1.4 Development of Accounting Standards

Consider this situation. A company decides to pay its managers partly in cash and partly in the form of options to buy the company’s stock. The options would be very valuable if the company’s stock price were to increase but would be worthless if the company’s stock price were to decline. Because the company gives these potentially valuable options to employees, cash salaries don’t need to be as high.

Should the value of the options be reported as salary expense or not? (You’ll learn the answer to this surprisingly explosive question in Chapter 13.) One alternative is to let each company decide for itself. Users then must be careful about comparing the financial statements of two companies that have accounted for the same thing differently. Another alternative is to have one standard accounting treatment. Who sets the standard?

Accounting principles and procedures have evolved over hundreds of years in response to changes in business practices. The formal standard-setting process that exists today in the United States, however, has developed in just the past 75 years. The triggering event was the Stock Market Crash of 1929. In the aftermath of the crash, many market observers claimed that stock prices had been artificially inflated through questionable accounting practices. The Securities and Exchange Commission (SEC) was created to protect the interests of investors by ensuring full and fair disclosure. The SEC was also given specific legal authority to establish accounting standards for companies desiring to publicly issue shares in the United States. The emergence of the SEC forced the U.S. accounting profession to unite and to become more diligent in developing accounting principles. This led over time to the formation of a series of different private-sector organizations, each having the responsibility of issuing accounting standards. These organizations, their publications, and the time they were in existence are identified in Figure 1.3. The SEC has generally allowed these private-sector organizations to make the accounting standards in the United States. These standards are commonly referred to as generally accepted accounting principles (GAAP). Remember, however, that the SEC retains the legal authority to establish U.S. accounting standards if it so chooses.

Financial Accounting Standards Board

The Financial Accounting Standards Board (FASB) is currently recognized as the privatesector body responsible for the establishment of U.S. accounting standards. The FASB was organized in 1973, replacing the Accounting Principles Board (APB). The APB was replaced because it had lost credibility in the business community and was seen as being too heavily influenced by accountants. As a result, the seven full-time members of the FASB are drawn from a variety of backgrounds—auditing, corporate accounting, financial services, and academia.1 The members are required to sever all connections with their firms or institutions prior to assuming membership on the Board. Members are appointed for five-year terms and are eligible for reappointment to one additional term. Headquartered in Norwalk, Connecticut, the Board has its own research staff and had program operating expenses of $28.6 million in 2018, much of which is paid from fees levied under the Sarbanes-Oxley Act on companies publicly traded in the United States.

Appointment of new Board members is done by the Financial Accounting Foundation (FAF). The FAF is an independent, self-perpetuating body that, like the FASB, is made up of representatives from the accounting profession, the business world, government, and academia. However, the FAF has no standard-setting power, and its members are not full time. The FAF serves somewhat like a board of directors, overseeing the operations of the FASB. In addition to overseeing the FASB, the FAF is also responsible for selecting and supporting members of the Governmental Accounting Standards Board (GASB). The GASB was established in 1984 and sets financial accounting standards for state and local government entities.

The Standard-Setting Process

The major functions of the FASB are to study accounting issues and to establish accounting standards. These standards are published as Accounting Standards Updates. The FASB has also issued Statements of Financial Accounting Concepts that provide a framework within which specific accounting standards can be developed. The conceptual framework of the FASB is detailed later in the chapter.

The hallmark of the FASB’s standard-setting process is openness. Because so many companies and individuals are impacted by the FASB’s standards, the Board is meticulous about holding open meetings and inviting public comment. At any given time, the Board has a number of major projects under way. For example, as of June 5, 2019, the FASB was engaged in 27 agenda projects. These FASB projects address fundamental issues such as the Conceptual Framework as well as technical issues relating to very complex business transactions such as hedge accounting and business combinations.

Each major project undertaken by the Board involves a lengthy process. The FASB staff assembles background information and the Board holds public meetings before a decision is made to even add a project to the FASB’s formal agenda. After more study and further hearings, the Board often issues a report summarizing its Preliminary Views, which identifies the principal issues involved with the topic. This document includes a discussion of the various points of view as to the resolution of the issues, as well as an extensive bibliography, but it does not include specific conclusions. Interested parties are invited to comment either in writing or orally at a public hearing.

After comments from interested parties have been evaluated, the Board meets as many times as necessary to resolve the issues. These meetings are open to the public, and the agenda is published in advance. From these meetings, the Board develops an Exposure Draft of a statement that includes specific recommendations for financial accounting and reporting.

After the Exposure Draft has been issued, reaction to the new document is again requested from the accounting and business communities. At the end of the exposure period, 60 days or longer if the topic is a major one, all comments are reviewed by the staff and the Board. Further deliberation by the Board leads to either the issuance of an Accounting Standards Update (if at least four of the FASB members approve), a revised Exposure Draft, or in some cases, abandonment of the project. As you can see, the standard-setting process is a political one, full of consensus building, feedback, and compromise

The final statement not only sets forth the actual standards but also establishes the effective date and method of transition. It also gives pertinent background information and the basis for the Board’s conclusions, including reasons for rejecting significant alternative solutions. If any members dissent from the majority view, they may include the reasons for their dissent as part of the document. These dissents are interesting reading. For example, the dissent to the standard on the statement of cash flows (released in 1987) reveals that the Board members disagreed about a fundamental issue—whether payment of interest is an operating activity or a financing activity.2

Emerging Issues Task Force

The methodical, sometimes slow, nature of the standard-setting process has been one of the principal points of criticism of the FASB. There seems to be no alternative to the lengthy process, however, given the philosophy that arriving at a consensus among members of the accounting profession and other interested parties is important to the Board’s credibility.

In an effort to overcome this criticism and provide more timely guidance on issues, in 1984 the FASB established the Emerging Issues Task Force (EITF). The EITF assists the FASB in the early identification of emerging issues that affect financial reporting. Members of the EITF include the senior technical partners of the major national CPA firms plus representatives from major associations of preparers of financial statements. In addition, observers from the SEC, the AICPA, and the IASB (three organizations discussed later in this chapter) are invited to participate in the EITF discussions. The EITF meets periodically, typically at least once every quarter.

As an emerging issue is discussed, an attempt is made to arrive at a consensus treatment for the issue. If a consensus is reached by the EITF, that consensus must then be approved by a majority of the FASB members. That consensus opinion then defines the generally accepted accounting treatment unless and until the FASB decides to reconsider the issue. The EITF not only helps the FASB and its staff to better understand emerging issues but also in many cases determines that no immediate FASB action is necessary

The consensus opinions of the EITF are published as Accounting Standards Updates. These updates are identified by a two-part number; the first part represents the year the issue was discussed, and the second part identifies the update number for that year. For example, among the consensuses reached in 2019 was Update No. 2019-02, “Improvements to Accounting for Costs of Films and License Agreements for Program Materials,” which deals with the timing of the capitalization of the production costs associated with episodic television series. (Note: We will talk about asset capitalization in Chapter 10.) Although many of the issues are very specialized by topic and industry, the importance of the EITF to the standard-setting process cannot be overemphasized. Because discussions rarely last more than a day or two and a consensus is reached on a majority of the issues discussed, timely guidance is provided to the accounting profession without the lengthy due process of the FASB.

Private Company Council

There has long been a concern that the FASB has focused more on large companies than smaller companies. Many believe accounting standards are more generally applicable to large companies and that they place a reporting burden on small companies that result in a higher cost without returning the same benefit.

In response to this concern, the American Institute of Certified Public Accountants (AICPA), the FAF, and the National Association of State Boards of Accountancy (NASBA) formed a blue-ribbon panel (the Panel) in December 2009 to study the issue. The Panel made recommendations related to accounting standards for private companies. Not all the recommendations were accepted but, as a result of the recommendations, the Private Company Council (PCC) was formed. The PCC advises the FASB on the appropriate accounting treatment for private companies for existing standards and standards being considered by the FASB. Soon after its formation, the PCC recommended several alternative accounting treatments for private companies that were issued as Accounting Standards Updates (ASU) by the FASB. Those standards had to do with goodwill, certain variable-interest entities, interest rate swaps, and other intangible assets acquired in a business combination. Since that time, the most common recommendations by the PCC are a one-year extension of the implementation date of most standards and the exclusion of selected disclosure requirements.

Private companies are not required to follow PCC standards. It is an accounting election they may make, if they choose. They may elect one or more PCC standards without electing others, if they wish, except in certain specific circumstances.

FASB Accounting Standards Codification^TM

As you saw in the discussion above, both the FASB standards and the EITF consensus opinions are published as Accounting Standards Updates. These Updates serve as formal notification that the official body of generally accepted accounting standards (GAAP) has been updated. This official source of U.S. GAAP is called the FASB Accounting Standards Codification (ASC) and is found on the FASB’s Web site at asc.fasb.org.

Prior to the launching of the FASB ASC in July 2009, the FASB standards and the EITF consensus opinions were made available as numbered lists of items. So, if you wanted to know about the accounting for research and development costs, for example, you had to know that the accounting for normal R&D costs was contained in FASB Statement of Financial Accounting Standards No. 2 (released in 1974), unless the R&D cost was for software development, in which case the accounting was described in Statement No. 86 (released in 1985). In other words, for everyone except the experienced practitioners and the old accounting professors who had been around for a thousand years, finding a specific accounting rule on a specific topic involved a primitive hunt-and-peck strategy.

The FASB ASC employs a topical menu structure. Accounting topics are grouped under nine broad categories. Each category contains a collection of topics. For example, under the Presentation group of topics, you can find Topic 210 on the balance sheet, Topic 230 on the statement of cash flows, Topic 260 on earnings per share, and more. Under the Broad Transactions group of topics, you can find Topic 805 on business combinations, Topic 842 on leases, and more. A list of topic groupings and individual topics is given in Figure 1.4.3

Within each Topic, the accounting standard content is organized in additional menus leading eventually down to the paragraph level. A paragraph in the FASB ASC is identified with a four-part address: Topic-Subtopic-Section-Paragraph. For example, the paragraph that explains that cash paid for interest is to be classified in the statement of cash flows as an operating activity is FASB ASC 230-10-45-17.

• The first number, 230, designates the topic Statement of Cash Flows (which is in the Presentation group of topics).

• The second number, 10, indicates that this is an Overall issue, or subtopic. Other types of subtopics provide standards for particular types of transactions or industries. For example, under Topic 230, there are subtopics explaining statement of cash flow issues related to foreign currency exchange rates, cash flows in the film industry, and others.

• The third number, 45, indicates that this section addresses “Other Presentation Matters.” The set of sections under each subtopic is standardized. For most subtopics you will see a section (10) on Objectives, another section (30) on how accounting items are to be initially measured, and so forth.

• Finally, the fourth number (17) indicates the exact paragraph where the text of the accounting standard is found. In this case, FASB ASC paragraph 230-10-45-17 reads as follows (in part): “All of the following are cash outflows for operating activities . . . (d) Cash payments to lenders and other creditors for interest.”

In this textbook you will see many, many references to the FASB ASC. Any person who plans to work in a field where financial statements are prepared or used needs to become comfortable with the Codification. Each chapter in this book includes a short research exercise to give you practice finding things in the ASC. And the end of each chapter includes a matrix that summarizes the FASB ASC material relating to the items covered in that chapter. This matrix also includes references to the old pre-Codification standard numbers, just in case you run across a long-time accountant who has refused to learn the new Codification references. Finally, these end-of-chapter matrices contain the corresponding references to the International Accounting Standards, which are discussed later in this chapter.

FASB Summary

Remember this: The FASB has no enforcement power. Legal authority to set U.S. accounting standards rests with the SEC. FASB standards are “generally accepted,” meaning that, overall, the FASB standards are viewed by the business community as being good accounting. However, the credibility of the FASB has fluctuated through the years as different issues have been resolved. For example, in the past, the business community has been outraged by proposed standards for accounting for stock-based compensation and for goodwill. In both of those cases (which are discussed in Chapters 13 and 10, respectively), the FASB was forced to significantly revise its initial proposal. The FASB’s job has been described as a “balancing act” between theoretical correctness and practical acceptability.

In addition to the FASB, several other bodies impact accounting standards and are important in other ways to the practice of accounting. Some of these bodies are discussed here.