1-1

FINANCIAL REPORTING AND ACCOUNTING STANDARDS

Financial Reporting

Before you start to study any subject or activity, it pays to ask the question why should we do this or what is the objective of this activity.

So, we start with this question, What are the objectives of financial reporting?

Financial reporting provides information that is useful in making investment and credit decisions, and assessing future cash flow prospects.

Who are the users of financial accounting information? How do they use accounting information?

The list of users of financial accounting information includes the following: Investors or potential investors who may want to decide whether they should invest in a

particular business enterprise. Suppose you have some money and are deciding which of two or three companies to invest in. You would want to know the financial condition and past earnings history of the companies (so that you can have some idea about these future prospects).

Creditors and suppliers who must to determine whether they can offer a loan or supply goods on credit to a potential customer. For example, a bank loan officer needs to know whether a credit applicant will be able to make periodic interest payments and repay the loan on time. A supplier needs to be sure that the potential credit buyer has enough resources to pay for the purchase later.

Employees who may want to know which company they should work for. For example, if an employee ahas an offer from two different companies, he or she would not want to go to work for one that is not in good financial condition. Starting to work for a company and then finding out that it has to close because of financial difficulties –which in turn means the employee could be out of a job soon after starting to work there –is not a good idea.

Other users of financial accounting information include: management, consumers, financial analysts and advisors, stock exchanges, and regulatory authorities.

Accounting Standards

Accounting is the language of business. Languages have rules about grammar so that people can to talk to, and understand each other. Accounting standards, which are the grammatical rules of accounting, enable companies and other entities to correspond with potential users of accounting information and for the users to understand the message sent. Accounting standards aid users by making it easier the comparison of the financial statements of different enterprises easier. They also serve to minimize bias, ambiguity, and misinterpretation of

1-2

information.

SEC & Accounting Standard Setting

The Securities and Exchange Commission (SEC) was established by law in 1934. Under the Exchange Act of 1934, public companies are required to file audited financial statements with the SEC. Congress gave the SEC the authority to prescribe accounting and reporting standards. However, the SEC delegated the responsibility of setting accounting standards to the private sector. These standards are referred to as generally accepted accounting principles (GAAP).

From 1939 to 1959, the Committee on Accounting Procedure (CAP) issued accounting standards, and the pronouncements of the CAP are known as accounting research bulletins.

From 1959 to 1973, another private sector body, the Accounting Principles Board (APB), set the accounting standards; the pronouncements of the APB are known as APB opinions.

In 1973, the APB was replaced by another private sector body, the Financial Accounting Standards Board (FASB). The FASB currently sets accounting standards; its pronouncements are known as statements of financial accounting standards. Note that only the responsibility has been delegated; the SEC retains the power to overrule the private sector body and set the necessary standards. With rare exceptions, the SEC has not done so but has allowed the private sector to set the necessary accounting standards.

The SEC has the power to require public companies to follow accounting standards. It requires all public companies to file quarterly financial statements with it (the relevant form for quarterly statements is called the 10-Q), and to also file audited annual financial statements (the relevant form for annual statements is called the 10-K). When the SEC takes action against a company or auditors, it issues a statement called financial reporting release.

FASB and GAAP

As noted, the FASB is a private sector organization currently responsible for setting accounting standards. It is an independent body and has seven full-time members. Its members are appointed by another private sector body, the Financial Accounting Foundation (FAF).

The FASB has issued six statements of financial accounting concepts (SFAC). These statements provide a logical framework for developing standards for specific issues.

The FASB follows standard procedures before issuing a standard. First, it issues a discussion memorandum (DM), which identifies the issues related to the topic under consideration. The DM discusses various points of view but does not include conclusions. Readers are invited to comment on the DM.

1-3

After reviewing the comments on the DM from practitioners and other interested individuals or groups, the FASB meets to discuss the various issues, and then issues an exposure draft of the new standard. The public is invited to comment on the exposure draft.

After considering the reaction to the exposure draft, the FASB then issues the final standard, known as a statement of financial accounting standard (SFAS) as mentioned earlier. This requires the approval of at least five of the seven members of the FASB. If questions arise about the implementation of a particular standard, the FASB may also issue an interpretation of a statement of financial accounting standard.

As can be expected, this process of issuing a new SFAS can be slow. Sometimes, more timely guidance is necessary for some questions. In 1984 the FASB established the Emerging Issues Task Force (EITF). The EITF identifies issues related to diversity of practices and develops a consensus as quickly as possible. The consensus view then becomes the accepted accounting treatment for the issue. Another source of GAAP is the American Institute of Certified Public Accountants (AICPA). The AICPA issues audit and accounting guides for specific industries, statements of position (SOP) on specific issues, and practice bulletins.

Thus, there are a number of sources of GAAP. However, there is a hierarchy of four levels as shown here, with descending level of authority. Level 1 is the most authoritative; level 4 is the least authoritative. If there is a difference of opinion on a certain issue based on different sources of GAAP in different levels, then the opinion based on the highest level of GAAP should be used.

Level 1 FASB statements, APB opinions, and CAP research bulletinsLevel 2 FASB technical bulletins, AICPA industry guides, and AICPA SOPsLevel 3 EITF consensus positions, AICPA practice bulletinsLevel 4 AICPA interpretations, answers by FASB staff, industry practices

Review Questions —1

1. ______ is the private sector organization currently responsible for setting accounting standards.

2. ______ is the organization that was given the legal authority by Congress to set accounting standards.

3. Before issuing a new SFAS, the FASB issues a(n) _______, which describes the issues related to the topic under consideration.

4. The _____ identifies issues about diversity of practices that can arise and develops a consensus as quickly as possible.

5. APB opinions are considered to be in level _____ in the hierarchy of GAAP.

1-4

6. AICPA industry guides are considered to be in level _____ in the hierarchy of GAAP.

ANSWERS:1. FASB. 2. SEC 3. discussion memorandum4. EITF 5. 1 6. 2

Conceptual Framework of Accounting

The conceptual framework is a theoretical foundation that guides the development of specific accounting standards. As noted earlier, the FASB has issued six SFAC. These statements address four major questions:1. What are the objectives of financial reporting?2. What are the qualities that make accounting information useful?3. What are the basic elements of financial statements?4. What are the assumptions and principles that should be used in the recognition, measurement, and reporting of accounting information?

OBJECTIVES OF FINANCIAL REPORTING

The FASB requires financial reporting to have the following objectives:

1. Usefulness: The overall objective of financial reporting is to provide information that is useful to present and potential investors and creditors and other users in making rational investment, credit, and similar decisions.

2. Assistance in future cash flows: Financial reporting must provide information that helps present and potential investors and creditors and other users to assess the amount, timing, and uncertainty of future cash flows.

3. Information about economic resources: Financial reporting must provide information about the economic resources of an enterprise, the claims on those resources, and the effects of transactions, events, and circumstances that change its resources and claims to those resources.

PRIMARY QUALITATIVE CHARACTERISTICS

The qualitative characteristics of accounting information include the following categories: primary characteristics, secondary characteristics, and overall constraints. Relevance and reliability are the two primary decision-specific qualities. Relevance means “capable of making a difference in a decision.” To be relevant, information must have predictive value or feedback value and be timely.

Predictive value means the worth of its ability to predict the future. For example, quarterly earnings data can be helpful in predicting annual earnings.

Feedback value means the worth of something to help confirm or correct earlier

1-5

beliefs. For example, when a company provides data about sales revenues in comparative income statements to confirm or correct beliefs about the company, a user can use this data to compare the current year’s revenue with that of the prior year.

Timely means that the information is available at a time when it can make a

difference.

Reliability means that the information is reasonably free from error and faithfully represents the underlying economic event. To be reliable, information must have verifiability, representational faithfulness, and neutrality.

Verifiability means that different people must be able to arrive at the same conclusion when using similar measurement methods. Thus, verifiability refers to consensus.

Representational faithfulness means that the information represents what it claims to represent. For example, if inventory is reported to be $90,000 when it actually is only $70,000, the reported amount is not a faithful representation.

Neutrality means that information presented should not be biased to favor one group of users over other users. For example, a company should not deliberately underreport earnings just because it is involved in contract negotiations with its employees’ union.

SECONDARY QUALITATIVE CHARACTEREISTICS

Comparability, Consistency, and Constraints

Comparability and Consistency are the two secondary qualitative characteristics of accounting information.

Comparability means that information must be measured and reported in a similar manner across different companies. This enables users to compare different sets of data and identify differences and similarities among different entities.

Consistency means that the same accounting principles and methods must be used to determine the same events over time. This enables users to identify trends and changes in trends.

The difference between comparability and consistency is that comparability refers to comparisons between different companies at the same point in time and consistency refers to comparisons between different time periods for the same company.

1-6

CONSTRAINTS

There are two constraints with respect to the preparation of financial reports: cost/benefit criterion and materiality.

The cost/benefit criterion means that the benefits from providing the information must be greater than the cost of providing the information. Information is not free. Collecting information to be reported in financial statements has costs.

Materiality refers to the concept of whether the amount in question is large enough to make a difference. A material amount is generally considered to be an amount that would influence a person’s decision. For example, in theory, a wastebasket is a long-term asset and must be depreciated over its useful life. However, because the cost is very low, it is usually expensed immediately because the difference is immaterial. Note that materiality is relative. What may be immaterial amount to a large company may be highly material for a small start-up company.

Elements of Financial Statements

SFAC No. 6 identifies 10 basic financial statement elements. They are discussed here.

1. Assets: Probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.

2. Liabilities: Probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events. Thus, liabilities are debts or obligations owed to creditors.

3. Equity: The residual interest in the assets that remains after deducting liabilities (that is, Assets – Liabilities). This is the ownership interest.

Note that items 1 through 3 constitute the balance sheet.

4. Investment by owners: An increase in the equity of a business. Investments by owners may be in the form of cash or other goods and services.

5. Distribution to owners: A decrease in the equity of a business. For example, dividends represent distributions to owners

6. Comprehensive income: The change in equity (net assets) of an entity during a period from transactions and other events and circumstances from nonowner sources. This includes all changes in equity during a period except those resulting from investments by owners and distributions to owners.

Note that items 4 through 6 constitute the statement of changes in owners’ equity.

7. Revenues: Inflows or other enhancements of assets of an entity or settlements of its liabilities

1-7

(or a combination of both) during a period from delivering or producing goods, rendering services, or performing other activities that constitute the entity’s ongoing major or central operations.

8. Expenses: Outflows or other forms of using up of assets or incurrences of liabilities (or a combination of both) during a period from delivering or producing goods, rendering services, or performing other activities that constitute the entity’s ongoing major or central operations.

9. Gains: Increases in equity (net assets) from peripheral or incidental transactions

10. Losses: Decreases in equity (net assets) from peripheral or incidental transactions.

Note that items 7 through 10 constitute the income statement.

ASSUMPTIONS AND PRINCIPLES OF FINANCIAL REPORTING

Assumptions used in financial reporting include the following:

1. Economic entity assumption: The business and its owner(s) are different entities. Hence, transactions of the business entity are kept separate from those of its owner(s). For example, if you own a company and you buy something for your personal use, it cannot be treated as an expense of the company.

2. Going concern (continuity) assumption: Unless there is evidence to the contrary, a firm is assumed to continue to operate indefinitely. For example, assume that you have some letterheads, envelopes, and other promotional material with your company’s name printed on them. If the company were to liquidate, these items would have very little value. However, because of the going concern assumption, you carry these items as supplies on your balance sheet.

3. Monetary unit assumption: The changes in the dollar’s purchasing power due to inflation are ignored. For example, assume that you bought some inventory for $500 last year. On this year’s balance sheet, the inventory is still valued at $500 even though a dollar last year purchased more than a dollar this year.

4. Periodicity (time period) assumption: The activities of a firm can be divided into different time periods. The reason for this is that users need timely information. This is the reason companies prepare annual financial statements (and public companies file quarterly statements with the SEC).

Principles used in financial reporting include the following:

1. Historical cost: Assets and liabilities are initially recorded at their original or historical cost and are not adjusted for subsequent changes in market value. This is the most commonly used valuation method in accounting because it is reliable and verifiable. For example, assume that 10 years ago land was bought for $400,000 and that the market value of the land is now $700,000.

1-8

On the balance sheet, land is still be shown at $400,000 because of the historical cost principle.

2. Revenue recognition: The determination of the timing of recognizing revenue (determines when revenue should be recorded). Under this principle, revenue can be recognized when it: (a) is realized or realizable and (b) has been earned (the earning process is complete or essentially complete).For example, customers may pay a company in advance for services to be rendered in the future. The company does not record the payments as revenues until services have been rendered to the customer because of the revenue recognition principle.

3. Matching: Expenses incurred in earning revenues are reported in the period in which those revenues are recognized. For example, bad debt expenses are recorded even if customers have not actually defaulted because all expenses related to revenues recognized in the current period must be matched with the revenues.

4. Full disclosure: Disclosure of any information that can influence the judgment of an informed user of financial statements must be made. For example, financial statements include detailed footnotes and supplementary information about various issues, such as pension plans, leases, income taxes, and contingencies.

5. Conservatism: The choice as to which alternative should be made should be the one that is least likely to overstate net income or assets. For example, if the market value of inventory is less than the historical cost, then the inventory is written down to market value.

Review Questions —2

1. _______ means capable of making a difference in a decision.

2. _______ means the information that is reasonably free from error and faithfully represents the underlying economic event.

3. _______ enables users to compare different sets of data at a given point in time.

4. _______ refers to the use of the same accounting principles and methods for the same events over time.

5. Under the ______ assumption, the transactions of the owner and the business are kept separate.

6. Under the ______ assumption, it is assumed that a firm will continue to operate indefinitely unless there is evidence to the contrary.

Answers:1. Relevance 2. Reliable 3. Comparability4. Consistency 5. economic entity 6. going concern

1-9

Glossary

Comparability refers to the concept that information should be measured and reported in a similar manner across different companies.

Conservatism is the principle that requires choosing the alternative that is least likely to overstate net income or assets.

Consistency is the principle that the same accounting principles and methods must be used for the same events over time.

Discussion memorandum (DM) is the initial document distributed by the FASB when dealing with a topic; it identifies the issues related to the topic under consideration without taking a position.

Economic entity is the assumption that the transactions of the business entity are kept separate from those of its owner(s).

EITF (Emerging Issues Task Force) identifies issues related to diversity of practices and develops a consensus as quickly as possible.

FASB (Financial Accounting Standards Board) is the private sector organization currently responsible for setting accounting standards.

Full disclosure is the principle requiring the disclosure of any information that can influence the judgment of an informed user of financial statements.

Going concern is the assumption that unless there is evidence to the contrary, a firm is assumed to continue to operate indefinitely.

Historical cost is the principle that assets and liabilities are initially recorded at their original or historical cost.

Matching is the principle that expenses incurred in earning revenues are reported in the period in which those revenues are earned.

Materiality is the concept of whether an amount in question is large enough to make a difference in influencing a person’s decision.

Monetary unit is the assumption that the changes in the dollar’s purchasing power due to inflation are ignored.

Periodicity is the assumption that the activities of a firm can be divided into different time periods.

Reliability means that the information is reasonably free from error and faithfully represents the underlying economic event.

1-10

Relevance means being capable of making a difference in a decision. To be relevant, information must (a) have predictive or feedback value and (b) be timely.

Revenue recognition is the principle used to answer questions related to the timing of recognizing revenue.

SEC (Securities and Exchange Commission) was given the legal authority by Congress to set accounting standards.

SFAS (statement of financial accounting standards) are issued by the FASB and constitute GAAP.

1-11

Practice Problem 1

1. The current source of GAAP is thea. FASB.b. SEC.c. APB.d. CAP.

2. The normal order of documents used by the FASB before it issues a new standard is a. exposure draft, discussion memorandum, statement.b. discussion memorandum, exposure draft, statement.c. discussion memorandum, statement, exposure draft.d. exposure draft, statement, discussion memorandum.

3. Information capable of making a difference is calleda. verifiable.b. relevant.c. reliable.d. understandable.

4. Which of the following is a feature of reliability?a. feedback value.b. predictive value.c. neutrality.d. materiality.

5. When a company uses the same accounting policies over different periods, then there isa. comparability.b. neutrality.c. verifiability.d. consistency.

6. The assumption that leads to the preparation of annual financial statementsa. economic entity.b. monetary unit.c. periodicity.d. going concern.

7. The accountant of a large company decided that supplies purchased for $100 should be expensed rather than carried as an asset on the balance sheet and then expensed when used. This is an example of applyinga. materiality.b. consistency.c. periodicity.

1-12

d. comparability.

8. Representational faithfulness is an ingredient ofa. neither relelance nor reliability.b. both relevance and reliability.c. relevance but not reliability.d. reliability but not relevance.

9. Recording bad debt expense each period is an example of a. revenue recognition.b. matching.c. full disclosure.d. historical cost.

10. The top level in the determination of GAAP isa. industry practice.b. answer by FASB staff.c. FASB statement.d. EITF consensus position.

1-13

Homework Problem 1

1. Congress gave the authority to set accounting standards toa. FASB.b. AICPA.c. APB.d. SEC.

2. The FASB issues all of the following excepta. statements of financial accounting standards.b. financial reporting release.c. statement of financial accounting concepts.d. interpretations of statement of financial accounting standards.

3. To be relevant, accounting information musta. have both predictive value and feedback value.b. be timely.c. have either predictive value or feedback value and be timely.d. have both predictive value and feedback value and be timely.

4. Which of the following is not a feature of reliability?a. feedback value.b. representational faithfulness.c. neutrality.d. verifiability.

5. When different companies use the same accounting policies and methods, then there isa. consistency.b. comparability.c. neutrality.d. representational faithfulness.

6. The assumption that leads to separating the transactions of the owner from those of the business isa. economic entity.b. monetary unit.c. periodicity.d. going concern.

7. Inventories on the balance sheet are valued on the basis of the lower of the historical cost or market value. This is an example ofa. materiality.b. consistency.

1-14

c. conservatism.d. reliability.

8. The two secondary qualitative characteristics of accounting information area. materiality and conservatism.b. comparability and conservatism.c. consistency and conservatism.d. comparability and consistency.

9. Details about pension plans are given in footnotes to the financial statements. This is an example ofa. consistency.b. matching.c. full disclosure.d. reliability.

10. The second level of GAAP includes all of the following excepta. FASB technical bulletins.b. APB opinions.c. AICPA industry guides.d. AICPA statements of position.

1-15

Homework Problem 2

1. Members of the FASB are appointed by thea. Securities and Exchange Commission.b. Congress.c. Financial Accounting Foundation.d. American Institute of Certified Public Accountants.

2. Public companies file their Form 10-K with thea. FASB.b. SEC.c. GASB.d. AICPA.

3. Timeliness is a feature ofa. relevanceb. reliabilityc. verifiabilityd. neutrality

4. When a certain piece of information represents what it claims to represent, then it has a. materiality.b. representational faithfulness.c. feedback value.d. neutrality.

5. To be useful for decision making, information must havea. either comparability or consistency.b. comparability but not consistency.c. consistency but not comparability.d. both comparability and consistency.

6. The assumption that leads to valuing inventory at values other than liquidation value isa. economic entity.b. monetary unit.c. periodicity.d. going concern.

7. Historical cost accounting is preferred over other valuation methods because of itsa. reliability.b. timeliness.c. conservatism.d. consistency.

8. Feedback value is an ingredient ofa. neither relevance nor reliability.

1-16

b. both relevance and reliability.c. relevance but not reliability.d. reliability but not relevance.

9. Recognizing and accruing loss contingencies but not gain contingencies is an example ofa. revenue recognition.b. matching.c. conservatism.d. historical cost.

10. The lowest level of GAAP includes all of the following excepta. AICPA interpretations.b. FASB technical bulletins.c. answers by FASB staff. d. industry practices.