Download accounting theory: text and readings

FINANCIAL ACCOUNTING
THEORY AND ANALYSIS:
TEXT AND CASES
11TH EDITION
RICHARD G.
SCHROEDER
MYRTLE W. CLARK
JACK M. CATHEY
CHAPTER 17
FINANCIAL REPORTING
DISCLOSURE
REQUIREMENTS AND
ETHICAL RESPONSIBILITIES
Financial Statement Disclosure
Chapter focuses on the
special importance of
disclosure in financial
reporting.
Disclosure requirements
issued by:


1.
2.
FASB
SEC
SFAC No. 5
outlines the various
methods of disclosure
that corporations should
utilize in published
financial statements
Relationship of SFAC No. 5 to Other
Method of Financial Reporting (Adapted)
All information useful for investment, credit, and similar decisions
Financial Reporting
Area directly affected by existing FASB standards
Basic Financial Statements
Scope of
Recognition &
Measurements
Concepts Stmts
Financial Stmts
Supplementary
Information
Notes to
Financial Stmts
Examples:
Stmt of Earnings &
Comprensive Income
Accounting Policies
Stmt of Financial
Position
Schedules and
Exhibits
Stmt of Cash Flows
Explanation of
Financial Statement
Items
Stmt of Investments
by & Distributions to
Owners
General Information
about the company
Examples:
Segment
Information
Changing Price Disclosures (SFAS
No.33
Oil and Gas
Reserve
Liquidation Basis
of Accounting SFAS No, 69
Auditor’s
Report
Interim Financial
Statements
Liquidation Basis
of Accounting
Other Means of
Financial
Reporting
Other
Information
Examples:
Analysts’ Reports
MD&A
News Articles
about Company
Letter to
Stockholders
Examples:
SFAC No. 5
Summarizes the building blocks
to disclosure as:

1.
2.
3.
4.
5.
The scope of recognition and
measurement
Basic financial statements
Areas directly affected by existing FASB
standards
Financial reporting
All information useful for investment,
credit and similar decisions
The Scope of Recognition and Measurement

Discussed earlier throughout the text.
Financial Statements


The financial statements described in SFAC No. 5 were
discussed previously in chapters 6 and 7.
In addition to the four basic statements, a full set of
financial statements also includes
supplementary
schedules
Footnotes
The most common examples
of footnotes are:

Accounting policies
Schedules and exhibits
1.
2.

Explanations of financial statement items
3.

4.
Example: schedules or exhibits concerning long-term debt
and income tax
Example: Pensions and post-retirement benefits
General information about the company
Accounting Policies
APB Opinion No. 22
(FASB ASC 235)

requires all companies
to disclose


Typically, companies disclose this
information in a Summary of
Significant Accounting Policies
preceding the footnotes.

the accounting policies
the firm follows
and the methods it uses
in applying these
policies.
Accounting Policies
APB Opinion No. 22

requires that the accounting
methods and procedures involving
the following be disclosed:
1.
A selection from existing
acceptable alternatives.
2.
Principles and methods peculiar
to the industry in which the
reporting entity operates.
3.
Unusual or innovative
applications of generally
accepted accounting principles.

The APB‘s principal
objective in issuing
Opinion No. 22:

to provide information
that helps investors
compare firms across
and between
industries.
Subsequent Events


During the period between the end of a
company’s fiscal year and the issuance of its
financial statements, events might occur that
aren’t reflected in its accounting records.
May be either

Events that provide further evidence of
conditions that existed on the balance sheet
date


GAAP requires these to be reported in financials
Events that provide evidence of conditions that
did not exist at the balance sheet date

GAAP requires no adjustment to financials
Areas Directly Affected by Existing FASB
Standards: Supplementary Information


Supplementary information may be mandated
by the FASB or the SEC.
Examples of supplementary information
include:
1.
Segment information (Chapter 16)
2.
The effects of price-level changes
3.
The auditor’s report
4.
Interim financial reports
Price Level Information


High level of inflation experienced in the
United States during the 1970s caused
concerns that financial statements
were being distorted.
Result





SEC ASR No. 190
FASB SFAS No. 33
Both pronouncements required the disclosure of
supplemental information on the effects of changing
prices in the 10-K and annual report to stockholders.
Disclosures generally made in separate schedules.
Later, after inflation subsided in the 1980s, these
requirements were suspended
Auditor’s Report


Informs users of the reliability of the
financial statements
The following guidelines for preparing the
auditor’s report were developed by the AICPA:
 Should state whether the financial statements are presented
in accordance with generally accepted accounting
principles.
 Must identify those circumstances in which such principles
have not been consistently observed in the current period in
relation to the preceding period.
 Informative disclosures in the financial statements are to be
regarded as reasonably adequate unless otherwise stated
in the report.
 The report shall either contain an expression of opinion
regarding the financial statements taken as a whole, or an
assertion to the effect than an opinion cannot be expressed.
Auditor’s Report

Types of opinions:






Unqualified
Qualified
Disclaimer
Adverse
Auditor’s Report on Internal Control
Going Concern
Interim Financial Statements

Two views
Integral view


Interim periods are an integral
part of the annual period
Thus revenues and expenses
might be allocated to various
interim periods even though they
occurred only in one period.

Discrete view



Each interim period is a
separate accounting period
Income should be determined
in the same manner as for the
annual period
Thus revenues and expenses
should be reported as they
occur.
APB conclusion - adopted integral view
Liquidation Basis of Accounting




July 2012 FASB issued proposed
amendment to FASB ASC Top 205
April 2013 FASB issued ASU 2013-07
Required when liquidation is deemed to be
imminent
Statements required:


Statement of Changes in Net Assets in Liquidation
Statement of Net Assets in Liquidation
Financial Reporting: Other Means of
Financial Reporting
Other relevant information



Can assist in understanding the financial
report
Presented in narrative form
Examples:
1.
2.
Management’s discussion and
analysis
Letter to stockholders
Management’s Discussion and Analysis


Required by the SEC
Explains the reasons for a company’s
performance during the preceding annual
period, including:



Liquidity, capital resources and results of
operations
Favorable and unfavorable trends
Significant events and uncertainties
Management’s Discussion and Analysis


Designed to allow financial
statement users to assess
the likelihood that past
performance is indicative of
future performance
Contains estimates that are
protected by “safe harbor”
clause
Management’s Discussion and Analysis


SEC also requires disclosure of qualitative and
quantitative information about market risk by all
companies registered with the SEC
Market risk: the risk of loss arising from adverse
changes in market rates and prices from such items
as:
1.
Interest rates
2.
Currency exchange rates
3.
Commodity prices
4.
Equity prices
Management’s Discussion and Analysis

The quantitative information about market risk
sensitive instruments is to be disclosed by using one
or more of the following alternatives:
1.
Tabular presentation
of fair value information and contract terms
relevant to determining future cash flows,
categorized by expected maturity dates
2.
Sensitivity analysis
expressing the potential loss in future earnings, fair
values, or cash flows from selected hypothetical
changes in market rates and prices
3.
Value at risk
disclosures expressing the potential loss in future
earnings, fair values, or cash flows from market
movements over a selected period of time and with a
selected likelihood of occurrence
Management’s Discussion and Analysis


Objective of the quantitative
disclosure requirements

provide investors with forward
looking information about a
registrant's potential exposures
to market risk
Registrants are required to
categorize market risk sensitive
instruments into

instruments entered into for
trading purposes, and

instruments entered into for
purposes other than trading
Management’s Discussion and Analysis

1.
2.
Specifically, companies must disclose:
Their primary market risk exposures
at the end of the current reporting
period
How they manage those exposures



such as a description of the objectives
general strategies
and instruments, if any, used to manage those exposures
Changes in
3.
either the primary market risk exposures
b)
or how those exposures are managed
…when compared to the most recent reporting period
and what is known or expected in future periods
a)
Management’s Discussion and Analysis
Hershey and Tootsie Roll


Both companies use derivative financial instruments
2003: SEC published new interpretive guidelines





Overall presentation of MD&A
Focus and content
Disclosure of liquidity and capital resources
Disclosure of critical accounting estimates
Letter To Stockholders
Four main purposes. It indicates that
management:

1.
2.
3.
4.
Is responsible for preparation and integrity of
statements
Has prepared statements in accordance with
GAAP
Has used their best estimates
and judgment
States that the company maintains
a system of internal controls
All Information Useful for Investment, Credit
and Similar Decisions: Other Information
Includes information about companies
Also available outside the company’s
annual report and 10-K.
Examples of these types of information
include



1.
2.
Analysts’ reports
News articles about the company.
Analysts’ Reports

Individual investors make essentially
three investment decisions
Buy
Hold
Sell

Potential investor decides to purchase a particular security
on the basis of all available disclosed information
Investor decides to retain a particular security basis of all
available disclosed information
Investor decides to dispose of a particular security basis
of all available disclosed information
Usually accomplished by fundamental analysis
as discussed in Chapter 4
Analysts’ Reports


Investment analysis may also be made by professional
security analysts

frequently specialize in certain industries

use their training and experience to process and disseminate
information more accurately and economically than individual investors
3 categories of financial analysts:
1.
Sell side - Work for full-service broker dealer and make
recommendations on securities they cover
2.
Buy side -Work for institutional money managers such as mutual funds
that purchase securities for their own accounts. Counsel their
companies to buy, hold and sell
3.
Independent - Not associated with firms that underwrite the securities
they cover. Often sell their recommendations on a subscription basis
Analysts’ Reports


Many analysts work in a world of
built-in conflicts of interest and
competing pressures
Sell-side firms want their individual
investor clients to be successful
over time because satisfied longterm investors are the key to the
firm’s reputation and success
Analysts’ Reports

Several factors can create pressure on an analyst’s
independence and objectivity
 An analysts’ firm may be underwriting a company’s
securities offering and client firms prefer favorable
research reports
 Positive reports can generate additional clients and
revenues
 Arrangements frequently tie
compensation to continuation
of clients
 Analysts may own securities
individually or they may be
owned by the analyst’s firm
SEC Disclosure Requirements

The Securities Act of 1933 (Going Public)



Registration statement
Prospectus
The Securities Exchange Act of 1934 (Being Public)

Form 10, 10K and 10Q


The Foreign Corrupt Practices Act 0f
1977
The Sarbanes-Oxley Act of 2002
Foreign Corrupt Practices Act of 1977

Provisions:
1
2
Makes it a criminal offense to offer
bribes to foreign officials
Requires detailed financial
records and a system of internal
control
The Sarbanes-Oxley Act of 2002


Early 2000s: dozens of
major corporations either
went bankrupt or faced
extreme financial difficulties
Included
 Enron
 WorldCom
 Xerox
 Global Crossing
 Arthur Andersen
 Merrill Lynch
 Tyco International
 Halliburton Oil Services.


Result:
 Americans lost billions of
their investment dollars
 jobs vanished
 thousands of people lost
their entire retirement
savings
Subsequently, corporate
reform became a
watchword
The Sarbanes-Oxley Act of 2002


Congress passed in 2002
Major provisions are:
1.
The creation of a Public Company Accounting
Oversight Board (PCAOB)
2.
The Establishment of Auditing, Quality Control,
and Independence Standards
3.
The Inspection of CPA Firms
4.
The Establishment of Accounting Standards
5.
The Delineation of Prohibited Services
6.
Prohibition of Acts that Influence the Conduct of
an Audit
7.
Requiring Specified Disclosures
8.
Requiring CEO and CFO Certification
The Sarbanes-Oxley Act of 2002: Sec. 404


Controversial
404(a)

Management’s responsibilities

Internal control report by management


Establishing and maintaining
Assessment
404(b)

Independent auditor’s responsibility




Report on management’s internal control
assessment
Assessment of company’s internal controls on
financial reporting
2 separate opinions required
The Sarbanes-Oxley Act of 2002: Sec. 404
Higher audit fees for accelerated filers
June 2007: PCAOB released Auditing Standard
No. 5





Integrated top-down, risk-based, materiality-focused
approach to audit
One opinion: whether management has
maintained internal control over financial
reporting
Compliance date extended for non-accelerated
filers
Recent Developments
July 2007: SEC chartered Advisory
Committee on Improvements to Financial
Reporting
August 2008: final committee report included
following recommendations


1.
2.
3.
4.
5.
Usefulness of information in SEC reports should be
increased
Accounting standards-setting process should be
enhanced
Substantive design of new accounting standards
should be improved
Authoritative interpretive guidance should be
delineated
Guidance on financial restatements and
accounting judgments should be clarified
Ethical Responsibilities





What is ethics?
Difference between morals
and ethics
Professions are different
Western ethics is based on the concept of
utilitarianism
Professional ethics proscribes a duty that
goes beyond the ordinary citizen
Ethical Conduct of Accountants

Ethical issues for accountants
1
2
3
4
5
Independence
Scope of service
Confidentiality
Practice development
Differences on accounting issues
Framework for Analysis of Ethical Issues






Obtain the relevant facts
Identify the ethical issues
Determine the individuals
or groups affected
Identify possible alternative
solutions
Determine how various individuals or groups
are affected by alternative decisions
Decide on appropriate action
The Ethical-Legal Question

Just because something is
legal it is not necessarily
ethical
AICPA Code of Professional Conduct
1
2
The AICPA represents itself as an ethical professional body
practicing an art rather than a science
Accounting should be viewed as practicing a service function
rather than as a profit-making function
3
4
As an art, accounting requires
judgment which encompasses
ethical conduct
To assist in satisfying its
responsibilities to society, the
accounting profession has
developed a code of professional
conduct
AICPA Code of Professional Conduct



Society viewed accounting favorably until the late 1960s
Watergate
Accountants argued they shouldn’t be held responsible
because



These activities were difficult if not impossible
to discover during a normal audit
Not material in many cases anyway
Also concern over audit failures for such
companies as Penn Central, National Student
Marketing and Equity Funding
AICPA Code of Professional Conduct

The role of Congress and Congressmen
Moss and Dingle
1
2
3

Were the rules deficient?
Were the qualifications to be a CPA sufficient?
Was self-policing working?
In response the Cohen Commission

The Expectations Gap
AICPA Code of Professional Conduct

The Anderson Report indicated that efficient
performance should meet six criteria:
1 Safeguard public interest
2 Recognize CPA’s paramount role in the
financial reporting process
3 Help assure quality performance and eliminate
substandard performance
4 Help assure objectivity and integrity in public
service
5 Enhance CPA’s prestige and creditability
6 Provide guidance as to proper conduct
AICPA Code of Professional Conduct

As a result new ethical standards were
developed in response to the expectations gap

The effect was:
1
2
3
Broader auditor responsibility to
consider reliability of internal control
system in planning an audit
Delineate audit responsibility for reporting errors, irregularities
and illegal acts by clients
Evaluate ability of a firm to continue as a going concern
AICPA Code of Professional Conduct

The new Code of Professional Conduct
contains four sections:
1
Principles






2
3
4
Responsibility
The public interest
Integrity
Objectivity and independence
Due care
Scope and nature of services
Rules of conduct
Interpretations
Ethical rulings
AICPA Code of Professional Conduct

Overall the goal of the Anderson Report and the revised
Code of Professional Conduct was to be more
responsive to the public’s concern by providing
1
2
3
4
5
6

Ethical guidance
Broad positive statements
Specific behavioral rules
Proactive monitoring
Broader rules application
Guidance on dealing with the changing environment
The profession’s image by the public has suffered but
has recently recovered.
International Accounting Standards
IAS No. 1: Presentation of
Financial Statements

Requires

companies to present a
statement disclosing each
item of





income
expense
gain
or loss
…required by other
standards to be presented
directly in equity
and the total of these items

Notes to the
financial statements




must present information
about the basis of preparation
of the financial statements
and the specific accounting
policies selected
must disclose all other
information required by IASC
standards not presented
elsewhere in the financial
statements
must provide all other
information necessary for a
fair presentation
IAS No 34:
Interim Financial Reporting




Does not specify which enterprises should
present interim financial reports
 left to be decided by laws or regulations
Adopts the discrete view
 U. S. GAAP which requires the integral view
The minimum content of an interim financial report is
 a condensed balance sheet
 condensed income statement
 condensed cash flow statement
 condensed statement of changes in equity
 explanatory notes.
Also requires disclosure of unusual events
End of Chapter 17
Prepared by Kathryn Yarbrough, MBA
Copyright © 2014 John Wiley & Sons, Inc. All rights reserved.
Reproduction or translation of this work beyond that permitted in
Section 117 of the 1976 United States Copyright Act without the
express written consent of the copyright owner is unlawful. Request
for further information should be addressed to the Permissions
Department, John Wiley & Sons, Inc. The purchaser may make backup copies for his/her own use only and not for distribution or
resale. The Publisher assumes no responsibility for errors,
omissions, or damages, caused by the use of these programs or from
the use of the information contained herein.