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What enables investors and creditors to rely on financial accounting information without fear that the management of the reporting enterprise has altered the information to make the company’s performance look better than it actually was? How can management be sure that internally generated information is free from bias that might favor one outcome over another? The word integrityThe qualities of being complete, unbroken, unimpaired, sound, honest, and sincere. refers to the following qualities: complete, unbroken, unimpaired, sound, honest, and sincere. Accounting information must have these qualities because of the significance of the information to individuals who rely on it in making important financial decisions.
The integrity of accounting information is enhanced in three primary ways. First, certain institutional features add significantly to the integrity of accounting information. These features include standards for the preparation of accounting information, an internal control structure, and audits of financial statements. Second, several professional accounting organizations play unique roles in adding to the integrity of accounting information. Finally, and perhaps most important, is the personal competence, judgment, and ethical behavior of professional accountants. These three elements of the accounting profession come together to ensure that users of accounting information—investors, creditors, managers, and others—can rely on the information to be a fair representation of what it purports to represent. INSTITUTIONAL FEATURESStandards for the Preparation of Accounting Information Accounting information that is communicated externally to investors, creditors, and other users, must be prepared in accordance with standards that are understood by both the preparers and users of that information. We call these standards generally accepted accounting principlesPrinciples that provide the framework for determining what information is to be included in financial statements and how that information is to be presented., often shortened to GAAP. These principles provide the general framework for determining what information is included in financial statements and how this information is to be prepared and presented. GAAP includes broad principles of measurement and presentation, as well as detailed rules that are used by professional accountants in preparing accounting information and reports. Accounting principles are not like physical laws; they do not exist in nature waiting to be discovered. Rather, they are developed by people, in light of what we consider to be the most important objectives of financial reporting. In many ways accounting principles are similar to the rules established for an organized sport, such as baseball or basketball. For example, accounting principles, like sports rules:
Accounting principles vary somewhat from country to country. The phrase “generally accepted accounting principles” refers to the accounting concepts in use in the United States. However, the principles in use in Canada, Great Britain, and a number of other countries are quite similar. Also, foreign companies that raise capital from American investors usually issue financial statements in conformity with generally accepted accounting principles. The International Accounting Standards Board (IASB) is currently attempting to establish greater uniformity among the accounting principles in use around the world in order to facilitate business activity that increasingly is carried out in more than one country. In the United States two organizations are particularly important in establishing generally accepted accounting principles—the Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission (SEC). Financial Accounting Standards Board Today, the most authoritative source of generally accepted accounting principles is the Financial Accounting Standards BoardA private-sector organization that is responsible for determining generally accepted accounting principles in the United States.. The FASB is an independent rule-making body, consisting of seven members from the accounting profession, industry, government, and accounting education. Lending support to these members are an advisory council and a large research staff. The FASB is authorized to issue Statements of Financial Accounting Standards (and other authoritative accounting pronouncements), which represent official expressions of generally accepted accounting principles. In addition to issuing authoritative Statements, the FASB has completed a project describing a conceptual framework for financial reporting. This conceptual framework sets forth the FASB’s views as to the:
The primary purpose of the conceptual framework is to provide guidance to the FASB in developing new accounting standards. By making each new standard consistent with this framework, the FASB believes that its official Statements resolve accounting problems in a logical and consistent manner. The FASB is part of the private sector of the economy—it is not a governmental agency. The development of accounting principles in the United States traditionally has been carried out in the private sector, although the government, acting through the SEC, exercises considerable influence. International Accounting Standards Board When an enterprise operates beyond the borders of its own country, differences in financial reporting practices between countries can pose significant problems. For example, when a company buys or sells products in another country, the lack of comparability of accounting information can create uncertainties. Similarly, cross-border financing where companies sell their securities in the capital markets of another country, is increasingly popular. Business activities that cross borders create the need for more comparable information between companies that reside in different countries. As a result of increasing cross-border activities, efforts are under way to harmonize accounting standards around the world. The International Accounting Standards Board (IASB)The group responsible for creating and promoting International Financial Reporting Standards (IFRSs). is playing a leading role in the harmonization process. The London-based IASB is an elite panel of 14 professionals with deep knowledge of accounting methods used in the most vibrant capital markets. The objectives of the IASB as stated in its constitution are:
The IASB issues International Financial Reporting Standards (IFRSs). Many countries’ stock exchange listing requirements or national securities legislation permit foreign companies that issue securities in those countries to prepare their consolidated financial statements using IFRSs, including Australia, Germany, and the United Kingdom. However, certain countries do not permit companies to use IFRSs without a reconciliation to domestic generally accepted accounting principles. Most notable among these countries are Canada, Hong Kong, Japan, and the United States.
Securities and Exchange Commission The Securities and Exchange CommissionA governmental organization that has the legal power to establish accounting principles and financial reporting requirements for publicly held companies in the United States. is a governmental agency with the legal power to establish accounting principles and financial reporting requirements for publicly owned corporations. In the past, the SEC has generally adopted the recommendations of the FASB, rather than develop its own set of accounting principles. Thus accounting principles continue to be developed in the private sector but are given the force of law when they are adopted by the SEC. To ensure widespread acceptance of new accounting standards, the FASB needs the support of the SEC. Therefore, the two organizations work closely together in developing new accounting standards. The SEC also reviews the financial statements of publicly owned corporations to ensure compliance with its reporting requirements. In the event that a publicly owned corporation fails to comply with these requirements, the SEC may initiate legal action against the company and the responsible individuals. Thus the SEC enforces compliance with generally accepted accounting principles that are established primarily by the FASB. Public Company Accounting Oversight Board The Public Company Accounting Oversight Board (PCAOB)A quasi-governmental body charged with oversight of the public accounting profession. The PCAOB sets auditing standards for audits of publicly traded companies. is a quasi-governmental body charged with oversight of the public accounting profession. The Board was created as a result of the Sarbanes-Oxley Act of 2002 and began operations in the spring of 2003. The PCAOB has extensive powers in overseeing the accounting profession. Any accounting firm wishing to audit a public company must register with the PCAOB. The PCAOB sets auditing standards for audits of publicly traded companies, an activity that previously was performed by the accounting profession. The Board also will inspect the quality of audits performed by public accounting firms and will conduct investigations and administer penalties when substandard audit work is alleged. The PCAOB is headquartered in Washington, D.C., and has regional offices in major cities throughout the United States. The PCAOB has five members who serve a five-year term and are eligible to be reappointed once. No more than two members of the Board can be certified public accountants. The Board also maintains a large and well-qualified staff. The PCAOB is funded by a mandatory assessment on publicly traded companies. The assessment is a function of the company’s market value relative to overall stock market value in the United States. The PCAOB has only issued a few auditing standards to date. Although it is premature to draw any firm conclusions, the auditing standards already issued by the Board are longer and more detailed than the auditing standards typically issued by the accounting profession. In the view of the authors, the public accounting profession and audits of public companies are likely to be significantly impacted as a result of the activities of the PCAOB. Audits of Financial Statements What assurance do outsiders have that the financial statements issued by management provide a complete and reliable picture of the company’s financial position and operating results? In large part, this assurance is provided by an audit of the company’s financial statements, performed by a firm of certified public accountants (CPAs). These auditors are experts in the field of financial reporting and are independent of the company issuing the financial statements. An auditAn investigation of financial statements designed to determine their fairness in relation to generally accepted accounting principles. is an investigation of a company’s financial statements, designed to determine the fairness of these statements. Accountants and auditors use the term fair in describing financial statements that are reliable and complete, conform to generally accepted accounting principles, and are not misleading. In auditing financial statements, generally accepted accounting principles are the standard by which those statements are judged. For the auditor to reach the conclusion that the financial statements are fair representations of a company’s financial position, results of operations, and cash flows, the statements must comply in all important ways with generally accepted accounting principles. Legislation As discussed previously, Congress passed the Sarbanes-Oxley Act in 2002. Among the more important provisions of Sarbanes-Oxley is the creation of the Public Company Accounting Oversight Board described earlier in this chapter. Another important provision of the Act is to ban auditors from providing many nonaudit services for their audit clients on an assumption that those services interfere with the objectivity required of auditors in rendering opinions regarding financial statements upon which investors and creditors rely. Sarbanes-Oxley also places additional responsibilities on corporate boards of directors and audit committees with regard to their oversight of external auditors, and it places responsibility on chief executive officers and chief financial officers of companies to certify the fairness of the company’s financial statements. PROFESSIONAL ORGANIZATIONS
Several professional accounting organizations play an active role in improving the quality of accounting information that is used by investors, creditors, management, and others. In addition to the Financial Accounting Standards Board and the Securities and Exchange Commission, discussed earlier, the American Institute of CPAs, the Institute of Management Accountants, the Institute of Internal Auditors, the American Accounting Association, and the Committee of Sponsoring Organizations of the Treadway Commission are particularly important. American Institute of CPAs (AICPA) The American Institute of CPAsA professional accounting organization of certified public accountants that engages in a variety of professional activities, including establishing auditing standards for private companies, conducting research, and establishing industry-specific financial reporting standards. is a professional association of certified public accountants. Its mission is to provide members with the resources, information, and leadership to enable them to provide valuable services in the highest professional manner to benefit the public, employers, and clients. The AICPA participates in many aspects of the accounting profession. The AICPA conducts accounting research and works closely with the FASB in the establishment and interpretation of generally accepted accounting principles. In fact, prior to the establishment of the FASB, the AICPA had primary responsibility for the establishment of accounting principles. The AICPA’s Auditing Standards Board has developed the standards by which audits of private companies are conducted, and the PCAOB has accepted most of these standards for audits of public companies. The AICPA also issues standards for the conduct of other professional services. Finally, the AICPA is responsible for the preparation and grading of the CPA examination, which is discussed later in this chapter. Institute of Management Accountants (IMA) The mission of the Institute of Management AccountantsA professional accounting organization that intends to influence the concepts and ethical practice of management accounting and financial management. is to provide members personal and professional development opportunities through education, association with business professionals, and certification. The IMA is recognized by the financial community as a respected organization that influences the concepts and ethical practice of management accounting and financial management. The IMA sponsors a number of educational activities for its members, including national seminars and conferences, regional and local programs, self-study courses, and in-house and online programs. Two certification programs are available through the IMA—the Certificate in Management Accounting (CMA) and the Certificate in Financial Management (CFM). These designations testify to the individual’s competence and expertise in management accounting and financial management. Institute of Internal Auditors (IIA) With more than 110,000 members in 165 countries, the Institute of Internal AuditorsA professional accounting organization that is dedicated to the promotion and development of the practice of internal auditing. is the primary international professional association dedicated to the promotion and development of the practice of internal auditing. It provides professional development through the Certified Internal Auditor® Program and leading-edge conferences and seminars; research through the IIA Research Foundation on trends, best practices, and other internal auditing issues; guidance through the Standards for the Professional Practice of Internal Auditing; and educational products on virtually all aspects of the profession. The IIA also provides audit specialty services and industry-specific auditing programs, as well as quality assurance reviews and benchmarking services. American Accounting Association (AAA) Membership in the American Accounting AssociationA professional accounting organization consisting primarily of accounting educators that is dedicated to improving accounting education, research, and practice. is made up primarily of accounting educators, although many practicing accountants are members as well. The mission of the AAA includes advancing accounting education and research, as well as influencing accounting practice. The focus of many of the AAA’s activities is on improving accounting education by better preparing accounting professors and on advancing knowledge in the accounting discipline through research and publication. An important contribution of the AAA to the integrity of accounting information is its impact through accounting faculty on the many students who study accounting in college and subsequently become professional accountants. Committee of Sponsoring Organizations of the Treadway Commission (COSO) COSOA voluntary private-sector organization dedicated to improving the quality of financial reporting through business ethics, effective internal controls, and corporate governance. is a voluntary private sector organization dedicated to improving the quality of financial reporting through business ethics, effective internal controls, and corporate governance. COSO was originally formed in 1985 to sponsor the National Commission on Fraudulent Financial Reporting (chaired by former SEC Commissioner James C. Treadway, Jr.). The National Commission on Fraudulent Financial Reporting studied the causal factors that lead to fraudulent financial reporting and made a series of recommendations for improving financial reporting, auditing, and accounting education. The original sponsors of the National Commission on Fraudulent Financial Reporting, and the current sponsors of COSO, are the AAA, the AICPA, Financial Executives International, the IIA, and the IMA. COSO is best known for its work in developing the standards for evaluating internal control—particularly internal control over financial reporting. As a result of the Sarbanes-Oxley Act, public companies now need to evaluate the effectiveness of their internal control over financial reporting on a yearly basis, as well as have their auditors separately report on the auditors’ evaluation of the effectiveness of internal control over financial reporting. The standard for evaluating the effectiveness of internal control over financial reporting is contained in COSO’s 1992 publication, Internal Control–Integrated Framework. More recently, in October 2005, COSO issued an exposure draft of a document (Guidance for Smaller Public Companies Reporting on Internal Control Over Financial Reporting) that seeks to provide implementation guidance to smaller businesses in applying the original COSO internal control framework. COMPETENCE, JUDGMENT, AND ETHICAL BEHAVIOR
Preparing and presenting accounting information is not a mechanical task that can be performed entirely by a computer or even by well-trained clerical personnel. A characteristic common to all recognized professions, including medicine, law, and accounting, is the need for competent individual practitioners to solve problems using their professional judgment and applying strong ethical standards. The problems encountered in the practice of a profession are often complex, and the specific circumstances unique. In many cases, the well-being of others is directly affected by the work of a professional. To illustrate the importance of competence, professional judgment, and ethical behavior in the preparation of financial statements, consider the following complex issues that must be addressed by the accountant:
Judgment always involves some risk of error. Some errors in judgment result from carelessness or inexperience on the part of the preparer of financial information or the decision maker who uses that information. Others occur simply because future events are uncertain and do not work out as expected when the information was prepared. If the public is to have confidence in the judgment of professional accountants, these accountants first must demonstrate that they possess the characteristic of competence. Both the accounting profession and state governments have taken steps to assure the public of the technical competence of certified public accountantsAn accountant who is licensed by a state after meeting rigorous education, experience, and examination requirements. (CPAs). CPAs are licensed by the states, in much the same manner as states license physicians and attorneys. The licensing requirements vary somewhat from state to state, but in general, an individual must be of good character, have a college education with a major in accounting, pass a rigorous examination, and have accounting experience. In addition, most states require all CPAs to spend at least 40 hours per year in continuing professional education throughout their careers. Beginning in the year 2000, the AICPA has required its new members to have completed 150 semester hours of college work. This represents about one additional year beyond a bachelor’s degree, which usually requires approximately 120–125 semester hours. Most states have changed their licensing requirements to reflect this expectation of better-educated entrants into the accounting profession. Management accountants are not required to be licensed as CPAs. However, they voluntarily may earn a Certificate in Management AccountingA professional designation issued by the Institute of Management Accountants signifying expertise in management accounting. (CMA) or a Certificate in Internal AuditingA professional designation issued by the Institute of Internal Auditors signifying expertise in internal auditing. (CIA) as evidence of their professional competence. These certificates are issued by the IMA and the IIA, and signify competence in management accounting and internal auditing, respectively. The requirements for becoming a CMA and CIA are similar to those for becoming a CPA. Integrity in accounting requires honesty and a strong commitment to ethical conduct—doing the right thing. For a professional accountant, ethical behavior is just as important as competence. However, it is far more difficult to test or enforce. Many professional organizations have codes of ethics or professional conduct that direct the activities of their members. The AICPA, for example, has a code of professional conduct that expresses the accounting profession’s recognition of its responsibilities to the public, to clients, and to colleagues. The principles included in the code guide AICPA members in the performance of their professional responsibilities. This code expresses the basic tenets of ethical and professional behavior and is enforced in conjunction with state professional societies of CPAs, although state regulatory boards take precedence in regulating the CPA license.
Exhibit 1–6 contains excerpts from the AICPA code of professional conduct. One of the principles expressed in the AICPA’s code of professional conduct is the commitment of CPAs to the public interest, shown in Article II. The public interest is defined as the collective well-being of the community of people and institutions the profession serves. Other principles emphasize the importance of integrity, objectivity, independence, and due care in the performance of one’s duties.
Expectations of ethical conduct are also important for other accountants. The code of ethics of the IMA, for example, includes the following requirements:
Users of accounting information—both external and internal—recognize that the reliability of the information is affected by the competence, professional judgment, and ethical standards of accountants. While the institutional features and professional organizations that were discussed earlier are important parts of the financial reporting system, the personal attributes of competence, professional judgment, and ethical behavior ultimately ensure the quality and reliability of accounting information. In this text, we address the topic of ethical conduct primarily through questions, exercises, problems, and cases that emphasize the general concepts of honesty, fairness, and adequate disclosure. Most chapters include assignment material in which you are asked to make judgment calls in applying these concepts. (These assignments are identified by the scales of justice logo appearing in the margin.) | |||||||||||||||||||||||||||
