1.7 A Conceptual Framework of Accounting

A strong theoretical foundation is essential if accounting practice is to keep pace with a changing business environment. Accountants are continually faced with new situations, technological advances, and business innovations that present new accounting and reporting problems. These problems must be dealt with in an organized and consistent manner. The conceptual framework is "a coherent system of interrated objectives and fundamental concepts that prescribes the nature, function, and limits of financial accounting and reporting" and plays a vital role in the development of new standards and in the revision of previously issued standards. The framework "provides structure and direction to financial accouting and reporting to facilitate the provision of unbiased financial and related information.” The FASB itself is a primary beneficiary of the conceptual framework as it "will guide the Board in developing accounting and reporting guidance by providing the Board with a common foundation and basic reasoning on which to consider merits of alternatives." 1

In addition, when accountants are confronted with new developments that are not covered by GAAP, the conceptual framework provides a reference for analyzing and resolving emerging issues. Thus, a conceptual framework not only helps in understanding existing practice but also provides a guide for future practice.

Nature and Components of the FASB’s Conceptual Framework

Serious attempts to develop a theoretical foundation of accounting can be traced to the 1930s. Among the leaders in such attempts were accounting educators, both individually and collectively, as a part of the AAA. In 1936, the Executive Committee of the AAA began issuing a series of publications devoted to accounting theory, the last of which was published in 1965 and entitled “A Statement of Basic Accounting Theory.” During the period from 1936 to 1973, the AAA and the AICPA issued several additional publications in their attempt to develop a conceptual foundation for the practice of accounting.2

Although these publications made significant contributions to the development of accounting thought, no unified structure of accounting theory emerged from these efforts. When the FASB was established in 1973, it responded to the need for a general theoretical framework by undertaking a comprehensive project to develop a “conceptual framework for financial accounting and reporting.” This project has been described as an attempt to establish a so-called constitution for accounting.

The conceptual framework project was one of the original FASB agenda items. Because of its significant potential impact on many aspects of financial reporting and, therefore, its controversial nature, progress was deliberately slow. The project had high priority and received a large share of FASB resources. In September 2010, after almost 40 years of discussions, the FASB issued the eighth of the Statements of Financial Accounting Concepts (usually referred to as Concepts Statements), which provide the basis for the conceptual framework.3 Concepts Statement No. 8 is the first in an expected series of Concepts Statements that are the joint work of the FASB and the IASB.

The eight Concepts Statements address four major areas.

1. Objectives: What are the purposes of financial reporting?

2. Qualitative characteristics: What are the qualities of useful financial information?

3. Elements: What is an asset? a liability? a revenue? an expense?

4. Recognition, measurement, and reporting: How should the objectives, qualities, and elements definitions be implemented?

Objectives of Financial Reporting

Without identifying the goals for financial reporting (e.g., who needs what kind of information and for what reasons), accountants cannot determine the recognition criteria needed, which measurements are useful, or how best to report accounting information. The key financial reporting objectives outlined in the conceptual framework are as follows:

• Usefulness

• Understandability

• Target audience: investors and creditors

• Assessing future cash flows

• Evaluating economic resources

• Financial performance reflected by accrual accounting

Usefulness

The overall objective of financial reporting is to provide information that is useful for decision making. The FASB states

Understandability

Financial reports cannot and should not be so simple as to be understood by everyone. Instead, the objective of understandability recognizes a fairly sophisticated user of financial reports, that is, one who has a reasonable understanding of accounting and business and who is willing to study and analyze the information presented.5 In other words, the information should be comprehensible to someone like you.

Target Audience: Investors, Lenders, and Other Creditors

Although there are many potential users of financial reports, the objectives are directed primarily toward investors and creditors. Other external users, such as the IRS or the SEC, can require selected information from individuals and companies. Investors and creditors, however, must rely to a significant extent on the information contained in the periodic financial reports supplied by management. In addition, information useful to investors and creditors in most cases will be useful to other external users (i.e., customers and employees).

Assessing Future Cash Flows

Investors and creditors are interested primarily in a company’s future cash flows. Creditors expect interest and loan principals to be paid in cash. Investors desire cash dividends and sufficient cash flow to allow the business to grow. Thus, financial reporting should provide information that is useful in assessing amounts, timing, and uncertainty (risk) of prospective cash flows.

Evaluating Economic Resources

Financial reporting should also provide information about a company’s assets, liabilities, and owners’ equity to help investors, creditors, and others evaluate the financial strengths and weaknesses of the enterprise and its liquidity and solvency. Such information will help users determine the financial condition of a company, which, in turn, should provide insight into the prospects of future cash flows.

Financial Performance Reflected by Accrual Accounting

Information about a company’s financial performance (the change in its economic resources caused by its operations) is useful in assessing a company’s ability to generate future cash flows. This financial performance is best reflected by accrual accounting.6

Qualitative Characteristics of Accounting Information

The overriding objective of financial reporting is to provide useful information. This is a very complex objective because of the many reporting alternatives. To assist in choosing among financial accounting and reporting alternatives, the conceptual framework identifies the qualitative characteristics of useful accounting information. These qualitative characteristics are separated into fundamental characteristics and enhancing characteristics. These characteristics are outlined in Figure 1.5.

Fundamental Characteristics

The two fundamental characteristics of useful accounting information are relevance and faithful representation. These characteristics are viewed as being absolutely necessary; without both of them, accounting information is not useful.7

Relevance

The conceptual framework describes relevant information as information that can make a difference to a decision. Qualities of relevant information are as follows:

• Predictive value

• Confirmatory value

• Materiality

Relevant information normally provides both confirmatory value and predictive value at the same time. Feedback on past events helps confirm or correct earlier expectations. Such information can then be used to help predict future outcomes. For example, when a company presents comparative income statements, an investor has information to compare last year’s operating results with this year’s. This provides a general basis for evaluating prior expectations and for estimating what next year’s results might be.

Materiality deals with this specific question: Is the item large enough to influence the decision of a user of the information? Quantitative guidance concerning materiality is lacking, so managers and accountants must exercise judgment in determining whether an item is material. All would agree that an item causing net income to change by 10% is material. How about 1%? Most accountants would say an item changing net income by 1% is immaterial unless the item results from questionable income manipulation or something else indicative of broader concern. Remember that there is no definitive numerical materiality threshold—the accountant must use her or his judgment. In recognition of the importance of the concept of materiality, the SEC released Staff Accounting Bulletin (SAB) No. 99 in August 1999 to offer additional guidance on this concept. The SEC confirmed that materiality can never be boiled down to a simple numeric benchmark. However, the SEC said that, in terms of an auditor considering whether an item is material, extra scrutiny should be given to items that change a loss to a profit, that allow a company to meet analyst earnings expectations, or that allow management to meet a bonus threshold that otherwise would have been missed.

Faithful Representation

Faithful representation means that there is agreement between a measurement and the economic activity or item that is being measured. Qualities of information exhibiting faithful representation are as follows:

• Complete

• Neutral

• Free from error

Complete information includes not only the numerical accounting summary of the item being depicted, such as its cost, but also all other facts necessary for the financial statement user to understand how that number was generated and what it means. For example, the summary balance sheet number for “property, plant, and equipment” must be accompanied by a listing of the type of assets included in this category, the useful life ranges for those assets, and the type of depreciation method used.

Neutrality is similar to the all-encompassing concept of “fairness.” If financial statements are to satisfy a wide variety of users, the information presented should not be biased in favor of one group of users to the detriment of others. Neutrality also suggests that accounting standard setters should not be influenced by potential effects a new rule will have on a particular company or industry. In practice, neutrality is very difficult to achieve because firms that expect to be harmed by a new accounting rule often lobby vigorously against the proposed standard.

Accrual accounting information by its nature is based on judgments and includes estimates and approximations. Accordingly, the financial statement numbers cannot be perfectly “accurate.” In fact, in a setting involving approximations and judgments, two different estimated numbers can reasonably be viewed as being equally “accurate.” What can be expected of accounting numbers is that the process used to generate the final accounting numbers be applied in an error-free way.

Enhancing Characteristics

The four enhancing characteristics of useful accounting information are comparability, verifiability, timeliness, and understandability. Once information exhibits both relevance and faithful representation, improvements in one or more of the four enhancing characteristics can make the accounting information even more useful.8

Comparability

The essence of comparability is that information becomes much more useful when it can be related to a benchmark or standard. The comparison may be with data for other firms, or it may be with similar information for the same firm but for other periods of time. Comparability of accounting data for the same company over time is often called consistency. Comparability requires that similar events be accounted for in the same manner in the financial statements of different companies and for a particular company for different periods. It should be recognized, however, that uniformity is not always the answer to comparability. Different circumstances may require different accounting treatments.

Verifiability

Verifiability implies consensus. Accountants seek to base the financial statements on measures that can be verified by other trained accountants using the same measurement methods.

Timeliness

Timeliness is essential for information to “make a difference” because if the information becomes available after the decision is made, it isn’t of much use. Financial reporting is increasingly criticized on the timeliness dimension because in the age of information technology, users are becoming accustomed to getting answers overnight, not at the end of a year or a quarter.

Understandability

As stated earlier, business events can be complex, and the financial statements should not be simplified to the degree that this business complexity is concealed. However, the concept of understandability implies that this complexity should be explained clearly in order to be understood by users who are both familiar with business and willing to put in the time needed to analyze the financial reports.

Benefits Greater Than Cost

Information is like other commodities in that it must be worth more than the cost of producing it. The difficulty in assessing cost effectiveness of financial reporting is that the costs and benefits, especially the benefits, are not always evident or easily measured. In addition, the costs are borne by an identifiable and vocal constituency, the companies required to prepare financial statements. The benefits are spread over the entire economy. Thus, the FASB more frequently hears complaints about the expected cost of a new standard than it hears praise about the expected benefits. When describing a new accounting standard, the FASB includes a section attempting to describe the expected costs and benefits of the standard.

What about Conservatism?

No discussion of the qualities of accounting information is complete without a discussion of conservatism, which historically has been the guiding principle behind many accounting practices. The concept of conservatism can be summarized as follows: When in doubt, recognize all losses but don’t recognize any gains. In formulating the conceptual framework, the FASB did not include conservatism in the list of qualitative characteristics. Financial statements that are deliberately biased to understate assets and profits lose the characteristics of relevance and faithful representation.

Elements of Financial Statements

The FASB definitions of the 10 basic financial statement elements are listed in Figure 1.6. These elements compose the building blocks upon which financial statements are constructed. These definitions and the issues surrounding them are discussed in detail as the elements are introduced in later chapters.

Recognition, Measurement, and Reporting

To recognize or not to recognize . . . THAT is the question. One way to report financial information is to boil down all the estimates and judgments into one number and then use that one number to make a journal entry. This is called recognition. The key assumptions and estimates are then described in a note to the financial statements. Another approach is to skip the journal entry and just rely on the note to convey the information to users. This is called disclosure.

The recognition versus disclosure question has been at the heart of many accounting standard controversies and compromises in recent years. Two examples follow.

• The business community absolutely refused to accept the FASB’s decision to require recognition of the value of employee stock options as compensation expense. The FASB initially compromised by requiring only disclosure of the information but finally insisted that, starting in 2006, businesses must recognize the expense rather than just disclose it.

• The FASB has used disclosure requirements to give firms some years of practice in reporting the fair value of financial instruments. Some standards now require recognition of those fair values, and the FASB provides extensive guidance on the use of and required disclosures regarding fair value measurements in the financial statements.

The conceptual framework provides guidance in determining what information should be formally incorporated into financial statements and when. These concepts are discussed here under the following three headings:

• Recognition criteria

• Measurement

• Reporting

Recognition Criteria

For an item to be formally recognized, it must meet one of the definitions of the elements of financial statements.9 For example, a receivable must meet the definition of an asset to be recorded and reported as such on a balance sheet. The same is true of liabilities, owners’ equity, revenues, expenses, and other elements. An item must also be reliably measurable in monetary terms to be recognized. For example, as mentioned earlier, many firms have obligations to clean up environmental damage. These obligations fit the definition of a liability, and information about them is relevant to users, yet they should not be recognized until they can be reliably quantified. Disclosure is preferable to recognition in situations in which relevant information cannot be reliably measured.

Measurement

Closely related to recognition is measurement. Five different measurement attributes are currently used in practice.

1. Historical cost is the cash equivalent price exchanged for goods or services at the date of acquisition. (Examples of items measured at historical cost: land, buildings, equipment, and most inventories.)

2. Current replacement cost is the cash equivalent price that would be exchanged currently to purchase or replace equivalent goods or services. (Example: some inventories that have declined in value since acquisition.)

3. Fair value is the cash equivalent price that could be obtained by selling an asset in an orderly transaction. (Example: many financial instruments.)

4. Net realizable value is the amount of cash expected to be received from the conversion of assets in the normal course of business. (Example: accounts receivable.)

Caution
You will be doing lots of present value calculations during your course in intermediate accounting. Check the batteries in your calculator.

5. Present value (or discounted value) is the amount of net future cash inflows or outflows discounted to their present value at an appropriate rate of interest. (Examples: long-term receivables, long-term payables, and long-term operating assets determined to have suffered an impairment in value.)

On the date an asset is acquired, all five of these measurement attributes have approximately the same value. The differences arise as the asset ages, business conditions change, and the original acquisition price becomes a less relevant measure of future economic benefit.

Current accounting practice in the United States is said to be based on historical costs, although, as illustrated, each of the five measurement attributes is used. Still, historical cost is the dominant measure and is used because of its high reliability. Many users believe that current replacement costs or fair values, though less reliable, are more relevant than historical costs for future-oriented decisions. Here we see the classic trade-off between relevance and reliability. In recent years, we have seen an increasing emphasis on relevance and thus a movement away from historical cost. Most financial instruments are now reported at fair value, and the present value of forecasted cash flows is becoming a more common measurement attribute. The importance of forecasted cash flow information is evidenced by the fact that a recent addition to the conceptual framework (Concepts Statement No. 7 adopted in February 2000) outlines the appropriate approach to computing the present value of cash flows. In spite of this trend, the United States still lags behind other countries in the use of market values in financial statements. For example, many British companies report their land and buildings at estimated market values.

Reporting

The conceptual framework indicates that a “full set of financial statements” is necessary to meet the objectives of financial reporting. Included in the recommended set of general-purpose financial statements are reports that show the following:

• Financial position at the end of the period

• Earnings (net income) for the period

• Cash flows during the period

• Investments by and distributions to owners during the period

• Comprehensive income (total nonowner changes in equity) for the period

The first three items have obvious reference to the three primary financial statements: balance sheet, income statement, and statement of cash flows. By the way, at the time the conceptual framework was formulated, there was no requirement to prepare a statement of cash flows. One of the early consequences of the completed conceptual framework was an increased emphasis on cash flow and the addition of the cash flow statement to the set of primary financial statements. The fourth reporting recommendation is typically satisfied with a statement of changes in owners’ equity. Finally, a statement of comprehensive income is intended to summarize all increases and decreases in equity except for those arising from owner investments and withdrawals. Comprehensive income differs from earnings in that it includes unrealized gains and losses not recognized in the income statement. Examples of these unrealized gains and losses include those arising from foreign currency translations, changes in the value of available-for-sale securities, and changes in the value of certain derivative contracts. Although the FASB discussed the concept of comprehensive income for 40 years, a forceful reporting requirement was not adopted until 2011. Beginning in 2011, companies are required to provide comprehensive income information at the bottom of the income statement or in a separate statement of comprehensive income that is shown immediately after the income statement.

For financial reporting to be most effective, all relevant information should be presented in an unbiased, understandable, and timely manner. This is sometimes referred to as the full disclosure principle. Because of the cost-benefit constraint discussed earlier, however, it would be impossible to report all relevant information. Further, too much information could adversely affect understandability and, therefore, decision usefulness. Those who provide financial information must use judgment in determining what information best satisfies the full disclosure principle within reasonable cost limitations.

Two final points to remember are that the financial statements represent just one part of financial reporting and that financial reporting is just one vehicle used by companies to communicate with external parties. Figure 1.7 illustrates the total information spectrum.

In one way, this chart is somewhat misleading. Financial reporting is represented as fourfifths of the information spectrum, with other information comprising the other fifth. In reality, the proportions are probably reversed. In a world where online information is available 24 hours a day, the accounting profession faces the challenge of maintaining the relevance of financial reporting in the information spectrum.

Traditional Assumptions of the Accounting Model

The FASB conceptual framework is influenced by several underlying assumptions, although these assumptions are not addressed explicitly in the framework. These five basic assumptions are

• Economic entity

• Going concern

• Arm’s-length transactions

• Stable monetary unit

• Accounting period

The business enterprise is viewed as a specific economic entity separate and distinct from its owners and any other business unit. Identifying the exact extent of the economic entity is difficult with large corporations that have networks of subsidiaries and subsidiaries of subsidiaries with complex business ties among the members of the group. The keiretsu in Japan (groups of large firms with ownership in one another and interlocking boards of directors) are an extreme example. At the other end of the spectrum, it is often very difficult to disentangle the owner’s personal transactions from the transactions of a small business.

In the absence of evidence to the contrary, the entity is viewed as a going concern. This continuity assumption provides support for the preparation of a balance sheet that reports costs assignable to future activities rather than market values of properties that would be realized in the event of voluntary liquidation or forced sale. This same assumption calls for the preparation of an income statement reporting only such portions of revenues and costs as are allocable to current activities.

Transactions are assumed to be arm’s-length transactions. That is, they occur between independent parties, each of which is capable of protecting its own interests. The problem of related-party transactions was at the heart of the Enron scandal. Concern about Enron’s accounting and business practices escalated dramatically when it was discovered that Enron’s CFO was also managing partnerships that were buying assets from Enron.

Transactions are assumed to be measured in stable monetary units. Because of this assumption, changes in the dollar’s purchasing power resulting from inflation have traditionally been ignored. To many accountants, this is a serious limitation of the accounting model. In the late 1970s, when inflation was in double digits in the United States, the FASB adopted a standard requiring supplemental disclosure of inflation-adjusted numbers. However, because inflation has remained fairly low for the past 20 years, interest in inflation-adjusted financial statements died in the United States, and the standard was repealed. Of course, many foreign countries with historically high inflation routinely require inflation-adjusted financial statements.

Because accounting information is needed on a timely basis, the life of a business entity is divided into specific accounting periods. By convention, the year has been established as the normal period for reporting, supplemented by interim quarterly reports. Even this innocent traditional assumption has come under fire. Many users want “flash” reports and complain that a quarterly reporting period is too slow. On the other hand, U.S. business leaders often claim that the quarterly reporting cycle is too fast and forces managers to focus on short-term profits instead of on long-term growth. Many other countries require financial statements only semiannually.

Impact of the Conceptual Framework

The conceptual framework provides a basis for consistent judgments by standard setters, preparers, users, auditors, and others involved in financial reporting. A conceptual framework will not solve all accounting problems but if used on a consistent basis over time, it should help improve financial reporting.

The impact of the conceptual framework has been seen in many ways. For example, in Concepts Statement No. 5, the FASB outlines the need for a statement of comprehensive income that would contain all of the changes in the value of a company during a period whether those value changes were created by operations, by changes in market values, by changes in exchange rates, or by any other source. This statement of comprehensive income is now a required statement (see FASB ASC Section 220). In addition, the existence of this statement as a place to report changes in market values of assets has facilitated the adoption of standards that result in more relevant values in the balance sheet. Examples are the market values of investment securities and the market values of derivatives. Without the conceptual framework to guide the creation of these standards, their provisions would have been even more controversial than they were.

Related to the conceptual framework is the push toward more “principles-based” accounting standards. In theory, principles-based standards would not include any exceptions to general principles and would not include detailed implementation and interpretation guidance. Instead, a principles-based standard would have a strong conceptual foundation and be applicable to a variety of circumstances by a practicing accountant using his or her professional judgment. A number of accounting standards in the United States, including those dealing with the accounting for leases and derivatives, are full of exceptions, special cases, and tricky implementation rules requiring hundreds of pages of detailed interpretation. The cry for an emphasis on principlesbased standards is a reaction to the huge costs of trying to understand and use these voluminous, detailed standards. The ideal of basing accounting standards on a strong conceptual foundation is what motivated the FASB’s conceptual framework project in the first place.

The framework discussed in this chapter will be a reference source throughout the text. In studying the remaining chapters, you will see many applications and a few exceptions to the theoretical framework established here. An understanding of the overall theoretical framework of accounting should make it easier for you to understand specific issues and problems encountered in practice.

Rules versus Principles

The most prominent difference between U.S. GAAP and IFRS is that U.S. GAAP contains many more detailed rules. In fact, a shorthand description is that U.S. GAAP is “rules oriented” and IFRS are “principles oriented.” This is best summarized in a startling statistic—the entire body of U.S. accounting rules is estimated to occupy 25,000 pages. In contrast, the entire body of IFRS is estimated to occupy 2,500 pages. The theory with IFRS is that the application details in individual circumstances will be determined by the professional judgment of the accountant herself or himself.

For years, the FASB has been prodded to transition from a rules approach to a principles approach.10 In July 2003, the SEC submitted a report to Congress recommending that the FASB move toward “objectives-oriented standards” which would have the following characteristics.

• Be based on an improved and consistently applied framework

• Clearly state the accounting objective of the standard

• Provide sufficient detail and structure so that the standard can be operationalized and applied on a consistent basis

• Minimize exceptions from the standard

• Avoid use of percentage tests (“bright-lines”) that allow financial engineers to achieve technical compliance with the standard while evading the intent of the standard

As you can see, an improved conceptual framework is a key element of this transition from rules to principles. Since receipt of this SEC report, the FASB, in conjunction with the IASB, has been moving toward more principles-based standards. The question that continues to be asked in the U.S. business community is whether principles-based accounting standards will work in the U.S. legal environment. Accountants and auditors are concerned that they can never be sure their application of the accounting “principle,” without the detailed guidance of rules, will bear up under the after-the-fact scrutiny of trial lawyers, juries, and judges.