Guided Readings for Financial Accounting, Lesson 6.1 – Mastery Level

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“Why Should Decision Makers Trust Financial Statements?” The following guided readings cards were created to accompany the updated third edition of Chapter Six (Version 3.1) of Financial Accounting authored by Joe Hoyle, C. J. Skender, and Leah Kratz and published by FlatWorld.

Copyright 2022 by Joe Hoyle

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Watch the opening video for Chapter Six in the textbook: Introduction to Chapter Six.

Previously, we have studied how financial statements are created so as to provide useful information to decision makers (investors and creditors). However, everyone knows that those statements are prepared by the company. What system is in place to provide assurance that this reported information can be trusted?

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SUGGESTION: Read the first section of Chapter Six (“The Need for the Securities and Exchange Commission”). It is just three pages but they contain vital information. The SEC was created more than 80 years ago in the midst of the Great Depression to ensure that security markets operate efficiently so that public confidence could be regained. To function properly, a capitalistic economy must have investors and creditors who are willing to risk their money based on the information that is available.

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The SEC does an excellent job of explaining its purpose: “The mission of the U.S. Securities and Exchange Commission is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation. As more and more first-time investors turn to the markets to help secure their futures, pay for homes, and send children to college, our investor protection mission is more compelling than ever.” To read more, go to:
https://www.sec.gov/about/whatwedo.shtml

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(6Q1) – What is the role of the Securities and Exchange Commission (also known as the SEC)?

(6A1) – The SEC is a federal government agency with authority over capital markets and the issuance of securities in the U.S. Its responsibility is wide. The SEC monitors the financial reporting of companies that issue securities that are publicly traded in the U.S. The SEC is responsible for ensuring that the buying and selling of those securities is carried out fairly with all needed information available to potential investors.

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(6Q2) – What is a security?

(6A2) – According to TheStreet (https://www.thestreet.com/topic/47042/securities.html), “At a basic level, a security is a financial asset or instrument that has value and can be bought, sold, or traded. Some of the most common examples of securities include stocks, bonds, . . ..” Many companies have one or more financial instruments outstanding that fall within this definition. That is why the SEC has such enormous power—most companies of any size issue securities that come under its jurisdiction. An ownership share of capital stock is one type of security.

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(6Q3) – What is a Form 10-K?

(6A3) – The Form 10-K is a document that publicly-held companies (those that issue securities that are sold to the public) must file each year with the SEC. The Form 10-K makes available to the public a significant amount of information about a company including its financial statements. Any decision maker who wants to gain extensive knowledge about a public company can analyze its Form 10-K. Companies frequently make them available on their websites. They can also be found at www.sec.gov.

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(6Q4) – How much authority does the SEC have for the creation of U.S. GAAP?

(6A4) – The SEC has authority to tell public companies what must be reported in their Form 10-K and other documents filed periodically with the SEC. That gives the SEC the legal power to set whatever accounting rules it might want to establish.

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(6Q5) – Given the legal authority of the SEC, why has it decided to allow FASB (a totally independent body) to produce U.S. GAAP? Why does the SEC not write all of the accounting rules itself and just require them through its legal power?

(6A5) – The SEC has chosen not to mandate the creation of U. S. GAAP as a function of the government. Many reasons exist for this decision. For example, the SEC hopes that public acceptance of the rules will be more easily attained if privately developed. There is also the belief that an independent group is in better position to carry out the months and years of in-depth study necessary to resolve complex reporting issues. Nevertheless, much debate continues as to whether a private group should be in charge of the creation of the country’s accounting rules. For example, no private group is assigned to set the income tax rules that all must follow.

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(6Q6) – FASB is in charge of the establishment and evolution of U. S. GAAP. When (if ever) does the SEC become involved in the creation of accounting rules?

(6A6) – The SEC will set rules to provide answers for issues not clearly addressed by U.S. GAAP. For example, new transactions often arise that are not yet covered by U.S. GAAP. Or, unique variations of transactions can take place where the handling is uncertain because they are not specifically addressed by U.S. GAAP. At times, U.S. GAAP can simply be vague. The SEC can create rules to clarify such matters until FASB chooses to establish formal accounting rules.

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(6Q7) – State and local governments also prepare and issue financial statements. Financial statements for cities like Boston and Chicago can be quickly found on the Internet. Who produces U.S. GAAP for these government entities?

(6A7) – U.S. GAAP for state and local governments is produced by the Governmental Accounting Standards Board (GASB). GASB is a sister organization to FASB. A state or local government includes its financial statements in a document known as a CAFR (comprehensive annual financial report). A link to the CAFR for the City of Greensboro, North Carolina, can be found at the following URL:
http://www.Greensboro-nc.gov/index.aspx?page=587

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(6Q8) – Who produces accounting rules for private not-for-profit entities such as charities as the American Heart Association or the YMCA?

(6A8) – Originally, a bit of controversy existed about whether accounting and financial reporting for private not-for-profit entities should be under the jurisdiction of FASB or GASB. The Financial Accounting Foundation (FAF) is responsible for the oversight, administration, financing, and appointment of members to both boards. FAF decided that FASB would be in charge of creating the U.S. GAAP rules that not-for-profit entities would have to follow in their financial reporting.

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(6Q9) – What is the role of the Accounting Standards Codification?

(6A9) – The Accounting Standards Codification (ASC) is the carefully organized accumulation of all U.S. GAAP that has been created to guide for-profit entities (such as businesses) and private not-for-profit entities (such as charities). Any interested party can study the Accounting Standards Codification and carry out the research necessary to identify the specific U.S. GAAP rules that apply to a particular reporting issue. The ASC is the official rule book for financial reporting in the U.S.

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(6Q10) – What function is performed by the Emerging Issues Task Force (EITF)?

(6A10) – The EITF was created in 1984 to assist FASB. It examines new reporting issues or transactions when they first begin to occur. The EITF attempts to achieve a level of consensus within its membership as to the specific portions of U.S. GAAP that apply to these new events. The EITF hopes to identify the appropriate U.S. GAAP to follow. The EITF does not actually create any new standards. In this way, FASB does not have to rush to study each new problem as it arises. Where necessary, FASB is able to take time to develop logical reporting resolutions.

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SUGGESTION: Work the Test Yourself question in Section 6.1 of Chapter Six (“The Barone Company is currently…”). This question was written to make sure each reader understands the specific roles played by the various groups mentioned in this chapter. Be sure to read the explanation of the answer because the role of each of those groups is described.

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In the end-of-chapter questions, the following statement is included as a True or False question. “FASB is a governmental agency that works under the jurisdiction of the SEC.” That statement is FALSE. Why is it false?

This statement is False for the simple reason that FASB is not a government agency and does not work under the jurisdiction of the SEC. FASB is an independent body given authority (by the SEC) for creating U.S. GAAP. Significant information about FASB and its mission can be found at:
http://www.fasb.org/jsp/FASB/Page/SectionPage&cid=1176154526495

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SUGGESTION: Read the second section of Chapter Six (“The Role of the Independent Auditor in Financial Reporting”). This chapter begins by covering the role performed by the SEC before and then moves to the function of the independent auditor. What work does the independent auditor do and how do the results of that work affect the financial reporting process?

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(6Q11) – What companies must have their financial statements audited by an independent auditing firm?

(6A11) – A public company under the jurisdiction of the SEC is required by law to have its financial statements examined by an independent auditor. Statements from Coca-Cola, for example, or Microsoft are always audited. Creditors or investors might also require smaller (nonpublic) companies to have an audit. After an audit examination, the independent expert hopes to provide assurance that the financial statements are presented fairly according to U.S. GAAP (that is, they contain no material misstatements).

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(6Q12) – Who are the primary beneficiaries of an independent audit that is performed on a set of financial statements? For example, after an audit has been carried out on the financial statements for McDonald’s, who benefits? What does an independent audit add to these financial statements?

(6A12) – An independent audit is performed for the primary benefit of outside decision makers. If satisfied by the examination, the auditor provides reasonable assurance that the company’s financial statements are presented fairly according to U.S. GAAP (they contain no material misstatements). The audit report enables decision makers to have faith in the figures and explanations that are reported. Thus, the independent audit is said to add credibility to a set of financial statements.

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SUGGESTION: Work the first Test Yourself question in Section 6.2 of Chapter Six (“Financial statements have been produced …”). This question was written to help ensure that you understand how the audit process adds credibility to a set of financial statements.

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(6Q13) – The Skender Company (a company that produces elegant menswear such as bow ties and suspenders) has prepared a set of financial statements in hopes of obtaining a bank loan that will allow the company to expand. Bank officials request that the company hire an independent auditing firm to examine and report on these financial statements. What will the auditing firm do?

(6A13) – The auditing firm will perform a thorough examination of the financial statements seeking evidence to support the assertion that no material misstatements are present. If sufficient evidence is obtained, the audit firm conveys its opinion that the financial statements are presented fairly in conformity with U.S. GAAP. Independent auditors gather evidence to support the reported balances and disclosures in a set of financial statements. An audit report (or opinion) provides assurance to decision makers about the auditor’s findings.

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(6Q14) – How does a person qualify to work as an independent auditor? They are viewed as “experts.” How does a person qualify as an accounting and auditing expert?

(6A14) – Individuals in charge of an independent audit must be Certified Public Accountants (CPAs). Each state sets its own rules for granting a CPA license but these rules include a significant amount of appropriate education (usually 150 hours of college credit including specified courses), a certain amount of qualified work experience, and a passing grade on each of the parts of the Uniform CPA Examination. More information about the CPA Exam can be found at:

https://www.aicpa.org/becomeacpa/cpaexam.html/

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(6Q15) – An audit is performed by an independent expert. Why do the rules require that each audit examination be performed by a party who is independent of the reporting entity?

(6A15) – Auditors must be independent of the reporting entity. They must hold no bias when making the complex judgments that are necessary during an audit about the existence of possible material misstatements. Like an umpire in a baseball game, the auditor is judging what happened and needs to be free of any internal pressures that could affect that responsibility. Just as importantly, decision makers must be willing to rely on the work of the auditor. Such trust is impossible if the auditor is not thought to be completely independent of the reporting entity. Tight rules exist to ensure this independence.

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(6Q16) – Who pays the independent auditor for the work done in an audit examination? Why do some parties view that arrangement as a concern?

(6A16) – In the U.S., the reporting company hires, fires, and pays for the work of the independent auditor. Over the decades, many people have asserted that such an arrangement gives the reporting company power over the auditor so that independence is impossible. Auditors respond by pointing to extensive ethical rules that must be followed as well as systems of checks and balances implemented within the firms to reduce the possibility of bias. Audits are costly. Someone has to pay. Should that be the reporting company?

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(6Q17) – FASB creates the accounting rules that go into making up U.S. GAAP. Who develops the rules and standards that guide the work of an independent auditor?

(6A17) – When an independent auditor performs an examination on a company that issues securities that are publicly-traded (thus, virtually all companies of any size), the auditing rules are established by the Public Company Accounting Oversight Board (PCAOB). When an audit is performed on a company that does not issue publicly-traded securities (many small companies), auditing rules are established by the Auditing Standards Board (ASB).

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(6Q18) – What is the role of the PCAOB in financial reporting?

(6A18) – According to its website, “The PCAOB is a nonprofit corporation established by Congress to oversee the audits of public companies in order to protect investors and the public interest by promoting informative, accurate, and independent audit reports.” The PCAOB was created as a result of the Sarbanes-Oxley Act of 2002 which was passed by Congress after several large reporting scandals threatened the integrity of the entire financial reporting process.

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Within the end-of-chapter material, the following statement is included within the True or False questions. “Nonpublic companies rarely have an audit performed on their financial statements because they do not issue publicly traded securities.” This statement is False. Explain why this statement is False.

The previous statement is False. All companies that have publicly-traded securities must have an independent audit because it is mandated by the SEC. A significant number of companies that do not have publicly-traded securities will also have independent audits. Banks or other creditors might require an audit. Investors could request an audit as a way to ensure that the information they are analyzing is presented fairly according to U.S. GAAP. Many businesses, even nonpublic ones, have audits each year.

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Within the end-of-chapter material, the following statement is included within the True or False questions. “Audits are paid for by the creditors and investors of a company that receive the actual benefit of the CPA’s work.” This statement is False. Think about the statement carefully. Then, explain why it is False.

The previous statement is False. Creditors and investors are the primary beneficiaries of an audit examination. Nevertheless, in the U.S., the cost of independent audit work is paid for by the reporting company. Although that arrangement seems to make the auditor dependent on the reporting company, rules and controls are in place to (hopefully) ensure that auditor’s remain independent.

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SUGGESTION: Work the second Test Yourself question in Section 6.2 of Chapter Six (“Fairchild Corporation is a large …”). This question compares the rules and the authoritative groups that are appropriate for public companies and their audits versus non-public companies and their audits. Determine your answer and then carefully compare it with the included answer.

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