RICHARD G SCHROEDER MYRTLE W CLARK JACK M CATHEY THEORY AND ANALYSIS TEXT AND CASES 11 TH EDITION Chapter 2 The Pursuit of the Conceptual Framework Introduction What is the conceptual framework ID: 461218
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FINANCIAL ACCOUNTING
RICHARD G. SCHROEDER MYRTLE W. CLARK JACK M. CATHEY
THEORY AND ANALYSIS: TEXT AND CASES11TH EDITIONSlide2
Chapter 2
The Pursuit of the Conceptual FrameworkSlide3
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 TheoristsPaton 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 processCanning
Suggested a framework for asset valuations and measurement based on future expectations as well as a model to match revenues and expenses.Slide4
Introduction
DR 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 accountingSlide5
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 timeSlide6
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 ReportsSlide7
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 accountingA Statement of Accounting PrinciplesSlide8
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 StandardsSlide9
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. Slide10
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.Slide11
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 studySlide12
ARS No. 1 (1961)
The Basic Postulates of AccountingHierarchy of postulatesGroup A: Economic and PoliticalBased on the economic and political environment in which accounting exists.
Represent descriptions of those aspects of the environment were presumed to be relevant for accountingGroup B: AccountingFocuses on the field of accounting. Designed to act as a foundation and assist in constructing accounting principles.Group C: ImperativesDiffers 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 outcomeSlide13
Early Authoritative and Semi-authoritative Organizational Attempts to Develop the Conceptual Framework of Accounting
ARS
No. 3
1962
APB Statement No. 4
ASOBAT
1966
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 income
Decision Usefulness
Standards for evaluating: relevance, verifiability, freedom from bias,
quantifiabilitySlide14
The Trueblood
Committee
Who needs financial statements?What information do they need?How much of the needed information can be provided by accountants?What framework is needed to provide the needed information?Slide15
The Trueblood
CommitteeCommittee report specified the following four information needs of users:
Making decisions concerning the use of limited resourcesEffectively directing and controlling organizationsMaintaining and reporting on the custodianship of resourcesFacilitating social functions and controls
Objectives of financial reporting
Difficulty in finding agreement and therefore answers
Viewed as first stepSlide16
Statement on Accounting Theory and Theory Acceptance
Rationale for the committee’s approachFundamental changes since ASOBATNo one theory exists
The approaches to accounting theory were condensed into Classical-deductive and disconnectedDecision Usefulness-usefulness is a basic objectiveInformation Economics- specify information necessary to make economic decisions Criticisms of the approaches to theorySlide17
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:
Acceptance of a paradigmWorking with that paradigm by doing normal scienceBecoming dissatisfied with that paradigmSearching for a new paradigmAccepting a new paradigmSATTA
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.
SATTASlide18
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:Selecting the transactions, events and circumstances to be accounted forDetermining how the selected transactions, events, and transactions should be measuredDetermining how to summarize and report the results of events, transactions and circumstances.Slide19
The Conceptual Framework
The FASB originally developed six SFACsIn 2010 SFAC No’s 1 & 2 were replaced by SFAC No. 8Figure 2.1 provides an overview of the FASB's conceptual framework for financial accounting and reporting.Slide20
The Conceptual Framework for Financial Accounting and Reporting
OBJECTIVE
SFAC No. 8
FUNDAMENTALS
SFAC No. 6
Revenue
Expense
Gain
Loss
Asset
Liability
Equity
ELEMENTS
SFAC No’s. 5 & 8
Relevance
Faithful Representation
QUALITATIVE
CHARACTERISTICS
IMPLEMENTATIONGUIDELINES
RECOGNITION, MEASUREMENT AND DISCLOSURE CONCEPTS
ASSUMPTIONS
Economic Entity
Going Concern
Monetary Unit
Periodicity
PRINCIPLES
Measurement
Revenue Recognition
Expense Recognition
Full Disclosure
C
ONSTRAINTS
Cost
Industry Practices
OBJECTIVESSlide21
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. Slide22
Statement of Financial Accounting Standards No. 8Chapter 1
Objective of general‐purpose financial reportingProvide 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. Slide23
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 omittedAccounting standard-setters fail to contact actual users of informationSlide24
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.Slide25
Statement of Financial Accounting Standards No. 8
Chapter 1The second level of the CFP contains the fundamental concepts. ProvideConceptual building blocksInclude the qualitative characteristics
of accounting information and the elements of financial statements. Slide26
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 hierarchySlide27
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
Free
from
error
Neutrality
Verifiability
Timeliness
UnderstandabilitySlide28
Primary Users of Financial Information
Existing or potential investors, lenders and other creditorsIts capital providersSlide29
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. Slide30
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 analysisSlide31
SFAS No. 8: Qualitative Characteristics
Distinguishing between better (more useful) information from inferior (less useful) information. These qualitative characteristics
Either fundamental or enhancing characteristicsDepending on how they affect the decision‐usefulness of information. The two fundamental qualities that make accounting information useful for decision‐making relevance and faithful representation. Slide32
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.Slide33
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:
CompletenessN
eutrality
F
ree
from error
.
SFAS No. 8: Faithful Representation
Financial reports represent economic phenomena in words and numbers.Slide34
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 RepresentationSlide35
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 agreementA 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. Slide36
Three additional phases of the CPF are currently inactive
The reporting entityMeasurementElements 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 PhasesSlide37
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 reportedDefined 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 Slide38
No. 5 “Recognition and Measurement in Financial Statements of Business Enterprises”
Measurement IssuesDefinitions.
The item meets the definition of an element contained in SFAC No. 6.Measurability. It has a relevant attribute measurable with sufficient reliability.Relevance. The information about the item is capable of making a difference in user decisions.Reliability. The information is representationally faithful, verifiable, and neutral.Slide39
SFAC No. 5 Gaps
Failure to define “earnings”No resolution on debate of current value vs historical costSlide40
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. Slide41
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?
Slide42
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”An estimate of the future cash flows
Expectations about variations in the timing of those cash flows
The time value of money represented by the risk-free rate of interest
The price for bearing the uncertainty
Other, sometimes unidentifiable, factors including illiquidity and market imperfectionsSlide43
Approaches to present value
Traditional-Single cash flow single interest rateExpected cash flow range
SFAC No. 7 “Using Cash Flow Information and Present Value in Accounting Measurements”
Expected Cash Flow
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 methodSlide44
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.Slide45
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. Slide46
Principles-Based
Better able to cope with speed of change of business environmentLess Voluminous
Encourages use of professional judgment with focus on what is rightSeen as possibly discouraging financial engineeringRules-BasedMore workable in large, complex economies & countries
Less room for interpretation
Provides more guidance for practical implementation
Less need for explanation in financial statementsSlide47
FASB Questions
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?Should the Board develop an overall reporting framework as in IAS 1?If so, should that framework include a true and fair override?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?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?
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?
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?Slide48
Principles Based vs. Rules Based Accounting Standards
The AAA’s positionWrong questionEconomic substance, not form
AAADissenting opinion
US standards also include rules-based elementsSlide49
Further developments
2003 SEC study submitted to Congress Included recommendations to FASB2004 FASB response to recommendationsIssuing Objectives-Oriented Standards
Conceptual FrameworkOne U.S. Standard SetterGAAP HierarchyAccess to Authoritative LiteratureComprehensive Review of LiteratureSlide50
International Convergence
Norwalk AgreementSeptember 18, 2002 FASB & IASB pledged
Achieve compatibilityMaintain compatibility3 Major aspects:Financial Statements Presentation ProjectConceptual Framework ProjectStandards Update ProjectSlide51
FASB-IASB Financial Statement Presentation Project
Establish common standard
GoalsUnderstand past and present financial positionUnderstand changes and causes of changesEvaluate future cash flowsSlide52
FASB-IASB Financial Statement Presentation Project
3 Phases
What constitutes complete set of statements?Fundamental issues for presentation of informationPresentation of interim financial information in U.S. GAAPSlide53
Further Developments
February 2006 Memorandum of Understanding (MOU)
Shared objective: develop high-quality, common accounting standards“Road map” for elimination of reconciliation requirementsDevelop new common standards rather than eliminate differencesSlide54
Convergence
Boards to reach conclusion on major
differences in focused areas2008 goalFASB & IASB seek to make continued progress in other areasSlide55
November 2009 Progress Report
Milestone targets for each project
Commitment to reporting quarterly on progressMake reports available on webHost monthly joint board meetingsSlide56
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 reportingSlide57
Phase B principles
Financial statement presentation
Cohesive financial pictureFinancing activities separatedLiquidity of assets & liabilities
Disaggregate line items
Understand
Measurement of assets & liabilities
Uncertainty & subjectivity
Causes of changes in assets & liabilitiesSlide58
Financial Statements
Comprehensive Income
Financial PositionCash Flows
Each statement to contain 2 primary section:
Business
Operating
Investing
Financing
Debt
EquitySlide59
Conceptual Framework Project
8 phases
Objectives and qualitative characteristicsDefinitions of elements, recognition and derecognitionMeasurement
Reporting entity conceptBoundaries of financial reporting, and presentation and disclosure
Purpose and status of framework
Application of framework to not-for-profit entities
Remaining issues, if anySlide60
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Prepared by Kathryn Yarbrough, MBA