FINANCIAL ACCOUNTING

RICHARD G. SCHROEDER MYRTLE W. CLARK JACK M. CATHEY

THEORY AND ANALYSIS:

TEXT AND CASES11TH EDITION

Chapter 2

The Pursuit of the Conceptual Framework

Introduction What is the conceptual framework?

An attempt by the FASB to develop concepts useful in guiding the Board in establishing standards and in providing a frame of reference for resolving accounting issues

The Early Theorists Paton

All changes in the value of assets and liabilities should be reflected in the financial statements, and that such changes should be measured on a current value basis. Also, basic assumptions or postulates underlying the accounting process

Canning Suggested a framework for asset valuations and

measurement based on future expectations as well as a model to match revenues and expenses.

IntroductionDR Scott and his conceptual framework

Was viewed as an outsider; however, his writings have proven to be quite insightful.

Heavily influenced by the views of his colleague, the economist and philosopher Thorstein Veblen.

Believed the industrial revolution caused managers to look for new methods of maintaining organizational control. As a result, scientific methods such as accounting and statistics became organizational control tools.

Need for a normative theory of accounting

The Basis for Accounting Principles Orientation Postulate

Accounting is based on a broad consideration of the current social, political, and economic environment.

The Pervasive Principle of Justice The second level in Scott’s conceptual framework was justice, which was

seen as developing accounting rules that offer equitable treatment to all users of financial statements.

The Principles of Truth and Fairness Truth was seen as an accurate portrayal of the information presented.

Fairness was viewed as containing the attributes of objectivity, freedom from bias, and impartiality.

The Principles of Adaptability and Consistency Adaptability was viewed as necessary because society and economic

conditions change; consequently, accounting must also change. However, need to balance adaptability with consistency by stating that accounting rules should not be changed to serve the temporary purposes of management.

Ahead of his time

Early Authoritative and Semi-authoritative Organizational Attempts to Develop the Conceptual Framework of Accounting Goal was to provide guidance to

the SEC. Widely criticized by academics

as relying too heavily on the historic cost model and the convention of conservatism.

Highlighted the distinction between the current operating performance and all-inclusive concepts of income.

A Tentative

Statement of

Accounting

Principles

Affecting

Corporate

Reports

Early Authoritative and Semi-authoritative Organizational Attempts to Develop the Conceptual Framework of Accounting

Goal was to provide guidance to the SEC on the best accounting practices

Study did not accomplish its objective because it was viewed as a defense of accepted practices rather than an attempt to develop a theory of accounting

A Statement of

Accounting

Principles

Early Authoritative and Semi-authoritative Organizational Attempts to Develop the Conceptual Framework of Accounting AAA benchmark study by Paton

and A. C. Littleton. Continued to embrace the use of

historical cost. Major contribution was the further

articulation of the entity theory. Also described the matching

concept. Later cited as developing a

theory that has been used in many subsequent authoritative pronouncements

An

Introduction

to Corporate

Accounting

Standards

The CAP and the Conceptual Framework Standard-setting bodies initially reluctant to deal with the issue of accounting theory.

At its inception, the Committee on Accounting Procedure (CAP) had considered developing a comprehensive set of accounting principles.

Dropped the idea because of the belief that the SEC might not be patient enough to allow the CAP enough time to develop the project and, as a consequence, might decide to develop its own accounting standards.

The CAP and the Conceptual Framework

Proposed the establishment of the Accounting Principles Board (APB) to replace the CAP.

Also proposed the establishment of a research division to assist the APB.

The Special Committee on Research Programs established to review and make recommendations on the AICPA’s role in establishing accounting principles.

The APB and the Conceptual Framework Committee’s first charge to the APB’s

research division was to commission studies on the postulates and principles that would serve as the foundation for future authoritative pronouncements.

This can be viewed as the first real attempt to establish a conceptual framework of accounting by an authoritative body.

The AICPA accepted the committee’s recommendations and in 1959, the APB replaced the CAP. Postulates study Research study

ARS No. 1 (1961)The Basic Postulates of Accounting

Hierarchy of postulates Group A: Economic and Political

Based on the economic and political environment in which accounting exists.

Represent descriptions of those aspects of the environment were presumed to be relevant for accounting

Group B: Accounting Focuses on the field of accounting. Designed to act as a foundation and assist in constructing

accounting principles. Group C: Imperatives

Differs fundamentally from the first two groups. Not primarily descriptive statements; instead, they represent a set of

normative statements of what should be rather than statements of what is. Disastrous outcome

Early Authoritative and Semi-authoritative Organizational Attempts to Develop the Conceptual Framework of Accounting

ARS No. 31962

APB Statement

No. 4

ASOBAT1966

Use of current values

Definition of accounting

Information system involving communication

Description of current practice

Departure from SEC’s advocacy

of historical

cost

Not GAAP

Sophistication of users

Economic incomeDecision

Usefulness

Standards for evaluating: relevance, verifiability, freedom from bias,

quantifiability

The Trueblood Committee

1. Who needs financial statements?

2. What information do they need?

3. How much of the needed information can be provided by accountants?

4. What framework is needed to provide the needed information?

The Trueblood Committee

Committee report specified the following four information needs of users:

1. Making decisions concerning the use of limited resources2. Effectively directing and controlling organizations3. Maintaining and reporting on the custodianship of resources4. Facilitating social functions and controls

Objectives of financial reporting Difficulty in finding agreement and therefore answers Viewed as first step

Statement on Accounting Theory and Theory Acceptance

Rationale for the committee’s approach Fundamental changes since ASOBAT No one theory exists

The approaches to accounting theory were condensed into

1. Classical-deductive and disconnected2. Decision Usefulness-usefulness is a basic

objective3. Information Economics- specify information

necessary to make economic decisions Criticisms of the approaches to theory

Statement on Accounting Theory and Theory Acceptance Committee suggested that the process of theorizing in accounting was

more revolutionary than evolutionary and turned to a perspective developed by Kuhn.

He suggests scientific progress proceeds in the following order:1. Acceptance of a paradigm2. Working with that paradigm by doing normal science3. Becoming dissatisfied with that paradigm4. Searching for a new paradigm5. Accepting a new paradigm

SATTA suggested that accounting theory at that time was in step 3 of this process because a number of theorists had become dissatisfied with the matching approach to specifying the content of financial reports.

SATTA

The FASB’s Conceptual Framework Project

The objectives identify the goals and purposes of financial accounting; whereas, the fundamentals are the underlying concepts that help achieve those objectives.

These concepts are designed to provide guidance in:1. Selecting the transactions, events and circumstances to be

accounted for2. Determining how the selected transactions, events, and

transactions should be measured3. Determining how to summarize and report the results of events,

transactions and circumstances.

The Conceptual Framework The FASB originally developed six SFACs In 2010 SFAC No’s 1 & 2 were replaced by

SFAC No. 8 Figure 2.1 provides an overview of the

FASB's conceptual framework for financial accounting and reporting.

The Conceptual Framework for Financial Accounting and Reporting

OBJECTIVESFAC No. 8

FUNDAMENTALS

SFAC No. 6RevenueExpense

GainLossAsset

LiabilityEquity

ELEMENTS

SFAC No’s. 5 & 8Relevance

Faithful Representation

QUALITATIVECHARACTERISTICS

IMPLEMENTATIONGUIDELINES

RECOGNITION, MEASUREMENT AND DISCLOSURE CONCEPTS

ASSUMPTIONS

Economic Entity

Going ConcernMonetary Unit

Periodicity

PRINCIPLES

MeasurementRevenue RecognitionExpense Recognition

Full Disclosure

CONSTRAINTS

CostIndustry Practices

OBJECTIVES

Conceptual Framework

Level 1: identifies the objective of financial reporting—that is, the purpose of financial reporting.

Level 2: outlines the fundamentals which are the qualitative characteristics that make accounting information useful and the

elements of financial statements (assets, liabilities, etc.)

Level 3: identifies the implementation guidelines of recognition, measurement, and disclosure used in establishing and applying

accounting standards and the specific concepts to put into practice the objective. These guidelines include the assumptions,

principles, and constraints that describe the present reporting environment.

Statement of Financial Accounting Standards No. 8Chapter 1

Objective of general‐purpose financial reporting Provide financial information about the reporting

entity that is useful to present and potential equity investors, lenders, and other creditors in making decisions about providing resources to the entity.

Decisions involve buying, selling, or holding equity and debt instruments, and providing or settling loans and other forms of credit.

Information that is decision‐useful to capital providers may also be useful to other users of financial reporting, who are not capital providers.

Statement of Financial Accounting Standards No. 8 Criticism

Young criticized FASB’s viewpoint that financial statement users are “rational decision-makers” Other types of information that might

be useful to other groups are omitted Accounting standard-setters fail to

contact actual users of information

Statement of Financial Accounting Standards No. 8 Chapter 1

The objective of financial reporting is foundation of the conceptual framework. Other aspects of the framework—qualitative

characteristics, elements of financial statements, recognition, measurement, and disclosure—flow logically from the objective.

Those aspects of the framework help to ensure that financial reporting achieves its objective.

Statement of Financial Accounting Standards No. 8 Chapter 1 The second level of the CFP contains the

fundamental concepts. Provide

Conceptual building blocks Include the qualitative characteristics

of accounting information and the elements of financial statements.

Statement of Financial Accounting Standards No. 8 Chapter 3 Identifies the qualitative characteristics of

accounting information that distinguish better (more useful) information from inferior (less useful) information for decision‐making purposes.

These characteristics may be viewed as a hierarchy

Capital Providers (Investors and Creditors) and their characteristics

Primary Users of Accounting Information

Pervasive Constraint

Fundamental qualities

Ingredients of Fundamental qualities

Enhancing qualities

Confirmatory value

Cost

Relevance Faithful Representation

Materiality

Comparability

Predictive value

Completeness Freefromerror

Neutrality

Verifiability Timeliness Understandability

Primary Users of Financial Information Existing or potential investors, lenders and

other creditors Its capital providers

SFAS No. 8: Cost Constraint

Cost is described as a pervasive constraint on the information that can be provided by financial reporting.

The measurement, summarization, and reporting of financial information imposes costs, and it is important that those costs are justified by the benefits of reporting that information.

SFAS No. 8: Cost Constraint This type of analysis is made on several levels. Companies must decide whether the benefits of

providing financial information outweigh the costs involved in collecting, processing, verifying, and disseminating that information.

Users of financial information must decide whether the benefits of analyzing and interpreting the information provided outweigh their costs.

Regulators must assess whether the benefits of reporting particular information are likely to justify the costs incurred to provide and use that information.

This is termed cost-benefit analysis

SFAS No. 8: Qualitative Characteristics Distinguishing between better (more useful)

information from inferior (less useful) information. These qualitative characteristics

Either fundamental or enhancing characteristics Depending on how they affect the decision‐usefulness

of information. The two fundamental qualities that make

accounting information useful for decision‐making 1. relevance and 2. faithful representation.

SFAS No. 8: Relevance Relevant financial information is capable of

making a difference in the decisions made by users.

Financial information is capable of making a difference in decisions if it has: Predictive value: it can be used as an input to

processes employed by users to predict future outcomes.

Confirmatory value: it provides feedback (confirms or changes) about previous evaluations.

Materiality: if omitting it or misstating it could influence decisions that users make on the basis of the financial information of a specific reporting entity.

To be useful, financial information Must represent relevant phenomena Must faithfully represent the phenomena that it purports to

represent. A perfectly faithful representation has three

characteristics: 1. Completeness2. Neutrality3. Free from error.

SFAS No. 8: Faithful Representation Financial reports represent economic phenomena in words and numbers.

Free from error There are no errors or omissions in the description of the phenomenon Process used to produce the reported information has been selected

and applied with no errors in the process. Information that is free from error will result in a more faithful

representation of financial results.

A neutral depiction Without bias in the selection or presentation of

financial information. Not slanted, weighted, emphasized,

deemphasized, or otherwise manipulated to increase the probability that financial information will be received favorably or unfavorably by users.

A complete depiction should include all information necessary for a user to understand the phenomenon being depicted.

SFAS No. 8: Faithful Representation

SFAS No. 8: Enhancing Qualities Qualitative characteristics enhance the usefulness of

information that is relevant and faithfully represented. Comparability is the qualitative characteristic that enables

users to identify and understand similarities in, and differences among, items.

Verifiability helps assure users that information faithfully represents the economic phenomena it purports to represent. Different knowledgeable and independent observers could reach

consensus, although not necessarily complete agreement A particular depiction is a faithful representation.

Timeliness means having information available to decision makers in time to be capable of influencing their decisions.

Understandability involves classifying, characterizing, and presenting information clearly and concisely.

Three additional phases of the CPF are currently inactive1. The reporting entity2. Measurement3. Elements and recognition phases.

The FASB has determined that because of the priority placed on other projects, it cannot devote the time necessary to properly address those issues in the near future.

May, 2012: The IASB announced that it will resume deliberations on the CFP as an IASB-run project, that is, no longer a joint project with the FASB.

Additional Phases

No. 5 “Recognition and Measurement in Financial Statements of Business Enterprises”

Sets forth recognition criteria and guidance on what information should be incorporated into financial statements and when this information should be reported

Defined comprehensive income as:Revenues EarningsLess: Expenses Plus or minus cumulative

accounting adjustmentsPlus: Gains Plus or minus other

non-owner changes in equityLess: Losses= Earnings = Comprehensive Income

No. 5 “Recognition and Measurement in Financial Statements of Business Enterprises” Measurement Issues1. Definitions.

The item meets the definition of an element contained in SFAC No. 6.

2. Measurability. It has a relevant attribute measurable with sufficient

reliability.3. Relevance.

The information about the item is capable of making a difference in user decisions.

4. Reliability. The information is representationally faithful, verifiable, and

neutral.

SFAC No. 5 Gaps

Failure to define “earnings” No resolution on debate of current value vs

historical cost

No. 6 “The Elements of Financial Statements”

Defines the ten elements of financial statements that are used to measure the performance and position of economic entities

These elements are discussed in more depth in Chapters 5 and 6.

How should present value amortizations be used when the estimates of cash flows change?

How should the estimates of cash flows and interest rates be developed?

Does the measurement of liabilities at present value differ from the measurement of assets?

SFAC No. 7 “Using Cash Flow Information and Present Value in Accounting Measurements”

Accounting measurement is a very broad topic. Consequently, the FASB focused on a series of questions relevant to

measurement and amortization conventions that employ present value techniques. Among these questions are:

What are the objectives of using present value in the initial recognition of assets and liabilities? And, do these objectives differ in subsequent fresh-start measurements of assets and liabilities?

What are the objectives of present value when used in conjunction with the amortization of assets and liabilities?

Purpose is to capture economic difference between sets of future cash flows.Present value measurements that fully captures the economic differences

between assets should include the following elements:

SFAC No. 7 “Using Cash Flow Information and Present Value in Accounting Measurements”

1. An estimate of the future cash flows

2. Expectations about variations in the timing of those cash flows

3. The time value of money represented by the risk-free rate of interest

4. The price for bearing the uncertainty

5. Other, sometimes unidentifiable, factors including illiquidity and market imperfections

Approaches to present value1. Traditional-Single cash flow single interest

rate2. Expected cash flow range

SFAC No. 7 “Using Cash Flow Information and Present Value in Accounting Measurements”

Incorporating probabilities The objective is to estimate the value of the assets

required currently to settle the liability with the holder or transfer the liability to an entity with a comparable credit standing

Use of the interest method

Principles Based vs. Rules Based Accounting Standards

Continuum ranging from highly rigid standards on one end

to general definitions of economics-based concepts on the other end.

Previous practice: Goodwill is to be amortized over a 40 life until it is fully amortized.

Example: Goodwill

New FASB rule: Goodwill is not amortized. Any recorded goodwill is to be tested for impairment and written

down to its current fair value on an annual basis.

Principles-Based

Better able to cope with speed of change of business environment

Less Voluminous Encourages use of

professional judgment with focus on what is right

Seen as possibly discouraging financial engineering

Rules-Based

More workable in large, complex economies & countries

Less room for interpretation

Provides more guidance for practical implementation

Less need for explanation in financial statements

FASB Questions

1. Do you support the Board’s proposal for a principles-based approach to U. S. standard setting?

Will that approach improve the quality and transparency of U. S. financial accounting and reporting?

2. Should the Board develop an overall reporting framework as in IAS 1?If so, should that framework include a true and fair override?

3. Under what circumstances should interpretive and implementation guidance be provided under a principles-based approach to U.S. standard setting?

Should the Board be the primary standard setter responsible for providing that guidance?4. Will preparers, auditors, the SEC, investors, creditors, and other users of financial

information be able to adjust to a principles-based approach to U.S. standard setting? If not, what needs to be done and by whom?

5. What other factors should the Board consider in assessing the extent to which it should adopt a principles-based approach to U.S. standard setting?

6. What are the benefits and costs (including transition costs) of adopting a principles-based approach to U.S. standard setting?

How might those benefits and costs be quantified?

Principles Based vs. Rules Based Accounting Standards

The AAA’s position Wrong question Economic substance, not form

Dissenting opinion US standards also include rules-based elements

Further developments

2003 SEC study submitted to Congress Included recommendations to FASB

2004 FASB response to recommendations1. Issuing Objectives-Oriented Standards2. Conceptual Framework3. One U.S. Standard Setter4. GAAP Hierarchy5. Access to Authoritative Literature6. Comprehensive Review of Literature

International Convergence

Norwalk Agreement September 18, 2002 FASB & IASB

pledgedAchieve compatibilityMaintain compatibility

3 Major aspects:1. Financial Statements Presentation Project2. Conceptual Framework Project3. Standards Update Project

FASB-IASB Financial Statement Presentation Project Establish common standard Goals

Understand past and present financial positionUnderstand changes and causes of changesEvaluate future cash flows

FASB-IASB Financial Statement Presentation Project 3 Phases

A. What constitutes complete set of statements?B. Fundamental issues for presentation of

informationC. Presentation of interim financial information in

U.S. GAAP

Further Developments

February 2006 Memorandum of Understanding (MOU)

Shared objective: develop high-quality, common accounting standards

“Road map” for elimination of reconciliation requirements

Develop new common standards rather than eliminate differences

Convergence

1. Boards to reach conclusion on major differences in focused areas• 2008 goal

2. FASB & IASB seek to make continued progress in other areas

November 2009 Progress Report

Milestone targets for each project Commitment to reporting quarterly on

progress Make reports available on web

Host monthly joint board meetings

FASB & IFRS Statements

4 New SFASs SFAS No. 151 (Superseded) SFAS No. 153 (Superseded) SFAS No. 154 SFAS No. 163

SFAS No. 141 revised IASB new standards on borrowing costs &

segment reporting

Phase B principles

Financial statement presentation1. Cohesive financial picture2. Financing activities separated3. Liquidity of assets & liabilities4. Disaggregate line items5. Understand

Measurement of assets & liabilities Uncertainty & subjectivity Causes of changes in assets & liabilities

Financial Statements

Comprehensive Income Financial Position Cash Flows

Each statement to contain 2 primary section:1. Business

Operating Investing

2. Financing Debt Equity

Conceptual Framework Project8 phases

1. Objectives and qualitative characteristics2. Definitions of elements, recognition and

derecognition3. Measurement4. Reporting entity concept5. Boundaries of financial reporting, and

presentation and disclosure6. Purpose and status of framework7. Application of framework to not-for-profit entities8. Remaining issues, if any

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Prepared by Kathryn Yarbrough, MBA

End of Chapter 2