1. The Environment of Financial Reporting
Unit Two
The Environment of Financial Reporting

2. Importance of Accounting
Identifying Select transactions and events
Recording
Input, measure and classify
Accounting is an information and measurement system that identifies, records, and communicates relevant, reliable, and comparable information about an organization’s business activities. Identifying business activities requires selecting transactions and events relevant to an organization. Recording business activities requires keeping a chronological log of transactions and events measured in dollars and classified and summarized in a useful format. Communicating business activities requires preparing accounting reports such as financial statements. It also requires analyzing and interpreting such reports.
Communicating
Prepare, analyze and interpret

3. Users of Accounting Information
Internal Users
External Users
Accountants prepare reports for both external and internal users. External users of accounting information are not directly involved in running the organization. Examples of external users are lenders, shareholders (investors), governments, consumer groups, customers, and the external auditors.
Internal users of accounting information are those directly involved in managing and operating an organization. They use the information to help improve the efficiency and effectiveness of an organization. Examples of internal users are managers, officers/directors, internal auditors, sales staff, budget officers and controllers.
Lenders
Shareholders
Governments
Consumer Groups
External Auditors
Customers
Managers
Officers/Directors
Internal Auditors
Sales Staff
Budget Officers
Controllers

4. Users of Accounting Information
Internal Users
External Users
Financial accounting is the area of accounting aimed at serving external users by providing them with financial statements.
Managerial accounting is the area of accounting that serves the decision-making needs of internal users.
Financial accounting provides external users with financial statements.
Managerial accounting provides information needs for internal decision-makers.

5. Generally Accepted Accounting Principles
Financial accounting practice is governed by concepts and rules known as generally accepted accounting principles (GAAP).
Relevant Information
Affects the decision of its users.
Financial accounting is governed by a set of rules we call Generally Accepted Accounting Principles, or GAAP for short.
Generally accepted accounting principles identify three major characteristics of information. First, the information must be relevant. Relevant information impacts the decision of the informed user for financial information. Second, the information must be reliable. Finally, the information must be comparable. Comparability helps us evaluate financial information from one period with that of the next period.
Reliable Information
Is trusted by users.
Comparable Information
Is helpful in contrasting organizations.

6. Setting Accounting Principles
Financial Accounting Standards Board is the private group that sets both broad and specific principles.
The Securities and Exchange Commission is the government agency that establishes reporting requirements for companies that issue stock to the public.
The Financial Accounting Standards Board is recognized as the group in the private sector that makes specific accounting principles. If an accountant departs from the principles established by the FASB, proper disclosure of the departure must be made.
In the public sector, the Securities and Exchange Commission has the authority to establish accounting principles for companies reporting to the agency. Currently, the Securities and Exchange Commission has accepted all pronouncements of the FASB for use by public reporting companies.
The International Accounting Standards Board (IASB) issues International Financial Reporting Standards that identify preferred accounting practices to create harmony among accounting practices of different countries.
The International Accounting Standards Board (IASB) issues International Financial Reporting Standards that identify preferred accounting practices to create harmony among accounting practices of different countries.

7. International Standards
The International Accounting Standards Board (IASB), an independent group (consisting of 16 individuals from many countries), issues International Financial Reporting Standards (IFRS) that identify preferred accounting practices.
In today’s global economy, there is increased demand by external users for comparability in accounting reports. This demand often arises when companies wish to raise money from lenders and investors in different countries.
If standards are harmonized, one company can potentially use a single set of financial statements in all financial markets. Differences between U.S. GAAP and IFRS are slowly fading as the FASB and IASB pursue a convergence process aimed to achieve a single set of accounting standards for global use.
IASB

8. International Standards
Like the FASB, the IASB uses a conceptual framework to aid in revising or drafting new standards. However, unlike the FASB, the IASB’s conceptual framework is used as a reference when specific guidance is lacking.
The IASB also requires that transactions be accounted for according to their substance (not only their legal form), and that financial statements provide a fair presentation, whereas the FASB narrows that scope to fair presentation in accordance with U.S. GAAP.

9. Sarbanes-Oxley (SOX)
Congress passed the Sarbanes-Oxley Act to help curb financial abuses at companies that issue their stock to the public. Management must issue a report stating that its internal controls are effective. Auditors must verify the effectiveness of internal controls.
Congress passed the Sarbanes-Oxley Act to help curb financial abuses at companies that issue their stock to the public. Management must issue a report stating that its internal controls are effective. Auditors must verify the effectiveness of internal controls. Here is a list of companies and the alleged accounting abuses. Many of these company actions lead directly to the passing of the Sarbanes-Oxley Act.

10. Financial Accounting Standards Board (FASB)
Organization presently responsible for establishing generally accepted accounting principles
All FASB members are also members of the Financial Accounting Foundation (FAF)
There are 5 members of FASB
FASB issues Statements of Financial Accounting Concepts, Technical Bulletins and Interpretations
FASB Emerging Issues Task Force issues Consensus Positions on the implementation of standards

11. Principles and Assumptions of Accounting
Revenue Recognition Principle
Recognize revenue when it is earned.
Proceeds need not be in cash.
Measure revenue by cash received plus cash value of items received.
Cost Principle
Accounting information is based on actual cost. Actual cost is considered objective.
Matching Principle
A company must record its expenses incurred to generate the revenue reported.
Listed on your screen are four fundamental principles of accounting. The revenue recognition principle states that revenue is to recognized when it is earned, that the revenue need not be in the form of cash and that we measure revenue by the cash received plus cash value of other items received. The cost principle tell us that accounting information is based upon actual cost incurred. We refer to this cost as historical cost. The matching principle dictates that expenses incurred by a company must be matched against revenue generated as a result of those expenses. The full disclosure principle states that a company is required to report the details behind the financial statements if the details so disclosed would impact the users’ decision-making process. Most of the details are reported in the notes to the financial statements.
Full Disclosure Principle
A company is required to report the details behind financial statements that would impact users’ decisions.

12. Accounting Assumptions
Now
Future
Going-Concern Assumption
Reflects assumption that the business will continue operating instead of being closed or sold.
Monetary Unit Assumption
Express transactions and events in monetary, or money, units.
Business Entity Assumption
A business is accounted for separately from other business entities, including its owner.
Time Period Assumption
Presumes that the life of a company can be divided into time periods, such as months and years.
Now we will look at four fundamental assumptions of accounting. The going-concern assumption states that, in the absence of information to the contrary, the business entity is assumed to continue operations into the foreseeable future. The monetary unit assumption tells us that we will only record accounting information that can be expressed in monetary units, usually dollars in the United States. The business entity assumption tells us that we must separate out the transaction of individual owners of a business from those of the business. Finally, the time period assumption presumes that the life of a company can be divided into time periods such as months and years, and that useful reports can be prepared for those periods.

13. Transaction Analysis and the Accounting Equation
Assets =
Liabilities +
Equity
The basic accounting equation states that assets are equal to liabilities plus equity of a company. The equation makes sense because in a general way it states that assets must be equal to the claims against those assets. If you have an asset we can have two broad categories of claims against that asset. First, we may have claims by creditors (liabilities). Finally, after all creditor claims are satisfied, the residual owners, the stockholders, have a claim on those assets.

14. Resources owned or controlled by a company
Assets
Cash
Accounts Receivable
Notes Receivable
Resources owned or controlled by a company
Vehicles
Land
Assets are resources a company owns or controls. These resources are expected to yield future benefits. Examples are Web servers for an online services company, musical instruments for a rock band, and land for a vegetable grower. The term receivable is used to refer to an asset that promises a future inflow of resources. A company that provides a service or product on credit is said to have an account receivable from that customer.
Buildings
Store Supplies
Equipment

15. Creditors’ claims on assets
Liabilities
Accounts Payable
Notes Payable
Creditors’ claims on assets
Liabilities are creditors’ claims on assets. These claims reflect company obligations to provide assets, products or services to others. The term payable refers to a liability that promises a future outflow of resources. Examples are wages payable to workers, accounts payable to suppliers, notes payable to banks, and taxes payable to the government.
Wages Payable
Taxes Payable

16. Owner’s Claims on Assets
Equity
Owner’s Claims on Assets
Equity is the owner’s claim on assets. Equity is equal to assets minus liabilities. This is the reason equity is also called net assets or residual equity. Net income occurs when revenues exceed expenses. Net income increases equity. A net loss occurs when expenses exceed revenues, which decreases equity.

17. Transaction Analysis Equation
The accounting equation MUST remain in balance after each transaction.
Liabilities
Equity
Assets = +
During the process of recording business transactions, it is important that we always keep the accounting equation in balance. We can’t let our books get out of balance. You have probably heard this saying before, but may not have been sure what we meant by keeping the books in balance.

18. Financial Statements Income Statement Statement of Owner’s Equity
Let’s prepare the financial statements reflecting the transactions we have recorded.
Income Statement
Statement of Owner’s Equity
Balance Sheet
Statement of Cash Flows
There are four fundamental financial statements used in accounting.
1. Income statement—describes a company’s revenues and expenses along with the resulting net income or loss over a period of time due to earnings activities.
2. Statement of owner’s equity—explains changes in equity from net income (or loss) and from any owner investments and withdrawals over a period of time.
3. Balance sheet—describes a company’s financial position (types and amounts of assets, liabilities, and equity) at a point in time.
4. Statement of cash flows—identifies cash inflows (receipts) and cash outflows (payments) over a period of time.
The first financial statement that we prepare is the income statement. Let’s get started.

19. Income Statement
Net income is defined as the difference between revenues and expenses. If expenses exceed revenues, we have a net loss rather than net income. Financial statements have a three line title with the company name, the name of the statement, and the period covered by the report. In our case, we had total revenues of $6,100 and total expenses of $1,700, so net income for the month ended December 31, 2011, was $4,400. After completing the income statement, we can prepare the statement of owner's equity.
The income statement describes a company’s revenues and expenses along with the resulting net income or loss over a period of time due to earnings activities.

20. STATEMENT OF OWNER’S EQUITY
In the statement of owner's equity, we start with the balance at the beginning of the period, add new owner investments and net income earned during the period, and deduct any withdrawals paid, resulting in the ending balance in owner's equity.
FastForward was started this month, so the beginning balance in owner's equity was zero. Chas Taylor invested $30,000 in the company at the beginning of the month. During December, net income of $4,400 was earned. Notice that the net income flows from the income statement to the statement of owner’s equity. We must complete the income statement before we can begin work on the statement of owner’s equity. In addition, $200 withdrawal was made by Chas Taylor, so the ending balance in owner's equity is $34,200. After we complete this statement, we can prepare the balance sheet.

21. Balance Sheet
The Balance Sheet describes a company’s financial position at a point in time.
The balance sheet is an summary of assets, liabilities and equity at the end of the month. Our total assets are equal to $40,400. This includes cash of $4,800, supplies of $9,600, and equipment of $26,000.
Liabilities include accounts payable of $6,200. Equity is composed of C. Taylor, Capital of $34,200. The account C.Taylor, Capital flows directly from the statement of owner’s equity. You can see that the books are in balance because total assets are equal to total liabilities plus equity.
Creditors have claims against our assets of $6,200. The owner has claims to assets of $34,200.

22. Statement of Cash Flows
We will cover the statement of cash flows in detail in a later chapter. Notice that the statement is divided into three major sections: (1) cash flows from operating activities; (2) cash flows from investing activities; and (3) cash flows from financing activities. The statement reconciles to the ending cash balance of $4,800. Recall that the ending cash balance of $4,800 flows from the balance sheet to the statement of cash flows.

23. Ethics Ethics - A Key Concept
Beliefs that distinguish right from wrong
Accepted standards of good and bad behavior
Ethical behavior is the cornerstone of the accounting profession. Recently, we have seen many corporate scandals involving individuals who acted in an unethical, and often times, illegal, way.
Ethics are beliefs that distinguish right from wrong. They are accepted standards of good and bad behavior.

24. Ethics - A Key Concept
Identifying the ethical path is sometimes difficult. The preferred path is a course of action that avoids casting doubt on one’s decisions. For example, accounting users are less likely to trust an auditor’s report if the auditor’s pay depends on the success of the client’s business. To avoid such concerns, ethics rules are often set. For example, auditors are banned from direct investment in their client and cannot accept pay that depends on figures in the client’s reports. On your screen are guidelines for making ethical decisions.

25. Some Additional Areas of Emphasis
Capital market terminology
Users of financial information
Financial reporting package
Standard setting organizations
FASB characteristics
Agency Theory