CHAPTER 17

FINANCIAL REPORTING DISCLOSURE REQUIREMENTS AND ETHICAL RESPONSIBILITIES

Financial Statement Disclosure

Chapter focuses on the special importance of disclosure in financial reporting. Disclosure requirements issued by:
1. 2.

SFAC No. 5
outlines the various methods of disclosure that corporations should utilize in published financial statements

FASB SEC

Relationship of SFAC No. 5 to Other Method of Financial Reporting (Adapted)

All information useful for investment, credit, and similar decisions Financial Reporting Area directly affected by existing FASB standards Basic Financial Statements Scope of Recognition & Measurements Concepts Stmts Financial Stmts
Stmt of Earnings & Comprensive Income Stmt of Financial Position Stmt of Cash Flows Stmt of Investments by & Distributions to Owners

Notes to Financial Stmts

Examples:
Accounting Policies General Information about the company

Supplementary Information
Examples:
Segment Information Auditors Report

Other Means of Financial Reporting

Examples: MD&A Notes

Other Information
Examples:
Analysts Reports Discussion of competition

SFAC No. 5

Summarizes the building blocks to disclosure as:

1.

2.
3.

4. 5.

The scope of recognition and measurement Basic financial statements Areas directly affected by existing FASB standards Financial reporting All information useful for investment, credit and similar decisions

The Scope of Recognition and Measurement

Discussed earlier throughout the text.

Financial Statements

The financial statements described in SFAC No. 5 were discussed previously in chapters 4 and 5. In addition to the four basic statements, a full set of financial statements also includes

supplementary schedules

Footnotes

The most common examples of footnotes are:

1. 2.

Accounting policies Schedules and exhibits

Example: schedules or exhibits concerning long-term debt and income tax

3.

Explanations of financial statement items

Example: Pensions and post-retirement benefits

4.

General information about the company

Accounting Policies
APB Opinion No. 22

requires all companies to disclose

Typically, companies disclose this information in a Summary of Significant Accounting Policies preceding the footnotes.

the accounting policies the firm follows and the methods it uses in applying these policies.

Accounting Policies
APB Opinion No. 22

requires 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 generally accepted accounting principles.

The APBs principal objective in issuing Opinion No. 22: to provide information that helps investors compare firms across and between industries.

Subsequent Events

During the period between the end of a companys fiscal year and the issuance of its financial statements, events might occur that arent reflected in its accounting records. May be either

Events that provide further evidence of conditions that existed on the balance sheet date

GAAP requires these to be reported in financials

Events that provide evidence of conditions that did not exist at the balance sheet date

GAAP requires no adjustment to financials

Areas Directly Affected by Existing FASB Standards: Supplementary Information

Supplementary information may be mandated by the FASB or the SEC. Examples of supplementary information include: 1. Segment information (Chapter 16) 2. The effects of price-level changes 3. The auditors report 4. Interim financial reports

Price Level Information

High level of inflation experienced in the United States during the 1970s caused concerns that financial statements were being distorted. Result

SEC ASR No. 190 FASB SFAS No. 33 Both pronouncements required the disclosure of supplemental information on the effects of changing prices in the 10-K and annual report to stockholders. Disclosures generally made in separate schedules. Later, after inflation subsided in the 1980s, these requirements were suspended

Auditors Certificate

Informs users of the reliability of the financial statements The following guidelines for preparing the auditors report were developed by the AICPA: Should state whether the financial statements are presented in accordance with generally accepted accounting principles. Must identify those circumstances in which such principles have not been consistently observed in the current period in relation to the preceding period. Informative disclosures in the financial statements are to be regarded as reasonably adequate unless otherwise stated in the report. The report shall either contain an expression of opinion regarding the financial statements taken as a whole, or an assertion to the effect than an opinion cannot be expressed.

Auditors Certificate

Types of opinions:

Unqualified Qualified Disclaimer Adverse

Interim Financial Statements

Two views Integral view Discrete view

Interim periods are an integral part of the annual period Thus revenues and expenses might be allocated to various interim periods even though they occurred only in one period.

Each interim period is a separate accounting period Income should be determined in the same manner as for the annual period Thus revenues and expenses should be reported as they occur.

APB conclusion - adopted integral view

Financial Reporting: Other Means of Financial Reporting

Other relevant information

can assist in understanding the financial report presented in narrative form Managements discussion and analysis Letter to stockholders

Examples:
1.

2.

Managements Discussion and Analysis

Required by the SEC Explains the reasons for a companys performance during the preceding annual period, including:

Liquidity, capital resources and results of operations Favorable and unfavorable trends Significant events and uncertainties

Managements Discussion and Analysis

Designed to allow financial statement users to assess the likelihood that past performance is indicative of future performance Contains estimates that are protected by safe harbor clause

Managements Discussion and Analysis

SEC also requires disclosure of qualitative and quantitative information about market risk by all companies registered with the SEC Market risk: the risk of loss arising from adverse changes in market rates and prices from such items as: 1. Interest rates 2. Currency exchange rates 3. Commodity prices 4. Equity prices

Managements Discussion and Analysis

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 of time and with a selected likelihood of occurrence

Managements Discussion and Analysis

Objective of the quantitative disclosure requirements provide investors with forward looking information about a registrant's potential exposures to market risk 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

Managements Discussion and Analysis

1.

2.

Specifically, companies must disclose: Their primary market risk exposures at the end of the current reporting period How they manage those exposures

such as a description of the objectives general strategies and instruments, if any, used to manage those exposures

3.
a)

Changes in
either the primary market risk exposures b) or how those exposures are managed when compared to the most recent reporting period and what is known or expected in future periods

Letter To Stockholders

Four main purposes. It indicates that management:

1.

2.

3.

4.

Is responsible for preparation and integrity of statements Has prepared statements in accordance with GAAP Has used their best estimates and judgment States that the company maintains a system of internal controls

All Information Useful for Investment, Credit and Similar Decisions: Other Information

Includes information about companies Also available outside the companys annual report and 10-K. Examples of these types of information include
1. 2.

Analysts reports News articles about the company.

Analysts Reports

Individual investors make essentially three investment decisions

Buy Hold Sell

Potential investor decides to purchase a particular security on the basis of all available disclosed information Investor decides to retain a particular security basis of all available disclosed information Investor decides to dispose of a particular security basis of all available disclosed information

Usually accomplished by fundamental analysis as discussed in Chapter 3

Analysts Reports

Investment analysis may also be made by professional security analysts frequently specialize in certain industries use their training and experience to process and disseminate information more accurately and economically than individual investors 3 categories of financial analysts: 1. Sell side - Work for full-service broker dealer and make recommendations on securities they cover 2. Buy side -Work for institutional money managers such as mutual funds that purchase securities for their own accounts. Counsel their companies to buy, hold and sell 3. Independent - Not associated with firms that underwrite the securities they cover. Often sell their recommendations on a subscription basis

Analysts Reports

Many analysts work in a world of built-in conflicts of interest and competing pressures Sell-side firms want their individual investor clients to be successful over time because satisfied longterm investors are the key to the firms reputation and success

Analysts Reports

Several factors can create pressure on an analysts independence and objectivity An analysts firm may be underwriting a companys securities offering and client firms prefer favorable research reports Positive reports can generate additional clients and revenues Arrangements frequently tie compensation to continuation of clients Analysts may own securities individually or they may be owned by the analysts firm

SEC Disclosure Requirements

The Securities Act of 1933 (Going Public)

Registration statement Prospectus Form 10, 10K and 10Q

The Securities Exchange Act of 1934 (Being Public)

The Foreign Corrupt Practices Act 0f 1977 The Sarbanes-Oxley Act of 2002

Foreign Corrupt Practices Act of 1977

Provisions:
1

Makes it a criminal offense to offer bribes to foreign officials Requires detailed financial records and a system of internal control

The Sarbanes-Oxley Act of 2002

Early 2000s: dozens of major corporations either went bankrupt or faced extreme financial difficulties Included Enron WorldCom Xerox Global Crossing Arthur Andersen Merrill Lynch Tyco International Halliburton Oil Services.

Result: Americans lost billions of their investment dollars jobs vanished thousands of people lost their entire retirement savings Subsequently, corporate reform became a watchword

The Sarbanes-Oxley Act of 2002

Congress passed in 2002 Major provisions are: 1. The creation of a Public Company Accounting Oversight Board (PCAOB) 2. The Establishment of Auditing, Quality Control, and Independence Standards 3. The Inspection of CPA Firms 4. The Establishment of Accounting Standards 5. The Delineation of Prohibited Services 6. Prohibition of Acts that Influence the Conduct of an Audit 7. Requiring Specified Disclosures 8. Requiring CEO and CFO Certification

The Sarbanes-Oxley Act of 2002: Sec. 404

Controversial 404(a) Managements responsibilities Internal control report by management

Establishing and maintaining Assessment

404(b)
Independent auditors responsibility
Report on managements internal control assessment Assessment of companys internal controls on financial reporting

2 separate opinions required

Ethical Responsibilities

What is ethics? Difference between morals and ethics Professions are different Western ethics is based on the concept of utilitarianism Professional ethics proscribes a duty that goes beyond the ordinary citizen

Ethical Conduct of Accountants

Ethical issues for accountants

1 2 3 4 5

Independence Scope of service Confidentiality Practice development Differences on accounting issues

Framework for Analysis of Ethical Issues

Obtain the relevant facts Identify the ethical issues Determine the individuals or groups affected Identify possible alternative solutions Determine how various individuals or groups are affected by alternative decisions Decide on appropriate action

The Ethical-Legal Question

Just because something is legal it is not necessarily ethical

AICPA Code of Professional Conduct

1
2

The AICPA represents itself as an ethical professional body practicing an art rather than a science Accounting should be viewed as practicing a service function rather than as a profit-making function
3

As an art, accounting requires judgment which encompasses ethical conduct To assist in satisfying its responsibilities to society, the accounting profession has developed a code of professional conduct

AICPA Code of Professional Conduct

Society viewed accounting favorably until the late 1960s Watergate Accountants argued they shouldnt be held responsible because

these activities were difficult if not impossible to discover during a normal audit and not material in many cases anyway

Also concern over audit failures for such companies as Penn Central, National Student Marketing and Equity Funding

AICPA Code of Professional Conduct

The role of Congress and Congressmen Moss and Dingle

1

2
3

Were the rules deficient? Were the qualifications to be a CPA sufficient? Was self-policing working? The Expectations Gap

In response the Cohen Commission

AICPA Code of Professional Conduct

The Anderson Report indicated that efficient performance should meet six criteria: 1 Safeguard public interest 2 Recognize CPAs paramount role in the financial reporting process 3 Help assure quality performance and eliminate substandard performance 4 Help assure objectivity and integrity in public service 5 Enhance CPAs prestige and creditability 6 Provide guidance as to proper conduct

AICPA Code of Professional Conduct

As a result new ethical standards were developed in response to the expectations gap

The effect was:

1

Broader auditor responsibility to consider reliability of internal control system in planning an audit Delineate audit responsibility for reporting errors, irregularities and illegal acts by clients Evaluate ability of a firm to continue as a going concern

AICPA Code of Professional Conduct

The new Code of Professional Conduct contains four sections:

1

Principles

Responsibility The public interest Integrity Objectivity and independence Due care Scope and nature of services

2 3 4

Rules of conduct Interpretations Ethical rulings

AICPA Code of Professional Conduct

Overall the goal of the Anderson Report and the revised Code of Professional Conduct was to be more responsive to the publics concern by providing
1 2 3 4 5 6

Ethical guidance Broad positive statements Specific behavioral rules Proactive monitoring Broader rules application Guidance on dealing with the changing environment

The professions image by the public has suffered but has recently recovered.

International Accounting Standards

IAS No. 1: Presentation of Financial Statements

Requires

companies to present a statement disclosing each item of

Notes to the financial statements

income expense gain or loss required by other standards to be presented directly in equity and the total of these items

must present information about the basis of preparation of the financial statements and the specific accounting policies selected must disclose all other information required by IASC standards not presented elsewhere in the financial statements must provide all other information necessary for a fair presentation

IAS No 34: Interim Financial Reporting

Does not specify which enterprises should present interim financial reports left to be decided by laws or regulations Adopts the discrete view U. S. GAAP which requires the integral view The minimum content of an interim financial report is a condensed balance sheet condensed income statement condensed cash flow statement condensed statement of changes in equity explanatory notes. Also requires disclosure of unusual events

Prepared by Kathryn Yarbrough, MBA

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