Chapter 1: Environment and Theoretical Structure of Financial Accounting PDF

Chapter 1 Environment and Theoretical Structure of Financial...

Chapter 1 Environment and Theoretical Structure of Financial Accounting Copyright © 2023 McGraw Hill LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw  LO1-1 Visualize the Important Role of Accounting Accounting provides useful information about economic activity to help: – Produce good decisions – Foster a prosperous society 01-02 Copyright© Copyright ©2023 2023McGraw McGrawHill HillLLC.. LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw  LO1-1 Primary Focus of Financial Accounting Providing financial information to various external users – Investors – Creditors – Other external users  InvestorUse different kinds of information To predict the s and future risk creditor and potential Financial return of s information is a key investments component of that or loans information set  Before supplying Copyright© Copyright ©2023 2023McGraw McGrawHill HillLLC.. capital to01-03 LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw  LO1-1 Financial Accounting Financial information is conveyed through financial statements and related disclosure notes – Balance sheet – Income statement (and the statement of comprehensive income) – Statement of cash flows – Statement of shareholders’ equity Financial Reporting – Refers to the process of providing financial information to external users 01-04 Copyright© Copyright ©2023 2023McGraw McGrawHill HillLLC.. LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw  LO1-1 Financial Information Providers and External User Groups PROVIDERS OF FINANCIAL USERS OF FINANCIAL INFORMATION INFORMATION Profit-oriented companies Investors Creditors (banks, bondholders, other lenders) Employees Not-for-profit entities (e.g., Labor unions government entities, Customers charitable organizations, Suppliers schools) Government regulatory agencies (e.g., Internal Revenue Service, Securities and Exchange Commission) Households Financial intermediaries (e.g., financial analysts, stockbrokers, mutual fund managers, credit-rating organizations) 01-05 Copyright © 2023 McGraw Hill LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw  LO1-1 The Economic Environment and Financial Reporting Capital markets provide a mechanism to help the economy allocate resources efficiently Corporations acquire capital from: Investors in exchange for ownership interest and; Creditors by borrowing – Either through individual loans or publicly traded debt such as bonds 01-06 Copyright© Copyright ©2023 2023McGraw McGrawHill HillLLC.. LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw  LO1-1 The Investment-Credit Decision— A Cash Flow Perspective Why do investors and creditors provide capital? They want to earn a fair return on the resources they provide Shareholders receive cash from: – Sale of the ownership shares of stock – Periodic dividends Key variables in investment decision Rate of return Uncertainty or risk 01-07 Copyright© Copyright ©2023 2023McGraw McGrawHill HillLLC.. LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw  LO1-1 Rate of Return Example calculation of rate of return: Assume an investor provides a company with $10,000 cash by purchasing stock at the end of 2023, receives $400 in dividends from the company during 2024, and sells the ownership interest (shares) at the end of 2024 for $10,600. $400 dividends + $600 share price appreciation = $10,000 initial investment 10% Investors and creditors like to invest in stocks or bonds that provide a high expected rate of return 01-08 Copyright © 2023 McGraw Hill LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw  LO1-1 Concept Check: Rate of Return Creecher purchased $200,000 worth of Troman stock, received four quarterly dividends of $1,000 each, and sold the Troman shares for $206,000 after one year. What is Creecher’s rate of return? a. 1% b. 2.5% c. 5% d. 10% The correct answer is c: Dividends = 4 × $1,000 = $4,000 Share price appreciation = $206,000 − $200,000 = $6,000 $4,000 + Rate of return $6,000 = = $200,000 5% 01-09 Copyright © 2023 McGraw Hill LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw  LO1-1 Example of Uncertainty Consider the following two investment options. Which would you pick? Investing $10,000 in a savings account insured by the U.S. government that will generate a 5% rate of return Investing $10,000 in a profit-oriented company Risk/Return tradeoff: Most investors would invest in the profit-oriented company only if the 01-10 potential return is high enough. Copyright © 2023 McGraw Hill LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw  LO1-1 Objective of Financial Accounting Primary objective of financial accounting – Provided information should be useful for decision making – Information should help investors and creditors evaluate the following characteristics of the enterprise’s future cash receipts and disbursements: 1. Amounts 2. Timing 3. Uncertainty 01-11 Copyright© Copyright ©2023 2023McGraw McGrawHill HillLLC.. LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw  LO1-2 Cash versus Accrual Accounting Cash Basis Accounting Measurement of cash receipts and cash payments from transactions related to providing goods and services Difference is net operating cash flow Accrual Basis Accounting Measurement of revenues and expenses, regardless of when cash is received or paid Difference is net income or net loss 01-12 Copyright© Copyright ©2023 2023McGraw McGrawHill HillLLC.. LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw  LO1-2 Cash Basis 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 Year 2 Year 3 Total Sales (on credit) $100,000 $100,00 $100,0 $300,00 0 00 0 Net Operating Cash Flows Cash receipts from customers $ 50,000 $125,00 $125,0 $300,00 0 00 0 Cash disbursements: Prepayment of three years’ rent (60,000) –0– –0– (60,000) Salaries to employees (50,000) (50,000 (50,000 (150,00 ) ) 0) Utilities (5,000) (15,000 (10,000 (30,000) ) ) 01-13 Copyright© Copyright Net © 2023operating 2023 McGrawHill McGraw cash HillLLC.. LLC. All flow $ rights reserved. No reproduction or distribution $ prior written without $ consent of McGraw $  LO1-2 Accrual Basis Example Carter Company paid $60,000 for 3 years’ rent at the beginning of year 1 Under accrual basis accounting, rent is recognized as an expense all three years even though it was paid CARTER in year 1 COMPANY Income Statements Year 1 Year 2 Year 3 Total Revenues $100,000 $100,00 $100,0 $300,00 0 00 0 Expenses: Rent 20,000 20,000 20,000 60,000 Salaries 50,000 50,000 50,000 150,000 Utilities 10,000 30,000 10,000 10,000 Total expenses 80,000 240,000 80,000 80,000 Net Income $ $ $ $ 01-14 Copyright© Copyright ©2023 2023McGraw McGrawHill HillLLC.. 20,000 LLC. All rights reserved. No reproduction 20,000 or distribution 20,000 without prior 60,000 written consent of McGraw  LO1-2 Concept Check: Accrual Accounting Which of the following is not an advantage of accrual accounting? a. Spreads out the influence of one-time events that affect multiple reporting periods b. Highlights cash effects of operations c. Captures long-run performance d. Recognizes assets and liabilities associated with receivables and payables The correct answer is b. Cash-basis accounting focuses on cash in and cash out, and so highlights the cash effects of ongoing operations. 01-15 Copyright © 2023 McGraw Hill LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw  LO1-3 The Development of Financial Accounting and Reporting Standards Generally Accepted Accounting Principles (GAAP) – GAAP is a dynamic set of both broad and specific guidelines that companies should follow when measuring and reporting the information in their financial statements and related notes – GAAP facilitates decision making by investors and creditors by allowing them to compare financial information among companies 01-16 Copyright© Copyright ©2023 2023McGraw McGrawHill HillLLC.. LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw  LO1-3 Accounting Standard Setting HIERARCHY OF STANDARD-SETTING AUTHORITY Congress SEC Private Sector CAP APB FASB 1938–1959 1959–1973 1973–Present 01-17 Copyright © 2023 McGraw Hill LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw  LO1-3 Historical Perspective and Standards Securities and Exchange Commission (SEC) – Created by Congress in response to the stock market crash of 1929 – Goal: To restore investor confidence 1933 Securities Act – Applies to initial offerings of securities (stocks and bonds) 1934 Securities Exchange Act – Applies to secondary market transactions – Mandates reporting requirements for companies whose securities are publicly traded 01-18 Copyright © 2023 McGraw Hill LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw  LO1-3 Early U.S. Standard Setting Committee on Accounting Procedure (CAP) (1938 to 1959) – First private-sector standard-setting body – Committee of the American Institute of Accountants (AIA) – AIA: National professional organization for certified professional public accountants – AIA: Renamed as American Institute of Certified Public Accountants (AICPA) – Issued 51 Accounting Research Bulletins (ARBs) Accounting Principles Board (APB) (1959 to 1973) – Issued 31 Accounting Principles Board Opinions (APBOs), various Interpretations, and four Statements – Replaced by Financial Accounting Standards Board (FASB) 01-19 Copyright© Copyright ©2023 2023McGraw McGrawHill HillLLC.. LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw  LO1-3 Financial Accounting Standards Board FASB created in 1973 (FASB) – Established to set U.S. accounting standards – Supported by Financial Accounting Foundation (FAF) – Seven full-time members Emerging Issues Task Force (EITF) created in 1984 – Identifies financial reporting issues and attempts to resolve them without involving the FASB Primarily addresses implementation issues Speeding up the standard-setting process – EITF rulings are ratified by the FASB and are considered part of GAAP Government Accounting Standards Board (GASB): develop accounting standards for 01-20 Copyright governmental units © 2023 McGraw Hill LLC. All rights reserved.such as states No reproduction andprior or distribution without cities written consent of McGraw  LO1-3 Concept Check: Accounting Standard Setting Accounting standards in the United States are currently set by: a. The FASB b. The AICPA c. The EITF d. The NCAA The correct answer is a. Since 1973, the FASB has been the primary standard-setting body in the United States. 01-21 Copyright © 2023 McGraw Hill LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw  LO1-3 Codification FASB Accounting Standards Codification – Only source of authoritative nongovernmental U.S. GAAP Organizes the thousands of U.S. GAAP pronouncements into roughly 90 accounting topics Also includes portions of SEC accounting guidance Accounting Standards Update (ASU): any new standard issued by FASB Located at the FASB website 01-22 Copyright© Copyright ©2023 2023McGraw McGrawHill HillLLC.. LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw  LO1-3 FASB Accounting Standards Codification Topics FASB Accounting Standards Codification Topics Topic Numbered General Principles 100–199 Presentation 200–299 Assets 300–399 Liabilities 400–499 Equity 500–599 Revenues 600–699 Expenses 700–799 Broad Transactions 800–899 Industry 900–999 01-23 Copyright© Copyright ©2023 2023McGraw McGrawHill HillLLC.. LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw  LO1-3 International Standard Setting International Accounting Standards Committee (IASC) – Formed in 1973 to develop global accounting standards – Created a new standard-setting body called the International Accounting Standards Board (IASB) (2001) IASB: – To develop a single set of high-quality, understandable, and enforceable global accounting standards – Endorsed 41 International Accounting 01-24 Copyright© Copyright ©Standards 2023McGraw 2023 McGrawHill LLC. All(IASs) HillLLC.. rights reserved. No reproduction or distribution without prior written consent of McGraw  LO1- Comparison of Organizations of 11 U.S. and International Standard Setters U.S. GAAP IFRS Regulatory oversight Securities Exchange Monitoring Board provided by: Commission (SEC) Foundation providing Financial Accounting IFRS Foundation: 22 oversight, appointing Foundation (FAF): 14-18 trustees members, raising funds: trustees Standard-setting board: Financial Accounting International Accounting Standards Board (FASB): Standards Board (IASB): 14 7 members members Advisory council providing Financial Accounting IFRS Advisory Council: input on agenda and Standards Advisory approx. 50 members projects: Council (FASAC): 30–40 members Emerging Issues Task Group to deal with IFRS Interpretations Force (EITF): approx. 15 emerging issues: Committee: 14 members members 01-25 Copyright© Copyright ©2023 2023McGraw McGrawHill HillLLC.. LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw  LO1-3 International Financial Reporting Standards (IFRS) Since 2001, the IASB has revised many International Accounting Standards (IASs) and has issued new standards of its own, called International Financial Reporting Standards (IFRS) More and more countries are basing their national accounting standards on IFRS By 2018, more than 120 jurisdictions, including Hong Kong, Egypt, Canada, Australia, and the countries in the European Union (EU), require or permit the use of IFRS or a local variant of IFRS 01-26 Copyright© Copyright ©2023 2023McGraw McGrawHill HillLLC.. LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw  LO1-3 Efforts to Converge U.S. and International Standards U.S. Conver GAAP ged Standar IFRS ds FASB and IASB have been working for many years to converge to one global set of accounting standards, however, recent events suggest that full convergence will not be achieved in the foreseeable future While it appears likely that the FASB and IASB will continue to work together to converge where possible, some differences between IFRS and U.S. GAAP will remain 01-27 Copyright© Copyright ©2023 2023McGraw McGrawHill HillLLC.. LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw  LO1-4 The FASB’s Standard-Setting Process Step Explanation 1. The Board identifies financial reporting issues based on requests/recommendations from stakeholders or through other means. 2. The Board decides whether to add a project to the technical agenda based on a staff-prepared analysis of the issues. 3. The Board deliberates at one or more public meetings the various issues identified and analyzed by the staff 4. The Board issues an Exposure Draft. (In some projects, a Discussion Paper may be issued to obtain input at an early stage that is used to develop an Exposure Draft.) 5. The Board holds a public roundtable meeting on the Exposure Draft, if necessary. 6. The staff analyzes comment letters, public roundtable discussion, and any other information. The Board redeliberates the proposed provisions at public meetings. 7. The Board issues an Accounting Standards Update describing amendments to the Accounting Standards Codification. 01-28 Copyright© Copyright ©2023 2023McGraw McGrawHill HillLLC.. LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw  LO1-4 Politics in Standard Setting Mid-1990’s—accounting for employee stock options Implementation of the fair value accounting standard issued in 2007 01-29 Copyright© Copyright ©2023 2023McGraw McGrawHill HillLLC.. LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw  LO1- 11 International Financial Reporting Standards: Politics in International Standard Setting Politics in International Standard Setting. Political pressures on the IASB’s standard-setting process are severe. Politicians from countries that use IFRS lobby for the standards they prefer. The European Union (EU) is a particularly important adopter of IFRS and utilizes a formal evaluation process for determining whether an IFRS standard will be endorsed for use in EU countries. Economic consequences for EU member nations are an important consideration in that process. For example, in 2008 the EU successfully pressured the IASB to suspend its due process and immediately allow reclassification of investments so that EU banks could avoid recognizing huge losses during a financial crisis. Commenting on standards setting at that time, Charlie McCreevy, European Commissioner for Internal Markets and Service, stated that "Accounting is now far too important to be left to...accountants!" 01-30 Copyright© Copyright ©2023 2023McGraw McGrawHill HillLLC.. LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw  LO1-5 Encouraging High-Quality Financial Reporting Role of an Auditor – Offer credibility to financial statements – Express an opinion on the compliance of financial statements with GAAP – Licensed by states to provide audit services—certified public accountants (CPAs) 01-31 Copyright© Copyright ©2023 2023McGraw McGrawHill HillLLC.. LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw  LO1-5 Financial Reporting Reform ACCOUNTING SCANDALS Enron WorldCom Xerox Merck Adelphia Communications Increased the pressure on lawmakers to pass measures that would restore credibility and investor confidence in the financial reporting process Sarbanes-Oxley 01-32 Copyright © 2023 McGraw Hill LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw  LO1-5 A Move Away from Rules-Based Standards? Principles-based vs.Rules-based Objectives- oriented A principles-based, or objectives-oriented, approach to standard-setting stresses professional judgment, as opposed to following a list of rules or bright lines Regardless, poor ethical values on the part of management are at the heart of accounting abuses and scandals 01-33 Copyright © 2023 McGraw Hill LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw  LO1-5 Ethics and Professionalism Ethics deals with the ability to distinguish right from wrong Codes of Ethics or Codes of Professional Conduct are provided by: – American Institute of Certified Public Accountants (AICPA) – Institute of Management Accountants (IMA) – Institute of Internal Auditors (IIA) 01-34 Copyright© Copyright ©2023 2023McGraw McGrawHill HillLLC.. LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw  LO1-5 Analytical Model for Ethical Decisions Step Determine the facts of the situation. This involves 1. determining the who, what, where, when, and how. Step Identify the ethical issue and the stakeholders. 2. Stakeholders may include shareholders, creditors, management, employees, and the community. Step Identify the values related to the situation. For 3. example, in some situations confidentiality may be an important value that might conflict with the right to know. Step Specify the alternative courses of action. 4. Step Evaluate the courses of action specified in step 4 in 5. terms of their consistency with the values identified in step 3. This step may or may not lead to a suggested course of action. Step Identify the consequences of each possible course of 6. action. If step 5 does not provide a course of action, assess the consequences of each possible course of 01-35 Copyright© Copyright ©2023 2023McGraw action McGrawHill HillLLC.. for all of the stakeholders involved. LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw  LO1-5 Concept Check: High-Quality Financial Reporting Which of the following is not one of the ways in which high- quality accounting is encouraged by the U.S. financial reporting system? a. Accounting standards encourage comparability b. Auditors assess whether financial statements are materially misstated c. Sarbanes-Oxley instituted reforms designed to improve the quality of financial reporting d. Managers are required to use frameworks for ethical decision making when deciding how to account for transactions The correct answer is d. Ethical frameworks can be very useful, but managers are not required to use them. 01-36 Copyright © 2023 McGraw Hill LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw  LO1-6 The Conceptual Framework Described as an Accounting Constitution Provides an underlying foundation for U.S. accounting standards – Guides the selection of events to be accounted for – Measurement of those events – Means of summarizing them and communicating them to interested parties Provides structure and direction to financial accounting and reporting Disseminated by FASB through Statements of Financial Accounting Concepts (SFACs) 01-37 Copyright© Copyright ©2023 2023McGraw McGrawHill HillLLC.. LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw  LO1-6 The Conceptual Framework (concluded) Objective Recognition and Qualitative Elements Measurement Characteristics Concepts Financial Constraints Statements 01-38 Copyright © 2023 McGraw Hill LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw  LO1- 11 International Financial Reporting Standards: Role of the Conceptual Framework Role of the conceptual framework. The conceptual frameworks in U.S. GAAP and IFRS are very similar and are converging even more with ongoing efforts by the FASB and IASB. However, in U.S. GAAP, the conceptual framework primarily provides guidance to standard setters to help them develop high-quality standards. In IFRS the conceptual framework guides standard setting, but in addition it provides a basis for practitioners to make accounting judgments when another IFRS standard does not apply. 01-39 Copyright© Copyright ©2023 2023McGraw McGrawHill HillLLC.. LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw  LO1-7 Objective of Financial Reporting Objective Recognition and Qualitative Elements Measurement Characteristics Concepts Financial Constraints Statements 01-40 Copyright © 2023 McGraw Hill LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw  LO1-7 Qualitative Characteristics of Financial Reporting Information Objective Recognition and Qualitative Elements Measurement Characteristics Concepts Financial Constraints Statements 01-41 Copyright © 2023 McGraw Hill LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw  LO1-7 Hierarchy of Qualitative Characteristics of Financial Information Decision usefulness Releva Faithful nce representation Predicti Free Confirmat Material Complete Neutral ve from ory value ity ness ity value error Comparab ility Verifiabili Timelines Understandab (consisten ty s ility cy) Cost effectiveness (benefits exceed costs) 01-42 Copyright© Copyright ©2023 2023McGraw McGrawHill HillLLC.. LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw  LO1-7 Concept Check: FASB Conceptual Framework—Relevance Which of the following is not a component of relevance as defined in the FASB’s conceptual framework? a. Free from error b. Materiality c. Predictive value d. Confirmatory value The correct answer is a. Free from error is a component of faithful representation. 01-43 Copyright © 2023 McGraw Hill LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw  LO1-7 Concept Check: FASB Conceptual Framework—Faithful Representation Which of the following is not a component of faithful representation as defined in the FASB’s conceptual framework? a. Free from error b. Neutrality c. Understandability d. Completeness The correct answer is c. Understandability is an enhancing characteristic of decision usefulness. 01-44 Copyright © 2023 McGraw Hill LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw  LO1-7 The Conceptual Framework: Elements Objective Recognition and Qualitative Elements Measurement Characteristics Concepts Financial Constraints Statements 01-45 Copyright © 2023 McGraw Hill LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw  LO1-7 Elements of Financial Statements Assets Liabilities Equity (or net assets) Investments by owners Distributions to owners Comprehensive income Revenues Expenses Gains Losses 01-46 Copyright© Copyright ©2023 2023McGraw McGrawHill HillLLC.. LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw  LO1-8 Underlying Assumptions Four basic assumptions underlie GAAP The economic entity assumption presumes that economic events can be identified specifically with an economic entity The going concern assumption anticipates that a business entity will continue to operate indefinitely The periodicity assumption allows the life of a company to be divided into artificial time periods to provide timely information The monetary unit used in U.S. financial 01-47 Copyright© Copyright ©2023 2023McGraw McGrawHill HillLLC.. LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw  The Conceptual Framework: LO1-9 Recognition, Measurement, and Disclosure Concepts Objective Recognition and Qualitative Elements Measurement Characteristics Concepts Financial Constraints Statements 01-48 Copyright © 2023 McGraw Hill LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw  LO1-9 Recognition, Measurement, and Disclosure Concepts Recognition refers to the process of admitting information into the financial statements Measurement is the process of associating numerical amounts with the elements Disclosure refers to the process of including additional pertinent information in the financial statements and accompanying notes 01-49 General Recognition Criteria Copyright© Copyright ©2023 2023McGraw McGrawHill HillLLC.. LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw  LO1-9 Revenue Recognition Revenue: Inflows of assets or settlements of liabilities resulting from providing a product or service to a customer Revenue recognition used to be guided by the realization principle (two criteria) – Earnings process is judged to be complete or virtually complete – Reasonable certainty as to the collectability of the asset to be received (usually cash) FASB issued ASU No. 2014-09, which requires that we recognize revenue when goods or services are transferred to customers for the amount the company expects to be entitled to01-50 Copyright© Copyright ©2023 2023McGraw McGrawHill HillLLC.. LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw  LO1-9 Expense Recognition Often matches revenues and expenses that arise from the same transactions or other events Four approaches: – Based on an exact cause-and-effect relationship – By associating an expense with the revenues recognized in a specific time period – By a systematic and rational allocation to specific time periods Copyright– In the period incurred, without regard Copyright©©2023 2023McGraw McGrawHill HillLLC.. 01-51 LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw  LO1-9 Measurement GAAP currently employs a “mixed attribute” measurement model The five attributes are: 1. Historical cost: original transaction value adjusted for depreciation and amortization 2. Net realizable value: the amount of cash into which an asset is expected to be converted in the ordinary course of business 3. Current cost: the cost that would be incurred to purchase or reproduce the asset 4. Present value: the current value of future cash flows, calculated by applying the time value of money 5. Fair value: the price that would be received to01-52 Copyright©©2023 2023McGraw McGrawHill HillLLC.. LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw Copyright  LO1-9 Historical Cost Historical Cost: Original transaction value – Bases measurements on the amount given or received in the exchange transactions For assets: – Value of what is given in exchange (usually cash) for the asset at its initial acquisition For liabilities: – Current cash equivalent received in exchange for assuming the liability Long-lived, revenue-producing assets (equipment): – Adjusted subsequent to its initial measurement by recognizing depreciation or amortization 01-53 Copyright© Copyright ©2023 2023McGraw McGrawHill HillLLC.. LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw  LO1-9 Net Realization Value, Current Cost, and Present Value Net Realizable Value – Estimated selling price in the ordinary course of business, less reasonably predictable costs of completion, disposal, and transportation – Amount of cash into which an asset or liability is expected to be converted in the ordinary course of business Current cost – Cost that would be incurred to purchase or reproduce the asset – Reported if the company operates in inflationary economies Present value (SFAC 7) – Framework for using future cash flows as the basis for accounting measurement – Indicates that the objective in valuing an asset or liability using present value is to approximate its fair value 01-54 Copyright© Copyright ©2023 2023McGraw McGrawHill HillLLC.. LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw  LO1-9 Fair Value Fair value, originally called current market value – Bases measurements on the price that would be received to sell assets or paid to transfer liabilities in an orderly market transaction Fair value can be measured using: – Market approach: Valuation based on market information – Income approach: Estimates future amounts and then mathematically converts those amounts to a single present value – Cost approach: Estimates the amount that would be required to buy or construct an asset of similar quality and condition 01-55 Copyright© Copyright ©2023 2023McGraw McGrawHill HillLLC.. LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw  LO1-9 Concept Check: FASB Conceptual Framework—Measurement Attributes Which of the following is not a measurement attribute defined in the FASB’s conceptual framework? a. Net realizable value b. Historical cost c. List price d. Fair value The correct answer is c. List price is not a measurement attribute. Rather, it is whatever sales price a seller indicates (which might be negotiable or subject to discounts). 01-56 Copyright © 2023 McGraw Hill LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw  LO1-9 Fair Value Hierarchy Fair Value Hierarchy Level Inputs Example 1 Quoted market prices in active In Chapter 12 you will learn that certain Most markets for identical assets or investments in marketable securities are Desirable liabilities. reported at their fair values. Fair value in this case would be measured using the quoted market price from the NYSE, NASDAQ, or other exchange on which the security is traded. 2 Inputs other than quoted prices that In Chapter 10 we discuss how companies are observable for the asset or liability. sometimes acquire assets with consideration These inputs include quoted prices for other than cash. In any noncash transaction, similar assets or liabilities in active or each element of the transaction is recorded at inactive markets and inputs that are its fair value. If one of the assets in the derived principally from or exchange is a building, for instance, then corroborated by observable related quoted market prices for similar buildings market data. recently sold could be used to value the building or, if there were no similar buildings recently exchanged from which to obtain a comparable market price, valuation could be based on the price per square foot derived from observable market data. 3 Unobservable inputs that reflect the Asset retirement obligations (AROs), discussed Least entity’s own assumptions about the in Chapter 10, are measured at fair value. Desirable assumptions market participants Neither Level 1 nor Level 2 inputs would be would use in pricing the asset or possible in most ARO valuation situations. Fair liability developed based on the best value would be estimated using Level 3 inputs information available in the to include the present value of expected 01-57 cash Copyright© Copyright ©2023 2023McGraw McGraw Hill Hill LLC. LLC.. circumstances. All rights reserved. No reproduction or distribution without prior written consent flows estimated using the entity’s own data ifof McGraw  LO1-9 Concept Check: Fair Value Hierarchy Which of the following is not true? a. The fair value hierarchy reflects the subjectivity of inputs used to compute fair values b. Level 1 of the fair value hierarchy refers to quoted market prices that can be directly observed c. Level 3 of the fair value hierarchy refers to inputs that are not directly observable, and so must be based on the entity’s own assumptions d. Level 3 inputs are preferred to Level 2, which are preferred to Level 1 The correct answer is d. Level 1 inputs are most preferable because they are the least subjective. Level 3 inputs are the least preferable because they are based on the entity’s own assumptions. 01-58 Copyright © 2023 McGraw Hill LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw  LO1-9 Fair Value Option Fair Value Option: GAAP gives a company the option, in some circumstances, to choose whether to report specified financial assets and liabilities at fair value – Provides companies a way to reduce volatility in reported earnings without having to comply with complex hedge accounting standards – Helps to converge with international accounting standards 01-59 Copyright© Copyright ©2023 2023McGraw McGrawHill HillLLC.. LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw  LO1-9 Disclosure Full-disclosure principle: requires that the financial reports should include any information that could affect the decisions made by external users Such information can be disclosed in a variety of ways: – Parenthetical comments or modifying comments » Placed on the face of the financial statements – Disclosure notes » Convey additional insights – Supplemental schedules and tables » Report more detailed information than is shown in the primary financial statements 01-60 Copyright© Copyright ©2023 2023McGraw McGrawHill HillLLC.. LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw  LO1-9 Summary of Recognition, Measurement, and Disclosure Concepts Concept Description Recognition General criteria: 1. Meets the definition of an element 2. Has a measurement attribute 3. Is relevant 4. Is reliable (representationally faithful) Examples of recognition timing: 5. Revenues 6. Expenses Measureme Mixed attribute model in which the attribute used to nt measure an item is chosen to maximize relevance and representational faithfulness. These attributes include: 1. Historical cost 2. Net realizable value 3. Current cost 4. Present (or discounted) value of future cash flows 5. Fair value Disclosure Financial reports should include all information that could affect the decisions made by external users. Examples of disclosures: 1. Parenthetical amounts 2. Notes to the financial statements 3. Supplemental schedules and tables 01-61 Copyright© Copyright ©2023 2023McGraw McGrawHill HillLLC.. LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw  LO1- 10 Evolving GAAP Revenue/Expense Approach – Emphasize principles for recognizing revenues and expenses, with some assets and liabilities recognized as necessary to make the balance sheet reconcile with the income statement Asset/Liability Approach – Recognize and measure the assets and liabilities that exist as of a balance sheet date – Recognize and measure the revenues, expenses, gains, and losses needed to account for the changes in these assets and liabilities from the previous measurement date 01-62 Copyright© Copyright ©2023 2023McGraw McGrawHill HillLLC.. LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw  LO1- 11 Accounting Concepts Development: GAAP vs. IFRS The FASB continues to work on its conceptual framework with focus on revising the definitions of some financial statement elements with the following proposals: – Assets and liabilities do not refer to probable future economic benefits that are obtained, controlled or sacrificed but instead focus on a present right to receive or obligation to provide economic benefits – Revenues and expenses no longer indicate that they arise from activities that constitute the entity’s ongoing major or central operations – Gains and losses no longer indicate that they arise from peripheral or incidental transactions rather they are defined algebraically as increases01-63 Copyright© Copyright ©2023 2023McGraw McGrawHill HillLLC.. LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw  End of Chapter 1 01-64 Copyright © 2023 McGraw Hill LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw