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CHAPTER
1
Financial Accounting
and Accounting Standards
LEARNING
As a result of the many concerns expressed by investors about the Identify the major policy-
setting bodies and their
completeness and the reliability of the accounting numbers, many companies role in the standards-
have expanded their financial disclosures in their annual reports. For setting process.
example, General Electrics CEO Jeffery Immelt stated, I want people to think Explain the meaning of
about GE as we think of GEas a transparent company. He noted that GEs generally accepted
annual report will be the size of New York Citys phone book, if necessary accounting principles.
to provide the information necessary to help investors and creditors make the Describe the impact of
proper investing decisions. user groups on the
standards-setting process.
It is our hope that meaningful reform will come out of these recent
investigations into sloppy or fraudulent accounting. Although the U.S. is still
Understand issues related
to ethics and financial
considered to have the finest reporting system in the world, we must do better. accounting.
As former chair of the FASB Ed Jenkins recently remarked, If anything
positive results . . . it may be that [these accounting issues] serve as an
indelible reminder to all that transparent financial reporting does matter and
that lack of transparency imposes significant costs on all who participate [in
our markets].
1
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PREVIEW OF CHAPTER 1
As the opening story indicates, relevant and reliable financial information must be pro-
vided so that our capital markets work efficiently. This chapter explains the environment
of financial reporting and the many factors affecting it. The content and organization
of this chapter are as follows.
ILLUSTRATION 1-1
Financial Reporting Users Capital Allocation Capital Allocation
(present and potential) Process
The financial information Investors and creditors The process of
a company provides to use financial reports to determining how and at
help users with capital make their capital what cost money is
allocation decisions about allocation decisions. allocated among
the company. competing interests.
Its not the economy anymore. Its the accounting. Thats what many investors seem to
be saying these days. As indicated in our opening story, even the slightest hint of any
type of accounting irregularity at a company leads to a subsequent pounding of the
companys stock. For example, a recent Wall Street Journal had the following headlines What do the
related to accounting and its effects on the economy. numbers mean?
Stocks take a beating as accounting worries spread beyond Enron
Williams Cos. delays earnings release to review a units obligations
Global Crossings accounting method now being called aggressive
Bank stocks fall as investors take issue with PNCs accounting
Investors, skeptical of Tycos breakup plan, send shares down 20%
It now has become clear that there must be trust in the numbers or investors will
abandon the market and put their resources elsewhere. That is why overseas investors
are pulling their money out of the U.S. market and why the dollar is dropping relative
to other currencies. With investor uncertainty, the cost of capital increases for compa-
nies who need additional resources. In short, relevant and reliable financial information
is necessary for markets to be efficient.
1
AICPA Special Committee on Financial Reporting, Improving Business Reporting A
Customer Focus, Journal of Accountancy, Supplement (October 1994).
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Is useful to present and potential investors and creditors and other users in mak-
ing rational investment, credit, and similar decisions. The information should be
comprehensible to those who have a reasonable understanding of business and eco-
nomic activities and are willing to study the information with reasonable diligence.
Helps present and potential investors, creditors, and other users assess the
amounts, timing, and uncertainty of prospective cash receipts from dividends or
interest and the proceeds from the sale, redemption, or maturity of securities or
loans. Since investors and creditors cash flows are related to enterprise cash flows,
financial reporting should provide information to help investors, creditors, and oth-
ers assess the amounts, timing, and uncertainty of prospective net cash inflows to
the related enterprise.
Clearly portrays the economic resources of an enterprise, the claims to those re-
sources (obligations of the enterprise to transfer resources to other entities and own-
ers equity), and the effects of transactions, events, and circumstances that change
its resources and claims to those resources.2
In brief, the objectives of financial reporting are to provide (1) information that is use-
ful in investment and credit decisions, (2) information that is useful in assessing cash
flow prospects, and (3) information about enterprise resources, claims to those re-
sources, and changes in them.
The emphasis on assessing cash flow prospects might lead one to suppose that
the cash basis is preferred over the accrual basis of accounting. That is not the case. In-
formation based on accrual accounting generally provides a better indication of an
enterprises present and continuing ability to generate favorable cash flows than does
information limited to the financial effects of cash receipts and payments.3
Recall from your first accounting course that the objective of accrual basis ac-
counting is to ensure that events that change an entitys financial statements are
recorded in the periods in which the events occur, rather than only in the periods in
which the entity receives or pays cash. Using the accrual basis to determine net income
means recognizing revenues when earned rather than when cash is received, and rec-
ognizing expenses when incurred rather than when paid. Under accrual accounting,
revenues, for the most part, are recognized when sales are made so they can be related
to the economic environment of the period in which they occurred. Over the long run,
trends in revenues are generally more meaningful than trends in cash receipts.
2
Objectives of Financial Reporting by Business Enterprises, Statement of Financial Ac-
counting Concepts No. 1 (Stamford, Conn.: FASB, November 1978), pars. 58.
3
SFAC No. 1, p. iv. As used here, cash flow means cash generated and used in operations.
The term cash flows is frequently used also to include cash obtained by borrowing and used to
repay borrowing, cash used for investments in resources and obtained from the disposal of in-
vestments, and cash contributed by or distributed to owners.
4
Managements responsibility to manage assets with care and trust is its fiduciary respon-
sibility.
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enterprise would have to develop its own standards, and readers of financial state-
ments would have to familiarize themselves with every companys peculiar account-
ing and reporting practices. It would be almost impossible to prepare statements that
could be compared.
This common set of standards and procedures is called generally accepted ac-
counting principles (GAAP). The term generally accepted means either that an au-
thoritative accounting rule-making body has established a principle of reporting in a
given area or that over time a given practice has been accepted as appropriate because
of its universal application.5 Although principles and practices have provoked both de-
bate and criticism, most members of the financial community recognize them as the
standards that over time have proven to be most useful. A more extensive discussion
of what constitutes GAAP is presented later in this chapter.
5
The terms principles and standards are used interchangeably in practice and throughout
this textbook.
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initiative for establishing and improving accounting standards should remain in the
private sector, subject to Commission oversight.
SEC Oversight
The SECs partnership with the private sector has worked well. The SEC has acted with
remarkable restraint in the area of developing accounting standards. Generally, the SEC
has relied on the AICPA and FASB to regulate the accounting profession and de-
velop and enforce accounting standards.
Over its history, however, the SECs involvement in the development of account-
ing standards has varied. In some cases the private sector has attempted to establish a
standard, but the SEC has refused to accept it. In other cases the SEC has prodded the
private sector into taking quicker action on certain reporting problems, such as ac-
counting for investments in debt and equity securities and the reporting of derivative
instruments. In still other situations the SEC communicates problems to the FASB, re-
sponds to FASB exposure drafts, and provides the FASB with counsel and advice upon
request.
The SEC has the mandate to establish accounting principles. The private sector,
therefore, must listen carefully to the views of the SEC. In some sense the private sec-
tor is the formulator and the implementor of the standards.6 While the partnership be-
tween the SEC and the private sector has worked well, it can be strained when ac-
counting problems are not addressed as quickly as the SEC would like. This was
apparent in the recent deliberations on the accounting for business combinations and
intangible assets and concerns over the accounting for special-purpose entities, high-
lighted in the failure of Enron.
Enforcement
As indicated earlier, companies listed on a stock exchange are required to submit their
financial statements to the SEC. If the SEC believes that an accounting or disclosure ir-
regularity exists regarding the form or content of the financial statements, it sends a
deficiency letter to the company. Usually these deficiency letters are resolved quickly.
However, if disagreement continues, the SEC has the power to issue a stop order,
which prevents the registrant from issuing securities or trading securities on the ex-
changes. Criminal charges may also be brought by the Department of Justice for vio-
lations of certain laws. The SEC program, private sector initiatives, and civil and crim-
inal litigation help to ensure the integrity of financial reporting for public companies.
International
Insight
American Institute of Certified Public Accountants (AICPA) Nations also differ in the de-
As indicated earlier, the American Institute of Certified Public Accountants (AICPA), gree to which they have devel-
which is the national professional organization of practicing Certified Public Accoun- oped national standards and
consistent accounting practices.
tants (CPAs), has been vital to the development of GAAP. Various committees and
One indicator of the level of a
boards established since the founding of the AICPA have contributed to this effort. nations accounting is the na-
ture of the accounting profes-
Committee on Accounting Procedure sion within the country. Profes-
At the urging of the SEC, the AICPA appointed the Committee on Accounting Proce- sional accounting bodies were
dure in 1939. The Committee on Accounting Procedure (CAP), composed of practic- established in the Netherlands,
ing CPAs, issued 51 Accounting Research Bulletins during the years 1939 to 1959. (See the U.K., Canada, and the U.S.
in the nineteenth century. In
contrast, public accountancy
bodies were established in
6 Hong Kong and Korea only in
One writer has described the relationship of the FASB and SEC and the development of fi-
the last half century.
nancial reporting standards using the analogy of a pearl. The pearl (financial reporting standard)
is formed by the reaction of certain oysters (FASB) to an irritant (the SEC)usually a grain of
sandthat becomes embedded inside the shell. The oyster coats this grain with layers of nacre,
and ultimately a pearl is formed. The pearl is a joint result of the irritant (SEC) and oyster (FASB);
without both, it cannot be created. John C. Burton, Government Regulation of Accounting and
Information, Journal of Accountancy (June 1982).
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list at the back of the book.) These bulletins deal with a variety of accounting prob-
lems. But this problem-by-problem approach failed to provide the structured body of
accounting principles that was both needed and desired. In response, in 1959 the AICPA
created the Accounting Principles Board.
In addition to research help from its own staff, the FASB relies on the expertise of
various task force groups formed for various projects and on the Financial Account-
ing Standards Advisory Council (FASAC). FASAC consults with the FASB on major
policy and technical issues and also helps select task force members.
Due Process
In establishing financial accounting standards, two basic premises of the FASB are:
(1) The FASB should be responsive to the needs and viewpoints of the entire economic
community, not just the public accounting profession. (2) It should operate in full view
of the public through a due process system that gives interested persons ample op-
portunity to make their views known. To ensure the achievement of these goals, the
steps shown in Illustration 1-2 are taken in the evolution of a typical FASB Statement
of Financial Accounting Standards.
ILLUSTRATION 1-2
Due Process
AGENDA Research Discussion
Business Memorandum What do
combinations? you think?
Derivatives?
Segment
reporting?
Topics identified and placed on Research and analysis conducted Public hearing on proposed
Board's agenda. and discussion memorandum of standard.
pros and cons issued.
Board evaluates research and public Board evaluates responses and changes
response and issues exposure draft. exposure draft, if necessary. Final
standard issued.
The passage of a new FASB Standards Statement requires the support of four of
the seven Board members. FASB Statements are considered GAAP and thereby bind-
ing in practice. All ARBs and APB Opinions that were in effect in 1973 when the FASB
became effective continue to be effective until amended or superseded by FASB pro-
nouncements. In recognition of possible misconceptions of the term principles, the
FASB uses the term financial accounting standards in its pronouncements.
Types of Pronouncements
The major types of pronouncements that the FASB issues are:
Standards and Interpretations.
Financial Accounting Concepts. Financial
APO 145 I12903NVDUS
Accounting Series
Technical Bulletins.
Emerging Issues Task Force Statements. Statement of
Financial Accounting
Standards No. 115
Standards and Interpretations. Financial accounting standards issued by the FASB are Accounting for Certain Investments
in Debt and Equity Securities
considered generally accepted accounting principles. In addition, the FASB also issues
interpretations that represent modifications or extensions of existing standards. The
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interpretations have the same authority as standards and require the same votes for
Financial
APO 145 I12903NVDUS
Accounting Series passage as standards. However, interpretations do not require the FASB to operate in
full view of the public through the due process system that is required for FASB Stan-
FASB Interpretation No.40 dards. The APB also issued interpretations of APB Opinions. Both types of interpreta-
Applicability of Generally Accepted
Accounting Principles to Mutual
Life Insurance and Other Enterprises
tions are now considered authoritative support for purposes of determining GAAP.
an Interpretation of FASB Statements No.12, 80, 97, and 113 Since replacing the APB, the FASB has issued 147 standards and 44 interpretations. (See
list at the back of the book.)
Financial Accounting Concepts. As part of a long-range effort to move away from the
problem-by-problem approach, the FASB in November 1978 issued the first in a series
of Statements of Financial Accounting Concepts as part of its conceptual framework
Financial
APO 145 I12903NVDUS
project. (See list at the back of the book.) The purpose of the series is to set forth fun-
Accounting Series
damental objectives and concepts that the Board will use in developing future standards
of financial accounting and reporting. They are intended to form a cohesive set of in-
Statement of
Financial Accounting terrelated concepts, a conceptual framework, that will serve as tools for solving exist-
Concepts No. 6 ing and emerging problems in a consistent manner. Unlike a Statement of Financial Ac-
Elements of Financial Statements
a replacement of FASB Concepts Statement No. 3
counting Standards, a Statement of Financial Accounting Concepts does not establish
(incorporating an amendment of
FASB Concepts Statement No. 2)
GAAP. Concepts statements, however, pass through the same due process system (dis-
cussion memo, public hearing, exposure draft, etc.) as do standards statements.
FASB Technical Bulletins. The FASB receives many requests from various sources for
Financial
APO 145 I12903NVDUS guidelines on implementing or applying FASB Standards or Interpretations, APB Opin-
Accounting Series ions, and Accounting Research Bulletins. In addition, a strong need exists for timely
FASB Technical Bulletin guidance on financial accounting and reporting problems. For example, in one tax law
1349 MVDN
Emerging Issues Task Force Statements. In 1984 the FASB created the Emerging Issues
Task Force (EITF). The EITF is composed of 13 members, representing CPA firms and
preparers of financial statements. Also attending EITF meetings are observers from the
FSAB SEC and AICPA. The purpose of the task force is to reach a consensus on how to ac-
count for new and unusual financial transactions that have the potential for creating
differing financial reporting practices. Examples include how to account for pension
EITF ABSTRACTS plan terminations; how to account for revenue from barter transactions by Internet
A Summary of Proceedings of the
FASB Emerging Issues Task Force
as of September 1999
companies; and how to account for excessive amounts paid to takeover specialists. The
EITF also provided timely guidance for the reporting of the losses arising from the ter-
rorist attacks on the World Trade Center on 9/11/01.
We cannot overestimate the importance of the EITF. In one year, for example, the
task force examined 61 emerging financial reporting issues and arrived at a consensus
on approximately 75 percent of them. The SEC has indicated that it will view consen-
sus solutions as preferred accounting and will require persuasive justification for de-
parting from them.
The EITF helps the FASB in many ways. For example, emerging issues often attract
public attention. If they are not resolved quickly, they can lead to financial crises and
scandal and can undercut public confidence in current reporting practices. The next
step, possible governmental intervention, would threaten the continuance of standards
setting in the private sector. In addition, the EITF identifies controversial accounting
7
Purpose and Scope of FASB Technical Bulletins and Procedures for Issuance, FASB Tech-
nical Bulletin No. 79-1 (Revised) (Stamford, Conn.: FASB, June 1984).
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problems as they arise and determines whether they can be quickly resolved, or whether
the FASB should become involved in solving them. In essence, it becomes a problem
filter for the FASB. Thus, it is hoped that the FASB will be able to work on more per-
vasive long-term problems, while the EITF deals with short-term emerging issues.
ILLUSTRATION 1-3
Financial Accounting Organizational Structure
Foundation for Setting Accounting
(FAF) Standards
Purpose
To select members of the FASB
and GASB and their Advisory
Councils, fund their activities,
and exercise general oversight.
Purpose Purpose
To establish and improve standards To establish and improve
of financial accounting and reporting standards of financial
for the guidance and education of the accounting for state and
public, including issuers, auditors local government.
and users of financial information. Staff and Task
Forces
Purpose
To assist respective
Boards on reporting
issues by performing
Financial Accounting research, analysis, Governmental Accounting
Standards Advisory Council and writing functions. Standards Advisory Council
(FASAC) (GASAC)
Purpose Purpose
To consult on major policy issues, To consult on major policy issues,
technical issues, project priorities technical issues, project priorities
and selection and organization of and selection and organization of
task forces. task forces.
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The AICPA has been the leader in developing auditing standards through its Au-
diting Standards Board. However, the Sarbanes-Oxley Act of 2002 requires the Public
Company Accounting Oversight Board to oversee the development of future auditing
standards. The AICPA will continue to develop and grade the CPA examination, which
is administered in all 50 states.
8
SAS No. 69 states that Audit Guides and Statements of Position are assumed to be cleared
(approved) by the FASB unless the pronouncement states otherwise.
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nouncements are lacking in guidance, then other sources might be considered. The hi-
erarchy of these sources is presented in Illustration 1-4.9 If the accounting treatment of
an event is not specified by a category (a) pronouncement, then categories (b) through
(d) should be investigated. If there is a conflict between pronouncements in (b) through
(d), the higher category is to be followed. For example, (b) is higher than (c).
ILLUSTRATION 1-4
The House of GAAP
House of GAAP
FASB AICPA
Category (a) APB
Standards and Accounting
(Most authoritative) Opinions
Interpretations Research Bulletins
If none of these pronouncements addresses the event, the support is sought from
other accounting literature. Examples of other accounting literature include FASB Con-
cepts Statements, International Accounting Standards, and accounting articles.
9
See for example, Remodeling the House of GAAP, by Douglas Sauter, Journal of Accoun-
tancy (July 1991), pp. 3037.
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ILLUSTRATION 1-5
User Groups that Business entities
Influence the
Formulation of
Accounting Standards CPAs and Financial community
accounting firms (analysts, bankers, etc.)
Government
Academicians
(SEC, IRS, other agencies)
Accounting standards,
interpretations, and bulletins
Should there be politics in setting standards for financial accounting and report-
ing? We have politics at home; at school; at the fraternity, sorority, and dormitory; at
the office; at church, temple, and mosquepolitics is everywhere. The FASB does not
exist in a vacuum. Standards setting is part of the real world, and it cannot escape pol-
itics and political pressures.
10
FASB board members have acknowledged that many of the Boards projects, such as Ac-
counting for Contingencies, Accounting for Pensions, Statement of Cash Flows, and Ac-
counting for Derivatives, were targets of political pressure.
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That is not to say that politics in standards setting is evil. Considering the economic
consequences11 of many accounting standards, it is not surprising that special interest
groups become vocal (some supporting, some opposing) when standards are being for-
mulated. The Board must be attentive to the economic consequences of its actions. What
the Board should not do is issue pronouncements that are primarily politically moti-
vated. While paying attention to its constituencies, the Board should base its standards
on sound research and a conceptual framework that has its foundation in economic re-
ality. Even so, the FASB can continue to expect politics and special interest pressures,
since as T. S. Eliot said, Humankind cannot bear very much reality.
Investors generally ignore an accounting change. But when it substantially affects net
income, stockholders pay attention. One change that will affect many companies is the
new goodwill rules. Before the change, companies that had goodwill were required to
charge it against revenues over time. Under the new rules, companies no longer have What do the
to write off this cost on a systematic basis. The effect on the bottom line for some com- numbers mean?
panies is substantial. For example, assuming no goodwill amortization, International
Paper estimates an income increase of 21 percent, Johnson Controls 16 percent, and
Pepsi Bottling Group 30 percent.
Some believe this change in the rules will make their stock more attractive. Others
argue that it should have no effect because the write-off is a mere bookkeeping charge.
Others argue that the change in the rules has no effect on cash flows, but that investors
will perceive the company to be more profitable, and therefore a good buy in the mar-
ketplace. In short, the numbers have consequences. What do you think?
11
Economic consequences in this context means the impact of accounting reports on the
wealth positions of issuers and users of financial information and the decision-making behavior
resulting from that impact. The resulting behavior of these individuals and groups could have
detrimental financial effects on the providers of the financial information (enterprises). For a
more detailed discussion of this phenomenon, see Stephen A. Zeff, The Rise of Economic Con-
sequences, Journal of Accountancy (December 1978), pp. 5663. Special appreciation is extended
to Professor Zeff for his insights on this chapter.
12
Sarbanes-Oxley Act of 2002, H. R. Rep. No. 107-610 (2002).
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CEOs and CFOs must forfeit bonuses and profits when there is an accounting re-
statement.
CEOs and CFOs are required to certify that the financial statements and company
disclosures are accurate and complete.
Audit committees will need independent members and members with financial
expertise.
Codes of ethics must be in place for senior financial officers.
Will these changes be enough? The expectations gapwhat the public thinks ac-
countants should be doing and what accountants think they can dois a difficult one
to close. The instances of fraudulent reporting have caused some to question whether
the profession is doing enough. Although the profession can argue rightfully that they
cannot be responsible for every financial catastrophe, it must continue to strive to meet
the needs of society. Efforts to meet these needs will become more costly to society be-
cause the development of a highly transparent, clear, and reliable system will require
considerable resources.
Given the current number of accounting scandals mentioned so far in the text, it is not
surprising that both political parties are working hard to ensure that corporate man-
agement be ethical. President Bush, for example, has announced a set of proposals to
crack down on unethical behavior by corporate officials, expanding the offenses sub- What do the
ject to criminal and civil penalties. And both the SEC and the Justice Department are numbers mean?
budgeted to get more funds to combat financial fraud. Bush has indicated that the fed-
eral government will be vigilant in prosecuting wrongdoers in American business. At
the same time, the Democratic Party also is pushing for more corporate-reform initia-
tives. One thing is certainrecent events have undermined consumer confidence re-
garding corporate America and the capital markets. Because these issues are hurting
the U.S. economy, politicians are now trying to find answers.
Conclusion
The FASB is in its thirtieth year as this textbook is written. Will the FASB survive in its
present state, or will it be restructured or changed as its predecessors were? The next
ten years will be interesting ones in the standards-setting arena. The possibility of global
standards, the crisis of confidence in the capital markets caused by Enron, Tyco, World-
Com, and other accounting failures, and the issue of principle-based versus rule-based
standards are major issues that will affect standards-setting in the United States.
At present, we believe that the accounting profession is reacting responsibly to rem-
edy identified shortcomings. Because of its substantive resources and expertise, the pri-
vate sector should be able to develop and maintain high standards. But it is a difficult
process requiring time, logic, and diplomacy. By a judicious mix of these three ingre-
dients, the profession should continue to develop its own reporting standards with SEC
oversight.
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Questions 19
Understand issues related to ethics and financial accounting. Financial accountants
are called on for moral discernment and ethical decision making. The decision is more
difficult because a public consensus has not emerged to formulate a comprehensive
ethical system that provides guidelines in making ethical judgments.
QUESTIONS
1. Differentiate broadly between financial accounting and 19. The chairman of the FASB at one time noted that the
managerial accounting. flow of standards can only be slowed if (1) producers fo-
2. Differentiate between financial statements and finan- cus less on quarterly earnings per share and tax benefits
cial reporting. and more on quality products, and (2) accountants and
lawyers rely less on rules and law and more on profes-
3. How does accounting help the capital allocation process?
sional judgment and conduct. Explain his comment.
4. What are some of the major challenges facing the ac-
20. What is the purpose of FASB Technical Bulletins? How
counting profession?
do FASB Technical Bulletins differ from FASB Interpre-
5. What are the major objectives of financial reporting? tations?
6. Of what value is a common set of standards in financial 21. Explain the role of the Emerging Issues Task Force in es-
accounting and reporting? tablishing generally accepted accounting principles.
7. What is the likely limitation of general-purpose finan- 22. What is the purpose of the Governmental Accounting
cial statements? Standards Board?
8. What are some of the developments or events that oc- 23. What are some possible reasons why another organiza-
curred between 1900 and 1930 that helped bring about tion, such as the Governmental Accounting Standards
changes in accounting theory or practice? Board, should not issue financial reporting standards?
9. In what way is the Securities and Exchange Commission 24. What is AcSEC and what is its relationship to the FASB?
concerned about and supportive of accounting principles
25. What are the sources of pressure that change and in-
and standards?
fluence the development of accounting principles and
10. What was the Committee on Accounting Procedure, and standards?
what were its accomplishments and failings?
26. Some individuals have indicated that the FASB must be
11. For what purposes did the AICPA in 1959 create the Ac- cognizant of the economic consequences of its pro-
counting Principles Board? nouncements. What is meant by economic conse-
12. Distinguish among Accounting Research Bulletins, quences? What dangers exist if politics play too much
Opinions of the Accounting Principles Board, and State- of a role in the development of financial reporting stan-
ments of the Financial Accounting Standards Board. dards?
13. If you had to explain or define generally accepted ac- 27. If you were given complete authority in the matter, how
counting principles or standards, what essential char- would you propose that accounting principles or stan-
acteristics would you include in your explanation? dards should be developed and enforced?
14. In what ways was it felt that the statements issued by 28. One writer recently noted that 99.4 percent of all com-
the Financial Accounting Standards Board would carry panies prepare statements that are in accordance with
greater weight than the opinions issued by the Ac- GAAP. Why then is there such concern about fraudulent
counting Principles Board? financial reporting?
15. How are FASB discussion memoranda and FASB expo- 29. What is the expectations gap? What is the profession
sure drafts related to FASB statements? doing to try to close this gap?
16. Distinguish between FASB statements of financial ac- 30. A number of foreign countries have reporting standards
counting standards and FASB statements of financial that differ from those in the United States. What are some
accounting concepts. of the main reasons why reporting standards are often
17. What is Rule 203 of the Code of Professional Conduct? different among countries?
18. Rank from the most authoritative to the least authorita- 31. How are financial accountants challenged in their work
tive, the following three items: FASB Technical Bulletins, to make ethical decisions? Is technical mastery of GAAP
AICPA Practice Bulletins, and FASB Standards. not sufficient to the practice of financial accounting?
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CONCEPTUAL CASES
C1-1 (Financial Accounting) Alan Rodriquez has recently completed his first year of studying ac-
counting. His instructor for next semester has indicated that the primary focus will be the area of finan-
cial accounting.
Instructions
(a) Differentiate between financial accounting and managerial accounting.
(b) One part of financial accounting involves the preparation of financial statements. What are the fi-
nancial statements most frequently provided?
(c) What is the difference between financial statements and financial reporting?
C1-2 (Objectives of Financial Reporting) Celia Cruz, a recent graduate of the local state university, is
presently employed by a large manufacturing company. She has been asked by Angeles Ochoa, controller,
to prepare the companys response to a current Discussion Memorandum published by the Financial Ac-
counting Standards Board (FASB). Cruz knows that the FASB has issued seven Statements of Financial Ac-
counting Concepts, and she believes that these concept statements could be used to support the companys
response to the Discussion Memorandum. She has prepared a rough draft of the response citing Statement
of Financial Accounting Concepts No. 1, Objectives of Financial Reporting by Business Enterprises.
Instructions
(a) Identify the three objectives of financial reporting as presented in Statement of Financial Account-
ing Concepts No. 1 (SFAC No. 1).
(b) Describe the level of sophistication expected of the users of financial information by SFAC No. 1.
(CMA adapted)
C1-3 (Accounting Numbers and the Environment) Hardly a day goes by without an article appear-
ing on the crises affecting many of our financial institutions in the United States. It is estimated that the
savings and loan (S&L) debacle of the 1980s, for example, ended up costing $500 billion ($2,000 for every
man, woman, and child in the United States). Some argue that if the S&Ls had been required to report
their investments at market value instead of cost, large losses would have been reported earlier, which
would have signaled regulators to close those S&Ls and, therefore, minimize the losses to U.S. taxpayers.
Instructions
Explain how reported accounting numbers might affect an individuals perceptions and actions. Cite two
examples.
C1-4 (Need for Accounting Standards) Some argue that having various organizations establish ac-
counting principles is wasteful and inefficient. Rather than mandating accounting standards, each com-
pany could voluntarily disclose the type of information it considered important. In addition, if an investor
wants additional information, the investor could contact the company and pay to receive the additional
information desired.
Instructions
Comment on the appropriateness of this viewpoint.
C1-5 (AICPAs Role in Standards Setting) One of the major groups involved in the standards-setting
process is the American Institute of Certified Public Accountants. Initially it was the primary organiza-
tion that established accounting principles in the United States. Subsequently it relinquished most of its
power to the FASB.
Instructions
(a) Identify the two committees of the AICPA that established accounting principles prior to the es-
tablishment of the FASB.
(b) Speculate as to why these two organizations failed. In your answer, identify steps the FASB has
taken to avoid failure.
(c) What is the present role of the AICPA in the standards-setting environment?
C1-6 (FASB Role in Standards Setting) A press release announcing the appointment of the trustees
of the new Financial Accounting Foundation stated that the Financial Accounting Standards Board (to be
appointed by the trustees) . . . will become the established authority for setting accounting principles
under which corporations report to the shareholders and others (AICPA news release July 20, 1972).
Instructions
(a) Identify the sponsoring organization of the FASB and the process by which the FASB arrives at a
decision and issues an accounting standard.
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Conceptual Cases 21
(b) Indicate the major types of pronouncements issued by the FASB and the purposes of each of these
pronouncements.
C1-7 (Government Role in Standards Setting) Recently an article stated the setting of accounting
standards in the United States is now about 60 years old. It is a unique process in our society, one that
has undergone numerous changes over the years. The standards are established by a private sector en-
tity that has no dominant sponsor and is not part of any professional organization or trade association.
The governmental entity that provides oversight, on the other hand, is far more a friend than a competi-
tor or an antagonist.
Instructions
Identify the governmental entity that provides oversight and indicate its role in the standards-setting
process.
C1-8 (Politicization of Standards Setting) Some accountants have said that politicization in the de-
velopment and acceptance of generally accepted accounting principles (i.e., standards setting) is taking
place. Some use the term politicization in a narrow sense to mean the influence by governmental agen-
cies, particularly the Securities and Exchange Commission, on the development of generally accepted ac-
counting principles. Others use it more broadly to mean the compromise that results when the bodies re-
sponsible for developing generally accepted accounting principles are pressured by interest groups (SEC,
American Accounting Association, businesses through their various organizations, Institute of Manage-
ment Accountants, financial analysts, bankers, lawyers, and so on).
Instructions
(a) The Committee on Accounting Procedures of the AICPA was established in the mid- to late 1930s
and functioned until 1959, at which time the Accounting Principles Board came into existence. In
1973, the Financial Accounting Standards Board was formed and the APB went out of existence.
Do the reasons these groups were formed, their methods of operation while in existence, and the
reasons for the demise of the first two indicate an increasing politicization (as the term is used in
the broad sense) of accounting standards setting? Explain your answer by indicating how the
CAP, the APB, and the FASB operated or operate. Cite specific developments that tend to sup-
port your answer.
(b) What arguments can be raised to support the politicization of accounting standards setting?
(c) What arguments can be raised against the politicization of accounting standards setting?
(CMA adapted)
C1-9 (Models for Setting Accounting Standards) Presented below are three models for setting ac-
counting standards.
1. The purely political approach, where national legislative action decrees accounting standards.
2. The private, professional approach, where financial accounting standards are set and enforced by
private professional actions only.
3. The public/private mixed approach, where standards are basically set by private-sector bodies that
behave as though they were public agencies and whose standards to a great extent are enforced
through governmental agencies.
Instructions
(a) Which of these three models best describes standards setting in the United States? Comment on
your answer.
(b) Why do companies, financial analysts, labor unions, industry trade associations, and others take
such an active interest in standards setting?
(c) Cite an example of a group other than the FASB that attempts to establish accounting standards.
Speculate as to why another group might wish to set its own standards.
Instructions
Presented below is a list of common accounting acronyms. Identify the term for which each acronym
stands, and provide a brief definition of each term.
(a) AICPA (e) FAF (i) CPA (m) GASB
(b) CAP (f) FASAC (j) FASB
(c) ARB (g) SOP (k) SEC
(d) APB (h) GAAP (l) IASB
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C1-11 (Accounting Organizations and Documents Issued) Presented below are a number of ac-
counting organizations and type of documents they have issued.
Instructions
Match the appropriate document to the organization involved. Note that more than one document may
be issued by the same organization. If no document is provided for an organization, write in 0.
Organization Document
1. _____ Securities and Exchange Commission (a) Opinions
2. _____ Accounting Standards Executive Committee (b) Practice Bulletins
3. _____ Accounting Principles Board (c) Accounting Research Bulletins
4. _____ Committee on Accounting Procedure (d) Financial Reporting Releases
5. _____ Financial Accounting Standards Board (e) Financial Accounting Standards
(f) Statements of Position
(g) Technical Bulletins
Instructions
Match the description to the pronouncements.
1. _____ Technical Bulletin (a) Official pronouncements of the APB.
2. _____ Interpretations (of the Financial Account- (b) Sets forth fundamental objectives and
ing Standards Board) concepts that will be used in develop-
3. _____ Statement of Financial Accounting ing future standards.
Standards (c) Primary document of the FASB that es-
4. _____ EITF Statements tablishes GAAP.
5. _____ Opinions (d) Provides additional guidance on im-
6. _____ Statement of Financial Accounting plementing or applying FASB Stan-
Concepts dards or Interpretations.
(e) Provides guidance on how to account
for new and unusual financial transac-
tions that have the potential for creat-
ing diversity in financial reporting
practices.
(f) Represent extensions or modifications
of existing standards.
C1-13 (Issues Involving Standards Setting) When the FASB issues new standards, the implementa-
tion date is usually 12 months from date of issuance, with early implementation encouraged. Paula
Popovich, controller, discusses with her financial vice president the need for early implementation of a
standard that would result in a fairer presentation of the companys financial condition and earnings.
When the financial vice president determines that early implementation of the standard will adversely
affect the reported net income for the year, he discourages Popovich from implementing the standard un-
til it is required.
Instructions
Answer the following questions.
(a) What, if any, is the ethical issue involved in this case?
(b) Is the financial vice president acting improperly or immorally?
(c) What does Popovich have to gain by advocacy of early implementation?
(d) Which stakeholders might be affected by the decision against early implementation?
(CMA adapted)
C1-14 (Securities and Exchange Commission) The U.S. Securities and Exchange Commission (SEC)
was created in 1934 and consists of five commissioners and a large professional staff. The SEC pro-
fessional staff is organized into five divisions and several principal offices. The primary objective of the
SEC is to support fair securities markets. The SEC also strives to foster enlightened stockholder partici-
pation in corporate decisions of publicly traded companies. The SEC has a significant presence in finan-
cial markets, the development of accounting practices, and corporation-shareholder relations, and has the
power to exert influence on entities whose actions lie within the scope of its authority.
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Conceptual Cases 23
Instructions
(a) Explain from where the Securities and Exchange Commission receives its authority.
(b) Describe the official role of the Securities and Exchange Commission in the development of fi-
nancial accounting theory and practices.
(c) Discuss the interrelationship between the Securities and Exchange Commission and the Financial
Accounting Standards Board with respect to the development and establishment of financial ac-
counting theory and practices.
(CMA adapted)
C1-15 (Standards-Setting Process) In 1973, the responsibility for developing and issuing rules on ac-
counting practices was given to the Financial Accounting Foundation and, in particular, to an arm of the
foundation called the Financial Accounting Standards Board (FASB). The generally accepted accounting
principles established by the FASB are enunciated through a publication series entitled Statements of Fi-
nancial Accounting Standards. These statements are issued periodically, and over 140 are currently in force.
The statements have a significant influence on the way in which financial statements are prepared by U.S.
corporations.
Instructions
(a) Describe the process by which a topic is selected or identified as appropriate for study by the Fi-
nancial Accounting Standards Board (FASB).
(b) Once a topic is considered appropriate for consideration by the FASB, a series of steps is followed
before a Statement of Financial Accounting Standards is issued. Describe the major steps in the process
leading to the issuance of a standard.
(c) Identify at least three other organizations that influence the setting of generally accepted ac-
counting principles (GAAP).
(CMA adapted)
C1-16 (History of Standards-Setting Organizations) Beta Alpha Psi, your universitys accounting so-
ciety, has decided to publish a brief pamphlet for seniors in high school, detailing the various facets of
the accountancy profession. As a junior accounting major, you have been asked to contribute an article
for this publication. Your topic is the evolution of accounting standards-setting organizations in the United
States.
Instructions
Write a 12 page article on the historical development of the organizations responsible for giving us GAAP.
(The most appropriate introduction would explain the increasing need for a more standardized approach
to accounting for a companys assets.)
C1-17 (Economic Consequences) Presented below are comments made in the financial press.
Instructions
Prepare responses to the requirements in each item.
(a) Rep. John Dingell, the ranking Democrat on the House Commerce Committee, threw his support
behind the FASBs controversial derivatives accounting standard and encouraged the FASB to
adopt the rule promptly. Indicate why a member of Congress might feel obligated to comment
on this proposed FASB standard.
(b) In a strongly worded letter to Senator Lauch Faircloth (R-NC) and House Banking Committee
Chairman Jim Leach (R-IA), the American Institute of Certified Public Accountants (AICPA) cau-
tioned against government intervention in the accounting standards-setting process, warning that
it had the potential of jeopardizing U.S. capital markets. Explain how government intervention
could possibly affect capital markets adversely.
C1-18 (Standards-Setting Process, Economic Consequences) The following letter was sent to the SEC
and the FASB by leaders of the business community.
Dear Sirs:
The FASB has been struggling with accounting for derivatives and hedging for many years. The FASB
has now developed, over the last few weeks, a new approach that it proposes to adopt as a final stan-
dard. We understand that the Board intends to adopt this new approach as a final standard without
exposing it for public comment and debate, despite the evident complexity of the new approach, the
speed with which it has been developed and the significant changes to the exposure draft since it
was released more than one year ago. Instead, the Board plans to allow only a brief review by
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selected parties, limited to issues of operationality and clarity, and would exclude questions as to the
merits of the proposed approach.
As the FASB itself has said throughout this process, its mission does not permit it to consider matters
that go beyond accounting and reporting considerations. Accordingly, the FASB may not have ade-
quately considered the wide range of concerns that have been expressed about the derivatives and
hedging proposal, including concerns related to the potential impact on the capital markets, the weak-
ening of companies ability to manage risk, and the adverse control implications of implementing costly
and complex new rules imposed at the same time as other major initiatives, including the Year 2000 is-
sues and a single European currency. We believe that these crucial issues must be considered, if not by
the FASB, then by the Securities and Exchange Commission, other regulatory agencies, or Congress.
We believe it is essential that the FASB solicit all comments in order to identify and address all ma-
terial issues that may exist before issuing a final standard. We understand the desire to bring this
process to a prompt conclusion, but the underlying issues are so important to this nations businesses,
the customers they serve and the economy as a whole that expediency cannot be the dominant con-
sideration. As a result, we urge the FASB to expose its new proposal for public comment, following
the established due process procedures that are essential to acceptance of its standards, and provid-
ing sufficient time to affected parties to understand and assess the new approach.
We also urge the SEC to study the comments received in order to assess the impact that these pro-
posed rules may have on the capital markets, on companies risk management practices, and on man-
agement and financial controls. These vital public policy matters deserve consideration as part of the
Commissions oversight responsibilities.
We believe that these steps are essential if the FASB is to produce the best possible accounting stan-
dard while minimizing adverse economic effects and maintaining the competitiveness of U.S. busi-
nesses in the international marketplace.
Very truly yours,
(This letter was signed by the chairs of 22 of the largest U.S. companies.)
Instructions
Answer the following questions.
(a) Explain the due process procedures followed by the FASB in developing a financial reporting
standard.
(b) What is meant by the term economic consequences in accounting standards setting?
(c) What economic consequences arguments are used in this letter?
(d) What do you believe is the main point of the letter?
(e) Why do you believe a copy of this letter was sent by the business community to influential mem-
bers of the United States Congress?
Kate recalls that during her accounting education there was a chapter or two regarding the environ-
ment of financial accounting and the development of accounting standards. However, she remembers that
little emphasis was placed on these chapters by her instructor.
Instructions
(a) Help Kate by identifying key organizations involved in accounting standards setting.
(b) Kate asks for guidance regarding authoritative support. Please assist her by explaining what is meant
by authoritative support.
(c) Give Kate a historical overview of how standards setting has evolved so that she will not feel that she
is the only one to be confused.
(d) What authority for compliance with GAAP has existed throughout the period of standards setting?
Instructions
(a) What is the International Accounting Standards Board, and what is its relation to the International
Accounting Standards Committee?
(b) What stakeholders might benefit from the use of International Accounting Standards?
(c) What do you believe are some of the major obstacles to harmonization?
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PROFESSIONAL SIMULATION
Directions
In this simulation, you will be asked various questions regarding accounting principles.
Prepare responses to all parts.
Situation
At the completion of Bloom Company's audit, the president, Judy Bloom, asks about the meaning of
the phrase in conformity with generally accepted accounting principles that appears in your audit
report on the management's financial statements. Judy observes that the meaning of the phrase must
include something more and different than what she thinks of as principles.
Explanation
(a) Explain the meaning of the term accounting principles as used in the audit report.
(Do not discuss in this part the significance of generally accepted.)
(b) President Bloom wants to know how you determine whether or not an accounting principle is
generally accepted. Discuss the sources of evidence for determining whether an accounting
principle has substantial authoritative support. Do not merely list the titles of publications.
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