Chapter 1The Economic and Institutional Setting for Financial ReportingLearning 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?

1

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.

2

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.

3

Financial Information

Accounting?

Identifies

and

Measures

and

Communicates

Financial Information

Accounting?

Identifies

and

Measures

and

Communicates

Balance Sheet

Income Statement

Statement of Cash Flows

Statement of Owners’ or Stockholders’ Equity

Note Disclosures

Balance Sheet

Income Statement

Statement of Cash Flows

Statement of Owners’ or Stockholders’ Equity

Note Disclosures

President’s letter

Prospectuses,

SEC Reporting

News releases

Forecasts

Environmental Reports

Etc.

President’s letter

Prospectuses,

SEC Reporting

News releases

Forecasts

Environmental Reports

Etc.

GAAPGAAP Not GAAPNot GAAP

Financial StatementsFinancial Statements Additional InformationAdditional InformationEconomic EntityEconomic Entity

Financial Statements and Financial Reporting

4

Learning Objective :

Describe the demand and supply for financial statements

5

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. Supplier’s 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

6

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.

Disclosures Other forms of information: Press releases and

management discussions (MD&A).

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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.

8

Disclosure Benefits

The following are benefits arising from voluntary disclosures : Increase investors’ confidence on the quality

of company’s equity offerings. Obtain capital cheaply from the capital

markets. Get better deals from suppliers.

9

Disclosure Costs

The costs which may arise from voluntary disclosures : Information collection, processing and

dissemination costs. Competitive disadvantage costs. Litigation costs. Political costs.

10

Case Study 1: WorldCom (source: RCJM textbook) (WSJ 8/5/2002 – Improper Capitalization) It’s 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 morning’s paper raises a new concern:

Sales

Costs Line%42

Fixed “rental” payment

Message volume

Holding steady despite declining message volume

11

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 ?

FUTURE

BENEFITS

NO FUTURE

BENEFITS

ASSET

EXPENSE

12

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.

13

Lessons learned Financial statement fraud is rare—but 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.

14

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)

15

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.16

GAAP (Contd.)

Public held companies and certain regulated companies are required to use GAAP in preparing financial statements.

Reasons?

17

Who Prescribes the Standards?

Securities and Exchange Commission

AICPA

Public Sector Private Sector

Financial Accounting Standard Board

International Accounting Standard Board

American Institute of Certified Public Accountants

IASB

U.S. Congress

SEC FASB

Year Authority Official Release1934 Congress

SEC Regulation S-XASR and FRRStaff Accounting Bulletins

1938 Accounting ProfessionAICPA

1938-1959 CAP ……… ARBs (51)1959-1973 APB ……… APB Opinions (31) 1973 FASB ……. 1. Statement of Financial

Accounting Standards2. Interpretations3. Concepts of Financial

Accounting4. Technique Bulletins5. Statements issued by EITF

19

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.)

20

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.

21

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.

22

Accounting Standards Codification (contd.) The Codification does not change

GAAP but only the way the existing accounting standards are organized.

23

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 Foundation’s Board of Trustees.

24

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.)

25

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 .

26

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).

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Learning Objective

Introduce the importance and the need of IFRS

28

Environment and Theoretical Structure of Financial Accounting 29

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 30

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 31

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 32

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.

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.

Environment and Theoretical Structure of Financial Accounting 34

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.

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.

35

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.

36

Learning Objective

The Financial Reporting Reform- the Sarbanes-Oxley Act

37

The Financial Reporting Reform• As a result of numerous financial scandals, Congress passed the Public Company Accounting Public Company Accounting Reform and Investor Protection Act of 2002Reform 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.

38

39

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.

Environment and Theoretical Structure of Financial Accounting 40

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 41

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 management’s assessment is fair, and 2)whether the internal control of the firm is effective.

Learning Objectives

• Identify the objectives of financial reporting, the qualitative characteristics of accounting information, and the elements of financial statements.

• Describe the four basicassumptions underlying GAAP

• Describe the four basic accountingprinciples that guide accounting practice.

43

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

Recognition and Measurement Criteria (SFAC No. 5)

Environment Implementation Implementationassumptions principles constraints

Objectives of Financial Reporting(SFAC No. 1)

Qualitative Characteristicsof Accounting Information

(SFAC No. 8)

Elements ofFinancial Statements

(SFAC No. 6)

44

45

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.

46

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

a) Predictive value

b) Confirmatory value

c) Materiality

2) Faithful Representation

a) Complete

b) Neutral

c) Free from error

47

SFAC No. 8 (contd.)

II. Enhancing Qualitative Characteristics

1) Comparability(including consistency)

2) Verifiability

3) Timeliness

4) Understandability

48

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)

49

SFAC No. 5 (contd.)

II. Principles1) Historical cost (exception:LCM of inventory)2) Revenue recognition (exceptions:3) Matching4) Full Disclosure (footnote disclosure)

III. Constraints1) Cost-Benefit2) Materiality3) Industry Practice4) Conservatism

50

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

51

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.

52

The Balance Sheet and Financial Disclosures 53

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 company’s data or assumptions.

The Balance Sheet and Financial Disclosures 54

Fair Value Measurements Disclosure : Footnote 28 of GE 2008 Annual ReportLevel 1 Level 2 Level 3 Fin. 39

NettingNet Bal.

Assets

Investment Securities $1,158 $27,332 $12,956 ___ $41,446

Derivatives ___ 18,911 1,142 (7,411) 12,642

Others 1 288 1,105 ____ 1,394

total $1,159 $46,531 15,203 $(7,411) $55,482

Liabilities

Derivatives $ 2

$12,643 $ 166 $(7,575) $ 5,236

Other ____ 1,031 ____ ____ 1,031

Total $ 2 $13,674 $ 166 $(7,575) $6,267

Question

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

a. True b. False

55

Question

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

56

Question

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

a. Accounting Principles Board b. Securities and Exchange Commission c. Financial Accounting Standards Board d. American Institute of CPAs

57

Question

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

58

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.

59

Summary (contd.) What governs the supply of financial

information? Mandatory reporting and voluntary

disclosure.

Benefit and cost considerations influence voluntary disclosure.

60

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.

61