Chapter Two Financial Reporting: The Cornerstone of a Market Economy.

Chapter Two

Financial Reporting:

The Cornerstone of a Market Economy

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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


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


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.


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)


Contributors to GAAP


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


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


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)


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


Other Private-Sector Standard Setters

• Institute of Management Accountants (IMA)

• Financial Executives International (FEI)


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


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


FASB’s Standard-Setting Process


Which accounting rules have the highest authority?


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


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


FASB’s Conceptual Framework


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


Hierarchy of Accounting Qualities


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?


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


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


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


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


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


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


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


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.


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.



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.



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.



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.



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.

Chapter Two Financial Reporting: The Cornerstone of a Market Economy.

Documents

financial statements

financial reporting

fasb slide

financial position

securities market slide

reporting standards

rights reser

defined accounting practices