Conceptual Framework & standard setting

G R O U P B

CONCEPTUAL FRAMEWORK & STANDARD SETTING

AGENDA

• FASB’s Conceptual Framework• Successes of the Framework• Failures of the Framework• Relevance vs. Reliability• Tradeoff with Examples

FINANCIAL ACCOUNTING STANDARDS BOARD (FASB)

• Not-for-profit organization created in 1973 • Primary purpose is to act in the public’s interest by

setting generally accepted accounting principles in the U.S.• Designated by the Securities and Exchange Commission

(SEC) to set standards for U.S. public companies

Intro to FASB

Successes of the CF

Failures of the CF

Relevance v. Reliability

Tradeoffs & Examples

CONCEPTUAL FRAMEWORK

• Developed by FASB to provide the accounting profession a generally accepted framework• Wanted financial reporting to provide useful information

to decision makers• Sets the objectives, qualitative characteristics and other

concepts that help guide the profession in choosing which economic events should be recognized and measured for financial reporting and how they are presented (3 levels)

Intro to FASB

Successes of the CF

Failures of the CF



CONCEPTUAL FRAMEWORK

• These 3 levels are outlined in statements of financial accounting concepts (SFACs)• A basis on which standards are set and allows the board

to develop more useful and consistent standards over time which allow for more reliable and relevant reporting

Intro to FASB

Successes of the CF

Failures of the CF



CICA SECTION 1000

• Outlines the financial statement concepts that are used in the generally accepted accounting principles• Section 1100 establishes the actual accounting principles

Intro to FASB

Successes of the CF

Failures of the CF



SUCCESSES OF THE FRAMEWORK

1. Guidance for Standard Setting Provides users with guidance in standards setting &

applying concepts that can be measured by their ability to achieve the goals of the accounting function

2. Economies of FASB’s time Many accounting cases have common points with

other accounting issues, thus the conceptual framework provides an effective solution to a variety of issues

Intro to FASB

Successes of the CF

Failures of the CF




3. Broad, perspective concepts Concepts contained in the framework should be

fundamental, in order to allow other concepts to flow from them

4. Apolitical Standards The framework should result in standards that have

not been developed as a result of political pressure on the FASB

Intro to FASB

Successes of the CF

Failures of the CF




5. Avoids inconsistencies between standards The framework provides an opportunity to reconcile

concepts based on accounting principles to ensure consistent application

Statements of Financial Accounting Concept 7 SFAC’s comprising the conceptual framework Justification of standard setting (SFAS) by the FASB

Intro to FASB

Successes of the CF

Failures of the CF



OPPOSING OPINIONS

Practitioners from small and mid-size firms disagrees that a conceptual framework would add any value to the existing problems

Hickok argues accountants merely report events of the past, it is not up to them to be forward thinking

Out of the 63 statements and 44 interpretations issued by the FASB between 1979 and 1985, only 28 references to the conceptual framework was made

Intro to FASB

Successes of the CF

Failures of the CF



SFAC 5

Revenue recognition and measurement Repeats what has been said in existing standards Does not set insight on how to solve complex

accounting issues and what methods are preferable Example: Accounting for income taxes (SFAS 96)-

measurement and recognition of deferred taxes

Intro to FASB

Successes of the CF

Failures of the CF



SFAC 2

Qualitative Characteristics of Accounting InformationSFAC 2 mainly introduces the importance of reliability and

relevancy of accounting information to decision makersSFAC 2 was bent and twisted to fit the use of FASB on foreign

exchange issues (SFAS 52)Explains how the conceptual framework is not useful to making

consistent decisions

Intro to FASB

Successes of the CF

Failures of the CF



TO ILLUSTRATE…

Company A is a Canadian company that has a subsidiary in Australia called Company B. Company has inventory recorded at historical cost of $100 and the market value of the inventory today is $105. The historical exchange rate at the date the inventory was acquired is 1.5 and the exchange rate today is 1.

Company A will need to write down inventory where Company B uses historical cost. This presents inconsistency in information.

Intro to FASB

Successes of the CF

Failures of the CF



Historical Cost

Market Value

Company A $100 x 1.5 = $150

$105 x 1 = $105

Company B $100 $105

OBJECTIVES OF FINANCIAL REPORTING: SFAC 1, 1978

• Objective: to provide useful information in order for financial statement users to make decisions• Stem from the primary needs of financial statement

users, to provide relevant information for decision making• Users are assumed to have a reasonable understanding

of business and economic activities• Intended for a broad use, general purpose in nature

Intro to FASB

Successes of the CF

Failures of the CF



PRIMARY QUALITIES OF USEFUL INFORMATION: SFAC 2, 1980

• Relevance and reliability are the 2 primary qualities• Verifiability and Representational Faithfulness• Neutrality• Comparability and Consistency

• Constrained by:• Materiality• Cost and Benefits

Intro to FASB

Successes of the CF

Failures of the CF



WHAT CONSTITUTES AS RESOURCES TO AN ENTERPRISE? SFAC 6, 1985

Basic elements of financial statements include the following: Assets Liabilities Equity Revenues Expenses Gains Losses

Intro to FASB

Successes of the CF

Failures of the CF



WHEN SHOULD RESOURCES BE RECOGNIZED? SFAC 5, 1984

Must meet 4 fundamental recognition criteria for a resource to be recognized:1. Definitions2. Measurability3. Relevance4. Reliability Subject to Cost-benefits and materiality

Intro to FASB

Successes of the CF

Failures of the CF



RELEVANCE VS. RELIABILITY

Relevance: information is timely and reflects the company’s current financial position

Reliability: information can be objectively verified by an outside third-party source

FASB’s Concept Statement states both are equally important

Intro to FASB

Successes of the CF

Failures of the CF



ACCOUNTING LOSES FOCUS ON REALITY

Accounting has lost its relevance because it fails to recognize some intangibles Brand: Coke and Nike R&D: Microsoft Human Capital: McDonald’s

Accounting practices have neglected the “future economic benefit” of intangibles and focus too much on expenses

Intro to FASB

Successes of the CF

Failures of the CF



ACCOUNTING REMAINS PATIENT

As pointed out in the conceptual framework “Financial accounting is not designed to measure directly the value of a business enterprise”

To base usefulness on the stock market valuation would be irrational as it would be based on a people’s non-sensical emotions

Intro to FASB

Successes of the CF

Failures of the CF



ACCOUNTING REMAINS PATIENT

Intangibles should be classified on the financial statements when they can reliably measured – “reasonably free from error”

Other characteristics not solely “future economic benefit” are included when categorizing an element as an asset Coke Microsoft McDonald’s

Intro to FASB

Successes of the CF

Failures of the CF



TRADE-OFFS BETWEEN RELEVANCE AND RELIABILITY

Definition: The exchange of one thing for another of more or less equal value, especially to affect a compromise.

Reliability dominates relevance Timeliness

Relevance dominates reliability Errors

Intro to FASB

Successes of the CF

Failures of the CF



EXAMPLES OF TRADE-OFFS

After the balance sheet date but before the date of issue a company wants to dispose of one of its subsidiaries and is in final stages of reaching a deal but the outcome is still uncertain. If the company waits they are expected to find more reliable information but that would cost them relevance. The information would be outdated and no longer very relevant.

After the balance sheet date during the time when audit is carried out, it becomes clear which debts were realized and where were not hence it improves the reliability of allowance for bad debts estimate but the information loses its relevance due to too much time being taken. Timeliness is key to relevance.

Intro to FASB

Successes of the CF

Failures of the CF



DIFFERENT GROUP PERCEPTIONS

Preparers of financial statements put greater emphasis on reliability measures to pass audit scrutiny

Auditors of financial statements put greater emphasis on reliability measures due to their legal exposure

Investors put greater emphasis on relevance on forecasting the company’s future earnings and financial position

Intro to FASB

Successes of the CF

Failures of the CF



FASB’S CONCEPT 2

“Concepts Statement 2 states: The qualities that distinguish “better” (more useful) information from “inferior” (less useful) information are primarily the qualities of relevance and reliability. . . . The objective of accounting policy decisions is to produce accounting information that is relevant to the purposes to be served and is reliable.” [Paragraph 15]

To be useful Concept 2 under FASB states that financial information must be both relevant and reliable

Intro to FASB

Successes of the CF

Failures of the CF



EARNINGS QUALITY

Whether a firm’s financial statements truly reflect its financial position

The economic value of transactions can be interpreted differently; the most “correct” way has the highest level of earnings quality

Associated with conservative accounting policiesRelated to accounting ethics

Intro to FASB

Successes of the CF

Failures of the CF



Conceptual Framework & standard setting

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Transcript of Conceptual Framework & standard setting