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chapter 1 Financial Accounting and Its Environment 1 LEARNING OBJECTIVES 1. Define accounting and identify its objectives. 2. Distinguish among the three major types of accounting. 3. List the three primary financial statements and briefly summarize the information contained in each. 4. Identify financial statement users and the decisions they make. 5. Define generally accepted accounting principles and explain how they are determined. 6. Describe the role of auditing. 7. List the economic consequences of accounting principle choice. 8. Assess the importance of ethics in accounting. INTRODUCTION Jane Johnson is considering selling T-shirts in the parking lot during her university’s football games. Jane, of course, will do this only if she expects to make a profit.To es- timate her profits, Jane needs certain pieces of information, such as the cost of a shirt, the university’s charge for the right to conduct business on its property, the expected selling price, and the expected sales volume. Suppose Jane has developed the follow- ing estimates: Sales price per shirt $ 12 Cost per shirt $ 7 Number of shirts sold per game day 50 University fee per game day $100 Although developing estimates is tricky, let’s take these estimates as given. Based on the estimates, Jane would earn a profit of $150 per game day. Sales ($12 ⳯ 50) $600 Cost of merchandise ($7 $350) University fee 100 Total expenses 450 Net income $150 2 Financial Accounting and Its Environment 2 CHAPTER 1 Since this looks like a reasonable profit, Jane puts her plan into action.After her first game day, Jane needs to assess her success (or failure). Based on her actual results, Jane prepares the following information: Sales ($12 ⳯ 40) $480 Less expenses: Cost of merchandise ($7 ⳯ 40) $280 University fee 100 Total expenses 380 Net income $100 Jane’s business was profitable, but not as profitable as she planned.This is because Jane sold fewer shirts than she hoped, but Jane is confident that she can sell any re- maining shirts on the next game day. The preceding illustration shows two ways in which accounting can be used. First, Jane used accounting to help plan her business.That is, she used accounting to project her expected profit. Second, after Jane operated her business for a day, she used accounting to determine if, in fact, she had made a profit. In general, accounting is used during all phases of planning and operating a business. ACCOUNTING Accounting is the systematic process of measuring the economic activity of a busi- ness to provide useful information to those who make economic decisions.Account- ing information is used in many different situations.The illustration in the introduc- tory section shows how a business owner (Jane) can use accounting information. Bankers use accounting information when deciding whether or not to make a loan. Stockbrokers and other financial advisers base investment recommendations on ac- counting information, while government regulators use accounting information to de- termine if firms are complying with various laws and regulations. TYPES OF ACCOUNTING The examples mentioned in the last section explained how accounting information can be helpful in a number of situations. In fact, the field of accounting consists of sev- eral specialty areas that are based on the nature of the decision.The following sections describe the three major types of accounting, which are summarized in Exhibit 1-1. Financial Accounting Financial accounting provides information to decision makers who are external to the business.To understand the role of financial accounting, consider a large cor- poration such as IBM.The owners of corporations are called shareholders, and IBM has more than 600,000 shareholders. Obviously, each shareholder cannot partici- pate directly in the running of IBM, and because IBM needs to maintain various trade secrets, its many thousands of shareholders are not permitted access to much of the firm’s information. Because of this, shareholders delegate most of their decision- making power to the corporation’s board of directors and officers. Exhibit 1-2 con- tains an organizational chart for a typical corporation. Shareholders, however, need information to evaluate (1) the performance of the business and (2) the advisability of retaining their investment in the business. Financial accounting provides some of the information for this purpose; such information is also used by potential share- holders who are considering an investment in the business. Financial Accounting and Its Environment 3 FINANCIAL ACCOUNTING AND ITS ENVIRONMENT 3 EXHIBIT 1-1 The Three Major Types of Accounting Accounting Specialty Decision Maker Examples of Decisions Financial accounting Shareholders Buy shares Hold shares Sell shares Creditors Lend money Determine interest rates Managerial accounting Managers Set product prices Buy or lease equipment Tax Managers Comply with tax laws Minimize tax payments Assess the tax effects of future transactions EXHIBIT 1-2 Organizational Chart of a Typical Corporation Shareholders Board of Directors President Vice President Vice President Vice President of Operations of Finance of Marketing Creditors and potential creditors are also served by financial accounting. Firms of- ten seek loans from banks, insurance companies, and other lenders. Although credi- tors are not internal parties of those firms, they need information about them so that funds are loaned only to credit-worthy organizations. Financial accounting will usually provide at least some of the information needed by these decision makers. Managerial Accounting Managers make numerous decisions.These include (1) whether to build a new plant, (2) how much to spend for advertising, research, and development, (3) whether to 4 Financial Accounting and Its Environment 4 CHAPTER 1 lease or buy equipment and facilities, (4) whether to manufacture or buy component parts for inventory production, or (5) whether to sell a certain product. Managerial ac- counting provides information for these decisions.This information is usually more de- tailed and more tailor-made to decision making than financial accounting information. It is also proprietary; that is, the information is not disclosed to parties outside the firm. Sterling Collision Centers, Inc. provides a good illustration of managerial ac- counting at work.Although Sterling only has 18 shops, it hopes to put a major dent in the automotive body shop business through aggressive expansion and the introduc- tion of innovative management techniques. One of its strategies is to use computers to better track repair times, which will provide both standards for different types of repair jobs as well as measures of how individual workers perform relative to the stan- dards. By tying pay to performance, Sterling hopes to improve worker productivity. Knowledge of repair times will also help Sterling to determine estimated bids for its repair jobs. Managerial accountants play a major role in all these activities. Although distinguishing between financial and managerial accounting is convenient, the distinction is somewhat blurred. For example, financial accounting provides informa- tion about the performance of a firm to outsiders. Because this information is essentially a performance report on management, managers are appropriately interested in and in- fluenced by financial accounting information.Accordingly, the distinction between finan- cial and managerial accounting depends on who is the primary user of the information. Tax Accounting Tax accounting encompasses two related functions: tax compliance and tax plan- ning.Tax compliance refers to the calculation of a firm’s tax liability.This process en- tails the completion of sometimes lengthy and complex tax forms. Tax compliance takes place after a year’s transactions have been completed. In contrast, tax planning takes place before the fact.A business transaction can be structured in a variety of ways; a car can be purchased by securing a loan, for exam- ple, or it can be leased from the dealer.The structure of a transaction determines its tax consequences.A major responsibility of tax accountants is to provide advice about the tax effects of a transaction’s various forms.Although this activity may seem to be an element of managerial accounting, it is separately classified due to the necessary specialized tax knowledge. Other Types of Accounting A few additional types of accounting exist.Accounting information systemsare the processes and procedures required to generate accounting information.These include 1. identifying the information desired by the ultimate user, 2. developing the documents (such as sales invoices) to record the necessary data, 3. assigning responsibilities to specific positions in the firm, and 4. applying computer technology to summarize the recorded data. Another type of accounting deals with nonbusiness organizations.These or- ganizations do not attempt to earn a profit and have no owners.They exist to fulfill the needs of certain groups of individuals. Nonbusiness organizations include 1. hospitals, 2. colleges and universities, 3. churches, Financial Accounting and Its Environment 5 FINANCIAL ACCOUNTING AND ITS ENVIRONMENT 5 4. the federal, state, and local governments, 5. many other organizations such as museums, volunteer fire departments, and dis- aster relief agencies. Nonbusiness organizations have a need for all the types of accounting we have just reviewed. For example, a volunteer fire department might need to borrow money to purchase a new fire truck. Its banker would then require financial accounting in- formation to make the lending decision. Nonbusiness organizations are fundamentally different from profit-oriented firms: They have no owners and they do not attempt to earn a profit. Because of this, the analysis of the financial performance of business and nonbusiness organizations is considerably different.This text addresses only business organizations. Most colleges and universities offer an entire course devoted to the accounting requirements of non- business organizations. A CLOSER LOOK AT FINANCIAL ACCOUNTING This text is primarily concerned with financial accounting, which summarizes the past performance and current condition of a firm.An overview of financial accounting is pre- sented in Exhibit 1-3. Each element of the exhibit is discussed in the following sections. Past Transactions and Other Economic Events Past transactions and events are the raw materials for the financial accounting process. Transactions typically involve an exchange of resources between the firm and other parties. For example, purchasing equipment with cash is a transaction that would be incorporated in the firm’s financial accounting records. Purchasing equipment on credit is also a transaction; equipment is obtained inexchange for a promise to pay for it in the future. Financial accounting also incorporates significant economic events that do not in- volve exchanges with other parties. For example, assume that a firm owns an unin- sured automobile that is completely destroyed in an accident. Financial accounting would reflect the effect of this event. Keep in mind that financial accounting deals with past transactions and events. It provides information about the past performance and current financial standing of a firm. Financial accounting itself does not usually make predictions about the future.Al- though financial statement users need to assess a firm’s future prospects, financial ac- counting does not make these predictions, but it does provide information about the past and present that is useful in making predictions about the future. EXHIBIT 1-3 Overview of Financial Accounting Past Transactions Financial and Other Accounting Financial Decision Statements Makers Economic Process Events 6 Financial Accounting and Its Environment 6 CHAPTER 1 The Financial Accounting Process The financial accounting process consists of 1. categorizing past transactions and events, 2. measuring selected attributes of those transactions and events, and 3. recording and summarizing those measurements. The first step places transactions and events into categories that reflect their type or nature. Some of the categories used in financial accounting include (1) purchases of inventory (merchandise acquired for resale), (2) sales of inventory, and (3) wage payments to workers. The next step assigns values to the transactions and events. The attribute mea- sured is the fair value of the transaction on the exchange date.This is usually indicated by the amount of cash that changes hands. If equipment is purchased for a $1,000 cash payment, for example, the equipment is valued at $1,000.The initial valuation is not subsequently changed. (Some exceptions are discussed in later chapters.) This original measurement is called historical cost. The final step in the process is to record and meaningfully summarize these mea- surements. Summarizing is necessary because, otherwise, decision makers would be overwhelmed with an extremely large array of information. Imagine, for example, that an analyst is interested in Ford Motor Company’s sales for 1998. Providing a list of every sales transaction and its amount would yield unduly detailed information. Instead, the financial accounting process summarizes the dollar value of all sales during a given time period and this single sales revenue number is included in the financial statements. Financial Statements Financial statements are the end result of the financial accounting process. Firms pre- pare three major financial statements: the balance sheet, the income statement, and the statement of cash flows.The following sections briefly describe these statements. The Balance Sheet The balance sheet shows a firm’s assets, liabilities, and own- ers’equity. Assets are valuable resources that a firm owns or controls.The simplified balance sheet shown in Exhibit 1-4 includes four assets.Cash obviously has value.Ac- counts receivable are amounts owed to Newton Company by its customers; these EXHIBIT 1-4 A Balance Sheet The Newton Company Balance Sheet December 31, 2000 Assets Liabilities and Owners’ Equity Cash $ 5,000 Liabilities Accounts receivable 7,000 Accounts payable $ 8,000 Inventory 10,000 Notes payable 2,000 Equipment 7,000 Total liabilities 10,000 Owners’ equity 19,000 Total assets $29,000 Total liabilities and owners’ equity $29,000 Financial Accounting and Its Environment 7 FINANCIAL ACCOUNTING AND ITS ENVIRONMENT 7 have value because they represent future cash inflows. Inventory is merchandise ac- quired that is to be sold to customers. Newton expects its inventory to be converted into accounts receivable and ultimately into cash. Finally, equipment (perhaps deliv- ery vehicles or showroom furniture) enables Newton to operate its business. Liabilities are obligations of the business to convey something of value in the fu- ture. Newton’s balance sheet shows two liabilities. Accounts payable are unwritten promises that arise in the ordinary course of business. An example of this would be Newton purchasing inventory on credit, promising to make payment within a short period of time. Notes payable are more formal, written obligations. Notes payable of- ten arise from borrowing money. The final item on the balance sheet is owners’ equity, which refers to the own- ers’interest in the business. It is a residual amount that equals assets minus liabilities. The owners have a positive financial interest in the business only if the firm’s assets exceed its obligations. The Income Statement Just as each of us is concerned about our income, in- vestors and creditors are interested in the ability of an organization to produce income (sometimes called earnings or profits).The income statement summarizes the earn- ings generated by a firm during a specified period of time. Exhibit 1-5 contains New- ton Company’s income statement for 2000. Income statements contain at least two major sections: revenues and expenses. Revenuesare inflows of assets from providing goods and services to customers. New- ton’s income statement contains one type of revenue: sales to customers. This in- cludes sales made for cash and sales made on credit. Expenses are the costs incurred to generate revenues. Newton’s income state- ment includes three types of expenses. Cost of goods sold is the cost to Newton of the merchandise that was sold to its customers. General and administrative expenses in- clude salaries, rent, and other items.Tax expense reflects the payments that Newton must make to the Internal Revenue Service and other taxing authorities. The differ- ence between revenues and expenses is net income (or net loss if expenses are greater than revenues). The Statement of Cash Flows From a financial accounting perspective, income is not the same as cash. For example, suppose that a sale is made on credit.Will this sale be recorded on the income statement?Yes. It meets the definition of a revenue EXHIBIT 1-5 An Income Statement The Newton Company Income Statement For the Year Ended December 31, 2000 Revenues Sales $63,000 Expenses Cost of goods sold $35,000 General and administrative 20,000 Tax 3,000 Total expenses 58,000 Net Income $ 5,000 8 Financial Accounting and Its Environment 8 CHAPTER 1 transaction: an inflow of assets (the right to receive cash in the future) in exchange for goods or services. Moreover, including this transaction in the income statement pro- vides financial statement readers with useful information about the firm’s accom- plishments. However, no cash has been received. Thus, the income statement does not provide information about cash flows. Financial statement users, though, are also interested in a firm’s ability to gener- ate cash. After all, cash is necessary to buy inventory, pay workers, purchase equip- ment, and so on.The statement of cash flows summarizes a firm’s inflows and out- flows of cash. Exhibit 1-6 illustrates Newton Company’s statement of cash flows, which has three sections. One section deals with cash flows from operating activi- ties, such as the buying and selling of inventory.The second section contains infor- mation aboutinvesting activities, such as the acquisition and disposal of equipment. The final section reflects cash flows from financing activities. These activities in- clude obtaining and repaying loans, as well as obtaining financing from owners. Notes to Financial Statements A full set of financial statements includes a num- ber of notes that clarify and expand the material presented in the body of the finan- cial statements.The notes indicate the accounting principles (rules) that were used to prepare the statements, provide detailed information about some of the items in the financial statements, and, in some cases, provide alternative measures of the firm’s as- sets and liabilities. Notes to financial statements are not illustrated in this chapter because they are highly technical and apply to specific accounting topics covered in subsequent chap- ters. Notes are, however, emphasized throughout much of this book. Annual Reports All large firms, and many smaller ones, issue their financial state- ments as part of a larger document referred to as anannual report. In addition to the financial statements and their accompanying notes, the annual report includes de- scriptions of significant events that occurred during the year, commentary on future plans and strategies, and a discussion and analysis by management of the year’s results. Appendixes C and D of this text contain substantial portions of two annual reports. EXHIBIT 1-6 A Statement of Cash Flows The Newton Company Statement of Cash Flows For the Year Ended December 31, 2000 Cash flows from operating activities: Cash received from customers $61,000 Cash paid to suppliers (37,000) Cash paid for general and administrative functions (19,900) Taxes paid (3,000) Net cash provided by operating activities 1,100 Cash flows from investing activities: Purchase of equipment (2,000) Cash flows from financing activities: Net borrowings 1,000 Net increase in cash 100 Cash at beginning of year 4,900 Cash at end of year $ 5,000 Financial Accounting and Its Environment 9 FINANCIAL ACCOUNTING AND ITS ENVIRONMENT 9 Decision Makers Recall that the primary goal of financial accounting is to provide decision makers with useful information.This section identifies the major users of financial statements and describes the decisions they make. Owners Present and potential owners (investors) are prime users of financial statements.They continually assess and compare the prospects of alternative invest- ments.The assessment of each investment is often based on two variables: expected return and risk. Expected return refers to the increase in the investor’s wealth that is expected over the investment’s time horizon.This wealth increase is comprised of two parts: (1) increases in the market value of the investment and (2) dividends (periodic cash dis- tributions from the firm to its owners). Both of these sources of wealth depend on the firm’s ability to generate cash.Accordingly, financial statements can improve decision making by providing information that helps current and potential investors estimate a firm’s future cash flows. Risk refers to the uncertainty surrounding estimates of expected return.The term expected implies that the return is not guaranteed. For most investments, numerous alternative future returns are possible. For example, an investor may project that a firm’s most likely return for the upcoming year is $100,000. However, the investor rec- ognizes that this is not the only possibility.There is some chance that the firm might generate returns of $90,000 or $110,000. Still other possibilities might be $80,000 and $120,000.The greater the difference among these estimates, the greater the risk. Fi- nancial statements help investors assess risk by providing information about the his- torical pattern of past income and cash flows. Investment selection involves a trade-off between expected return and risk. In- vestments with high expected returns generally have a high risk. Each investor must assess whether investments with greater risk offer sufficiently higher expected re- turns. To illustrate the trade-off between risk and expected return, assume that an in- vestor has two choices: InvestmentA and Investment B. Each investment costs $100. The return provided by the investments during the next year depends on whether the economy experiences an expansion or recession.The following chart summarizes the possibilities: Expected Return Investment A Investment B Expansion $10 $4 Recession $ 0 $2 Assuming that expansion and recession are equally as likely, the expected return of the two investments can be calculated as follows: Investment A ($10 ⫻ .5) ⫹ ($0 ⫻ .5) ⫽ $5 Investment B ($4 ⫻ .5) ⫹ ($2 ⫻ .5) ⫽ $3 Although InvestmentA has the higher expected return, it also has the higher risk. Its return next year can vary by $10, while Investment B’s return can vary by only $2. Investors must decide for themselves whether InvestmentA’s higher expected return is worthwhile, given its greater risk. 10 Financial Accounting and Its Environment 10 CHAPTER 1 Creditors The lending decision involves two issues: whether or not credit should be extended, and the specification of a loan’s terms. For example, consider a bank loan officer evaluating a loan application.The officer must make decisions about the amount of the loan (if any), interest rate, payment schedule, and collateral. Because repayment of the loan and interest will rest on the applicant’s ability to generate cash, lenders need to estimate a firm’s future cash flows and the uncertainty surrounding those flows.Although investors generally take a long-term view of a firm’s cash gen- erating ability, creditors are concerned about this ability only during the loan period. Lenders are not the only creditors who find financial statements useful. Suppliers often sell on credit, and they must decide which customers will or will not honor their obligations. Other Users A variety of other decision makers find financial statements helpful. Some of these decision makers and their decisions include the following: 1. Financial analysts and advisors. Many investors and creditors seek expert ad- vice when making their investment and lending decisions.These experts use fi- nancial statements as a basis for their recommendations. 2. Customers.The customers of a business are interested in a stable source of sup- ply. They can use financial statements to identify suppliers that are financially sound. 3. Employees and labor unions.These groups have an interest in the viability and profitability of firms that employ them or their members.As described in Reality Check 1-1, unions in the airline industry have recently made several important de- cisions based, in part, on financial statements. 4. Regulatory authorities. Federal and state governments regulate a large array of business activities.The Securities and Exchange Commission ( SEC ) is a prominent example. Its responsibility is to ensure that capital markets, such as the NewYork Stock Exchange, operate smoothly.To help achieve this, corporations are required to make full and fair financial disclosures.The SEC regularly reviews firms’finan- cial statements to evaluate the adequacy of their disclosures. Reality Check 1-2 de- scribes another regulatory use of accounting information. The accounting profession views financial statements as being general purpose. They are intended to meet the common information needs of a wide variety of users, such as those in the preceding list. REALITY CHECK 1-1 United Airlines: Employees of United Airlines gained controlling ownership of United’s paUALtCorporation, by agreeing to billions of dollars in wage and benefit concessions. The employees needed to estimate theUALlusoof that they could determine the extent of the wages and benefits to sacrifice. Financial statements are frequently used in valuing businesses. Northwest Airlines: In 1993, Northwest asked its pilots to forgo $886 million in wages and benefits over three years. Northwest’s reported 1993 loss of $115 million played a role in securing the pilots’ agreement. However, in 1997, Northwest reported a profit of $597 million. As you might imagine, the pilots became much more assertive in their bar- gaining, asking for wage increases, profit sharing, and bonuses. Financial Accounting and Its Environment 11 FINANCIAL ACCOUNTING AND ITS ENVIRONMENT 11 REALITY CHECK 1-2 California has perhaps the country’s toughest standards for vehicle emissions. One aspect of its program requires the ma- jor automakers to generate 10% of their California sales from electric vehicles by 2003. Compliance with this regulation will be assessed from financial accounting information. GENERALLY ACCEPTED ACCOUNTING PRINCIPLES Decision makers often wish to compare the financial statements of several firms.To permit valid comparisons, the firms’statements need to be based on the same set of accounting principles, which are the rules and procedures used to produce the fi- nancial statements. To illustrate how one event might be accounted for in more than one way, con- sider a movie production company that has just produced a new film costing $25,000,000. Assume that a balance sheet is to be prepared before the film is mar- keted. Does the firm have a $25,000,000 asset?The real value of the film rests on its capability to generate future revenues.A successful film will generate revenue that is many times greater than its cost; an unsuccessful film may not even cover its cost.At the balance sheet date, the future revenue is unknown. As a potential investor or creditor, how would you prefer that this film be re- flected on the balance sheet?Two obvious alternatives are $25,000,000 and $0.The latter is clearly more conservative; it results in a lower asset value. Some financial state- ment readers would prefer this conservative approach. Others would maintain that management expects to reap at least $25,000,000 in revenue; otherwise, they would not have undertaken the project.Thus, they feel that $25,000,000 is the most reason- able figure.There is no obvious answer to this issue. However, to permit valid com- parisons of various firms’ balance sheets, the same accounting principle should be used. Current accounting practice, in general, is to record assets at historical cost; in this case, the movie would be recorded at $25,000,000. The Financial Accounting Standards Board The most widely used set of accounting principles is referred to as generally accepted accounting principles GAAP ).GAAP is currently set by the FinancialAccounting Stan- dards Board (FASB).The FASB is a private organization located in Norwalk, Connecti- cut.The board is comprised of seven voting members who are supported by a large staff.As of June 1, 1998, tFASB issued 132 Statements of FinancialAccounting Stan- dards (SFASs).These standards are the primary source ofGAAP . The FASB ’s predecessor was the Accounting Principles Board ( APB ).The APB issued 31 Opinions, which are still part oGAAP , unless they have been superseded by an SFAS. The FASB faces a difficult task in seGAAPg . Financial accounting is not a natural science; no fundamental accounting laws have been proven to be correct.Accounting exists to provide information useful for decision making.TFASB ’s responsibility is to specify the accounting principles that will result in highly useful information. How- ever, given that financial statement users are rather diverse, this is not a simple task. The FASB employs an elaborate due process procedure prior to the issuance of an SFAS. Exhibit 1-7 summarizes the FASB ’s procedures.This process is designed to en- sure that all those who wish to participate in the setting of accounting standards have an opportunity to do so. 12 Financial Accounting and Its Environment 12 CHAPTER 1 EXHIBIT 1-7 FASB’s Due Process Procedures Placement on Agenda Issuance of an Invitation to Comment or a Discussion Memorandum Public Hearings Issuance of an Exposure Draft Public Hearings Issuance of a Statement of Financial Accounting Standard The FASB publishes several preliminary documents during its deliberations on each SFAS. The documents include an Invitation to Comment or a Discussion Memoran- dum that identify the fundamental accounting issues to be addressed. AnExposure Draft is theFASB’s initial attempt at resolving such issues.These documents are widely disseminated, and interested parties are invited to communicate with the board, both in writing and by making presentations at public hearings.An affirmative vote of five of the sevenFASB members is needed to issue a new SFAS. An interesting aspect oGAAP is that more than one accounting method (or prin- ciple) is acceptable for some transactions. For example, there are several acceptable inventory accounting methods.This provides managers with considerable discretion in preparing their financial statements. Several accountants, judges, and legislators have criticized this situation.They believe that only a single method should be allowed for a given transaction. In generASB th is attempting to narrow the availability of multiple acceptable accounting procedures. The Securities and Exchange Commission The Securities and Exchange Commission ( SEC ) was created by the Securities Ex- changeAct of 1934.The act empowered the SEC to set accounting principles and fi- Financial Accounting and Its Environment 13 FINANCIAL ACCOUNTING AND ITS ENVIRONMENT 13 nancial disclosure requirements for the corporations that it regulates.These corpora- tions are quite large and have ownership interests that are widely dispersed among the public. Such corporations are referred to as publicly held.Thus, for at least pub- licly held corporations, tSEC has legislative authority toGAAP .This raises a ques- tion about the relationship between theSEC and the FASB. The FASB is a private (nongovernment) organization whose authority to seGAAP derives from two sources. First, the business community and the accounting profes- sion, by acceptingFASB rulings, provide one source of support. In the United States, accounting principles have traditionally been set in the private sector, anFASBe’s standards have received a reasonable amount of support.At the same time, not every- one is entirely happy with the FASB ’s pronouncements. Some people criticize the FASB for issuing standards that are too complex and too costly to implement. Part of the FASB’s responsibility is to balance financial statement users’demands for better in- formation with the costs incurred by those who provide that information. The second source of the FASB’s standard-setting authority is tSEC. Although the SEC has legislative authority to GAAP for publicly held corporations, it prefers to rely on the accounting profession’s private rule-making bodies to do this. In fact, the SEC has formally indicated that it will recognGAAP as prescribed by theFASB . The SEC does, however, retain the right to overrulFASB pronouncements, and it oc- casionally exercises this right. Exhibit 1-8 shows the relationships among the different organizations involved in setting accounting standards. THE ROLE OF AUDITING A firm’s management is primarily responsible for preparing its financial statements.Yet the financial statements can be viewed as a report on the performance of manage- ment. The conflict of interest in this situation is apparent. As a result, the financial statements of all corporations reporting to thSEC must be audited. Audits are re- quired because they enhance the credibility of the financial statements.The financial statements of many privately held businesses are also subject to an audit. Banks, for EXHIBIT 1-8 Groups Involved in Setting Accounting Standards President/Congress SEC FASB Business Community GAAP 14 Financial Accounting and Its Environment 14 CHAPTER 1 example, require many loan applicants to submit audited financial statements so that lending decisions can be based on credible financial information. One of the most important auditing relationships, which are depicted in Exhibit 1-9, is the role of the independent certified public accountanCPA) who conducts the audit.CPA s are licensed by the individual states by meeting specified educational and experience requirements and passing the uniform CPA exam, which takes two days to complete. CPAs are also required to attend continuing professional education classes and participate in a peer review process, whereby one CPA firm reviews and critiques the work of another firm.1 Exhibit 1-10 contains an auditor’s report.The wording has been carefully chosen by the accounting profession to communicate precisely what an audit does and does not do. The first paragraph identifies the company, the specific financial statements that were audited, and the years of the audit. Management’s responsibility for the fi- nancial statements is also acknowledged. The second paragraph states that the audit has been conducted in accordance with generally accepted auditing standards ( GAAS ). These standards have been developed by the accounting profession to provide guidance in the performance of an audit, which consists of an examination of evidence supporting the financial state- ments. Because audits are costly, auditors cannot retrace the accounting for every transaction. Accordingly, only a sample of a corporation’s many transactions are re- viewed. Based on the results of these tests, the auditor draws an inference about the fairness of the financial statements. The second paragraph also notes that audits provide reasonable (not absolute) as- surance that financial statements are free of material error.The lesser standard of rea- sonable assurance is employed for two reasons. First, auditors do not examine every transaction and thus they are unable to state conclusions in too strong a fashion. Sec- EXHIBIT 1-9 Auditing Relationships Shareholders/ Board of Directors Company Management GAAP Financial Statements Audit Opinion CPA Firm 1 More detailed descriptions of the accounting profession are provided inAppendix B. Financial Accounting and Its Environment 15 FINANCIAL ACCOUNTING AND ITS ENVIRONMENT 15 EXHIBIT 1-10 An Auditor’s Report To the Stockholders and Board of Directors of Merck & Co., Inc.: We have audited the accompanying consolidated balance sheet of Merck & Co., Inc. (a New Jersey corporation) and subsidiaries as of December 31, 1997 and 1996, and the related consolidated statements of income, retained earnings, and cashflows for each of the three years in the period ended December 31, 1997. These financial statements are the responsibility of the company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assur- ance about whether the financial statements are free of material misstatement. An audit in- cludes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Merck & Co., Inc. and subsidiaries as of December 31, 1997 and 1996, and the results of their operations and cash flows for each of the three years in the period ended December 31, 1997, in conformity with generally accepted ac- counting principles. New York, New York ARTHUR ANDERSEN LLP January 27, 1998 ond, even if auditors were to examine every transaction, collusion between two par- ties could make the detection of an error virtually impossible. The third paragraph contains theauditor’s opinion.The opinion reflects the au- ditor’s professional judgment regarding whether the financial statements are fairly pre- sented in accordance with GAAP . Some readers mistakenly assume that auditors“cer- tify”the financial statements.Auditors do not provide financial statement readers with that level of assurance.Auditors do not guarantee the correctness of the financial state- ments. Auditors merely express an educated professional judgment based on audit tests conducted according to acceptable professional standards. An analogy can be drawn to a medical doctor diagnosing a patient. Based on a se- ries of appropriate tests, the doctor develops a diagnosis. In many cases, the doctor cannot be absolutely certain of the diagnosis. This is why, for example, exploratory surgery is sometimes necessary. Doctors do not issue guarantees, and neither do auditors. The report that appears in Exhibit 1-10 is an unqualified opinion, indicating that Arthur Andersen has no reservations about the reasonableness of Merck’s financial statements. However, a variety of concerns may arise that would cause the auditor to qualify the opinion or to include additional explanatory material. We know, for ex- ample, that there are several acceptable methods of accounting for inventory. If a 16 Financial Accounting and Its Environment 16 CHAPTER 1 company were to change its inventory method from one year to the next, the com- parability of the financial statements for those years would be impaired, and financial statement readers would certainly want to be aware of such a situation. Because of this, changes in accounting methods are noted in the auditor’s report. ECONOMIC CONSEQUENCES AND MANAGERIAL PREFERENCES FOR ACCOUNTING PRINCIPLES The selection of accounting principles occurs at two levels. First, theetermines which principles constituteGAAP . In a number of instances, however, theSB allows the use of more than one method. Thus, corporate managers also make accounting policy decisions.Which criteria are used by tFASB and corporate managers to select accounting principles? The FASB’s primary objective is to select accounting principles that provide use- ful information to financial statement readers. However, businesses incur costs to gen- erate the information required by theFASB . Thus, theFASB attempts to balance the costs and benefits of its rulings. Some members of the financial community suggest that corporate managers act in the same way. For example, in choosing an inventory method, managers balance the costs of implementing each method with the quality of the information that each method yields.A more sophisticated view recognizes that accounting principles have economic consequences to managers and their firms, and that these consequences are considered by managers when choosing accounting principles. Beyond imple- mentation costs, accounting principles can affect the wealth of managers and firms via (1) compensation plans, (2) debt contracts, and (3) political costs. Compensation Plans Many corporations pay their top managers a fixed salary plus an annual bonus, which is often a percentage of reported net income.A number of bonus agreements include a floor and a ceiling on the bonus.The floor requires that net income must exceed a predetermined amount before the bonus is activated.The ceiling places a limit on the size of the bonus; once the annual bonus reaches the ceiling, additional increases in net income no longer increase the bonus. Bonus plans are intended to align the interests of managers and shareholders. Managers frequently face alternative courses of action, where one course is in their best interest, and another course is in the shareholders’best interest. For example, a manager’s career might be aided by expanding the business (empire building), even when such expansion is not particularly profitable and is not in the shareholders’best interest. Expansion may result in more prestige and visibility for the firm and its man- agers, thus enhancing a manager’s employment opportunities. Because (1) bonus plans motivate managers to make decisions that increase net income and (2) in- creased net income is usually in the shareholders’best interest, the goals of these two groups come more in line when a manager’s compensation depends on reported net income. Given that managers’compensation is tied to reported accounting earnings, how would we expect managers to select accounting principles? Most managers probably consider the effect that different accounting principles have on net income, and con- sequently on their compensation. In particular, bonuses often motivate managers to select accounting methods that increase reported net income. Financial Accounting and Its Environment 17 FINANCIAL ACCOUNTING AND ITS ENVIRONMENT 17 Debt Contracts Lenders are concerned about limiting their risk and maximizing the probability that principal and interest will be paid. Debt contracts between borrowers and lenders can help accomplish this. Many of these contracts impose constraints on the behav- ior of borrowers. For example, some contracts limit the total amount of debt a bor- rower can incur. In such cases, measurement of the borrower’s debt is based on the liabilities reported in the balance sheet.As another example, some contracts limit the cash dividends a borrower can distribute. This limitation is defined in terms of re- tained earnings, a component of owners’ equity that appears on the balance sheet. Penalties exist for violating debt contracts.These include 1. an interest rate increase, 2. an increase in collateral (assets pledged to secure the debt), 3. a one-time renegotiation fee, and 4. an acceleration in the maturity date. Because these contracts are defined in terms of financial statement numbers, the use of accounting principles that increase reported net income can reduce the chances of contract violation. Accordingly, the likelihood of violating debt contracts is another influence on managers’accounting policy choices. Political Costs Federal and state governments have the power to regulate many operations of a busi- ness. Pollutant emissions and employment practices are just two illustrations. Gov- ernments also have the power to tax corporations. Because regulation and taxation are costly to firms, managers can be expected to take actions that minimize these costs. Because these costs are imposed via the political process, they are referred to as political costs. Some accountants suggest that highly profitable firms are more exposed to polit- ical costs than less profitable ones. Relatively profitable firms are more likely to be the target of antitrust investigations or special tax assessments. For example, in the mid- 1970s, firms in the oil industry earned unusually high profits due to a steep rise in oil prices. As a result, Congress enacted the Windfall ProfitsTax, which subjected these companies to an additional tax on their earnings. More recently, Microsoft, Inc. has been the target of intense scrutiny by federal regulators because of its dominance in the computer operating system market and its resultant profitability. Some accountants also argue that larger firms are more susceptible to regulation and taxation because their size attracts more attention.Accordingly, the managers of larger firms are particularly motivated to undertake actions that minimize political costs. One of these actions is the selection of accounting principles that reduce re- ported net income. Note that compensation plans and debt contracts motivate man- agers to select accounting principles that increase reported income, whereas political costs have the opposite effect. The Two Roles of Financial Accounting At the beginning of this chapter, the informational role of financial accounting was emphasized. From this perspective, both the FASB and corporate managers select ac- counting principles that yield the most useful information. However, as shown above, accounting principles also have economic consequences.These consequences arise 18 Financial Accounting and Its Environment 18 CHAPTER 1 in several ways. First, accounting serves as a basis for contracting.That is, some con- tracts (compensation plans and debt contracts) are based on accounting numbers. Be- cause different accounting principles result in different accounting numbers, the choice of accounting principles can modify the terms of these contracts. Second, ac- counting principles may affect a firm’s exposure to political costs, such as taxes and regulation. Finally, the costs to implement different accounting principles vary. Some accounting principles are quite complex and costly, whereas others are rather simple. For all these reasons, accounting principles can affect the wealth of a firm and its managers. The managers have an obvious incentive to select the principles that in- crease their wealth. Such an incentive may conflict with the notion that managers se- lect accounting principles to provide useful information. This implies that financial statement readers must carefully evaluate the accounting principles used by a firm. The selection may not result in the most useful financial statement information. In subsequent chapters, managers’selections of accounting principles will be examined from both informational and economic incentive perspectives. The Political Nature of Accounting Standard Setting Economic incentives associated with accounting principles might motivate an addi- tional element of managerial behavior. As mentioned in an earlier section, the FASB conducts an elaborate due process procedure prior to issuing an accounting standard. This process provides corporate m
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