CHAPTER 3

THE CONCEPTUAL FRAMEWORK OF ACCOUNTING

Opening ScenarioAccounting and financial reporting present many difficult challenges—particularly for intangible

assets. Companies such as Coca-Cola and McDonald’s have created worldwide brandname recognition through highly effective advertising and marketing campaigns that undoubtedly will provide significant benefits to each company well into the future. However, the balance sheets of these companies do not recognize any increase in value to the company because of this brandname recognition.

Another significant asset to many companies is human capital. Jack Welsh was the CEO for General Electric from 1981 until his retirement in 2001. During that time, the market value of GE’s stock grew from $3 billion to well over $400 billion, and GE became one of the most highly valued companies in the world. Mr. Welsh established an outstanding reputation within the business world and in 1999, Fortune magazine named him “Manager of the Century.” Yet, during Welsh’s tenure, GE’s balance sheet never displayed an asset signifying the benefits from superior management.

Finally, accounting for goodwill continues to be the topic of much debate among accounting standard-setters and the business community. For almost thirty years, the Financial Accounting Standards Board required companies to record purchased goodwill as an asset and to amortize it over a period not to exceed forty years. But, as of 2002, the FASB requires companies to record purchased goodwill as an asset without amortization, which instead is written down when it is determined that its value is impaired. Further, the FASB requires that internally developed goodwill be expensed as incurred. Thus, in the United States there have been three different methods of accounting for goodwill. Alternatively, some people argue that goodwill should be written off directly to stockholders’ equity and not affect reported earnings, which is a method of accounting for goodwill that is used in several countries.

Questions:1. What determines whether an item should be recognized on the balance sheet?2. What information about goodwill should be reported that would be the most useful?3. What measurement tools should be used to record assets and other financial statement

elements, i.e., liabilities, revenues, expenses?4. How does the FASB justify keeping goodwill on the balance sheet without amortization?

What was the justification for the old method of amortizing goodwill over a maximum of 40 years?

5. Ultimately, what are the main objectives of financial reporting in the U.S.? How do these objectives differ from those of some other countries?

Learning Objectives1. Defend the need for a conceptual framework. 2. Identify the components of the FASB’s user-oriented conceptual framework, including:

The assumption regarding the users of financial reporting, The objectives of financial reporting,

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The primary qualitative characteristics of financial reporting (i.e., those qualities that make accounting information useful),

The role of materiality and cost-benefit constraints in financial reporting, The elements of financial reporting, The measurement principles (e.g., historical cost, revenue recognition, etc.) and The measurement tool.

3. Define the traditional assumptions of the Accounting Model and their implications in financial reporting.

4. Identify the similarities between the conceptual frameworks of the FASB and the IASB.5. Describe the uniqueness of financial reporting in code-law countries and recognize the impact

that such uniqueness has upon implementing a conceptual framework in all countries.

The search for accounting and financial reporting principles parallels their respective lives. That is, the search for accounting principles, consisting of properly recording transactions, is as ancient as accounting. Whereas, the search for financial reporting principles, consisting of reporting information to parties external to the business, is relatively new. After learning something about electronic data processing systems, Pacioli, who lived in the fifteenth century, would be quite comfortable with accounting systems of today. But identifying what information should be communicated to external parties has been, and continues to be, a source of controversy.

With (1) the impact that the internet is having upon the dissemination of information, (2) the growth of international business, and (3) the growth in individual investors, the debate about financial reporting is increasing—including the debate as to what role accountants will play in disseminating financial information about an enterprise. This chapter focuses upon the FASB’s conceptual framework, which primarily is intended to give guidance to the FASB in developing financial reporting principles but, when understood, can also give valuable guidance in solving both accounting and financial reporting issues facing all practicing accountants.

The FASB’s Conceptual FrameworkThe FASB is constructing its conceptual framework through issuing Statements of Financial

Accounting Concepts (SFAC). The FASB’s goal is to establish “a coherent system of interrelated objectives and fundamentals that is expected to lead to consistent standards and that prescribes the nature, function, and limits of financial accounting and reporting.”1 To date, the FASB has issued seven conceptual statements. Since conceptual statement number four deals with non-business entities and statement number three was replaced with statement number six, the FASB’s conceptual framework of accounting and financial reporting for businesses is comprised of Concepts Statements 1, 2, 5, 6 and 7.

The FASB adopted a financial statement-user approach to developing its accounting and financial reporting conceptual framework. Essentially, the approach is to:

1. Identify potential readers of financial statements and their common needs for information (addressed in SFAC No. 1, which was issued in November 1978),

2. Determine the qualities that make information useful or more useful (addressed in SFAC No. 2, which was issued in May 1980),

3. Define the measuring tools to be used in determining the amounts reported on the financial statements (addressed in SFACs No. 6, which was issued in December 1985, and 7, which was issued in February 2000),

1 Statement of Financial Accounting Concepts No. 6, p. i.4-2

The FASB’s web-site is http://www.fasb.org. You may want to become familiar with that site, including where the text for the FASB’s pronouncements are found.

4. Identify those elements and attributes of those elements to be measured (addressed in SFACs No. 5, 6, and 7), and

5. Determine how best to present that information to the financial statement-users (addressed in SFAC No. 5).

The FASB’s conceptual framework does not comprise “truth.” Rather, it is the FASB’s view as to what constitutes quality accounting and financial reporting given the economic, legal, political, and social environment that gives rise to it.2 So, it is to be expected that as knowledge of the informational needs of the financial statement-users increases, as the need for information changes, and even as the medium through which financial information is communicated improves, so too will the FASB’s conceptual framework evolve. Also, the FASB’s conceptual framework pronouncements do not comprise accounting and financial reporting standards that must be complied with; that is, they are not Rule 203 documents. Rather, the conceptual framework pronouncements establish principles that will aid the FASB in formulating accounting and financial reporting standards, and assist other accountants in understanding and implementing the published standards of the FASB.

The Financial Statement Reader and General-Purpose Financial StatementsAlthough many individuals and groups are interested in financial information about any particular

business enterprise, the FASB noted that the objectives of financial reporting are directed primarily towards the needs of those external users who lack the authority to receive the information desired.3 Further, the FASB identified the users of financial reporting as having “a reasonable understanding of business and economic activities and are willing to study the information with reasonable diligence.”4 Although the FASB’s statements recognize the many and varied financial statement users, it gave a focus to the conceptual standards by phrasing its comments to investors and creditors. But, those users are to be seen as representatives of all external users. Further, recognizing that the many individuals and groups external to a business enterprise have a variety of different informational needs, the FASB stated its intent to focus only upon the common needs for information of the users.

These common needs for information are communicated through a set of general-purpose financial statements, which are the primary financial statements that a company issues to people external to the company. The information contained in the general purpose financial statements comprise only a portion of a corporation’s rather lengthy financial report. As the name indicates, the general-purpose financial statements—as compared to specific-purpose financial statements5—focus on meeting the common needs for information of all financial statement readers. Because such statements focus on the common needs of many readers, such statements are not “all-purpose” financial statements. So, it is expected that financial statement-users will find an enterprise’s financial statements of varying usefulness and likely, all users will desire information not contained in the financial statements or the financial report. To take any other approach implies that the FASB knows the needs of all users of financial

2 Statement of Financial Accounting Concepts No. 1, par. 9.3 Ibid., par. 28, 30.4 Ibid., par. 34, emphasis added.5 A tax return is an example of a specific-purpose financial statement. Most government agencies, because they have the authority to demand the information they desire, receive specific-purpose financial statements.

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Extending the ConceptOne significant reason the conceptual framework pronouncements are not Rule 203 documents is that knowing and following GAAP would be confusing in those areas where the conceptual framework pronouncements conflict with other previously issued Rule 203 documents. Rather, the FASB intends to implement the principles contained in the conceptual framework gradually, in a thought-out fashion, and in this way, replace existing standards where appropriate.

reports and that providing information can be done without cost. Figure 4-1 presents the total information spectrum relative to investment and credit decisions and the role financial reporting and financial statements have thereto.

FIGURE 4-16 Total Information Spectrum

All Useful Information

Financial Reporting

Area Directly Affected by FASB Standards

Basic Financial Statements

Recognition and Measurements Statements

Financial Statement Notes to Supplementary Other Means of Other Information Financial Information Financial Statements Reporting

Objectives of Financial ReportingHaving defined who the users of financial information are and the role financial statements and

financial reporting have in meeting the informational needs of those users, the FASB then set forth the objectives of financial reporting, which are really a hierarchy of objectives, each objective elaborating on the previous one. The chief objective of financial reporting is to

“. . . provide information that is useful to present and potential investors and creditors and other users in making rational investment, credit, and similar decisions.”7

Regarding this objective, the FASB noted that financial information is a tool and like any tool, it is of no value to those who are unable to use it, including those who are unwilling to learn how to use it and to use it appropriately. Also, like any tool, the usefulness of financial reporting increases as efforts to learn its purpose and function are made. Thus, the financial statement-user has the responsibility to learn how to use financial information. But, the FASB also noted that it has the responsibility of continually assessing the usefulness of the financial information provided and where indicated, to increase its understandability.

In the hierarchy of financial reporting objectives, the FASB’s second objective of financial reporting is to define what constitutes useful information, which is

“. . . information to help . . . [assess] the amounts, timing, and uncertainty of prospective cash [flows]. . ..”8 Prospective cash receipts could be from interest, dividends, selling merchandise, redeeming

securities, maturing loans, etc. Prospective cash disbursements could be from paying operating expenses,

6 Adapted from Statement of Financial Accounting Concept No. 5.7 Ibid., par. 34, emphasis added.8 Ibid., par. 37, emphasis added.

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purchasing merchandise to resell, paying interest and dividends, acquiring long-term assets, etc. The FASB considers information to be useful if it assists users in determining the amount of net cash to be received, when it will be received, and the degree of uncertainty or risk that is attached to the cash flow prospects. All decisions to either loan or invest in a business enterprise are made with the expectation that cash flows received eventually will be greater than the cash loaned or invested and, as a result, total cash resources to the investor or creditor will increase. Ultimately, the test of any business decision is whether more cash is returned than was used. Investors and lenders are interested in both a return of their investment and a return on their investment and it is usually from an enterprise’s cash resources that a dividend is paid to the investor, or interest and principle is paid to a creditor. Further, an enterprise’s ability to generate cash is a determinant of the market price of its securities, which—by selling securities held—is another way an investor can receive a cash flow. So, assessing future cash flow prospects is a vital function of both lending and investing decisions.

The third objective of financial reporting is to

“. . . provide information about [a business enterprise’s] resources, . . . the claims to those resources, . . . and [changes in those] resources and claims.”9

Such information (elaborating upon the previous financial reporting objective of cash flows) aids the financial statement-user in identifying the enterprise’s net cash flow prospects. With information about the enterprise’s resources and obligations, the financial statement-user can evaluate the cash flow potential of the resources and the cash flow requirements of the claims on those resources. And, changes in resources and claims to those resources are a result of the enterprise’s profitability; thus, information about an enterprise’s profitability is also useful information in assessing future cash flow prospects.

Accrual-Based and Cash-Based Financial StatementsUseful information about a business enterprise’s ability to generate cash flow in the short-run is

found in cash-based financial statements, which focus on cash received and cash paid during the year. But such statements by themselves do not meet the needs of most investors and creditors whose decisions are typically long-run in nature. Information of a business enterprise’s long-run ability to generate cash is better found in accrual based financial statements. That is why the FASB stated that, “interest in an enterprise’s future cash flows and its ability to generate favorable cash flows leads primarily [but not exclusively] to an interest in information about its earnings rather than information directly about its cash flows . . .. Information about enterprise earnings and its components measured by accrual accounting generally provides a better indication of enterprise performance than information about current cash receipts and payments.”10

Cash flows typically occur at the beginning and end of business transactions and, by focusing only on the two ends of a transaction and ignoring what happens in between, cash-based financial statements are short-term in nature. However, accrual accounting records the financial effects of transactions in the periods in which they occur, not just when cash is received or paid. Or stated differently, accrual accounting records the effects of an entire transaction or earnings-process and not just with the beginning or end of that transaction or earnings-process. Accrual accounting recognizes that business activities, such as buying, producing, selling, etc., do not always coincide with the cash flows, and so by relating effort to accomplishment, accrual-based financial statements are a better predictor of the company’s long-run cash flow generating ability. Because cash-based statements focus on short-run cash flows and accrual-based statements focus on long-run cash flows, both types of statements are needed.

9 Ibid., par. 40.10 Ibid., par. 43-44.

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The example contained in Exhibit 4-1 is given to illustrate the difference between the two bases of accounting and how the financial statements would look.

EXHIBIT 4-111

Comparing Accrual-Accounting and Cash-Accounting Transaction #1. A retail company buys $5,000 of merchandise that it intends on reselling. It pays $1,500 now and promises to pay the difference in 30 days.

Accrual Accounting Cash AccountingInventory $ 5,000 Expense $ 1,500 Cash $ 1,500 Cash $ 1,500 Accounts payable 3,500Explanation: Accrual accounting recognizes the entire transaction, whereas only the cash portion is recognized under cash accounting and then it is recognized as an expense.

Transaction #2: The Company sells 20% of the merchandise for $3,200 collecting $1,200 with the customer promising to pay the difference later.

Accrual Accounting Cash AccountingCash $ 1,200 Cash $ 1,200Accounts receivable 2,000 Sales $ 1,200 Sales $ 3,200

Cost of goods sold $ 1,000 Inventory $ 1,000Explanation: Again, accrual accounting recognizes the entire transaction of selling the merchandise, whereas, under cash accounting, only the cash portion is recognized.

Transaction #3: Equipment that will be used in the company is purchased for $4,000. Financing is done with a short-term note payable.

Accrual Accounting Cash AccountingEquipment $ 4,000 No Entry Note Payable $ 4,000Explanation: Since cash is not affected, there is no entry under cash accounting. However, under accrual accounting, the fact that an asset was acquired is recognized and the means of financing it is also recognized.

Qualitative Characteristics of InformationHaving defined the users of financial reporting and the objectives that financial reporting should

meet, the FASB’s next phase of the conceptual framework was to identify those qualities that make accounting information useful. In SFAC #1, The FASB stated that information about an enterprise’s resources, claims to resources, and changes in those is useful information—see Objective of Financial Reporting #2 above.12 But the decision still had to be made as to what qualities of resources and claims to resources should be reported. For example, a building represents one resource of an enterprise, but what particular characteristic about that building should be reported? It’s size? Its age? Or, granting that the attribute reported should be financial in nature, what financial measurement should be used? The price

11 Also, see Chapter 2 for information on converting from cash accounting to accrual accounting.12 Resources seems to be another word for assets, and claims to resources seems to mean liabilities, but the FASB deliberately refrained from using those words in the earlier phases of its framework because they wanted to keep an open mind as to where the conceptual framework would eventually lead them.

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paid to acquire the building? The price at which the building could be sold? The price at which the building could be replaced? Or, some other financial measurement? By identifying those attributes that make financial information useful, the FASB and others are assisted in determining what should be reported to external parties to meet their common needs for information and this was the FASB’s next task in developing their conceptual framework.

So, the objective of the FASB’s second conceptual statement was to state those qualities that make information about a company’s resources, claims to those resources, etc. useful. A recap of the FASB’s conclusions is provided in Figure 4-2.

Primary QualitiesIn SFAC No. 2, the FASB identified relevance and reliability as the two primary qualities that

make accounting information useful for making business decisions. Relevant information is that which is capable of making a difference in a decision. If information has no effect on a decision, the information is not relevant. The FASB identified the following three components of relevance:

1. Timeliness—providing information to the decision-maker while it has the capacity to make a difference.

2. Predictive Value—that quality of information that increases the likelihood the decision-maker will correctly predict future events.

3. Feedback Value—that quality of information that enables decision-makers to confirm or correct prior expectations.

Relevance is decision-dependent; meaning that what information is relevant depends upon the question asked or the decision to be made. For example, a vehicle’s selling price is relevant information when making a decision to sell it, but the vehicle’s selling price is not relevant to the decision of whether to use a vehicle for business or pleasure. Further, replacement cost or what it costs to replace a vehicle is relevant when considering which new vehicle to buy, but totally irrelevant to most other decisions.

Information is reliable when it contains the three following qualities:

1. Is reasonably free from error and bias (i.e., neutrality)—meaning that the financial statements were not prepared to obtain a predetermined result or to induce a particular mode of behavior or decision. Useful accounting information is neutral to any particular viewpoint, result, or party, and it is not consistently too high or too low.

2. Faithfully represents what it professes to represent (i.e., representational faithfulness or validity), meaning there is a correspondence between the accounting measure and the phenomenon it represents. Useful accounting information reports in words and numbers the economic substance of reality, not its form or a misleading description.

3. Is verifiable—meaning there is a consensus among measurers (e.g., accountants, analysts, etc.). However, verifiability does not require unanimity among measurers.

FIGURE 4-213

Hierarchy of Qualitative Characteristics

USERS OF ACCOUNTINGINFORMATION

13 Adapted from Statement of Financial Accounting Concept No. 2.4-7

Decision makers and their characteristics (e.g., understanding or prior knowledge)

PERVASIVE CONSTRAINTS

USER-SPECIFICQUALITIES

PRIMARY DECISION-SPECIFIC QUALITIES

INGREDIENTS OFPRIMARY QUALITIES

SECONDARY ANDINTERACTIVE QUALITIES

THRESHOLD FORRECOGNITION

The most useful information is both completely relevant and totally reliable. But, frequently a trade-off must be made between relevance and reliability; more of one can be obtained only by giving up some of the other. Sometimes, it seems that the most reliable information is the least relevant, and vice-versa. For example, the most reliable information is historical cost information as it is relatively easy to verify, truly represents its original cost, and is neutral. Yet, all decisions are future oriented and historical data is often of little relevance to making future decisions. But, as attempts are made to obtain more relevant data (for example, some current value), the information becomes less reliable. So, both preparers and users of financial reporting must compromise as to the degree of reliability they will sacrifice in order to have more relevant information.

Secondary Qualities The secondary qualities that make financial information useful are comparability and consistency.

Comparability is that quality of information that enables users of financial reporting to identify similarities in and differences between sets of data of two or more different enterprises. In essence, information is more useful when it can be compared to some standard or to similar data of other companies, particularly companies in the same industry. For example, knowing that a business enterprise’s net income is $1 million is not particularly useful. Knowing what the budgeted income is forcasted to be or knowing what another business enterprises’ net income is makes the $1 million figure

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Benefits > Costs

Understandability

Decision Usefulness

Relevance Reliability

PredictiveValue

FeedbackValue

Verifiability Neutrality

Timeliness RepresentationalFaithfulness

Materiality

Comparabilityand

Consistency

much more meaningful, particularly when the other business enterprise is in the same industry and is comparable in size.

Consistency is the application of the same accounting policies and procedures from period to period within the same business enterprise. Again, there is little usefulness of a $1 million net income figure if during the same period, the business enterprise changed several accounting policies and procedures. In this case, the financial statement user cannot determine how much of the $1 million is due to business operations and how much is due to accounting changes. Hence, there is a presumption that an accounting policy or procedure, once adopted, should not be changed, unless the change is to a preferable accounting policy or procedure since a preferred accounting policy or procedure will provide more relevant information. Failure to permit a change to a preferable accounting procedure could adversely affect relevance, which is a more important quality of useful information than is consistency.

Cost-Benefit Constraint Underlying the qualitative characteristics that make information useful are two pervasive

constraints: the cost-benefit constraint and the threshold materiality constraint. The pervasive cost-benefit constraint is that the benefits of providing information should exceed the cost of providing it. Individuals often perceive information to be a “free” good; they think it is already available in the business enterprise’s information system and only needs to be reported. But, several times in the past, new requirements to provide additional information have resulted in increased costs to business. Examples include the requirement for segment information, reporting supplemental current cost information, and pension disclosures. However, increased cost to business is justified when the benefits of the information outweigh the costs of providing it. Applying the cost-benefit constraint seems easy at first glance, but often neither the costs of providing the information nor the benefits of the information are easily quantifiable. Adding to the difficulty of comparing the benefits of information to the costs of supplying it is that the costs and benefits do not always occur in the same period.

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EXHIBIT 4-2How Important Is Consistency of Accounting Principles?

Consistency and comparability are two important characteristics of accounting information, according to the FASB’s conceptual framework. The following excerpt from an article provided by “TheStreet.com” illustrates how confusing it can be for financial analysts to evaluate a company’s performance when consistency is violated.

“Hashing out the reconstructed numbers provided by Hoechst for 1998 shows, according to German accounting methods, that earnings per share totaled 1.38 euros. But the shift to the new IAS standard means the company has reported no fewer than three separate EPS figures scattered about various official statements. These include two estimates that include goodwill charges – 1.65 euros (according to an ‘old’ version of IAS) and 1.61 euros (according to a new, and current version of IAS) – as well as a number (2.40) that doesn’t include a heap of previously unamortized goodwill.

“In Hoechst’s case, as inscrutable as German accounting methods may or may not have been, the move to IAS standards has caused many an analyst headaches and sleepless nights. The new IAS standards ‘most probably have improved transparency, but if you don’t have a clearly defined and understandable basis, it does make life frustrating,’ says Guy Phillips, an analyst for Societe Generale in London.

“Even with the data provided by the company, he and other analysts have adopted a wait-and-see attitude toward Hoechst’s earnings this year. ‘The ability to define exactly what constitutes the business at any one time, or have pro-forma comparisons, has been enormously difficult,’ Phillips says.

“Unfortunately, investors figuring Hoechst’s move to IAS standards will allow them to throw away their secret decoder rings next year may be in for a nasty surprise. Due to more favorable business conditions, the newly merged Hoechst-Rhone-Poulenc entity will be incorporated in France. In the merger prospectus the companies state the new firm, to be called Aventis, will adhere to French GAAP….”

SOURCE: Young, Marc. “Cracking the Books II: Despite Shift to International Accounting Standards, Transparency Still Evades Hoechst,” TheStreet.com, Oct. 21, 1999.

Materiality Constraint Data is material when its omission or misstatement makes it probable that the judgements of a

reasonable person will be changed or influenced. Materiality is frequently confused with relevance, but the two are different. Materiality allows for deviations from strict compliance with accounting procedures when the impact on the financial statements is not material, whereas, relevance has to do with the nature of information that impacts a decision.

Materiality has both a quantitative and a qualitative aspect. The quantitative aspect of materiality permits non-adherence to strict accounting procedures when the amount is not material. For example, according to the strict application of accounting principles, a $9.95 pencil sharpener should be depreciated over its useful life of several years. However, because of the immateriality of the results of strictly applying the accounting rule, the materiality constraint allows the $9.95 expenditure to be expensed in the year the pencil sharpener is acquired. This quantitative aspect of materiality considers not only the size of the expenditure (e.g., $9.95) but also the size of the expenditure in relation to the size of the business enterprise. Hence, a $10 million expenditure may be devastating to some business enterprises, but not even justify separate disclosure for another much larger business enterprise. The qualitative aspect of materiality permits the nature of the transaction or event to be examined in determining materiality. So, an expenditure may be material due to the nature of the transaction (i.e., embezzlement, bribing a public official, etc.) although the dollar amount is small enough to be considered immaterial.

Presently, there are few available guidelines to determine materiality. Hence, the financial statement preparers must use judgment in determining whether the failure to adhere strictly to accounting

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procedures would cause the judgment of a reasonable person to be changed or influenced.14 There are difficulties in leaving the determination of materiality to the judgment of a few because what one individual considers immaterial, another may consider very material. But, lacking any guidelines, the financial statement preparers are left with nothing but the following statement from the FASB’s conceptual framework for guidance:

The omission or misstatement of an item in a financial report is material if, in the light of surrounding circumstances, the magnitude of the item is such that it is probable that the judgment of a reasonable person relying upon the report would have been changed or influenced by the inclusion of the item.15

EXHIBIT 4-3When Is An Item Material?

In determining materiality, many companies employ a “rule-of-thumb” of allowing a deviation from strict guidelines when the overall effect is less than a specified percent (typically 2-5 percent) of income. The U.S. Securities and Exchange Commission has criticized firms for exploiting the ambiguity of the materiality concept in this way. In a speech at New York University, the SEC Chairman, Arthur Levitt, made the following remarks:

[Some companies] intentionally record errors within a defined percentage ceiling. They then try to excuse that fib by arguing that the effect on the bottom line is too small to matter. If that’s the case, why do they work so hard to create these errors? Maybe because the effect can matter, especially if it picks up that last penny of the consensus estimate. When either management or the outside auditors are questioned about these clear violations of GAAP, they answer sheepishly, “It doesn’t matter. It’s immaterial.”

Recent anecdotal evidence and empirical research indicates that not meeting analysts’ consensus forecasts results in serious stock price repercussions. Chairman Levitt believes that management is increasingly avoiding booking losses on the grounds of materiality merely to report earnings that meet analysts’ forecasts.

Traditional Assumptions of Accounting and Financial ReportingThere are several traditional assumptions of accounting and financial reporting that are not

mentioned in the FASB’s conceptual framework but that underlie it. The separate-entity assumption is that the business enterprise is viewed as a separate economic unit from both its owners and from other business enterprises. That is, any user of financial information assumes that the financial statements comprise only the activities and all the activities of a particular business entity, and that the activities of any owner or any other business are not included. A violation of this assumption makes it impossible to assess the past performance or predict the future performance of a business entity and, hence, it would violate the relevance criterion.

The going-concern assumption assumes that in the absence of information to the contrary the business enterprise will continue. This does not imply permanent continuance, but rather a time period long enough for the entity to complete its contemplated operations, contracts, and commitments. This assumption adds focus as to which qualities (e.g., historical cost, selling prices, etc.) of information should be measured. For example, selling prices for long-lived assets are largely irrelevant when it is assumed the enterprise will continue in business rather than be liquidated. Therefore, under the going-

14 Paragraph 165 of Statement of Financial Accounting Concepts No. 2 provides some illustrations of what the courts have decided constitute materiality.15 Ibid, par. 132.

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concern assumption a financial measure other than selling price probably should be reported for long-lived assets. However, when a business enterprise’s future is uncertain (i.e., the going-concern assumption is violated), then selling prices of assets become very relevant and those are the values that probably should be reported in the financial statements.

The periodicity assumption assumes that it is possible to divide the life of a business into arbitrary time periods and measure performance for that time period. The results of a business enterprise can be known with certainty only when it goes through final liquidation—a period of time that may encompass hundreds of years or more. However, users of financial information need more timely (i.e., relevant) information upon which to base their decisions. Hence, the reason for periodic reporting and the assumption that it is possible to divide the life of a business into segments. This assumption and the need for periodic reporting results in measuring transactions that are not yet complete, which is the basis for yearly adjusting entries.

The measurement tool used in financial reporting is money or nominal dollars. Of course, the ideal measurement tool is one that is stable over time but unfortunately, unlike the typical yardstick that is always of the same length, money or dollars change in real value constantly due to inflation. However, in the United States both the preparers and the readers of financial reports have traditionally used financial statements not adjusted for inflation, and so assuming that the dollar is a stable measurement tool. The FASB notes that it “expects that nominal units of money will continue to be used to measure items recognized in financial statements.”16 This assumption of a stable dollar means that the readers of financial reports can make whatever adjustments to reported financial information they consider necessary as a result of inflation.

EXHIBIT 4-4Stable Monetary Unit Assumption

The assumption that the value of the U.S. dollar is constant over time is an example where a country’s economic environment has a significant influence on the financial reporting system. Historically, the U.S. has experienced relatively low rates of inflation and, therefore, presenting assets at historical cost on the balance sheet has supposedly not presented serious problems. However, other countries have experienced hyper-inflationary rates, and in that type of environment, showing long-lived assets at historical cost amounts seriously understates the asset values in periods subsequent to acquisition.

As a result of persistent inflation, Brazil, Mexico, and other countries have implemented accounting systems that adjust year-end historical cost values of such assets as property, plant, and equipment for the effects of inflation, and a gain or loss is recognized in the income statement for the effect of holding cash and similar assets and liabilities in times of inflation. That is, holding cash during a period of inflation results in a loss since the cash will not be able to purchase as much at the end of the year as it could at the beginning of the year.

During the late 1970’s and early 1980’s, the U.S. experienced higher-than-usual inflation rates in excess of 10%, which created considerable controversy concerning whether financial statements in the United States should be adjusted for inflation. In response, the FASB issued SFAS 33, “Financial Reporting and Changing Prices,” which required companies to include extensive footnote disclosures related to the impact of inflation and changing prices on the business’s financial condition. However, inflation subsided in the mid-1980’s and the FASB eliminated the disclosure requirements of SFAS 33 (which is an example of applying the cost-benefit constraint).

16 Statement of Financial Accounting Concepts No. 5, par. 72.4-12

Financial Statement ElementsThe objectives, qualitative characteristics, cost-benefit and materiality constraints, and traditional

assumptions of accounting are the tools used to build useful financial statements. The material or building blocks (called elements) upon which the financial statements are based are assets, liabilities, revenues (and gains), expenses (and losses), and equities. Accountants and non-accountants use these terms frequently, but with different meanings. For example, company management often refers to its workforce as the company’s greatest asset. However, the accountant never reports “company workforce” on the balance sheet as an asset. Similarly, the accountant is quite precise in his use of revenues and gains, while the businessperson may think of them as practically the same. An important part of understanding financial reporting, which then increases one’s ability to use financial statements, is understanding the accountant’s definitions of the various financial statement elements.

SFAC No. 6 provides definitions for the ten elements of financial statements, which definitions are an important contribution of the FASB’s conceptual framework and are presented in Exhibit 4-5. Although in most cases, it is easy to classify items into their appropriate financial statement element (e.g., cash is obviously an asset), the FASB’s deliberations on issues have been facilitated numerous times by referring to the definitions provided in the conceptual framework. Also, as another example, determining whether some costs should be accounted for as assets or expenses might prove to be difficult without explicit guidance from the definitions. (Exhibit 4-5 on the following page should be read now.)

The first three elements in Exhibit 4-5 (assets, liabilities, and owners’ equity) are the building blocks of the balance sheet. The definition of an asset explains why “company workers” are not shown on the balance sheet as an asset. Although the workforce is controlled by the company and will provide future economic benefits, “company workers” was not acquired through a past exchange transaction.17 Note that both assets and liabilities are expressed in terms of future economic benefits or transfer of benefits and therefore, information about assets and liabilities should provide information about future cash flows. Equity is expressed merely as the mathematical equivalent of assets minus liabilities.

The next three elements in Exhibit 4-5 (investments by and distributions to owners, and comprehensive income) provide information related to the third objective—which is to provide information about the company’s resources, claims to those resources, and changes in those resources and claims (meaning comprehensive income, of which net income is a key component). Comprehensive income is a relatively new element and is discussed in greater detail later in the text.

The last four elements in Exhibit 4-5 (revenues, gains, expenses, and losses) are presented in the income statement and provide information about the past performance of the business enterprise. The sum (or net) of these revenues, gains, expenses, and losses constitute net income, which is expected to be a key indicator of future cash flows. The definitions of these elements clearly indicate that the key difference between revenues and gains (and also expenses and losses) is whether the transaction (or event) is related to the enterprise’s ongoing operations. The definitions in Exhibit 4-4 are important, will be frequently referred to in the text and, therefore, some time should be spent becoming familiar with the components of each definition.

17 The qualitative characteristic of reliability would also explain why company management is not recognized as an asset. Measuring the value of the asset with precision would prove to be extremely difficult.

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EXHIBIT 4-5DEFINITIONS OF FINANCIAL STATEMENT ELEMENTS

Assets. (1) Probable future economic benefits (2) obtained or controlled by a particular entity (3) as a result of past transactions or events. Normally has a debit balance.

Liabilities. (1) Probable future sacrifices of economic benefits (2) arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future (3) as a result of past transactions or events. Normally has a credit balance.

Equity. The residual interest in the assets of an entity that remains after deducting its liabilities. In a business enterprise, the equity is the ownership interest. Normally has a credit balance.

Investments by owners. Causes net assets (and owners’ interests) to increase and is the result of the owners transferring something of value to the company. Normally has a credit balance.

Distributions to owners. Causes net assets (and owners’ interest) to decrease as a result of transferring assets or rendering services to the owners, or of incurring liabilities in behalf of the owners. The most common form of distributions to owners in a proprietorship and a partnership is owners’ drawings, and the most common form of distributions to owners in a corporation is dividends. Normally has a debit balance.

Comprehensive income. All changes in owners’ equity during a period except those resulting from investments by owners and distributions to owners. Transactions captured by an accounting system are included in comprehensive income, but so are other events and circumstances that are not typically captured in an accounting information system. Could have either a debit or a credit balance.

Revenues. Inflows or other enhancements of assets of an entity or settlement of its liabilities (or a combination of both) during a period from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations. Normally has a credit balance.

Expenses. Outflows or other using up of assets or the incurring of liabilities (or a combination of both) during a period from delivering services, producing goods, or carrying out other activities that constitute the entity’s ongoing major or central operations. Normally has a debit balance.

Gains. Increases in equity from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity during a period except those that result from revenues or investments by owners. Normally has a credit balance.

Losses. Decreases in equity from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity during a period except those that result from expenses or distributions to owners. Normally has a debit balance.

SOURCE: “Elements of Financial Statements,” Statement of Financial Accounting Concepts No. 6 (Stamford, Conn.: FASB, December 1985), pp. ix and x.

To illustrate a model for determining which type of element (e.g., assets, liabilities, etc.) should be used and how these definitions are helpful in making that decision, consider the following examples. Example #1: A freight company acquires a vehicle to be used for short-hauls around the city. Cash is credited, but determining which account to debit in this transaction begins with selecting the candidates from the ten elements listed above. The candidates are those elements that normally have a debit balance,

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which are: assets, expenses, losses, and distributions to owners. After the candidates are identified, one or several can be eliminated immediately as not fitting the description of the transaction. In this example, losses and distributions to owners are those that are immediately eliminated because they are not descriptive of what is occuring. Then, the definitions are consulted and in this example, the following are noted: (1) expenditures that result in future economic benefits are assets, and (2) expenses result from selling products, rendering services, etc., none of which occurred when the vehicle was acquired. Thus, the conclusion is that the company should record the expenditure to acquire the truck as an asset.

Example #2: The same delivery company sells some shares of stock in another company that it had acquired several years previously. Management of the company considered the stock price to have reached an optimum and, therefore, made the decision to sell. Cash is debited and one account that is credited is an Investment account, but what other account should be credited for the excess received over the price paid for the investment? The candidates are those elements that normally have credit balances, which are: liabilities, equities, investments by owners, revenues, and gains. Equities and investment by owners are eliminated immediately because they are not descriptive of what is happening. Liabilities are also eliminated because the company is not under any obligation, but should a gain or a revenue be credited? Referring to the above definitions, it is learned that the difference between a gain and revenue is whether the increase in net assets arose from the primary operations of the company or from a peripheral activity. Since the company’s major or central operations consists of delivering freight, a gain is credited.

Example #3: A new accountant is faced with recording a transaction where the company is leasing an asset. The asset will remain the property of the leasing company, but the length of the lease is such that the company has substantially obtained the right to use the asset for its economic life. The questions the new accountant is considering are: Should the leased asset be recorded as an asset on the company’s book? If an asset should be recorded, what account should be credited? (You may want to apply the logic listed above and then compare your answer to the following.) Reviewing the definition of an asset, it is noted that the essential elements are: (a) future economic benefits, (2) obtained or controlled, (3) as a result of a past transaction. The description of the above lease seems to meet all three criteria and thus, an asset should be recorded. Regarding the credit account, a liability is credited because referring to the definition of a liability, there is a probable future sacrifice of making the payments that resulted from a past transaction and that also has given rise to a present obligation.

These examples emphasize the benefits that are obtained from knowing the definitions of the elements of financial statements. Accountants often solve relatively difficult accounting and financial reporting problems by considering the definitions of the various elements. There will be ample opportunities for you in this text to also resort to these definitions to solve accounting or financial reporting problems.

Measurement PrinciplesWith the financial statements being comprised of ten elements, it is not surprising that different

measurement principles are used. The historical cost principle is used to measure assets at acquisition, the revenue recognition principle specifies the time when revenue is measured, the matching principle determines when costs become expenses, and liabilities are measured using discounted cash flow procedures. Owners’ equity is a residual interest, and once assets and liabilities or revenues and expenses are recognized, owners’ equity is pretty much determined. Each of these measurement principles are defined below and covered in much more detail in subsequent chapters of the book. So, for instance, the historical cost principle is the subject of Chapter 5, the matching concept is covered in Chapters 6 and 7, etc.

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Historical Cost Principle

When assets are acquired, they are recorded at their historical cost, which at the date of acquisition, is the same as their fair value. Referring to what value is reported in the financial statements, the FASB in conceptual statement No. 5 stated that, “Property, plant, and equipment . . . are reported at their historical cost, which is the amount of cash, or its equivalent, paid to acquire an asset.”18 Since fair value is also defined in terms of the amount that would be paid in a non-forced transaction, it is evident that at acquisition, historical cost and fair value are the same. Under the historical cost principle the necessary and reasonable costs incurred to acquire an asset and get it ready for its intended use become the historical cost of the asset. Examples of necessary and reasonable costs include sales taxes and shipping costs for purchased inventory, or installation charges for purchased equipment. Also, the cost of manufacturing a product includes the cost of materials, labor, and overhead.

Measuring assets when they are acquired at their historical cost conforms with the primary qualitative characteristics of being relevant and reliable. The historical cost of an asset is relevant at the date of acquisition because it is also the asset’s fair value at that date. Historical cost is also reliable as such amount can be verified by referring to sales documents, it faithfully represents the market’s perception of the asset’s value, and such information is not biased when acquired in a non-forced transaction.

At times, the historical cost principle has been viewed as being such an important part of accounting in the United States that the entire accounting system has been, perhaps incorrectly, referred to as an historical cost accounting system. The reason for this reference is that subsequent to acquiring assets, some of them continue to be carried on the accounting records and reported on the balance sheet at their historical cost (i.e., the amount at which they were acquired) even though the asset’s fair value has probably changed. However, when fair value information is available—as, for example, most investments in securities and some inventories—then these assets are reported at their current fair value because such is more reflective of the business enterprise’s financial condition and thus, is more relevant. Why more assets are not reported at their fair value rather than at their historical cost continues to be a controversy. Those who want more assets reported at their fair value argue that such information is more relevant and that the sacrifice of some reliability in getting more relevant information is in the best interest of those who rely upon financial statements. Those who want to continue reporting some assets at historical cost amounts argue that such information is more reliable and that it is better to have information that can be relied upon even if some relevance is sacrificed.

Regardless of the controversy, it is clear that when markets exist and are sufficiently developed so that current market values can be obtained at the financial statement date, then those market values are reported in the financial statements instead of historical cost amounts. However, when markets are not developed sufficiently to provide market values, then historical cost amounts are usually reported in the financial statements.

Revenue Recognition Principle

Besides the historical cost-fair value controversy, another challenge accountants have is determining when to recognize revenue in the accounting records. The revenue recognition principle dictates that revenue must be (1) realized or realizable, and (2) earned before it is recorded in the financial records and reported on the income statement. Realized means that goods or services have been exchanged for cash or a claim to cash such as a note receivable or an account receivable. Realizable means that goods or services have been exchanged for assets (e.g., stock) that are readily convertible into known amounts of cash or claims to cash. Readily convertible means the asset received has a quoted price in an available, active market where the market price would not be affected by sale of the asset. Revenue is earned when the business entity has substantially completed what it must do to be entitled to the benefits represented by the revenues. Frequently, these two criteria are easy to apply, but at other

18 Statement of Financial Accounting Concept No. 5, par. 67.4-16

times, identifying if revenue should be recorded is very difficult. The following examples relating to service revenue illustrate the basic aspects of the revenue recognition rule.

Example #1: Service worth $1,000 is rendered with the customer paying cash.

Transaction analysis: Revenue is recorded because the service has been rendered and is therefore, earned. Also, cash is received and is therefore, realized. This transaction is recorded by debiting cash and crediting revenue as follows.

Cash $1,000Service Revenue $1,000

(Cash received for services rendered.)

Example #2: Service worth $1,000 is rendered with the customer promising to pay next month.

Transaction analysis: Revenue is recorded because the service has been rendered (i.e., it is earned) and the rendering of the service has given rise to a claim to cash (i.e., it is realized), which is recorded as an Accounts Receivable. So, the resulting journal entry is as follows:

Accounts Receivable $1,000Service Revenue $1,000

(Services rendered and the customer promised to pay later.)

Example #3: Payment of $1,000 is received for services to be rendered next month.

Transaction analysis: Revenue is not recorded. Even though the realization criterion has been met (i.e., cash is received), the earned criterion has not (i.e., the company has not yet done what is required). Accordingly, the credit is to a liability account inasmuch as there is a present obligation to render services in the future as a result of a past transaction.

Cash $1,000Unearned Revenue $1,000

(To recognize the receipt of cash and that an obligation exists toprovide agreed upon services.)

Example #4: An agreement is reached to provide a service next month for $1,000 and payment will be received after the service has been completed.

Transaction analysis: No journal entry is required since there is no asset affected, no revenue earned, and no liability incurred.

The recording of sales revenue is analogous to these examples for recognizing service revenue. For sales of merchandise, the second requirement of the revenue recognition principle (i.e., earned) is generally met when ownership of the goods is transferred to the buyer. Ownership transfers when the goods are delivered or when they are shipped through a common courier with shipping terms of f.o.b. shipping point.

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Matching Principle

All businesses incur costs when trying to generate revenues. In its purest sense, a cost is an outlay, either in the form of cash paid, transferring other assets, or incurring a liability. When a cost is incurred, the first decision that must be made is whether to recognize the expenditure as an asset or as an expense. As shown in Exhibit 4-5, an expenditure is recorded as an asset when probable future benefits will result from the expenditure, which generally is interpreted to mean the benefits will extend beyond one year. However, when the benefits are immediate, or there is doubt about their being future benefits, then the cost is expensed. When these costs relate to the purpose for why the company exists, they are recognized as expenses, and when these costs relate to a peripheral activity, they are recognized as a loss of the period. This immediate recognition of a cost as an expense/loss is one aspect of the matching principle and is referred to as “immediate recognition.”

When the expenditure is recorded as an asset rather than immediately recognizing the amount as an expense/loss, a second decision must be made: When should the cost of that asset become an expense? This is another aspect of the matching principle. When an expenditure is recorded as the asset “inventory” all costs directly related to the selling of the inventory are expensed in the period it is sold, ion a cause-and-effect manner. These types of expenditures are referred to as inventoriable costs19. Until the product is sold, inventoriable costs are shown as inventories and then, when the inventory is sold, the cost is moved from the balance sheet to the income statement. The following examples illustrate the accounting for inventoriable costs in acquiring and selling merchandise.

Example: A retailer purchases merchandise on account for $8,000. Sales taxes on the order are $400. Payment for the inventory is to be made within thirty days after receipt of the invoice.

Transaction analysis: The expenditure of acquiring Inventory results in acquiring an asset as there is future benefit to the company from owning the inventory. Thus, at acquisition, the Inventory account is debited and a liability account is credited because the company has an obligation that will result in the future transfer of an asset. Since an asset was acquired, the transaction is measured initially using the historical cost principle. So, the asset is recorded at the sum of the costs incurred to acquire it, which cost includes sales taxes because that is also a necessary cost in gaining ownership. The resulting journal entry to record the acquisition of the merchandise is as follows:

Merchandise Inventory $8,400Accounts Payable $8,400

(Record the acquisition of inventory using the perpetual inventory method.)

Subsequently, the retailer sells one-fourth of the acquired merchandise for $4,000, of which, cash of $2,500 is received and the remainder is to be paid within 30 days. First, revenue is recorded because revenue has been both realized and earned, and the journal entry to record the sale is as follows:

Cash $2,500Accounts Receivable 1,500

Sales $4,000(Record a sale with partial payment.)

Second, those costs that were directly related to selling the merchandise are now recorded as expenses according to the matching principle, and the journal entry to record the cost of the inventory sold as an expense is as follows:

19 Inventoriable costs are also referred to as product costs, as contrasted to period costs. Period costs have no relationship to a product and therefore, are expensed according to the first aspect of the matching principle.

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Cost of Goods Sold $2,100Merchandise Inventory $2,100

(Record the cost of the merchandise sold in the above sale.)

Since one-fourth of the inventory was sold, then one-fourth of the cost of the inventory is recognized as an expense, which is called Cost of Goods Sold (1/4 x $8,400 = $2,100).

The third aspect of the matching principle applies to the cost of long-lived assets and relates to when and how these costs become an expense. This aspect states that the costs of such long-lived assets (except for land and intangible assets with indeterminate lives such as Goodwill) are recorded as expenses according to a systematic and rational allocation procedure over the time periods benefited. These systematic and rational allocation procedures are called depreciation for tangible assets such as equipment or building, depletion for natural resources, and amortization for assets that do not have tangible substance such as patents, copyrights, etc.

To summarize the matching principle and the thinking process in applying it, the first decision the accountant faces when an expenditure is incurred is whether to record an asset or an expense, which decision is made based upon whether future benefits are obtained.

When future benefits are not obtained, an expense (or loss) is recorded immediately according to the first aspect of the matching principle.

When future benefits are obtained and relate to inventory, then the costs of acquiring the inventory become an expense when the inventory is sold according to the second aspect of the matching principle.

When future benefits are obtained because long-lived assets are acquired, then the costs of those long-lived assets (except land and intangible assets with indeterminate lives) are expensed according to a systematic and rational allocation procedure according to the third aspect of the matching principle.

This relationship between cost, asset, and expense is displayed graphically in Exhibit 4-6. One important point of Exhibit 4-6 is that all assets (except land and perhaps certain intangible assets) eventually become expenses.

EXHIBIT 4-6Relationship between Cost, Asset and Expense

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Extending the ConceptHow should the costs that an oil company incurs in extracting the oil from the ground, transporting it to the refinery, storing the raw oil until it is refined, refining it, and storing the finished product be accounted? As an asset or as an expense?

Assuming the answer to the above question is that these costs should be recorded as an asset and be recorded in an inventory account, when should these costs be recognized as expenses?

Future Benefits

Yes

No

Present Value Principle

Theoretically, all liabilities are recorded at the amount that would be required to liquidate them at the date of the financial statements. This amount is not their maturity value (i.e., the amount that will be paid to satisfy the obligation when the liability comes due). Rather, the amount reported is the amount that is equivalent to the maturity value given the difference in time. For example, $1 today is not equal to $1 in ten years, or even one year from today. The reason is that, given the difference in time, the $1 today can grow to become more than a dollar because of interest. Saying the same thing in reverse, if the company owes a $1,000 debt that will be paid in one year, then the amount reported on today’s balance sheet is not the $1,000 but rather the present value of the $1,000, which—at 10% return, is equal to $909 and this is the amount that would be reported on this year’s balance sheet. This present value concept is the basis of valuing liabilities.

As with the other measurement principles, the cost-benefit and materiality thresholds also apply to measuring liabilities. So, liabilities that are due in a short period of time (i.e., current liabilities) are reported at their maturity value because, due to the short period before they mature, the present value amount is essentially the same as the maturity value. This departure from the theoretically preferred measurement is justified because the amount is immaterial and there is little benefit to reporting a present value. Thus, current liabilities are reported at their maturity value and long-term liabilities are reported at their present value, which is an equivalent amount now as the maturity value will be given the difference in time.

So in summary, the financial statement elements and the measurement principle that determines its reporting are as shown in Exhibit 4-7.

EXHIBIT 4-7Financial Statement Elements and

Their Corresponding Measurement PrincipleElement Measurement Principle

at AcquisitonAssets Historical CostLiabilities Present Value ConceptsRevenues/Gains Revenue RecognitionExpenses/Losses Matching

ConservatismUnderlying all measurement and recognition principles is the conservatism convention, which

means that when two equally viable alternatives are available, the accountant should choose the method that is least likely to overstate net income and/or total assets. The conservatism convention does not imply that accountants should purposely understate net income. Doing so would violate both primary

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Cost Incurred

Expense Immediately

Record as an Asset.

If inventory, record as an expense when inventory is sold.

If long-lived asset (except land), expense through systematic and rational allocation.

qualitative characteristics of relevance and reliability. Intentionally distorted information is not relevant information. Nor is intentionally distorted information either neutral or representationally faithful. The conservatism convention when used inappropriately results in bad accounting. Because of the continuing development of accounting theory, there now should be relatively few cases when the conservatism convention should be applied. Even when applied appropriately, some accountants criticize the conservatism convention because it has a preference for reporting bad news in preference to good news. Today, the most frequent application of the conservatism convention in U.S. GAAP is valuing inventory at the lower-of-cost-or-market.

International Perspectives on Financial Reporting So far, this chapter has focused on the FASB’s conceptual framework. However, as discussed in Chapter 1, not all countries have the same objectives for financial reporting due to legal, economic, cultural, and technological differences across countries.

The International Accounting Standards BoardThe International Accounting Standards Board’s (IASB) conceptual framework is very similar to

the FASB’s. According to the IASB, the main objective of financial reporting is to provide information, particularly information related to future cash flows, that is useful for making economic decisions. Similar to the FASB’s focus, the IASB’s objective is oriented to existing and potential stockholders and creditors who are external to the company. Under this model, financial reporting is critical in communicating unbiased information about the financial health of a company.

The IASB’s conceptual framework establishes accrual accounting and going concern as the two basic underlying assumptions of accounting. And, as with the FASB’s conceptual framework, the separate entity and the periodicity assumptions are implicit in the IASC’s conceptual framework. Also, the IASB’s conceptual framework recognizes that the four qualities that make accounting information useful are 1) understandability, 2) relevance, 3) reliability, and 4) comparability. (Remember that the FASB does not recognize understandability as a quality but rather as an objective, and that the FASB puts the qualities of relevance and reliability ahead of comparability.) Other components of the IASB’s conceptual framework that are also stated in the FASB’s framework include, representational faithfulness, prudence (i.e., conservatism), substance over form, materiality, and neutrality. And, finally, the definitions of the financial statement elements (e.g., assets, liabilities, etc.) closely mirror those of the FASB’s conceptual framework.

From the similarities of their respective frameworks, the IASB obviously was influenced substantially by the FASB’s previous work. A possible reason for this influence is that although the IASC is comprised of numerous countries, it was organized in the U.K. and given the cultural, legal, and economic similarities between the U.S. and the U.K., it should not be surprising that the conceptual frameworks are similar. One question that has not been completely answered is how the IASB’s conceptual framework will work in countries not having a cultural, legal, and economic environment similar to the U.S. and the U.K.

Germany: A Code-Law CountryBoth the U.S. and the U.K. are common-law countries, meaning that the respective federal

governments generally allow private sector organizations to establish rules governing their profession. Other countries, such as Germany, Japan, and France, are described as code-law countries, meaning that a branch of the federal government typically establishes financial reporting rules. Thus, accounting systems in code-law countries are heavily influenced by the objectives of governmental organizations, which do not necessarily include the presentation of accurate financial information to investors and creditors since governmental organizations have access to whatever information desired through private

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communication with management. Instead, governmental organizations usually place a higher priority on macro-economic issues such as tax revenue, unemployment, and foreign trade.

Besides the government, the other major stakeholders of code-law countries are usually banks and employees. For instance, in contrast to the U.S. where common stock is a primary source of capital, businesses in Germany rely heavily on banks for debt financing. Also, banks typically hold major blocks of common stock and have representatives on boards of directors. In addition, Germany has relatively strong labor unions that have been successful in having laws enacted that require employees (or their representatives) to hold 50% of the seats on company boards of directors. Because of these close relationships, banks and employees also have access to private communications with management and thus, are not as concerned that financial statements reflect the true financial health of the company.

As with all financial reporting systems throughout the world, Germany’s financial reporting system is organized to serve the primary stakeholders of a business: the government, banks, and employees. But due to the different cultural/economic environment, those needs are much different than they are in the United States. One difference is that the government makes the financial reporting rules and the tax rules and so, it is no coincidence that the two sets of rules are very similar. Also, the influence of the banks and employees has resulted in a very conservative financial reporting system (perhaps excessively conservative to a U.S. accountant) that allows German companies to “smooth” earnings. Smoothing earnings means that financial reporting techniques are used that dampen the income reported in good years and increase the income reported in not-so-good years. The essential characteristic—even goal—is to have less volatility in the reported earnings. One common technique used to “smooth earnings” is to use “reserve accounts.” During years of high earnings, these reserve accounts are credited and are reported as liabilities with the corresponding debit to an expense account, thus decreasing earnings. Then, during years of poor operating performance, companies can reverse these reserve accounts and, thereby, increase earnings. The overall result is to report a smooth flow of income.

All of the major stakeholders of German companies find this “smoothing” of earnings to be in their best interests. Banks benefit from smoothed earnings because excessive volatility increases the probability of penalties from government established regulation laws. Also, dividends received from companies are a primary source of bank earnings and thus, smoothed earnings facilitate a smooth earnings flow to the bank. In addition, remembering that bank loans are a primary source of business capital, companies are encouraged to report conservative balance sheets, which indicates a reduced ability to pay dividends in good years and, thus, also indicates an increased ability to meet debt payments. Smoothing earnings also protects the government’s interests in that smoothed earnings means a smooth flow of tax revenues received. Finally, smoothing practices also serve the employees’ interests by providing a smooth flow of bonuses.

Examining the financial reporting practices of a code-law country illustrates that the financial reporting objectives in the U.S. are fundamentally different than the financial reporting objectives of some other countries. Of importance is that the FASB’s and the IASB’s conceptual frameworks are oriented towards providing useful information to external financial statement users. Whereas, in countries such as Germany where the major stakeholders have access to private communication with management, the accounting system is oriented towards the allocation of company resources among the major stakeholders. Although the European Community, of which Germany is a member, has adopted the common-law philosophy of presenting a “true and fair view” in financial statements, national influences have had a greater impact on the accounting system within Germany than has international financial reporting bodies because the national financial reporting system better serves the needs of the major stakeholders.

`When beginning the task of developing the conceptual framework, the FASB stated that the

conceptual statements would guide them in developing sound accounting and financial reporting

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principles. Interestingly, since the issuance of SFAC No. 6, the FASB has taken a decided shift from emphasizing the measurement of income and now is focusing on properly measuring the elements of the balance sheet. Perhaps this shift in measurement is partly due to the insights the FASB gained in developing its conceptual framework.

This discussion of the FASB’s conceptual framework is intended to provide a frame of reference for the study of subsequent chapters. Rather than providing a thorough coverage of all aspects of the conceptual framework, the authors choose to present the essentials here and will then build upon them throughout the book. Also, differences in financial reporting practices across countries will be discussed in the book, which financial statement-users should be aware of and which, hopefully, will assist the reader to understand the diversity in financial reporting practices and also allow the reader to assess the efforts being made to harmonize financial reporting practices.

SummaryThe first step in formulating the FASB’s Conceptual Framework was to identify those parties

external to the company who are interested in obtaining information about the company but who did not have the authority to demand the desired information. It is assumed users of financial reports have a reasonable understanding of business and economic activities and are willing to study the information provided with reasonable diligence. Although the conceptual statements are phrased in terms of creditors and investors, these groups are to be viewed as representatives of all the readers of financial reports.

The objectives of financial reporting are in a hierarchal format with each objective expanding upon the preceding objective. The first objective of financial reporting is to provide useful information. The second objective elaborates upon what useful information is, which is information about the amounts, timing, and uncertainty of future cash flows. And, the third objective of financial reporting indicates that this information about future cash flows can be obtained from information about the resources, claims to those resources, and changes in those resources and claims during the period.

The next step in formulating the FASB’s Conceptual Framework was to specify those attributes of information that make it more useful than if these attributes were not present. The two primary qualities that make information useful are relevance and reliability. Information is relevant when it is (1) provided in a timely manner, (2) aids in predicting the future, and/or (3) confirms or corrects prior expectations (i.e., has feedback value). Information is reliable when it (1) is reasonably free from error and bias, (2) represents what it professes to represent, and (3) is agreed to by a consensus of measurers. In addition to relevance and reliability, the secondary qualities that make information useful are consistency and comparability.

The measurement tool is the dollar, which is assumed to be stable over time (i.e., inflation does not exist). This is acceptable because the readers of financial reports are accustomed to the dollar and presumably, can make any necessary adjustments to the data because of inflation.

In addition to the assumption of a stable dollar, other assumptions of the financial reporting model are:

The economic-entity assumption, which assumes that the transactions of the business have been separately reported from the transactions of the owners and other business enterprises.

The going-concern assumption, which points to the type of information reported on financial statements. Thus, liquidation values, or the value at which assets could be sold, customarily are not reported because such values are only relevant should the business cease operations.

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The periodicity assumption, which is that it is possible to divide the life of a business into intervals and report performance for each interval. Because of this assumption, adjusting entries are necessary.

The elements that comprise the financial statements contained in a financial report are: assets, liabilities, owners’ equity, revenues, expenses, gains and losses, comprehensive income, and investment by and distributions to owners. Assets are measured using the historical cost principle. Liabilities are measured using present value concepts. Revenue and gains are measured using the revenue recognition principle. And, expenses and losses are measured using the matching principle. Each of these measurement principles is the topic of its own chapter to be covered later in the text.

These objectives, qualitative characteristics, elements, measurement tool, and underlying assumptions currently comprise the FASB’s Conceptual Framework of financial reporting. When beginning the task of developing this framework, the FASB stated that these conceptual statements would guide them in developing sound accounting and financial reporting principles. Interestingly, since the issuance of SFAC No. 6, the FASB has taken a decided shift from emphasizing the measurement of income and now is focusing on properly measuring the balance sheet elements. Perhaps this shift in measurement is partly due to the insights the FASB gained in developing its conceptual framework.

This discussion of the FASB’s conceptual framework is intended to provide a frame of reference for the study of subsequent chapters. Rather than providing a thorough coverage of all aspects of the conceptual framework, the author chooses to present the essentials here and then build upon them throughout the text.

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GLOSSARY

Cause-and-effect: See matching principle.

Code law countries: A branch of the federal government of a country sets the rules governing a profession (i.e., establishes financial reporting rules).

Common law countries: The federal government of a country allows a private sector organization to establish the rules governing their profession.

Comparability: That quality of information that enables readers of financial statements to identify similarities in and differences between sets of data of two or more enterprises.

Consistency: That quality of information that enables readers of financial statements to identify similarities in and differences between sets of data of the same enterprise over two or more years.

Conservatism: The concept that when two or more equally good alternatives exist that the accountant should select the one that is least likely to overstate net income and/or total assets.

Cost-benefit constraint: The control placed in financial reporting that requires that the benefits received from information exceeds the cost of providing it.

Earned: The business has substantially done what it must to be entitled to the benefits represented by the revenues.

Feedback value: The quality of information that enables decision makers to confirm or correct prior expectations.

General-purpose financial statements: Financial statement(s) issued with the intent of meeting the common informational needs of all parties external to a business entity.

Going concern assumption: The notion that the existence of a business will continue at least into the foreseeable future so as to be able to complete its contemplated operations, contracts, and commitments.

Historical cost: The principle of measuring assets at acquisition at the sum of the cash, or its equivalent, that was paid to acquire the asset. In this regard, it is only the necessary and reasonable costs incurred to acquire the asset and get it ready for its intended use that becomes the historical cost of the asset.

Immediate recognition: See matching principle.

Matching principle: The principle that determines when costs become expenses. The three aspects of the matching principle are: (1) Immediate recognition which expenses an expenditure when it does not result in probable future benefits, (2) Cause-and-effect which expenses those costs connected of a product when the product is sold, and (3) Systematic and rational allocation which expenses the cost of long-lived assets.

Materiality: The provision in financial reporting that permits an exception to the rule because the information provided from the exception is not considerably different from the information that would have been provided by adhering to the rule.

Neutrality: Information that is reasonably free from error and bias.

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Nominal dollars: Measuring and reporting amounts on the financial statements in terms of dollars assuming that the dollar does not change in purchasing power over time.

Periodicity assumption: The notion that it is possible to measure the performance of a business for a time interval that is shorter than its existence.

Predictive value: The quality of information that increases the likelihood of correctly predicting future events.

Present value principle: The concept that liabilities are reported at the theoretical amount that would be required to liquidate them at the balance sheet date given the time value of money.

Realizable: Goods or services have been exchanged for assets that are readily convertible into known amounts of cash or a claim to cash.

Realized: Goods or services have been exchanged for cash or a claim to cash.

Relevance or relevant: The quality of information that makes a difference in the decision.

Reliable: The measure of confidence that can be placed in information.

Representational faithfulness: There is a close relationship between financial numbers and the economic substance of reality.

Revenue recognition principle: The principle that governs when revenue is recognized, which is that it must be (1) realized or realizable, and (2) earned.

Separate-entity assumption: The notion that the business is a separate economic unit from its owners and from other business enterprises.

Smoothing earnings: The selecting of financial reporting techniques to dampen the income reported in good years and increase the income reported in not-so-good years.

Statements of financial accounting concepts: The set of guidelines issued by the FASB that forms their conceptual framework of accounting.

Systematic and rational allocation: See matching principle.

Timliness: Providing or receiving information while it has the capacity to affect a decision.

Verifiable: There is a consensus among measurers.

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