Ucla Ch. 1 Lecture Notes.docx

HW problems for this chapter: Q1-5, Q1-7, Q1-10, E1-6, E1-7, E1-9, E1-14, E1-15 Announcements: 1. I sometimes write some announcements here at the top of my notes in italics. However, I may also: a. Say some additional important announcements during lecture or b. Post them online in CCLE as an announcement If you were absent, late, or not paying attention in class, you are still accountable for all announcements I make in class—even if it is not posted here or under the CCLE announcement area. If you miss hearing an announcement, please e-mail or ask 2-3 of your classmates (after class) and not me. 2. Please make sure to access CCLE once every 2 days (7 days a week) to check for new announcements and postings. 3. Tape recorders a. You are more than welcome to tape my lectures. However, based on past experience, most students who tape lectures never listen to them or listen to it partly. b. Taping lectures causes most students to be too relaxed in taking notes in class. c. If you are taping my lecture, you need to sit in the front for best recording. 4. Note taking steps a. Students should always try to their best to take as many notes as they can in class. b. After class, go home and carefully review/rewrite notes. This is the best way to study and reinforce what you learned anyway. c. Compare your final notes with other students (and not the professor) to make sure you have everything. d. AS YOU TAKE NOTES AND ESPECIALLY WHEN WE DO JOURNAL ENTRIES IN CLASS. PLEASE WRITE OUT THE COMPLETE ACCOUNT NAME. I EXPECT STUDENTS TO WRITE OUT THE COMPLETE ACCOUNT NAME ON ALL EXAMS. FOR EXAMPLE, I WILL ONLY ACCEPT (ACCOUNTS RECEIVABLE, I WILL NOT ACCEPT A/R) 5. If you have a learning disability, make sure you followed the instructions on my syllabus for accommodations 6. If you plan to miss class due to religious holidays, please let me know the exact dates within by the end of this week. 7. I usually post my notes as MS Word files. However, I sometimes also post some notes as MS Excel files. In these situations, make sure to print out notes for each Excel tab. If you are trying to print an excel file with multiple tabs, when you click the print button, make sure to select the button that says "Entire workbook" instead of "Active worksheet(s)."

Ch. 1 Environment and Theoretical Structure of Financial Accounting

I. General Info A. Definitions of accounting 1. Accounting is used to identify, measure, and communicate financial information about economic entities (businesses) to interested parties. 2. Accounting is an information system that measures business activity, processes the information into reports, and communicates the results to decision makers. 3. Accounting is the “language of business.”

B. Different types of accounting 1. Financial accounting a. Financial accounting is the process that results in the preparation of financial reports (aka financial statements) on the business for use by both internal and external parties. b. External use: It is primarily concerned with providing information to those outside an organization such as investors/stockholders, creditors (money lenders), government agencies, etc. c. Must follow Generally Accepted Accounting Principles (GAAP) i. GAAP is a set of common standards and procedures that is generally accepted by most companies and practiced by most accountants in the U.S. ii. GAAP is basically US accounting rules. d. Taught in Intro to Fin Acct (Mgmt 1A & 1B) and Interm Acct (Mgmt 120A, 120B, and 124). e. Why do we need GAAP? If GAAP didn’t exist, each company would have to develop its own standards and readers of financial statements would have to familiarize themselves with every company's unique accounting and reporting practices. Consequently, it would be almost impossible to compare different financial statements. 2. Managerial accounting a. Managerial accounting is the process of identifying, measuring, analyzing, and communicating financial information needed by management to plan, control, and evaluate a company's operations. b. Internal use: It is concerned with providing information to managers—that is, people inside an organization who direct and control a firm’s operations. c. May or may not follow GAAP- b/c only the management is using it d. Taught in Intro to Fin Acct (Mgmt 1B), and Management/Cost Acct (Mgmt 122) 3. Other types of accounting include tax accounting, governmental accounting, etc.

C. Financial statements 1. A company communicates its financial information to those outside of the company primarily through financial statements. 2. Provides information about a company in monetary terms. 3. 5 Key Financial Statements a. Balance Sheet (aka Statement of Financial Position) b. Income Statement (aka Profit and Loss Statement or Statement of Operations) c. Statement of Cash Flows d. Statement of Owners' Equity or Statement of Stockholders' Equity (aka Statement of Stockholders' Equity) e. Statement of Comprehensive Income

4. a. b. c. d. e. f.

Note some financial information is disclosed outside of the formal financial statements. Examples include… President's letter or supplementary schedules in the corporate annual report Prospectuses Reports filed with government agencies News releases Management's forecasts Social or environmental impact statements

II. Objective of Financial Accounting/Financial Reporting A. General Info 1. According to one textbook The objective of general purpose financial reporting is to provide financial information about companies that is useful to capital providers in making decisions. 2. Another take from a different textbook The objective of financial reporting is to provide financial information about the reporting entity that is useful to equity investors (aka stockholders) and creditors in decisions about providing resources to the entity. 3. From FASB’s website The objective of general purpose external financial reporting is to provide information that is useful to present and potential investors and creditors and others in making investment, credit, and similar resource allocation decisions. B. Note Although the focus is on providing info for primary users (investors and creditors), this information may also be helpful to other users of financial reporting such as government agencies, management, unions, etc.

III. Organizations Involved in Developing GAAP A. Securities and Exchange Commission (SEC)- Public Sector 1. The SEC is a federal agency (established by the federal government after the 1929 stock market crash) to help develop and standardize financial information presented to stockholders. However, it generally relies on FASB (see below) to develop accounting standards. 2. The SEC enforces the Securities Exchange Act of 1934 and several other acts. 3. The SEC currently regulates over 12,000 companies that are listed on the major exchanges (the New York Stock Exchange and the Nasdaq). These publicly traded companies are required to filed audited financial statements with the SEC. 4. The SEC requires publicly traded companies to follow GAAP, but can also prescribe any accounting practices and standards it deems necessary. 5. Ways SEC is involved in developing GAAP a. The SEC can reject standards proposed by the private sector (AICPA or FASB) b. The SEC can bug the private sector into taking quicker on action on certain reporting problems. c. The SEC works specifically with FASB in the following way: i. The SEC communicates problems to FASB ii. Responds to FASB draft exposures iii. Provides FASB with counsel and advice upon request B. American Institute of Certified Public Accountants (AICPA)- Private Sector 1. The AICPA is the national professional organization of practicing Certified Public Accountants (CPAs)

2. It regulates the accounting profession and develops and enforces accounting practices more than any other organization. 3. The AICPA develops and grades the U.S. CPA exam, which is administered in all 50 states. 4. The AICPA used to be an important contributor to the development of GAAP. Various committees and boards established since the founding of the AICPA have contributed to this effort (to be discussed below). The role of the AICPA in standard-setting is now diminished. a. It now longer issues authoritative guidance for public companies. It just has a Financial Reporting Executive Committee (FinREC), which is authorized to make public statements on behalf of the AICPA on financial reporting matters. b. FinREC’s goal is to serves the public interest by improving financial reporting. It does this by i. Determining the AICPA's technical policies regarding financial reporting standards. ii. Issues audit and accounting guides, which address particular areas in financial reporting that require attention, such as specialized accounting practices, significant or unique accounting issues, and unique regulatory considerations within the construction, casino, and airline industries. These guides provide specific direction on matters not addressed by the FASB. c. AICPA has been the leader in developing auditing standards through its Auditing Standards Board. However, the Sarbanes-Oxley Act of 2002, requires the Public Company Accounting Oversight Board to oversee this now. C. Committee on Accounting Procedure (lasted from 1939-1959)- Private Sector 1. In 1939, the AICPA formed the Committee on Accounting Procedure (CAP) at the urging of the SEC. a. CAP was of composed of practicing CPAs b. From 1939-1959, CAP issued 51 Accounting Research Bulletins (ARBs). These ARB’s were documents that dealt with a variety of accounting problems based on a problem-by-problem approach D. Accounting Principles Board (lasted from 1959-1973)- Private Sector 1. In 1959, the AICPA created the Accounting Principles Board (APB) because the Accounting Research Bulletins only addressed issues a problem-by-problem approach. It lacked the needed structured body of accounting principles. 2. a. b. c. 3. a. b.

The major purposes of the APB were to Advance the written expression of accounting principles. Determine appropriate practices Narrow the areas of difference and inconsistency in practice. To achieve these objectives, the APB's mission was twofold: Develop an overall conceptual framework to assist in the resolution of problems as they become evident Substantively research individual issues before the AICPA issued pronouncements.

4. The APB was a senior committee of the AICPA. 5. a. b. c. d.

Board member details 18 to 21 board members Primarily selected from public accounting, but also included representatives from industry and academia. Volunteered for their work part time. Still retained their private positions with firms or institutions. Required to be CPA’s and members of the AICPA.

6. From 1939-1959, the APB issued 31 APB Opinions. APB Opinions are pronouncements (statements, standards, interpretations and other financial reporting guidelines) that were intended to be based mainly on research studies and supported by reasons and analysis.

7. a. b. c.

The APB was dissolved in 1973 because it: Lacked of productivity and failed to act promptly to accounting abuses Faced opposition from industry and CPA firms when it tackled thorny accounting issues Occasionally ran into governmental interference

8. In 1971, the accounting profession's leaders appointed a Study Group on Establishment of Accounting Principles (known as the Wheat Committee) to examine the APB and determine the necessary changes to attain better results. As a result, the APB was replaced with the Financial Accounting Standards Board (FASB) in 1973. More specifically, this resulted in the creation of 3 organizations to set standards. a. Financial Accounting Foundation (FAF)- Private Sector i. Selects the members of the FASB and the Advisory Council ii. Funds their activities iii. Oversee the FASB's activities. b. Financial Accounting Standards Advisory Council (FASAC)- Private Sector i. Consults with the FASB on major policy and technical issues. ii. Helps select task force members for FASB. c. Financial Accounting Standards Board (FASB)- which replaced the APB.

E. FASB- Private Sector 1. FASB’s job is to establish and improve standards of accounting and reporting (for the guidance and education of the public). 2. The FASB relies on 2 guidelines in creating new financial accounting standards. a. The FASB should be responsive to the needs and viewpoints of the entire economic community, not just the public accounting profession. b. It should operate in full view of the public through a due process system (elaborated below). 3. a. b. c.

FASB relies on help From research conducted by its own staff The expertise of various task force groups formed for various projects On FASAC.

4. Differences between FASB and APB: FASB 7 members

APB 18 members

Full-time paid membership

Well-paid full-time members appointed for renewable 5 year terms

Volunteered part-time

Greater autonomy

Not part of any single professional organization. It is appointed by and answers only to the FAF.

Was a senior committee of the AICPA

Smaller membership

Increased independence

Members must sever all previous employment ties.

Broader representation

Members not required to be a CPA

Members retained their private positions with firms, companies, or institutions. Members required to be CPAs and members of the AICPA

F. Emerging Issues Task Force (EITF) 1. This organization was created in 1984 by the FASB. 2. a. b. c.

Consists of Reps from CPA firms Financial statement preparers Observers from the SEC and AICPA also attend task force meetings

3. Its purpose was to reach a quick consensus on how to account for new and unusual financial transactions that may potentially create differing financial reporting practices (i.e. accounting for pension plan termination, revenue from barter transactions from Internet companies, excessive amounts paid to takeover specialists, reporting of losses from the 9/11 terrorist attack, etc.) 4. The EITF is the “problem filter” for the FASB. a. It quickly identifies controversial accounting problems as they arise. b. Determining whether it can quickly resolve them or whether it needs FASB help to help resolve it. 5. FASB tends to work on long-term accounting problems while the EITF deals with short-term emerging issues. 6. The EITF was designed to minimize the need for the FASB to spend time and effort addressing narrow implementation, application, or other emerging issues that can be analyzed within existing GAAP. 7. The FASB reviews and approves all EITF consensuses. 8. The SEC views all consensus solutions as preferred accounting. It requires persuasive justification for departing from them.

IV. Sarbanes-Oxley Act A. In 2002, the Sarbanes-Oxley Act was passed by Congress as a result of the various accounting scandals at companies like Enron, Cendant, Sunbeam, Rite-Aid, Xerox, and WorldCom. B. 1. 2. 3.

This law Increased the resources to the SEC to combat fraud and poor reporting practices. Changed new auditor independence rules and materiality guidelines for financial reporting. Affected the institutional structure of the accounting profession.

C. Key provisions of the act 1. Created the Public Company Accounting Oversight Board (PCAOB) – remember by using peek-a-boo a. PCAOB has oversight for accounting practices and enforcement authority b. PCAOB establishes auditing, quality control, and independence standards and rules 2. Implemented stronger independence rules for auditors. For example, audit partners are required to rotate every 5 years, and auditors are prohibited from offering certain types of consulting services to corporate clients. 3. Requires CEO’s and CFO’s to personally certify that financial statements and disclosures are accurate and compete 4. Requires CEO’s and CFO’s to forfeit bonuses and profits when there is an accounting restatement. 5. Requires audit committees to be made of independent members and member with financial expertise. 6. Requires code of ethics for senior financial officers. 7. Requires public companies to attest to the effective of internal controls a. Internal controls are a system of checks and balances designed to prevent and detect fraud and errors. b. Most companies have these systems in place, but many have never completely documented them. Companies are finding that it is a costly process but perhaps badly needed.

V. Due Process A. This is a system developed by FASB that gives interested parties an opportunity to have their opinions heard by the board. These are the steps involved in developing new FASB guidance/pronouncements in the form of an Accounting Standards Update.

B. The diagram below shows the steps involved in FASB’s due process system.

C. 4 out the 7 board members need to vote in favor of new FASB guidance/pronouncements before it is passed of in the form of an Accounting Standards Update. D. FASB pronouncements are considered GAAP and thereby binding in practice. E. All ARBs and APB Opinions implemented prior to the formation of FASB continue to be in effect until it is amended or superseded by FASB pronouncements.

VI. Types of FASB Pronouncements A. Accounting Standards Updates (aka ASUs or Updates) 1. Accounting Standards Codification, which represents the source of authoritative accounting standards, other than standards issued by the SEC. These ASU’s amend the Codification. ASU’s were previously Statements of

Financial Accounting Standards (SFASs), FASB Interpretations, Staff Positions, Technical Bulletins, and EITF Issue Consensuses. 2. Each ASU explains how the Codification has been amended and also includes information to help the reader understand the changes and when those changes will be effective. 3. Common forms of amendments are accounting standards issued that address a broad area of accounting practice (such as the accounting for leases) or interpretations that modify or extend existing standards. Prior standard-setters such as the APB also issued interpretations of APB Opinions. B. Financial Accounting Concepts (aka Statement of Financial Accounting Standards) 1. First issued by FASB in Nov 1978, these concepts are way to move away from the problem-by-problem approach to dealing with accounting issues. 2. Sets forth guidelines that FASB can use in developing future standards of financial accounting and reporting. It is meant to serve as a tool for solving current and future problems in a consistent manner. 3. Concepts statements pass through the same due process system as do Accounting Standards Updates. 4. Unlike an Accounting Standards Update, a Statement of Financial Accounting Concepts does not establish GAAP.

VII. Generally Accepted Accounting Principles (GAAP) A. U.S. companies must follow GAAP 1. The AICPA's Code of Professional Conduct requires that members prepare financial statements in accordance with GAAP. 2. Rule 203 of this Code specifically prohibits a member from expressing an unqualified opinion on financial statements that contain a material departure from GAAP. B. GAAP in the past (pre-2009) 1. The major sources of GAAP come from the organizations discussed earlier in this chapter. It is composed of a mixture of over 2,000 documents that have been developed over the last 70 years or so including a. APB Opinions b. AICPA Research Bulletins c. FASB Standards 2. As you can see, these documents that made up GAAP varied in format, completeness, and structure. In some cases, these documents were inconsistent and difficult to interpret. As a result, financial statement preparers sometimes were not sure whether they had the right GAAP. Determining what was authoritative and what was not became difficult. C. FASB Codification (starting in 2009) 1. FASB developed the Financial Accounting Standards Board Accounting Standards Codification (aka the Codification) in 2009. This system simplifies user access to all authoritative U.S. generally accepted accounting principles by providing all the authoritative literature related to a particular topic in one place. 2. The Codification changed the way GAAP is documented, presented, and updated. Codification organized existing GAAP by accounting topic regardless of its source (FASB Statements, APB Opinions, etc.). It explains what GAAP is and eliminates nonessential information such as redundant document summaries, basis for conclusion sections, and historical content. 3. The codified standards are then considered to be GAAP and to be authoritative. All other literature will be considered nonauthoritative. 4. In rare case if the Codification does not cover a certain type of transaction, other accounting literature should be considered (i.e. as FASB Concept Statements, international financial reporting standards, and other professional literature).

5. FASB developed the Financial Accounting Standards Board Codification Research System (CRS) to provide easy online access to the Codification. 6. The Codification and CRS provide a topically organized structure, subdivided into topic, subtopics, sections, and paragraphs, using a numerical index system. 7. Below is an example of how the Codification framework is cited for loans and trade receivables not held for sale subsequent to initial measurement. Topic

Go to FASB ASC 310 to access the Receivables topic.

Subtopics Go to FASB ASC 310-10 to access the Overall Subtopic of the Topic 310. Sections

Go to FASB ASC 310-10-35 to access the Subsequent Measurement Section of the Subtopic 310-10.

Paragraph

Go to FASB ASC 310-10-35-47 to access the Loans and Trade Receivables not Held for Sale paragraph of Section 310-10-35.

VIII. GAAP and Politics A. GAAP is a product of logic or empirical findings. Unfortunately, it is also influenced by politics. B. Special Interest Groups

1. Like lobbyists, special interest user groups (those most interested in or affected by accounting rules) influence the development of GAAP. 2. These special interest user groups may want particular economic events accounted for or reported in a particular way, and they fight hard to get what they want. They know that the most effective way to influence GAAP is to participate in the creation of these rules or to try to influence those who create them. 3. Special interest user groups often target the FASB to pressure it to change existing rules or develop new ones. 4. Some groups demand that the accounting profession act more quickly to solve its problems while other groups prefer to implement change more slowly or not at all. 5. Special interest user groups should vocalize their reactions to proposed rules because accounting rules have real economic consequences. However, FASB ideally should not issue pronouncements that are primarily politically motivated. FASB should ultimately base GAAP on sound research and a conceptual framework that has its foundation in economic reality. 6. The diagram below shows the various user groups that influence FASB.

IX. International Accounting Standards A. Most companies outside of the U.S. do not use U.S. GAAP to prepare financial accounting statements. Multinational companies (i.e. Coca-Cola, Microsoft, and IBM) have to develop financial information in different ways. B. There are currently 2 sets of rules 1. GAAP- discussed above 2. International Financial Reporting Standards (IFRS) a. Issued by the International Accounting Standards Board (IASB) b. Less extensive and less detailed than U.S. GAAP c. Over 115 countries already use IFRS d. Required by the European Union for all listed companies in Europe (over 7,000 companies). C. Note:

1. U.S. companies that list overseas are still permitted to use GAAP, and foreign companies listed on U.S. exchanges are permitted to use IFRS. 2. There are many similarities between GAAP and IFRS. D. 2 sets of standards cause problems such as… 1. Financial statement users have the burden of needing to understand 2 sets of accounting standards. 2. It harder to compare U.S. with foreign companies 3. Companies incur additional costs for financial reporting. 4. It is more difficult for U.S. companies to raise capital in foreign markets. E. GAAP and IFRS Convergence 1. FASB and IASB formalized their commitment to the convergence of GAAP and IFRS by issuing a memorandum of understanding (often referred to as the Norwalk agreement). They agreed to use their best efforts to: a. Make their existing financial reporting standards fully compatible as soon as practicable and b. Coordinate their future work programs to ensure that once achieved, compatibility is maintained. 2. They identified a number of short-term and long-term projects that would lead to convergence. 3. Unfortunately, as of today, it seems there will still continue to be 2 sets of financial reporting standards in the near future because: a. U.S. is reluctant to fully adopt IFRS. There is almost no support for having the SEC mandate IFRS for public companies, and there is little support for the SEC to provide an option allowing U.S. companies to prepare their financial statements under IFRS. b. Both the FASB and the IASB seem to be taking different approaches to various financial reporting problems, such as the measurement and recognition of financial instruments. c. IASB has decided to move forward on the conceptual framework project independent of the FASB.

X. Ethics in Financial Accounting A. Definitions 1. Ethics refers to a code or moral system that provides criteria for evaluating right and wrong. 2. An ethical dilemma is a situation in which an individual or group is faced with a decision that tests this code. 3. Example: Management might be tempted break accounting rules to inflate revenue. B. People often encounter ethical dilemmas in accounting. Unfortunately, technical competence is not enough when encountering ethical decisions, and there is no comprehensive ethical system to provide guidelines. Time, job, client, personal, and peer pressures can complicate the process of ethical decision making. 1. Companies that concentrate on “maximizing the bottom line,” “facing the challenges of competition,” and “stressing short-term results” place accountants in an environment of conflict and pressure. 2. Questions such as, “Is this way of communicating financial information good or bad?” “Is it right or wrong?” and “What should I do in this circumstance?” cannot always be answered by simply following GAAP or the rules of the profession. 3. Doing the right thing is not always easy or obvious. The pressures “to bend the rules,” “to play the game,” or “to just ignore it” can be considerable. For example, “Will my decision affect my job performance negatively?” “Will my superiors be upset?” and “Will my colleagues be unhappy with me?” are often questions business people face in making a tough ethical decision.

Conceptual Framework

I. General Info A. In 1976, the FASB began to develop a conceptual framework that would be a basis for setting accounting rules and for resolving financial reporting controversies. B. What is the conceptual framework? 1. Our textbook definition- The conceptual framework provides structure and direction to financial accounting and reporting, but does not directly prescribe GAAP. It is 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. 2. Another textbook definition- A system of concepts that flow from the financial reporting objective. C. Basically, it is similar to a constitution D. The conceptual framework enables 1. FASB to issue more useful, consistent, and coherent standards and rules over time 2. The profession to more quickly solve new issues by referring to it. E. Overview of the FASB's conceptual framework 1. From our textbook

2. From another textbook

The 1st level of the conceptual framework has to do with the why of accounting (the objective). II. Objective of Financial Reporting

A. The objective of general-purpose financial reporting is to provide financial information about the reporting entity that is useful to present and potential equity investors, lenders, and other creditors in making decisions about providing resources to the entity. B. This is the foundation of the conceptual framework as it identifies the purpose of financial reporting. C. Other aspects of the framework flow logically from this objective. D. Things to note about this objective 1. Companies prepare general-purpose financial statements to provide information to decision-makers. 2. There is an assumption that the users (investors and creditors) have reasonable knowledge of business and financial accounting matters to understand the information contained in financial statements. This assumption impacts the way companies report their information.

The 2nd level of the conceptual framework are fundamental concepts that consists of 2 parts qualitative characteristics AND elements. It bridges the why of accounting (the objective) with the how of accounting (recognition, measurement, and disclosure concepts). II. Qualitative Characteristics A. General Info 1. Qualitative characteristics are meant to enhance decision-usefulness a. States the characteristics that make accounting information useful b. Helps distinguish better (more useful) information from inferior (less useful) information for decisionmaking purposes. c. Note Providing useful financial information is limited by a cost constraint on financial reporting. Basically, cost should not exceed the benefits of a reporting practice. 2. Depending on how they affect the decision usefulness of information, qualitative characteristics are either a. Fundamental qualities OR b. Enhancing qualities

5. The hierarchy of qualitative characteristics.

B. Fundamental Qualities (that make accounting info useful for decision making) 1. Relevance- info must make a difference in decision making. Financial information is capable of making a difference when it has the following 3 ingredients. a. Predictive value- info must help users predict future events Example: If potential investors are interested in purchasing stocks in United Parcel Service, they may analyze its balance sheet, its dividend payments, and its income statement to predict the amount, timing, and uncertainty of the company future cash flows. b. Confirmatory value- info must help users confirm or change past (or present) expectations. c. Materiality- it must make a difference in decision making. i. Relates to an item’s impact on a financial reporting. Information is material if omitting it or misstating it could influence decisions users make. If an information is immaterial, it is not relevant—meaning it has no impact on a decision-maker and need not be disclosed. ii. Materiality depends on each company's situation and is based on the nature or magnitude of the item that is being reported. iii. The general rule of thumb is that anything under 5% of net income is considered immaterial. However, again, it really depends on the situation. Materiality varies with both relative amounts (quantitative) and relative importance (qualitative). Thus, good judgment and professional expertise must be applied to determine materiality.

Example Company A and B each reported an unusual loss shown below. Company A Company B Sales

$10,000,000 $100,000

Costs and expenses

9,000,000

90,000

Income from operations $ 1,000,000 $ 10,000 Unusual loss

$

20,000 $ 5,000

For Company A, it appears to be immaterial because the amount is only 2% (20,000/1,000,000) of its income from operations. On the other hand, Company B had an unusual loss of only $5,000. However, it is relatively much more significant because $5,000 amounts to 50% (5,000/10,000) of its income from operations.

2. Faithful Representation- the info is what it really is. Example: If General Motors' income statement reports sales of $180,300 million when it had sales of $155,399 million, then the statement fails to faithfully represent the proper sales amount. a. Completeness- all the information is there and nothing is missing. Example: When Citigroup fails to provide info needed to assess the value of its subprime loan receivables (toxic assets), the information is not complete. b. Neutrality- info must be unbiased, cannot have info that shows favoritism. Example: R.J. Reynolds (a tobacco company) should not suppress information in the notes to financial statements about the numerous lawsuits that have been filed because of tobacco-related health concerns—even though such disclosure is damaging to the company. Conservatism i. In cases of uncertainty, many accountants practice conservatism in accounting treatments. This means that accountants require greater verification before recognizing good news than bad news. ii. As a result losses are reflected in net income more quickly than are gains AND net assets tend to be understated instead of overstated. iii. Example: The lower-of-cost-or-market method is used for measuring inventory. iv. Note the conceptual framework does not include conservatism because it is biased and inconsistent with neutrality (undermining representational faithfulness). Even so, it is likely to continue as an important consideration. c. Free from Error i. Info must be accurate. ii. Note this does not imply total freedom from error because most financial reporting measures involve estimates that come from management's judgment (i.e. allowance for doubtful accounts). Example: If JPMorgan Chase accidentally misstates its loan losses, its financial statements are misleading.

C. Enhancing Qualities (qualities that make accounting info even more useful) 1. Comparability

a. Info would be better if it were measured and reported in a similar manner. Users could then compare it with similar info from another company. b. Another type of comparability is consistency. This is when companies consistently use the same accounting standards from period to period. c. Example: The accounting for pensions in Japan differed historically from that in the U.S. In Japan, companies generally recorded little or no charge to income for these costs. U.S. companies recorded pension cost as incurred. As a result, it is difficult to compare and evaluate the financial results of Toyota or Honda to General Motors or Ford. Investors can only make valid evaluations if comparable information is available. 2. Verifiability- independent measurers, using the same methods, can obtain similar conclusions on the info. Example: Two auditors count PepsiCo's inventory and arrive at the same physical quantity amount for inventory. 3. Timeliness- info must be useful to users before it loses its value in the decision-making process. Example: If Dell waited to report its interim results until 9 months after the period, the information would be much less useful for decision-making purposes. 4. Understandability a. Info must be presented clearly to users so that they can see its significance. b. Note users of financial reports are assumed to have a reasonable knowledge of business and economic activities.

III. Basic Elements A. These are terms using in financial accounting. B. Elements of Financial Statements- defines the elements of financial statements (i.e. assets, liabilities, etc).

The 3rd level of the conceptual framework has to do with recognition and measurement concepts. IV. Recognition, Measurement, and Disclosure Concepts A. General Info 1. Consists of concepts that implement the basic objectives. 2. Explains how companies should recognize, measure, and report financial elements and events. 3. Consists of 3 loosely classified parts

B. Assumptions 1. Economic Entity Assumption (aka Separate Entity Assumption or Business Entity Concept) a. The concept that an organization or a section of an organization that, for accounting purposes, stands apart from other organizations, and individuals as a separate entity b. Assumes a company keeps its activity separate from its owners and other business units c. Example Assume when Bill Gates started Microsoft on his own, he borrowed $100,000 from Wells Fargo. Following the economic entity assumption, Bill would account for the $100,000 separately from his personal assets (his house, his clothes, his car, etc.) To mix the $100,000 of Microsoft cash with his personal assets would make it difficult to measure the financial position of Microsoft. 2. Going Concern Assumption a. Assumes that the business will be continuing its operation for a while. b. Assumes that the company will have a long life. 3. Monetary Unit Assumption (aka Unit of Measure Assumption) a. Assumes that money is the appropriate basis to measure economic activity and performance. b. The U.S. dollar is a very stable unit of measurement and ignores price-level changes (inflation and deflation). 4. Periodicity Assumption (aka Time Period Assumption ) a. Assumes companies can divide its economic activities into time periods. b. These periods can be monthly, quarterly, or yearly. c. In accounting, the time period most used to measure the financial status of a company is 1 year. They are either a i. Calendar year Companies that have accounting periods that run from Jan 1 to Dec. 31. ii. Fiscal year - Companies that have accounting periods that last one year and end on a date other than Dec 31. - The year end is usually the low point in business activity for the year. - Example: Wal-Mart and Target use a fiscal year that ends on Jan 31, b/c the low point in business activity is after Christmas.

C. Principles of Accounting 1. Measurement Principle a. GAAP has 5 measurement attributes - Historical cost - Fair value (aka fair market value or market value). - Net realizable value

- Current cost - Present (or discounted) value of future cash flows The 2 most commonly used are historical cost and fair value, which we will discuss further below. b. Historical Cost Principle i. GAAP requires that companies must report most assets and liabilities based on the original acquisition price (aka historical cost) ii. Accounting records should maintain the historical cost of an asset over its useful life. iii. Historical cost is used because it is verifiable. iv. Example Acme, Inc. buy a TV at a store going out of business for $200. The TV would cost $300 elsewhere. The cost principle would require Acme, Inc. to record the equipment for $200 instead of $300. Suppose, later the price of TV’s rises to $350. Based on the cost principle, the value of the TV in Acme, Inc.’s accounting books is still $200. c. Fair Value Principle i. Fair value is a market-based measure. Fair value information may be more useful than historical cost for certain types of assets and liabilities and in certain industries. ii. GAAP is increasingly calling for the use of fair value measurements in the financial statements. iii. Fair value information may be more useful than historical cost for certain types of assets and liabilities and in certain industries. Example: Some assets such as financial instruments are recorded at fair value. iv. Historical cost initially equals fair value when something is first purchased. As time passes, the fair value usually changes. Thus, fair value measures or estimates often provide more relevant information about the asset or liability. v. FASB is now giving companies the option to use fair value (referred to as the fair value option) as the basis for measurement of financial assets and financial liabilities. FASB considers fair value more relevant than historical cost because it reflects the current cash equivalent value of financial instruments. You will learn more about this as you progress in Acct 10B and 10C.

2. Revenue Recognition Principle a. The revenue recognition principle requires that companies recognize revenue in the accounting period in which the performance obligation is satisfied. b. A company has a performance obligation when it agrees to perform a service or sell a product to a customer. c. Examples Example #1 Klinke Cleaners cleans clothing on June 30 but customers do not claim and pay for their clothes until the first week of July. The company should record revenue in June when it performed the service (satisfied the performance obligation) rather than in July when it received the cash. On June 30, it would report a receivable on its balance sheet and revenue in its income statement for the service performed. Example #2 Boeing Corporation signs a contract to sell airplanes to Delta Air Lines for $100 million. To determine when to recognize revenue, Boeing uses the 5 steps shown below.

The 5 Steps of Revenue Recognition

d. You will learn more about revenue recognition in Ch. 5.

3. Expense Recognition Principle (aka Matching Principle) a. Expenses should be matched with revenues whenever it is reasonable or practicable to do so. Basically, you identify all expenses incurred during a period, measure the expenses, and match them against the revenues earned during that same time period b. Some costs are difficult to associate with revenue. As a result, companies often use an allocation policy that will approximate the expense recognition principle. This type of expense recognition involves assumptions

about the benefits that a company receives as well as the cost associated with those benefits. A good example is depreciation of fixed assets. c. Companies charge some costs to the current period as expenses (or losses) simply because they cannot determine a connection with revenue. Examples of these types of costs are officers' salaries and other administrative expenses. d. Product Costs vs. Period Costs i. Product costs - Use matching because they defer some cost into the future. - Materials, labor, and overhead costs ii. Period costs - Are expensed immediately when incurred because it is difficult to determine the relationship b/t expense and revenue. - Examples include officers' salaries and other administrative expenses 4. Full Disclosure Principle a. Companies must provide information that is of sufficient importance to influence the judgment and decision of an informed user. This doesn’t mean every single detail needs to be presentation, but rather adequate info needs to be presented to allow users to fairly interpret the financial statements and understand how the company is doing. b. Users find information about financial position, income, cash flows, and investments in 3 places i. Financial statements ii. Notes to those statements - These elaborate or explain the items presented in the financial statements. - They provide additional info needed. - Examples: Descriptions of the accounting policies and methods used in measuring the elements reported in the statements, explanations of uncertainties and contingencies, statistics, etc. iii. Supplementary information - May include details or amounts that present a different perspective from that adopted in the financial statements. - It may be quantifiable information that is high in relevance but low in faithful representation. For example, oil and gas companies typically provide information on proven reserves as well as the related discounted cash flows. - May also include management's explanation of the financial information and its discussion of the significance of that information. For example, many business combinations have produced financing arrangements that demand new accounting and reporting practices and principles

V. Cost Constraint (aka Cost-Benefit Relationship) to reporting in accounting A. This is the idea that we must weigh the costs of providing information against the benefits that can be derived from it B. FASB and other governmental rule making agencies should use cost-benefit analysis before making final their informational requirements. In order to justify requiring a particular measurement or disclosure, the benefits perceived to be derived from it must exceed the costs perceived to be associated with it. C. The challenge in cost-benefit analysis is that the costs and especially the benefits are not always evident or measurable.