(Test Bank) Financial Accounting Theory and Analysis Text and Cases

Schroeder, 11

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11th Edition

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1 Accounting Theory and Analysis 11th Edition Test Bank By Richard G. Schroeder University of North Carolina at Charlotte Myrtle W. Clark University of Kentucky Jack M. Cathey University of North Carolina at Charlotte 2 Example Test Questions Chapter 1 Multiple Choice: 1. Which of the following bodies has the ultimate authority to issue accounting pronouncements in the United States? a. Securities and Exchange Commission b. Financial Accounting Standards Board c. International Accounting Standards Committee d. Internal Revenue Service Answer a 2. What historical evidence of the business operations of the private estate of Apollonius was discovered early inthe20th century? a. The Iliad b. Plato's Republic c. The Zenon papyri d. Pacioli’s work, Summa de Arithmetica Geometria Proportioni et Proportionalita, Answer c 3. Who has been given credit or developing the double-entry system of bookkeeping? a. Francis Wheat b. Fra Luca Pacioli c. A. C. Littleton d. William Paton Answer b 4. Which of the following was not a criticism of the development of accounting standards by the Accounting Principles Board? a. The independence of the members of the APB. The individuals serving on the board had full-time responsibilities elsewhere that might influence their views of certain issues. b. The structure of the board. The largest eight public accounting firms (at that time) were automatically awarded one member, and there were usually five or six other public accountants on the APB. c. Harmonization. The accounting standards developed were dissimilar to those developed by the International Accounting Standards Committee. d. Response time. The emerging accounting problems were not being investigated and solved quickly enough by the part-time members. Answer c 5. Which of the following is the professional organization of university accounting professors? a. American Accounting Association b. American Institute of Certified Public Accountants 3 c. American Institute of Accountants d. Financial Executives Institute Answer a 6. What controversy originally highlighted the need for standard setting groups to have more authority? a. Accounting for stock options b. Accounting for derivatives c. Accounting for marketable securities d. Accounting for the investment tax credit Answer d 7. Which of the following committees recommended abolishing the Accounting Principles Board and replacing it with the Financial Accounting Board? a. Wheat b. Cohen c. Trueblood d. Anderson Answer a 8. Which of the following is a public sector accounting standard setter? a. FASB b. SEC c. APB d. CAP Answer b 9. Which of the following types of pronouncements now establishes generally accepted accounting principles? a. Statements of Concepts b. Statements of Financial Accounting Standards c. APB Opinions d. Accounting Standards Updates Answer d 10. Which of the following types of pronouncements are intended to establish the objectives and concepts that the FASB will use in developing standards of financial accounting and reporting? a. Statements of Concepts b. Statements of Financial Accounting Standards c. APB Opinions d. Accounting Standards Updates Answer a 4 11. Which of the following is not a consequence of the standards overload problem to small businesses? a. If a small business omits a GAAP requirement from audited financial statements, a qualified or adverse opinion may be rendered. b. Small businesses do not need to keep financial records c. The cost of complying with GAAP requirements may cause a small business to forgo the development of other, more relevant information. d. Small CPA firms that audit smaller companies must keep up to date on all the same requirements as large international firms, but they cannot afford the specialists that are available on a centralized basis in the large firms. Answer b 12. Some accountants maintain that accounting standards are as much a product of political action as they are of careful logic or empirical findings. This belief is an example of the concept of a. Standard setting as apolitical process b. Standards overload c. Economic consequences d. The role of ethics in accounting Answer a 13. The impact of accounting reports on various segments of our economic society is the definition of the concept of a. Standard setting as apolitical process b. Standards overload c. Economic consequences d. The role of ethics in accounting Answer c 14. Considering and understanding how business decisions affect the financial statements is a. The sole responsibility of the Securities and Exchange Commission. b. Provided in the auditor’s report. c. Referred to as an economic consequence perspective. d. Interpreted strictly by the company’s suppliers. Answer c 15. Economic consequences of accounting standard-setting means: a. Standard-setters must give first priority to ensuring that companies do not suffer any adverse effect as a result of a new standard. b. Standard-setters must ensure that no new costs are incurred when a new standard is issued. c. The objective of financial reporting should be politically motivated to ensure acceptance by the general public. d. Accounting standards can have detrimental impacts on the wealth levels of the providers of financial information. Answer d 5 16. Which of the following is a source of nonauthoritative accounting guidance and literature? a. Financial Accounting Standards Board Statements b. Financial Accounting Standards Board Interpretations c. Financial Accounting Standards Board Technical Bulletins d. Practices that are widely recognized and prevalent either generally or in the industry Answer d 17. Which of the following companies was involved in an accounting failure that caused the public accounting firm Arthur Andersen to gout of business? a. Goldman Sachs b. Wachovia c. Enron d. AIG Answer c Essay 1. What is the difference between normative and positive theory? Normative theories explain what should be, whereas positive theories explain what is. Ideally, there should be no such distinction, because a well-developed and complete theory encompasses both what should be and what is. 2. Why is the development of a general theory of accounting important The development of a general theory of accounting is important because of the role accounting plays in our economic society. We live in a capitalistic society, which is characterized by a self-regulated market that operates through the forces of supply and demand. Goods and services are available for purchase in markets, and individuals are free to enter or exit the market to pursue their economic goals. All societies are constrained by scarce resources that limit the attainment of all individual or group economic goals. In our society, the role of accounting is to report how organizations use scarce resources and to report on the status of resources and claims to resources. 3. Discuss the evolution of accounting during the 1930s. One of the first attempts to improve accounting began shortly after the inception of the Great Depression with a series of meetings between representatives of the New York Stock Exchange (NYSE) and the American Institute of Accountants. The purpose of these meetings was to discuss problems pertaining to the interests of investors, the NYSE, and accountants in the preparation of external financial statements. Similarly, in 1935 the American Association of University Instructors in Accounting changed its name to the American Accounting Association (AAA) and announced its intention to expand its activities in the research and development of accounting principles and standards. The first result of these expanded activities was the publication, in 1936, of a brief report cautiously titled “A Tentative Statement of Accounting Principles Underlying Corporate Financial Statements.” The 6 four-and-one-half-page document summarized the significant concepts underlying financial statements at that time. The cooperative efforts between the members of the NYSE and the AIA were well received. However, the post-Depression atmosphere in the United States was characterized by regulation. There was even legislation introduced that would have required auditors to be licensed by the federal government after passing a civil service examination. Two of the most important pieces of legislation passed at this time were the Securities Act of 1933 and the Securities Exchange Act of 1934, which established the Securities and Exchange Commission (SEC). The SEC was created to administer various securities acts. Under powers provided by Congress, the SEC was given the authority to prescribe accounting principles and reporting practices. Nevertheless, because the SEC has acted as an overseer and allowed the private sector to develop accounting principles, this authority has seldom been used. However, the SEC has exerted pressure on the accounting profession and has been especially interested in narrowing areas of difference in accounting practice. From 1936 to 1938 the SEC was engaged in an internal debate over whether it should develop accounting standards. Despite the fact that the then–SEC chairman, and later Supreme Court justice, William O. Douglas disagreed, in 1938 the SEC decided in Accounting Series Release (ASR) No. 4 to allow accounting principles to be set in the private sector. ASR No. 4 indicated that reports filed with the SEC must be prepared in accordance with accounting principles that have “substantial authoritative support.” The profession was convinced that it did not have the time needed to develop a theoretical framework of accounting. As a result, the AIA agreed to publish a study by Sanders, Hatfield, and Moore titled A Statement of Accounting Principles. The publication of this work was quite controversial in that it was simply a survey of existing practice that was seen as telling practicing accountants “do what you think is best.” Some accountants also used the study as an authoritative source that justified current practice. In 1936 the AIA merged with the American Society of Certified Public Accountants, forming a larger organization later named the American Institute of Certified Public Accountants (AICPA). This organization has had increasing influence over the development of accounting theory. For example, over the years, the AICPA established several committees and boards to deal with the need to further develop accounting principles. The first was the Committee on Accounting Procedure. It was followed by the Accounting Principles Board, which was replaced by the Financial Accounting Standards Board. Each of these bodies has issued pronouncements on accounting issues, which have become the primary source of generally accepted accounting principles that guide accounting practice today. 4. Discuss the evolution of the three private sector accenting standard setting organizations. Professional accountants became more actively involved in the development of accounting principles following the meetings between members of the New York Stock Exchange and the AICPA and the controversy surrounding the publication of the Sanders, Hatfield, and Moore study. In 1936 the AICPA’s Committee on Accounting Procedure (CAP) was formed. This committee had the authority to issue pronouncements on matters of accounting practice and procedure in order to establish generally accepted practices. 7 The CAP was relatively inactive during its first two years but became more active in response to the SEC’s release of ASR No. 4 and voiced concerns that the SEC would become more active if the committee did not respond more quickly. One of the first responses was to expand the CAP’s membership from seven to twenty-one members. A major concern over the use of the historical cost model of accounting arose. The then-accepted definition of assets as unamortized cost was seen by some critics as allowing management too much flexibility in deciding when to charge costs to expense. This was seen as allowing earnings management to occur. Another area of controversy was the impact of inflation on reported profits. During the 1940s several companies lobbied for the use of replacement cost depreciation. These efforts were rejected by both the CAP and the SEC, which maintained that income should be determined on the basis of historical cost. This debate continued over a decade, ending when Congress passed legislation in 1954 amending the IRS Tax Code to allow accelerated depreciation. The works of the CAP were originally published in the form of Accounting Research Bulletins (ARBs); however, these pronouncements did not dictate mandatory practice and received authority only from their general acceptance. The ARBs were consolidated in 1953 into Accounting Terminology Bulletin No. 1, “Review and Resume,” and ARB No. 43. ARBs No. 44 through No. 51 were published from 1953 until 1959. The recommendations of these bulletins that have not been superseded are contained in the FASB Accounting Standards Codification (FASB ASC). Those not superseded can be accessed through the cross reference option on the FASB ASC website (asc.fasb.org). By 1959 the methods of formulating accounting principles were being questioned as not arising from research or based on theory. The CAP was also criticized for acting in a piecemeal fashion and issuing standards that, in many cases, were inconsistent. Additionally, all of its members were part time and as a result their independence was questioned. Finally, the fact that all of the CAP members were required to be members of the AICPA prevented many financial executives, investors, and academics from serving on the committee. As a result, accountants and financial statement users were calling for wider representation in the development of accounting principles. The AICPA responded to the alleged shortcomings of the CAP by forming the Accounting Principles Board (APB). The objectives of this body were to advance the written expression of generally accepted accounting principles (GAAP), to narrow areas of difference in appropriate practice, and to discuss unsettled and controversial issues. However, the expectation of a change in the method of establishing accounting principles was quickly squelched when the first APB chairman, Weldon Powell, voiced his belief that accounting research was more applied and pure, with the usefulness of the end product being a major concern. The APB was composed of from seventeen to twenty-one members, who were selected primarily from the accounting profession but also included individuals from industry, government, and academia. The lack of support for some of the APB’s pronouncements and concern over the formulation and acceptance of GAAP caused the Council of the AICPA to adopt Rule 203 of the Code of Professional Ethics. This rule requires departures from accounting principles published in APB Opinions or Accounting Research Bulletins (or subsequently FASB Statements and now the FASB ASC ) to be disclosed in footnotes to financial statements or in independent auditors’ reports when the effects of such departures are material. This action has had the effect of requiring companies and public accountants who deviate from authoritative pronouncements to justify such departures. 8 The members of the APB were, in effect, volunteers. These individuals had full-time responsibilities to their employers; therefore, the performance of their duties on the APB became secondary. By the late 1960s, criticism of the development of accounting principles again arose. This criticism centered on the following factors: a. The independence of the members of the APB. The individuals serving on the board had full-time responsibilities elsewhere that might influence their views of certain issues. b. The structure of the board. The largest eight public accounting firms (at that time) were automatically awarded one member, and there were usually five or six other public accountants on the APB. c. Response time. The emerging accounting problems were not being investigated and solved quickly enough by the part-time members. As a result of the growing criticism of the APB, in 1971, the board of directors of the AICPA appointed two committees. The Wheat Committee, chaired by Francis Wheat, was to study how financial accounting principles should be established. The Trueblood Committee, chaired by Robert Trueblood, was asked to determine the objectives of financial statements. The Wheat Committee issued its report in 1972 recommending that the APB be abolished and the Financial Accounting Standards Board (FASB) be created. This new board was to comprise representatives from various organizations, in contrast to the APB, whose members were all from the AICPA. The members of the FASB were also to be full-time paid employees, unlike the APB members, who served part time and were not paid. The Trueblood Committee, formally known as the Study Group on Objectives of Financial Statements, issued its report in 1973 after substantial debate and with considerably more tentativeness in its recommendations about objectives than the Wheat Committee had with respect to the establishment of principles. The study group requested that its report be regarded as an initial step in developing objectives and that significant efforts should be made to continue progress on the refinement and improvement of accounting standards and practices. The AICPA quickly adopted the Wheat Committee recommendations, and the FASB became the official body charged with issuing accounting standards. The structure of the FASB is as follows. A board of trustees nominated by organizations whose members have special knowledge and interest in financial reporting is selected. The organizations originally chosen to select the trustees were the American Accounting Association; the AICPA; the Financial Executives Institute; the National Association of Accountants (The NAA’s name was later changed to Institute of Management Accountants in 1991) and the Financial Analysts Federation. In 1997 the Board of Trustees added four members from public interest organizations. The board that governs the FASB is the Financial Accounting Foundation (FAF). The FAF appoints the Financial Accounting Standards Advisory Council (FASAC), which advises the FASB on major policy issues, the selection of task forces, and the agenda of topics. The number of members on the FASAC varies from year to year. The bylaws call for at least twenty members to be appointed. However, the actual number of members has grown to about thirty in recent years to obtain representation from a wider group of interested parties 5. What were the purposes of the Wheat and Trueblood committees? The Wheat Committee, chaired by Francis Wheat, was to study how financial accounting principles should be established. The Trueblood Committee, chaired by Robert Trueblood, was asked to determine the objectives of financial statements. 9 6. What was the purpose of the GAAP Hierarchy? The purpose of the GAAP Hierarchy was to categorize the sources of accounting principles1 that are generally accepted into descending order of authority. 7. What were the four types of pronouncements originally issued by the FASB prior to the adoption of the FASB ASC? 1. Statements of Financial Accounting Concepts (SFACs) and conveyed required accounting methods and procedures for specific accounting issues and officially created GAAP. 2. Interpretations were modifications or extensions of issues pronouncements. SFACs are intended to establish the objectives and concepts that the FASB will use in developing standards of financial accounting and reporting. To date, the FASB has issued seven 3. Statements of Financial Accounting Concepts which differed from Statements of Financial Accounting Standards in that they did not establish GAAP. Similarly, they were not intended to invoke Rule 203 of the Rules of Conduct of the Code of Professional Ethics. It is anticipated that the major beneficiary of these SFACs will be the FASB itself. However, knowledge of the objectives and concepts the board uses should enable financial statement users to better understand the content and limitations of financial accounting information. 4. Technical Bulletins were strictly interpretive in nature and did not establish new standards or amend existing standards. They were intended to provide guidance on financial accounting and reporting problems on a timely basis. 8. Discuss why standard setting may be viewed as a political process. A highly influential academic accountant stated that accounting standards are as much a product of political action as they are of careful logic or empirical findings. This phenomenon exists because a variety of parties are interested in and affected by the development of accounting standards. Various users of accounting information have found that the best way to influence the formulation of accounting standards is to attempt to influence the standard setters. The CAP, APB, and FASB have all come under a great deal of pressure to develop or amend standards so as to benefit a particular user group. For example, the APB had originally intended to develop a comprehensive theory of accounting before attempting to solve any current problems; however, this approach was abandoned when it was determined that such an effort might take up to five years and that the SEC would not wait that long before taking action. The Business Roundtable engaged in what initially was a successful effort (later reversed) to increase the required consensus for passage of a SFAS from a simple majority to five of the seven members of the FASB. Congressional action was threatened over the FASB’s proposed elimination of the pooling of interest method of accounting for business combinations. 9. Define the following terms a. Economic consequences Economic consequences refers to the impact of accounting reports on various segments of our economic society. This concept holds that the accounting practices a company adopts affect its security price and value. Consequently, the choice of accounting methods influences decision making rather than just reflecting the results of these decisions. 10 b. Standards overload Over the years, the FASB, the SEC, and the AICPA have been criticized for imposing too many accounting standards on the business community. This standards overload problem has been particularly burdensome for small businesses that do not have the economic resources to research and apply all the pronouncements issued by these authoritative bodies. Those who contend that there is a standards overload problem base their arguments on two allegations: (1) Not all GAAP requirements are relevant to small business financial reporting needs and (2) even when GAAP requirements are relevant, they frequently violate the pervasive cost–benefit constraint. Critics of the standard-setting process for small businesses also assert that GAAP were developed primarily to serve the needs of the securities market. Many small businesses do not raise capital in these markets; therefore, it is contended that GAAP were not developed with small business needs in mind. 10. Discuss the evolution of the phrase “generally accepted accounting principles. One result of the meetings between the AICPA and members of the NYSE following the onset of the Great Depression was a revision in the wording of the certificate issued by CPAs. The opinion paragraph formerly stated that the financial statements had been examined and were accurate. The terminology was changed to say that the statements are “fairly presented in accordance with generally accepted accounting principles.” This expression is now interpreted as encompassing the conventions, rules, and procedures that are necessary to explain accepted accounting practice at a given time. Therefore, financial statements are fair only to the extent that the principles are fair and the statements comply with the principles. The expression generally accepted accounting principles (GAAP) has thus come to play a significant role in the accounting profession. The precise meaning of the term, however, evolved rather slowly. In 1938 the AICPA published a monograph titled Examinations of Financial Statements, which first introduced the term. Later, in 1939, an AICPA committee recommended including the wording, ‘present fairly…in conformity with generally accepted accounting principles’ in the standard form of the auditor’s report. The meaning of the term was not specifically defined at that time, and no single source exists for all established accounting principles. However, later Rule 203 of the AICPA Code of Professional Ethics required compliance with accounting principles promulgated by the body designated by the Council of the Institute to establish such principles, except in unusual circumstances. Currently, that body is the FASB. The guidance for determining authoritative literature was originally outlined in Statement of Auditing Standards (SAS) No. 5. Later, SAS No. 5 was amended by SAS No. 43. This amendment classified the order of priority that an auditor should follow in determining whether an accounting principle is generally accepted. Also, it added certain types of pronouncements that did not exist when SAS No. 5 was issued to the sources of established accounting principles. SAS No. 43 was further amended by SAS No. 69, whose stated purpose was to explain the meaning of the phrase “present fairly … in conformance with generally accepted accounting principles” in the independent auditor’s report. SAS No. 69 noted that the determination of the general acceptance of a particular accounting principle is difficult because no single reference source exists for all such principles. In July 2003, the SEC issued the Study Pursuant to Section 108(d) of the Sarbanes-Oxley Act of 2002 on the Adoption by the United States Financial Reporting System of a Principles-Based Accounting System (the Study). Consistent with the recommendations presented in the Study, the FASB undertook a number of initiatives aimed at improving the 11 quality of standards and the standard-setting process, including improving the conceptual framework, codifying existing accounting literature, transitioning to a single standard-setter regime, and converging FASB and International Accounting Standards Board (IASB) standards. In 2008, the FASB issued SFAS No 162 The Hierarchy of Generally Accepted Accounting Principles. SFAS No 162 categorized the sources of accounting principles1 that are generally accepted into descending order of authority. Previously, the GAAP hierarchy had drawn criticism because it was directed toward the auditor rather than the enterprise, it was too complex, and it ranked FASB Concepts Statements, which are subject to the same level of due process as FASB Statements, below industry practices that are widely recognized as generally accepted but are not subject to due process. According to SFAS No 162, the sources of generally accepted accounting principles were: a. AICPA Accounting Research Bulletins and Accounting Principles Board Opinions that are not superseded by action of the FASB, FASB Statements of Financial Accounting Standards and Interpretations, FASB Statement 133 Implementation Issues, and FASB Staff Positions. b. FASB Technical Bulletins and, if cleared by the FASB, AICPA Industry Audit and Accounting Guides and Statements of Position. c. AICPA Accounting Standards Executive Committee Practice Bulletins that have been cleared by the FASB and consensus positions of the FASB Emerging Issues Task Force (EITF). d. Implementation guides published by the FASB staff, AICPA accounting interpretations, and practices that are widely recognized and prevalent either generally or in the industry. Finally in 2009, the FASB issued SFAS No. 168, The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles—a replacement of FASB Statement No. 162. SFAS No. 168 identified the FASB ASC (discussed below) as the official source of U. S. GAAP. Throughout much of the book, special attention is given to the pronouncements referred to in Rule 203 of the AICPA Code of Professional Ethics. The reason for this special attention is apparent. Practicing CPAs have an ethical obligation to consider such pronouncements as the primary source of GAAP in their exercise of judgment as to the fairness of financial statements. Opposing views as well as alternative treatments are considered in the text narrative; however, the reader should keep in mind that the development of GAAP has been narrowly defined by the AICPA. Despite the continuing effort to narrow the scope of GAAP, critics maintain that management is allowed too much leeway in the selection of the accounting procedures used in corporate financial reports. These criticisms revolve around two issues that are elaborated on later in the text: (1) Executive compensation is frequently tied to reported earnings, so management is inclined to adopt accounting principles that increase current revenues and decrease current expenses and (2) the value of a firm in the marketplace is determined by its stock price. This value is highly influenced by financial analysts’ quarterly earnings estimates. Managers are fearful that failing to meet these earnings estimates will trigger a sell-off of the company’s stock and a resultant decline in the market value of the firm. Previously, SEC Chairman Levitt noted these issues and indicated his belief that financial reports were descending “into the gray area between illegitimacy and outright fraud.” As a consequence, the SEC has set up an earnings management task force to uncover accounting distortions. Some companies have already voluntarily agreed to restructure their financial statements as a result of this new effort by the SEC. For example, SunTrust Bank, Inc., of Atlanta, though not accused of 12 any wrongdoing, agreed to a three-year restructuring of earnings for the period ended December 31, 1996. 11. What controversy caused the AICPA to issue Rule 203 that requires companies to use GAAP when issuing financial statements? Initially, the pronouncements of the APB, termed “opinions,” were not mandatory practice; however, the issuance of APB Opinion No. 2 (See FASB ASC 740-10- 25 and 45) and a subsequent partial retraction contained in APB Opinion No. 4 (See FASB ASC 740-10-50) highlighted the need for standard setting groups to have more authority. This controversy was over the proper method to use in accounting for the investment tax credit. In the early 1960s the country was suffering from the effects of a recession. After President John F. Kennedy took office, his advisors suggested an innovative fiscal economic policy that involved a direct income tax credit (as opposed to a tax deduction) based on a percentage of the cost of a qualified investment. Congress passed legislation creating the investment tax credit in 1961. The APB was then faced with deciding how companies should record and report the effects of the investment tax credit. It considered two alternative approaches: \ 1. The flow-through method, which treated the tax credit as a decrease in income tax expense in the year it occurred. 2. The deferred method, which treated the tax credit as a reduction in the cost of the asset and therefore was reflected over the life of the asset through reduced depreciation charges. The APB decided that the tax credit should be accounted for by the deferred method and issued APB Opinion No. 2. This pronouncement stated that the tax reduction amounted to a cost reduction, the effects of which should be amortized over the useful life of the asset acquired. The reaction to this decision was quite negative on several fronts. Members of the Kennedy administration considered the flow-through method more consistent with the goals of the legislation, and three of the then–Big Eight accounting firms advised their clients not to follow the recommendations of APB Opinion No. 2, and in 1963, the SEC issued Accounting Series Release No. 96, allowing firms to use either the flow-through or deferred method in their SEC filings. 12. Discuss the FASB ASC including the reasons for its adoption and the FASB’s goals in developing it. On July 1, 2009 the FASB ASC became the single source of generally accepted accounting principles. The FASB ASC became effective for interim and annual periods ending after September 15, 2009. On that date, all pronouncements issued by previous standard setters were superseded. The major reason for embarking on the codification process was that researching multiple authoritative sources complicated the research process. For example, using the previously existing structure, an individual needed to review existing FASB, EITF, AICPA, and SEC literature to resolve even a relatively simple issue. As a result, it was easy to inadvertently overlook relevant guidance. Codifying all existing U.S. GAAP literature into one authoritative source eliminates the previous need to research multiple sources. In addition, creating one source will allow the FASB to more easily isolate differences in its ongoing effort to converge with international accounting standards. The codification represents the sole authoritative source of U.S. GAAP. Creating the codification is only the first step, but is only part of the overall 13 solution. Going forward, the standard setting process will be changed to focus on the codification text. By implementing such an approach, constituents immediately will know the revised codification language as soon as the standard setter issues the standard. This approach eliminates delays and ensures an integrated codification. The FASB has also developed a searchable retrieval system to provide greater functionality and timeliness to constituents. The FASB had three primary goals in developing the Codification: 1. Simplify user access by codifying all authoritative US GAAP in one spot. 2. Ensure that the codified content accurately represented authoritative US GAAP as of July1, 2009. 3. Create a codification research system that is up to date for the released results of standard-setting activity. The Codification is expected to: 1. Reduce the amount of time and effort required to solve an accounting research issue 2. Mitigate the risk of noncompliance through improved usability of the literature 3. Provide accurate information with real-time updates as Accounting Standards Updates are released 4. Assist the FASB with the research and convergence efforts. 13. Discuss the role of ethics in accounting. Ethics are concerned with the types of behavior society considers right and wrong. Accounting ethics incorporate social standards of behavior as well as behavioral standards that relate specifically to the profession. The environment of public accounting has become ethically complex. The accountants’ Code of Professional Ethics developed by the AICPA has evolved over time, and as business transactions have become more and more complex, ethical issues have also become more complex. The public accountant has a Ralph Nader–type overseer role in our society. This role was described by former Chief Justice of the United States Warren Burger: Corporate financial statements are one of the primary sources of information available to guide the decisions of the investing public. In an effort to control the accuracy of their financial data available to investors in the securities markets, various provisions of the federal securities laws require publicly held corporations to file their financial statements with the Securities and Exchange Commission. Commission regulations stipulate that these financial reports must be audited by an independent certified public accountant. By certifying the public reports that collectively depict a corporation’s financial status, the independent accountant assumes a public responsibility transcending any employment relationship with the client. The independent public accountant performing this special function owes ultimate allegiance to the corporation’s creditors and stockholders as well as the investing public. This “public watchdog” function demands that the accountant maintain total independence from the client at all times and requires complete fidelity to the public trust. The SEC requires the filing of audited financial statements in order to obviate the fear of loss from reliance on inaccurate information, thereby encouraging public investment in the nation’s industries. It is, therefore, not enough that financial statements be accurate; the public must perceive them as being accurate. Public faith in the reliability of a corporation’s financial 14 statements depends upon the public perception of an outside auditor as an independent professional. 14. What is a special purpose entity and how do they work? A special purpose entity (SPE) now termed a variable interest entity is used to access capital and hedge risk. By using SPEs such as limited partnerships with outside parties, a company may be permitted to increase its financial leverage and return on assets without reporting debt on its balance sheet. The arrangement works as follows: An entity contributes fixed assets and related debt to an SPE in exchange for an ownership interest. The SPE then borrows large sums of money from a financial institution to purchase assets or conduct other business without the debt or assets showing up on the originating company’s financial statements. The originating company can also sell leveraged assets to the SPE and record a profit. At the time these transactions took place, the FASB required that only 3 percent of a SPE be owned by an outside investor. If this guideline is met, the SPE didn’t need to be consolidated and the SPE’s debt was not disclosed on the originating company’s financial statements. 15. How did the Sarbanes-Oxley Act change the way the FASB is funded? The Sarbanes-Oxley Act changed the way the FASB is funded. Previously, about a third of FASB’s annual budget came from voluntary contributions from public accounting firms, the AICPA, and about one thousand individual corporations. Under SOX, those voluntary contributions are replaced by mandatory fees from all publicly owned corporations based on their individual market capitalization. But the fees are to be collected by the PCAOB. The SEC oversees the PCAOB. As a result, some fear that SOX has inadvertently made FASB more vulnerable to political pressure 16. Discuss the objectives of the International Accounting Standards Board. The International Accounting Standards Board is an independent private-sector body that was formed in 1973 to achieve this purpose. Its objectives are: 1. To formulate and publish in the public interest accounting standards to be observed in the presentation of financial statements and to promote their worldwide acceptance and observance; 2. To work generally for the improvement and harmonization of regulations, accounting standards, and procedures relating to the presentation of financial statements. These objectives have resulted in attempts to coordinate and harmonize the activities of the many countries and agencies engaged in setting accounting standards. The IASB standards also provide a useful starting point for developing countries wishing to establish accounting standards. 1 Chapter 2 Multiple Choice 1. Which early accounting theorist was among the first to express the view that all changes in the value of assets and liabilities should be reflected in the financial statements? a. A. C. Littleton b. John Canning c. William Paton d. DR Scott Answer c 2. Which of the following economists most influenced the views of DR Scott? a. Thorstein Veblen b. John Hicks c. Karl Marx d. John Smith Answer a 3. Which of the following is not one of DR Scott’s hierarchy of accounting postulates and principles? a. Orientation postulate. b. The principles of truth and fairness. c. The materiality principle d. The principles of adaptability and consistency. Answer c 4. Which of the following organizations published the monograph titled A Tentative Statement of Accounting Principles Affecting Annual Corporate Reports a. SEC b. AAA c. AIA d. NAA Answer b 5. Which of the following organizations published the monograph titled A Statement of Accounting Principles? a. SEC b. AAA c. AIA d. NAA Answer c 2 6. Who was the author of Accounting Research Study No. 1, The Basic Postulates of Accounting? a. Robert Sprouse b. Maurice Moonitz c. Alvin Jennings\ d. Thomas Hatfield Answer b 7. Which of the following is not an approach to accounting theory As categorized by Statement on Accounting Theory and Theory Acceptance? a. Classical, b. Neoclassical c. Decision usefulness d. Information economics. Answer b 8. What is the objective of financial reporting? a. Provide information that is useful to management in making decisions. b. Provide information that clearly portrays nonfinancial transactions. c. Provide information about the reporting entity that is useful to present and potential equity investors, lenders, and other creditors. d. Provide information that excludes claims to the resources. Answer c 9. Under Statement of Financial Accounting Concepts No. 8, confirmatory value is an ingredient of the primary quality of Relevance Faithful representation a. No No b. No Yes c. Yes Yes d. Yes . No Answer d 10. Which of the following is considered a constraint by Statement of Financial Accounting Concepts No. 8? a. Cost b. Conservatism c. Timeliness d. Verifiability Answer a 11. Under Statement of Financial Accounting Concepts No. 8, which of the following is an ingredient of the primary quality of relevance? 3 a. Neutrality b. Completeness c. Understandability d. Verifiability Answer b 12. Under Statement of Financial Accounting Concepts No. 8, which of the following is an ingredient of the primary quality of faithful representation? a. Understandability b. Verifiability c. Predictive value d. Materiality Answer b 13. Under Statement of Financial Accounting Concepts No. 8, the ability through consensus of measures to ensure that information represents what it purports to represent is an example of the concept of a. Relevance b. Verifiability c. Faithful representation d. Feedback value Answer c 14. Under Statement of Financial Accounting Concepts No. 8, which of the following relates to both relevance and reliability? a. Timeliness b. Materiality c. Predictive value d. Neutrality Answer a 15. Under Statement of Financial Accounting Concepts No. 8, which of the following is not a qualitative characteristic associated with faithful representation? a. Completeness b. Free from error c. Neutrality d. Predictive value Answer d 16. What is meant by comparability when discussing financial accounting information? 4 a. Information has predictive or confirmatory value. b. Information is reasonably free from error. c. Information that is measured and reported in a similar fashion across companies. d. Information is timely. Answer c 17. What is meant by consistency when discussing financial accounting information? a. Information that is measured and reported in a similar fashion across points in time. b. Information is timely. c. Information is measured similarly across the industry. d. Information is verifiable Answer a 18. An item is considered material if a. It doesn’t cost a lot of money. b. It is of a tangible good. c. It is likely to influence the decision of an investor or creditor. d. The cost of reporting the item is greater than its benefits Answer c 19. What is the purpose of Emerging Issues Task Force? a. Provide interpretation of existing standards. b. Provide a consensus on how to account for new and unusual financial transactions. c. Provide interpretive guidance. d. Provide timely guidance on select issues Answer b Essay 1. Discuss the contributions of Paton and Canning to the development of accounting theory. The first attempts to develop accounting theory in the United States have been attributed to William A. Paton and John B. Canning. Paton’s work, based on his doctoral dissertation, was among the first to express the view that all changes in the value of assets and liabilities should be reflected in the financial statements, and that such changes should be measured on a current value basis. He also maintained that all returns to investors (both dividends and interest) were distributions of income, and consequently he espoused the entity concept rather than the prevailing proprietary concept. An additional contribution of this work was an outline of what Paton believed to be the basic assumptions or postulates underlying the accounting process. Paton’s basic assumptions and postulates can be viewed as the first step in the development of the conceptual framework of accounting. Canning’s work suggested a framework for asset valuations and measurement based on future expectations as well as a model to match revenues and expenses. At this time, the balance sheet was viewed as the principal financial statement, and the concept of capital maintenance was just emerging. 2. Discuss the contribution DR Scott to the development of accounting theory. 5 During this early period, significant contributions to the development of a conceptual framework of accounting were also made by DR Scott. Scott was viewed as an outsider; however, his writings have proven to be quite insightful. Scott was originally trained as an economist and was heavily influenced by the views of his colleague, the economist and philosopher Thorstein Veblen. He adopted Veblen’s view that many academics were overly occupied with refining the details of existing theories when there was a need for the reexamination of fundamental assumptions. Both Scott and Veblen viewed the Industrial Revolution as changing the fundamental fabric of our society. Scott believed the Industrial Revolution caused managers to look for new methods of maintaining organizational control. As a result, scientific methods such as accounting and statistics became organizational control tools. Scott contributed to the development of accounting theory by recognizing the need for a normative theory of accounting. This view, described in several publications from 1931 to 1941, evolved into a description of his conceptual framework in “The Basis for Accounting Principles. In his first important work, The Cultural Significance of Accounts, Scott argued that accounting theory was not a progression toward a static ideal but rather a process of continually adapting to an evolving environment. The notion of adaptation later became one of Scott’s principles in his conceptual framework. He approached accounting from a sociological perspective. The basic premise presented in Cultural Significance was that the economic basis of any culture is shaped by the institutional superstructure of the society in question. This view later evolved into his orientation postulate. Scott’s next important work was a response to the American Accounting Association’s “A Tentative Statement of Principles Underlying Corporate Financial Statements” (discussed later in the chapter). Scott criticized the AAA monograph as having a too narrow view of accounting in that it addressed only accounting’s transaction function. Rather, he saw accounting as encompassing other important functions, such as managerial control and the protection of the interests of equity holders. He also viewed accounting as having both an internal control function and an external function to act for the protection of various economic interests such as stockholders, bond holders, and the government. Although Scott’s first two works contain what were to become elements of his conceptual framework, the first step in its articulation is contained in “Responsibilities of Accountants in a Changing Environment.” In this work he again alluded to the influence of the Industrial Revolution on a changing economy and saw it as requiring improved financial reporting to meet the needs of all investors. Scott supported Paton’s earlier acceptance of the entity theory and went on to emphasize that accounting must meet the needs of external users. This view is an example of why Scott was considered an outsider, because the prevailing view was that accounting should be designed to benefit the firm’s management or proprietor (the proprietary theory). 3. Discuss DR Scott’s hierarchy of postulates and principles. In 1941 Scott unveiled his conceptual framework in “The Basis for Accounting Principles.” He maintained that it could serve as a vehicle for the development of internally consistent accounting principles. Scott’s framework includes the following hierarchy of postulates and principles to be used in the development of accounting rules and techniques. a. Orientation Postulate. —Accounting is based on a broad consideration of the current social, political, and economic environment. 6 b. The Pervasive Principle of Justice. —The second level in Scott’s conceptual framework was justice, which was seen as developing accounting rules that offer equitable treatment to all users of financial statements. c. The Principles of Truth and Fairness. —Scott’s third level contained the principles of truth and fairness. Truth was seen as an accurate portrayal of the information presented. Fairness was viewed as containing the attributes of objectivity, freedom from bias, and impartiality. d. The Principles of Adaptability and Consistency. —The fourth level of the hierarchy contained two subordinate principles, adaptability and consistency. Adaptability was viewed as necessary because society and economic conditions change; consequently, accounting must also change. However, Scott indicated a need to balance adaptability with consistency by stating that accounting rules should not be changed to serve the temporary purposes of management. 4. Discuss the contributions of the works by Sanders Hatfield and More, and Paton and Littleton to accounting theory. In 1938, the American Institute of Accountants (AIA) also published a monograph, A Statement of Accounting Principles, written by Thomas H. Sanders, Henry Rand Hatfield, and Underhill Moore, that ostensibly described accounting theory. The goal of this publication was to provide guidance to the SEC on the best accounting practices. However, the study did not accomplish its objective because it was viewed as a defense of accepted practices rather than an attempt to develop a theory of accounting. In 1940, the AAA published a benchmark study by Paton and A. C. Littleton, An Introduction to Corporate Accounting Standards. While this study continued to embrace the use of historical cost, its major contribution was the further articulation of the entity theory. It also described the matching concept, whereby management’s accomplishments (revenue) and efforts (expenses) could be evaluated by investors. This monograph was later cited as developing a theory that has been used in many subsequent authoritative pronouncements. 5. Discuss accounting Research Study No. 1. Accounting Research Study No. 1, The Basic Postulates of Accounting, was published in 1961. It consisted of a hierarchy of postulates encompassing the environment, accounting, and the imperatives as follows: Group A Economic and Political Environmental Postulates This group is based on the economic and political environment in which accounting exists. They represent descriptions of those aspects of the environment that Sprouse and Moonitz presumed to be relevant for accounting. A-1. Quantification Quantitative data are helpful in making rational economic decisions. Stated differently, quantitative data aid the decision maker in making choices among alternatives so that the actions are correctly related to consequences. A-2. Exchange Most of the goods and services that are produced are distributed through exchange and are not directly consumed by the producers. 7 A-3. Entities Economic activity is carried on through specific units of entities. Any report on the activity must identify clearly the particular unit or entity involved. A-4. Time period. (Including specification of the time period.) Economic activity transpires during specifiable time periods. Any report on that activity must specify the period involved. A-5. Unit of measure. (Including identification of the measuring unit.) Money is the common denominator in terms of which goods and services, including labor, natural resources, and capital, are measured. Any report must clearly indicate which monetary unit is being used. Group B Accounting Postulates The second group of postulates focuses on the field of accounting. They are designed to act as a foundation and assist in constructing accounting principles. B-1. Financial statements. (Related to A-1.) The results of the accounting process are expressed in a set of fundamentally related financial statements that articulate with each other and rest on the same underlying data. B-2. Market prices. (Related to A-2.) Accounting data are based on prices generated by past, present, or future exchanges that have actually taken place or are expected to. B-3. Entities. (Related to A-3.) The results of the accounting process are expressed in terms of specific units or entities. B-4. Tentativeness. (Related to A-4.) The results of operations for relatively short periods are tentative whenever allocations between past, present, and future periods are required. Group C Imperative Postulates The third group differs fundamentally from the first two groups. They are not primarily descriptive statements but instead represent a set of normative statements of what should be, rather than statements of what is. C-1 Continuity. (Including the correlative concept of limited life.) In the absence of evidence to the contrary, the entity should be viewed as remaining in operation indefinitely. In the presence of evidence that the entity has a limited life, it should not be viewed as remaining in operation indefinitely. C-2. Objectivity Changes in assets and liabilities and the related effect (if any) on revenues, expenses, retained earnings, and the like should not be given formal recognition in the accounts earlier than the point of time at which they can be measured objectively. C-3. Consistency 8 The procedures used in accounting for a given entity should be appropriate for the measurement of its position and its activities and should be followed consistently from period to period. C-4. Stable unit Accounting reports should be based on a stable measuring unit. C-5. Disclosure Accounting reports should disclose that which is necessary to make them not misleading. 6. How did ASOBAT define accounting and what two new ideas arose from this monograph? A Statement of Basic Accounting Theory (ASOBAT) in 1966 defined accounting as “the process of identifying, measuring and communicating economic information to permit informed judgments and decision by users of the information.” Two new ideas arose out of ASOBAT’s definition of accounting. The members of the committee were mainly academics, so they looked upon accounting as an information system. Therefore, they saw communication as an integral part of the accounting process. Additionally, the inclusion of the term economic income broadened the scope of the type of information to be provided to assist in the allocation of scarce resources. The committee also embraced the entity concept by indicating that the purpose of accounting was to allow users to make decisions. In essence they were defining accounting as a behavioral science whose main function was to assist in decision making. As a consequence, the committee adopted a decision-usefulness approach and identified four standards to be used in evaluating accounting information: relevance, verifiability, freedom from bias, and quantifiability. ASOBAT maintained that if these four standards could not be attained, the information was not relevant and should not be communicated. ASOBAT noted the inherent conflicts between relevance and verifiability in making one final recommendation. The monograph called for the reporting of both historical cost and current cost measures in financial statements. The current cost measures to be used included both replacement cost and price level adjustments. 7. Discuss the objectives of accounting as outlined by the T rueblood Committee. The Trueblood Committee report specified the following four information needs of users: 1. Making decisions concerning the use of limited resources 2. Effectively directing and controlling organizations 3. Maintaining and reporting on the custodianship of resources 4. Facilitating social functions and controls Like its predecessors, the Trueblood Committee had difficulty agreeing on the answers to the questions proposed by the AICPA. As a result, it indicated that its final report be regarded as a first step in the process. The report listed the following objectives for financial reporting: 1. The basic objective of financial statements is to provide information useful for making economic decisions. 2. An objective of financial statements is to serve primarily those users who have limited authority, ability, or resources to obtain information and who rely on financial statements as their principal source of information about an enterprise’s economic activities. 9 3. An objective of financial statements is to provide information useful to investors and creditors for predicting, comparing, and evaluating potential cash flows in terms of amount, timing, and related uncertainty. 4. An objective of financial statements is to provide users with information for predicting, comparing, and evaluating enterprise earning power. 5. An objective of financial statements is to supply information useful in judging management’s ability to use enterprise resources effectively in achieving its primary enterprise goal. 6. An objective of financial statements is to provide factual and interpretative information about transactions and other events that is useful for predicting, comparing, and evaluating enterprise earning power. Basic underlying assumptions with respect to matters subject to interpretation, evaluation, prediction, or estimation should be disclosed. 7. An objective is to provide a statement of financial position useful for predicting, comparing, and evaluating enterprise earning power. 8. An objective is to provide a statement of periodic earnings useful for predicting, comparing, and evaluating enterprise earning power. 9. Another objective is to provide a statement of financial activities useful for predicting, comparing, and evaluating enterprise earning power. This statement should report mainly on factual aspects of enterprise transactions having or expecting to have significant cash consequences. This statement should report data that require minimal judgment and interpretation by the preparer. 10. An objective of financial statements is to provide information useful for the predicting process. Financial forecasts should be provided when they will enhance the reliability of the users’ predictions. 11. An objective of financial statements for governmental and not-for-profit organizations is to provide information useful for evaluating the effectiveness of the management of resources in achieving the organization’s goals. Performance measures should be quantified in terms of identified goals. 12. An objective of financial statements is to report on the enterprise’s activities affecting society that can be determined and described or measured and that are important to the role of the enterprise in its social environment. This objective was an attempt to draw attention to those enterprise activities that require sacrifices from members of society who do not benefit from those activities. 8. What were the approaches to accounting theory identified by SATTA? SATTA first embarked on a review of accounting theories and found that a number of theories explained narrow areas of accounting. The committee noted that while there was general agreement that the purpose of financial accounting is to provide economic data about accounting entities, divergent theories had emerged because of the way different theorists specified users of accounting data and the environment. For example, users might be defined either as the owners of the accounting entity or more broadly to include creditors, employees, regulatory agencies, and the general public. Similarly, the environment might be specified as a single source of information or as one of several sources of financial information. The various approaches to accounting theory were condensed into (1) classical, (2) decision usefulness, and (3) information economics. 9. According to Kuhn, how dies scientific progress occur? SATTA noted that although the evolutionary view of accounting had considerable appeal, the evidence suggests that the existing accounting literature was inconsistent with that view. It suggested that the process of theorizing in accounting was more revolutionary than evolutionary 10 and turned to a perspective developed by Kuhn. He suggests scientific progress proceeds in the following order: 1. Acceptance of a paradigm. 2. Working with that paradigm by doing normal science. 3. Becoming dissatisfied with that paradigm. 4. Search for a new paradigm. 5. Accepting a new paradigm. 10. What is the purpose of the conceptual framework? The CFP first attempted to develop principles or broad qualitative standards to permit the making of systematic rational choices among alternative methods of financial reporting. Subsequently, the project focused on how these overall objectives could be achieved. As a result, the CFP is a body of interrelated objectives and fundamentals. The objectives identify the goals and purposes of financial accounting, whereas the fundamentals are the underlying concepts that help achieve those objectives. These concepts are designed to provide guidance in: 1. Selecting the transactions, events, and circumstances to be accounted for 2. Determining how the selected transactions, events, and transactions should be measured 3. Determining how to summarize and report the results of events, transactions, and circumstances. The FASB intends the CFP to be viewed not as a package of solutions to problems but rather as a common basis for identifying and discussing issues, for asking relevant questions, and for suggesting avenues for research. 11. Define the following terms: a. Comprehensive income Comprehensive income is the change in equity (net assets) of an entity during a period from transactions and events and circumstances from non-owner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners. b. Relevance Relevant accounting information can make a difference in a decision by helping users to form predictions about the outcomes of past, present, and future events or to confirm or correct prior expectations. Relevant information has predictive value, feedback value, and timeliness. c. Faithful representation Faithful representation has three characteristics: completeness, neutrality, and free from error . Although perfection is difficult or even impossible to achieve, the objective is to maximize those qualities to the extent possible. A complete depiction should include all information necessary for a user to understand the phenomenon being depicted. For some items, a complete depiction also might entail explanations of significant facts about the quality and nature of the items, factors, and circumstances that might affect their quality and nature and the process used to determine the numerical depiction. A neutral depiction is 11 without bias in the selection or presentation of financial information. A neutral depiction is not slanted, weighted, emphasized, deemphasized, or otherwise manipulated to increase th probability that financial information will be received favorably or unfavorably by users. Neutral information does not mean information with no purpose or no influence on behavior. On the contrary, relevant financial information is, by definition, capable of making a difference in users’ decisions. Free from error means there are no errors or omissions in the description of the phenomenon, and th process used to produce the reported information has been selected and applied wit no errors in the process. Information that is free from error will result in a more faithful representation of financial results. 12. According to SFAC No. 5, what should a full set of financial statements for a period show? According to SFAC No. 5, a full set of financial statements for a period should show: 1. Financial position at the end of the period. 2. Earnings for the period. 3. Comprehensive income for the period. 4. Cash flows during the period. 5. Investments by and distributions to owners during the period. 13. What is the purpose of SFAC No. 7: “Using Cash Flow Information and Present Value in Accounting Measurements? The FASB indicated that the purpose of present-value measurements is to capture the economic difference between sets of future cash flows. For example, each of the following assets with a future cash flow of $25,000 has an economic difference: a. An asset with a certain, fixed contractual cash flow due in one day of $25,000. b. An asset with a certain, fixed contractual cash flow due in ten years of $25,000. c. An asset with a certain, fixed contractual cash flow due in one day of $25,000. The actual amount to be received may be less but not more than $25,000. d. An asset with a certain, fixed contractual cash flow due in ten years of $25,000. The actual amount to be received may be less but not more than $25,000. e. An asset with expected cash flow of $25,000 in ten years with a range of $20,000 to $30,000. These assets are distinguished from one another by the timing and uncertainty of their future cash flows. Measurements based on undiscounted cash flows would have the result of recording each at the same amount. Since they are economically different, their expected present values are different. A present value measurement that fully captures the economic differences between the five assets should include the following elements: a. An estimate of future cash flows b. Expectations about variations in the timing of those cash flows c. The time value of money represented by the risk-free rate of interest d. The price for bearing the uncertainty e. Other, sometimes unidentifiable, factors including illiquidity and market imperfections 14. What two approaches to present value were discussed in SFAS No. 7? The two approaches to present value were discussed in SFAC No. 7: • Traditional. A single cash flow and a single interest rate as in a 12 percent bond due in ten years. Cases a and b above are examples of the use of the traditional approach.