Financial Accounting Standards

Chapter 1: Financial Accounting and Accounting Standards

This is Intermediate Accounting Chapter 1. For more Intermediate Accounting topics, see Intermediate Accounting Study Guide.

Financial Reporting Environment

Accounting is the the identification, measurement, and communication of financial information about economic entities to interested parties. Financial accounting is the preparation of financial reports on the entity. These financial reports are used by both internal and external parties.

Financial statements are the way a company communicates financial information to the public. The financial statements are:

  1. Balance sheet
  2. Income statement
  3. Cash flow statement
  4. Stockholders’ equity statement

Note disclosures are an integral part of each financial report. These disclosures are explanatory notes added to the financial reports.

Accounting is important for financial markets because it provides information that leads to capital allocation. The better the information, the more effective the process of capital allocation at less cost.

Objectives of Financial Reporting

The objective of financial reporting is to provide financial information about the reporting entity that is useful to present and potential equity investors, lenders, and other creditors. Financial statements provide financial reporting information to many different stakeholders.

Financial reporting provides information about a company’s:

  1. Financial position—the company’s assets, liabilities, and equity.
  2. Cash inflows and outflows—the company’s cash receipts and payments.
  3. Operating results—the company revenues and expenses and profitability.

The goals of financial reporting relate directly to three of the company financial statements. See the table below.

Financial Reporting GoalFinancial Statement
Financial positionBalance Sheet
Cash inflows and outflowsCash Flow Statement
Operating resultsIncome Statement

The entity concept assumes companies are separate and distinct from their owners.

The common set of rules and procedures in the United States is called generally accepted accounting principles (GAAP). GAAP is the set of rules for financial reporting for every U.S. business.

Securities and Exchange Commission

The Securities and Exchange Commission (SEC) has the legal authority to set financial standards in the United States. The federal government established the SEC to develop accounting standards. This standardizes financial information reported by companies.

The SEC is a federal agency that regulates the financial markets. Companies that issue securities to the public or are listed on an exchange are required to file audited financial statements with the SEC. The SEC has legal authority to set the accounting practices in the U.S.

In addition to the Securities Exchange Act of 1934, which created it, the SEC enforces the Securities Act of 1933, the Investment Company Act of 1940, the Investment Advisers Act of 1940, the Sarbanes–Oxley Act of 2002, and other statutes.

Financial Accounting Standards Board

When the SEC was created, it allowed the creation of a private standards-setting body. As a result, accounting standards were developed in the private sector. Here are the entities that developed accounting standards in the U.S.

  1. Committee on Accounting Procedure (CAP) 1939-1959
    • Accounting Research Bulletins (ARBs)
    • Committee of the American Institute of Certified Public Accountants (AICPA)
  2. Accounting Principles Board (APB) 1959-1973
    • APB Opinions
    • Board of the AICPA
  3. Financial Accounting Standards Board (FASB) 1973-present
    • Independent nonprofit board of 7 full time members
    • Accounting Standards Updates
    • Financial Accounting Concepts

The SEC has the legal authority to set accounting standards in the United States. However, the SEC allows the FASB to produce these standards that establish GAAP.

Sarbanes-Oxley Act

In 2002, the Sarbanes-Oxley Act implemented stronger independence rules for auditors, requires CEOs and CFOs to personally certify that financial statements and disclosures are accurate and complete, requires audit committees to be comprised of independent members, and requires a code of ethics for senior financial officers. In addition, the Sarbanes-Oxley Act requires public companies to attest to the effectiveness of their internal controls over financial reporting.

International Accounting

As business became more global, the need rose for more global accounting standards. The International Accounting Standards Board (IASB) is the global accounting standard setting body. The IASB produces the International Financial Reporting Standards (IFRS).

There are two accounting systems: U.S. GAAP and IFRS. GAAP in the United States and IFRS around the world. The goal of the FASB and the IASB is to reconcile GAAP and IFRS to make the two systems converge.

There is a need for one set of international accounting standards because of multinational corporations, mergers and acquisitions, information technology, and financial markets.

GAAP is rules-based and is more complex. IFRS is principles-based tends to be more flexible in its disclosure requirements. GAAP developed for only one country while IFRS developed to meet the needs of many different countries.

The SEC allows foreign companies that trade shares in U.S. markets to file their IFRS financial statements without reconciliation to GAAP. This reconciliation to GAAP was expensive and a barrier to entry into the U.S. capital market.

Differences between GAAP and IFRS have developed because of different user needs in countries. In some countries, the primary users of financial statements are private investors. In others, the primary users are tax authorities and government agencies.

Challenges in Financial Reporting

  1. Politicization on the development of GAAP
  2. Expectations gap
    1. What people think accountants should do vs. what accountants actually do
    2. Sarbanes-Oxley Act (SOX)
  3. Financial reporting doesn’t report
    1. Nonfinancial measures
    2. Forward-looking information
    3. Soft assets—intangibles and nonfinancial assets
    4. Timeliness
    5. IFRS vs. GAAP

Accounting Standards Codification

The FSAB developed the Accounting Standards Codification in 2009 to combine all the authoritative literature related to a particular topic. This simplifies user access to all authoritative U.S. GAAP.

Accounting Standards Updates amend the Codification. The Codification represents the authoritative accounting standards for the U.S.

The mission of the FASB is to establish and improve standards of financial accounting and reporting for the guidance and education of the public, which includes issuers, auditors, and users of financial information.

Two basic premises of the FASB are that in establishing financial accounting standards it should:

  1. Respond to the needs of the entire economic community, not just the accounting profession
  2. Operate in full view of the public through a “due process” system that gives interested parties opportunity to make their views known.

Codification Classification

The FASB developed a classification system specifically for the Codification. The following is the structure of the classification system:

  • Topic
  • Subtopic
  • Section
  • Paragraph
  • Subparagraph

Codification Example: FASB ASC 310-10-15-2(a)

ClassificationCodeName
Topic310Receivables
Subtopic10Overall
Section15Scope
Paragraph2Transactions
SubparagraphaTrade Accounts Receivable

Codification Example: Leases

Here is another example with the topic of leases. For example, the partial classification for Leases is:

  • 840 = Leases (Topic)
  • 840-10 = Overall (Subtopic)
  • 840-10-15 = Scope and Scope Exceptions (Section)
  • 840-10-50 = Disclosure (Section)
  • 840-30 = Capital Leases (Subtopic)
  • 840-30-15 = Scope and Scope Exceptions (Section)
  • 840-30-50 = Disclosure (Section)

How to Cite the Codification

For purposes of establishing a consistent referencing approach for items such as working papers, articles, textbooks, and other similar items, the FASB suggests the following approach for referencing Codification content from outside the Codification:

  • FASB ASC [Codification reference], for example:
  • Topic—FASB ASC Topic 310 [Receivables]
  • Subtopic—FASB ASC Subtopic 310-10 [Receivables—Overall]
  • Section—FASB ASC Section 310-10-15 [Receivables—Overall—Scope]
  • Paragraph—FASB ASC paragraph 310-10-15-2
  • Subparagraph—FASB ASC subparagraph 310-10-15-2(a)

Financial Accounting Standards Video


Intermediate Accounting Study Guide

This is Intermediate Accounting Chapter 1. For more Intermediate Accounting topics, see Intermediate Accounting Study Guide.

Jeff Mankin

Jeff Mankin teaches financial literacy. His website is FinallyLearn.com.

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