Intermediate Accounting September 30th, 2010 Turn in Take-home Quiz (using Folders by last name) General Course Questions: (Syllabus, Student Enrollment & Wait List, Other) Follow-up Chapter 3: The Accounting Information System Introduce Chapter 1, IFRS & the Codification Assignments for Tuesday, October 5th: A. Readings: Chapter 2 and IFRS pp. 8-9 B. Codification CE2-1 thru CE2-3 C. Chapter 2: BE2-2 thru BE2-11, E2-3, E2-5 D. Discussion Questions Kapnick & Wyatt

Chapter 1 Learning Objectives Understand the “Objectives of Financial Reporting” and how they effect an efficient use of scarce resources Historical events substantiate the need for improving accounting standards Who sets Accountings Standards and How are they developed? A. SEC B. AICPA C. FASB and the Codification D. IFRS 4. Challenges facing the Accounting Profession

Objectives of Financial Accounting To provide information that is Useful in investment and credit decisions Useful in assessing cash flow prospects About company resources, claims to those resources and changes in them Financial Statement Elements Assets Liabilities Stockholders’ Equity Revenues Expenses 3

Characteristics of Financial Accounting Accounting identifies, measures and communicates financial information. This information is about economic entities. Information is communicated to interested parties such as investors, creditors, unions and governmental agencies. Is accounting an art or a science? Is there only one correct Net Income amount? 4

What level of sophistication is assumed of Financial Statement Users? Financial reporting should provide information that is useful to present and potential investors and creditors and other users in making investment, credit, and similar decisions rational. The information should be comprehensible to those who have a reasonable understanding of accounting concepts, financial statements, and business and economic activities and are expected to be willing to study and interpret the information with reasonable diligence. (Statement of Financial Accounting Concepts #1)

Why Do we Need Rules to Play the Game of Business? The Need for Accounting Rules: Stockholders & Creditors have limited resources and need to make wise investment choices. Establishing rules levels the playing field by requiring companies to report comparable information. The SEC was established in 1932 to regulate reporting of Financial Information. The SEC delegates most of its rule making authority to the private sector (AICPA, FASB, etc.) to establish the rules called Generally Accepted Accounting Principles (GAAP). Stock market crash of 1929 led calls for government regulation of business, financial institutions and the stock market. SEC encouraged a private rule setting body by the accounting profession CAP (1939-1959) 51 Accounting Research Bulletins APB (1959-1973) 31 APB Opinions - Wheat Commission FASB Statements of Fin. Accounting Standards, Interpretations, Technical Bulletins and Emerging Issues Task Force Stmts SEC delegated their authority to the Acctg Profession Sarbanes Oxley 2002 Public Company Accounting Oversight Board AICPA Cm. Acctg. Procedure AICPA Acctg. Principles Board FASB Sarbanes Oxley Act Public Co. Oversight Board Co. B Co. A 6

Securities and Exchange Commission Established by federal government Accounting and reporting for public companies Securities Act of 1933 Securities Act of 1934 Delisting and fines by SEC for violations Encouraged private standard-setting body SEC requires public companies to adhere to GAAP SEC Oversight Enforcement Authority 7

American Institute of CPAs National professional organization Established the following: Committee on Accounting Procedures Accounting Principles Board 1939 to 1959 Issued 51 Accounting Research Bulletins (ARBs) Problem-by-problem approach failed 1959 to 1973 Issued 31 Accounting Principle Board Opinions (APBOs) Wheat Committee recommendations adopted in 1973 http://www.aicpa.org/ 8

Financial Accounting Standards Board Missions is to establish and improve standards of financial accounting and reporting. Differences between FASB and APB include: Smaller Membership Full-time, Remunerated Membership Greater Autonomy Increased Independence Broader Representation http://www.fasb.org/ 9

The SEC and the FASB establish GAAP in the United States

US Standard Setters 11

FASB Due Process for Standard Setting Process operates in full view of the public, thus is open to political influences and can take considerable time. FASB drafts and releases a discussion memorandums for identified accounting issues: Describes the possible accounting treatments Describes FASB’s preliminary views on the issue Receives public feedback on the discussion memorandum Prepares an exposure draft (proposed new accounting standard) after analyzing and evaluating feedback Accepts public feedback on the exposure draft Decides whether to: Remove the exposure draft from further consideration Revise and reissue the exposure draft Vote upon the current version of the exposure draft 12

Government (SEC, IRS, other agencies) Standard Setting Business Entities User Groups that Influence Accounting Standards CPAs and Accounting Firms Financial Community AICPA (AcSEC) FASB Preparers (e.g., FEI) Academicians Government (SEC, IRS, other agencies) Investing Public Industry Associations Accounting standards, interpretations, and bulletins 13

Types of Pronouncements Issued by the FASB: Standards, Interpretations, and Staff Positions. Financial Accounting Concepts Emerging Issues Task Force Statements 14

Supply and Demand of Financial Accounting Information Demand: external parties demand financial accounting information to facilitate their resource allocation decisions Supply: Firms supply financial accounting info based on the expected economic consequences of doing so Ultimately better financial reporting will result in more efficient functioning of our capital markets 15

Accounting and Capital Allocation Review An effective process of capital allocation is critical to a healthy economy, which a. promotes productivity. b. encourages innovation. c. provides an efficient and liquid market for buying and selling securities. d. All of the above. 16

Sarbanes-Oxley Act (SOX) CEO and CFO certifications over F/S and internal controls Prohibition on loans to executive officers and directors SOX Section 404 internal control audits Audit committee members Independent Financially literate Must approve all services performed by audit firm Responsible for retaining and terminating the auditor Firm must disclose financial experts on the audit committee Certain non-audit services prohibited by audit firm Audit partner rotation Certain employment prohibitions Created Public Company Accounting Oversight Board (PCAOB) Creates auditing standards Performs CPA firm inspections Required consideration of Principles Based Accounting System! Audit firms previously subjected onlyt to Peer review 17

Who’s Who in the Regulatory Zoo? U.S. AICPA FASB “Codification” SEC The Sarbanes Oxley Act (SOX) PCAOB International (appx 100 countries) IASB IFRS IFRS for SMEs Individual countries Jurisdictional IFRS Codification eliminated need to determine which pronouncement was authoritative 18

SEC IFRS Roadmap Issued in 2008, SEC to decide by 2011 if mandatory adoption will begin in 2014 Milestones Improving accounting standards Improving funding and structure of IASB Facilitating XBRL under IFRS Updating education & licensing of US Accountants Concerns raised Cost of conversion, time to convert IFRS not as Robust as US GAAP In-Consistencies under “Jurisdictional” IFRS Private companies, Industry specific concerns (i.e., LIFO) IFRS Enforcement IFRS Principles-based model rejected by the SEC 19

International Standard Setters 20

IASB Standard Setting Potential agenda items discussed in meetings open to the public Discussion papers and exposure drafts are published for public comment The IASB solicits comments from various standard setting and regulatory bodies, as well as other users of financial statements 21

Accounting Profession Challenges Facing the Accounting Profession Nonfinancial Measurements Forward-looking Information Soft Assets Timeliness An Expectations gap The difference that exists between what the public thinks accountants and auditors should do and what accountants and auditors think they can do Consider: what is earnings management? Is it unethical? Do accountants “manage” earnings by recording accruals, adjustments, and depreciation? Transparency 22

Trust Trust drives the accounting profession SOX, PCAOB, and class action lawsuits are a result of a breach of trust From a broad perspective, we pay a heavy price for low trust: Waits at airports, audit fees Implications for personal conduct (Ethics, Character and Integrity) 23

Issues in Financial Reporting Ethics in the Environment of Financial Accounting In accounting, we frequently encounter ethical dilemmas. GAAP does not always provide an answer Doing the right thing is not always easy or obvious 24

AICPA Principles of Professional Conduct Exercise sensitive professional and moral judgments in all activities Accept the obligation to act in a way that will serve the public interest, honor the public trust and demonstrate commitment to professionalism Perform all professional responsibilities with the highest sense of integrity to maintain and broaden public confidence. Maintain objectivity, be free of conflicts of interest, be independent in fact and appearance. Observe the profession’s technical and ethical standards, strive continually to improve confidence and quality of services and discharge professional responsibility to the best of one’s ability. Observe the Principles of the Code of Professional Conduct, section 52-57, in determining the services provided to the public. 25

STANDARDS OF ETHICAL CONDUCT FOR MANAGEMENT ACCOUNTANTS (adapted from IMA) 1. COMPETENCE Maintain professional competence. Follow laws, regulations, and standards Prepare complete and clear reports and recommendations after appropriate analysis. 2. CONFIDENTIALITY Don't disclose confidential information. Ensure that subordinates do not disclose confidential information. Do not use confidential information for personal gain or advantage See next slide for items 3 & 4 26

STANDARDS OF ETHICAL CONDUCT FOR MANAGEMENT ACCOUNTANTS (adapted from IMA) continued 3. INTEGRITY Avoid actual or apparent conflicts of interest. Refuse gifts, favors, or hospitality that might influence objectivity. Refrain from subverting the organization's legitimate objectives. Recognize and communicate personal limitations. Communicate unfavorable as well as favorable information and opinions. Refrain from actions that discredit the profession. 4. OBJECTIVITY Communicate information fairly and objectively. Fully disclose all information that could be expected to influence a user's understanding. 27

Resolving Ethical Dilemmas Identify the Ethical Issues involved Identify the Stakeholders involved (persons or organizations affected by the outcome of the dilemma) Identify the alternative courses of action that can be taken Decide on the best course of action consistent with the principles of honesty, integrity, and fairness and also consistent with any existing code of ethical conduct.. 28

Resolving Ethical Dilemmas Follow the organization’s established policies for conflict resolution. If the ethical conflict is not resolved, consider the following course of action: Discuss the problem with the immediate superior except whet it appears that the superior is involved, in which case the problems should be presented initially to the next higher managerial level. If satisfactory resolutions cannot be achieved when the problem is initially presented, submit the issues to the next higher managerial level. If the immediate superior is the chief executive officer, or equivalent, the acceptable reviewing authority may be a group such as the audit committee, executive committee, board of directors, board of trustees, or owners. Contact with levels above the immediate superior should be initiated only with the superior’s knowledge, assuming the superior is not involved Continued on next slide….. 29

Resolving Ethical Dilemmas, continued Clarify relevant concepts by confidential discussion with an objective advisor to obtain an understanding of possible courses of action. If the ethical conflict still exists after exhausting all levels of internal review, the management accountant may have no other recourse on significant matters than to resign from the organization and to submit an informative memorandum to an appropriate representative of the organization. Except where legally prescribed, communication of such problems to authorities or individuals not employed or engaged by the organization is not considered appropriate.   *Institute of Management Accountants, Formerly National Association of Accountants, Statements on Management Accounting: Objectives of Management Accounting. Statement No. 1B, New York, NY., June 17, 1982. . 30

Common Features of Criminal and Ethical Misconduct Secret Problem Opportunity Rationalization

It should be modeled after the principles-based IFRS standards What does the SEC Study conclude about the U.S. financial reporting system? It is fundamentally sound, of the highest quality and needs no further improvement It is fundamentally sound and generally of the highest quality but recent corporate accounting scandals are a call to action It should be modeled after the principles-based IFRS standards Page 1 paragraph 1 and page Page 7 middle paragraph

IFRS standards are mainly rules-based What does the SEC Study conclude about International Financial Reporting Standards (IFRS)? IFRS standards are mainly rules-based Most IFRS standards are overly general and should be characterized as principles only Many of the IFRS standards are rules-based and others are overly general and could be fairly characterized as principles only Page 7 middle paragraph

SEC Study on U.S. Adoption of a Principles Based Accounting System Which does the study claim is better? Financial reporting based on a Principles-only approach Financial reporting based on objectives-oriented standards Financial reporting based on a Rules-base approach And why (what are the pros and cons of each)? Page 5, “we believe financial reporting based on objectives-oriented standards strikes an optimal balance and should increase both comparability and transparency of information as compared to either a principles-only approach or a rules-based approach to standard setting.” Principles only problems (expressed about principles-based but more applicable to principles ONLY): High-level standard with little if any operational guidance (page 4 4th paragaph) Insufficient guidance to make the standards reliably operational. (page 4 4th paragaph) Requires the exercise of judgment without providing a sufficient structure to frame the judgment (page 4 paragraph 4) Relies totally on management and auditor discretion in the application of principles resulting in loss of comparability There would be greater difficulty in seeking remedies against “bad” actors either through enforcement or litigation Regulatory agencies may not accept “good faith” judgments Advantages of Principles based (objectives oriented) standards: Focus is on the fulfilling the acctg objective of the standard which minimizes opportunities for financial engineering designed to evade the intene of the standard (page 3 #1) Each standard is drafted in accordance with objectives set by an overarching coherent framework meant to unify the accounting system as a whole (page 3 #2) Avoids exceptions, which by their vary nature are contrary to fulfilling a principled objective, create internal inconsistencies within the standard and inherently creaete a need for more detailed guidance (page 3 #3) Avoids bright line tests which are often a product of exceptions. Slight shifts in the form or structure of a transaction can cause it to move across the threshold resultingin profoundly different acctg for transactions that are eocnomically similar (page 3 #4) Provides structure and contain sufficiently detailed guidance thus lands solidly between the abstract principles only and the very specific rules only (page 3 #5) Application for professional judgment is much narrower and provides a basis for more informative financial info. Potential to improve actual comparability since they are more likely to reflect the underlying economic substance of transactions or events Degrees of freedom to achieve “desired” accounting results is minimized- relative to either a rules based or principles-only approach. Requires less professional judgement and may serve to better facilitate efforts to enforce compliance with the standards page 4 Better align the incentives of those who produce the financial info with the interest of investors which should result in more informative financial info page 7 1st paragraph Cons of Rules based approach: Bottom of page 3 Contain numerous bright-line test, which can ultimately be misused by financial engineers as they comply with the letter but not the spirit Contain numerous exceptions to the principles purportedly underlying the standards resulting in inconsistencies in acctg treatment of transactions and events with similar economic substance. The need and demand for detailed implementation guidance creates complexity and uncertainty about the application of the standard Rewards those who are willing to engineer their way around the intent of standards page 4 3rd paragraph Act of compliance rather than an act of communication, leads to ever increasing complexity as financial engineering and implementation guidance vie to keep up with one another

Pros and Cons of Rules vs Pros and Cons of Rules vs. Principle-base and Principles-only Accounting Standards 1. Rules Based: Pros: Cons: 2. Principle-based 3. Principles- only

Qualitative Characteristics HOUSE OF GAAP GAAP’s Objective is to provide Financial Information that is: Useful in investment & credit decisions Useful in assessing future cash flows About the enterprise resources, claims to resources, and changes in them Qualitative Characteristics Relevance Predictive or Feedback Value Timeliness Reliability Comparability Consistency Elements Assets Liabilities Stockholders’ Equity Other Comprehensive Income Revenues Expenses Assumptions Economic Entity Going Concern Monetary Unit Periodicity Principles Historical Cost Revenue Recognition Matching Full Disclosure Constraints Cost/Benefit Materiality Industry Practice Conservatism

Financial Reporting for Public Companies: The 10K Background – discussion of nature of business, markets, customers, and products/services. Management Discussion and Analysis (MD&A) – discussion of results of operations (including comparisons to prior years), liquidity, capital resources (including forward-looking information). Selected financial data – five or ten-year time series of selected financial and non-financial data (allows analysis of trends). Financial statements – comparative B/S (2 years), I/S (3 years), SCF (3 years), and SE (3 years). Notes and supplemental disclosures – explanations, elaborations, and supplements to information reported in the financial statements Auditor report – independent auditor’s opinion on whether the financial statements and notes are fairly presented according to generally accepted accounting principles (unqualified, qualified, adverse, or disclaimer). 37

Generally Accepted Accounting Principles (GAAP) Why do we need accounting rules? Is GAAP rigid or flexible? Is there more than one type of GAAP? U.S. IFRS Other Why do we care about “other GAAP”? Comparability Roadmap for adoption of IFRS 38