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Accounting Information and Control System

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Various users of financial statements (also known as external decision makers) employ accounting information in quite different ways. For example, many individ­ual investors seldom look closely at the financial information contained in an annual report or the quarterly earnings statements that publicly owned companies must send to their shareholders. Being relatively unsophisticated in finance and invest­ment matters, they may read the introductory text (normally written by public relations people, not accountants) and look at the glossy pictures. But the accounting information contained in the auditor's statement typically holds little interest for them, and most simply don't bother to read it, much less try to understand it.

On the other hand, securities analysts, lawyers, institutional investors, and corpo­rate financial people pore over a company's financial statements; sometimes more intensely than the company's own management staff. The same intensity can be found inside banks and other lending institutions, especially if a multimillion dollar financing deal happens to be in the works.

Somewhere in the middle is the so-called prudent investor, a person who is reasonably sophisticated in business and finance matters, and who is said to make informed investment decisions. Informed investment decisions are based on factual matters and interpretation of facts—not on intuition and hearsay. Also in the middle ground is the prudent creditor, who is believed to make decisions concerning advancing loans or extending credit on factual matters, not simply on gut reaction.

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In “SFAC No. 1” the Board recognizes the problem of diversity among users, knowing that the information needs of the full spectrum of users cannot all be satisfied at the same time. Thus, the Board aims at the middle-ground users, those investors and creditors most in need of accurate, reliable, and unbiased accounting information that they can apply in making investment and credit decisions. The people at the two opposite ends of the spectrum are not being ignored by the Board in its thinking, but they are not the target audience.

“SFAC No. 1” identifies the target audience within the full range of financial statement users to be investors and creditors (and those who advise or represent them) who:

  1. "Lack the authority to prescribe the information they want and must rely on information management communicates to them."
  2. "Have a reasonable understanding of business and economic activities and are willing to study the information with reasonable diligence."

In truth, the professionals and institutional investors at one end of the spectrum have the power to get virtually whatever information they want from a corporation, whereas the people at the other end would be unlikely to change their behavior (through study with reasonable diligence) even if they had all the information they needed.

The FASB's conception of reasonably sophisticated investors and creditors (and those who represent or advise them) includes employees, managers and directors of the company, customers, lawyers, stock exchanges, taxing authorities, researchers, teachers, and students of business and accounting. Read also about s ources of accounting standards

“SFAC No. 1” states that the objective of financial reporting is to provide information that:

  1. Is useful to both present and potential investors and creditors (and other users) in making rational investment, credit, and other related decisions.
  2. Is helpful to current and potential investors and creditors (and other users) in assessing the amounts, timing, and uncertainty of future cash flows due them. These include dividends or interest payments, among other items. Also to be assessed is the degree of certainty of any future proceeds due them from the company. These include items such as the sale back, redemption, or maturity of securities or loans. An investor's incoming cash flow from an investment depends on the degree of certainty attached to the company's prospective net cash flows. The same is true for creditors of the company.
  3. Is accurate in reporting the economic resources of the business, including any claims to those resources held by other entities (outstanding liabilities). Also, the effects of any pending transactions, events, and circumstances that will affect the company's resources and claims to those resources as presently reported must be made known.

”SFAC No. 1” implicitly recognizes that there is a decision-making process that most investors and creditors use in evaluating various investment opportunities. This process helps investors in predicting, among other things, the future net cash receipts expected from the investment. Termed a “discounted cash flow analysis”, this process is designed to render an economic justification for making, or not making, an investment based on the investment's current price. The process requires estimating:

  1. The timing and amounts of all expected cash flows (dividend or interest payment dates and amounts due).
  2. The risk that the company may not realize cash flows needed to make future dividend and/or interest payments.
  3. An appropriate interest rate for discounting all expected cash flows (normally, interest rates prevailing at the time the investment is being contemplated are used).

Items 2 and 3 above are interrelated because the interest rate may attempt to reflect the risk.

In issuing “SFAC No. 1”, the FASB informed the accounting profession that the directives contained in this first concept’s statement was not a complete enumera­tion of the Board's thinking. In addition to defining users of financial statements and setting forth objectives for financial reporting, other components of the conceptual framework were yet to come. The Board alerted its constituency that criteria were needed for identifying and evaluating accounting information for quality, consis­tency, and conformity with GAAP.

These criteria would offer increased assurance that accounting information was being prepared and reported in accordance with the objectives of financial statements communicated in this first concept's statement. Also, accountants needed a more systematic approach to constructing financial statements and determining what information was reported and where, along with directives for recognizing and measuring various kinds of accounting information reported in financial statements. These additional matters are the subject of subse­quent SFACs issued by the Board and are detailed next.

“SFAC No. 2” was published by the FASB in May of 1980, approximately two years after “SFAC No. 1” was published. “SFAC No. 2” identifies and defines a hierarchy of characteristics of accounting information. The purpose of the hierarchy—divided into primary and secondary tiers—is to provide preparers of financial statements and other interested parties with a checklist of quality standards for evaluating the usefulness of the accounting information being reported to external users.

One reason the hierarchy places substantial weight on the qualitative characteristics of accounting data is that accounting numbers are estimates or statistical measures; they are typically not facts or truths. The value of an accounting measure is in its use as related to a specified objective.

In formulating “SFAC No. 2”, the FASB specified that the two most important attributes of accounting information in terms of usefulness to external decision makers were relevance and reliability. In arriving at this conclusion, the Board found itself in accord with similar conclusions reached in the “Trueblood Report” in 1973.

Relevance refers to the capacity of accounting information to make a difference to the external decision makers who use financial reports. They use accounting information with either or both of two viewpoints in mind:

  1. Forecasting what the economic future is likely to hold.
  2. Confirming the accuracy of past forecasts (to improve future forecasting tech­niques).

Stated more technically, relevant accounting information helps users to make predic­tions about future events (predictive value), to confirm or correct prior expectations (feedback value), and to evaluate current conditions.

The degree to which accounting information is deemed to be relevant can be measured using three aspects of this quality:

  1. Timeliness: Accounting information should be made available to external deci­sion makers before it loses its capacity to influence decisions. Like the news of the world, stale financial information never carries the same impact fresh infor­mation carries. Lack of timeliness reduces relevance.
  2. Predictive value: Accounting information should be helpful to external decision makers by increasing their ability to make predictions about the outcome of future events. Decision makers working from accounting information that has little or no predictive value are merely speculating intuitively.
  3. Feedback value: Accounting information should also be helpful to external deci­sion makers in confirming past predictions or in making updates, adjustments, or corrections to predictions currently outstanding.

The next concept is reliability. For accounting information to have reliability it must be free from error and bias, and it must faithfully represent what it purports to represent. External decision makers must feel confident that the information they rely on for making economic forecasts and confirming results is prepared by competent professionals who have no intention to mislead or deceive.

Like relevance, its twin evaluation characteristic, reliability must meet three quality aspects:

  1. Representational faithfulness: Sometimes called validity, this attribute of account­ing information applies to the whole of the text and numbers contained in a financial report and to what is being conveyed to the reader. Does the information give a faithful picture of the facts and circumstances involved? Accounting information must report in words and figures the economic substance of transac­tions, not just its form and surface appearance.
  2. Verifiability: This quality standard is needed to ensure that a given piece of accounting information is what it purports to be. The concern here is that the source(s) from which the information is compiled may be in error or otherwise unreliable. Verifiability pertains to having audit trails back to information source documents that can be checked for accuracy. Verifiability also pertains to having alternative information sources as backup.
  3. Neutrality: This standard is met if the accounting information is free from bias, and not subject to opinions that might influence the reader of financial statements. There should be no attempt on the part of the preparers of financial reports to induce a predetermined outcome or a particular mode of behavior (such as to induce investors to buy the company's stock). Accounting information should be unbiased regarding a particular viewpoint, predetermined result, or particular party.

External decision makers should be able to count on relevance and reliability in all accounting information communicated to them in financial statements. For example, a statement of cash flows has relevance for decision makers only if it provides information about current inflows and outflows of cash. Current data is essential for assessing and predicting future cash flows. Further, a statement of cash flows must present current data that is properly classified and understandable to decision makers. Finally, a statement of cash flows, like all financial statements, must be reliable. It must report only what it purports to report, and the information should be both verifiable and free from bias.

Certain types of accounting information hold little value for external decision makers unless the data can be compared with similar data from other companies, industry averages, or composite data on a group of like business enterprises. Similarly, specific information on a company covering one accounting period may be of no real significance unless the data can be compared to like information for other accounting periods.

Comparability is the quality of information that enables users to iden­tify similarities and differences between two or more sets of economic phenomena. The ability to evaluate accounting information based on a comparison with similar data from other companies, industry averages, or internationally is possible only if the data are comparable. For example, an income statement should be designed so that revenue, expense, and net income information can be compared from one company to other companies in the same industry. The comparison is basically an across-firms notion.

The next quality is consistency. Information is consistent if it conforms to procedures that remain unchanged from period to period. This quality pertains to comparing accounting information between accounting periods (fiscal year to fiscal year, current quarter to past quarters, etc.). Comparisons over time are difficult unless there is consistency in the way the accounting principles are applied. Otherwise, it's a situation of apples and oranges. The comparison here is across time.

The following example from the airline industry illustrates both consistency and comparability. Prior to 1988, Delta Air Lines depreciated its planes over 10 years; American Airlines used 14- and 16-year depreciation schedules for most of its aircraft. The difference in depreciation methods was a major factor behind Delta's reporting a loss of $3.06 per share in 1980 while American reported per-share earnings of $4.69 for the same period: a comparability problem.

In the airline industry and in many other industries too, comparing financial information on two or more companies is not easy, even if the person making the comparisons is aware of differences in accounting principle applications. Thus, on July 1, 1986, Delta Air Lines increased the useful service life on its fleet of planes from 10 years to 15 years, with each aircraft expected to have a residual value of 10% upon retirement from service.

Increasing the service life and thereby reducing depreciation expense added $69 million to Delta's net income and increased the carrier's 1987 per-share earnings by $1.54. Moreover, Delta switched from a 10-year to a 15-year service life, while Pan American was estimating 25 years of useful life for the same aircraft, with a 15% residual value. Not only was comparability affected, but the consistency with Delta's prior statements was reduced.

On a somewhat contradictory note, “APB Opinion No. 20”, "Accounting Changes," argues that "there is a presumption that an accounting principle once used should not be changed." However consistency carried too far can adversely affect relevance. Thus, a change to a preferred accounting principle is appropriate at times, even at the risk of impaired consistency.

This apparent conflict can be resolved by the inclusion of supplemental note disclosures with the financial state­ments explaining the reason for the change and disclosing the effects of the change. The note disclosures act to restore consistency and comparability between financial statements for periods before and after the change in accounting principle applica­tion is in effect. Notes could be used to explain (and perhaps justify) the accounting choices made by Delta.

Financial accounting is concerned with the manner and extent to which businesses communicate financial information about themselves to the outside public. The outside public, in this case, refers to the various categories of people who invest in, lend money to, or do business with a company. To varying degrees, these people rely on a company's financial statements and other information reports as input for making investment and other financial decisions related to that company.

One of several specialized branches of accounting, financial accounting focuses on the information needs of people outside the company. Other specialized branches are primarily concerned with the internal needs of a company. Management ac­counting, in particular, addresses the needs of internal managers and the role accounting information plays in maintaining control over business operations and product lines, monitoring budgets and profit performance, and directing the com­pany's future success. What applies to giant publicly owned corporations largely applies to smaller sole proprietorships as well, and to every type and size of business enterprise in between.

Financial accounting differs substantially from the other branches of accounting in several significant ways: first, the guiding principles of financial accounting are more open to interpretation and individual circumstances than is true of other specialized accounting fields. Tax accounting, by contrast, is an accounting field that tends to be dominated by exacting rules and regulations, leaving less room for interpretation.

Second, the rule-making body that establishes the financial account­ing principles—the Financial Accounting Standards Board—tends to be influenced more by issues that are not purely accounting in nature and by political pressure exerted by various business and special interest groups. Third, financial accounting is the one branch of accounting over which the Securities and Exchange Commission (SEC) exercises direct oversight authority. The SEC not only exerts influence over the financial accounting rule-making body, but can (and has) established certain accounting practice rules.

The rules and guiding principles of financial accounting often are complex, and some may seem somewhat contradictory. Even so, understanding the complex nature of financial accounting is vital. Moreover, many issues involved in the practice of public accounting are controversial, and differences of opinion and interpretations may have a substantive impact on the public's decision-making process. Only rarely is there a single, correct resolution or definitive answer to a financial accounting issue. And, when alternative resolutions and courses of action exist, the choice made may very well produce large differences in the accounting data being reported as well as the impression the figures leave with the public.

Bibliography

Bartow, Eli, Patricia Fairfield, Eric Hirst, Teresa E. Iannaconi, Laureen A. Maines. Evaluating Concepts-Based vs. Rules-Based Approaches to Standard Setting. Accounting Horizons. Volume: 17. Issue: 1. 2003.

“FASB Pronouncements and EITF Abstracts.” Financial Accounting Standards Board. Accessed on the web March 26, 2006. Available at: http://www.fasb.org/pdf/fas1.pdf until http://www.fasb.org/pdf/fas23.pdf

Herz, Robert H., Teresa E. Iannaconi, Laureen A. Maines, Krishna Palepu, Stephen G. Ryan, Catherine M. Schrand. Evaluation of the FASB's Proposed Accounting for Financial Instruments with Characteristics of Liabilities, Equity, or Both: AAA Financial Accounting Standards Committee.  Accounting Horizons. Volume: 15. Issue: 4. 2001.

Hussey, R. A Dictionary of Accounting. Oxford: Oxford University Press. 1999.

“Original Pronouncements.” Federal Accoutning Standards Advisory Board. Accessed on the web March 26, 2006. Available at: http://www.fasab.gov/codifica.html

Sannella, Alexander John. The Impact of GAAP on Financial Analysis: Interpretations and Applications for Commercial and Investment Banking. New York: Quorum Books. 1991.

“SEC Final Rules.”U.S. Securities and Exchange Commission. Accessed on the web March 26, 2006. Available at: http://www.sec.gov/rules/final.shtml

Solomons, David. Making Accounting Policy: The Quest for Credibility in Financial Reporting. New York: Oxford US. 1986.

Van Riper, Robert. Setting Standards for Financial Reporting: FASB and the Struggle for Control of a Critical Process. Westport, CT: Quorum Books. 1994.

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