1.3 Within What Kind of Environment Does Accounting Operate?

Accounting functions in a dynamic environment. Changes in technology as well as economic and political factors can significantly influence accounting practice. For example, the downfall of Enron and WorldCom and the resulting demise of Arthur Andersen have significantly changed the way accounting is done. As a result of these scandals, the U.S. government has taken a more active role in the development of accounting rules and oversight of the accounting industry. Four particularly important factors that influence the environment in which accounting operates are the development of generally accepted accounting principles (GAAP), international business, ethical considerations, and technology.

The Significance and 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 Topic 8.) 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?

There are many situations in business, such as the option compensation case just described, in which reasonable people can disagree about how certain items should be handled for accounting purposes. And, since financial accounting information is designed to be used by people outside a company, it is important that outsiders understand the rules and assumptions used by the company in constructing its financial statements. This would be extremely difficult and costly for outsiders to find out if every company formulated its own set of accounting rules. Accordingly, in most countries in the world, a committee or board establishes the accounting rules for that country.

The Financial Accounting Standards Board

In the United States, accounting standards for publicly listed companies are set by the Financial Accounting Standards Board (FASB). The FASB is based in Norwalk, Connecticut, and its seven full-time members are selected from a variety of backgrounds—professional accounting, business, government, and academia. Note that the FASB is not a government agency; the FASB is a private body established and supported by fees received from companies that are audited by public accounting firms. Therefore, it has no legal power to enforce the accounting standards it sets.

The FASB gets its authority to establish rules from the Securities and Exchange Commission (discussed later). The FASB maintains its influence as the accounting standard setter for the United States (and significantly influences accounting standards around the world) by carefully protecting its prestige and reputation for setting good standards. In doing so, the FASB must walk a fine line between constant improvement of accounting practices to provide more full and fair information for external users and practical constraints on financial disclosure to appease businesses that are reluctant to disclose too much information to outsiders. To balance these opposing forces, the FASB seeks consensus by requesting written comments and sponsoring public hearings on all its proposed standards. The end result of this public process is a set of accounting rules described as generally accepted accounting principles (GAAP).

As you study this text, you will be intrigued by the interesting conceptual issues the FASB must wrestle with in setting accounting standards. The FASB has deliberated over the correct way to compute motion picture profits, the appropriate treatment of the cost of dismantling a nuclear power plant, and the best approach for reflecting the impact of changes in foreign currency exchange rates. And since U.S. companies are always suspicious that any change in the accounting rules will make them look worse on paper, almost all FASB decisions are made in the midst of controversy.

Another organization called the Governmental Accounting Standards Board (GASB) sets the accounting and financial reporting standards for state and local governments following GAAP. Like the FASB, it is a private, nongovernmental organization that seeks to improve accounting practices and procedures.

Other Organizations

In addition to the FASB and GASB, several other organizations, like the ones discussed in an upcoming section, affect accounting standards and are important in other ways to the practice of accounting.

Securities and Exchange Commission

In response to the stock market crash of 1929, Congress created the Securities and Exchange Commission (SEC) to regulate U.S. stock exchanges. Part of the SEC’s job is to make sure that investors are provided with full and fair information about publicly traded companies. The SEC is not charged with protecting investors from losing money; instead, the SEC seeks to create a fair information environment in which investors can buy and sell stocks without fear that companies are hiding or manipulating financial data.

As part of its regulatory role, Congress gave the SEC specific legal authority to establish accounting standards for companies soliciting investment funds from the American public. Generally, the SEC refrains from exercising this authority and allows the FASB to set U.S. accounting standards. However, because of the accounting scandals of the early 2000s, the SEC was given more responsibility and authority to monitor financial reporting. Congress provided this additional authority with the Sarbanes-Oxley Act (SOX). This act created, among other things, the Public Company Accounting Oversight Board (PCAOB). The act also required the SEC to implement many changes in the way corporations are governed.

While the FASB is charged with creating the rules that dictate financial reporting practices, the SEC is always looming in the background, legally authorized to take over the setting of U.S. accounting standards should the FASB lose its credibility with the public.

American Institute of Certified Public Accountants

The label “CPA” has two different uses: there are individuals who are CPAs and there are CPA firms. A certified public accountant (CPA) is someone who has taken a minimum number of college-level accounting classes, has passed the CPA exam administered by the American Institute of Certified Public Accountants (AICPA), has gained a certain amount of experience in accounting, and has met other requirements set by his or her state. In essence, the CPA label guarantees that the person has received substantial accounting training.

The second use of the label “CPA” is in association with a CPA firm. A CPA firm is a company that performs accounting services, just as a law firm performs legal services. Obviously, a CPA firm employs a large number of accountants, not all of whom have the training and experience necessary to be certified public accountants. CPA firms help companies establish accounting systems, formulate business plans, redesign their operating procedures, and just about anything else you can think of. A good way to think of a CPA firm is as a freelance business-advising firm with a particular strength in accounting issues.

CPA firms are also hired to perform independent audits of the financial statements of a company. The important role of the independent audit in ensuring the reliability of the financial statements is discussed in Topic 5.

Internal Revenue Service

Financial accounting reports are designed to provide information about the economic performance and health of a company. Income tax rules are designed to tax income when the tax can be paid and to provide concrete rules to minimize arguing between taxpayers and the Internal Revenue Service (IRS). Financial accounting and tax accounting involve different sets of rules because they are designed for different purposes. Therefore, companies must maintain two sets of books—one set from which the financial statements can be prepared and the other set to comply with income tax regulations. There is nothing shady or underhanded about this. Individuals studying accounting often confuse financial accounting standards and income tax regulations. Keep in mind that what is done for accounting purposes is not necessarily accounted for in the same way for tax purposes.

International Business

As consumers, we are familiar with the wide array of products from other countries, such as electronics from Japan and clothing made in China. On the other hand, many U.S. companies have operating divisions in foreign countries. Other American companies are located totally within the United States but have extensive transactions with foreign companies. The economic environment of today’s business is truly based on a global economy.

Accounting practices among countries vary widely. The international nature of business requires companies to be able to make their financial statements understandable to users all over the world. The significant differences in accounting standards that exist throughout the world complicate both the preparation of financial statements and the understanding of these financial statements by users.

In an attempt to harmonize conflicting national standards, the International Accounting Standards Board (IASB) was formed in 1973 to develop international accounting standards. The 14 board members of the IASB come from many countries and represent a variety of professional backgrounds. As of December 2018, the 14 board members included individuals from the United States, the United Kingdom, Germany, Brazil, Canada, South Korea, France, the Netherlands, China, Australia, South Africa, and Japan. Like the FASB, the IASB develops proposals, circulates them among interested organizations, receives feedback, and then issues a final pronouncement.

The good news is that the demands of international financial statement users are forcing accountants around the world to harmonize differing accounting standards. Accordingly, the differences that currently exist across countries are gradually diminishing over time.

Ethics in Accounting

Ethics are the basic moral principles that govern an individual’s behavior, including how an individual conducts himself or herself in a business-related activity. Personal ethics is not a topic one typically expects to study in an accounting course. However, accounting-related scandals, such as the one involving Enron, have demonstrated that personal ethics and financial reporting are inextricably connected. The flexibility inherent in the assumptions underlying the preparation of financial statements means that an accountant can intentionally deceive financial statement users and yet still technically be in compliance with GAAP. Thus, a financial reporting system is of limited value if the accountants who operate the system do not have strong personal ethics.

There is growing concern over ethics in accounting and business in general. The accounting scandals of the early 2000s involving companies like Enron, WorldCom, and Tyco (to name a few) resulted from the undetected falsification of financial reports by upper management (with the help of the company’s internal accountants). Accounting rules and the resulting information are designed to capture and reflect the underlying performance of a company. When management is tempted to use accounting numbers to misrepresent a company’s performance, accountants (both inside and outside the company) are perceived by the public as being responsible for ensuring that the misrepresentation does not occur. The public’s confidence in the accounting profession was weakened when these scandals came to light with the common denominator being that accounting information was used to mislead the public.

As mentioned previously, the SEC has taken action to restore public confidence in the accounting profession. The creation of the PCAOB is an example of the SEC’s intent to ensure the quality of reported financial information. In addition, other organizations (like the Auditing Standards Board and the major stock exchanges) have taken measures to increase the public’s confidence and to restore the image of the accounting professional as ethical and competent. Do not let yourself naively think that ethical dilemmas in business are rare. Such issues occur quite frequently. Ethics is an important topic that should be considered carefully, with the ultimate goal of improving individual and collective behavior in society.

Most people believe that intentionally trying to deceive others is wrong. You will be reminded throughout this text that accounting choices often impact real economic decisions such as whether to grant a loan, make an investment, or fire an employee. Real economic decisions impact peoples’ lives, and it is sobering to think that accountants have this power in their hands. Your personal ethical standards are of paramount importance.

Technology

Few developments have changed the way business is conducted as much as computers have. Consider being able to use your desktop computer to track the status of a package shipped from Los Angeles to New York. Companies like UPS and FedEx incorporate this type of technology as an integral part of their business. Financial institutions use computer technology to wire billions of dollars each day to locations around the world.

So how have computers changed the way accounting is done? That question can be addressed on several levels. First, computer technology allows companies to easily gather vast amounts of information about individual transactions. For example, information relating to the customer, the salesperson, the product being sold, and the method of payment can be easily gathered for each transaction using computer technology.

Second, computer technology allows large amounts of data to be compiled quickly and accurately, thereby significantly reducing the likelihood of errors. As you will soon discover, a large part of the mechanics of accounting involves moving numbers to and from various accounting records as well as adding and subtracting a lot of figures. Computers have made this process virtually invisible. What once occupied a large part of an accountant’s time can now be done in an instant.

Third, in the precomputer world of limited analytical capacity, it was essential for lenders and investors to receive condensed summaries of a company’s financial activities. Now, lenders and investors have the ability to receive and process gigabytes of information, so why should the report of Walmart’s financial performance be restricted to three short financial statements? Why can’t Walmart provide access to much more detailed information online? In fact, why can’t Walmart allow investors to directly tap into its own internal accounting database? Information technology has made this type of information acquisition and analysis possible; the question accountants face now is how much information companies should be required to make available to outsiders. Twenty years ago, the only way you could get a copy of Walmart’s financial statements was to call or write to receive paper copies in the mail. Now you can download those summary financial statements from Walmart’s website. How will you get financial information 10 years from now? No one knows, but the rapid advances in information technology guarantee that it will be different from anything we are familiar with now.

Finally and most importantly, although technology has changed the way certain aspects of accounting are carried out, on a fundamental level the mechanics of accounting are still the same as they were 500 years ago. People are still required to analyze complex business transactions and input the results of that analysis into the computer. Technology has not replaced judgment.

So, if you are asking, “Why do I need to understand accounting? Can’t computers just do it?” the answer is a resounding “No!” You need to know what the computer is doing if you are to understand and interpret the information resulting from the accounting process. You need to understand that since judgment was required when the various pieces of information were put into the accounting systems, judgment will be required to appropriately use that information. We have included numerous end-of-topic opportunities for you to experience how technology helps in the accounting process. These opportunities will illustrate the important role that technology can play in the accounting process as well as emphasize the critical role that the accountant plays as well.

Questions Practice Exercises