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Chapter 5 Chapter 1 Environment and Theoretical Structure of Financial Accounting Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education. Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education. In this chapter, we’ll discuss why financial accounting provides useful information for decision making, the process by which accounting standards are produced, and the conceptual framework that underlies financial accounting. The perspective you gain in this chapter serves as a foundation for a more detailed study of financial statements, the way the statement elements are measured, and the concepts underlying these measurements and related disclosures. 1 Visualize the Important Role of Accounting Accounting provides useful information about economic activity to help: Produce good decisions Foster a prosperous society LO1-1 01-02 Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education. Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education. Illustration 1–1 Pathways Commission visualization: "THIS is accounting!" Think of accounting as a special “language” that companies like Target use to communicate financial information to help people inside and outside of the business to make decisions. The Pathways Commission of the American Accounting Association developed an illustration to help visualize this important role of accounting. As shown in the illustration, accounting provides useful information about economic activity to help produce good decisions and foster a prosperous society. Economic activity is complex, and decisions have real consequences, so critical thinking and many judgments are needed to produce the most useful accounting information possible. This book focuses on financial accounting, which is chiefly concerned with providing financial information to various external users. 2 Primary Focus of Financial Accounting Providing financial information to various external users Investors Creditors Other external users Investors and creditors To predict the future risk and potential return of investments or loans Before supplying capital to businesses Use different kinds of information LO1-1 Financial information is a key component of that information set 01-03 Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education. Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education. The primary focus of financial accounting is on the financial information provided by profit-oriented companies to their present and potential investors and creditors. One external user group, often referred to as financial intermediaries, includes financial analysts, stockbrokers, mutual fund managers, and credit rating organizations. These users provide advice to investors and creditors and/or make investment-credit decisions on their behalf. Investors and creditors use many different kinds of information before supplying capital to businesses. They might learn about a company’s products or its management, and consider its competitors and the health of the economy more generally. Financial information is a key component of their information set. 3 Financial Accounting Financial information is conveyed through financial statements and related disclosure notes Balance sheet Income statement (and the statement of comprehensive income) Statement of cash flows Statement of shareholders’ equity Financial Reporting Refers to the process of providing financial information to external users LO1-1 01-04 Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education. Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education. The primary means of conveying financial information to investors, creditors, and other external users is through financial statements and related disclosure notes. The financial statements most frequently provided are (1) the balance sheet, also called the statement of financial position, (2) the income statement, also called the statement of operations, along with the statement of comprehensive income, (3) the statement of cash flows, and (4) the statement of shareholders’ equity. The entire process of providing the financial information to external users is called financial reporting. As we progress through the chapters, we will review and expand our knowledge of the information in these financial statements, the way the elements in these statements are measured, and the concepts underlying these measurements and related disclosures. 4 Financial Information Providers and External User Groups LO1-1 PROVIDERS OF FINANCIAL INFORMATION Profit-oriented companies Not-for-profit entities (e.g., government entities, charitable organizations, schools) Households USERS OF FINANCIAL INFORMATION Investors Creditors (banks, bondholders, other lenders) Employees Labor unions Customers Suppliers Government regulatory agencies (e.g., Internal Revenue Service, Securities and Exchange Commission) Financial intermediaries (e.g., financial analysts, stockbrokers, mutual fund managers, credit-rating organizations) 01-05 Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education. Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education. Illustration 1–2 Financial Information Providers and External User Groups In this slide, we see the different providers of financial information, and the external user groups to which they provide that information. 5 The Economic Environment and Financial Reporting Capital markets provide a mechanism to help the economy allocate resources efficiently Corporations acquire capital from: Investors in exchange for ownership interest and; Creditors by borrowing Either through individual loans or publicly traded debt such as bonds LO1-1 01-06 Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education. Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education. In the United States, we have a highly developed free-enterprise economy with the majority of productive resources privately owned rather than government owned. For the economy to operate efficiently, these resources should be allocated to private enterprises that will use them best to provide the goods and services desired by society, and not to enterprises that will waste them. The mechanisms that foster this efficient allocation of resources are the capital markets. We can think of the capital markets simply as a composite of all investors and creditors. Businesses go to the capital markets to get the cash necessary for them to function. The three primary forms of business organization are the sole proprietorship, the partnership, and the corporation. In the United States, sole proprietorships and partnerships outnumber corporations. However, the dominant form of business organization, in terms of the ownership of productive resources, is the corporation. Investors provide resources, usually cash, to a corporation in exchange for an ownership interest, that is, shares of stock. Creditors lend cash to the corporation, either by making individual loans or by purchasing publicly traded debt such as bonds. 6 The Investment-Credit Decision— A Cash Flow Perspective LO1-1 Why do investors and creditors provide capital? They want to earn a fair return on the resources they provide Shareholders receive cash from: Sale of the ownership shares of stock Periodic dividends Key variables in investment decision Rate of return Uncertainty or risk 01-07 Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education. Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education. Investors and creditors are willing to provide capital to a corporation by buying stocks or bonds only if they expect to receive a return on their investment. In other words, they want to receive more cash from the corporation at some future date than they invest in the corporation. A corporation’s shareholders will receive cash from their investment through the ultimate sale of the ownership shares of stock. In addition, many corporations distribute cash to their shareholders in the form of periodic dividends. When contemplating whether to purchase or retain an investment in a company, shareholders will weigh the rate of return against the uncertainty or risk that they will realize that return. 7 Rate of Return Example calculation of rate of return: Assume an investor provides a company with $10,000 cash by purchasing stock at the end of 2020, receives $400 in dividends from the company during 2021, and sells the ownership interest (shares) at the end of 2021 for $10,600. Investors and creditors like to invest in stocks or bonds that provide a high expected rate of return LO1-1 $400 dividends + $600 share price appreciation= 10% $10,000 initial investment 01-08 Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education. Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education. In this example, the investor initially invests $10,000 and later sells that investment for $10,600, which implies that the investment appreciated by $600. In addition, the investor received $400 in dividends that were declared while they owned the shares. The rate of return is calculated by dividing the sum of the dividends and the share price appreciation by the initial investment. In this case, $400 + $600 = $1,000, ÷ $10,000 = 10%. All else being equal, investors and creditors would like to invest in stocks or bonds that provide the highest expected rate of return. But, of course, all else isn’t always equal. 8 Concept Check: Rate of Return Creecher purchased $200,000 worth of Troman stock , received four quarterly dividends of $1,000 each, and sold the Troman shares for $206,000 after one year. What is Creecher’s rate of return? 1% 2.5% 5% 10% LO1-1 The correct answer is c: Dividends = 4 × $1,000 = $4,000 Share price appreciation = $206,000 − $200,000 = $6,000 Rate of return = $4,000 + $6,000= 5% $200,000 01-09 Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education. Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education. 9 The correct answer is c: Dividends = 4 × $1,000 = $4,000 Share price appreciation = $206,000 − $200,000 = $6,000 Rate of return = ($4,000 + $6,000) / $200,000 = 5% Example of Uncertainty Consider the following two investment options. Which would you pick? Investing $10,000 in a savings account insured by the U.S. government that will generate a 5% rate of return Investing $10,000 in a profit-oriented company Risk/Return tradeoff: Most investors would invest in the profit-oriented company only if the potential return is high enough. LO1-1 01-10 Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education. Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written