chp 1 notes

Chapter 1 – Environment & Theoretical Structure of Financial Accounting

Purposes of Accounting

• Measure Economic Activities: The first main purpose of accounting is to measure the economic activities (transactions) of a business.

• Communicate Results: The second main purpose of accounting is to communicate the results of that measurement to interested parties.

Principal Communication Channel for Accounting Measurements

• Financial Statements: The principal way accounting measurements are communicated is through the preparation of financial statements and related disclosures, including footnotes to the financial statements (F/S).

Main Financial Statements Prepared by Profit-Oriented Companies

1. Balance Sheet: Provides a snapshot of the company’s assets, liabilities, and equity at a specific point in time.

2. Income Statement: Shows the company’s revenues and expenses, resulting in net income or loss over a period.

3. Statement of Comprehensive Income: Includes all changes in equity from non-owner sources during a period.

4. Statement of Stockholders’ Equity: Details changes in the equity section of the balance sheet during a period.

5. Statement of Cash Flows: Reports cash generated and used during a period in operating, investing, and financing activities.

Stakeholders of Financial Statements

• Primary Users: The primary users or stakeholders of a company’s financial statements include:

  • Investors: Both current and potential shareholders.

  • Financial Intermediaries: Such as stockbrokers and financial analysts.

  • Creditors: Including banks and bondholders.

  • Credit-Rating Organizations: Examples include Moody’s, Standard & Poor’s, and Fitch.

  • Customers: Interested in the company's stability and capacity.

  • Government Regulators: Such as the Securities and Exchange Commission (SEC).

  • Employees: Interested in job security and company performance.

Sources of Capital for Profit-Oriented Companies

• Methods of Obtaining Capital: Profit-oriented companies typically obtain capital in two main ways:

  1. Issuing Capital Stock: In exchange for cash.

  2. Borrowing Funds: From banks (Notes Payable) or from individual bondholders (Bonds Payable).

Investor Motivation for Providing Capital

• Return on Investment: Investors provide capital to finance business ventures because they want to earn a fair return on the resources they provide, which can come in forms such as interest or dividend income, or capital appreciation.

Objectives of Financial Accounting

• Useful Information for Decision Making: Another main objective of financial accounting is to provide information useful for decision-making, helping investors and creditors evaluate and estimate a company’s future cash flows, including their amounts, timing, and uncertainty.

Cash Basis vs. Accrual Basis Accounting

Cash Basis Accounting

• Definition: Measures and records cash receipts and cash payments of a business. The difference equals Net Operating Cash Flow.

• Example: Carter Company paid $60,000 for 3 years’ rent at the beginning of year 1:

  • Under cash basis accounting, the rent payment is shown when paid.

    • Year 1:

      • Total Sales (on credit): $100,000

      • Cash receipts from customers: $50,000

      • Cash disbursements:

      • Prepayment of rent: ($60,000)

      • Salaries to employees: ($50,000)

      • Utilities: ($5,000)

      • Net operating cash flow: $(65,000)

    • Year 2:

      • Cash receipts: $125,000

      • Cash disbursements:

      • Salaries to employees: ($50,000)

      • Utilities: ($15,000)

      • Net operating cash flow: $60,000

    • Year 3:

      • Cash receipts: $125,000

      • Cash disbursements:

      • Salaries to employees: ($50,000)

      • Utilities: ($10,000)

      • Net operating cash flow: $65,000

Accrual Basis Accounting

• Definition: Measures and records revenues and expenses of a business, irrespective of when cash is received or paid. The difference is reflected as Net Income or Net Loss.

• Example: Under accrual basis accounting for Carter Company, rent is recognized as an expense over the three years despite payment occurring at year 1.

CARTER COMPANY Income Statements:

• Year 1:

  • Revenues: $100,000

  • Expenses:

  • Rent: $20,000

  • Salaries: $50,000

  • Utilities: $10,000

  • Net Income: $20,000

• Year 2:

  • Revenues: $100,000

  • Expenses:

  • Rent: $20,000

  • Salaries: $50,000

  • Utilities: $10,000

  • Net Income: $20,000

• Year 3:

  • Revenues: $100,000

  • Expenses:

  • Rent: $20,000

  • Salaries: $50,000

  • Utilities: $10,000

  • Net Income: $20,000

GAAP and its Regulatory Bodies

• GAAP: Stands for Generally Accepted Accounting Principles.

• Ultimate Authority: The U.S. Securities and Exchange Commission (SEC) has ultimate authority over U.S. accounting standards but cedes most authority to the FASB (Financial Accounting Standards Board).

• FASB: Established in 1973, this board sets U.S. accounting standards. Coexists alongside international standards such as IFRS.

Accounting Standards Codification

• ASC: Stands for Accounting Standards Codification. It is a comprehensive codification of all active rules set by the FASB over the years into one location.

Updates to the ASC

• Accounting Standards Update (ASU): Issued when the ASC needs updating. For example, ASU 2016-13 was the 13th update issued in 2016.

International Accounting Standards

• Setting Body: International Accounting Standards Board (IASB) sets international accounting standards.

• Standards: IASB’s standards are known as International Financial Reporting Standards (IFRSs) and International Accounting Standards (IASs; older standards that have been superseded by IFRSs).

Conceptual Framework

• Definition: The Conceptual Framework serves as the underlying principles and foundation that guide U.S standard-setting.

  • Guidance Provider: It helps standard setters in developing high-quality standards.

  • Key Components: It includes definitions and concepts, such as what constitutes assets or liabilities. It is often referred to as the "Accounting Constitution."

• Location: Located within the SFACs (Statements of Financial Accounting Concepts) particularly SFAC 8 (can be accessed via Codification website).

Objective of Financial Information

• Main Objective: The overarching objective of financial information is to provide usefulness to others in decision-making and to aid in predicting a company’s future cash flows.

Qualitative Characteristics of Financial Information

1. Relevance: Ensures that information is predictive and confirms prior assessments.

   • Predictive Value: E.g., helps predict a company's future cash flows.

   • Confirmatory Value: Adjusts or confirms prior assessments regarding a company’s cash-flow-generating ability.

   • Materiality: Financial information is considered material if omitting or misstating it can influence users’ decisions.

2. Faithful Representation: Exists when the reported information accurately depicts reality.

   • Enhanced by:

     1. Completeness: Includes all necessary information.

     2. Neutrality: Free from bias.

     3. Freedom from Error: No inaccuracies or omissions in the reported information.

Elements of Financial Statements

1. Assets: Probable future economic benefits controlled by an entity due to past transactions.

2. Liabilities: Future sacrifices of economic benefits due to present obligations of an entity from past transactions.

3. Equity: Residual interest in assets after deducting liabilities, known as shareholders' equity for corporations.

4. Investments by Owners: Increases in equity from asset transfers that increase ownership interests.

5. Distributions to Owners: Decreases in equity from transfers to owners.

6. Revenues: Inflows or enhancements of assets during a period from major operational activities.

7. Expenses: Outflows or uses of assets during a period from major operational activities.

8. Gains: Increases in equity from peripheral or incidental transactions.

9. Losses: Decreases in equity from peripheral or incidental transactions.

10. Comprehensive Income: Changes in equity resulting from non-owner sources, encompassing all equity changes except those from owners.

Recognition, Measurement, and Disclosure Concepts

• Recognition: Process of including information in financial statements.

• Measurement: Associating numerical amounts with recognized elements.

• Disclosure: Providing additional relevant information in financial statements and accompanying notes.

Revenue Recognition Principle

• When to Recognize Revenue: When goods or services are transferred to a customer, regardless of cash transactions.

Matching Principle

• When to Recognize Expenses: At the same time as the revenues they are related to, regardless of whether cash was paid.

Measurement Attributes

1. Historical Cost: Original transaction value adjusted for depreciation and amortization.

2. Net Realizable Value: Expected cash from converting an asset, less selling costs.

3. Current Cost: Cost incurred to purchase or reproduce the asset.

4. Present Value: Current value of future cash flows, considering the time value of money.

5. Fair Value: Price received to sell assets or paid to transfer liabilities in orderly transactions.

Full-Disclosure Principle

• Principle: Requires that any information useful to decision-makers be included in financial reports, subject to cost-effectiveness constraints, typically via footnotes and supplemental disclosures.