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chapter_5:conceptual_framework

Chapter 5 The Conceptual Framework

CHAPTER OBJECTIVES

After studying this chapter, you will be able to:

  • Distinguish financial reporting from financial accounting.
  • List and define the elements of the IASB's and FASB's Conceptual Framework for financial accounting and reporting.
  • List and critique the objectives of financial reporting as they are currently understood by the IASB and the FASB.
  • Discuss and apply the qualitative characteristics that, according to the IASB and the FASB, make information useful, relating each characteristic to the others in the set.
  • Define the fundamental concepts of financial accounting and explain their significance for setting accounting standards.
  • Discuss the changes that the proposed common Conceptual Framework will bring.

CHAPTER OVERVIEW

Hierarchy of Elements

Both the IASC, predecessor to the IASB, and the FASB developed Conceptual Frameworks as a basis for setting accounting standards. The relationships between the various elements in the FASB’s framework, which is very similar to that of the IASC, are outlined and the new common framework being developed jointly by the two boards is introduced.

The Objectives of Accounting

The main objective_of_financial_reporting is to support shareholders and others in their financial decisions by assisting them in predicting corporate cash flows.

Qualitative Characteristics

Information that is useful for this purpose is deemed to have a number of characteristics, such as relevance and representational faithfulness. It should provide more benefits than costs, be understandable, and permit comparisons across companies.

Fundamentals

Fundamental concepts underpinning accounting include the notion of the entity, the going concern, periodicity, conservatism, and the monetary unit as the basis for measurement.

Conclusion

Objectives, qualitative characteristics, and fundamentals form part of a Conceptual Framework with which accounting standards should be consistent. They also provide the necessary terminology in which financial reporting issues may be discussed.

The previous chapter told the story of the search for generally accepted principles. It also told how the search for principles changed to a search for a conceptual framework of which standards were an important part. As that chapter noted, a number of different accounting organizations around the world produced their own conceptual frameworks. This chapter focuses on three of those frameworks, namely the FASB's version, on grounds that it was one of the earlier efforts and remains one of the most complete, the IASB's version, since it is the foundation for standard-setting internationally, and the proposed common framework, being developed by the IASB and the FASB. This chapter begins with an outline of the framework in Exhibit 5.1. It then continues with a discussion of three of the major features of the framework:

  1. The objectives of accounting.
  2. The qualitative characteristics of useful accounting information.
  3. The fundamental concepts in accounting.

The remaining parts of the framework are discussed in subsequent chapters.

The Evolution of Conceptual Frameworks

The FASB’s Conceptual Framework appeared, as Exhibit 5-1 shows, in six separate statements over a period of seven years at an estimated cost to the FASB of millions of dollars. A seventh statement dealing with cash flow information and present value was added in February 2000. The first two chapters of a new common framework appeared in 2010 as SFAC 8. In a discussion memorandum that preceded the Conceptual Framework, the FASB described it as a constitution on which standards would be based much as the laws of the land derive from the U.S. Constitution. The choice of words is not insignificant, because it underlines the political nature of accounting standard setting. The IASB's predecessor, the IASC did not adopt its Conceptual Framework until 1989. The delay according to David Cairns, secretary-general of the IASC from 1985-1994, was deliberate and was intended to allow the new organization to create a body of standards first and to give it time to resolve two questions.

  • The first question was whether a framework should be prescriptive or descriptive. This parallels the controversy that haunted the APB, as described in the previous chapter. As noted there, ARS 1 and ARS 3 were both issued with underlying intent of suggesting how accounting should be done. Both were soundly rejected. ARS 7 was issued in their place and is well described as simply a compendium of existing, less than satisfactory, practices.
  • The second question was whether a single framework would be able to capture the cultural differences across the many countries represented at the IASC. Accounting in countries that had been part of the old British Empire, including the United States of America, all tended to have a bias toward investors. Capital in these countries is raised through well-defined equity markets with financial reporting targeted at the providers of this capital. Accounting in many Continental European countries and their old colonies was, and to a lesser extent still is, more driven by tax considerations. Capital in these countries tended to come more from large banks with a lesser need, therefore to provide general purpose financial reports to a myriad of small equity investors.

EXHIBIT 5-1 The Conceptual Framework

  • SFAC 1 (November 1978) The objectives of accounting for business enterprises. The objectives in this statement (and those in SFAC 4) lean heavily on the list of objectives developed by the Trueblood Committee.
  • SFAC 2 (May 1980) The qualitative characteristics of financial information.
  • SFAC 3 (December 1980) Definitions of the elements of financial statements for business enterprises. This statement was superseded by SFAC 6, which encompassed not-for-profit organizations as well as business enterprises.
  • SFAC 4 (December 1980) The objectives of accounting for non-business enterprises.
  • SFAC 5 (December 1984) Definitions of concepts such as recognition, realization, and measurement for business enterprises giving guidance on what should be included in financial statements and when. Measurement rules relating to questions of recognition are discussed.
  • SFAC 6 (December 1985) SFAC 6 replaced SFAC 3 by defining the elements of financial statements for all enterprises.
  • SFAC 7 (February 2000) Provides a framework for using future cash flows as the basis for accounting measurement using present value techniques.
  • SFAC 8 (September 2010) Replaces SFAC 1, Objectives and SFAC 2, Qualitative Characteristics.

As standards appeared and globalization took increasing hold, it became increasingly apparent that a common language would be useful to guide discussions. The IASC began to take steps to create its own framework based in part on concepts already developed in its early standards. The framework appeared as a single document with a series of chapters, but otherwise follows the FASB's format quite closely moving from objectives, through qualitative characteristics, recognition and measurement to the elements of financial statements. Its purpose is firstly to “assist the Board of the IASC (sic) in the development of future International Accounting Standards and in its review of existing International Accounting Standards.”

The focus on the IASB’s Framework is the business enterprise, while the FASB’s, with the introduction of private non-profit reporting, is wider. Both organizations take a decision-usefulness approach and see their responsibility to external users as opposed to management. While the IASC initially intended to produce a framework for financial reporting like the FASB’s, it ended with a “Framework for the Preparation and Presentation of Financial Statements” as a result of a concern that financial reporting was not in its charter. Financial statements as the IASC understood it, included the statements themselves together with any explanatory material such as footnotes. It did not include management’s discussion and analysis, which was seen as part of a larger financial reporting package. The FASB, on the other hand, contended that “some useful information is better provided by financial statements and some is better provided, or can only be provided, by means of financial reporting other than financial statements.” Examples of such other reporting include supplementary statements such as on inflation and in oil and gas reports, management discussion and analysis, and letters to stockholders. The acceptance of other sources of information as relevant was a significant departure from prior thinking that all material information be reflected in the financial statements themselves.

Common Framework

The IASB and the FASB began an effort to produce a single Conceptual Framework for use around the globe in July 2006 and issued a joint Exposure Draft in May 2008. This Exposure Draft covers the objectives and qualitative characteristics of accounting information only. Work is continuing on the remaining sections. Both Boards believe that accounting must be “based on a framework that is sound, comprehensive, and internally consistent” if this is to lead to principles-based standards, which appears to be the common goal. They acknowledge the many commonalities between the two frameworks and seek only to bring convergence where necessary. The end product will be a single document and at this point the Boards are focusing on business entities only.

As will become apparent in later sections, the changes in the Framework have been almost entirely terminological. The term feedback value, for instance, has been replaced by the term confirmatory value without any change in the basic concept that is being described. The term reliability has been dropped and the unfortunate term representationally faithful has been elevated in its place, but again the underlying concepts are unchanged. Other terms, such as comparability, which the FASB termed “secondary or interactive qualities” have now been described as “enhancing qualities” but, again, the goal was simply to clarify not to alter the framework conceptually. Indeed, the overall structure of the Conceptual Framework as laid out by the Trueblood Committee in 1973 remains essentially intact.

One of the items that will need reconciliation is the status of a Conceptual Framework in an accounting hierarchy. Currently, an entity “preparing financial statements under International Financial Reporting Standards (IFRS)” is required to consult the Framework when the standards are silent. While there is no such requirement in US GAAP, respondents to the Exposure Draft are advised that “the framework’s authoritative status will be elevated in the U.S. GAAP hierarchy to be comparable to the status of the Framework in IFRS.”

THE HIERARCHY OF ELEMENTS

The FASB’s Conceptual Framework, all those following it and the Common Framework, are all based on a discussion memorandum drawn up by the Study Group on the Objectives of Financial Statements, also called the Trueblood Committee after its chairman Robert M. Trueblood, that appeared in 1974. A diagram from its appendix is reproduced in Exhibit 5-2. This diagram seeks to tie together the various parts of the Conceptual Framework.

EXHIBIT 5-2 Hierarchy of Elements in a Conceptual Framework for Financial Accounting and Reporting

The terms in the hierarchy shown in Exhibit 5-2 were defined by the FASB in the following way:

1. Objectives are “something toward which effort is directed, an aim or end of action, a goal.” These objectives were the subject of SFAC 1. 2. Information needed “involves identification of the broad categories of financial accounting information needed by users. For example, several objectives specified in the Objectives Study deal with specific types of financial statements perceived to be necessary to meet the information needs of users.” This element is similar to the objectives in APB Statement No. 4 discussed in Chapter 4. 3. Qualitative characteristics “are attributes of accounting information which tend to enhance its usefulness. Such qualitative characteristics might be expected to be

a. Able to withstand the test of time.
b. Pervasive—that is, apply to all accounting entities.

c. Implementable—that is, capable of application and susceptible to objective verification.” This element is similar to the qualitative objectives in APB Statement No. 4. These characteristics were the subject of SFAC 2. 4. Fundamentals “are the basic concepts underlying the measurement of transactions and events and disclosing them in a manner meaningful to users of accounting information. . . . Such fundamentals might include the definitions of an accounting entity, assets, liabilities, income, revenue, expense, realization, and others.” These fundamentals were treated in SFAC 3 originally and now appear in SFAC 5 and 6. 5. Standards “represent general solutions to financial accounting problems.” 6. Interpretations “clarify, explain, or elaborate upon the accounting and reporting standards as an aid to their application in accounting practices.” 7. Practices are “the means to attain the basic objective(s) of financial statements.”

This chapter seeks to develop in detail several parts of the framework, leaving other parts to be dealt with in later chapters. Specifically, this chapter focuses on the supposed objectives of accounting and This chapter seeks to develop in detail several parts of the framework leaving other parts to be dealt with in later chapters. Specifically, this chapter focuses on the supposed objectives of accounting and the qualitative characteristics that are believed to enhance the usefulness of accounting information. This chapter also speaks to some of the fundamental concepts used in accounting, such as going concern. Later chapters deal with the nature of the environment and the elements of financial statements, such as assets and liabilities. Standards and their interpretations are the focus of several still later chapters.

CHECKPOINTS

1. List the six statements that form the FASB’s Conceptual Framework. 2. What are the seven elements that form the FASB’s Conceptual Framework's hierarchy? 3. Define, in your own words, each of the elements in the hierarchy.

QUALITATIVE CHARACTERISTICS

Qualitative characteristics were defined earlier as “those attributes of accounting information which tend to enhance it usefulness. The Board suggested a number of different qualitative characteristics in the framework. The FASB distinguished between user-specific and decision-specific qualities. • The former classification focuses on qualities related to a user. For instance, knowledgeable users might find some information irrelevant because they are already aware of it. Sophisticated users might find complex information more relevant than novices. Thus, the nature of the user is a key determinant in deciding what information to release. Because the intelligibility or understandability of proposed information is dependent on the nature of the user, this characteristic is classified as user-specific. • On the other hand, a characteristic such as timeliness is independent of users, because all users want timely information. Other information is specific to a particular decision. For example, variable costs are often more relevant to volume-related decisions than fixed costs. This too is a decision-specific property. In fact, as a general statement relevance is by definition related to a decision. Representational faithfulness, too, is a decision-specific characteristic.

The FASB then developed its own hierarchy of qualitative characteristics in SFAC 2. It suggested that relevance and reliability were primary decision-specific qualities. It suggested that predictive value, feedback value, and timeliness were ingredients of relevance; and that verifiability, neutrality, and representational faithfulness were ingredients of reliability. Understandability was seen as a user-specific quality while comparability was seen as a secondary quality and materiality as a “threshold” quality. All of the above was seen as subject to the constraint that the benefits of providing this information should exceed its costs. The IASC's Framework was similar in intent. As the two Board's grappled with the development of a Common Framework, it became apparent to them that the term reliability was not well understood and that users were giving it varying meanings. The Boards decided to drop its use and to replace it with the term faithful representation, which previously had been seen as an ingredient of reliability. The IASB preferred the term confirmatory value to feedback value and the FASB agreed to its use. The rest of the terms were then reshuffled to create a hierarchy of elements that has relevance and faithful representation as the two fundamentals. Predictive value and confirmatory value are now seen as the two co-equal ingredients of relevance. Timeliness has now been relegated to an enhancing characteristic along with comparability, verifiability, and understandability. The distinction between user-specific and decision-specific qualities has been discarded. The ingredients of faithful representation are now seen to be completeness, neutrality, and freedom from error. Being complete and free from error were drawn from the IASC's Framework, paragraphs 38 and 31 respectively. All of the above are subject to their benefits exceeding their costs.

Benefits and Costs

Information must be cost-beneficial, that is, its benefits must exceed its costs. Despite its seeming simplicity, a cost-benefit analysis of accounting information is exceedingly difficult to do; it may even be impossible. As the IASB noted: Costs do not necessarily fall on those users who enjoy the benefits. Benefits my also be enjoyed by users other than those for whom the information is prepared; for example, the provision of further information to lenders may reduce the borrowing costs of an entity. For these reasons, it is difficult to apply a cost-benefit test in any particular case. Or as the FASB noted: Most of the costs of providing financial information fall initially on the preparers, while the benefits are reaped by both preparers and users. Ultimately, the costs and benefits are diffused quite widely. The costs are mostly passed on to the users of information and to the consumers of goods and services. The benefits also are presumably passed on to consumers by assuring a steady supply of goods and services and more efficient functioning of the marketplace. But, even if the costs and benefits are not traced beyond the preparers and users of information, to say anything precise about their incidence is difficult. The Boards recognize the difficulties but feel they can be circumvented. As the FASB said: Despite the difficulties, the Board does not conclude that it should turn its back on the matter, for there are some things that it can do to safeguard the cost-effectiveness of its standards. Before a decision is made to develop a standard, the Board needs to satisfy itself that the matter to be ruled on represents a significant problem and that a standard that is promulgated will not impose costs on the many for the benefit of a few. Events during 1989, such as the Business Roundtable's complaints about the actions of the FASB and the subsequent decision to use the FAF more actively to respond to such complaints, indicate that a cost-benefit equilibrium may be harder to achieve than the Board at first acknowledged. We return to this issue in Chapter 8, where we note again the user-specific character of cost-benefit analysis. The Board then turned its attention back to the primary issue in its objective statements: how to ensure that financial reporting be most useful for making investment decisions; that is, it turned to decision-specific considerations. It began by asserting that usefulness is a function of two basic characteristics: relevance and representational faithfulness. Each of these terms is discussed in detail below. Relevance Relevance has been variously defined. At its most basic, relevant information is information that has a bearing on the matter at hand. Information can have a bearing in at least three ways: by affecting goals, by affecting understanding, and by affecting decisions. (See Exhibit 5-3.) Each way provides a definition of relevance. The FASB also put itself firmly on the side of decision relevance when it defined the term as the capacity of information “to make a difference” in a decision; likewise the IASB defines relevance as the ability to influence an economic decision.

Exhibit 5-3 Relevance Goal relevance Attained when information enables goals of users to be achieved. Difficult to determine when met because goals are subjective. Semantic relevance Attained when receiver of information understands the intended meaning of the information reported. An essential prerequisite but not an ultimate objective. Decision relevance Attained when information facilitates decisions made by users. This is the ultimate objective of the FASB.

A decision-relevant concept was the primary standard in ASOBAT, where it was suggested that: Relevance . . . requires that the information must bear upon or be usefully associated with actions it is designed to facilitate or results desired to be produced.

The FASB went on to argue in the next paragraph that this difference would be accomplished by “helping users to form predictions about the outcome of past, present, and future events or to confirm or correct prior expectations.” These two roles of information have been referred to as the predictive value and the confirmatory value of information, respectively. The Common Framework reaffirms these earlier definitions of decision relevance noting that “relevant financial information is capable of making a difference in the decisions made by users. The Boards are careful to distinguish the concept of statistical predictability from the concept of predictive value. They note that financial information is an “input to processes employed by users to predict future outcomes” so as long as it aids users it can be said to have predictive value. Predictive Value. The concept of predictive value is defined by the FASB in the glossary to SFAC 2 as: The quality of information that helps users to increase the likelihood of correctly forecasting the outcome of past or present events. If accounting data are to be relevant for decision making by investors, they must provide input into investors' decision models. And since only expectations of future objects and events are relevant for these decision models, it follows that if accounting data are to be relevant, they must provide or permit predictions of future objects or events. However, the emphasis on prediction leaves several questions unanswered: 1. What objects or events are or should be included in investors' decision models? 2. What relationships should be assumed or sought between accounting data and the inputs into decision models? 3. What alternative sets of accounting data and what alternative accounting procedures best meet the predictive ability criterion? Before the predictive ability test can be applied, there must be some knowledge of what decision models are in use or what decision models investors should be using. The former can be studied through descriptive theories of investors and market reactions to accounting data. The main difficulty with using descriptive theories is that investors are limited by the information made available to them. Therefore, it is difficult to evaluate the effect of alternative, currently unavailable, accounting data or procedures. The normative approach has the advantage of permitting freedom to include alternative accounting procedures and accounting data not currently reported. Normative theories, however, are always difficult to evaluate and must always be subject to change as new information is obtained. As suggested by the 1969–71 American Accounting Association Committee on Corporate Financial Reporting, there are at least four ways by which accounting data can be related to the inputs of decision models: by direct prediction, by indirect prediction, by the use of lead indicators, and as corroborative evidence. The roles of each are summarized in Exhibit 5-4. EXHIBIT 5-4 Predictive Value

Direct Provision of forecasts by management; for example, projected cash flows. Potential misuse and liability, in the case of inaccurate forecasts, constrain their use. Indirect Provision of past data; for example, past cash flows to enable users to predict future cash flows. Assumes high correlation between past and future events, which may not be justified. Lead indicators Provision of data whose movements precede the movements in the objects or events being predicted; for example, increasing debt-equity ratios might precede a deterioration in cash flows. Assumes indicators that led turning points in the past will do so in the future. Corroborating

  information		Provision of accounting data which may be used to predict other data; for example, an increase in the return on assets may reflect increased managerial efficiency that may herald increased cash flows. Assumes the relationship between accounting data and other data is known.

The predictive ability concept has considerable potential for future development of relevant financial reporting. However, several major obstacles stand in the way at the present time. A major obstacle is the lack of tested normative (or even descriptive) investor decision models with a sufficient description of the model inputs. A second obstacle is the lack of understanding of the relationship between accounting data and relevant objects or events that may be inputs into decision models. It is improper to assume that a given concept of income, for example, is a relevant predictor just because it permits a prediction of future values of itself. Accounting income is an artifact derived from the formal accounting structure and is relevant for prediction purposes only if it is also a good substitute or surrogate for a relevant input into the decision models. At the present time, the complexities of the business environment, the lack of understanding of the relationships of past and future measurements of objects and events, and the inability to formulate reliable normative or descriptive decision models make the predictive ability test a difficult one. Confirmatory Value. Information also has an important role to play in confirming or correcting earlier expectations. Decisions are seldom made in isolation. Information about the outcome of one decision is often a key input into making the next decision. This kind of information is often called feedback. It is often illustrated by a thermostat, which does not only “decide” at what temperature to set a room but continues to seek feedback by monitoring the room so as to adjust the temperature when needed. Accounting ideally performs a similar service for investors, enabling them to adjust their investment strategies over time. Relevance, Information, and Data. The concept of relevance enables one to make a useful distinction between information and data. Data can be defined as measurements or descriptions of objects or events. If these data are already known, or are of no concern to the person to whom they are communicated, they cannot be information. Information can be defined as data that have a surprise effect on the receiver. Furthermore, information should reduce uncertainty, communicate a message to the decision maker that has a value greater than its cost, and potentially evoke a response in the decision maker. It follows that a starting point in the selection of data for presentation is to ensure that they are at least information; otherwise they cannot be relevant. When users have already obtained from other sources the accounting data included in financial statements, they do not contain surprise characteristics and, therefore, are not information (e.g., dividend announcement dates or data relating to economic conditions published in the financial press). If this is the case and if there is any cost to their inclusion, such data should be omitted from the financial statements. Furthermore, some information may be obtainable from alternative sources at a lower total social cost (including the cost to the user of obtaining the information separately). When this is the case, consideration should be given to excluding such information from accounting reports and permitting the alternative source to provide the information. CHECKPOINTS 1. Contrast feedback value and predictive value. Can information have both? 2. Contrast information and data. 3. Compare goal relevance and decision relevance.

Representational Faithfulness

Reliability was defined in the glossary to SFAC 2 as: The quality of information that assures that information is reasonably free from error and bias and faithfully represents what it purports to represent. In the debate surrounding the new Common Framework, it became apparent to the Boards that users saw reliability as either an alternative word for freedom from error or as an alternative word for faithful representation. Given the confusion, the Boards decided to drop the use of the word reliability and to replace it by the word representational faithfulness. In other words, the Boards say that if one is to depend on information, it is essential for the information to report faithfully the phenomena that it purports to represent. To use the FASB's own illustration: A spelling test is administered orally to a group of students. The words are read aloud by the tester, and the students are required to write down the test words. Some students, though they can usually spell well, fail the test. The reason, it turns out, is that they have hearing problems. The test score purports to measure ability to spell, whereas it, in fact, is partly measuring aural acuity. The test score lacks true representational faithfulness. In light of this illustration, the FASB in the glossary to SFAC 2 defined representational faithfulness as: Correspondence or agreement between a measure or description and the phenomenon that it purports to represent (sometimes called validity). The difficulty with this definition is that many of the measures used in accounting have no economic interpretation. The price paid for an asset at the time of its purchase may have been a meaningful exchange price, but its depreciated value 10 years later has no significant meaning at all. It is faithful only to the mechanics that created it in the first place. One cannot verify the result; at best, one can check the inputs to its computation and recompute it to test for arithmetical accuracy. In such circumstances, representational faithfulness has a more limited meaning which is better captured by the term verifiability, which now appears as an enhancing quality described below. Complete The term complete did not appear in the FASB's Framework but did appear in the IASC's in paragraph 38 where it was stated that “to be reliable (sic), the information in financial statements must be complete within the bounds of materiality and cost.” As they said, “an omission can cause information to be false of misleading and thus unreliable and deficient in terms of its relevance.” The Common Framework adds that “a complete depiction includes all information necessary for a user to understand the phenomenon being depicted, including all necessary descriptions and explanations. This has overtones of semantic relevance rather that the stated goal of decision relevance. Neutrality Bias, said the FASB, is “the tendency of a measure to fall more often on one side than the other of what it represents instead of being equally likely to fall on either side.” Freedom from bias then represents the ability of the measurement procedure to provide an accurate description of the attribute under consideration. The concept is most easily illustrated by the diagrams in Exhibit 5-5. Bias is determined by the relative deviation of the mean value xm determined by the measurement procedure and the alleged, or “true,” value x* of the attribute. Therefore, measurement procedure C is more verifiable than D, and procedure D is less biased than C because the mean value produced lies closer to the alleged value x*. Historical costs provide a good example of a biased measure when used as an estimate of current costs if prices have changed since the date of acquisition. On the other hand, a procedure that adjusts historical cost for changes in the specific prices of that class of asset may be less verifiable, but result in less bias. When a true value for an attribute cannot be determined, the difference between the mean value xm and the alleged value x* must be based upon expert judgment, taking into consideration the logical relationship between the measurement procedure and the attribute being measured.

EXHIBIT 5-5 Bias

The term neutrality is closely related, but not identical, to the term freedom from bias. Unfortunately, the Common Framework has chosen to conflate the two terms. Neutrality means that a person is not biased toward a predetermined result. Neutrality is particularly important for the FASB, because it has decided as a matter of policy not to allow its standards to be used to seek a particular economic or political goal. This is not to say that accounting does not have economic consequences; it does mean that the FASB is determined not to seek particular economic consequences.  Whether, though, neutrality can be achieved remains a relatively controversial matter.

Substance over form. The IASC added that a prerequisite for representational faithfulness was that accounting be done “in accordance with their substance and economic reality and not merely their legal form.” The FASB disagreed with this position quite sharply, saying that the notion of reporting “substance over form was redundant and “in any case, a rather vague idea that defies precise definition.” They did not deny the notion, but felt it was already captured by the concept of representational faithfulness. Summary The Boards' decision to elevate the concept of representational faithfulness over the concept of verifiability strongly suggests to this author that there is an attempt by the Boards to return to a more semantic approach to accounting. The last decade has seen what one might call real accounting completely overwhelmed by accounting for financial instruments. There have been no standards issued on items such as fixed assets and inventory. There has been no progress in managerial accounting, which remains stuck in a 1940's paradigm of product and period costs that go back to Paton & Littleton's views on matching. Instead, there have been a steady stream of standards on financial products. The Boards have argued fairly consistently for fair value measurement of financial instruments. When a share is traded on the NYSE and its price is publicly available, there can be little argument for reporting it at the price paid a decade earlier. Its fair value is the relevant value. Its market price is the measure of the phenomenon, the share value that the entity is reporting. The same, though, cannot be said about real assets. The LIFO measure of inventory is nothing but an accounting artifact that has no connection to any conceivable economic measure. Accounting depreciation is an accounting artifact that has no economic meaning – to claim otherwise is to reveal that one has not read Art Thomas's contributions to the accounting literature. Other comprehensive income is by the admission of the two Boards not well defined. There is no economic basis for what gets excluded from net income and dumped in other comprehensive income. As a result, net income has no economic significance whatsoever. It too is an accounting artifact only. This is not to say that accounting numbers do not have predictive and confirmatory value. As noted earlier, accounting artifacts are inputs to the models of users (currently largely still unknown) and if found useful by users then they have predictive value by definition. But having predictive value does not ensure that net income is representationally faithful. On the other hand, it is potentially verifiable. Stated otherwise, all accounting measures should be verifiable but not all accounting measures can be representationally faithful. This author, therefore, would have much preferred it if the Boards had chose verifiability as the other fundamental qualitative characteristic to put alongside relevance. This would also have meant that the ingredients of completeness and freedom from error would have been appropriately placed. As the IASC's own definitions of these terms indicate, neither term has anything to do with representational faithfulness; both have a great deal to do with the verifiable half of reliability. CHECKPOINTS 1. Compare representational faithfulness with verifiability. 2. Contrast neutrality and freedom from bias. 3. Compare relevance and reliability. Can information be both?

ENHANCING QUALITIES

The Common Framework introduces a new class of qualitative characteristics, which it calls enhancing qualities. Essentially these are terms that were part of the old relevance/reliability paradigm that no longer fit into the new framework but from which the two Boards were reluctant to part. Timeliness Information cannot be relevant if it is not timely, that is, it must be available to a decision maker before it loses its capacity to influence decisions. Timeliness does not guarantee relevance, but relevance is not possible without timeliness. Timeliness, therefore, is an important constraint on the publication of financial statements. The accumulation, summarization, and subsequent publication of accounting information should be as rapid as possible to ensure the availability of current information in the hands of the users. Timeliness also implies that financial statements should be presented at frequent intervals so as to reveal changes in the firm's situation that may in turn affect the user's predictions and decisions.

Verifiability

The word verify derives from the Latin verus meaning truth. To verify something means to establish its truth. Truth seems to imply that the measurement has an existence separate from the person making the measurement. Thus, an absence of subjective valuation and personal bias is assumed. However, particularly in accounting, an important question is whether or not a measurement can exist independent of the measurer. The existence of an external transaction does not automatically imply that an objective measure of the transaction exists. The accountant must still determine the value of what is given up and the value of what is received. Value, like beauty, may be in the eye of the beholder. In an attempt to escape the dilemma of the interaction between the measurer and the measured, some have placed emphasis on the evidence, rather than on the measurement, and suggested that information is verifiable when objective evidence can be found to support it. The difficulty with this approach is that the selection of the evidence to be used may be subject to personal bias. A third approach was developed, therefore. In this approach, measurements are verifiable if they can be corroborated by the intersubjective consensus of qualified experts. Accounting Research Study No. 1, for example, states that verifiable “means . . . unbiased; subject to verification by another competent investigator.” ASOBAT defined verifiability similarly as that attribute of information which allows qualified individuals working independently of one another to develop essentially similar measures or conclusions from an examination of the same evidence. These were the definitions drawn on by the FASB when it defined verifiability in the glossary to SFAC 2 as: The ability through consensus among measurers to ensure that information represents what it purports to represent or that the chosen method of measurement has been used without error or bias. The astute reader will note how the FASB has attempted to cover both the situation where an interpretation can be given to a measure and the situation where only a method exists. The FASB’s concept of verifiability is illustrated in Exhibit 5-6: First, one notes that, even if several investigators use the same or similar methods of measurement of an attribute and base their measurements on similar evidence, it is still probable that they will provide a range of values. If the measurements are free from personal bias, it is probable, although not necessary, that a frequency distribution of these measurements will produce a symmetrical curve. For any given number of observations or measurements, then, the degree of objectivity or verifiability may be said to depend upon the dispersion of the measurement values around a mean or average figure. This definition of verifiability is demonstrated by the two measurement procedures in Exhibit 5-7, which result in the same average value. EXHIBIT 5-6 Verifiability

Measurement procedure A is more verifiable than procedure B, since any measurement value x1 has a greater probability of being close to the mean value xm by using procedure A than by using procedure B. Thus, verifiability is a relative concept. Very few procedures will result in values upon which many accountants would have complete agreement. Although verifiability cannot be obtained unless the measurements are relatively free from personal bias, measurement errors and differences in interpretation may also result in the loss of verifiability. Note that the relative degree of verifiability alone does not determine whether the measurement procedure accurately describes the attribute under consideration. Even the mean value xm may fail to measure the attribute accurately. Comparability The Board claimed that the usefulness of information is greatly enhanced when it is presented in such a fashion that one is able to compare one entity with another—or with the same entity over time. Comparability was then defined in the glossary to SFAC 2 as that quality of information that enables users to identify similarities in and differences between two sets of economic phenomena. The former depends in part upon uniformity; the latter on consistency. Uniformity. The term uniformity implies that like events are being accounted for identically. Accounting theorists Harry Wolk, Jere Francis, and Michael Tearney distinguish between finite uniformity and rigid uniformity. They define the latter as “prescribing one method for generally similar transactions, even though relevant circumstances may be present.” Accounting for research and development costs is an example of rigid uniformity in accounting. Finite uniformity permits relevant circumstances to be considered. Accounting for loss contingencies, which permits different treatment according to the degree of probability, is offered as an example of finite uniformity in accounting. Uniformity among firms in their financial reporting is frequently thought to represent a desirable goal for its own sake. That is, the goal of uniformity frequently encourages the presentation of financial statements by different firms using the same accounting procedures, measurement concepts, classifications, and methods of disclosure, as well as a similar basic format in the statements. As used in this context, the concept is rightfully criticized; the objective should be comparability, not strict or rigid uniformity. The primary objective of comparability should be to facilitate the making of predictions and financial decisions by creditors, investors, and others. It may be defined as the quality or state of having enough like characteristics to make comparison appropriate. The main opposition to uniformity is based on the claims that: 1. It would infringe on the basic rights and freedoms of management. 2. It would place accounting in a straitjacket of rules and procedures that would make financial statements less comparable. 3. It would stifle progress and prevent desirable changes. On the other hand, the arguments for some degree of uniformity are that: 1. The wide variety of acceptable practices makes comparability among different firms impossible or at least difficult. 2. The freedom of management to choose their own methods may introduce the possibility of bias through manipulation of reported information to suit the purposes of those who control the reports. 3. If the private sector does not take steps to achieve greater uniformity, it may be imposed by the SEC or some other governmental agency. Narrowing the areas of difference in financial reporting among firms may be desirable as an objective of accounting policy; however, it can be only one of the means of achieving the basic goals of moving toward an optimum level of social and economic welfare. If diverse procedures or methods of disclosure are found to provide greater or even equal benefits, the firms are likely to choose the methods that are least costly or that have the more favorable economic consequences for themselves. Since it is impossible to anticipate all of the possible economic consequences, there is some merit in permitting each firm to make some choices so long as investors and creditors are not harmed. This suggests that accounting standards should require finite uniformity only. Consistency. Consistency, as with many of the terms used in this chapter, has been variously defined. It has been used to refer to the use of the same accounting procedures by a single firm or accounting entity from period to period, the use of similar measurement concepts and procedures for related items within the statements of a firm for single period, and the use of the same procedures by different firms. This latter meaning of the term was considered above in the discussion of uniformity, and the term consistency will be applied to the first two meanings only. The IASC treats these two uses of consistency under the heading of their purpose: comparability. Consistency in the use of accounting procedures over time is required because of the difficulty of making predictions based on time-series data that are not measured and classified in the same way over time. If different methods or measurement procedures are used, it is difficult to project trends or discern the effects from period to period on the firm caused by external factors (changes in economic conditions, actions of competitors, etc.) or separate the fluctuations caused by internal and external economic factors. For instance, if assets were valued at cost in some periods and at replacement cost in others, both the fluctuations from period to period and the trend may be distorted, especially if price changes are significant over time. However, care must be taken in the use of the concept of consistency. For instance, while the continued use of historical costs may be consistent in one sense, all it produces in times of changing prices is an aggregate of very dissimilar costs. The result is a number that is actually inconsistently measured from one period to the next. Also, consistency should not be used to prevent a change to a method that provides more accurate or more useful information for predictions or decision making. When a change is made, however, the effect of the change should be stated clearly so that users of the data can take the change into account in their decisions. Of course, disclosure is not necessary if the change would not affect any of the decisions likely to be based on the accounting data. According to APB Opinion No. 20, an accounting change includes a change in an accounting principle, an accounting estimate, or in the reporting entity. It states further that once adopted, an accounting principle should not be changed unless the new method can be justified as being preferable. Changes should be disclosed in the period in which the change is made. Only a few types of changes should be reported by restating the financial statements of prior years. Consistency can, and should, be interpreted more broadly to mean disclosure, each period, of all relevant information necessary for users to make predictions. Consistency then becomes one means to achieve relevance and is not a goal in its own right. As with uniformity, consistency of disclosure is more important than consistency of procedures CHECKPOINTS 1. What factors make financial information comparable? 2. Compare consistency with uniformity.

Materiality

Materiality, which is described by the FASB as a pervasive characteristic, is very similar to the concept of relevance in many respects. As indicated above, the concept of relevance implies that all information should be presented that may aid in the prediction of the types of information required in the decision processes or that may aid directly in the making of decisions. But materiality has also been used in a positive sense to determine what should be disclosed for general, undefined uses. That is, information may be considered to be material (and thus disclosure is necessary) if the knowledge of this information may be significant to the users of accounting reports. According to SFAC 2 and the Framework, the basic nature of materiality is that it is probable that the judgment of a reasonable person relying upon the report would have been changed or influenced by the inclusion or correction of the item. Information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements. Materiality may be looked upon also as a constraint determined by the inability of the specific users to handle large masses of detail. Financial information that may be relevant for investment and other decisions can generally be made available in considerable detail, particularly with the widespread use of computers and other communication devices. One of the responsibilities of the accountant in financial reporting is to summarize this mass of data in such a way that it will be meaningful to the users of the reports. Too much data can be just as misleading as too little. If too much is presented, the relevant items are buried, and the reader must base decisions on inadequate data, in which case the decisions are not likely to be sound. Just as too little information does not promote good predictions and decisions, information that is replete with insignificant details may also detract from good prediction and decision-making. Thus, materiality places a restriction on what should be disclosed.

Materiality may relate to the significance of value changes, to corrections of errors in prior reports, or to the several means of disclosure of quantified data and relevant descriptions or qualifications of these data. These changes, corrections, and descriptions should be considered material if they are large enough or significant enough to influence the decisions of the users of financial reports. The types of items where materiality may be involved in the decision to disclose, or not, include the following:

1. Quantitative data, such as items affecting net income and asset valuation. 2. The extent of aggregation or itemization of quantitative data in the formal statements. 3. Quantitative data that cannot be estimated accurately enough to be included in the statements. 4. Quantitative features that must be disclosed by descriptive phrases or sentences. 5. Special relationships between the firm and particular individuals or groups affecting the rights and interests of other individuals or groups. 6. Relevant plans and expectations of management. Materiality regarding the measurement of accounting data is assumed throughout this book. CHECKPOINTS 1. Define materiality. 2. Contrast relevance and materiality. 3. Look back at the diagram in Exhibit 5-4 that lays out the qualitative characteristics that make information useful. Briefly define each characteristic in your own words.

FUNDAMENTALS

Featured in the hierarchy of elements listed in Exhibit 5-2, but not appearing in the Conceptual Framework, are some concepts and elements underlying the measurement of transactions that the FASB termed fundamentals. The elements of financial statements, that is, assets, liabilities, and so on, are discussed in detail in subsequent chapters. This section treats those basic concepts that are truly fundamental to accounting but which are not discussed elsewhere. The list is long, so the focus here is on a few key concepts. The basis for much of the discussion is drawn from APB Statement No. 4, which appeared shortly before the Conceptual Framework and was the Accounting Principles Board's last attempt to create a framework for its deliberations. Entity A definition of the accounting entity is significant because it defines the area of interest and thus narrows the possible objects and activities and their attributes that may be selected for inclusion in financial reports. Furthermore, the entity concept may aid in determining how best to present information regarding the entity. Thus, relevant features may be disclosed and irrelevant features that cloud the basic information may be omitted. One approach to the definition of the accounting entity is to determine the economic unit that has control over resources, accepts responsibilities for making and carrying out commitments, and conducts economic activity. Such an accounting entity may be either an individual, a partnership, or a legal corporation or a consolidated group engaged in carrying out either profit-seeking or not-for-profit activity. An alternative approach is to define the entity in terms of the area of economic interest of particular individuals, groups, or institutions. In this approach, the boundaries of an economic entity are identifiable: 1. By determining the interested individual or group. 2. By determining the nature of that individual's or that group's interest. Thus, this approach is oriented to the interests of the users of financial reports. Both approaches may lead to the same conclusions, but the latter, more user-oriented approach may lead to a selection of different information than the former, economic-activity approach. Additionally, the user approach may extend the boundaries of the entity to include some environmental activity, such as attempts to improve sociological relations within the enterprise or within the community, and information regarding the social responsibilities of the enterprise. The concept of the accounting entity may include the legal enterprise, a division of the enterprise, or a “super-enterprise,” such as a consolidation of several interrelated firms. The choice of the appropriate entity and the determination of its boundaries depend upon the objectives of the reports and the interests of the users of the reported information. The nature of the entity and the interests in it may be classified according to proprietary, entity, funds, or enterprise theories. These theories are discussed in Chapter 22. Going Concern An assumption generally made regarding the nature of the relevant accounting entity is that most economic units are organized for operation over an indefinite period of time. Therefore, it is frequently argued that it is a logical step to recognize that the entity should be viewed as remaining in operation indefinitely under normal circumstances (the traditional going-concern postulate). As generally applied, the continuity postulate assumes that the accounting entity will continue in operation long enough to carry out its existing commitments. Some argue that, since commitments are of varying time periods, new commitments will have to be made continually into the future to carry out all commitments, thus, in effect, making the continuity assumption one of indefinite life. Others argue that a going concern is simply a firm that is adapting itself by the sale of its assets in the ordinary course of its business, that is, it is in orderly liquidation as opposed to forced liquidation. SAS 59 goes in another direction and defines the expected life of a concern as a reasonable “period of time not to exceed one year from the date of the financial statement.” The reason for including the concept of continuity in the set of fundamentals at all is generally to support the benefits theory of valuation, or in some cases to support the use of historical costs as opposed to liquidation values. As indicated earlier, the objective of financial reporting is to permit investors and others to make predictions. Information regarding a specific firm should be presented in such a way that users of financial reports can make their own assessments regarding the future of the enterprise. Therefore, in the authors' opinion, the continuity postulate should not be interpreted to be either a status quo assumption, or a justification for historical cost, or even the benefits concept, in the valuation of assets. However, it is a relevant assumption, leading to the presentation of information regarding resources and commitments and operational activity, such as the sales of goods and services over several years, or even for one year, on the ground that such information may aid in the prediction of future operational activities. Continuity assumes some connection between the past and the future, although not necessarily that the future will be a repetition of the past. SAS 59 seeks to fulfill this information objective by requiring an explanatory paragraph from the auditor when there is substantial doubt about the entity's ability to continue as a going concern for a reasonable period of time. Periodicity The concept of periodicity refers to the fact that accountants measure income over regular calendar periods, such as a year, a quarter, or a month. As Luca Pacioli noted, “Books should be closed each year, especially in a partnership, because frequent accounting makes for long friendships.” The significance of the concept lies in the fact that income is relatively easily measured over the full life of a project—in general, lifetime income is equal to the cash earned over the life of the project. It is a considerably more difficult problem to determine income before the end of a project. Consider, by way of illustration, the buccaneer setting sail from London for the New World. When the ship returns, the total income for the voyage is the cash value of the sale of the booty less the amount invested at the outset less depreciation on the ship. But what income has the buccaneer earned if December 31, the financial year-end, happens to fall while the ship is still in mid-Atlantic? Uncertainty and Conservatism Uncertainty in accounting arises from two main sources. First, accounting generally relates to entities that are expected to have continuity of existence into the future. Since allocations are frequently made between past and future periods, assumptions must be made regarding the logic of these allocations on the basis of expectations regarding the future. Although some of these assumptions and expectations regarding allocations may be validated in later periods, many allocations can never be verified completely. Second, accounting measurements are frequently assumed to represent monetary expressions of wealth that require estimates of uncertain future amounts. The reliability of these estimates may vary considerably: No monetary quantification of wealth can be known with certainty. Thus, any measurement based on estimates can only be tentative. However, this does not mean that estimates and predictions should not be made as accurately as possible if they are relevant. But it does imply that measurements based on past estimates should be scrutinized closely and adjusted as new and more reliable estimates become possible. The general constraint of uncertainty has served as the basis for the traditional accounting concept of conservatism. As it is generally stated, the concept of conservatism is a constraint on the presentation of data that may otherwise be reliable and relevant. To understand conservatism in accounting, we should try to understand the conditions that give rise to it and point out the element of truth in the constraint, if indeed there is any. The term conservatism is generally used to mean that accountants should report the lowest of several possible values for assets and revenues and the highest of several possible values for liabilities and expenses. It also implies that expenses should be recognized sooner rather than later and that revenues should be recognized later rather than sooner. Therefore, net assets are more likely to be valued below current exchange prices than above them, and the computation of income is likely to result in the lowest of several alternative amounts. Thus, pessimism is assumed to be better than optimism in financial reporting. One of the arguments for conservatism is that the accountant's tendency toward pessimism is assumed to be necessary to offset the overoptimism of managers and owners. Entrepreneurs are naturally optimistic about their own enterprises. This optimism tends to be reflected in both the selection and emphasis in accounting reports. Through the pressure of creditors and other users of financial reports, the accountants of the 19th century were continually under pressure to refrain from reflecting this optimism in their reports. Thus, many of the traditional tenets in accounting were supported by conservatism, and many of these concepts permeate accounting practice today. A second argument for conservatism is that overstatement of profit and valuations is more dangerous for the business and its owners than understatement. That is, the consequences of loss or bankruptcy are much more serious than the consequences of a gain. Therefore, it is argued, there is no reason for the measurement and recognition rules for losses to be the same as for gains when the consequences are different. The basis, presumably, for this argument is that the accountant is in a better position to evaluate risk than is the investor or creditor. However, the evaluation of risk and the preference or aversion for it is a subjective judgment, which cannot be assumed by the accountant. Instead of applying conservatism, the objective of financial reports should be to provide adequate information to permit users to make their own evaluations of risk. A third argument for conservatism is based upon the assumption that the accountant has access to much more information than can be communicated to investors and creditors and that the accountant is faced with two types of risk in doing an audit. On the one hand, there is the risk that what is reported may turn out subsequently to be untrue. On the other hand, there is the risk that what is not reported may subsequently turn out to be true. Conservatism implies that the penalties of disclosure are greater than the penalties of nondisclosure. The objection to this practice is that there is no basic evidence that the consequence of the one risk is so much greater than the consequence of the other to justify this bias in accounting reports. The accountant should attempt to balance these risks as much as possible and provide information for a proper evaluation of the risk whenever possible. Conservatism is, at best, a very poor method of treating the existence of uncertainty in valuation and income. At its worst, it results in a complete distortion of accounting data. The main danger is that, because conservatism is a very crude method, its effects are capricious. Therefore, conservatively reported data are not subject to proper interpretation even by the most informed readers. Conservatism also conflicts with the objective to disclose all relevant information, and with consistency to the extent to which that is a relevant constraint. It can also lead to a lack of comparability because there can be no uniform standards for its implementation. The authors believe, therefore, that conservatism has no place in accounting theory. Deliberate understatements may lead to poor decisions just as frequently as do overstatements. Monetary Unit Although accounting data are not limited to measurement in terms of a monetary unit, accounting reports have traditionally included primarily financial information. And in many cases, the monetary unit provides the best measurement unit, particularly where aggregation is necessary or desirable. However, the monetary unit has its limitations as a method of communicating information. The most serious limitation or constraint is due to the fact that the value of the monetary unit is not stable over time. Since many predictions and decisions must rely on valid comparisons of accounting data over time, the lack of a stable monetary unit means that accounting data based on past exchange prices must be translated into current monetary values in order to be relevant and reliable for making appropriate predictions and decisions. In other words, the measurement constraint of instability of the measuring unit requires some modification in the use of exchange prices of different time periods expressed in terms of money. The problems resulting from this instability and the effect on the derivation of accounting principles are discussed at greater length in Chapter 12. CHECKPOINTS 1. Define, in your own words, each of the fundamental concepts: entity, going concern, monetary unit, and periodicity. 2. Explain how conservatism was a response to uncertainty and why it is an inadequate response. 3. What is the most serious limitation of using money as the basis for measurement in accounting? 4. Do the concepts of conservatism and freedom from bias conflict? Explain.

CONCLUSION

The FASB’s Conceptual Framework is an attempt to establish a constitution for resolving issues in setting accounting standards in the United States. Other countries, such as Australia, Britain and Canada, and the IASC have followed the example of the United States in attempting to establish their own conceptual frameworks. This is despite New York professor Lee Seidler's contention that there are “no conceptual frameworks in the social sciences.” This is not to say that attempts to draw up conceptual frameworks are completely useless. The language and the terminology are all extremely valuable intellectual exercises—they provide what they are supposed to provide: a conceptual framework within which fruitful debate can take place about standards. What they have not done, what they should never have been expected to do, is to provide a single statement from which standards could be derived without further debate. SUMMARY This chapter provides an overview of the Conceptual Framework for Financial Accounting and Reporting that was developed by the FASB between 1972 and 1985 with a few references to frameworks developed by others. It discusses the five statements that cover the framework (one was superseded); the elements that make up the framework (objectives, qualitative characteristics, and fundamental concepts); the qualitative characteristics (relevance and reliability); and the fundamental concepts (entity, going concern, periodicity, conservatism, and the monetary unit). Discussion of the elements of financial statements (assets, liabilities, revenues, expenses) and of other fundamental concepts such as revenue recognition and matching are left to later chapters. Financial reporting was seen as more encompassing than financial accounting since it can include supplemental data. The essential objective of financial reporting is the provision of information to enable investors, particularly those who lack authority to specify what information they want, to predict the future cash flows of the enterprise. For this information to be useful it should be relevant (i.e., it should be timely and have predictive and feedback value) and it should be reliable (i.e., it should be representationally faithful, verifiable, and neutral). Later chapters use these concepts in showing how the FASB and others have attempted to develop accounting standards. As the IASC notes, the application of the qualitative characteristics described above and the standards that result below “convey what is generally understood as a true and fair view” or in the US context of presenting financial information fairly.

QUESTIONS

Multiple Choice

1. According to the FASB Conceptual Framework, predictive value is an ingredient of

RelevanceReliability a. YesNo b. YesYes c. NoYes d. NoNo 2. According to the FASB Conceptual Framework, which of the following relates to both relevance and reliability? ConsistencyVerifiability a. YesYes b. YesNo c. NoYes d. NoNo

3. Under Statement of Financial Accounting Concepts No. 2, which of the following relates to both relevance and reliability?

a. Timeliness. b. Materiality. c. Verifiability. d. Neutrality.

4. Under Statement of Financial Accounting Concepts No. 2, feedback value is an ingredient of the primary quality of

RelevanceReliability a. NoNo b. NoYes c. YesYes d. YesNo 5. Under Statement of Financial Accounting Concepts No. 2, timeliness is an ingredient of the primary quality of a. Reliability. b. Relevance. c. Verifiability. d. Representational faithfulness. 6. According to the FASB conceptual framework, the objectives of financial reporting for business enterprises are based on a. The need for conservatism. b. Reporting on management’s stewardship. c. Generally accepted accounting principles. d. The needs of the users of the information. 7. According to the FASB conceptual framework, which of the following situations violates the concept of reliability? a. Financial statements were issued nine months late. b. Report data on segments having the same expected risks and growth rates to analysts estimating future profits. c. Financial statements included property with a carrying amount increased to management’s estimate of market value. d. Management reports to stockholders regularly refer to new projects undertaken, but the financial statements never report project results. 8. What are the Statements of Financial Accounting Concepts intended to establish? a. Generally accepted accounting principles in financial reporting by business enterprises? b. The meaning of “Present fairly in accordance with generally accepted accounting principles.” c. The objectives and concepts for use in developing standards of financial accounting and reporting. d. The hierarchy of sources of generally accepted accounting principles. ===== PROBLEMS ===== 1. The FASB's objectives focus on private enterprise. For an objective which points to a new and different goal, but one which is not necessarily acceptable, one might turn to the English Corporate Report. Their list, which parallels the FASB's in most respects, also includes as an objective: Evaluating the economic function and performance of the entity in relation to society and the national interest and the social costs and benefits attributable to the entity. What sets this objective off from the FASB's is the stress placed upon social costs and benefits as opposed to private costs and benefits. With growing concerns in society about pollution and the like, is this a foretaste of things to come? 2. The objective of financial statements according to the Canadian Institute of Chartered Accountants is to communicate information that is useful to investors, members, contributors, creditors, and other users (“users”) in making their resource allocation decisions and/or assessing management stewardship. Compare and contrast this statement with that of the FASB. 3. Nicholas Dopuch and Shyam Sunder, professors at the University of Chicago at the time of writing this, said We should not be surprised if auditors, like everyone else, seek to maximize their own wealth through participation in the accounting process. If the provision of economically useful information implies greater exposure to the risk of being sued without corresponding benefits of higher compensation, they will not see the provision of economically useful information (however defined) as their objective of the financial accounting process. Discuss this view in the light of determining who the users of accounting are and whether they have an objective in common. 4. Arthur Andersen & Co. stated that: . . . the overall purpose of financial statements is to communicate information concerning the nature and value of the economic resources of a business enterprise, the interests of creditors and the equity of owners in the economic resources, and the changes in the nature and value of those resources from period to period. Compare and contrast this objective with those of the FASB. Is this a pragmatic, a semantic, or a syntactic objective? 5. Ernst & Ernst (later Ernst & Whinney and now Ernst & Young) was sharply critical of the Conceptual Framework and is quoted as having said: The proposed objectives of financial statements are narrowly directed to benefit investors, a single, special interest, with inadequate consideration of the effect this might have on the total economy or on other interests in financial reporting. Discuss their concerns. You might begin by listing the other interests and how they might conflict with those of investors. What response could you make in defense of the FASB's position? 5. Many of the concerns of the FASB in regard to financial reporting such as relevance and reliability could be expressed with regard to standardized tests such as the SATs, GMATs, and GREs. Based on your personal experiences with these tests, sketch out a “conceptual framework” that would guide the use and disclosure of the results and use of these tests. You might want to consider questions such as: Is a score of 1,330 materially different from a score of 1,340? Do the tests have predictive value? Are the tests reliable? Are they relevant? 7. The current objectives of financial reporting in the United States are directed toward investors. Should they be, in your opinion? Can you make a case for more social reporting? Can you make a case for no social reporting? What do you think the ethical obligations of corporations are in this regard? 8. ”Information that is not reliable has no place in financial statements. If it appears anywhere, it should be in the notes or in management's discussion.” Discuss the pros and cons of this statement. 9. Companies typically report a higher income figure to their shareholders than to the tax authorities. One way to achieve this is to use accelerated depreciation for tax purposes but straight-line depreciation for financial reporting purposes. The effect is to shift a portion of the tax burden from the current year to future years. What assumptions are we making when we assume that the burden shifted to the future years will be paid? 10. It has been pointed out that accounting earnings can differ between companies despite similar situations for at least three reasons: 1. Management has open to it several generally accepted accounting alternatives such as FIFO and LIFO. 2. Management has to choose parameters within a given accounting alternative such as the length of an asset's life or the size of the provision for bad debt. 3. Business judgments such as when to retire an asset or when to purchase a new asset will vary across managements. For these reasons, some question whether comparability through uniformity can ever be achieved. Chapter 8 notes that George O. May initially had preferred more complete disclosure as the better route to comparability. Discuss the impact on comparability of the alternatives open to management. WELLSHIRE FOODS Bill Webster, newly appointed controller of a division of Wellshire Foods, working late one night, fell asleep with a cigarette in his hand. He woke moments later, appalled to discover that a fire started by his lighted cigarette had destroyed the financial records on which he was working. Duplicates were available from head office, but this would take time and would also mean that he would have to confess what had happened. It was already July 2 and reports in a format set by the corporate controller for all divisions were due the next day, not enough time to get copies from head office, even if he did confess. Fortunately, the bankers’ bag that he took home with him each evening contained copies of some of the missing material. Frantically, he began to attempt to reassemble what material he had. He did not have a copy of the corporate controller’s memo setting out the desired format so he did his best to recreate it from memory. He lacked some of the asset values in the plant in his records, which meant he had to do some quick estimates of their values for the balance sheet. He had to make estimates for those payables whose records were missing. To be safe, he put these down at the highest at which he could remember them ever being. He knew he was unable to remember all the prepaid items, but he hoped these would not prove to be material. Midyear staff bonuses were paid at the end of the first six months. To avoid potential problems with his colleagues, he made a low estimate of the division’s cost of sales, confident that he could adjust it later when his records were restored. Working day and night, including US Independence Day on July 4th, he was able to complete his estimates, which he sent to head office that day. To his great surprise, the corporate controller took one look at his report and said, “You seem to have broken every principle in the Conceptual Framework!” Required: Which of the qualitative characteristics, do you think, Mr. Webster abandoned in his efforts to reconstitute the accounts? APACHE INDUSTRIES Apache Industries are furniture manufacturers with sales of some $120 million a year. During 1994, the company wanted to establish an additional line of credit with Grand Bank to permit them to expand. In preparing the financial statements for the bank, Tom Hansen, one of the partners of Crockett & Hansen, a firm of auditors in Atlanta, Georgia, tried to persuade Don Walker, vice president of Finance for Apache, to bring his accounting procedures more into line with those of the industry. Apache was a private company and had, to a large extent, followed its own accounting policies over the years. Hansen's feeling was that restating the financials would permit the bank to more easily compare Apache with its competitors, and so it would make a strong line of credit more likely. As Tom Hansen put it: “Don, you do realize that we want to be able to compare ratios between your company and that of your industry. We use your current ratio and your debt-equity ratio, for instance, to evaluate your risk and we use your rate of return on assets to measure your performance. It would really be nice if your ratios were comparable to others in your industry. It would be even nicer if you would use the same accounting procedures as everyone else so that your ratios ar guaranteed to be comparable.” “I must tell you that we at the bank think that there should only be differences in accounting procedures within an industry if conditions in the firms are very different. Choose procedures that provide you with the most accurate or most reliable data, but where there is little difference in the various procedures, get into line with your industry and adopt a uniform procedure.” Don Walker was not persuaded. Tom, he said: “We have always argued that all relevant information for Apache should be presented to permit our investors and creditors to make predictions for the firm. With all the information we provide them, our investors and creditors, including yourselves, can make their own estimates of the present value of the firm and evaluate our risk. Frankly, Tom, I just don't believe that banks should do ratio analysis like that. The only sensible comparisons between companies should be made at an aggregate level. In other words, we maintain that you should make your decisions based on your estimates of our present values and our risk, rather than relying on comparisons of information between firms in our industry. If we’re right, accountants should be concerned with presenting relevant information for each firm, rather than being concerned with presenting comparable data. “Of course, we agree with you that it is important that predictions be based on equally reliable data. And we will also allow that some general standards are necessary regarding the choice of information to be presented, the degree of detail to be presented, and the selection of measurement concepts and procedures relevant for specific users in their making of predictions and decisions. However, in the end, we believe that uniformity of disclosure is more important than uniformity of procedures if the goal is to improve the information available to efficient capital markets.” Required: With whom do you agree most, Tom Hansen or Don Walker? ===== PRIMARY SOURCES ===== Those interested in learning more about the topics covered in this chapter might begin by consulting these sources. Each has numerous excellent citations. American Institute of Certified Public Accountants, Accounting Principles Board, Basic Concepts and Accounting Principles Underlying Statements of Business Enterprises, APB Statement No. 4 (AICPA, 1970). Anthony, Robert N. Tell It Like It Was (Homewood, Ill.: Richard D. Irwin, 1983). Financial Accounting Standards Board, Discussion Memorandum of the issues related to the Conceptual Framework for Financial Accounting and Reporting: Elements of Financial Statements and Their Measurement (FASB, December 2, 1976). Financial Accounting Standards Board, Statements of Financial Accounting Concepts (Homewood, Ill.: Richard D. Irwin, 1987). Flegm, Eugene H. How to Meet the Challenges of Relevance and Regulation (New York: John Wiley & Sons, 1984). Miller, Paul B. W. “The Conceptual Framework as Reformation and Counter Reformation,” Accounting Horizons, June 1990, pp. 23-32. Solomons, David. Making Accounting Policies (New York: Oxford University Press, 1986). SELECTED ADDITIONAL READINGS In addition to the works cited in the primary sources and the footnotes in the chapter, the reader is referred to the following authors: Objectives Aitken, Michael J. & Trevor D. Wise. “The Real Objective of the International Accounting Standards Committee,” International Journal of Accounting, Fall 1984, pp. 171-178. Anton, H. R. “Objectives of Financial Accounting. Review and Analysis.” Journal of Accountancy, January 1976, pp. 40–51. – Beaver, William H., and Joel S. Demski. “The Nature of Financial Accounting Objectives: A Summary and Synthesis.” Studies on Financial Accounting Objectives, Supplement to Journal of Accounting Research, 1974, pp. 170–87. Goetz, B. E., and J. G. Birnberg. “A Comment on the Trueblood Report.” Management Accounting, April 1976, pp. 18–20. Govindarajan, V. “The Objectives of Financial Statements: An Empirical Study of the Use of Cash Flow and Earnings by Security Analysts.” Accounting, Organizations, and Society, 1980, pp. 457–78. Kenley, W. John, and George J. Staubus. “Objectives and Concepts of Financial Statements.” Accounting Research Study No. 3 (Melbourne: Accountancy Research Foundation, 1972). Page, M. “The ASB’s Proposed Objective of Financial Statements: Marching in Step Backwards? A Review Essay,” The British Accounting Review, March 1992, pp. 77-86. Sterling, Robert R. “Decision-Oriented Financial Accounting.” Accounting and Business Research, Summer 1972, pp. 198–208. Relevance & Reliability Chambers, R. J. “Usefulness—The Vanishing Premise in Accounting Standard Setting.” Abacus, December 1979, pp. 71–92. Harris, Trevor S., Mark H. Lang & H.P. Moller. “The Value Relevance of German Accounting Measures: An Empirical Analysis,” Journal of Accounting Research, Autumn 1994, pp. 187-209. Kirk, Donald J. “Completeness and Representational Faithfulness of Financial Statements,” Accounting Horizons, December 1991, pp. 135-141. Martin, Alvin. “An Empirical Test of the Relevance of Accounting Information for Investment Decisions.” Empirical Research in Accounting. Selected Studies, 1971, pp. 1–31. Morton, J. R. “Qualitative Objectives of Financial Accounting: A Comment on Relevance and Understandability.” Journal of Accounting Research, Autumn 1974, pp. 288–98. Revsine, Lawrence. “The Selective Financial Misinterpretation Hypothesis,” Accounting Horizons, December 1991, pp. 16-27. Shwayder, Keith. “Relevance.” Journal of Accounting Research, Spring 1968, pp. 86–97. Warfield, T.D. & J.J. Wild. “Accounting Recognition and the Relevance of Earnings as an Explanatory Variable for Returns,” Accounting Review, October 1992, pp. 821-842. Continuity Asare, Stephen K. “The Auditor’s Going-Concern Opinion Decision: A Review and Implications for Future Research,” Journal of Accounting Literature, 1990, pp. 39-64. Devine, Carl Thomas. “Entity, Continuity, Discount, and Exit Values.” Essays in Accounting Theory 3 (1971), pp. 111–35. Ellingsten, J.E., Kurt Pany & P. Fagan. “SFAS 59: How to Evaluate the Going Concern,” Journal of Accountancy, January 1989, pp. 24-31. Fremgren, James M. “The Going Concern Assumption. A Critical Appraisal.” The Accounting Review, October 1968, pp. 649–56. Mutchler, J. F. “A Multivariate Analysis of the Auditor's Going-Concern Opinion Decision.” Journal of Accounting Research, Autumn 1985, pp. 668–82. Sterling, Robert R. “The Going Concern. An Examination.” The Accounting Review, July 1968, pp. 481–502. Yu, S. C. “A Reexamination of the Going Concern Postulate.” International Journal of Accounting, Education, and Research, Spring 1971, pp. 37–58. Materiality Estes, R., and D. D. Reames. “Effects of Personal Characteristics on Materiality Decisions: A Multivariate Analysis.” Accounting and Business Review, Autumn 1988, pp. 291–96. Frishkoff, Paul. “An Empirical Investigation of the Concept of Materiality in Accounting.” Empirical Research in Accounting. Selected Studies. Journal of Accounting Research, 1970, pp. 116–37. Hostrum, G. L., and W. F. Messier. “A Review and Integration of Empirical Research on Materiality.” Auditing: A Journal of Practice and Theory, Fall 1982, pp. 45–63. Jennings, M.; D. C. Kneer; and P. M. J. Reckers. “A Reexamination of the Concept of Materiality: Views of Auditors, Users and Officers of the Court.” Auditing: A Journal of Practice and Theory, Spring 1987, pp. 104–15. Morris, M. H., and W. D. Nichols. “Consistency Exceptions: Materiality Judgments and Audit Firm Structure.” The Accounting Review, April 1988, pp. 237–54. Ro, B. T. “An Analytical Approach to Accounting Materiality.” Journal of Business Finance and Accounting, Autumn 1982, pp. 397–412. Rose, J.; W. H. Beaver; S. Becker; and G. Sorter. “Toward an Empirical Measure of Materiality.” Empirical Research in Accounting: Selected Studies. Journal of Accounting Research, 1970, pp. 138–56. Steinbart, P. J. “Materiality: A Case Study Using Expert Systems.” The Accounting Review, January 1987, pp. 97–116. Timeliness Atiase, Rowland K., Linda S. Bamber & Senyo Y. Tse. “Timeliness of Financial Reporting, the Firm Size Effect and Stock Price Reactions to Annual Earnings Announcements,” Contemporary Accounting Research, Spring 1989, pp. 526-552. Also the discussion by G.D. Richardson, pp. 553-555. Chambers, A. E., and S. H. Penman. “Timeliness of Reporting and the Stock Price Reaction to Earnings Announcements.” Journal of Accounting Research, Spring 1984, pp. 21–47. Courtis, J. K. “Relationships between Timeliness in Corporate Reporting and Corporate Attributes.” Accounting and Business Research, Winter 1976, pp. 45–56. Gilling, Donald M. “Timeliness in Corporate Reporting. Some Further Comment.” Accounting and Business Research, Winter 1977, pp. 34–36. Givoly, D., and D. Palmon. “Timeliness of Annual Earnings Announcements: Some Empirical Evidence.” The Accounting Review, July 1982, pp. 486–508. Keller, S. B. “Reporting Timeliness in the Presence of Subject to Audit Qualifications.” Journal of Business, Finance, and Accounting, Spring 1986, pp. 117–24. Whittred, G., and I. Zimmer. “Timeliness of Financial Reporting and Financial Distress.” The Accounting Review, April 1984, pp. 287–95. Zeghal, D. “Timeliness of Accounting Reports and Their Informational Content on the Capital Market.” Journal of Business, Finance, and Accounting, Autumn 1984, pp. 367–80. Applications Daley, Lane & Terry Tranter. “Limitations on the Value of the Conceptual Framework in Evaluating Extant Accounting Standards, Accounting Horizons, March 1990, pp. 43-50. Glazer, Alan S. & Henry J. Jaenicke. “The Conceptual Framework, Museum Collections, and User-Oriented Financial Statements,” Accounting Horizons, December 1991, pp. 28-43. Tyson, Thomas N. & Fred A. Jacobs, “Segment Reporting in the Banking Industry: Does it Meet the Criteria of the Conceptual Framework,” Accounting Horizons, December 1987, pp. 35-42.

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