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12 Chapter 13 Introduction to Financial Reporting . . . . . . . . . . . .
Introduction to Financial Statements and Other Financial
Reporting Topics. . . . . . . . . . . . . . . . . . . . . .
Balance Sheet . . . . . . . . . . . . . . . . . . . . . . .
Income Statement. . . . . . . . . . . . . . . . . . . . . .
Basics of Analysis. . . . . . . . . . . . . . . . . . . . .
Liquidity of Short-term Assets; Related Debt-Paying Ability
Long-Term Debt-Paying Ability . . . . . . . . . . . . . . .
Profitability . . . . . . . . . . . . . . . . . . . . . . .
For the Investor. . . . . . . . . . . . . . . . . . . . . .
Statement of Cash Flows . . . . . . . . . . . . . . . . . .
Expanded Analysis . . . . . . . . . . . . . . . . . . . . .
Special Industries: Banks, Utilities, Oil and Gas,
Transportation, Insurance, Real Estate Companies. . . . . .
Personal Financial Statements and Accounting for
Governments and Not-For-Profit Organizations. . . . . . . . 1 1
366 Chapter 1
Introduction to Financial Reporting
TO THE NET
1. a. he Mission of the Financial Accounting Standard Board
The mission of the Financial Accounting Standards
Board (FASB)is to establish and improve standards of
financial accounting and reporting for the guidance
and education of the public, including issuers,
auditors and users of financial information.
Accounting standards are essential to the efficient
functioning of the economy because decisions about
the allocation of resources rely heavily on credible,
concise, transparent and understandable financial
information. Financial information about the
operations and financial position of individual
entities also is used by the public in making various
other kinds of decisions.
To accomplish its mission, the FASB acts to:
• Improve the usefulness of financial
reporting by focusing on the primary
characteristics of relevance and
reliability and on the qualities of
comparability and constancy; • Keep standards current to reflect
changes in methods of doing business and
changes in the economic environment; • Consider promptly any significant areas
of deficiency in financial reporting that
2 might be improved through the standardsetting process; b • Promote the international convergence of
accounting standards concurrent with
improving the quality of financial
reporting; and • Improve the common understanding of the
nature and purposes of information
contained in financial reports. Financial Accounting Standards Advisory Council
The Financial Accounting Standards Advisory Council,
FASAC or “the Council” for short, was formed in 1973
concurrent with the establishment of the Financial
Accounting Standards Board (the FASB or the Board).
The primary function of FASAC is to advise the Board
on issues related to projects on the Board’s agenda,
possible new agenda items, project priorities,
procedural matters that may require the attention of
the FASB, and other matters as requested by the
chairman of the FASB. FASAC meetings provide the
Board with an opportunity to obtain and discuss the
views of a very diverse group of individuals from
varied business and professional backgrounds.
The members of FASAC are drawn from the ranks of
CEOs, CFOs, senior partners of public accounting
firms, executive directors of professional
organizations, and senior members of the academic and
analyst communities, all disclosure.
Carrying Out the Mission
It is the job of the FASB to establish the “generally
accepted accounting principles,” or GAAP, to which
public financial reporting by U.S. corporations must
conform and to keep those principles current.
In conducting its activities, the Board strives to
carefully weight the views of its users, preparers,
and auditors of financial report. The Council
provides an important sounding board to help the FASB
understand what constituents are thinking about a
wide range of issues.
3 FASAC’s role is not to reach a consensus or to vote
on the issues that it considers at its meetings.
Rather, FASAC operates as a window through which the
Board can obtain and discuss the representative views
of the diverse groups the FASB affects. Thus, FASAC
provides the forum for two-way communication. While
it is important to convene the Council members as a
group, that is so that the Board can hear the
individual views of those members and so that the
members can hear and respond to each other’s views.
Members of FASAC are urged to speak out publicly on
matters before the FASB and also to be supportive of
the Board’s process, and the principle of privatesector standard setting. Individual Council members
are not expected to agree with the Board’s decisions
on all of the technical aspects of the projects on
the Board’s agenda, but it is important that FASAC
members support the institution and its due process.
Structure of the Organization
FASAC is an operating arm of the financial Accounting
Foundation, an organization that is independent of
any other business or professional organization. The
Foundation is run by a 16-member Board of Trustees
who are leaders in the business, accounting,
financial, government and academic communities.
The Foundation selects the members of FASAC including
the chairman and broadly oversees its operations.
The Council comprises 33 members who represent a
broad cross section of the Board’s constituency.
They are appointed for a one-year term are eligible
to be reappointed for three additional one-year
The Council meets once a quarter at the FASB’s
offices in Norwalk, Ct. Like the FASB, FASAC is
committed to following an open, orderly process that
is open to public observation. In addition to eh
Council members, the members of the FASB, its
director of research and technical activities,
several members of the FASB’s staff, and the chief
accountant of the SEC attend each meeting.
2. Each student will select a company and obtain a copy
of their annual report, 10-K, and proxy.
4 5 QUESTIONS
1- 1. a. b. The Financial Accounting Standards Board replaced the
Accounting Principles Board as the primary rulemaking body. It is an independent organization and
includes members other than public accountants.
c. The AICPA is an organization of CPAs that prior to
1973 accepted the primary responsibility for the
development of generally accepted accounting
principles. Their role was substantially reduced in
1973 when the Financial Accounting Standards Board
was established. Their role was further reduced with
the establishment of the Public Company Accounting
Oversight Board was established in 2002. The SEC has the authority to determine generally
accepted accounting principles and to regulate the
accounting profession. The SEC has elected to leave
much of the determination of generally accepted
accounting principles to the private sector. For
accounting standards the Financial Accounting
Standards Board has played the major role since 1973.
Regulation of the accounting profession was
substantially turned over to the Public Company
Accounting Oversight Board in 2002. 1- 2. Consistency allows for the same accounting principle from
period to period. A change in principle requires
statement disclosure. 1- 3. The concept of historical cost determines the balance
sheet valuation of land. The realization concept
requires that a transaction has occurred for the profit
to be recognized. 1- 4. a. Entity b. Realization c. Materiality d. Conservatism e. Historical cost 1- 5. f.
g. Historical cost Disclosure Entity concept 6 1- 6. Generally accepted accounting principles do not apply
when a firm does not appear to be a going concern. In
this case the liquidation values are the appropriate
figures. 1- 7. With the time period assumption, inaccuracies of
accounting for the entity, short of its complete life
span, are accepted. The assumption is made that the
entity can be accounted for reasonably accurately for a
particular period of time. In other words, the decision
is made to accept some inaccuracy because of incomplete
information about the future in exchange for more timely
reporting. The statements are considered to be
meaningful because material inaccuracies are not
acceptable. 1- 8. It is true that the only accurate way to account for the
success or failure of an entity is to accumulate all
transactions from the opening of business until the
business eventually liquidates. But it is not necessary
that the statements be completely accurate in order for
them to be meaningful. 1- 9. a. Natural business year A year that ends when operations are at a low ebb for the
b. Calendar year
The accounting time period is ended on December 31. c. Fiscal year
A twelve-month accounting period that ends at the end of
a month other than December 31. 1-10. Money. 1-11. When money does not hold a stable value, the financial
statements can lose much of their significance. To the
extent that money does not remain stable, it loses
usefulness as the standard for measuring financial
transactions. 1-12. No.
There is a problem with determining the index in order to
adjust the statements. The items that are included in
7 the index must be representative and the price of items
change because of various factors, such as quality,
technology, and inflation.
Yes. A reasonable adjustment to the statements can be made for
inflation. 8 1-13. False.
An arbitrary write-off of inventory cannot be justified
under the conservatism concept. The conservatism concept
can only be applied where there are alternative
measurements and each of these alternative measurements
has reasonable support. 1-14. Yes, inventory that has a market value below the
historical cost should be written down in order to
recognize a loss. This is done based upon the concept of
conservatism. Losses that can be reasonably anticipated
should be taken in order to reflect the least favorable
effect on net income of the current period. 1-15. End of production
The realization of revenue at the completion of the
production process is acceptable when the price of the
item is known and there is a ready market.
Receipt of cash
This method should only be used when the prospects of
collection are especially doubtful at the time of sale. During production
This method is allowed for long-term construction
projects because recognizing revenue on long-term
construction projects as work progresses tends to give a
fairer picture of the results for a given period in
comparison with having the entire revenue realized in one
period of time from a project.
1-16. It is difficult to apply the matching concept when there
is no direct connection between the cost and revenue.
Under these circumstances, accountants often charge off
the cost in the period incurred in order to be
conservative. 1-17. If the entity can justify the use of an alternative
accounting method on the basis that it is preferable,
then the change can be made. 1-18. The accounting reports must disclose all facts that may
influence the judgment of an informed reader. Usually
this is a judgment decision for the accountant to make.
Because of the complexity of many businesses and the
9 increased expectations of the public, the full disclosure
concept has become one of the most difficult concepts for
the accountant to apply.
1-19. There is a preference for the use of objectivity in the
preparation of financial statements, but financial
statements cannot be completely prepared based upon
objective data; estimates must be made in many situations. 1-20. This is a true statement. The concepts of materiality
allow the accountant to handle immaterial items in the
most economical and expedient manner possible. 1-21. Some industry practices lead to accounting reports that
do not conform to generally accepted accounting
principles. These reports are considered to be
acceptable, but the accounting profession is making an
effort to eliminate particular industry practices that do
not conform to the normal generally accepted accounting
principles. 1-22. Events that fall outside of the financial transactions of
the entity are not recorded. An example would be the
loss of a major customer. 1-23. True. The accounting profession is making an effort to
reduce or eliminate specific industry practices. 1-24. The entity must usually use the accrual basis of
accounting. Only under limited circumstances can the
entity use the cash basis. 1-25. There is no one source or list of accounting principles
that has substantial authoritative support; therefore,
the accountant must be familiar with acceptable sources
to refer to in order to decide whether any particular
accounting principle has substantial authoritative
support. The ultimate responsibility is with the
accountant to prove that generally acceptable accounting
principles have been followed. 1-26. The separate entity concept directs that personal
transactions of the owners not be recorded on the books
of the entity. 1-27. At the point of sale. 1-28. a. The building should be recorded at cost, which is
10 b. Revenue should not be recorded for the savings between
the cost of $50,000 and the bid of $60,000. Revenue
comes from selling, not from purchasing. 11 1-29. The materiality concept supports this policy. 1-30. The Securities and Exchange Commission (SEC). 1-31. The basic problem with the monetary assumption when there
has been significant inflation is that the monetary
assumption assumes a stable dollar in terms of purchasing
power. When there has been inflation, the dollar has not
been stable in terms of purchasing power and, therefore,
dollars are being compared that are not of the same
purchasing power. 1-32. The matching principle deals with the costs to be matched
against revenue. The realization concept has to do with
the determination of revenue. The combination of revenue
and costs determine income. 1-33. The term "generally accepted accounting principles" is
used to refer to accounting principles that have
substantial authoritative support. 1-34. The process of considering a Statement of Financial
Accounting Standards begins when the Board elects to add
a topic to its technical agenda. The Board only
considers topics that are "broke" for its technical
On projects with a broad impact, a Discussion Memorandum
or an Invitation to Comment is issued. The Discussion
Memorandum or Invitation to Comment is distributed as a
basis for public comment. After considering the written
comments and the public hearing comments, the Board
resumes deliberations in one or more public Board
meetings. The final Statement on Financial Accounting
Standards must receive a majority affirmative vote of the
Board. 1-35. The FASB Conceptual Framework for Accounting and
Reporting is intended to set forth a system of
interrelated objectives and underlying concepts that will
serve as the basis for evaluating existing standards of
financial accounting and reporting. 1-36. a. Committee on Accounting Procedures: A committee of the AICPA that played an important role
in the determination of generally accepted accounting
principles in the United States between 1939 and 1959.
12 b. Committee on Accounting Terminology:
A committee of the AICPA that played an important role
in the defining of accounting terminology between
1939 and 1959. c. Accounting Principles Board:
An AICPA board that played a leading role in the
development of generally accepted accounting
principles in the United States between 1959 and 1973. d. Financial Accounting Standards Board:
The Board that has played the leading role in the
development of generally accepted accounting
principles in the United States since 1973. 1-37. Concepts Statement No. 1 indicates that the objectives of
general-purpose external financial reporting are
primarily for the needs of external users who lack the
authority to prescribe the information they want and must
rely on information management communicates to them. 1-38. Financial accounting is not designed to measure directly
the value of a business enterprise. Concepts Statement
No. 1 indicates that financial accounting is not designed
to measure directly the value of a business enterprise,
but the information it provides may be helpful to those
who wish to estimate its value. 1-39. According to Concepts Statement No. 2, to be relevant,
information must be timely and it must have predictive
value or feedback value or both. To be reliable,
information must have representational faithfulness and
it must be verifiable and neutral. 1-40. 1. Definition
1-41. 1. Historical cost
2. Current cost
3. Current market value
4. Net realizable value
5. Present value
13 1-42. The accrual basis income statement recognizes revenue
when it is realized (realization concept) and expenses
recognized when they are incurred (matching concept).
The cash basis recognizes revenue when the cash is
received and expenses when payments are made. 1-43. True. Usually the cash basis does not indicate when the
revenue was earned and when the cost should be
recognized. The cash basis recognizes cash receipts as
revenue and cash payments as expenses. 1-44. When cash is received and when payment is made is
important. For example, the timing of cash receipts and
cash payments can have a bearing on a company's ability
to pay bills on time. 14 PROBLEMS
f__ 9. g__ PROBLEM 1-2
n PROBLEM 1-3
a. 2 Typically, much judgment and estimates go into
the preparation of financial statements. b. 4 Financial accounting is not designed to measure
directly the value of a business enterprise.
The end result statements can be used as part
of the data to aid in estimating the value of
the business. c. 4 FASB Statement of Concepts No. 2 lists
timeliness, predictive value, and feedback
value as ingredients of the quality of
relevance. d. 2 The Securities and Exchange Commission has the
primary right and responsibility for generally
accepted accounting principles. They have
primarily elected to have the private sector
develop generally accepted accounting
principles and have designated the Financial
Accounting Standards Board as the primary
source. e. 4 The concept of conservatism directs that the
measurement with the least favorable effect on
net income and financial position in the
current period be selected. f. 3 The Internal Revenue Service deals with Federal
tax law, not generally accepted accounting
15 g. 5 Opinions were issued by The Accounting
Principles Board. 16 PROBLEM 1-4
a. 1 Statements of Position have been issued by the
AICPA. b. 2 This is the definition contained in SFAC No. 6 c. 2 This is the definition contained in SFAC No. 6. d. 5 Comparability is not one of the criteria for an
item to be recognized. e. 2 Future cost is not one of the measurement
attributes recognized in SFAC No. 5. f. 1 Revenue is usually recognized at point of sale. g. 1 Financial accounting is not designed to measure
directly the value of a business enterprise. PROBLEM 1-5
a. Sales on credit
Cost of inventory sold on credit
Payment to sales clerk
Income b. Collections from customers
Payment for purchases
Payment to sales clerk
Loss $ 80,000
$< 5,000> 17 CASES
CASE 1-1 STANDARDS OVERLOAD?
(As more financial accounting standards were issued, a charge of...
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