Intermediate Accounting Chapter 1 Notes

Intermediate Accounting - Chapter 1: The Environment and Conceptual Framework of Financial Reporting

Financial Reporting Environment

• Importance of Accounting and Decision-Usefulness

  • User Groups of Accounting Information

  • Owners/Managers

  • Creditors

  • Stockholders

Capital Allocation Process

• Capital Allocation: The process of determining how and at what cost money is allocated among competing interests.

  • Illustration: Users of financial information include investors and creditors who utilize financial reports to make informed capital allocation decisions regarding present and potential investments in a company.

Purpose of Notes in Financial Statements

• Review Question: What is the purpose of information presented in the notes to the financial statements?

  • To provide disclosure required by generally accepted accounting principles (GAAP).

  • To correct improper presentation in the financial statements.

  • To provide recognition of amounts not included in totals of the financial statements.

  • To present management’s responses to auditor comments.

Objective of Financial Reporting

• Provide financial information about the reporting entity that is useful to:

  • Present and potential equity investors

  • Lenders

  • Other creditors in making resource allocation decisions.

General-Purpose Financial Statements

• Objectives:

  • To provide financial reporting information to a wide variety of users.

  • To deliver the most useful information possible at the least cost.

  • Primary Users: Equity investors and creditors.

Perspective in Financial Accounting

• Entity Perspective: Companies are viewed as separate entities distinct from their owners.

• Decision-Usefulness: Investors and creditors assess a company's ability to:

  • Generate net cash inflows.

  • Protect and enhance the investments of capital providers.

Standard Setting Entities

• Securities and Exchange Commission (SEC):

  • Established by federal government under the Securities Exchange Act of 1934.

  • Oversees accounting and reporting for public companies.

  • Encourages private standard-setting bodies and requires adherence to GAAP by public companies.

• Financial Accounting Foundation (FAF):

  • Purpose: Selects members of the Financial Accounting Standards Board (FASB) and its advisory councils, funds activities, and provides oversight.

• Financial Accounting Standards Board (FASB):

  • Purpose: Establishes and improves standards for financial accounting and reporting, guiding and educating the public, including issuers, auditors, and users of financial information.

• Financial Accounting Standards Advisory Council (FASAC):

  • Purpose: Consults on major policy and technical issues, project priorities, and the selection and organization of task forces.

Organizational Structure for Setting Accounting Standards

• Illustration:

  • FAF: Oversees FASB and advisory councils, selects members.

  • FASB: Sets accounting standards.

  • FASAC: Provides consultation on key issues.

Other Organizations Involved in Standard Setting

• American Institute of Certified Public Accountants (AICPA): A national professional organization.

• International Accounting Standards Board (IASB): Utilized in over 120 countries.

FASB Due Process for Establishing Standards

• Steps:

  1. Topics identified and placed on the agenda.

  2. Research and analysis conducted; preliminary views issued.

  3. Public hearing on proposed standards.

  4. Board evaluates research and public input; issues exposure draft.

  5. Final standards are issued after evaluation and changes if necessary.

Types of Financial Statements Pronouncements by FASB

• Accounting Standards Updates: Updates to the standards.

• Financial Accounting Concepts: Conceptual framework for accounting standards.

FASB Codification

• A comprehensive repository of authoritative literature related to a topic in U.S. GAAP.

  • Simplifies access to GAAP.

  • Establishes documentation and updating methods.

  • Eliminates nonessential information.

Conceptual Framework Overview

• Categories include:

  1. Objective

  2. Reporting Entity

  3. Measurement

  4. Recognition/Derecognition

  5. Presentation and Notes to Financial Statements

Basic Objective of Financial Reporting

• Informs decisions made by investors and lenders, indicating whether to buy, sell, or hold stock, or lend money and at what terms.

Hierarchy of Accounting Qualities

• Fundamental Qualities:

  • Relevance:

  • Predictive Value

  • Confirmatory Value

  • Materiality

  • Faithful Representation:

  • Completeness

  • Neutrality

  • Free from Error

• Enhancing Qualities:

  • Comparability

  • Verifiability

  • Timeliness

  • Understandability

Elements of Financial Statements

• Assets: Present rights to economic benefits.

• Liabilities: Present obligations to transfer economic benefits.

• Equity: Residual interest in assets after deducting liabilities.

Additional Elements

• Investments by Owners: Increases in net assets resulting from transfers to the enterprise.

• Distributions to Owners: Decreases in net assets resulting from transfers to owners, reducing equity.

• Comprehensive Income: Change in equity from non-owner sources except investments or distributions.

• Revenues: Inflows from delivering goods or performing services.

• Expenses: Outflows from delivering goods or services.

• Gains and Losses: Changes in equity from transactions not related to owner transactions.

Basic Assumptions in Accounting

1. Economic Entity Assumption: Identifies economic activity with a specific unit of accountability.

2. Going Concern Assumption: Assumes the entity will continue its operations in the foreseeable future.

3. Monetary Unit Assumption: Economic activity is measured in a common monetary unit.

4. Periodicity Assumption: Allows dividing economic activities into artificial time periods.

Principles of Accounting

1. Measurement Principle: Based on historical cost or fair value.

2. Revenue Recognition Principle: Revenue recognized when performance obligations are met.

3. Expense Recognition Principle: Expenses recognized in the same period as the revenues they help generate.

4. Full Disclosure Principle: Disclosures reflect necessary information for users’ understanding.

Fair Value Hierarchy

• Level 1: Observable inputs reflecting quoted prices for identical assets in active markets.

• Level 2: Inputs other than quoted prices that are observable either directly or through corroborated data.

• Level 3: Unobservable inputs requiring significant judgment.

Revenue Recognition Framework

• Five Steps:

  1. Identify the contract with the customer.

  2. Identify separate performance obligations.

  3. Determine the transaction price.

  4. Allocate the transaction price to obligations.

  5. Recognize revenue when obligations are satisfied.

Expense Recognition

• Types of Costs:

  • Product Costs: Directly related to revenue, recognized when revenue is recorded.

  • Period Costs: No direct relationship to revenue, recognized as incurred.

Summary of Conceptual Framework

• First Level: Purpose of accounting - to provide useful information to capital providers.

• Second Level: Describes specific elements and qualitative characteristics.

• Third Level: Outlines implementation methods through assumptions and principles.

Comparison of GAAP and IFRS

• Similarities:

  • Both have oversight boards (FASB for GAAP, IASB for IFRS).

  • Focus on convergence of standards, e.g., revenue recognition.

• Differences:

  • GAAP is detailed and rules-based, while IFRS is more flexible and principles-based.

  • IFRS applies fair value more broadly than GAAP.

Key Terms

• Financial Accounting Standards Board (FASB): U.S. organization for setting financial reporting standards.

• American Institute of Certified Public Accountants (AICPA): National accounting professional organization.

• Generally Accepted Accounting Principles (GAAP): Common standards for financial reporting.

• Securities and Exchange Commission (SEC): Federal agency overseeing securities markets.

• International Accounting Standards Board (IASB): Global organization for financial reporting standards.

• Public/Private Partnership: SEC support for FASB’s standards governance.

• Codification: Integration of all authoritative accounting literature by topic.

• Statements of Financial Accounting Concepts: Framework supporting FASB in standard development.