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Chapter 1 Introduction to Financial Reporting U sers of financial statements include a company's managers, stockholders, bondholders, security analysts, suppliers, lending institutions, employees, labor unions, regulatory authorities, and the general public. These are internal and external stakeholder groups. They use the financial reports to make decisions. For example, potential investors use the financial reports as an aid in deciding whether to buy the stock. Suppliers use the financial reports to decide whether to sell merchandise to a company on credit. Labor unions use the financial reports to help determine their demands when they negotiate for employees. Management could use the financial reports to determine the company's profitability. Demand for financial reports exists because users believe that the reports help them in decision making. In addition to the financial reports, users often consult competing information sources, such as new wage contracts and economyoriented releases. This book concentrates on using financial accounting information properly. A basic understanding of generally accepted accounting principles and traditional assumptions of the accounting model are introduced. This aids the user in recognizing the limits of financial reports. The ideas that underlie financial reports have developed over several hundred years. This development continues today to meet the needs of a changing society. A review of the evolution of generally accepted accounting principles and the traditional assumptions of the accounting model should help the reader understand the financial reports and thus analyze them better. Development of Generally Accepted Accounting Principles (GAAP) in the United States Generally accepted accounting principles (GAAP) are accounting principles that have substantial authoritative support: The accountant must be familiar with acceptable reference sources in order to decide whether any particular accounting principle has substantial authoritative support. The formal process of developing accounting principles that exist today in the United States began with the Securities Acts of 1933 and 1934. Prior to these securities acts, the New York Stock Exchange (NYSE), which was established in 1792, was the primary mechanism for establishing specific requirements for the disclosure of financial information. These requirements could be described as minimal and only applied to corporations whose shares were listed on the NYSE. The prevailing view of management was that financial information was for management's use. 2 Chapter 1 Introduction to Financial Reporting The stock market crash of 1929 provoked widespread concern about external financial disclosure. Some alleged that the stock market crash was substantially influenced by the lack of adequate financial reporting requirements to investors and creditors. The Securities Act of 1933 was designed to protect investors from abuses in financial reporting that developed in the United States. This act was intended to regulate the initial offering and sale of securities in interstate commerce. In general, the Securities Exchange Act of 1934 was intended to regulate securities trading on the national exchanges, and it was under this authority that the Securities and Exchange Commission (SEC) was created. In effect, the SEC has the authority to determine GAAP and to regulate the accounting profession. The SEC has elected to leave much of the determination of GAAP and the regulation of the accounting profession to the private sector. At times, the SEC will issue its own standards. Currently, the SEC issues Regulation S-X, which describes the primary formal financial disclosure requirements for companies. The SEC also issues Financial Reporting Releases (FRRs) that pertain to financial reporting requirements. Regulation S-X and FRRs are part of GAAP and are used to give the SEC's official position on matters relating to financial statements. The formal process that exists today is a blend of the private and public sectors. A number of parties in the private sector have played a role in the development of GAAP. The American Institute of Certified Public Accountants (AICPA) and the Financial Accounting Standards Board (FASB) have had the most influence. AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS (AICPA) The AICPA is a professional accounting organization whose members are certified public accountants (CPAs). During the 1930s, the AICPA had a special committee working with the New York Stock Exchange on matters of common interest. An outgrowth of this special committee was the establishment in 1939 of two standing committees, the Committee on Accounting Procedures and the Committee on Accounting Terminology. These committees were active from 1939 to 1959 and issued 51 Accounting Research Bulletins (ARBs). These committees took a problem-by-problem approach, because they tended to review an issue only when there was a problem related to that issue. This method became known as the brushfire approach. They were only partially successful in developing a well-structured body of accounting principles. ARBs are part of GAAP unless they have been superseded. In 1959, the AICPA replaced the two committees with the Accounting Principles Board (APB) and the Accounting Research Division. The Accounting Research Division provided research to aid the APB in making decisions regarding accounting principles. Basic postulates would be developed that would aid in the development of accounting principles, and the entire process was intended to be based on research prior to an APB decision. However, the APB and the Accounting Research Division were not successful in formulating broad principles. The combination of the APB and the Accounting Research Division lasted from 1959 to 1973. During this time, the Accounting Research Division issued 14 Accounting Research Studies. The APB issued 31 Opinions (APBOs) and four Statements (APBSs). The Opinions represented official positions of the Board, whereas the Statements represented the views of the Board but not the official opinions. APBOs are part of GAAP unless they have been superseded. Various sources, including the public, generated pressure to find another way of developing GAAP. In 1972, a special study group of the AICPA recommended another approach the establishment of the Financial Accounting Standards Board (FASB). The AICPA adopted these recommendations in 1973. FINANCIAL ACCOUNTING STANDARDS BOARD (FASB) The structure of the FASB is as follows: A panel of electors is selected from nine organizations. They are the AICPA, the Financial Executives Institute, the Institute of Management Accountants, the Financial Analysts Federation, the American Accounting Association, the Security Industry Association, and three not-for-profit organizations. The electors appoint Chapter 1 Introduction to Financial Reporting the board of trustees that governs the Financial Accounting Foundation (FAF). There are 16 trustees. The FAF appoints the Financial Accounting Standards Advisory Council (FASAC) and the FASB. There are approximately 30 members of the FASAC. This relatively large number is to obtain representation from a wide group of interested parties. The FASAC is responsible for advising the FASB. There are seven members of the FASB. Exhibit 1-1 illustrates the structure of the FASB. Exhibit 1-1 Electors STRUCTURE OF THE FASB Appoint Board of Trustees t oin App Financial Accounting Standards Advisory Council (FASAC) Advise Govern Financial Accounting Foundation (FAF) Appoint Financial Accounting Standards Board (FASB) The FASB issues four types of pronouncements: 1. Statements of Financial Accounting Standards (SFASs). These Statements establish GAAP for specific accounting issues. SFASs are part of GAAP unless they have been superseded. 2. Interpretations. These pronouncements provide clarifications to previously issued standards, including SFASs, APB Opinions, and Accounting Research Bulletins. The interpretations have the same authority and require the same majority votes for passage as standards (a supermajority of five or more of the seven members). Interpretations are part of GAAP unless they have been superseded. 3. Technical bulletins. These bulletins provide timely guidance on financial accounting and reporting problems. They may be used when the effect will not cause a major change in accounting practice for a number of companies and when they do not conflict with any broad fundamental accounting principle. Technical bulletins are part of GAAP unless they have been superseded. 4. Statements of Financial Accounting Concepts (SFACs). These Statements provide a theoretical foundation upon which to base GAAP. They are the output of the FASB's Conceptual Framework project, but they are not part of GAAP. OPERATING PROCEDURE FOR STATEMENTS OF FINANCIAL ACCOUNTING STANDARDS (SFASS) The process of considering a SFAS begins when the Board elects to add a topic to its technical agenda. The Board receives suggestions and advice on topics from many sources, including the FASAC, the SEC, the AICPA, and industry organizations. 3 4 Chapter 1 Introduction to Financial Reporting For its technical agenda, the Board considers only \"broken\" items. In other words, the Board must be convinced that a major issue needs to be addressed in a new area or an old issue needs to be reexamined. The Board must rely on staff members for the day-to-day work on projects. A project is assigned a staff project manager, and informal discussions frequently take place among Board members, the staff project manager, and staff. In this way, Board members gain an understanding of the accounting issues and the economic relationships that underlie those issues. On projects with a broad impact, a Discussion Memorandum (DM) or an Invitation to Comment is issued. A Discussion Memorandum presents all known facts and points of view on a topic. An Invitation to Comment sets forth the Board's tentative conclusions on some issues related to the topic or represents the views of others. The Discussion Memorandum or Invitation to Comment is distributed as a basis for public comment. There is usually a 60-day period for written comments, followed by a public hearing. A transcript of the public hearing and the written comments become part of the public record. Then the Board begins deliberations on an Exposure Draft (ED) of a proposed Statement of Financial Accounting Standards. When completed, the Exposure Draft is issued for public comment. The Board may call for written comments only, or it may announce another public hearing. After considering the written comments and the public hearing comments, the Board resumes deliberations in one or more public Board meetings. The final Statement must receive affirmative votes from five of the seven members of the Board. The Rules of Procedure require dissenting Board members to set forth their reasons in the Statement. Developing a Statement on a major project generally takes at least two years, sometimes much longer. Some people believe that the time should be shortened to permit faster decision making. The FASB standard-setting process includes aspects of accounting theory and political aspects. Many organizations, companies, and individuals have input into the process. Some input is directed toward achieving a standard less than desirable in terms of a strict accounting perspective. Often, the end result is a standard that is not the best representation of economic reality. FASB CONCEPTUAL FRAMEWORK The Conceptual Framework for Accounting and Reporting was on the agenda of the FASB from its inception in 1973. The Framework is intended to set forth a system of interrelated objectives and underlying concepts that will serve as the basis for evaluating existing standards of financial accounting and reporting. Under this project, the FASB has established a series of pronouncements, Statements of Financial Accounting Concepts (SFACs), intended to provide the Board with a common foundation and the basic reasons for considering the merits of various alternative accounting principles. SFACs do not establish GAAP; rather, the FASB eventually intends to evaluate current principles in terms of the concepts established. To date, the Framework project has issued seven Concept Statements: 1. Statement of Financial Accounting Concepts No. 1, \"Objectives of Financial Reporting by Business Enterprises.\" 2. Statement of Financial Accounting Concepts No. 2, \"Qualitative Characteristics of Accounting Information.\" 3. Statement of Financial Accounting Concepts No. 3, \"Elements of Financial Statements of Business Enterprises.\" 4. Statement of Financial Accounting Concepts No. 4, \"Objectives of Financial Reporting by Nonbusiness Organizations.\" 5. Statement of Financial Accounting Concepts No. 5, \"Recognition and Measurement in Financial Statements of Business Enterprises.\" 6. Statement of Financial Accounting Concepts No. 6, \"Elements of Financial Statements\" (a replacement of No. 3). 7. Statement of Financial Accounting Concepts No. 7, \"Using Cash Flow Information and Present Value in Accounting Measurements.\" Chapter 1 Introduction to Financial Reporting Concepts Statement No. 1, issued in 1978, deals with identifying the objectives of financial reporting for business entities and establishes the focus for subsequent concept projects for business entities. Concepts Statement No. 1 pertains to general-purpose external financial reporting and is not restricted to financial statements. The following is a summary of the highlights of Concepts Statement No. 1.1 1. Financial reporting is intended to provide information useful in making business and economic decisions. 2. The information should be comprehensible to those having a reasonable understanding of business and economic activities. These individuals should be willing to study the information with reasonable diligence. 3. Financial reporting should be helpful to users in assessing the amounts, timing, and uncertainty of future cash flows. 4. The primary focus is information about earnings and its components. 5. Information should be provided about the economic resources of an enterprise and the claims against those resources. Issued in May 1980, \"Qualitative Characteristics of Accounting Information\" (SFAC No. 2) examines the characteristics that make accounting information useful for investment, credit, and similar decisions. Those characteristics of information that make it a desirable commodity can be viewed as a hierarchy of qualities, with understandability and usefulness for decision making of most importance (see Exhibit 1-2). Relevance and reliability, the two primary qualities, make accounting information useful for decision making. To be relevant, the information needs to have predictive and feedback value and must be timely. To be reliable, the information must be verifiable, subject to representational faithfulness, and neutral. Comparability, which includes consistency, interacts with relevance and reliability to contribute to the usefulness of information. The hierarchy includes two constraints. To be useful and worth providing, the information should have benefits that exceed its cost. In addition, all of the qualities of information shown are subject to a materiality threshold. SFAC No. 6, \"Elements of Financial Statements,\" which replaced SFAC No. 3 in 1985, defines 10 interrelated elements directly related to measuring performance and financial status of an enterprise. The 10 elements are defined as follows:2 1. Assets. Assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. 2. Liabilities. Liabilities are probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events. 3. Equity. Equity is the residual interest in the assets of an entity that remains after deducting its liabilities: Equity = Assets - Liabilities 4. Investments by owners. Investments by owners are increases in equity of a particular business enterprise resulting from transfers to the enterprise from other entities of something of value to obtain or increase ownership interests (or equity) in it. Assets, most commonly received as investments by owners, may also include services or satisfaction or conversion of liabilities of the enterprise. 5. Distribution to owners. Distribution to owners is a decrease in equity of a particular business enterprise resulting from transferring assets, rendering services, or incurring liabilities by the enterprise to owners. Distributions to owners decrease ownership interest (or equity) in an enterprise. 6. Comprehensive income. Comprehensive income is the change in equity (net assets) of a business enterprise during a period from transactions and other events and circumstances from nonowner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners. 5 6 Chapter 1 Introduction to Financial Reporting Text not available due to copyright restrictions 7. Revenues. Revenues are inflows or other enhancements of assets of an entity or settlements of its liabilities (or a combination of both) from delivering or producing goods, rendering services, or other activities that constitute the entity's ongoing major or central operations. 8. Expenses. Expenses are outflows or other consumption or using up of assets or incurrences of liabilities (or a combination of both) from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity's ongoing major or central operations. 9. Gains. Gains are increases in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity during a period except those that result from revenues or investments by owners. 10. Losses. Losses are decreases in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity during a period except those that result from expenses or distributions to owners. \"Objectives of Financial Reporting by Nonbusiness Organizations\" (SFAC No. 4) was completed in 1980. Organizations that fall within the focus of this statement include churches, foundations, and human-service organizations. Performance indicators for nonbusiness organizations Chapter 1 Introduction to Financial Reporting include formal budgets and donor restrictions. These types of indicators are not ordinarily related to competition in markets. Issued in 1984, \"Recognition and Measurement in Financial Statements of Business Enterprises\" (SFAC No. 5) indicates that an item, to be recognized, should meet four criteria, subject to the cost-benefit constraint and materiality threshold:3 1. 2. 3. 4. Definition. The item fits one of the definitions of the elements. Measurability. The item has a relevant attribute measurable with sufficient reliability. Relevance. The information related to the item is relevant. Reliability. The information related to the item is reliable. This concept statement identifies five different measurement attributes currently used in practice and recommends the composition of a full set of financial statements for a period. The following are five different measurement attributes currently used in practice:4 1. 2. 3. 4. 5. Historical cost (historical proceeds) Current cost Current market value Net realizable (settlement) value Present (or discounted) value of future cash flows This concept statement probably accomplished little, relating to measurement attributes, because a firm, consistent position on recognition and measurement could not be agreed upon. It states: \"Rather than attempt to select a single attribute and force changes in practice so that all classes of assets and liabilities use that attribute, this concept statement suggests that use of different attributes will continue.\"5 SFAC No. 5 recommended that a full set of financial statements for a period should show the following:6 1. 2. 3. 4. 5. Financial position at the end of the period Earnings (net income) Comprehensive income (total nonowner change in equity) Cash flows during the period Investments by and distributions to owners during the period At the time of issuance of SFAC No. 5, financial position at the end of the period and earnings (net income) were financial statements being presented. Comprehensive income, cash flows during the period, and investments by and distributions to owners during the period are financial statements (disclosures) that have been subsequently developed. All of these financial statements (disclosures) will be extensively covered in this book. SFAC No. 7, issued in February 2000, provides general principles for using present values for accounting measurements. It describes techniques for estimating cash flows and interest rates and applying present value in measuring liabilities. The FASB Conceptual Framework for Accounting and Reporting project represents the most extensive effort undertaken to provide a conceptual framework for financial accounting. Potentially, the project can have a significant influence on financial accounting. Additional InputAmerican Institute of Certified Public Accountants (AICPA) As indicated earlier, the AICPA played the primary role in the private sector in establishing GAAP prior to 1973. However, the AICPA continues to play a part, primarily through its Accounting Standards Division. The Accounting Standards Executive Committee (AcSEC) serves as the official voice of the AICPA in matters relating to financial accounting and reporting standards. 7 8 Chapter 1 Introduction to Financial Reporting The Accounting Standards Division published numerous documents considered as sources of GAAP. These include Industry Audit Guides, Industry Accounting Guides, and Statements of Position (SOPs). Industry Audit Guides and Industry Accounting Guides are designed to assist auditors in examining and reporting on financial statements of companies in specialized industries, such as insurance. SOPs were issued to influence the development of accounting standards. Some SOPs were revisions or clarifications to recommendations on accounting standards contained in Industry Audit Guides and Industry Accounting Guides. Industry Audit Guides, Industry Accounting Guides, and SOPs were considered a lower level of authority than FASB Statements of Financial Accounting Standards, FASB Interpretations, APB Opinions, and Accounting Research Bulletins. However, since the Industry Audit Guides, Industry Accounting Guides, and SOPs deal with material not covered in the primary sources, they, in effect, became the guide to standards for the areas they cover. They are part of GAAP unless they have been superseded. Emerging Issues Task Force (EITF) The FASB established the Emerging Issues Task Force (EITF) in July 1984 to help identify emerging issues affecting reporting and problems in implementing authoritative pronouncements. The Task Force has 15 memberssenior technical partners of major national CPA firms and representatives of major associations of preparers of financial statements. The FASB's Director of Research and Technical Activities serves as Task Force chairperson. The SEC's Chief Accountant and the chairperson of the AICPA's Accounting Standards Executive Committee participate in Task Force meetings as observers. The SEC's Chief Accountant has stated that any accounting that conflicts with the position of a consensus of the Task Force would be challenged. Agreement of the Task Force is recognized as a consensus if no more than two members disagree with a position. Task Force meetings are held about once every six weeks. Issues come to the Task Force from a variety of sources, including the EITF members, the SEC, and other federal agencies. The FASB also brings issues to the EITF in response to issues submitted by auditors and preparers of financial statements. The EITF statements have become a very important source of GAAP. The Task Force has the capability to review a number of issues within a relatively short period of time, in contrast to the lengthy deliberations that go into an SFAS. EITF statements are considered to be less authoritative than the sources previously discussed in this chapter. However, since the EITF addresses issues not covered by the other sources, its statements become important guidelines to standards for the areas they cover. A New Reality In November 2001, Enron, one of the largest companies in the United States, recognized in a federal filing that it had overstated earnings by nearly $600 million since 1997. Within a month, Enron declared bankruptcy. The Enron bankruptcy probably received more publicity than any prior bankruptcy in U.S. history. This was influenced by the size of Enron, the role of the auditors, the financial loss of investors, and the losses sustained by Enron employees. Many Enron employees lost their jobs and their pensions. There were approximately two dozen guilty pleas or convictions in the Enron case including Ken Lay, former Enron chairman. Ken Lay died before he was sentenced; therefore, Judge Sim Lake erased his convictions. In June 2002, WorldCom announced that it had inflated profits by $3.8 billion over the previous five quarters. This represented the largest financial fraud in corporate history. Soon after the WorldCom fraud announcement, WorldCom declared bankruptcy. (In November 2002, a special bankruptcy court examiner indicated that the restatement would likely exceed $7.2 billion.) On July 13, 2005, Bernard J. Ebbers, founder and former chief executive of WorldCom, was sentenced to 25 years in prison for orchestrating the biggest corporate accounting fraud in U.S. history. Chapter 1 Introduction to Financial Reporting The WorldCom fraud compelled Congress and President George W. Bush to take action. Congress acted swiftly, with the support of President Bush, to pass legislation now known as the Sarbanes-Oxley Act of 2002. The Sarbanes-Oxley Act has many provisions. While it is not practical to review the Act in detail, it is clear that it has far-reaching consequences for financial reporting and the CPA profession. Because of the importance of the Sarbanes-Oxley Act to financial reporting, some additional comments are in order. Sarbanes-Oxley Section 404 requires companies to document adequate internal controls and procedures for financial reporting. They must be able to assess the effectiveness of the internal controls and financial reporting. Companies have found it difficult to comply with Section 404 for many reasons. Internal auditing departments have been reduced or eliminated at many companies. Some companies do not have the personnel to confront complex accounting issues. This lack of adequate competent personnel to confront complex accounting issues in itself represents an internal control weakness. Sarbanes-Oxley makes it an administrative responsibility to have adequate internal controls and procedures in place. Management must acknowledge their responsibility and assert the effectiveness of internal controls and procedures in writing. The SEC requires companies to file an annual report on their internal control systems. The report should contain the following:7 1. A statement of management's responsibilities for establishing and maintaining an adequate system. 2. Identification of the framework used to evaluate the internal controls. 3. A statement as to whether or not the internal control system is effective as of year-end. 4. The disclosure of any material weaknesses in the system. 5. A statement that the company's auditors have issued an audit report on management's assessment. The financial statements auditor must report on management's assertion as to the effectiveness of the internal controls and procedures as of the company's year-end. Sarbanes-Oxley has changed the relationship between the company and the external auditor. Prior to SarbanesOxley, some companies relied on the external auditor to determine the accounting for complex accounting issues. This was a form of conflict of interest, as the auditor surrendered independence in assessing the company's controls, procedures, and reporting. Not only have some companies found that they did not have adequately trained personnel to confront complex accounting issues, but external auditors have also been pressed to provide trained accounting personnel. This has led some auditing firms to reduce the number and type of companies that they will audit. The spring of 2005 represented the first reporting season under Sarbanes-Oxley. Hundreds of companies acknowledged that they had \"material weaknesses\" in their controls and processes. In some cases, this led to financial statements being restated. Implementing Sarbanes-Oxley has resulted in several benefits. Companies have improved their internal controls, procedures, and financial reporting. Many companies have also improved their fraud prevention. Systems put in place to review budgets will enable companies to be more proactive in preventing potential problems. Users of financial statements benefit from an improved financial product that they review and analyze to make investment decisions. Unfortunately, implementing Sarbanes-Oxley has been quite costly. Some firms question the cost/benefit of compliance with Sarbanes-Oxley. In time, we will know how much of the cost was represented by start-up cost and how much was annual recurring costs. The substantial cost of implementing Sarbanes-Oxley will likely result in future changes to this law. Publicly held companies are required to report under Sarbanes-Oxley, whereas private companies are not. Many state-level legislators have proposed extending certain provisions of Sarbanes-Oxley to private companies. Such proposals are controversial because of the cost. Some private companies support these proposals. Most of the publicity relating to Sarbanes-Oxley has been related to Section 404, but the Act includes many other sections. This book will revisit Sarbanes-Oxley when covering other areas, such as ethics, in Chapter 2. 9 10 Chapter 1 Introduction to Financial Reporting Sarbanes-Oxley created a five-person oversight board, the Public Company Accounting Oversight Board (PCAOB). The PCAOB consists of five members appointed by the SEC. Two must be CPAs, but the others cannot be CPAs. Among the many responsibilities of the PCAOB is to adopt auditing standards. This will materially decrease or eliminate the role of the AICPA in setting auditing standards. The PCAOB sets an annual accounting support fee for the standard-setting body (FASB). The PCAOB also establishes an annual accounting support fee for the PCAOB. These fees are assessed against each issuer. The chief executive officer (CEO), and the chief financial officer (CFO), of each issuer must prepare a statement to accompany the audit report to certify disclosures fairly present, in all material respects, the operations and financial condition of the issuer. In addition to appointing the five members of the PCAOB, the SEC is responsible for the oversight and enforcement authority over the Board. In effect, the PCAOB is an arm of the SEC. As described in this chapter, the setting of accounting standards has been divided among the SEC, FASB, EITF, and AcSEC. By law, the setting of accounting standards is the responsibility of the SEC. The SEC elected to have most of the accounting standards developed in the private sector with the oversight of the SEC. This substantially meant that the SEC allowed the FASB to determine accounting standards. The FASB allowed some of the standards to be determined by the EITF, and the AcSEC of the AICPA. The FASB has announced that it was streamlining the accounting rule-making process by taking back powers it had vested to AcSEC (an arm of the AICPA). The AcSEC will be allowed to continue with industry-specific accounting and audit guides (A&A guides). The AICPA is to stop issuing general-purpose accounting Statements of Position (SOPs). The FASB also streamlined the accounting rule-making process by taking back powers it had vested to EITF (an arm of the FASB). Two FASB members will be involved in the agendasetting process of the EITF. Statements of the EITF will go to the FASB before release. FASB Accounting Standards CodificationTM (Codification) As indicated in this chapter, there have been many sources of authoritative U.S. GAAP. This has resulted in thousands of pages addressing U.S. GAAP and some confusion as to the level of authoritative GAAP. To provide a single source of authoritative U.S. GAAP, the FASB commenced a project to provide a Codification of U.S. GAAP. The result will be one source and one level of authoritative GAAP. The Codification does not change GAAP. This project reached a verification stage in late 2007. During a one-year verification period the Codification is available to solicit feedback and confirm that the Codification is accurate. The Codification will likely become the single authoritative source of U.S. GAAP in 2009. The Codification reorganizes the accounting pronouncements into approximately 90 accounting topics. A separate section of the Codification will include SEC guidance. The SEC guidance will use the same 90 accounting topics. The Codification addresses U.S. GAAP for nongovernmental entities. Traditional Assumptions of the Accounting Model The FASB's Conceptual Framework was influenced by several underlying assumptions. Some of these assumptions were addressed in the Conceptual Framework, and others are implicit in the Framework. These assumptions, along with the Conceptual Framework, are considered when a GAAP is established. Accountants, when confronted with a situation lacking an explicit standard, should resolve the situation by considering the Conceptual Framework and the traditional assumptions of the accounting model. In all cases, the reports are to be a \"fair representation.\" Even when there is an explicit GAAP, following the GAAP is not appropriate unless the end result is a \"fair representation.\" Following GAAP is not an appropriate legal defense unless the statements represent a \"fair representation.\" Chapter 1 Introduction to Financial Reporting BUSINESS ENTITY The concept of separate entity means that the business or entity for which the financial statements are prepared is separate and distinct from the owners of the entity. In other words, the entity is viewed as an economic unit that stands on its own. For example, an individual may own a grocery store, a farm, and numerous personal assets. To determine the economic success of the grocery store, we would view it separately from the other resources owned by the individual. The grocery store would be treated as a separate entity. A corporation such as Ford Motor Company has many owners (stockholders). The entity concept enables us to account for the Ford Motor Company entity separately from the transactions of the owners of Ford Motor Company. GOING CONCERN OR CONTINUITY The going-concern assumption, that the entity in question will remain in business for an indefinite period of time, provides perspective on the future of the entity. The going-concern assumption deliberately disregards the possibility that the entity will go bankrupt or be liquidated. If a particular entity is in fact threatened with bankruptcy or liquidation, then the going-concern assumption should be dropped. In such a case, the reader of the financial statements is interested in the liquidation values, not the values that can be used when making the assumption that the business will continue indefinitely. If the going-concern assumption has not been used for a particular set of financial statements, because of the threat of liquidation or bankruptcy, the financial statements must clearly disclose that the statements were prepared with the view that the entity will be liquidated or that it is a failing concern. In this case, conventional financial report analysis would not apply. Many of our present financial statement figures would be misleading if it were not for the going-concern assumption. For instance, under the going-concern assumption, the value of prepaid insurance is computed by spreading the cost of the insurance over the period of the policy. If the entity were liquidated, then only the cancellation value of the policy would be meaningful. Inventories are basically carried at their accumulated cost. If the entity were liquidated, then the amount realized from the sale of the inventory, in a manner other than through the usual channels, usually would be substantially less than the cost. Therefore, to carry the inventory at cost would fail to recognize the loss that is represented by the difference between the liquidation value and the cost. The going-concern assumption also influences liabilities. If the entity were liquidating, some liabilities would have to be stated at amounts in excess of those stated on the conventional statement. Also, the amounts provided for warranties and guarantees would not be realistic if the entity were liquidating. The going-concern assumption also influences the classification of assets and liabilities. Without the going-concern assumption, all assets and liabilities would be current, with the expectation that the assets would be liquidated and the liabilities paid in the near future. The audit opinion for a particular firm may indicate that the auditors have reservations as to the going-concern status of the firm. This puts the reader on guard that the statements are misleading if the firm does not continue as a going concern. For example, the annual report of Trump Hotels & Casino Resorts, Inc. indicated a concern over the company's ability to continue as a going concern. The Trump Hotels & Casino Resorts, Inc. annual report included these comments in Note 1 and the auditor's report. Trump Hotels & Casino Resorts, Inc. Notes to Consolidated Financial Statements (in Part) December 31, 2004 Accounting Impact of Chapter 11 Filing (Part of Note 1) The accompanying consolidated financial statements have been prepared in accordance with AICPA Statement of Position No. (SOP) 90-7, \"Financial Reporting by Entities in Reorganization under the Bankruptcy Code\" (\"SOP 90-7\") and on a going concern basis, 11 12 Chapter 1 Introduction to Financial Reporting which contemplates continuity of operations, realization of assets and liquidation of liabilities in the ordinary course of business. The ability of the Company, both during and after the chapter 11 cases, to continue as a going concern is dependent upon, among other things, (i) the ability of the Company to successfully achieve required cost savings to complete its restructuring; (ii) the ability of the Company to maintain adequate cash on hand; (iii) the ability of the Company to generate cash from operations; (iv) the ability of the Company to confirm a plan of reorganization under the Bankruptcy Code and obtain emergency financing; (v) the ability of the Company to maintain its customer base; and (vi) the Company's ability to achieve profitability. There can be no assurance that the Company will be able to successfully achieve these objectives in order to continue as a going concern. The accompanying consolidated financial statements do not include any adjustments that might result should the Company be unable to continue as a going concern. Report of Independent Registered Public Accounting Firm (in Part) Board of Directors Trump Hotels & Casino Resorts, Inc. We have audited the accompanying consolidated balance sheets of Trump Hotels & Casino Resorts, Inc. as of December 31, 2003 and 2004, and the related consolidated statements of operations, stockholders' equity/deficit, and cash flows for each of the three years in the period ended December 31, 2004. Our audits also included the financial statement schedules as listed in the index at item 15(a). These financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits. The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As more fully described in Note 1, the Company has experienced increased competition, incurred significant recurring losses from operations, has an accumulated deficit and has filed a voluntary petition seeking to reorganize under chapter 11 of the federal bankruptcy laws. Such circumstances raise substantial doubt about its ability to continue as a going concern. Although the Company is currently operating as a debtor-in-possession under the jurisdiction of the Bankruptcy Court, the continuation of the business as a going concern is contingent upon, among other things: (1) the ability of the Company to maintain compliance with all terms of its current debt structure; (2) the ability of the Company to generate cash from operations and to maintain adequate cash on hand; (3) the resolution of the uncertainty as to the amount of claims that will be allowed; (4) the ability of the Company to confirm a plan of reorganization under the Bankruptcy Code and obtain the required debt and equity financing to emerge from bankruptcy protection; and (5) the Company's ability to achieve profitability. Management's plans in regard to these matters are also described in Note 1. The accompanying consolidated financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classification of liabilities that may result from the outcome of this uncertainty. Ernst & Young, LLP Philadelphia, Pennsylvania March 30, 2005 TIME PERIOD The only accurate way to account for the success or failure of an entity is to accumulate all transactions from the opening of business until the business eventually liquidates. Many years ago, this time period for reporting was acceptable, because it would be feasible to account for and divide up what remained at the completion of the venture. Today, the typical business has a relatively long duration, so it is not feasible to wait until the business liquidates before accounting for its success or failure. This presents a problem: Accounting for the success or failure of the business in midstream involves inaccuracies. Many transactions and commitments are incomplete at any particular time between the opening and the closing of business. An attempt is made to eliminate the Chapter 1 Introduction to Financial Reporting inaccuracies when statements are prepared for a period of time short of an entity's life span, but the inaccuracies cannot be eliminated completely. For example, the entity typically carries accounts receivable at the amount expected to be collected. Only when the receivables are collected can the entity account for them accurately. Until receivables are collected, there exists the possibility that collection cannot be made. The entity will have outstanding obligations at any time, and these obligations cannot be accurately accounted for until they are met. An example would be a warranty on products sold. An entity may also have a considerable investment in the production of inventories. Usually, until the inventory is sold in the normal course of business, the entity cannot accurately account for the investment in inventory. With the time period assumption, we accept some inaccuracies of accounting for the entity short of its complete life span. We assume that the entity can be accounted for with reasonable accuracy for a particular period of time. In other words, the decision is made to accept some inaccuracy, because of incomplete information about the future, in exchange for more timely reporting. Some businesses select an accounting period, known as a natural business year, that ends when operations are at a low ebb in order to facilitate a better measurement of income and financial position. In many instances, the natural business year of a company ends on December 31. Other businesses use the calendar year and thus end the accounting period on December 31. Thus, for many companies that use December 31, we cannot tell if December 31 was selected because it represents a natural business year or if it was selected to represent a calendar year. Some select a 12-month accounting period, known as a fiscal year, which closes at the end of a month other than December. The accounting period may be shorter than a year, such as a month. The shorter the period of time, the more inaccuracies we typically expect in the reporting. At times, this text will refer to Accounting Trends & Techniques. This is a book compiled annually by the American Institute of Certified Public Accountants, Inc. Accounting Trends & Techniques is \"a compilation of data obtained by a survey of 600 annual reports to stockholders undertaken for the purpose of analyzing the accounting information disclosed in such reports. The annual reports surveyed were those of selected industrial, merchandising, technology, and service companies for fiscal periods ending between February 25, 2005, and February 3, 2006.\"8 Exhibit 1-3 summarizes month of fiscal year-end from a financial statement compilation in Accounting Trends & Techniques. In Exhibit 1-3 for 2005, 171 survey companies were on a 52- to 53-week fiscal year.9 Jack in the Box Inc. was one of those companies. Jack in the Box disclosed in its notes to consolidated financial statements: \"Our fiscal year is 52 or 53 weeks ending the Sunday closest to September 30. Fiscal years 2005 and 2003 includes 52 weeks, and fiscal year 2004 includes 53 weeks.\"10 Text not available due to copyright restrictions 13 14 Chapter 1 Introduction to Financial Reporting MONETARY UNIT Accountants need some standard of measure to bring financial transactions together in a meaningful way. Without some standard of measure, accountants would be forced to report in such terms as 5 cars, 1 factory, and 100 acres. This type of reporting would not be very meaningful. There are a number of standards of measure, such as a yard, a gallon, and money. Of the possible standards of measure, accountants have concluded that money is the best for the purpose of measuring financial transactions. Different countries call their monetary units by different names. For example, Japan uses the yen. Different countries also attach different values to their money1 dollar is not equal to 1 yen. Thus, financial transactions may be measured in terms of money in each country, but the statements from various countries cannot be compared directly or added together until they are converted to a common monetary unit, such as the U.S. dollar. In various countries, the stability of the monetary unit has been a problem. The loss in value of money is called inflation. In some countries, inflation has been more than 300% per year. In countries where inflation has been significant, financial statements are adjusted by an inflation factor that restores the significance of money as a measuring unit. However, a completely acceptable restoration of money as a measuring unit cannot be made in such cases because of the problems involved in determining an accurate index. To indicate one such problem, consider the price of a car in 1997 and in 2007. The price of the car in 2007 would be higher, but the explanation would not be simply that the general price level has increased. Part of the reason for the price increase would be that the type and quality of the equipment have changed between 1997 and 2007. Thus, an index that relates the 2007 price to the 1997 price is a mixture of inflation, technological advancement, and quality changes. The rate of inflation in the United States prior to the 1970s was relatively low. Therefore, it was thought that an adjustment of money as a measuring unit was not appropriate, because the added expense and inaccuracies of adjusting for inflation were greater than the benefits. During the 1970s, however, the United States experienced double-digit inflation. This made it increasingly desirable to implement some formal recognition of inflation. In September 1979, the FASB issued Statement of Financial Accounting Standards No. 33, \"Financial Reporting and Changing Prices,\" which required that certain large, publicly held companies disclose certain supplementary information concerning the impact of changing prices in their annual reports for fiscal years ending on or after December 25, 1979. This disclosure later became optional in 1986. Currently, no U.S. company provides this supplementary information. HISTORICAL COST SFAC No. 5 identified five different measurement attributes currently used in practice: historical cost, current cost, current market value, net realizable value, and present value. Often, historical cost is used in practice because it is objective and determinable. A deviation from historical cost is accepted when it becomes apparent that the historical cost cannot be recovered. This deviation is justified by the conservatism concept. A deviation from historical cost is also found in practice where specific standards call for another measurement attribute such as current market value, net realizable value, or present value. CONSERVATISM The accountant is often faced with a choice of different measurements of a situation, with each measurement having reasonable support. According to the concept of conservatism, the accountant must select the measurement with the least favorable effect on net income and financial position in the current period. To apply the concept of conservatism to any given situation, there must be alternative measurements, each of which must have reasonable support. The accountant cannot use the conservatism concept to justify arbitrarily low figures. For example, writing inventory down Chapter 1 Introduction to Financial Reporting to an arbitrarily low figure in order to recognize any possible loss from selling the inventory constitutes inaccurate accounting and cannot be justified under the concept of conservatism. An acceptable use of conservatism would be to value inventory at the lower of historical cost or market value. The conservatism concept is used in many other situations, such as writing down or writing off obsolete inventory prior to sale, recognizing a loss on a long-term construction contract when it can be reasonably anticipated, and taking a conservative approach in determining the application of overhead to inventory. Conservatism requires that the estimate of warranty expense reflects the least favorable effect on net income and the financial position of the current period. REALIZATION Accountants face a problem of when to recognize revenue. All parts of an entity contribute to revenue, including the janitor, the receiving department, and the production employees. The problem becomes how to determine objectively the contribution of each of the segments toward revenue. Since this is not practical, accountants must determine when it is practical to recognize revenue. In practice, revenue recognition has been the subject of much debate. This has resulted in fairly wide interpretations. The issue of revenue recognition has represented the basis of many SEC enforcement actions. In general, the point of recognition of revenue should be the point in time when revenue can be reasonably and objectively determined. It is essential that there be some uniformity regarding when revenue is recognized, so as to make financial statements meaningful and comparable. Point of Sale Revenue is usually recognized at the point of sale. At this time, the earning process is virtually complete, and the exchange value can be determined. There are times when the use of the point-of-sale approach does not give a fair result. An example would be the sale of land on credit to a buyer who does not have a reasonable ability to pay. If revenue were recognized at the point of sale, there would be a reasonable chance that sales had been overstated because of the material risk of default. There are many other acceptable methods of recognizing revenue that should be considered, such as the following: 1. 2. 3. 4. End of production Receipt of cash During production Cost recovery End of Production The recognition of revenue at the completion of the production process is acceptable when the price of the item is known and there is a ready market. The mining of gold or silver is an example, and the harvesting of some farm products would also fit these criteria. If corn is harvested in the fall and held over the winter in order to obtain a higher price in the spring, the realization of revenue from the growing of corn should be recognized in the fall, at the point of harvest. The gain or loss from the holding of the corn represents a separate consideration from the growing of the corn. Receipt of Cash The receipt of cash is another basis for revenue recognition. This method should be used when collection is not capable of reasonable estimation at the time of sale. The land sales business, where the purchaser makes only a nominal down payment, is one type of business where the collection of the full amount is especially doubtful. Experience has shown that many purchasers default on the contract. 15 16 Chapter 1 Introduction to Financial Reporting During Production Some long-term construction projects recognize revenue as the construction progresses. This exception tends to give a fairer picture of the results for a given period of time. For example, in the building of a utility plant, which may take several years, recognizing revenue as work progresses gives a fairer picture of the results than does having the entire revenue recognized in the period when the plant is completed. Cost Recovery The cost recovery approach is acceptable for highly speculative transactions. For example, an entity may invest in a venture search for gold, the outcome of which is completely unpredictable. In this case, the first revenue can be handled as a return of the investment. If more is received than has been invested, the excess would be considered revenue. In addition to the methods of recognizing revenue described in this chapter, there are many other methods that are usually industry-specific. Being aware of the method(s) used by a specific firm can be important to your understanding of the financial reports. MATCHING The revenue realization concept involves when to recognize revenue. Accountants need a related concept that addresses when to recognize the costs associated with the recognized revenue: the matching concept. The basic intent is to determine the revenue first and then match the appropriate costs against this revenue. Some costs, such as the cost of inventory, can be easily matched with revenue. When we sell the inventory and recognize the revenue, the cost of the inventory can be matched against the revenue. Other costs have no direct connection with revenue, so some systematic policy must be adopted in order to allocate these costs reasonably against revenues. Examples are research and development costs and public relations costs. Both research and development costs and public relations costs are charged off in the period incurred. This is inconsistent with the matching concept because the cost would benefit beyond the current period, but it is in accordance with the concept of conservatism. CONSISTENCY The consistency concept requires the entity to give the same treatment to comparable transactions from period to period. This adds to the usefulness of the reports, since the reports from one period are comparable to the reports from another period. It also facilitates the detection of trends. Many accounting methods could be used for any single item, such as inventory. If inventory were determined in one period on one basis and in the next period on a different basis, the resulting inventory and profits would not be comparable from period to period. Entities sometimes need to change particular accounting methods in order to adapt to changing environments. If the entity can justify the use of an alternative accounting method, the change can be made. The entity must be ready to defend the changea responsibility that should not be taken lightly in view of the liability for misleading financial statements. Sometimes the change will be based on a new accounting pronouncement. When an entity makes a change in accounting methods, the justification for the change must be disclosed, along with an explanation of the effect on the statements. FULL DISCLOSURE The accounting reports must disclose all facts that may influence the judgment of an informed reader. If the entity uses an accounting method that represents a departure from the official position of the FASB, disclosure of the departure must be made, along with the justification for it. Several methods of disclosure exist, such as parenthetical explanations, supporting schedules, cross-references, and notes. Often, the additional disclosures must be made by a note in Chapter 1 Introduction to Financial Reporting order to explain the situation properly. For example, details of a pension plan, long-term leases, and provisions of a bond issue are often disclosed in notes. The financial statements are expected to summarize significant financial information. If all the financial information is presented in detail, it could be misleading. Excessive disclosure could violate the concept of full disclosure. Therefore, a reasonable summarization of financial information is required. Because of the complexity of many businesses and the increased expectations of the public, full disclosure has become one of the most difficult concepts for the accountant to apply. Lawsuits frequently charge accountants with failure to make proper disclosure. Since disclosure is often a judgment decision, it is not surprising that others (especially those who have suffered losses) would disagree with the adequacy of the disclosure. MATERIALITY The accountant must consider many concepts and principles when determining how to handle a particular item. The proper use of the various concepts and principles may be costly and time-consuming. The materiality concept involves the relative size and importance of an item to a firm. A material item to one entity may not be material to another. For example, an item that costs $100 might be expensed by General Motors, but the same item might be carried as an asset by a small entity. It is essential that material items be properly handled on the financial statements. Immaterial items are not subject to the concepts and principles that bind the accountant. They may be handled in the most economical and expedient manner possible. However, the accountant faces a judgment situation when determining materiality. It is better to err in favor of an item being material than the other way around. A basic question when determining whether an item is material is: \"Would this item influence an informed reader of the financial statements?\" In answering this question, the accountant should consider the statements as a whole. The Sarbanes-Oxley Act has materiality implications. \"The Sarbanes-Oxley Act of 2002 has put demands on management to detect and prevent material control weaknesses in a timely manner. To help management fulfill this responsibility, CPAs are creating monthly key control processes to asses and report on risk. When management finds a key control that does not meet the required minimum quality standard, it must classify the result as a key control exception.\"11 INDUSTRY PRACTICES Some industry practices lead to accounting reports that do not conform to the general theory that underlies accounting. Some of these practices are the result of government regulation. For example, some differences can be found in highly regulated industries, such as insurance, railroad, and utilities. In the utility industry, an allowance for funds used during the construction period of a new plant is treated as part of the cost of the plant. The offsetting amount is reflected as other income. This amount is based on the utility's hypothetical cost of funds, including funds from debt and stock. This type of accounting is found only in the utility industry. In some industries, it is very difficult to determine the cost of the inventory. Examples include the meat-packing industry, the flower industry, and farming. In these areas, it may be necessary to determine the inventory value by working backward from the anticipated selling price and subtracting the estimated cost to complete and dispose of the inventory. The inventory would thus be valued at a net realizable value, which would depart from the cost concept and the usual interpretation of the revenue realization concept. If inventory is valued at net realizable value, then the profit has already been recognized and is part of the inventory amount. The accounting profession is making an effort to reduce or eliminate specific industry practices. However, industry practices that depart from typical accounting procedures will probably never be eliminated completely. Some industries have legitimate peculiarities that call for accounting procedures other than the customary ones. 17 18 Chapter 1 Introduction to Financial Reporting TRANSACTION APPROACH The accountant records only events that affect the financial position of the entity and, at the same time, can be reasonably determined in monetary terms. For example, if the entity purchases merchandise on account (on credit), the financial position of the entity changes. This change can be determined in monetary terms as the inventory asset is obtained and the liability, accounts payable, is incurred. Many important events that influence the prospects for the entity are not recorded and, therefore, are not reflected in the financial statements because they fall outside the transaction approach. The death of a top executive could have a material influence on future prospects, especially for a small company. One of the company's major suppliers could go bankrupt at a time when the entity does not have an alternative source. The entity may have experienced a long strike by its employees or have a history of labor problems. A major competitor may go out of business. All these events may be significant to the entity. They are not recorded because they are not transactions. When projecting the future prospects of an entity, it is necessary to go beyond current financial reports. Some of the items not recorded will be disclosed. This is done under the full disclosure assumption. CASH BASIS The cash basis recognizes revenue when cash is received and recognizes expenses when cash is paid. The cash basis usually does not provide reasonable information about the earning capability of the entity in the short run. Therefore, the cash basis is usually not acceptable. ACCRUAL BASIS The accrual basis of accounting recognizes revenue when realized (realization concept) and expenses when incurred (matching concept). If the difference between the accrual basis and the cash basis is not material, the entity may use the cash basis as an alternative to the accrual basis for income determination. Usually, the difference between the accrual basis and the cash basis is material. A modified cash basis is sometimes used by professional practices and service organizations. The modified cash basis adjusts for such items as buildings and equipment. The accrual basis requires numerous adjustments at the end of the accounting period. For example, if insurance has been paid for in advance, the accountant must determine the amounts that belong in prepaid insurance and insurance expense. If employees have not been paid all of their wages, the unpaid wages must be determined and recorded as an expense and as a liability. If revenue has been collected in advance, such as rent received in advance, this revenue relates to future periods and must, therefore, be deferred to those periods. At the end of the accounting period, the unearned rent would be considered a liability. The use of the accrual basis complicates the accounting process, but the end result is more representative of an entity's financial condition than the cash basis. Without the accrual basis, accountants would not usually be able to make the time period assumptionthat the entity can be accounted for with reasonable accuracy for a particular period of time. The following illustration indicates why the accrual basis is generally regarded as a better measure of a firm's performance than the ca