1. RICHARD G. SCHROEDER MYRTLE W. CLARK JACK M. CATHEY
FINANCIAL ACCOUNTING
THEORY AND ANALYSIS: TEXT AND CASES
11TH EDITION
RICHARD G. SCHROEDER
MYRTLE W. CLARK
JACK M. CATHEY 4

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

3. Introduction What is the conceptual framework? The Early Theorists
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.

4. 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 accounting

5. 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

6. 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

7. A Statement of Accounting Principles
Early Authoritative and Semi-authoritative Organizational Attempts to Develop the Conceptual Framework of Accounting
A Statement of Accounting Principles
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

8. An Introduction to Corporate Accounting Standards
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

9. 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.

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

11. 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

12. 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

13. Information system involving communication
Early Authoritative and Semi-authoritative Organizational Attempts to Develop the Conceptual Framework of Accounting
ASOBAT
1966
APB Statement No. 4
ARS No. 3
1962
Information system involving communication
Definition of accounting
Use of current values
Sophistication of users
Departure from SEC’s advocacy of historical cost
Description of current practice
Economic income
Decision Usefulness
Not GAAP
Standards for evaluating: relevance, verifiability, freedom from bias, quantifiability

14. 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?

15. 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
Difficulty in finding agreement and therefore answers
Viewed as first step

16. 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
Classical-deductive and disconnected
Decision Usefulness-usefulness is a basic objective
Information Economics- specify information necessary to make economic decisions
Criticisms of the approaches to theory

17. 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 paradigm
Working with that paradigm by doing normal science
Becoming dissatisfied with that paradigm
Searching for a new paradigm
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

18. 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.

19. 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.

20. The Conceptual Framework for Financial Accounting and Reporting
OBJECTIVES
OBJECTIVE SFAC No. 8
ELEMENTS
QUALITATIVE
CHARACTERISTICS
SFAC No. 6
Revenue
Expense
Gain
Loss
Asset
Liability
Equity
FUNDAMENTALS
SFAC No’s. 5 & 8
Relevance
Faithful Representation
IMPLEMENTATIONGUIDELINES
RECOGNITION, MEASUREMENT AND DISCLOSURE CONCEPTS
ASSUMPTIONS
PRINCIPLES
CONSTRAINTS
Economic Entity
Going Concern
Monetary Unit
Periodicity
Measurement
Revenue Recognition
Expense Recognition
Full Disclosure
Cost
Industry Practices

21. Conceptual Framework
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.
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 1: identifies the objective of financial reporting—that is, the purpose of financial reporting.

22. Statement of Financial Accounting Standards No. 8 Chapter 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.

23. 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 19

24. 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.

25. 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.

26. 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

27. Primary Users of Accounting Information
Capital Providers (Investors and Creditors) and their characteristics
Pervasive Constraint
Cost
Fundamental qualities
Relevance
Faithful Representation
Ingredients of
Fundamental qualities
Predictive
value
Materiality
Completeness
Free from error
Confirmatory
value
Neutrality
Enhancing qualities
Comparability
Verifiability
Timeliness
Understandability 17

28. Primary Users of Financial Information
Existing or potential investors, lenders and other creditors
Its capital providers

29. 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.

30. 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

31. 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
relevance and
faithful representation.

32. 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.

33. SFAS No. 8: Faithful Representation
Financial reports represent economic phenomena in words and numbers.
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:
Completeness
Neutrality
Free from error.

34. SFAS No. 8: Faithful Representation
A complete depiction should include all information necessary for a user to understand the phenomenon being depicted.
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.
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.

35. 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.

36. Additional Phases
Three additional phases of the CPF are currently inactive
The reporting entity
Measurement
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.

37. 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

38. 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.

39. SFAC No. 5 Gaps Failure to define “earnings”
No resolution on debate of current value vs historical cost

40. 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. 19

41. 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?

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

43. SFAC No. 7 “Using Cash Flow Information and Present Value in Accounting Measurements”
Approaches to present value
Traditional-Single cash flow single interest rate
Expected cash flow range
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

44. 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.

45. 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.

46. Principles-Based Rules-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
More workable in large, complex economies & countries
Less room for interpretation
Provides more guidance for practical implementation
Less need for explanation in financial statements

47. 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?

48. Principles Based vs. Rules Based Accounting Standards
The AAA’s position
Wrong question
Economic substance, not form
AAA
Dissenting opinion
US standards also include rules-based elements

49. Further developments 2003 SEC study submitted to Congress
Included recommendations to FASB
2004 FASB response to recommendations
Issuing Objectives-Oriented Standards
Conceptual Framework
One U.S. Standard Setter
GAAP Hierarchy
Access to Authoritative Literature
Comprehensive Review of Literature

50. International Convergence
Norwalk Agreement
September 18, 2002 FASB & IASB pledged
Achieve compatibility
Maintain compatibility
3 Major aspects:
Financial Statements Presentation Project
Conceptual Framework Project
Standards Update Project

51. FASB-IASB Financial Statement Presentation Project
Establish common standard
Goals
Understand past and present financial position
Understand changes and causes of changes
Evaluate future cash flows

52. FASB-IASB Financial Statement Presentation Project
3 Phases
What constitutes complete set of statements?
Fundamental issues for presentation of information
Presentation of interim financial information in U.S. GAAP

53. 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

54. Convergence
Boards to reach conclusion on major differences in focused areas
2008 goal
FASB & IASB seek to make continued progress in other areas

55. 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

56. FASB & IFRS Statements 4 New SFASs SFAS No. 151 (Superseded)
SFAS No. 141 revised
IASB new standards on borrowing costs & segment reporting

57. Phase B principles Financial statement presentation
Cohesive financial picture
Financing activities separated
Liquidity of assets & liabilities
Disaggregate line items
Understand
Measurement of assets & liabilities
Uncertainty & subjectivity
Causes of changes in assets & liabilities

58. Financial Statements Comprehensive Income Financial Position
Cash Flows
Each statement to contain 2 primary section:
Business
Operating
Investing
Financing
Debt
Equity

59. Conceptual Framework Project 8 phases
Objectives and qualitative characteristics
Definitions of elements, recognition and derecognition
Measurement
Reporting entity concept
Boundaries of financial reporting, and presentation and disclosure
Purpose and status of framework
Application of framework to not-for-profit entities
Remaining issues, if any

60. Prepared by Kathryn Yarbrough, MBA
End of Chapter 2
Prepared by Kathryn Yarbrough, MBA
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