Intermediate Financial Accounting I

Environment and Theoretical Structure of Financial Accounting

by Professor Hsieh

Objectives of the Chapters

1. Understand the need to develop accounting standards.

2. Study the development of accounting standards from a historical perspective. 3. Define the GAAP. 4. Study the role of the AICPA and the SEC in developing GAAP. 5. Introduce the accounting standard setting process.
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Objectives of the Chapters (contd.)

6. Study the relationship between the changes in the economic environment and the development of accounting standards. 7. Understand the economic consequence of accounting standards. 8. Understand the accounting standard compliance system in the U.S.
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Objectives of the Chapters (contd.)

9. Discuss financial reporting reform and the Sarbanes and Oxley Act (the Public
Company Accounting Reform and Investor Protection Act of 2002)

10. Study the convergence of the U.S. accounting standards with the International Accounting Standards. 11. Study the Conceptual framework underlying financial reports.
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Financial Reporting: An Introduction and Historical Development

1. What is accounting for? 2. How do we communicate financial information? Tools: Four financial statements. 3. How do we prepare financial statements? Identify, measure and record business transactions for business entities. Journal entries, posting to ledger accounts, work sheet (including adjustments), F/S, 4. Why do we need accounting standards?
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Accounting Standards

Accounting methods with substantial authoritative support to be used by business entities in preparing external reports for users.

Environment and Theoretical Structure of Financial Accounting

Issues Related to Accounting Standards

1. Who are the authorities to set these standards (Generally Accepted Accounting Principles, GAAP)? 2. What are these standards?
3. The role of the AICPA and the SEC in developing GAAP. 4. The accounting standard setting process of the FASB.
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Authority Official Release Congress SEC Regulation S-X ASR and FRR Staff Accounting Bulletins 1938 Accounting Profession AICPA 1938-1959 CAP ARBs (51) 1959-1973 APB APB Opinions (31) 1973 FASB . 1. Statement of Financial Accounting Standards 2. Interpretations 3. Concepts of Financial Accounting 4. Technique Bulletins 5. Statements issued by EITF
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Year 1934

Pronouncements of the FASB

1. Statement of Financial Accounting Standards (SFAS) 2. Interpretations 3. Statements of EITF (Emerging Issue Task Force) 4. Technique Bulletins

5. Statements of Financial Accounting Concepts

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GAAP

(General Accepted Accounting Principles)

Accounting methods having substantial authoritative support and used by business entities in preparing financial statements.

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GAAP (contd.)

Including:
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 of the FASB, and Staff Acct. Bulletins of the SEC, Statements of Position, Statements of EITF and Practice Bulletins of the AICPA, etc.)
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Tool Books
A. Original Pronouncements of Accounting Standards Volume 1: FASB statements of standards Volume 2: AICPA Pronouncements (ARB & APB opinions) FASB Interpretations FASB Concepts Statements (SFAC) FASB Technical Bulletins B. Current Text of Accounting Standards
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The Role of the AICPA On Standard Setting

1939 - 1959 1959 - 1973 1973 - Present

CAP ARBs APB Opinions 1. Issue Papers (by AcSEC)a 2. Statements of Position 3. Practice Bulletins 4. Auditing Standards (by the Auditing Standards Board)

a. The Accounting Standards Executive Committee which was established within the Accounting Standard Division of the AICPA.

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The Accounting Standard Setting Process of the FASB (A Due Process)

Identify a topic and place it on the Boards agenda. Form a task force to define problems and issues related to the topic. A discussion memorandum (DM, an impartial discussion of issues) is drafted by the FASBs technical staff in consulting with a group of knowledge people in accounting and business community.
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The Accounting Standard Setting Process of the FASB (contd.)

A public hearing held 60 days after the release of DM. The Board evaluates the public response, prepares and releases an exposure draft (ED). The ED is exposed to the public for at least 30 days for public comment. A committee studies the public comment and revise the ED if necessary. Vote by 7 members of the Board. The passage of a new FASB statement requires 5 votes.
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Other Issues Related to Accounting Standards

1. Changes of the economic environment and the development of accounting standards. 2. The economic consequence of accounting standards. 3. The accounting standard compliance system in the U.S. and the interrelationship of the Securities and Exchange Commission (SEC) and the Financial Accounting Standards Board (FASB).
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Changes of the Economic Environment and the Development of Accounting Standards.

Example:
SFAS

No. 13 (Accounting for Leases) SFAS No. 33 and 89 (Financial Reporting and changing prices) SFAS No. 52 (Foreign Currency Translation) SFAS No. 123 (Accounting for StockBased Compensation)
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Economic Consequence of Accounting Standards

Examples:

SFAS No. 106 (Employers accounting for post-retirement benefits other than pensions.)

SFAS No. 115 (Accounting for certain investments in debt and equity securities.)
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The Accounting Standard Compliance System

The interrelationship of the SEC and the FASB:

FASB: the rule making body.

SEC: the enforcing agency.

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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, Sarbanes and Oxley Act was passed 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 Oversight board: establish auditing standards(i.e., auditing,quality control,
ethics, independence for the preparation of the audit report.

Increasing Corporate Executive Accountability: they must personally certify both

the financial statements and disclosures)

Prohibition of Non-Audit Services (I.e.,

bookkeeping, internal audit, appraisal, and other consulting services)
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The Financial Reporting Reform and the Sarbanes and Oxley Act (Cont.)

Retention of work Papers for 5 years.

Auditor Rotation.

Conflict of Interest.
Hiring of Auditor: by the audit committee of the board of directors,not the management. Evaluation of Internal Control: the management
needs to document and assess the effectiveness of internal control. Auditors of the firm need to state:1)whether the managements assessment is fair, and 2)whether the internal control of the firm is effective.
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The Need for International Accounting Standards

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.
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The History of International Accounting Standard Setting (cont.)

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).
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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).
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Short-Term International Convergence (source: FASB Project Updates)

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.
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Short-Term International Convergence (contd.)

The following areas have been or will be addressed: 1. Share-Based Payment (SFAS No.
123 (R): Accounting for Stock-Based Compensation. (issued in 12/2005) Substantially converging with IFRS requirements.

Revision: required the option expense to be recognized in the income statement.

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Short-Term International Convergence (contd.)

2. Inventory Costs (SFAS No. 151:

Inventory Costs (for idle capacity and spoilage) : an amendment of ARB No. 43, Chapter 4. Issued in 11/2004, converging with IFRB requirements.

Revision: The amounts of costs (I.e., idle facility expense, freight, handling costs, spoilage) are expensed.

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Short-Term International Convergence (contd.)

3. Asset Exchanges (SFAS No. 153:

Exchanges of Nonmonetary Assets, issued in December 2004): an amendment of APB

Opinion No. 29. Converging with IFRB requirements.

Changes: eliminating some differences in measurement between APB 29 and that of IAS 16 and IAS 38 (i.e., difference in the treatment of nonmonetary exchange of similar productive assets.)
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Short-Term International Convergence (contd.)

4. Accounting Changes (SFAS No. 154:

Accounting Changes and Error Corrections, issued in May 2005): a replacement of APB

No. 20 and FASB No. 3. Converging with the IFRS requiremenets.

Eliminating the current period approach in accounting for the voluntary accounting changes. Result: improve the comparability of international financial reporting by eliminating the differences between APB 20 and IAS 8.Environment and Theoretical Structure of Financial Accounting 30

Short-Term International Convergence (contd.)

6. Discontinued activities:
The IASB issued IFRS 5 (Non-current Assets Held for Sale and discountinued Operatins) in 2004 which substantial convergence with US GAAP on this topic. However, the definitions of discontinued Operations between two sets of standards remain divergent. .

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Short-Term International Convergence (contd.)

7. Earnings Per Share

8. Balance Sheet Classification

9. Income Taxes

10. Accounting for Leases (announced 7/18.06)

For details of the above areas of short-term convergence project, go to: http://www.fasb.org/project/shortterm_intl_convergence.shtml
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Short-Term International Convergence (contd.)

The IASB has also addressed several issues in the short-term convergence project and is working on a few topics. For further information, go to: http://www.iasb.org/current/iasb.asp ?showPageContent=no&xml=16_13_ 67_23092003.htm
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Current Compliances

Since there is no single set of highquality 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.
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Conceptual Framework of Financial Reporting

How does the current accounting standard setting authority (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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Financial Reporting: A Theoretical Structure

A Conceptual Framework for Financial Reporting
SFAC N0. 1 First Level Objectives
Qualitative SFAC No. 2 Characteristic Elements Second Level of Accounting (SFAC No. 6) Information

SFAC No.5

Recognition and Measurement Concepts

Principles Historical Cost Revenue Matching Full Disclosure

Third level

Assumptions Entity GoingConcern Monetary unit Periodicity

Constraints Cost/Benefit Materiality Industry Practice Conservatism

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SFAC No. 1

(Level One of The Conceptual Framework)

Objectives of financial reporting:
Providing information
1. useful in making investment and

credit decisions; 2. useful in assessing future cash flows; 3. about entity resources, claims to the resources and changes of these resources.
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SFAC No. 2

(Level Two of The Framework)

Qualitative (Characteristics of Accounting Information)

I. Primary Qualities 2) Reliability 1) Relevance a) Verifiability a) Predictive value b) Representational b) Feedback value Faithfulness c) Timeliness c) Neutrality
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SFAC No. 2 (contd.)

II. Secondary Qualities

1) Comparability
2) Consistency

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SFAC No. 5

(Level Three of The Conceptual Framework)

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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SFAC No. 5 (contd.)

II. Principles
1) Historical cost (exception:LCM of inventory) 2) Revenue recognition (exceptions: 3) Matching 4) Full Disclosure (footnote disclosure)

III. Constraints
1) Cost-Benefit 2) Materiality 3) Industry Practice 4) Conservatism
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