ACCT 327 - Ch 1, TAMU, Cline

Why does Accounting matter?

Accounting information is used for investment decisions, and good credit and investment decisions are necessary for proper capital allocation on a macroeconomic level, which contributes to a healthy society.

What does GAAP stand for?

Generally Accepted Accounting Principles

What are the parties involved in setting GAAP?

SEC, AICPA until 1973, FASB

Codification

Integrates GAAP until "one roof", combines the 2,000+ documents to make it easier to find information, reduces redundancy, and creates one level of authoritative GAAP.

How is the codification organized?

topic, subtopic, section, paragraph

The FASB follows a due process of standard setting...

I. Identify topic based on input by stakeholders, FASB members, or staff.

II. Make a decision to put topic on agenda.

III. Deliberate the issues at a public meeting.

IV. Issues a preliminary document for public comment. This usually results in the publication of an Exposure Draft, which is open to public comment for a period of time.

V. Exposure draft is revised based on public response through comments, public hearings, and round table discussions. There may be several rounds of exposure drafts.

VI. Accounting Standards Update is issued if 4 of 7 FASB members approve of the final draft.

How many steps are taken by the FASB to issue an Accounting Standards Update?

6

What is step 1 taken by the FASB to issue an Accounting Standards Update?

Identify topic based on input by stakeholders, FASB members, or staff

What is step 2 taken by the FASB to issue an Accounting Standards Update?

Make a decision to put topic on agenda

What is step 3 taken by the FASB to issue an Accounting Standards Update?

Deliberate the issues at a public meeting

What is step 4 taken by the FASB to issue an Accounting Standards Update?

Issues a preliminary document for public comment. This usually results in the publication of an Exposure draft, which is open to public comment for a period of time

What is step 5 taken by the FASB to issue an Accounting Standards Update?

Exposure draft is revised based on public response through comments, public hearings, and round table discussions. There may be several rounds of exposure drafts

What is step 6 taken by the FASB to issue an Accounting Standards Update?

Accounting Standards Update is issued if 4 of 7 FASB members approve of the final draft

What is the SEC and what is their role?

Securities and Exchange Commission: Federal agency that enforces GAAP and can prescribe accounting practices for companies, but typically doesn't.

What is the AICPA and what is their role?

American Institute of Certified Public Accountants: developed GAAP until 1973, over private companies. AICPA members work for other companies.

What is the FASB and how have they improved from previous standard setting boards?

Federal Accounting Standards Board: More autonomy and independence that previous standard setting boards and wider representation because FASB board members are full-time employees.

What pronouncements does the FASB issue?

1. Financial Accounting Concepts: fundamental objectives and concepts making up conceptual framework. These are NOT GAAP because they are guiding principles.

2. Accounting Standards Updates makes amendments to the Codification.

3. The Emerging Issues Task Force (EITF) provides implementation guidance to reduce diversity in practice on new, controversial, or challenging issues.

What is the EITF?

Emerging Issues Task Force: provides implementation guidance to reduce diversity in practice on new, controversial, or challenging issues. Once EITF guidance is passed by the FASB, it is considered authoritative.

What is IFRS?

International Financial Reporting Standards: required or permitted by most other countries, including EU.

What are the top reasons for wanting IFRS and US GAAP to converge?

1. Ease international mergers and acquisitions

2. Ease financial statement preparation for multinational companies

3. increase understandably for users

4. Facilitate international commerce

What are the recent changes to GAAP and IFRS that are working towards convergence?

Revenue Recognition (Software companies) and Lease accounting (not as similar between the two).

What are 4 of the main differences in IFRS and US GAAP?

1. Required Applicability: IFRS covers international markets.

2. Industry Specificity: IFRS has very litte, US GAAP has a lot.

3. Inventory Standards: IFRS does NOT allow LIFO. US GAAP does NOT allow reversal of inventory write-downs

4. Comprehensive Income Statements: Not included in IFRS financial statements, but is included in GAAP.

Why does the SEC not want to switch to IFRS?

IFRS is principles based which is more lenient and harder to enforce than rules based US GAAP.

What is the Sarbanes-Oxley Act (SOX)?

SOX regulates how accountants and auditors should behave, it does NOT regulate how to implement specific accounting standards. Keeps things ethical.

What are the 5 provisions of SOX?

1. Public Company Accounting Oversight Board

2. Statement/Confirmation that auditors are independent

3. CEO and CFO certification of the accuracy and completeness of the financials

4. Requirement of a code of ethics

5. Company must attest to the effectiveness of their internal controls

What board was created as a result of SOX?

Public Company Accounting Oversight Board (PCAOB)

Who does the PCAOB oversee?

Auditors

How can an auditor prove they are independent?

No financial ties, no affiliated companies, no family ties

What is the role of an audit partner?

Sign off and take responsibility for audit

What is the point of rotating an audit partner every 5 years?

Avoid building ties

Why is it important to have the CEO and CFO sign off on the financials?

Makes them liable

Why is it important to have a code of ethics?

To hold people accountable

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 (Decision Usefulness)

The fundamental decision-useful characteristics

Relevance and Faithful Representation

What are the 3 qualities of relevance?

1. Predictive Value

2. Confirmatory Value

3. Materiality

Predictive Value

Information can be used to predict future outcomes

Confirmatory Value

Can confirm or correct prior expectations

Materiality

Omitting or misstating information could influence decisions

What are the 3 qualities of Faithful Representation?

1. Completeness

2. Neutrality

3. Error-free

What is Completeness?

All information necessary for an informed decision is provided

What is Neutrality?

Cannot select information to manipulate financial statement users

What are the 4 enhancing characteristics?

1. Comparability

2. Verifiability

3. Timeliness

4. Understandability

What are the assumptions made to prepare and use financial statements?

1. Economic Entity

2. Going Concern

3. Monetary Unit

4. Periodicity

Economic Entity

The company is separate from owners, managers, and other business units. This is not the same as legal entity.

Going Concern

financial statements are prepared with the expectation that a business will remain in operation indefinitely

What does the Going Concern effect?

Depreciation and Current/Non-Current Assets/Liabilities

Monetary Unit

Money is the best way to express information to interested parties. Inflation is not considered in the U.S.

Periodicity

Activities of business can be divided into artificial time periods (months, quarters, etc.) Shorter time periods = more errors

What is the FASB's recently adopted approach to revenue recognition?

Contract-based

How many step are there to recognize revenue?

5

What is the first step in revenue recognition?

Identify contracts with the customer

What is the second step in revenue recognition?

Identify separate performance obligations in the contract. A performance obligation is created when a company agrees to provide a service or sell a product.

What is the third step in revenue recognition?

Determine the transaction price

What is the fourth step in revenue recognition?

Allocate the transaction price to the separate obligations

What is the fifth and final step in revenue recognition?

Recognize revenue when each performance obligation is satisfied

What is the matching principle?

Expenses follow the revenue, such as COGS are recognized in association with the revenue for that period.

What is done when the matching principle can't be followed?

Depreciation or other allocation processes are used.

What are period expenses?

Expenses such as salary of some employees that don't have a direct role in revenues are recorded as some period expense account.

What are the 2 measurement principles?

1. Historical Cost

2. Fair Market Value (FMV)

Historical Cost

Assets and liabilities are recorded at the acquisition price. This is verifiable (faithful representation) and is the traditional measurement approach for most assets.

Fair Market Value (FMV)

The price a reasonable, unpressured buyer would pay for property on the open market. Often more relevant than Historical cost, but less verifiable.

When do you list an asset at FMV?

When FMV is more conservative than historical cost.

What assets are listed at FMV?

Some non-inventory assets, but always investments because they are intended to be sold for a probable gain.

How many levels are there to determine the reliability of fair market value?

3

What is level 1 FMV?

Observable inputs, quoted prices, identical asset/liabilities, active market

What is an example of a level 1 FMV?

Stock that can be accurately valued at any time on the public stock market.

What is level 2 FMV?

Non-quoted, but observable inputs that can be corroborated by observed information or directly observed

What is an example of a level 2 FMV?

The value of a used car will vary depending on each owner and it's unlikely to get the same quote from 2 different people.

What is level 3 FMV?

Unobservable inputs (i.e. company's own data), transactions measured using level 3 inputs require significantly more disclosure in the financial statements.

What is an example of a level 3 FMV?

A one-of-a-kind car developed by the company for internal use and there is not an active market for something similar (if something similar existed)

Cost Effectiveness Constraint

The cost of implementing an accounting rule should not exceed the benefits to users of financial statements.