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Employees and Labor Unions

Individuals that work for the company and the organizations that represent the employees interests Employees and labor unions use financial statements to assess the economic performance and liquidity of entities employing members of the union. For example, The United Auto Workers represents employees in the automobile industry. Financial statement information can be useful during the negotiation of new labor agreements and compensation contracts

Revenues

Inflows or other enhancements of an entity's assets or settlements of its liabilities from delivering or producing goods, rendering services, or other activities that constitute the entity's ongoing major or central operations

Understandability

Information is understandable to reasonably informed financial statement users when financial statements classify, characterize, and clearly present all information. Because many companies are incredibly complex, it is very important to distill the vast amounts of financial data into a manageable report for users to read and understand. As an example of how financial statements are organized to aid understandability, companies separate current and non-current assets on their balance sheets. As a result, financial statement users can better understand a company's current and long- term resources.

Financial accounting

Is the process of identifying, measuring, and communicating financial information about an economic entity to various user groups within the legal, economic, political, and social environment

Fair Value Hierarchy

Level 1 Quoted prices in active markets for an identical assets or liability. A publicly traded equity security is classified at this level Level 2 Inputs other than the quoted prices included in level 1 that are observable for the asset or liability. For example, a building could be valued using a price per square foot obtained form transactions in a comparable building in a similar location Level 3 Unobservable inputs to value the asset or liability. For example, to measure the fair value of a private equity investment, a company might perform an analysis that relies on the present value of the expected future cash flows of that investment

Auditors

Auditors can be external or internal. External auditors are independent of the company and are responsible for ensuring that management prepares and issues financial statements that comply with accounting standards and fairly present the financial position and economic performance of the company. Because external auditors are independent parties, they lend a significant amount of credibility to the financial statements. Internal auditors are employees of the company serving in an advisory role to management and providing information regarding the company's operations and proper functioning of its internal controls

Rules- versus Principles- Based Standards

Both the US GAAP and IFRS systems of accounting standards are based on principles and rules. A principles-based standard relies on theories, concepts, and principles of accounting that are linked to a well-developed theoretical framework. A rules-based standard contains specific, prescriptive procedures rather than relying on a consistent theoretical framework. For example, assumer your parents tell you that you must maintain a GPA of at least 3.0 to receive a car at graduation if you do well in school. This is an example of a principles-based standard. The SEC uses the term objectives-oriented standard to refer to a standard that is somewhere between a pure principles- based standard and a pure rules-based standard

Capital

Capital is a scarce resource. How do investors and creditors make decisions regarding the amount of capital to invest in a given entity? Accountants report the economic performance and financial position of the firm so that potential debt and equity investors can adequately assess the risks and returns of investing in the entity. Similarly, lenders can use the financial statements to assess the potential for payment. For example, a bank limited in the number of loans that it can make would clearly prefer to lend to a business that has been profitable over the last five years rather than one that has not Transparent and complete financial statements aid investors in assessing the amounts and timing of future cash flows, as well as the uncertainty of cash flow realization. However, financial statement users should be aware that performance-based compensation can create and incentive for managers to strategically manage- or misreport- financial statements. Compensating managers based upon reporting net income provides a financial incentive to inflate net income. For example, when the Securities and Exchange Commission found that the CSC committed accounting fraud that increased net earnings in 2010 and 2011, CSC' CEO agreed to pay back 3.7 Million of compensation he received based on the fraudulent earnings. Financial accounting standards seek to limit this type of management behavior. Most managers faithfully report their financial statements, but it is important for standard setters and auditors to be aware of incentives to alter net income.

Competitors

Companies that produce the same service or product Competitors use financial information to determine their market position relative to the reporting entity. Companies analyze a competitor's financial information to identify its strategy and determine if it is possible to successfully compete with the company. An analysis of a competitor's financial information enables a financial statement user to identify that entity's objectives, assumptions, overall business strategy, and capabilities. For example, a pharmaceutical company would be interested in any increases in a rival's research and development expenses that could indicate new and competing products in the future.

Losses

Decreases in equity (net assets) from an entity's peripheral or incidental transactions and from all other transactions and other events and circumstances affecting the entity except those that result from expenses or distributions to owners

Distributions to Owners

Decreases in equity of a particular business enterprise resulting from transferring assets, rendering services, or incurring liabilities by the enterprise to owners. Distributions to owners decrease ownership interest (or equity) in an enterprise

Creditors and Other Debt Investors

Entities including banks and other financial institutions that lend money to the company either through a private agreement or through a public debt offering Creditors and other debt investors are entities, including banks and other financial institutions, that lend money to the company. Debt can either be public or privately held. In the case of a publicly traded debt, market participants invest in the entity's debt-specifically, the entity's bonds. Creditors typically receive a return on their investment in the form of interest income. However, in the case of public debt, they may also receive a return in the form of an increase in the price of the bonds. Creditors use financial information to determine whether the principal and interest on their loans will likely be paid by debtors when due. Creditors are also concerned with the priority of claims against the assets of the debtor company. Some lenders have priority over others when determining the order of repayment. Finally creditors can use financial information to assess the entity's current and future profitability and growth prospects.

Enhancing Characteristics

Even if information is relevant and representationally faithful, it may not be the most useful data available for decision making. The FASB identifies the following four enhancing characteristics that help distinguish more useful information from less useful information Comparability Verifiability Timeliness Understandability

Standard Setting Process

FASB follows a seven step process to issue a final standard Step 1: Identification of an issue. FASB identifies a financial reporting issue based on recommendations from analysts, government agencies, or other market participants Step 2: Decision to purse. After consultation with FASB members and others as appropriate, the FASB Chairperson decides whether to add the issue to the technical agenda Step 3: Public meetings. Once added to the agenda, the Board holds public meetings where it deliberates the various issues identified by the FASB staff Step 4: Exposure Draft: The Board issues an Exposure Draft (ED) which is intended to solicit input from financial statement preparers, auditors, and users of the financial statements Step 5: Public roundtables. The Board may hold public roundtables to discuss the ED, if needed. Step 6: Redeliberation. The FASB staff analyzes the comment letters received form preparers, financial statement users and auditors, public roundtable discussions, and any other information. The Board then redliberates the issue Step 7: Publication of the final standard. The Board issues an Accounting Standards Update, which is the final standard. It requires a majority vote of the Board to issue a new standard. The ASU will then be incorporated into the body of the Accounting Standards Codification that makes up US GAAP

Proactive Factors

Financial accounting is proactive in that it can change or influence its environment by providing feedback information that is used by organizations and individuals to reshape the economy. Accounting information is used to efficiently allocate resources throughout the economy by directing capital flows to their most productive uses. For example, start-up capital is needed to develop new technology such as solar power and electric vehicles Accounting standards can also influence managerial behavior. For example, expensing research and development costs may slow investment in research during economic downturns because this accounting treatment results in lower earnings figures

Going Concern Concept

Many assumptions in the financial statements are based on long term periods. How can a manger assert with certainty that a business will be viable in , say 25 years? The going concern concept indicates that accountants will record transactions and prepare financial statements as if the entity will continue to operate for an indefinite period of time unless there is evidence to the contrary. That is, the entity will exist for a period of time long enough to carry out contemplated operations, utilize existing productive capacity, and liquidate outstanding obligations. This concept justifies accounting practices such as the long-term/short-term classifications on the balance sheet and the depreciation of buildings for as long as 40 years The going concern concept is also tied to the use of historical cost. A business planning to operate for an indefinite period of time will not sell productive assets. Consequently, market values are less relevant. If a business is in jeopardy of failing, then the going concern assumption would not be valid. If the assumption is not applicable, accountants would measure assets and liabilities at the amount at which they expect to dispose of them, their liquidation values

US GAAP and IFRS

Neither US GAAP nor IFRS fits perfectly into a rules- or principles- based approach. The greatest difference between the two standards is that US GAAP contains more rules than does the IFRS. Although US GAAP includes more rules than IFRS, it is not purely rules based. Similarly, IFRS is not purely principles based. Both US GAAP and IFRS base standards on their respective conceptual frameworks

Conceptual Framework Components

Objective of financial reporting Characteristics associated with high-quality financial information Elements of the financial reporting system Recognition and measurement criteria

General Recognition Principles: IFRS

IFRS also has four recognition criteria. Notice that the first three recognition criteria are similar to US GAAP 1. The item meets the definition of one of the elements 2. The item is measurable 3. The measurement of the item must be reliable 4. It is probable that future economic benefits will flow to or from the company To illustrate the fourth criterion, assume management determines it is probable that the company will collect an estimated amount of receivables, resulting in an economic benefit to the company. Management should not include any receivables unlikely to be collected as assets by establishing an allowance for uncollectible accounts. The fourth criterion is used instead of relevance under US GAAP The IFRS cost- benefit constraint and materiality constraint are similar to US GAAP.

Assumptions in Financial Reporting: IFRS

IFRS explicitly addresses the going concern assumption. The other assumptions are implicit in the standard- setting process

Period of Time Elements: IFRS

IFRS identifies four period of time elements 1. Performance 2. Income (includes both revenues and gains) 3. Expenses (includes both expenses and losses) 4. Capital maintenance adjustments IFRS explicitly identifies performance, or profit, as a separate element. In contrast, profit is the result of adding revenues and gains and subtracting expenses and losses under US GAAP. Where US GAAP identifies revenues and gains as separate elements, the income element in IFRS encompasses both revenues and gains as both increase equity. Similarly, where US GAAP identifies expenses and losses as separate elements, the expense element under IFRS encompasses both expenses and losses as both decrease equity Unlike US GAAP, IFRS determines capital maintenance adjustments from period to period. IFRS defines capital maintenance adjustments as restatements or revaluations of reported amounts assets and liabilities that companies usually report in other comprehensive income. The concept of capital maintenance relates to how a company seeks to assess changes in its equity. Capital is maintained when the amount of equity in the current year is at least as much as it was in the prior year. Because capital maintenance assesses changes in equity, it is linked to how profit is determined. There are two concepts of capital maintenance: Financial capital maintenance Physical capital maintenance Under the concept of financial capital maintenance, capital is viewed as the financial amount, or money amount, invested in a company. A company earns profit only if the financial amount, or dollar amount, of the equity at the end of the period is higher than it was at the beginning of the period. For example, financial capital is maintained and a profit is earned when the ending balance of equity is 750,000 higher than the beginning balance Under the concept of physical capital maintenance, capital is viewed as the productive capacity of a company, such as units of output per day. A company earns a profit if its productive capacity is greater at the end of the period than it was at the beginning of the period. The concept of physical capital maintenance relies on current cost measurement and is consistent with the revaluation or restatement of long lived operating assets and liabilities. For example, physical capital is maintained and a profit is earned when the output of goods is 200,000 units higher in the current year than in the prior year. IFRS allows a company to determine the concept of capital maintenance that is most appropriate for its business Finally also not that unlike US GAAP, IFRS does not treat transactions with the owners as separate elements

Point-in-Time Elements: IFRS

IFRS identifies the same three point-in-time elements as US GAAP 1. Assets 2. Liabilities 3. Equity The definitions of these elements differ slightly in IFRS. Companies usually identify the same assets and liabilities under both US GAAP and IFRS, however, so we do not explore the details of the IFRS definitions

Bases of Measurement: IFRS

IFRS includes four of the five measurement bases under US GAAP. The four IFRS measurement bases are: 1. Historical cost 2. Current cost 3. Net realizable value 4. Present value of future cash flows IFRS does not include current market value as a separate measurement basis. Rather, the view under IFRS is that current cost, net realizable value, and the present value of future cash flows are all current market value measures

Summary Detail the standard-setting process

In the US, the Financial Standards Board (FASB) sets GAAP. In setting standards, the FASB follows a seven strip process: Step 1: Identification of an issue Step 2: Decision to pursue Step 3: Public meetings Step 4: Exposure Draft Step 5: Public roundtables Step 6: Redeliberation Step 7: Publication of the final standard The International Accounting Standards Board (IASB) issues International Financial Reporting Standards (IFRS_. The IASB has a similar process as the FASB, and it conducts a post- implementation review after an IFRS is issued

Gains

Increase in equity (net assets) from an entity's peripheral or incidental transactions and from all other transaction and other events and circumstances affecting the entity except those that result from revenues or investments by owners

Investments by Owners

Increases in equity of a particular business enterprise resulting from transfers to it from other entities of something valuable to obtain or increase ownership interests (or equity) in it. Assets are most commonly received as investments by owners, but that which is received may also include services or satisfaction or conversion of liabilities of the enterprise

Financial Analysis

Individuals employed at investment banks, commercial banks, and brokerage houses that use financial information to provide guidance to individuals and other entities in making investment and credit decisions Analysts use various techniques to estimate the value of an entity based on information obtained from the annual report and other publicly available information, as well as from interviews with company officers and outside industry or economic experts. Some financial analysts are equity analysts who follow an industry or certain companies and provide their opinions or recommendations on a regular basis. These reports result in a recommendation as to whether investors should buy or sell the stock of that company. For example, in the first quarter of 2017, there were 39 analyst recommendations issued for twitter-4 of which were buys, 27 were holds, and 8 were sells or underperforms. Financial analysts act as market intermediaries in that they are trained to examine an extensive volume of financial data and reduce it to a manageable amount of information for use by investors

Comparability

Investors and creditors must be able to compare entities in making capital allocation decisions. Comparability allows financial statement users to identify and understand similarities and differences among several entities. Accounting standards often allow alternative methods, such as straight- line or accelerated deprecation, and require estimates, like the useful lives of long-lived assets. A company's financial information is useful if financial statement users can compare it with similar information from another company, companies in its industry, or to its prior year. For example, the requirement to disclose the useful lives of long-lived assets allows financial statement users to compare the aircraft fleets of AA and DA. American uses a 16-30 year useful life for its fleet whereas Delta uses a longer 20-32 year useful life. The differing useful lives imply that American has aircraft with a shorter useful life and probably has different types of planes in its fleet than Delta

Suppliers and Customers

Organizations that provide the necessary inputs for the products or services produced by the entity and companies or individuals that purchase the goods or services from the entity Suppliers and customers use financial statements to determine a company's financial position. For suppliers, it is critically important to assess the company's ability to pay for goods and services provided. A company's financial condition indicates the quality of its products and its ability to honor warranties to potential customers. General Motors lost many prospective customers when it was in bankruptcy during the economic crisis of 2008. In this case auto buyers were concerned that GM would not be in business long enough to fulfill its warranty obligation to its customers

Expenses

Outflows or other consumption of assets or incurrences of liabilities from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity's ongoing major or central operations

Period of Time Elements

Period of time elements represent the results of events and circumstances that occur between two balance sheet dates. The point in time and period of time element groups interrelate or are said to articulate. Period of time elements will change point in time elements. For example, revenues will increase equity and expenses will decrease equity. Dividends declared will decrease equity. Another example is accounts receivables increasing when a sale is made on account. Salaries payable increases when employees have not yet been paid for work performed but equity is decreased In the conceptual framework, US GAAP identifies seven Period of Time elements 1. Investment by owners 2. Distribution to owners 3. Revenues 4. Gains 5. Expenses 6. Losses 7. Comprehensive income The first two elements, investments by owners and distributions to owners, represent transactions with owners. Investments by owners include the issuance of stock. Dividends are an example of distribution to owners. The remaining five elements relate to business activities occurring during the period Revenues and expenses are changes in equity that arise in the ordinary course of business. Gains and losses also change equity but re not considered part of normal operations. Target records depreciation expense on the buildings as part of its operating income. Now assume that Target sold one of its stores. It would have a gain or loss on the sale measured as the difference between the sale proceeds and the building's carrying value. Target did not include the gain or loss in normal operations and it would not classify it as revenue or expense. Rather, it would recognize the amount as either a gain or loss on disposal Comprehensive income includes all changes in equity during a period except those resulting from investments by owners and distributions to owners. As a result, comprehensive income includes net income and other gains or losses currently not recognized on the traditional income statement. For example, if a company invests in certain debt securities and the fair value of these shares declines, the equity of the company decreases. The decline in equity is part of other comprehensive income and may not be included on the traditional income statement.

Summary Explain three recent trends in standard setting: principles- based, rules- based, and objectives- oriented standards; the asset/liability approach; and fair value measurements

Principles- based standards are standards consistent with a theoretical framework. Rules- based do not rely on a consistent theoretical framework but rather contain more specific, prescriptive rules. Objectives- oriented standards refer to standards that are somewhere between pure principles- based and pure rules- based When deciding if a transaction should be recorded, the asset/liability approach bases the decision on whether an asset or liability should be reported on the balance sheet rather if revenue of expenses should be recognized on the income statement Fair value measurement, contrasted with historical cost, reports some items on the balance sheet at fair value We often thing of US GAAP as being more rules based than IFRS, but it is not purely rules based. Nor is IFRS purely principles based

American Institute of Certified Public Accountants

Professional organizations such as the American Institute of Certified Public Accountants are also involved int he financial reporting process. The AICPA is the national professional association for CPAs in the United States. The AICPA prepares and grades the Uniform CPA Examination. This organization also supports accounting professionals throughout their careers by providing training, professional skills development, and other resources

Cost Constraint

Providing all relevant and representationally faithful information available is costly. As a result, the conceptual framework stipulates that standard setters should compare the cost of requiring information to the benefits derived from presenting this information when developing accounting standards. Standard setters consider costs for both financial statement reporters and users. A company consumes a significant amount of resources in collecting, processing, verifying, and communicating its financial results. New standards or significant revisions of existing standards require companies to increase training, update accounting systems, and renegotiate existing contracts based on updated accounting information. On the other had, if the information required under a new standard is not provided to the users, they incur costs in obtaining or estimating that information on their own To illustrate, assume that standard setters are considering requiring that retail stores report the sales and operating profit generated by each store by month. This information may be useful to investors and financial analysts. However, the cost of providing such detailed store- by store information every month can be greater than its benefits. As a result, the information will not be required

Principle Based Standards

Pure principles-based standards exhibit the following characteristics: Provide a clear discussion of the accounting objective related to the standard Involve, few, if any, exceptions Involve no tests (refereed to as bright-line tests) that require meeting a pre-established numerical threshold Provide insufficient guidance to implement the standard Involve a significant amount of interpretation in application With pure principle-based standards, comparability across entities is often lost due to the extensive amount of preparer judgement required. In addition, preparers and auditors worry that regulators will not support the judgement used when reporting under a principles - based system, even judgements made honestly without intent to bias. Finally, the lack of application guidance can make it difficult to enforce principles-based reporting requirements in practice

Role of Standard Setters

Standard setters work diligently to develop rules, and guidelines for financial reporting that will satisfy the requirement to accurately present the economic performance and financial position of the firm. These standards are designed to encourage transparent and truthful reporting. Publicly traded entities must follow the rules and guidelines set forth by the standard setters to maintain public trust and to ensure the efficient functioning of capital markets. The FASB promulgates accounting standards in the United States, and the IASB issues global accounting standards, called International Financial Reporting Standards

Business of Economic Entity Concept

The business or economic entity concept states that all transactions and events relate to the reporting entity and must be kept separate from the personal affairs of the owner, related businesses, and the owner's outside business interests. For example, Kyle Perry owns and operates several sporting good shops called Perry's Sports. Perry's Sports is an economic entity separate from Kyle Perry. Perry's Sports owns its store buildings and reports them in the company's financial statements of Perry's Sports. Financial reporting for different entities must be separate and included disclosures describing transactions among related entities

Comprehensive Income

The change in equity of a business enterprise during a period from transactions and other events and circumstances from nononwer sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners.

General Recognition Principles: IFRS v. US GAAP

An item is recognized in the financial statement if it is An element of the financial statements Similar under US GAAP and IFRS Measurable Similar under US GAAP and IFRS Reliable Similar under US GAAP and IFRS Relevant Not included in IFRS Not included in US GAAP Probable that any future economic benefit associated with the item will flow to or from the company Recognition is subject to the Cost- benefit constraint Similar under US GAAP and IFRS Materiality constraint Similar under US GAAP and IFRS

Other Parties Involved in the Preparation and Use of Financial Information

Another important group involved in the financial reporting process is the preparers themselves. Financial statement preparers are the companies that issue the financial statements In addition to preparers and users of the financial statements, other parties involved in the financial reporting process include: Auditors Accounting standard setters such as the Financial Accounting Standards Board and the International Accounting Standards Board Regulatory bodies such as the Securities and Exchange Commission and the Public Company Accounting Oversight Board Professional organizations such as the American Institute of Certified Public Accountants

Fair Value Measurements

Another trend in standard setting is the movement toward the use of fair value measurements as a viable alternative to historical cost. Fair value is the amount at which an asset (or liability) could be bought (or incurred) or sold (or settled) in a current transaction between willing parties. Twenty years ago, firms reported very few items on the balance sheet at fair value. Today, firms use fair values to measure some balance sheet accounts. For example, firms must report some investments in equity securities that have a readily determinable fair value and some investments in debt at fair value, as opposed to historical cost

Summary Explain what a conceptual framework is and why it is important in accounting standard setting

A conceptual framework sets forth the theory, concepts, and principles that underlie financial reporting. The FASB is working on a conceptual framework project divided into topics with the first one completed to date: 1. Objective and Qualitative Characteristics 2. Elements and Recognition 3. Measurement 4. Reporting Entity 5. Presentation 6. Disclosure Similar under US GAAP and IFRS

Overview of the Conceptual Framework

A conceptual framework sets forth theory, concepts, and principles to ensure that accounting standards are coherent and uniform. The conceptual framework states that a purpose of the conceptual framework is to assist standard setters in developing and revising accounting standards. However, the conceptual framework does not override accounting standards

Trends in Standard Setting

A move toward a less rules-based (or a more principles-based) systems as found in International Financial Reporting Standards A move toward standards that are focused on the asset/liability approach A move toward measuring balance sheet items at fair value rather than historical cost

Summary Explain the assumptions used in financial reporting

Assumptions in financial reporting Going concern concept Business or economic entity assumption Monetary unit assumption Periodicity assumption IFRS explicitly addresses the going concern assumption. The other assumptions are implicit in the standard- setting process

The Objective of Financial Reporting

According to the conceptual framework, the objective of financial reporting is: To provide financial information about the reporting entity that is useful to existing and potential investors, lenders, and other creditors in making decisions about providing resources to the entity. Those decisions involve buying, selling, or holding equity and debt instruments and providing or setting loans and other forms of credit The conceptual framework indicates that the primary users of financial information are the investors, lenders, and other creditors who cannot demand information from the entity. For instance, if Bank of America extends credit to Johnson and Johnson, the bank can demand any information needed to approve the loan. However, an individual investor in Johnson and Johnson's publicly traded debt usually cannot obtain additional information from the entity to help assess the amount, timing, and uncertainty of future cash flows. Investors also require financial information to form an opinion about a company's future cash flows and earnings- and many of the standard setting board's decisions are based on this . need

Accounting standard setters

Accounting standard setters develop and promulgate accounting concepts, rules, and guidelines that provide information that is relevant and faithfully represents the economic performance and the financial position of the reporting entity. The Financial Accounting Standards Board, the primary standard setter in the United States, promulgates US Generally Accepted Accounting Principles. The International Accounting Standards Board sets International Financial Reporting Standards

Bases of Measurement

After a company determines that it should recognize an item, it has to measure the item. For example, when a company purchases inventory from a supplier, it also incurs freight costs to have the inventory shipped to its stores. The company recognizes inventory as an asset. It measures the value of the inventory asset as the purchase price plus the freight costs and reports the amount on the balance sheet The initial measurement of elements in the financial statements and their subsequent measurement are both pertinent to financial reporting. US GAAP identifies five measurement bases used in financial reporting 1. Historical cost is the amount of cash that the firm paid to acquire the asset. In the case of a liability, historical cost is the amount of cash that the firm received when it incurred the obligation. The historical cost of an asset may be adjusted for depreciation of amortization 2. Current cost is the amount of cash that would be required if the firm acquired the asset currently 3. Current market value is the amount of cash that the firm would receive by selling the asset in an orderly liquidation. Liabilities may also be measured at current market value 4. Net realizable value is the amount of cash to be received in exchange for an asset, less the direct costs of disposal. In the case of a liability, it is the amount of cash expected to be paid to liquidate the obligation, including any direct costs of liquidations 5. Present value of future cash flows result from discounting net cash flows the firm expects to receive on the exchange of an asset or to pay to liquidate a liability The historical cost approach results in the general policy that firms initially record assets (and liabilities) at cost cost and maintain them at cost until selling, consuming, or otherwise disposing of them. Historical cost is the agreed upon acquisition price arrived at objectively through an arms-length transaction. An arms-length transaction involves a buyer and seller who are independent and unrelated parties, each bargaining to maximize his or her own wealth. Although historical costs are unrelated to current market values, firms continue to use historical cost information for most assets and in most industries. The use of historical cost is justified because it is objective and subject to verification The current cost, current market value, net realizable value, and present value of future cash flows measurement bases are all consistent with fair value reporting. There are times when fair value is observable, such as for a publicly traded equity security. When fair value is not directly observable- for example, an equity security that is not publicly traded- management uses judgement- based models to determine its fair value

Government Agencies

Agencies representing the government that are in charge of reviewing and/or regulating the company Government agencies review the financial statements of publicly traded companies for a variety of reasons. For example, the US Federal Trade Commission may review publicly available financial information to identify a potential monopoly of an entity in violation of antitrust laws

The Importance of Understanding International Accounting Standards

Although US GAAP and IFRS are converged in many areas, some differences still remain. Why is it important for an accountant in the United States to learn international accounting standards? US companies operate subsidiaries outside of the United States. Many of these subsidiaries report under IFRS in their home countries. Accountants must convert the subsidiaries' financial statements to US GAAP when preparing consolidated financial statements. For example, Johnson and Johnson operates in over 60 countries throughout the world Non-US companies operate in the US and prepare their financial statements using IFRS. ConConsequently, if you are working at or auditing an international firm, you will likely see IFRS. For example, GlaxoSmith is a worldwide pharmaceutical company based in the UK with 18% of its employees in the US and a US headquarters in Philadelphia The SEC permits the use of IFRS-based financial statements by international companies with shares trading on US stock exchanges. US accountants and auditors often assist these non-US companies in preparing US regulatory reports. As of September 2016, these companies represented a worldwide market capitalization in excess of 7 T across more than 500 companies The SEC promotes high-quality, globally accepted accounting standards. US accountants and auditors need a working knowledge of IFRS to implement global standards in companies and perform audits Many US accountants now spend time working outside of the US. IFRS is required or permitted in over 130 countries worldwide. The accounting profession has determined that a working knowledge of IFRS is important for today's accountant. For example, the American Institute of Certified Public Accountants tests IFRS on the CPA exam

Objectives- Oriented Standards

An SEC report studying rules- based and principles- based standard setting indicated that an objectives- oriented standard is optimal. Similar to principles - based standards, objectives-oriented standards are derived from and are consistent with a high quality theoretical framework and clearly stated accounting objectives. However, objectives- oriented standards include a sufficient level of rules to provide detail and structure, resulting in the consistent application of accounting standards across entities and across time. An objectives- oriented standard would minimize exceptions to a particular standard and reduce the number of bright-line tests used in its implementation. Many of the existing standards in both US GAAP and IFRS qualify as objectives- oriented standards

Summary Define financial accounting and describe the demand for financial information, including the role of general- purpose financial statements, the information needs to financial statement users and other parties, and the factors that influence financial reporting

Financial accounting is the process of identifying, measuring, and communicating financial information about an economic entity to various user groups within the political, social, legal, and economic environment Financial reporting aids investors, lenders, and other creditors in assessing the amounts and timing of future cash flows, as well as any uncertainty regarding those cash flows when making investment and credit decisions General- purpose financial statements provide information to a wide spectrum of user groups: investors, creditors, financial analysts, insurance companies, unions, government agencies, and such Financial statement users include equity investors, creditors, financial analysts, employees, labor unions, suppliers, debt investors, competitors, government agencies, and customers Environmental factors such as legal, economic, political, or social factors impact the financial reporting process Financial accounting is reactive when it reacts to pressure (lobbying) from various groups and changes in its environment Financial accounting is proactive in that it can change or influence its environment by providing feedback information that is used by organizations and individuals to reshape the economy

Reactive Factors

Financial accounting reacts to pressure (lobbying) from various groups and changes in its environment. Accounting theories and procedures evolve to meet the dynamic changes and demands from the environment. For example, FASB made changes in the accounting for off-balance sheet subsidiaries following the discovery of the massive fraud scheme at Enron in the early 2000s In addition, accounting conforms to economic conditions, legal standards, and social values. Today, accounting disclosures highlight a company's policies regarding pollution control, community service, and diversity in business. For example, in the letter to shareholders in Johnson and Johnson's 2015 annual report, CEO Alex Gorsky highlighted Johnson and Johnson's "legacy of caring through strategic partnerships" The development of accounting standards is also a political process that is heavily influenced by the various groups within the reporting environment. Lobby groups include investors, creditors, financial analysts, the financial community, academics, accounting organizations, and industry associations

Financial Information

Financial information falls into two categories: information that is or that is not governed by rules et forth by the accounting standard-setting bodies. Firms prepare the financial statements and the footnotes to the financial statements (also refereed to as footnote disclosures) based on accounting standard setters' rules. IN contrast, the letter to the owners, management's discussion and analysis, the auditor's report, the management report, and press releases are not governed by the accounting standard-setting bodies, although they are regulated to some degree by other authoritative bodies

Relevance

Financial information is relevant if it is capable of making a difference in decision making by exhibiting the following attributes: Predictive value Confirmatory value Materiality Information has predictive value if decision makers can use it as an input into processes that help forecast future outcomes. For example, companies report sales revenue each year. Financial statement users may use the prior year's revenues to predict future revenues. Both BMW and Porsche, German automobile manufacturers, reported sales increases int heir earnings announcements for fiscal 2015. By highlighting the increase in sales, the companies implicitly benchmarked the current sales against public sales. The sales from prior years can then be useful to investors in forecasting future revenues in periods beyond 2015 Information has confirmatory value if it provides feedback about prior evaluations. For example, financial statement users will often compare reported net income to prior earnings forecasts. Consider Johnson and Johnson, which beat or exceeded analysts' forecasted earnings per share in the fourth quarter of 2016, by reporting earnings of 1.58 The concept of materiality also determines the relevance of information. Information is material if reporting it inaccurately or omitting it would affect financial statement users' decisions. The materiality of an item can depend on its size and nature. The conceptual framework does not specify a quantitative threshold for the materiality of an item nor does it identify the specific nature of items that would be considered material. Rather, whether an item is material depends on the company and its financial reporting. Preparers and auditors must use professional judgement to determine the materiality of an item As an example of materiality varying with size, consider a 5,000 loss incurred when a computer is damaged. For a small start-up consulting firm, the loss could be material- that is, it could affect a financial statement users' decision such as extending credit to the firm. For a large, profitable consulting firm, a 5,000 loss would likely be immaterial. The planned disposition of a major operating segment is an example of an item that is material by nature. Even though there is no quantifiable amount that would be reported in the financial statements, not informing financial statement users of the planned disposition could affect their assessment of the company's future performance and their decisions about investing in or extending credit to the company

Legal, Economic, Political, and Social Environment

Financial reporting takes place in a complex and dynamic world: Financial statement users' information needs change as business evolves. So, it is natural that environmental factors- legal, economic, political, and social- shape and influence the financial reporting process. The environment is the fourth element of the financial accounting definition. Financial accounting interacts with its environment in both a reactive and a proactive fashion

Summary Describe the qualitative characteristics of financial information, including the fundamental and enhancing characteristics of financial reporting

Fundamental characteristics are relevance and faithful representation that distinguish useful financial reporting information form non useful information Relevant information is capable of making a difference in decision making because Of its predictive value: It can be used an input into processes that help predict future outcomes Of its confirmatory value: It provides feedback about prior evaluations It is material: Reporting it inaccurately or omitting it would affect the decisions made by the financial statement users Financial information is a faithful representation if it depicts the substance of an economic event Completely Neutrally Free from error Enhancing characteristics distinguish more useful information from less useful information. There are four enhancing characteristics: Comparability Verifiability Timeliness Understandability Similar under US GAAP and IFRS

Fundamental Characteristics

Fundamental characteristics are those basic characteristics that distinguish useful financial information from information not useful. The FASB identifies the two fundamental characteristics as relevance and faithful representation

Assumptions in Financial Reporting

Going concern Concept Business or economic entity concept Monetary unit assumption Periodicity assumption US GAAp does not directly state these four items as assumptions in the conceptual framework. Yet, they are implicit in determining financial reporting standards

Summary Demonstrate an understanding of recognition and measurement in financial reporting including general recognition principles, revenue and expense recognition, and accrual accounting

Recognition is the process of including an item as a line item in the financial statements of the entity Under general recognition principles, an item is recognized in the financial statements if it is an element of the financial statements, measurable, reliable, and relevant. Recognition is subject to the cost- benefit constraint and materiality threshold constraint In the FASB's conceptual framework, the revenue recognition principle states that revenue is recognized when it is 1. Realized or realizable: An item is considered realized or realizable when a good or service has been exchanged for cash or claims to cash 2. Earned: Revenues are considered earned when the entity has substantially accomplished what it must do to be entitled to the benefits represented by the revenues New revenue recognition standards apply different guidance to recognize revenue- the notion of the transfer of control of goods or services to recognize revenue Expense recognition involves the timing of when an expense is reported on the income statement. Expenses are recognized when 1. The entity's benefits are consumed in the process of producing or delivering goods or rendering services 2. As asset has experienced a reduced future benefit of when a liability has been incurred or increased without an associated economic benefit There are three main approaches to determine when to report an expense: Match with revenues Expense in period incurred Systematically allocate over periods of use IFRS differs from US GAAP in how it defines when items are recognized and in revenue and expense recognition criteria Under IFRS general recognition principles, an item is recognized in the financial statements if it is an element of the financial statements, measurable, reliable, and probable that any future economic benefit associated with the item will flow to or from the company The IASB conceptual framework states that revenue is recognizable when the following two criteria are met 1. An increase in future economic benefits related to an increase in an asset or a decrease of a liability has arisen 2. It can be measured reliably Similar to US GAAP, IFRS now uses the notion of a transfer of control of goods or services to recognize revenue Expenses are recognized when 1. A decrease in future economic benefits related to a decrease in an asset or an increase of a liability has arisen 2. They can be measured reliably IFRS does not recognize the matching approach

General Recognition Principles

Recognition is the process of reporting an economic event in the financial statements. Recognized events are included in a line item on the financial statements as opposed to in the notes to the statements Companies should recognize items when (and only when) they have met the following four criteria 1. The item meets the definition of one of the elements of the financial statements. For example, before a company records an asset, the item must meet the definition of an asset 2. The item is measurable. Events that relevant to decision making are recognizable only if the firm can measure them. Consider an entity that has been sued. In the early stages of the lawsuit, it may not be possible to reliably estimate the amount of the potential obligation. Therefore, it does not report a liability on the balance sheet 3. The item must be reliable. This notion is similar to the faithful representation characteristic discussed earlier in that reliable financial information depicts the substance of an economic event in a manner that is complete, neutral, and free from error 4. The item is relevant. That is, it must allow financial statement users to make rational economic decisions An item could meet all four of the above criteria and still not be recognized due to the cost- benefit constraint or a materiality threshold. Similar to the cost constraint that standard setters apply when setting accounting standards, companies use the cost- benefit constraint when determining when to recognize an item in the financial statements. The cost- benefit constraint requires that the expected benefits from recognition exceed the costs of recognition. Reporting the individual wages and salaries for 2500 employees worldwide in a company may be more useful in certain analyses than simply reporting total wage and salary expense on the income statement. However, the cost of providing that information will probably exceed its benefit The materiality threshold requires that an item be recognized in the financial statements if its omission or misstatement would significantly influence the judgement of a reasonably informed statement user. Materiality can apply to a numerical value or a non quantifiable concern. For example, a company facing an antitrust violation has no amounts to report because the litigation is still in process. However, the firm must disclose the litigation to ensure its financial statements are transparent

Regulatory Bodies

Regulatory Bodies protect investors and oversee the accounting standard-setting process. In the United States, the US Securities and Exchange Commission regulates publicly traded companies. Privately held companies are not required to comply with the SEC's regulations. The SEC gives the FASB the authority to issue US GAAP. In addition, the SEC reviews the filings of public companies in the United States. The Public Company Accounting Oversight Board sets auditing standards and oversees the audits of public companies in the United States

Equity Investors

Shareholders of the company That is an equity investor purchases a percentage ownership of the company. Equity investors include individuals, other corporations, partnerships, mutual funds, pension plans, and other financial institutions that expect to receive a return on their investment either through dividends or in the form of an increase in the price of their equity shares Equity investors use financial information to determine a company's ability to generate earnings and cash flow, aw well as to make an assessment of the potential risks and returns on their investments. Equity investors also use financial information to assess the ability of their entity to pay dividends and to grow over time. Firm growth in earnings and cash flow are important for the investor to sell his or her investment at a gain

The Standard Setting Structure

The FASB is part of a larger organizational structure that also includes the Financial Accounting Foundation (FAF) Governmental Accounting Standards Board (GASB) Financial Accounting standards Advisory Council (FAFSAC) Governmental Accounting Standards Advisory Council (GASAC) Emerging Issues Task Force (EITF) Private Company Council (PCC) The FAF is responsible for the oversight, administration, and finances of the FASB. The FAF obtains funds primarily through the Public Company Accounting Oversight Board (PCAOB), which assess charges known as accounting support fees against issuers of equity securities based on their market capitalization. Other sources of funds include publications, subscriptions, and contributions from state and local governments for the GASB The GASB sets standards for state and local governmental units. The FASAC exists to advise FASB on technical issues and the GASAC serves as an advisory board to the GASB The EITF was formed in 1984 to assist the FASB by addressing issues that are not as broad in scope as those found on the FASB's agenda. For example, EITF agenda items often include industry-specific issues. The EITF is made up of 13 reps, including preparers, auditors, and financial statement users. The group reaches an EITF Consensus when three or fewer members object to a proposed position that has been exposed for public comment. Although the FASB members do not vote on the consensus at the EITF meetings, all consensus decisions must be approved by the majority of the FASB members before they become part of US GAAP In 2012 the PCC was established to set accounting standards for US private companies. Before this time, if a private company was required to present financial information according to US GAAP, it followed the same rules as public companies with minor exceptions. Now the PCC is responsible for determining whether modifications to existing US GAAP standards are warranted for private companies, and if so, it has the responsibility of developing, deliberating, and voting on these modifications. However, the FASB retains the authority to make the final decision as to incorporating these changes into US GAAP for private companies

Summary Discuss the role of financial accounting standards setters in the US and Internationally

The Financial Accounting Standards Board (FASB) is the accounting standard setter in the US The International Accounting Standards Board (IASB) establishes International Financial Reporting Standards (IFRS) IFRS is required or permitted in over 130 countries worldwide. US GAAP is required for US companies

Standard Setting Process: IFRS

The IASB follows a similar process to the FASB's standard setting process When a topic is identified, the Board considers the nature of the issues, seeks input from its constituents, and prepares an exposure draft. After receiving comments on the exposure draft, the IASB may modify the proposed standard before approving a final standard Unlike the FASB, the IASB required to carry out a post-implementation review of each new standard or significant change to an existing standard. The review focuses on controversial issues identified during the development stage, unexpected costs, and implementation problems. This review is normally carried out up to two new years after the new standard has been in effect

The Global Standard Setting Structure: IFRS

The IASB is part of a larger organizational structure that also includes: The IFRS Foundation The Monitoring Board The IFRS Advisory Council The IFRS Interpretations Committee The IFRS Foundation oversees the IASB and is responsible for financing the IASB's operations. Unlike funding for the FASB, the IASB relies on contributions from companies and other parties that have an interest in promoting international accounting standards. The Monitoring Board was formed to enhance the public accountability of the IFRS Foundation while still allowing for independence in the standard setting process The Monitoring Board oversees the IFRS Foundation, participates in nominating individuals to serve as foundation trustees, and approves appointments. The IFRS Advisory Council advises the IASB and the IFRS Foundation on many issues, including the IASB's agenda and the implementation of standards. The IFRS Interpretations Committee is the interpretative body of the IASB, similar to the EITF in the US The IASB is composed of 14 members who are appointed by the IFRS FOundation's board of trustees. At least 11 members serve full time, and no more than 3 can be part-time members. To ensure broad and diverse international representations, the IASB is composed of: Four members form the Asia/Oceania region Four members from Europe Four members from the Americas One member from Africa One member appointed from any area, subject to maintaining overall geographical balance The IFRS Interpretations Committee (IFRSIC) develops interpretations of standards that must be approved by the IASB. Whenever the need arises, the IFRS Interpretations Committee forms working groups, which are task forces for individual agenda projects. The IASB will also normally form working groups or other types of specialized advisory groups to advise on major projects; an example is the Emerging Economies Groups

Conceptual Framework: IFRS

The IASB's objective and qualitative characteristics are identical to US GAAP. However, they differ in the description of elements of financial reporting and principles of recognition and measurement in financial reporting. The IASB is also currently revising in framework

Revenue and Expense Recognition

The financial markets' emphasis on reported earnings makes revenue and expense recognition principles important. Recall from our earlier discussion that Johnson and Johnson beat analysts' forecasts in the fourth quarter of 2016. The ability to report earnings in line with or higher than forecasts can be critical to a company's stock price. The intent of the revenue and expense recognition principles is to recognize revenue and expenses in the appropriate time period The revenue recognition principle in the conceptual framework states that a company should recognize revenue when it is realized or realizable and earned 1. An item is realized or realizable when a company exchanges a good or service for cash of claims to cash 2. Revenues are considered earned when the seller has accomplished what it must do to be entitled to the revenues A new revenue standard, which public companies can start adopting in 2017, is not completely aligned with the conceptual framework. That is, the new revenue standard indicates that the overarching principle of revenue recognition is the notion of the transfer of control of the goods or service. Fire steps are applied to determine the timing and measurement of revenue: 1. Identify the contract with the customer 2. Identify the separate performance obligations in the contract 3. Determine the transaction price 4. Allocate the transaction price to separate performance obligations 5. Recognize revenue when each performance obligation is satisfied We except the FASB will align the conceptual framework with the new standard when it rewrites the framework Expense recognition are used to determine the period when a company reports an expense on the income statement. Firms recognize expenses when: 1. The entity's economic benefits are consumed in the process of producing or delivering goods or rendering services 2. An asset has experienced a reduced future benefit, or when a liability has been incurred or increased, without an associated economic benefit Therefore, a company reports an expense when economic benefits are consumed. There are three main approaches to determine when to report an expense Match with revenues Expense in period incurred Systematically allocate over periods of use The approach used depends on the type of expense. For example, some expenses- such as cost of goods sold- consume inventory when used and are matched with their related revenues. Specifically, firms match the cost of goods sold expense directly with the sales of inventory during the same period. Firms can also record expenses in the period in which they are incurred. For example, the salary of a staff accountant is recorded in the period worked. Finally, firms systematically allocate some expenses over the periods during which the related assets provides benefits. For example, a firm depreciates (expenses) a building over the periods that it will provide a benefit to the entity Commonly firms reduce an assets or increase a liability when expected future cash flows change. For example, in the period that a company determines it can no longer sell certain inventory, it will record a loss on the income statement and write the inventory down on the balance sheet

Sources of Financial Information

The financial reporting process generates a significant amount of financial information that yields the four basic financial statements, as well as the footnote disclosures. The balance sheet- referred to as the statement of financial position The statement of comprehensive income The statement of cash flows The statement of shareholders' equity Published financial statements are called general-purpose financial statements because they provide information to a wide spectrum of user groups: investors, creditors, financial analysts, customers, employees, competitors, suppliers, unions, and government agencies. Although considered general purpose, most financial information is provided to satisfy users with limited ability or authority to obtain additional information, which includes investors and creditors. The Financial Accounting Standards Board which is the body responsible for promulgating US GAAP, identifies investors, lenders, and other creditors as the primary users of financial statements Financial statements are the culmination of the financial reporting process. These financial statements, along with the accompanying footnote disclosures, are the primary source of publicity available financial information for investors and creditors. None of the other sources of financial information-such as management forecasts, press releases, and regulatory reports-provide as much information as the financial statements The term financial information includes more information that the financial statements. The financial statements include the four basic financial statements and the related footnotes. However, financial information also includes items such as: A letter to the shareholders A formal discussion and analysis of the firm by the management of the firm Management report Auditors' report Financial summary Therefore the general purpose financial statements and the related footnotes are subsets of financial information. The financial statements and footnotes are governed by US GAAP which may not always be the case for all components of financial information

Demand for Financial Information

The form, content, and extent that firms provide financial information is based on market participant demand. Financial accounting provides information that enables users to evaluate economic entities and make efficient resource allocation decisions based on the risks and returns of a particular investment. This process directs capital flows to their most productive uses. In this way the demand for financial information is linked to the allocation of scarce resources. User groups- Decisions regarding risks and rewards of resource allocation- Information is required to aid in decision making- Economic entities produce financial information

Standard Setting as a Political Process

The issuance of new standards and changes in existing standards can have significant effects on an entity's reported net income. IN turn, these income effects impact the flow of capital throughout the economy At the company level, managers have incentives to oppose changes in standards that reduce their company's reported net earnings. On the financial statement user level, a new standard or a change in existing standards should provide better and more transparent financial information that will assist users in making more effective investment and credit decisions Standard setters address the concerns of both the managers and financial statement users by employing the standard setting processes we described in the previous section. These processes rely on the information gathered and opinions of users, managers, and auditors along with comments obtained from responses to exposure drafts and public roundtables. The standard-setting bodies analyze this information to gauge the economic consequences of the proposed standard and to assess the improvements in the quality of the financial information disseminated to the market. Standard setters address this trade off between the income effects and the value of financial information, reaching a balance before issuing the final standard.

Monetary Unit Assumption

The monetary unit assumption stipulates that an entity measure and report its economic activities in dollars. These dollars are assumed to remain relatively stable over time in terms of purchasing power. This assumption ignores inflation or deflation experienced in the economy in which the entity operates. This assumption justifies adding dollars of different purchasing power on the balance sheet. For example, a company would add land purchased in the current period to the balance of land acquired in 1969

Asset/Liability Approach

The next trend relates to the interrelationship between the balance sheet and income statement. When a firm reports an event on the income statement, the transaction typically also changes a balance sheet account. For example, if a firm reports revenue, it also increases the balance in accounts receivables or cash Although the two financial statements are interrelated, which set of accounts is dominant- the revenues and expenses on the income statement or assets and liabilities on the balance sheet For example, in a typical sales transaction, an accountant will increase accounts receivable and revenue. But how does the accountant decide whether to record the transaction 1. Recording based on revenue recognition criteria involves an income statement approach 2. Basing the decision on whether an economic resource is received and it meets the definition of an asset, such as accounts receivable, is an asset/liability (balance sheet) approach IN FASB's early years, it tended to focus on an income statement approach. However, in recent years, it has shifted to the asset/liability approach

Summary Define the objective of financial reporting

The objective of financial reporting is to provide financial information that is useful to investors, lenders and other creditors in making decisions about providing resources to an entity Similar under US GAAp and IFRS

The Qualitative Characteristics of Financial Information

The objective of financial reporting is to provide useful information for decision making by investors, lenders, and other creditors. What characteristics make financial information useful? The conceptual framework divides the qualitative characteristics into fundamental characteristics and enhancing characteristics, and discusses the cost constraint on providing information

Periodicity Assumption

The periodicity assumption specifies that an economic entity can divide its life into artificial time periods for the purpose of providing reports on its economic activities. The periodicity assumption results in the need for accrual accounting because revenue and expenses must be reported in a given period under this assumption. In addition, the time periods used will vary depending on the demands of financial statement users. For example, the SEC currently requires quarterly financial statements for publicly traded firms. These statements use significant estimates and may be less representationally faithful than the annual report. However, quarterly statements are more timely than reporting on an annual basis because timely information is more useful in decision making

Economic Entity

The second element in the definition of financial accounting involves the economic entity for which the financial statements and other financial information are presented. An economic entity is an organization or unit with activities that are separate from those of its owners and other entities. Financial information always relates to a particular economic entity. Economic entities can be corporations, partnerships, sole proprietorships, or governmental organizations. Also, economic entities may be privately held or publicly held. If the entity is publicly held, then its equity can be bought and sold by external parties on stock exchanges The management of a particular economic entity prepares its financial information, including the financial statements. While the management of the entity may also use the financial information to some extent, they are better classified as preparers than users of financial information .

Elements of Financial Reporting

The second phase of the conceptual framework project builds on the objective of financial reporting and characteristics of financial information. 1. Point in time elements represent resources, claims to resources, or interests in resources as of a specific point in time and appear on the balance sheet. For example, accounts receivable and accounts payable are point in time elements 2. Period-of- time elements represent the results of events and circumstances that affect an entity during a period of time and appear on the income statement, statement of comprehensive income, or statement of shareholders' equity. Sales revenue, depreciation expense, and dividends declared are examples of period of time elements

Faithful Representation

The second qualitative characteristic, faithful representation, indicates whether financial information depicts the substance of an economic event in a manner that is Complete Neutral Free from error The depiction of an economic event is considered complete if it includes all information- both descriptions and explanations- necessary for the financial statement user to understand the underlying economic event. For example, a company reports a balance of long-lived assets on its balance sheet. From this one amount, a financial statement user cannot fully understand the company's investment in its long-lived assets. A complete depiction of a company's long-lived assets includes a description of the nature of the assets. the balance by type, and a description of the depreciation method used for each type. For example, Johnson and Johnson reported 15,905 million of net property, plant, and equipment on its January 2016 balance sheet, representing about 12% of its total assets. It presents its property, plant, and equipment in more depth in its footnotes to the financial statements to provide a more complete depiction of the company's property, plant, and equipment. In the footnote, Johnson and Johnson includes the amount of each major class of property, plant, and equipment such as the 22,511 million of machinery and equipment. After the table, Johnson and Johnson includes other information on its property, plant, and equipment such as the amounts of capitalized interest expense and depreciation expense. In its financial statement notes, Johnson and Johnson also states that its property, plant, and equipment are reported at cost. The company indicates that it depreciates plant and equipment using the straight-line method and provides estimated useful lives. Further, the company identifies and reports the historical costs of four different categories of property, plant, and equipment. Johnson and Johnson also reports the total accumulated depreciation on these assets. Information is neutral if its free from bias in both the selection and presentation of financial data. For example, assume the Haster Incorporated has three lawsuits pending at the end of the year. It discloses information only about the lawsuit that it expects to have a favorable outcome but not the two for which it expects unfavorable outcomes. This biased reporting does not faithfully represent the firm's financial position Information is reported free from error when there are no mistakes or omissions in the description of an event or in the process used to produce the financial information. However, the information need not be accurate in all respects. Specifically, firms report a significant amount of financial information based on estimates. For example, companies estimate the amount of receivables that will ultimately become uncollectible. Because the amount of uncollectible receivables is an estimate, the actual amount could be different.

Financial statement user groups

The third element in the financial accounting definition involves identifying the primary user groups that demand financial information. Some users employ accounting information to make economic decisions for their own benefit while other users employ accounting information to make economic decisions for the benefit of others or to assist others in making investment or credit decisions Equity investors Creditors and other debt investors Competitors Financial Analysts Employees and Labor Unions Suppliers and Customers Government Agencies

Fair value Measurement and the Fair Value Hierarchy

The trend toward measuring financial assets and liabilities at fair value discussed in Chapter 1 impacts the amounts reported on the balance sheet. In order to improve user confidence in fair value measurements reported, the FASB requires disclosures that indicate the reliability of the inputs used in all fair value measures reported on the financial statements. This disclosure takes the form of a fair value hierarchy that provides three levels of reliability from the most to the least- objective inputs used in the fair value measurement process Ideally, companies would measure all financial assets and liabilities using Level 1 inputs, but that is not possible. Nonetheless, companies should use the highest level of reliability possible when determining fair values of financial assets or liabilities The standard setters' decision as to whether a particular asset of liability should be measured at fair value often trades off the relevance of information provided with the ability of the information to be a faithful representation of the value of the asset of liability. For example, fair value is more relevant than historical cost, but it is typically a less faithful representation in terms of measuring the economic event than is historical cost However, US companies generally do not report their non-financial assets such as equipment or land at market or appraisal values or adjust them for inflation. An exception is when an asset is impaired. For declines in fair value, firms are required to write down, or reduce, asset values. In most industries, non-financial assets are not valued above initial cost

Principles of Recognition and Measurement

The use of the accrual basis, rather than the cash basis, is a distinguishing feature of financial accounting. General recognition Revenue and expense recognition Bases of measurement

Summary Identify the elements of financial reporting

There are two main groups of elements: point in time and period of time US GAAP Point in Time Elements: Assets: Probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events Liabilities: Probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events Equity: Or net assets, the residual interest in the assets of an entity that remains after deducting its liabilities US GAAP Period of Time Elements Investments by owners: Increases in an entity's equity resulting from transfers to it from other entities of something valuable to obtain or increase ownership interests in the entity Distributions to owners: Decreases in an entity's equity resulting from transferring assets, rendering services, or incurring liabilities to owners. Distributions to owners decrease ownership interest in an enterprise Revenues: Inflows of other enhancements of assets or settlements of liabilities from delivering or producing goods, rendering services, or other activities of the entity's ongoing major or central operations Gains: Increases in an entity's equity from peripheral or incidental transactions and from all other transactions and other events and circumstances except those that result from revenues of investments by owners Expenses: Outflows or other using up of assets or incurrences of liabilities from delivering or producing goods, rendering services, or carrying out other activities of the entity's ongoing major or central operations Losses: Decreases in equity from peripheral or incidental transactions and other events and circumstances except those that result from expenses of distributions from owners Comprehensive income: The change in equity of a business enterprise during a period from transactions and other events and circumstances from nonowner sources The point in time elements of financial reporting are defined slightly differently under US GAAp and IFRS. In practice, though, IFRS and US GAAP often lead to the same decisions on what is reported as an asset, liability, or equity for the items The period of time elements are different under US GAAP and IFRS. The only element in common is expenses, but it is defined differently under US GAAP and IFRS IFRS Period of Time Elements 1. Performance: A separate element in IFRS. Under GAAp, profit is the result of adding revenues and gains and subtracting expenses and losses 2. Income (both revenues and gains) 3. Expenses (both expenses and losses) 4. Capital maintenance adjustments: Restraints or revaluations or reported amounts of assets and liabilities

Timeliness

Timely information is available to financial statement users early enough to make a difference in decision making. In the US, public companies prepare financial statements every quarter and annually. Imagine trying to make an investment decision if financial statements were issued only every five years:You would possess outdated information irrelevant to decision making in the current period. Generally, older information is less useful than more recent information

Point in Time Elements

US GAAP identifies the three point in time elements, which represent resources, claims to resources, and interests in resources as of a point in time such as a specific balance sheet date. The point in time elements are: Assets Liabilities Equity Assets are probable future economic benefits from some past event. In addition to the asset definition, US GAAP identifies three enhancing characteristics of an asset 1. It embodies a probable future benefit that involves a capacity, singly or in combination with other assets, to contribute directly or indirectly to future net cash inflows 2. A particular entity can obtain the benefit and control others' access to it, and 3. The transaction or other event giving rise to the entity's right to or control of the benefit has already occurred. The future economic benefit from an asset is the cash flows generated from its use. For instance, an account receivable is an asset because it generates cash upon collection. Controlling an asset means that no other entity can use or access it without permission. For example, another entity does not have the right to use another company's plant and equipment unless these assets are under a lease agreement. Finally, the asset arises when a completed sale transaction occurs. US GAAP defines liabilities as probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events. US GAAP also identifies three characteristics that enhance the definition of a liability 1. It embodies a present duty or responsibility to one or more other entities that entail settlement by probable future transfer or use of assets at a specified or determinable date, on occurrence of a specified event, or on demand 2. The duty or responsibility obligates a particular entity, leaving it little or no discretion to avoid the future sacrifice 3. The transaction or other event obligating the entity has already happened These characteristics indicate that a liability will result in a future sacrifice, which can be the transfer of an asset such as cash of the use of an asset to fulfill the obligation. For example, salaries payable are a liability because the entity must pay its employees cash in the future in exchange for services that have already provided to the company Equity, or net assets, is the difference between assets and liabilities. This residual interest in a company's assets remains after the claim of creditors have been satisfied and therefore represents the ownership interest. The amount of equity is the cumulative result of investments by owners, comprehensive income, and distributions to owners

Cash versus Accrual Accounting

US GAAP is based on accrual accounting. It follows that US GAAP does not allow a cash basis system.

Verifiability

Verifiability means that a group of reasonably informed financial statement users are able to reach a consensus decision that reported information is a faithful representation of an underlying economic event. For example, two independent accountants would agree that a company owes 100,000 to a commercial bank by examining the loan agreement

History of Standard Setting

US financial reporting standard setting began with the 1934 Securities and Exchange Act, which gave the SEC the power to promulgate accounting standards for all publicly traded firms. The SEC delegated its standard-setting power to the private sector, prompting the accounting profession to establish the first US standard setting board. The Committee on Accounting Procedures (CAP) was formed in 1939 as a subcommittee of the American Institute of Certified Public Accountants (AICPA) to reduce the number of accounting methods used in practice. Prior to the formation of the CAP, there were significant inconsistencies in the form and content of financial statements. For example, some companies would provide only a balance sheet while others would report only an income statement. During its tenure, the CAP produced 51 standards, refereed to as Accounting Research Bulletins The CAP accomplished its goal of reducing accounting alternatives and was replaced in 1959 by the Accounting Principles Board. The APB, another subcommittee of the AICPA, issued pronouncements known as Opinions and Statements. The APB's primary objective was to respond to existing and emerging problems in financial reporting. The APB issued 31 APB Opinions and four APB statements The APB was criticized for being slow to develop accounting standards and inactive on several controversial issues. The part-time board members were all CPA's still affiliated with their employees. As a result, board members were not viewed as independent. Further, the APB did not develop standards in anticipation of changes in the accounting environment. Rather, the Board simply responded to long-existing, controversial accounting issues. Due to these criticisms, the Financial Accounting Standards Board (FASB) replaced the APB in 1973 The FASB is a more independent board than the APB. The seven members employed as full time board members must sever all relationships with outside entities. In addition, board members of the FASB do now have to accountants or CPAs- the members can join the board from industry, education, and public service. Members on the board have represented a broad range of constituencies, including members from the corporate world, the accounting profession, the investment community, government, and academia. The FASB is not a subcommittee of the AICPA and is not affiliated with any professional organization The FASB currently issues Accounting Standards Updates (ASU) as part of the Accounting Standards Codification (ASC). The Accounting Standards Codification is the single source of GAAP in the US and includes all pronouncements issued by any of the standard-setting bodies that not been superseded

Accrual Accounting

Under the accrual basis, firms recognize revenues and expenses according tot he principles we have discussed. When the firm receives or pays cash does not matter. Rather, the accrual basis seeks to report the underlying economics of each transaction on the company. In summary, the accrual basis of accounting recognizes revenues when control of a good or service passes to the customer and expenses when incurred. As a result, the major difference between cash and accrual accounting is the timing of revenue and expense recognition

Cash-Basis Accounting

Under the cash basis, firms recognize revenues only when they receive cash and recognize expenses only when they pay cash. Consequently, the cash basis measures cash receipts and disbursements but does not measure economic activity. Further, the cash basis enables firms to manipulate net income with the timing of cash flows. For example, a company using the cash basis could report higher net income by delaying payment of expenses until the next accounting period. Alternatively, to reduce reported earnings, a company could delay billing its customers until the next accounting period to ensure that it would not receive cash revenues in the current period

Revenue and Expense Recognition : IFRS

Under the current IFRS conceptual framework, firms recognize revenue when they meet both of the following criteria: 1. An increase in future economic benefits related to an increase in an asset or a decrease of a liability has occurred 2. The revenue can be measured reliably Similar to US GAAP, the IASB's recently adopted new revenue standard is not completely aligned with IFRS conceptual framework. The IASB adopted the same new revenue standard as the FASB, applying the notion of the transfer ok control of the goods or services for revenue recognition. We expect that IASB will align the conceptual framework with the new standard when it rewrites the framework Firms recognize expenses in the income statement when both of the following criteria are met: 1. A decrease in future economic benefits related to a decrease in an asset or an increase of a liability has occurred 2. The expense can be measured reliably Firms recognize expenses simultaneously with an increase in liabilities or a decrease in assets. For example, salaries payable is increased when a company recognized salary expense. Unlike US GAAP, IFRS does not use the matching approach for expense recognition

Rules- Based Standards

Unlike principles-based standards, rules- based standards may not relate to a consistent theoretical framework. In addition, pure rules- based standards: Contain numerous exceptions to the types of firms and industries that are covered by the standard Contain numerous bright-line tests Result in inconsistencies between standards Contain detailed application guidance Do not rely on extensive use of professional judgement As is the case with pure principles- based standards, pure rules- based standards also result in implementation problems. At times, reporting entities may circumvent rules and are therefore able to override intent of the standard. A system of rules based standards is difficult to interpret from a user perspective. Rules- based standards tend to result in an environment where financial reporting is viewed as an act of compliance rather than a process of disseminating transparent financial information to investors and creditors

History of Global Standard Setting: IFRS

Until recently, most countries established their own accounting standards. For instance, France, Germany, and Australia each had its own GAAP. The GAAP of each nation varied due to the country's specific needs for accounting information. Factors such as the country's sources of capital, its culture, tax laws, or other regulations influenced the development of their accounting standards. Given almost 200 countries in the world and almost as many sets of different GAAp standards, global investors and creditors struggled to compare accounting standards when analyzing companies and making investment and credit decisions Recognizing the need for comparable accounting information internationally, the professional accounting organizations from 10 countries formed the International Accounting Standards Committee (IASC). At that time, the IASC consisted of up to 16 part time volunteer members setting International Accounting Standards (IAS). Companies in each country could adopt IAS on a voluntary basis. However, the IASC was criticized for allowing highly flexible accounting standards. As a result, most major developed countries continued to require the use of their own standards As global business relationships continued to grow, the need for a comparable and rigorous international set of accounting standards became apparent. In the 1990s the IASC initiated an improvement project to develop a cohesive and uniform set of core accounting standards to meet the needs of investors in cross border offerings and exchange listings. Shortly after this improvement project was completed, the International Organization of Securities Commissions endorsed IAS for use in cross-border stock offerings and listings, allowing companies to report under IAS within their jurisdiction and on their exchanges Around the same time, the IASC began to recognize the limitations in its existing organizational structure. As a result the International Accounting Standards Board (IASB) replaced the IASC. The IASB now promulgates standards called International Financial Reporting Standards (IFRS) The IASB also developed a set of accounting standards to address the needs of private companies, called IFRS for small and medium sized entities. IFRS and SMEs is based on IFRS but eliminates certain costly reporting requirements that are designed to provide information to external financial statement users. IFRS and SMEs was developed because some countries require all public and private companies to prepare financial statements under IFRS. These countries can then allow private companies the option to use the less costly IFRS for SMEs