CHAPTER 1 FINANCIAL ACCOUNTING AND ACCOUNTING STANDARDS Overview The primary function of financial accounting is to provide useful financial information to users external to the business enterprise The focus of financial accounting is on the information needs of investors and creditors These users make critical resource allocation decisions that affect the nation s economy The primary means of conveying financial information to investors creditors and other external users is through financial statements and related notes In this chapter you explore important topics such as the FASB s conceptual framework that serve as a foundation for a more detailed study of financial statements the way the elements of these statements are measured and the concepts underlying these measurements and related disclosures Learning Objectives LO1 1 Describe the function and primary focus of financial accounting LO1 2 Explain the difference between cash and accrual accounting LO1 3 Define generally accepted accounting principles GAAP and discuss the historical development of accounting standards including convergence between U S and international standards LO1 4 Explain why the establishment of accounting standards is characterized as a political process LO1 5 Explain factors that encourage high quality financial reporting LO1 6 Explain the purpose of the conceptual framework LO1 7 Identify the objective and qualitative characteristics of financial reporting information and the elements of financial statements LO1 8 Describe the four basic assumptions underlying GAAP LO1 9 Describe the recognition measurement and disclosure concepts that guide accounting practice LO1 10 Contrast a revenue expense approach and an asset liability approach to accounting standard setting LO1 11 Discuss the primary differences between U S GAAP and IFRS with respect to the development of accounting standards and the conceptual framework underlying accounting standards FINANCIAL INFORMATION SUPPLIER GROUPS AND EXTERNAL USER GROUPS PROVIDERS OF FINANCIAL INFORMATION EXTERNAL USER Profit oriented companies Investors GROUPS Creditors banks bondholders other lenders Employees Labor unions Not for profit entities e g government entities charitable organizations schools Customers Suppliers Government regulatory agencies e g Internal Revenue Service Securities and Exchange Commission Households Financial intermediaries e g financial analysts stockbrokers mutual fund managers credit rating organizations ACCOUNTING STANDARD SETTING HIERARCHY OF STANDARD SETTING AUTHORITY Congress SEC Private Sector CAP APB FASB FASB Accounting Standards Codification Topics Topic Numbered General Principles 100 199 Presentation 200 299 Assets 300 399 Liabilities 400 499 Equity 500 599 Revenues 600 699 Expenses 700 799 Broad Transactions 800 899 Industry 900 999 THE FASB s STANDARD SETTING PROCESS STEP EXPLANATION 1 The Board receives requests recommendations for possible projects and reconsideration of existing standards from various sources 2 The FASB Chairman decides whether to add a project to the technical agenda subject to oversight by the Foundation s Board of Trustees and after appropriate consultation with FASB Members and others 3 The Board deliberates at one or more public meetings the various issues identified and analyzed by the staff 4 The Board issues an Exposure Draft In some projects a Discussion Paper may be issued to obtain input at an early stage that is used to develop an Exposure Draft 5 The Board holds a public roundtable meeting on the Exposure Draft if necessary 6 The staff analyzes comment letters public roundtable discussion and any other information The Board redeliberates the proposed provisions at public meetings 7 The Board issues an Accounting Standards Update describing amendments to the Accounting Standards Codification THE SARBANES OXLEY ACT Key Provisions of the Act Oversight board The five member two accountants Public Company Accounting Oversight Board has the authority to establish standards dealing with auditing quality control ethics independence and other activities relating to the preparation of audit reports or can choose to delegate these responsibilities to the AICPA Prior to the act the AICPA set auditing standards The SEC has oversight and enforcement authority Corporate executive accountability Corporate executives must personally certify the financial statements and company disclosures with severe financial penalties and the possibility of imprisonment for fraudulent misstatement Non audit services The law makes it unlawful for the auditors of public companies to perform a variety of non audit services for audit clients Prohibited services include bookkeeping internal audit outsourcing appraisal or valuation services and various other consulting services Other non audit services including tax services require pre approval by the audit committee of the company being audited Retention of workpapers Auditors of public companies must retain all audit or review work papers for seven years or face the threat of a prison term for willful violations Auditor rotation Lead audit partners are required to rotate every five years Mandatory rotation of audit firms came under consideration Conflicts of interest Audit firms are not allowed to audit public companies whose chief executives worked for the audit firm and participated in that company s audit during the preceding year Hiring of auditor Audit firms are hired by the audit committee of the board of directors of the company not by company management Internal Control Section 404 of the Act requires that company management document and assess the effectiveness of all internal control processes that could affect financial reporting The PCAOB s Auditing Standard No 2 since replaced by Auditing Standard No 5 requires that the company auditors express an opinion on whether the company has maintained effective internal control over financial reporting