Learning Questions and Answers for Financial Accounting, Lesson 6.1 – Mastery Level

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Chapter Six is an overview of the financial reporting process in the United States. This system has slowly evolved over many decades to encourage decision makers to trust the financial information that is available to them about an organization so they can assess its potential risks and rewards.

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U.S. financial reporting is littered with acronyms (SEC, PCAOB, FASB, GASB, EITF, and the like) that are well known to the business people who invest in and lend money so that businesses and other entities have the chance to grow and prosper. In the U.S., official groups such as these wield enormous power and influence but often go unnoticed by a vast array of the population. One of the purposes of a college education is to learn about the mechanisms that allow society to function in an efficient and effective manner.

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As always, you will receive a list of questions. Read them. Think about them. Provide your answer for each one. Then, scroll down and read each of the answers. Take notes of the important topics, especially concerning any question that you did not know. Then, go back through the questions again.

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Repeat this process (read the questions one at a time and then read the questions with the answers) until every answer is easy for you to discuss and explain. Think of yourself teaching these topics to a friend. What level of knowledge would you need to attain to be able to explain U.S. financial reporting to another person?

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(1) – Susan Davan’te recently inherited $25,000 in cash and wants to put the money to good use so that she can buy a nice car in the future or put a down payment on a house. For the time being, she might invest the money by buying a plot of land or several ounces of gold. As an alternative, she can buy shares of capital stock in a publicly-traded company such as Amazon or Procter & Gamble. What are the advantages and disadvantages of each of these possible investments?

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(2) – Stock markets provide an easy method for investors to buy and sell the capital stock of publicly-traded corporations. Careful analysis of available financial information can enable investors to limit the amount of risk being taken. An astute investor hopes to be able to assess which companies are most likely to prosper in the future. Why does the government want investors to have trust in the financial information that they receive?

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(3) – When was the SEC created? Why is that date significant?

(4) – In general, what is the role of the SEC?

(5) – The SEC requires information reported by publicly-traded companies to be presented fairly. The SEC could set rules to establish the accounting procedures to be followed. Rather than do that, it has designated FASB (a private organization) to be in charge of the creation of U.S. GAAP. Why does the SEC simply not create its own accounting rules?

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(6) – What is a Form 10-K?

(7) – Where is U.S. GAAP found?

(8) – What is the role of the EITF?

(9) – Coca-Cola is a for-profit organization. PETA is a charity (a private not-for-profit entity). The City of Cleveland, Ohio, is a local government. Do they all follow the same accounting rules?

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(10) – McDonald’s produces a set of financial statements. Before being released, those statements are examined by an independent auditor. What is the role of the independent auditor?

(11) – Why does an independent auditor have to be independent?

(12) – Who pays for an independent audit? Why is this arrangement viewed by some as a problem?

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(13) – An independent auditor needs to be an expert at both accounting rules and auditing procedures. How do independent auditors prove that they are appropriate experts?

(14) – An independent auditor is performing an audit of a major technology company. The auditing firm is unsure what actions should be taken about one specific area of the examination. Who sets the rules on the performance of an audit of a publicly-traded corporation?

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When you can answer each of these questions, you have attained a solid foundation of knowledge about how the financial reporting process is maintained in the U.S. so that investors and creditors will trust the financial information and be willing to use it to make wise investing decisions. As a member of the general public, you should know what organizations are involved and what their responsibilities are.

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Read each question again and consider your answer. Then, read the answers below. When you have a good answer for each question, you should have an excellent level of knowledge about this material.

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(1) – Susan Davan’te recently inherited $25,000 in cash and wants to put the money to good use so that she can buy a nice car in the future or put a down payment on a house. For the time being, she might invest the money by buying a plot of land or several ounces of gold. As an alternative, she can buy shares of capital stock in a publicly-traded company such as Amazon or Procter & Gamble. What are the advantages and disadvantages of each of these possible investments?

The land is tangible and might have many possible uses. If well selected, its value can rise and will probably not fall far even in bad times. Nevertheless, land can be difficult to sell. The owner has to find a buyer who wants that property in that location and is willing to pay a reasonable price. Gold can be easily bought and sold but the value often goes up and down quickly. These swings in value are unpredictable because they are based on a wide variety of factors. Consequently, ownership of gold can be risky. Because the capital shares here are in a publicly-traded company, the purchase and sale are easy to accomplish. The stock price can go up and down but if the investor has studied the available financial information the amount of risk is reduced. The ability to use financial information to assess the potential risks and rewards is a fundamental reason for the popularity of investing in capital stock. Millions of individuals buy and sell these shares on a regular basis.

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(2) – Stock markets provide an easy method for investors to buy and sell the capital stock of publicly-traded corporations. Careful analysis of available financial information can enable investors to limit the amount of risk being taken. An astute investor hopes to be able to assess which companies are most likely to prosper in the future. Why does the government want investors to have trust in the financial information that they receive?

The U.S. economy is built on businesses being able to obtain money through investment and borrowing. It is a capitalistic system where most of the country's industries are controlled by private investments made for profit, rather than by government edict. Few people will risk that money if they are not able to make a reasonable prediction of what is going to happen. Financial information is essential to that process. However, information alone is not sufficient. Decision makers must believe the information is fairly presented so they can feel comfortable using it. If they thought the information contained material misstatements, they would likely choose to make other investments such as land or gold. The U.S. economy needs investors to provide capital for businesses.

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(3) – When was the SEC created? Why is that date significant?

The SEC was created by the U.S. Congress in 1934. That was only a few years after the stock market crash and in the midst of the Great Depression. People justifiably did not trust stock markets or investments in the capital stock of businesses. Businesses were having great difficulty creating enough business growth to help emerge from the bad economic times. The SEC was created to do whatever was necessary so that people would once again trust stock markets and investments in capital stock.

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(4) – In general, what is the role of the SEC?

The SEC has wide sweeping powers to ensure that stock markets operate fairly and that investors are protected from any unfair practices. The SEC requires companies to report specific information and do so in a timely manner so that no one receives an unfair advantage.

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(5) – The SEC requires information reported by publicly-traded companies to be presented fairly. The SEC could set rules to establish the accounting procedures to be followed. Rather than do that, it has designated FASB (a private organization) to be in charge of the creation of U.S. GAAP. Why does the SEC simply not create its own accounting rules?

Developing logical accounting standards is a slow and arduous task. The SEC believes that FASB is better able to carry out this process and have the resulting rules accepted by the investing public. The SEC does provide guidance where it feels that U.S. GAAP is not clear. Otherwise, the SEC leaves the setting of accounting standards to FASB.

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(6) – What is a Form 10-K?

The Form 10-K is a document that publicly-traded companies must file with the SEC each year. It contains extensive information including financial statements that must be presented-fairly according to U.S. GAAP. The SEC makes the Form 10-K available to investors and other interested parties. Many companies post their latest Form 10-K on their websites for any and all to read.

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(7) – Where is U.S. GAAP found?

FASB has organized U.S. GAAP into an indexed system known as the Accounting Standards Codification.

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(8) – What is the role of the EITF?

The Emerging Issues Task Force tries to gain the consensus of its membership as to what areas of U.S. GAAP apply to any new transactions and accounting issues. The creation of rules by FASB can be slow and meticulous. When new accounting issues arise, quick guidance is needed. The EITF indicates what part of the current rules should be applied until FASB has the necessary time to pass any updated changes.

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(9) – Coca-Cola is a for-profit organization. PETA is a charity (a private not-for-profit entity). The City of Cleveland, Ohio, is a local government. Do they all follow the same accounting rules?

For-profit businesses have one set of accounting rules that are created by FASB. Reporting rules for private not-for-profit entities (such as PETA or the American Heart Association) are also created by FASB but they have some areas that are unique from the rules applied to for-profit businesses. GASB creates accounting rules for state and local governments and, consequently, those rules are often different in significant ways from the rules used by a for-profit business.

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(10) – McDonald’s produces a set of financial statements. Before being released, those statements are examined by an independent auditor. What is the role of the independent auditor?

The independent auditor provides credibility to the statements. The independent auditor carries out an extensive examination until sufficient evidence is found so that the assessment can be made that the financial statements are presented fairly according to U.S. GAAP. As stated previously, that means the auditors believe the statements contain no material misstatements according to U.S. GAAP rules. In simple terms, the independent auditor is saying, “These financial statements can be used by outside parties to make wise financial decisions about the reporting company.”

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(11) – Why does an independent auditor have to be independent?

Many precise rules are set up to ensure that an independent auditor is truly independent. Independence is essential for two reasons. First, by being independent, the auditor is more likely to be totally unbiased when making difficult judgments about the reported information. Second, decision makers are more likely to trust the financial information if the audit opinion comes from an auditor who is totally independent of the reporting company.

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(12) – Who pays for an independent audit? Why is this arrangement viewed by some as a problem?

The reporting company pays the independent auditor. The reporting company has the authority to hire and fire the auditor. Over the decades, many have argued that the outside auditor cannot be truly independent if the ability to hire and fire resides with the reporting company. However, audit examinations are very expensive and no one seems to have a better answer as to who else should provide that money.

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(13) – An independent auditor needs to be an expert at both accounting rules and auditing procedures. How do independent auditors prove that they are appropriate experts?

Independent auditors must become Certified Public Accountants (CPAs). That official designation is established by the individual states and is based on their laws. Typically, to become a CPA, the individual must pass all four parts of the CPA Exam within a listed period of time, must have a designated amount of work experience (typically a year or two), and must achieve a defined level of education (often 150 hours of college credit including several specific courses).

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(14) – An independent auditor is performing an audit of a major technology company. The auditing firm is unsure what actions should be taken about one specific area of the examination. Who sets the rules on the performance of an audit of a publicly-traded corporation?

The Public Company Accounting Oversight Board (PCAOB) was created by the U.S. Congress as a result of several major accounting scandals (such as Enron which went bankrupt in 2001 and WorldCom and Global Crossing that both collapsed in 2002). The PCAOB sets auditing rules to help ensure that such scandals never occur again.

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If you missed any of these answers, go back through the questions again and make sure to work on them until you have great answers for each one. The questions are not easy, but you are capable of learning this material and using it to become a wise decision maker.

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