Chapter Two Financial Reporting: The Cornerstone of a Market Economy

Copyright © Houghton Mifflin Company.All rights reserved Economic Demand for Financial Information Financial information is needed to: Provide information for investment decisions Assure lenders that borrowers can repay debt Assess performance or plan future growth by internal managers

Copyright © Houghton Mifflin Company.All rights reserved Regulatory Demand for Financial Information Financial information is required for: Enforcement of tax codes Promulgating regulations Protection of investors and regulation of the securities market

Copyright © Houghton Mifflin Company.All rights reserved Critical Thinking Discussion: Imagine a business world in which there were no clearly defined accounting practices, no regulation of securities markets, and no enforcement of accounting practices. What consequences might result? Investors would have no means by which to compare financial statements between companies or understand how each company computed its income and financial position.

Copyright © Houghton Mifflin Company.All rights reserved Setting Accounting Standards Standard-setting bodies Public- Sector Entities Private- Sector Entities Issue standards, reports, bulletins, and positions that constitute generally acceptable accounting principles (GAAP)

Copyright © Houghton Mifflin Company.All rights reserved Contributors to GAAP

Copyright © Houghton Mifflin Company.All rights reserved Public-Sector Standard Setter: SEC Securities and Exchange Commission: Regulates U.S. securities markets Holds authority to set accounting and reporting standards Charged with protecting investors from fraud or inadequate financial disclosures

Copyright © Houghton Mifflin Company.All rights reserved Public-Sector Standard Setter: Oversight Board Public Company Accounting Oversight Board: Operates under the SEC; established by the Sarbanes-Oxley Act Actively participates in standard setting in cooperation with accountants and advisory groups Establishes or adopts auditing, quality control, ethics, independence, and other standards relating to audits Conducts inspections of accounting firms Conducts investigations and disciplinary proceedings; imposes appropriate sanctions

Copyright © Houghton Mifflin Company.All rights reserved Private-Sector Standard Setter: AICPA American Institute of Certified Public Accountants (AICPA) DateStandard-Setting Committee Operated by AICPA Before 1959Committee on Accounting Procedure (CAP) Accounting Principles Board (APB) presentAccounting Standards Executive Committee (AcSEC)

Copyright © Houghton Mifflin Company.All rights reserved Private-Sector Standard Setter: FASB Financial Accounting Standards Board (FASB): Establishes and improves standards of financial accounting and reporting Issues Statements of Financial Accounting Standards (SFASs), Statements of Financial Accounting Concepts (SFACs), and other bulletins Emerging Issues Task Force (EITF) studies and resolves emergency issues for FASB

Copyright © Houghton Mifflin Company.All rights reserved Other Private-Sector Standard Setters Institute of Management Accountants (IMA) Financial Executives International (FEI)

Copyright © Houghton Mifflin Company.All rights reserved International Standard Setter International Accounting Standards Board (IASB): Independent, privately funded organization based in London Cooperates with national accounting standard setters to achieve convergence in global standards Endorsed International Accounting Standards (IAS) created from 1997 – 2002 Issues International Financial Reporting Standards (IFRS) at present

Copyright © Houghton Mifflin Company.All rights reserved Challenges in Standard Setting Process is too slow for the fast-changing business environment Results in complex and detailed accounting standards Current rule-based accounting standards encourage a check-box mentality and diminish the overall objective of the standard

Copyright © Houghton Mifflin Company.All rights reserved FASB’s Standard- Setting Process

Copyright © Houghton Mifflin Company.All rights reserved Which accounting rules have the highest authority?

Copyright © Houghton Mifflin Company.All rights reserved Why is Transparency in Financial Reporting Important? Enables investors, creditors, and the market to evaluate a firm Increases confidence in the fairness of U.S. markets Fundamental to corporate governance

Copyright © Houghton Mifflin Company.All rights reserved FASB’s Conceptual Framework for Financial Reporting The framework addresses: 1.Objectives of financial reporting 2.Qualitative characteristics of accounting information 3.Elements of financial statements 4.Environmental assumptions, principles, and constraints that guide financial reporting

Copyright © Houghton Mifflin Company.All rights reserved FASB’s Conceptual Framework

Copyright © Houghton Mifflin Company.All rights reserved Objectives of Financial Reporting 2. Provide information that will help assess the amounts, timing, and uncertainty of future cash flows 3. Provide information that will help investors do fundamental analysis of the assets, liabilities, and business activities for a given period of time 1. Provide information that is useful in making rational investment, credit, and similar decisions

Copyright © Houghton Mifflin Company.All rights reserved Hierarchy of Accounting Qualities

Copyright © Houghton Mifflin Company.All rights reserved User-Specific Qualities of Accounting Information Understandability—Are users able to perceive the information’s significance? Decision Usefulness—Can users translate the information for making credit, investment, and other decisions?

Copyright © Houghton Mifflin Company.All rights reserved Primary Qualities of Decision UsefulnessRelevance: Information is capable of making a difference in users’ decisionsReliability: Information is relatively free from error and bias. It measures what it claims to measure. Timeliness Predictive Value Feedback Value Neutrality Representational Faithfulness Verifiability

Copyright © Houghton Mifflin Company.All rights reserved Secondary Qualities of Decision UsefulnessComparability: Information is measured and reported in such a way that users can identify similarities and differences among sets of dataConsistency: A company applies the same accounting rules across time to allow for comparability

Copyright © Houghton Mifflin Company.All rights reserved What Constraints Impact Financial Reporting?Materiality: Information must have the capacity to affect users’ decisionsCost-Benefit: Benefits to users must exceed costs when preparing and communicating financial information

Copyright © Houghton Mifflin Company.All rights reserved Accounting and Ethics AICPA Code of Professional Conduct— defines the minimum level of professional responsibility and conduct applicable to all practicing AICPA members Most critical section of the code: Auditor Independence

Copyright © Houghton Mifflin Company.All rights reserved Auditor Independence Maintain independence both in fact and in appearance Do nothing to undermine the perception of outside users that the auditor has any interest in the outcome of the audit or performance of the client No financial interest in client

Copyright © Houghton Mifflin Company.All rights reserved Auditor-Client Relationship An accounting firm cannot provide the following services for a client at the same time it is performing an audit for that client: Legal Actuarial Internal audit Management Human resources Broker/dealer Valuation Investment banking Bookkeeping Design and implementation of financial information systems

Copyright © Houghton Mifflin Company.All rights reserved Ethical Decision Making Requires commitment beyond rules of conduct Requires the ability to make distinctions between competing choices and understand consequences of each choice Requires a framework of principles and a model form applying these principles to problems

Copyright © Houghton Mifflin Company.All rights reserved Ethical Decision-Making Model 1.Define the problem and gather facts. 2.List parties affected by decision. 3.List values and principles to consider. 4.List alternative actions. 5.Choose and prioritize: a)Which party is most important in this situation? b)Which value is the highest value in this situation? c)Which action will cause greatest good or least harm? d)Prioritize a, b, and c for most important consideration. 6.Make the decision based on the above factors.

Copyright © Houghton Mifflin Company.All rights reserved Check Your Understanding QList three economic needs for financial information. ATo provide information for investment decisions, to assure lenders that borrowers can repay debt, and to assess performance or to plan future growth by internal managers.

Copyright © Houghton Mifflin Company.All rights reserved Check Your Understanding QName two public-sector entities and three private-sector entities that play a role in standard setting. AThe SEC and Congress play a role in standard setting in the public sector. In the private sector, the FASB, IMA, FEI, AICPA, and IASB contribute to standard setting.

Copyright © Houghton Mifflin Company.All rights reserved Check Your Understanding QWhat criticisms have been voiced regarding the current standard-setting process? AThe process moves too slowly for today’s marketplace. Resulting standards are too complex and detailed.

Copyright © Houghton Mifflin Company.All rights reserved Check Your Understanding QWhat issues are addressed by the FASB’s conceptual framework? AThe objectives of financial reporting; the qualitative characteristics of accounting information; the elements of financial statements; and the environmental assumptions, principles, and constraints that guide financial reporting.

Copyright © Houghton Mifflin Company.All rights reserved Check Your Understanding QDescribe the concept of reliability as it relates to the decision usefulness of information. AInformation should be relatively free of error or bias. It should also measure what it claims to measure.