Chapter 1

• Introduction to
Financial Reporting

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
 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 Corporation. All rights reserved.
 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 Corporation. All rights reserved.
A Hierarchy of Accounting Qualities
Exhibit 1-2

Source: “Qualitative Characteristics of

Accounting Information.” Adapted from Figure
Chapter 1, Slide #4 1 in FASB Statement of Financial Accounting
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Concepts No. 2 (Stamford, Conn.: Financial
Accounting Standards Board, 1980).
 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 owner’s residual interest in the assets after
deducting liabilities

Chapter 1, Slide #5
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
 Elements of Financial Statements
(SFAC 6) (con’t)
• 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 Corporation. All rights reserved.
 Elements of Financial Statements
(SFAC 6) (con’t)
• 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
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 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 Corporation. All rights reserved.
 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 Corporation. All rights reserved.
Annual Report on Internal Control Systems

Required by the SEC to include

1. A statement of management’s 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 company’s auditors have
issued an audit report on management’s
assessment
Chapter 1, Slide #10
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
 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 Corporation. All rights reserved.
 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

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
 1) Business Entity (cont’d)
Sole
Proprietorship Partnership Corporation
Number of 2 or more Numerous
1
owners (partners) (shareholders)
Legally separate
No No Yes
from owners
Owners liable for
Yes Yes No
business debts
To the
corporation as
earnings;
To the
Profits taxable To the owner to the owners
owners
when
dividends are
received
“Subchapter
S”
“LLC”
profits are
Modified form limits liability of owner; may
taxed at
increase income tax exposure
ownership
level only
Chapter 1, Slide #13
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
 2) Going Concern (Continuity)

• The entity 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 Corporation. All rights reserved.
 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
entity’s life

Chapter 1, Slide #15

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
 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 Corporation. All rights reserved.
 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 Corporation. All rights reserved.
 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 Corporation. All rights reserved.
 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 Corporation. All rights reserved.
 7) Realization of Revenue (cont’d)

• 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

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 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 Corporation. All rights reserved.
 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 Corporation. All rights reserved.
 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 Corporation. All rights reserved.
 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 Corporation. All rights reserved.
 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 owner’s assets with company’s
assets

Chapter 1, Slide #25

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
 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 Corporation. All rights reserved.
 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 Corporation. All rights reserved.
 Accrual Basis (cont’d)

• 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

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