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Chapter 3—DEVELOPMENT OF INSTITUTIONAL STRUCTURE OF FINANCIAL ACCOUNTING
TRUE/FALSE
1. The accounting profession has been regulated by Congress since the 1880s when it became clear
that accounting was an important instrument in America for conducting business.
ANSWER: F
2. The SEC was created by Congress to replace the AICPA’s standard-setting group.
ANSWER: F
3. The SEC is legally empowered to regulate accounting principles.
ANSWER: T
4. Most of the responsibility for establishing accounting principles has remained with the private
sector rather than the SEC.
ANSWER: T
5. The Securities Act of 1933 and the Securities and Exchange Act of 1934 were the first national
securities legislations in the United States.
ANSWER: T
6. The Journal of Accountancy was founded by the American Association of Public Accountants in
1905.
ANSWER: T
7. The American Accounting Association was originally called the American Society of Certified
Public Accountants.
ANSWER: F
8. The Committee on Accounting Procedures (CAP) used a formalized deductive approach to

develop a comprehensive accounting theory.
ANSWER: F
9. The Committee on Accounting Procedures (CAP) represented the profession’s first sustained
attempt to develop workable financial accounting rules.
ANSWER: T
10. APB Opinions were originally expected to be based on in-depth research studies.
ANSWER: T
11. The Trueblood Study Group formed the FASB and called for significant changes in the
establishment of financial accounting standards.
Accounting Theory: 9th edition Page 1 of 13

ANSWER: F
12. The responsibility of the Financial Accounting Foundation is to elect the board of trustees, which
selects FASB members, funds the board’s activities, and performs the oversight role.
ANSWER: T
13. The FASB has made more extensive use of research than did its predecessors.
ANSWER: T
14. FASB statements have resulted in a more conservative balance sheet and immediate recognition
of events on the income statement.
ANSWER: T
15. The Accounting Standards Executive Committee of the AICPA (ASEC) and the Emerging Issues
Task Force (EITF) were established to solve the problems of particular industries as well as
narrow technical issues.
ANSWER: T
16. A normal four-to-three majority vote is required for passing new accounting standards.
ANSWER: T
17. The Federal Litigation Reform Act of 1995 replaced the previous proportionate liability
requirement with joint and several liability for damages suffered by third parties who rely on the
financial statement of firms attested to by CPAs.
ANSWER: F
18. The AICPA has exclusive authority in the private sector for promulgating auditing rules.
ANSWER: F
19. Congress has recently been concerned with the laxity of auditors in detecting and disclosing
fraud.
ANSWER: T
20. An important role of the AICPA is to curb “shopping for accounting principles.”
ANSWER: T

21. An annual report to stockholders prepared using FASB accounting standards generally has more
disclosure of nonfinancial statement information than does the typical annual report filed with the
SEC.
ANSWER: F
22. The Litigation Reform Act of 1995 requires that an audit include procedures designed to
guarantee that illegal acts that would materially affect financial statements will be detected.
ANSWER: F
23. The importance of the auditing function relative to the management consulting function is
declining in major auditing firms.
ANSWER: T
24. A problem with the increased importance of the management consulting function in auditing
firms is the possible erosion of the integrity of the auditing function.
ANSWER: T
25. The AICPA has developed an electronic filing of financial data called EDGAR.
ANSWER: F
26. FASB lost a significant amount of independence from the SEC due to Sarbanes-Oxley’s passage.
ANSWER: T
27. The International Accounting Standards Board’s role in establishing standards has decreased
significantly since 2002.
ANSWER: F
MULTIPLE CHOICE
1. Which of the following characteristics does not apply to accounting practices and procedures in
the United States prior to 1930?
a. They were applied uniformly among companies.
b. They were considered confidential by the companies applying them.
c. They met the needs of creditors to a greater extent than they met the needs of
shareholders.
d. They emphasized the disclosure of cash and near-cash resources.
ANSWER: A

2. Which of the following was an accomplishment of the American Association of Public

Accountants?
a. The passage of a law in 1896 that created the professional designation of “Certified Public
Accountant”
b. The founding of The Journal of Accountancy in 1905
c. The development of a list of terms and definitions in 1915
d. All of the above
ANSWER: D
3. In 1918, the American Institute of Accountants (AIA) worked with which of the following
organizations to publish minimum standards for conducting a balance sheet audit?
a. The Federal Trade Commission (FTC)
b. The Securities and Exchange Commission (SEC)
c. The American Society of Certified Public Accountants
d. The New York Stock Exchange (NYSE)
ANSWER: A
4. Which state passed the law that first created the designation “Certified Public Accountant”?
a. Massachusetts
b. California
c. Ohio
d. New York
e. Iowa
ANSWER: D
5. Which of the following factors led to significant changes in accounting practices?

a. The Great Depression of 1929
b. The election of Franklin D. Roosevelt to the presidency in 1932
c. The enactment of the New Deal legislation
d. All of the above
ANSWER: D
6. Which of the following is not true regarding Accounting Series Release No. 4?
a. It stated that financial statements filed with the SEC and prepared in accordance with
accounting principles for which there is no substantial authoritative support would be
presumed to be misleading.
b. It implied that the SEC might in the future determine acceptable accounting practices and
mandate methods to be used in reports filed with it.
c. It established an authoritative body for the development of accounting standards.
d. It indicated that the SEC was growing impatient with the accounting profession.
ANSWER: C

7. Which of the following is true regarding the Committee on Accounting Procedures (CAP)?
a. It developed a comprehensive statement of accounting principles.
b. It adopted a policy of attacking specific problems and recommending preferred methods of
accounting when possible.
c. It was formed by the SEC in 1936.
d. It eliminated the use of alternative accounting practices by establishing an underlying
accounting theory.
ANSWER: B
8. The Committee on Accounting Procedures (CAP) was immediately succeeded by:

a. the Financial Accounting Standards Board (FASB).
b. the Accounting Principles Board (APB).
c. the Accounting Research Board (ARB).
d. the Financial Accounting Foundation (FAF).
ANSWER: B
9. Which of the following was a controversial issue faced by the Accounting Principles Board
(APB)?
a. The investment tax credit
b. Income tax allocation
c. Business combinations and goodwill
d. All of the above
ANSWER: D
10. What was the purpose of APB Statement 4, Basic Concepts and Accounting Principles
Underlying Financial Statements of Business Enterprises?
a. To provide a foundation for evaluating existing accounting practices
b. To assist in solving accounting problems and to guide the future development of financial
accounting
c. To enhance understanding of the purposes of financial accounting
d. All of the above
ANSWER: D
11. Criticism of the standard-setting process under the APB included:

a. exposure for tentative opinions was too limited and occurred too late in the process.
b. the standard-setting process was too long and subject to too many outside pressures.
c. both a and b.
d. none of the above.
ANSWER: C

12. In which of the following ways did the charge to the Financial Accounting Standards Board
(FASB) differ from that given to the Accounting Principles Board (APB)?
a. The FASB was to establish standards of financial accounting and reporting in the most
efficient and complete manner possible.
b. The FASB was to work toward standard setting with a two-pronged approach.
c. The FASB was expected to stipulate principles of accounting as an underlying framework.
d. The accounting standards established by the FASB were to be advisory rather than
mandatory.
ANSWER: A
13. Which of the following are true regarding the Financial Accounting Standards Board (FASB)?
a. The FASB includes ten members, each serving a term of three years.
b. Each member of the FASB must be a Certified Public Accountant.
c. There must be no conflict between the FASB members’ private interest and the public
interest.
d. All of the above are true.
ANSWER: C
14. The establishment of which of the following groups has resulted in a challenge to the FASB’s
standard-setting powers?
a. The Governmental Accounting Standards Board (GASB)
b. The Emerging Issues Task Force (EITF)
c. The Accounting Standards Executive Committee (AcSEC)
d. All of the above
ANSWER: D
15. The liability concept that restricts liability to each defendant’s share of the damages based upon
the judge or jury’s assessment of their share of the damages is called:
a. proportionate liability.
b. compensatory liability.
c. joint and several liability.
d. disproportionate liability.
ANSWER: A
16. The liability concept that can result in one party having to pay for more than its proportionate
share of damages is called:
a. proportionate liability.
b. compensatory liability.
c. joint and several liability.
d. punitive liability.
ANSWER: C

17. Post-SOX, the accounting/auditing standards setting function has been relegated to:
a. The FASB alone.
b. The FASB and the PCAOB.
c. The AICPA.
d. The IASB.
ANSWER: B
18.Which of the following professional associations has an interest in the accounting standard-setting
process?
a. The AICPA
b. The Financial Executives Institute (FEI)
c. The American Accounting Association (AAA)
d. All of the above
ANSWER: D
19. Which of the following events resulted in shareholders’ beginning to question whether accounting
and reporting practices were adequate to assess investments?
a. The stock market crash of 1929
b. The federal government’s lump-sum payments for the retirement of Liberty Bonds
c. The creation of the SEC in 1934
d. None of the above
ANSWER: A
20. In 1930, the AICPA began working with which of the following organizations to prepare “five
broad accounting principles,” one of the most important documents in the development of
accounting rule making?
a. The SEC
b. The NYSE
c. The AAA
d. The FTC
ANSWER: B
21. Which of the following represented the first formal attempt to develop “generally accepted
accounting principles”?
a. “Approved Methods for the Preparation of Balance Sheet Statements” in 1918
b. “Five broad accounting principles” in 1932
c. Accounting Research Bulletin (ARB) 43
d. The FASB’s conceptual framework project
ANSWER: B

22. Which of the following is a true statement?

a. The SEC initially required the accounting profession to consult with it before setting any
specific accounting principles.
b. The SEC was created by Congress to oversee the accounting profession.
c. The SEC was given authority to prescribe the form and content of financial information
filed with the SEC.
d. The SEC formed the Committee on Accounting Procedure to develop a comprehensive set
of accounting principles.
ANSWER: C
23. Which of the following is true regarding the Emerging Issues Task Force (EITF)?
a. It has formal authority to establish GAAP.
b. Members of this group consist of CEOs of six major corporations and the chief accountant
of the SEC.
c. It is concerned with highly technical issues, such as financial instruments, which may
affect firms in virtually every industry.
d. All of the above
ANSWER: C
24. Major complaints aimed at the FASB’s standard setting process include:
a. the cost of preparing standards is too high.
b. some standards are very difficult to understand.
c. both a and b
d. none of the above
ANSWER: C
25. Which of the following bodies was created to deal with municipal accounting issues?
a. GASB
b. FASB
c. FAF
d. EITF
ANSWER: A
26. In which of the following ways has the Financial Executives Institute (FEI) become involved in
the accounting standard-setting process?
a. By funding research projects in accounting and related areas
b. By reviewing FASB discussion memorandums and exposure drafts and communicating an
official position to FASB.
c. By participating in FASB public hearings
d. All of the above
ANSWER: D

27. Which of the following are characteristics of the FASB?

a. It is part of the AICPA.
b. Members are part-time employees of the FASB.
c. A member must be a CPA.
d. It makes more extensive use of research than its predecessors.
ANSWER: D
28. The accounting standard-setting process begins with which of the following steps?
a. A problem is identified.
b. A task force is formed.
c. Public hearings are held.
d. An exposure draft is issued.
ANSWER: A
29. Which of the following is NOT true regarding the PCAOB?

a. The PCAOB is a governmental sector regulatory body.
b. The PCAOB is overseen by the SEC.
c. The PCAOB was established by the Sarbanes-Oxley Act.
d. The PCAOB has authority to set auditing standards.
ANSWER: A
30. Which of the following is NOT true regarding the passage of the Sarbanes-Oxley (SOX) Act?
a. SOX more clearly defined auditor independence.
b. SOX was intended to erode public confidence in the accounting profession due to recent scandals.
c. SOX replaced peer review with inspection by the PCAOB.
d. SOX implementation became the immediate focus of public companies and CPA firms.
ANSWER: B
31 The Private Company Council (PCC):

a. sets accounting standards for private companies in the United States.
b. sets accounting standards for IASB private companies.
c. is funded by the SEC.
d. serves an advisory role to the FASB.
ANSWER: D

ESSAY
1.Why did accounting and reporting practices in the U.S. prior to 1930 not meet the needs of
shareholder investors?
In the United States prior to 1930, accounting was unregulated and accounting practices and
procedures were considered confidential. This resulted in a lack of uniformity in accounting
practices among companies. American public did not invest large sums in private corporations
until the 1920s
ANSWER:
In the United States prior to 1930, accounting was unregulated and accounting practices and
procedures were considered confidential. This resulted in a lack of uniformity in accounting
practices among companies, both from year to year and within the same industry. Also, the
American public did not invest large sums in private corporations until the 1920s, when private
corporations were expanding, and both they and government leaders encouraged the public to
invest in stock. Before that time, banks and other creditors were the primary users of financial
information, resulting in an emphasis on a company’s debt-paying ability. When individuals
began investing in corporate stock, financial reporting lagged behind and continued to be
prepared primarily for the needs of creditors. It wasn’t until the stock market crash of 1929 that
shareholders began to question whether accounting and reporting practices were adequate to
assess investments.
2.Compare and contrast the characteristics of the CAP, APB, and FASB.
ANSWER:
The FASB is separate from the AICPA, while the CAP and the APB were part of the AICPA.
FASB members are more independent since they are full-time employees of the FASB. CAP and
APB members were also employed elsewhere, usually by a CPA firm. FASB members need not
be a CPA. CAP and APB members were required to be CPAs. The FASB allows for a more
extensive due process. The CAP engaged in little if any due process and the APB engaged in only
very limited due process. The FASB succeeded in developing a conceptual framework, something
the CAP did not attempt and the APB failed to accomplish. FASB also makes more extensive use
of research than did its predecessors and has been more productive.
3. Discuss the steps in the accounting standard-setting process and explain why it may not be
capable of dealing with the complex environment of the 2000s and beyond.
ANSWER:

The standard-setting procedure starts with the identification of a problem. A task force then
explores all aspects of the problem and circulates a discussion memorandum that identifies the
issues and possible solutions. The FASB then convenes a public hearing where interested parties
may make their views known to the board. An exposure draft of the final standard is then issued
and written comments requested. After consideration of written comments, either a revised
exposure draft is issued or a final vote is taken by the board. Five votes are needed for the
issuance of a final standard.
The FASB process developed in the 1970s may not be capable of dealing with the more complex
environment of the 1990s and beyond. Financial markets are now globalized, communication is
almost instantaneous, institutions are more competitive, and information technology makes it
possible to better determine current valuations of both assets and liabilities. Secondly, some non-
financial measures may correlate more closely with security prices than financial measures such
as income that are addressed in the typical financial statements generated under GAAP. An
additional issue involves how the conceptual framework might need to be amended and extended
to adapt to newly emerging types of business.
4. How has the Government Accounting Standards Board (GASB) challenged the FASB’s standard
setting powers?
ANSWER:
The GASB establishes another jurisdiction. It was created by the FAF in 1984 to deal with
municipal accounting issues. However, its responsibilities overlap with those of the FASB.
Separately issued general-purpose financial statements of such entities as hospitals, colleges and
universities, and pension plans are supposed to utilize FASB standards except where the GASB
has issued a particular standard covering a specific type of entity or a precise economic practice
or activity. As a result of this overlap, GASB standards tend to “muscle out” particular FASB
standards for governmental entities.
5. Discuss what is meant by “the liability crisis in public accounting.” How did the Federal
Litigation Reform Act of 1995 address this issue?
ANSWER:
There has been tremendous pressure to turn the audit into a fraud detection mechanism with the
auditor to report to the SEC, in the case of publicly traded companies, if management and the
board of directors do not take corrective action. Though auditors share some of the blame when
fraud is undetected, there have been some inherent problems in the legal system combined with
the fact that auditors are seen to have very “deep pockets.” Prior to the Federal Litigation Reform
Act of 1995, auditors in both federal and state cases were subject to joint and several liability for
damages suffered by third parties who relied on the financial statements of firms attested to by
CPAs. Auditors could be stuck with more than their proportional share of judgments. Under the
1995 Act, joint and several liability is not applicable in federal court unless the defendant
knowingly violates security laws. The Act replaced joint and several liability with proportionate
liability which restricts liability to each defendant’s proportionate share of the damages based
upon the judge’s or jury’s assessment of their share of the damages.
6. Describe the controversy surrounding the issuance of APB Opinion No. 2, which addressed the
investment tax credit? How did the APB resolve this controversy and what was the resulting
effect on the board’s authority?
ANSWER:

The accounting profession was divided on how to account for the investment tax credit. Two
alternatives existed: (1) recognize the tax benefit in the year received (the flow-through method),
or (2) recognize the tax benefit over the life of the related asset (the deferral method). The APB
did not commission a research study on the subject and issued Opinion No. 2, which opted for the
deferral method. Three large CPA firms made it known that they would not require their clients to
follow the opinion and the SEC continued to allow its registrants to use either method. As a result
of this challenge to its authority, the APB issued Opinion No. 4, which permitted the use of either
method. This successful challenge caused the binding authority of APB opinions to be questioned
in the press for several years.

7. Explain how Sarbanes-Oxley of 2002 significantly changes how the FASB will operate in the
future.
ANSWER:
The FASB’s funding originally came from accounting firm contributions and publication sales.
Sarbanes-Oxley now requires that FASB be funded through an assessment of annual fees on
public companies and accountants. This change increases FASB’s independence from the
constituents it serves, but increases its dependence on the SEC. Now the SEC potentially controls
FASB’s funding by its recognition. If not recognized by the SEC, FASB cannot assess fees
required for operations. Laws are now in place to make movement to 100% government
regulation relatively simple should the FASB fail to restore the public’s confidence in the
accounting profession.
8. How and why did the AICPA’s role change under Sarbanes-Oxley?
ANSWER: The AICPA no longer has exclusive authority in the private sector for promulgating
auditing standards. The Auditing Standards Board advises the PCAOB before it sets auditing,
attestation, and quality control standards. Audit firms became more advocates for clients than
protectors of the public interest and the AICPA campaigned for a broader certification that
deemphasized the CPA’s auditing responsibilities, leading to the loss of its role as police officer
for self-regulation.
9. How might the AICPA regain some of the power it has lost over the years? Are there any
disadvantages to these proposals?
ANSWER:
The AICPA might regain some power by becoming the standard-setting body for smaller firms –
referred to as baby GAAP. There has been some question whether this differentiation should be
small firms versus large firms or public versus privately owned firms. The FASB has joined with
the AICPA in proposing that the AICPA participate in a separate standards-setting process for
private companies. Disadvantages of this proposal are that this would add complexity to the
standards-setting process, and make the AICPA the representative of the privately owned firms.
Another important role for the AICPA is to curb opinion shopping, where clients try to find an
auditing firm who will either “lowball” its bid to secure a client or will go along with a
questionable accounting method that the client desires to employ. The AICPA had been
attempting to strengthen professional standards and rules of performance and behavior.
Also, the AICPA has formed the AICPA Special Committee on Financial Reporting, which was
given the charge of recommending what additional information management should provide for
users and the extent to which auditors should report on the information.

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Chapter 3—DEVELOPMENT OF INSTITUTIONAL STRUCTURE OF FINANCIAL ACCOUNTING

3. The SEC is legally empowered to regulate accounting principles.

8. The Committee on Accounting Procedures (CAP) used a formalized deductive approach to

Accounting Theory: 9th edition Page 1 of 13

Accounting Theory: 9th edition Page 2 of 13

Accounting Theory: 9th edition Page 3 of 13

2. Which of the following was an accomplishment of the American Association of Public

5. Which of the following factors led to significant changes in accounting practices?

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8. The Committee on Accounting Procedures (CAP) was immediately succeeded by:

11. Criticism of the standard-setting process under the APB included:

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Accounting Theory: 9th edition Page 7 of 13

22. Which of the following is a true statement?

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27. Which of the following are characteristics of the FASB?

29. Which of the following is NOT true regarding the PCAOB?

31 The Private Company Council (PCC):

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