatory oversight provided by: Securities Exchange Monitoring Board

Commission (SEC)

Foundation providing oversight, Financial Accounting IFRS Foundation: 22 trustees

appointing members, raising funds: Foundation (FAF): 14-18
trustees

Standard-setting board: Financial Accounting Standards International Accounting

Board (FASB): 7 members Standards Board (IASB): 14
members

Advisory council providing input on Financial Accounting Standards IFRS Advisory Council: approx. 50
agenda and projects: Advisory Council (FASAC): 30– members
40 members

Emerging Issues Task Force IFRS Interpretations Committee:

Group to deal with emerging issues:
(EITF): approx. 15 members 14 members

01-11
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education.
 LO1-4

The FASB’s Standard-Setting Process

Step Explanation

1. The Board identifies financial reporting issues based on

requests/recommendations from stakeholders or through other means.
2. The Board decides whether to add a project to the technical agenda
based on a staff-prepared analysis of the issues.
3. The Board deliberates at one or more public meetings the various issues
identified and analyzed by the staff
4. The Board issues an Exposure Draft. (In some projects, a Discussion
Paper may be issued to obtain input at an early stage that is used to
develop an Exposure Draft.)
5. The Board holds a public roundtable meeting on the Exposure Draft, if
necessary.
6. The staff analyzes comment letters, public roundtable discussion, and
any other information. The Board redeliberates the proposed provisions
at public meetings.
7. The Board issues an Accounting Standards Update describing
amendments to the Accounting Standards Codification.

01-12
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education.
 LO1-4

Sustainability Accounting Standards Board

• Established in 2011—accounting for material events

related to the triple bottom line
• Focus by industry as a guide to report on
sustainability practices
• Uses an extensive review and feedback model like
the FASB when new standards are established

Triple bottom line- practice of reporting on economic,

environmental, and social aspects of an organization.

01-13
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education.
 LO1-5

Encouraging High-Quality Financial Reporting

• Role of an Auditor
– Offer credibility to financial statements
– Express an opinion on the compliance of
financial statements with GAAP
– Licensed by states to provide audit services—
certified public accountants (CPAs)

01-14
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education.
 LO1-5

Key Provisions of the Sarbanes-Oxley Act

• Oversight board
• Corporate executive accountability
• Nonaudit services
• Retention of work papers
• Auditor rotation
• Conflicts of interest
• Hiring of auditor
• Internal control

01-15
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education.
 LO1-5

Ethics and Professionalism

• Ethics deals with the ability to distinguish right from wrong

• Codes of Ethics or Codes of Professional Conduct are

provided by:
– American Institute of Certified Public Accountants (AICPA)
– Institute of Management Accountants (IMA)
– Institute of Internal Auditors (IIA)

01-16
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education.
 LO1-5

Analytical Model for Ethical Decisions

Step 1. Determine the facts of the situation

Step 2. Identify the ethical issue and the stakeholders
Step 3. Identify the values related to the situation
Step 4. Specify the alternative courses of action
Step 5. Evaluate the courses of action specified in step 4 in terms
of their consistency with the values identified in step 3
Step 6. Identify the consequences of each possible course of
action
Step 7. Make your decision and take any indicated action

01-17
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education.
 LO1-6

The Conceptual Framework

• Described as an Accounting Constitution
• Provides an underlying foundation for U.S. accounting
standards
– Guides the selection of events to be accounted for
– Measurement of those events
– Means of summarizing them and communicating them to
interested parties
• Provides structure and direction to financial accounting and
reporting
• Disseminated by FASB through Statements of Financial
Accounting Concepts (SFACs)

01-18
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education.
 LO1-6

The Conceptual Framework (concluded)

Objective

Recognition and
Qualitative
Elements Measurement
Characteristics Concepts

Financial
Constraints Statements

01-19
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education.
 LO1-7

Hierarchy of Qualitative Characteristics of

Financial Information
Decision usefulness

Relevance Faithful Representation

Predictive Confirmatory Free from

Materiality Completeness Neutrality
Value value error

Comparability
Verifiability Timeliness Understandability
(Consistency)

Cost effectiveness
(benefits exceed costs)
01-20
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education.
 LO1-7

The Conceptual Framework: Elements

Objective

Recognition and
Qualitative
Elements Measurement
Characteristics Concepts

Financial
Constraints Statements

01-21
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education.
 LO1-7

Elements of Financial Statements

• Assets
• Liabilities
• Equity (or net assets)
• Investments by owners
• Distributions to owners
• Comprehensive income
• Revenues
• Expenses
• Gains
• Losses

01-22
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education.
 LO1-8

Underlying Assumptions
Four basic assumptions underlie GAAP
• The economic entity assumption presumes that
economic events can be identified specifically with
an economic entity
• The going concern assumption anticipates that a
business entity will continue to operate indefinitely
• The periodicity assumption allows the life of a
company to be divided into artificial time periods to
provide timely information
• The monetary unit used in U.S. financial statements
is the U.S. dollar
01-23
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education.
 LO1-9

The Conceptual Framework: Recognition,

Measurement, and Disclosure Concepts

Objective

Recognition and
Qualitative
Elements Measurement
Characteristics Concepts

Financial
Constraints Statements

01-24
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education.
 LO1-9

Recognition, Measurement, and Disclosure

Concepts
• Recognition refers to the process of admitting
information into the financial statements
• Measurement is the process of associating numerical
amounts with the elements
• Disclosure refers to the process of including
additional pertinent information in the financial
statements and accompanying notes

General Recognition Criteria

– Definition, Measurability, Relevance, and Reliability
01-25
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education.
 LO1-9

Revenue Recognition

• Revenue: Inflows of assets or settlements of liabilities

resulting from providing a product or service to a customer
• Revenue recognition used to be guided by the realization
principle (two criteria)
– Earnings process is judged to be complete or virtually complete
– Reasonable certainty as to the collectability of the asset to be received
(usually cash)
• FASB issued ASU No. 2014-09, which requires that we
recognize revenue when goods or services are transferred to
customers for the amount the company expects to be entitled
to receive in exchange for those goods or services

01-26
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education.
 LO1-9

Expense Recognition

Often matches revenues and expenses that arise from

the same transactions or other events
Four approaches:
– Based on an exact cause-and-effect relationship
– By associating an expense with the revenues
recognized in a specific time period
– By a systematic and rational allocation to specific
time periods
– In the period incurred, without regard to related
revenue
01-27
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education.
 LO1-9

Measurement
• GAAP currently employs a “mixed attribute” measurement model.
• The five attributes are:
1. Historical cost: original transaction value adjusted for
depreciation and amortization
2. Net realizable value: the amount of cash into which an asset is
expected to be converted in the ordinary course of business
3. Current cost: the cost that would be incurred to purchase or
reproduce the asset
4. Present value: the current value of future cash flows,
calculated by applying the time value of money
5. Fair value: the price that would be received to sell assets or
paid to transfer a liability in an orderly transaction between
market participants at the measurement date
01-28
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education.
 LO1-9

Historical Cost

• Historical Cost: Original transaction value

– Bases measurements on the amount given or received in the
exchange transactions
• For assets:
– Value of what is given in exchange (usually cash) for the asset at its
initial acquisition
• For liabilities:
– Current cash equivalent received in exchange for assuming the
liability
• Long-lived, revenue-producing assets (equipment):
– Adjusted subsequent to its initial measurement by recognizing
depreciation or amortization

01-29
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education.
 LO1-9

Net Realization Value, Current Cost, and

Present Value
• Net Realizable Value
–Estimated selling price in the ordinary course of business, less
reasonably predictable costs of completion, disposal, and
transportation
–Amount of cash into which an asset or liability is expected to be
converted in the ordinary course of business
• Current cost
–Cost that would be incurred to purchase or reproduce the asset
–Reported if the company operates in inflationary economies
• Present value (SFAC 7)
–Framework for using future cash flows as the basis for accounting
measurement
–Indicates that the objective in valuing an asset or liability using
present value is to approximate its fair value
01-30
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education.
 LO1-9

Fair Value

• Fair value, originally called current market value

– Bases measurements on the price that would be received to
sell assets or paid to transfer liabilities in an orderly market
transaction
• Fair value can be measured using:
• Market approach: Valuation based on market
information
• Income approach: Estimates future amounts and then
mathematically converts those amounts to a single
present value
• Cost approach: Estimates the amount that would be
required to buy or construct an asset of similar quality
and condition
01-31
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education.
 LO1-9

Fair Value Option

• Fair Value Option: GAAP gives a company the option,

in some circumstances, to choose whether to report
specified financial assets and liabilities at fair value
– Provides companies a way to reduce volatility in
reported earnings without having to comply with
complex hedge accounting standards
– Helps to converge with international accounting
standards

01-32
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education.
 LO1-9

Disclosure

• Full-disclosure principle: requires that the financial

reports should include any information that could affect
the decisions made by external users
• Such information can be disclosed in a variety of ways:
– Parenthetical comments or modifying comments
» Placed on the face of the financial statements
–Disclosure notes
» Convey additional insights
–Supplemental schedules and tables
» Report more detailed information than is shown in the
primary financial statements
01-33
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education.
 LO1-9

Summary of Recognition, Measurement, and

Disclosure Concepts
Concept Description
Recognition General criteria:
1. Meets the definition of an element
2. Has a measurement attribute
3. Is relevant
4. Is reliable (representationally faithful)
Examples of recognition timing:
5. Revenues
6. Expenses
Measurement Mixed attribute model in which the attribute used to measure an item
is chosen to maximize relevance and representational faithfulness.
These attributes include:
1. Historical cost
2. Net realizable value
3. Current cost
4. Present (or discounted) value of future cash flows
5. Fair value
Disclosure Financial reports should include all information that could affect the
decisions made by external users.
Examples of disclosures:
1. Parenthetical amounts
2. Notes to the financial statements
3. Supplemental schedules and tables

01-34
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education.
 End of Chapter 1

01-35
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education.