CHAPTER 1

Financial Accounting and Accounting Standards

4 Sections in this document: A. B. C. D. Learning Objectives Chapter Review Lecture Outline Illustrations (attached below)

Note: the exhibits at the bottom of this document are only viewable in the pdf version of this file.

A. LEARNING OBJECTIVES LEARNING OBJECTIVES

1. 2. 3. 4. 5. 6. 7. 8. 9.
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Identify the major financial statements and other means of financial reporting. Explain how accounting assists in the efficient use of scarce resources. Describe some of the challenges facing accounting. List the objectives of financial reporting. Explain the need for accounting standards. Identify the major policy-setting bodies and their role in the standard-setting process. Explain the meaning of generally accepted accounting principles. Describe the impact of user groups on the standard-setting process. Understand issues related to ethics and financial accounting.

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B. CHAPTER REVIEW
1. Chapter 1 describes the environment that has influenced both the development and use of the financial accounting process. The chapter traces the development of financial accounting standards, focusing on the groups that have had or currently have the responsibility for developing such standards. Certain groups other than those with direct responsibility for developing financial accounting standards have significantly influenced the standard-setting process. These various pressure groups are also discussed in Chapter 1. Nature of Financial Accounting
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2. (S.O. 1) Financial accounting is the process that culminates in the preparation of financial reports on the enterprise for use by both internal and external parties. 3. Financial statements are the principal means through which a company communicates its financial information to those outside it. The financial statements most frequently provided are (1) the balance sheet, (2) the income statement, (3) the statement of cash flows, and (4) the statement of owners or stockholders equity. Other means of financial reporting include the presidents letter or supplementary schedules in the corporate annual report, prospectuses, and reports filed with government agencies. 4. (S.O. 2) Accounting is important for markets, free enterprise, and competition because it assists in providing information that leads to capital allocation. The better the information, the more effective the process of capital allocation and then the healthier the economy. 5. (S.O. 3) The challenges facing financial accounting are the following: a. Non-financial measurements such as customer satisfaction indexes, backlog information, and reject rates on goods purchased. b. Forward-looking information. c. Soft assets. d. Timeliness. 6. (S.O. 4) The objectives of financial accounting are to provide information that: a. is useful to present and potential investors and creditors and other users in making rational investment, credit, and similar decisions; b. 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; and c. clearly portrays the economic resources of an enterprise, the claims to those resources, and the effects of transactions, events, and circumstances that change its resources and claims to those resources.
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7. (S.O. 5) The accounting profession has developed a common set of standards and procedures known as generally accepted accounting principles (GAAP). These principles serve as a general guide to the accounting practitioner in accumulating and reporting the financial information of a business enterprise. Securities and Exchange Commission (SEC) 8. (S.O. 6) After the stock market crash in 1929 and the Great Depression, there were calls for increased government regulation and supervisionespecially of financial institutions and the stock market. As a result, the federal government established the Securities and Exchange Commission (SEC). The SEC is a federal agency and administers the Securities Exchange Act of 1934 and several other acts. Most companies that issue securities to the public or are listed on a stock exchange are required to file audited financial statements with the SEC. In addition, the SEC has broad powers to prescribe the accounting practices and standards to be employed by companies that fall within its jurisdiction. 9. At the time the SEC was created, it encouraged the creation of a private standards-setting body. As a result, accounting standards have generally been developed in the private sector either through the American Institute of Certified Public Accountants (AICPA) or the Financial Accounting Standards Board (FASB). The SEC has affirmed its support for the FASB by indicating that financial statements conforming to standards set by the FASB will be presumed to have substantial authoritative support. 10. Over its history, the SECs involvement in the development of accounting 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 setting standards. 11. If the SEC believes that an accounting or disclosure irregularity exists regarding a companys financial statements, the SEC sends a deficiency letter to the company. If the companys response to the deficiency letter proves unsatisfactory, the SEC has the power to issue a stop order, which prevents the registrant from issuing securities or trading securities on the exchanges. Criminal charges may also be brought by the Department of Justice.
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The AICPA and Development of Accounting Principles 12. The first group appointed by the AICPA to address the issue of uniformity in accounting practice was the Committee on Accounting Procedure (CAP). This group served the accounting profession from 1939 to 1959. During that period it issued 51 Accounting Research Bulletins (ARBs) that narrowed the wide range of alternative accounting practices then in existence. 13. In 1959, the AICPA created the Accounting Principles Board (APB). The major purposes of this group were (a) to advance the written expression of accounting principles, (b) to determine appropriate practices, and (c) to narrow the areas of difference and inconsistency in practice. The APB was designated as the AICPAs sole authority for public pronouncements on accounting principles. Its pronouncements, known as APB Opinions, were intended to be based mainly on research studies and be supported by reasons and analysis.
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The FASB 14. The APB operated in a somewhat hostile environment for 13 years. Early in its existence it was criticized for overreacting to certain issues. A committee, known as the Study Group on Establishment of Accounting Principles (Wheat Committee), was set up to study the APB and recommend changes in its structure and operation. The result of the Study Groups findings was the demise of the APB and the creation of the Financial Accounting Standards Board (FASB). The FASB represents the current rule-making body within the accounting profession. 15. The mission of the FASB is to establish and improve standards of financial accounting and reporting for the guidance and education of the public, which includes issuers, auditors, and users of financial information. The FASB differs from the predecessor APB in the following ways: a. Smaller membership (7 versus 18 on the APB). \ b. Full-time remunerated membership (APB members were unpaid and part-time). c. Greater autonomy (APB was a senior committee of the AICPA). d. Increased independence (FASB members must sever all ties with firms, companies, or institutions). e. Broader representation (it is not necessary to be a CPA to be a member of the FASB). Two basic premises of the FASB are that in establishing financial accounting standards: (a) it should be responsive to the needs and viewpoints of the entire economic community, not just the public accounting profession, and (b) it should operate in full view of the public through a due process system that gives interested persons ample opportunity to make their views known. 16. The FASB issues three major types of pronouncements: a. Standards, Interpretations, and Staff Positions. b. Financial Accounting Concepts. c. Emerging Issues Task Force Statements. The Standards, Interpretations, and Staff Positions are considered GAAP and must be followed in practice in the same manner as APB Opinions. The Statements of Financial Accounting Concepts (SFAC) represent an attempt to move away from the problem-by-problem approach to standard setting that has been characteristic of the accounting profession. The Concept Statements are intended to form a cohesive set of interrelated concepts, a conceptual framework, that will serve as tools for solving existing and emerging problems in a consistent manner. Unlike FASB statements, the Concept Statements do not establish GAAP.
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17. In 1984, the FASB created the Emerging Issues Task Force (EITF). The purpose of the Task Force is to reach a consensus on how to account for new and unusual financial transactions that have the potential for creating differing financial reporting practices. The EITF can deal with short-term accounting issues by reaching a consensus and thus avoiding the need for deliberation by the FASB and the issuance of an FASB Statement. 18. The Governmental Accounting Standards Board (GASB) was created in 1984 to address state and local governmental reporting issues. The operational structure of the GASB is similar to that of the FASB. 19. When the FASB was established, the AICPA established the Accounting Standards Division to act as its official voice on accounting and reporting issues. Within the Division the Accounting Standards Executive Committee (AcSEC) was established and spoke through its written communications called Audit and Accounting Guidelines, Statements of Position (SOP) and Practice Bulletins. Recently the role of the AICPA has diminished. After a transition period the AICPA and AcSEC no longer will issue authoritative accounting guidance for public companies. In addition the Sarbanes-Oxley Act of 2002 requires the Public Company Accounting Oversight Board (PCAOB) to oversee the development of auditing standards. 20. (S.O. 7) Generally accepted accounting principles (GAAP) are those principles that have substantial authoritative support. Accounting principles that have substantial authoritative support are those found in FASB Statements, Interpretations, and Staff Positions; APB Opinions; and Accounting Research Bulletins (ARBs). If an accounting transaction is not covered in any of these documents, the accountant may look to other authoritative accounting literature for guidance. 21. (S.O. 8) Although accounting standards are developed by using careful logic and empirical findings, a certain amount of pressure and influence is brought to bear by groups interested in or affected by accounting standards. The FASB does not exist in a vacuum, and politics and special-interest pressures remain a part of the standard-setting process. 22. In 2002, along with establishing the PCAOB, the Sarbanes-Oxley Act implements stronger independence rules for auditors, requires CEOs and CFOs to personally certify that financial statements and disclosures are accurate and complete, requires audit committees to be comprised of independent members, and requires a code of ethics for senior financial officers. In addition, the Sarbanes-Oxley Act requires public companies to attest to the effectiveness of their internal controls over financial reporting. 23. Most countries have recognized the need for more global standards. The International Accounting Standards Board (IASB) and U.S. rule-making bodies are working together to reconcile U.S. GAAP with the IASB Standards. 24. (S.O. 9) In accounting ethical dilemmas are encountered frequently. The whole process of ethical sensitivity and selection among alternatives can be complicated by pressures that may take the form of time pressures, job pressures, client pressures, personal pressures, and peer pressures. Throughout the textbook, ethical considerations are presented to sensitize you to the type of situations you may encounter in your profession.
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C. LECTURE OUTLINE
The material in this chapter usually can be covered in one class session. The issues in this chapter can be addressed by organizing a lecture around the following questions. A. (L.O. 1) What is accounting? 1. Identification, measurement, and communication of financial information (discuss difference between financial statements and financial reporting).
TEACHING TIP

Illustration 1-1 can be used to identify the essential characteristics of accounting and financial reporting. a. Financial statements: (1) Income statement. (2) Balance sheet. (3) Statement of cash flows. (4) Statement of changes in owners or stockholders equity. b. Financial reporting: (1) Presidents letter or supplementary schedules in the annual report. (2) Prospectuses. (3) Reports filed with the SEC and other government agencies. (4) News releases and management forecasts.
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About economic entities (discuss types of entities, corporations, partnerships, and proprietorships). To interested parties (discuss stockholders, creditors, government agencies, management, employees, consumers, labor unions, etc.).

3.

B. (L.O. 2) What is the environment in which accounting operates? 1. A world of scarce resources. Accounting helps to identify efficient and inefficient users of resources. Capital allocation. Accounting assists in the effective capital allocation process by providing financial reports to interested users.
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Changing user needs. Accounting will continue to be faced with challenges to providing information needed for an efficient capital allocation process.

C. (L.O. 3) What are the challenges facing financial accounting?

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Use Illustration 1-2 to facilitate the discussion of the problems facing financial accounting. (1) Non-financial measurements. (2) Forward-looking information. (3) Soft assets. (4) Timeliness. D. (L.O. 4) What are the objectives of accounting? Objectives of financial reporting identified in SFAC No. 1, are to provide: 1. Information that is useful to present and potential investors and creditors and other users in making rational investment, credit, and similar decisions. (Note the FASBs emphasis on investors and creditors as primary users. However, this does not exclude other interested parties.) Information to help present and potential investors and creditors and other users in assessing 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. (Emphasize the difference between the cash basis and the accrual basis of accounting. Accountants believe that the accrual basis is more useful for predicting future cash flows.) 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. (Discuss how each of the four primary financial statements is used to meet this objective. What other possible financial statements that are not presently provided might also be useful in meeting this objective?)

2.

3.

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2. (L.O. 5) Why are standards needed? 1. 2. Need for comparability among the financial statements of different enterprises. Need to minimize bias, ambiguity, inexactness, and misinterpretation.

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3. (L.O. 6) Who has authority to set standards? a. Standard setting in the public sector: a. Discuss the role of the SEC, reasons for its establishment, SEC Financial Reporting Releases.

(1) Delegation of SECs authority to the private sector (AICPA and FASB). b. Standard setting in the private sector. (a) History of private-sector setting from the CAP to the APB to the FASB. (b) Reasons for establishment of the FASB. (c) Composition, membership, and voting rules of the FASB. (d) Organization and funding of the FASB.
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Describe the organization structure of FASB using Illustration 1-4. (e) Description of the FASBs due process system in setting standards.
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Illustration 1-5 can be used to discuss the steps taken in the development of a typical FASB Statement of Financial Accounting Standard. (f) Emerging Issues Task ForceCreated by FASB for the purpose of reaching a consensus on how to account for new and unusual financial transactions that have a potential for creating diversity in financial reporting practices.

c.

SEC continues to play an active role in influencing standards, e.g., accounting for business combinations and intangible assets; and concerns about off-balance sheet items raised by the failure of EARN.

4. How are standards enforced? 1. SECs requirements for filing. Companies that issue securities must file registration statements and periodic reports with the SEC. AICPA code of ethics. Rule 203 requires that AICPA members prepare financial statements in accordance with GAAP.

2.
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Stock exchange requirements. Companies that are listed on stock exchanges must file annual audited financial statements with the SEC. Requirements of bankers for loans. Many bankers require audited financial statements for the past 15 years before consideration of a loan application.

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5. (L.O. 7) What is meant by GAAP? Those principles that have substantive authoritative support: 1. Principles established by an authoritative rule-making body.
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Describe the House of GAAP as shown in Illustration 1-3, emphasizing the various levels of authoritative support. a. Category (A)FASB Standards and Interpretations, APB Opinions, CAP Accounting Research Bulletins. (Most authoritative.) Category (B)AICPA Accounting and Audit Guides, AICPA Statements of Position, FASB Technical Bulletins. Category (C)FASB Emerging Issues Task Force, AICPA AcSEC Practice Bulletins. (1) Mention that, after a transition period, the AICPA will no longer issue authoritative accounting guidance for public companies. d. Category (D)AICPA Issues Papers, FASB Concepts Statements, other authoritative pronouncements. (Least authoritative.)

b.

c.

2. General acceptance over time of accounting practices that have received widespread application. Examples include: a. b.
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Use of gross profit method for estimating inventory. Dollar-value LIFO inventory method.

6. (L.O. 8) Why are pressure groups interested in accounting?

TEACHING TIP

Illustration 1-6 can be used to discuss the major groups that are influential in the standard setting process. 1. 2. Describe pressure groups, their composition and their interests. Discuss impact of accounting on the interests of each group.
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Discuss impact of economic consequences. Although accounting standards should be based on sound concepts, the FASB must be attentive to the economic consequences of its pronouncements.

7. What is the role of political considerations in accounting? 1. 2. Discuss lobbying before the FASB by interested parties. Discuss the role of Congress in standard settingthe Moss, Metcalf, and Dingell Committees.

8. What has been the response of the accounting profession to government concerns about standard setting? The profession desires self-regulation, not government regulation. b. c. d. The AICPA established the Accounting Firms Division. The AICPA established the Public Oversight Board. FASB actionsopen meetings, change in voting requirements for FASB pronouncements, less CPA representation on FASB, etc.

9. What is the expectations gap? 1. 2. What people think accountants should be doing vs. what accountants think they can do. Discuss the Sarbanes-Oxley Act.
TEACHING TIP

Illustration 1-7 can be used to discuss how the Sarbanes-Oxley Act has changed the accounting profession.
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10. How does the diversity of accounting practices found in countries throughout the world affect standard setting in the U.S.? 1. Accounting standards are different among countries because standards reflect the social, political, and economic characteristics of a particular national environment. Firms operating in a multinational environment have a need for uniform accounting and reporting standards. The International Accounting Standards Board (IASB) was formed in 1973 to promote uniform accounting standards among countries and to narrow areas of divergence.

2.

3.

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SEC has indicated that foreign companies will be allowed to use IASB standards in security offerings in the U.S., if the IASB meets the following three conditions: (1) The core standards must constitute a comprehensive generally accepted basis of accounting. The standards must be of high quality. The standards must be rigorously interpreted and applied.

(2) (3)

11. (L.O. 9) Steps to take in resolving an ethical dilemma: 1. Recognize an ethical dilemma exists. 2. Identify and analyze the elements of the dilemma. 3. Identify and analyze the alternatives available. 4. Select the best or most ethical alternative.
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D. ILLUSTRATIONS ILLUSTRATION 1-1 THE ESSENTIAL CHARACTERISTICS OF ACCOUNTING AND FINANCIAL REPORTING

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Economic Entity Financial Information Financial Statements Accounting Corporation annual reports President's letter Supplemental schedules Prospectuses News releases Manangement forecasts Etc. Not necessarily covered by GAAP Prepared in accordance with GAAP
Source: Kieso, Weygandt, and Warfield, Intermediate Accounting, 12th Edition

Financial Reporting
Additional Information

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Identifies and Measures and Communicates

Balance Sheet Income Statement Statement of Cash Flows Statement of Changes in Owners' or Stockholders' Equity

ILLUSTRATION 1-2 THE CHALLENGES FACING FINANCIAL ACCOUNTING

Non-financial measurements Forward-looking information Soft assets Timeliness

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ILLUSTRATION 1-3 HOUSE OF GAAP

House of GAAP

Category (d) (Least Authoritative) FASB Implementation Guides (Q & A)

AICPA Accounting Interpretations

Widely recognized and prevalent Industry Practices

Category (c) FASB Emerging Issues Task Force

AICPA AcSEC Practice Bulletins

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Category (b)

FASB Technical Bulletins (no longer issued)

AICPA Industry Audit and Accounting Guides

AICPA Statements of Position

Category (a) (Most Authoritative)

FASB Statements and Interpretations

APB Opinions

AICPA Accounting Research Bulletins

Source: Kieso, Weygandt, and Warfield, Intermediate Accounting, 12th Edition

ILLUSTRATION 1-4 ORGANIZATIONAL STRUCTURE FOR SETTING ACCOUNTING STANDARDS

Financial Accounting Foundation (FAF) Purpose To select members of the FASB and GASB and their Advisory Councils, fund their activities, and exercise general oversight.

Financial Accounting Standards Board (FASB) Purpose To establish and improve standards of financial accounting and reporting for the guidance and education of the public, including issuers, auditors and users of financial information. Staff and Task Forces Purpose To assist respective Boards on reporting issues by performing research, analysis, and writing functions.

Governmental Accounting Standards Advisory Council (GASAC) Purpose To establish and improve standards of financial accounting for state and local government.

Financial Accounting Standards Advisory Council (FASAC) Purpose To consult on major policy issues, technical issues, project priorities and selection and organization of task forces.

Governmental Accounting Standards Advisory Council (GASAC) Purpose To consult on major policy issues, technical issues, project priorities and selection and organization of task forces.

Source: Kieso, Weygandt, and Warfield, Intermediate Accounting, 12th Edition

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ILLUSTRATION 1-5 STEPS TAKEN IN THE EVOLUTION OF A FASB STATEMENT OF THE FINANCIAL ACCOUNTING STANDARDS BOARD

A topic or project is identified and placed on the Board's agenda. A task force of experts from various sectors is assembled to define problems, issues, and alternatives related to the topic. Research and analysis are conducted by the FASB technical staff. A discussion memorandum is drafted and released. A public hearing is often held, usually 60 days after release of the memorandum. The Board analyzes and evaluates the public response. The Board deliberates on the issues and prepares an exposure draft for release. After a 30-day (minimum) exposure period for public comment, the Board evaluates all of the responses received. A committee studies the exposure draft in relation to the public responses, reevaluates its position, and revises the draft if necessary. The full Board gives the revised draft final consideration and votes on issuance of a Standards Statement.
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ILLUSTRATION 1-6 USER GROUPS THAT INFLUENCE THE FORMULATION OF ACCOUNTING STANDARDS

Business entities CPAs and accounting firms Financial community (analysts, bankers, etc.)

AICPA (AcSEC)

FASB

Preparers (e.g., Financial Executives Institute)

Academicians

Government (SEC, IRS, other agencies)

Investing public

Industry associations

Accounting standards, interpretations, and bulletins

Source: Kieso, Weygandt, and Warfield, Intermediate Accounting, 12th Edition

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ILLUSTRATION 1-7 KEY PROVISIONS OF THE SARBANES-OXLEY ACT

Establishes the Public Company Accounting Oversight Board (PCAOB) Implements stronger independence rules for auditors Requires CEOs and CFOs to personally certify that financial statements and disclosures are complete and accurate Requires CEOs and CFOs to forfeit bonuses and profits when there is an accounting restatement Requires audit committe members to be independent and to have financial expertise Requires codes of ethics for senior financial officers Requires public companies to attest to the effectiveness of their internal controls
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