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

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.
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Author:James, Marianne L.
Publication:Academy of Educational Leadership Journal
Geographic Code:1USA
Date:Sep 1, 2006
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