FINANCIAL REPORTING ENVIRONMENT

The essential characteristics of accounting are

(1) the identification, measurement, and communication of financial information about
(2) economic entities to (3) interested parties.
 Financial accounting is the process that culminates in the preparation of financial
reports on the enterprise for use by both internal and external parties. Users of these financial
reports include investors, creditors, managers, unions, and government agencies. In contrast,
Managerial accounting is the process of identifying, measuring, analyzing, and
communicating financial information needed by management to plan, control, and evaluate a
company’s operations.

 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 decisions about providing resources to the entity.

 The decisions relate to buying, selling, or holding debt or equity instruments. The
investors, lenders, and other creditors need information that will help them assess the amount
of, timing of, and prospects for future net cash inflows to the entity to make their decisions.

 Internal and External Users. Internal users make decisions within the firm.
External users make decisions from outside of the firm about whether or not to begin a
relationship, continue a relationship, or change their relationship with the firm.

 Financial statements are the principal means through which a company

communicates its financial information to those outside it. The financial statements most
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 each financial statement.

 The notes to financial statements are also considered an integral part of the financial
statements but are not an actual financial statement. The purpose of the notes is to provide
informative disclosures required by U.S. GAAP

 To be useful, information presented in the financial statements must be relevant and

faithfully represented.
● Usefulness is enhanced when the information is comparable with similar information for
other entities and the same entity for another period or date. Comparability allows users to
understand similarities and differences.
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 Financial statements are prepared under the going-concern assumption, which
means that the entity is assumed to continue operating and that it will not be liquidated in the
near future

 Financial statements complement each other. They describe different aspects of

the same transactions, and more than one statement is necessary to provide information for a
specific economic decision.
 The components (elements) of one statement relate to those of other statements. Among the
relationships are:
● Net income or loss from the statement of income is reported and accumulated in the retained
earnings account, a component of the equity section of the statement of financial position.
● The components of cash and equivalents from the statement of financial position are
reconciled with the corresponding items in the statement of cash flows.
● Items of equity from the statement of financial position are reconciled with the balances on
the statement of changes in equity.
● Ending inventories are reported in current assets on the statement of financial position and
are reflected in the calculation of cost of goods sold on the statement of income.
● Amortization and depreciation reported in the statement of income also are reflected in asset
and liability balances in the statement of financial position.
 Financial statements are prepared under the accrual basis of accounting.
● Revenues are recognized in the period in which they were earned even if the cash will be
received in a future period. This is referred to as the revenue recognition principle.
● Expenses are recognized in the period in which they were incurred even if the cash will be
paid in a future period.

 Under the matching principle, expenses are recognized in the same period as
the related revenue.

 Under the cash basis, revenues are recognized when cash is received and
expenses are recognized when cash is paid. Under GAAP, financial statements cannot be
prepared under the cash basis of accounting.

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 Questions:
Question: 1A primary objective of external financial reporting is
A. Direct measurement of the value of a business enterprise.
B. Provision of information that is useful to present and potential investors, creditors, and others in
making rational financial decisions regarding the enterprise
C. Establishment of rules for accruing liabilities.
D. Direct measurement of the enterprise’s stock price.
Question: 2 Which of the following is true regarding the comparison of managerial and
financial accounting?
A. Managerial accounting is generally more precise.
B. Managerial accounting has a past focus, and financial accounting has a future focus.
C. The emphasis on managerial accounting is relevance, and the emphasis on financial accounting is
timeliness.
D. Managerial accounting need not follow generally accepted accounting principles (GAAP), while
financial accounting must follow them.
Question: 3 An objective of financial reporting is
A. Providing information useful to investors, creditors, donors, and other users for decision making.
B. Assessing the adequacy of internal control.
C. Evaluating management results compared with standards.
D. Providing information on compliance with established procedures
Question: 4 The financial statements included in the annual report to the shareholders are
least useful to which one of the following?
A. Stockbrokers.
B. Bankers preparing to lend money.
C. Competing businesses.
D. Managers in charge of operating activities.
Question: 5 The accounting measurement that is not consistent with the going concern concept is
A. Historical cost.
B. Realization.
C. The transaction approach.
D. Liquidation value.

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Question: 6 Which basis of accounting is most likely to provide the best assessment of an
entity’s past and future ability to generate net cash inflows?
A. Cash basis of accounting.
B. Modified cash basis of accounting.
C. Accrual basis of accounting.
D. Tax basis of accounting.
Question: 7 All of the following support the objective of financial reporting except providing
information that
A. Is useful for making investment and credit decisions.
B. Helps management evaluate alternative projects.
C. Concerns enterprise resources and claims to those resources.
D. Helps investors and creditors predict future cash flows.

Question: 8 Accountants refer to an economic event as a

A. purchase.
B. sale.
C. transaction.
D. change in ownership.
Question: 9 The starting point of the accounting process is
A. communicating information to users.
B. identifying economic events.
C. recording economic events.
D. None of these answers are correct.
Question: 10 Communication of economic events is the part of the accounting process that
involves
A. identifying economic events.
B. quantifying transactions into dollars and cents.
C. preparing accounting reports.
D. recording and classifying information.
Question: 11 The accounting process is correctly sequenced as
A. identification, communication, recording.
B. recording, communication, identification.
C. identification, recording, communication.
D. communication, recording, identification.

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Question: 12 Which of the following would not be considered an external user of accounting
data for the LMN Company?
A. Internal Revenue Service Agent.
B. Management.
C. Creditors.
D. Customers.
Question: 13 Which of the following is an external user of accounting information?
A. Labor unions.
B. Finance directors.
C. Company officers.
D. Managers.
Question: 14 Generally accepted accounting principles are
A. income tax regulations of the Internal Revenue Service.
B. standards that indicate how to report economic events.
C. theories that are based on physical laws of the universe.
D. principles that have been proven correct by academic researchers.
Question: 15 The historical cost of an asset and its fair value are
A. never the same.
B. the same when the asset is sold.
C. irrelevant when the asset is used by the business in its operations.
D. the same on the date of acquisition.
Question: 16 Financial information that is capable of making a difference in a decision is
A. faithfully representative.
B. relevant.
C. convergent.
D. generally accepted.
Question: 17 The economic entity assumption requires that the activities
A. of different entities can be combined if all the entities are corporations.
B. must be reported to the Securities and Exchange Commission.
C. of a sole proprietorship cannot be distinguished from the personal economic events of its owners.
D. of an entity be kept separate from the activities of its owner.
Question: 18 A business organized as a corporation
A. is not a separate legal entity in most states.
B. requires that stockholders be personally liable for the debts of the business.
C. is owned by its stockholders.
D. terminates when one of its original stockholders dies.
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