ACCOUNTING THEORY: TEXT AND READINGS

RICHARD G. SCHROEDER MYRTLE CLARK JACK CATHEY

Chapter 2
The Pursuit of the Conceptual Framework

Introduction

What is the conceptual framework?

The Early Theorists

Paton and Canning DR Scott and his conceptual framework

Early Authoritative and Semi-authoritative Organizational Attempts to Develop the Conceptual Framework of Accounting
A Tentative Statement of Accounting Principles Affecting Corporate Reports

A Statement of Accounting Principles

An Introduction to Corporate Accounting Standards

APB Statement No. 4

ASOBAT

ARSs No. 1 and No. 3

The Trueblood Committee

Committee report specified the following four information needs of users:

1. 2. 3. 4.

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 committees approach The approaches to accounting theory were condensed into
1. 2. 3. Classical Decision Usefulness Information Economics.

Criticisms of the approaches to theory

The FASBs 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. 2. 3. 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

1. 2.

3.

4. 5.

6.
7.

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

No. 2 Qualitative Characteristics of Accounting Information

Addresses the question: What makes accounting information useful? Develops a Hierarchy of Accounting Qualities

A Hierarchy of Accounting Qualities

Users of Accounting Information
Decision makers and their characteristics (for example, understanding of prior knowledge)
Benefits > Costs

Pervasive Constraint

Understandability

User-specific qualities
Decision Usefulness

Primary Decision-specific qualities

Relevance

Reliability

Timeliness

Verifiability

Ingredients of primary qualities

Representational Faithfulness

Predictive value

Feedback value

Neutrality

Comparability and Consistency

Threshold for recognition

Materiality

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:
Earnings Plus or minus cumulative accounting adjustments Plus or minus other non-owner changes in equity = Comprehensive Income

Revenues Less: Expenses

Plus: Gains
Less: Losses = Earnings

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.

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.

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:
1. 2. 3. 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 riskfree rate of interest

4.
5.

The price for bearing the uncertainty

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. 2. 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:
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

1.

Do you support the Boards 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. 3. 4. 5. 6.

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 principlesbased approach to U.S. standard setting?
How might those benefits and costs be quantified?

Principles Based vs. Rules Based Accounting Standards

The AAAs position

Dissenting opinion

International Convergence

FASB & IASB pledged

Achieve compatibility Maintain compatibility

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?
1. 2. 3. 4. Financial position Earnings and comprehensive income Cash flows Changes in equity

FASB-IASB Financial Statement Presentation Project

3 Phases
B. Fundamental issues for presentation of information C. Presentation of interim financial information in U.S. GAAP

Prepared by Kathryn Yarbrough, MBA

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