chapter two financial reporting: the cornerstone of a market economy
TRANSCRIPT
Chapter Two
Financial Reporting:
The Cornerstone of a Market Economy
Copyright © Houghton Mifflin Company.All rights reserved. 2 - 2
Economic Demand for Financial Information
Financial information is needed to:
• Provide information for investment decisions
• Assure lenders that borrowers can repay debt
• Assess performance or plan future growth by internal managers
Copyright © Houghton Mifflin Company.All rights reserved. 2 - 3
Regulatory Demand for Financial Information
Financial information is required for:
• Enforcement of tax codes
• Promulgating regulations
• Protection of investors and regulation of the securities market
Copyright © Houghton Mifflin Company.All rights reserved. 2 - 4
Critical Thinking
• Discussion: Imagine a business world in which there were no clearly defined accounting practices, no regulation of securities markets, and no enforcement of accounting practices. What consequences might result?
• Investors would have no means by which to compare financial statements between companies or understand how each company computed its income and financial position.
Copyright © Houghton Mifflin Company.All rights reserved. 2 - 5
Setting Accounting Standards
Standard-setting bodies
Public-
Sector
Entities
Private-
Sector
Entities
Issue standards, reports, bulletins, and positions that constitute generally acceptable accounting principles
(GAAP)
Copyright © Houghton Mifflin Company.All rights reserved. 2 - 6
Contributors to GAAP
Copyright © Houghton Mifflin Company.All rights reserved. 2 - 7
Public-Sector Standard Setter: SEC
Securities and Exchange Commission:
• Regulates U.S. securities markets
• Holds authority to set accounting and reporting standards
• Charged with protecting investors from fraud or inadequate financial disclosures
Copyright © Houghton Mifflin Company.All rights reserved. 2 - 8
Public-Sector Standard Setter: Oversight Board
Public Company Accounting Oversight Board:• Operates under the SEC; established by the
Sarbanes-Oxley Act• Actively participates in standard setting in
cooperation with accountants and advisory groups
• Establishes or adopts auditing, quality control, ethics, independence, and other standards relating to audits
• Conducts inspections of accounting firms• Conducts investigations and disciplinary
proceedings; imposes appropriate sanctions
Copyright © Houghton Mifflin Company.All rights reserved. 2 - 9
Private-Sector Standard Setter: AICPA
American Institute of Certified Public Accountants (AICPA)
Date Standard-Setting Committee
Operated by AICPA
Before 1959 Committee on Accounting Procedure (CAP)
1959 - 1973 Accounting Principles Board (APB)
1973 - present Accounting Standards Executive Committee (AcSEC)
Copyright © Houghton Mifflin Company.All rights reserved. 2 - 10
Private-Sector Standard Setter: FASB
Financial Accounting Standards Board (FASB):• Establishes and improves standards of financial
accounting and reporting• Issues Statements of Financial Accounting
Standards (SFASs), Statements of Financial Accounting Concepts (SFACs), and other bulletins
• Emerging Issues Task Force (EITF) studies and resolves emergency issues for FASB
Copyright © Houghton Mifflin Company.All rights reserved. 2 - 11
Other Private-Sector Standard Setters
• Institute of Management Accountants (IMA)
• Financial Executives International (FEI)
Copyright © Houghton Mifflin Company.All rights reserved. 2 - 12
International Standard Setter
International Accounting Standards Board (IASB):• Independent, privately funded organization
based in London• Cooperates with national accounting standard
setters to achieve convergence in global standards
• Endorsed International Accounting Standards (IAS) created from 1997 – 2002
• Issues International Financial Reporting Standards (IFRS) at present
Copyright © Houghton Mifflin Company.All rights reserved. 2 - 13
Challenges in Standard Setting
• Process is too slow for the fast-changing business environment
• Results in complex and detailed accounting standards
• Current rule-based accounting standards encourage a check-box mentality and diminish the overall objective of the standard
Copyright © Houghton Mifflin Company.All rights reserved. 2 - 14
FASB’s Standard-Setting Process
Copyright © Houghton Mifflin Company.All rights reserved. 2 - 15
Which accounting rules have the highest authority?
Copyright © Houghton Mifflin Company.All rights reserved. 2 - 16
Why is Transparency in Financial Reporting Important?
• Enables investors, creditors, and the market to evaluate a firm
• Increases confidence in the fairness of U.S. markets
• Fundamental to corporate governance
Copyright © Houghton Mifflin Company.All rights reserved. 2 - 17
FASB’s Conceptual Framework for Financial Reporting
The framework addresses:
1. Objectives of financial reporting
2. Qualitative characteristics of accounting information
3. Elements of financial statements
4. Environmental assumptions, principles, and constraints that guide financial reporting
Copyright © Houghton Mifflin Company.All rights reserved. 2 - 18
FASB’s Conceptual Framework
Copyright © Houghton Mifflin Company.All rights reserved. 2 - 19
Objectives of Financial Reporting
2. Provide information that will help assess the amounts, timing, and uncertainty of future cash flows
3. Provide information that will help investors do fundamental analysis of the assets, liabilities, and business activities for a given period of time
1. Provide information that is useful in making rational investment, credit, and similar decisions
Copyright © Houghton Mifflin Company.All rights reserved. 2 - 20
Hierarchy of Accounting Qualities
Copyright © Houghton Mifflin Company.All rights reserved. 2 - 21
User-Specific Qualities of Accounting Information
• Understandability—Are users able to perceive the information’s significance?
• Decision Usefulness—Can users translate the information for making credit, investment, and other decisions?
Copyright © Houghton Mifflin Company.All rights reserved. 2 - 22
Primary Qualities of Decision Usefulness
Relevance:Relevance:• Information is
capable of making a difference in users’ decisions
Reliability:Reliability:• Information is relatively
free from error and bias. It measures what it claims to measure.
Timeliness
Predictive Value
Feedback Value
Neutrality
Representational
Faithfulness
Verifiability
Copyright © Houghton Mifflin Company.All rights reserved. 2 - 23
Secondary Qualities of Decision Usefulness
Comparability:Comparability:• Information is
measured and reported in such a way that users can identify similarities and differences among sets of data
Consistency:Consistency:• A company applies
the same accounting rules across time to allow for comparability
Copyright © Houghton Mifflin Company.All rights reserved. 2 - 24
What Constraints Impact Financial Reporting?
Materiality:Materiality:
• Information must have the capacity to affect users’ decisions
Cost-Benefit:Cost-Benefit:
• Benefits to users must exceed costs when preparing and communicating financial information
Copyright © Houghton Mifflin Company.All rights reserved. 2 - 25
Accounting and Ethics
• AICPA Code of Professional Conduct—defines the minimum level of professional responsibility and conduct applicable to all practicing AICPA members
Most critical section of the code:
Auditor Independence
Copyright © Houghton Mifflin Company.All rights reserved. 2 - 26
Auditor Independence
• Maintain independence both in fact and in appearance
• Do nothing to undermine the perception of outside users that the auditor has any interest in the outcome of the audit or performance of the client
• No financial interest in client
Copyright © Houghton Mifflin Company.All rights reserved. 2 - 27
Auditor-Client Relationship
• An accounting firm cannot provide the following services for a client at the same time it is performing an audit for that client:
• Legal• Actuarial• Internal audit • Management• Human
resources
• Broker/dealer• Valuation• Investment
banking
• Bookkeeping• Design and
implementation of financial information systems
Copyright © Houghton Mifflin Company.All rights reserved. 2 - 28
Ethical Decision Making
• Requires commitment beyond rules of conduct
• Requires the ability to make distinctions between competing choices and understand consequences of each choice
• Requires a framework of principles and a model form applying these principles to problems
Copyright © Houghton Mifflin Company.All rights reserved. 2 - 29
Ethical Decision-Making Model
1. Define the problem and gather facts. 2. List parties affected by decision. 3. List values and principles to consider. 4. List alternative actions. 5. Choose and prioritize:
a) Which party is most important in this situation?b) Which value is the highest value in this situation?c) Which action will cause greatest good or least
harm?d) Prioritize a, b, and c for most important
consideration.
6. Make the decision based on the above factors.
Copyright © Houghton Mifflin Company.All rights reserved. 2 - 30
Check Your Understanding
Q List three economic needs for financial information.
A To provide information for investment decisions, to assure lenders that borrowers can repay debt, and to assess performance or to plan future growth by internal managers.
Copyright © Houghton Mifflin Company.All rights reserved. 2 - 31
Check Your Understanding
Q Name two public-sector entities and three private-sector entities that play a role in standard setting.
A The SEC and Congress play a role in standard setting in the public sector. In the private sector, the FASB, IMA, FEI, AICPA, and IASB contribute to standard setting.
Copyright © Houghton Mifflin Company.All rights reserved. 2 - 32
Check Your Understanding
Q What criticisms have been voiced regarding the current standard-setting process?
A The process moves too slowly for today’s marketplace. Resulting standards are too complex and detailed.
Copyright © Houghton Mifflin Company.All rights reserved. 2 - 33
Check Your Understanding
Q What issues are addressed by the FASB’s conceptual framework?
A The objectives of financial reporting; the qualitative characteristics of accounting information; the elements of financial statements; and the environmental assumptions, principles, and constraints that guide financial reporting.
Copyright © Houghton Mifflin Company.All rights reserved. 2 - 34
Check Your Understanding
Q Describe the concept of reliability as it relates to the decision usefulness of information.
A Information should be relatively free of error or bias. It should also measure what it claims to measure.