GROUP 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 Relevance v. Reliability Tradeoffs & Examples

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 Relevance v. Reliability Tradeoffs & Examples

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 Relevance v. Reliability Tradeoffs & Examples

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 Relevance v. Reliability Tradeoffs & Examples

SUCCESSES OF THE FRAMEWORK 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 Relevance v. Reliability Tradeoffs & Examples

SUCCESSES OF THE FRAMEWORK 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 Relevance v. Reliability Tradeoffs & Examples

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 Relevance v. Reliability Tradeoffs & Examples

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 Relevance v. Reliability Tradeoffs & Examples

SFAC 2  Qualitative Characteristics of Accounting Information  SFAC 2 mainly introduces the importance of reliability and relevancy of accounting information to decision makers  SFAC 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 Relevance v. Reliability Tradeoffs & Examples

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 Relevance v. Reliability Tradeoffs & Examples Historical CostMarket 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 Relevance v. Reliability Tradeoffs & Examples

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 Relevance v. Reliability Tradeoffs & Examples

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 Relevance v. Reliability Tradeoffs & Examples

WHEN SHOULD RESOURCES BE RECOGNIZED? SFAC 5, 1984  Must meet 4 fundamental recognition criteria for a resource to be recognized: 1.Definitions 2.Measurability 3.Relevance 4.Reliability  Subject to Cost-benefits and materiality Intro to FASB Successes of the CF Failures of the CF Relevance v. Reliability Tradeoffs & Examples

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 Relevance v. Reliability Tradeoffs & Examples

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 Relevance v. Reliability Tradeoffs & Examples

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 Relevance v. Reliability Tradeoffs & Examples

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 Relevance v. Reliability Tradeoffs & Examples

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 Relevance v. Reliability Tradeoffs & Examples

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 Relevance v. Reliability Tradeoffs & Examples

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 Relevance v. Reliability Tradeoffs & Examples

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 Relevance v. Reliability Tradeoffs & Examples

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 policies  Related to accounting ethics Intro to FASB Successes of the CF Failures of the CF Relevance v. Reliability Tradeoffs & Examples