ACC 340 Shields Chapter 1 – Financial Reporting Environment and Conceptual Framework
The Environment and Conceptual Framework of Financial Reporting (ACC 340 Shields Chapter 1)
Introduction to Financial Reporting
Purpose of Chapter 1: Discusses how financial reports are utilized by investors and creditors, how Generally Accepted Accounting Principles (GAAP) are established by the Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission (SEC), and the necessity of GAAP.
Key Topics Covered:
FASB's Codification Research system.
FASB's Conceptual Framework, providing insight into the "what," "why," and "how" of financial statements and disclosures.
The political nature of accounting standard-setting.
Comparison and contrast between FASB and International Accounting Standards Board (IASB).
Users of Financial Reports
Financial reports are used by various stakeholders to make informed decisions and facilitate capital allocation.
Primary User Groups (LO 1):
Owners and Managers of business enterprises or other organizations.
Creditors (e.g., bankers and other lenders).
Stockholders (both current and potential).
Facilitating Capital Allocation: Financial reports, along with news reports and advice from experts (like investment bankers) and rating agencies, help investors and creditors determine their investment levels, aiding in the efficient allocation of capital.
Accounting Standard-Setting in the U.S.: FASB and SEC
Securities Exchange Act of 1934 (LO 1): Established the requirement for uniform accounting standards, specifically for public companies.
Role of the SEC (Securities and Exchange Commission) (LO 1):
Originally charged with setting accounting standards.
Delegated this authority to private standard-setting bodies over time.
Requires public companies to adhere to GAAP.
Maintains oversight responsibility and enforcement authority over accounting standards.
Evolution of Standard-Setting Bodies (LO 1):
Committee on Accounting Procedure (CAP) was the initial private body.
Accounting Principles Board (APB) succeeded CAP.
Financial Accounting Standards Board (FASB) succeeded APB and is the current standard-setter in the U.S.
FASB's Purpose (LO 1): 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.
Organizational Structure and Due Process of FASB
FASB Structure (LO 1):
FASB (Financial Accounting Standards Board): Responsible for setting accounting standards.
FASAC (Financial Accounting Standards Advisory Council): Consults on major policy issues, technical issues, project priorities, and the selection and organization of task forces.
FASB Due Process (Process for Setting Standards):
Topic Identification: Topics are identified and placed on the Board's agenda.
Preliminary Views: Research and analysis are conducted, leading to the issuance of preliminary views on pros and cons.
Public Hearing: A public hearing is held on the proposed standard to gather stakeholder input.
Exposure Draft: The Board evaluates research and public response and then issues an exposure draft.
Accounting Standards Update: The Board evaluates responses, makes necessary changes to the exposure draft, and then issues a final standard.
Types of FASB Pronouncements
Accounting Standards Updates (Authoritative): These are the formal standards that establish U.S. GAAP.
Financial Accounting Concepts (Not Authoritative): These statements set forth the fundamental objectives and concepts that the FASB uses in developing standards of financial accounting and reporting.
FASB Codification
Organization of Accounting Rules (LO 1): The FASB Accounting Standards Codification is the single source of authoritative U.S. GAAP for nongovernmental entities.
Key Features:
Provides all authoritative literature related to a specific topic.
Simplifies user access to all authoritative U.S. GAAP.
Establishes the way GAAP is documented, presented, and updated.
Eliminates nonessential information.
Codification Framework (Example: Receivables):
Topic: A collection of related guidance on a given subject (e.g., 310 - Receivables).
Subtopics: A subset of a topic, distinguished by type or scope (e.g., 10 - Overall, 40 - Troubled-Debt Restructurings by Creditors).
Sections: Type of content within a subtopic (e.g., 30 - Initial Measurement, 35 - Subsequent Measurement).
Paragraphs: The level containing the substantive content related to the researched issue (e.g., 47 - Loans and Trade Receivables Not Held for Sale).
Other Organizations Involved in Accounting Rule-Making
American Institute of Certified Public Accountants (AICPA) (LO 1):
A national professional organization for CPAs.
Provides guidance on both accounting and auditing rules and procedures.
International Accounting Standards Board (IASB) (LO 1):
A separate organization based in London.
Issues accounting rules (International Financial Reporting Standards - IFRS) for most of the world.
Used in over 120 countries globally.
FASB's Conceptual Framework: An Overview (LO 3)
Serves as a foundation for understanding the "what," "why," and "how" of financial statements.
First Level: Basic Objective of Financial Reporting (The "Why")
Objective (LO 2): To provide information about the reporting entity that is useful to present and potential equity investors, lenders, and other creditors in their capacity as capital providers.
Decision-Usefulness: Investors and creditors are interested in assessing:
The company's ability to generate net cash inflows.
Management's ability to protect and enhance the capital providers' investments.
Entity Perspective: Companies are viewed as separate and distinct from their owners.
Types of Decisions (LO 2):
Investors: Decide whether to buy, sell, or hold stock in a company.
Lenders: Decide whether to lend money to a company, and determine the interest rate and loan term.
Second Level: Fundamental & Enhancing Qualitative Characteristics (Bridge between levels 1 and 3)
These characteristics make financial information useful for decision-making.
Decision-Usefulness is the pervasive criterion.
Fundamental Qualities (LO 2):
Relevance: Information is relevant if it is capable of making a difference in a decision. It includes:
Predictive Value: Helps users form their own expectations about future outcomes.
Confirmatory Value: Helps users confirm or correct prior expectations.
Materiality: A company-specific aspect of relevance. An item is material if its omission or misstatement could influence a decision-maker. This requires evaluating both relative size and importance.
Materiality Example (LO 2):
Company A: Sales 10,000,000, Income from operations 1,000,000. An unusual gain of 20,000 would be a 2.00% misstatement of income from operations. (Immaterial)
Company B: Sales 100,000, Income from operations 10,000. An unusual gain of 5,000 would be a 50.00% misstatement of income from operations. (Material)
A normal threshold for materiality is 5.00% of revenue, net income, or total assets, but this can vary.
Faithful Representation: Information accurately depicts what it purports to represent. It includes:
Completeness: All necessary information for faithful representation is provided.
Neutrality: Information cannot be selected to favor one set of interested parties over another.
Free from Error: Information is accurate and without material error.
Enhancing Qualities (LO 2): Complementary to fundamental qualities.
Comparability: Ability to compare information across different entities and over time for the same entity (includes consistency).
Verifiability: Independent parties using the same methods would arrive at similar conclusions.
Timeliness: Information is available to decision-makers before it loses its capacity to influence decisions.
Understandability: Information is comprehensible to users with a reasonable knowledge of business and economic activities and a willingness to study the information.
Example: Applying Qualitative Characteristics to Investment Decisions (AROD Case) (LO 2):
A broker provides old, unaudited financial statements for AROD (online sports memorabilia seller).
Statements show 3,500,000 profit and low debt-equity ratio for last year.
No comparative prior year amounts or disclosures on accounting methods (inventory, depreciation, liabilities).
Conclusion: The AROD statements are neither relevant nor a faithful representation.
Lack of Relevance:
Timeliness: Statements are a year old; much could have changed, decreasing their decision-influencing ability.
Predictive Value: No historical trends (comparative data) prevent investors from predicting future profitability.
Confirmatory Value: Provides no feedback on past strategies.
Lack of Faithful Representation:
Verifiability: Unaudited statements are not verified by independent parties, making claims about profit and debt-equity ratio unreliable.
Neutrality: Statements prepared by the owner (Roderick Andrews) lack neutrality as the owner is an interested party, potentially presenting a favorable bias.
Second Level: Elements of Financial Statements (Assets, Liabilities, Equity, etc.)
Elements (LO 2):
Assets: Resources owned by or owed to the entity that will generate probable future economic benefits.
Liabilities: Probable future sacrifices to settle an obligation from a past transaction.
Equity: The residual claims of owners.
Investments by Owners: Increases in equity due to original investment by owners.
Distributions to Owners: Decreases in equity due to dividends.
Comprehensive Income: All other changes in equity except those from investments by owners and distributions to owners. Includes:
Net Income
Four "Other Comprehensive Income" (OCI) items:
Gains or Losses on "Available for Sale" Securities.
Translation Adjustments on Foreign Currency.
Pension Liability Adjustments.
Unrealized Gains/Losses from Hedging Transactions.
Revenues: Inflows of assets or settlement of liabilities from performing services or delivering goods from ongoing operations.
Expenses: Outflows of resources as a result of ongoing operations.
Gains: Increases in equity due to incidental or peripheral transactions.
Losses: Decreases in equity due to incidental or peripheral transactions.
Third Level: Recognition, Measurement, and Disclosure Concepts (The "How")
These consist of Assumptions, Principles, and a Constraint that support the implementation of the conceptual framework.
Underlying Assumptions (LO 3)
Economic Entity Assumption: The owner and the business are separate and distinct entities. All economic activities of an entity can be identified with one accountable unit (e.g., parent company reports aggregated results of subsidiaries).
Going Concern Assumption: The company will continue to operate into the foreseeable future.
If not assumed, historical cost principle would be of limited usefulness.
Depreciation and amortization approaches might need adjustment.
Current and noncurrent classification of assets and liabilities might lose significance.
Monetary Unit Assumption: Financial statements are reported in a stable monetary unit (e.g., U.S. Dollar), ignoring price level changes due to inflation/deflation.
Periodicity (Time Period) Assumption: A company must report its results before the information loses its value (e.g., quarterly, annually).
Principles (LO 3)
Measurement Principle: The two most common measurements are:
Historical Cost: Report assets/liabilities based on their original acquisition cost.
Advantage: Objective, Reliable, and Verifiable.
Fair Value: The current cash equivalent value (what a willing party would pay/receive today on the balance sheet date).
Advantage: Relevant.
Disadvantage: Can be more subjective.
FASB's Fair Value Hierarchy (Examples):
Level 1: Closing price for public company stock (e.g., Microsoft, Inc.).
Level 2: "Blue Book" price for a used automobile (observable inputs other than quoted prices).
Level 3: Calculated value of a division based on the present value of its expected future cash flows (unobservable inputs).
Revenue Recognition Principle: States when revenue should be recognized.
Performance Obligation: Occurs when a company agrees to perform a service or sell a product to a customer.
Revenue is recognized when the company satisfies a performance obligation.
Satisfaction can be at a single point of sale or over time.
Five Steps of Revenue Recognition:
Identify the contract with customers.
Identify the separate performance obligations in the contract.
Determine the transaction price.
Allocate the transaction price to the separate performance obligations.
Recognize revenue when (or as) the entity satisfies each performance obligation.
Example (Apple iPhone): Sells an iPhone for 1,000 and agrees to software updates for two years. 80.00% of cost associated with the phone, 20.00% with software upgrades, indicating two performance obligations affecting steps 4 and 5. (Specific step details were omitted from transcript but implied by breakdown).
Expense Recognition Principle: Expenses are recorded when resources are "used up" to generate revenue, thereby matching expenses with revenues to determine periodic income.
Direct Matching: Assumes a cause-and-effect relationship (e.g., Cost of Goods Sold with Revenue).
Indirect Matching (Systematic and Rational Allocation): Allocates costs to expense over periods benefited (e.g., Depreciation Expense, Rent Expense, Insurance Expense).
Immediate Recognition: Costs are expensed immediately if difficulty or impracticality in determining related revenues (e.g., Advertising Expense when ad is run, Research and Development in period of expenditure).
Full Disclosure Principle: A company must provide sufficient footnote disclosure of important information.
Must be detailed enough to make a difference to the user.
Must be sufficiently condensed to be understandable.
Constraint (LO 3)
Cost Constraint: The cost of providing financial reporting information should not exceed the benefits derived from that information.
Industry Practice: Provide information as it is customarily provided in a given industry.
User Groups Influencing Standard Formulation (Political Nature)
The formulation of accounting standards can be a political process, influenced by various groups:
CPAs and accounting firms.
Business entities.
AICPA (FinREC).
Academicians.
Financial community (analysts, bankers, etc.).
Preparers (e.g., Financial Executives Institute).
Government (SEC, IRS, other agencies).
Investing public.
Industry associations.
Major Challenges in Financial Reporting (LO 4)
The Expectations Gap: The difference between what the public believes accountants should do and what accountants believe they can do. Difficult to close due to accounting scandals.
Sarbanes-Oxley Act (2002): Legislation enacted to address corporate accounting scandals.
Public Company Accounting Oversight Board (PCAOB): Focuses on audit quality and management's responsibility for the quality of financial statements.
Significant Financial Reporting Issues:
Nonfinancial Measurements: Financial reports often lack key performance measures used by management (customer satisfaction, backlog, reject rates, sustainability efforts).
Forward-looking Information: Reports often fail to provide future-oriented information needed by investors and creditors, being primarily historical.
Soft Assets (Intangibles/Intellectual Property): Focus on hard assets (inventory, plant assets) means less information on crucial soft assets (e.g., Microsoft's know-how, Walmart's supply chain, P&G's brand image).
Timeliness: Financial statements are prepared quarterly and annually, lacking real-time information.
Understandability: Concerns exist regarding the complexity of financial reports.
U.S. GAAP vs. International Financial Reporting Standards (IFRS) (LO 5)
Similarities
Private Organizations: Both GAAP (FASB) and IFRS (IASB) are developed by private organizations.
SEC oversees FASB in the U.S.
International Organization of Securities Commissions (IOSCO) oversees IASB internationally.
Similar Governance Structure: Both IASB and FASB have comparable structures: a Foundation for oversight, a Board, an Advisory Council, an Interpretations Committee, and public interest involvement.
Convergence Efforts: Both bodies are working towards convergence, as evidenced by the joint issuance of a new revenue recognition standard.
Same Basic Approach to Conceptual Framework: The objectives of financial reporting and the qualitative characteristics of useful information are shared between the two frameworks.
However, the IASB has completed its conceptual framework, while the FASB has not.
Differences
Rules-Based vs. Principles-Based:
GAAP: More detailed and rules-based.
IFRS: Tends to be simpler, more flexible, and principles-based.
This difference fuels debate over the merits of each approach.
Different User Needs: Standards are developed in response to varied user needs.
In some countries, primary users are private investors, tax authorities, or central government planners.
In the United States, investors and creditors have primarily driven accounting standard formulation.
IASB More Focused on Stewardship:
The IFRS conceptual framework explicitly emphasizes the need for information about an entity's resources to assess management's effectiveness and efficiency in discharging their stewardship responsibilities.
Also includes the need for information to help users understand prospects for future net cash inflows.
IASB on Relevance vs. Measurement Uncertainty:
The IFRS framework clarifies that measurement uncertainty does not necessarily prevent information from being useful.
In some cases, information with slightly less relevance but lower measurement uncertainty may be more useful.
Fair Value Accounting:
IFRS: More broadly adopts fair value accounting for a wider range of asset classes (e.g., property, plant, and equipment, natural resources, and some intangible assets).
GAAP: Is increasing fair value use but less extensively than IFRS at present.