FINANCIALACCOUNTINGANDREPORTINGINNORTHAMERICAPresentedatSchoolofManagement,UESTCByGeorgeLan,PhDAssociateProfessorofAccountingUniversityOfWindsorWindsor,Ontario,CanadaMarch19,2003FINANCIALACCOUNTINGANDREPOROutlineofPresentation-1Rolesofstandardsettingbodies(FASB,CICA),Managers,AuditorsandSuppliersofCapital(InvestorsandCreditorsorlenders)[SeeDiagram]InformationEconomicsApproachandEfficiencyofcapitalmarketsWorldCom,EnronandArthurAndersenIncentivesofManagementtoManageEarningsOutlineofPresentation-1RoleOutlineofPresentation-2Stepstopreventscandalsfromoccurringinthefuture?SomeEthicalPrinciplesAnEthicalCaseQuestionsregardingpresentationoranyother(accounting)questions.OutlineofPresentation-2StepInformationEconomicsApproachInformationAsymmetryexistsbetweenthepartiesinbusinesstransactions.Themanagers(agents)havemoreinformationthantheinvestors(principals).Managersmayattempttoselectpoliciesortoreleasebiasedinformationthatbenefitthemselvestotheexpenseoftheowners.RoleofAccounting:toprovideinformationusefulforrationaldecision-making.InformationEconomicsApproachDecisionUsefulnessApproachSection1000ofCICAHandbook(par.1000.15):Theobjectiveoffinancialstatementsistocommunicateinformationthatisusefultoinvestors,members,contributors,creditorsandotherusers…inmakingtheirresourceallocationdecisionsand/orassessingmanagementstewardship.DecisionUsefulnessApproachSeObjectivesofFinancialStatementsStatementsofFinancialAccountingConcepts(1978)(SFAC1):Toprovideinformationthatisusefultopresentandpotentialinvestorsandcreditorsandotherusersinmakingrationalinvestment,credit,andsimilardecisions.Toprovideinformationtohelppresentandpotentialinvestorsandcreditorsinassessingtheamounts,timinganduncertaintyofprospectivecashreceiptsfromdividendsorinterest.ObjectivesofFinancialStatemRelevanceandReliabilityTobeuseful,accountinginformationshouldprovideaninformativeinformationsystemthatlinkscurrentfinancialstatementswithfuturestaterealizationsandpayoffs.AccountinginformationshouldberelevantI.e.hasthecapacitytoaffectinvestors’beliefsaboutfuturereturns.Accountinginformationshouldbereliablei.e.shouldfaithfullyrepresentswhatitpurportstomeasure.Itshouldbepreciseandfreefrombias.RelevanceandReliabilityTobeElementsofFinancialStatementsAssets:Probablefutureeconomicbenefitsobtainedorcontrolledasaresultofpasttransactions.Liabilities:ProbablefuturesacrificesofeconomicbenefitsOwner’sEquity:residualInterestinassetsafterdeductingliabilitiesi.e.A=L+O.E.orO.E=A–L.Revenues:inflowsofassets(orsettlementofliabilities)arisingfromtheentity’smajororongoingactivities.ElementsofFinancialStatemenAccountingPrinciples-1HistoricalCostPrinciplei.e.recognise(recordandreport)assetsandliabilitiesinitiallyatthecash-equivalentcost.RevenueRecognitionPrinciplei.e.recogniserevenueswhenearned(earningprocessiscompleteandanexchangehastakenplace).Allnecessarycostshavebeenincurredandcollectionisassured–usuallyatpointatsale.AccountingPrinciples-1HistorAccountingPrinciples-2MatchingPrinciplei.e.recogniseallexpensesincurredinproducingrevenuesinthesameperiodastherevenues.FullDisclosurePrinciplei.e.discloseallrelevantinformation.AccountingPrinciples-2MatchiLAN’SCLOTHINGCOMPANYInvest10,000Yuans(Y)tostartthebusinessBuy1000shirtsat5Yeach.Paywagesof1000Yforthefirstmonth.Sell400shirtsat20Yeach.Payrentof600Yforthefirst6months.Incurredmiscellaneousexpensesof500Y.Borrowed4800Yandboughtatruck.Truckwilllastfor4years.Whatismynetincomeforfirstmonth?LAN’SCLOTHINGCOMPANYInvest1Lan’sClothing

NetIncomeforfirstmonthNetIncomebeforetaxes= Revenues–Expenses= 400X20(sales)-400X5(costofshirtssold)–1000(wagesexpense)–600/6(rentforonemonth)–500(miscellaneousexpenses)-4800/48(amortisationexpensefor1month)=4,300YuansLan’sClothing

NetIncomeforStandardSetting&Auditing-1Standardsettingorregulationisnecessarytoprotecttheinvestors(conflictinginterestsofinvestorsandmanagers).TheFASB(FinancialAccountingStandardsBoardandtheCICA(CanadianInstituteofCharteredAccountants)areindependentbodies.StandardSetting&Auditing-1StandardSetting&Auditing-2Auditing(external)ensuresthatathirdindependentpartyhasexaminedthefinancialstatementsandthattheyareinaccordancetoGAAP(GenerallyAcceptedAccountingPrinciples).StandardSetting&Auditing-2EfficientSecuritiesMarketsThepricesofsecurities(stocks)“properlyreflect”allinformationthatispubliclyknownaboutthesesecurities.Investorswillquicklyadjusttoneworcorrectedinformationasitbecomesavailable.Investorscannotexpecttoearnabnormalreturnsi.e.areturnonasecurityinexcessofitsnormalexpectedreturn.EfficientSecuritiesMarketsThWORLDCOM(CommunicationsIndustry)-1LargestBankruptcyinhistory.Bankruptcydate=July21,2002.Totalassets(pre-bankruptcy)=US$103,914,000,000approximately850,000millionsYuansorRMB(assuming1usdollarapproximatelyequalto8.2Yuans)WORLDCOM(CommunicationsIndustWORLDCOM(CommunicationsIndustry)-2InternalAuditor(CynthiaCooper-TimeMagazinePersonoftheyearfor2002)wenttoBoardofDirectors,claimingassetsshouldbewrittenoffthebalancesheet.B.O.D.agreewithher.Onwritingoffassets,largelosses.Stockpricesfelldownsteeply.WORLDCOM(CommunicationsIndustEnronCorp

(EnergyIndustry)CompanywentbankruptonDecember2,2001.Totalassetspre-bankruptcy=US$63,392,000,000approximatelyequalto520,000millionsYuansorRMB.Profitsoverstated;revenuesrecognizedbeforetheyareearned.Liabilitieshiddenfrombalancesheet.Gamblingonenergyfuturescontracts.SherriWatkins(Enronmanager)blewthewhistlebutnoonelistened.EnronCorp

(EnergyIndustry)ArthurAndersen(Former“BigFive”AccountingFirm)Issuedunqualifiedopiniontofinancialstatements.Didnotdiscloseaccountingirregularities.Shreddeddocumentstohideevidence.Guiltyofobstructingjustice.ArthurAndersen(Former“BigFManagement’sIncentivestoManageEarningsIncometaxes—PostponepaymentbyminimizingreportedincomeBonus—MaximizetheirbonusesbyincreasingreportedincomeDebtAgreements–Easiertomeetdebtagreements(covenants)byincreasingincomeandassetsStockoptions(giveyoutherighttopurchaseastockatafixedpriceinsomefutureperiod)—maximizeshareprices(believedtoberelatedtoreportedincome).Management’sIncentivestoMaAccrualsandEarningsManagementAmortizationexpenseIncreaseinnetreceivablesIncreaseininventoryDecreaseinaccountspayableandaccrualliabilitiesAccrualsandEarningsManagemeWhatcouldbedone?Betteraccountingstandardsandbetterdisclosure.Lessemphasisonhistoricalcostandmoreemphasisoncurrentmarketvalueofassetsandliabilitiesonbalancesheet.Foreexample,recordallstockoptionsasanexpenseonincomestatement,whenissued.Restrictionsonauditorse.g.auditorsnotallowedtodoconsultingworkforfirmtheyauditGreateraccountabilityofboardofdirectorsandmorepunishmentforwrongdoings.Whatcouldbedone?BetteraccoEthicsandaccountingEthicsRulesOfProfessionalConductLegalWhatislegalormeettherulesofprofessionalconductmaynotbeconsideredethical.EthicsandaccountingEthicsSomePrinciplestoEvaluateOne’sActions-1Non-Maleficence:AmIcausingharmbyfailingtodosomethingoragreeingwithit?Beneficence:Domyactionsbenefitotherpersonsbesidesmyself?Justice:DoItreatthoseforwhomIamresponsibleequitably(fairly)?SomePrinciplestoEvaluateOnSomePrinciplestoEvaluateOne’sActions-2Fidelity:DoIupholdmypartoftherelationship?ActConsciously:DoIknowtheassumptionsonwhichIbasemyactionsandaretheyvalid?UtilitarianismDeontologySomePrinciplestoEvaluateOnConsequencesorNatureofActions?Utilitarianism:[BritishPhilosopherJohnStuartMill(1806-1873)]—Domyactionspromote“theGreatestGoodfortheGreatestNumberofIndividuals”?Deontology:[GermanPhilosopherImmanuelKant(1724-1804)]–Examinethenatureofactionsratherthantheoutcomesachieved.Doingtherightthingwhatevertheconsequences.ConsequencesorNatureofActiAnEthicalDilemma(conflictinduties)SupposeyouaretheauditorofABCauditingcompanyandyouaredoinganauditofXYZCompany(yourclient).TheCFOofXYZCorefusestowritedownsomeinventoryyoustronglybelievetobeobsoleteandnotworthmuch.YoudiscussthesituationwithyourownbossatABC.Yourboss(agoodfriendoftheCFO)tellsyoutoagreewiththeCFO.Whatshouldyoudo?AnEthicalDilemma(conflictiAnEthicalCaseAnalysisFrameworkWhatarethefacts?Whoarethestakeholders(thoseaffected)?Whatarethealternatives?WhatEthicalPrinciplesApply?Examinepros(advantages)andcons(disadvantages)ofeachalternative.MakeadecisionAnEthicalCaseAnalysisFrameApplyingtheFrameworkStakeholders:yourselfandfamily,yourbossandcompany,yourclient,thepublic(investorsandcreditors)whodependonfinancialstatements.Alternatives:1.AgreewithCFOofXYZCoI.e.donotwritedowninventory2.Disagreewithyourboss3.DiscusssituationwithaseniorpartnerProsandConsApplyingtheFrameworkStakeholNoEasyAnswers!!!-1AGREE.PROS:Keepbosshappy.Positionsecureforthemoment;promotionnotaffected.CONS:Yourintegrityandtheintegrityofthefinancialstatementsaffected.Investorsandotheruserscanlosealotofmoney.Potentiallawsuitagainstyourcompany.Yourprofessionalcertificationmayberevoked.NoEasyAnswers!!!-1AGREE.NoEasyAnswers!!!-2DISAGREE.PROS:Integritymaintained.Actingequitably.Doingthe‘rightthing”.CONS:Mayharmyourcareerprospects.CONSULTSENIORPARTNER.NoEasyAnswers!!!-2DISAGREE.ForFurtherInformationForFurtherInformationThankYouThankYouFINANCIALACCOUNTINGANDREPORTINGINNORTHAMERICAPresentedatSchoolofManagement,UESTCByGeorgeLan,PhDAssociateProfessorofAccountingUniversityOfWindsorWindsor,Ontario,CanadaMarch19,2003FINANCIALACCOUNTINGANDREPOROutlineofPresentation-1Rolesofstandardsettingbodies(FASB,CICA),Managers,AuditorsandSuppliersofCapital(InvestorsandCreditorsorlenders)[SeeDiagram]InformationEconomicsApproachandEfficiencyofcapitalmarketsWorldCom,EnronandArthurAndersenIncentivesofManagementtoManageEarningsOutlineofPresentation-1RoleOutlineofPresentation-2Stepstopreventscandalsfromoccurringinthefuture?SomeEthicalPrinciplesAnEthicalCaseQuestionsregardingpresentationoranyother(accounting)questions.OutlineofPresentation-2StepInformationEconomicsApproachInformationAsymmetryexistsbetweenthepartiesinbusinesstransactions.Themanagers(agents)havemoreinformationthantheinvestors(principals).Managersmayattempttoselectpoliciesortoreleasebiasedinformationthatbenefitthemselvestotheexpenseoftheowners.RoleofAccounting:toprovideinformationusefulforrationaldecision-making.InformationEconomicsApproachDecisionUsefulnessApproachSection1000ofCICAHandbook(par.1000.15):Theobjectiveoffinancialstatementsistocommunicateinformationthatisusefultoinvestors,members,contributors,creditorsandotherusers…inmakingtheirresourceallocationdecisionsand/orassessingmanagementstewardship.DecisionUsefulnessApproachSeObjectivesofFinancialStatementsStatementsofFinancialAccountingConcepts(1978)(SFAC1):Toprovideinformationthatisusefultopresentandpotentialinvestorsandcreditorsandotherusersinmakingrationalinvestment,credit,andsimilardecisions.Toprovideinformationtohelppresentandpotentialinvestorsandcreditorsinassessingtheamounts,timinganduncertaintyofprospectivecashreceiptsfromdividendsorinterest.ObjectivesofFinancialStatemRelevanceandReliabilityTobeuseful,accountinginformationshouldprovideaninformativeinformationsystemthatlinkscurrentfinancialstatementswithfuturestaterealizationsandpayoffs.AccountinginformationshouldberelevantI.e.hasthecapacitytoaffectinvestors’beliefsaboutfuturereturns.Accountinginformationshouldbereliablei.e.shouldfaithfullyrepresentswhatitpurportstomeasure.Itshouldbepreciseandfreefrombias.RelevanceandReliabilityTobeElementsofFinancialStatementsAssets:Probablefutureeconomicbenefitsobtainedorcontrolledasaresultofpasttransactions.Liabilities:ProbablefuturesacrificesofeconomicbenefitsOwner’sEquity:residualInterestinassetsafterdeductingliabilitiesi.e.A=L+O.E.orO.E=A–L.Revenues:inflowsofassets(orsettlementofliabilities)arisingfromtheentity’smajororongoingactivities.ElementsofFinancialStatemenAccountingPrinciples-1HistoricalCostPrinciplei.e.recognise(recordandreport)assetsandliabilitiesinitiallyatthecash-equivalentcost.RevenueRecognitionPrinciplei.e.recogniserevenueswhenearned(earningprocessiscompleteandanexchangehastakenplace).Allnecessarycostshavebeenincurredandcollectionisassured–usuallyatpointatsale.AccountingPrinciples-1HistorAccountingPrinciples-2MatchingPrinciplei.e.recogniseallexpensesincurredinproducingrevenuesinthesameperiodastherevenues.FullDisclosurePrinciplei.e.discloseallrelevantinformation.AccountingPrinciples-2MatchiLAN’SCLOTHINGCOMPANYInvest10,000Yuans(Y)tostartthebusinessBuy1000shirtsat5Yeach.Paywagesof1000Yforthefirstmonth.Sell400shirtsat20Yeach.Payrentof600Yforthefirst6months.Incurredmiscellaneousexpensesof500Y.Borrowed4800Yandboughtatruck.Truckwilllastfor4years.Whatismynetincomeforfirstmonth?LAN’SCLOTHINGCOMPANYInvest1Lan’sClothing

NetIncomeforfirstmonthNetIncomebeforetaxes= Revenues–Expenses= 400X20(sales)-400X5(costofshirtssold)–1000(wagesexpense)–600/6(rentforonemonth)–500(miscellaneousexpenses)-4800/48(amortisationexpensefor1month)=4,300YuansLan’sClothing

NetIncomeforStandardSetting&Auditing-1Standardsettingorregulationisnecessarytoprotecttheinvestors(conflictinginterestsofinvestorsandmanagers).TheFASB(FinancialAccountingStandardsBoardandtheCICA(CanadianInstituteofCharteredAccountants)areindependentbodies.StandardSetting&Auditing-1StandardSetting&Auditing-2Auditing(external)ensuresthatathirdindependentpartyhasexaminedthefinancialstatementsandthattheyareinaccordancetoGAAP(GenerallyAcceptedAccountingPrinciples).StandardSetting&Auditing-2EfficientSecuritiesMarketsThepricesofsecurities(stocks)“properlyreflect”allinformationthatispubliclyknownaboutthesesecurities.Investorswillquicklyadjusttoneworcorrectedinformationasitbecomesavailable.Investorscannotexpecttoearnabnormalreturnsi.e.areturnonasecurityinexcessofitsnormalexpectedreturn.EfficientSecuritiesMarketsThWORLDCOM(CommunicationsIndustry)-1LargestBankruptcyinhistory.Bankruptcydate=July21,2002.Totalassets(pre-bankruptcy)=US$103,914,000,000approximately850,000millionsYuansorRMB(assuming1usdollarapproximatelyequalto8.2Yuans)WORLDCOM(CommunicationsIndustWORLDCOM(CommunicationsIndustry)-2InternalAuditor(CynthiaCooper-TimeMagazinePersonoftheyearfor2002)wenttoBoardofDirectors,claimingassetsshouldbewrittenoffthebalancesheet.B.O.D.agreewithher.Onwritingoffassets,largelosses.Stockpricesfelldownsteeply.WORLDCOM(CommunicationsIndustEnronCorp

(EnergyIndustry)CompanywentbankruptonDecember2,2001.Totalassetspre-bankruptcy=US$63,392,000,000approximatelyequalto520,000millionsYuansorRMB.Profitsoverstated;revenuesrecognizedbeforetheyareearned.Liabilitieshiddenfrombalancesheet.Gamblingonenergyfuturescontracts.SherriWatkins(Enronmanager)blewthewhistlebutnoonelistened.EnronCorp

(EnergyIndustry)ArthurAndersen(Former“BigFive”AccountingFirm)Issuedunqualifiedopiniontofinancialstatements.Didnotdiscloseaccountingirregularities.Shreddeddocumentstohideevidence.Guiltyofobstructingjustice.ArthurAndersen(Former“BigFManagement’sIncentivestoManageEarningsIncometaxes—PostponepaymentbyminimizingreportedincomeBonus—MaximizetheirbonusesbyincreasingreportedincomeDebtAgreements–Easiertomeetdebtagreements(covenants)byincreasingincomeandassetsStockoptions(giveyoutherighttopurchaseastockatafixedpriceinsomefutureperiod)—maximizeshareprices(believedtoberelatedtoreportedincome).Management’sIncentivestoMaAccrualsandEarningsManagementAmortizationexpenseIncreaseinnetreceivablesIncreaseininventoryDecreaseinaccountspayableandaccrualliabilitiesAccrualsandEarningsManagemeWhatcouldbedone?Betteraccountingstandardsandbetterdisclosure.Lessemphasisonhistoricalcostandmoreemphasisoncurrentmarketvalueofassetsandliabilitiesonbalancesheet.Foreexample,recordallstockoptionsasanexpenseonincomestatement,whenissued.Restrictionsonauditorse.g.auditorsnotallowedtodoconsultingworkforfirmtheyauditGreateraccountabilityofboardofdirectorsandmorepunishmentforwrongdoings.Whatcouldbedone?BetteraccoEthicsandaccountingEthicsRulesOfProfessionalConductLegalWhatislegalormeettherulesofprofessionalconductmaynotbeconsideredethical.EthicsandaccountingEthicsSomePrinciplestoEvaluateOne’sActions-1Non-Maleficence:AmIcausingharmbyfailingtodosomethingoragreeingwithit?Beneficence:Domyactionsbenefitotherpersonsbesidesmyself?Justice:DoItreatthoseforwhomIamresponsibleequitably(fairly)?SomePrinciplestoEvaluateOnSomePrinciplestoEvaluateOne’sActions-2Fidelity:DoIupholdmypartoftherelationship?ActConsciously:DoIknowtheassumptionsonwhichIbasemyactionsandaretheyvalid?UtilitarianismDeontologySomePrinciplestoEvaluateOnConsequen