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Session 1: Introduction and Overview of Financial Reporting in the U.S.
Who cares about accounting?
An important objective of accounting is to provide information to investors and creditors
who are trying to make the best investment decisions they can. The better those decisions
are, the more eKiciently resources will be allocated in the economy, and the more goods
and services the economy will be able to produce. Because everyone has the chance to
benefit from production of more goods and services, nearly everyone cares about
accounting, either directly or indirectly.
We first examine the characteristics of a modern economy that give rise to a demand for
accounting information. The typical production process in a modern economy requires
investors and creditors to commit funds to an enterprise in which they invest for a long
period of time. However, the existence of stock and bond markets allows them to change
their minds at a later date. They could change their minds just because they need their
money back for some other purpose, or because they have new information that changes
their opinion of what will happen in the future. This is where accounting comes in--as an
important source of information that may influence the decisions that investors and
creditors make.
There are two important points that we make about accounting here. First, providing
accounting information about past events also requires making predictions about an
uncertain future (e.g., will customers we sell to on credit pay us back?). In this sense,
accounting is more of an art than a science. Second, accountants frequently disagree on
the best way to account for many types of transactions. These disagreements are resolved
through the accounting standard setting process. Because the standards that are set can
aKect both the amount of goods and services in the economy and how each person
benefits from production of those goods and services, the process of setting accounting
standards can be intensely political.
The Role of Capital Markets
When investors purchase common stock in a company, they are buying a residual interest
in that company, meaning that they get all of the resources of the firm after the creditors
are satisfied. This residual interest is the same as a car owner’s interest if the owner has a
bank loan on the car. For example, assume that you purchase a car for $15,000, paying
$5,000 down and borrowing the remaining $10,000 from a bank. At that time your residual
interest in the car is $5,000, the amount that remains after satisfying the creditors (the
bank).
There is no specific date at which common stockholders will receive their money back.
When investors purchase bonds issued by a company, they are buying the right to receive
their money back (plus interest) at a specific time in the future, but that specific time is
frequently many years away. The timing of these cash payments to the bondholders (or
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creditors) can vary. In some cases, the firm promises to pay only interest for a number of
years, and then returns the creditor’s original investment in the last year. In other cases, the
firm pays nothing for many years, and then returns both interest and principal in one lump
sum. In still other cases, the firm returns interest and part of the principal each year for
many years.
These stocks and bonds are initially issued in the primary capital market. These
transactions take place between the firm issuing the stock and the investors who are first
purchasing the stock and are usually facilitated by investment banking firms. However, a
secondary capital market also exists in which common stocks and bonds can be traded
after they are initially issued. Transactions in this market take place between two investors,
one selling the common stock or bond and the other purchasing it. Trading in these
secondary markets is undoubtedly most familiar to you and is the subject of news reports
every day. The most important secondary stock markets in the United States are the New
York Stock Exchange, the American Stock Exchange, and the National Association of
Securities Dealers’ Automated Quotation System (NASDAQ). Millions of shares of stock
that were originally issued by thousands of companies are traded among investors in these
markets every business day. In this course we will focus primarily on financial reporting for
these companies (“publicly traded companies”).
These secondary markets for stocks and bonds play an important role in the willingness of
individuals to invest their money (through the primary market) in a firm that will not be able
to return their money until the output from their productive facilities has been sold. When
investors purchase a company’s stock, they nominally commit their money for an indefinite
period of time. Investors are often willing to do this only because they know that there is a
secondary market in which they can get their money back if they need it for another
purpose. Similarly, when investors purchase a company’s bonds, they nominally commit
their money to the company for a finite, but often lengthy period of time. They are willing to
do so only because there is a secondary market in which they can sell their investments
and get their money back if they need it for another purpose.
Trading in the secondary market may occur because investors disagree with about the
fundamental value of a firm (information-based trading) or because investors need their
money for some other reason (liquidity trading). We call it information-based trading
because investors’ expectations about future cash flows shape their estimates of a firm’s
fundamental value. Obviously because the future is uncertain, investors rely on
information to shape their expectations of future cash flows. The role of accounting reports
is to provide just such information about the enterprise that will be useful in making
predictions about the amount of future cash flows the enterprise will generate, when these
cash flows will be received, and the degree of uncertainty over whether these cash flows
will actually be received.
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Financial Reporting Regulations
Companies whose securities (equity and debt) trade publicly in the U.S. face strict
regulations. This is not a business law course, but you should have a high-level
understanding of the scope and objective of the following three important regulations:
Securities Act of 1933: This Act is focused on regulating the initial public oKering (IPO) of
securities, meaning the first sale of stocks or bonds by a company to the public. It aims to
protect investors by ensuring they receive accurate and complete information about the
securities they are buying.
Securities Exchange Act of 1934: This Act is focused on regulating securities, particularly in
the secondary market. This Act established the Securities and Exchange Commission
(SEC) to oversee the securities industry and enforce its provisions. The objective of this law
is to protect investors by ensuring fair and transparent markets through requirements for
corporate reporting, disclosure, and prohibitions against fraud and manipulation. Thus, this
is the Act that requires ongoing disclosures for publicly traded companies (e.g., 10-K, 10Q), as well as includes several other important provisions (e.g., anti-fraud, insider trading
restrictions, proxy solicitations).
Sarbanes-Oxley Act of 2002 (SOX): SOX was enacted following a series of high-profile
accounting frauds (e.g., Enron, Worldcom). Its objective is to improve the accuracy and
reliability of financial reporting and corporate disclosures of public companies. It
mandates specific practices for financial record keeping and reporting (i.e., internal control
reports), required stronger CEO/CFO certifications of financial statements. It also
established the Public Company Accounting Oversight Board (PCAOB) to oversee public
accounting firms.
Reporting requirements
SEC issuers must file a variety of forms with the SEC. Here is an overview of some of the key
filings, which we will see examples of throughout the course:
Filing
Description
Form 10-K
Annual report including audited financials, risk factors, and
management discussion.
Form 10-Q
Quarterly report including unaudited financial statements.
Form 8-K
Current report filed for major events (e.g., CEO resignation, M&A
activity).
Form S-1
Initial registration statement for new securities issuance.
Proxy Statement Discloses executive compensation, shareholder voting items, and
(DEF 14A)
governance.
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Regulatory bodies in the U.S.
You should also have a general understanding of each of the following players in capital
markets:
Securities and Exchange Commission (SEC): The primary regulator of securities markets
in the U.S. The SEC requires that all financial statements filed with it be audited for
conformity with GAAP. The SEC monitor companies for compliance with federal securities
laws, and investigate and prosecute suspected violations. Financial statements filed with
the SEC that do not conform to GAAP violate federal law, and the filers may be prosecuted
under the abovementioned laws. While the SEC has agreed to let most accounting
standards be set in the private sector (i.e., the FASB) for more than sixty years, they have
also adopted some additional rules that must be followed in SEC filings. These additional
rules for the most part require additional disclosures in the financial statements rather
than the use of alternative accounting methods.
Financial Accounting Standards Board (FASB): The FASB is a private sector organization
that consists of seven members, one of whom serves as the Chair. The accounting
standards that the FASB set are the authoritative accounting standards for US companies
(“US Generally Accepted Accounting Principles, or US GAAP). In this course we will focus
on the standards that apply to publicly traded companies (not private companies).
Public Company Accounting Oversight Board (PCAOB): The PCAOB was created by SOX,
in part due to concerns about client-auditor relations in the aforementioned corporate
accounting scandals. The PCAOB oversees the audits of US-listed public companies and
broker-dealers. The PCAOB’s budget must be approved by the SEC, as too must PCAOB
rules and standards.
Accrual vs. cash accounting
US GAAP requires financial statements to be prepared using accrual accounting. Accrual
accounting requires accountants to recognize the eKects of events, transactions, and
circumstances in the period in which they are incurred, not necessarily when the cash is
received. Because accrual accounting also requires accountants to make estimates about
the future, substantial judgment is required in accrual accounting. Throughout this
semester, we will explore some of the sources of this judgment and discuss its
consequences.
Why is accrual accounting preferred? Consider the following example:
• StreamForYou charges customers an annual subscription fee upfront to get access
to video and audio streaming services for the entire year.
• In January 2024, 1,000 new customers sign up, each paying $120 for a year-long
subscription.
• The cost of providing the service is $4/month, which the company incurs and pays in
cash each month.
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Calculate profit per month on an accrual and cash basis:
Jan
Feb
Mar
Apr
May
Jun
Accrual
$6,000
$6,000
$6,000
$6,000
$6,000
$6,000
Cash
$116,000
($4,000)
($4,000)
($4,000)
($4,000)
($4,000)
With this information, which approach to profit measurement provides a better predictor of
cash inflow for next year? Why?
Accrual accounting provides a better predictor of cash inflow because it reflects underlying
economic activity. It is more persistent over the long-term.
Important Conceptual Note: Over the life of a transaction/contract/asset: Profit under
accrual basis = profit under cash basis. In other words, accrual accounting simply adjusts
the timing of when we recognize income, not the total amount.
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Self-Review Questions
1. What is the primary objective of the FASB?
2. What is the primary objective of the SEC?
3. Which of the following SEC filings provides information about a firm’s quarterly financial
statements?
a. S-1
b. S-Q
c. 10-Q
d. 10-K
e. 8-K
4. Which of the following regulations do not form part of U.S. securities laws?
a. Securities Act of 1933
b. Securities Exchange Act of 1934
c. Sarbanes-Oxley Act of 2002
d. Occupational Health and Safety Act
e. All of the above govern U.S. securities laws.
5. An investor sells their shares in Company X (a publicly-traded company) because they
want funds to invest in Company Y. Which of the following statements are true regarding
this transaction? Choose the best answer.
a. This is an example of liquidity-based trading.
b. Company X must pay Company Y the dollar amount that the investor sells.
c. Company X debits an equity account for this transaction.
d. Company X receives cash for this transaction
e. All of the above statements are true.
6. Which of the following entities are assist with the enforcement of U.S. GAAP?
a. FASB
b. SEC
c. PCAOB
d. b and c
e. All of the above
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Solutions to Self-Review Questions
1. In summary: to create GAAP. For a more in depth understanding of their objective and
mission, spend some time navigating their website. You will need to do so various times
throughout the semester! From their website: The collective mission of the FASB, the
Governmental Accounting Standards Board (GASB) and the FAF is to establish and
improve financial accounting and reporting standards to provide useful information to
investors and other users of financial reports and educate stakeholders on how to most
eKectively understand and implement those standards
2. In summary: to protect investors through regulation and enforcement of financial
regulations, including GAAP. From their website: The SEC protects investors, promotes
fairness in the securities markets, and shares information about companies and
investment professionals to help investors make informed decisions and invest with
confidence.
3. C – 10-Q (see homework 1 solutions)
4. D - Occupational Health and Safety Act (see homework 1 solutions)
5. A – when investors sell their shares in a company because they require the funds for
another use, this is an example of liquidity trading. When investors sell shares in the
secondary market, the company does not report the eKect of the transaction in their
financial statements.
6. B – The FASB set U.S. GAAP. The PCAOB are responsible for overseeing the audits of
public companies, not ensuring that public companies follow U.S. GAAP
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