Professional Documents
Culture Documents
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
5
Who are the users of Financial Statements ?
Why do they demand financial Statements?
Shareholders and Managers and employees
investors
1. Performance assessment
1. Investment
2. Compensation contracts
decisions/stewardship
3. Company-sponsored
function
pension plans
2. Proxy contests
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
markets.
Get better deals from suppliers.
9
Disclosure Costs
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
BENEFIT
S
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
17
Who Prescribes the Standards?
Public Sector Private Sector
American Institute of Certified
U.S. Congress AICPA Public Accountants
21
The Codification Research System
(CRS) (Source: SFAS 168)
Codification Research System
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
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).
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,
2002
commonly referred to as the Sarbanes-Oxley Act.
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.
43
The Conceptual Framework
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:
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
Liabilities
Derivatives $ 2 $12,643 $ 166 $(7,575) $ 5,236
Total $ 2 Sheet
The Balance $13,674
and Financial$ 166 $(7,575) $6,267
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
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.
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.