FINANCIAL ACCOUNTING

THEORY AND ANALYSIS:

TEXT AND CASES
11TH EDITION

RICHARD G. SCHROEDER
MYRTLE W. CLARK
JACK M. CATHEY
Chapter 2

The Pursuit of the

Conceptual Framework
Introduction
 What is the conceptual framework?
The concepts that be useful in guiding Board in
establishing standards and providing a frame of
reference for resolving accounting issues
 The Early Theorists
Paton (1922)
All changes in the value of assets and
liabilities should be reflected in Fin.
Statements and should be measured on a
current value basis.
Espoused the entity concept
The Early Theorists
 Canning (1929)
 Suggested a framework for assets valuations and
meeasurement based on future expectation as well as a
model to match revenues and expenses
 Balance sheet was viewed as principal fin. Statement
The Early Theorists
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
DR Scott

 Contributed to the development of accounting theory by

recognizing the need for normative theory of accounting.
 Accounting theory was a process continually adapting to
an envolving environment.
 Accounting was not only transaction function but olso
having both an internal control function and external
function to act for the protection of various economic
interest (stockholders, bondholders and the government
 DR Scott - 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.
Early Authoritative and Semi-authoritative
Organizational Attempts to Develop the Conceptual
Framework of Accounting
A An
A Tentative
Statement of Statement Introduction
Accounting of to Corporate
Principles Accounting
Accounting Standards
Affecting
Corporate Principles
Reports

APB ARSs
Statement ASOBAT No. 1
No. 4 and
No. 3
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.
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
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
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

 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.
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
ASOBAT (a
ARS (acc
APB stat. of basic acc
Statement theory
)
research studies

No. 3
No. 4 1966
Definition of Information
1962 accounting system involving
Use of current communication
Sophistication of
values
users
Departure
from SEC’s Description of
Economic income
advocacy current practice
Decision
of Not GAAP
Usefulness
historical
cost 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 resources

2. Effectively directing and controlling organizations
3. Maintaining and reporting on the custodianship of resources
4. 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 disconnected
2. Decision Usefulness-usefulness is a basic
objective
3. 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 paradigm
2. Working with that paradigm by doing normal science
3. Becoming dissatisfied with that paradigm
4. Searching for a new paradigm
5. Accepting a new paradigm
 SATTA : Statement on Accounting Theory and Theory Acceptance
 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.
 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 for
2. Determining how the selected transactions, events, and
transactions should be measured
3. Determining how to summarize and report the results of events,
transactions and circumstances.
The Conceptual Framework

 The FASB originally developed six SFACs

 SFAC : Statement of Financial Accounting
Concept.
 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

OBJECTIVE
OBJECTIVES
SFAC No. 8

ELEMENTS QUALITATIVE
CHARACTERISTICS
SFAC No. 6
Revenue SFAC No’s. 5 & 8
FUNDAMENTALS Expense Relevance
Gain Faithful
Loss Representation
Asset
Liability
Equity

RECOGNITION, MEASUREMENT AND DISCLOSURE CONCEPTS

IMPLEMENTATION
ASSUMPTIONS PRINCIPLES CONSTRAINTS
GUIDELINES
Economic Measurement Cost
Entity Revenue Recognition Industry
Going Concern Expense Recognition Practices
Monetary Unit Full Disclosure
Periodicity
 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.
 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.
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(Conceptual

Framework Project) 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
Primary Users of Accounting Capital Providers
Information (Investors and Creditors) and
their characteristics

Pervasive Constraint Cost

Fundamental qualities
Relevance Faithful Representation

Ingredients of
Fundamental Predictive Free
Materiality Completeness
qualities value from
Confirmatory error
value Neutrality

Enhancing
qualities Comparability 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.
 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:
1. Completeness
2. Neutrality
3. Free from error.
 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.
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.
Additional Phases

 Three additional phases of the CFP are currently

inactive
1. The reporting entity
2. Measurement
3. 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.
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
 No. 5 “Recognition and Measurement
in Financial Statements of Business
Enterprises”
 Measurement Issues
1. 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.
 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”

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:

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

 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:
 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.
 Principles-Based Rules-Based

 Better able to cope  More workable in large,

with speed of change of complex economies &
business environment countries
 Less Voluminous  Less room for
 Encourages use of interpretation
professional judgment  Provides more guidance
with focus on what is for practical
right implementation
 Seen as possibly  Less need for
discouraging financial explanation in financial
engineering 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 recommendations
1. Issuing Objectives-Oriented Standards
2. Conceptual Framework
3. One U.S. Standard Setter
4. GAAP Hierarchy
5. Access to Authoritative Literature
6. Comprehensive Review of Literature
International Convergence

 Norwalk Agreement
 September 18, 2002 FASB & IASB
pledged
Achieve compatibility
Maintain compatibility
 3 Major aspects:
1. Financial Statements Presentation Project
2. Conceptual Framework Project
3. Standards Update Project
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
FASB-IASB Financial Statement
Presentation Project
 3 Phases
A. What constitutes complete set of statements?
B. Fundamental issues for presentation of
information
C. 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 presentation

1. Cohesive financial picture
2. Financing activities separated
3. Liquidity of assets & liabilities
4. Disaggregate line items
5. 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 Project
8 phases
1. Objectives and qualitative characteristics
2. Definitions of elements, recognition and
derecognition
3. Measurement
4. Reporting entity concept
5. Boundaries of financial reporting, and
presentation and disclosure
6. Purpose and status of framework
7. Application of framework to not-for-profit entities
8. Remaining issues, if any
 End of Chapter 2

Prepared by Kathryn Yarbrough, MBA

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