CHAPTER 1
The Financial Reporting Environment
Solutions
Questions
Q1-1 Financial information is a much broader concept than simply the financial statements and
footnotes to the financial statements. Financial information includes items such as the President‘s
letter to the owners, management‘s discussion and analysis, the auditors‘ report, the management
report and press releases. Of course, the basic financial statements and footnotes are included in
the term financial information. The basic financial statements are: the balance sheet (also
referred to as the statement of financial position), the statement of comprehensive income (also
referred to as the statement of net income and the statement of comprehensive income), the
statement of cash flows, and the statement of shareholders‘ equity. Financial information is not
synonymous with the term financial statements because the financial statements are a subset of
the different types of financial information provided.
Q1-2 The purpose of generating financial statements is to provide useful information to users to
evaluate economic entities and make efficient resource allocation decisions based on the risks
and returns of a particular investment. The Financial Accounting Standards Board (FASB)
identifies investors, lenders and other creditors as the primary users of the financial statements.
The financial statements are the culmination of the financial reporting process.
Q1-3 Capital is a scarce resource. Investors and creditors have to make decisions as to how much
capital to invest in any given entity; therefore, they demand relevant and faithfully representative
information about the economic performance and financial position of a company. This
information is provided in the financial statements.
Q1-4 External auditors ensure that the management of a company has prepared financial
statements in accordance with Generally Accepted Accounting Principles and fairly present the
financial position and economic performance of a company. In addition, external auditors must
be an independent party and cannot be employees of the company they are auditing. External
auditors provide a significant amount of credibility to the financial statements.
Q1-5 Data analytics is the process of analyzing large data sets in order to draw useful
conclusions. It involves converting raw data into useful knowledge. In financial reporting, data
analytics can be used to improve the quality of estimates and valuations.
Q1-6 Standard setters create accounting concepts, rules, and guidelines to ensure that financial
statements accurately present the economic performance and financial position of a firm. The
standards encourage transparent and truthful reporting.
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Q1-7 U.S. companies listed on U.S. stock exchanges do not have the option to report under
IFRS. However, foreign companies that trade in the U.S. exchanges can report under IFRS. The
SEC permits the use of IFRS-based financial statements by international companies with shares
trading on U.S. stock exchanges.
Q1-8 The FASB seeks and welcomes comments from all parties in the financial reporting
process including managers, investors, accountants, preparers, creditors, lenders, financial
statement users, governmental agencies, financial analysts, industry groups, and auditors. FASB
also receives feedback from public roundtable discussions, public meetings, the FASAC, the
Private Company Council, and EITF.
Q1-9 Yes, the promulgation of financial accounting standards is a political process. There are
several groups that influence the standard setting process. The standard setting process is a
political process that is affected by the impact of several lobbying groups. The government,
through the SEC, influences accounting standards. The SEC has the authority to issue accounting
standards but has assigned this responsibility to the private sector. Nonetheless, the SEC can
exert pressure on the FASB to issue accounting standards and veto the standards promulgated by
the FASB. Auditing firms, the corporate sector, creditors, financial analysts, the financial
community, accounting organizations, industry groups, and investors can influence the FASB by
written comments about Exposure Drafts and participation in public meetings and public
roundtables regarding a proposed financial reporting standard.
Q1-10 A principles-based standard is consistent with a theoretical framework. In contrast, a
rules-based standard does not necessarily rely on a consistent theoretical framework. Rather, it
contains more specific and prescriptive rules.
Q1-11 Recently, the FASB has taken an asset/liability approach in setting standards. With this
approach, a transaction is recorded based on whether an asset or liability is created. Another
trend has been the movement toward the use of fair value measurements as an alternative to
historical cost. FASB has also focused on the promulgation of principles-based standards instead
of rules-based standards.
Brief Exercises
Solution to BE1-1
General-purpose financial statements provide general financial information about an entity that
will be useful to many types of users. General-purpose financial statements provide information
to a wide spectrum of user groups: investors, creditors, financial analysts, customers, employees,
competitors, suppliers, unions, and government agencies. Most financial information in general
purpose financial statements is provided to satisfy users with limited ability or authority to obtain
additional information, which includes investors and creditors. The Financial Accounting
Standards Board (FASB) identifies investors, lenders, and other creditors as the primary users of
the financial statements.
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, CH AP TE R 1 T HE FIN ANC I AL RE PO RT IN G EN VIR ON MENT 1-3
Solution to BE1-2
Financial accounting is the process of identifying, measuring, and communicating financial
information about an economic entity to various user groups within the legal, economic,
political, and social environment. This definition contains four major elements: 1. Financial
information; 2.Economic entity; 3. User groups and 4. Legal, economic, political, and social
environment
Solution to BE1-3
Financial Statement Users
and Other Parties Role
10. Are shareholders of the company.
10 Equity Investors
1. Are banks and other financial institutions that lend
1 Creditors money to the company.
5. Use financial information to review and analyze
5 Financial Analysts reported results of the companies they cover and
make investment recommendations.
8 Employees and Labor Unions
8. Use financial information during negotiation of
2 Suppliers and Customers new labor agreements and compensation contracts.
2. Use financial statements to determine whether to
7 Government Agencies conduct business or purchase products from a
company.
3 Competitors 7. Review the financial statements of publicly traded
companies for a variety of reasons that are in the
4 External Auditors
public interest.
6 Internal Auditors 3. Use financial information to determine their market
position relative to the reporting entity and to
11 Regulatory Bodies attempt to identify future strategies of the reporting
entity.
9 Professional Organizations 4. Are independent of the company and responsible
for ensuring that management prepares and issues
financial statements that comply with accounting
standards and fairly present the financial position
and economic performance of the company.
6. Are employees of the company serving in an
advisory role to management. They provide
information to management regarding the
company‘s operations and proper functioning of its
internal controls.
11. Protect investors and oversee the accounting and
auditing standard setting processes.
9. Support accounting professionals throughout their
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careers by providing training, professional skills
development, and other resources.
Solution to BE1-4
Financial statement users and why each would use the financial statements are summarized
below:
1. Equity investors - Equity investors buy stock in the company, that is, they purchase a
percentage of the company itself. The financial statements help them make investment
decisions.
2. Creditors - Creditors loan money to the company. The financial statements help them assess
the creditworthiness of the company, and whether principal and interest will be repaid.
3. Competitors - Competitors use financial statements to determine their market position
relative to the reporting entity.
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, CH AP TE R 1 T HE FIN ANC I AL RE PO RT IN G EN VIR ON MENT 1-5
4. Financial analysts - Financial analysts use financial statements to perform financial analyses.
Their analyses often result in a recommendation as to whether investors should buy or sell
the stock of that company. These analysts act as market intermediaries.
5. Employees and labor unions - Employees and labor unions use the financial statements to
assess the company‘s economic performance and liquidity, which are important information
in wage negotiations.
6. Suppliers and customers - Suppliers and customers can use the financial statements to
determine a company‘s financial position and whether they want to do business with the
company. For suppliers, it is important to assess the company‘s ability to pay for goods and
services. For customers, it is important to assess the company‘s ability to honor warranties.
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Solution to BE1-5
Parties in the financial reporting process and why each would be interested in the financial
statements:
1. Auditors – External auditors are important players in the financial reporting process. It is
their job to ensure that the management of the company has prepared financial statements
that follow the accounting rules and fairly present the financial position and economic
performance of the company. Because auditors are an independent party, they lend a
significant amount of credibility to the financial statements. External auditors will carefully
examine the financial statements.
2. Accounting standard setters such as the Financial Accounting Standards Board and the
International Accounting Standards Board - Standard setters create accounting concepts,
rules, and guidelines that will result in financial statements that provide financial information
that is relevant and that faithfully represents the financial performance and position of the
reporting entity.
3. Regulatory bodies such as the Securities and Exchange Commission and the Public Company
Accounting Oversight Board - The Securities and Exchange Commission‘s role is to protect
investors. They oversee the accounting standard setting process, including giving the FASB
the authority to determine U.S. GAAP. They also review the filings of public companies in
the U.S., which includes the financial statements and footnotes. The Public Company
Accounting Oversight Board (PCAOB) sets auditing standards and oversees the audits of
public companies in the U.S. External auditors focus on the financial statements.
Solution to BE1-6
The second element in the definition of financial accounting involves the economic entity for
which the financial statements and other financial information are presented. An economic
entity is an organization or unit with activities that are separate from those of its owners and
other entities. Financial information always relates to a particular economic entity. Economic
entities can be corporations, partnerships, sole proprietorships, or governmental organizations.
Also, economic entities may be privately held or publicly held. If the entity is publicly held, then
its equity can be bought and sold by external parties on stock exchanges.
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, CH AP TE R 1 T HE FIN ANC I AL RE PO RT IN G EN VIR ON MENT 1-7
Solution to BE1-7
Accounting standard setters follow a process to set accounting standards that involves financial
statement preparers, users and other interested parties at several stages.
In identifying issues to consider by the FASB, standard setters consider input from these
parties.
Once an issue is added to the technical agenda, standard setters usually have public
meetings where they seek comments from these interested parties.
When an exposure draft is issued, interested parties are invited to prepare comment
letters.
After an exposure draft is issued, standard setters sometimes hold roundtables, or public
forums, which include these various parties.
When deliberating on an issue before publishing a final standard, the standard setters
consider the inputs obtained from outside parties at the various stages in the standard
setting process.
The IASB uses a similar process.
Solution to BE1-8
The FASB follows a seven-step process to issue a final standard.
Step 1:Identification of an issue. FASB identifies a financial reporting issue based on
recommendations from analysts, government agencies, or other market participants.
Step 2:Decision to pursue. After consultation with FASB members and others as appropriate,
the FASB Chairperson decides whether to add the issue to the technical agenda.
Step 3:Public meetings. Once added to the technical agenda, the Board holds public meetings
where it deliberates the various issues identified by the FASB staff.
Step 4:Exposure Draft. The Board issues an Exposure Draft (ED), which is intended to solicit
input from financial statement preparers, auditors, and users of the financial statements.
Step 5:Public roundtables. The Board may hold public roundtables to discuss the ED, if
needed.
Step 6:Redeliberation. The FASB staff analyzes the comment letters received from preparers,
financial statement users and auditors, public roundtable discussions, and any other
information. The Board then redeliberates the issue.
Step 7:Publication of the final standard. The Board issues an Accounting Standards Update
(ASU), which is the final standard. It requires a majority vote of the Board to issue a new
standard. The ASU will then be incorporated into the body of the Accounting Standards
Codification that makes up U.S. GAAP.
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Solution to BE1-9
The steps in the Financial Accounting Standards Board‘s standard setting process in the correct
order from 1 to 7.
4 The Board issues an Exposure Draft (ED), which is intended to solicit input.
2 After consultation with FASB members and others as appropriate, the FASB Chairperson
decides whether to add the issue to the technical agenda.
6 The FASB staff analyzes the comment letters received, public roundtable discussions and
any other information. The Board then redeliberates the issue.
5 The Board may hold public roundtables to discuss the ED, if needed.
7 The Board issues an Accounting Standards Update (ASU), which is the final standard. It
then incorporates the ASU into the Accounting Standards Codification that makes up
U.S. GAAP.
1 A financial reporting issue is identified either by requests of financial statement users or
by some other means.
3 The Board holds public meetings where it deliberates the various issues identified by the
FASB staff.
Solution to BE1-10
The IASB is comprised of 14 members who are appointed by the IFRS Foundation‘s board of
trustees. At least 11 members serve full time, and not more than three can be part-time members.
To ensure broad and diverse international representation, the IASB is composed of:
• Four members from the Asia/Oceania region.
• Four members from Europe.
• Four members from the Americas.
• One member from Africa.
• One member appointed from any area, subject to maintaining overall geographical balance.
Solution to BE1-11
U.S. financial reporting standard setting began with the 1934 Securities Exchange Act, which
gave the SEC the power to promulgate accounting standards for all publicly traded firms. The
SEC delegated its standard-setting power to the private sector, prompting the accounting
profession to establish the first U.S. standard-setting board. Currently, the SEC issues standards
and continues in an oversight function over the US standards-setting bodies such as the FASB.
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, CH AP TE R 1 T HE FIN ANC I AL RE PO RT IN G EN VIR ON MENT 1-9
Solution to BE1-12
The items below are characteristics of a principles-based (P) or rules-based (R) accounting
system:
P Provides a clear discussion of the accounting objective related to the standard
R Contains detailed application guidance
R Contains numerous exceptions to the types of firms and industries that are
covered
P Involves no bright-line tests
R Contains numerous bright-line tests
P Involves a significant amount of interpretation in application
P Involves few, if any, exceptions
P Provides insufficient guidance to implement the standard
R Would not rely on extensive use of professional judgment
R Results in inconsistencies between standards
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Exercises
Solution to E1-1
Financial accounting is the process of identifying, measuring, and communicating financial
information about an economic entity to various user groups within the political, social, legal and
economic environment.
This definition contains four major elements. These elements are:
1. Financial information - Financial information includes items such as the financial statements,
footnotes to the financial statements, the letter to the owners, management‘s discussion and
analysis, the auditors‘ report, the management report, and press releases.
2. Economic entities - An economic entity is an organization or unit with activities that are
separate from those of its owners and other entities. Economic entities can, for example, be
corporations, partnerships, sole proprietorships, or governmental organizations. Also,
economic entities may be privately held or publicly held.
3. User groups – User groups demand financial information about an economic entity. Users
include equity investors, debt investors, creditors, competitors, financial analysts, employees
and labor unions, suppliers, customers, and government agencies.
4. Environment – The environment includes the legal, economic, political, and social factors
that shape and influence the financial reporting process.
Solution E1-2
Accounting and financial reporting are far from isolated from society. Accounting and financial
reporting interact with environmental factors - legal, economic, political, and social – that shape
and influence the financial reporting process. The information needs of financial statement users
change as business evolves. So, it is natural that financial accounting interacts with its
environment in both a reactive and a proactive fashion.
In a reactive fashion, financial accounting reacts to pressure (lobbying) from various groups and
changes in its environment. Accounting theories and procedures evolve to meet the dynamic
changes and demands from the environment. The development of accounting standards is also a
political process that is heavily influenced by the various groups within the reporting
environment. Lobby or pressure groups include investors, creditors, financial analysts, the
financial community, academics, accounting organizations, and industry associations.
Financial accounting is also proactive. That is, it can change or influence its environment by
providing feedback information that is used by organizations and individuals to reshape the
economy. Accounting standards can also influence managerial behavior.
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