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FIN Chapter 1 - Environment and Theoretical Structure of...

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Unformatted text preview: Environment and Theoretical Structure of Financial Accounting What is the environment in which accounting operates? A world of scarce resources – Accounting helps to identify efficient and inefficient Accounting users of resources users Investors and creditors use information to Investors assess risk and return of investment opportunities. Capital allocation – Accounting assists in the effective capital allocation Accounting process by providing financial reports to interested users users What is financial reporting? Financial reporting – financial Financial statements plus news releases, management forecasts, prospectuses, MD&A, reports filed with regulatory agencies. with Who uses financial accounting? The primary focus of financial accounting is to The provide information to present and potential investors and creditors (external users). investors 1. Investors 2. Creditors (outside parties who are owed money by Creditors the company such as banks, bondholders and other lenders) 3. Employees and labor unions 3. 4. Customers and suppliers 5. Regulatory agencies (IRS, SEC, FTC – antitrust) 6. Financial intermediaries (financial analysts, Financial stockbrokers, mutual fund managers, credit-rating organizations). organizations). Who uses financial accounting? For each user, specify a question that For could be addressed with F/S information. Capital Allocation Capital markets are a mechanism to allocate the scarce Capital resources of our society (funds). resources – Investors provide cash to a corporation in exchange for an Investors provide ownership interest (capital stock). ownership – Creditors lend cash to a corporation (loans, notes, bonds). Creditors lend – Stock sold to investors (and bonds) trade in a secondary market Stock which does not directly affect the cash flow of the corporation. not Financial statements provide valuable insight into the Financial success of a company’s strategic plan. – F/S highlight those portions of the strategic plan that proved to F/S be effective, and thus, warrant additional capital investment. be Investment Cash Flows Investors expect to receive cash from two Investors sources: dividends and price appreciation (upon sources dividends selling the stock to another party). selling Stock price is a function of two variables: Stock expected rate of return and uncertainty (risk). expected – Company can generate a positive return only if there Company is an expectation of profit in the future. is – Financial accounting information should help Financial investors assess the amounts, timing, and uncertainty of future cash flows. of Net Operating Cash Flow = Cash Receipts from Net providing goods and services to customers less Cash Disbursements from providing goods and services to customers services – Cash flows are not “smooth” – the cash flows in any Cash given period do not always serve as a good predictor of future cash flows. of Cash versus Accrual Accounting Accrual accounting gives us a more accurate Accrual prediction of future operating cash. prediction – Accrual accounting measures the accomplishments Accrual (revenues) and sacrifices (expenses) that occurred during the year (which may be different from actual cash flows in terms of timing). cash Development of Financial Accounting and Reporting Standards Pressure to develop standards (which enhance Pressure comparability) came after the stock market crash of 1929. of 1933 Securities Act – governs accounting and 1933 disclosure requirements for initial offerings. 1934 Securities Act – requirements for 1934 secondary trading and reporting; also created the SEC. the Trivia: Who was the first chairman of the SEC? Trivia: The SEC SEC has ultimate power to establish SEC accounting standards but has chosen to delegate to the private sector. delegate – SEC issues Financial Reporting Releases SEC Financial (FRRs) dealing with reporting and disclosure requirements which are usually consistent with GAAP. – SEC issues Staff Accounting Bulletins (SAB) SEC Staff which do not necessarily represent official position of SEC. position Enforcement by SEC Letter of deficiency used if there are Letter questions or irregularities that arise in the financial statements and/or reports. financial – If the problems persist, a “stop order” will be If issued. issued. – Criminal charges are possible. Early Standard Setting Committee on Accounting Procedure Committee (CAP) (1938 to 1959) – a committee of the American Institute of Accountants (AIA) (which later became the AICPA). – Issued Accounting Research Bulletins Issued (ARBs). (ARBs). – No theoretical framework was established. American Institute of Certified Public Accountants (AICPA) AICPA is a professional organization for AICPA CPA’s, membership is voluntary. – Maintains a Code of Professional Conduct – Responsible for preparing and grading the Responsible Uniform CPA examination. Uniform Early Standard Setting Accounting Principles Board (APB) (1959 Accounting to 1973) to – Issued APB Opinions. Issued – Consisted of accountants; 18-21 voluntary, Consisted part-time members. part-time – Criticisms: Lack of independence; also did Criticisms: not create theoretical framework. not Current Standard Setting Financial Accounting Standards Board (FASB) Financial (1973 to present). – Five full-time members – Represent various constituencies. FASB supported by Financial Accounting FASB Foundation (FAF) which is responsible for selecting members of FASB and its Advisory Council; and ensuring adequate funding for FASB activities. Financial Accounting Standards Advisory Financial Council (FASAC) sets FASB’s agenda. Council – FAF members chosen from user constituency groups. FASB FASB established conceptual framework FASB (seven Statements of Financial Accounting Concepts). Also issue Statements of Financial Also Accounting Standards (SFAS) and numerous other types of pronouncements. numerous – Financial Interpretations (FINs) – FASB Staff Positions – FASB Technical Bulletins Emerging Issues Task Force Emerging Issues Task Force (1984) Emerging formed to provide FASB with more timely responses to emerging issues. – 15 members from public accounting and 15 private industry, plus a FASB and SEC observer. – If EITF can reach consensus – then issue If does not go to the FASB. does Codification FASB has announced a plan for FASB Accounting Standards Codification (will integrate and topically organize all guidance) and will eliminate the GAAP hierarchy. hierarchy. – Expected in summer of 2009 Establishment of Accounting Standards 1. 2. 3. 4. 5. 6. 7. 8. Identification of Problem (by FASAC or EITF) Task Force – 15 members appointed Research and Analysis – by FASB technical Research staff staff Discussion Memorandum Public Response – public hearings Exposure Draft Public Response – written responses by public Statement Issued Discussion Memorandum Document issued by FASB that identifies Document the principal issues involved with the accounting and reporting of a topic. Includes various points of view but does Includes not reach a specific conclusion. not Exposure Draft Preliminary statement of a standard that Preliminary includes specific recommendations. includes Reaction to the exposure draft is Reaction requested from the accounting and business community and comments received are considered before final standard is issued. Due Process Encourages public input into the standardsetting process. setting However, this solicitation of input politicizes the However, politicizes process. – Parties are known to lobby for or against proposed Parties standards according to their economic interests. How would standard-setting be improved by How eliminating lobbying? How would it be harmed? eliminating Criticisms of the FASB Standards are too theoretical Standards Standards are costly to implement Standards negatively impact companies’ Standards bottom lines bottom FASB reacts to slowly to issues FASB Accounting is Global Global differences: Global legal systems, levels of inflation, culture, degrees of sophistication of capital markets, political and economic ties to other countries. and Different standards make accounting Different costly for multinational corporations. costly International Accounting Standards Board (IASB) International Accounting Standards Committee International (now International Accounting Standards Board (IASB)) was formed in 1973 to deal with global standard setting. – Independent, privately funded accounting standards setter based in London, UK. Goal is accounting standards convergence. Goal Set of standards called International Financial Set Reporting Standards (IFRS). Reporting Norwalk Agreement (2002) Formal agreement between FASB and IASB to Formal pursue convergence. pursue U.S. companies will be required to use IFRS by U.S. 2013. 2013. Foreign companies listing in U.S. using IFRS no Foreign longer have to reconcile to U.S. GAAP. longer SEC is considering permitting U.S. companies to SEC use IFRS instead of U.S. GAAP. use Stockholders, Firm, and Auditors Audit Committee Audit committee consists solely of outside Audit directors and cannot include the CEO. – The audit committee focuses on internal The controls and selection of the auditor. controls Management’s Assertions The financial statements and related materials The contain several assertions by management: 1. F/S are prepared by management (assumption of 1. F/S responsibility responsibility 2. F/S are prepared in conformity with GAAP 3. F/S are audited by an external auditing firm 4. Board of directors has an audit committee to oversee Board the financial accounting system and system of internal controls internal 5. Management is responsible for establishing and Management maintaining adequate internal control over financial reporting. reporting. Auditor Opinion The basic “clean” audit report includes these assertions: 1. F/S present fairly, in all material respects a company’s financial 1. F/S condition, in conformity with GAAP condition, 2. F/S are management’s responsibility; auditor responsibility is to F/S express an opinion on those statements express 3. Auditing involves a sampling of transactions, not investigation of Auditing each transaction each 4. Audit opinion provides reasonable assurance that statement are Audit free from material misstatements, not a guarantee free 5. Auditors review accounting policies used by management and Auditors the estimates used in preparing the statements. the Recent Accounting Scandals Adelphia Communications – Founding Rigas family collected $1.3 billion in offbalance sheet loans backed by Adelphia; overstated balance results by inflating capital expenses and hiding debt. results TWX Time Warner – As the ad market faltered and AOL’s purchase of As Time Warner loomed, AOL inflated sales by booking revenue for barter deals and ads it sold for third parties. These questionable revenues boosted growth rates and sealed the deal. AOL also boosted sales via “round-trip” deals with advertisers and suppliers. suppliers. Recent Accounting Scandals Bristol-Myers Squibb – Inflated its 2001 revenue by $1.5 billion by “channel Inflated stuffing” or forcing wholesalers to accept more inventory than they could sell to get inventory off Bristol-Myers’ books. Bristol-Myers’ Enron – Created profits and hid debt totaling over $1 billion by Created improperly using off-balance sheet partnerships; manipulated the Texas power market; bribed foreign governments to win contracts abroad; manipulated California energy market California Recent Accounting Scandals Global Crossing – Engaged in network capacity “swaps” with Engaged other carriers to inflate its revenue; shredded documents related to accounting practices documents Halliburton – Improperly booked $100 million in annual Improperly construction cost overruns before customers agreed to pay for them. agreed Recent Accounting Scandals Qwest Communication International – Inflated revenue using network capacity Inflated “swaps” and improper accounting for long“swaps” term deals Tyco – Ex-CEO Dennis Kozlowski indicted for tax Ex-CEO evasion; Kozlowski and former CFO Mark Swartz, convicted of taking unauthorized loans from the company. loans Recent Accounting Scandals WorldCom WorldCom – Overstated cash flow by booking $11 billion in Overstated operating expenses as capital costs; loaned founder Bernie Ebbers $400 million off-thefounder books Xerox – Falsified financial results for five years, overreported income by $1.5 billion Sarbanes Oxley (2002) SOX sought to rectify perceived problems in SOX accounting related to: weak audit committees, non-independent auditors, limited management responsibility for accounting, and deficient internal controls. internal SOX prohibits auditors from offering certain SOX types of consulting services to audit clients and mandates audit partner rotation every five years; requires CEO and CFO certification of F/S; and requires audit committees to consist of independent (outside) directors. independent Sarbanes Oxley (2002) Section 404 – companies are required to Section document internal controls and assess their adequacy and auditors must issue an opinion on management’s assessment. management’s SOX established the Public Company SOX Accounting Oversight Board (PCAOB) – Auditing Standard #2 requires auditors to issue a second opinion on whether effective internal controls are in place. in – Auditing Standard #2 now replaced by Auditing Auditing Standard #5 – aimed at reducing compliance costs of Section 404. Makes tests based on risk (more focused). focused). What’s wrong with consulting? How might consulting fees generated from How audit clients affect auditor independence? What other conflicts of interest might exist for auditors? for Move Away from Rules­Based Standards Under rules-based environment, companies can Under structure transactions to satisfy or avoid rules such that the reporting is not consistent with economic substance of the transaction. Principles-based standards rely on professional Principles-based judgment as opposed to rules. – Principles-based standards involve assessing risk and Principles-based rewards of transaction. – May lead to different interpretations for similar May transactions which decreases comparability. transactions Ethics in Accounting Name a situation where the accounting Name environment can put ethical pressure on a manager. manager. The Conceptual Framework The conceptual framework provides the The underlying foundation for accounting standards. Not GAAP in the U.S. but the IASB’s Not conceptual framework serves as GAAP where no specific standards exist. The Conceptual Framework Objectives of Financial Reporting (SFAC #1) Provide information: Provide 1. useful for decision-making of investors and 1. useful creditors (those with a reasonable understanding of business and economic activities through due diligence) activities 2. that helps predict amounts, timing, and that uncertainty of future cash flows uncertainty 3. about economic resources, claims to those about resources, and changes in resources and claims. claims. Dual Accounting Little attempt is made to reconcile accounting Little standard differences between the FASB and the IRS. The existence of these differences results in The companies keeping two sets of books. Many countries such as Japan and Germany Many have closely aligned financial and tax reporting systems. Should the U.S. work to eliminate the differences Should between financial and tax reporting? Why or why not? why Qualitative Characteristics of Accounting Information (SFAC #2) Understandability – user-specific quality Understandability means user must understand information in context-specific scenario in – To be useful, information must make a To difference in the decision process Qualitative Characteristics of Accounting Information (SFAC #2) Qualitative Characteristics ­ Primary Characteristics Relevance Relevance – Predictive value – the ability of reported earnings to predict Predictive future earnings (earnings quality) future – Feedback value – the ability of information to confirm users’ Feedback expectations expectations – Timeliness - available to users early enough to use in decisionmaking Reliability Reliability – Verifiability - implies consensus among different measurers – Representational faithfulness - agreement between a measure Representational and the real-world phenomenon that it is supposed to represent and – Neutrality - does not favor any particular group or induce Neutrality behavior in any particular way behavior Qualitative Characteristics ­ Secondary Characteristics Comparability - comparable across Comparability multiple companies within a single period multiple within Consistency - comparable for a single Consistency single company across multiple time periods across Practical Boundaries (Constraints) Cost Effectiveness – benefits of financial reporting (increased decision-usefulness) must exceed the costs (information gathering, processing and dissemination; also proprietary costs) processing – A company’s performance depends on both success and the market’s company’s awareness of that success. awareness – Competitive advantage costs – market will imitate products, processes, Competitive strategic alliances, technical or system innovations, quality improvements, etc. Also, highly profitable segments will draw competition to those segments which will eventually decrease profits. competition Materiality – information is material when it has an effect on decision-making; measured by relative value of transactions (requires professional judgment). – Staff Accounting Bulletin 99 (SEC) – reliance on quantitative Staff benchmarks to assess materiality is inappropriate. – Other factors to consider: lawfulness of transaction, etc. Conservatism – justification for certain practices, but not necessarily a desirable trait. Driven by legal system. desirable You are the Product Manager Assume you are a key product-manager at Assume your company. Your department has testyour marketed a potentially lucrative new marketed product, which it plans to further finance. You are asked for advice on the extent of information to disclose about the new product in the MD&A section of the company’s upcoming annual report. What advice to you provide and why? advice Elements of Financial Statements (SFAC #6) Elements of Financial Statements (SFAC #6) Financial Statements Income Statement Statement of Retained Earnings (and/or Statement Stockholders Equity) Stockholders Balance Sheet Statement of Cash Flows Financial Statements Financial Reporting Publicly-traded companies must file reports with Publicly-traded the SEC: the – 10-K – the audited annual report that includes four financial statements, explanatory notes (footnotes), and management’s discussion and analysis (MD&A) and – 10-Q – the unaudited quarterly report that includes summary versions of the four financial statements and limited additional disclosures. limited – 8K – discloses information about other events (filed when needed). when Form 8­K Must be filed within 4 days of any of the Must following events: following – Entry into or termination of a material definitive Entry agreement (including petition for bankruptcy) agreement – Exit from a line of business or impairment of assets – Change in the company’s certified public accounting Change firm firm – Change in control of the company – Departure of the company’s executive officers – Changes in the company’s articles of incorporation or Changes bylaws bylaws Recognition and Measurement Concepts (SFAC #5 and #7) Recognition – process of admitting information into the Recognition basic financial statements. – SFAC #5 states four criteria must be met to recognize an item: SFAC Defintion - the item meets the definition of a financial statement Defintion element element Measurability - can be measured with sufficient reliability Relevance - information is capable of affecting decision-making Reliability - information is verifiable, representationally faithful and Reliability neutral neutral Measurement – process of associating numerical Measurement amounts to elements. – Involves choice of monetary unit and measurement model (i.e., Involves historical cost, net realizable value, present value of future cash flows, current market value, etc.) flows, Assumptions Economic Entity – economic events can be Economic identified specifically with an economic entity. identified Going Concern – a business will operate Going indefinitely (otherwise everything should be valued at its liquidation value) valued Periodicity – allows the life of a company to be Periodicity divided into artificial time periods to provide timely information (fiscal year may differ from calendar year). calendar Monetary Unit – in the U.S. states that financial Monetary transactions must be measured in U.S. dollars. (U.S. dollar is relatively stable over time). (U.S. Principles Historical Cost – asset and liability measurements should Historical be based on amount given or received in original acquisition transaction (completely objective and verifiable). – Some departures are allowed within GAAP. Realization (also called revenue recognition principle) – Realization revenue should be recognized when the earnings process is complete and collection is reasonably assured (realizable). (realizable). – This usually occurs at point of sale (some departures are This allowable under GAAP). – Revenue is often realized before cash is received (only the Revenue promise of future cash which is deemed collectible is required). promise The Realization Principle A new client, the Wolf Company, asks your new advice concerning the point in time that the company should recognize revenue from the rental of its office buildings. Renters usually pay rent on a quarterly basis at the beginning of the quarter. The owners contend that the critical event that motivates revenue recognition should be the date the cash is received from the renters. After all, the money is in hand and is very seldom returned. very The Realization Principle Describe the two criteria that must be Describe satisfied before revenue can be recognized. recognized. Do you agree or disagree with the position Do of the owners of Wolf Company? of Principles Matching – Expenses are recognized in the same period Matching as the related revenues. – Specifically, an expense can be recognized 1. based on cause and effect 1. 2. based on a time-period association 3. through a systematic and rational allocation across time periods 4. when incurred (without regard to related revenue) Full Disclosure – any information useful to decision Full makers should be provided in the financial statement (subject to cost/benefit constraint) (i.e., face of financial statements, disclosure footnotes, supplemental schedules). schedules). Disclosure Warren Buffett – “…unintelligible footnotes Warren usually indicate untrustworthy management. If you can’t understand a footnote or other managerial explanation, it’s usually because the CEO doesn’t want you to. Enron’s descriptions of certain transactions still baffle me.” of Passage of Regulation Fair Disclosure (FD) by Passage the SEC in 2000 which prohibits giving selective disclosure to certain parties such as analysts without making it also available to the general public. public. Capitalize or Expense? When a company makes an expenditure When that is neither a payment to a creditor nor a distribution to an owner, management must decide if the expenditure should be capitalized (recorded as an increase in an asset) or expensed (recorded as an expense thereby decreasing owners’ equity). equity). Capitalize or Expense? What factor or factors should the company What consider when making this decision? consider Which key accounting principle is Which involved? involved? Are there any constraints that could cause Are the company to alter its decision? the Evolution of Accounting Principles Which is theoretically correct? Which – Income statement approach (changes in Income assets and liabilities are most important) or assets – Balance sheet approach (amounts of assets Balance and liabilities are most important) and Evolution of Accounting Principals You are evaluating your company’s recent You operating performance and trying to decide on the relative weights to put on the income statement, the balance sheet, and statement of cash flows. Discuss the information on each of these statements and its role in performance evaluation. and ...
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