(Solution Manual) Financial Accounting Theory and Analysis Text and Cases

Schroeder, Clark, Cathey, 12

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Author(s): Schroeder, Clark, Cathey

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Solutions Manual for Financial Accounting Theory and Analysis Text and Cases 12e Richard Schroeder Myrtle Clark Jack Cathey (All Chapters ) 1 CHAPTER 1 Case l -1 a. 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. b. The Codification is expected to improve accounting practice by: 1. Reducing the amount of ti me and effort required to solve an accounting research issue 2. Mitigating 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. Assisting the FASB with the research and convergence efforts. c. The FASB ASC is composed of the following literature issued by various standard setters: 1. Financial Accounting Standards Board (FASB) a. Statements (FAS) b. Interpretations (FIN) c. Technical Bulletins (FTB) d. Staff Positions (FSP) e. Staff Implementation Guides (Q&A) f. Statement No. 138 Examples. 2. Emerging Issues Task Force (EITF) a. Abstracts b. Topic D. 3. Derivative Implementation Group (DIG) Issues 4. Accounting Principles Board (APB) Opinions 5. Accounting Research Bulletins (ARB) 6. Accounting Interpretations (AIN) 7. American Institute of Certified Public Accountants (AICPA) a. Statements of P osition (SOP) b. Audit and Accounting Guides (AAG) —only incremental accounting guidance c. Practice Bulletins (PB), including the Notices to Practitioners elevated to Practice Bulletin status by Practice Bulletin 1 d. Technical Inquiry Service (TIS) —only for Software Revenue Recognition Additionally, in an effort to increase the utility of the FASB ASC for public companies, relevant portions of authoritative content issued by the SEC and selected SEC staff interpretations and administrative guidance have been included for reference in the Codification, such as: 1. Regulation S -X (SX) 2. Financial Reporting Releases (FRR)/Accounting Series Releases (ASR) 3. Interpretive Releases (IR) 4. SEC Staff guidance in: a. Staff Accounting Bulletins (SAB) b. EITF Topic D and SEC Staff Observer co mments 2 d. The FASB ASC contains all current authoritative accounting literature. However, if the guidance for a particular transaction or event is not specified within it, t he first source to consider is accounting principles for similar transactions or events within a source of authoritative GAAP. If no similar transactions are discovered, nonauthoritative guidance from other sources may be considered. Accounting and financi al reporting practices not included in the Codification are nonauthoritative. Sources of nonauthoritative accounting guidance and literature include, for example, the following: 1. Practices that are widely recognized and prevalent either generally or in th e industry 2. FASB Concepts Statements 3. American Institute of Certified Public Accountants (AICPA) Issues Papers 4. International Financial Reporting Standards of the International Accounting Standards Board Pronouncements of professional associations or regul atory agencies 5. Technical Information Service Inquiries and Replies included in AICPA Technical Practice Aids 6. Accounting textbooks, handbooks, and articles Case 1 -2 a. Inclusion or omission of information that materially affects net income harms particular stakeholders. Accountants must recognize that their decision to implement (or delay) reporting requirements will have immediate consequences for some stakeholders. b. Yes. Because the FASB standard results in a fairer presentation, it should be implemented as soon as possible --regardl ess of its impact on net income. c. The accountant's responsibility is to provide financial statements that present fairly the financial condition of the company. By advocating early implementation, Hoger ful fills this task. d. Potential lenders and investors, who read the financial statement and rely on its fair representation of the financial condition of the company, have the most to gain by early implementation. A stockholder who is considering the sale of stock may be harmed by early implementation that lowers net income (and may lower the value of the stock). Case 1 -3 a. CAP. The Committee on Accounting Procedure, CAP, which was in existence from 1939 to 1959, was a natural outgrowth of AICPA (then AIA) committees, which were in existence during the period 1933 to 1938. The committee was formed in direct response to the criticism received by the accounting profession during the financial crisis of 1929 and the years thereafter. The authorizat ion to issue pronouncements on matters of accounting principles and procedures was based on the belief that the AICPA had the responsibility to establish practices that would become generally accepted by the profession and by corporate management. As a ge neral rule, the CAP directed its attention, almost entirely, to resolving specific accounting problems and topics rather than to the development of generally accepted accounting principles. The committee voted on the acceptance of specific Accounting Rese arch Bulletins published by the committee. A two -thirds majority was required to issue a particular research bulletin. The CAP did not have the authority to require acceptance of the issued bulletins by the general membership of the AICPA, but rather rec eived its authority only upon general acceptance of the pronouncement by the members. That is, the bulletins set forth normative accounting procedures that "should be" followed by the accounting profession, but were not "required" to be followed. It was not until well after the demise of the CAP, in 1964, that the Council of the AICPA adopted recommendations that departures from effective CAP Bulletins should be disclosed in financial statements or in audit reports of members of the AICPA. The demise of the CAP 3 could probably be traced by four distinct factors: (1) the narrow nature of the subjects covered by the bulletins issued by the CAP, (2) the lack of any theoretical groundwork in establishing the procedures presented in the bulletins, (3) the l ack of any real authority by the CAP in prescribing adherence the procedures described by the bulletins, and (4) the lack of any formal representation on the CAP of interest groups such as corporate managers, governmental agencies, and security analysts. APB. The objectives of the APB were formulated mainly to correct the deficiencies of the CAP as described above. The APB was thus charged with the responsibility of developing written expression of generally accepted accounting principles through consi deration of the research done by other members of the AICPA in preparing Accounting Research Studies. The committee was in turn given substantial authoritative standing in that all opinions of the APB were to constitute substantial authoritative support f or generally accepted accounting principles. If an individual member of the AICPA decided that a principle of procedure outside of the official pronouncements of the APB had substantial authoritative support, the member had to disclose the departure from the official APB opinion in the financial statements of the firm in question. The membership of the committee comprising the APB was also extended to include representation from industry, government, and academe. The opinions were also designed to includ e minority dissents by members of the board. Exposure drafts of the proposed opinions were readily distributed. The demise of the APB occurred primarily because the purposes for which it was created were not being accomplished. Broad generally accepte d accounting principles were not being developed. The research studies supposedly being undertaken in support of subsequent opinions to be expressed by the APB were often ignored. The committee in essence became a simple extension of the original CAP in that only very specific problem areas were being addressed. Interest groups outside of the accounting profession questioned the appropriateness and desirability of having the AICPA directly responsible for the establishment of GAAP. Politicization of the establishment of GAAP had become a reality because of the far -reaching effects involved in the questions being resolved. FASB. The formal organization of the FASB represents an attempt to vest the responsibility of establishing GAAP in an organization r epresenting the diverse interest groups affected by the use of GAAP. The FASB is independent of the AICPA. It is independent, in fact, of any private or governmental organization. Individual CPAs, firms of CPAs, accounting educators, and representatives of private industry will now have an opportunity to make known their views to the FASB through their membership on the Board. Independence is facilitated through the funding of the organization and payment of the members of the Board. Full -time members are paid by the organization and the organization itself is funded solely through contributions. Thus, no one interest group has a vested interest in the FASB. Conclusion. The evolution of the current FASB certainly does represent "increasing politici zation of accounting standard setting." Many of the efforts extended by the AICPA can be directly attributed to the desire to satisfy the interests of many groups within our society. The FASB represents, perhaps, just another step in this evolutionary pr ocess. b. Arguments for politicization of the accounting rule -making process: 1. Accounting depends in large part on public confidence for its success. Consequently, the critical issues are not solely technical, so all those having a bona fide interest in the output of accounting should have some influence on that output. 2. There are numerous conflicts between the various interest groups. In the face of this, compromise is necessary, particularly since the critical issues in accounting are va lue judgments, not the type which are solvable, as we have traditionally assumed, using deterministic models. Only in this way (reasonable compromise) will the financial community have confidence in the fairness and objectivity of accounting rule making. 4 3. Over the years, accountants have been unable to establish, on the basis of technical accounting elements, rules, which would bring about the desired uniformity and acceptability. This inability itself indicates rule setting is primarily consensual in nature. 4. The public accounting profession, through bodies such as the Accounting Principles Board, made rules which business enterprises and individuals "had" to follow. For many years, these businesses and individuals had little say as to what the ru les would be, in spite of the fact that their economic well -being was influenced to a substantial degree by those rules. It is only natural that they would try to influence or control the factors that determine their economic well -being. c. Arguments aga inst the politicization of the accounting rule -making process: 1. Many accountants feel that accounting is primarily technical in nature. Consequently, they feel that substantive, basic research by objective, independent and fair -minded researchers ultimately will result in the best solutions to critical issues, such as the concepts of income and capital, even if it is accepted that there isn't necessarily a single "right" solution. 2. Even if it is accepted that there are no "absolute t ruths" as far as critical issues are concerned, many feel that professional accountants, taking into account the diverse interests of the various groups using accounting information, are in the best position, because of their independence, education, train ing, and objectivity, to decide what generally accepted accounting principles ought to be. 3. The complex situations that arise in the business world require that trained accountants develop the appropriate accounting principles. 4. The use of consensus to develop accounting principles would decrease the professional status of the accountant. 5 This approach would lead to "lobbying" by various parties to influence the establishment of accounting principles. Case 1 -4 a. The term "accounting principles" in the auditor's report includes not only accounting principles but also \practices and the methods of applying them. Although the term quite naturally emphasizes the primary or fundamental character of some principles, it includes general rules adopted or professed as guides to action in practice. The term does not however, mean rules from which there can be no deviation. In some cases, the question is which of several partially relevant principles has determining applicability. Neither is the t erm "accounting principles" necessarily synonymous with accounting theory. Accounting theory is the broad area of inquiry devoted to the definition of objectives to be served by accounting, the development and elaboration of relevant concepts, the promotio n of consistency through logic, the elimination of faulty reasoning, and the evaluation of accounting practice. b. Generally accepted accounting principles are those principles (whether or not they have only limited usage) that have substantial authoritative support. Whether a given principle has authoritative support is a question of fact and a matter of judgment. Since September 15, 2009 the primary source of GAAP has been the FASB’s accounting standards codification. However, if the guidance for a transact ion or event is not specified within a source of authoritative GAAP for that entity, an entity shall first consider accounting principles for similar transactions or events within a source of authoritative GAAP for that entity and then consider nonauthorit ative guidance from other sources (FASB ASC 105 -10-5-2). The CPA is responsible for collecting the available evidence of authoritative support and judging whether it is sufficient to bring the practice within bounds of generally accepted accounting princip le. 5 c. The auditor’s report states that a company’s financial statements present “fairly,” in all material respects, its financial position, based on his or her judgment as to whether the accounting principles selected and applied have general acceptance and that the accounting principles selected are appropriate given the circumstances. This statement is necessary because there are many areas where companies make choices among and between accounting principles (Depreciation method, inventory cost flow assum ptions, etc). Therefore, it is expected that financial reports are prepared in a manner that reflects the underlying economic events and activities of the reporting entity. This expectation was stressed in SAS No. 90 which stated, "In each SEC engagement, the auditor should discuss with the audit committee the auditor's judgments about the quality, not just the acceptability, of the entity's accounting principles applied in its financial reporting. The discussion should also include items that have a signif icant impact on the representational faithfulness, verifiability, and neutrality of the accounting information included in the financial statements. “As a consequence, the choices of accounting principles made by one company are often different than those made by another company. Case 1 -5 A factor that influenced the development of accounting during the 19th century was the evolution of joint ventures into business corporations in England. The fact that many individuals, external to the business, needed information about the corporation's activities created the necessity for periodic reports. Additionally, the emerging existence of corporations created the need to distinguish between capital and income. The statutory establishment of cor porations in England in 1845 stimulated the development of accounting standards, and laws were subsequently passed that were designed to safeguard shareholders against improper actions by corporate officers. Dividends were required to be paid from profits, and accounts were required to be kept and audited by persons other than the directors. However, initially anyone could claim to be an accountant, as there were no organized professions or standards of qualifications. The industrial revolution and the suc cession of Companies Acts in England also served to increase the need for professional standards and accountants. In the later part of the 19th century, the industrial revolution arrived in the United States, and with it came the need for more formal accou nting procedures and standards. This period was also characterized by widespread speculation in the securities markets, watered stocks, and large monopolies that controlled segments of the United States economy. In the 19th century the progressive movemen t was established in the United States, and in 1898 the Industrial Commission was formed to investigate and report on questions relating to immigration, labor, agriculture, manufacturing, and business. Although no accountants were either on the Commission or used by the Commission, a preliminary report issued in 1900 suggested that an independent public accounting profession should be established in order to curtail observed corporate abuses. Although most accountants did not necessarily subscribe to the d esirability of the progressive reforms, the progressive movement conferred specific social obligations on accountants. As a consequence accountants generally came to accept three general levels of progressiveness: (1) a fundamental faith in democracy, a co ncern for morality and justice and a broad acceptance of the efficiency of education as a major tool in social amelioration; (2) an increased awareness of the social obligation of all segments of society and introduction of the idea of accountability to th e public of business and political leaders; and (3) an acceptance of pragmatism as the most relevant operative philosophy of the day. The major concern of accounting during the early 1900s was the development of a theory that could cope with corporate abu ses that were occurring at that time, and capital maintenance emerged as a concept. This concept evolved from maintaining invested capital intact, to the maintenance of the physical productive capacity of the firm, to the maintenance of real capital. In es sence this last view of capital maintenance was an extension of the economic concept of income (see Chapter 3) that there 6 could be no increase in wealth unless the stockholder or the firm were better off at the end of the period than at the beginning. During the period 1900 -1915 the concept of income determination was not well developed. There was, however, a debate over which financial statement should be viewed as most important, the balance sheet or the income statement. Implicit in this debate was the view that either the balance sheet or the income statement must be viewed as fundamental and the other residual, and that relevant values could not be disclosed in both statements. The 1904 International Congress of Accountants marked the initial developm ent of the organized accounting profession in the United States, although there had been earlier attempts to organize and several states had state societies. At this meeting, the American Association of Public Accountants was formed as the professional org anization of accountants in the United States. In 1916, after a decade of bitter interfactional disputes, this group was reorganized into the American Institute of Accountants (AIA). The American Association of the University Instructors in Accounting was also formed in 1916. Initially this group focused on matters of curriculum development, and it was not until much later that it attempted to become involved in the development of accounting theory. World War I changed the public's attitude toward the business sector. Many people believed that the successful completion of the war could be, at least partially, attributed to the ingenuity of American businesses. As a consequence, the public perceived that business had reformed, and external reg ulation was no longer necessary. The accountant's role changed from a protector of third parties to the protector of business interests. Critics of accounting theory during the 1920s suggested that accountants abdicated the stewardship role, placed too mu ch emphasis on the needs of management, and permitted too much flexibility in financial reporting. During this time financial statements were viewed as the representations of management, and accountants did not have the ability to require businesses to use accounting principles they did not wish to employ. Case 1 -6 a. Historically, accounting has been considered a highly trustworthy profession. Public accounting firms trained new accountants in the audit function with oversight from senior partners who believed that their firm’s integrity rode on every engagement. That is, new auditors were assigned client responsibility after minimal formal audit training. Most of the training of new accountants took place on -site, and the effectiveness of the new audit or depended on the effectiveness of the instructor. CPA firms have always called their customers “clients” and have worked hard to cultivate them. Partners routinely entertained clients at sporting events, country clubs, and restaurants, and many CPA firm employees later moved on to work in their clients’ firms. Any conflicts in these relationships were, at least partially, offset by the CPA firm’s commitment to professional ethics. These relationships changed as information technology advisory services g rew in the late 1970s and early ’80s. Also in the mid -1980s, the AICPA lifted its ban on advertising. As a result, revenue generation became more critical to partners’ compensation. Thereafter, the profit structure of CPA firms changed dramatically and in 1999, revenues for management consulting accounted for more than 50 percent of the then Big Five’s revenue. As a result, the audit function evolved into a loss leader that public accounting firms offered in conjunction with vastly more lucrative consulting engagements. But as pubic accounting firms competed more aggressively on price for audit engagements, they were forced by cost considerations to reduce the number of procedures performed for each client engagement. This resulted in increased test of controls and statistical models, and fewer of the basic, time - consuming tests of transactions that increase the l ikelihood of detecting fraud. In addition, junior auditors were frequently assigned the crucial oversight roles usually filled by senior 7 partners, who were otherwise engaged in marketing activities to prospective clients. This reduced the effectiveness of the instructor –new accountant training process. b. 1. Arthur Andersen, formerly one the Big Five audit firms, has gone out of business. 2. In July 2002, President George W. Bush signed into law the Sarbanes -Oxley Bill, which imposes a number of corporate governance rules on publicly traded companies 3. Establishment of PCAOB. Case 1 -7 a. 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 Accou ntants 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 Account ing 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 ap pointed. However, the actual number of members has grown to about thirty in recent years to obtain representation from a wider group of interested parties. The FAF appoints the Financial Accounting Standards Advisory Council, which advises the FASB on major policy issues, the selection of task forces, and the agenda of topics. The FAF is also responsible for appointing the seven members of the FASB and raisin g the funds to operate the FASB. The FAF currently collects in excess of $23 million a year to support the activities of the FASB. b. The members of the Financial Accounting Foundation are nominated by electors from nine organizations that support the act ivities of the FASB. These nine organizations are the AICPA, the Financial Executives Institute, the National Association of Accountants, the Financial Analysts Federation, the American Accounting Association, the Security Industry Association, and three n ot-for-profit organizations. FASB ASC 1 -1 Variable Interest Entities (VIEs) Special purpose entities are accounted for by using the requirements for variable interest entities (VIEs). The information for this question is found by searching the topic “v ariable interest entities.” 1. The definition of variable interest entities is contained in FASB ASC 810 -10- 25-20 2. The guidance of the consolidation of VIEs is contained in 810 -10-05-8 to 13. FASB ASC 1 -2 Status of ARBs First search the glossary for t he three terms Revenue recognition topic 605 Treasury stock topic 505 -30 Comparative financial statements topic 205 Then Search ARB 43 in cross reference Look for topic 605 (revenue) in the results Treasury Stock 8 Search ARB 43 in cross reference Look for topic 505 - 30 (treasury stock) in the results Comparative Financial Statements Search ARB 43 in cross reference Look for topic 205 (comparative financial statements ) in the results 205-10-45 Use print function printer friendly with sources FASB ASC 1 -3 Accounting for the Investment Tax Credit Search investment tax credit Found at 740-10-25- 45 7 46 740-10-47-27 & 28 FASB ASC 1 -4 SEC Comments 1. Search revenue recognition Found under customer payment and incentives 605 -50-S99-1 Comments Made by SEC Observer at Emerging Issues Task Force (EITF) Meetings 2. Search debt with conversions and other options Found under 470 -20 -S99 Comments Made by SEC Observer at Emerging Issues Task Force (EITF) Meetings 3. Search software cost o f sales and services Found under 985 -705-S99 Comments Made by SEC Observer at Emerging Issues Task Force (EITF) Meetings FASB ASC 1 -5 GAAP Guidelines Search “generally accepted accounting principles.” Found under 105 -10 Room for Debate Debate 1 -1 Which Body Should Set Accounting Standards in the United States? This question has no one correct answer. It is meant to get students talking about something that they probably haven’t thought about before. Students in favor of the SEC bei ng the rule making body could argue that the FASB has failed to ensure that financial statements fairly present the results of operations. They could then cite the recent scandals. They could argue that the SEC has the power to regulate and they don’t se e why the profession should then need to be self -regulated. They could also argue that under the FASB there is too much flexibility and too much reliance on managerial intent, thereby allowing management to manage earnings and otherwise manipulate its fin ancial statements. Moreover, lack of exercise of government direct oversight could result in diminishing the effectiveness of accountants to audit due to a potential erosion of independence. They could point to Sarbanes -Oxley. 9 Students in favor of the FASB making the rules could argue against big government. They could point out that government sets accounting standards in countries that are not capitalistic. The result in those countries is a cookie cutter approach to financial statements and lack of flexibility that leaves no room for professional judgment. Whereas, the standards provided by the FASB are aimed to provide financial statements that fairly present financial statements, taking into consideration the circumstances in which a company oper ates. They could also argue that accountants, not government officials, best understand their role and how best to measure and report financial information. Debate 1 -2 Should the scope of accounting standards be narrowed further? Team 1. This question should prompt the student to investigate how management might benefit from alternative accounting choices. They can go to the web and find out that accounting choices provide managerial incentives that are either income increasing or income decreasing. T hey may also find instances that management can choose methods of presenting financial information that make the company appear less risky. Income -increasing choices afford management the ability to paint a better picture of company performance. Manageme nt may be inclined to select income increasing policies because • They believe the stock market will react favorably and their own personal wealth and position in the firm may be more secure. • Their bonus may be tied to the bottom line. • The company may appear better able to pay suppliers and thus may be in a better po sition to negotiate favorable terms with suppliers • The company may appear better able to repay debt and thus look good to a lender. • Students can cite real -world examples, e.g., World Com capitalized expenses Income -decreasing choices may be selected by co mpanies that • Are highly regulated, such as utility companies. Poor performance can support the notion that the company deserves a rate increase • If a company is having a bad year, it may choose to load up the income statement with expenses and losses so th at it will appear better off in future years. • Have labor unions hope to fare better in negotiations for labor contracts Companies have used off -balance sheet financing to improve the perception of a company’s riskiness. Enron is a prime example. Enron u sed special purpose entities to hide debt from investors. The student can also argue that accounting choice can be used to provide more relevant financial statements. For example, SFAS 115 provides choices that are intended to result in financials that b etter disclose the results of management investment choices. Team 2. All of the above can be used as arguments against the proliferation of accounting choices. Narrowing accounting choices has been a goal of accounting professionals for many years. For example, one of the objectives of the APB was to narrow areas of difference in 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 (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 th e 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 res ultant decline in the market value of the firm. The large number of accounting frauds that were evident during recent years provide examples of the ways that management has manipulated financial statement in order to fool 10 the public. Many of these cases m ight not have occurred if management were not afforded the discretion to choose accounting procedures and practices. In short, accounting choice can result in earnings management, fraudulent financial reporting, a lack of financial statement transparency, financial statements that are not reliable, and financial statements that are biased. WWW Case 1 -8 a. The Securities and Exchange Commission (SEC) was created by the Securities Act of 1933 and the Securities Exchange Act of 1934, 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 generally acted as an overseer and allowed the private sector to develop accounting principles, and this authority has seldom been used. However, the SEC has exerte d pressure on the accounting profession and has been especially interested in narrowing areas of difference in accounting practice. In 1936 the AICPA’s Committee on Accounting Procedure (CAP) was formed. This committee had the authority to issue pronounc ements on matters of accounting practice and procedure in order to establish generally accepted practices. The works of the CAP were originally published in the form of Accounting Research Bulletins (ARBs); however, these pronouncements did not dictate man datory 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. ARB s No. 44 through No. 51 were published from 1953 until 1959. T he recommendations of these bulletins that have not been superseded are contained in the FASB Accounting Standards Codification (FASB ASC; discussed below) and referenced throughout this text where the specific topics covered by the ARBs are discussed. By 1959 the methods of formulating accounting principles were being questioned as not arising from research or based on theory. The AICPA responded to the alleged shortcomings of the CAP by forming the Accounting Principles Board (APB). The objectives of th is body were to advance the written expression of generally accepted accounting principles (GAAP), to narrow areas of difference in appropriate practice, to narrow areas of difference in appropriate practice and to discuss unsettled controversial issues. T he pronouncements of this body were termed “APB Opinions.” In 1974 the APB was replaced with the Financial Accounting Standards Board. The pronouncements of this organization were originally terms Statements of Financial Accounting Standards. Subsequentl y, after the publication of the Accounting Standards Codification, they have been termed Accounting Standards Updates. b. This term, initially proposed by Carman Blough, the first chief accountant of the SEC, is meant to mean authority of 'substantial weight ' or importance, and not necessarily a majority view. Thus there might be three authoritative positions all of which are appropriate at a point in time before some standard is established. The majority may have gone in one direction, but the minority who w ere also considered 'authoritative' and could be used. c. The SEC and the AICPA have been the sources of authority for compliance with accounting standards. The SEC has indicated that financial statements conforming to standards set by the FASB will be presumed to have authoritative support . The AICPA, in Rule 20 3 of the Code of Professional Ethics, requires that members prepare financial statements in accordance with GAAP. Failure to follow Rule 203 can lead to the loss of a CPA’s license to practice. Case 1 -9 11 The answer to this case requires an analysis of th e financial statements of the two companies at the time it is assigned. Case 1 -10 The answer to this case requires a visit to the Microsoft Corporation’s homepage at the time it is assigned. Financial Analysis Case The solutions to the financial analysis case depend upon the company and year selected. 20 CHAPTER 2 Case 2 -1 a. The FASB's conceptual framework study should provide benefits to the accounting community such as: 1. Guiding the FASB in establishing accounting standards on a consistent basis. 2. Determining bounds for judgment in preparing financial statements by prescribing the nature, functions, and limits of financial accounting and reporting. 3. Increasing users understanding of and confidence in financial reporting. b. The two fundamental qualities that make accounting inform ation useful for decision making are relevance and faithful representation . Relevant financial information is capable of making a difference in the decisions made by users. Financial information is capable of making a difference in decisions if it has predictive value and confirmatory value and is material. Financial information has predictive value if it can be used as an input to processes employed by users to predict future outcomes. Financial information has confirmatory value if it provides feedbac k (confirms or changes) about previous evaluations. Information is material if omitting it or misstating it could influence decisions that users make on the basis of the financial information of a specific reporting entity. In other words, materiality is an entity -specific aspect of relevance based on the nature or magnitude or both of the items to which the information relates in the context of an individual entity’s financial report. Consequently, the FASB was not able to specify a uniform quantitative th reshold for materiality or predetermine what could be material in a particular situation. Financial reports represent economic phenomena in words and numbers. To be useful, financial information not only must represent relevant phenomena but also must faithfully represent the phenomena that it purports to represent. A perfectly faithful represe ntation 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 al l 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 21 process used to determine the numerical depiction. A neutral depiction is without bias in the selection or presentation of financial information. A neutral depiction is not slanted, weighted, emphasized, deemphasized, or o therwise manipulated to increase the 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 i nformation 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 the process used to produce the reported information has been selected and ap plied with no errors in the process. Information that is free from error will result in a more faithful representation of financial results. Comparability, verifiability, timeliness, and understandability are the qualitative characteristics that enhance the usefulness of information that is relevant and faithfully represented. Comparability is the qualitative characteristic that enables users to identify and understand similarities in, and differences among, items. Consistency refers to the use of the sa me methods for the same items, either from period to period within a reporting entity or in a single period across entities. Comparability is the goal; consistency helps to achieve that goal. Verifiability helps assure users that information faithfully represents the economic phenomena it purports to represent. Verifiability means that different knowledgeable and independent observers could reach consensus, although not necessarily complete agreement, that a particular depiction is a faithful representat ion. Quantified information need not be a single point estimate to be verifiable. A range of possible amounts and the related probabilities also can be verified. Timeliness means having information available to decision makers in time to be capable of influencing their decisions. Generally, the older the information is, the less useful it is. However, some information can continue to be timely long after the end of a reporting period because, for example, some users might need to identify and assess tre nds. Understandability involves classifying, characterizing, and presenting information clearly and concisely. Case 2 -2. a. i. The Conceptual Framework Project is an attempt by the FASB to develop concepts useful in guiding the board in establishing standards and in providing a frame of reference for resolving accounting issues. Over the years this project first attempted to devel op 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 well these overall objectives could be achieved. The FASB has stated that it intends the Conceptual Framework Project to be viewed not as a package of solutions to problems but rather as a common basis for identifying and discussing issues, for asking 22 relevant questions, and for suggesting avenues for research. The Conceptu al Framework Project has resulted in the issuance of eight statements of Financial Accounting Concepts that impact upon financial accounting: No.1 -Objectives of Financial Reporting by Business Enterprises (superseded); No.2 -Qualitative Characteristics of A ccounting Information (Superseded); No.3 -Elements of Financial Statements of Business Enterprises (Superseded); No.5 -Recognition and Measurement in Financial Statements of Business Enterprises; No.6 - Elements of Financial Statements;” No. 7 -“Using Cash Flow Information and Present Value in Accounting Measurements” and No. 8 “Conceptual Framework for Financial Reporting (Chapters 1 & 3). ii. The FASB has been criticized for failing to provide timely guidance on emerging implementation and practice problems. During 1984 the FASB attempted to respond to this criticism by (1) establishing a task force to assist in identifying issues and problems that might require action, the Emerging Issues Task Force, and (2) expanding the scope of the FASB Technical Bulletins in an effort to offer quicker guidance on a wider variety of issues. Emerging issues arise because of new types of transactions, variations in accounting for existing types of transactions, new types of securities, and new products and service s. They frequently involve the company's desire to achieve "off balance sheet" financing or "off income statement" accounting. The Emerging Issues Task Force was formed to assist the FASB in issuing timely guidance on these emerging issues. That is, the task force's responsibility is to identify emerging issues as they develop, investigate and review them, and finally to advise the board whether the issue merits its attention. The members of the task force all occupy positions that make them aware of emerging issues. The current members include the directors of accounting and auditing from 11 public accounting firms (including all of the "Big Four"), two representatives from the Financial Executives Institute, one from the National Association of Accountants and the Business Roundtable, and the FASB's Director of Research who serves as Chairman. b. The Financial Accounting Standards Board, the Securities and Exchange Commissi on, and the American Institute of Certified Public Accountants have been criticized for imposing too many accounting standards on the business community. The Standards overload problem has been particularly burdensome on small businesses that do not have t he necessary economic resources to research and apply all of the pronouncements issued by these sources. Those who contend that there is a standards overload problem base their arguments on two allegations. 23 1. Not all GAAP requirements arc relevant to s mall business financial reporting needs. 2. Even when they are relevant, they frequently violate the pervasive cost benefit constraint. Critics of the standard -setting process for small business also assert that GAAP were developed primary 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. Some of the consequences of the standards overload problem to small business are as follows. 1. If a small business omits a GAAP requirement from audited financial statements, a qualified or adverse opinion may be rendered. 2. The cost of complying with GAAP requirements may cause a small business to forgo the development of other, more relevant information. 3. Small CPA firms that audit smaller companies must keep up to date on all of the same requirements as large international firms, but cannot afford the specialists that are available on a centra lized basis in the large firms. Many accountants have argued for differential disclosure standards as a solution to the standards overload problem. That is, standards might be divided into two groups. One group would apply to business regardless of siz e. The second group would be applied selectively only to large businesses, small businesses, or particular industries. For example, the disclosure of significant accounting policies would pertain to all businesses, whereas a differential disclosure such as earnings per share would be applicable only to large businesses. Case 2 -3 a. 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. b. ASOBAT defined accounting as “the process of identifying, measuring, and communicating economic information to permit informed judgments and decision by users of the information.” Both this definition and Sprouse and Moonitz believe that communicating inf ormation is helpful for users to make rational decisions and informed judgments. 24 c. Similarly, SFAC No. 8 states that accounting information should be useful for investment decision -making. The user should be able to use accounting information to make decis ions about investing in a company. Case 2 -4 a. In describing continuity, Sprouse and Moonitz stated that 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 ent ity has a limited life, it should not be viewed as remaining in operation indefinitely. b. No. Since a business is presumed to continue indefinitely, the value relevant to a purchaser is fair market value. This value measures the present value of future cas h flows to the buyer. It is relevant for the buyer because the buyer presumes that the business will continue and thus will generate those future cash flows. c. No. A bankruptcy provides evidence that the business is not expected to remain in operation ind efinitely. In this case, the assets that are reported in the company’s balance sheet should be measured at net realizable value. Case 2 -5 a. SFAC No. 6 defines assets as “probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.” If your company is using a building to produce automobiles, the probable future economic benefit is the expected inflow of resources from the sales of automobiles. This benefit accrues to the company who may then u se them, if it wishes, to make more automobiles. The prior transaction that caused the asset to exist is the acquisition of the building. b. In this case, the probable future economic benefit is the net realizable value that the company will receive when it sells the building. Again, the acquisition of the building is the result of a prior transaction or event. c. In this case, the probable future economic benefit is the inflow of resources that will eventually flow into the company when it produces the autom obiles. The transaction that caused the asset to exist was the acquisition of the building. Case 2 -6 a. Employees meet the definition of an asset. An asset has three essential characteristics: (a) it embodies a probable future benefit that involves a capa city, singly or in combination with other assets, to contribute directly or indirectly to future net cash inflows, (b) a particular entity can obtain the benefit and control others' access to it, and (c) the transaction or other event giving rise to the en tity's right to or control of the benefit has already occurred. Employees embody a probable future benefit that will contribute to future net cash flows. They will work so that the company can have revenues. The company will benefit because they control what 25 the employees do on the job. Employment of the employees gave rise to the entity’s right to control the benefit. b. No. According to SFAC No. 5 , to report an asset in the balance sheet, it not only must meet the definition of an asset, but it must be capable of being measured. c. i. The value would be more relevant because it would measure the expected future cash flows that the employees would be expected to generate. It would be less reliable because there is no precise method to measure the value of human capital. It can only be estimated. Therefore, two measurements made by two different measurers are unlikely to be the same. ii. Yes. Representational faithfulness means that the items in the balance reflect what they purport to be. If human capital is an asset, then reporting its estimated value would reflect the value of that asset and would as a result provide representational faithfulness. Case 2 -7 a. According to SFAC No. 7 the bonds are distinguished by the uncertainty of their future cash flows. The bonds would sell at the present value of their future cash flows, discounted at the market rate of interest. The company with the better credit rating would yield a lower ma rket rate, assuming that the stated rates for both companies are the same. So, if the stated rates are the same, Company A’s bond might be more valuable it its credit rating were better than Company B’s. b. If both companies have the same credit rating, the n the one reason that Company A’s bond would have a higher market value than would Company B’s bond would be that Company A’s bond has a shorter term than Company B’s bond. If they both have the same term, then Company A’s bond would sell for more than Co mpany B’s bond if Company A were offering a higher stated interest rate. FASB ASC FASB ASC 2 -1 Use of Present Value The information on present value is contained in the FASB ASC at FASB ASC 820 - 10-55. It can be accessed through the glossary. FASB ASC 2 -2 Conceptual Framework Search conceptual framework Found under 605 Revenue Recognition 10 Overall S99 SEC Materials 26 FASB ASC 2 -3 Decision -Maker Concept Search decision maker 10 hits FASB ASC 2 -4 Understandability Concept Search understandability Found under 715 c ompensation —Retirement Benefits > 10 Overall > 10 Objectives FASB ASC 2 -5 Relevance Concept Search relevance – 15 hits FASB ASC 2 -6 Recognition and Measurement Guidance Search recognition and measurement -over 70 hits FASB ASC 2 -7 Reporting Comprehensive Income is contained in sections FASB ASC 220 -10. It is found by searching comprehensive income. FASB ASC 2 -8 Using Present Value Search present value -over 100 hits Room for Debate Debate 2 -1 A Question of Materiality Team 1: Arguments for capitalization of boxes. 1. Objectives of financial reporting Decision usefulness requires that companies report the status of enterprise resources. The boxes provide future service potential. As such, they meet the definition of an asset found in SFAC No. 6. Hence, they are a resource that should be reported. 27 2. Definition of assets SFAC No. 6 defines assets as probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. The boxes are assets. They will provide future economic benefits for a particular entity (Roper Co). The company will use them fo r at least 10 years. They result from past transaction - a purchase. 3. Qualitative Characteristics Relevance Capitalization is relevant because it provides information about outcomes of past transactions or events. The user is informed that the boxes are assets. They were purchased by the company, and the company intends to use them over an extended period of time. Hence their cost is not a current period expense. Faithfull Representation Capitalization provides reliability. Because the boxes will be used over an extended period of time, they meet the definition of an asset found in SFAC No. 6. Hence, capitalization presents the economic facts and provides information that is representationally faithful. If they are assets, they should be reported as such, rather than expensed, a representation that would not report them as they purport to be. Also, capitalization of the cost would be neutral because it would provide an unbiased representation of the economic substance of the purchase t ransaction. Team 2 Arguments against the capitalization of the boxes. 1. Materiality Materiality was defined in SFAC No 2 as the threshold for recognition. When the dollar amount is small, the particular accounting treatment will not affect the decisi ons of an informed user. In this case, the cost of boxes is clearly immaterial, implying that they need not be capitalized as assets. 2. Cost Constraint The benefits derived from capitalization should exceed the cost of capitalization. Since the cost o f the boxes is not material, capitalization would not provide sufficient benefit, in terms of decision usefulness, to warrant this accounting treatment. Capitalization would require depreciation over the useful life of the boxes. This 28 would require adjus ting entries for a ten -year period. The amount of depreciation reported each period would be trivial and would have essentially no effect on earnings. Hence, the cost of the bookkeeping effort would be greater than the benefits, if any, derived. 3. Objectives of financial reporting The primary objective of financial reporting is decision usefulness. Accounting information should provide information that is useful to investors, creditors and other users in making decisions regarding investing, lendi ng, etc. This implies that accounting information is relevant to the decision -maker. Even though the boxes will last 10 years, the cost is immaterial and hence irrelevant. 4. Qualitative Characteristics of accounting information Relevance As stated ab ove, relevance means that the information provided will make a difference in the decisions of investors, creditors and other users. The expenditure is immaterial and as such, the accounting treatment is irrelevant, and capitalization is irrelevant. Debat e 2-2 The Need for A Universally Accepted Theory of Accounting Team 1: A universally accepted theory of accounting is needed for the development of internally consistent accounting principles. Accounting practices have developed in response to changing ec onomic conditions and, in some cases, in response to what are perceived as crises. For example, SFAS No. 114, was prompted to inconsistent practices of reporting impaired loans, and SFAS No. 94 was prompted by off -balance sheet recognition of lease liabil ities. This piece -meal, reactionary approach to accounting has resulted in standards that are not only internally inconsistent, but are also inconsistent with international standards. A theory of accounting would provide a common basis for identifying and discussing issues. This is the goal of the FASB’s conceptual framework project. Such a theory could be used to help narrow the number of accounting choices currently available to management, thereby reducing management’s ability to manipu late financial statements to suit their personal, or company goals. As such, it could help guide the development of neutral standards, which aids in the allocation of scarce resources and the efficient functioning of capital markets In addition to helpin g reduce managerial bias in reporting results of operations and financial position, a universally accepted theory of accounting could serve to reduce personal biases in the standard setting process itself. Reliance on such a theory could result in the dev elopment of those standards that are consistent with the theory itself. 29 A universal theory of accounting would be consistent with the concepts -based approach to accounting standards described by the American Accounting Association. A universally accepte d accounting theory could provide a basis for standard setting that would satisfy the following. 1. Economic substance, not the form, of a given transaction should guide its financial reporting. 2. The mapping between economic substance of a transaction and it s financial statement representation could be supported by a common theoretical basis, thereby providing understandability and a common basis of comparison across companies and over time. Team 2: To date, no standard setting body has developed a universal ly accepted theory of accounting. An argument against a universal theory of accounting can be based on the complexity of the phenomena that financial statements purport to represent. According to SATTA , while there has been general agreement that the pur pose of financial accounting is to provide economic data about accounting entities, divergent theories have 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. SATTA discussed why none of the approaches to theory had gained general acceptance, SATTA raised six issues. 1. The problem with relating theory to practice . The real world is much more complex than the world specified in most accounting theori es. For example, most theory descriptions begin with unrealistic assumptions such as holding several variables constant. 2. Allocation problem . Allocation is an arbitrary process. For example, the definition of depreciation as a rational and systematic method of allocation has led to a variety of interpretations of these terms. 3. The difficulty with normative standards. Normative standards are desired states; however, different users of accounting information have different desired states. As a result, no set of standards can satisfy all users. 4. The difficulties in interpreting security price behavior research . Market studies (such as the efficient market studies discussed in Chapter 4) attempt to determine how users employ accounting numbe rs. These studies have attempted to control for all variables except the one of interest, but there have been disagreements over 30 whether their research designs have actually accomplished this goal. 5. The problem cost -benefit considerations accounting the ories . A basic assumption of accounting is that the benefits derived from adopting a particular accounting alternative exceed its costs. However, most existing theories do no indicate how to measure benefits and costs. 6. Limitations of data expansion . At the time SATTA was published, a view was emerging that more information is preferable than less. Subsequent research has indicated that users have a limited ability to process accounting information. (The issue of information processing is discussed in C hapter 4.) The FASB’s conceptual framework project (CPF) cannot be viewed as a universally accepted theory of accounting, nor does the FASB purport that it is. The FASB intends the CFP to be viewed not as a package of solutions to problems but rather as a common bas is for identifying and discussing issues. For example, SFAC Nos. 1 and 2 can be described as the goals to guide practice. It does not even directly affect practice. Rather, the SFAC s affect practice only by means of their influence on the development of new accounting standards. So, rather than a universally accepted theory of accounting, we have settled for the CFP, which does not provide all the answers, but has been relied upon to aid the standard -setting process. And, it has provided a basis to nar row alternatives and to eliminate those that are inconsistent with it. It also is used to guide the development of neutral standards, which aids in the allocation of scarce resources and the efficient function of capital markets In other words, we can ope rate with concept -based accounting standards by relying upon the CFP rather than a universally accepted theory of accounting. The CFP has been criticized and will evolve to address criticism from the SEC that the objectives of the standards that are deriv ed from it need to be more clearly defined, implementation guidance needs to be improved, scope exceptions need to be reduced and the asset -liability approach to standard setting should be retained WWW Case 2 -8 The conceptual framework contains three levels. The apex, the first level, identifies the objective of financial reporting —that is, the purpose of financial reporting. The second level outlines the fundamentals, which are the qualitative characteristics that make accounting information useful, and the elements of financial statements (assets, liabilities, and so on). The third level identifies the implementation guidelines of recognition, measurement, and disclosure used in establishing and applying accoun ting standards and 31 the specific concepts to put into practice the objective. These guidelines include the assumptions, principles, and constraints that describe the present reporting environment. Case 2 -9 The qualitative characteristics of accounting information are: Primary Users The primary users of financial information are existing or potential investors, lenders, and other creditors, that is, its capital providers. Cost Constraint Cost is described in SFAC No. 8 as a pervasive constra int on the information that can be provided by financial reporting. The measurement, summarization, and reporting of financial information imposes costs, and it is important that those costs are justified by the benefits of reporting that information. Qualitative Characteristics The qualitative characteristics are described in Chapter 3 of SFAC No. 8 and distinguish between better (more useful) information and inferior (less useful) information. These qualitative characteristics are either fundamental or enhancing characteristics, depending on how they affect the decision usefulness of information. The two fundamental qualities that make accounting information useful for decision making are relevance and faithful representation . Case 2 -10 a. Materiality was originally defined in SFAC No. 2 as the threshold for recognizing the elements of accounting information as: “The magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement.” b. The proposed amendment would define materiality as a legal concept. In the United States, a legal concept may be established or changed through legislative, executive, or judicial action. The Board observes but does not promulgate definitions of materiality. Currently, the Board observes that the U.S. Supreme Court’s definition of materiality, in the c ontext of the antifraud provisions of the U.S. securities laws, generally states that information is material if there is a substantial likelihood that the omitted or misstated item would have been viewed by a reasonable resource provider as having signifi cantly altered the total mix of information. Consequently, the Board cannot specify or advise specifying a uniform quantitative threshold for materiality or predetermine what could be material in a particular situation. 32 In general, the critics maintain th at the change of the definition is being driven by issuers and their auditors rather than the investing public. For example, Tom Selling noted that the FASB stated, in justifying the changed definition, that: “Respondents … have requested these amendments to eliminate inconsistencies between the framework and the legal concept of materiality.” However, Selling maintained that the term respondents is: “FASB -speak for issuers and their auditors,” and that these ‘respondents’ would prefer a strictly legal defi nition of materiality. Therefore, if sued by misled investors, they can claim that they relied on an independent legal opinion that an omit ted disclosure was not “material” as defined by previous Supreme Court cases. Additionally, Lynn Turner, the past Chief Accountant for the SEC, said the proposal is “giving a pass to management who put out bad, incorrect and misleading numbers.” And, Barba ra Roper of the Consumer Federation of America stated “If Lynn Turner is concerned I’m concerned,” She also opined that this change has been on the agenda of the corporate and auditing community for a while and that: “There’s a sense that the project is no t being driven by a conversation with investors about what would make disclosures more effective, … [but rather] more by a conversation with issuers and auditors.” Finally, at a meeting of the Investor Advisory Committee, attended by the SEC’s Chief Accoun tant, Jim Schnurr, Roy Katzovicz, chairman of the private investment group Saddle Point, asked Schnurr: “Is this a clarification of what materiality was all along, or a change in the standards, such that it’s a less sensitive standard that would allow for less disclosure? It was also reported that the overall feeling of the Investor Advisory Committee is that more disclosure is better than less in general but he clear drift of the new materiality proposal is in the other direction. Case 2 -11 The answer to this case requires a visit to the FASB’s home page at the time it is assigned. Case 2 -12 The answer to this case requires a visit to the FASB’s home page at the time it is assigned. Case 2 -13 The answer to this case requires a visit to the FASB’s home page at the time it is assigned. Case 2 -14 During the early 2000s, the FASB noted that concerns were being expressed about the quality and transparency of accounting information. One of the main concerns was the increasing complexity of FASB standards. The Board concluded that much of the detail an d complexity associated with accounting standards was the result of rule -driven implementation guidance,