Financial Accounting - Terms/Conceptual Framework

Define financial accounting (all four elements).

The process of identifying, measuring, and communicating (1) financial information about (2) an economic entity to (3) various user groups within (4) the legal, economic, political, and social environment.

Why does financial accounting exist — what economic job does it do?

Capital is scarce. Financial information lets investors and creditors assess risks and returns, so capital flows to its most productive uses.

Name the four basic financial statements.

Balance sheet (statement of financial position); statement of comprehensive income; statement of cash flows; statement of shareholders' equity.

Financial statements vs. financial information — what's the difference?

Financial information is broader: the four statements + notes (GAAP-governed) PLUS the shareholder letter, MD&A, management report, auditors' report, press releases (NOT governed by accounting standard setters).

Who are the PRIMARY users of financial statements per FASB?

Existing and potential investors, lenders, and other creditors — specifically those who CANNOT demand information directly from the entity.

What is an economic entity? What forms can it take?

An organization or unit whose activities are separate from those of its owners and other entities. Corporation, partnership, sole proprietorship, or governmental organization; privately or publicly held.

Are managers of the entity preparers or users?

Preparers. They may use the information somewhat, but they are better classified as preparers.

What do equity investors look for in the statements?

Ability to generate earnings and cash flow, pay dividends, and grow; the risk and return of their ownership stake.

What do creditors look for in the statements?

Whether principal and interest will be paid when due; priority of their claims; current and future profitability and growth.

Why do COMPETITORS read your financial statements?

To determine market position relative to you and infer strategy and capabilities (e.g., a rival's rising R&D spending signals new products coming).

External vs. internal auditors — who does what?

External: independent of the company; ensure statements comply with standards and fairly present — lend credibility. Internal: employees advising management on operations and internal controls.

What are the SEC's and PCAOB's roles?

SEC: regulates publicly traded companies, reviews filings, holds statutory standard-setting power (delegated to FASB). PCAOB: sets auditing standards and oversees audits of public companies.

What does the AICPA do?

National professional association for CPAs; prepares and grades the Uniform CPA Examination; provides training and professional development.

Financial vs. tax vs. managerial accounting?

Financial: communicates position and performance to outside users (output: annual reports, 10-K, 10-Q). Tax: compliance and planning. Managerial: internal to the company.

Accounting is 'reactive' and 'proactive' toward its environment — give an example of each.

Reactive: FASB changed off-balance-sheet subsidiary rules after Enron. Proactive: reported information reshapes behavior — expensing R&D can slow research investment in downturns.

Walk the U.S. standard-setting history line: bodies, years, pronouncements.

SEC created 1934 (delegates to private sector) → CAP 1939–59 (Accounting Research Bulletins) → APB 1959–73 (Opinions and Statements) → FASB 1973–present (SFASs, now Accounting Standards Updates).

What is the Accounting Standards Codification (ASC)?

The single source of U.S. GAAP — includes all non-superseded pronouncements; new ASUs are incorporated into it.

What does the FAF do and how is it funded?

Oversight, administration, and finances of the FASB (and GASB). Funded primarily through accounting support fees assessed on public issuers (by market cap) through the PCAOB.

What does the FASAC do? The GASB and GASAC?

FASAC advises the FASB on technical issues. GASB sets standards for state and local governments; GASAC advises the GASB.

What is the EITF and how does a consensus become GAAP?

Emerging Issues Task Force (1984): handles narrower/industry-specific issues; 13 members (preparers, auditors, users). Consensus when 3 or fewer object — but a majority of the FASB must approve before it becomes U.S. GAAP.

What is the PCC?

Private Company Council (2012): decides whether U.S. GAAP modifications are warranted for private companies (cost vs. benefit) and develops them — but the FASB has final authority to accept them.

List the FASB's 7-step standard-setting process in order.

1 Identification of an issue; 2 Decision to pursue (chairperson adds to technical agenda); 3 Public meetings; 4 Exposure Draft; 5 Public roundtables (if needed); 6 Redeliberation (staff analyzes comment letters); 7 Publication of the final standard (ASU, majority vote, into the Codification).

Who sets global standards, and what replaced what?

IASC (1973–2001) issued International Accounting Standards (IAS); replaced by the IASB (2001–present), which issues IFRS.

Name the IFRS-side structure and each body's job.

IFRS Foundation: oversees and finances the IASB. Monitoring Board (2009): public accountability, nominates/approves trustees. IFRS Advisory Council: advises IASB. IFRS Interpretations Committee: interpretive body (like the EITF).

Give four reasons a U.S. accountant must understand IFRS.

U.S. companies have IFRS-reporting subsidiaries to consolidate; non-U.S. IFRS companies operate here; the SEC permits IFRS filings by international registrants on U.S. exchanges; IFRS is required/permitted in 150+ countries and careers cross borders.

What is a conceptual framework FOR — and what does it NOT do?

Sets forth theory, concepts, and principles so standards are coherent and uniform; guides standard setters in developing/revising standards. It does NOT override accounting standards.

List the components of the FASB conceptual framework (Concepts Statement No. 8).

Objective of general-purpose financial reporting; reporting entity; qualitative characteristics; elements; recognition and derecognition; measurement; presentation; notes to the financial statements.

State the objective of financial reporting (close to quote).

To provide financial information about the reporting entity that is useful to existing and potential investors, lenders, and other creditors in making decisions about providing resources to the entity (buy/sell/hold equity or debt; provide/settle loans and credit).

Define 'reporting entity' under U.S. GAAP.

A circumscribed area of economic activities that can be represented by general-purpose financial reports useful to existing and potential investors, lenders, and other resource providers.

The two FUNDAMENTAL characteristics — and the standing tension between them.

Relevance and faithful representation. There is often a trade-off between the two (e.g., fair value is more relevant; historical cost is more faithfully representational).

Relevance = capable of making a difference. Through which three attributes?

Predictive value (input to forecasts), confirmatory value (feedback on prior evaluations), and materiality (misstatement/omission would change users' decisions).

Does the framework set a quantitative materiality threshold?

No. Materiality depends on size OR nature, judged against the company and its reporting — professional judgment by preparers and auditors.

Faithful representation requires three things.

Complete (all descriptions/explanations needed), neutral (free from bias in selection and presentation), free from error (no mistakes in description or process — estimates are still permitted).

Name and define the four ENHANCING characteristics.

Comparability (identify similarities/differences across entities and time); verifiability (informed users reach consensus the depiction is faithful); timeliness (available early enough to matter); understandability (classified, characterized, clearly presented).

What is the cost constraint — and whose costs count?

Standard setters require information only when expected benefits justify the costs — counting costs to preparers (collect, verify, systems, contracts) AND to users (who otherwise estimate it themselves).

Point-in-time vs. period-of-time elements — and where does each live?

Point-in-time: resources/claims/interests at a date → balance sheet (assets, liabilities, equity). Period-of-time: results of events between two balance-sheet dates → income statement / statement of SE. They articulate: period flows change point balances.

Define an ASSET and its two essential characteristics.

A present right of an entity to an economic benefit. (1) It is a present right; (2) the right is to an economic benefit.

Define a LIABILITY and its two essential characteristics.

A present obligation of an entity to transfer an economic benefit. (1) It is a present obligation; (2) it requires the entity to transfer or otherwise provide economic benefits to others.

Define EQUITY.

Net assets — the residual interest in the assets of an entity after deducting its liabilities; the cumulative result of owner investments, comprehensive income, and distributions to owners.

List the seven period-of-time elements under U.S. GAAP.

Investments by owners; distributions to owners; comprehensive income; revenues; gains; expenses; losses.

Revenues vs. gains — and the classic example.

Revenues arise from delivering/producing goods, rendering services, or other central activities; gains are equity increases from everything else (except owner investments). Target depreciating stores = expense; Target selling a store = gain/loss (proceeds − carrying value).

Define comprehensive income.

The change in equity during a period from transactions and circumstances from NON-owner sources — all equity changes except owner investments and distributions. Includes net income plus other comprehensive income items.

What does it mean to RECOGNIZE an item?

Report the economic event in the financial statements as a line item (through journal entries) — as opposed to disclosing it only in the notes.

The three general recognition criteria (plus the two overlays).

Recognize when and only when: (1) meets the definition of an element; (2) is measurable; (3) can be depicted/measured with faithful representation. Overlays: cost-benefit constraint and materiality.

What is derecognition and when is it required?

Removing an item from the financial statements (via a journal entry) when it FAILS any of the three recognition criteria — e.g., a sold building no longer gives a present right to benefits.

The overarching revenue recognition principle?

Recognize revenue when CONTROL of the goods or services transfers to the customer (ASU 606; five-step model, detailed in a later course).

Name the three expense-recognition approaches with an example of each.

(1) Directly associate with revenues — COGS with the sale; (2) expense in period incurred — supplies, salaries; (3) systematically allocate over periods of use — depreciation.

What is 'presentation'? What should presented information help users do?

The line items, totals, and subtotals in the statements. Help users: distinguish recurring from non-recurring; estimate amounts/timing/probability of cash flows; understand resources and claims; estimate when resources settle claims.

Primary purpose of the notes — and their three content areas.

Further explain what is recognized on the face. Content: (1) detail behind line items (inventory → RM/WIP/FG); (2) the reporting entity (activities, restrictions, related parties); (3) unrecognized past events/current conditions that may affect cash flows (contingencies, commitments).

Cash basis vs. accrual basis — define both. Which does GAAP require?

Cash: revenue when cash received, expense when cash paid — measures cash flows, not economic activity, and invites timing manipulation. Accrual: revenue when control transfers, expense when incurred, regardless of cash. GAAP requires accrual.

Over the life of the firm, how do cash-basis and accrual-basis totals compare?

They are identical in total. Only the TIMING of revenue/expense recognition differs period to period.

Yards, Inc.: 200 customers prepay $100/mo for May–Aug ($80,000 received in May). Expenses $10k/$13k/$12k/$10k paid monthly. May net income under each basis?

Cash: $80,000 − $10,000 = $70,000. Accrual: $20,000 (80,000 ÷ 4 months) − $10,000 = $10,000. Both bases total $35,000 NI over the four months.

Trim Lawn: 140 customers prepay $75/mo for May–Aug ($42,000 in May). Expenses 8,000 / 7,800 / 2,200 / 6,000 paid in month incurred. Monthly accrual NI?

Monthly revenue = $10,500. NI: May 2,500; June 2,700; July 8,300; August 4,500. (Cash basis: May 34,000; then −7,800, −2,200, −6,000. Both total $18,000.)

Client billed $2,000 this month, collected next month. Revenue this month under cash? Under accrual?

Cash: $0 (no cash received). Accrual: $2,000 (control of services transferred).

Collected $700 THIS month for services to be performed NEXT month. Revenue this month under each basis?

Cash: $700. Accrual: $0 — it's deferred (unearned) until the service is provided.

Reported EPS lands $0.60 below analysts' forecasts — which attribute of which characteristic is at work?

Confirmatory value (relevance): the information provides feedback on prior evaluations.

An analyst uses five years of COGS to forecast next year's gross margin — attribute?

Predictive value (relevance).

A company discloses both favorable AND unfavorable tax settlements — attribute?

Neutrality (faithful representation): free from bias in selection and presentation.

Writing off a receivable from a customer who is 35% of current assets — which concept makes disclosure non-optional?

Materiality (relevance) — by size, it would affect users' decisions.

Two audit offices agree on the measurement of a client's plant assets — characteristic, and satisfied or violated?

Verifiability — satisfied.

A company reports income only every two years — characteristic and verdict?

Timeliness — violated. (Periodicity assumption also offended.)

Gladys Groceries uses cost while the rest of the industry uses fair value for investments — characteristic and verdict?

Comparability — violated.

Complex transactions properly classified, characterized, clearly presented, fully disclosed — characteristic and verdict?

Understandability — satisfied.

Classify under U.S. GAAP, IFRS, or BOTH: investments by owners; losses; liabilities; comprehensive income; revenues.

Investments by owners: U.S. GAAP only. Losses: GAAP separate element; under IFRS folded into expenses. Liabilities: both (point-in-time). Comprehensive income: U.S. GAAP element. Revenues: GAAP element; IFRS folds revenues+gains into INCOME.

IFRS period-of-time elements — how many and what are they?

Two: INCOME (encompassing revenues and gains) and EXPENSES (encompassing expenses and losses). IFRS has no separate owner-transaction elements.

IFRS has FOUR general recognition criteria — what's the fourth?

Element definition, measurable WITHOUT high uncertainty, faithful representation, PLUS the item must provide RELEVANT information.

Under IFRS, when are income and expenses recognized?

Income: with initial recognition/increase of an asset or derecognition/decrease of a liability. Expenses: with initial recognition/increase of a liability or derecognition/decrease of an asset. IFRS does not use a 'matching' approach.

Why is an early-stage lawsuit NOT recognized as a liability — and what happens instead?

It may meet the element definition but is not reliably MEASURABLE (criterion 2 fails). It is disclosed in the notes (materiality can apply to non-quantifiable items).

Entry price vs. exit price.

Entry: price PAID to acquire an asset / RECEIVED to assume a liability → historical (acquisition) cost policy, allocated over the benefit period. Exit: price RECEIVED to sell an asset / PAID to transfer a liability → fair value.

The fair value hierarchy — levels, inputs, examples.

Level 1: quoted prices in active markets for identical items (traded stock). Level 2: other observable inputs (price/sq ft from comparable buildings). Level 3: unobservable, model-based inputs (PV of expected cash flows for private equity).

Fair value vs. historical cost in characteristic terms.

Fair value: more RELEVANT, less faithfully representational. Historical cost: more verifiable/faithful, less relevant. Standard setters trade these off; FASB keeps expanding fair value for financial assets/liabilities.

Do U.S. companies write nonfinancial assets UP to market value?

No — no write-ups to market/appraisal and no inflation adjustments. They write DOWN when impaired.

IFRS measurement bases — name them (and current value's sub-bases).

Historical cost; and current value: fair value, value in use (assets — PV of expected benefits), fulfillment value (liabilities — PV of cash to pay), current cost (cash needed to acquire the asset today).

Name the four assumptions and what each justifies.

Going concern (historical cost, current/noncurrent classification, 40-year depreciation); economic entity (owner's affairs separate); monetary unit (stable dollars — add 1969 and current land); periodicity (artificial periods → quarterly reporting and accrual adjustments).

If going concern FAILS, how are assets and liabilities measured?

At liquidation values — the amounts at which they are expected to be disposed.

Division managers report to HQ monthly — which assumption?

Periodicity (artificial time periods for reporting).

Rainbow Paints owns 15% of New Elam and does NOT consolidate because it lacks control — which assumption?

Economic entity — financial reporting follows the boundaries of the reporting entity.

An analyst values the firm with an infinite-growth model — which assumption?

Going concern.

Buildings reported as the sum of a 1951 plant and a 2014 plant — which assumption?

Monetary unit (dollars of different purchasing power treated as stable and additive).

Which assumption does IFRS make EXPLICIT?

Going concern. The others (economic entity, monetary unit, periodicity) are implicit — as all four are under U.S. GAAP.

Land reported at appraised value by a U.S. GAAP filer — what's violated?

Historical-cost (entry-price) measurement — nonfinancial assets are not written up (going concern underpins this).

Paying one business's property taxes from another business's checking account — violation?

Economic entity — the entities' affairs must be kept separate.

A $2.5M equipment purchase charged to expense — what breaks?

Recognition (it meets the asset definition) and expense recognition (should be systematically allocated via depreciation); the amount is clearly material.

A large multinational expenses a $4,000 computer — defensible?

Yes — materiality/cost-benefit: immaterial to a huge firm, so capitalizing and depreciating isn't worth it.

Deliberately booking excessive write-downs to report the LOWEST possible income ('playing it safe') — what's violated?

Neutrality (faithful representation). Intentional downward bias is still bias.

Why was the APB replaced in 1973?

Criticized as slow and reactive on controversial issues; part-time members were practicing CPAs still tied to employers — not seen as independent.

How is the FASB structurally more independent than the APB was?

Seven FULL-TIME members who sever all outside relationships; members need not be CPAs (industry, academia, government, investment community); not a committee of the AICPA.

How many pronouncements did CAP and APB issue?

CAP: 51 Accounting Research Bulletins. APB: 31 Opinions and 4 Statements.

IASB composition (count and geography).

14 members: 4 Asia/Oceania, 4 Europe, 4 Americas, 1 Africa, 1 appointed from any area for balance; at least 11 full-time.

What review does the IASB perform that the FASB does not require?

A post-implementation review of each new/significantly changed standard, normally within about two years — focused on controversial issues, unexpected costs, implementation problems.

What is IFRS for SMEs and why does it exist?

A lighter IFRS for small and medium-sized (private) entities — eliminates certain costly external-user reporting requirements, for countries that make all companies report under IFRS.

What role did IOSCO play in IFRS adoption?

After the IASC's 1990s core-standards improvement project, IOSCO endorsed IAS for cross-border offerings and listings — a key legitimacy step.

Why is standard setting called a POLITICAL process?

New standards change reported income, so managers lobby against income-reducing rules while users want transparency; the Board weighs income effects against information quality through due process (comment letters, roundtables).

IFRS adds what to the objective of financial reporting?

Assessing management's STEWARDSHIP — the careful and responsible management of resources entrusted to it (e.g., returns on long-lived asset investments).

How does IFRS define the reporting entity — and what if its boundary is unclear?

An entity required to, or choosing to, prepare financial statements; can be a single entity, a portion, or more than one entity (consolidated group — e.g., Spotify's subsidiaries). Unclear boundary → primary users' information needs decide.

Materiality by NATURE — the book's example.

The planned disposition of a major operating segment: no quantified amount yet, but omitting it would change users' assessment — material by nature.

What makes a depiction of long-lived assets COMPLETE (J&J example)?

Not just the net balance: classes of PP&E (land, buildings, machinery, CIP), accumulated depreciation, depreciation method and useful lives, capitalized interest — in the note.

Estimates and 'free from error' — reconcile them.

Free from error means no mistakes/omissions in the DESCRIPTION or PROCESS — not perfect accuracy. Estimated uncollectibles can differ from actuals without violating faithful representation.

Comparability example with airlines.

Alaska Air depreciates its fleet over 15–25 years vs. Delta's 20–34 — disclosed useful lives let users compare fleet assumptions and economics.

Name the three current trends in the accounting profession (Ch 1 LO 4).

(1) ESG and sustainability reporting; (2) increased disclosure and transparency in financial reporting; (3) emerging technology — AI, ML, cloud — transforming practice.