1
Introduction Chapter to
Financial Reporting
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GAAP
Generally Accepted Accounting Principles
(GAAP)
Rules by which Financial Statements are prepared
Chapter 1, Slide #2
Copyright 2007 by Thomson South-Western, a part of The Thomson
Objectives of Financial Reporting
(SFAC 1)
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
Information is historical
Past Performance does not mean future success
Chapter 1, Slide #3
Copyright 2007 by Thomson South-Western, a part of The Thomson
A Hierarchy of Accounting Qualities
Exhibit 1-2
Source: Qualitative Characteristics of
Accounting Information. Adapted from Figure
1 in FASB Statement of Financial Accounting
Concepts No. 2 (Stamford, Conn.: Financial
Accounting Standards Board, 1980).
Chapter 1, Slide #4
Copyright 2007 by Thomson South-Western, a part of The Thomson
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 owners residual interest in the assets after
deducting liabilities
Chapter 1, Slide #5
Copyright 2007 by Thomson South-Western, a part of The Thomson
Elements of Financial Statements
(SFAC 6) (cont)
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
Chapter 1, Slide #6
Copyright 2007 by Thomson South-Western, a part of The Thomson
Elements of Financial Statements
(SFAC 6) (cont)
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
Chapter 1, Slide #7
Copyright 2007 by Thomson South-Western, a part of The Thomson
The Financial Statements
Income statement
Statement of owners' equity
Balance sheet
Statement of cash flows
Support for the financial statements is
provided by notes
Chapter 1, Slide #8
Copyright 2007 by Thomson South-Western, a part of The Thomson
A New Reality
Major financial failures
Enron
WorldCom
Major legislation: Sarbanes-Oxley Act of 2002 (SOX)
Public Companies Accounting Oversight Board
Established a definition of internal controls by which companies must
evaluate their internal controls using PCAOB established criteria
CEOs and CFOs must certify financial statement disclosures
SOX Section 404 requires companies to document adequate
internal controls and procedures
Chapter 1, Slide #9
Copyright 2007 by Thomson South-Western, a part of The Thomson
Annual Report on Internal Control Systems
Required by the SEC to include
1. A statement of managements 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 companys auditors have
issued an audit report on managements
assessment
Chapter 1, Slide #10
Copyright 2007 by Thomson South-Western, a part of The Thomson
Assumptions
1)
Business Entity
7)
Realization of Revenue
2)
Going Concern
8)
Matching
3)
Time Period
9)
Consistency
4)
Monetary Unit
10) Full Disclosure
5)
Historical Cost
11) Materiality
6)
Conservatism
12) Transaction Approach
Chapter 1, Slide #11
Copyright 2007 by Thomson South-Western, a part of The Thomson
1) 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
Chapter 1, Slide #12
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1) Business Entity (contd)
Sole
Proprietorship Partnership
Number of
owners
Legally separate
from owners
Owners liable for
business debts
Corporation
1
2 or more
(partners)
Numerous
(shareholders)
No
No
Yes
Yes
Yes
No
To the
owners
Profits taxable
To the owner
Modified form
LLC
limits liability of owner; may
increase income tax exposure
To the
corporation as
earnings;
to the owners
when
dividends are
received
Subchapter
S
profits are
taxed at
ownership
level only
Chapter 1, Slide #13
Copyright 2007 by Thomson South-Western, a part of The Thomson
2) Going Concern (Continuity)
entity The 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
Chapter 1, Slide #14
Copyright 2007 by Thomson South-Western, a part of The Thomson
3) Time Period
Finite reporting periods applied to the
presumed indefinite life of a business
Natural business year
Calendar year
Fiscal year
Allows measurement of the results of
operations prior to the liquidation of a business
entitys life
Chapter 1, Slide #15
Copyright 2007 by Thomson South-Western, a part of The Thomson
4) 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
Chapter 1, Slide #16
Copyright 2007 by Thomson South-Western, a part of The Thomson
5) 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
Chapter 1, Slide #17
Copyright 2007 by Thomson South-Western, a part of The Thomson
6) 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
Chapter 1, Slide #18
Copyright 2007 by Thomson South-Western, a part of The Thomson
7) 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
Chapter 1, Slide #19
Copyright 2007 by Thomson South-Western, a part of The Thomson
7) Realization of Revenue (contd)
During production
Revenue is recognized proportional to effort
Cost recovery
Applicable for highly speculative transactions
There are many other acceptable methods of
recognizing revenue
Chapter 1, Slide #20
Copyright 2007 by Thomson South-Western, a part of The Thomson
8) 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
Chapter 1, Slide #21
Copyright 2007 by Thomson South-Western, a part of The Thomson
9) 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 is explained
Chapter 1, Slide #22
Copyright 2007 by Thomson South-Western, a part of The Thomson
10) 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
Chapter 1, Slide #23
Copyright 2007 by Thomson South-Western, a part of The Thomson
11) 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
Chapter 1, Slide #24
Copyright 2007 by Thomson South-Western, a part of The Thomson
12) 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
Do not record estimates
Do not mix owners assets with companys
assets
Chapter 1, Slide #25
Copyright 2007 by Thomson South-Western, a part of The Thomson
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
Chapter 1, Slide #26
Copyright 2007 by Thomson South-Western, a part of The Thomson
Accrual Basis
Revenue recognized when realized
(realization concept)
Expenses recognized when incurred
(matching concept)
Numerous year-end adjustments required
More complex than cash basis
Chapter 1, Slide #27
Copyright 2007 by Thomson South-Western, a part of The Thomson
Accrual Basis (contd)
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
Chapter 1, Slide #28
Copyright 2007 by Thomson South-Western, a part of The Thomson