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Learning Objectives: What is accounting? Why financial statements are important? Who are the users of financial statements? How do these users use financial statements? What is GAAP? What is the standard setting process? What are some qualitative characteristics of accounting information? What are some major concepts and assumptions underlying accounting principles?
What is Accounting ?
An information system to account for all business transactions and translate these transactions into accounting/financial terms to be reported in financial statements.
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Assess the risks (i.e., credit risk, asset risk) Provide a comprehensive economic history of a business entity Thus, financial statement can be used for various purposes (p3 of the textbook):
As an analytical tool. As a management report card. As an early warning signal. As a basis for prediction. As a measure of accountability.
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Additional Information
Presidents letter Prospectuses, SEC Reporting News releases Forecasts Environmental Reports Etc.
GAAP
Not GAAP
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Learning Objective :
Shareholders and investors 1. Investment decisions/stewardship function 2. Proxy contests Lenders and suppliers 1. Lending decisions 2. Covenant compliance Customers 1. Suppliers health 2. Repeat purchases 3. Warranties & supports
Managers and employees 1. Performance assessment 2. Compensation contracts 3. Company-sponsored pension plans Government and regulatory agencies 1. Mandatory reporting 2. Taxing authorities 3. Regulated industries
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Relevant financial information is provided primarily through financial statements and related disclosure notes.
Major Financial statements: Balance Sheet, Income Statement, Statement of Stockholders Equity and Statement of Cash Flows.
Disclosures
Other forms of information: Press releases and management discussions (MD&A).
Type of Disclosures:
Mandatory Disclosure (i.e., leases, pension plans, etc.): Required by the SEC and accounting standards. Voluntary disclosure: Guided by cost/benefit considerations.
Disclosure Benefits
The following are benefits arising from voluntary disclosures : Increase investors confidence on the quality of companys equity offerings. Obtain capital cheaply from the capital markets. Get better deals from suppliers.
Disclosure Costs
The costs which may arise from voluntary disclosures : Information collection, processing and dissemination costs. Competitive disadvantage costs. Litigation costs. Political costs.
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Its May 2002 and your brother says you should buy WorldCom shares. The shares look incredibly cheap at $2.00 because the company has a book value of $20.50/share and cash of $0.73/share. WorldCom has weathered the industry downturn better than other companies. But an article in this mornings paper raises a new concern:
Holding steady despite declining message volume
42%
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Epilogue of WorldCom
In June 2002, WorldCom says $3.8 billion in line cost expenses were wrongly transferred to the balance sheet as assets. Share price falls to $0.06. $11 billion of improper transfers are eventually uncovered. In July 2002, the company declares bankruptcy.
ASSET
$3.8 b ? EXPENSE
AOL spent $363 million on subscription promotion (costs paid for subscriber starter kits, direct marketing mailers, etc.) in 1996 while only recognized $126 million of that amount as advertising expense in 1996, deferring the rest as assets.
In May 2000, AOL agreed to pay a fine of $3.5 million to SEC due to its violation of GAAP in deferring subscriber acquisition costs in 1995 and 1996.
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Lessons learned
Financial statement fraud is rarebut users should NOT simply accept the numbers at face value. Flexibility in accounting standards provides opportunities for companies to manipulate the information reported in the financial statements. Self-interest can also drive managers to overstate the income number, especially when compensation is based on earnings.
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Learning Objectives
Define generally accepted accounting principles (GAAP) The need for GAAP The historical development of accounting standards The standard setting process of the Financial Accounting Standards Board (FASB)
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GAAP: Accounting methods with substantial authoritative support to be used by business entities in preparing external reports for users. Most of what constitutes U.S. GAAP is in the form of written pronouncements issued by the FASB and its predecessors.(i.e., APB). The need for the GAAP.
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GAAP (Contd.)
Public held companies and certain regulated companies are required to use GAAP in preparing financial statements. Reasons?
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Private Sector
AICPA
American Institute of Certified Public Accountants
SEC
Securities and Exchange Commission
FASB
Financial Accounting Standard Board
IASB
International Accounting Standard Board
Year
1934
Authority
Congress SEC
Official Release
1938
Regulation S-X ASR and FRR Staff Accounting Bulletins Accounting Profession AICPA CAP ARBs (51) APB APB Opinions (31) FASB . 1. Statement of Financial Accounting Standards 2. Interpretations 3. Concepts of Financial Accounting 4. Technique Bulletins
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The U. S. GAAP
Includes: 1. FASB statements (1973 - Present) 2. FASB Interpretations ( 1973 - Present) 3. APB Opinions (1959 - 1973) 4. APB Interpretations (1959 - 1973) 5. CAP, ARBs (1938 - 1959) 6. Other Authoritative Pronouncements (i.e., ASR & FRR of the SEC, Technique
Bulletins/Staff Positions of FASB, and Staff Acct. Bulletins of the SEC, Abstracts of EITF, SOP of the AICPA, etc.)
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Effective July 1, 2009, FASB Accounting Standards Codification became the single source of authoritative, nongovernmental U.S. GAAP. The pronouncements of the SEC are also sources of authoritative GAAP for SEC registrants.
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The Codification Research System (CRS) (Source: SFAS 168) Codification Research System (CRS): An online database developed by the FASB to allow easy access to the Codification (and therefore, the GAAP) online. CRS uses a numerical index system in which numerical numbers are used to correspond with topics, subtopics, sections and paragraphs.
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The Codification does not change GAAP but only the way the existing accounting standards are organized.
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The Board identifies an accounting issue based on requests received from various sources. The Chairman decides whether to add a project to the technical agenda after consulting with other members and subject to oversight by the Foundations Board of Trustees.
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The Board deliberates the various issues identified and analyzed by the staff at one or more public meetings.
The Board issues an Exposure Draft (In some case, the Board may issue a Discussion Paper to obtain comments prior to issuing the Exposure Draft.)
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The Board holds a public roundtable meeting on the Exposure Draft, if necessary. The staff analyzes comment letters, public roundtable discussion, and any other information .
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The Board re-deliberates the proposed provisions at one or more public meetings. The Board issues an Accounting Standards Update (ASU) to amend ASC by a simple majority vote. The passage of an ASU requires 3 votes. (note: effective 7/2008, FASB members reduced from 7 to 5).
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Learning Objective
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Companies doing business in more than one nations found that it is hard to comply with more than one set of accounting standards established by authorities in different nations. In response to this problem, International Accounting Standards Committee (IASC) was formed in 1973 to develop a single set of global accounting standards.
Environment and Theoretical Structure of Financial Accounting 29
41 International Accounting Standards (IAS) was issued by IASC. IASC created International Accounting Standards Board (IASB) in April, 2001 to be in charge of prescribing the standards. IASB endorsed 41 IAS and named its pronouncement as International Financial Reporting Standard (IFRS).
Environment and Theoretical Structure of Financial Accounting
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Convergence of the U.S. Accounting Standards and the International Accounting Standards
To increase the international comparability and the quality of US accounting standards, the FASB has been engaged in activities to increase the convergence of the accounting standards.
The FASB is working closely with the IASB toward the convergence of accounting standards (i.e. to develop a single set of standards).
Environment and Theoretical Structure of Financial Accounting 31
The IASB and the FASB acknowledged that convergence of IFRS and U.S. GAAP is a primary objective of both Boards. To achieve this objective and to improve the financial reporting in the US, the FASB started a short term project, conducted jointly with the IASB, to eliminate narrow differences between US GAAP and IFRS (or IAS) in October, 2002.
Environment and Theoretical Structure of Financial Accounting 32
The Securities and Exchange Commission (SEC) is proposing a Roadmap for the potential use of financial statements prepared in accordance with IFRS by U.S. issuers for purposes of their filings with the SEC.
This Roadmap sets forth several milestones that, if achieved, could lead to the required use of IFRS by U.S. issuers in 2014.
Current Compliances
Since there is no single set of high-quality accounting standards, domestic (U.S.) firms filing reports with the SEC must use U.S. GAAP. Foreign issuers filing reports with the SEC can use U.S. GAAP, the international standards or the GAAP of its home country. If foreign firms chose not to use U.S. GAAP, they must file reports with reconciliation to U.S. GAAP.
Environment and Theoretical Structure of Financial Accounting 34
Learning Objective
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The Financial Reporting Reform and the Sarbanes and Oxley Act
The collapse of Enron, the dissolving of Arthur Andersen and the accounting scandals of some high-profile firms
(WorldCom, Xerox, Global Crossing, etc.)
severely damaged public confidence in the accounting profession and the financial reporting.
At the demand of the public, the Sarbanes-Oxley Act was passed in July 2002 to restore the public confidence in the credibility of the financial reports.
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The Financial Reporting Reform and the Sarbanes and Oxley Act (Cont.)
Key Provisions of the Act including: Creating the Public Accounting Company Oversight Board: establish auditing standards.
Learning Objectives
Identify the objectives of financial reporting, the qualitative characteristics of accounting information, and the elements of financial statements.
Describe the four basic assumptions underlying GAAP
Describe the four basic accounting principles that guide accounting practice.
How does the FASB prescribe the accounting standards? Definition of Conceptual Framework of Financial Reporting: A system of interactive objectives and fundamentals which can lead to a set of consistent standards in preparing financial reports.
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Environment assumptions
Implementation principles
Implementation constraints
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I. Primary Qualities
1) Relevance
2) Faithful Representation a) Complete a) Predictive value b) Confirmatory value b) Neutral c) Free from error c) Materiality
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1) Comparability(including consistency)
2) Verifiability 3) Timeliness
4) Understandability
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Measurement and Recognition Concepts I. Assumptions 1) Economic Entity 2) Going-concern (continuity) 3) Monetary unit 4) Periodicity (Period of time)
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III. Constraints
1) Cost-Benefit 2) Materiality 3) Industry Practice 4) Conservatism
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The interrelationship of the SEC and the FASB: FASB: the current rule making body. SEC: the enforcing agency of securities laws and accounting standards; regulating the stock market.
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Learning Objectives
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Level 2
Level 3
Fin. 39 Netting
Net Bal.
Total
$13,674
$ 166
$(7,575)
$6,267
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Question
The function of financial accounting is to identify, measure and communicate financial information about economic entities to interested parties.
a. True b. False
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Question
Generally accepted accounting principles include both standards set by various rule making bodies and certain accounting practices that have evolved over time.
a. True b. False
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Question
The major financial accounting standards setting body in the U.S.A. is the
a. b.
c. d.
Accounting Principles Board Securities and Exchange Commission Financial Accounting Standards Board American Institute of CPAs
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Question
The Financial Accounting Standards Board develops accounting and reporting standards independent of public, business and political pressures. a. True b. False
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Financial statements are an important source of information about a company, its economic health, and its prospects. Financial statements help improve decision making of investors and make it possible to monitor managers activities. They also help creditors to make credit decisions and financial analysts to make recommendations to their clients. Therefore, there is a demand for the financial statements.
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Summary (contd.)
What governs the supply of financial information? Mandatory reporting and voluntary disclosure. Benefit and cost considerations influence voluntary disclosure.
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Summary (contd.)
Financial accounting standards (GAAP) are often imprecise and subject to interpretations. This imprecision gives managers an opportunity to shape financial statements: Most use the accounting flexibility to paint a truthful economic picture of the company. Other managers shape the financial statements to mask weaknesses and to hide problems. So analysts must maintain a healthy skepticism about the numbers.
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