Chapter 1 Module 1: Professional Standards

Introduction:
The United States has several standard-setting bodies that you will be required to be familiar
with when taking the FAR section of the CPA exam. The following is a comprehensive list of
regulatory bodies pertaining to financial reporting.

Conceptual Framework:
The conceptual framework is regarded as a guiding principle for U.S. GAAP and for the
Financial Accounting Standards Board (FASB) when setting new standards. For CPA exam
purposes, the key concept to understand regarding the conceptual framework is that it is
primarily used to make financial reporting useful for decision-making purposes.
Securities and Exchange Commission (SEC):
The SEC was established by the Securities and Exchange Commission Act of 1934. The SEC
governs all public companies that are subject to SEC rules and regulations. Regulation S-X
issues more specific public accounting rules and regulations. The SEC issues laws and
regulations for issuing both debt and equity securities within the United States. Congress
enabled the SEC to have the authority to establish United States Generally Accepted
Accounting Principles (GAAP) for firms within its jurisdiction (e.g., companies traded on
public stock exchanges), however, the FASB (private body) generally has the rights over
securities at this time.
Financial Accounting Standards Board (FASB):
The Financial Accounting Standards Board (FASB) was established in 1973 and has since
determined GAAP. The FASB is a private-sector body that establishes GAAP for businesses
within the United States. This principles and accounting standards that are set forth by the
FASB should be deemed unbiased or in favor of any specific industry and should purely be
for the overall benefit of the financial statement users (e.g., investors, creditors, lenders).

U.S. GAAP FASB Accounting Standards Codification:

The FASB Accounting Standards Codification has become the single
source of authoritative information for the nongovernmental U.S.
Generally Accepted Accounting Principles. The FASB is constantly
updating the accounting standards codification for updated GAAP
guidance and amendments to the SEC content with Accounting
Standards Updates.

Committee on Accounting Procedures (CAP):

The Committee of Accounting Procedures is a part-time committee of the AICPA.

Accounting Principles Board (APB):

The APB is a part-time committee of the AICPA and has determined GAAP from 1959 until
1973. It issues APB interpretations and Accounting Principles Board Opinions.
Accounting Standard Updates:
The FASB issues an Accounting Standards Update (ASU) to formally update financial
statement readers on final changes made to the FASB Codification, including changes to
non-authoritative SEC content. Please note, ASUs are not considered authoritative
standards.

Private Company Council (PCC):

The Private Company Council was created to improve standard setting for privately held
companies in the United States.

Governmental Accounting Standards Board (GASB):

The Governmental Accounting Standards Board (GASB) governs state and local
governmental entities. The fundamental priority of GASB is to establish and improve
standards of state and local governmental accounting and financial reporting that will:
• Result in useful information for users of financial reports; and
• Provide guidance to the public regarding the required financial reporting criteria for
financial statement issuing bodies.
Financial Statement Users:
CPA candidates will be required to have an understanding of the difference between users
who have both a direct and indirect interest in the financial reporting entity. General purpose
financial statements should be providing information that is deemed “useful” to present and
potential investors, lenders, and creditors, in order to enable them to make educated
decisions about whether or not they should provide resources to the company. The overall
objective of the conceptual framework is to alleviate doubt and provide greater usefulness
and credibility to the financial reports.

Primary users - of the financial statements are considered existing and potential investors,
creditors, and lenders. Primary users obtain financial statement information and allow them
to understand the overall health of the company such as its net cash flow status etc. Such
users make decisions related to purchasing or selling interest in these reporting entities.
Other information can be provided about the company such as information related to
management and the board of directors. This will give primary users a greater
understanding of qualitative characteristic about the company.

A common trap that the examiners attempt to trick candidates is on the concept of primary
users. Questions will often require candidates to select parties that are considered “primary
users”. Please note that regulators are not primary users of the financial statements as
setting industry regulations will generally not be impacted based on financial information
presented by specific entities.
Users with a direct interest - will generally have an economic interest in the specific entity.
Direct interest users will consist of:
• Company management
• Company staff
• Company suppliers or lenders
• Investors in the company (or potential investors)

Users with an indirect interest - will merely represent users that have direct interests.
Indirect users will consist of:
• Financial advisors
• Financial analysis
• Stock exchanges
• Regulatory bodies
Furthermore, CPA candidates will need to know the definition of external users and internal
users of the financial statements. External users of the financial statements will use
information reported in the financial statements to determine whether engaging in business
with the company would be beneficial. Internal users will use financial statements to make
decisions that might affect the operations of the business.

External users of the financial statements will include:

1. Regulatory agencies that would require financial statements to evaluate the
company’s conformity with regulations and for determining price levels in specified
industries that have more strict regulation.
2. Investors that require information when deciding on whether to invest in the financial
reporting entity.
3. Creditors that are determining specific lines of credit.
4. Financial analysts and stock exchanges that use financial statement information to
evaluate whether to invest in or accept the stock price listing.

Internal users of the financial statements will include:

1. Management
2. Company board of directors
3. Company staff

Fundamental Qualitative Characteristics:

There are two primary qualitative characteristics and their components. You are expected to
understand the fundamental qualitative characteristics and the enhancing characteristics.
Both characteristics should be present in order for financial information to be useful to
readers. The two fundamental characteristics to remember are relevance and faithful
representation.

Relevance:
Financial information is relevant and influences financial statement readers decision
making process. Financial information is considered relevant if it has predictive value,
confirmatory value, and materiality.

1. Predictive value - Financial information that has predictive value can be applied to
predict future information.

2. Confirmatory value - Financial information that has confirmatory value can be applied to
provide information that confirms or changes previous determinations.

3. Materiality - Financial information is considered material such that if absent or omitted, it

would cause a potential influence on existing or potential decisions.

Faithful Representation:
Financial information is faithfully represented if it is considered reliable to financial
statement readers and alleviates doubt in their decision-making process. Financial
information is considered faithfully represented if it has completeness, neutrality, and
freedom from error.
1. Completeness - Financial statements are considered complete if it allows the user to have
all information that is pertinent and necessary to come to an appreciated decision.

2. Neutrality - Financial statements are considered neutral if they are reported without bias
in the selection or the presentation of the financial information.

3. Freedom from error - Financial information is considered to be free from error when no
omissions or errors have been applied when selecting reporting processes.
Enhancing Qualitative Characteristics:
These characteristics enhance the usefulness of the information in order for it to be relevant
and faithfully represented. You should be familiar with the following characteristics and how
to interpret them:

1. Comparability – Comparability enables financial statement readers the ability to

compare differences and similarities with the financial reporting entity.

2. Verifiability – Verifiability enables financial statement readers to verify the accuracy of

the information being reported based on outside parties’ ability to reach the same
conclusion.

3. Timeliness – Timeliness enables financial statement readers to obtain information in

time to have the ability to reach their decisions.

4. Understandability – Understandability enables financial statement readers to have the

ability to characterize and classify various components of the financial statements that
are being presented.
Standard Setting Process:
The standard setting process is a comprehensive process that is set in place to govern the
way that standards are distributed and regulated for financial reporting purposes. \

The Full Set of Financial Statements:

Company’s use financial statements to communicate the financial health of the organization
to financial statement users. Outside of the major financial statements (income statement,
cash flows, balance sheet statements), properly reported financial statements will also
include supplementary information (e.g. management’s discussion and analysis) notes to
the financial statements with their related disclosures.

SFAC No. 5, Recognition and Measurement in the Financial Statements:

This statement is meant to apply direction on what types of items should be presented in the
financial statements as well as the associated timing of its recognition. Recognition is
considered the process of including certain items in the financial statements and
categorizing them appropriately as revenue or expense items on the income statement and
assets or liabilities on the balance sheet. Recognition can be displayed both with words or
numbers.
Notes to the financial statements will include:
• Note describing significant accounting policies (e.g., revenue recognition
methodology)
• Additional critical information that should be recognized and considered an integral
part of the statements that have been prepared in accordance with Generally
Accepted Accounting Principles (GAAP).

Financial statement items and their associated relevant information should meet four
fundamental recognition elements in order to achieve full recognition. The item can
subsequently become recognized on the company’s financial statements once the four
criteria are met (subject to cost constraints and relevant materiality thresholds):

SFAC No. 4, Objectives of Financial Reporting by Nonbusiness Organizations:

This statement provided by the FASB illustrates various intents provided for general purpose
financial reporting to external financial statement users of nonbusiness organizations.
Nonbusiness organizations that are often referenced on the CPA exam include churches,
foundations, not-for-profit educational and healthcare institutions. Nonbusiness
organizations are better outlined as those organizations that:
• Receive the majority of its financial resources from parties who have no intention of
receiving future economic benefits or future reimbursements based on provided
amounts.
• Operating purposes that are beyond those that provide businesses (e.g. sales of
goods or services) at a profit (i.e. not-for-profit organizations).
• The inability to sell or transfer ownership.
• Potential ability to claim a share of outstanding distributions of resources in the
event of liquidation of the organization.

Many users of nonbusiness organizations are those users that base many investment and
economic decisions on their knowledge of these organizations.

Overall Financial Reporting Objectives:

The overall objective of financial reporting of nonbusiness organizations is to provide
financial statement readers with the following:

1) Information useful in making resource allocation decisions – Financial reporting by

nonbusiness organizations should provide lenders and those making financial decisions
based on the statements with available information in order to come to a decision as to
whether they should allocate resources to the organization.

2) Information useful in assessing services and ability to provide services – Financial

reporting should provide appropriate information to assist in presenting prospective
resource providers with an understanding as to whether that organization can currently
provide and will be able to continue providing services into the future.
3) Information useful in assessing management stewardship and performance – Financial
reporting should provide information that is useful to users in determining if and how
managers of a nonbusiness organization have discharged their stewardship responsibilities.

4) Information about economic resources, obligations, net resources, and changes in them -
Financial reporting should provide information about the economic resources, obligations,
and net resources of an organization.

Types of Users and Respective Interests in Nonbusiness Organizations:

• Resource providers – providers of resources (e.g. lenders) and are those who are not
considered compensated based on the proportion of the resources that they provide.

• Constituents – those who both use and benefit from the goods or services that are
being distributed by the nonbusiness organizations (e.g. taxpayers who pay dues).

• Governing and oversight bodies – bodies that are responsible for oversight and
regulation are the same parties that are responsible for managing members on
nonbusiness organizations.

• Managers – are members who are responsible for managing day-to-day operations of
the nonbusiness organization.

Concept of Accrual Accounting:

Accrual accounting recognizes revenue when earned and recognizes expenses when
incurred. Cash accounting recognizes revenue and expenses when cash has been received
and spend.
Concept of Management vs Financial Accounting:
Financial accounting is used to prepare financial information for external decision makers
and is the primary basis for the external financial statement that are prepared in accordance
with US GAAP (for US based public companies). Managerial accounting is used to create
internal financial statements that management of the company would use for internal
decision making.

Assumptions and Principles: Objectives of the Codification:

The FASB Codification Research System is the online, real-time database that enables the
general public to access the Codification and better understand its literature. The online
structure of the Codification has been designed to achieve the following objectives:
• Provide all authoritative literature in a single location.
• Decrease the time and energy required to research an accounting matter.
• Reduce the risk of noncompliance with GAAP.
• Enable updating of accounting standards.
• Streamline the structure and accessibility of authoritative GAAP.

Four Principles:
• Cost principle
• Revenue recognition
• Expense recognition
• Full disclosure

Cost principle – is the concept that purchased items are recorded at their original cost.
Revenue recognition – Items are deemed recognized when they have an impact on the
financial statements and are actually recorded. Under U.S. GAAP revenue is recognized
when it is earned (not when cash is received).
Expense recognition - – Items are deemed recognized when they have an impact on the
financial statements and are actually recorded. Under U.S. GAAP expenses are recognized
when they are incurred (not when cash is paid).
Full disclosure – represents the principle of disclosing all necessary information that might
impact the users’ decisions.

Five Assumptions:
• Going concern assumption
• Monetary unit assumption
• Measurability assumption
• Entity assumption
• Periodicity assumption

Going concern assumption - It is assumed that an entity will continue to operate for the
foreseeable future (i.e., approximately 1 year from the financial statement issuance date).
Monetary unit assumption – The monetary unit principle assumes that money (e.g. US
dollar) is the primary unit of measurement and that all transactions and/or economic events
will be measured in a form of currency.

Measurability principle - Enables assets and liabilities to have various valuations.

Entity assumption - Economic activities can be accounted for while considering an

identifiable set of activities.
Periodicity assumption - Economic activities can be divided into relevant time periods. This
means that the company can report their results on a monthly, quarterly, or annual basis.

Two Constraints: There are two constraints to preparing financial statements that you should
be familiar with:

1) Materiality – represents the concept

that only material information is
presented in the financial statements.

2) Cost constraint – represents the

concept that only information that is
economically beneficial is presented
in the financial statements.