• Provide the structure for building a set of coherent accounting standards.

• Levels:1. “Why” - Provides objectives of financial reporting 2. “Bridges levels 1 and 3” - Defines qualitative

characteristics of accounting information and the elements of financial statements

3. “How/implementation” - Explains recognition and measurement criteria

• US and IFRS similar, but are not exactly the same• Convergence project underway, not yet approved

Chapter 2Chapter 2Conceptual FrameworksConceptual Frameworks

General Conceptual General Conceptual Framework Framework

Per SFAC 1-2, 4-7• Provide information that is

useful to those making investment & credit decisions.

• Helpful to present and potential investors, creditor and other users in assessing the amounts, timing and uncertainty of future cash flows; and

• About economic resources, the claims to those resources and the changes in them.

Per IASB Framework (April 1989)• The objective of f/s’s is to provide

information about the financial position, performance and changes in financial position of an entity that is useful to a wide range of users in making economic decisions.

• Users are present & potential investors, employees, lenders, suppliers & other trade creditors, customers, gov’ts & their agencies & the general public.

IFRSUS GAAP

Level 1: Level 1: Objectives of Financial Objectives of Financial

ReportingReporting

U.S. Conceptual Framework U.S. Conceptual Framework Level 2: Hierarchy of Qualitative Level 2: Hierarchy of Qualitative

CharacteristicsCharacteristics

Primary characteristics• Relevance

– Predictive value– Feedback value– Timeliness

• Reliability– Verifiability– Representational

faithfulness– Neutrality

Secondary Characteristics

• Comparability• Consistency

UnderstandabilityRelevance• Predictive value• Confirmatory value• Materiality

Reliability• Faithful representation• Substance over form• Neutrality • Prudence• Completeness

Comparability

IFRSUS GAAP

Level 2: Level 2: Qualitative Qualitative

CharacteristicsCharacteristics

Example: Suppose a biotech firm spends $1,000,000 on research and development expenditures. How could the firm record the expenditures? CR Cash

DR Expense?

DR R&D Asset?

For each alternative consider: What is the relevance/reliability tradeoff?

How can the treatment be theoretically supported?

Does US or IFRS allow?

Relevance and Reliability – Relevance and Reliability – Tradeoff Example Tradeoff Example

Constraints• Cost/Benefit• Materiality• Industry Practices• Conservatism

Constraints on relevant & reliable info

• Timeliness• Balance between benefit and

cost• Balance between qualitative

characteristics

IFRSUS GAAP

Level 2: Level 2: Qualitative Qualitative

Characteristics con’tCharacteristics con’t

Scumbag Corp. pays a bonus to the CFO of $10,000 if the company earns net income over $1 million in any given year. – Draft f/s for 2004 show net income of $1.5 million dollars– However, the CFO argues that slowing sales indicate that

inventory may be overvalued, and advocates the following journal entry:

Dr. Cost of Goods Sold (overvalued goods) 400,000 Cr. Inventory 400,000– What would this entry do? Cause COGS to be 400K lower

in following year• Sometimes this practice is called the “cookie jar”

– What if projected net income in 2005 was $800,000 (before this journal entry was made)?

How to Cheat with Conservatism

AssetsLiabilitiesEquityInvestment by OwnersDistributions to OwnersComprehensive IncomeRevenuesExpensesGainsLosses

AssetLiabilitiesEquity

IncomeExpensesCapital Maintenance • result from revaluation of

assets and liabilities

IFRSUS GAAP

Level 2: Level 2: Elements of Financial Elements of Financial

StatementsStatements

(a) Arises from peripheral or incidental transactions.

(b) Obligation to transfer resources arising from a past transaction.

(c) Increases ownership interest.

(d) Declares and pays cash dividends to owners.

(e) Increases in net assets in a period from nonowner sources.

(f) Items characterized by future economic benefit.

(g) Equals increase in net assets during the year, after adding distributions to owners and subtracting investments by owners.

(h) Arises from income statement activities that constitute the entity’s ongoing major or central operations.

(i) Residual interest in the net assets of the enterprise.

(j) Increases assets through sale of product.

(k) Decreases assets by purchasing the company’s own stock.

(l) Changes in equity during the period, except those from investments by owners and distributions to owners.

Element Definitions Element Definitions

Assumptions• Economic Entity• Going concern• Monetary Unit• PeriodicityPrinciples• Measurement

– Historical Cost– Fair value

• Revenue Recognition• Expense Recognition• Full disclosure

Underlying Assumptions• Accrual Basis• Going concern

Principles• Measurement

– Historical cost– Current cost– Realizable value– Fair value

• Revenue Recognition• Expense Recognition• Full disclosure

IFRSUS GAAP

Level 3: Basic Assumptions, Level 3: Basic Assumptions, PrinciplesPrinciples

Measurement: Consider this example under US GAAP and IFRS.

If a firm bought land in 1950 for $10K and still owned it in 2009, would it appear on the 2009 financial statements at $10K even if it is now worth $1 million?

How is your answer justified by the conceptual framework?

Level 3: Level 3: PrinciplesPrinciples

Revenue Recognition – Criteria Earned – seller substantially completed what it must do to be

entitled to keep resources received from the transaction. Realized or realizable –buyer provided resources or resources

to be received are readily convertible to some other asset.

Revenue is generally at the point of sale. Exceptions:(1) During production – long term construction contracts (%

Completion Method)(2) End of production – when ready market at quoted price exists

(mining and agriculture)(3) Upon receipt of cash – when collections uncertain at time of sale

(Installment sales method)

Level 3: Level 3: PrinciplesPrinciples

Matching Idea: Record expense in same period as the

revenue it helped generate.

To do: Determine revenue recognition

Choices to match expenses Direct (COGS)

Rational allocation (rent)

Immediate

Level 3: Level 3: PrinciplesPrinciples

Full Disclosure –Nature and amount of information included in financial reports reflects a series of judgmental trade-offs (between providing sufficient detail and keeping information understandable).

Financial statements

Notes to financial statements

Supplementary information

Level 3: Level 3: PrinciplesPrinciples

Level 3 Principles - Full Level 3 Principles - Full DisclosureDisclosure

Readings: “Study Pursuant to Section 108(d) of the Sarbanes-Oxley

Act of 2002 on…Principles-Based Accounting System” Kapnick (1974) and Wyatt (2004)

Questions: What is meant by principles vs. rules based accounting?

Why did Congress want this examined?

What are the benefits and concerns with principles based accounting?

Are judgment and professional ethics more or less important under principles based accounting?

Professional Ethics and Professional Ethics and Principles Based Principles Based

AccountingAccounting