Generally accepted accounting principles (GAAP) - Financial Reporting and Analysis

Gaap Concept

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.

The stock market crash of 1929 provoked wide spread 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 Actof 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 privatesector. 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 AICPAis 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 out growth of this special committee was the establishment in 1939 of two standing committees, theCommittee on Accounting Proceduresand 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.

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 4 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.

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 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. The FAF also is responsible for funding the 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 illustrates the structure of the FASB.

The FASB issues four types of pronouncements:

  1. Statements of Financial Accounting Standards (SFASs). These Statements establish GAAP for specific accounting issues.
  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 super majority of five or more of the seven members). Interpretations are part of GAAP.
  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.
  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 (SFAS)

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.

Structure of The FASB

Structure of The FASB

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 Commentis 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 aproposed 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.

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.

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. Listed below is a summary of the highlights of Concepts Statement No.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.
  6. Issued in May 1980, “Qualitative Characteristics of Accounting Information” (SFACNo.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 figure below.

Relevanceand 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.

A Hierarchy of Accounting Qualities

Hierarchy of Accounting Qualities

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 ten interrelated elements directly related to measuring performance and financial status of an enterprise. The ten elements are defined as follows:

  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 satisfactionor 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.
  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 on going 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 on going 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 with in the focus of this statement include churches, foundations, and human - service organizations. Performance indicators for nonbusiness organizations 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:

  1. Definition. The item fits one of the definitions of the elements.
  2. Measurability. The item has a relevant attribute measurable with sufficient reliability.
  3. Relevance. The information related to the item is relevant.
  4. 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:

  1. Historical cost (historical proceeds)
  2. Current cost
  3. Current market value
  4. Net realizable (settlement) value
  5. 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. ”

SFAC No. 5 recommended that a full set of financial statements for a period should show the following:

  1. Financial position at the end of the period
  2. Earnings (net income)
  3. Comprehensive income (total nonowner change in equity)
  4. Cash flows during the period
  5. 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.

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.

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