How does accounting help the capital allocation process attract investment capital

Understanding accounting and capital allocation.

Accounting refers to summarizing, evaluating, and thereafter reporting the business transactions. It is done to keep track of the business activities and plays an important role in management, compliance of legal formalities, auditing, etc.

Understanding the relation of Accounting and Capital Allocation Process

Accounting is an important criterion that needs to be studied before allocating capital. Analysis of accounting helps to understand the business activities that generate revenue and the activities that lead to major expenses for the business. This further helps in eliminating unnecessary expenses and allocating capital effectively. Hence, accounting is the basic step in the complete capital allocation process.

Q1. Differentiate broadly between financial accounting & managerial accounting

Financial Accounting - process that culminates in the preparation of financial reports for the use by both internal & external parties. Users of these financial reports include investors, creditors, managers, unions, & government agencies.

Managerial Accounting - process of identifying, measuring, analyzing, & communicating financial information needed by management to plan, control, & evaluate a company's operations.

Q3. How does accounting help the capital allocation process.

Accountants must measure performance accurately & fairly on a timely basis, so that managers & companies are able to attract investment capital. Relevant & reliable financial information allows investors & creditors to compare the income & assets employed by companies. These users can assess the relative return & risks associated with investment opportunities thus channel resources more effectively.Capital Allocation Process 1. Financial Reporting - The financial information a company provides to help users with capital allocation decisions about the company.
2. Users (present & potential) - Investors & creditors use financial reports to make their capital allocation decisions.
3. Capital Allocation - The process of determining how & at what cost money is allocated among competing interests.

Q4. What is the objective of financial reporting?

The objective of general-purpose financial reporting is to provide financial information about the reporting entity that is useful to present and potential equity investors, lenders, & other creditors in decisions about providing resources to the entity. Decisions include buying, selling, or holding equity & debt instruments, & providing or settling loans and other forms of credit.

Q5. Briefly explain the meaning of decision-usefulness in the context of financial reporting.

Investors are interested in financial reporting because it provides information that is useful for making decisions. When making decisions investors are interested in assessing (1) the company's ability to generate net cash inflows & (2) management's ability to protect & enhance the capital providers' investments.

Q6. Of what value is a common set of standards in financial accounting & reporting?

Preparing financial statements prepared according to accepted accounting standards contributes to the comparability of accounting information. Common set of standards & procedures are called generally accepted accounting principles (GAAP). "Generally accepted" means either that an authoritative accounting rule-making body has established a principle of reporting in a given area or that over time a given practice has been accepted as appropriate because of its universal application.

Q7. What is the likely limitation of "general-purpose financial statements"?

Likely limitation of the general-purpose financial statements is it does not bring the user a clear, fair, and complete picture of a company's financial operations. This could make the the accounting information incomparable among companies.

Q8. In what way is the Securities & Exchange Commission concerned about & supportive of accounting principles and standards?

SEC helps develop & standardize financial information presented to stockholders. Most companies that issue securities to the public or are listed on a stock exchange are required to file audited financial statements with the SEC. SEC has broad powers to prescribe, in detail it desires, the accounting practices & standards to be employed by companies that fall within its jurisdiction. The SEC encourages the creation of a private standard-setting body because it believes the private sector has the appropriate resources & talent to achieve this task. Thus, accounting standards have developed in the private sector either through AICPA or the FASB. SEC has affirmed it's support for the FASB by indicating that financial statements conforming to standards set by the FASB are presumed to have substantial authoritative support. SEC relies on the FASB to develop accounting standards. SEC requires registrants to adhere to GAAP. SEC believes the establishing & improving accounting standards should remain in the private sector with SEC oversight.

Q9. What was the Committee on Accounting Procedure, and what were its accomplishments and failings?

Committee on Accounting Procedure (CAP) was appointed by the AICPA in 1939 with the urging of the SEC. CAP was composed of practicing CPAs that composed 51 Accounting Research Bulletins during the years 1939 to 1959. The bulletins dealt with a variety of accounting problems. This problem-by-problem approach failed to provide the needed structured body of accounting principles which led the AICPA in 1959 to create the Accounting Principles Board.

Q10. For what purposes did the AICPA in 1959 create the Accounting Principles Board?

1. Advance the written expression of accounting principles
2. Determine appropriate practices
3. Narrow the areas of difference & inconsistency in practice

To achieve these objectives APB's mission was to develop an overall conceptual framework to assist in the resolution of problems as they become evident & to substantively research individual issues before the AICPA issued pronouncements.

The Board's official pronouncements are called APB'S Opinions which were intended to be based on research studies & be supported by reason & analysis.

Q11. Distinguish among Accounting Research Bulletins, Opinions of the Accounting Principles Board, & Statements of the Financial Accounting Standards Board.

Accounting Research Bulletins - CAP issued 51 of these during the years 1939 to 1959. Deal with a variety of accounting problems. Since 1964 these bulletins have been recognized as accepted accounting practices unless superseded in part or whole by an opinion of the APB'S or an FASB standard.Opinions of the Accounting Principles Board - APB's official pronouncements are called APB Opinions and intended to be based mainly on research studies & be supported by reason & analysis. Inception 1959 & dissolution in 1973 - APB issued 31 opinions. Are recognized as accepted practice unless superseded by FASB statements.
Statements of the FASB - These are pronouncements of the FASB & represent the accounting profession's authoritative pronouncements on financial accounting & reporting practices. FASB pronouncements are considered GAAP & thereby binding in practice. All ARBs & APB Opinions implemented by 1973 when FASB was formed, continue to be effective until amended or superseded by FASB PRONOUNCEMENTS.

Q11. Two types of FASB pronouncements.

Accounting Standards Updates - FASB issues accounting pronouncements through these; these amend the Accounting Standards Codification, which represents the source of authoritative accounting standards, other than standards issued by the SEC. Second type of Update is through a consensus of the Emerging Issues Task Force (EITF), created in 1984 by the FASB.

Financial Accounting Concepts - Part of FASB's conceptual framework project. The series sets forth fundamental objectives & concepts the the FASB uses in developing future standards of financial accounting & reporting. Unlike the Statement of Financial Accounting Standards, these do not establish GAAP.

Q12. If you had to explain or define "generally accepted accounting principles or standards," what essential characteristics would you include in your explanation?

1. Have substantial authoritative support.2. AICPA's Code of Professional Conduct requires that members prepare financial statements in accordance with GAAP.
3. Rule 23 of this Code prohibits a member from expressing an unqualified opinion on financial statements that contain a material departure from GAAP.
4. GAAP includes APB Opinions, FASB Standards, & AICPA Research Bulletins. FASB has issued interpretations & FASB Staff Positions that modified or extends existing standards.

Q13. In what ways was it felt that the pronouncements issued by the FASB would carry greater weight than the opinions issued by the APB?

The FASB had (1) smaller membership - FASB had 7 members, APB had 18 members, (2) full-time, remunerated membership - FASB are well-paid, full- time members appointed for renewable 5 yr terms while APB members volunteered their part-time work, (3) greater autonomy - APB a senior committee of the AICPA while the FASB is not involved is any single professional organization - FASB appointed by & answerable only to the Financial Accounting Foundation (FAF), (4) increased independence - FASB members must sever their ties with their private positions while APB did not, & (5) broader representation - APB members were required to be CPAs & members of the AICPA while FASB members do not.

Q14. How are FASB preliminary views & FASB exposure drafts related to FASB "statements"?

1. Topics identified & placed on Board's agenda.
2. Research & analysis conducted & preliminary views of pros & cons issued.
3. Public hearing on proposed standard.4. Board evaluates research & public response & issues exposure draft.
5. Board evaluates responses & changes exposure draft, if necessary. Final standard issued.

Q15. Distinguish between FASB Accounting Standards Updates & FASB Statements of Financial Accounting Concepts?

FASB Accounting Updates - FASB issues accounting pronouncements through these. Updates amend the Accounting Standards Codification & explains how the Codification had been amended & also includes information to help the reader understand the changes & when those changes will be effective.

Statements of Financial Accounting Concepts - part of FASB's conceptual framework project. Sets forth a set of interrelated concepts - a conceptual framework - that will serve as tools for solving existing & emerging problems in a consistent manner. These do not establish GAAP like a Statement of Financial Accounting Standards.

Q16. What is rule 203 of the Code of Professional Conduct?

Prohibits an AICPA member from expressing an unqualified opinion on financial statements that contain a material departure from GAAP. AICPA members are required to prepare financial statements in accordance with GAAP.

Q17. The chairman of the FASB at one time noted that "the flow of standards can only be slowed if 1) producers focus less on quarterly earnings per share and tax benefits and more on quality products, and 2) accountants and lawyers rely less on rules and law and more on professional judgment and conduct." Explain his comment.

too much attention is put on the bottom line and not enough on the development of quality products. Managers should be less concerned with short-term results and be more concerned with the long-term results. In addition, short-term tax benefits often lead to long-term problems.

Accountants are overly concerned with following a set of rules, so that if litigation ensues, they will be able to argue that they followed the rules exactly. The problem with this approach is that accountants want more and more rules with less reliance on professional judgment. Less professional judgment leads to inappropriate use of accounting procedures in difficult situations.

In the accountants' defense, recent legal decisions have imposed vast new liability on accountants. The concept of accountant's

Q18. What is the purpose of FASB Staff Positions?

These modify or extend existing standards. Makes minor amendments to existing standards. Uses the same due process as Accounting Standards Updates.

Q19. Explain the role of the Emerging Issues Task Force (EITF) in GAAP.

A 2nd type of Accounting Standards Update is a consensus of the EITF. EITF is comprised of representatives from CPA firms & financial statement preparers. The purpose of the task force is to reach a consensus on how to account for new & unusual financial transactions that may potentially create differing financial reporting practices. EITF identifies controversial accounting problems as they arise. EITF determines whether they can quickly resolve them or whether to involve the FASB in solving them. EITF is a "problem filter" for the FASB. FASB works on more long-term problems while EITF deals with the short-term emerging issues.

Q20. What is the difference between the Codification & the Codification Research System?

Codification - a compilation of all GAAP in one place. It integrates & synthesizes existing GAAP; it does not create new GAAP. Creates one level of GAAP, which is considered authoritative.

Codification Research System (CRS) - an online, real-time database that provides easy access to Codification. The Codification & the related CRS provides a topically organized structure, subdivided into topic, subtropics, sections, & paragraphs, using a numerical index system.

Q21. What are the primary advantages of having a Codification of GAAP?

Help users to better understand GAAP. The time to research accounting issues & the risk of noncompliance with GAAP will be reduced. Web-based format will make updating easier & help users stay current with GAAP. Streamlines & simplifies how to determine what GAAP is, which will lead to better financial accounting & reporting.

Q22. What are the sources of pressure that change & influence the development of GAAP?

CPAs & accounting firms, AICPA, Academicians, Investing public, financial community (analysts, bankers, etc.), preparers (Financial Executives Institute), Govrnment (SEC, IRS, other agencies), & industry associations. All these business entities put pressure on the FASB to changes existing rules & development new ones. Put pressure on FASB to change GAAP.

Q23. Some individuals have indicated that the FASB must be cognizant of the economic consequences of its pronouncements. What is meant by "economic consequences"? What dangers exist if politics play too much of a role in the development of GAAP?

Economic consequences means the impact of accounting reports on the wealth positions of issuers and users of financial information and the decision-making behavior resulting from that impact. The resulting behavior of these individuals & groups could have detrimental financial effects on the providers of the financial information.the rules will be subject to manipulation for the purpose of furthering whatever policy prevails at the moment. No matter how well intentioned the rule maker may be, if information is designed to indicate that investing in a particular enterprise involves less risk than it actually does, or is designed to encourage investment in a particular segment of the economy, financial reporting will suffer an irreplaceable loss of credibi

Q24. If you were given complete authority in the matter, how would you propose that GAAP should be developed & enforced?

(1) The method must be efficient, responsive, and expeditious.
(2) The method must be free of bias and be above or insulated from pressure groups.
(3) The method must command widespread support if it does not have legislative authority.
(4) The method must produce sound yet practical accounting principles or standards.

Q25. One writer recently noted that 99.4% of all companies prepare statements that are in accordance to GAAP. Why then is there such concern about fraudulent financial reporting?

Concern exists about fraudulent financial reporting because it can undermine the entire financial reporting process. Failure to provide information to users that is accurate can lead to inappropriate allocations of resources in our economy. In addition, failure to detect massive fraud can lead to additional governmental oversight of the accounting profession. Also, misinterpretation of GAAP can lead to fraudulent financial reporting & statements.

Q26. What is the "expectations gap"? What is the profession trying to do to close this gap?

Is what the public thinks accountants should do & what accountants think they can do.The accounting profession recognizes it must play an important role in narrowing this gap. To meet the needs of society, the profession is continuing its efforts in developing accounting standards, such as numerous pronouncements issued by the FASB, to serve as guidelines for recording and processing business transactions in the changing economic environment.

Q27. The Sarbanes-Oxley Act was enacted to combat fraud & curb poor reporting practices. What are some key provisions of this legislation?

● Establishes an oversight board for accounting practices. The Public Company Accounting Over-sight Board (PCAOB) has oversight and enforcement authority and establishes auditing, quality control, and independence standards and rules.
● Implements stronger independence rules for auditors. Audit partners, for example, are required to rotate every five years and auditors are prohibited from offering certain types of consulting services to corporate clients.
● Requires CEOs and CFOs to personally certify that financial statements and disclosures are accurate and complete and requires CEOs and CFOs to forfeit bonuses and profits when there is an accounting restatement.
● Requires audit committees to be comprised of independent members and members with finan-cial expertise.
● Requires codes of ethics for senior financial officers.
● Section 404 of the Sarbanes-Oxley Act requires public companies to attest to the effectiveness of their internal controls over financial reporting.

Q28. What are some of the major challenges facing the accounting profession?

Nonfinancial measurement—how to report significant key performance measurements such as customer satisfaction indexes, backlog information and reject rates on goods purchased.
Forward-looking information—how to report more future oriented information.
Soft assets—how to report on intangible assets, such as market know-how, market dominance, and well-trained employees.
Timeliness—how to report more real-time information.   Understandability - investors & market regulators are raising concerns about the complexity & lack of understandability of financial reports.

CA1-1. True or False1. GAAP is the term used to indicate the whole body of FASB authoritative literature.

GAAP not only includes FASB authoritative literature but other major sources of literature from other organizations. GAAP is a mixture of over 2,000 documents that has been developed over the last 70 years. It includes APB Opinions, FASB Standards, & AICPA Research Bulletins. In addition, the FASB issues interpretations & FASB Staff Positions that modifies or extends existing standards. The APB also issues interpretations of APB Opinions. Both types of interpretations are considered authoritative for purposes of determining GAAP.

See pg. 13, Illustration 1-4 for the many different types of documents that comprise GAAP.

CA1-1.True or False2. Any company claiming compliance with GAAP must comply with most standards & interpretations but does not have to follow the disclosure requirements.

False. Sarbanes-Oxley Act requires CEOs & CFOs of public companies to personally certify that financial statements & disclosures are accurate & complete, & requires CEOs & CFOs to forfeit bonuses & profits when there is an accounting restatement.

CA1-1.True or False3. The primary governmental body that has influence over the FASB is the SEC.

False. SEC supports the FASB & requires registrants to adhere to GAAP. SEC believes the establishment & improvement of accounting standards should remain in the private sector with SEC oversight. SEC acts with remarkable restraint in the area of developing accounting standards. SEC relies on the FASB to develop accounting standards. SEC's mandate is to establish accounting principles not standards.

CA1-1.True or False4. The FASB has a government mandate & therefore does not have to follow due process in issuing a standard.

False. FASB operates in full view of the public through a "due process" system that gives interested persons ample opportunity to make their views known before a standard is issued.

See pg. 12, Illustration 1-3 The Due Process System of the FASB

If each company voluntarily disclosed the type of information they considered important, there would be no comparable data among companies. It would be hard for investors & creditors to determine if one company is doing better than another. Also the companies voluntarily disclosing information would probably disclose only the positive information on the company and not the negative information. There would also be no consistency of financial data.

The sponsoring organization of the FASB is the Financial Accounting Foundation (FAF) who selects the members of the FASB & the Advisory Council, funds their activities, & oversees the FASB's activities.Due Process System of the FASB:
1. Topics identified & placed on FASB's agenda
2. Research & analysis conducted & preliminary views of pros & cons issued
3. Public hearing on proposed standard
4. FASB evaluates research & public response & issues exposure draft
5. FASB evaluates responses & changes exposure draft, if necessary - Final standard is issued

Major types of pronouncements:
1. Accounting Standards Updates - See pg. 12
2. Financial Accounting Concepts - See pg. 13

CA1-12 GAAP Terminolgy

AICPA

American Institute of Certified Public Accountants - national professional organization of practicing Certified Public Accountants (CPAs), has been an important contributor of the development of GAAP.

Committee on Accounting Procedure - composed of practicing CPAs appointed by the AICPA who issued 51 Accounting Research Bulletins during the years 1939 to 1959.

Accounting Research Bulletins - dealt with a variety of accounting problems but this problem-by-problem approach failed to provide the needed structured body of accounting principle. In response, the AICPA in 1959 created the Accounting Principles Board.

Accounting Principles Board - (1) advance the written expression of a accounting principles, (2) determine appropriate practices, & (3) narrow the areas of difference & inconsistency in practice. Mission to develop an overall conceptual framework to assist in the resolution of problems as they become evident & to substantively research individual issues before the AICPA issued pronouncements. Issued APB Opinions based mainly on research studies & be supported by reason & analysis.

Financial Accounting Foundation - selects members of the FASB & the Advisory Council, funds their activities, & generally oversees the FASB's activities.

Financial Accounting Standards Advisory Council - consults with the FASB on major policy & technical issues & also helps select task force members.

See pg. 11 Illustration 1-2 - Organizational Structure for Setting Accounting Standards

Statement of Positions - provides guidance on financial reporting topics until the FASB sets standards on the issues in question. These may update, revise, & clarify audit & accounting guides or provide free-standing guidance. Done through the AICPA.

Generally Accepted Accounting Principles - have substantial authoritative support. Authoritative accounting rule-making body has established a principle of reporting in a given area or that over time a given practice has been accepted as appropriate because of universal application.

Certified Public Accountant - 

Financial Accounting Standards Board - mission to establish & improve standards of financial accounting & reporting for the guidance & education of the public, which include issuers, auditors, & users of financial information.

Securities Exchange Commission - helps develop & standardize financial information presented to stockholders. A federal agency established after the 1929 stock market crash. It administers the Securities Exchange Act of 1934 & several other acts. Most companies that issue securities to the public or are listed on a stock exchange are required to file audited financial statements with the SEC.

International Accounting Standards Board - issued GAAP & International Financial Reporting Standards (IFRS). U.S. companies that list overseas are permitted to use GAAP, & foreign companies listed on U.S. exchanges are permitted to IFRS. London- based. The IASB is working with the FASB toward international convergence of GAAP.

How does accounting help the capital allocation process allocate investment capital?

How does accounting help investors in making investment decisions?

How does accounting help in the allocation of resources in the economy?

What is accounting and capital allocation?