The standard setting process

The recent, high profile accounting scandals shook the foundations of the capital markets. Financial reporting furnishes investors and other stakeholders with reliable and relevant information. In the short term unethical financial reporting resulted in loss of billion dollars, but in the long term the impact was even more severe: loss of confidence in financial reporting as reliable source of information. The following reforms aimed to restore investor confidence in financial reporting and accounting profession. They reinforced the importance of ethics in financial reporting and provided recommendation on accounting standard setting process. The following paper provides a brief discussion on standard setting organizations and process and the authoritative sources of accounting. This study also covers the objectives of financial reporting and its role in today’s economy and concludes that ethics will remain cornerstone of the accounting profession.

Table of Contents
Abstract 2
The standard setting process 4
Standard setting process and authoritative sources of accounting information 5
Objectives of financial reporting 6
Ethics’ role in financial reporting 6

Conclusion 7
References 10

The standard setting process
The dawn of the new century brought an economic downturn. The tragic events of 9/11 and the burst of the dot.com bubble accelerated the general decline. Investors kept corporate managements under constant pressure to beat expectations related to metrics such as earnings per share or net income. The combination of market downturn and profit expectations led to the adoption of unethical or outright illegal practices. The high profile accounting scandals eroded investor confidence, which is the foundation of a free market society. The quality of financial reporting was questioned and the accounting standards were under scrutiny.. Sarbanes-Oxley Act (SOX) was implemented in the wake of the collapse of Enron and WorldCom to restore investor confidence. The legislators aim was to promote transparency through consistent and accurate information to protect investors and deter corporate fraud. The following study will discuss the importance of financial reporting in the free market economies, the authoritative sources of accounting and the standard setting process.

Standard setting process and authoritative sources of accounting information
The main objective of the accounting standard setting process is to create rules that serve as a framework for high quality and transparent financial reporting. The accounting rules are set under the ultimate authority of the Securities and Exchange Commission (SEC), who delegated the accounting rule development to the private sector. SEC retained its oversight of the standard setting process to ensure that accounting standards serve the investors’ interest. Originally, the Committee on Accounting Procedure (CAP) of American Institute of Certified Public Accountants (AICPA) was responsible for standard setting and issued Accounting Research Bulletins (ARB), later the Accounting Principles Board issued its APB Opinions. Since 1973, FASB has been serving as the primary standard setting organization designated to establish authoritative financial accounting standards. FASB’s standard setting process is open, equitable, and follows a due process system. The due process system is based public decision making, taking inputs from the constituents and performing an extensive research before issuing an exposure draft for public comments. The FASB analyzes the comments before adopts a new pronouncement with simple majority (FASB, 2009).
The foundation of US Generally Accepted Accounting Principles (US GAAP) hierarchy built on four pillars. The most prominent, authoritative sources of GAAP are the statements and interpretations issued by FASB, opinions issued by the APB and ARBs issued by the CAP. In addition, there are several, less prominent source of accounting rules such as AICPA Statements of Position and Industry Audit and Accounting Guides in the second tier, FASB Emerging Issues Task Force (“EITF”) and AICPA AsSec Practice Bulletins as third tier and AICPA Accounting Interpretations, FASB Implementation Guides and industry practices in the least authoritative fourth tier.
Several sources of GAAP create a quilt work of standards, interpretations and rules, therefore it is important to assign a different level of authority each successive category in the hierarchy (Sauter, 1991). The various sources sometimes are in conflict with each other therefore a clear hierarchy is critical to guide the users, which source should be followed.

Objectives of financial reporting
The primary objective of financial reporting is to provide information that facilitates investors, prospective investors and other stakeholders in making rational business decisions (FASB, 2006). Recently, financial reporting is viewed as an important governance tool to assess the management’s accountability and stewardship. Financial reporting describes all relevant affairs of a company, therefore efficient capital markets are dependent on reliable and relevant financial information, which mitigates the information asymmetry between informed management and outside investors with limited information (Mueller, 2000). The reduced information asymmetry smoothes out market volatility and channels further investments to the best performing businesses.

Ethics’ role in financial reporting
The high profile accounting scandals resulted in loss of billions in market value for investors. However, the loss of confidence in the reliability of financial reporting and accountability of management was inflicted an even more severe damage to the failing economy. Ethics plays a key role that management does not abuse their access to insider information and they give a true and fair picture of the company affairs, even if those are unfavorable, placing the public interest in front of self interest. The importance of trustworthy financial reporting is the result of the above mentioned information asymmetry between corporate management and investors. As Geoffrey Whittington (2000) explains “The effectiveness of the financial reports depends upon shareholders being able to trust directors to tell the truth.” Following the accounting scandals the increased oversight from various watchdog organizations and increased regulatory pressure strengthened corporate accountability and quality of financial reporting.

Conclusion Matt Kelly, managing editor of Compliance Week noted that the SOX requirements are similar to starting a healthy lifestyle: first it is hard, but in the long term everyone benefits from the changes (Lazaroff, 2006). Indeed, SOX restored the investors’ confidence; however, the recent scandals proved that there is plenty of room for improvement.
The recent codification created a single source of authoritative nongovernmental accounting information superseding the earlier “patchwork” system. The streamlined GAAP literature and SEC staff preference for “plain English” financial statements will benefit investors to get more reliable and relevant information (Center for Audit Quality, 2009). The regulators and standard setters helped to improve financial reporting; now the responsibility to regain the investing public’s confidence in financial reporting is with us, accountants.

References

Center for Audit Quality. (2009). CAQ Alert #2009-76. Retrieved October 27, 2009, from http://thecaq.org/members/alerts/CAQAlert2009_76_08172009.pdf.

Financial Accounting Standards Board. (2009). Facts about FASB. Retrieved October 14, 2009, from http://www.fasb.org/jsp/FASB/Page/SectionPage&cid=1176154526495

Lazaroff, L. (2006, April 23). Debate rages on costs, value of Sarbanes-Oxley. Chicago Tribune. Retrieved October 28, 2009, from http://www.dailypress.com/business/yourmoney/sns-yourmoney-0423watch,0,7205976.story.

Mueller, G. G. (2000). The role of financial reporting: discussion. Retrieved October 28, 2009, from http://www.bos.frb.org/economic/conf/conf44/cf44_8.pdf

Sauter, Douglas. (1991). Remodeling the House of GAAP. Journal of Accountancy, 172(1), 30. Retrieved October 28, 2009, from ABI/INFORM Global. (Document ID: 556938).

Whittington, G. (1999). Trust in Financial Reporting. Pacific Accounting Review. 11 (1/2). 181 - 188. DOI: 10.1108/eb037941