Essential Characteristics of Accounting
Essential Characteristics of Accounting are:
1. The identification, measurement, and communication of financial information about
2. Economic entities to
3. Interested parties
Financial accounting s the process that culminates in the preparation of financial reports on the enterprise for use by both internal and external parties.
- Users of these reports include investors, creditors, managers, unions, and government agencies.
accounting used to provide information and analyses to managers inside the organization to assist them in decision making
The principal means through which a company communicates its financial information. These statements reflect the collection, tabulation, and final summarization of the accounting data. The statements most frequently provided are (1) the balance sheet, (2) the income statement, (3) the statement of cash flows, and (4) the statement of owners' or stockholders' equity.
- Note disclosures are an integral part of a company's financial statements. (p. 89).
Objective of Financial Reporting
The Objective of Financial Reporting is to provide financial information about the reporting entity that is useful to present and potential equity investors, lenders, and other creditors in decisions about providing resources to the entity.
General-purpose financial statements
Provide financial reporting information to a wide variety of users at the least cost. (p. 5).
- The objective of financial reporting identifies investors and creditors as the primary users for general-purpose financial statements because they have the most critical and immediate need for information in financial reports
The view that companies are distinct and separate from their owners (present shareholders). (p. 6).
Perspective that financial reporting should be focused only on the needs of shareholders, not an appropriate reporting perspective.
Responsibility for protecting its economic resources from unfavorable effects of economic factors
Approach that requires that financial reporting be useful to investors by helping them assess (1) the company's ability to generate net cash inflows and (2) management's ability to protect and enhance the capital providers' investments.
records revenues when earned and expenses when incurred, regardless of the timing of cash receipts or payments
Generally Accepted Accounting Principles (GAAP)
Accounting guidelines, formulated by the Financial Accounting Standards Board, that govern how accountants measure, process, and communicate financial information.
Parties Involved in Standard Setting
Three organizations are instrumental in the development of financial accounting standards (GAAP) in the United States:
1. Securities and Exchange Commission (SEC)
2. American Institute of Certified Public Accounts (AICPA)
3. Financial Accounting Standards Board (FASB)
Securities and Exchange Commission (SEC)
1934 - Created to supervise stock exchanges and to punish fraud in securities trading.
- SEC currently exercises oversight over 12,000 companies that are listed on the major exchanges
- SEC requires registrants to adhere to GAAP
Securities Exchange Act of 1934
A federal law dealing with securities regulation that established the securities and exchange commission to oversee the securities industry
If the SEC believes that an accounting or disclosure irregularity exists regarding the form or content of the financial statements, it send a deficiency letter to the company.
SEC Stop order
If a disagreement continues, the SEC may issue a "stop order," which prevents the registrant form issuing or trading securities on the exchanges.
American Institute of Certified Public Accounts (AICPA)
The AICPA, which is the national professional organization of practicing Certified Public Accounts (CPAs), has been an important contributor to the development of GAAP
Committee on Accounting Procedure (CAP)
Committee established by the AICPA in 1939 at the urging of the SEC to deal with accounting problems. The CAP issued 51 Accounting Research Bulletins and was replaced by the Accounting Principles Board in 1959.
Accounting Principles Board (APB)
Private standard-setting organization from 1959 to 1973, whose mission was to develop an overall conceptual framework. Its official pronouncements, called APB Opinions, were to be based mainly on research studies and be supported by reasons and analysis. The APB issued 31 opinions in its lifetime. (p. 9).
The Study Group on Establishment of Accounting Principles, chaired by Francis Wheat, that examined the organization and operation of the Accounting Principles Board and determined the changes needed to attain better productivity and more timely correction of accounting abuses. The Study Group submitted its recommendations to the AICPA Council in the spring of 1972, which adopted the recommendations in total and implemented them by early 1973.
Financial Accounting Standards Board (FASB)
The major organization of the standard-setting structure for financial accounting. Its mission is to establish and improve standards of financial accounting and reporting for the guidance and education of the public. The FASB consists of five members, appointed for five-year terms by the Financial Accounting Foundation. Standards issued by the FASB are considered generally accepted accounting principles (GAAP). (p. 10).
Financial Accounting Standards Advisory Council (FASAC)
Consults with the FASB on major policy and technical issues and also helps select task force members
FASB Standard Statements
The passage of a new FASB Standard Statement requires support of four of the seven Board Members. FASB Statements are considered GAAP and thereby binding in practice.
Statements of Financial Accounting Concepts
Does Not Establish GAAP. Part of the conceptual framework project of the FASB that sets forth fundamental objectives and concepts that the FASB uses in developing future standards of financial accounting and reporting. These statements pass through the same FASB Due-Process system.
Emerging Issues Task Force (EITF)
Group created in 1984 by the FASB to reach a consensus on how to account for new and unusual financial transactions that might create differing financial reporting practices. The FASB reviews and approves all EITF consensuses, and the SEC views consensus solutions as preferred accounting. (p. 12).
Accounting Standards Executive Committee (AcSEC)
Accounting Standards Executive Committee: It is autorized to speak in behalf of AICPA, Also creates; Audit and Accounting Guides.Statements of Position (SOP).
Audit and Accounting Guides
Summarize the accounting practices of specific industries and provide specific guidance on matters not addressed by the FASB
Statements of Position (SOP)
Provide guidance on Financial reporting topics until the FASB sets standards on the issue in question, may update, revise, and clarify audit and accounting guides or provide free-standing guidance
indicate AcSEC's views on narrow financial reporting issues not considered by FASB
Auditing Standards Board
The arm of the AICPA that had been responsible for developing auditing standards. The Public Company Accounting Oversight Board, established by the Sarbanes-Oxley Act, now oversees the development of auditing standards. (p. 13).
Rule 203 - Accounting Principles: A member shall not (1) express an opinion or state affirmatively that the financial statements or other financial data of any entity are presented in conformity with GAAP or (2) state that he or she is not aware of any material modifications that should be made to such statements or data in order for them to be in conformity with GAAP, if such statements or data contain any departure from an accounting principle promulgated by bodies designated by Council to establish such principles that has a material effect on the statements or data taken as a whole.
Primary Goal: Provide in one place all the authoritative literature related to a particular topic.
- Changes the way GAAP is documented, presented, and updated.
- It explains what GAAP is and eliminates nonessential information such as redundant document summaries, basis for conclusions sections, and historical content. (P.14)
Accounting Standards Update
The process by which a new FASB standard, staff position, etc., is included in the FASB Codification. The update includes the background and basis for conclusions for the new pronouncement in a common format, regardless of the form in which such guidance may have been issued. Updates are also issued for amendments to the SEC content in the Codification. (p. 14).
FASB Codification Research System (CRS)
online real-time database that provides easy access to the codification.
Fair Value Reporting
Market Value- Level 1 (Identical) & Level 2 (Similar)
Estimates Level 3(discounted cash flows)and valuation methods may be used when market values are not available.
Changes in fair value measurement may be treated in different ways under GAAP.
- Federal legislation passed in 2002
- Sets higher ethical standards for public corporations and accounting firms.
- Addressed loss of confidence in financial reporting and corporate ethics
- Limits conflict-of-interest issues
- Requires financials officers and CEO to certify validity of financial statements.
- Far-reaching control and accounting regulations (p.18)
Section 404 of the Sarbanes-Oxley Act
requires public companies to report management's assessment of the effectiveness of internal control
the processes by which a company safeguards its assets and provides reasonable assurance regarding the reliability of the company's financial reporting, the effectiveness and efficiency of its operations, and its compliance with applicable laws and regulations
the difference between what the public thinks accountants should do vs. what accountants think they can do
eXtensible Business Reporting Language (XBRL)
an XML based language consisting of a set of tags that are used to unify the presentation of business reporting information into a single format, easily read by almost any software package, and easily searched by web browsers, provides the framework for uniformity of information for financial statements and other business reporting to simplify the delivery and use of that infromation, and enhances the searchability of the information, its comparability among periods and organization and enables easy transfer of information among a variety of systems
International Financial Reporting Standards (IFRS)
Accounting guidelines, formulated by the International Accounting Standards Board, that govern how accountants measure, process, and communicate financial information
International Financial Reporting Standards (IFRS)
Accounting guidelines, formulated by the International Accounting Standards Board, that govern how accountants measure, process, and communicate financial information
International Organization of Securities Commissions (IOSCO)
Does not set accounting standards.
Dedicated to ensuring that global markets can operate in an efficient and effective basis.
- The organization is dedicated to ensuring that the global market can operate in an efficient and effective basis. (P.34)
IOSCO Memorandum or Understanding (MOU)
In 2005 IOSCO endorsed the IOSCO MOU to facilitate cross-border cooperation, reduce global systematic risk, protect investors, and ensure fair and efficient securities markets.
Standard Advisory Council (SAC)
To consult with the IASB on major policy and technical issues and help select task force members
For the accounting profession, a coherent system of objectives and fundamentals established by the FASB, which determine the nature, function, and limits of financial accounting and which lead to consistent accounting standards. (p. 44).
Development of a Conceptual Framework
In 1976, the FASB began to develop a conceptual framework that would be a basis for setting accounting rules and for resolving financial reporting controversies.
- The FASB has since issued seven Statements of Financial Accounting Concepts that relate to financial reporting for business enterprises.
Statement of Financial Accounting Concepts (SFAC)
FASB tends to be the major user of the SFAC and as a result it may be amended, superseded or withdrawn by it. The statement of financial accounting concepts details future concepts that may be used to develop accounting standards. The SFAC is used as a blueprint for the future development of reporting policy and procedures.
SFAC No. 1
"Objectives of General Purpose Financial Reporting":
The objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to the primary users of general purpose financial reports in making decisions about providing resources to the reporting entity.
1. Primary Users: Existing/Potential investors; lenders and other Creditors
2. financial information provided in general purpose financial reports, meet financial needs
SFAC No. 2
SFAC No. 2, "Qualitative Characteristics of Accounting Information," examines the characteristics that make accounting information useful.
SFAC No. 3
SFAC No. 3, "Elements of Financial Statements of Business Enterprises," provides definitions of items in financial statements, such as assets, liabilities, revenues, and expenses.
SFAC No. 5
SFAC No. 5, "Recognition and Measurement in Financial Statements of Business Enterprises" sets forth fundamental recognition and measurement criteria and guidance on what information should be formally incorporated into financial statements and when
SFAC No. 6
SFAC No. 6, "Elements of Financial Statements"- Ten Elements: Comprehensive Income; Revenues; Expenses; Gains; Losses; Assets; Liabilities; Equity (of net assets); Investments by Owners; Distributions to Owners
SFAC No. 7
SFAC No. 7, "Using Cash Flow Information and Present Value in Accounting Measurments". Based on Future Cash Flows only
SFAC No. 8
SFAC No. 8, Chapter 1, "The Objective of General Purpose Financial Reporting," and Chapter 3, "Qualitative Characteristics of Useful Financial Information," replaces SFAC No 1 and No 2
Conceptual Framework for Financial Reporting
The concepts that underlie financial reporting. the framework system of concepts that flow from an objective. it shows how things should be recognized and measured and how they should be summarized in the financial reports.
Overview of the Conceptual Framework
Overview of the Conceptual Framework:
- The first level identifies the objective of financial reporting
- The second level provides the qualitative characteristics that make accounting information useful and the elements of financial statements
- The third level identifies the recognition, measurement, and disclosure concepts used in establishing and applying accounting standards and the specific concepts to implement the objective
Conceptual Framework (First level: Basic objective)
The objective of general-purpose financial reporting is to provide financial information about the reporting entity that is useful to present and potential equity investors, lenders, and other creditors in making decisions about providing resources to the entity.
General-purpose financial reporting
The format for providing information to decision-makers at the least cost. (p. 47).
Conceptual Framework (Second level: Fundamental concepts)
The second level provides conceptual building blocks that explain the qualitative characteristics of accounting information and define the elements of financial statements.
Qualitative Characteristics of Accounting Information
Qualitative Characteristics of Accounting Information help entities determine what information provides the most useful information for decision making purposes (derision-usefulness).
- Qualitative characteristics are either fundamental or enhancing, depending on how they affect the decision-usefulness of information.
- Providing useful financial information is limited by a pervasive constraint on financial reporting - cost should not exceed the benefits of a reporting practice.
Hierarchy of Accounting Qualities
Hierarchy of Accounting Qualities from the Top Down:
1. Primary Users of accounting information
3. Pervasive criterion
4. Fundamental qualities
5. Ingredients of Fundamental Qualities
6. Enhancing Qualities
Fundamental Quality: Relevance
Relevance is one of the two fundamental qualities that make accounting information useful for decision-making.
- To be relevant, accounting information must be capable of making a difference in a decision.
- Financial information is capable of making a difference when it has predictive value, confirmatory value, or both.
One characteristic of relevant information, indicating that information must help users predict the ultimate outcome of past, present, and future events.
One of the ingredients of the fundamental quality of relevance, it helps to confirm or correct prior expectations based on previous evaluations of financial reporting information. (p. 49).
the magnitude of an omission or misstatement of accounting information that, in light of surrounding circumstances, makes it probable that the judgement of a reasonable person relying on the information would have been changed or influenced
- Relative size of an item in determining materiality is important
- Companies must consider both quantitative and qualitative factors in determining whether an item is material
Fundamental Quality: Faithful Representation
Faithful representation is the second fundamental quality that makes accounting information useful for decision-making.
- Faithful representation means that the numbers and descriptions match what really existed or happened.
- Faithful representation is a necessity because most users have neither the time nor the expertise to evaluate the factual content of the information.
Fundamental Quality: Faithful Representation
To be a faithful representation, information must be:
1. Complete - all information that is necesary for faithful representation is provided
2. Neutral - a company cannot select information to favor one set of interested parties overe another.
3. Free from error - an information item that is free from error will be a more accurate (faithful) representation of a financial item.
Enhancing qualitative characteristics are complementary to the fundamental qualitative characteristics.
- These characteristics distinguish more-useful information from less useful information.
Enhancing Qualitative characteristics
Enhancing Qualitative characteristics are:
1. Comparability - Information that is measured and reported in a similar manner for different companies and is consistent
2. Verifiability - when independent measures, using the saame methods, obtain similar results.
3. Timeliness - means having information available to decisions-makers before it losses its capacity to influence decisions.
4. Understandability - Decision-makers may vary widely in the types of decisions they make, how they make decisions, they informative they already poses or can obtain from other sources, and their ability to process the information
Enhancing qualities: Understandability
is the quality of information that let reasonably informed users see its significance. Understandability is enhanced when information is classified, characterized, and presented clearly and concisely.
Basic Elements of Financial Statements
Basic Elements of Financial Statements are:
Basic Elements of Financial Statements: Assets
Probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events
Basic Elements of Financial Statements: 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.
Basic Elements of Financial Statements: Equity
Residual interest in the assets of an entity that remains after deducting its liabilities. In a business enterprise, the equity is the ownership interest.
Basic Elements of Financial Statements: Investments by owners
Increases in net assets of a particular enterprise resulting from transfers to it from other entities of something of value 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.
Basic Elements of Financial Statements: Distributions to owners
Decreases in net assets of a particular enterprise resulting from transferring assets, rendering services, or incurring liabilities by the enterprise to owners. Distributions to owners decrease ownership interests (or equity) in an enterprise.
Basic Elements of Financial Statements: Comprehensive income
Change in equity (net assets) of an entity during a period from transactions and other events and circumstances from nonowner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners.
Basic Elements of Financial Statements: Revenues
Inflows or other enhancements of assets of an entity or settlement of its liabilities (or a combination of both) during a period from delivering or producing goods, rendering services, or other activities that constitute the entity's ongoing major or central operations.
Basic Elements of Financial Statements: Expenses
Outflows or using up of assets as part of operations of a business to generate sales.
Basic Elements of Financial Statements: Gains
Increases in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity during a period except those that result from revenues or investments by owners.
Basic Elements of Financial Statements: Losses
Decreases in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity during a period except those that result from expenses or distributions to owners.
Third Level: Recognition and Measurement Concepts
These concepts explain how companies should recognize, measure, and report financial elements and events.
- According to SFAC No. 5, to be recognized, an item (event or transaction) must meet the definition of an "element of financial statements" and must be measurable
Understanding the concepts
The accounting profession continues to us the concepts in SFAC No. 5 as operational guidelines.
- The concepts can be identified as:
1. Basic assumptions
Four basic assumptions underlie the financial accounting structure:
2. Going Concern
3. Monetary unit
Economic entity assumtions
means that economic activity can be identified with a particular unit of accountability. (p. 56)
Going Concern Assumption
Accounting assumption that a company will continue in operation for the foreseeable future. Only in situations in which liquidation appears imminent is the assumption inapplicable. (p. 57).
Monetary Unit Assumption
Accounting assumption that money is the common denominator of economic activity and provides an appropriate basis for accounting measurement and analysis. (p. 57).
Accounting assumption that implies that a company can divide its economic activities into artificial time periods. These time periods vary, but the most common are monthly, quarterly, and yearly. (p. 57).
Understanding the Concepts: Basic Principles of Accounting
We generally use four basic principles of accounting to record and report transactions:
2. Revenue recognition
3. Expense recognition
4. Full disclosure
existing gaap permits the use of historical cost, fair value, and other valuation bases. although the historical cost principle (measurement based on acquisition price) continues to be an important valuation, recording and reporting of fair value information is increasing
Historical Cost Principle
An accepted accounting principle that companies account for and report most assets and liabilities on the basis of acquisition price. Historical cost is verifiable and neutral and therefore contributes to reliability.
Fair Value Principle
assets and liabilities should be reported in the statements at their fair value (what an item is worth and what would need to be paid to settle a liability). This is becoming more and more common for assets that are actively traded.
Fair Value Option
The choice allowed by the FASB to use fair value in the financial statements as the basis of measurement for financial assets and liabilities. Under the fair value option, the item is recorded at fair value at each reporting date, and unrealized holding gains or losses are reported as part of net income. (p. 59).
Fair Value Hierarchy
The fair value hierarchy provides insight into the priority of valuation techniques that are used to determine fair value. The fair value hierarchy is divided into three broad levels.
Fair Value Hierarchy
Level 1: Observable inputs that reflect quoted prices for
identical assets or liabilities in active markets. (Least Subjective)
Level 2: Inputs other than quoted prices included in Level 1 that are observable for the asset or liability either directly or through corroboration with observable data.
Level 3: Unobservable inputs (for example, a company's own data or assumptions). (Most Subjective)
Level 1 is the most reliable because it is based on quoted prices, like a closing stock price in the Wall Street Journal. Level 2 is the next most reliable and would rely on evaluating similar assets or liabilities in active markets. At the least-reliable level, Level 3, much judgment
is needed based on the best information available to arrive at a relevant and reliable fair value measurement.(P. 59)
Revenue Recognition Principles
revenues are recognized when:
- goods and services are delivered
-there is an arrangement for customer payment
-the price is fixed or determinable
-collection is reasonably assured
Upon Receipt of Cash
Receipt is another basis for revenue recognition. Companies use the cash-basis approach when collection is uncertain at the time of sale.
Recognizes income in periods of collection rather than in the period of sales
Ex: home furnishings farm/home equipment
Expense Recognition Principle
Accounting principle that dictates that the recognition of expenses is related to net changes in assets and earning revenues, that is, "let the expense follow the revenues." (P. 61)
Costs that attach to a specific product. Examples are material, labor, and overhead. Companies carry product costs into future periods if they recognize the revenue from the product in subsequent periods. (p. 61).
Costs that attach to a specific accounting period. Examples are officers' salaries and other administrative expenses. Companies charge off such period costs in the immediate period, even though benefits associated with these costs may occur in the future. Period costs are not included as part of inventory cost; instead, they are matched with revenue of a specific time period and expensed as incurred.
The generally accepted accounting principle that determines when expenses should be recorded in the accounting records. The revenue earned during an accounting period is matched (offset) with the expenses incurred in generating that revenue.
- A major concern is that matching permits companies to defer certain costs and treat them as assets on the balance sheet. In fact, these costs may not have future benefits. If abused, this principle permits the balance sheet to become a "dumping ground" for unmatched costs.
Full Disclosure Principle
Accounting principle that dictates that in deciding what information to report, companies follow the general practice of providing information that is of sufficient importance to influence the judgment and decisions of an informed user. It recognizes that the nature and amount of information included in financial reports reflects a series of judgmental trade-offs between sufficient detail that makes a difference to users, sufficient condensation to make the information understandable, and the costs and benefits of providing the information.
Notes to financial statements
Notes that clarify information presented in the financial statements, as well as expand upon it where additional detail is needed.
Information included in the notes to financial statements, which includes details or amounts that present a different perspective from that adopted in the financial statements. It may be quantifiable information that is high in relevance but low in reliability and may include management's explanation of the financial information and its discussion of the significance of that information. (p. 62).
Too often, users assume that information is free, but it's not. Therefore, companies must consider the cost constraint. They must weigh the costs of providing the information against the benefits that can be derived from using it.
- In order to justify requiring a particular measurement or disclosure, the benefits perceived to be derived from it must exceed the costs perceived to be associated with it.
- The difficulty in cost-benefit analysis is that the costs and especially the benefits are not always evident or measurable.
Peculiarities of some industries and business concerns that cause variations from basic accounting theory or practice. For example, agricultural companies often report crops at fair value because it is costly to develop accurate cost figures on individual crops. (p. 63).
projected or anticipated, usually applied to financial data such as balance sheets and income statements.
Enhancing qualities of accounting information include:
comparability and verifiability, Timeliness, understandability
Companies and their auditors have adopted a general rule of thumb that anything under 5% of _______ is considered not material.
Preparation of consolidated financial statements when a parent-subsidiary relationship exists is an example of the
Economic Entity Assumption
The assumption that implies that the economic activities of an enterprise can be divided into artificial time periods is the:
Revenue is generally recognized when realized or realizable and earned. This statement describes the
revenue recognition principle.
A GAAP principle that requires matching expenses incurred in an accounting period with the revenue earned in the same period
Generally, expenses are recognized when the:
work or product actually makes its contribution to revenue.
Providing information that is of sufficient importance to influence the judgment and decisions of an informed user is required by the
full disclosure principle.
What is a primary objective of financial reporting as indicated in the conceptual framework?
provide information that is useful to those making investing and credit decisions
Which of the following is a primary characteristic of useful accounting information?
What is meant by comparability when discussing financial accounting information?
Information that is measured and reported in a similar fashion across companies
What is meant by consistency when discussing financial accounting information?
Information that is measured and reported in a similar fashion across points in time.
Company A issuing its annual financial reports within one month of the end of the year is an example of which ingredient of fundamental quality of accounting information?
What is the quality of information that enables users to better forecast future operations?
Neutrality representation faithful is an ingredient of which fundamental quality of information?
If the FIFO inventory method was used last period, it should be used for the current and followings periods because of
The pervasive criterion by which accounting information can be judged is that of
The quality of information that means the numbers and descriptions match what really existed or happened is
The characteristic that is demonstrated when a high degree of consensus can be secured among independent measurers using the same measurement methods is
Financial information exhibits the characteristic of consistency when
companies apply the same accounting treatment to similar events, from period to period.
Information about different companies and about different periods of the same company can be prepared and presented in a similar manner. Comparability and consistency are related to which of these objectives?
According to the FASB Conceptual Framework, the elements - assets, liabilities, and equity - describe amounts of resources and claims to resources at/during a
moment in time
Which basic assumption is illustrated when a firm reports financial results on an annual basis?
The basic accounting concept that refers to the tendency of accountants to resolve uncertainty in favor of understating assets and revenues and overstating liabilities and expenses is known as
prudence or conservatism.
Valuing assets at their liquidation values rather than their cost is inconsistent with the
historical cost principle.
Which of the following serves as the justification for the periodic recording of depreciation expense?
systematic and rational allocation of cost over the periods benefited
Which of the following is an argument against using historical cost in accounting?
Fair values are more relevant.
Which of the following are the two components of the revenue recognition principle?
1. Realized or realizable
2. when earned