Accounting majors' financial reporting knowledge and their ability to identify and correct financial statement errors and omissions.

James, Marianne L.

ABSTRACT

Financial statement frauds that have impaired the integrity of financial reporting and led to new regulation (i.e., the Sarbanes-Oxley Act of 2002) have reemphasized the importance of financial reporting knowledge. Accounting majors must not only know the multitude of accounting rules, but also the overall reporting requirements. Yet, students frequently lack some knowledge in this area.

The purpose of this study was to investigate accounting majors' financial reporting knowledge, which is necessary to succeed in the challenging accounting profession, and to develop recommendations that will help accounting educators address any weaknesses. A multi-course case project consisting of financial statements and notes containing intentional errors and omissions was utilized in Intermediate Accounting courses.

The study found that students' identification and correction of errors and omissions varied depending on the specific reporting issue. Overall, a higher percentage of students correctly identified errors and omissions on the face of the financial statements than in the notes. Furthermore, only a relatively small percentage of the students noticed that several comparative financial statement years had been omitted. The results from this study suggest that additional instruction is needed, particularly with respect to overall reporting requirements and the relevance of financial statement note disclosures.

INTRODUCTION

The accounting profession has experienced significant changes during the past few years. Highly publicized accounting frauds involving large companies such as WorldCom and Enron and some surprising audit failures have enhanced the scrutiny of the profession and have led to additional regulation (i.e., the creation of the Sarbanes-Oxley Act of 2002). These recent financial reporting scandals have enhanced cognizance of a long recognized need for high quality and truthful financial reporting.

Accounting professionals must be quite knowledgeable about financial reporting. For example, accounting professionals must be able to prepare financial statements and notes that are free of material misstatements and omissions, and must be able to detect financial statement errors and omissions. Accounting majors should acquire fundamental financial reporting knowledge while completing their accounting curriculum. However, frequently accounting majors experience difficulties preparing financial statements and notes that are relevant, reliable, and in compliance with Generally Acceptable Accounting Principles (GAAP). Accounting educators must utilize the limited time available in financial accounting courses (particularly Intermediate Accounting) to help their students learn and understand the fundamental principles and concepts underlying financial accounting and reporting, as well as the multitude of specific accounting rules that comprise GAAP. An understanding of the strengths and weaknesses of students' financial reporting knowledge is needed for the effective and efficient utilization of this limited class time.

Thus, the purpose of this study was (1) to identify accounting majors' specific strengths and weaknesses regarding financial reporting and (2) to develop recommendations that will help accounting educators address these weaknesses. A multi-course financial reporting project containing errors and omissions was utilized for analysis of students' financial reporting knowledge. Overall, a higher percentage of students were able to identify errors and omissions on the face of the financial statements than in the financial statement notes. Additional discussions regarding the relevance of full disclosures in financial statement notes from the user perspective, and additional time devoted to required note disclosures may be useful in addressing this weakness. Furthermore, additional discussions of overall reporting requirements and reinforcement of basic concepts may be needed.

BACKGROUND LITERATURE

The accounting profession has experienced significant change during the past few years. Large, highly publicized accounting frauds have led to enhanced scrutiny of the profession and to additional regulation. The Sarbanes-Oxley Act of 2002 (SOX), which was signed into law on July 30, 2002 was enacted to address some of the accounting and corporate problems that came to light as a result of these accounting fraud cases.

The stated purpose of the SOX is "To protect investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws, and for other purposes." (U.S. Congress, H.R. 3763, 2002). The provisions of the SOX are organized into eleven titles, many of which directly affect financial accounting professionals. For example, consistent with Section 302: "Corporate Responsibility For Financial Reports," the Chief Financial and the Chief Executive officers of a Securities and Exchange Commission (SEC) reporting firm must certify the "... appropriateness of the financial statements and disclosures contained in the periodic report, and that those financial statements and disclosures fairly present, in all material respects, the operations and financial condition of the issuer." (U.S. Congress, HR 3763, 2002, 302). Furthermore, consistent with Section 401(a): "Disclosures In Periodic Reports; Disclosures Required," all required financial reports prepared consistent with Generally Accepted Accounting Principles (GAAP) must "reflect all material correcting adjustments ... that have been identified by a registered accounting firm...." (U.S. Congress, HR 3763, 2002, 401a). In addition, quarterly and annual financial reports "... shall disclose all material off-balance sheet transactions" and "other relationships" with "unconsolidated entities" that may have a material current or future effect on the financial condition of the issuer." (U.S. Congress, HR3763, 2002, 401a).

High quality financial statements and truthful and thus useful financial reporting can be achieved only if financial statements are both relevant and reliable. While SOX specifically emphasizes the objective of improving financial reporting reliability, it is not a new objective, but one that provides the foundation for financial accounting and reporting and expressly has been stipulated a quarter of a century ago in the Financial Accounting Standards Board's (FASB) conceptual framework. Specifically, Statement of Financial Accounting Concepts No. 2 "Qualitative Characteristics of Accounting Information," (SFAC 2) identified "reliability" and "relevance" as essential ingredients of useful financial statements (FASB, 1980). Reliability is defined as "The quality of information that assures that information is reasonably free from error and bias and faithfully represents what it purports to represent." (FASB, 1980, Glossary). FASB identified verifiability, representational faithfulness, and neutrality as key ingredients of reliability (FASB, 1980). Relevance is defined as "The capacity of information to make a difference in a decision..." (FASB, 1980, Glossary).

Mr. John M. Foster, former FASB member, recently stated that neutral financial reporting continues to represent one of FASB's most important issues. In addition, he also emphasized the importance of neutrality to U.S. capital markets and stated that the efficient allocation of U.S. capital market resources requires that "creditable, reliable and neutral financial information" is available (Foster, 2003).

The basic concepts and principles underlying financial accounting and reporting and the most important specific accounting rules typically are taught in intermediate accounting courses. A sound conceptual understanding of the significance and applicability of these basic concepts and principles tends to help students understand the many detailed rules dealing with specific accounting issues. For example, the full disclosure principle, which specifies that information that is important enough to influence users' decisions and judgement should be reported (Kieso et al., 2004) provides the conceptual basis for many note disclosures. Accrual of costs of good sold, bad debt expense, and warranty expense represent an application of the matching principle, which specifies that all expenses associated with the earning of revenue should be recognized in the same accounting period as the revenue (Kieso, 2004).

Future accounting professionals must be knowledgeable not only about the broad concepts that lead to high quality financial reporting, but must also be familiar with the detailed rules and regulations. In addition, accounting standards setting and thus financial accounting and reporting may change in the future and become more principles-based, with fewer specific accounting rules. The FASB has issued a proposal "Principles-Based Approach to U.S. Standard Setting" (FASB, 2002) that if adopted will lead to more principle-based accounting standards, which would reduce the existing overload of specific accounting standards and likely require more professional judgment.

Robert Herz, current chairman of FASB perceived the following potential advantages of principles-based standards: According to Mr. Herz, they may (1) allow companies and auditors to exercise professional judgement, which may enhance the professionalism, (2) lead to easier to understand accounting standards, (3) reduce opportunities to utilize "form over substance," (4) reduce the double jeopardy risk, (5) and support the convergence with the International Accounting Standards Board, which currently utilizes a principles-based approach (Herz, 2003). If this proposal is adopted, an understanding of basic concept will become more important than ever for accounting professionals. Consistent with this project, in October 2004, the FASB added a joint IASB-FASB project to its agenda to develop a common conceptual framework to its agenda (FASB, 2005).

Because accounting rules are very complex, students tend to focus on knowing how to calculate and account for certain numbers, and less on overall financial reporting requirements and note disclosures. However, proper and sufficient disclosures are just as important and notes typically convey much needed information to the financial statement user. In addition, after initially learning the basic concepts and principles, students tend to "forget" their significance to specific accounting issues. In his luncheon address at the annual meeting of the American Accounting Association, Mr. Herz stated that a goal of the FASB-IASB conceptual framework project was that "Curriculum development & teaching should focus on the conceptual framework." (Herz, 2005, 17). He also referred to the revised conceptual framework as a "better teaching tool." (Herz, 2005,16).

Furthermore, the Uniform Certified Public Accounting (CPA) Exam has changed and includes problems that require research and judgment in addition to critical/strategic thinking and good communication skills. Specifically, the new computerized CPA exam requires that students are able to research and analyze situations, statements, and standards and to solve interdisciplinary problems (AICPA, 2002). Financial reporting knowledge is necessary to accomplish this objective.

RESEARCH PURPOSE AND HYPOTHESIS DEVELOPMENT

Educators must help students prepare for the challenging accounting profession. A fundamental and comprehensive understanding of basic accounting concepts and principles, overall reporting rules, as well as detailed accounting rules is essential to enable them to participate in preparing or analyzing highly reliable and relevant financial reports. To help educators utilize the scarce time available in intermediate accounting courses, more must be known about the issues and concepts that students are very knowledgeable about, and about those that require additional instruction. The results of this study will help identify students' strengths and weaknesses in financial reporting.

Repeated application of some basic concepts and accounting issues and reporting rules will tend to reinforce the concepts, lead to deeper understanding of the issues and concepts, and will tend to improve students' ability to identify errors and omissions and the correct treatment and/or supplementation. Thus, hypothesis H1 and H2 state:

H1: Students enrolled in Intermediate Accounting II are more likely to identify overall financial reporting errors and omissions (omitted financial statement years, mathematical errors), than those enrolled in Intermediate Accounting I.

H2: Students enrolled in Intermediate Accounting II are more likely to identify specific financial reporting errors and omissions that are based on the basic financial reporting concepts, than those enrolled in Intermediate Accounting I.

RESEARCH METHODOLOGY

The researcher developed a multi-course financial reporting project that consists of financial statements and financial statement notes of realistic content and length for a consolidated entity. These financial statements and notes contain a total of 28 intentional errors and omissions relating to Intermediate Accounting I and 32 intentional errors and omissions relating to Intermediate Accounting II. Several of the items coincided in both courses. These were compared and tested in hypothesis H1 and H2. Ninety-two students enrolled in three sections of Intermediate Accounting I during the Winter and Summer 2002 quarters and 78 students enrolled in three sections of Intermediate Accounting II during the Fall and Winter 2002 quarters worked on the project for eight weeks while the related subject matter was covered in class. The students were required to assess the overall correctness, completeness, and articulation of (1) the financial statements and notes as a whole and (2) the statements and notes related to specific issues and topics covered in the particular course. Students were asked to address specific accounting issues covered in only their particular course (e.g., a detailed analysis of accounting for inventory would be required of those students enrolled in Intermediate Accounting I and not of those enrolled in Intermediate Accounting II).

A three-step approach was necessary for the students to meet the objectives of the financial reporting project; these were: (1) a review of the financial statements and notes as they are presented in the project; (2) a review of pertinent financial accounting and reporting requirements related to each specific issue; and (3) an assessment of whether the requirements are met. If the requirements were not met, identification of errors and omissions and suggestions regarding necessary changes and supplementation had to be made. These steps helped students develop and enhance their financial reporting knowledge.

During the ninth week of the quarter, students submitted a written report describing the errors and omission that they had identified and suggesting changes and additions that would correct these errors and omissions consistent with GAAP. These student project reports were utilized for this analysis. Students could choose the format for preparing their reports, but were asked to group items consistent with the sequence of course topics and utilize a concise format. Students were not required to identify all errors and omissions in order to earn a high score on the report. Correct responses were summarized and the data was evaluated utilizing descriptive statistics and two-sample t-tests.

RESULTS

Demographics

Sixty-three percent of the students were female and 37% were male. The majority of the students were juniors, with a small percentage of graduate students enrolled in the courses. Because the data was collected utilizing student project reports, no other demographics data (such as age and ethnicity) were collected. Based on past experience, approximately 60-70% of the students enrolled in Intermediate Accounting at this Western university typically work, more than half of the students tend to be of Asian ethnicity, and their age range tends to be widely dispersed.

Study Results

Tables 1 and 2 present descriptions of the financial statement errors and omissions, the specific financial reporting and accounting issues as well as the needed corrections or supplementation, the applicable accounting concepts, and the mean percentage and associated standard deviations of students who correctly identified the errors/omissions and the needed corrections and necessary supplementation. These results are discussed for each course separately. Table 1 presents study results for Intermediate Accounting I and Table 2 for Intermediate Accounting II.

Intermediate Accounting I

Students enrolled in Intermediate Accounting I could identify a total of 28 errors and omissions. The specific topics covered in Intermediate Accounting I and addressed in the project fall under the following broad topics: (The number of errors and omissions for each category are shown in parentheses). Overall financial statement completeness and integrity (3) The balance sheet (6) The income statement and retained earnings statement (13) The accounts receivable/revenue cycle (4) Inventory (2)

The mean percent of correct answers to the 28 items varied considerably between financial reporting categories and items.

Overall Financial Statement Completeness and Integrity

The students were asked to assess the overall completeness and integrity of the financial statements. The applicable accounting concepts were completeness and intra-company comparability, and reliability.

The set of financial statements, which consisted of two comparative balance sheets, two statements of cash flows, and one statement of retained earnings were incomplete. In addition, several totals or subtotals were incorrect because of incorrect classifications and statement items. Correct identification of these omissions was quite low. Only 9% of students enrolled Intermediate Accounting I identified the omissions of one comparative year for the statement of cash flows and two years of the statement of retained earnings. Fifty-six percent of the students were able to identify the mathematical errors.

Balance Sheet

On the balance sheet, five items were misclassifed within major categories and within time periods (current, non-current). In addition, one major subsection category (contributed capital) had been omitted. The mean percentage of correct identification of errors and omissions varied from 21 to 58 percent between different classification items, with the highest percentage associated with the correct classification of investment securities and the lowest associated with the classification of liabilities. Approximately half of the students noticed that the subcategory "contributed capital" was needed.

The Income Statement and Retained Earnings Statement

On the income statement, net income did not agree with the net income shown on the statement of retained earnings, violating the concept of financial statement articulation. Furthermore, five errors/omissions were related to the accounting for and disclosure of discontinued operations, violating concepts of full disclosure, relevance, articulation between statements and notes, accuracy and usefulness. In addition, two items were related to the presentation of earnings per share, violating the concepts of full disclosure and relevance. Further, the cumulative change in accounting principle was categorized incorrectly, impairing financial statement usefulness, and an income statement subcategory was omitted, impairing relevance. Furthermore, two items related to the adoption and disclosure of Statements of Financial Accounting Standards Numbers 123 and 130, impairing the concepts of reliability, relevance, materiality, and full disclosure.

Mean correct responses varied considerably. The lowest percent related to the proper adoption year for SFAS 130 (1%), the omitted disclosure of a prior year discontinued operations (5%), note and statement articulation for the discontinued operations (3%), and the articulation problem between the income and retained earnings statements (10%). The highest percentage was associated with the proper financial statement categorization for the discontinued operations (60%), the omission of an income statement subcategory (49%), and the proper categorization of the cumulative change in accounting standards (36%).

Accounts Receivable/Revenue Cycle

Of the four error/omission items two pertained to the disclosures and presentation of accounts receivables and two to accounting for and disclosure of warranty expenses. Seven percent of the students correctly identified the insufficient disclosure of the allowance method, while 18% of the students identified the incorrect presentation of net accounts receivables on the balance sheet, impairing full disclosure, materiality, and relevance. Sixteen percent identified the incorrect description of the proper timing of recognition of warranty expense that violated the matching principle and relevance. In addition, only 7% recognized that some relevant disclosures regarding warranties were omitted, violating full disclosure and relevance.

Inventory

Two items related to an omitted relevant inventory disclosure and the incorrect financial statement classification of a gain on an inventory loss, which violated the concepts of full disclosure, relevance and representational faithfulness. Fifty-one percent of the students correctly identified the misclassifed gain on the inventory loss and 10% identified the insufficient disclosures regarding the inventory costing methods.

Intermediate Accounting II

Students enrolled in Intermediate Accounting II could identify a total of 32 errors and omissions. The specific topics covered in Intermediate Accounting II and addressed in the project fall under the following broad topics: (The number of errors and omissions for each category are shown in parentheses). Overall financial statement completeness and integrity (3); The statement of cash flows (7); Accounting for investments (9); Accounting for bonds (3); Accounting for stockholders' equity (6); Accounting for property, plant, and equipment (4).

The mean percent of correct answers to the 32 items varied considerably between financial reporting categories and items.

Overall Financial Statement Completeness and Integrity

Intermediate Accounting II students were asked to assess the overall completeness and integrity of the financial statements. The applicable accounting concepts were completeness, intracompany comparability, reliability, and accuracy.

The set of financial statements, which consisted of two comparative balance sheets, two statements of cash flows, and one statement of retained earnings were incomplete. In addition, several totals or subtotals were incorrect because of incorrect classifications and statement items. Correct identification of these omissions and errors varied, with the highest percentages associated with the mathematical errors in some of the totals and subtotals. Specifically, 69% of the students identified the mathematical errors. Fifty-one percent and 30% respectively were able to identify the missing comparative cash flow statement for one of the prior years and the comparative retained earnings statement for two prior years.

The Statement of Cash Flows

In the operating section of the statement of cash flows, two reconciling items (wages payable and accounts payable) did not agree with the change reflected on the balance sheet. This error violated financial statement articulation and verifiability. Seventy-one percent were able to correctly identify the error regarding wages payable and 51% the error regarding accounts payable. In addition, the goodwill amortization was not added back as required to reconcile net income to cash from operations. This omission, which impairs financial statement reliability and accrual accounting was identified by 16% of the students.

In the investing section of the statement of cash flows, the trade-in allowance associated with the sale of property plant and equipment was omitted from the proceeds, violating the cost principle. This error was identified by 30% of the students. In addition, the total of cash from investing activities was incorrectly added, violating verifiability. This error was identified by 44% of the students.

In the cash from financing activities section, the bond proceeds did not agree with the amount of the increase shown on the balance sheet; this violated financial statement articulation, verifiability and reliability. This error was identified by 40% of the students.

Furthermore, one of the most common supplemental disclosures required under the indirect Method--the amount of taxes paid - was omitted; this omission, which was identified by 60% of the students violated the full disclosure principle and impaired the concept of relevance.

Accounting for Investments

Nine errors and omissions pertained to accounting for investments. Correct identification ranged from 9 to 57 percent. The highest percentages were associated with the proper balance sheet classification of goodwill (57%), the proper valuation of investment securities available for sale (53%), and the classification of securities held to maturity (51%). The lowest percentages were associated with three errors in the notes regarding (1) the method for calculating goodwill (11%), violating the cost principle, (2) the proper valuation of held to maturity securities (11%), and the proper valuation of business combinations that had been accounted for as a pooling of interests (9%), violating the principle of financial statement valuation.

Accounting for Bonds

Three errors and omissions relating to accounting for bonds impaired relevance, representational faithfulness, the full disclosure principle, and the articulation between the financial statements and the notes. Thirty-four percent of the students identified that the notes did not disclose sufficient information regarding the bond issue, 27% noticed that the premium shown on the balance sheet did not agree with the amount shown in the notes, and 26% recognized that the gross bonds payable and the premium must be reported together.

Accounting for Stockholders' Equity

Six errors and omissions pertained to accounting for and reporting of stockholders' equity. These errors and omissions impaired relevance, representational faithfulness, financial statement and note articulation, full disclosure, and reliability. The mean percentage of students who correctly identified these errors and omissions and the appropriate corrections and supplementations varied between 7 and 59 percent. The highest percentages correct were associated with the inconsistency between the notes and the balance sheet information regarding the additional common shares issued (59%) and the omitted deduction of the stock dividend value from retained earnings (47%). Thirty-seven percent noticed that a contributed capital subsection should be added to the balance sheet. Twenty-three percent recognized that no prior period adjustment to the retained earnings balance was necessary for an inventory error that already had counterbalanced. A relatively small percentage of the students recognized that the required statement of comprehensive income consistent with SFAS 130 (10%) and a proforma statement regarding stock options consistent with SFAS 123 (7%) had been omitted.

Accounting for Property, Plant, and Equipment

Four errors and omissions pertained to accounting for property, plant, and equipment violating the concepts of full disclosure, relevance, reliability, financial statement classification, and representational faithfulness. The mean correct responses ranged from 3 to 24 percent. Only 3% of the students noticed that gains and losses from the disposal of equipment had been treaded incorrectly as an operating income item, 14% realized that the estimated useful life of property, plant and equipment must be disclosed and 20% that the types of assets that comprise property, plant, and equipment must be disclosed. Twenty-four percent of the students noticed that organizational expense cannot be amortized and must be expensed.

Tests of Hypotheses

Hypothesis H1 tested whether students enrolled in Intermediate Accounting II were more likely to identify overall financial reporting errors and omissions (omitted financial statement years, mathematical errors), than those enrolled in Intermediate Accounting I. Both the Intermediate I and the Intermediate II students were expected to notice that one comparative year of the statement of cash flows and two comparative years of the statement of retained earnings had been omitted. Two-sample t-tests showed that a significantly higher percentage of the students enrolled in Intermediate II noticed these omissions (p<0.01) than did the students enrolled in Intermediate I. Surprisingly, students enrolled in Intermediate II were not more likely than those enrolled in Intermediate I to notice mathematical errors in the statements.

Hypotheses H2 tested whether students enrolled in Intermediate Accounting II were more likely to identify specific financial reporting errors and omissions that violate basic financial reporting concepts, than those enrolled in Intermediate Accounting I. Three items related to both Intermediate Accounting I and II. These were misclassified goodwill, an omitted contributed capital subcategory, and the separate recognition of the bond premium apart from the payable. Contrary to expectation, students enrolled in Intermediate Accounting II did not identify a significantly higher percentage of these errors than those enrolled in Intermediate I. Thus, knowledge and understanding of balance sheet classifications and the relevance of these classifications do not appear to be significantly higher for students enrolled in a more advanced course.

CONCLUSIONS AND RECOMMENDATIONS

Students' ability to recognize and correct errors and omissions varied considerably depending on the particular accounting issues and concepts. Students' knowledge tended to be stronger with respect to mathematical errors, financial statement classifications--both with respect to the distinction between current and non-current items and within financial statement categories, and omitted financial statement subcategories. Students' knowledge and understanding in both courses were weakest with respect to errors and especially omissions in financial statement notes, and disclosures relating to new or pending legislation.

The percentage of students who noticed that comparative financial statement years were omitted was disappointingly low, although a significantly higher percentage students enrolled in Intermediate Accounting II identified these omissions. Educators play a vital role in preparing accounting majors for a challenging and rewarding career.

Additional emphasis in intermediate accounting classes is needed to address these weaknesses. Students in both courses should routinely be exposed to comparative financial statements, and discussions of the importance of financial statement note disclosures should be enhanced. Furthermore, the type and detail of relevant and usefulness accounting information that users need for informed decision making should be discussed in class. This could be facilitated by utilizing short exercises or cases that require that students assume the role of investor or creditor and derive the type of information that they would perceive as relevant. This exercise could then be followed by a discussion of the required disclosures for each major accounting topic, including a discussion of how each disclosure meets the information needs of the user.

Furthermore, whenever possible, a new specific accounting topic should be related back to the fundamental accounting concepts (e.g., relevance, reliability, matching, full disclosure, articulation). This will tend to help students understand that specific accounting rules are not discrete rules, but tend to complement the basic conceptual framework. This approach will become even more useful as accounting standard setting may become more principles driven and the accounting profession continues to address environmental and regulatory changes. Students enrolled in Intermediate Accounting II were better able to identify lack of completeness (i.e., missing years) than were students enrolled in Intermediate Accounting I, but were not more likely to correctly evaluate mathematical accuracy and thus financial statement reliability.

REFERENCES

American Institute of Certified Public Accountants (2002). Uniform CPA Examination. Examination Content Specifications. Retrieved August 31, 2005 from http://www.cpaexam.org/download/CSOs%20for%20revised%20CPA%Exam.pdf.

Financial Accounting Standards Board. (1980). Statement of Financial Accounting Concepts No. 2 Qualitative Characteristics of Accounting Information: Stamford, Conn.

Financial Accounting Standards Board. (2002, October 21). Proposal "Principles-Based Approach to U.S. Standard Setting. Stamford, Conn.

Financial Accounting Standards Board. (2005). Project Updates. Principles-based Approach to U.S. Standard Setting. Retrieved September 4, 2005 from http://www.fasb.org/project/principles-based_approach_project.shtml.

Foster, J. M. (2003). The FASB and the Capital Markets. Financial Accounting Standards Board. Retrieved July 31, 2003 from http://www.fasb.org/articles&reports/Fosters_FASBReports.pdf.

Herz, R H. (2003, September) Commentary. A Year of Challenges and Change for the FASB. Accounting Horizons, 17 (3), 247-255.

Herz, R.H. (2005). The Conceptual Framework Project. 2005 FARS Luncheon. Retrieved September 3, 2005 from http://www.fasb.org/-05_AAA_FARS_Luncheon.ppt.

Kieso, D.E., J.J. Weygandt, & T.D. Warfield. (2004) Intermediate Accounting, (11th ed.) John Wiley & Sons, Inc. p. 42.

U.S. Congress. (2002). One Hundred Seventh Congress of the United States of America at the second Session. Sarbanes-Oxley Act of 2002. H.R. 3763.

Marianne L. James, California State University, Los Angeles Table 1: Intermediate Accounting I Financial Reporting and Accounting Financial Statement Error Issue/necessary (E) or Omission (O) Correction Accounting Concepts Overall Financial Statement Completeness and Integrity Cash flow statement for Three years should Completeness; one prior year is missing be presented Intra-company (O) comparability Retained earnings Three years should Completeness; statement for two prior be presented Intra-company years is missing (O) comparability Mathematical errors Incorrect Financial Financial Statement resulting from incorrect Statement totals or reliability line items or incorrect subtotals. classifications (E) The Balance Sheet Debt securities due after Debt securities due Time period one year are classified after one year or concept; financial as current (E) the operating cycle statement (whichever is classification longer) must be classified as non-current Available for sale These securities Time period concept securities expected to be should be financial statement held for more than one classified as classification year are classified as noncurrent. current (E) Goodwill is classified Goodwill must be Financial statement incorrectly (E) classified as an classification intangible asset Premium on bonds payable Premium on bonds Financial statement is listed apart from the payable must be classification; bonds payable (E) added to the gross relevance; bonds payable representational faithfulness Notes payable was paid The classifications Financial statement off during the current of liabilities; classification; year, yet it was liabilities that full disclosure; classified as non-current are expected to be relevance during prior year (E) paid off within one year or the operating cycle (whichever is longer) should be classified as current The subsection Subsections needed Financial statement "contributed capital" on a balance sheet; classifications; is missing (O) a contributed relevance capital section will help users readily differentiate between sources of funds. The Income Statement Net income on income The amount of net Financial statement statement does not agree income shown on the articulation with income shown in income statement retained earnings must agree with the statement (E) amount that is added to the retained earnings statement for the same year. The subsection "other Multiple step Relevance revenues and expense" is income statements missing (O) are organized by the sources of income. Discontinued operations Proper Financial statement are classified classifications of classifications; incorrectly and are income statement relevance listed after items; discontinued extraordinary items (E) operations must be classified after income from continuing operations and before extraordinary items Discontinued items is Financial statement Relevance listed as only one line detail provided for item (O) discontinued items: discontinued operations are broken into two items: (1) operating income from discontinued items and (2) gain or loss on disposal (actual or estimated). The tax effect on Detail provided on Relevance discontinued items was discontinued items; omitted (O) tax effect and the net amount must be disclosed. Disclosure on prior year Detailed Relevance; full discontinued operations disclosure about a disclosure was omitted (O) discontinued segment or product line must be provided. Amount shown in notes Financial statement Articulation regarding current year /note articulation. between statement discontinued item does The amount shown in and notes; accuracy not agree with income the notes must statement amount (E). agree with the amount shown on the income statement. Cumulative change in Financial statement Financial statement accounting principle is classification of classification; classified incorrectly change in usefulness (E) accounting principle. It should be the last item before net income. Earnings per share Earnings per share Full disclosure; amount is not broken down presentation: EPS relevance into all the required amounts must be components (O) broken down between EPS from continuing, discontinued, extraordinary, cumulative change in accounting principle and added to EPS from net income. Individual EPS items are Earnings per share Full disclosure; not added to EPS from net presentation relevance income (O) The retained earnings Accounting Reliability adjustment for the treatment for prior inventory misstatement is year inventory incorrect (E) error: No adjustment is made because the error has already counterbalanced Incorrect adoption year Compliance with a Reliability; full for SFAS 130 (E) new mandatory disclosure change in accounting principles: According to the effective year, the standard should have been adopted in 1998. The note regarding SFAS Consistency between Materiality; 123 stated that there was financial relevance no significant effect; statements and however, the income notes: Given the statement shows and financial position, effect of $500,000 (E) $500,000 may be significant to the entity Accounts Receivable/Revenue Cycle Notes disclose that Disclosure Relevance; full allowance method of regarding allowance disclosure estimating uncollectibles for uncollectibles: is used; the information some information concerning the percentage concerning the estimates has been percentage omitted (O) estimates is needed Notes indicate that Timing of Accrual accounting; warranties are accrued recognition of timing or expense when customer returns warranty related recognition; merchandise (E) expense: warranty relevance; matching expense must be accrued during year of sale as operating expense An estimate of warranty Estimation of Full disclosure; cost was not provided (O) future obligations recognition; related to warranty materiality; on sales: an relevance estimate of warranties must be provided The net accounts The net accounts Realizability; receivable balance was receivable balance relevance not shown on the face of must be shown on balance sheets (O) face of balance sheets Inventory The note indicates that Disclosure when Full disclosure; FIFO and LIFO inventory several GAAP relevance cost flow assumptions are inventory methods utilized; no disclosure are utilized: is provided with respect disclosure is to the type of inventory needed in respect that is carried at LIFO to the type of and what type of inventory that is inventory is carried at carried at LIFO FIFO (O) and FIFO. Gain from insurance Classification of Income statement proceeds from damaged gain from insurance classification; inventory was not proceeds -damaged representational classified as an inventory. A gain faithfulness. extraordinary item or loss from arising from insurance proceeds from damaged inventory is considered unusual and infrequent and must be classified as an extraordinary item and shown net of tax, listed between discontinued items and cumulative change in accounting. Principles Mean Percent Correct Financial Statement Error n=92 (E) or Omission (O) (SD) Overall Financial Statement Completeness and Integrity Cash flow statement for 9 one prior year is missing (28) (O) Retained earnings 9 statement for two prior (28) years is missing (O) Mathematical errors 56 resulting from incorrect (50) line items or incorrect classifications (E) The Balance Sheet Debt securities due after 58 one year are classified (50) as current (E) Available for sale 53 securities expected to be (50) held for more than one year are classified as current (E) Goodwill is classified 48 incorrectly (E) (50) Premium on bonds payable 34 is listed apart from the (48) bonds payable (E) Notes payable was paid 21 off during the current (41) year, yet it was classified as non-current during prior year (E) The subsection 49 "contributed capital" (50) is missing (O) The Income Statement Net income on income 10 statement does not agree (30) with income shown in retained earnings statement (E) The subsection "other 49 revenues and expense" is (50) missing (O) Discontinued operations 60 are classified (49) incorrectly and are listed after extraordinary items (E) Discontinued items is 24 listed as only one line (43) item (O) The tax effect on 28 discontinued items was (45) omitted (O) Disclosure on prior year 5 discontinued operations (21) was omitted (O) Amount shown in notes 3 regarding current year (17) discontinued item does not agree with income statement amount (E). Cumulative change in 36 accounting principle is (48) classified incorrectly (E) Earnings per share 30 amount is not broken down (46) into all the required components (O) Individual EPS items are 22 not added to EPS from net (41) income (O) The retained earnings 7 adjustment for the (25) inventory misstatement is incorrect (E) Incorrect adoption year 1 for SFAS 130 (E) (10 The note regarding SFAS 4 123 stated that there was (20) no significant effect; however, the income statement shows and effect of $500,000 (E) Accounts Receivable/Revenue Cycle Notes disclose that 7 allowance method of (25) estimating uncollectibles is used; the information concerning the percentage estimates has been omitted (O) Notes indicate that 16 warranties are accrued (36) when customer returns merchandise (E) An estimate of warranty 7 cost was not provided (O) (25) The net accounts 18 receivable balance was (38) not shown on the face of balance sheets (O) Inventory The note indicates that 10 FIFO and LIFO inventory (30) cost flow assumptions are utilized; no disclosure is provided with respect to the type of inventory that is carried at LIFO and what type of inventory is carried at FIFO (O) Gain from insurance 51 proceeds from damaged (50) inventory was not classified as an extraordinary item Table 2: Intermediate Accounting II Financial Reporting and Accounting Financial Statement Error Issue/necessary (E) or Omission (O) Correction Accounting Concepts Overall Financial Statement Completeness and Integrity Cash flow statement for Three years should Completeness; one prior year is missing be presented Intra-company (O) comparability Retained earnings Three years should Completeness; statement for two prior be presented Intra-company years is missing (O) comparability Mathematical errors Incorrect Financial Financial Statement resulting from incorrect Statement totals or reliability line items or incorrect subtotals classifications (E) The Statement of Cash Flows The increase in wages The effect of Verifiability; payable was shown changes in wages financial statement incorrectly as $50,000 payable on cash articulation; (E) from operations. accuracy The correct change was $80,000. The increase in accounts The effect of Verifiability, payable was shown change in accounts financial statement incorrectly (E) payable on cash articulation; from operations accuracy. must agree with the change shown in balance sheet account Cash flows from investing The effect of Verifiability; activities was calculated various investing financial statement incorrectly (E) activities on total articulation; cash from investing accuracy activities; the correct amount is 2534 The proceeds from Consistent with the Financial statement issuing bonds was notes and the and note incorrectly stated (E) increase in net articulation; bonds payable, the verifiability; amount should be reliability 5,220. The taxes paid were not Supplemental Full disclosure; disclosed (O) disclosure required relevance per SFAS 95 for the indirect method: Income tax paid must be disclosed as a supplemental disclosure to the statement of cash flows The trade-in allowance on The treatment of a Cost principle an old machine was not trade-in allowance netted against the cost in an asset of the new machine (E) exchange: the trade-in allowance must be netted against the cost of the new machine. The goodwill amortization The effect of Reliability; cash expense was not be added non-cash versus accrual in the calculation of transactions on cash from operations cash from under the indirect operations: the method (E) good-will amortization expense must be added in the calculation of cash from operations under the indirect method Investments The market value of Consistent with Fair market value available for sale SFAS 115, of financial investments is "available for instruments; incorrectly stated as sale" securities relevance 1,750,000 (E) are recognized at market value at the end of the accounting period. Some of the "held to Consistent with the Relevance; maturity" investments are information financial statement incorrectly classified as provided in the classification non-current. (E) notes, $100,000 of the held to maturity investments must be classified as non-current because they are due later than one year from the balance sheet date. The market valuation Calculation of the Reliability adjustment was calculated market value incorrectly (E) adjustment for available for sale securities The goodwill amortization Calculation of Reliability does not appear to be goodwill reasonable (E) amortization; given the information provided in the notes regarding the subsidiaries, the goodwill amortization appears incorrect The notes incorrectly The nature of Cost principle; refer to goodwill as the goodwill; goodwill intangible assets difference between cost represent the and book value (E) unidentifiable asset and is the difference between acquisition cost and fair market value of identifiable assets. The notes incorrectly Valuation of held Valuation state that "held to to maturity maturity" investments are securities. carried at fair market Consistent with value (E) SFAS 115, "held to maturity" investments are carried at amortized cost. Goodwill is not Classification of Financial statement classified as an an unidentifiable classification intangible asset (E) asset; goodwill must be classified as an intangible asset The intercompany accounts The effect of Representational receivable and accounts intercompany faithfulness. payable were not transaction on the eliminated (E) consolidated financial statements The notes state Accounting for the Valuation of assets incorrectly that goodwill excess of cost over acquired in a arises from a pooling of book values under a pooling of interests business pooling of interests business combination (E) interests method. combination. Consistent with APBO 16 (now superceded), goodwill is not associated with a pooling of interests; assets and liabilities remain at cost; the excess over cost is reflected in retained earnings and additional paid in capital. Bonds The bond premium is shown Classification of Relevance; separately from the gross premium on bonds. representational bond payable (E) The bonds premium faithfulness; net must be added to present value par to show the entire bond liability at net present value The amount of the premium The amount shown in Financial statement shown on the balance the notes must and note sheet does not agree with agree with the articulation; the amount shown in the amount shown on the reliability notes (E) balance sheet The notes regarding the Disclosure Full disclosure; bond payable are regarding bonds; relevance inadequate; the effective extensive (market) interest rate disclosure and the issue date(s), regarding and detail on associated significant bond costs are not disclosed payables are (O) required; these include the effective (market) interest rate and the issue date(s), and detail on associated costs. Stockholders' Equity The notes are incorrect Consistency between Reliability; regarding the additional financial statement articulation shares issued and are and note disclosures inconsistent with the increase shown on the balance sheet (E) The subsection Subsections needed Financial statement "contributed capital" is on a balance sheet; classifications; missing (O) a contributed relevance capital section will help users readily determine The statement of Consistent with Full disclosure; comprehensive income has SFAS 130, a relevance been omitted, yet the statement of notes indicate that the comprehensive applicable accounting income must be standard has been adopted shown. (O) According to the notes, Financial statement Reliability; a stock dividend was effect of a stock representational granted; this dividend is dividend: this faithfulness not reflected in retained dividend must be earnings (E) shown as a reduction of retained earnings The required proforma Required Full disclosure; statement, showing the disclosures for relevance effect of the market stock options: value of stock options consistent with on income, has been SFAS 123, a company omitted (O) that utilizes the intrinsic value method must provide proforma disclosures assuming the fair market value was used No prior period Effect of an error Reliability; full adjustment was needed; on subsequent disclosure the prior years should years; The error have been restated (E,O) counterbalanced; the prior year financial statements should have been restated Property, Plant and Equipment The notes state that Classification of Representational gains and losses from peripheral faithfulness; disposal were treated as activities: gains relevance; operating income (E) and losses from financial statement disposal of classification property, plant and equipment must be classified as "other income." The estimated useful life Required Full disclosure; of the depreciable assets disclosures for relevance was not disclosed (O) depreciable assets; the useful life (the period over which the assets are depreciated) must be disclosed The type of assets that Disclosures for Full disclosure, comprise property, plant property, plant and relevance and equipment was not equipment: The disclosed (O) classes of assets that comprise property, plant and equipment must be disclosed According to the notes, Accounting Reliability; organizational expense is treatment of compliance with being amortized (E) organizational GAAP costs; consistent with SOP 98-5, organizational costs are expensed as incurred Mean Percent Financial Statement Error Correct n=78 (E) or Omission (O) (SD) Overall Financial Statement Completeness and Integrity Cash flow statement for 51 one prior year is missing (50) (O) Retained earnings 30 statement for two prior (46) years is missing (O) Mathematical errors 69 resulting from incorrect (47) line items or incorrect classifications (E) The Statement of Cash Flows The increase in wages 71 payable was shown (46) incorrectly as $50,000 (E) The increase in accounts 51 payable was shown (50) incorrectly (E) Cash flows from investing 44 activities was calculated (50) incorrectly (E) The proceeds from 40 issuing bonds was (49) incorrectly stated (E) The taxes paid were not 60 disclosed (O) (49) The trade-in allowance on 30 an old machine was not (46) netted against the cost of the new machine (E) The goodwill amortization 16 expense was not be added (37) in the calculation of cash from operations under the indirect method (E) Investments The market value of 53 available for sale (50) investments is incorrectly stated as 1,750,000 (E) Some of the "held to 51 maturity" investments are (50) incorrectly classified as non-current. (E) The market valuation 14 adjustment was calculated (35) incorrectly (E) The goodwill amortization 33 does not appear to be (47) reasonable (E) The notes incorrectly 11 refer to goodwill as the (32) difference between cost and book value (E) The notes incorrectly 11 state that "held to (31) maturity" investments are carried at fair market value (E) Goodwill is not 57 classified as an (50) intangible asset (E) The intercompany accounts 24 receivable and accounts (43) payable were not eliminated (E) The notes state 9 incorrectly that goodwill (28) arises from a pooling of interests business combination (E) Bonds The bond premium is shown 26 separately from the gross (44) bond payable (E) The amount of the premium 27 shown on the balance (45) sheet does not agree with the amount shown in the notes (E) The notes regarding the 34 bond payable are (48) inadequate; the effective (market) interest rate and the issue date(s), and detail on associated costs are not disclosed (O) Stockholders' Equity The notes are incorrect 59 regarding the additional (50) shares issued and are inconsistent with the increase shown on the balance sheet (E) The subsection 37 "contributed capital" is (49) missing (O) The statement of 10 comprehensive income has (30) been omitted, yet the notes indicate that the applicable accounting standard has been adopted (O) According to the notes, 47 a stock dividend was (50) granted; this dividend is not reflected in retained earnings (E) The required proforma 7 statement, showing the (26) effect of the market value of stock options on income, has been omitted (O) No prior period 23 adjustment was needed; (42) the prior years should have been restated (E,O) Property, Plant and Equipment The notes state that 3 gains and losses from (17) disposal were treated as operating income (E) The estimated useful life 14 of the depreciable assets (35) was not disclosed (O) The type of assets that 20 comprise property, plant (41) and equipment was not disclosed (O) According to the notes, 24 organizational expense is (43) being amortized (E) Table 3: Tests of Hypothesis Hypothesis Error or Omission P-value H1 Omitted statement of cash flows 0.00 ** H1 Omitted statement of retained earnings 0.00 ** H1 Mathematical errors 0.06 H2 Misclassifed investment--held to 0.14 maturity--non-current H2 Goodwill classification 0.08 H2 Bond premium 0.36 Note: ** significant at p < 0.01.