Financial Accounting Environment and Theoretical Structure PDF

1 CHAPTER Environment and Theoretical Structure of Financial Accounting /// OVERVIEW The primary function of financial accounting...

1 CHAPTER Environment and Theoretical Structure of Financial Accounting /// OVERVIEW The primary function of financial accounting is to provide useful financial information to users who are external to the business enterprise, particularly investors and creditors. These users make critical resource allocation decisions that affect the global economy. The primary means of conveying financial information to external users is through financial statements and related notes. In this chapter you explore important topics, such as the reason why financial accounting is useful, the process by which accounting standards are produced, and the conceptual framework that underlies financial accounting. The perspective you gain in this chapter serves as a foundation for a more detailed study of financial statements, the way the statement elements are measured, and the concepts underlying these measurements and related disclosures. L EA R NING OB JEC TIV E S After studying this chapter, you should be able to: LO1 Describe the function and primary focus of financial accounting. (p. 4) LO2 Explain the difference between cash and accrual accounting. (p. 7) LO3 Define accounting standards and discuss the historical development of accounting standards, including convergence between U.S. and international standards. (pp. 8, 10, and 12) LO4 Explain why the establishment of accounting standards is characterized as a political process. (p. 13) LO5 Explain the purpose of the IASB’s conceptual framework. (p. 19) LO6 Identify the objective of financial reporting, the qualitative characteristics of financial reporting information, and the elements of financial statements. (pp. 21 and 24) LO7 Describe the basic assumptions underlying the measurement and reporting of financial statement information. (p. 25) LO8 Describe the recognition, measurement and disclosure concepts that guide accounting practice. (pp. 27, 29, and 32) 2 FINANCIAL REPORTING CASE Misguided Marketing Major During a class break in your investments class, a marketing major tells the following story to you and some friends: The chief financial officer (CFO) of a large company is interviewing three candidates for the top accounting position with his firm. He asks each the same question: CFO: What is two plus two? First candidate: Four. CFO: What is two plus two? Second candidate: Four. CFO: What is two plus two? Third candidate: What would you like it to be? CFO: You’re hired. After you take some good-natured ribbing from the nonaccounting majors, your friend says, “Seriously, though, there must be ways the accounting profession prevents that kind of behavior. Aren’t there some laws, or rules, or something? Are they based on some sort of theory, or are they just arbitrary?” By the time you finish this chapter, you should be able to respond appropriately to the questions posed in this case. Compare your response to the solution provided at the end of the chapter. QU ES TIONS /// 1. What should you tell your friend about the presence of accounting standards and regulations? Who has the authority for standard setting? Who has the responsibility? (pp. 8 and 10) 2. What is the economic and political environment in which standard setting occurs? (p. 13) 3. What is the relationship among management, auditors, investors, and creditors that tends to preclude the “What would you like it to be?” attitude? (p. 15) 4. In general, what is the conceptual framework that underlies accounting principles? (p. 19) 3 4 SECTION 1 The Role of Accounting as an Information System PART A FINANCIAL ACCOUNTING ENVIRONMENT Have you been on board an Airbus A380, the world’s largest passenger airliner? It is a double-decker plane that offers more cabin space, larger windows, bigger overhead com- partments, and less cabin noise and air pressure than other passenger airliners. Singapore Airlines was the first airline to operate the A380, which made its first commercial flight on 25 October 2007 from Singapore to Sydney. Singapore Airlines’ A380 has 12 first-class suites containing one full seat, a full-sized bed and a desk; four of the suites can be con- verted to two double suites with a double bed. Singapore Airlines is one of the world’s leading air transportation carriers. It has a reputa- tion of providing quality service and introducing various innovations to the airline industry, such as the first global sky telephone service; the first to engage world-renowned chefs to prepare in-flight meals; the first longest direct commercial flight without stopovers between Singapore and Los Angeles, and between Singapore and Newark; and the first to operate the world’s largest plane, the A380. Singapore Airlines’ flight routes span over 63 destina- tions in 34 countries around the world. The company’s revenues for the financial year ended March 31, 2011 exceeded S$14 billion and profits exceeded S$1 billion. The total value of the company’s shares exceeded S$17 billion in 2011. A key factor contributing to the growth and success of Singapore Airlines was its access to external capital (resources) in that it had the ability to raise external capital from investors and creditors. For example, in the third quarter of 2010, Singapore Airlines’ public offering of the company’s corporate bonds provided S$300 million in debt financing. Investors and creditors Investors and creditors use many different kinds of information before supplying capital use information to to business enterprises like Singapore Airlines. The information is used to assess the future assess risk and return. risk and return of their potential investments in the enterprise.1 For example, information about the enterprise’s products and its management is of vital importance to this assessment. In addition, various kinds of financial information are extremely important to investors and creditors. LO1 You might think of accounting as a special “language” used to communicate financial information about a business to those who wish to use the information to make decisions. The primary focus of Financial accounting, in particular, is concerned with providing relevant financial infor- financial accounting mation to various external users. The chart in Illustration 1–1 lists a number of financial is on the information needs of investors and information supplier groups as well as several external user groups. Of these groups, the creditors. primary focus of financial accounting is on the financial information provided by profit- oriented companies to their present and potential investors and creditors. The reason for this focus is discussed in a later section of this chapter. One external user group, often referred to as financial intermediaries, includes financial analysts, stockbrokers, mutual fund man- agers, and credit rating organizations. These users provide advice to investors and creditors and/or make investment-credit decisions on their behalf. The collapse of Enron Corpora- tion in 2001 and other high profile accounting failures made immensely clear the impor- tance of reporting reliable financial information. On the other hand, managerial accounting deals with the concepts and methods used to provide information to an organization’s internal users, that is, its managers. You study managerial accounting elsewhere in your curriculum. Financial statements convey financial The primary means of conveying financial information to investors, creditors, and other information to external external users is through financial statements and related disclosure notes. The finan- users. cial statements most frequently provided are (1) the statement of financial position or balance sheet, (2) the income statement and/or the statement of comprehensive income, (3) the statement of cash flows, and (4) the statement of changes in equity. Also, starting in 2012, companies must either provide a statement of other comprehensive income imme- diately following the income statement, or present a combined statement of comprehen- sive income that includes the information normally contained in both the income statement and the statement of other comprehensive income. As you progress through this text, you 1 Risk refers to the variability of possible outcomes from an investment. Return is the amount received over and above the investment and usually is expressed as a percentage.  CHAPTER 1 Environment and Theoretical Structure of Financial Accounting 5 ILLUSTRATION 1–1 PROVIDERS OF FINANCIAL INFORMATION EXTERNAL USER GROUPS Financial Information Supplier Groups and Profit-oriented companies Investors External User Groups Creditors (banks, bondholders, other lenders) Employees Labor unions Not-for-profit entities (e.g., government entities, Customers charitable organizations, Suppliers schools) Government regulatory agencies (e.g., tax authorities, securities and stock exchange authorities) Financial intermediaries Households (e.g., financial analysts, stockbrokers, mutual fund managers, credit-rating organizations) will review and expand your knowledge of the information in these financial statements, the way the elements in these statements are measured, and the concepts underlying these measurements and related disclosures. We use the term financial reporting to refer to the process of providing this information to external users. Keep in mind, though, that external users receive important financial information in a variety of other formats as well, including news releases and management forecasts, prospectuses, and reports filed with regulatory agencies. Singapore Airlines’ financial statements and related disclosure notes for the financial year ended March 31, 2011 are provided with all new copies of the text. You can also locate the 2011 statements and notes online at www.singaporeair.com. To provide context for our discussions throughout the text, we occasionally refer to these statements and notes. Also, as new topics are introduced in later chapters, you might want to refer to the information to see how Singapore Airlines reported the items being discussed. The Economic Environment and Financial Reporting Many countries have a highly developed free-enterprise economy with the majority of pro- ductive resources privately owned rather than government owned. It’s important in this type of system that a mechanism exists to allocate the scarce resources of our society, both natu- ral resources and labor, in an efficient manner. Resources should be allocated to private enterprises that will use them best to provide goods and services desired by society and not to enterprises that will waste them. The mechanisms that foster this efficient allocation of The capital markets resources are the capital markets. We can think of the capital markets simply as a compos- provide a mechanism ite of all investors and creditors. to help our economy Businesses go to the capital markets to get the cash necessary for them to function. The allocate resources efficiently. three primary forms of business organization are the sole proprietorship, the partnership, and the corporation. In many countries, sole proprietorships and partnerships outnumber corporations. However, the dominant form of business organization, in terms of the owner- Corporations acquire ship of productive resources, is the corporation. Investors provide resources, usually cash, capital from investors to a corporation in exchange for an ownership interest, that is, shares. Creditors lend cash in exchange for ownership interest to the corporation, either by making individual loans or by purchasing publicly traded debt and from creditors by such as bonds. borrowing. 6 SECTION 1 The Role of Accounting as an Information System Initial market Shares and bonds are usually traded on organized security markets such as the New transactions involve York Stock Exchange and the London Stock Exchange. New cash is provided in initial issuance of shares and bonds by the market transactions in which the corporation sells shares or bonds to individuals or other corporation. entities that want to invest in it. Subsequent transfers of these shares and bonds between investors and creditors are referred to as secondary market transactions. Corporations Secondary market receive no new cash from secondary market transactions. Nevertheless, secondary market transactions provide transactions are extremely important to the efficient allocation of resources in our econ- for the transfer of shares and bonds omy. These transactions help establish market prices for additional shares and for bonds among individuals and that corporations may wish to issue in the future to acquire additional capital. Also, many institutions. shareholders and bondholders might be unwilling to initially provide resources to corpo- rations if there were no available mechanism for the future sale of their shares and bonds to others. What information do investors and creditors need when determining which companies will receive capital? We explore that question next. The Investment-Credit Decision—A Cash Flow Perspective Investors and creditors While the decisions made by investors and by creditors are somewhat different, they are are interested in similar in at least one important way. They both are concerned with providing resources to earning a fair return on the resources provided. companies, usually cash, with the expectation of receiving more cash in return at some time in the future. A corporation’s shareholders will receive cash from their investment through the ultimate sale of the ownership shares. In addition, many corporations distribute cash to their shareholders in the form of periodic dividends. For example, if an investor provides a company with $10,000 cash (that is, purchases ownership shares) at the end of 2012, receives $400 in dividends from the company during 2013, and sells the ownership inter- est (shares) at the end of 2013 for $10,600 ($600 share price appreciation), the investment would have generated a rate of return of 10% for 2013, calculated as follows: $400 dividends + $600 share price appreciation _______________________________________ = 10% $10,000 initial investment Investors often face more than one investment opportunity. There are many factors to consider before one of these opportunities is chosen. Two extremely important vari- The expected rate of ables are the expected rate of return from each investment option, and the uncertainty, return and uncertainty, or risk, of that expected return. For example, consider the following two investment or risk, of that return are key variables in the options: investment decision. 1. Invest $10,000 in a savings account insured by the government that will generate a 5% rate of return. 2. Invest $10,000 in a profit-oriented company. While the rate of return from option 1 is known with virtual certainty, the return from option 2 is uncertain. The amount and timing of the cash to be received in the future from option 2 are unknown. Investors require information about the company that will help them estimate the unknown return. A company will be able In the long run, a company will be able to provide investors with a return only if it can to provide a return to generate a profit. That is, it must be able to use the resources provided by investors and investors and creditors only if it can generate creditors to generate cash receipts from selling a product or service that exceed the cash dis- a profit from selling its bursements necessary to provide that product or service. If this excess can be generated, the products or services. marketplace is implicitly saying that society’s resources have been efficiently allocated. The marketplace is assigning a value to the product or service that exceeds the value assigned to the resources used to produce that product or service. The objective of In summary, the primary objective of financial accounting is to provide investors and financial accounting is creditors with information that will help them make investment and credit decisions. More to provide investors and creditors with specifically, the information should help investors and creditors evaluate the amounts, useful information for timing, and uncertainty of the enterprise’s future cash receipts and disbursements. The bet- decision making. ter this information is, the more efficient will be investor and creditor resource allocation  CHAPTER 1 Environment and Theoretical Structure of Financial Accounting 7 decisions. But financial accounting doesn’t only benefit companies and their investors and creditors. By providing key elements of the information set used by capital market par- ticipants, financial accounting plays a vital role by providing information that helps direct society’s resources to the companies that utilize those resources most effectively. Cash versus Accrual Accounting Even though predicting future cash flows is the primary goal of many users of financial LO2 reporting, the model best able to achieve that goal is the accrual accounting model. A competing model is cash basis accounting. Each model produces a periodic measure of performance that could be used by investors and creditors for predicting future cash flows. CASH BASIS ACCOUNTING. Cash basis accounting produces a measure called net Net operating cash operating cash flow. This measure is the difference between cash receipts and cash pay- flow is the difference between cash receipts ments from transactions related to providing goods and services to customers during a and cash disbursements reporting period. from providing goods Over the life of a company, net operating cash flow definitely is the variable of concern. and services. However, over short periods of time, operating cash flows may not be indicative of the company’s long-run cash-generating ability. Sometimes a company pays or receives cash in one period that relates to performance in multiple periods. For example, in one period a company receives cash that relates to prior period sales, or makes advance payments for costs related to future periods. Therefore, net operating cash flow may not be a good predic- tor of long-run cash-generating ability. To see this more clearly, consider Carter Company’s net operating cash flows during its first three years of operations, shown in Illustration 1–2. Over this three-year period, Carter generated a positive net operating cash flow of $60,000. At the end of this three-year period, Carter has no outstanding debts. Because total sales and cash receipts over the three-year period were each $300,000, nothing is owed to Carter by customers. Also, there are no uncompleted transactions at the end of the three-year period. In that sense, we can view this three-year period as a micro version of the entire life of a company. At the beginning of the first year, Carter prepaid $60,000 for three years’ rent on the facilities. The company also incurred utility costs of $10,000 per year over the period. How- ever, during the first year only $5,000 was actually paid, with the remainder being paid the second year. Employee salary costs of $50,000 were paid in full each year. Is net operating cash flow for year 1 (negative $65,000) an accurate indicator of future cash-generating ability?2 Clearly not, given that the next two years show positive net cash flows. Is the three-year pattern of net operating cash flows indicative of the company’s year- by-year performance? No, because the years in which Carter paid for rent and utilities are not the same as the years in which Carter actually consumed those resources. Similarly, the amounts collected from customers are not the same as the amount of sales in each period. ILLUSTRATION 1–2 Year 1 Year 2 Year 3 Total Cash Basis Sales (on credit) $100,000 $100,000 $100,000 $300,000 Accounting Net Operating Cash Flows Cash receipts from customers $ 50,000 $125,000 $125,000 $300,000 Cash disbursements: Prepayment of three years’ rent (60,000) –0– –0– (60,000) Salaries to employees (50,000) (50,000) (50,000) (150,000) Utilities (5,000) (15,000) (10,000) (30,000) Net operating cash flow $ (65,000) $ 60,000 $ 65,000 $ 60,000 2 A negative cash flow is possible only if invested capital (i.e., owners contributed cash to the company in exchange for ownership inter- est) is sufficient to cover the cash deficiency. Otherwise, the company would have to either raise additional external funds or go bankrupt. 8 SECTION 1 The Role of Accounting as an Information System Net income is the ACCRUAL ACCOUNTING. If we measure Carter’s activities by the accrual accounting difference between model, we get a more accurate prediction of future operating cash flows and a more reason- revenues and able portrayal of the periodic operating performance of the company. The accrual account- expenses. ing model doesn’t focus only on cash flows. Instead, it also reflects other resources provided and consumed by operations during a period. The accrual accounting model’s measure of resources provided by business operations is called revenues, and the measure of resources sacrificed to earn revenues is called expenses. The difference between revenues and expenses is net income, or net loss if expenses are greater than revenues.3 Illustration 1–3 shows how we would measure revenues and expenses in this very simple situation. ILLUSTRATION 1–3 Accrual Accounting CARTER COMPANY Income Statements The accrual Year 1 Year 2 Year 3 Total accounting model Revenues $100,000 $100,000 $100,000 $300,000 provides a measure of periodic Expenses: performance called net Rent 20,000 20,000 20,000 60,000 income, the difference Salaries 50,000 50,000 50,000 150,000 between revenues and expenses. Utilities 10,000 10,000 10,000 30,000 Total expenses 80,000 80,000 80,000 240,000 Net Income $ 20,000 $ 20,000 $ 20,000 $ 60,000 Net income is Revenue for year 1 is the $100,000 sales. Given that sales are eventually collected in considered a better cash, the year 1 revenue of $100,000 is a better measure of the inflow of resources from indicator of future operating cash flows company operations than is the $50,000 cash collected from customers. Also, net income of than is current net $20,000 for year 1 appears to be a reasonable predictor of the company’s cash-generating operating cash flow. ability, as total net operating cash flow for the three-year period is a positive $60,000. Com- paring the three-year pattern of net operating cash flows in Illustration 1–2 to the three-year pattern of net income in Illustration 1–3, the net income pattern is more representative of Carter Company’s steady operating performance over the three-year period.4 While this example is somewhat simplistic, it allows us to see the motivation for using the accrual accounting model. Accrual income attempts to measure the resource inflows and outflows generated by operations during the reporting period, which may not correspond to cash inflows and outflows. Does this mean that information about cash flows from operating activities is not useful? No. Indeed, one of the basic financial statements—the statement of cash flows—reports information about cash flows from operating, investing and financing activities, and provides important information to investors and creditors.5 The key point is that focusing on accrual accounting as well as cash flows provides a more complete view of a company and its operations. The Development of Financial Accounting and Reporting Standards LO3 Accrual accounting is the financial reporting model used by the majority of profit-oriented FINANCIAL companies and by many not-for-profit companies. The fact that companies use the same Reporting Case model is important to investors and creditors, allowing them to compare financial information among companies. To facilitate these comparisons, financial accounting employs a set of Q1, p. 3 accounting standards that provide both broad and specific guidelines that companies should LO3 follow when measuring and reporting the information in their financial statements and related 3 Net income also includes gains and losses, which are discussed later in the chapter. 4 Empirical evidence that accrual accounting provides a better measure of short-term performance than cash flows is provided by Patricia Dechow, “Accounting Earnings and Cash Flows as Measures of Firm Performance: The Role of Accrual Accounting,” Journal of Accounting and Economics 18 (1994), pp. 3–42. 5 The statement of cash flows is discussed in detail in Chapters 4 and 21.  CHAPTER 1 Environment and Theoretical Structure of Financial Accounting 9 notes. The more important broad principles or standards are discussed in a subsequent section of this chapter and revisited throughout the text in the context of accounting applications for which they provide conceptual support.6 Specific standards, such as how to measure and report a lease transaction, receive more focused attention in subsequent chapters. Generally, there are two major sets of accounting standards in the world. One set of accounting standards is the International Financial Reporting Standards (IFRS) and the other is the set of standards issued by standard-setting bodies in the United States. Note that in the United States, accounting standards are known as generally accepted accounting principles, often abbreviated as GAAP (and pronounced as gap). Historical Perspective and Standards INTERNATIONAL STANDARD SETTING. Most industrialized countries have orga- nizations responsible for determining accounting and reporting standards. In many coun- tries, such as Canada, New Zealand, and the Philippines, accounting standards are set by a private-sector professional accounting body. In a few countries, such as Japan, the United Kingdom, and the United States, the private-sector standard-setting body is inde- pendent of the government and of the accounting profession. In many other countries, such as Australia, France, India, and Singapore, the standard-setting organization is a govern- mental body. Accounting standards prescribed by these various groups are not the same. Standards Differences among differ from country to country due to differences in legal systems, inflation rate, degrees national accounting standards cause of sophistication and use of capital markets, use of financial reports by tax or government problems for authorities, and political and economic ties with other countries. These differences can multinational cause problems for multinational corporations who may find it difficult to comply with a corporations and few different sets of accounting standards. These differences also cause problems for inves- investors. tors who are comparing companies whose financial statements are prepared using differ- ent standards. It has also been suggested that different national accounting standards affect comparability in financial information and impair the ability of companies to raise capital in international markets. INTERNATIONAL FINANCIAL REPORTING STANDARDS. In response to this The International problem, the International Accounting Standards Committee (IASC) was formed in Accounting Standards Board (IASB) is 1973 to develop global accounting standards. The IASC consisted of member representatives dedicated to from countries such as France, Germany, Japan, the United Kingdom, and the United developing a single set States. The IASC reorganized itself in 2001 and created a new standard-setting body called of global accounting the International Accounting Standards Board (IASB). The IASB’s objectives are to standards. develop, promote, and coordinate the use of a single set of high-quality, understandable, and enforceable global and harmonized accounting standards that help participants in worldwide capital markets and other users to make economic decisions.7 The IASC issued 41 International Accounting Standards (IASs), which were endorsed by the IASB when it was formed in 2001. These IASs will continue to be effective until the IASB revises or replaces them. The IASB has revised many IASs and issued new stan- dards of its own, called International Financial Reporting Standards (IFRS). Some of these are new standards, and some may replace the old IASs. The term “IFRS” refers to all the standards issued by the IASB, including the Conceptual Framework, the old IASs, and Interpretations issued by the IFRS Interpretations Committee. The IASB differs from its predecessor in many ways. There are currently 15 full-time IASB members, compared to the mainly part-time volunteers serving in IASC. Members include representatives from the various constituencies concerned with accounting stan- dards, such as the accounting profession, multinational businesses, financial analysts, aca- demics, regulators, and government. In addition, the IASB is supported financially by the IFRS Foundation (formerly known as International Accounting Standards Commit- tee Foundation (IASCF)), whose Trustee members are responsible for selecting the IASB 6 The terms standards and principles are sometimes used interchangeably. 7 www.ifrs.org. 10 SECTION 1 The Role of Accounting as an Information System members, exercising general oversight of the IASB’s activities, and ensuring adequate funding. The Trustees are in turn appointed and monitored by the Monitoring Board, which consists of public capital market authorities such as the chairpersons of the European Commission and the United States’ Securities Exchange Commission. The IFRS Foundation also appoints the members of the IFRS Advisory Council and the IFRS Inter- pretations Committee. The IFRS Advisory Council (formerly known as Standards Advisory Council (SAC)) advises the IASB on matters concerning its agenda, projects, and work priorities. The IFRS Interpretations Committee (formerly known as International Financial Reporting Interpretations Committee (IFRIC), which was formed in 2001 to replace the Stand- ing Interpretations Committee (SIC)) was formed to improve accounting standards by resolving accounting issues that are not specifically addressed by the IFRS, within the framework of existing IFRS, and providing interpretations for the application of existing IFRS. Regulatory oversight of the IASB is provided by the International Organization of Securities Commissions (IOSCO), which includes representatives from securities markets regulators and seeks to facilitate coordination among market regulators in implementing consistent international standards and enforcement against misconduct, thereby developing effective global capital markets. Illustration 1–4 shows the structure of the IASB and its supporting organizations. ILLUSTRATION 1–4 STRUCTURE OF THE INTERNATIONAL ACCOUNTING STANDARDS BOARD8 Structure of the IASB FINANCIAL Reporting Case Q1, p. 3 LO3 International Financial It is important to note that the IASB is a private and non-governmental standard-setting Reporting Standards body and has no authority to enforce the use of IFRS in different jurisdictions. It has to are gaining support depend on each jurisdiction’s regulatory authority to enforce the application of IFRS in that around the globe. jurisdiction. Nevertheless, more and more countries are basing their national accounting standards on IFRS. By 2011, over 120 jurisdictions, including Australia, Canada, Egypt, and 8 International Accounting Standards Board and the IFRS Foundation, “Who we are and what we do,” (London, U.K.: IASB, 2012).  CHAPTER 1 Environment and Theoretical Structure of Financial Accounting 11 Hong Kong, and the countries in the European Union (EU), either require or permit the use of IFRS or a local variant of IFRS.9 STANDARD SETTING IN THE UNITED STATES. In the 1934 Securities Exchange Act, the United States Congress created the Securities and Exchange Commission The Securities and (SEC) and gave the SEC the authority to set accounting standards for companies whose Exchange Commission (SEC) in the United securities are publicly traded. However, the SEC, a government appointed body, has States has the delegated the task of setting accounting standards to the private sector. Nevertheless, if the authority to set SEC does not agree with a particular standard issued by the private sector, it can force a accounting standards change in the standard, and has done so in the past. The SEC does issue its own accounting for companies, but has delegated the task to standards in the form of Financial Reporting Releases (FRRs), which regulate what the private sector. information companies must report to it. The SEC also issues Staff Accounting Bulletins as authoritative supplements for reporting issues. The first private-sector standard-setting body was the Committee on Accounting Procedure (CAP). The CAP was formed in 1938 and was a committee of the American Institute of Certified Public Accountants (AICPA), the professional organization for certified public accountants in the United States. In 1959 the Accounting Principles Board (APB) replaced the CAP. The APB suffered from a variety of problems. It could not develop a financial reporting conceptual framework that was broadly accepted. Its members also served on a voluntary, part-time basis, so it had difficulty keeping up with the development of financial reporting issues. The most important flaw of the APB was a perceived lack of independence from the accounting profession, because it was composed almost entirely of certified public accountants and supported by the AICPA. Criticism of the APB led to the creation in 1973 of the Financial Accounting Standards The FASB currently sets Board (FASB). The FASB is an independent, private-sector body with seven full-time accounting standards in the United States. members representing the accounting profession, financial analysts, businesses, account- ing academics, and government.10 The FASB is supported financially by the Financial Accounting Foundation (FAF). The FAF is responsible for selecting the members of the FASB and its Advisory Council, and overseeing and raising funds for the FASB’s activities.11 In 1984, the FASB’s Emerging Issues Task Force (EITF) was formed to address implementation issues and resolve narrowly defined financial accounting issues within the framework of existing U.S. GAAP. The FASB has issued over 160 accounting standards, called Statements of Financial Accounting Standards (SFASs), a conceptual framework underlying the development of the standards, as well as FASB Interpretations, Staff Positions, Technical Bulletins and EITF Issue Consensuses.12 The SEC has also issued various important pronounce- ments. In 2009, the FASB implemented its FASB Accounting Standards Codification, which The FASB Accounting integrates and topically organizes all relevant pronouncements comprising U.S. GAAP Standards Codification is now the only source in a searchable, online database. It represents the single source of authoritative non- of authoritative U.S. governmental U.S. GAAP, and also includes portions of SEC guidance relevant to financial GAAP, other than rules reports filed with the SEC. When FASB issues a new standard, it is called an Accounting and interpretative Standards Update (ASU) and becomes authoritative when it is entered into the Codifica- releases of the SEC, which remain as tion. The Codification is organized into nine main topics and approximately 90 subtopics, sources of authoritative and can be located at www.fasb.org. GAAP. As shown in Illustration 1–5, the way standard setting is structured in the United States is similar in many respects to the way IFRS standard setting is structured. 9 See www.iasplus.com/country/useias.htm. 10 The FASB organization also includes the Financial Accounting Standards Advisory Council (FASAC). The major responsibility of the FASAC is to advise the FASB on the priorities of its projects, including the suitability of new projects that might be added to its agenda. 11 The FAF’s primary sources of funding are contributions and the sales of the FASB’s publications. The FAF is governed by trustees, the majority of whom are appointed from the membership of eight sponsoring organizations. These organizations represent important con- stituencies involved with the financial reporting process. For example, one of the funding organizations is the Association of Investment Management and Research (formerly known as the Financial Analysts Federation) which represents financial information users, and another is the Financial Executives International which represents financial information preparers. 12 For more information, go to the FASB’s Internet site at www.fasb.org. 12 SECTION 1 The Role of Accounting as an Information System ILLUSTRATION 1–5 U.S. GAAP IFRS Comparison of U.S. GAAP and IFRS Regulatory oversight Securities Exchange International Organization Standard-Setting provided by: Commission (SEC) of Securities Commissions Organizations (IOSCO) and the Monitoring Board LO3 Foundation providing Financial Accounting IFRS Foundation: 21 trustees oversight, appointing Foundation (FAF): members, raising funds: 20 trustees Standard-setting board: Financial Accounting International Accounting Standards Board (FASB): Standards Board (IASB): 7 full-time members 15 full-time members Advisory council providing Financial Accounting IFRS Advisory Council input on agenda and Standards Advisory Council 40–50 members projects: (FASAC): 30–40 members Group to deal with Emerging Issues Task Force IFRS Interpretations emerging issues: (EITF): 15 members Committee: 14 members EFFORTS TO CONVERGE U.S. GAAP AND IFRS. The FASB and IASB have been working for several years to converge to one global set of accounting standards, with the goal of eventually enabling the United States to shift to IFRS. In 2002, an important step occurred when the FASB and IASB signed the Norwalk Agreement, formalizing their com- mitment to convergence and pledging to remove existing differences between U.S. GAAP and IFRS and to coordinate their future standard-setting agendas so that major issues are worked on together. In the spring of 2008, the FASB and IASB agreed to accelerate the con- vergence process, and the two boards have been working very hard on convergence projects since that time. Already-converged standards that you will encounter later in this textbook deal with topics such as earnings per share, share-based compensation, inventory costs, cal- culation of fair value, and presentation of comprehensive income. Whether or not the United States eventually shifts to IFRS will be determined by the SEC. In 2007 the SEC signaled its view that IFRS are of high quality by eliminating the require- ment for foreign companies that issue shares in the United States to include in their financial statements a reconciliation of IFRS to U.S. GAAP. Thus, those companies have access to U.S. capital markets with IFRS-based financial statements. Then, in November 2008, the SEC proposed a Roadmap that listed the necessary conditions that must be achieved before the United States will shift to requiring use of IFRS by companies listed on stock exchanges in the United States. The first milestone, “Improvements in accounting standards,” refers to the completion of 11 major joint projects intended to improve standards while further aligning U.S. GAAP and IFRS. While several convergence projects have been completed, other important projects are still underway or have been deferred. You will read about these projects in the Where We’re Headed boxes throughout the text. At the time this textbook is written, the SEC has not decided whether the United States would report under IFRS. It may be that convergence will take the form of a required whole-scale adoption of IFRS by companies, or a standard-by-standard endorsement of IFRS standards in the United States. On the other hand, convergence is already gradually occurring through cooperation between the FASB and IASB that has resulted in recently issued Accounting Standards Updates in the United States. The Establishment of Accounting Standards The IASB undertakes a DUE PROCESS. When developing accounting standards, the accounting standards series of information- board must understand the nuances of the economic transactions the standards address and gathering steps before issuing a new or the views of key constituents concerning how accounting would best capture that economic revised standard. reality. For example, the IASB undertakes a series of elaborate information-gathering steps  CHAPTER 1 Environment and Theoretical Structure of Financial Accounting 13 before issuing a new or revised standard. These steps include open hearings, deliberations, and requests for written comments from interested parties. Illustration 1–6 outlines the IASB’s standard-setting process.13 ILLUSTRATION 1–6 Step Explanation The IASB’s Standard- 1. Setting the agenda. The Board decides whether to add a project to its agenda Setting Process by considering users’ needs and factors such as the availability of existing guidance and resource constraints, and after appropriate consultation with its IASB members, the IFRS Advisory Council, the IFRS Interpretations Committee, other standard setters, and other interested parties. 2. Planning the project. The Board decides whether to conduct the project on its own or jointly with other standard setters, forms a project team, and comes up with a project plan. 3. Developing and publishing the discussion paper. The Board develops and publishes a discussion paper that provides an overview of the issue, possible ways to approach the issue, the preliminary views, and an invitation for public comment. A discussion paper is not mandatory and hence, the Board may decide to omit this step but needs to state the reason for this decision. 4. Developing and publishing the exposure draft. The Board develops and publishes an Exposure Draft, after considering the comments received on the discussion paper and suggestions from the IFRS Advisory Council, the public, and other parties. (In some projects, a second exposure draft may be published to obtain additional public comment.) 5. Developing and publishing the standard. The Board develops and issues the IFRS, after considering the comments received on the exposure draft and resolving the issues arising from the exposure draft. 6. After the standard is issued. The Board holds meetings with interested parties to discuss issues related to the implementation and potential impact of the IFRS, and may organize educational activities and studies related to the application of the IFRS. These steps are part of the IASB’s efforts to consult with and acquire information from various groups such as accountants, financial analysts, the international business commu- nity, regulatory authorities, and academics to help determine accounting requirements for recognition, measurement, and disclosures. However, as a practical matter, this information gathering also exposes the IASB to political pressure by various interest groups who want to put in place an accounting treatment that serves their best economic interests. POLITICS IN STANDARD SETTING. A change in accounting standards can result in a substantial redistribution of wealth within our economy. Therefore, it is no surprise that FINANCIAL there are political pressures on the IASB’s standard-setting process. One source of pres- Reporting Case sure comes from the international business community. Unlike the FASB, which is funded through fees paid by companies listing securities on stock exchanges, the IASB receives Q2, p. 3 much of its funding through voluntary donations by accounting firms and corporations, and LO4 there is concern that this financial support may compromise the IASB’s independence. In fact, one of the milestones specified by the Securities Exchange Commission for the even- tual adoption of IFRS in the United States is that the IASB’s independence be increased by creating a funding mechanism more like the FASB’s. Another source of political pressure arises from the fact that politicians from countries that use IFRS lobby for the standards they prefer. The European Union (EU) is a particu- larly important adopter of IFRS and utilizes a formal evaluation process before determining whether an IFRS standard will be endorsed for use in EU countries. Economic consequences 13 International Accounting Standards Board and the IFRS Foundation, “Due Process Handbook for the IASB,” (London, U.K.: IASB, 2012). 14 SECTION 1 The Role of Accounting as an Information System for EU member nations are an important consideration in that process. The EU has been known to apply political pressure on the IASB by rejecting its standards or “carving out” certain unfavorable provisions of the standards, and through the EU members of the IASB Board and Trustees. In addition, EU interest groups directly lobby the IASB. For example, in 2003 and 2004, several EU countries such as France, Italy, and Spain lobbied against some aspects of accounting for financial instruments stridently enough that the EU eventu- ally “carved out” two key provisions relating to portfolio hedging and the fair value option before endorsing the relevant accounting standard (IAS No. 39). The EU lobbied the IASB to revise the carved-out provisions, and in 2005, the IASB revised the provision relating to the fair value option. Similarly, in 2005, after the EU stated its intention to reject an IASB Interpretation (IFRIC No. 3) regarding the reporting of emissions assets and liabilities, the IASB withdrew IFRIC No. 3.14 During the financial crisis of 2008–2009, many argued that the use of fair value to mea- sure financial assets and liabilities and the inclusion of fair value changes in net income had exacerbated the financial crisis by forcing financial institutions to take larger than nec- essary write-downs of financial assets in the illiquid markets that existed at that time. The EU successfully pressured the IASB to suspend its due process and immediately revise its standards to allow reclassification of investments so that EU banks could avoid recognizing huge investment losses.15 There remains ongoing pressure from lobbyists and politicians for the IASB to reduce the extent to which fair value changes are included in the determina- tion of net income. Presumably, in its endeavors to engage a larger and more diverse group of stakeholders, the IASB on July 1, 2011, appointed a new chairman, Hans Hoogervorst, a securities regulator with extensive diplomatic experience and who is not an accountant. Although the IASB’s vice-chairman, Ian Mackintosh, has a long career in accounting and standard setting, the appointment of a non-accountant as IASB’s Chairman perhaps signals a new focus on political considerations. Other standard setters, such as the FASB, has also sometimes changed standards in response to intense political pressure. For example, in the mid 1990s, the FASB proposed that share options paid to employees be recognized as compensation expense. Many com- panies applied intense political pressure against this proposal, and eventually the FASB backed down and required only disclosure of options-related compensation expense in the disclosure notes. Nearly a decade later, this contentious issue resurfaced in a more amenable political climate, and the FASB issued a standard requiring expense recognition. Another example relates to business combinations which previously could be accounted for using the purchase method or pooling of interest method. Many companies structured their busi- ness combinations as a pooling of interests to avoid amortizing (expensing) goodwill, an intangible asset that arises only when the purchase method was used. When the FASB pro- posed eliminating the pooling method, many companies strongly objected, arguing that they would not undertake business combinations important to economic growth if the purchase method was required, due to the negative impact on earnings caused by goodwill amortiza- tion. Eventually the FASB compromised. In the final standard issued in 2001, only the pur- chase method, now called the acquisition method, is acceptable, but the resulting goodwill is not amortized.16 Encouraging High-Quality Financial Reporting Numerous factors affect the quality of financial reporting. In this section, we discuss the role of the auditor, recent reforms in financial reporting, and the debate about whether account- ing standards should emphasize rules or underlying principles. 14 Kennard S. Brackney and Philip R. Witmer, “The European Union’s Role in International Standards Setting,” www.nysscpa.org/ cpajournal/2005/1105/infocus/p20.htm, CPA Journal, November 2005. 15 Sarah Deans and Dane Mott, “Lowering Standards,” www.morganmarkets.com, October 14, 2008. 16 FASB ASC 805: Business Combinations (previously “Business Combinations,” Statement of Financial Accounting Standards No. 141 (revised) (Norwalk, Conn.: FASB, 2007)), and FASB ASC 350: Intangibles—Goodwill and Other (previously “Goodwill and Other Intangible Assets,” Statement of Financial Accounting Standards No. 142 (Norwalk, Conn.: FASB, 2001)).  CHAPTER 1 Environment and Theoretical Structure of Financial Accounting 15 The Role of the Auditor FINANCIAL It is the responsibility of management to apply accounting standards appropriately. Another Reporting Case group, auditors, serves as an independent intermediary to help ensure that management has in fact appropriately applied accounting standards in preparing the company’s finan- Q3, p. 3 cial statements. Auditors examine (audit) financial statements to express a professional, independent opinion about whether the statements fairly present the company’s finan- cial position, its results of operations, and its cash flows in compliance with accounting standards. The report of the independent auditors of Singapore Airlines’ financial statements is in the annual report information included with the text. The first few paragraphs explain management’s responsibility for the financial statements, auditors’ responsibility, and the scope of the audit. The last paragraph states the auditors’ opinion. After conducting its audit, the accounting firm of Ernst & Young LLP stated that “in our opinion, the … financial Auditors express statements... are properly drawn up in accordance with the provisions of the (Companies’) an opinion on the compliance of financial Act and Singapore Financial Reporting Standards so as to give a true and fair view of the statements with state of affairs of the Group and of the Company …” This is known as a clean opinion. accounting standards. Had there been any material departures from accounting standards or other problems that caused the auditors to question the fairness of the statements, the report would have been modified to inform readers. Normally, companies correct any material misstatements that auditors identify in the course of an audit, so companies usually receive clean opinions. In the United States, the audit report also contains the auditors’ opinion on the effectiveness of the company’s internal control over financial reporting. We discuss this opinion on internal controls in the next section. The auditor adds credibility to the financial statements, increasing the confidence of capi- Auditors offer tal market participants who rely on the information. Auditors, therefore, play an important credibility to financial statements. role in the resource allocation process. In most countries and states, only individuals licensed as certified public accountants Certified public (CPAs) can represent that the financial statements have been audited in accordance with accountants (CPAs) are licensed by the country generally accepted auditing standards. Requirements to be licensed as a CPA vary across or state to provide different countries and states, but all countries or states would specify education, testing, audit services. and experience requirements. Financial Reporting Reform in the United States In the United States, the dramatic collapse of Enron in 2001 and the dismantling of the Sarbanes-Oxley international public accounting firm of Arthur Andersen in 2002 severely shook U.S. capital markets. The credibility of the accounting profes- PAUL SARBANES— sion itself as well as of corporate America was called U.S. SENATOR into question. Public outrage over accounting scandals at We confront an increasing high-profile companies like WorldCom, Xerox, Merck, crisis of confidence with the Adelphia Communications, and others increased the pres- public’s trust in our markets. sure on lawmakers to pass measures that would restore If this continues, I think it poses a real threat to our credibility and investor confidence in the financial reporting economic health.17 process. Driven by these pressures, Congress acted swiftly and passed the Public Company Accounting Reform and Investor Protection Act of 2002, commonly referred to as the Sarbanes-Oxley Act or SOX for the two congressmen who sponsored the bill. SOX applies to public securities- issuing entities. It provides for the regulation of auditors and the types of services they furnish to clients, increases corporate executives’ accountability, addresses conflicts of interest, and has stiff penalties for violators. Illustration 1–7 outlines the key provisions of SOX. 17 James Kuhnhenn, “Bush Vows to Punish Corporate Lawbreakers,” San Jose Mercury News (July 9, 2002), p. 8A. 16 SECTION 1 The Role of Accounting as an Information System ILLUSTRATION 1–7 Public Company Key Provisions of the Act: Accounting Reform Oversight board. The Public Company Accounting Oversight Board has the authority and Investor to establish standards dealing with activities relating to the preparation of audit Protection Act reports, or can choose to delegate these responsibilities to the AICPA. Prior to the act, of 2002 the AICPA set auditing standards. The SEC has oversight and enforcement authority. (Sarbanes-Oxley) Corporate executive accountability. Corporate executives must certify the financial statements with severe financial and criminal penalties for fraudulent misstatement. Nonaudit services. Auditors of public companies are not allowed to perform nonaudit services such as bookkeeping, internal audit outsourcing, and appraisal or valuation services. Other nonaudit services, such as tax services, require pre-approval by the audit committee of the company being audited. Retention of work papers. Auditors of public companies must retain all audit work papers for seven years or face the threat of a prison term for willful violations. Auditor rotation. Lead audit partners are required to rotate every five years. Mandatory rotation of audit firms came under consideration. Conflicts of interest. Audit firms are not allowed to audit public companies whose chief executives worked for the audit firm and participated in that company’s audit during the preceding year. Hiring of auditor. The audit committee, and not company management, hires the audit firm. Internal control (Section 404). Management has to document and assess the effectiveness of internal control over financial reporting. Auditors express opinions on whether management’s internal control assessment is fairly stated and whether the company has maintained effective internal control over financial reporting. Section 404 of SOX requires that management report on the adequacy of their internal controls. Auditors must also express an opinion on whether the company has maintained effective control over financial reporting. Many argued that the benefits of Section 404 did not justify its compliance costs. There is research evidence that 404 reports affect investors’ risk assessments and share prices, indicating these reports are seen as useful by investors.18 However, the compliance costs are steep. For example, one survey of Fortune 1,000 compa- nies estimated that large companies spent, on average, $8.5 million and $4.8 million (includ- ing internal costs and auditor fees) during the first two years of the act to comply with 404 reporting requirements.19 As expected, the costs dropped significantly in the second year, and would likely to continue to drop as the efficiency of internal control audits increased. Fortunately, many companies now perceive that the benefits of these internal control reports exceed their costs.20 Principles-Based or Rules-Based Standards? The accounting scandals at Enron and other companies involved managers using elaborately structured transactions to try to circumvent specific rules in accounting standards. One con- sequence of those scandals was a rekindled debate over principles-based, or more recently termed objectives-oriented, versus rules-based accounting standards. In fact, a provision of the Sarbanes-Oxley Act required the SEC to study the issue and provide a report to Congress on its findings. That report, issued in July 2003, recommended that accounting standards be developed using an objectives-oriented approach.21 A principles-based, or An objectives-oriented approach to standard setting emphasizes using professional judg- objectives-oriented, ment to interpret broad principles and concepts and apply them to various situations, as approach to standard opposed to following a list of detailed rules, when choosing the accounting treatment for a setting stresses professional judgment 18 Hollis Ashbaugh Skaife, Daniel W. Collins, William R. Kinney, Jr., and Ryan LaFond, “The Effect of SOX Internal Control Deficien- to apply broad cies on Firm Risk and Cost of Equity,” Journal of Accounting Research 47 (2009): 1–43. principles to various 19 “Sarbanes-Oxley 404 Costs and Implementation Issues: Spring 2006 Survey Update,” CRA International (April 17, 2006). situations, as opposed 20 Protiviti, Inc., 2011 Sarbanes-Oxley Compliance Survey (June, 2011). to following a list of 21 “Study Pursuant to Section 108(d) of the Sarbanes-Oxley Act of 2002 on the Adoption by the United States Financial Reporting rules. System of a Principles-Based Accounting System,” Securities and Exchange Commission (July 2003).  CHAPTER 1 Environment and Theoretical Structure of Financial Accounting 17 transaction. IFRS is more principles-based or objectives-oriented and provides less precise guidance. In general, the IASB does not provide much guidance such as implementation guidance or discussions of its staff views and positions for its standards. This is because the IFRS emphasizes the general concepts and principles drawn from the IASB’s underlying conceptual framework that provides the basis for recognition, measurement, and disclosure of financial statement elements. Hence, the IFRS tends to provide only a limited amount of guidance and fewer illustrative examples and interpretations, and instead encourages the use of professional judgment in applying general principles to specific transactions. In contrast, U.S. GAAP is more rules-based and contains an extremely large amount of detailed and precise guidance. Proponents of an objectives-oriented approach argue that the approach results in a more accurate reflection of the true economic substance of a company’s transac- tions and actual performance in the financial statements, because a focus on professional judgment means a lower likelihood of companies structuring transactions to circumvent the accounting rules, and we are more likely to arrive at an appropriate accounting treatment. Proponents also believe that an objectives-oriented approach will result in shorter and less complex standards. Detractors, on the other hand, argue that the absence of detailed rules opens the door to even more abuse, because management can use the latitude provided by objectives to justify their preferred accounting approach. Even in the absence of intentional misuse, reliance on professional judgment might result in different interpretations for simi- lar transactions, raising concerns about comparability and consistency. Also, detailed rules help auditors withstand pressure from clients who want a more favorable accounting treat- ment, and help companies ensure that they are complying with accounting standards and avoid litigation. Given ongoing efforts to converge IASB and FASB standards, it is likely that this debate will continue. Regardless of whether accounting standards are based more on rules or on objectives, prior research highlights that there is some potential for abuse, either by structuring transac- tions around precise rules or opportunistically interpreting underlying principles.22 The key is whether management is dedicated to high-quality financial reporting. It appears that poor ethical values on the part of management are at the heart of accounting abuses and scandals like Enron and Parmalat, so we now turn to a discussion of ethics in accounting. Ethics in Accounting Ethics is a term that refers to a code or moral system that provides criteria for evaluating Ethics deals with the right and wrong. An ethical dilemma is a situation in which an individual or group is faced ability to distinguish right from wrong. with a decision that tests this code. Many of these dilemmas are simple to recognize and resolve. For example, have you ever been tempted to call your professor and ask for an extension on the due date of an assignment by claiming a fictitious illness? Temptation like this will test your personal ethics. Accountants, like others operating in the business world, are faced with many ethical dilemmas, some of which are complex and difficult to resolve. For instance, the capital mar- kets’ focus on periodic profits may tempt a company’s management to bend or even break accounting rules to inflate reported net income. In these situations, technical competence is not enough to resolve the dilemma. Ethics and Professionalism One of the elements that many believe distinguishes a profession from other occupations is the acceptance by its members of a responsibility for the interests of those it serves. A high standard of ethical behavior is expected of those engaged in a profession. These standards often are articulated in a code of ethics. For example, law and medicine are professions that have their own codes of professional ethics. These codes provide guidance and rules to members in the performance of their professional responsibilities. Mark W. Nelson, John A. Elliott, and Robin L. Tarpley, “Evidence From Auditors About Managers’ and Auditors” Earnings Manage- 22 ment Decisions,” The Accounting Review 77 (2002): 175–202. 18 SECTION 1 The Role of Accounting as an Information System Public accounting has achieved widespread recognition as a profession. In the United States, the AICPA, the U.S. organization of certified public accountants, has its own Code of Professional Conduct which prescribes the ethical conduct members should strive to achieve. Similarly, the Institute of Management Accountants (IMA)—the primary U.S. organization of accountants working in industry and government—has its own code of ethics, as does the Institute of Internal Auditors—the U.S. organization of accountants providing internal auditing services for their own organizations. Analytical Model for Ethical Decisions Ethical codes are informative and helpful. However, the motivation to behave ethically must come from within oneself and not just from the fear of penalties for violating professional codes. Presented below is a sequence of steps that provide a framework for analyzing ethical issues. These steps can help you apply your own sense of right and wrong to ethical dilemmas:23 Step 1. Determine the facts of the situation. This involves determining the who, what, where, when, and how. Step 2. Identify the ethical issue and the stakeholders. Stakeholders may include shareholders, creditors, management, employees, and the community. Step 3. Identify the values related to the situation. For example, in some situations confidentiality may be an important value that may conflict with the right to know. Step 4. Specify the alternative courses of action. Step 5. Evaluate the courses of action specified in step 4 in terms of their consistency with the values identified in step 3. This step may or may not lead to a suggested course of action. Step 6. Identify the consequences of each possible course of action. If step 5 does not provide a course of action, assess the consequences of each possible course of action for all of the stakeholders involved. Step 7. Make your decision and take any indicated action. E T H I C A L D I LE MMA You have recently been employed by a large retail chain that sells sporting goods. One of your tasks is to help prepare periodic financial statements for external distribution. The chain’s largest creditor, National Savings & Loan, requires quarterly financial statements, and you are currently working on the statements for the three-month period ending June 30, 2013. During the months of May and June, the company spent $1,200,000 on a large radio and TV advertising campaign. The $1,200,000 included the costs of producing the commercials as well as the radio and TV time purchased to run the commercials. All of the costs were charged to advertising expense. The company’s chief financial officer (CFO) has asked you to prepare a June 30 adjusting entry to remove the costs from advertising expense and to set up an asset called prepaid advertising that will be expensed in July. The CFO explained that “This advertising campaign has produced significant sales in May and June and I think it will continue to bring in customers through the month of July. By recording the ad costs as an asset, we can match the cost of the advertising with the additional July sales. Besides, if we expense the advertising in May and June, we will show an operating loss on our income statement for the quarter. The bank requires that we continue to show quarterly profits in order to maintain our loan in good standing.” 23 Adapted from Harold Q. Langenderfer and Joanne W. Rockness, “Integrating Ethics into the Accounting Curriculum: Issues, Problems, and Solutions,” Issues in Accounting Education (Spring 1989). These steps are consistent with those provided by the American Accounting Association’s Advisory Committee on Professionalism and Ethics in their publication Ethics in the Accounting Curriculum: Cases and Readings, 1990.  CHAPTER 1 Environment and Theoretical Structure of Financial Accounting 19 Ethical dilemmas are presented throughout the text. These dilemmas are designed to raise your consciousness on accounting issues with ethical ramifications. The analytical steps outlined above provide a framework with which to evaluate these situations. In addi- tion, your instructor may assign end-of-chapter ethics cases for further discussion and application. THE CONCEPTUAL FRAMEWORK PART B The increasing complexity of our business world creates growing pressure on accounting standard setters to delicately balance the many constituents of the accounting standard- setting process and to develop a set of accounting standards that are consistent with each R other. This task is made less complex if there exists a set of cohesive objectives and fundamental concepts on which financial accounting and reporting can be based. The Framework for the Preparation and Presentation of Financial Statements, adopted by TE the IASB in 2001, provides an underlying foundation for financial reporting standards. In 2010, a revised framework, The Conceptual Framework for Financial Reporting, was issued. “The conceptual framework deals with (a) the objective of financial reporting; FINANCIAL AP (b) the qualitative characteristics of useful financial information; (c) the definition, recognition, and measurement of the elements from which financial statements Reporting Case are constructed; and (d) concepts of capital and capital maintenance.”24 The purpose of the framework is to assist the board in reviewing existing accounting Q4, p. 3 standards, developing future standards, and promoting harmonization of H regulations and standards, and to assist preparers of financial statements, and assist users in interpreting financial statements.25 C It is important to realize that the IASB conceptual framework provides structure and LO5 direction to financial accounting and reporting and does not directly prescribe the account- The conceptual ing standards. framework does In the United States, the conceptual framework issued by the FASB is disseminated not prescribe the E through seven Statements of Financial Accounting Concepts (SFACs). As part of the accounting standards. ongoing efforts to converge U.S. GAAP and IFRS, the FASB and IASB are working It provides an underlying foundation together to develop a common and improved conceptual framework that will provide the PL for accounting foundation for developing principles-based, common standards. standards. The joint conceptual framework project consists of eight phases: A. Objective and Qualitative Characteristics B. Definitions of Elements, Recognition, and Derecognition M C. Measurement D. Reporting Entity Concept E. Boundaries of Financial Reporting, and Presentation and Disclosure SA F. Purpose and Status of the Framework G. Applicability of the Framework to Not-For-Profit Entities H. Remaining Issues When formulated, this framework will replace the existing IASB conceptual frame- work. The Boards are currently working on the first four phases of the project and at the time this textbook is written, only Phase A has been completed. Phase A pertains to the objective of financial reporting and the qualitative characteristics of financial information, and that material is incorporated in this and subsequent chapters where applicable. The remaining phases of the project are likely to take several years to be completed. 24 “The Conceptual Framework for Financial Reporting,” IASB Conceptual Framework (London, U.K.: IASB, 2010), p. A25. 25 Ibid., p. A25. 20 SECTION 1 The Role of Accounting as an Information System ILLUSTRATION 1–8 The IASB Conceptual OBJECTIVE OF FINANCIAL REPORTING Framework To provide financial information that is useful to capital providers Phase A QUALITATIVE UNDERLYING CHARACTERISTICS ASSUMPTION Going concern FUNDAMENTAL Relevance RECOGNITION OF Predictive value ELEMENTS Confirmatory value Probability of Materiality ELEMENTS future economic R Financial Position benefit Faithful Reliability of Representation Assets Liabilities measurement Completeness TE Neutrality Equity MEASUREMENT OF Free from Error ELEMENTS Performance Income Basis of ENHANCING measurement Comparability Expenses (including CAPITAL AND AP consistency) CAPITAL Verifiability MAINTENANCE Timeliness Concepts of Understandability capital FINANCIAL STATEMENTS Concepts of Phase A H capital maintenance Statement of financial and determination position of profit Income statement Statement of comprehensive C CONSTRAINT income Cost effectiveness Statement of cash flows Statement of changes in Phase A shareholder’s equity Notes and supplementary E disclosures PL In the remainder of this section, we discuss the components of the conceptual frame- work that influence financial statements as depicted in Illustration 1–8. The financial statements and their elements are most informative when they possess specific qualita- M tive characteristics, subject to certain constraints. Proper recognition and measurement of financial information rely on several assumptions and principles that underlie the financial reporting process. SA Our discussions of the objective and qualitative characteristics of financial reporting information are based on the completed first phase of the joint FASB and IASB project (indicated as Phase A in Illustration 1–8), while the remainder of our conceptual framework coverage relies on the existing IASB framework that is still in effect. We discuss and illus- trate the financial statements themselves in subsequent chapters. The conceptual frameworks in U.S. GAAP and IFRS are very similar, and are converg- ing even more with ongoing efforts by the FASB and IASB. However, in U.S. GAAP, the conceptual framework primarily provides guidance to standard setters to help them develop high-quality standards. In IFRS the conceptual framework guides standard setting, but in addition it is supposed to provide a basis for practitioners to make accounting judgments when another IFRS standard does not apply. Also, IFRS emphasizes the overarching con- cept of the financial statements providing a “true and fair representation” of the company. U.S. GAAP does not include a similar requirement, but U.S. auditing standards require this consideration.  CHAPTER 1 Environment and Theoretical Structure of Financial Accounting 21 Objective of Financial Reporting The objective of general purpose financial reporting is to provide financial information LO6 about companies that is useful to capital providers in making decisions. For example, inves- tors decide whether to buy, sell, or hold equity or debt securities, and creditors decide whether to provide or settle loans.26 Information that is useful to capital providers may The primary objective also be useful to other users of financial reporting information, such as regulators or taxing of financial reporting is to provide useful authorities. information to capital Both investors and creditors are directly interested in the amount, timing, and uncer- providers. tainty of a company’s future cash flows. Information about a company’s economic resources (assets) and claims against resources (liabilities) is also useful. Not only does this informa- tion about resources and claims provide insight into future cash flows, it also helps decision R makers identify the company’s financial strengths and weaknesses and assess liquidity and solvency. TE Qu