The Conceptual Framework and Objectives of Financial Reporting Chapter 1 The Conceptual Framework and Objectives of Financial Reporting

What is Accounting Used For? Decision Making Evaluation of past performance Expectations of future performance Allocation of Resources

Free enterprise principle Resources will flow to the segments of the economy that will use them most efficiently in the creation of new wealth

Accounting Information Role of Accounting Accounting Information Investors Efficient Markets Hypothesis— Implies alternative accounting methods will not significantly affect stock prices Implies investors receive information form a variety of sources

Chapter 1 -- Learning Objective 2. Trace the evolution of generally accepted accounting principles GAAP

GAAP A consensus The conventions, rules, and procedures necessary to define accepted accounting practice

Sources of GAAP Committee on Accounting Procedures Accounting Principles Board Financial Accounting Principles Board

Committee on Accounting Procedure CAP 1939 - 1959 First private body concerned with writing accounting rules Issued 51 Accounting Research Bulletins Members were practicing CPAs An “ad hoc” approach

Accounting Principles Board APB 1959 - 1973 Appointed by the AICPA Primarily from public accounting Issued 31 APB Opinions Criticized for failing to deal with problems on a timely basis Many saw a need for independence

Financial Accounting Foundation FAF Established 1973 Appoints members of Financial Accounting Standards Board (FASB) Appoints members of Financial Accounting Standards Advisory Committee (FASAC) Provides financial support to FASB Contributions from industry & CPA firms Wheat committee

Financial Accounting Standards Board FASB Established 1973 7 members Members are full time, well paid Responsible only to FAF Passage of standards requires 5 out of 7 votes

Securities and Exchange Commission Appointed by President Reports to Congress Final authority on reporting by public companies

International Accounting Standards International Accounting Standards Committee Standards less specific “Principle Based” Not allowed by SEC

Accounting Standard Setting A political process Example—options Congress, SEC, EITF 13

Chapter 1 -- Learning Objective 3. Relate the objectives of financial reporting as stated in the conceptual framework to the accounting process

Conceptual Framework Statements of Financial Accounting Concepts (SFACs) Purpose: Establish the objectives and concepts to be used by the FASB in developing standards for financial reporting Why is there a conceptual framework? The need for a logical and cohesive set of interrelated concepts serve as a guide for the development of financial accounting and reporting standards

Conceptual Framework SFACs Objectives of Financial Reporting Qualitative Characteristics Objectives for Nonbusiness Organizations Recognition & Measurement Elements of Financial Statements

Objectives of Financial Reporting SFAC No. 1 To provide information: 1. Useful in investment and credit decisions 2. Useful in assessing future cash flows 3. About enterprise resources, claims and changes Key is decision making Liquidity, Solvency, Financial Flexibility, Profitability

Chapter 1 -- Learning Objective 4. Interpret the meaning of the qualitative characteristics of accounting information enumerated in the conceptual framework

Objectives Useful for decision making Information about future cash flows Information about resources, claims to resources, changes in resources Liquidity Solvency Flexibility Profitability

Qualitative Characteristics SFAC No. 2 Primary Qualities Understandability Relevance Reliability Secondary Qualities Comparability Consistency Qualities to make F.S. most useful for decision making Must be Understandable

The capacity for information to make a difference Relevance The capacity for information to make a difference Predictive Value Feedback Value Timeliness

Reliability User has confidence in the information: Verifiability Representational Faithfulness Neutrality Representational Faithfulness to Underlying Economic Events Neutrality—Free from Bias

Secondary Qualities Comparability—With other enterprises Consistency—Period to Period Changes in accounting must be to Better principles

Measurement and reporting practices are affected by: Constraints Measurement and reporting practices are affected by: Cost/benefits Materiality Industry practices

Chapter 1 -- Learning Objective 5. Understand the assumptions and conventions underlying the recognition and measurement of accounting data for financial reporting

Recognition and Measurement SFAC No. 5 Reporting an item in the financial statements Measurement The amount reported for an item in financial statements

Recognition Criteria Definition Measurability Relevance Reliability Must meet definition of an element of financial statements found in SFAC No. 6 Measurability Must be measurable with sufficient reliability Relevance Must be capable of making a difference Reliability Must be representationally faithful, verifiable & neutral

Basic Accounting Assumptions: Economic entity Going concern (Continuity) Periodicity Monetary unit Monetary Unit—must be stable Ex. Cost of gas 10 years ago

Basic Conventions and Practices Cost or other measurement attributes Revenue recognition Matching Conservatism Full disclosure Matching revenues to expenses Ex. depreciation

Chapter 1 -- Learning Objective 6. Distinguish among the elements of the financial statements

Elements of Financial Statements SFAC No. 6 Basic Building Blocks

Elements of Financial Statements Assets Liabilities Equity Investments by owners Distributions to owners Comprehensive Income Revenues Expenses Gains Losses Balance Sheet Assets—future economic benefits Liabilities—future claims against assets Income Statement

Chapter 1 -- Learning Objective 7. Understand how accounting information is used in investment decision models

Investment Decision Model Factors Operating efficiency Capital generation Asset productivity Financial leverage Income Statement Goal Growth potential Balance Sheet Also consider downside risk

Chapter 1 -- Learning Objective 8. Develop an appreciation of ethical and moral considerations in business

Decision Model Determine the Facts Define the ethical issues Identify major values Specify the Alternatives Compare values and alternatives Assess consequences Decide Relativism—widespread acceptance Absolutism—rules Utilitarianism--stakeholders

Decision Model for Ethical Dilemmas 1. Determine the facts 2. Define the ethical issue 3. Identify major values 4. Specify the alternatives 5. Compare values and alternatives 6. Assess the consequences 7. Make the decision Problem