Chapter 1 Notes - IM1: Financial Reporting

Chapter 1-- Environment & Structure of Financial Reporting p 1 \-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-- 1. Financial Reporting Environment 2. Parties involved in Standard setting 3. The...

Chapter 1-- Environment & Structure of Financial Reporting p 1 \-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-- 1. Financial Reporting Environment 2. Parties involved in Standard setting 3. The Conceptual Framework of Financial Reporting 4. Evolution and Challenges \-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-- **There are a number of new terms in this class. LEARN THEM!! If you don't understand the terms, you won't understand concepts.** To increase your chances for success in this class: - Focus on **LEARNING** the material instead of memorizing -- you will not be able to memorize or cram all of the important material in this class - Read assigned materials **BEFORE** class -- if you are not prepared for class, you will not understand the lecture - Attend class and **pay active attention** - **After class, spend 15-25 minutes reviewing** what we covered in class to reinforce what you have learned - **Outline the chapter material in YOUR OWN words** -- if you can restate the material in your own words, your knowledge and retention will increase - **Form study groups** -- meet regularly - **Do the homework yourself**. We learn by practicing - homework is practice - **DO NOT FALL BEHIND**. Keeping current is more effective to learning - If you do not understand something, **ASK -- use office hours and class time; use the tutor**s, use your classmates Chapter 1 covers the history and development of the Financial Accounting Conceptual Framework and the financial accounting standards-setting process. Chapter 2 goes over the financial accounting cycle. In Principles, we said Financial Accounting is "the language of business" because it is used to measure business activities and communicate the results of these activities to stakeholders. There are actually many different types of accounting: Financial, Cost/Managerial, Tax, Governmental, Forensic, Audit, Information Systems, and more. Each of these has its own purpose and its own rules. Chapter 1-- Environment & Structure of Financial Reporting p 2 \-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-- In Intermediate Accounting, we focus on Financial Accounting. Financial Accounting is a **written, numbers-based language** that **identifies, measures, records,** **summarizes,** and **communicates** the economic activity and financial position of the organization to "interested parties". Who are these "interested parties"? Some are internal to the organization (management, employees, etc); others external (stockholders, creditors, government, news sources, unions, etc). Having said that, not all "interested parties" are equally important. According to the Conceptual Framework for Financial Reporting, **the primary objective of Financial Accounting is providing information to EXTERNAL PROVIDERS OF CAPITAL**: stockholders, bondholders, creditors, suppliers Why is the focus on **external providers of capital**? Our economy depends on businesses and other organizations being able to get the capital (money) they need to produce goods and services, create jobs, develop new products, expand, etc. The primary source of these funds is the Capital Markets.[^1^](#fn1){#fnref1.footnote-ref} In order to make effective investment and credit decisions, the Capital Markets need information. Financial accounting provides information in the form of financial reports - most common are Income Statement, Statement of Comprehensive Income, Balance Sheet, Statement of Cash Flows, and Statement of Stockholders' Equity (or Statement of Retained Earnings). In addition, an integral part of the financial statements are the Notes to the Financial Statements that detail the various accounting methods and other information to explain the numbers on the financial statements.[^2^](#fn2){#fnref2.footnote-ref} Publicly traded companies are required to file their financial statements with the Securities and Exchange Commission (SEC) on a quarterly (10Q) and annual (10K) basis. These documents are available to the public. In addition to financial statements, these filings include discussions of business and market risk factors, legal proceedings, management discussion and analysis of operations, significant internal controls, listing of Board members and Executive officers, Corporate Governance, Executive Compensation, Related Parties, and other matters. The 10K is typically included as part of the company's annual report. Chapter 1-- Environment & Structure of Financial Reporting p 3 \-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-- With a few exceptions, privately held companies are not required to release their financial statements to the public or file reports with the SEC. However, they are required to file financial information annually via their income tax returns (private records). There are situations where privately held companies are required to provide financial information that can be accessed by the public such as a bankruptcy filing. In the United States, publicly traded companies are required to follow Generally Accepted Accounting Principles (GAAP) when preparing their financial statements. Why? The purpose of language is to communicate. Company financial statements are distributed to a external users. In most cases, this communication is one-way -- the statements are sent to users; but most users do not have access to management to ask questions. So, to reduce opportunities for misunderstandings, we require companies to follow a standard set of "grammatical" rules when preparing their statements (GAAP). Plus, if publicly traded companies follow the same set of financial accounting rules, users can compare the performance of one company to another (or the company's current performance against its prior performance). Why would this be important? Publicly traded companies are required by Federal law to have their annual financial statements audited by a Certified Public Accounting firm. Auditors gather and evaluate evidence to determine if the financial statements present fairly, in all material respects, the results of operations and financial position in accordance with Generally Accepted Accounting Principles. If the statements present fairly, the auditors issue an unqualified audit report. Statements that do not follow GAAP receive a qualified or adverse audit report or a disclaimer of opinion. Why is a financial statement audit important? While following GAAP is required for publicly traded companies, most privately held companies are not required to follow GAAP.[^3^](#fn3){#fnref3.footnote-ref} Small privately held companies typically use cash or modified cash accounting because it is easier than using the accrual method. Also, users are usually internal or close externals -- folks who have first-hand knowledge of the business Chapter 1-- Environment & Structure of Financial Reporting p 4 \-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-- **Parties involved in Standard setting** During the 19^th^ and early 20^th^ centuries, the United States economy was based on agriculture and most businesses were small and owner-operated. The need for accounting information was limited. Why? Early in the 20th century, the US economy industrialized, companies grew larger, and manufacturing became a significant part of our economy (Industrial Revolution). The increased size and complexity of these companies required significant capital investment. This need led to the development and growth of the Capital Markets and a new class of passive owners (stockholders who were not involved in running the business). These passive external owners relied on financial statements to tell them how the company was doing. Unfortunately, development of Accounting principles and market regulation (by New York state) did not keep up with increased complexity of business operations or growth of the Capital Markets. The stock market crash of 1929 highlighted significant problems including numerous cases of fraud. This created great mistrust of the Capital Markets and our system of financial reporting in the minds of investors and the general public. **Securities and Exchange Commission.** In response to the market crash and public mistrust, Congress passed the Securities Act of 1933, and Securities Exchange Act of 1934 to establish Federal oversight of the Capital Markets through a newly created Securities and Exchange Commission (SEC). The SEC received broad authority to regulate publicly traded companies including the authority to set financial accounting standards. However, in the beginning, the SEC delegated much of its standard-setting authority back to the public accounting profession. Why? Regardless, the SEC retains its authority to set financial accounting standards for publicly traded companies and can accept or reject any standards proposed by the Financial Accounting Standards Board (FASB) or American Institute of Certified Public Accountants (AICPA). The SEC also has authority to set filing requirements for publicly traded companies, investigate violations of its regulations, order suspension of trading of company securities (stocks, bonds), file civil actions against violators, and refer criminal charges to the Department of Justice. The SEC also oversees the Public Companies Accounting Oversight Board (PCAOB). Chapter 1-- Environment & Structure of Financial Reporting p 5 \-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-- **Public Companies Accounting Oversight Board**. The Securities Act of 1933 and the Securities Exchange Act of 1934 helped rebuild investor confidence in the Capital Markets and financial statements for several decades. However, during the 1990's, Arthur Levitt, chairman of the SEC, repeatedly expressed concern that companies were using accounting gimmicks and manipulating their financial statements to support elevated stock prices, and that their auditors were not willing to confront them over questionable accounting practices. Unfortunately, as long as the stock market continued to go up, Levitt was unable to convince Congress or the Clinton Administration of the need for reforms. However, after the massive financial statement frauds were exposed at Enron, WorldCom, etc., it became clear (even to Congress) that reforms were necessary. Congress responded by passing the Sarbanes-Oxley Act of 2002. SOX applies to most publicly traded companies. Act provisions were designed to address deficiencies in corporate governance and in the financial statement audit process. Among those things, SOX established the **PCAOB** with authority to regulate the CPA firms that audit public companies. The PCAOB has the authority to set standards for the audits of public companies, require CPA firms who audit public companies to register with the PCAOB, to perform quality inspections of registered CPA firms, and investigate violations of laws and standards by registered CPA firms, and impose sanctions for violations. **The AICPA** (and State CPA societies like the PICPA) is a professional trade organizations. The AICPA develops and publishes professional resource materials, administers and grades the CPA Exam and promotes the Accounting profession. Membership in the AICPA is voluntary - you do not have to join in order to practice as a CPA. The AICPA is the oldest and largest professional accounting organization in the United States (about 400,000 members). It traces its roots back to 1887 when Edwin Guthrie, a Chartered Accountant in New York City, founded the American Association of Public Accountants (AAPA). Eventually, the AAPA became the AICPA. Soon after its formation, the AAPA began lobbying for state licensing of public accountants. 1896, the New York State Legislature became passed legislation recognizing the Certified Public Accountant designation.[^4^](#fn4){#fnref4.footnote-ref} The AICPA has been active in developing financial accounting standards including formation of the Committee on Accounting Procedure (CAP), Accounting Principles Board (APB), and Financial Accounting Standards Board (FASB) -- more details in the section on the Conceptual Framework. The AICPA is also involved in developing audit standards for private companies through the Audit Standards Board (ASB). Chapter 1-- Environment & Structure of Financial Reporting p 6 \-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-- **The State Boards of Accountancy** (SBA) are responsible for certifying and licensing CPAs within each state. Each SBA issues certificates and licenses to practice, and can suspend or revoke them (if your certificate and license are revoked, you are no longer a CPA). Each SBA has its own education, CPA exam, and work experience requirements to become certified and licensed and that these requirements often differ between states. You must meet the requirements of the SBA where you practice. In recent years, the trend is to reduce the differences between the various SBAs.[^5^](#fn5){#fnref5.footnote-ref} What are the requirements to become a CPA in Pennsylvania? January 1, 2012, Pennsylvania legislature amended the Pennsylvania CPA Law to require 150 credit hours, completion of the CPA exam, and one-year accounting experience before certification and granting of the CPA license **Education Requirements:** you may **sit for the CPA Exam** after you have earned 120 credit hours at an accredited college or university approved by the Pennsylvania State Board of Accountancy (SBA); with at least 24 semester hours in accounting, auditing, business law, finance, tax, economics To be **licensed as a CPA**, you must have a bachelor or master's degree and have completed at least 150 semester credit hours with 36 credit hours in accounting subjects. The 150 credit hours can be undergraduate, or a combination of undergraduate and graduate study **Requirements to Pass the CPA Exam:** The CPA Exam is a four-part, computer-based examination administered during each quarter - Candidates may take any part of the examination individually or in any combination and in any order - No requirement on the number of sections passed to receive credit - Credit for passing each part of the exam is done without regard to the scores on parts not passed - Candidates have 18 months to pass all four parts, beginning when the first section is passed. If all parts are not passed within 18 months, the candidate loses credit for the first passed part of the examination - Minimum passing grade: 75 **Work Experience to become Certified and Licensed:** CPA candidates must also satisfy certain work experience requirements: - Employment in public accounting, industry, government, or academia within five years of the application for certification. Chapter 1-- Environment & Structure of Financial Reporting p 7 \-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-- - One year (1,600 hours) of work experience involving accounting, attest, compilation, consulting, financial advisory, management advisory, tax. All experience must be of a "caliber satisfactory to the State Board of Accountancy and verified by an individual who is currently licensed to practice public accounting in Pennsylvania or another state. **International Accounting Standards Board (IASB).** Each country sets its own financial accounting standards and there are significant differences between countries. In the "old" days this was not an issue, most companies operated within one country and followed that country's accounting rules. Post WW2, we saw an increase in multinational corporations operating in many different countries. With this, companies had to use multiple systems of financial accounting. The question was raised -- could we have common international financial accounting standards (this is not new, calls for international standards date back more than 40 years). One would think it would be a relatively simple task to develop one set of international financial reporting standards (IFRS). One would be mistaken. Why? The United States is the world's largest economy.[^6^](#fn6){#fnref6.footnote-ref} We have the largest capital markets and the most complex transactions and business operations. As such, we have developed complex accounting standards to account for these transactions. Following these complex standards is expensive. Many other countries have less complex transactions. They have developed accounting standards that are much simpler, less expensive to follow, and fit their needs. Given these differences, which standards should adopted -- simple standards or more complex standards? What are the arguments for and against each? Chapter 1-- Environment & Structure of Financial Reporting p 8 \-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-- The Conceptual Framework of Financial Reporting ----------------------------------------------- Because public company financial statements are widely distributed to a large number of external users, it is important these statements follow standard grammatical structure and rules to reduce opportunities for misunderstandings. For publicly traded companies, this structure is Generally Accepted Accounting Principles. GAAP is the accumulation of standards, opinions, interpretations, research bulletins issued by authoritative standard setting bodies (AICPA, CAP, APB, FASB) and consolidated into the FASB Accounting Standards Codification (there are GAAP Guides that summarize the standards). Following GAAP not only increases information usefulness by promoting consistency and comparability in financial reporting, but also aids in the development of future standards that address new and emerging issues (over time, languages evolve). Is it useful to review the history of GAAP including development of the Conceptual Framework of Financial Accounting. You are responsible for knowing the terms AND where they fit into the Framework. Rapid growth and industrialization of the U.S. economy during the early 1900s created large companies with more complex operations. - Larger companies with more complex operations had more complex transactions that had to be accounted for (development of accounting standards and rules lagged behind this need) - The demand for capital investment to fund this expansion created significant growth of the debt and equity Capital markets - Increased investment in stocks meant more passive owners not directly involved in the business and a greater reliance by these owners on the financial statements to report performance and position After the Stock Market Crash of 1929 and during the Great Depression (1929-1939), the Federal Government assumed greater authority over Capital markets and financial reporting by passing the Securities Act of 1933 and Securities Exchange Act of 1934. Although this legislation gave the Securities and Exchange Commission (SEC) the authority to set financial accounting standards, the SEC let the Accounting profession take the lead. 1939, the AICPA formed the Committee on Accounting Procedure (CAP) to develop more advanced financial accounting theory and standards. Over the next 20 years, the CAP issued 51 Accounting Research Bulletins (ARB). These ARBs were issued as accounting issues arose. However, this piecemeal approach and the increasing complexity of accounting highlighted the need to develop a framework in which a comprehensive set of accounting standards could be developed. Chapter 1-- Environment & Structure of Financial Reporting p 9 \-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-- 1959, the AICPA replaced CAP with the Accounting Principles Board (APB) and charged it with developing a Conceptual Framework of Financial Reporting and further development of financial accounting standards While the APB issued 31 opinions from 1959-1973, there were complaints about the Board's lack of activity and failure to respond to accounting abuses. There were also complaints that APB members had to be CPAs and members of the AICPA; that Board members continued working at their firms (representing their firms' interests over those of the public); and that other groups like statement users were not represented on the Board. 1973, the AICPA replaced the APB with the Financial Accounting Standards Board (FASB). The seven FASB Board members are full-time, paid members who serve five-year (renewable) terms. They are not required to be CPAs and must quit their jobs in order to serve full-time on the Board. The FASB is funded primarily through accounting support fees paid by U.S. corporations that issue publicly traded securities. The FASB also receives revenue from the sales of subscriptions and publications. In addition to the Conceptual Framework of Financial Accounting, the FASB continues to develop financial accounting standards. To this end, the FASB issues two types of pronouncements: - Accounting Standard Updates modify existing standards. Initially, the FASB issues an exposure draft detailing a proposed accounting standard and inviting comments and holding meetings with affected parties. After this period of comment, the FASB may change the draft, withdraw the draft, or issue the final pronouncement which will become part of GAAP - Financial Accounting Concepts are issued aid the development of the Conceptual Framework. The Conceptual Framework comes from Statements of Financial Accounting Concepts (SFAC) issued by the FASB and is codified in the Accounting Standard Codification (ASC) 105: - SFAC 1 defined the objective purpose of financial reporting - SFAC 2 defined the qualitative characteristics that make accounting information useful to decision makers - SFAC 3 defined the elements of financial statements - SFAC 4 defined the recognition, measurement, and disclosure criteria as to the information to be reported on the financial statements The Framework was subsequently updated by SFAC 6, 7, and 8. ::: {.section.footnotes} ------------------------------------------------------------------------ 1. ::: {#fn1} The best known Capital Markets are the New York Stock Exchange, American Stock Exchange, NASDAQ/OTC, New York Bond Exchange. In a given day, BILLIONS of dollars are transacted in stock and bond exchanges.[↩](#fnref1){.footnote-back} ::: 2. ::: {#fn2} WalMart's 2024 10K filing is 92 pages. There are 14 financial statement footnotes covering 21 pages to explain the financial statements[↩](#fnref2){.footnote-back} ::: 3. ::: {#fn3} Some privately held companies, because of their size, investment base, or government regulations are required to file annual reports with the Federal government and are required to follow GAAP.[↩](#fnref3){.footnote-back} ::: 4. ::: {#fn4} The first CPA certificate was awarded to Frank Broaker, Millerstown, PA, 1896[↩](#fnref4){.footnote-back} ::: 5. ::: {#fn5} There are 55 State Boards of Accountancy -- one for each state + Washington DC, Guam, Puerto Rico, US Virgin Islands, and the Northern Marianna Islands[↩](#fnref5){.footnote-back} ::: 6. ::: {#fn6} US 2023 GDP is approximately \$27.4 trillion, China GDP \$17.7 trillion. The US has been world\'s largest economy since 1871; currently almost 25% of the global economy[↩](#fnref6){.footnote-back} ::: :::