Chapter 1

The Economic and Institutional Setting for

Financial Reporting
Learning Objectives:
 What is accounting?
 Why financial statements are important? Who are the
users of financial statements? How do these users use
financial statements?
 What is GAAP? What is the standard setting process?
 What are some qualitative characteristics of
accounting information?
 What are some major concepts and assumptions
underlying accounting principles?

1
What is Accounting ?

 An information system to
account for all business
transactions and translate
these transactions into
accounting/financial terms
to be reported in financial
statements.

2
Why Financial Statements Are Important ?
 Assess the risks (i.e., credit risk, asset risk)
 Provide a comprehensive economic history
of a business entity
 Thus, financial statement can be used for
various purposes (p3 of the textbook):
 As an analytical tool.
 As a management report card.
 As an early warning signal.
 As a basis for prediction.
 As a measure of accountability.

3
 Financial Statements and Financial Reporting

Economic Entity Financial Statements Additional Information

Financial Balance Sheet President’s letter

Information
Income Statement Prospectuses,
Accounting?
Statement of Cash SEC Reporting
Identifies Flows
News releases
and Statement of Owners’
Forecasts
Measures or Stockholders’ Equity
Environmental Reports
and Note Disclosures
Etc.
Communicates

GAAP Not GAAP

4
Learning Objective :

Describe the demand and supply for

financial statements

5
Who are the users of Financial Statements ?
Why do they demand financial Statements?
 Shareholders and  Managers and employees
investors
1. Performance
1. Investment assessment
decisions/stewardship
2. Compensation contracts
function
3. Company-sponsored
2. Proxy contests
pension plans
 Lenders and suppliers
1. Lending decisions
Government and
2. Covenant compliance regulatory agencies
 Customers 1. Mandatory reporting
1. Supplier’s health 2. Taxing authorities
2. Repeat purchases 3. Regulated industries
3. Warranties & supports 6
Supply of financial information
 Relevant financial information is provided
primarily through financial statements and
related disclosure notes.
 Major Financial statements: Balance Sheet,
Income Statement, Statement of Stockholders’
Equity and Statement of Cash Flows.
 Disclosures
 Other forms of information: Press releases and
management discussions (MD&A).

7
Type of Disclosures:

 Mandatory Disclosure (i.e., leases,

pension plans, etc.): Required by the
SEC and accounting standards.
 Voluntary disclosure: Guided by
cost/benefit considerations.

8
Disclosure Benefits

 The following are benefits arising from

voluntary disclosures :
 Increase investors’ confidence on the quality

of company’s equity offerings.

 Obtain capital cheaply from the capital

markets.
 Get better deals from suppliers.

9
Disclosure Costs

 The costs which may arise from voluntary

disclosures :
 Information collection, processing and
dissemination costs.
 Competitive disadvantage costs.

 Litigation costs.

 Political costs.

10
Case Study 1: WorldCom (source: RCJM
textbook) (WSJ 8/5/2002 – Improper Capitalization)
 It’s May 2002 and your brother says you should buy
WorldCom shares.
 The shares look “incredibly cheap” at $2.00 because the
company has a book value of $20.50/share and cash of
$0.73/share.
 WorldCom has weathered the industry downturn better
than other companies.
 But an article in this morning’s paper raises a new
concern:
Holding steady Line Costs Fixed “rental” payment
despite declining 42 % 
message volume Sales Message volume

11
Epilogue of WorldCom
 In June 2002, WorldCom
says $3.8 billion in line
cost expenses were
wrongly transferred to the
balance sheet as assets.
 Share price falls to $0.06.
 $11 billion of improper
transfers are eventually
uncovered. In July 2002,
the company declares
bankruptcy.

FUTURE
ASSET
BENEFITS

$3.8 b ?
EXPENSE NO FUTURE
BENEFITS

12
Case Study 2: AOL (Source: RCJM Textbook)

 AOL spent $363 million on subscription

promotion (costs paid for subscriber starter kits, direct
marketing mailers, etc.) in 1996 while only
recognized $126 million of that amount as
advertising expense in 1996, deferring the rest
as assets.
 In May 2000, AOL agreed to pay a fine of
$3.5 million to SEC due to its violation of
GAAP in deferring subscriber acquisition
costs in 1995 and 1996.
13
Lessons learned
 Financial statement fraud is rare—but users
should NOT simply accept the numbers at
face value.
 Flexibility in accounting standards provides
opportunities for companies to manipulate
the information reported in the financial
statements.
 Self-interest can also drive managers to
overstate the income number, especially
when compensation is based on earnings.
14
Learning Objectives

• Define generally accepted

accounting principles (GAAP)
• The need for GAAP
• The historical development of
accounting standards
• The standard setting process of the
Financial Accounting Standards
Board (FASB)
15
Generally Accepted Accounting
Principles (GAAP)
 GAAP: Accounting methods with
substantial authoritative support to be
used by business entities in preparing
external reports for users.
 Most of what constitutes U.S. GAAP is
in the form of written pronouncements
issued by the FASB and its
predecessors.(i.e., APB).
 The need for the GAAP.
16
GAAP (Contd.)

 Public held companies and certain

regulated companies are required to
use GAAP in preparing financial
statements.
 Reasons?

17
Who Prescribes the Standards?
Public Sector Private Sector
American Institute of Certified
U.S. Congress AICPA Public Accountants

SEC FASB IASB

Securities and Exchange Financial Accounting International Accounting
Commission Standard Board Standard Board
Year Authority Official Release
1934 Congress
SEC Regulation S-X
ASR and FRR
Staff Accounting Bulletins
1938 Accounting Profession
AICPA
1938-1959 CAP ……… ARBs (51)
1959-1973 APB ……… APB Opinions (31)
1973 FASB ……. 1. Statement of Financial
Accounting Standards
2. Interpretations
3. Concepts of Financial
Accounting
4. Technique Bulletins 19
 The U. S. GAAP
 Includes:
1. FASB statements (1973 - Present)
2. FASB Interpretations ( 1973 - Present)
3. APB Opinions (1959 - 1973)
4. APB Interpretations (1959 - 1973)
5. CAP, ARBs (1938 - 1959)
6. Other Authoritative Pronouncements
(i.e., ASR & FRR of the SEC, Technique
Bulletins/Staff Positions of FASB, and Staff Acct.
Bulletins of the SEC, Abstracts of EITF, SOP of
the AICPA, etc.)
20
FASB Accounting Standards
Codification (ASC) (Source: SFAS 168)
 Effective July 1, 2009, FASB
Accounting Standards Codification
became the single source of
authoritative, nongovernmental U.S.
GAAP.
 The pronouncements of the SEC are
also sources of authoritative GAAP
for SEC registrants.

21
The Codification Research System (CRS)
(Source: SFAS 168)
 Codification Research System
(CRS): An online database developed
by the FASB to allow easy access to
the Codification (and therefore, the
GAAP) online.
 CRS uses a numerical index system
in which numerical numbers are used
to correspond with topics, subtopics,
sections and paragraphs.

22
Accounting Standards
Codification (contd.)
 The Codification does not change
GAAP but only the way the existing
accounting standards are organized.

23
The Accounting Standard Setting
Process of the FASB (A Due Process)
(source: FASB Website)

 The Board identifies an accounting

issue based on requests received from
various sources.
 The Chairman decides whether to add
a project to the technical agenda after
consulting with other members and
subject to oversight by the Foundation’s
Board of Trustees.

24
The Accounting Standard Setting Process
(contd.)
 The Board deliberates the various
issues identified and analyzed by the
staff at one or more public
meetings.
 The Board issues an Exposure
Draft (In some case, the Board may
issue a Discussion Paper to obtain
comments prior to issuing the
Exposure Draft.)
25
The Accounting Standard Setting
Process (contd.)
 The Board holds a public
roundtable meeting on the
Exposure Draft, if necessary.
 The staff analyzes comment letters,
public roundtable discussion, and
any other information .

26
The Accounting Standard Setting
Process (contd.)
 The Board re-deliberates the proposed
provisions at one or more public
meetings.
 The Board issues an Accounting
Standards Update (ASU) to amend
ASC by a simple majority vote.
 The passage of an ASU requires 3
votes. (note: effective 7/2008, FASB
members reduced from 7 to 5).
27
Learning Objective

Introduce the importance and the need

of IFRS

28
The Need for International Accounting
Standards
 Companies doing business in more than one
nations found that it is hard to comply with
more than one set of accounting standards
established by authorities in different
nations.
 In response to this problem, International
Accounting Standards Committee (IASC)
was formed in 1973 to develop a single set
of global accounting standards.
Environment and Theoretical Structure of
Financial Accounting 29
The History of International Accounting
Standard Setting (cont.)
 41 International Accounting Standards (IAS)
was issued by IASC.
 IASC created International Accounting
Standards Board (IASB) in April, 2001 to be
in charge of prescribing the standards.
 IASB endorsed 41 IAS and named its
pronouncement as International Financial
Reporting Standard (IFRS).

Environment and Theoretical Structure of

Financial Accounting 30
Convergence of the U.S. Accounting
Standards and the International Accounting
Standards
 To increase the international comparability
and the quality of US accounting standards,
the FASB has been engaged in activities to
increase the convergence of the accounting
standards.
 The FASB is working closely with the IASB
toward the convergence of accounting
standards (i.e. to develop a single set of
standards).
Environment and Theoretical Structure of
Financial Accounting 31
Short-Term International Convergence
(source: FASB Project Updates)
 The IASB and the FASB acknowledged that
convergence of IFRS and U.S. GAAP is a
primary objective of both Boards.
 To achieve this objective and to improve the
financial reporting in the US, the FASB
started a short term project, conducted
jointly with the IASB, to eliminate narrow
differences between US GAAP and IFRS
(or IAS) in October, 2002.
Environment and Theoretical Structure of
Financial Accounting 32
A Single Global Accounting Language
- International financial reporting standards?
 The Securities and Exchange Commission
(SEC) is proposing a Roadmap for the
potential use of financial statements prepared
in accordance with “IFRS” by U.S. issuers for
purposes of their filings with the SEC.

 This Roadmap sets forth several milestones

that, if achieved, could lead to the required
use of IFRS by U.S. issuers in 2014.
Current Compliances

 Since there is no single set of high-quality

accounting standards, domestic (U.S.) firms
filing reports with the SEC must use U.S.
GAAP.
 Foreign issuers filing reports with the SEC
can use U.S. GAAP, the international
standards or the GAAP of its home country.
 If foreign firms chose not to use U.S. GAAP,
they must file reports with reconciliation to
U.S. GAAP.
Environment and Theoretical Structure of
Financial Accounting 34
A Single Global Accounting Language
- International financial reporting standards
 In November 2008, the Securities and
Exchange Commission (SEC) proposed
a roadmap for the US issuers to
prepare financial statements in
accordance with “IFRS” for the
purposes of their filings with the SEC.
 This roadmap, if achieved, could lead to
the required use of IFRS by U.S.
issuers in 2014.
35
A Single Global Accounting Language
(contd.)
 In February 2010, the SEC reaffirms its
commitment to one set of accounting
standard and continues to encourage
the convergence of standards between
the US and IFRS.
 The SEC will make the decision of
adopting IFRS for US issuers in 2011
with a progress report on this issue
expected in October 2010.
36
Learning Objective

The Financial Reporting Reform- the

Sarbanes-Oxley Act

37
The Financial Reporting Reform
• As a result of numerous financial scandals,
Congress passed the Public Company Accounting
Reform and Investor Protection Act of 2002,
commonly referred to as the Sarbanes-Oxley Act.

• The purpose of Sarbanes Oxley (SOX) is both to

enforce accurate financial reporting and to drive the
development of stronger internal processes.

38
The Financial Reporting Reform and the
Sarbanes and Oxley Act
 The collapse of Enron, the dissolving of
Arthur Andersen and the accounting
scandals of some high-profile firms
(WorldCom, Xerox, Global Crossing, etc.)
severely damaged public confidence in the
accounting profession and the financial
reporting.
 At the demand of the public, the
Sarbanes-Oxley Act was passed in July
2002 to restore the public confidence in
the credibility of the financial reports.
39
The Financial Reporting Reform and the
Sarbanes and Oxley Act (Cont.)
 Key Provisions of the Act including:
 Creating the Public Accounting Company
Oversight Board: establish auditing standards.
 Increasing Corporate Executive Accountability:
they must personally certify both the financial
statements and disclosures)
 Prohibition of Non-Audit Services (i.e.,
bookkeeping, internal audit, appraisal, and other
consulting services)
Environment and Theoretical Structure of
Financial Accounting 40
The Financial Reporting Reform and the
Sarbanes-Oxley Act (Cont.)
 Retention of work Papers for 5 years.
 Auditor Rotation
 Conflict of Interest.
 Hiring of Auditor: by the audit committee, not
the management.
 Evaluation of Internal Control: the management
needs to document and assess the effectiveness of internal
control. Auditors of the firm need to state:1)whether the
management’s assessment is fair, and 2)whether the
internal control of the firm is effective.
Environment and Theoretical Structure of
Financial Accounting 41
Learning Objectives

• Identify the objectives of financial reporting, the

qualitative characteristics of accounting information,
and the elements of financial statements.

• Describe the four basic

assumptions underlying GAAP

• Describe the four basic accounting

principles that guide accounting practice.
Conceptual Framework of
Financial Reporting
 How does the FASB prescribe the
accounting standards?
 Definition of “Conceptual Framework of
Financial Reporting”: A system of
interactive objectives and fundamentals
which can lead to a set of consistent
standards in preparing financial reports.

43
The Conceptual Framework

Objectives of Financial Reporting

(SFAC No. 1)

Qualitative Characteristics Elements of

of Accounting Information Financial Statements
(SFAC No. 8) (SFAC No. 6)

Recognition and Measurement Criteria

(SFAC No. 5)
Environment Implementation Implementation
assumptions principles constraints
44
SFAC No. 1
(Level One of The Conceptual Framework)
 Objectives of financial reporting:
Providing information
1. useful in making investment and credit
decisions;
2. useful in assessing future cash flows;
3. about entity resources, claims to the
resources and changes of these
resources.
45
SFAC No. 8 (Chapter 3: Qualitative Characteristics of Useful
Financial Information ) (Level Two of The Framework)
 Qualitative Characteristics of Accounting
Information

I. Primary Qualities
1) Relevance 2) Faithful Representation
a) Predictive value a) Complete
b) Confirmatory value b) Neutral
c) Materiality c) Free from error
46
SFAC No. 8 (contd.)
II. Enhancing Qualitative Characteristics

1) Comparability(including consistency)

2) Verifiability

3) Timeliness

4) Understandability

47
SFAC No. 5
(Level Three of The Conceptual Framework)
 Measurement and Recognition Concepts
I. Assumptions
1) Economic Entity
2) Going-concern (continuity)
3) Monetary unit
4) Periodicity (Period of time)
48
SFAC No. 5 (contd.)
II. Principles
1) Historical cost (exception:LCM of inventory)
2) Revenue recognition (exceptions:
3) Matching
4) Full Disclosure (footnote disclosure)

III. Constraints
1) Cost-Benefit
2) Materiality
3) Industry Practice
4) Conservatism
49
The Accounting Standard
Compliance System in the US
 The interrelationship of the SEC and
the FASB:

FASB: the current rule making body.

SEC: the enforcing agency of

securities laws and accounting
standards; regulating the stock
market.
50
Learning Objectives

The Move Toward Fair Value

51
Fair Market value measurement

 Although the historical cost principle is the basis of

measurement for most assets and liabilities, there
are many instances in GAAP in which assets or
liabilities are required or permitted to be measured
at fair value.
 SFAS No. 157 establishes a framework for
measuring fair values.
 SFAS No. 159 gives companies the option to report
some or all of their financial assets and liabilities at
fair value.

52
Fair Value Hierarchy (SFAS 157)

 Level 1 (most reliable) measures are based on

quoted prices for identical instruments in
active markets.
 Level 2 measures are based on quoted prices
for similar instruments (assets or liabilities) in
active markets.
 Level 3 (least reliable) measures are based on
unobservable inputs such company’s data or
assumptions.
The Balance Sheet and Financial Disclosures 53
Fair Value Measurements Disclosure :
Footnote 28 of GE 2008 Annual Report
Level 1 Level 2 Level 3 Fin. 39 Net Bal.
Netting
Assets
Investment Securities $1,158 $27,332 $12,956 ___ $41,446

Derivatives ___ 18,911 1,142 (7,411) 12,642

Others 1 288 1,105 ____ 1,394

total $1,159 $46,531 15,203 $(7,411) $55,482

Liabilities
Derivatives $ 2 $12,643 $ 166 $(7,575) $ 5,236

Other ____ 1,031 ____ ____ 1,031

Total $ 2 $13,674 $ 166 $(7,575) $6,267

The Balance Sheet and Financial Disclosures 54
Question
The function of financial accounting is to
identify, measure and communicate
financial information about economic
entities to interested parties.

 a. True
 b. False

55
Question
Generally accepted accounting
principles include both standards set by
various rule making bodies and certain
accounting practices that have evolved
over time.

 a. True
 b. False

56
Question
The major financial accounting standards
setting body in the U.S.A. is the

 a. Accounting Principles Board

 b. Securities and Exchange
Commission
 c. Financial Accounting Standards
Board
 d. American Institute of CPAs
57
Question
The Financial Accounting Standards
Board develops accounting and
reporting standards independent of
public, business and political pressures.
 a. True

 b. False

58
Summary (p37 and p38 of textbook)
 Financial statements are an important
source of information about a company, its
economic health, and its prospects.
 Financial statements help improve
decision making of investors and make it
possible to monitor managers’ activities.
 They also help creditors to make credit
decisions and financial analysts to make
recommendations to their clients.
 Therefore, there is a demand for the
financial statements.
59
Summary (contd.)
 What governs the supply of financial
information?
 Mandatory reporting and voluntary
disclosure.

 Benefit and cost considerations influence

voluntary disclosure.

60
Summary (contd.)
 Financial accounting standards (GAAP) are
often imprecise and subject to interpretations.
 This imprecision gives managers an
opportunity to shape financial statements:
 Most use the accounting flexibility to paint a
truthful economic picture of the company.
 Other managers shape the financial
statements to mask weaknesses and to hide
problems.

 So analysts must maintain a healthy skepticism

about the numbers.
61