Skip to content

 Browse
 Search
 Expand Nav
o Resource Centers
o Playlists
o History
o Topics
o Learning Paths
o Newsletters
o Highlights
o Settings
o Support
o Sign Out

Table of Contents for

Financial Accounting Theory and Analysis:
Text and Cases, 11th Edition

 Search in book...


 Toggle Font Controls

o Twitter
o Facebook
o Google Plus
o Email

Prev Previous Chapter
CHAPTER 16: Accounting for Multiple Entities

Next Next Chapter
Index
In the preceding chapters of this text, we have attempted to give a concise yet
comprehensive explanation of current generally accepted accounting principles (GAAP). We
have given primary attention to those principles promulgated by the Financial Accounting
Standards Board (FASB) and its predecessors in their roles as the bodies of the accounting
profession authorized to issue financial accounting standards. The discussion, therefore, has
often been directed toward identifying transactions to be treated as accounting information,
the appropriate measurement of those transactions, criteria for classifying the data in the
financial statements, and the reporting and disclosure requirements of the various
Accounting Principles Board (APB) opinions and Statements of Financial Accounting
Standards (SFASs).
This chapter seeks to draw additional attention to the special importance of disclosure in
financial reporting. Specifically, we review the disclosure requirements issued by the FASB
and the Securities and Exchange Commission (SEC). Additionally, we examine accountants'
ethical responsibility to society.

Recognition and Measurement Criteria

Statement of Financial Accounting Concepts (SFAC) No. 5, discussed in Chapter 2, outlines
the various methods of disclosure that corporations should use in published financial
statements. These disclosure requirements are summarized in Exhibit 17.1.
As seen in Exhibit 17.1, SFAC No. 5 summarizes the building blocks to disclosure as
follows:

1. The scope of recognition and measurement

2. Basic financial statements

EXHIBIT 17.1   Relationship of SFAC No. 5 to Other Methods of Financial

Reporting
 3. Areas directly affected by existing FASB standards
4. Financial reporting
5. All information useful for investment, credit, and similar decisions

The issues addressed under item 1 have been addressed earlier in this text. Therefore, in
this chapter, we focus on the issues addressed by items 2 through 5. Note from Exhibit
17.1 that in addition to corporate annual reports, the disclosure vehicles in corporate annual
reports include the footnotes to the financial statements; supplementary information, such as
segmental information; other methods of financial disclosure, such as management's
discussion and analysis; and other company information, such as analysts' reports and news
reports. However, the most relevant information should always appear in one of the financial
statements, provided that it meets the SFAC No. 5 criteria for measurement and recognition.

Basic Financial Statements

The financial statements described in SFAC No. 5 were discussed in Chapters 6 and 7. In
addition to the four basic statements (the balance sheet, the income statement, the statement
of cash flows, and the statement of owners' equity), a full set of financial statements also
includes footnotes, supplementary schedules, and parenthetical disclosures.
The footnotes to a company's financial statements provide a significant amount of
additional information about the items on the company's financial statements. In general, the
footnotes disclose information that explains, clarifies, or develops items appearing on the
financial statements, which cannot easily be incorporated into the financial statements
themselves. The most common examples of footnotes are as follows:

1. Accounting policies (discussed below)

2. Schedules and exhibits. Firms typically report schedules or exhibits
concerning long-term debt and income tax, for example.
 3. Explanations of financial statement items. Some items require additional
explanation so that users can make sense of the reported information.
Pensions and postretirement benefits are two examples.
4. General information about the company. Occasionally, firms face events
that can affect their financial performance or position but cannot yet be
recognized on the financial statements. In that case, investors have an
interest in learning this information as soon as possible. Information
concerning subsequent events and contingencies are two examples.

The purpose of supplementary schedules is to improve the understandability of the

financial statements. They may be used to highlight trends, such as five-year summaries, or
they may be required by FASB pronouncements, such as information on current costs.
Parenthetical disclosures are contained on the face of the financial statements (usually on
the balance sheet). They are generally used to describe the valuation basis of a particular
financial statement element but also may provide other kinds of information, such as the par
value and number of shares authorized and issued for various classes of a company's stock.

Accounting Policies
APB Opinion No. 22, “Disclosure of Accounting Policies” (see FASB ASC 235), required
all companies to disclose both the accounting policies the firm follows and the methods it
uses in applying those policies. Examples of accounting policies include the method of
depreciation and the method of inventory valuation. Typically, companies disclose this
information in a Summary of Significant Accounting Policies preceding the other footnotes.
Specifically, APB Opinion No. 22 required that the accounting methods and procedures
involving the following be disclosed:

1. A selection from existing acceptable alternatives

2. Principles and methods peculiar to the industry in which the reporting entity
operates
3. Unusual or innovative applications of GAAP

The APB's principal objective in issuing Opinion No. 22 was to provide information that
helps investors compare firms across and between industries. Because accounting policies
have a significant impact on numbers reported in the financial statements, investors need to
know what those policies are so they can draw meaningful comparisons between firms in the
same industry or between firms in different industries. Ultimately, knowing these accounting
policies allows investors to make economic decisions with more confidence because they can
make legitimate comparisons.

Subsequent Events
Because of the complexities of closing the books, the requirements of the audit, and the
length of time it takes to print and distribute the annual report, companies usually issue their
financial statements several weeks after the close of their fiscal years. During the period
between the end of a company's fiscal year and the issuance of its financial statements,
events might occur that aren't reflected in its accounting records. These events are referred to
as subsequent events and may be either (1) events that provide further evidence of
conditions that existed on the balance sheet date or (2) events that provide evidence of
conditions that did not exist at the balance sheet date.
GAAP requires events in the first category to be reported on the company's financial
statements. In other words, when a company experiences an event—after the balance sheet
date but before it issues its financial statements—that provides further evidence of some
condition existing at the balance sheet date, it is required to adjust its records to reflect the
financial impact of that condition. If, for example, a company settles litigation for an amount
significantly different than the amount it had originally accrued, then it must adjust the
amount it originally accrued and report the adjusted accrual on the financial statements. The
adjusted disclosure is required because the event that gave rise to the adjustment occurred
before the balance sheet date. If such an adjustment were not made, then the financial
statements would not fully reflect the true financial condition at the balance sheet date or
performance of the company that occurred during the fiscal year.
On the other hand, GAAP does not require adjustments to the financial statements for
category 2 events; however, companies often disclose these events in the footnotes to their
financial statements. These footnote disclosures allow the company to discuss the impact of
the new information. Companies often disclose this type of subsequent event when they issue
debt or equity securities, incur casualty losses, sell significant assets, or settle litigation
initiated as the result of events that occurred after the balance sheet date.

Areas Directly Affected by Existing FASB Standards:

Supplementary Information
The accounting quality of understandability, defined in SFAC No. 8, requires financial
statement data to be summarized to enable it to be useful to reasonably informed readers. As
a consequence, significant information that does not meet the measurement and reporting
requirements for presentation in the financial statements is presented as supplementary
information. This information may be included in the footnotes or in a separate section
commonly termed financial highlights. Supplementary information may also be mandated
by the FASB or the SEC. Examples of supplementary information include segment
information, information describing the effects of price-level changes, information on oil
and gas reserves for companies in the extractive industry, the auditor's report, interim
financial reports, and the liquidation basis of accounting. Segment information was
discussed in Chapter 15, and the disclosure of information on oil and gas reserves is beyond
the scope of this text.

Price-Level Information
The high level of inflation experienced in the United States during the 1970s caused
concerns that financial statements were being distorted. As a result, both the SEC (ASR No.
190) and the FASB (SFAS No. 33, superseded) issued pronouncements requiring the
disclosure of supplemental information on the effects of changing prices in the 10-K and
annual report to stockholders. These disclosures were generally made in separate schedules.
Later, after inflation subsided in the 1980s, these requirements were suspended;
consequently, supplemental disclosure of this information is no longer required.

Auditor's Report
The SEC requires every company that sells securities to the general public to obtain an
auditor's opinion. The auditor is an independent accountant whose responsibility it is to
examine the financial statements prepared by management and determine if they are
presented “fairly” and in conformity with GAAP. In performing these duties, the auditor is
acting as an intermediary agent between the company's management and its stockholders,
whose duty is to validate management's assertions contained in the financial statements. This
process is enhanced by regular communication with the company's audit committee.1
The auditor's opinion is not a method of disclosure but an unqualified opinion implies that
the company's level of disclosure is, at least, adequate. The following guidelines for
preparing the auditor's report were developed by the AICPA:

1. The report shall state whether the financial statements are presented in
accordance with generally accepted accounting principles.
2. The report shall identify those circumstances in which such principles have
not been consistently observed in the current period in relation to the
preceding period.
3. Informative disclosures in the financial statements are to be regarded as
reasonably adequate unless otherwise stated in the report.
4. The report shall either contain an expression of opinion regarding the
financial statements taken as a whole, or an assertion to the effect that an
opinion cannot be expressed. When an overall opinion cannot be expressed,
the reasons therefore should be stated. In all cases where an auditor's name
is associated with financial statements, the report should contain a clear-cut
indication of the character of the auditor's work, if any, and the degree of
responsibility the auditor is taking.

In most cases, the audit will result in the issuance of a standard, or unqualified, audit
report that contains three sections:

1. An opening paragraph that indicates an audit was performed and includes a

declaration that the financial statements are the responsibility of
management
2. A scope paragraph that indicates the audit was performed in accordance
with generally accepted auditing standards
3. An opinion paragraph that indicates the financial statements are presented
fairly in accordance with generally accepted accounting principles

In the event the auditor cannot satisfy the criteria necessary to make the above three
assertions, he or she may issue one of the following types of opinions:

1. Qualified opinion. This type of audit report indicates that except for the
effects to which the qualification relates, the financial statements are
presented fairly. A qualified audit opinion is issued when
a. Circumstances prevent the auditor from performing all audit
procedures necessary to comply with generally accepted auditing
standards,
b. The financial statements contain a material departure form GAAP
c. Not all informative disclosures have been made in the financial
statements
 2. Disclaimer of opinion. This type of opinion states that the auditor does not
express an opinion on the financial statements because
a. A lack of independence, or material conflict(s) of interest, exist
between the auditor and the auditee
b. There are significant scope limitations, whether intentional or not,
that hinder the auditor's work in obtaining evidence and performing
procedures
c. There is a substantial doubt about the auditee's ability to continue as a
going concern or, in other words, continue operating
d. There are significant uncertainties within the auditee
3. Adverse opinion. This type of opinion results when the statements are not
prepared in accordance with generally accepted accounting principles.
4. Auditor's report on internal controls. Following the enactment of the
Sarbanes–Oxley Act of 2002, the Public Company Accounting Oversight
Board (PCAOB) was established to monitor and regulate audits of public
companies (discussed later in the chapter). The PCAOB now requires
auditors of public companies to include additional disclosures and form an
opinion regarding the auditee's internal controls and to opine about the
company's and auditor's assessment on the company's internal controls over
financial reporting. These new requirements have modified the audit opinion
to include all necessary disclosures by either presenting the report
subsequent to the audit report on the financial statements or combining both
reports into one auditor's report.
5. Going concern opinion. The going concern assumption is a basic accounting
principle. This assumption means that an entity is expected continue to
operate in the near future. Auditing standards require auditors to evaluate the
conditions or events discovered during an audit that raise questions about
the validity of the going-concern assumption. An auditor who concludes that
substantial doubt exists about the entity's ability to continue as a going
concern and who is not satisfied that management's plans are enough to
mitigate these concerns is required to issue a modified (but unqualified)
report. If the auditor considers that the auditee is not a going concern, or will
not be a going concern in the near future, the auditor is required to include
an explanatory paragraph before the opinion paragraph or following the
opinion paragraph, in the audit report explaining the situation. Additionally,
financial statement users make judgments throughout the year about a
company's prospects. Thus, they would benefit from disclosures by the
company in its interim and annual financial statements of factors that could
affect the going concern assumption.

The combined audit and internal control report of Hershey Company are contained
in Exhibit 17.2.

Interim Financial Statements

The SEC requires companies to issue quarterly summary financial statements on Form 10-Q.
Information on financial performance and operating results for periods of less than a year are
termed interim financial reports. Most publicly traded companies also release information
on their periodic performance through various news media. The major value of interim
financial reports and news releases is their timeliness. Stated differently, investors need to be
aware of any changes in the financial position of the company as soon as possible. In
addition, much of the information disclosed in interim financial statements enters into the
analytical data used by the government to develop information on the state of the economy,
the need for monetary controls, or the need for modifications in the tax laws. There is also
evidence that interim reporting has an impact on stock prices, indicating that investors do
use interim financial information. It is therefore important that interim information be as
reliable as possible.

EXHIBIT 17.2   Hershey Company 2011 Independent Auditor's Report

 A wide variety of practices have existed with regard to the methods of reporting in interim
periods. Thus, such things as seasonal fluctuations in revenues and the application of fixed
costs to the various periods have a significant impact on the reported results for interim
periods.
In 1973 the APB studied this problem and issued its conclusions in APB Opinion No. 28,
“Interim Financial Reporting” (see FASB ASC 270). In reviewing the general question, the
Board noted that two views existed as to the principal objective of interim financial
reporting.

1. One view held that each interim period was a separate accounting period and
that income should be determined in the same manner as for the annual
period, and thus revenues and expenses should be reported as they
occur (discrete view).
2. The other view held that interim periods were an integral part of the annual
period, and thus revenues and expenses might be allocated to various
interim periods even though they occurred only in one period (integral
view).2

In Opinion No. 28, the APB stated that interim financial information is essential to provide
timely data on the progress of the enterprise and that the usefulness of the data rests on its
relationship to annual reports. Accordingly, the Board determined that interim periods should
be viewed as integral parts of the annual period and that the principles and practices followed
in the annual period should be followed in the interim period. However, certain
modifications were deemed necessary to provide a better relationship to the annual period.
Additionally, publicly traded companies that present summary information for financial
analysis should provide, at minimum, certain information for the interim period in question
and the same interim period for the previous year. These guidelines are intended to partially
offset the reduction in detail from interim reports. Among the items to be disclosed are sales,
earnings per share, seasonal revenues, disposal of a business segment, contingencies, and
changes in accounting principles.
Interim financial information is essential to provide timely data on the progress of the
enterprise. Moreover, the usefulness of the data rests on its relationship to annual reports. In
short, interim periods should be viewed as integral parts of the annual period, and the
principles and practices followed in the annual period should be followed in the interim
period.

Liquidation Basis of Accounting

In July 2012, the FASB issued a proposed amendment to FASB ASC Topic
205, Presentation of Financial Statements,3 that would require an entity to prepare its
financial statements using the liquidation basis of accounting when liquidation is deemed to
be imminent. In April 2013, the FASB issued Accounting Standards Update 2013-07,
Presentation of Financial Statements (Topic 205): Liquidation Basis of Accounting.
Liquidation is defined as “the process by which an entity converts its assets to cash or
other assets and partially or fully settles its obligations with creditors in anticipation of the
entity ceasing its operations.”4 Liquidation is considered to be imminent when either of the
following situations occurs:
 1. A plan for liquidation has been approved by the person or persons with the
authority to make such a plan effective and the likelihood is remote that the
execution of the plan will be blocked by other parties.
2. A plan for liquidation is being imposed by other forces (for example,
involuntary bankruptcy) and the likelihood is remote that the entity will
subsequently return from liquidation.

Additionally, if a plan for liquidation was specified in the entity's governing documents at
the entity's inception (for example, limited-life entities), liquidation would be considered
imminent when significant management decisions about furthering the ongoing operations of
the entity have ceased or they are substantially limited to those necessary to carry out a plan
for liquidation other than the plan specified at inception. The ASU also requires financial
statements prepared using the liquidation basis to reflect relevant information about an
entity's resources and obligations in liquidation by measuring and presenting assets and
liabilities in the entity's financial statements as the amount of cash or income that it expects
to earn during the expected duration of the liquidation, including any costs associated with
settlement of those assets and liabilities. These financial statements should include

1. Statement of Changes in Net Assets in Liquidation: A statement that

includes information about the changes during the period in net assets or
other consideration that the entity expects to pay during the course of
liquidation
2. Statement of Net Assets in Liquidation: A statement that includes
information about the net assets available for distribution to investors and
other claimants during liquidation as of the end of the reporting period

The ASU also requires disclosures about the entity's plan for liquidation, the methods and
significant assumptions used to measure assets and liabilities, the type and amount of costs
and income accrued, and the expected duration of liquidation. The ASU is effective for
entities that determine liquidation is imminent during annual reporting periods beginning
after December 15, 2013, and interim reporting periods therein. Entities should apply the
requirements prospectively from the day that liquidation becomes imminent. Early adoption
is permitted.

Other Means of Financial Reporting

The financial statements, footnotes, and supplementary schedules constitute the company's
financial report. All significant information should be included in the financial report, and
other relevant information that can assist in understanding the financial report is presented in
narrative form. Examples of these types of items are management's discussion and analysis
and the letter to stockholders.

Management's Discussion and Analysis (MD&A)

The SEC requires all publicly held companies to include an MD&A section in their annual
reports. The reasons for including this information in the annual report were originally
outlined in SFAC No. 1, which stated:
Management knows more about the enterprise and its affairs than investors,
creditors, or other “outsiders” and can often increase the usefulness of financial
 information by identifying certain transactions, other events, and circumstances that
affect the enterprise and explaining their financial impact on it.5
Basically, the MD&A section evaluates the causes and explains the reasons for a
company's performance during its preceding annual period. The required disclosures include
information about liquidity, capital resources, and the results of operations. The SEC also
requires management to highlight favorable or unfavorable trends and to identify significant
events or uncertainties that affect those three factors. Since a company must disclose matters
that could affect its financial statements in the future, the MD&A allows financial statement
users to evaluate a company's past performance and its likely impact on future performance.
Of course, in order to discuss the influence of past performance on the future, management
must use various estimates or approximations. Although these particular discussions often
depend on subjective estimates, the SEC indicated that the information's relevance to users
exceeds its potential lack of reliability. In fact, in an effort to encourage these presentations,
the SEC has provided “safe harbor” rules that protect the firm against fraud charges as long
as management uses estimates that are prepared in a reasonable manner and disclosed in
good faith.6
In 1997 the SEC issued new disclosure rules in an amendment to Regulation S-X titled
“Disclosure of Accounting Policies for Derivative Financial Instruments and Derivative
Commodity Instruments and Disclosure of Quantitative and Qualitative Information about
Market Risk Inherent in Derivative Financial Instruments, Other Financial Instruments, and
Derivative Commodity Instruments.” As indicated by its title, this release requires the
disclosure of qualitative and quantitative information about market risk by all companies
registered with the SEC. Market risk is defined as the risk of loss arising from adverse
changes in market rates and prices from such items as

 Interest rates
 Currency exchange rates
 Commodity prices
 Equity prices

The required disclosures are designed to provide investors with forward-looking information
about a company's exposures to market risk, such as the risks associated with changes in
interest rates, foreign currency exchange rates, commodity prices, and stock prices. The
information should indicate the market risk a company faces as well as how the company's
management views and manages its market risk. This amendment was issued in response to
the large derivative losses that were incurred by companies in the early 1990s, such as Show
a Shell Sekiya's $1.5 billion loss on currency derivatives, Procter and Gamble's $157 million
loss on leveraged currency swaps and Arco's employee earnings loss of $22 million on
money market derivatives.
The expanded disclosure requirements mandate the inclusion of quantitative and
qualitative information about the market risk inherent in market-risk-sensitive instruments.
This information is disclosed both outside the financial statements and in the related notes.
The quantitative information about market-risk-sensitive instruments is to be disclosed by
using one or more of the following alternatives:

1. Tabular presentation of fair value information and contract terms relevant to

determining future cash flows, categorized by expected maturity dates
 2. Sensitivity analysis expressing the potential loss in future earnings, fair
values, or cash flows from selected hypothetical changes in market rates and
prices
3. Value-at-risk disclosures expressing the potential loss in future earnings, fair
values, or cash flows from market movements over a selected period and
with a selected likelihood of occurrence.

These three alternative methods were allowed because the SEC wanted to permit
disclosure requirements about market risk that were flexible enough to accommodate
different types of registrants, different degrees of market risk exposure, and alternative
methods of measuring market risk.
A primary objective of the quantitative disclosure requirements is to provide investors
with forward-looking information about a registrant's potential exposures to market risk.
Consequently, in preparing quantitative information, registrants are required to categorize
market-risk-sensitive instruments into instruments entered into for trading purposes, and
instruments entered into for purposes other than trading. Specifically, companies must
disclose

1. Their primary market risk exposures at the end of the current reporting
period
2. How they manage those exposures (such as by a description of the
objectives, general strategies, and instruments, if any, used to manage those
exposures)
3. Changes in either the primary market risk exposures or how those exposures
are managed, when compared to the most recent reporting period and what
is known or expected in future periods

An examination of Hershey's and Tootsie Roll's financial statements revealed that both
companies use derivative financial instruments to manage risk. The following information
about Hershey's use of derivatives was contained in its 2011 10-K report:
We use certain derivative instruments, from time to time, to manage risks. These
include interest rate swaps to manage interest rate risk, foreign currency forward
exchange contracts and options to manage foreign currency exchange rate risk, and
commodities futures and options contracts to manage commodity market price risk
exposures. We enter into interest rate swap agreements and foreign exchange
forward contracts and options for periods consistent with related underlying
exposures. These derivative instruments do not constitute positions independent of
those exposures.
We enter into commodities futures and options contracts and other derivative
instruments for varying periods. These commodity derivative instruments are
intended to be, and are, effective as hedges of market price risks associated with
anticipated raw material purchases, energy requirements and transportation costs. We
do not hold or issue derivative instruments for trading purposes and are not a party to
any instruments with leverage or prepayment features.
In entering into these contracts, we have assumed the risk that might arise from the
possible inability of counterparties to meet the terms of their contracts. We mitigate
this risk by performing financial assessments prior to contract execution, conducting
 periodic evaluations of counterparty performance and maintaining a diverse portfolio
of qualified counterparties. We do not expect any significant losses from
counterparty defaults.
In 2003 the SEC published new interpretive guidelines regarding the disclosure of items in
the MD&A section of the 10-K report. 7 Specifically, additional guidance was provided for
the following areas:

1. The overall presentation of MD&A. Within the universe of material

information, companies should present their disclosures so that the most
important information is most prominent, companies should avoid
unnecessary duplicative disclosure that can tend to overwhelm readers and
act as an obstacle to identifying and understanding material matters, and
many companies would benefit from starting their MD&A with a section
that provides an executive-level overview that gives context for the
remainder of the discussion.
2. The focus and content of MD&A (including materiality, analysis, key
performance measures, and known material trends and uncertainties). In
deciding on the content of MD&A, companies should focus on material
information and eliminate immaterial information that does not promote
understanding of companies' financial condition, liquidity and capital
resources, changes in financial condition, and results of operations (both in
the context of profit and loss and cash flows); companies should identify
and discuss key performance indicators, including nonfinancial performance
indicators, that their management uses to manage the business and that
would be material to investors; companies must identify and disclose known
trends, events, demands, commitments, and uncertainties that are reasonably
likely to have a material effect on financial condition or operating
performance; and companies should provide not only disclosure of
information responsive to MD&A's requirements, but also an analysis that is
responsive to those requirements that explains management's view of the
implications and significance of that information and that satisfies the
objectives of MD&A.
3. The disclosure of liquidity and capital resources. Companies should
consider enhanced analysis and explanation of the sources and uses of cash
and material changes in particular items underlying the major captions
reported in their financial statements, rather than recitation of the items in
the cash-flow statements; companies using the indirect method in preparing
their cash-flow statements should pay particular attention to disclosure and
analysis of matters that are not readily apparent from their cash-flow
statements; and companies also should consider whether their MD&A
should include enhanced disclosure regarding debt instruments, guarantees,
and related covenants.
4. The disclosure of critical accounting estimates. Companies should consider
enhanced discussion and analysis of these critical accounting estimates and
assumptions that supplements, but does not duplicate, the description of
 accounting policies in the notes to the financial statements and that provides
greater insight into the quality and variability of information regarding
financial condition and operating performance.

Letter to Stockholders
Management's letter to the stockholders has four main purposes. It indicates that
management

1. Is responsible for preparation and integrity of statements

2. Has prepared statements in accordance with GAAP
3. Has used its best estimates and judgment
4. Maintains a system of internal controls

Other Useful Information for Investment, Credit, and Similar

Decisions
Information about companies is also available outside the company's annual report and 10-
K. Examples of these types of information include analysts' reports and news articles about
the company.

Analysts' Reports
Individual investors make essentially three investment decisions:

1. Buy. A potential investor decides to purchase a particular security on the

basis of all available disclosed information.
2. Hold. An investor decides to retain a particular security on the basis of all
available disclosed information.
3. Sell. An investor decides to dispose of a particular security on the basis of
all available disclosed information.

As discussed in Chapter 4, the decision process used by most investors is

termed fundamental analysis. Fundamental analysis attempts to identify securities that are
mispriced by reviewing all available information. The investor then incorporates the
associated degree of risk to arrive at an expected share price. The expected share price is then
compared to the current price, allowing the investor to make buy–hold–sell decisions.
Professional security analysts also make investment analyses. They often specialize in
certain industries, using their training and experience to process and disseminate information
more accurately and economically than individual investors. There are three categories of
financial analysts:

1. Sell side. These analysts work for full-service broker dealers and make
recommendations on securities they cover. Many work for the most
prominent brokerage firms, which also provide investment banking services
to companies, including those whose securities the analysts cover.
 2. Buy side. These analysts work for institutional money managers, such as
mutual funds, that purchase securities for their own accounts. They counsel
their companies to buy, hold, and sell.
3. Independent. These analysts are not associated with firms that underwrite
the securities they cover. They often sell their recommendations on a
subscription basis.

Many analysts work in a world of built-in conflicts of interest and competing pressures.
Sell-side firms want their investor clients to be successful over time because satisfied long-
term investors are the key to the firm's reputation and success. On the other hand, several
factors can create pressure on an analyst's independence and objectivity. Such pressures don't
necessarily mean analysts are biased, but investors should understand these points:

1. An analysts' firm may be underwriting a company's securities offering, and

client firms prefer favorable research reports.
2. Positive reports can generate additional clients and revenues.
3. Arrangements often tie compensation to continuation of clients.
4. Analysts might own securities individually, or the securities may be owned
by the analyst's firm.

Consequently, investors should confirm whether the analyst's firm underwrote a

recommended company's stock by looking at the prospectus, which is part of the registration
statement for the offering. A list of the lead or managing underwriters can be found on the
front cover of both the preliminary and final copies of the prospectus. Additionally, a
company's registration statement and its annual report on Form 10-K discloses the identities
of the beneficial owners of more than 5 percent of a class of equity securities and lists the
private sales of the company's securities during the past three years.
If a financial analyst or the firm acquired ownership interests through venture investing,
the shares generally are subject to a lock-up agreement during and after the issuer's initial
public offering. Lock-up agreements prohibit company insiders—including employees, their
friends and family, and venture capitalists—from selling their shares for a set period without
the underwriter's permission. Although the underwriter can choose to end a lock-up period
early—because of market conditions, the performance of the offering, or other factors—lock-
ups generally last for 180 days after the offering's registration statement becomes effective.
After the lock-up period ends, the firm or the analyst may sell the stock. Anyone
considering investing in a company that has recently conducted an initial public offering
should check whether a lock-up agreement is in effect and when it expires, or whether the
underwriter waived any lock-up restrictions. This is important information, because a
company's stock price may be affected by the prospect of lock-up shares being sold into the
market when the lock-up ends. It is also a data point to consider when assessing research
reports issued just before a lock-up period expires; those reports are sometimes known
as booster shots.
Above all, it must be remembered that even the soundest recommendation from the most
trustworthy analyst may not be a good choice. That's one reason investors should never rely
solely on an analyst's recommendation when buying or selling a stock. Before acting,
investors should determine whether the decision fits with their goals, time horizon, and
tolerance for risk. In other words, they should know what they are buying or selling—and
why.
Securities and Exchange Commission
Many of the disclosure techniques and accounting conventions discussed in the preceding
sections are the result of evolving GAAP and consensus. However, since the mid-1930s, the
U.S. government has also been involved in standard-setting and disclosure issues. The
Securities and Exchange Commission (SEC) is the regulatory agency responsible for
administering federal securities laws. The purpose of these laws is to protect investors and to
attempt to ensure that investors have all relevant information about companies that issue
publicly traded securities. The SEC is also responsible for enforcing all of the laws passed
by Congress that affect the public trading of securities. Among these laws are the Securities
Act of 1933, the Securities Exchange Act of 1934, the Foreign Corrupt Practices Act of
1977, and the Sarbanes–Oxley Act of 2002. These acts stress the need to provide
prospective investors with full and fair disclosure of the activities of a company offering and
selling securities to the public.

The Securities Act of 1933

The Securities Act of 1933 regulates the initial public sale and distribution of a corporation's
securities (going public). The goal of this legislation is to protect the public from fraud when
a company is initially issuing securities to the general public. The provisions of the
Securities Act of 1933 require a company initially offering securities to file a registration
statement and a prospectus with the SEC. The registration statement becomes effective on
the 20th day after filing unless the SEC requires amendments. This 20-day period is termed
the waiting period, and it is unlawful for a company to offer to sell securities during this
period. Registration of securities under the provisions of the 1933 act is designed to provide
adequate disclosures of material facts to allow investors to assess the degree of potential
risk. Nevertheless, registration does not completely protect investors from the possibility of
loss, and it is unlawful for any company officials to suggest that registration prevents
possible losses.

The Securities Exchange Act of 1934

The Securities Exchange Act of 1934 regulates the trading of securities of publicly held
companies being public). This legislation addresses the personal duties of corporate officers
and owners (insiders) and corporate reporting requirements, and it specifies information that
is to be contained in the corporate annual reports and interim reports issued to shareholders.
The act established extensive reporting requirements to provide continuous full and fair
disclosure. Each corporation that offers securities for sale to the general public must select
the appropriate reporting forms. The most common reporting forms, all of which can be
obtained from the SEC's website, are as follows:

 Form 10. The normal registration statement for securities to be sold to the
public
 Form 10-K. The annual report
 Form 10-Q. The quarterly report of operations8
 Proxy statement. Used when a company makes a proxy solicitation for its
stockholder meetings

A major goal of the 1934 act is to ensure that any corporate insider (broadly defined as any
corporate officer, director, or shareholder owning 10 percent or more) does not achieve an
advantage in the purchase or sale of securities because of a relationship with the corporation.
The act also established civil and criminal liabilities for insiders making false or misleading
statements when trading corporate securities. The specific SEC reporting requirements for
going public and being public are beyond the scope of this text; however, note that the SEC's
stipulation that much of the information provided in the 10-K, 10-Q, and proxy reports must
be certified by an independent certified public accountant has been a significant factor in the
growth and importance of the public accounting profession in the United States.

The Foreign Corrupt Practices Act of 1977

The Foreign Corrupt Practices Act (FCPA) of 1977 contains two main elements. The first
makes it a criminal offense to offer bribes to political or governmental officials outside the
United States and imposes fines on offending firms. It also provides for fines and
imprisonment of officers, directors, or stockholders of offending firms.
The second element of the FCPA is a requirement that all public companies must (1) keep
reasonably detailed records that accurately and fairly reflect company financial activity and
(2) devise and maintain a system of internal control that provides reasonable assurance that
transactions were properly authorized, recorded, and accounted for. This element is an
amendment to the Securities Exchange Act of 1934 and therefore applies to all corporations
that are subject to the act's provisions.
The major goals of the FCPA are to prevent the bribery of foreign officials and to ensure
the maintenance of adequate corporate financial records.

The Sarbanes–Oxley Act of 2002 (SOX)

During the early 2000s, dozens of major companies either went bankrupt or faced extreme
financial difficulties. These included such familiar names as Enron, WorldCom, Xerox,
Global Crossing, Arthur Andersen, Merrill Lynch, Tyco International, and Halliburton Oil
Services. As a result, Americans lost billions of their investment dollars, jobs vanished, and
thousands of people lost their entire retirement savings. Subsequently, “corporate reform”
became a watchword, and the feelings of the public can be illustrated by this observation
from noted economist and television commentator Larry Kudlow:
It's not the economy that is driving the stock market down. There's a malaise over
Wall Street because people are worried, fearful, aggravated, and downright blown
away by the incongruous behavior of our leaders and elected officials.9
In addition to the scandals, the cavalier attitude of the executives of some of the failed
companies further unsettled the nation. For example, in congressional testimony, Jeffrey
Skilling, CEO of Enron, maintained that detailed financial reporting and disclosure vigilance
was the proper domain not of a CEO but of Enron's accountants and lawyers. Similarly,
Bernie Ebbers, the CEO of WorldCom, alleged that he was totally unaware of his CFO's
financial reporting wrongdoing. Public unrest resulted in a hearing before Congress, and on
April 25, 2002, the House of Representatives passed the Oxley Bill. On July 15, 2002, the
Senate passed the Sarbanes Bill. Together these two bills became known as the Sarbanes–
Oxley Act of 2002 (SOX), which President George W. Bush signed into law on July 30,
2002.

Major Provisions of the Legislation

Creation of the Public Company Accounting Oversight Board (PCAOB) The PCAOB
oversees audits of public companies that are subject to the Securities Act of 1933 and the
Securities Exchange Act of 1934. The PCAOB contains five members appointed from
among prominent individuals of integrity and reputation. These individuals must have a
demonstrated commitment to the interests of investors and the public and an understanding
of the responsibilities for the financial disclosures required in the preparation of financial
statements and audit reports. PCAOB duties include

1. Registering public accounting firms that prepare audit reports

2. Establishing auditing, quality control, ethics, independence, and other
standards relating to the preparation of audit reports
3. Conducting inspections of registered public accounting firms
4. Conducting investigations and disciplinary proceedings and, where
appropriate, imposing appropriate sanctions where justified upon registered
public accounting firms and CPAs within those firms
5. Performing any other duties or functions necessary or appropriate to
promote high professional standards among, and to improve the quality of
audit services offered by, CPA firms and CPAs within those firms
6. Enforcing compliance with the Securities Exchange Act of 1934

Among the PCAOB's powers are

1. To sue and be sued, complain and defend, in its corporate name and through
its own counsel, with the approval of the SEC, in any federal, state, or other
court
2. To conduct its operations and exercise all rights and powers authorized by
the SEC, without regard to any qualification, licensing, or other provision of
law in effect in any state or political subdivision

Establishment of Auditing, Quality Control, and Independence Standards The PCAOB

is required to cooperate with various professional groups of CPAs related to the standard-
setting process. The PCAOB may adopt standards proposed by the profession; however, it
has the authority to amend, modify, repeal, and/or reject any standards suggested by the
profession. Additionally, CPA firms are required to prepare, and maintain for a period of not
less than seven years, audit work papers and other information in sufficient detail to support
the conclusions reached in each of its audit reports. CPA firms must also use a second-
partner review and approval of its audit reports.
The PCAOB developed an audit standard to implement internal control reviews. This
standard requires auditors to evaluate whether internal controls include records that
accurately and fairly reflect transactions of the reporting entity and provide reasonable
assurance that the transactions are recorded in a manner that will permit the preparation of
financial statements in accordance with the technical literature. Auditors must also disclose
any material weaknesses in internal controls they discover during audits.
Inspection of CPA Firms The PCAOB will conduct annual quality reviews for CPA firms
that audit financial statements of more than 100 publicly traded entities. Other firms must
undergo this quality review and inspection process every three years. The SEC and/or the
PCAOB may order a special inspection of any CPA firm at any time.
Establishment of Accounting Standards The SEC is authorized to recognize as generally
accepted accounting principles those that are established by a standard-setting body that
meet all of the criteria within the Sarbanes–Oxley Act, which include requirements that the
standard-setting body

1. Be a private entity.
2. Be governed by a board of trustees or equivalent body, the majority of
whom are not or have not been associated with a CPA firm within the two-
year period preceding service on this board of trustees.
3. Be funded in a manner similar to the PCAOB, through fees collected from
CPA firms and other parties.
4. Have adopted procedures to ensure prompt consideration of changes to
accounting principles by a majority vote. Consider, when adopting
standards, the need to keep the standards current and the extent to which
international convergence of standards is necessary or appropriate.

Delineation of Prohibited Services The legislation makes it unlawful for a CPA firm to

provide any nonaudit service to the reporting entity contemporaneously with the financial
statement audit. Prohibited services include the following:

1. Bookkeeping or other services related to the accounting records or financial

statements of the reporting entity
2. Design and implementation of financial information systems
3. Appraisal or valuation services, fairness opinions, or contribution-in-kind
reports
4. Actuarial services
5. Internal audit outsourcing services
6. Management functions or human resources
7. Broker-dealer, investor advisor, or investment banker services
8. Legal services and expert services unrelated to the audit, or any other
service that the Board rules is not permissible

The legislation allows the PCAOB, on a case-by-case basis, to provide an exemption to

these prohibitions, subject to review by the SEC, and does not make it unlawful to provide
other nonaudit services (those not prohibited) if those services are approved in advance by
the audit committee. The audit committee must disclose to investors in periodic reports the
decision to preapprove those services. The preapproval requirement is waived if the
aggregate amount of the fees for all of the services provided constitutes less than 5 percent of
the total amount of revenues paid by the issuer to the auditing firm.
Prohibition of Acts That Influence the Conduct of an Audit The act makes it unlawful
for any officer or director of an entity to fraudulently influence, coerce, manipulate, or
mislead a CPA performing an audit.
Requirement for Specified Disclosures Each financial report must reflect all material
correcting adjustments a CPA determines are necessary. Each annual or quarterly financial
report must disclose all material off–balance sheet transactions and other relationships with
unconsolidated entities that might have a material current or future effect on the financial
condition of the entity. The SEC will issue rules providing that pro forma financial
information must be presented in a manner such that it does not contain an “untrue
statement” or omit a material fact necessary for the information not to be misleading.
Requirement for CEO and CFO Certification CEOs and CFOs must certify in each
annual and quarterly report that the officer has reviewed the report, that based on the
officer's knowledge the report contains no untrue statement of a material fact or omits a
material fact, and that based on the officer's knowledge, the financial statements and other
financial information included in the report fairly present the financial condition and results
of operations of the issuer. They must also attest that they are responsible for establishing
and maintaining internal controls, that they have designed such controls to ensure that
material information is made known to the officers, that they have presented their
conclusions about the effectiveness of those controls in the report, and that they have
disclosed both to the outside auditors and to the company's audit committee (1) all
significant deficiencies in the design or operation of internal controls that could adversely
affect the issuer's ability to record, process, summarize, and report financial data and (2) any
fraud, whether or not material, involving any employee who has a significant role in the
issuer's internal controls.

Section 404
Section 404 is one of the more controversial provisions of SOX. It contains two subsections
—404(a) and 404(b). Section 404(a) outlines management's responsibility under the act and
requires that the annual report include an internal control report by management that (1)
acknowledges its responsibility for establishing and maintaining adequate internal control
over financial reporting and (2) contains an assessment of the effectiveness of internal
control over financial reporting as of the end of the most recent fiscal year. It also requires
the principal executive and financial officers to make quarterly and annual certifications as
to the effectiveness of the company's internal control over financial reporting. Section
404(b) outlines the independent auditor's responsibility. It requires the auditor (1) to report
on the internal control assessment made by management and (2) to make a separate
independent assessment of the company's internal controls over financial reporting.
The result of these provisions initially was to require the auditor to issue two separate
opinions. The first opinion stated whether management's assessment of internal control was
fairly stated, in all material respects. The second opinion indicated whether, in the auditor's
opinion, the company maintained, in all material respects, effective internal control over
financial reporting as of the specific date, based on the control criteria used by management.
In summary, the auditor reported on (1) whether management's assessment of the
effectiveness of internal control was appropriate and (2) whether he or she believed that the
company had maintained effective internal control over financial reporting.
The cost of compliance with this legislation was seen by some as excessive. According to
one study, the net private cost amounted to approximately $1.4 trillion. 10 This amount was
obtained by an econometric estimate of the loss in total market value caused by SOX. It
measured the costs minus the benefits as perceived by the stock market as the new rules were
enacted. This study's results were later questioned on the grounds that no single factor can be
attributed as the cause of stock market behavior. Critics noted that all of the stock market
trends around the time SOX was enacted were attributed to the legislation, while the
subsequent increase in market value was ignored.11 Nevertheless, a survey by the Financial
Executives Institute in 200512 estimated that companies' total costs for the first year of
compliance with SOX averaged $4.6 million.
The SOX 404 provisions that emphasize the importance of internal control have obvious
benefit; however, a standard rule of thumb for internal control measures is that the benefits
should outweigh their costs. Some critics of SOX maintain that its effect has been that the
costs of regulation exceed its benefits for many corporations.13 SOX was originally effective
for companies meeting the definition of accelerated filers (having an equity market
capitalization of over $75 million and filing a report with the SEC) for fiscal years ending on
or after December 15, 2004; consequently, December 31, 2004, was the first filing date for
most of these companies. Companies that did not meet the definition of accelerated filers
were initially required to comply with SOX's provisions for fiscal periods ending on or after
July 15, 2006.
A subsequent study of the economic consequences of SOX Section 404 indicated that
audit fees for the companies meeting the definition of accelerated filers increased by an
average of 65 percent in the first year SOX was effective and by 0.9 percent in the second
year.14 This increased cost was found to cause an average decrease in earnings of 0.5 percent
during the first year of compliance. Similar analyses apparently caused the SEC to revisit the
issue. In June 2007, the PCAOB released Auditing Standard No. 5 (AS No. 5) to supersede
the previous guidelines under which auditors were seen as so focused on the detail and the
shear breadth of the internal controls that there was little room for judgment and a clear
perspective over the overall process goals. AS No. 5 adopts an integrated top-down, risk-
based, and materiality-focused approach to the audit. As such, the auditor's report on internal
control over financial reporting will express one opinion—an opinion on whether the
company has maintained effective internal control over financial reporting as of its fiscal
year-end. For the auditor to render an opinion, AS No. 5 requires the auditor to evaluate and
test both the design and the operating effectiveness of internal control to be satisfied that
management's assessment about whether the company maintained effective internal control
over financial reporting as of its fiscal year-end is correct and, therefore, is fairly stated.
The cost of complying with the Section 404 provisions was also viewed as especially
burdensome for smaller companies. In an attempt to reduce this impact, in May 2006, the
SEC announced it intended to take a series of actions to improve the implementation of
Section 404 of SOX, and in December 2006, it first extended the date for compliance by
nonaccelerated filers to fiscal years ending on or after December 15, 2007. Later, The SEC
extended the date for compliance for nonaccelerated filers to June 15, 2010.
Initially, the SEC did not play an active role in the accounting standard–setting process
and encouraged the private sector to develop accounting standards. However, in recent years
the SEC has taken a more proactive role. For example, in 2008 the SEC issued a study on the
impact of mark-to-market accounting (discussed in Chapter 7). Earlier in July 2007, the SEC
chartered the Advisory Committee on Improvements to Financial Reporting. This
committee's mandate was to examine the U.S. financial reporting system in order to make
recommendations intended to increase the usefulness of financial information to investors,
while reducing the complexity of the financial reporting system to investors, preparers, and
auditors.
In August, 2008 the committee issued its final report.15 Among its recommendations were
the following:

1. The usefulness of the information in SEC reports should be increased. One

of the committee's primary objectives was to make financial information
more useful to investors while minimizing additional burdens on preparers.
As part of this effort, the committee recommends including a short
executive summary at the beginning of a company's annual report on Form
10-K. This recommendation was in response to the committee's belief that
individual investors find a company's periodic reports overly complex and
 detailed. The summary should describe concisely the most important themes
or other significant matters management is primarily concerned with, along
with a page index showing where investors could find more detailed
information on particular subjects. The committee also encouraged the
private sector to develop key performance indicators, on an activity and
industry basis, that would capture important aspects of a company's
activities that might not be fully reflected in its financial statements or might
be nonfinancial.
2. The accounting standards–setting process should be enhanced. The
committee maintained that the financial reporting system would be best
served by recognizing the preeminence of the perspective of investors
because they are the primary users of financial reports. To promote this
perspective, it supported increased investor representation on the FASB and
in the Financial Accounting Foundation. The committee believed that
increasing investor direct and indirect representation in the process was the
best way to assure that financial reports will be useful to investors.
3. The substantive design of new accounting standards should be improved.
The committee asserted that some accounting standards do not clearly
articulate their underlying objectives and principles and are sometimes
obscured by dense language, detailed rules, and numerous exemptions. In an
attempt to overcome this shortcoming, the committed supported the
objective of the FASB's project on financial statement presentation to divide
a company's individual financial statements into cohesive components.
Although recognizing that the current mixed-attribute system of historic cost
and fair value was likely to continue, it urged a judicious approach to further
expansions of fair value. Additionally, the committee advocated portraying
the different sources of changes in a company's income—for example, by
clearly distinguishing cash receipts from unrealized changes in fair value.
This distinction was seen as helping companies better explain to investors
the earnings volatility during each accounting period. The committee also
opposed rule-based bright-line tests because such tests might result in very
different accounting for transactions with quite similar economics. To
decrease complexity and increase comparability, the committee advocated a
move away from industry-specific guidance in authoritative literature unless
it was justified by strong conceptual arguments. The committee held that a
better approach would be to focus on the nature of the business activity
itself. Finally, the committee recommended that the FASB eliminate
alternative accounting methods for the same transaction, unless the
alternative has a compelling rationale.
4. Authoritative interpretive guidance should be delineated. The committee
noted that historically, interpretive guidance on implementing accounting
standards proliferated from many public and private sources and thus
increased the volume of U.S. GAAP. To reduce the avoidable complexity
associated with the proliferation of U.S. GAAP, the committee voiced
 support for the FASB's efforts to complete the codification of all U.S.
GAAP in one document, which would clearly delineate authoritative from
nonauthoritative literature. To help integrate SEC accounting guidance into
this codification, the committee recommended that the SEC should
formulate its guidance in a format consistent with the one used by the
FASB. The committee also voiced its belief that there should be a single
standards setter for all authoritative accounting standards and interpretive
implementation guidance of general significance.
5. Guidance on financial restatements and accounting judgments should be
clarified. The committee noted that in 2006, more than 9 percent of all U.S.
public companies restated their financial statements because of accounting
errors. This restatement process, which often takes longer than 12 months,
imposes significant costs on investors as well as preparers. As a result,
companies often go into a dark period and issue very little financial
information to the public. Consequently, the committee recommended that
the determination of whether an accounting error is material be separated
from the decision on how to correct the error, and it supported a stricter rule
than the current practice on accounting errors. That is, a company should
promptly correct and prominently disclose any accounting error unless it is
clearly insignificant. In addition, the correction and disclosure of any
accounting error should not automatically result in a financial restatement.
Also, due to the high probable cost to investors during the dark period, prior
period financial statements should be amended only if the error would be
material to investors making current investment decisions. The committee
also noted that the preparation and audit of financial statements has always
required the exercise of judgment and that a recent trend in accounting has
been to move away from prescriptive guidance toward greater use of
judgment. In recognition of the increasing exercise of accounting and audit
judgments, the committees recommend that the SEC and PCAOB adopt
policy statements on this subject. These policy statements should provide
more transparency into how these regulators evaluate the reasonableness of
a judgment, so that investors can have more confidence in the ways that
accounting and auditing judgments are being exercised.

The committee went on to make numerous recommendations on how to implement these

recommendations. They can be accessed through the web address contained in the report's
citation.

Ethical Responsibilities
From a philosophical perspective, the study of ethics explores and analyzes moral
judgments, choices, and standards and asks the question: How should I act? Consequently,
society's moral value judgments and the bases for choices of moral beliefs and standards
require more comprehensive analysis than is attainable from the data of other disciplines.
For example, consider the distinction between science and philosophy. While acting in a
professional capacity, the scientist does not find it necessary to pass value judgments on his
or her work. In fact, the scientist might disclaim responsibility for the uses of his or her
findings, as in the case of biological and nuclear weapons. However, philosophers do
evaluate and pass moral judgments on the work of scientists, because the goal of philosophy
is to evaluate all aspects of human character, conduct, and experience. Similarly, the
scientist (and the accountant), as a thinking person, is required to make value judgments
concerning his or her own work and its consequences.
The terms ethics and morals are not used interchangeably. In general, ethics (derived from
the Greek ethike, “the science of character”) is the study of moral issues, whereas morals
(derived from the Greek mores, “customs and manners”) are standards that individuals
observe in their daily conduct. The professions, including accounting, provide an exception
to this general rule. Professional codes of conduct delineate minimum standards for the
practice of a profession. Violation of these standards makes a professional unethical. For a
layperson, the violation of his or her personal code of ethics makes the individual immoral.
The ethical philosophy of Western civilization is based largely on the concept
of utilitarianism, the greatest happiness of the greatest number, as defined by John Stuart
Mill.16 Professional ethics by accountants prescribes a duty that goes beyond that of an
ordinary citizen. The special responsibility accountants have to society was summarized by
Chief Justice Warren Burger, as discussed in Chapter 1 (see page 22). Meeting this
responsibility requires accountants to maintain high ethical standards of professional
conduct. Society has granted many of the professions autonomy, including self-regulation, as
a privilege. In return, these professions must assume the obligation to promote ethical
conduct among their members, or public policymakers may react by reducing or removing
self-regulation and autonomy. Ethical conduct by accountants, based on the concept of
utilitarianism, should include consideration of all possible consequences of professional
decisions for all individuals or groups affected by a decision. Among these individuals or
groups are actual and potential stockholders, creditors, suppliers, customers, employees, and
society as a whole.
The practice of professional accounting is characterized by uncertainties that can create
ethical dilemmas. Loeb has identified several major ethical issues or dilemmas that might
confront individual accountants and accounting firms.17

1. Independence. The concept of independence requires the complete

separation of the business and financial interests of the public accountant
from the client corporation. Consequently, the auditor must serve the role of
an impartial observer maintaining the public watchdog function. How do
firms develop policies to ensure that this duty is maintained?
2. Scope of services. What other services (e.g., consulting, tax return
preparation, tax advice) are compatible with financial auditing? At what
point does the auditor lose independence by providing nonaudit services to a
client?
3. Confidentiality. When does the auditor's public watchdog function conflict
with his or her duty to keep client activities confidential?
4. Practice development. The removal of the rule prohibiting advertising
(discussed later in the chapter) allows a great deal of latitude; however, an
advertisement cannot be misleading or untrue. How do firms develop
policies to delineate the nature and extent of practice development
activities?
 5. Differences on accounting issues. How do public accounting firms develop
policies to deal with situations in which a company wishes to account for a
transaction in a manner not believed to be acceptable to the firm? (In these
situations, the company might threaten to fire the auditor and seek a public
accounting firm that will agree with management's position on the
accounting issue. This practice is termed opinion shopping.)

The resolution of ethical dilemmas can be assisted through a framework of analysis. The
purpose of such frameworks is to help identify the ethical issues and to decide on an
appropriate course of action. For example, the following six-step approach may be used:

1. Obtain the relevant facts.

2. Identify the ethical issues.
3. Determine the individuals or groups affected by the dilemma.
4. Identify the possible alternative solutions.
5. Determine how the individuals or groups are affected by the alternative
solutions.
6. Decide on the appropriate action.

Another aspect of the ethics issue is the legal–ethical question. That is, if a particular
action is legal, does that automatically make it ethical? The obvious answer to this question
is no, given that slavery was once legal in the United States. In fact, there is a presumption in
our society that ethical behavior should be at a higher level than legal behavior.
Consequently, acts that are consistent with current ethical standards but inconsistent with
current legal standards may point to a need to change unethical legal standards. For example,
consider the issues of sexual and racial discrimination. Not long ago, public accounting firms
hired neither women nor racial minorities. Various actions throughout society, including
some that violated the law, helped eliminate these practices to the point that today more than
50 percent of new hires by large public accounting firms are women, and the profession and
public accounting firms are currently engaging in a variety of activities to encourage racial
minorities to choose accounting as a career.

The Professional Code of Conduct

Accountants, as professionals, are expected to maintain a level of ethical conduct that goes
beyond society's laws. The reason for this high level of ethical conduct is the need for public
confidence in the quality of services provided by the profession, regardless of the individual
providing the service. Public confidence in the quality of professional service is enhanced
when the profession encourages high standards of performance and ethical conduct by its
members.
Over the years, the AICPA has represented itself as an ethical professional body engaged
in practicing an art rather than a science. Accounting was to be viewed by society, in a
manner similar to the medical and legal professions, as more influenced by a service motive
than by a profit motive. As an art, the judgmental nature of accounting precludes a uniform
set of rules to cover all situations; consequently, the foundation of the profession rests not on
standardization and regulation but on ethical conduct.
In attempting to solidify this view by society, the accounting profession in the United
States has had some form of the Code of Professional Conduct since the early twentieth
century. The original code, which was part of the bylaws of the American Association of
Professional Accountants (AAPA), a predecessor of the AICPA, was first published in 1905
and contained only two rules. One prohibited members from allowing nonmembers to
practice in the member's name, thereby requiring all members of the firm, not just the
managing partner, to join the AAPA. The second rule prohibited the payment of referral fees,
now commonly known as kickbacks. The limited scope of the earliest version of the code
was based on a belief that a written code could not and should not be taken as a complete
representation of the moral obligations of accounting's responsibility to society.
In 1917 and through subsequent adopted rules, the renamed organization, the American
Institute of Accountants, amended the Code of Professional Conduct to include rules
prohibiting various actions such as contingency fees, competitive bidding, advertising, the
formation of partnerships, forecasts, and a substantial financial interest in a public
corporation client. In addition, in response to the securities acts of 1933 and 1934, a rule on
independence was adopted in 1934. In 1941, the rules were recodified to include a section on
technical standards.
As discussed in Chapter 1, after the collapse of the stock market in 1929, accountants were
viewed very favorably by society. Consequently, it was not necessary for the profession to
undertake any drastic measures to attain the public's confidence. Up to 1941, the profession's
main concerns were bound up with the concepts of confidentiality, competence, and
independence. The main emphasis of the profession's disciplinary actions during this period,
and even somewhat later, was directed toward restrictions on unprofessional competitive
practices such as competitive bidding, advertising, encroachment on the practice of other
CPAs, and the pirating of other firms' employees. The rules prohibiting such actions were
based on the belief that they would erode independence and destroy harmony among
practitioners.18
In 1962 the Code of Professional Conduct was again amended. Although the amended
code contained essentially the same rules as did the 1941 code, they were classified into five
articles. Article 1, “Relations with Clients and Public,” contained a more explicit description
of independence. Article 2 defined “Technical Standards.” Article 3, “Promotional
Practices,” covered advertising, promotional practices, and competitive bidding. Article 4
discussed the rules of membership and was termed “Operating Practices.” Finally, Article 5,
“Relations with Fellow Members,” defined unacceptable client and employee acquisition
practices.
The subsequent social upheaval of the 1960s, the collapse of Equity Funding,19 and the
impact of the Watergate investigation of 1974 affected the accounting profession. For
example, it was found that many of the largest corporations had made illegal contributions to
the Republican Party, and investigations discovered secret bank accounts that were used to
hide bribes and kickbacks. The profession argued that it was difficult, if not impossible, to
discover such transactions in a normal audit. In addition, it was maintained that, even if
detected, such illegal transactions would not have a material effect on companies' financial
statements and therefore did not require disclosure. Nevertheless, the failure to uncover these
illegal activities by normal audits served to erode confidence in the ethical conduct of the
accounting profession.
During this period, the House Subcommittee on Oversight and Investigations (the
congressional body that oversees the SEC) was engaging in an inquiry of accounting
practices in the oil and gas industry that culminated in a much larger investigation. In a
report issued in 1978, the committee's chair, John Moss, summarized Congress's concern
over the incidents that had occurred.20 Especially troubling were events such as bankruptcies
with no warnings from auditors to investors that anything was amiss, the demise of more
than 100 brokerage firms in the late 1960s because of inconsistent methods of determining
capital ratios, lack of uniform accounting procedures in the energy industry, and the incidents
discovered in relation to the Watergate incident.21
During this same period, a U.S. Senate subcommittee chaired by Sen. Lee Metcalf also
initiated a investigation of the accounting profession. The subcommittee's 1,760-page staff
study, titled The Accounting Establishment,22 was an examination of the Big Eight firms, the
AICPA, and the FASB and included a number of highly controversial conclusions. Two of
the staff study's conclusions were that the Big Eight firms lacked independence from their
clients and that they dominated both the Institute and the process of setting of accounting
standards. The study also asserted that the Big Eight firms, through their influence on the
FASB, did the bidding of their corporate clients. 23 The Metcalf subcommittee's staff study
also recommended that the federal government set accounting and auditing standards for
publicly traded corporations; however, neither subcommittee's recommendations produced
legislation.
In the mid-1980s, congressional interest in the accounting profession emerged again in the
form of more hearings before the House Subcommittee on Oversight and Investigations,
chaired by Representative John Dingell. The committee's primary concern was the role of
auditors in detecting fraud. Dingell questioned whether the public's and the profession's
perception of accountants' responsibility coincided. He also asked: Were the rules deficient?
Were the qualifications to be a CPA sufficient? Was self-policing of the accounting
profession adequate?24 In other words, he was questioning the maintenance of ethical
standards by the profession and suggesting that the profession did not have the ability to
regulate itself.
Public policymakers were not the only ones voicing concerns. During the 1970s some
accountants were joining the critics of the accounting profession. For example, Abraham
Briloff (an accounting professor at Baruch College, City University of New York), in a series
of books, articles, and testimony before Congress, maintained that many published financial
statements were not “prepared fairly” in accordance with GAAP, the FASB had not fulfilled
its responsibility to develop accounting standards, and public accounting firms had not
adequately resolved their ethical dilemmas (discussed above), thus resulting in several cases
of successful opinion shopping.25
The events of the 1970s and 1980s served to question the ability of accountants to detect
fraud, uncover illegal contributions, and predict bankruptcy; consequently, their competence
as professionals was also being questioned. As a result, the profession was facing legislation
that threatened to regulate the practice of accounting.
Partially in response to these issues, the AICPA engaged in several activities in an attempt
to neutralize criticism of the accounting profession. In 1973 the Code of Professional
Conduct was again amended. A major feature of the amended code was the requirement to
comply with auditing standards and the prohibition from expressing an opinion that financial
statements are prepared in conformity with GAAP if such statements depart from an
accounting principle. As discussed earlier in the text, the inclusion of this rule made ARBs,
APB Opinions, SFASs, and now the FASB ASC enforceable under the Code of Professional
Conduct.26 The 1973 code also included a discussion of the philosophical fashion by which
the rules flow from the concepts and why these concepts were of importance to the
profession.
Next, in 1974 the AICPA formed a commission on auditors' responsibilities. The
commission's final report, known as the Cohen Report, called upon the Auditing Standards
Executive Committee to consider developing an improved auditor's report. It also
recommended the development of criteria for evaluating internal accounting controls and
establishing independent audit committees. Later, the AICPA established a new division for
CPA firms with two sections, one for firms with clients registered with the SEC and one for
firms that had clients in private practice. Membership in the SEC Practice Section requires
self-regulation, including external peer review of its practice procedures. In addition, the
activities of the SEC Practice Section are monitored by the PCAOB. As noted by Rep.
Dingell, some of the criticism of the professional practice of accounting can be attributed to
an expectations gap. That is, there is a difference between what financial statement users and
society as a whole perceive as the responsibility of public accountants versus what
accountants and the profession perceive as their responsibility. As a result, the AICPA's
Auditing Standards Board issued nine new standards in 1988 in an attempt to narrow this
expectations gap. Specifically, the effect of these new standards was to (1) broaden auditors'
responsibility to consider the reliability of a company's internal control system when
planning an audit; (2) delineate the responsibility of auditors for reporting errors,
irregularities, and illegal acts by clients; and (3) require auditors to evaluate a company's
ability to continue as a going concern.
At the same time, the Code of Professional Conduct was undergoing a review. In 1983 the
AICPA appointed a committee to study the relevance and effectiveness of the code in the
contemporary environment. The committee's report, commonly known as the Anderson
Report, indicated that effective performance should meet six criteria:

1. Safeguard the public's interest.

2. Recognize the CPA's paramount role in the financial reporting process.
3. Help ensure quality performance and eliminate substandard performance.
4. Help ensure objectivity and integrity in public service.
5. Enhance the CPA's prestige and credibility.
6. Provide guidance as to proper conduct.27

The members of the AICPA accepted the recommendations of the Anderson Report and
amended the Code of Professional Conduct in 1988. The code now consists of four sections:

1. Principles. The standards of ethical conduct stated in philosophical terms

2. Rules of conduct. Minimum standards of ethical conduct
3. Interpretations. Interpretations of the rules by the AICPA Division of
Professional Ethics
4. Ethical rulings. Published explanations and answers to questions about the
rules submitted to the AICPA by practicing accountants and others
interested in ethical requirements

The first two sections of the Code of Professional Conduct consist of general statements
emphasizing positive activities that encourage a high level of performance (principles) and
minimum levels of performance that must be maintained (rules). Consequently, implicit in
the Code of Professional Conduct is the expectation that CPAs will abide by the rules at the
minimum and strive to achieve the principles at the maximum. The following six ethical
principles, which are not enforceable, are contained in the Code of Professional Conduct:

1. Responsibilities. In carrying out their responsibilities as professionals,

members should exercise sensitive professional and moral judgments in all
their activities.
 2. The public interest. Members should accept the obligation to act in a way
that will serve the public interest, honor the public trust, and demonstrate
commitment to professionalism.
3. Integrity. To maintain and broaden public confidence, members should
perform all professional responsibilities with the highest level of integrity.
4. Objectivity and independence. A member should maintain objectivity and be
free of conflict of interest in discharging professional responsibilities. A
member in public practice should be independent in fact and appearance
when providing auditing and other attestation services.
5. Due care. A member should observe the profession's technical and ethical
standards, strive continually to improve competence and the quality of
services, and discharge professional responsibility to the best of the
member's ability.
6. Scope and nature of services. A member in public practice should observe
the Principles of the Code of Professional Conduct in determining the scope
and nature of services to be provided.

The principles, which are goal-oriented, also provide the framework for the rules, which
represent the enforceable provisions of the code. The rules deal with issues such as
independence, integrity, and objectivity; compliance with standards of practice;
confidentiality of client information; advertising; and contingent fees and commissions.
Later, some of these rules were required to be liberalized because of a consent decree
between the AICPA and the Federal Trade Commission arising from a claim of restraint of
fair trade. For example, CPA firms may now accept contingent fees from nonattest clients,
and advertising by CPA firms is now an acceptable practice.
The issue of ethical principles gained new prominence during the accounting scandals of
the early 2000s, which resulted in the demise of Arthur Andersen. Before the passage of
SOX, the SEC had established a list of nonaudit functions that a CPA firm could not perform
in conjunction with an audit. These prohibited functions are the same as those contained in
the delineation of prohibited services in the SOX (discussed earlier). Additionally,
companies were required to disclose the amounts received from auditors from nonaudit
services in the notes to the financial statements. Although no substantial legal evidence has
been uncovered that indicates Arthur Andersen engaged in any of the forbidden nonaudit
functions, in each of the company failures the amounts of Andersen's nonaudit fees exceeded
their audit fees. As a result, it is now unlawful for a CPA firm to provide any nonaudit
services to its clients.
The need for interpretations of the Code of Professional Conduct arises when individuals
or firms have questions about a particular rule. Ethics rulings are explanations concerning
specific factual situations. They have been published in the form of questions and answers. A
detailed review of the interpretations and ethical rulings is beyond the scope of this book.
In summary, the past two decades have brought forward questions from some critics
concerning the ethical conduct of professional accountants. The profession has responded by
further delineating its responsibilities and by attempting to narrow the expectations gap. The
accounting scandals at the beginning of the century resulted in a less favorable view of the
profession; however, a Gallup poll in 2008 found the profession's image to be recovering.
According to the poll's analysis, the profession whose image has improved the most
compared to the previous year's is accounting. Its rating rose from a net rating of 0 percent
(i.e., as many people gave it a negative rating as a positive one) to 130 percent. 28 Yet, the
profession has still not recovered to the 139 percent rating it received in 2001, before the
Enron and other scandals cast such negative light on accounting firms' roles in these
companies' alleged malfeasance. However, the accounting profession must strive to improve
this perception, and the Code of Professional Conduct should be viewed as a starting point in
determining the ethical behavior of professional accountants. It may also be necessary to
revisit the scope-of-services issue because this same Gallup poll detected some concerns
over the variety of services offered by CPA firms to the same client. This and other issues
that trouble the public must be resolved in order for accounting to continue to serve its public
watchdog function in a manner that is accepted by society.

International Accounting Standards

The IASB standard that addresses disclosure requirements and ethical responsibilities is IAS
No. 1, “Presentation of Financial Statements.” The objective of IAS No. 1 is to prescribe the
basis for presentation of general-purpose financial statements so as to ensure comparability
both with the entity's financial statements of previous periods and with the financial
statements of other entities. IAS No. 1 sets out the overall requirements for the presentation
of financial statements, guidelines for their structure, and minimum requirements for their
content. Standards for recognizing, measuring, and disclosing specific transactions are
addressed in specific standards and interpretations. This statement replaced IAS No. 1,
originally titled “Disclosure of Accounting Policies” (as well as IAS No. 5 and No. 13). It
requires companies to present a statement disclosing each item of income, expense, gain, or
loss required by other standards to be presented directly in equity and to provide the total of
these items. It also requires that the notes to the financial statements present information
about the basis on which financial statements were prepared and the specific accounting
policies selected, disclose all other information required by IASB standards not presented
elsewhere in the financial statements, and provide all other information necessary for a fair
presentation.
The International Accounting Standards Committee addressed the issue of subsequent
events in IAS N.10. “Events after the Reporting Period.” The requirements contained in this
pronouncement are quite similar to U.S. GAAP and outline the accounting and disclosure
requirements to be used when events after the end of the end of the reporting period should
be adjusted in the financial statements. Adjusting events are defined as those providing
evidence of conditions existing at the end of the reporting period, whereas nonadjusting
events are defined as those providing evidence of conditions arising after the reporting
period. According to IAS No. 10, the financial statements should be amended for adjusting
events including events that indicate that the going-concern assumption in relation to the
whole or part of the enterprise is not appropriate. The financial statements should not be
amended for nonadjusting events; however, nonadjusting events should be disclosed if they
are of such importance that nondisclosure would affect the ability of users to make proper
evaluations and decisions. The required disclosure is (a) the nature of the event and (b) an
estimate of its financial effect or a statement that a reasonable estimate of the effect cannot
be made. IAS No. 10 also indicates the an entity should not prepare its financial statements
on a going-concern basis if management determines after the end of the reporting period
either that it intends to liquidate the entity or to cease trading, or that it has no realistic
alternative but to do so.
The IASB also addressed interim financial reporting in IAS No. 34, “Interim Financial
Reporting.” This release defined the minimum content of an interim financial report,
provided presentation and measurement guidance, and defined the recognition and
measurement principles to be followed in the presentation of interim financial reports. The
IASB concluded that the decision to publish and the frequency of reporting are matters best
decided by national law.
The minimum content of an interim financial report was defined as a condensed balance
sheet, condensed income statement, condensed statement of cash flows, condensed statement
of changes in stockholders' equity, and all footnotes necessary to understand the financial
statements. IAS No. 34 requires companies to use the same accounting principles in interim
financial reports that are used in the annual report and thus adopts the integral view of
interim financial reports.

Cases

 Case 17-1 Two Viewpoints on Accounting Standards

The proponents of neoclassical, marginal economics (see Chapter 4) maintain that
mandatory accounting and auditing standards inhibit contracting arrangements and the
ability to report on company operations. Opponents of this view argue that market forces
alone cannot be relied on to produce the high-quality information required by society.

Required:
Present arguments support both viewpoints. What is your opinion? (Hint: You might wish to
consult Richard Leftwich, “Market Failure Fallacies and Accounting Information,” Journal
of Accounting and Economics (December 1980): 193–221; and Steven Johnson, “A
Perspective on Solomon's Quest for Credibility in Financial Reporting,” Journal of
Accounting and Public Policy 7, no. 2 (1988): 137–54.)

 Case 17-2 Ethical Dilemma

Barbara Montgomery is a first-year auditor for Coppers and Rose, a large public accounting
firm. She has been assigned to the audit of Lakes Brothers, a clothing retailer with retail
outlets throughout the United States. This audit has proved troublesome in the past, and
during a staff meeting preceding the audit, Robert Cooley, the supervisor on the audit, says:
“We are going to be required to work several hours ‘off-the-clock’ each week until this audit
is completed.” He also observes that the client is putting a great deal of pressure on the firm
to maintain an acceptable level of fees.
Barbara has just been to staff training school, where it was emphasized that not charging a
client for hours actually worked is a violation of Coppers and Rose's employment policy, a
violation that could cause her to be dismissed. She also knows that only staff personnel are
paid overtime and that supervisors are evaluated on successfully completing audits within
allowable budgets. Barbara discusses the issue with John Reed, a second-year staff
accountant. John says, “Don't worry, if you go along nobody will find out and Robert will
give you a good evaluation.” John also says that Robert is very highly regarded by the senior
members of the firm and is likely to be promoted to manager in the near future.

Required:

a. Is it ethical for Barbara to work hours and not charge them to the client?
b. Use the six-step approach outlined in this chapter to resolve this ethical
dilemma.
  Case 17-3 Types of Disclosure
Lancaster Electronics produces electronic components for sale to manufacturers of radios,
television sets, and phonographic systems. In connection with his examination of Lancaster's
financial statements for the year ended December 31, 2014, Don Olds, CPA, completed
fieldwork two weeks ago. Mr. Olds is now evaluating the significance of the following items
before preparing his auditor's report. Except as noted, none of these items has been disclosed
in the financial statements or footnotes.

1. Recently, Lancaster interrupted its policy of paying cash dividends quarterly

to its stockholders. Dividends were paid regularly through 2012,
discontinued for all of 2013 to finance equipment for the company's new
plant, and resumed in the first quarter of 2014. In the annual report, dividend
policy is to be discussed in the president's letter to stockholders.
2. A 10-year loan agreement, which the company entered into three years ago,
provides that dividend payments may not exceed net income earned after
taxes subsequent to the date of the agreement. The balance of retained
earnings at the date of the loan agreement was $298,000. From that date
through December 31, 2014, net income after taxes has totaled $360,000,
and cash dividends have totaled $130,000. Based on these data, the staff
auditor assigned to this review concluded that there was no retained earnings
restriction at December 31, 2014.
3. The company's new manufacturing plant building, which cost $600,000 and
has an estimated life of 25 years, is leased from the Sixth National Bank at
an annual rental of $100,000. The company is obligated to pay
property taxes, insurance, and maintenance. At the conclusion of its 10-year
noncancelable lease, the company has the option of purchasing the property
for $1. In Lancaster's income statement, the rental payment is reported on a
separate line.
4. A major electronics firm has introduced a line of products that will compete
directly with Lancaster's primary line, which is now being produced in the
specially designed new plant. Because of manufacturing innovations, a
competitor's line will be of comparable quality but priced 50 percent below
Lancaster's line. The competitor announced its new line during the week
following completion of fieldwork. Mr. Olds read the announcement in the
newspaper and discussed the situation by telephone with Lancaster
executives. Lancaster will meet the lower prices with prices that are high
enough to cover variable manufacturing and selling expenses but will permit
recovery of only a portion of fixed costs.

Required:
For each of the preceding items, discuss any additional disclosures in the financial
statements and footnotes that the auditor should recommend to his client. (The cumulative
effect of the four items should not be considered.)
  Case 17-4 Preparation of Footnotes
You have completed your audit of Carter Corporation and its consolidated subsidiaries for
the year ended December 31, 2014, and are satisfied with the results of your examination.
You have examined the financial statements of Carter for the past three years. The
corporation is now preparing its annual report to shareholders. The report will include the
consolidated financial statements of Carter and its subsidiaries and your short-form auditor's
report. During your audit, the following matters came to your attention:

1. The Internal Revenue Service, which is examining the corporation's 2014

federal income tax return, questions the amount of a deduction claimed by
the corporation's domestic subsidiary for a loss sustained in 2014. The
examination is still in process, and any additional tax liability is
indeterminable at this time. The corporation's tax counsel believes that there
will be no substantial additional tax liability.
2. A vice president who is also a stockholder resigned on December 31, 2013,
after an argument with the president. The vice president is soliciting proxies
from stockholders and expects to obtain sufficient proxies to gain control of
the board of directors so that a new president will be appointed. The
president plans to have a footnote prepared that would include information
about the pending proxy fight, management's accomplishments over the
years, and an appeal by management for the support of stockholders.

Required:

a. Prepare the footnotes, if any, that you would suggest for the foregoing listed
items.
b. State your reasons for not making disclosure by footnote for each of the
listed items for which you did not prepare a footnote.

 Case 17-5 Interim Reporting

The unaudited quarterly statements of income issued by many corporations to their
stockholders are usually prepared on the same basis as annual statements—the statement for
each quarter reflects the transactions of that quarter.

Required:

a. Why do problems arise in using such quarterly statements to predict the

income (before extraordinary items) for the year? Explain.
b. Discuss the ways quarterly income can be affected by the behavior of the
costs recorded in an account for repairs and maintenance of factory
machinery.
c. Do such quarterly statements give management opportunities to manipulate
the results of operations for a quarter? If so, explain or give an example.
  Case 17-6 Methods of Disclosure
The concept of adequate disclosure continues to be one of the most important issues facing
accountants, and disclosure may take various forms.

Required:

a. Discuss the various forms of disclosure available in published financial

statements.
b. Discuss the disclosure issues addressed by each of the following sources:
i. The AICPA Code of Professional Ethics
ii. The Securities Act of 1933
iii. The Securities Exchange Act of 1934
iv. The Foreign Corrupt Practices Act of 1977
v. Section 404 of the Sarbanes–Oxley Act of 2002

 Case 17-7 The Securities Acts of 1933 and 1934

The Securities Act of 1933 and the Securities Exchange Act of 1934 established guidelines
for the disclosures necessary and the protection from fraud when securities are offered to the
public for sale.

Required:

a. Discuss the terms going public and being public as they relate to these

pieces of legislation.
b. Regulation S-X requires management to discuss and analyze certain
financial conditions and results of operations. What are these items?

 Case 17-8 Code of Professional Conduct

Certified public accountants have imposed on themselves a rigorous code of professional
conduct.

Required:

a. Discuss the reasons that the accounting profession adopted a code of

professional conduct.
b. One rule of professional ethics adopted by CPAs is that a CPA cannot be an
officer, director, stockholder, representative, or agent of any corporation
engaged in the practice of public accounting, except for the professional
corporation form expressly permitted by the AICPA. List the arguments
supporting the rule that a CPA's firm cannot be a corporation.

 Case 17-9 Consolidated Reporting

As discussed in Chapter 14, leases that are in-substance purchases of assets should be
capitalized—an asset and associated liability should be recorded for the fair value acquired.
Mason Enterprises is considering acquiring a machine and has the option to lease or to buy
by issuing debt. Mason also has debt covenants that restrict its debt-to-equity ratio to 2:1.
The purchase alternative would increase the debt-to-equity ratio precariously close to the
restrictive limit and could result in the company's going into default. Also, management
bonuses are affected when the debt-to-equity ratio exceeds 1.5:1.
Mason's management is aware that majority-owned subsidiaries must be consolidated. The
president, Penny Mason, persuades the board to form a subsidiary that would own 49 percent
of the stock. The rest of the stock would be sold to the public. Mason would retain control of
the subsidiary by maintaining membership on the board of directors and selling the majority
shares in small blocks to a number of investors.

Required:

a. What is the economic substance of the lease transaction from the perspective
of Mason Enterprises? Discuss.
b. By forming the subsidiary, is Mason able to lease the equipment and keep
the transaction off its balance sheet?
c. According to the efficient market hypothesis, discussed in Chapter 3, would
investors be fooled by the Mason financing strategy? Explain.
d. According to agency theory, discussed in Chapter 3, management may act in
its own best interest at the expense of owners. In light of this theory, what
are the ethical implications of the Mason financing strategy? Discuss.
e. Does the financing strategy provide financial statements that are
representationally faithful and unbiased? Discuss.

 Case 17-10 The Ethics of Accounting Choices

The Fillups Company has been in the business of exploring for oil reserves. During 2013,
$10 million was spent drilling wells that were dry holes. Under GAAP, Fillups has the
option of accounting for these costs by the successful efforts method or the full-cost method.
Under successful efforts, the $10 million would be expensed once it was determined that the
wells were dry. Under full cost, the $10 million would be capitalized. It would not be
expensed until the oil from successful wells is extracted and sold.
Fillups decides to use the full-cost method because of its positive effect on the bottom line.

Required:

a. What are the ethical considerations implied in the rationale for Fillups's
decision? Explain.
b. Do you believe that an accounting alternative should be selected solely on
the basis of financial statement effects? Discuss.

FASB ASC Research

For each of the following FASB ASC research cases, search the FASB ASC database for
information to address the issues. Cut and paste the FASB paragraphs that support your
responses. Then summarize briefly what your responses are, citing the pronouncements and
paragraphs used to support your responses.

 FASB ASC 17-1 Disclosure of Loss Contingency and Subsequent Event

A company car is in a wreck and the company expects to have to pay a substantial sum to
persons who were injured. Search the FASB ASC database to determine what type of
disclosure, if any, is required under each of the following two circumstances. For each
circumstance, cut and paste your findings (citing the source) and then write a brief summary
of what your research results mean. In both cases, assume the company's year-end is
December 31.

1. The accident occurred in November.

2. The accident occurred in January of the following year. Financial statements
will not be issued until February.

 FASB ASC 17-2 Accounting Policies

APB Opinion No. 22 and the EITF both addressed the disclosure of accounting policies.

1. Search the FASB ASC database to find the paragraphs relating to the
disclosure of accounting policies. Cite and summarize these paragraphs.
2. Cite and summarize the FASB ASC paragraphs where supplemental
guidance was provided by the EITF.

 FASB ASC 17-3 Accounting for Changing Prices

The FASB ASC indicates that a business entity that prepares its financial statements in U.S.
dollars and in accordance with U.S. GAAP is encouraged, but not required, to disclose
supplementary information on the effects of changing prices. It also describes the
information that should be disclosed if such supplemental information is provided. Find,
cite, and copy the FASB ASC paragraphs that discuss this issue.

 FASB ASC 17-4 Interim Financial Reports in the Oil and Gas Industry
The FASB ASC provides guidance on the disclosure of certain events in the oil and gas
industry in interim financial reports. Find, cite, and copy the FASB ASC paragraphs that
discuss this issue.

 FASB ASC 17-5 Accounting Policies in the Construction Industry

The FASB ASC provides guidance on disclosures specific to the construction industry. Find,
cite, and copy the FASB ASC paragraphs that discuss this issue.

 FASB ASC 17-6 Disclosure of Foreign Activities

The SEC has issued regulations requiring the disclosure of foreign activities of financial
services depository and lending companies when certain financial statement elements exceed
10 percent of the corresponding financial statement amount. Find, cite, and copy the FASB
ASC paragraphs that discuss this issue.

 FASB ASC 17-7 Common-Interest Realty Associations

The FASB ASC addresses disclosure requirements for common-interest realty associations.
Find, cite, and copy the FASB ASC paragraphs that define common-interest realty
associations. Additionally, find, cite, and copy the FASB ASC paragraphs that proscribe the
additional disclosures requited for common-interest realty associations.

Room for Debate

 Debate 17-1 Ethical Consideration of Off–Balance Sheet Financing

Snappy Corporation enters into a lease agreement with Long Leasing. Long requires that the
lease qualify as a sale. Snappy can fill this requirement by either guaranteeing the residual
value itself or having a third party guarantee the residual value. Self-guarantee of the
residual value will result in a capital lease to Snappy. The third-party guarantee will allow
Snappy to report the lease as an operating lease (off–balance sheet financing).

Team Debate:

Team Argue for recording the lease as a capital lease. Your arguments should take into
1: consideration the definition of relevant elements of financial statements found
in SFAC No. 6, representational faithfulness, and the substance and form of the lease
transaction. In addition, discuss the ethical implications of selecting this alternative as
opposed to the operating lease.

Team Argue for treating the lease as an operating lease. Your arguments should take into
2: consideration the definitions of relevant elements of financial statements found
in SFAC No. 6, representational faithfulness, and the substance and form of the lease
transaction. In addition, discuss the ethical implications of selecting this alternative as
opposed to the capital lease.

 Debate 17-2 Booking the Budget

In 2002 the SEC investigated Microsoft's accounting practices that occurred during the late
1990s. The Commission found that Microsoft typically reported budgeted marketing
expenses in its interim reports. At year-end, Microsoft reported actual marketing expenses in
its annual report.

Team Debate:

Team Argue in favor of Microsoft's interim reporting practices. Use the integral view of
1: interim reporting to support your argument.
 Team Argue against Microsoft's interim reporting practices. Use the discrete view of
2: interim financial reporting to support your argument.

 Debate 17-3 Full Disclosure

Investors, creditors, and other users of financial statements often argue that there should be
more transparency in published financial statements. This argument is based, at least to
some extent, on concerns that management has too much leeway in the selection of
accounting alternatives.

Team Debate:

Team Argue that management should continue to be allowed to choose among different
1: accounting alternatives because full disclosure in the notes to financial statements
provides sufficient transparency.

Team Argue that there should be a narrowing of accounting alternatives because full
2: disclosure in the notes is not sufficient to curb potential management abuses.
1. The audit committee is responsible for the oversight of the quality and integrity of a company's
accounting and reporting practices. In 2012, the Public Company Accounting Oversight Board
(discussed later in the chapter) described some of the interactions auditors will be required to have
with the audit committee, comprising an evaluation of the quality of the company's financial
reporting, which includes conclusions regarding critical accounting estimates and the company's
financial statement presentation; difficult or contentious matters for which the auditor consulted
outside the audit team; the auditor's evaluation of the company's ability to continue as a going
concern; and difficulties encountered in performing the audit.
2. Accounting Principles Board, Opinion No. 28, “Interim Financial Reporting” (New York:
American Institute of Certified Public Accountants, 1973), para. 5.
3. FASB. Proposed Accounting Standards Update Presentation of Financial Statements, Topic 205.
(Norwalk, CT: FASB, 2012).
4. FASB. Accounting Standards Update No. 2013–07 Presentation of Financial Statements, Topic
205. Liquidation Basis of Accounting (Norwalk, CT: FASB, 2013) para. 2.
5. Financial Accounting Standards Board, SFAC No. 1, “Objectives of Financial Reporting by
Business Enterprises” (Stamford, CT: FASB, 1974), para. 54.
6. Safe-Harbor Rule for Protection, Release No. 5993 (Washington, DC: Securities and Exchange
Commission, 1979).
7. Interpretation: Commission Guidance Regarding Management's Discussion and Analysis of
Financial Condition and Results of Operations. Release No. 33-8350; 34-48960; IC-21399 December
19, 2003.SEC, www.sec.gov/news/press/2003-179.htm.
8. The SEC first required quarterly reports to be issued in 1970.
9. Larry Kudlow, “Investing America's on Hold Because the World's Turned Upside Down,” NRO
Online (June 5, 2002), http://66.216.126.164/.
10. I. X. Zhang, “Economic Consequences of the Sarbanes–Oxley Act of 2002,” unpublished working
paper (Rochester, NY: William E. Simon Graduate School of Business Administration, University of
Rochester, 2005).
11. See, for example, C. Creelman, “Estimated SOX Year-One Compliance Costs $1.4 Trillion:
Increase in Investor Confidence Priceless,” Pennsylvania Institute of Certified Public Accountants
(2006), www.cpazone.org.
12. “404 Compliance: Is the Gain Worth the Pain?” Financial Executive 21 (2005): 30–32.
13. W. J. Carney, “The Costs of Being Public after Sarbanes–Oxley: The Irony of Going
Private,” Emory Law Journal 55 (2006): 141–159.
14. S. Bhamornsiri, R. Guinn, and R. Schroeder, “International Implications of Section 404 of the
Cost of Compliance with Section 404 of Sarbanes–Oxley,” International Advances in Economic
Research. 15 1 (Feb. 2009) 17–29.
15. Final Report of the Advisory Committee on Improvements to Financial Reporting to the United
States Securities and Exchange Commission, SEC (August 1,
2008), www.sec.gov/about/offices/oca/acifr/acifrfinalreport.pdf.
16. See, for example, J. B. Schneewind, Mill's Ethical Writings (New York: Collier, 1965).
17. Stephen E. Loeb, “Ethical Committees and Consultants in Public Accounting,” Accounting
Horizons (December 1989): 1–10.
18. W. E. Olson, The Accounting Profession: Years of Trial: 1969–1980 (New York: AICPA, 1982).
19. Equity Funding Corporation of America was a financial conglomerate that marketed mutual funds
and life insurance to private individuals in the 1960s and 70s. It collapsed in scandal in 1973 after two
ex-employees blew the whistle on massive accounting fraud, including a computer system dedicated
exclusively to creating and maintaining fictitious insurance policies.
20. U.S. Congress, Accounting and Auditing Practices and Procedures: 95th Congress, 1st session
(Washington, DC: U.S. Government Printing Office, 1978).
21. One outcome of these hearings was a Congressional report recommending that the SEC no longer
rely on FASB for accounting standards but instead issue the standards itself, thereby again raising the
issue of public-sector versus private-sector standards setting, but in the end, no Congressional action
was taken on this recommendation.
22. U.S. Congress, The Accounting Establishment: 95th Congress, 1st session (Washington, DC: U.S.
Government Printing Office, 1977).
23. The Accounting Establishment 1976, 20.24).
24. J. Dingell, “Accountants Must Clean Up Their Act: Rep. John Dingell Speaks Out,” Management
Accounting (May 1985), 52–55.
25. See, for example, Unaccountable Accounting (New York: Harper & Row, 1972); More Debits
Than Credits (New York: Harper & Row, 1976); The Truth about Corporate Accounting (New York:
Harper & Row, 1981); “Standards without Standards/Principles Without Principles/Fairness Without
Fairness,” Advances in Accounting 3 (1986), 25–50; and “Accounting and Society: A Covenant
Desecrated,” Critical Perspectives on Accounting 11 (March 1990), 5–30.
26. If an auditor can demonstrate that due to unusual circumstances the financial statements or data
would otherwise have been misleading, the auditor can comply with the rule by describing the
departure, its approximate effects, if practicable, and the reasons compliance with the principle would
result in a misleading statement.
27. Recruiting Professional Standards to Achieve Professional Excellence in a Changing
Environment (New York: AICPA, 1986), 11.
28. Lydia Saad, “Nurses Shine, Bankers Slump in Ethics Ratings.” Gallup (Nov. 24,
2008), www.gallup.com/poll/112264/Nurses-Shine-While-Bankers-Slump-Ethics-Ratings.aspx.
Prev Previous Chapter
CHAPTER 16: Accounting for Multiple Entities

Next Next Chapter
Index
Find answers on the fly, or master something new. Subscribe today. See pricing
options.

Back to top

 Browse
 Resource Centers
 Playlists
 History
 Topics
 Learning Paths
 Highlights
 Settings
 Support
 Sign Out

© 2019 O'Reilly Media, Inc. Terms of Service / Privacy Policy