Expert, comprehensive resource lists all GAAP pronouncements with intepreations and applications of the authoritative accounting literature
The latest edition of this definitive, annual guide includes both AICPA accounting Standards Executive Committee Statements of Position and Emerging Issues Task Force Abstracts, explains with relevant terminology an practice-oriented, real-world examples. Each chapter contains a through analysis of its topic, sources of GAAP, definitions of terms, concepts, and rules, and specific appendices when appropriate. This indispensable staple of corporate and public accountants and CPA candidates also provides a detailed index for easy reference use.
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About the Author
Patrick R. DelaneyPhD, CPA, was the Arthur Andersen LLP Alumni Professor of Accountancy and Chair of the Department of Accountancy at Northern Illinois University. He received his PhD in Accountancy from the University of Illinois. Professor Delaney served as a Faculty Resident with Arthur Andersen LLP. He was the author of CPA Examination Review, 2-volume and 4 part sets, including the related components of the Wiley CPA preparation system. He was past president of the Rockford Chapter, Institute of Management Accountants; served on Illinois CPA Society Committees (previously as Vice-President and member, Board of Directors; Chairman of Accounting Principles Committee; chair of the Relations with Accounting Educators and Students Committee; and chair of Educator CPA Issues Committee_; and had served on numerous other professional committees. He was a member of the American Accounting Association, American Institute of Certified Public Accountants, and the Institute of Management Accountants. Professor Delaney had published in The Accounting Review and was the recipient of NIU's Excellence in Teaching Award and the Illinois CPA Society's Outstanding Educator Award.
Barry J. Epstein, PhD, CPA, is a partner with the Chicago-based firm Gleeson, Sklar, Sawyers & Cumpata, LLP, where he specializes in technical consultation on accounting and auditing matters and corporate governance, as well as litigation matters including accountants' malpractice, contractual dispute resolution, and commercial damages modeling. He has previously served in senior technical and litigation consulting positions with several regional and national CPA firms, as a corporate finance executive, and as a college professor. Dr. Epstein has authored or coauthored six books (including Wiley IAS Interpretation and Application) and several articles, and coauthored a weekly business column for an international newspaper. He served on several state and national technical committees, including the AICPA's Board of Examiners, and has lectured widely on technical accounting and auditing topics over most of his thirty-five-year career, which has been primarily in public accounting. Dr. Epstein holds a doctorate from the University of Pittsburgh, as well as degrees from DePaul University and the University of Chicago. He is a member of the Illinois CPA Society, the AICPA, and the American Accounting Association.
Ralph Nach, CPA, is a managing director with the Chicago office of American Express Tax & Business Services, Inc. where he serves as a technical consultant and as the director of professional development. Mr. Nach has been a public accounting practitioner for over 25 years, during which he has specialized in accounting, auditing, and financial reporting issues. Mr. Nach holds a BSBA with honors from the Walter E. Heller School of Business Administration of Roosevelt University in Chicago, and is a CPA in Illinois. Previously Mr. Nach worked for a "Big 5" CPA firm and taught graduate accounting and finance at Northwestern University. Mr. Nach has coauthored several other books and speaks nationally on accounting and auditing topics. He is a member pf the American Institute of Certified Public Accountants and its Educational Management Exchange Subcommittee (EDMAX), and the Illinois CPA Society, where he has served as a chairman and/or member of numerous committees.
Susan Weiss Budak, CPA, is a consultant and author. As a consultant, she has worked primarily with the FASB, the American Institute of Certified Public Accountants, Blackbaud, and the National Center for Education Statistics (NCES). Prior to becoming self-employed, Ms. Budak worked for the FASB and GASB as a project manager on research and technical activities. Her work at FASB included the contributors, financial statement display, and investment parts of the FASB not-for-profit organizations project. At the GASB, she worked on the GASB reporting model for public colleges and universities. Ms. Budak has also held positions as assistant controller and director of accounting services at Northwestern University in Evanston, Illinois, and senior accountant at Deloitte & Touche in Chicago, Illinois. Ms. Budak received her MM from the Kellogg Graduate School of Management and her BBA from Loyola University. She has coauthored five books on not-for-profit organizations.
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DEVELOPMENT OF GAAP
What Is GAAP?
Generally accepted accounting principles (GAAP) are concerned with the measurement of economic activity, the time when such measurements are made and recorded, the disclosures surrounding these activities, and the preparation and presentation of summarized economic information in the form of financial statements. GAAP develops when questions arise about how to best accomplish those activities--measurement, timing of recognition, disclosure, or presentation. In response to those questions, either GAAP is promulgated via official pronouncements of authoritative bodies empowered to create it, or it evolves over time when authoritative bodies fail to respond. Thus, GAAP is a reaction to and a product of the economic environment in which it is developed. As such, the development of accounting and financial reporting standards has somewhat lagged the progression of increasingly intricate economic structures and transactions.
An audit report expresses an opinion about whether the financial statements "present fairly in conformity with generally accepted accounting principles" the financial position and results of operations of the reporting entity. The Auditing Standards Board (ASB), which is the senior authoritative organization in the promulgation of generally accepted auditing standards, has defined the meaning of that phrase. It has stated, in AU 411, that
The phrase "generally accepted accounting principles" is a technical accounting term that encompasses the conventions, rules, and procedures necessary to define accepted accounting practice at a particular time. It includes not only broadguidelines of general application, but also detailed practices and procedures. Those conventions, rules, and procedures provide a standard by which to measure financial presentations.
Accounting principles are usually directed toward solutions that are objective, conservative, and verifiable. There are two broad categories of accounting principles--recognition and disclosure. Recognition principles determine the timing and measurement of items that enter the accounting cycle and impact the financial statements. These are quantitative standards that require economic information to be reflected numerically.
Disclosure principles deal with factors that are not always numerical. Disclosures involve qualitative information that is an essential ingredient of a full set of financial statements. Their absence would make the financial statements created by recognition principles misleading by themselves. Disclosure principles complement recognition principles by explaining assumptions underlying the numerical information and giving other information on accounting policies, contingencies, uncertainties, etc., which are essential ingredients in the analytical process of accounting.
The Hierarchy of GAAP
The determination of which accounting principle is applicable under a particular set of conditions might be difficult or even impossible without a determination of the hierarchy of GAAP by an authoritative body. In AU 411 (SAS 69), the ASB identified the following as the sources of established generally accepted accounting principles:
Accounting principles promulgated by a body designated by the AICPA Council to establish such principles, pursuant to rule 203 [ET section 203.01] of the AICPA Code of Professional Conduct.
Pronouncements of bodies, composed of expert accountants, that deliberate accounting issues in public forums for the purpose of establishing accounting principles or describing existing accounting practices that are generally accepted, provided those pronouncements have been exposed for public comment and have been cleared by a body referred to in category A.
Pronouncements of bodies, organized by a body referred to in category A and composed of expert accountants, that deliberate accounting issues in public forums for the purpose of interpreting or establishing accounting principles or describing existing accounting practices that are generally accepted, or pronouncements referred to in category B that have been cleared by a body referred to in category A but have not been exposed for public comment.
Practices or pronouncements that are widely recognized as being generally accepted because they represent prevalent practice in a particular industry, or the knowledgeable application to specific circumstances of pronouncements that are generally accepted.
Compliance with accounting pronouncements included in category A is mandatory. An auditor should not express an unqualified opinion if the financial statements contain a material departure from category A pronouncements unless, due to unusual circumstances, adherence to the pronouncements would make the statements misleading. Rule 203 implies that application of officially established accounting principles almost always results in fair presentation in conformity with generally accepted accounting principles.
If an accounting treatment is not specified by a pronouncement covered by Rule 203, the accountant/ auditor should proceed next to categories B, C, or D using the treatment specified by the source in the highest category. If an accounting pronouncement in category B, C, or D is relevant to the circumstances, an auditor must follow that pronouncement or be able to justify the conclusion that another treatment is generally accepted.
For financial statements of entities other than governmental entities
Category A, officially established accounting principles, consists of Financial Accounting Standards Board (FASB) Statements of Financial Accounting Standards and Interpretations, Accounting Principles Board (APB) Opinions, and AICPA Accounting Research Bulletins.
Category B consists of FASB Technical Bulletins and, if cleared by the FASB, AICPA Industry Audit and Accounting Guides and AICPA Statements of Position.
Category C consists of AICPA Accounting Standards Executive Committee (AcSEC) Practice Bulletins that have been cleared by the FASB and consensus positions of the FASB Emerging Issues Task Force.
Category D includes AICPA accounting interpretations and implementation guides (Qs and As) published by the FASB staff, and practices that are widely recognized and prevalent either generally or in the industry.
In the absence of one of the above sources of established accounting principles, other accounting literature may be considered. These would include FASB Statements of Financial Accounting Concepts, AICPA Issues Papers, International Financial Reporting Standards of the International Accounting Standards Board and of its predecessor, the International Accounting Standards Committee, Governmental Accounting Standards Board (GASB) Statements, Interpretations and Technical Bulletins, Federal Accounting Standards Advisory Board (FASAB) Statements, Interpretations, and Technical Bulletins, pronouncements of other professional associations or regulatory agencies, Technical Information Service Inquiries and Replies included in AICPA Technical Practice Aids, and accounting textbooks, handbooks and articles. The use of those other sources depends upon their relevance to particular circumstances, the specificity of the guidance, and the general recognition of the author or issuing organization as an authority. This would mean that FASB publications in this category would be more influential in establishing an acceptable accounting practice than would an accounting textbook. Guidance in this category would require more judgment and a broader search of literature than would be true in the other three categories.
Who Created GAAP?
Committee on Accounting Procedure. The first serious attempt to create generally accepted accounting principles began in 1930, primarily as a consequence of the stock market crash of the 1920s and the widespread perception that an absence of uniform and stringent financial reporting requirements had contributed to that crash. The American Institute of Accountants, later to become the American Institute of Certified Public Accountants (AIPCA), created a special committee to work with the New York Stock Exchange toward the goal of establishing standards for accounting procedures. The special committee recommended five rules to the Exchange that later (in 1938) were published as Accounting Research Bulletin (ARB) 1 of the Committee on Accounting Procedure. The Committee subsequently published 51 such bulletins, including Accounting Research Bulletin 43, which consolidated and superseded Bulletins 1-42. (A listing of the Accounting Research Bulletins that have not been completely superseded appears at the front of this publication with references to the pages of this publication that discuss those pronouncements.) The Committee was also instrumental in attempting to achieve uniformity in accounting terminology. However, the Committee's limited resources and lack of serious research efforts in support of its pronouncements were questioned in the late 1950s, particularly as a number of very complex controversial topics loomed on the horizon.
Accounting Principles Board. The profession's response was to substitute the Accounting Principles Board (APB) for the Committee on Accounting Procedure, in order to facilitate the development of principles based primarily on the research of the Accounting Research Division. Under this new strategy, the Division was to undertake extensive and exhaustive research, publish its findings, and then permit the Accounting Principles Board to take the lead in the discussions that would ensue concerning accounting principles and practices. The Board's authority was enforced primarily through prestige and Rule 203 of the Code of Professional Ethics. Furthermore, formal approval of Board issuances by the Securities and Exchange Commission (SEC) gave additional support to its activities.
During the fourteen years of the Board, 31 opinions and 4 statements were issued. They dealt with amendments of Accounting Research Bulletins, opinions on the form and content of financial statements, and issuances requiring changes in both the recognition and disclosure principles of the profession. (A listing of the Opinions that have not been completely superseded appears at the front of this publication with references to the pages of this publication that discuss those pronouncements.) However, the Board did not utilize the Accounting Research Division, which published fifteen research studies during its lifetime. Both the Board and the Division acted independently in selecting topics for their respective agendas. The Board issued pronouncements in areas where little research had been done, and the Division performed research studies without seeking to be all-inclusive or exhaustive in analysis. The Accounting Principles Board did not operate differently than the Committee on Accounting Procedure.
Financial Accounting Standards Board. As a result of these operational problems and based on the recommendations of the Wheat Study Group, the Financial Accounting Standards Board (FASB) was formed in 1972. The Board consists of seven full-time members; they have diverse backgrounds with three coming from public accounting, two from private industry and one each from academia and an oversight body. The Board is assisted by a staff of professionals who conduct research and work directly with the Board.
The FASB is recognized as authoritative through Financial Reporting Release 1 by the Securities and Exchange Commission and through Rule 203, Rules of Conduct by the AICPA.
The FASB is an independent body relying on the Financial Accounting Foundation for selection of its members and receipt of its budgets. Funds are raised from contributions made to the Foundation. The Board of Trustees of the Foundation is made up from members of the
American Accounting Association
American Institute of Certified Public Accountants
Association for Investment Management and Research
Financial Executives Institute
Government Finance Officers Association
Institute of Management Accountants
National Association of State Auditors, Comptrollers, and Treasurers
Securities Industry Association
The Board issues several types of pronouncements. Statements of Financial Accounting Standards and Interpretations are the most important of these because they are category A GAAP. Interpretations are used to clarify or elaborate on existing Statements or pronouncements of predecessor bodies. Technical Bulletins, which are category B GAAP, usually address issues not covered directly by existing standards and are primarily used to provide guidance where it is not expected to be costly or create a major change. Bulletins are discussed at Board meetings and subject to Board veto. Both Bulletins and Interpretations are designed to be responsive to implementation and practice problems on relatively narrow subjects.
A listing of the Statements, Interpretations, and Technical Bulletins that have not been completely superseded appears at the front of this publication with references to the pages of this publication that discuss those pronouncements.
American Institute of Certified Public Accountants (AICPA). The Accounting Standards Executive Committee (AcSEC) is the senior technical committee at the AICPA. It is composed of fifteen volunteer members, representative of industry, academia, analysts, and both national and regional public accounting firms. All AcSEC members are CPAs and members of the AICPA.
AcSEC is authorized to set accounting standards and to speak for the AICPA on accounting matters. The accounting standards that AcSEC issues are prepared largely through the work of AICPA committees and task forces. AcSEC issues Statements of Position (SOPs) and industry audit and accounting guides, which are reviewed and cleared by the FASB and thus are category B GAAP. SOPs provide guidance on financial accounting and reporting issues. Industry audit and accounting guides provide guidance to auditors in examining and reporting on financial statements of entities in specific industries and provide standards on accounting problems unique to a particular industry. AcSEC Practice Bulletins (category C GAAP) usually provide guidance on very narrowly defined accounting issues. AcSEC's standards-setting activities are often industry-specific or narrow in their scope, unlike the majority of FASB's projects, which are broader in scope. A listing of the Statements of Position, Audit and Accounting Guides, and Practice Bulletins that have not been completely superseded appears at the front of this publication with references to the pages of this publication that discuss those pronouncements.
AcSEC also issues technical practice aids and issues papers. Technical Practice Aids are answers published by the AICPA Technical Information Service to questions about accounting and auditing standards. AICPA Issues Papers are research documents about accounting and reporting problems that the AICPA believes should be resolved by the FASB. They provide information about alternative accounting treatments used in practice. These two AICPA publications, which are not approved by the FASB, have no authoritative status but can be helpful in understanding and resolving issues for which there is no authoritative literature. However, because the AICPA is the primary professional organization of accountants, those who depart from guidance in their nonauthoritative publications must be prepared to justify that departure based upon the facts and circumstances of the particular situation.
Emerging Issues Task Force (EITF). The Emerging Issues Task Force (EITF) was formed in 1984 by the FASB in order to assist the Board in identifying current or emerging issues and implementation problems before divergent practices become entrenched. The guidance provided is often on narrow issues that are of immediate interest and importance. Task Force members are drawn primarily from public accounting firms but also include individuals who would be aware of issues and practices that should be considered by the group. The Task Force meets every other month with persons representing the SEC and FASB in attendance for discussion but not voting purposes.
For each agenda item, an issues paper is developed by members, their firms, or the FASB staff. After discussion by the Task Force, a consensus may be reached on the issue, in which case further action by the FASB is not needed. If no consensus is reached, the problem may end up on the Board agenda or be resolved by the SEC or AICPA. It is also possible that no consensus is reached and the issue remains unresolved with no organization currently working on the problem. These may be in especially narrow areas having little broad-based interest. Occasionally, the FASB may include a narrow issue in the scope of a broader project and reaffirm or supersede the work of the Task Force.
The FASB publishes a volume of EITF Abstracts, which are summaries of each issue paper and the results of Task Force discussion. A listing of the Issues considered by the EITF, the status of discussion on those issues, and references to the pages of this publication that discuss those issues appears at the front of this publication.
The SEC believes that a Task Force consensus is GAAP for public companies, and they will question any accounting that differs from it. Although EITF pronouncements are technically category C GAAP, they are so specialized that there is really no category A or B GAAP on their topics. In addition, the SEC believes that the EITF works to supply a forum to discuss accounting concerns and to assist in providing advice in a public forum. Thus, they are supportive of the Task Force work.
The EITF also publishes Discussion Issues, which are FASB staff announcements and SEC staff announcements of technical matters that are deemed important by the FASB or SEC staff, but that do not relate specifically to a numbered EITF issue. These announcements are designed to help provide guidance on the application of relevant accounting pronouncements. A listing of the EITF Discussion Issues, with a short summary of each, appears at the front of this publication following the listing of the EITF Issues.
Other sources. Not all GAAP resulted from a deliberation process and the issuance of pronouncements by authoritative bodies. Certain principles and practices evolved into current acceptability without adopted standards. For example, depreciation methods such as straight-line and declining balance are both acceptable, as are inventory costing methods such as LIFO and FIFO. There are, however, no definitive pronouncements that can be found to state this. Furthermore, there are many disclosure principles that evolved into general accounting practice because they were required by the SEC in documents submitted to them. Among these are reconciling the actual rate with the statutory rate used in determining income tax expense, when not otherwise obvious from the financial statements themselves. Even much of the content of balance sheets and income statements has evolved over the years.
How Is GAAP Created?
The FASB and AICPA adhere to rigorous "due process" when creating new guidance in category A and category B GAAP. The goal is to involve experts who would be affected by the newly issued guidance so that the standards created will result in information that reports economic activity as objectively as possible without attempting to influence behavior in any particular direction. Ultimately, however, the guidance is the judgment of the FASB or the AICPA, based on research, public input, and deliberation. The process described below is the FASB's procedures; the AICPA follows similar procedures in its projects.
The FASB receives requests for new standards from all parts of its diverse constituency, including auditors, industry groups, the EITF, and the SEC. Requests for action include both suggestions for new topics and suggestions for reconsideration of existing pronouncements. For each major project it adds to its technical agenda, the FASB begins by appointing an advisory task force of approximately fifteen outside experts. Care is taken to ensure that various points of view are represented on the task force. The task force meets with and advises the Board and staff on the definition and scope of the project and the nature and extent of any additional research that may be needed. The FASB and its staff then meet to debate the significant issues in the project and to arrive at tentative conclusions. As it does so, the FASB and its staff study existing literature on the subject and conduct or commission any additional research as may be necessary. The task force meetings and the Board meetings are open to public observation and a public record is maintained.
If the accounting problem being considered by the Board is especially complex, the FASB will begin by publishing a Discussion Memorandum or other discussion document. The discussion document generally sets forth the definition of the problem, the scope of the project, and the financial accounting and reporting issues; discusses research findings and relevant literature; and presents alternative solutions to the issues under consideration and the arguments and implications relative to each. It is distributed to interested parties by request and available on the FASB website. The document is prepared by the FASB staff with the advice and assistance of the task force. It specifies a deadline for written comments and often contains an invitation to present viewpoints at a public hearing.
Any individual or organization may request to speak at the public hearing, which is conducted by the FASB and the staff assigned to the project. Public observers are welcome. After each individual speaks, the FASB and staff ask questions. Questions are based on written material submitted by the speakers prior to the hearing as well as on the speaker's oral comments. In addition to the hearing, the staff analyzes all the written comments submitted. The FASB members study this analysis and read the comment letters to help them in reaching conclusions. The hearing transcript and written comments become part of the public record.
After the comment letters and oral presentations responding to the discussion document are considered, formal deliberations begin. (If the accounting problem is not as complex and no discussion document was issued, the due process begins at this point.) The FASB deliberates at meetings that are open to public observation, although observers do not participate in the discussions. The agenda for each meeting is announced in advance. Prior to each Board meeting, the staff presents a written analysis and recommendations of the issues to be discussed. During the meeting, the staff presents orally a summary of the written materials and the Board discusses each issue presented. The Board meets as many times as is necessary to resolve the issues.
When the Board has reached tentative conclusions on all the issues in the project, the staff prepares an Exposure Draft. The Exposure Draft sets forth the Board's conclusions about the proposed standards of financial accounting and reporting, the proposed effective date and method of transition, background information, and an explanation of the basis for the Board's conclusions. The Board reviews, and if necessary, revises, the Exposure Draft. Then, a vote is taken about whether the Exposure Draft can be published for public comment. A majority of the Board members must vote to approve an Exposure Draft for issuance for comment. If four votes are not obtained, the FASB holds additional meetings and redrafts the Exposure Draft.
Any individual or organization can provide comments about the conclusions in the Exposure Draft during the exposure period, which is generally sixty days or more. The Board may also decide to have a public hearing to hear constituents' views. At the conclusion of the comment period, all comment letters and oral presentations are analyzed by the staff, and the Board members read the letters and the staff analysis. Then, the Board is ready to re-deliberate the issues, with the goal of issuing final accounting standards.
As in the earlier process, all Board meetings are open to the public. During these meetings, the Board considers the comments received and may revise their earlier conclusions. If substantial modifications are made, the Board will issue a revised Exposure Draft for additional public comment. If so, the Board also may decide that another public hearing is necessary. When the Board is satisfied that all reasonable alternatives have been adequately considered, the staff drafts a final pronouncement for the Board's vote. Four votes are required for adoption of a pronouncement. Once issued, the standards become GAAP after the effective date stated in the pronouncement.
Materiality as a concept has great significance in understanding, researching, and implementing GAAP. Each Statement of Financial Accounting Standards (SFAS) issued by the FASB concludes by stating that the provisions of the statement are not applicable to immaterial items.
Materiality is defined by the FASB as the magnitude of an omission or misstatement in the financial statements that makes it probable that a reasonable person relying on those statements would have been influenced by the information or made a different judgment if the correct information had been known. However, that definition does not sufficiently explain the concept to provide guidance in distinguishing material information from immaterial information. The individual accountant must exercise professional judgment in evaluating information and concluding on its materiality.
Quantitatively, materiality has been defined in a few pronouncements. For example, in SFAS 131, Disclosures about Segments of an Enterprise and Related Information, a material segment or customer is defined as 10% or more of revenues. The Securities and Exchange Commission has in several of its pronouncements defined materiality as 1% of total assets for receivables from officers and stockholders, 5% of total assets for separate balance sheet disclosure of items, and 10% of total revenue for disclosure of oil and gas producing activities.
Although materiality judgments are primarily quantitative, the nature of a transaction or event can affect a determination of whether that transaction or event is material. For example, a transaction that, if recorded, changes a profit to a loss or changes compliance with ratios in a debt covenant to noncompliance would be material even if it involved an otherwise immaterial amount. Also, a transaction that might be judged immaterial if it occurred as part of routine operations may be material if it occurs in abnormal circumstances.
Another factor in judging materiality is the degree of precision that is possible to attain when making an estimate. For example, accounts payable can usually be estimated more accurately than a possible loss from the incurrence of a disposal obligation. An error that would be material in estimating accounts payable might be acceptable in estimating the contingency.
Materiality as a criterion has both qualitative and quantitative aspects. Certain events or transactions may be deemed to be material because of the nature of the item, regardless of the dollar amounts involved, and thus to require disclosure under any circumstance. Offers to buy or sell assets for more or less than book value, litigation proceedings against the company pursuant to price-fixing or antitrust allegations, and active negotiations involving future profitability are all examples of items that would not be capable of being evaluated for materiality based solely upon numerical calculations.
The Crisis of Confidence Regarding GAAP
In recent years, GAAP as a body of standards, and the standard-setting process itself, have increasingly come under attack. Criticisms have come from all quarters--from within the profession itself, from business leaders, and from the legislative and executive branches of the federal government. While the need for a codified set of principles to serve as a foundation for financial reporting is not disputed, the number of voices calling for changes in the process and in some or all of the standards themselves have multiplied. The criticisms seemingly fall into three categories.
Some accountants and preparers complain about "standards overload," implying that there are too many accounting standards, which are individually too complex to be understood and implemented, and that too many organizations (SEC, FASB, AICPA, etc.) are empowered to issue these pronouncements.
Others in the business community complain that the implementation of certain recent accounting standards will harm their ability to be competitive in the global marketplace and impede their ability to raise debt or equity capital on favorable terms. On some occasions, they have even asked Congress to interfere in the standard-setting process, such as when FASB proposed standards on stock compensation and on the elimination of the pooling of interests method of accounting for business combinations.
Several Congressional Committees have challenged the validity or wisdom of specific accounting standards, as well as the process that creates them. In many such instances, the critics have confused auditing failures with GAAP deficiencies. The most recent investigations are in response to the collapse of Enron (essentially an audit failure) and have resulted in demands that a body under the SEC's jurisdiction assume the responsibility for the establishment of accounting principles from FASB.
Standards overload. Complaints regarding standards overload are not new, and with 145 FASB Statements and myriad other standards (including hundreds of EITF Issues), these complaints must be given some credence. However, the solution, if there is one, is not obvious. Nor is it clear that financial reporting frauds, audit failures, or other such phenomena have been the result of this overload.
Some say that a solution would be to reduce and simplify GAAP, especially for entities having characteristics suggesting that the risk of misleading the users of the financial statements might be low. For example, some recommend a size test, with smaller entities following a subset of the standards that would be mandated for larger entities (a system actually in place in the UK). Even this superficially simplistic suggestion has complications, however: size could arguably be determined by assets, revenues, net worth, or number of owners. Others recommend that public entities, regardless of size, follow a more comprehensive set of standards than privately owned businesses.
Those who disagree say that differing standards would reduce the quality of financial reporting. For example, if decisions about which entities should follow which standards were made using a single criterion for all standards (such as size or ownership), some entities that engage heavily in a certain type of transaction (e.g., derivative financial instruments) might not be subject to the standards for that transaction--even though the recognition, measurement, and disclosure of those transactions was critical to understanding the financial condition and results of operations of the entity. To solve that problem, criteria would need to be based in some way on the underlying subject matter of the standard, which would result in an accountant having to examine each standard to determine if it would apply to a particular entity. That could compound the standards overload problem rather than solve it.
This "big GAAP vs. little GAAP" debate has raged off and on for decades. When advocates of differential standards are challenged, however, they typically have been unable to identify alternative recognition or measurement principles for large (or public) entities vs. those for smaller (or privately held) entities. Generally, at best certain disclosures are cited as candidates for slimming down in financial statements of the smaller or private companies. In short, there may be less than meets the eye to this entire controversy.
In fact, the FASB has experimented in recent years with differential standards for disclosures. SFAS 126 exempts nonpublic companies from certain financial instrument disclosures if the entity's total assets are less than $100 million and the entity has not held or issued any derivative financial instruments. Nonpublic companies also are not required to disclose earnings per share (SFAS 128), segment information (SFAS 131), or certain pension and postretirement information (SFAS 132). These exemptions have not, however, been widely cited as representing progress on this presumed problem of standards overload.
To address the perceived problem that there are too many organizations issuing standards, FASB has indicated that it will begin to include references to all applicable US accounting literature in its future standards and in the Current Text. In addition, the FASB is seeking to partner with others in developing an online database that will include all of the US accounting literature in a single, more easily accessed form.
The FASB also will attempt to reduce the complexity of accounting literature by exploring the possibility of issuing standards that are less detailed and have few, if any, exceptions or alternatives. That may be difficult to achieve, however, because the complexity of the underlying transactions often necessitates complexity in the standards. FASB also wants to more thoroughly assess the cost-benefit relationships of proposed standards; presumably, complex standards are more costly to implement, and thus the costs are more likely to out-weigh the expected benefits to users. If so, enactment is less probable.
More recently, it has been suggested that the answer to the problem of complexity of standards might lie in embracing a principles-based, as opposed to rules-based, approach to accounting standards. These critics observe that prior to FASB's creation, US GAAP was generally principles-based, with much less specific guidance provided for dealing with varied nuances of transactions and events. To some extent, the standards published by the International Accounting Standards Board continue to have this characteristic, although perhaps to lesser an extent than these critics believe. It is true that increasingly complex rules (e.g., capital lease requirements such as the "90% test") encourage evasions (e.g., "89% leases") which often provoke even more detailed rules.
However, many observers have concluded that complex rules are primarily driven by increasingly complex economic transactions (e.g., the explosive growth in the use of hedging and financial derivatives), and that there is no way to return to a simpler time or to simpler GAAP. Also, the well-known penchant for litigation means that, as former Federal Reserve Board Chairmen Paul Vocker noted, "(T)he American tradition is to have clear and definite rules, so firms can defend themselves from the hoards of lawyers who stand ready to sue auditors for making a bad judgment."
Undoubtedly, the debate about standards will continue. For the reasons noted, however, a lessening of the burden of GAAP is not deemed likely.
Potential harmful effects of standards. In general, reporting entities have not welcomed proposals for new standards, since these inevitably involve change, costs of implementation, and perhaps, a period of confusion while the marketplace assimilates the new information. The business community often claims that FASB does not understand the economic impact of new standards on their businesses. Two early examples were the issuance of SFAS 43 (compensated absences) and SFAS 106 (postretirement benefits). In both cases, the business community said that the new standard would force them to reduce benefits to employees--and in some cases they did just that. The counterargument was perhaps more impressive: as a consequence of formerly failing to fully account for promises made or benefits granted, companies were misled regarding their true financial condition, which, once exposed, resulted in changes in behavior that were long overdue. Managers were harmed by their former ignorance; they were not hurt by the truth.
In two recent cases, dissatisfaction with proposed standards escalated to the point where the business community asked the federal government to intervene. When the FASB proposed that the value of stock options granted to employees should be reflected as an expense in the financial statements, the business community, and particularly technology firms, loudly claimed that the proposed recognition would have a dramatic and negative economic effect. First, the argument went, it would force them to discontinue issuing stock options, which would prevent the companies from compensating valuable employees. Second, to the extent options were granted and reflected in expense, it would cause the firms' costs of capital to increase significantly because of lower levels of reported profitability. Finally, it would put US firms at a competitive disadvantage to foreign companies that did not have to expense the value of stock options (or were not offering this benefit to employees).
Before the battle was over, "sense of the House" and "sense of the Senate" resolutions had been introduced, objecting to the FASB's tentative conclusions, and a bill had been introduced that would have, if enacted, precluded the recognition of the value of stock options as an expense as a matter of law. This debate threatened not only the stock-based compensation standard, but the future of accounting standard-setting in the private sector itself. That concern contributed to FASB's decision to issue SFAS 123 with only a requirement for disclosure of the value of stock options, with recognition and measurement optionally continuing under prior (APB 25) rules. Not surprisingly, virtually all publicly-held companies continued to utilize the "implicit value" approach of APB 25, even though SFAS 123 clearly states that the "fair value" approach is preferable GAAP.
Later, when FASB was pursuing its derivative financial instruments project, the business community again approached the Congress with a request for it to intercede in the debate. Although the federal government was not as quick to intervene in this instance, the FASB was again criticized by several members of Congress and by their staff. To have been thus criticized and, in part, thwarted by influential government officials twice in a span of five years might prove to be detrimental as the next challenge to private sector standard-setting unfolds--the collapse of Enron Corp. in the fall of 2001.
Lack of independence and failure to protect investors. In November 2001, Enron publicly acknowledged that it had failed to comply with existing accounting requirements in at least two areas--sales of stock to special-purpose entities (SPEs) and nonconsolidation of certain SPEs. This noncompliance caused material overstatements of assets, shareholders' equity, and net income, and the concealment of substantial debt obligations for several years. Within days of this announcement, Enron's stock price fell, eventually to under twenty-five cents. As the ensuing events unfolded, public policy discussions and media criticisms of GAAP, of standard-setting in the private sector, and of the accounting industry reached unprecented levels. The criticisms centered primarily on the failure of financial statements to warn investors of the impending collapse of Enron, and on the lack of independence of a self-regulating profession that offers both consulting and auditing services to its clients. In July 2002 an announcement by WorldCom of its accounting irregularities led to a similar drop in stock price and criticism of the profession.
By mid-2002, more than a dozen bills had been introduced in Congress, with the stated goal of bringing reform to the accounting industry. For example, the House had passed H.R. 3763, the Corporate and Auditing Accountability, Responsibility, and Transparency Act of 2002. The House Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises was considering another bill, H.R. 3795, which would establish a Federal Bureau of Audits within the SEC to conduct audits of all publicly registered companies. That subcommittee was also considering H.R. 3818, which would overhaul corporate disclosures made pursuant to the securities laws and enhance regulation of public accountants (auditors). The House Financial Services subcommittee was conducting hearings on the topic, "Corporate Accounting Practices: Is There a Credibility GAAP?" The House Energy Committee had put its final touches on H.R. 3970, Financial Accounting Standards Board Act, and the General Accounting Office was advocating direct government intervention to create a new body to oversee the accounting industry. The outcomes of these and many other proposals is not yet known, although there remains the strong possibility that none of these will be enacted, at least not in 2002.
Prominent leaders of the profession and others, including the SEC chief accountant, have responded in testimony before House and Senate committees, rejecting the suggestion that the activities of FASB should be federalized rather than remaining in the private sector. However, there was wide agreement that a new regulatory organization, under SEC oversight and dominated by individuals from outside the accounting profession, should perform quality reviews of the practices of public company auditors and should be empowered to discipline those auditors when warranted. There was also agreement that some reforms were necessary to expedite the standard-setting process, and to address investors' needs for more information, provided in a plain English, on-line, real-time reporting model.
Congressional committees have been critical of the SEC in instances where they felt that too much power had been ceded to the profession itself without adequate oversight by the Commission. Greater oversight of auditors is likely to be the major result of the recent audit failures and the well-publicized Enron and WorldCom collapses. This oversight is expected to largely address the performance of audits, including compliance with GAAP by audited companies. Even in the current climate, with many presumed audit failures having occurred and serious questions having been raised about certain accounting practices (such as the use of SPEs), it is expected that accounting standard-setting will remain almost entirely in the private sector.
It will be interesting to see how GAAP and the FASB survive these newest challenges.
The Business Reporting Research Project
In answering Congressional and other challenges to continued private sector standard-setting and to GAAP as it currently exists, the AICPA's chair cited the fact that economic change has been much more swift than has been the response of those setting standards, and that the existing financial reporting model may have become obsolete. Annual and quarterly reporting has become insufficient to meet investor needs and, ultimately, there must be a move towards a real-time disclosure system. As reported in the AICPA study, Improving Business Reporting--A Customer Focus (1994), investors and creditors have many unmet needs for information. Those needs far beyond what is provided by the current financial reporting model. To capture the sense of reporting nonfinancial information in addition to financial information, the study adopted the broader term "business reporting."
In early 1996, FASB issued an Invitation to Comment on the study's conclusions and those of another group. One of the issues raised was whether FASB should broaden its attention beyond financial statements and related disclosures to also address the types of non-financial information that would be included in a comprehensive business-reporting model. Overall, respondents had mixed views on FASB involvement with nonfinancial information. Nonetheless, in 1998 the Board decided to undertake research on business reporting, with the goal of identifying the types of information businesses were already voluntarily providing, and the means used to deliver it.
The FASB has produced three reports setting forth results of this project as follows:
Electronic Distribution of Business Reporting Information (January 2000), which describes the reporting of business information over the Internet and identifies notable practices.
Improving Business Reporting: Insights into Voluntary Disclosures (January 2001), which identifies the kinds of business information that corporations in eight selected industries are reporting outside of their financial statements.
GAAP-SEC Disclosure Requirements (March 2001), which identifies redundancies between GAAP and SEC disclosure requirements and ways to eliminate them.
FASB recently announced that the electronic distribution report will be updated in 2002 to survey changes occurring since 1999 in how companies use websites to communicate with investors and others interested in business reporting information. It has not added any projects to its agenda to require disclosure of nonfinancial information as of this date, however.
Table of Contents
Authoritative Accounting Pronouncements.
1 Researching GAAP Problems.
Appendix : Conceptual Framework.
2 Balance Sheet.
3 Statements of Income and Comprehensive Income.
4 Statement of Cash Flows.
5 Cash, Receivables, and Prepaid Expenses.
6 Short-Term Investments and Financial Instruments.
Appendix A: LIFO Conformity Rule.
Appendix B: Task Force on LIFO Inventory.
8 Revenue Recognition-Evolving Principles and Specialized Applications.
Revenue Recognition-General Principles.
Long-Term Construction Contracts.
Sales When Collection Is Uncertain.
Revenue Recognition When Right of Return Exists.
Profit Recognition on Real Estate Sales.
Real Estate Operations.
Franchising: Accounting by Franchisors.
Other Special Accounting and Reporting Issues.
9 Long-Lived Assets.
11 Business Combinations and Consolidated Financial Statements.
12 Current Liabilities and Contingencies.
13 Long-Term Debt.
Appendix: Leveraged Leases.
15 Income Taxes.
Appendix A: Accounting for Income Taxes in Interim Periods.
Appendix B: Schedule of Common Permanent and Temporary Differences.
17 Stockholders' Equity.
Appendix: Financial Statement Presentation.
18 Earnings Per Share.
Appendix: Comprehensive Example.
19 Interim and Segment Reporting.
Appendix: Comprehensive Illustration.
20 Accounting Changes and Correction of Errors.
Appendix: Accounting Changes in Interim Periods.
21 Foreign Currency.
Appendix: Accounts to Be Remeasured Using Historical Exchange Rates.
22 Personal Financial Statements.
Appendix: Hypothetical Set of Personal Financial Statements.
23 Specialized Industry GAAP.
Banking and Thrift Industries.
Benefit Plans, Including Pension Funds.
Cable Television Industry.
Computer Software Costs and Revenues.
Insurance Industry Transactions.
Mortgage Banking Activities.
Motion Picture Industry.
Oil and Gas Producing Activities.
Recording and Music Industry.
Appendix A: Disclosure Checklist.
Appendix B: International vs. US Accounting Standards.
2003 Self-Study CPE Program.