Chapter 1 - The Accounting Environment

Financial accounting

primarily for external users

for profit-oriented business entities

for governmental entities, such as municipalities, states, countries, airport authorities, etc.

for nonprofit entities, such as the Boy Scouts of America, Salvation Army, etc.

Managerial accounting

for the internal use by an economic entity

Tax accounting

for the preparation of federal and state tax returns

for the preparation of other required tax documents

for tax planning

Auditing: external

the examination of another firm’s financial statements by a Certified Public Accountant (CPA) in order to express an opinion on those statements

Auditing: internal

financial audit

operational audit

Financial audit

the examination of an entity’s financial data by the entity itself to determine if the data has been recorded correctly

Operational audit

the examination of an operation of an entity by the entity itself to determine if this operation is being performed in the prescribe manner

SEC reporting

reporting information to the Securities & Exchange Commission based on the rules and guidelines of the Commission

SEC reporting is required for

only required for those companies that are publicly held or that issue financial instruments in public markets

Other regulatory reporting

accounting type reports that must be sent by regulated entities to their regulatory bodies, such as:

* banks sending required reports to banking authorities
* utilities sending required reports to rate-setting bodies

What financial accounting involves

identifying, measuring, recording, summarizing, classifying, communicating, and interpreting financial information about: economic entities to interested parties (investors, lenders, and other creditors) so that those interested parties may make economic decisions

\*most interpreting is left to the users of financial statements

The objective of general purpose financial reporting

is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders, and other creditors in making decisions about providing resources to the entity

Major financial statements

* income statement
* statement of comprehensive income
* statement of retained earnings (or stockholders’ equity)
* balance sheet
* statement of cash flows

\* the income statement and statement of comprehensive income many be combined and issued as a single statement called “statement of income and comprehensive income”

Current contents of an audited annual report

* management’s letter to shareholders - unaudited
* management’s discussion and analysis - unaudited
* the auditors written audit opinion - audited
* the four or five required financial statements - audited
* footnote disclosures - audited

The five types of auditors written opinion

* unmodified (clear) opinion
* unmodified opinion with emphasis-of-matter explanatory paragraph or non-standard wording
* qualified opinion
* adverse opinion
* disclaimer opinion

Unmodified (clear) opinion

what the client company desires, the auditor states that the financial statements of the client company:

* “present fairly” the financial position of the company and the results of its operations are “free of material misstatement and were prepared in accordance with “generally accepted accounting principles

Note about unmodified opinion

although an unmodified opinion does not specifically state that the reporting entity is a “going concern” it certainly implies it

Unmodified opinion with emphasis-of-matter explanatory paragraph or nonstandard wording

a complete audit took place with satisfactory results and the financial statements are fairly presented, but the auditor believes that it is important or is required to provide additional information

Qualified opinion

the client company can often live with this opinion, the auditors states that

* overall the financial statements of the client company “present fairly” that financial position of the company and results of its operations
* however, the auditor does not have some qualifications regarding the client company’s financial statements and these qualifications are clearly outlined in the auditor’s opinion

The qualifications in a qualified opinion are

* the scope of the audit was materially restricted, but the restrictions were not pervasive
* there were material misstatements in the financial statements, but the misstatements were not pervasive
* applicable accounting standards were not always followed in preparing the financial statements

Adverse opinion

the client company cannot live with this opinion because the auditor stated that the financial statement of the client company

* do not “present fairly” the financial position of the company and the results of its operations
* are not “free of material misstatements”
* were not prepared in accordance with “generally accepted accounting principles”

Disclaimer opinion

the client company cannot live with this opinion because the audit firm states that because of scope limitations, it was not able to gather enough evidence to give an opinion one way or the other regarding the client company’s financial statements

Expected differences in future financial reports

* more non-financial data, especially of the type that will help the user evaluate the performance of management
* greater analysis by management both of its past and its future
* more forward-looking information
* more information about a company’s soft assets
* more information about management and shareholders
* greater information about the company

Expected difference in future financial reports: more forward-looking information

* opportunities and risks
* management’s plans
* comparison of actual performance to previously disclosed expectations

Expected difference in future reports: more information about a company’s soft assets

* intangibles (patents and copyrights)
* company know-how
* marketing innovations
* employees’ training, experience, and strengths
* brand image

Expected difference in future reports: greater information about the company

* its broad objectives and strategies
* the scope of its business and properties
* the impact on the company of past industry changes and expected future industry changes

Important environment factors

* there are always important economic considerations; such as the fact that resources are scarce
* there are always important legal considerations; such as the fact that state law regulates most corporate equity transactions
* there are always important ethical considerations; such as the fact that both fairness to companies and fairness to financial statement users most be considered
* the influences of business and finance are important; such as the importance of the time value of money (present value) to accounting standard-setting
* there are important social considerations; such as the importance of accounting and its effects on the social good of the country and the world

Note on environment factors

although these environmental factors clearly influence accounting, it is equally important to remember that accounting and its stated rules and regulations can also influence the environment

Historical Development of Accounting

* American Institute of Certified Public Accountants (AICPA)
* Securities and Exchange Commission 1934
* Committee on Accounting Procedures (CAP) 1939-1959
* Accounting Principles Board (APB) 1959-1973

American institute of certified public accountants

AICPA

* an organization composed of practicing certified public accountants (CPAs)
* did not really ever set accounting standards, but was the major organization offering leadership and advice on proper accounting methodologies in the early 1900s
* the was done primarily through its publication of Journal of Accountancy

Securities and exchange commission

* a governmental agency which oversees the selling of stocks and bonds to the public
* the SEC regulates publicly held companies and entities that issue financial instruments in public markets
* it was given that power by Congress to set accounting rules and standards for all American companies, but in 1938, it delegated that authority to the accounting profession

Committee on accounting procedures

CAP

* the organization within the accounting profession that set accounting guidelines
* this was a committee of the AICPA, but was supposed to operate independently of the AICPA
* the guidelines CAP set were not in the form of a rule or regulation, but rather in the form of “this is accepted practice”
* CAP’s major publication was an Accounting Research Bulletin (ARB)
* CAP’s authority rested only with general acceptance by the business community and the accounting profession - there was no law that gave it its power

Accounting principles board

APB

* an agency (committee) of the AICPA
* established to create accounting principles, which had to be followed by any company needing to be audited by a CPA
* the APB’s major publication was an APB “opinion”
* the APB’s authority rested only with general acceptance by the business community and the accounting profession - there was no law that gave it its power

The current status of the financial reporting environment

* The Financial Accounting Standards Board (FASB)
* lobbying groups influencing FASB
* “Generally Accepted Accounting Principles” (GAAP)
* international accounting standard setting
* The Sarbanes-Oxley Act
* accounting and ethics

The financial accounting standards board

FASB

* created in 1973
* replaced the APB

FASB is better than APB because

* smaller membership: 7 instead of 18-21 members
* broader representation: not all members of the board are CPAs, there can be former bankers, members of the financial community, corporate CEOs or CFOs etc.
* more independence: members of the board must sever all connections with old employers
* more time: board membership is a full-time, fully remunerated position
* more autonomy: the board is not under the auspices of the AICPA

The FASB operates under the supervision and support of both the

* Financial Accounting Foundation (FAF), which appoints the members of FASB
* Financial Accounting Standards Advisory Council (FASAC)

The financial accounting standards advisory council

FASAC

* raises the funds for the operations of FASB
* provides input on FASB appointments
* also consults with FASB on major topics and policy issues

FASB pronouncements

* concept statements
* accounting standards updates
* interpretations
* technical bulletins
* staff positions

Concept statements

relating to the conceptual framework of accounting, these statements are concepts which FASB should use when it writes new financial reporting standards

Accounting standards updates

ASUs

* a pronouncement that outlines the appropriate way of accounting for a particular situation or event - this is considered a primary source of “GAAP” because after this ASU is approved, its guidance will be inserted into the FASB codification
* this standard should be followed by any entity needing to be audited by a certified public accountant

The process of writing this ASU

* may include the issuance of an invitation to comment
* may include the issuance of a document called preliminary views
* will normally include the publication of an exposure draft

Invitation to comment

a request by FASB for input from the accounting and business community regarding a topic for which FASB is writing an accounting standards update

Preliminary views

which provides preliminary insights on where FASB is likely to be heading when writing a new accounting standards update on a controversial topic

Exposure draft

a draft of the final accounting standards update, it is issued prior to making the ASU official

Note about writing accounting standards updates

all three documents give individuals and groups the opportunity to provide feedback on a topic on FASB’s agenda, thus FASB receives greater input for its deliberations

Interpretations

rules/regulations written by FASB in areas where there is a current standards statement or accounting standards update, but minor adjustments to this guidance are needed to cover a new but similar situation

Technical bulletins

guidelines on how certain interpretations and standards should be implemented or applied - examples are provided to practicing accountants

* they are no longer published by FASB

Staff positions

similar to technical bulletins, staff positions provide interpretive guidance on existing standards, accounting standards updates, or interpretations and also provide minor amendments to standard, ASU and interpretations

Development of an FASB Accounting Standards Update

* the board receives requests/recommendations for possible project topics
* the FASB staff summarizes information and makes a presentation at a public board meeting
* a vote is taken by FASB to place a topic on the FASB agenda
* a task force of experts - including one member of the board - defines problems, issues, and alternatives related to the agenda topic
* research and analysis is conducted by the FASB research staff
* the board deliberates the agenda topic at public meetings
* the board may draft and issue an invitation to comment or preliminary views on the agenda topic
* if so, it may hold a public hearing on the agenda topic. in addition to or in lieu of a public hearing, FASB will request written public comment from interested parties
* the board prepares and issues an exposure draft
* there is a 30-day or more waiting period for public comment on the exposure draft
* the public response to the exposure draft is evaluated and the exposure draft is then revised, if needed
* the full board votes on the acceptance and issuance of the final accounting standards update

Notes about the development of accounting standards update

* unlike APB opinion the FASB accounting standards updates are usually written by a team of individuals working together. the APB opinions were often times the work of several individuals, working separately, which made them seem uneven when making a transition from one section to another
* several times in the past, there has been such a negative outcry to an exposure draft that FASB has backtracked and released a second exposure draft

Lobbying groups influencing FASB

* government
* accounting
* non-accounting

Governmental influence

* securities and exchange commission (SEC)
* internal revenue service (IRS)
* the united states congress

Securities and exchange commission publishes

* financial reporting releases (FRR)
* staff accounting bulletins (SAB)
* regulation x
* sec decisions

Financial reporting release

issuances of the SEC (that replaced accounting series releases) that state the SEC’s position on financial reporting matters

Staff accounting bulletins

interpretations and practices followed by the SEC in administering the disclosure requirements of the federal securities laws

Regulation x

guidelines on the form and content of financial statements and schedules required to be filed with the SEC

SEC decisions

decisions on cases that were brought before the SEC

The SEC still has

legal authority to set accounting standards, but has continued to delegate that authority to the accounting profession, however, the SEC has wielded its power in several cases

SEC has wielded its power directly

* overruling the APB on how to account for the investment credit
* overruling FASB on how to account for “exploration costs” in the extractive industries (oil & gas)

SEC has wielded its power indirectly

* urging FASB to create a statement on inflation accounting
* urging FASB to create a statement on financial forecast

Internal revenue service

* its decisions are of a legal nature (tax code)
* its decisions do not reflect directly on financial accounting since good tax accounting is not necessarily good financial accounting

The united state congress

* it has scrutinized and criticized the accounting profession several times in the past
* despite this scrutiny, congress has permitted the accounting profession to continue to set financial accounting standards

Note about governmental influence

although the government has continued to stay our of the area of setting financial reporting standards, it has become involved in setting auditing standard. the Sarbanes-Oxley Act created the Public Company Accounting Oversight Board, a non-governmental entity, that sets auditing standards for publicly held companies

Note #2 about governmental influence

despite the creation of the PCAOB and despite an increase in the education of investors and creditors concerning the financial audit, there is still a great “expectations gap” between what auditors “say they do” (and are able to do) and what investors, creditors, and government bureaucrats “want” (and expect) auditors to do

Accounting influence

* american institute of certified public accounting (AICPA)
* american accounting association (AAA)
* institute of management accounting (IMA)
* governmental accounting standards board (GASB)
* emerging issues task force (EITF)

American institute of certified public accounting

* composed primarily of accounting practitioners (CAPs)
* both the CAP and the APB fell under the auspices of the AICPA

Through the auditing standards board AICPA have published

auditing standards

Auditing standards

are enforceable standards relating to auditing and professional ethics

Note on auditing standards

although currently the PCAOB authors auditing standards for audits of publicly held companies, the ASB still authors auditing standards for audits of commercial enterprises that are not publicly held

Through the accounting standards executive committee AICPA publishes

* audit and accounting guides
* statements of position
* practice bulletins

Audit and accounting guides

these were guides to help the auditor audit certain types of businesses and certain types of business transactions

Statement of position (SOPs)

were written in accounting topics where FASB had not set current accounting standards

Practice bulletins

which identified AcSEC’s views on narrow accounting issues not addressed in FASB

The AICPA also publishes

journal of accountancy; a monthly periodical on financial accounting and auditing tips

American accounting association

* composed primarily of accounting academicians
* it is interested probably more in accounting theory than in accounting practice
* it publishes the accounting review; a monthly periodical

Institute of management accounting

* it is composed primarily of management accountants (accountants working for a private company)
* it published strategic finances; a monthly periodical on internal accounting and finance

Governmental accounting standards board

* created under the auspices of the financial accounting foundation
* its purpose is to establish standards of financial reporting for state and local governments

Emerging issues task force

* created under the auspices of FASB
* its purpose is the early identification and solution of emerging issues in the accounting profession

Non-accounting influences

* the financial executive institute (FEI)
* client companies
* brokerage firms and their analysts
* institutional investors
* individual investors
* bankers (and other creditors)
* state societies of CPAs
* industrial trade organizations
* lobbyists
* CPA firms and individual CPAs

Generally accepted accounting principles

“principles”, in this case really means “methods” that is, LIFO inventory valuation, straight-line depreciation and the allowance method of accounting for bad debts are examples of GAAP

* accounting principles such as “full disclosure”, “matching”, and “consistency” are not examples of GAAP

These are methods of accounting that are “generally accepted”

historically, if a method had “substantial authoritative support”, then it was considered GAAP

A method had “substantial authoritative support” if

* it was a rule/regulation/guideline of FASB or the APB or CAP
* it had the support of some other meaningful organizations, such as:
* the SEC
* practicing accountants or CPA firms
* the AICPA, AAA, or IMA
* industry trade organizations
* a regulatory authority or other governmental agency
* many other sources

FASB created a new hierarchy with

the issuance of a new FASB standards statement that categorizes GAAP as either being “authoritative” or “non-authoritative”; this involves a codification of GAAP that is a FASB written codification of what is GAAP

GAAP is accrual accounting rather than cash accounting, that is

* revenues are recorded when earned (not when cash is received)
* expenses are recorded when incurred (not when the cash is paid)

Who must follow GAAP?

companies that require an audit

Who needs an audit?

most companies that deal with third-party (an investors, a lender, or another creditor) who demands audited financial statements before dealing with the company

International accounting standard setting

is now considered the “official” international accounting standard setting body

IASB versus FASB

IASB standards are generally “principles-based” standards whereas FASB standards are “rules-based”

* international standards are called either “iGAAP” or “IFRS”

The IASB currently has

a “hierarchy of GAAP” that practicing accountants are supposed to use rather than a codification

The SEC currently permits

all foreign companies that trade their securities in U.S. markets to provide their IFRS financial statements to the SEC without reconciliations to U.S. GAAP

There are discussions

that the SEC will permit all US publicly held companies to follow iGAAP in the near future

* there is not much agreement on which GAAP or iGAAP - private companies in the US will eventually follow if US publicly held companies move to iGAAP reporting

Any power that the IASB has

comes from users of financial statements who demand that companies dealing with them have their financial statements audited according to iGAAP just as FASB’s power comes from users in the US who have historically demanded that companies dealing with them have their financial statements audited according to US GAAP

The sarbanes-oxley act

* this act created the PCAOB, which sets auditing standards for publicly held companies
* this act also created other requirements for publicly held companies

The PCAOB first decided

that all of the auditing standards written by the ASB were still “generally accepted auditing standards” and would remain as such until the PCAOB chooses to supercede them

One of the first new auditing standard written by the PCAOB

involved “auditor independence” and requires greater auditor independence than previous standards required

This act created other requirements for publicly held companies, including

* bonus forfeiture by company officers who head companies that are required to later have restatements of company financial statements that resulted in thos bonuses being earned

Required board of director “audit committees” that work with the company auditor

* these committees should consist of independent (outside) board members
* these committees should consists of one or more “financial experts” that is members who have a knowledge of finance, financial reporting, the audit process, and the industry in which the reporting entity is operating

Required companies to

* create a code of ethics for the members of their top management or explain why there is no code of ethics
* disclosure any expectations made to the company’s code of ethics by top management

Certification of financial statements by the company CEO and CFO

this certification is a written statement by the CEO and CFO stating among other things:

* that based on their knowledge the financial statements do not include any untrue statements
* that based on their knowledge the financial statements present fairly in all material respects the financial condition and results of operations of the company
* that they are responsible for establishing and maintaining internal control over financial reporting and also controls and procedures over reporting entity disclosures