Current financial accounting issues

- Imagine a company that compensates a key employee with first, a cash salary of $80,000. Second, a new car with a value of $30,000. And third, an option to become a 5% owner of the company at the end of three years in exchange for an investment of $200,000 at that time. - Now if the company does well in the coming three years the company will increase in value, the $200,000 price tag for 5% ownership will look like a great deal, and the employee will exercise the option. - If the company does poorly it will decline in value, the $200,000 price will be too much and the employee will just throw the option away. - The company also sells these ownership options to interested outside investors for $25,000. - Okay, so how would you summarize in one number the company's compensation expense associated with this employee? - Now we all agree to include the $110,000, $80,000 plus $30,000 compensation expense from the cash salary and the new car. - So what about the option? On the one hand, if the employee were to buy the option from the company just like any other outside investor the employee would have to pay $25,000. - And on the other hand, the option doesn't cost the company a thing. In fact, the option merely increases the probability that the employee will invest $200,000 into the company in the future. - So, should the company add the $25,000 option value to total compensation expense to be reported in the income statement? - Or should each company decide for itself whether to include the $25,000 option value as part of compensation expense? - Or, should there be an overall accounting standard followed by all companies? And if there is a standard, who sets it? - Now there are many situations in business such as the option compensation case just described in which reasonable people can disagree about how certain items should be handled for accounting purposes. - And because financial accounting information is designed to be used by people outside a company it's important that outsiders understand the rules and assumptions used by the company in constructing its financial statements. - Now a company's rules and assumptions would be extremely difficult and costly for outsiders to discover if every company formulated its own set of accounting rules. - In the United States accounting standards are set by the Financial Accounting Standards Board, the FASB. The FASB is based in Norwalk, Connecticut. - The financial accounting standards published by the FASB are called GAAP, which stands for Generally Accepted Accounting Principles. - Outside the United States almost all other countries follow the financial accounting standards established by the International Accounting Standards Board, the IASB, which is based in London. - And the standards of the IASB are called International Financial Reporting Standards, or IFRS. - IFRS? I just call them I-F-R-S. - There you go. - Now because the FASB and the IASB are not government agencies they lack the legal power to enforce the accounting standards they set. - They maintain their influence by carefully protecting their prestige and reputation for setting good accounting standards. - The FASB and IASB seek business community consensus by requesting written comments and sponsoring public hearings on all their proposed standards. - And in recent years important standards by the IASB and the FASB have addressed such topics as the following. - When a company signs a contract with a customer to deliver a set of goods and services over several years when should the company report the sale in its income statement? - When a company leases a building under a long-term lease contract should that company report the leased building as an asset in its balanced sheet? - The IASB and the FASB have created and disseminated standardized answers to these and many other financial accounting questions. - The existence of good financial accounting standards means that financial statement users around the world can read the financial statements with an assurance that the numbers have been compiled on a consistent and reasonable basis. - By the way, both the FASB and the IASB have decided that the granting of the employee ownership purchase option should be recorded as $25,000 in compensation expense.