The Pursuit of the Conceptual Framework Chapter 2 The Pursuit of the Conceptual Framework 4

Introduction What is the conceptual framework? The Early Theorists Paton and Canning DR Scott and his conceptual framework

ASOBAT ARSs No. 1 and No. 3 A Statement of Accounting Principles Early Authoritative and Semi-authoritative Organizational Attempts to Develop the Conceptual Framework of Accounting A Statement of Accounting Principles A Tentative Statement of Accounting Principles Affecting Corporate Reports An Introduction to Corporate Accounting Standards ARSs No. 1 and No. 3 APB Statement No. 4 ASOBAT

The Trueblood Committee Committee report specified the following four information needs of users: Making decisions concerning the use of limited resources Effectively directing and controlling organizations Maintaining and reporting on the custodianship of resources Facilitating social functions and controls Objectives of financial reporting

Statement on Accounting Theory and Theory Acceptance Rationale for the committee’s approach The approaches to accounting theory were condensed into Classical Decision Usefulness Information Economics. Criticisms of the approaches to theory

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 for Determining how the selected transactions, events, and transactions should be measured Determining how to summarize and report the results of events, transactions and circumstances.

SFAC No. 1 “Objectives of Financial Reporting By Business Enterprises” Assess cash flow prospects Report on enterprise resources, claims against resources and changes in them Report economic resources, obligations and owners equity Report enterprise performance and earnings Evaluate liquidity, solvency, and flow of funds Evaluate management stewardship and performance Explain and interpret financial information 15

No. 2 “Qualitative Characteristics of Accounting Information Addresses the question: What makes accounting information useful? Develops a Hierarchy of Accounting Qualities 16

A Hierarchy of Accounting Qualities Users of Accounting Information Decision makers and their characteristics (for example, understanding of prior knowledge) Pervasive Constraint Benefits > Costs Understandability User-specific qualities Decision Usefulness Primary Decision-specific qualities Relevance Reliability Verifiability Representational Faithfulness Timeliness Ingredients of primary qualities Predictive value Feedback value Neutrality Comparability and Consistency Threshold for recognition Materiality 17

Defined comprehensive income as: 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 Earnings Less: Expenses Plus or minus cumulative accounting adjustments Plus: Gains Plus or minus other non-owner changes in equity Less: Losses = Earnings = Comprehensive Income 18

Measurement Issues Definitions. Measurability. Relevance. Reliability. No. 5 “Recognition and Measurement in Financial Statements of Business Enterprises” Measurement Issues Definitions. 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.

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 6 and 7. 19

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? Does the measurement of liabilities at present value differ from the measurement of assets? How should the estimates of cash flows and interest rates be developed? What are the objectives of present value when used in conjunction with the amortization of assets and liabilities? How should present value amortizations be used when the estimates of cash flows change?

SFAC No. 7 “Using Cash Flow Information and Present Value in Accounting Measurements” Present value measurements that fully captures the economic differences between assets should include the following elements: 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 imperfections

Expected Cash Flow Approaches to present value SFAC No. 7 “Using Cash Flow Information and Present Value in Accounting Measurements” Expected Cash Flow Approaches to present value Traditional 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 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.

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

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?

Principles Based vs. Rules Based Accounting Standards AAA The AAA’s position Dissenting opinion

Prepared by Kathryn Yarbrough, MBA End of Chapter 2 Prepared by Kathryn Yarbrough, MBA Copyright © 2005 John Wiley & Sons, Inc.  All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written consent of the copyright owner is unlawful.  Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc.  The purchaser may make back-up copies for his/her own use only and not for distribution or resale.  The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.