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Chapter 1 The Economic and Institutional Setting for Financial Reporting

Learning Objectives: What is accounting? Why financial statements are important? Who are the users of financial statements? How do these users use financial statements? What is GAAP? What is the standard setting process? What are some qualitative characteristics of accounting information? What are some major concepts and assumptions underlying accounting principles?

What is Accounting ?

An information system to account for all business transactions and translate these transactions into accounting/financial terms to be reported in financial statements.

Why Financial Statements Are Important ?

Assess the risks (i.e., credit risk, asset risk) Provide a comprehensive economic history of a business entity Thus, financial statement can be used for various purposes (p3 of the textbook):

As an analytical tool. As a management report card. As an early warning signal. As a basis for prediction. As a measure of accountability.

Financial Statements and Financial Reporting

Economic Entity Financial Information Accounting? Identifies and Measures and Communicates Financial Statements
Balance Sheet Income Statement Statement of Cash Flows Statement of Owners or Stockholders Equity Note Disclosures

Additional Information
Presidents letter Prospectuses, SEC Reporting News releases Forecasts Environmental Reports Etc.



Learning Objective :

Describe the demand and supply for financial statements

Who are the users of Financial Statements ?

Why do they demand financial Statements?

Shareholders and investors 1. Investment decisions/stewardship function 2. Proxy contests Lenders and suppliers 1. Lending decisions 2. Covenant compliance Customers 1. Suppliers health 2. Repeat purchases 3. Warranties & supports

Managers and employees 1. Performance assessment 2. Compensation contracts 3. Company-sponsored pension plans Government and regulatory agencies 1. Mandatory reporting 2. Taxing authorities 3. Regulated industries

Supply of financial information

Relevant financial information is provided primarily through financial statements and related disclosure notes.

Major Financial statements: Balance Sheet, Income Statement, Statement of Stockholders Equity and Statement of Cash Flows.

Other forms of information: Press releases and management discussions (MD&A).

Type of Disclosures:
Mandatory Disclosure (i.e., leases, pension plans, etc.): Required by the SEC and accounting standards. Voluntary disclosure: Guided by cost/benefit considerations.

Disclosure Benefits

The following are benefits arising from voluntary disclosures : Increase investors confidence on the quality of companys equity offerings. Obtain capital cheaply from the capital markets. Get better deals from suppliers.

Disclosure Costs

The costs which may arise from voluntary disclosures : Information collection, processing and dissemination costs. Competitive disadvantage costs. Litigation costs. Political costs.


Case Study 1: WorldCom (source: RCJM

textbook) (WSJ 8/5/2002 Improper Capitalization)

Its May 2002 and your brother says you should buy WorldCom shares. The shares look incredibly cheap at $2.00 because the company has a book value of $20.50/share and cash of $0.73/share. WorldCom has weathered the industry downturn better than other companies. But an article in this mornings paper raises a new concern:
Holding steady despite declining message volume


Line Costs Sales

Fixed rental payment Message volume


Epilogue of WorldCom

In June 2002, WorldCom says $3.8 billion in line cost expenses were wrongly transferred to the balance sheet as assets. Share price falls to $0.06. $11 billion of improper transfers are eventually uncovered. In July 2002, the company declares bankruptcy.

$3.8 b ? EXPENSE


Case Study 2: AOL (Source: RCJM Textbook)

AOL spent $363 million on subscription promotion (costs paid for subscriber starter kits, direct marketing mailers, etc.) in 1996 while only recognized $126 million of that amount as advertising expense in 1996, deferring the rest as assets.

In May 2000, AOL agreed to pay a fine of $3.5 million to SEC due to its violation of GAAP in deferring subscriber acquisition costs in 1995 and 1996.

Lessons learned

Financial statement fraud is rarebut users should NOT simply accept the numbers at face value. Flexibility in accounting standards provides opportunities for companies to manipulate the information reported in the financial statements. Self-interest can also drive managers to overstate the income number, especially when compensation is based on earnings.

Learning Objectives
Define generally accepted accounting principles (GAAP) The need for GAAP The historical development of accounting standards The standard setting process of the Financial Accounting Standards Board (FASB)

Generally Accepted Accounting Principles (GAAP)

GAAP: Accounting methods with substantial authoritative support to be used by business entities in preparing external reports for users. Most of what constitutes U.S. GAAP is in the form of written pronouncements issued by the FASB and its predecessors.(i.e., APB). The need for the GAAP.

GAAP (Contd.)
Public held companies and certain regulated companies are required to use GAAP in preparing financial statements. Reasons?


Who Prescribes the Standards?

Public Sector
U.S. Congress

Private Sector
American Institute of Certified Public Accountants

Securities and Exchange Commission

Financial Accounting Standard Board

International Accounting Standard Board


Congress SEC

Official Release


1938-1959 1959-1973 1973

Regulation S-X ASR and FRR Staff Accounting Bulletins Accounting Profession AICPA CAP ARBs (51) APB APB Opinions (31) FASB . 1. Statement of Financial Accounting Standards 2. Interpretations 3. Concepts of Financial Accounting 4. Technique Bulletins


The U. S. GAAP

Includes: 1. FASB statements (1973 - Present) 2. FASB Interpretations ( 1973 - Present) 3. APB Opinions (1959 - 1973) 4. APB Interpretations (1959 - 1973) 5. CAP, ARBs (1938 - 1959) 6. Other Authoritative Pronouncements (i.e., ASR & FRR of the SEC, Technique
Bulletins/Staff Positions of FASB, and Staff Acct. Bulletins of the SEC, Abstracts of EITF, SOP of the AICPA, etc.)

FASB Accounting Standards Codification (ASC) (Source: SFAS 168)

Effective July 1, 2009, FASB Accounting Standards Codification became the single source of authoritative, nongovernmental U.S. GAAP. The pronouncements of the SEC are also sources of authoritative GAAP for SEC registrants.

The Codification Research System (CRS) (Source: SFAS 168) Codification Research System (CRS): An online database developed by the FASB to allow easy access to the Codification (and therefore, the GAAP) online. CRS uses a numerical index system in which numerical numbers are used to correspond with topics, subtopics, sections and paragraphs.

Accounting Standards Codification (contd.)

The Codification does not change GAAP but only the way the existing accounting standards are organized.


The Accounting Standard Setting Process of the FASB (A Due Process)

(source: FASB Website)

The Board identifies an accounting issue based on requests received from various sources. The Chairman decides whether to add a project to the technical agenda after consulting with other members and subject to oversight by the Foundations Board of Trustees.

The Accounting Standard Setting Process (contd.)

The Board deliberates the various issues identified and analyzed by the staff at one or more public meetings.

The Board issues an Exposure Draft (In some case, the Board may issue a Discussion Paper to obtain comments prior to issuing the Exposure Draft.)

The Accounting Standard Setting Process (contd.)

The Board holds a public roundtable meeting on the Exposure Draft, if necessary. The staff analyzes comment letters, public roundtable discussion, and any other information .


The Accounting Standard Setting Process (contd.)

The Board re-deliberates the proposed provisions at one or more public meetings. The Board issues an Accounting Standards Update (ASU) to amend ASC by a simple majority vote. The passage of an ASU requires 3 votes. (note: effective 7/2008, FASB members reduced from 7 to 5).

Learning Objective

Introduce the importance and the need of IFRS


The Need for International Accounting Standards

Companies doing business in more than one nations found that it is hard to comply with more than one set of accounting standards established by authorities in different nations. In response to this problem, International Accounting Standards Committee (IASC) was formed in 1973 to develop a single set of global accounting standards.
Environment and Theoretical Structure of Financial Accounting 29

The History of International Accounting Standard Setting (cont.)

41 International Accounting Standards (IAS) was issued by IASC. IASC created International Accounting Standards Board (IASB) in April, 2001 to be in charge of prescribing the standards. IASB endorsed 41 IAS and named its pronouncement as International Financial Reporting Standard (IFRS).
Environment and Theoretical Structure of Financial Accounting


Convergence of the U.S. Accounting Standards and the International Accounting Standards

To increase the international comparability and the quality of US accounting standards, the FASB has been engaged in activities to increase the convergence of the accounting standards.
The FASB is working closely with the IASB toward the convergence of accounting standards (i.e. to develop a single set of standards).
Environment and Theoretical Structure of Financial Accounting 31

Short-Term International Convergence (source: FASB Project Updates)

The IASB and the FASB acknowledged that convergence of IFRS and U.S. GAAP is a primary objective of both Boards. To achieve this objective and to improve the financial reporting in the US, the FASB started a short term project, conducted jointly with the IASB, to eliminate narrow differences between US GAAP and IFRS (or IAS) in October, 2002.
Environment and Theoretical Structure of Financial Accounting 32

A Single Global Accounting Language - International financial reporting standards?

The Securities and Exchange Commission (SEC) is proposing a Roadmap for the potential use of financial statements prepared in accordance with IFRS by U.S. issuers for purposes of their filings with the SEC.
This Roadmap sets forth several milestones that, if achieved, could lead to the required use of IFRS by U.S. issuers in 2014.

Current Compliances

Since there is no single set of high-quality accounting standards, domestic (U.S.) firms filing reports with the SEC must use U.S. GAAP. Foreign issuers filing reports with the SEC can use U.S. GAAP, the international standards or the GAAP of its home country. If foreign firms chose not to use U.S. GAAP, they must file reports with reconciliation to U.S. GAAP.
Environment and Theoretical Structure of Financial Accounting 34

A Single Global Accounting Language - International financial reporting standards

In November 2008, the Securities and Exchange Commission (SEC) proposed a roadmap for the US issuers to prepare financial statements in accordance with IFRS for the purposes of their filings with the SEC. This roadmap, if achieved, could lead to the required use of IFRS by U.S. issuers in 2014.

A Single Global Accounting Language (contd.)

In February 2010, the SEC reaffirms its commitment to one set of accounting standard and continues to encourage the convergence of standards between the US and IFRS. The SEC will make the decision of adopting IFRS for US issuers in 2011 with a progress report on this issue expected in October 2010.

Learning Objective

The Financial Reporting Reform- the Sarbanes-Oxley Act


The Financial Reporting Reform

As a result of numerous financial scandals,
Congress passed the Public Company Accounting Reform and Investor Protection Act of 2002, commonly referred to as the Sarbanes-Oxley Act.
The purpose of Sarbanes Oxley (SOX) is both to enforce accurate financial reporting and to drive the development of stronger internal processes.


The Financial Reporting Reform and the Sarbanes and Oxley Act

The collapse of Enron, the dissolving of Arthur Andersen and the accounting scandals of some high-profile firms
(WorldCom, Xerox, Global Crossing, etc.)

severely damaged public confidence in the accounting profession and the financial reporting.

At the demand of the public, the Sarbanes-Oxley Act was passed in July 2002 to restore the public confidence in the credibility of the financial reports.

The Financial Reporting Reform and the Sarbanes and Oxley Act (Cont.)

Key Provisions of the Act including: Creating the Public Accounting Company Oversight Board: establish auditing standards.

Increasing Corporate Executive Accountability:

they must personally certify both the financial statements and disclosures)

Prohibition of Non-Audit Services (i.e.,

bookkeeping, internal audit, appraisal, and other consulting services)
Environment and Theoretical Structure of Financial Accounting 40

The Financial Reporting Reform and the Sarbanes-Oxley Act (Cont.)

Retention of work Papers for 5 years.

Auditor Rotation Conflict of Interest.

Hiring of Auditor: by the audit committee, not the management.

Evaluation of Internal Control: the management

needs to document and assess the effectiveness of internal control. Auditors of the firm need to state:1)whether the managements assessment is fair, and 2)whether the internal control of the firm is effective.
Environment and Theoretical Structure of Financial Accounting 41

Learning Objectives
Identify the objectives of financial reporting, the qualitative characteristics of accounting information, and the elements of financial statements.
Describe the four basic assumptions underlying GAAP

Describe the four basic accounting principles that guide accounting practice.

Conceptual Framework of Financial Reporting

How does the FASB prescribe the accounting standards? Definition of Conceptual Framework of Financial Reporting: A system of interactive objectives and fundamentals which can lead to a set of consistent standards in preparing financial reports.

The Conceptual Framework

Objectives of Financial Reporting
(SFAC No. 1)

Qualitative Characteristics of Accounting Information

(SFAC No. 8)

Elements of Financial Statements

(SFAC No. 6)

Recognition and Measurement Criteria

(SFAC No. 5)

Environment assumptions

Implementation principles

Implementation constraints

SFAC No. 1 (Level One of The Conceptual Framework)

Objectives of financial reporting:

Providing information 1. useful in making investment and credit decisions; 2. useful in assessing future cash flows; 3. about entity resources, claims to the resources and changes of these resources.

SFAC No. 8 (Chapter 3: Qualitative Characteristics of Useful

Financial Information )

(Level Two of The Framework)

Qualitative Characteristics of Accounting Information

I. Primary Qualities

1) Relevance

2) Faithful Representation a) Complete a) Predictive value b) Confirmatory value b) Neutral c) Free from error c) Materiality

SFAC No. 8 (contd.)

II. Enhancing Qualitative Characteristics

1) Comparability(including consistency)
2) Verifiability 3) Timeliness

4) Understandability

SFAC No. 5 (Level Three of The Conceptual Framework)

Measurement and Recognition Concepts I. Assumptions 1) Economic Entity 2) Going-concern (continuity) 3) Monetary unit 4) Periodicity (Period of time)

SFAC No. 5 (contd.)

II. Principles
1) Historical cost (exception:LCM of inventory) 2) Revenue recognition (exceptions: 3) Matching 4) Full Disclosure (footnote disclosure)

III. Constraints
1) Cost-Benefit 2) Materiality 3) Industry Practice 4) Conservatism

The Accounting Standard Compliance System in the US

The interrelationship of the SEC and the FASB: FASB: the current rule making body. SEC: the enforcing agency of securities laws and accounting standards; regulating the stock market.

Learning Objectives

The Move Toward Fair Value


Fair Market value measurement

Although the historical cost principle is the basis of measurement for most assets and liabilities, there are many instances in GAAP in which assets or liabilities are required or permitted to be measured at fair value. SFAS No. 157 establishes a framework for measuring fair values. SFAS No. 159 gives companies the option to report some or all of their financial assets and liabilities at fair value.

Fair Value Hierarchy (SFAS 157)

Level 1 (most reliable) measures are based on quoted prices for identical instruments in active markets. Level 2 measures are based on quoted prices for similar instruments (assets or liabilities) in active markets. Level 3 (least reliable) measures are based on unobservable inputs such companys data or assumptions.
The Balance Sheet and Financial Disclosures


Fair Value Measurements Disclosure :

Footnote 28 of GE 2008 Annual Report
Level 1
Assets Investment Securities Derivatives Others total Liabilities Derivatives Other $ 2 ____ $12,643 1,031 $ 166 ____ $(7,575) ____ $ 5,236 1,031 $1,158 ___ 1 $1,159 $27,332 18,911 288 $46,531 $12,956 1,142 1,105 15,203 ___ (7,411) ____ $(7,411) $41,446 12,642 1,394 $55,482

Level 2

Level 3

Fin. 39 Netting

Net Bal.



$ 166



The Balance Sheet and Financial Disclosures

The function of financial accounting is to identify, measure and communicate financial information about economic entities to interested parties.

a. True b. False


Generally accepted accounting principles include both standards set by various rule making bodies and certain accounting practices that have evolved over time.

a. True b. False


The major financial accounting standards setting body in the U.S.A. is the

a. b.

c. d.

Accounting Principles Board Securities and Exchange Commission Financial Accounting Standards Board American Institute of CPAs

The Financial Accounting Standards Board develops accounting and reporting standards independent of public, business and political pressures. a. True b. False


Summary (p37 and p38 of textbook)

Financial statements are an important source of information about a company, its economic health, and its prospects. Financial statements help improve decision making of investors and make it possible to monitor managers activities. They also help creditors to make credit decisions and financial analysts to make recommendations to their clients. Therefore, there is a demand for the financial statements.

Summary (contd.)

What governs the supply of financial information? Mandatory reporting and voluntary disclosure. Benefit and cost considerations influence voluntary disclosure.


Summary (contd.)

Financial accounting standards (GAAP) are often imprecise and subject to interpretations. This imprecision gives managers an opportunity to shape financial statements: Most use the accounting flexibility to paint a truthful economic picture of the company. Other managers shape the financial statements to mask weaknesses and to hide problems. So analysts must maintain a healthy skepticism about the numbers.