Chapter 1: Introduction to Financial Reporting

Harmonization of International Accounting Standards & Organizations Involved in Harmonization

• Domestic accounting standards have developed to meet the needs of domestic environments • Increased interest in the harmonization due to expansion of international business and global capital markets • However, the push towards international standards has significantly declined in the past 10 years. So International standards have not replaced GAAP as was originally intended. • The United Nations (UN) appointed a group to study harmonization in 1973 o To facilitate development of standards • Other organizations o FASB o European Economic Community (EEC) o Organization for Economic Cooperation and Development (OECD) o International Federation of Accountants (IFAC) o Accounting Standards Committee (IASC)

Time Period

• Finite reporting periods applied to the presumed indefinite life of a business o Natural business year: usually ends when the entity's operations are at a low ebb o Calendar year: end Dec. 31 • Fiscal year (NOT "physical" year): For an example, if an entity has a May 31 year-end, then its most recent year would cover June 1, 2019, through May 31, 2020.

SFAC 5: Recognition and Measurement of Elements

• For an element to be recognized (recorded), an item should meet the following criteria: 1) Meets the definition of an element 2) Measurable with sufficient reliability 3) Information should be relevant 4) Information should be reliable

International Accounting Standards Committee (IASC)

• Formed in 1973 • Issued International Accounting Standards (IAS) from 1973 to 2000 • Objectives include o Developing international accounting standards and disclosure o Developing standards to meet the needs of developing and newly industrialized countries o Working toward increased comparability between national and international accounting standards

GAAP and its Development in the United States

• Generally Accepted Accounting Principles (GAAP) o Are rules with authoritative support for allowable reporting methods & information disclosure requirements o There is a constant process of evaluation; not static o The development of GAAP is continually evolving... new revenue recognition rules and how report lease transactions • Major parties involved in development of GAAP: o *Financial Accounting Standards Board (FASB)* concerns itself with evaluation & development o *Securities and Exchange Commission (SEC)* monitors and ensures compliance o *American Institute of Certified Public Accountants (AICPA)* provides input and support for evaluation & development.

Financial Reporting Standards for SMEs

• IASB published an IFRS for Small and Medium-Sized Entities (SMEs) in 2009 • A blue ribbon panel on Private Company Financial Reporting was appointed in 2010 o The panel made recommendations to the Financial Accounting Foundation (FAF) 1) For a new company, separate board with standard setting authority under the oversight of the FAF 2) Changes and modifications to GAAP recognizing the unique needs of users of private company financial statements

Realization: Determining when to record revenue under GAAP

• In general, the point of recognition of revenue should be the point in time when revenue can be reasonably and objectively determined and earned (old GAAP). The new revenue recognition standard requires that the performance obligation is complete. • Point of sale of a product (inventory) is the simplest to determine • There are exceptions including "percentage of completion" for firms that create and sell long-term assets (such as Boeing) • If collection of cash is uncertain, new GAAP requires the revenue to be recorded but also an offsetting bad debt expense & allowance for the receivable should be recorded • There are other acceptable methods of recognizing revenue that are usually industry-specific • The method a firm uses to record revenue should be included in Note 1 of the financial statements.

Industry Practices

• Industry-specific reports • Do not conform to general accounting guidelines o Government regulation o Unique needs or peculiarities of an industry • Effort to minimize but will probably never be completely eliminated

A New Reality: Regulation imposed due to the occurrence of major financial frauds

• Major financial frauds o Enron o WorldCom • Such frauds led to the legislation called Sarbanes-Oxley Act of 2002 (SOX) o Section 404 requires companies to document adequate internal controls and procedures o Must be able to assess the effectiveness of the internal controls and financial reporting

Matching of expenses to related revenue

• Match revenue recognized with their associated costs • Direct association (i.e. inventory sales revenue and cost of the inventory or CGS)

Historical Cost

• Often used to record an asset because it is objective and determinable (reliable) • Acceptable deviations o When it becomes apparent that the historical cost cannot be recovered (justified by the conservatism concept) o Where specific standards call for another measurement attribute such as current market value, net realizable value, or present value

Important Terms describing a firm's financial condition that can be evaluated using financial statements

• Profitability: Has revenue covered expenses? • Liquidity: Has the firm been able to pay its short-term obligations? • Solvency: Has the firm been able to pay its long-term obligations & continue as a "going concern"? • Efficiency: How well has the firm managed its assets & generated revenue using its assets? • Growth: Has the firm grown in assets, revenue, income, dividends? • Investor data: Such as EPS (used to calculate P/E ratio), dividend yield, etc.

FASB Accounting Standards Codification

• Provides a single source of authoritative U.S. GAAP • 2009 Codification is organized in a tiered structure o Organized into eight areas from industry-specific to general financial statement matters o Provides electronic real time updates

Cash Basis

• Recognize revenue when cash is received • Recognize expense when cash is paid • Usually does not provide reasonable information about the earning capability of the entity in the short run •Acceptability o Usually not accepted by GAAP o May be used if difference between cash basis and accrual basis is not material

Transaction Approach

• Record transactions that o Affect the financial position of the entity o Can be reasonably determined in monetary terms; measurable • Many transactions are nonmonetary in nature o Not recorded o May be disclosed in compliance with "full disclosure" assumption

Qualities of information

• Relevant makes a difference to the user/stakeholder o Info should have predictive value & feedback value, and o Must be timely • Reliable means that information must be Verifiable (based on fact) & has Representational Faithfulness o Neutral is based on fact (can be objectively documented) not subjective; e.g. historical cost is generally used to record asset value since it is objective • Information should be both Comparable & Consistent o Format of presentation should be consistent from period to period & comparable to financial reports of other companies o Accounting methods used should be consistently applied within a firm (e.g. inventory method used remain the same for asset groups) & allowable methods used should be consistent among companies (e.g. the new revenue recognition rules will apply to all firms)

International Accounting Standards Board (IASB)

• Replaced the IASC in 2001 • Standards have been adopted in whole or in part by approximately 100 countries o But does not have authority to enforce its standards • Issues International Financial Reporting Standards (IFRSs) o IFRSs now refers to the entire body of international standards • Employs a due-process procedure similar to that of the FASB to issue standards

Annual Report on Internal Control Systems: Required by SOX

• Required by the SEC to include the following: o A statement of management's responsibilities for establishing and maintaining an adequate system o Identification of the framework used to evaluate the internal controls o A statement as to whether or not the internal control system is effective as of year-end o The disclosure of any material weaknesses o A statement that the company's auditors have issued an audit report on management's assessment

Revenues: Recorded using accrual basis per GAAP

• Revenue may be recorded at the same time the related cash is collected (e.g. at the point of sale for a retail business) • Revenue may be recorded after cash is received if cash is received before performance of the sale or service is completed. Unearned or deferred revenue (liability) is recorded when cash is received. When performance is complete, liability is removed & revenue recorded. • Revenue may be recorded before the related cash is collected o An "accounts receivable" (A/R) from the customer is recorded when the revenue is recorded o When/if the cash is later collected, the A/R is decreased • Revenues should be supported by cash inflows.

Accrual Basis accounting (GAAP requires)

• Revenue recognized when realized (realization concept); new revenue recognition says when the performance obligation completed (for the client/customer). • Expenses recognized when incurred (or matching or rational allocation) • Numerous year-end adjustments required when using accrual accounting so accrual is more complex than cash basis • Result is more representational of financial condition • Supports the time period assumption

Consistency

• Same accounting treatment should be given to comparable transactions from period to period • Helps make financial reports comparable • Supports trend analysis • If a change is made o Justification of change is disclosed o Impact of the change on the financial must be explained

Securities Regulations issued in the 1930's

• Securities Act of 1933 o To regulate the initial offerings and sale of securities in interstate commerce • Securities Exchange Act of 1934 o Its purpose was to regulate securities traded on national exchanges o The Act created the Securities and Exchange Commission (SEC)

Monetary Unit

• Standard of measure for financial transactions • U.S. dollar for domestic entities • Inflation: The loss in value of money • For countries with significant inflation, financial statements are adjusted by an inflation factor; this is not done in the U.S.

SFAC #1

• States the objective of financial reporting is to provide information that is useful for business & economic decision-making that is comprehensible to those having a reasonable understanding of business & economic activities • The primary focus is on earnings (the Income Statement); earnings = income • Information is provided about economic resources assets) and the claims (liabilities) against those resources (the Balance Sheet) • Helps users to assess future cash flows (the Cash Flow Statement provides a summary of the change in cash & cash flows; past info)

FASB's Conceptual Framework: Development began in 1973

• The *"Conceptual Framework"* is intended to be a system of interrelated objectives & underlying concepts to serve as a *basis for evaluating existing standards of financial accounting and reporting (GAAP).* • The *"Statements of Financial Accounting Concepts" (or SFAC's)-provide the FASB with a foundation for considering merits of alternative accounting principles.*

Convergence

• The FASB and the IASB met jointly in Norwalk, Connecticut, 2002 o Commit to the development of high-quality, compatible accounting standards • Other joint meetings reaffirmed their commitment and agreed to the convergence of U.S. GAAP and IFRS • 2007 agreement between US and European Union allowed companies to drop US GAAP if financial statements were prepared by IFRS

Going Concern or Continuity Assumption

• The entity will remain in business for an indefinite period of time as a "going concern" • Disregards possibility of bankruptcy or liquidation unless evidence indicates this is likely • Impacts how assets and liabilities are measured and reported; if bankruptcy is imminent, then assets should be valued at their net realizable value • In case of a threat of liquidation or bankruptcy, financial statements must disclose that the presumption of continuity is not applicable

SFAC 5: Recognition and Measurement: Various types used for assets

• The five different measurement attributes used: 1) Historical cost = amount "paid" for the asset o Historical cost is the most reliable value but not always the most relevant, this is the general rule 2) Current market value/fair market value. concerns itself ask the questions: o What is the asset worth now? o What can you sell it for? 3) Current cost = cost to purchase the asset now 4) Net realizable (settlement) value = expected sales price less costs to sell (e.g. commission or shipping) 5) Present (or discounted) value of the asset's future cash flows

Conservatism in Accounting

• There are various measures of value for an asset, each having reasonable support • Conservatism guides selection of the alternative value that has the o Least favorable impact on net income and financial position o Tendency is to understate an asset's value and understate revenue and income rather than overstate; also a tendency to record or "accrue" a loss that is uncertain (as long as probably and reasonably estimable)

Continuous Evaluation & Development of GAAP: the benefit must outweigh the cost of the imposed requirements

*Process of GAAP development* • A topic is added to the technical agenda • Public comments are solicited o FASB issues a Discussion Memorandum o FASB invites the public to comment & holds a hearing to review comments • Issues Exposure Draft (ED) • GAAP is continually evolving & users weigh in on the process

Expenses: When recorded using accrual basis accounting per GAAP & cash basis (not GAAP)

*• Accrual basis:* an expense is oftentimes recorded when an invoice/bill is received and/or when the liability is owed; cash payment may occur later, when due (e.g. within 30 days); so a liability may be recorded simultaneously when the expense is recorded. Recognition: 1. When the cost is incurred & the benefit is used o If an Expense is incurred and used, then an expense (debited) and liability is recorded or accrued 2. Rational allocation of certain expenses: o Depreciation expense: the cost of the asset is spread & expensed over its expected useful life while accumulated depreciation grows and reduces the asset's net book value. o The cost of insurance paid in advance over the coverage period; insurance expense is recorded as the coverage period expires. 3. Matching: CGS is recorded when the related Sales Revenue is recorded. o When inventory is purchased and before it's sold, its cost is recorded as an asset in the inventory account. *• For cash basis accounting*, an expense is only recorded when the payment is made (via check or credit card).

SFAC #6 Defines Elements of Financial Statements: How financial info is recorded & presented in the financial statements. Basis is the Accounting Equation: Assets = Liabilities + Equity

*• Assets:* Probable future economic benefits obtained and/or controlled as a result of past business transactions o An Asset has value & can be recorded in monetary terms (measureable), can be tangible or intangible; but not all "assets" are recorded; if not measurable. *• Liabilities:* Obligations to transfer assets or provide services in the future as a result of past business transactions; debts *• Equity:* Residual interest in the assets after deducting liabilities so what's left for the S/H's o Primary components: Contributed Capital (from investors) + Retained Earnings o Equity = Assets less Liabilities o Book value and market value of equity are not equal; BV is normally less than Market value *• Investments by owners (Contributed Capital)* o Increases in the equity due to transfers of value to obtain or increase ownership interests in it *• Distribution to owners (Dividends & Stock repurchases or "buybacks")* o Decrease in equity resulting from transferring assets, [rendering services, or incurrence of liabilities by the enterprise] to owners *• Comprehensive income* includes Net Income plus other unrealized income or expense items *• Revenues (Sales and/or Service Revenue):* Inflows and other enhancements of assets or settlements of liabilities from delivering or providing goods, rendering services, or carrying out other activities related to the central operations *• Expenses:* Outflows or consumption of assets or incurrence of liabilities from delivering or providing goods, rendering services, or carrying out other activities related to the central operations *• Gains:* Increases in equity from peripheral or incidental transactions of an entity (e.g. sale of an asset for more than its book value creates a gain) *• Losses:* Decreases in equity from peripheral or incidental transactions of an entity (e.g. sale of an asset for less than its book value creates a loss)

American Institute of Certified Public Accountants or "AICPA"

*• Is a professional accounting organization whose members are certified public accountants (CPAs)* • Established two standing committees in 1939 o Committee on Accounting Procedures o Committee on Accounting Terminology • AICPA replaced the 2 committees in 1959 with: o The Accounting Principles Board (APB) o The Accounting Research Division • In 1972 a special study group of the AICPA recommended establishment of the *Financial Accounting Standards Board (FASB)* which continues to be the major player in the development of GAAP.

Role of the Securities and Exchange Commission (SEC)

*• SEC has authority to determine GAAP & regulate the accounting profession* *• SEC has elected to leave much of the determination of GAAP & regulation of the accounting profession to the private sector (primarily to the FASB)* • SEC issues Regulation S-X which describes disclosure requirements for companies; & the SEC issues Financial Reporting Releases (FRR's) that pertain to financial reporting requirements

The 4 Financial Statements

1) Balance Sheet at a specific period end o Reports the balances in all the assets, liability, and equity accounts at a particular date (usually year-end or quarter-end). 2) Income Statement for a period of time (month, quarter, or year) o Net Income = Earnings = Revenue - Expenses o The income statement is used to assess profitability. 3) Statement of Stockholders' Equity- shows changes for a period of time 4) Statement of Cash Flows for a period of time. o Summarizes the inflows (cash received) and outflows (cash payments) for the period reported on (either for the year or for the quarter); classifies the inflows/outflows into 3 categories: Operating, Investing & Financing • Financial statements provide a summary of PAST information.

Financial Accounting Standards Board (FASB): 4 types of pronouncements

1) Statements of Financial Accounting Standards (SFAS's) 2) Interpretations of SFAS's, APBO's, and ARB's 3) Technical Bulletins 4) Statement of Financial Accounting Concepts (SFAC's) o Output of the FASB's Conceptual Framework project o Not a part of GAAP

Who are The Decision-makers/Users of Financial Statements/Stakeholders that rely or use financial statements

Parties who rely on financial statements: 1. Investors/Shareholders/Owners: current & potential 2. Management 3. Employees 4. Creditors (bondholders, banks, suppliers) 5. Regulators/watchdogs: SEC & IRS

Business Entity

• A business entity is separate and distinct from the owners of the entity • The entity is an economic unit that stands on its own • Financial statements should be the results of one entity unless for a consolidated group of entities where parent owns one or more subsidiaries.

SFAC 5: Recognition and Measurement—A full set of financial statements:

• A full set of financial statements for a period should include: 1) Financial position at the end of the period (Balance Sheet) 2) Earnings/Net Income (Income Statement) 3) Comprehensive income (total nonowner change in equity); this includes Net Income plus other items 4) Cash flows during the period (Statement of Cash Flows) 5) Investments by and distributions to owners during the period (Statement of Stockholders' Equity)

Full Disclosure

• Accounting reports must disclose all the facts that may influence the judgment of an informed reader • Methods of disclosure o Parenthetical explanations o Supporting schedules o Cross-references o Notes • Reasonable summarization of significant financial information is required

The Basic Accounting Equation: The foundation for the 4 financial statements

• Assets = Liabilities + Equity • All recorded transactions affect this equation which MUST stay in balance. A transaction much affect at least 2 accounts. • Examples: 1. When a firm issues stock & receives cash from stockholders, cash (an asset) increases & an equity account increases. 2. When inventory is purchased on credit, inventory (an asset) is increased and Accounts payable (liability) is also increased. 3. When an invoice for utilities is received for services already used, the firm would record an expense (reduces net income and thus equity at year end) and a liability (accounts payable).

Basic Accounting Equation Components

• Assets = Liabilities + Equity • Equity = Contributed Capital + Retained Earnings ("RE") • Retained Earnings or RE = income that has been accumulated & retained by the firm rather than distributed to shareholders. The amount retained each year: (Revenues - Expenses) - Dividends • The RE ending balance for a given year carries over to the following year as its opening balance so it accumulates from year to year.

Reliability of F/S's: Audited vs. Non-audited

• Audited F/S's should be more reliable than F/S's of an entity that are not audited, meaning they are not reviewed or compiled • Publicly traded companies that are required to be filed with the SEC and are available to the public. o Annual F/S's must be audited by a CPA o Quarterly F/S's must be reviewed by a CPA

Overall Pervasive Constraint of information provided to users:

• Benefit of providing financial info should outweigh the cost of providing • The methods used and information provided is subject to a "materiality threshold" which depends on size of the company • The proper application of GAAP for a particular transaction may be too costly, so GAAP treatment may not be followed if an item is deemed immaterial. o E.G. a firm may have a policy that depreciable assets purchased less than a certain amount, like less than $500, are expensed rather than capitalized (recorded as an asset) & depreciated. o Proper treatment per GAAP may be deemed too costly for an immaterial transaction *so GAAP is subject to materiality.*

Cash Basis Revenue: Not GAAP and who uses this method

• Common for tax purposes for small businesses • Revenue is recorded when cash is received regardless of when the performance of the sales or service contract is complete.

Materiality

• Considers the relative size and importance of an item to the business entity • Immaterial items not subject to concepts and principles o Handle in most economical and expedient manner • Does the information influence an informed reader of the financial statements? o Yes, if it is material o No, if it is immaterial

The Public Company Accounting Oversight Board (PCAOB)

• Created by the Sarbanes-Oxley Act • Consists of 5 members—2 CPAs, 3 non-CPAs • Promulgates auditing standards for companies subject to the Sarbanes-Oxley Act o Impact on the AICPA's role in setting auditing standards • Fee-based financial support • CEOs and CFOs must certify the financial statement disclosures