- 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.