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Theoretical Structure of
Financial Accounting
I N T ERMEDIATE ACCOU N T I NG I
CHA PT ER 1
Financial Accounting Environment
 The primary focus of financial accounting is on the information needs
of investors and creditors (capital providers).
 Financial statements convey financial information to external users.
• Investors
• Creditors
• Employees
• Customers
• Suppliers
• Government
Financial Statements
 The primary means of conveying financial information to investors, creditors,
and other external users is through financial statements and related notes.
The financial statements most frequently provided are:
1.
2.
3.
4.
5.
Balance sheet or statement of financial position
Income statement or statement of operations
Statement of cash flows
Statement of shareholders' equity
Either
a) a statement of other comprehensive income immediately following the
income statement, or
b) a statement of comprehensive income (including information on the
income statement as well as on the statement of other comprehensive
income).
Cash vs Accrual Basis of Accounting
 Two primary methods of measuring income exist
 Cash basis – income and expenses are only recognized when received or
paid in cash
 Accrual basis – income is recognized when earned regardless of whether
or not cash has been received
Net Operating Cash Flow vs Net Income
 Cash Basis - Net operating cash flow is the difference between cash receipts
and cash disbursements from providing goods and services.
 Income is recognized when received in cash
 Expenses are recognized when paid in cash
 Accrual Basis - Net income is the difference between revenues and expenses.
 Income is recognized when a good or service has been provided
 Expenses are recognized when incurred
 Cash basis net operating cash flow can be converted to accrual net income.
 Measuring the same activities by the accrual accounting model provides a more
accurate prediction of future operating cash flows.
Exercise 1-1, page 38 (adjusted)
Listed below are several transactions that took place during the first two years of operations for
the law firm of Pete, Pete, and Roy. In addition, you learn that the company incurred utility
costs of $35,000 in year 1, that there were no liabilities at the end of year 2, no anticipated bad
debts on receivables, and the insurance policy covers a three-year period.
a) Determine the amount of net income to be recognized each year using accrual basis
accounting.
b) Determine the amount receivables due from customers in Year 2.
Year 1
Amounts billed to customers for services rendered
Year 2
$170,000
$220,000
160,000
190,000
Salaries paid to employees for services rendered during the year
90,000
100,000
Utilities
30,000
40,000
Purchase of insurance policy
60,000
-0-
(20,000)
50,000
Cash collected from customers
Cash disbursements
Net Operating Cash Flow
Exercise 1-1, page 38 (adjusted) - Solution
Part b
Part a
Pete, Pete, and Roy
Comparative Income Statements
Year 1
Amount billed to customers
$170,000
Less: Cash collected
(160,000)
Ending Accounts Receivable
Revenues
Expenses:
Salaries
Utilities
Insurance
Net Income
Year 1
$170,000
(90,000)
(35,000)
(20,000)
$ 25,000
Year 2
$220,000
(100,000)
(35,000)
(20,000)
$ 65,000
Explanation of Utilities Expense: $35,000 of utilities were
incurred in Year 1 and should therefore be recognized in
Year 1. Since only $30,000 of the $35,000 of utilities were
paid in Year 1, $5,000 of utilities payable were carried into
Year 2. Therefore, $5,000 of the $40,000 paid in Year 2
was actually incurred in Year 1 leaving $35,000 of utilities
actually incurred, and therefore recognized, in Year 2.
Year 2
$10,000
Beginning Accounts Receivable
$10,000
Plus: Amounts billed to customers
220,000
Less: Cash collected
Ending Accounts Receivable
(190,000)
$40,000
Financial Accounting and Reporting Standards
 Generally accepted accounting principles (GAAP) are a set of
guidelines companies follow in measuring and reporting financial
information.
 The Financial Accounting Standards Board (FASB) currently sets
accounting standards.
 The Securities and Exchange Commission (SEC) has the authority to
set accounting standards for companies, but always has delegated the
task to the accounting profession.
The Conceptual Framework
A coherent system of interrelated objectives and fundamentals that
is intended to lead to consistent standards and that prescribes the
nature, function, and limits of financial accounting and reporting.
 Underlying foundation for accounting standards
 Underlying concepts of accounting that guide the selection of events to
be accounted for, the measurement of those events, and the means of
summarizing and communicating them to interested parties
 Does not set GAAP
 Provides structure and direction to financial accounting and reporting
 See Conceptual Framework, Intermediate Accounting text, page 21
Qualitative Characteristics of Accounting Information
To be useful for decision making, accounting information should possess the
primary characteristics of relevance and faithful representation.
FUNDAMENTAL QUALITATIVE CHARACTERISTICS

Relevance




Predictive value – helps to predict a future condition
Confirmatory value – assists users in validating or changing a prior assessment of a
company’s condition
Materiality (enhancing aspect) – has an effect on decisions
Faithful representation



Completeness – All information that is necessary for faithful representation.
Neutrality – Accounting standards should be set with overall societal goals and specific
objectives in mind, and should try not to favor particular groups or companies.
Free from error
Financial Accounting and Reporting Standards
ENHANCING QUALITATIVE CHARACTERISTICS
 Comparability - Ability to help users see similarities and differences
among events and conditions (also includes consistency).
 Verifiability - Consensus among different measurers.
 Timeliness - Available to users before a decision is made.
 Understandability - Users must understand the information.
Financial Accounting and Reporting Standards
CONSTRAINT
 Cost Effectiveness – The benefits received should exceed the cost to
generate the benefits
ELEMENTS OF FINANCIAL STATEMENTS
Assets
Liabilities
Equity (or net assets)
Investments by owners
Distributions to owners
Comprehensive income
Revenues
Expenses
Gains
Losses
Probable future economic benefits obtained or controlled by a particular entity as a result of past
transactions or events.
Probable future sacrifices of economic benefits arising from present obligations of a particular entity
to transfer assets or provide services to other entities in the future as a result of past transactions or
events.
the residual interest in the assets of an entity that remains after deducting its liabilities. Called
shareholders’ equity or stockholders’ equity for a corporation.
Increases in equity of a particular business enterprise resulting from transfers to it from other entities
of something of value to obtain or increase ownership interests in it.
Decreases in equity of a particular enterprise resulting from transfers to owners.
The change in equity of a business enterprise during a period from transactions and other events and
circumstances from nonowner sources. It includes all changes in equity during a period except those
resulting from investments by owners and distributions to owners.
Inflows or other enhancements of assets of an entity or settlements of its liabilities during a period
from delivering or producing goods, rendering services, or other activities that constitute the entity’s
ongoing major or central operations.
Outflows or other using up of assets or incurrences of liabilities during a period from delivering or
producing goods, rendering services, or other activities that constitute the entity’s ongoing major, or
central, operations.
Increases in equity from peripheral or incidental transactions of an entity.
Represent decreases in equity arising from peripheral or incidental transactions of an entity.
Recognition, Measurement and
Disclosure Concepts
It is important to accurately determine when the
financial elements should be recorded and how
they should be measured and disclosed.
Underlying Assumptions

Economic Entity Assumption
All economic events can be identified with a particular economic entity.

Going Concern Assumption
In the absence of information to the contrary, it is anticipated that a business entity will
continue to operate indefinitely.

Periodicity Assumption
The life of a company can be divided into artificial time periods to provide timely
information to external users.

Monetary Unit Assumption
Financial statement elements should be measured in terms of the United States dollar.
Recognition
 Revenue Recognition Principle

Revenue should be recognized in the period it is earned (when goods or
services are transferred to customers), not necessarily in the period in
which cash is received.

Revenue is only recognized to the extent it is probable the seller will
receive the amounts it is entitled to receive.
 Matching Principle

Expenses are typically recognized in the same period as the related
revenues.
General Recognition Criteria
An item should be recognized in the basic financial statements when it meets the
following criteria:
 Definition — the item meets the definition of an element of financial statements.
 Measurability — the item has a relevant attribute measurable with sufficient
reliability.
 Relevance — the information about it is capable of making a difference in user
decisions.
 Reliability — the information is representationally faithful, verifiable, and neutral.
MEASUREMENT
Measurement — Associating numerical amounts to the elements.
 GAAP uses a “mixed attribute” model including
 Historical Cost – measurement is based on the amount given or
received in the exchange transaction
 Net Realizable Value – measurement is based on the amount of
cash into which the asset or liability could be converted in the
ordinary course of business
 Current Cost – measurement is based on the current replacement
cost
 Present Value of Future Cash Flows – measurement is based on
future cash flows discounted for the time value of money
 Fair Value – measurement is based on the price that would be
received to sell assets or transfer liabilities in an orderly market
transaction
FULL-DISCLOSURE PRINCIPLE
►
The full-disclosure principle means that the financial reports should include any
information that could affect the decisions made by external users, subject to the cost
effectiveness constraint.

Supplemental information is disclosed in a variety of ways, including parenthetical or
modifying comments placed on the face of the financial statements.

Disclosure notes conveying additional insights about company operations, accounting
principles, contractual agreements, and pending litigation.

Supplemental financial statements that report more detailed information than is
shown in the primary financial statements.
Theoretical Structure of
Financial Accounting
I N T ERMEDIATE ACCOU N T I NG I – CHA PT ER 1
E N D OF P R ESENTATION