Chapter 4 Synopsis

Financial Accounting and the Structure of Accounting Regulation

    Modern capital markets depend on an abundance of financial information readily available on the internet and many other sources. Annual and quarterly reports, 10-Ks, prospectuses and other information provides certain finds of information that is highly regulated. Financial information of public companies is subject to Secirities and Exchange Commission (SEC) and Financial Accountind Standards Board (FASB), and other bodies. This information is considered the most complete and most reliable in the world. How this come about? And how good is this information anyway?

Early Financial Reporting

    Until the 19th century, firms were small and raised money from partnerships, short-term bank loans, or profits. New industries from the early 19th century including canals, railroads, and utilities needed large amounts of capital from private sources. English and American organized exchanges provide the mechanisms for the needed cash. Parliament regulated business and capital markets through British Companies Acts. American regulations were based on state laws, which were not particularly effective.

    The earliest American exchanges, the New York Stock Exchange and the Philadelphia Stock Exchange were founded in the late 18th century. They provided some of the capital for canals and railroads as they became chartered. The new companies typically presented annual reports, which could include financial statements. By the mid 1800s, statements of cash and balance sheets were relatively common and, occasionally, income statements in some form were presented. There was little regulation beyond the demands of investors for information. The need for financial audits became more common by the end of the 19th century.

The Need for Regulation

    Around the turn of the century, American overtook Britain as the leading industrial power in the world, after a century of unrestricted capitalism. Financiers provided the capital to establish large corporations and combinations and , as demonstrated by J. P. Morgan, maintained substantial power over industires. Insiders benefitted from price fixing, stock manipulation, and various schemes of questionable legality. Accountants usually aided managers and speculators. Mergers, cutthroat competitions, railraod rebates, and bribery were some of the techniques used by business. Beginning with Standard Oil, the trust was used to acquire businesses across state lines. By 1890 300 trusts controlled 5,000 companies. By 1900 the largest dozen trusts had capital of over $1 billion. The investment bankers becam directors (78 companies at J. P. Morgan). The companies needed capital, the bankers claimed to represent the bond holders.

    Government regualtion was demanded by the public, often subject to monopoly pricing and various preditory practices. States were generally unsuccessful. Federal regulations began with the Interstate Commerce Commission (ICC) Act of 1887 to regulated railroads. Federal antitrust began with the Sherman Act of 1890. Following the panic of 1907, the U. S. experienced a decade of reform legislation. The Clayton Act of 1913 prohibited interlocking directorships, the Federal Reserve was established the next year, as was the Federal Trade Commission (FTC).

   Disclosure of financial information was voluntary. During the 19th and early 20th century the balance sheet was paramount.  The income statement was neglected because it was open to abuse (no accounting standard regulations existed) and the concept of earnings power had to wait to the post-World War I period. At the turn of the century the stock exchanges were dominated by the railroad industry (60% of NYSE firms at 1900, for example). They were considered safe investments because they paid fairly consistent dividends--and ignoring bankruptcies which did occur in this industry.  Industrial firms did catch on in the 1920s (44% of NYSE firms in 1920) and the income statement became more important as industrials tended to pay dividends based on earnings.

    Unfortunately, the Roaring Twenties also was a time of rampent speculation, with securites bought on credit and with little regard to underlying earnings power. Until 1910 the NYSE had an "unlisted department" for firms that disclosed no financial information. Although 90% of NYSE firms had audits in some form by 1926, audited financial statements were not required until 1933--when stock prices stood at 10% of 1929 highs. Insider trading was common and not illegal. "Preferred list" sales of new securities at discounted prices were made before the issues went public. Syndicated stock pools manipulated stock prices--at least 100 NYSE stocks were openly rigged in the 1920s.

    Before the Great Depression, regulations existed. The above-mentioned federal laws, state Blue Sky Laws on securities regulation, and so on. Companies issued prospectuses that typcially audited financial statements and attorney review. However, these were not very effective. Lawyers, auditors, and brokers worked for the companies, not the potential investors. State laws were ineffective for regulating interstate commerce. The federal laws were still inadequate.

The Great Crash and Government Response

    The U. S. economy was in recession by the summer of 1929. Then stock prices plunged, first on October 24 and then on October 29, Black Tuesday, the biggest drop for the NYSE in its history. From a high of 386 in the autumn of 1929 the Dow Jones average fell to 220. It continued to tumbe, eventually to 41 in 1933. The regulators panicked. The federal reserve cut back the money supple, turning a recession and stock panic into a major depression. From 1929 until 1932 11,000 banks failed, gross national product fell about 10% a year, steel production dwindled to 12% of capacity, and the unemployment rate hit 25%. The Hawley-Smoot Tariff Act dramatically increased tariffs, with effect being to limit world trade--which effectively made this a global depression.

    Franklin D. Roosevelt was President Hoover's opponent in 1932, promising a New Deal. He won in a landslide and delivered. During the first 100 days a remarkable amount of legislation was passed (some of it a holdover from the Hoover administration). The Glass-Steagall Act separated commercial from investment banking (but overturned at the turn of the millenium) and created the Federal Deposit Insurance Corporation to insure bank deposits; the Social Security Act established retirement and disability pensions funded with payroll taxes.

    New Deal legislation led to federal responsibility for protecting investors from malpractice in the investment markets with the Securities Act of 1933. The Act was modeled on state regulations, British Companies Acts, and earlier Congressional legislation. The Securities and Exchange Commission (SEC) Act of 1934 created the SEC to administor the legislation. The Securities Acts required  companies to present registration statements with new public offerings of stocks, bonds, and other securities, to make "full and fair" disclosure of financial information. Information relevant to the "prudent investor" was to be disclosed in the registration statement. Antifraud and liability regulations increased the legal responsibilities of accountants, who became liable to  the public as well as the management of the firms audited.

    Modern financial reporting and the development of generally accepted accounting principles (GAAP) started with this federal legislation. The SEC has the authority to regulate accounting. This was delegated to the private sector and the American Institute of Accountants (AIA--later the American Institute of Certified Public Accountants or AICPA) gave the Committee on Accounting Procedure (CAP) responsibility to issue accounting standards in 1938. The CAP's standards were called Accounting Research Bulletins (ARBs) and from 1938-1959 51 ARBs were issued. Few ARBs are still in effect, but the basic structure of financial accounting has not changed much from these initial standards. Both the accounting profession and the financial community critized the CAP and this was replaced by the Accounting Principles Board (APB) in 1959. This was another AICPA committee and had many of the same problems. The APB would issue 31 Opinions until they were superceded in 1973.

The Financial Accounting Standards Board 

    In 1971 the AICPA appointed the Wheat Commission to examine the standard setting structure. The Commission recommended a framework to establish the Financial Accounting Standards Board (FASB), which was adopted. FASB was established in 1973 to be an independent body with a full time board, a research staff, and full due process to allow public input into the process. To achieve this goal, the FASB has a complex structure. The Financial Accounting Foundation (FAF) is the oversight body and provides financial support (through donations from various accounting and business organizations). The FAF also appoints member of the Financial Accounting Standards Advisory Committee (FASAC). Beginning in 1984 an Emerging Issues Task Force (EITF) provides advice to the FASB on new area and technical issues. Also in 1984 the Government Accounting Standards Board (GASB) was established in the FAF to issue standards for state and local governments, with a structure similar to the FASB.

    The seven members of the FASB are appointed by the FAF for a five-year term and can be reappointed for one additional term. The Board has a Director of Research and a staff of about 40 professionals. The Board's mission is "to establish and improve standards of financial accounting and reporting for the guidance and education of the public..." (Facts About FASB, p. 1). The FASB's Rules of Procedure require extensive due process.
 
 

Back to Accounting History Page