Ch 1 : Environment and Conceptual Framework for Financial Accounting

The hierarchy of accounting qualities identifies relevance and faithful representation as:

fundamental qualities

IFRS insights: similarities

international financial reporting system •Generally accepted accounting principles (GAAP) for U.S. companies are developed by the Financial Accounting Standards Board (FASB). The FASB is a private organization. The Securities and Exchange Commission (SEC) exercises oversight over the actions of the FASB. The IASB is also a private organization. Oversight over the actions of the IASB is regulated by IOSCO. •Both the IASB and the FASB have essentially the same governance structure, that is, a Foundation that provides oversight, a Board, an Advisory Council, and an Interpretations Committee. In addition, a general body that involves the public interest is part of the governance structure. •Both the IASB and the FASB are working together to find common grounds for convergence. A good example is the recent issuance of a new standard on revenue recognition that both organizations support. •As indicated above, the IASB has completed its conceptual framework, whereas the FASB has not. •The objective of financial reporting and the qualitative characteristics of useful information are the same between the two frameworks.

SEC and FASB

primarily responsible for the development of GAAP in the United States

SEC Public/Private Partnership

- At time of creation, no public or private group issued accounting standards - Encouraged the creation of a private standard-setting body - SEC requires registrants (public companies included) to adhere to GAAP as developed by the FASB. Presently, accounting standards are developed in the private sector by FASB - "it continues to believe that the initiative for establishing and improving accounting standards should remain in the private sector, subject to Commission oversight."

Major Challenges in Financial Reporting

- Political environment GAAP is as much a product of political action as it is of careful logic or empirical findings. - Expectations gap - Financial reporting issues - International accounting standards - Ethics

Statement of Financial Accounting Concepts (SFAC)

- Sets forth fundamental objectives and concepts that the Board uses in developing standards of financial accounting and reporting. - A set of interrelated concepts—a conceptual framework—that will serve as tools for solving existing and emerging problems in a consistent manner. - Unlike an Accounting Standards Update, a Statement of Financial Accounting Concepts does not establish GAAP. (Concepts statements, however, pass through the same due process system (preliminary views, public hearing, exposure draft, etc.) as do standards updates)

SEC Oversight

- The SEC relies on the FASB for developing accounting standards. - SEC can reject a standard proposed by private sector - SEC can prod private sector to take faster action on certain reporting problems - SEC communicates problems to the FASB

Financial Accounting Standards Board (FASB)

- major standard-setting organization in the private sector - The FASB operates with oversight from the FAF 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. In establishing financial accounting standards, the FASB relies on two basic premises. The FASB should: 1) Be responsive to the needs and viewpoints of the entire economic community, not just the public accounting profession. 2) Operate in full view of the public through a due process system that gives interested persons ample opportunity to make their views know

Conceptual Framework

- process that FASB uses to develop a set of generally accepted reporting standards. - needed because financial statement users (creditors/investors) rely on high-quality information to make better resource allocation decisions. - high-quality financial reporting results in increased investor confidence, which supports efficient capital markets.

General Purpose Financial Statements

- provide financial reporting information to a wide variety of users - provide most useful information possible at the least cost

Solutions to Challenges

-Companies are voluntarily disclosing information deemed relevant to investors. Increasingly, companies are preparing reports on their sustainability efforts by reporting such information as water use and conservation, carbon impacts, and labor practices. In some cases, "integrated reports" are provided, which incorporate sustainability reports into the traditional annual report, leading some to call for standards for sustainability reporting. - The FASB is now working on projects that address disclosure effectiveness, a reporting framework for non-public companies, and a simplification initiative. The projects could go a long way toward addressing complexity and understandability of the information in financial statements, allowing for more-effective, less-complex, and flexible reporting to meet the needs of investors. - Most companies publish their annual reports in several formats on the Internet. The most innovative companies offer sections of their annual reports in a format that the user can readily manipulate, such as in an electronic spreadsheet format.

User Groups of Accounting Info

1)Owner/Manager: 2)Creditors 3)Stockholders

SEC Enforcement

1. Authorized to stop registrations when irregularities in disclosure are discovered first issues deficiency letter to company, then a stop order, which prevents company from issuing/trading 2. can file for injunctions in federal court 3. may refer to willful violators to the dept of justice for prosecution with max fines of 10,000 and five years in prison The SEC process, private sector initiatives, and civil and criminal litigation help to ensure the integrity of financial reporting for public companies.

5 Steps of Revenue Recognition

1. Identify the contract(s) with the customer 2. Identify the separate performance obligations in the contract 3. Determine the transaction price 4. Allocate the transaction price to the separate performance obligations 5. Recognize revenue when each performance obligation is satisfied

Principles of Accounting

1. Measurement Principle - historical cost or fair value 2. Revenue Recognition Principle - revenue must be recognized when the performance obligation is satisfied 3. Expense Recognition Principle - expenses must follow the revenues 4. Full Disclosure Principle - recognizes that the nature and amount of information included in financial reports reflects a series judgmental trade-offs.

Financial Reporting Issues

1. Non-financial measurements. Financial reports fail to provide some key performance measures widely used by management, such as customer satisfaction indexes, backlog information, reject rates on goods purchased, as well as the results of companies' sustainability efforts. 2. Forward-looking information. Financial reports fail to provide forward-looking information needed by present and potential investors and creditors. One individual noted that financial statements in 2020 should have started with the phrase, "Once upon a time," to signify their use of historical cost and accumulation of past events. 3. Soft assets. Financial reports are focused on hard assets (inventory, plant assets) but fail to provide much information about a company's soft assets (intangibles). The best assets are often intangible. Consider Microsoft's know-how and market dominance, Walmart's expertise in supply chain management, and Procter & Gamble's brand image. 4. Timeliness Companies only prepare financial statements quarterly and provide audited financials annually. Little to no real-time financial statement information is available. 5. Understandability Investors and market regulators are raising concerns about the complexity and lack of understandability of financial reports.

Due Process

4 parts: 1) Topics identified and placed on board's agenda 2) Preliminary Views : Research and analysis is conducted and preliminary views of pros and cons are presented 3) Public hearing on proposed standard 4) Exposure Draft: Board evaluates research and public response, and issues exposure draft 5) Accounting Standards Update: Board evaluates responses and changes exposure draft, if necessary. A final standard is issued The passage of new FASB guidance in the form of an Accounting Standards Update requires the support of four of the seven Board members. FASB pronouncements are considered GAAP and are thereby binding in practice.

Sarbanes-Oxley Act

A law passed by Congress that requires the CEO and CFO to certify that their firm's financial statements are accurate. -Was passed in response to a string of accounting scandals at companies like Enron, Cendant, Sunbeam, Rite-Aid, Xerox, and WorldCom. -This law increased the resources for the SEC to combat fraud and curb poor reporting practices. -In addition, the Sarbanes-Oxley Act introduced sweeping changes to the institutional structure of the accounting profession. The following are some of the key provisions of the legislation. -Establishes an oversight board, the Public Company Accounting Oversight Board (PCAOB), for accounting practices. The PCAOB has oversight and enforcement authority and establishes auditing, quality control, and independence standards and rules. - Requires CEOs and CFOs to personally certify that financial statements and disclosures are accurate and complete, and requires CEOs and CFOs to forfeit bonuses and profits when there is an accounting restatement. - Requires audit committees to be comprised of independent members and members with financial expertise and requires codes of ethics for senior financial officers. - Requires large public companies to document and evaluate the effectiveness of their internal controls over financial reporting.

What is the purpose of information presented in the notes to the financial statements? A .To provide disclosure required by generally accepted accounting principles. B .To correct improper presentation in the financial statements. C .To provide recognition of amounts not included in the totals of the financial statements. D .To present management's responses to auditor comments.

A .To provide disclosure required by generally accepted accounting principles.

Generally Accepted Accounting Principles (GAAP)

A set of accounting standards that is used in the preparation of financial statements. Helpful for comparisons among companies.

What is the purpose of information presented in the notes to the financial statements? A. To provide disclosure required by generally accepted accounting principles. B. To correct improper presentation in the financial statements. C. To provide recognition of amounts not included in the totals of the financial statements. D. To present management's responses to auditor comments.

A. To provide disclosure required by generally accepted accounting principles.

Which of the following groups influence the formulation of accounting standards?

All of these are correct: Government, Academicians, CPAs and accounting firms. This list is not exclusive.

Economic Entity Assumption

An assumption that every economic entity can be separately identified with a particular unit of accountability.

Monetary Unit Assumption

An assumption that requires that only those things that can be expressed in money are included in the accounting records. In other words, money is the common denominator of economic activity, and provides an appropriate basis for accounting measurement and analysis.

Periodicity Assumption

An assumption that the life of a business can be divided into artificial time periods (and that useful reports covering those periods can be prepared for the business.)

Codification Research System (CRS)

An online, real-time database that provides easy access to the Codification

Decision-Usefulness

Burden on the accounting profession to provide useful information for decision-making Investors are interested in assessing the company's 1. ability to generate net cash inflows and 2. management's ability to protect and enhance the capital providers' investments.

Entity Perspective

Companies are viewed as separate and distinct from their owners

The first step taken in the establishment of a typical FASB statement is A. The board conducts research and analysis and a discussion memorandum is issued. B. A public hearing on the proposed standard is held. C. The board evaluates the research and public response and issues an exposure draft. D. Topics are identified and placed on the board's agenda.

D. Topics are identified and placed on the board's agenda.

Primary users for general-purpose financial statements

Equity Investors and Creditors

Elements of a financial statements are classified into two groups. Which of the following is an element that describes the effect to a company during a period of time:

Expenses Explanation: Expenses is one of the 7 elements that describes transactions, events, and circumstances that affect a company during a period of time. Elements include:

Put it Into Practice LO 1.1 Discuss Financial Reporting and Organizations

FACTS The first part of this chapter discusses general concepts related to financial reporting and various organizations involved in the standard-setting process. Here are some terms used in the first part of the chapter. a.Financial Accounting Standards Board b.American Institute of Certified Public Accountants c.Generally accepted accounting principles d.Securities and Exchange Commission e.International Accounting Standards Board f.Public/private partnership g.Codification h.Statements of Financial Accounting Concepts INSTRUCTIONS Describe the significance of each of the items as it relates to financial reporting. a. Financial Accounting Standards Board: the U.S. organization established to improve standards of financial reporting for the guidance and education of the public, which includes issuers, auditors, and users of the financial statements. b. American Institute of Certified Public Accountants: the national professional organization of practicing certified public accountants. c. Generally accepted accounting principles: GAAP is the common set of standards and protocols either established by an authoritative accounting rule-making body or accepted as appropriate because of its universal application in practice. d. Securities and Exchange Commission: the SEC is a federal agency that administers the Securities Act of 1934 and other acts. Most companies that issue securities to the public or are listed on the stock exchanges are required to file audited GAAP financial statements with the SEC. e. International Accounting Standards Board: the IASB is the international organization established to improve standards of financial reporting for the guidance and education of the public, which includes issuers, auditors, and users of the financial statements. Their statements apply to many countries outside the United States. f. Public/private partnership: reflects the SEC's support for the FASB by indicating that financial statements conforming to standards by the FASB are presumed to have authoritative support. g. Codification: provides in one place all the authoritative accounting literature related to a topic. h. Statements of Financial Accounting Concepts: the series that sets forth fundamental objectives

FASB Codification

FASB Codification (or simply, "the Codification") integrates and synthesizes existing GAAP; it does not create new GAAP. Considered Authoritative Goals: • Provide all the authoritative literature related to a topic. • Simplify user access to all authoritative U.S. GAAP. • Establish the way GAAP is documented, presented, and updated. • Eliminate nonessential information

Capital Allocation Process (3 parts)

Financial Reporting--> Users --> Capital Allocation

Lighthouse Incorporated is determining the extent of information to include in the notes of the financial statements. They want to make sure that there is sufficient information to aid users with their decision-making. What principle does this reflect?

Full Disclosure

Hierarchy of Accounting Qualities

Hierarchy of Accounting Qualities from the Top Down: 1. Primary Users of accounting information 2. Constraint 3. Pervasive criterion 4. Fundamental qualities 5. Ingredients of Fundamental Qualities 6. Enhancing Qualities

Ethics in the Environment of Financial Accounting

In accounting, we frequently encounter ethical dilemmas. - GAAP does not always provide an answer. - Doing the right thing is not always easy or obvious.

2) Users (present and potential)

Investors and creditors use financial reports to make their capital allocation decisions

Foundation of the Conceptual Framework

Objective of financial reporting Think about the types of decisions that investors and lenders are making about companies. • Investors decide whether to buy, sell, or hold stock in a company. • Lenders decide whether to lend money to a company and at what interest rate and for how long.

Need to Develop Standards

Preparing financial statements according to accepted accounting standards contributes to the comparability of accounting information.

Parties Involved in Standard Setting

Primary: SEC (Securities & Exchange Commission), FAF (Financial Accounting Foundation), FASB (Financial Accounting Standards Board), FASAC (Financial Accounting Standards Advisory Council) Others: American Institute of Certified Public Accountants (AICPA) is a national professional organization that established the International Accounting Standards Board (IASB), which is used in over 120 countries

Financial Accounting Standards Board Financial Accounting Standards Advisory Council (FASAC)

Purpose: To consult on major policy issues, technical issues, project priorities, and selection and organization of task forces.

Financial Accounting Foundation (FAF)

Purpose: To select members of the FASB and their Advisory Councils, fund their activities, and exercise general oversight.

Expense Recognition

Record expenses in the period the related revenue is recognized

Fundamental Quality - Relevance

Relevance is one of the two fundamental qualities that make accounting information useful for decision-making. Relevance and related ingredients of this fundamental quality are shown in pic

Accounting Standards Update

These Updates amend the Accounting Standards Codification, which represents the source of authoritative accounting standards, other than standards issued by the SEC. Each update consists: 1) An explanation of how the Codification has been amended. 2) Information to help the reader understand the changes. 3) A date for when the changes will be effective. Common forms of amendments are standards issued that address a broad area of accounting practice, or interpretations that modify or extend existing standards.

Going Concern Assumption

The assumption that the company will continue in operation for the foreseeable future. The going concern assumption has three significant implications: 1. The historical cost principle is of limited usefulness if we assume eventual liquidation. 2. Depreciation and amortization approaches may need to be adjusted. 3. Current and noncurrent classification of assets and liabilities may lose their significance.

Objective of Financial Reporting

To provide financial information about the reporting entity that is useful to - present and potential equity investors - lenders, and - other creditors in decisions about providing resources to the entity

Fair Value Hierarchy

The fair value hierarchy provides insight into the priority of valuation techniques that are used to determine fair value. The fair value hierarchy is divided into three broad levels. Fair Value Hierarchy Level 1: Observable inputs that reflect quoted prices for identical assets or liabilities in active markets. Level 2: Inputs other than quoted prices included in Level 1 that are observable for the asset or liability either directly or through corroboration with observable data. Level 3: Unobservable inputs (for example, a company's own data or assumptions). Level 1 is the most reliable because it is based on quoted prices, like a closing stock price in the Wall Street Journal. Level 2 is the next most reliable and would rely on evaluating similar assets or liabilities in active markets. Level 3 is the least most reliable; much judgment is needed based on the best information available to arrive at a relevant and reliable fair value measurement.

1) Financial Reporting

The financial information a company provides to help users with capital allocation decisions about the company

Which of the following is the objective of financial reporting?

To provide information about the reporting entity that is useful to present and potential equity investors, lenders, and other creditors for decision-making

Codification Framework

Topic Subtopics Sections Paragraphs

3) Capital Allocation

The process of determining how and at what cost money is allocated among competing interests

Assumptions (4)

We generally rely on four assumptions in accounting: • economic entity • going concern • monetary unit • periodicity

The Expectations Gap

What the public thinks accountants should do versus what accountants think they can do. •Difficult to close in light of accounting scandals •Sarbanes-Oxley Act •Public Company Accounting Oversight Board (PCAOB)

Elements of Financial Statements

assets, liabilities, equity, investments by owners, distributions to owners, comprehensive income, revenues, expenses, gains, losses Assets. Probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. 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. Equity. Residual interest in the assets of an entity that remains after deducting its liabilities. In a business enterprise, the equity is the ownership interest. Investments by owners. Increases in net assets of a particular enterprise resulting from transfers to it from other entities of something of value to obtain or increase ownership interests (or equity) in it. Assets are most commonly received as investments by owners, but that which is received may also include services or satisfaction or conversion of liabilities of the enterprise. Distributions to owners. Decreases in net assets of a particular enterprise resulting from transferring assets, rendering services, or incurring liabilities by the enterprise to owners. Distributions to owners decrease ownership interests (or equity) in an enterprise. Comprehensive income. Change in equity (net assets) of an entity during a period from transactions and other events and circumstances from non-owner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners. Revenues. Inflows or other enhancements of assets of an entity or settlement of its liabilities (or a combination of both) during a period from delivering or producing goods, rendering services, or other activities that constitute the entity's ongoing major or central operations. Expenses. Outflows or other using up of assets or incurrences of liabilities (or a combination of both) during a period from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity's ongoing major or central operations. Gains. Increases in equity (net assets) from peripheral or incidental transactions

Fundamental Quality - Faithful Representation

• Completeness - All information that is necessary for faithful representation is provided. • Neutrality - Company cannot select information to favor one set of interested parties over another. • Free from Error - Information that is free from error will be more a more accurate representation of a financial item.

Securities and Exchange Commission (SEC)

• Established by the federal government Federal agency to help develop and standardize financial information presented to stockholders • Responsible for administering the Securities Exchange Act of 1934 among other acts • Requires most companies that issue securities to the public or are listed on a stock exchange to file audited financial statements with the SEC. • Has broad powers to prescribe, in whatever detail it desires, the accounting practices and standards to be employed by companies that fall within its jurisdiction. • Currently exercises oversight over 12,000 companies that are listed on the major exchanges (e.g., the New York Stock Exchange and the Nasdaq).

IFRS insights: differences

•GAAP is more detailed or rules-based. IFRS tends to simpler and more flexible in its accounting and disclosure requirements. The difference in approach has resulted in a debate about the merits of principles-based versus rules-based standards. •Differences between GAAP and IFRS should not be surprising because standard-setters have developed standards in response to different user needs. In some countries, the primary users of financial statements are private investors. In others, the primary users are tax authorities or central government planners. In the United States, investors and creditors have driven accounting-standard formulation. •The IASB gives more emphasis to stewardship in its conceptual framework. The framework indicates that users need information about the resources of the entity not only to access an entity's prospects for future cash inflows but also to determine how effectively and efficiently management has discharged their responsibilities to use the entity's exiting resources (i.e. ,stewardship). In other words, the IASB conceptual framework explicitly discusses the need to provide information related to stewardship of an entity's resources as well as the need for information to help users understand related the prospects for future net cash inflows to the entity. •The IASB also clarified two other concepts - measurement uncertainty and substance over form. The framework indicates that measurement uncertainty does not prevent information from being useful. However, in some cases the most relevant information may have such a high degree of uncertainty that the most useful information is that which uses slightly less relevant but is subject to lower measurement uncertainty. Although both GAAP and IFRS are increasing the use of fair value to report assets, as this point IFRS has adopted it more broadly. As examples, under IFRS, companies can apply fair value to property, plant, and equipment; natural resources; and, in some cases, intangible assets.

Relevance

•Predictive Value - Information has predictive value if it helps users form their own expectations. •Confirmatory value - Accounting information has confirmatory value if it helps users confirm or correct prior expectations. •Materiality - A company-specific aspect of relevance.