1. Towards a New Conceptual Framework Presented June 18, 2009 at the Main Line Association for Continuing Education by Joel Wagoner, MBA, CPA, CMA, CFM Assistant Professor of Business Administration Arcadia University

2. Towards a New Conceptual Framework What is the “conceptual framewok”? Why do we need a new one? What’s wrong with the one that we already have?

3. Towards a New Conceptual Framework The current movement towards a new conceptual framework is an outgrowth of the effort towards convergence of GAAP and International Accounting Standards (IFRS’s).

4. Financial Accounting Standards Board Established in 1973 Headquartered in Norwalk, Connecticut Replaced Accounting Principles Board

5. International Accounting Standards Board Founded in 1973 Based in London, UK Has representatives on standards setting boards of United States, United Kingdom, Japan, Australia, Canada, France, Germany

6. Towards a New Conceptual Framework Norwalk Agreement: 2002 FASB and IASB “each acknowledged their commitment to the development of high- quality compatible accounting standards that could be used for both domestic and cross- border financial reporting.”

7. Conceptual Framework Project Memorandum of 2006 recommitted both boards to the convergence effort, including the joing development of a new conceptual framework. Purpose: “To develop an improved common conceptual framework that provides a sound foundation for developing future accounting standards.”

8. Conceptual Framework Project “Such a framework is essential to...developing standards that are principles-based, internally consistent, and internationally converged.” “The new framework will build on the existing IASB and FASB frameworks and consider developments subsequent to the issuance of those frameworks.”

9. Conceptual Framework Project The FASB and IASB are, as a joint project: – “Focussing on changes in the environment since the original frameworks were issued, as well as omissions in the original frameworks” – “Giving priority to addressing and deliberating those issues within each phase that are likely to yield benefits...in the short term” – “Initially considering concepts applicable to private sector business entities.”

10. Conceptual Framework Project “A common goal of the...(FASB and IASB)... is for their standards to be clearly based on consistent principles. To be consistent, principles must be rooted in fundamental concepts rather than a collection of conventions. To consistently achieve useful financial reporting, the body of standards taken as a whole and the application of those standards should be based on a framework that is sound, comprehensive, and internally consistent.”

11. Conceptual Framework Project Eight Phases (four active): – Objective and Qualitative Characteristics – Elements and Recognition – Measurement – Reporting Entity – Framework Purpose and Status in GAAP Hierarchy (inactive) – Applicability to Not-for-Profit Sector (inactive) – Presentation and Disclosure (inactive) – Remaining Issues (inactive)

12. Objective and Qualitative Characteristics Purpose: To consider – “The objective of financial reporting”; – “The qualitative characteristics of financial reporting information”; – “The trade-offs among qualitative characteristics and how they relate to the concepts of materiality and cost-benefit relationshps”.

13. Objective and Qualitative Characteristics The two boards issued an exposure draft on May 29, 2008. The FASB has since published the comments that they received in response to the exposure draft.

14. Objective and Qualitative Characteristics According to the exposure draft, “The objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to present and potential equity investors, lenders and other creditors in making decisions in their capacity as capital providers.” The exposure draft identifies capital providers “as the primary users of financial reporting.”

15. Objective and Qualitative Characteristics The exposure draft describes qualitative characteristics as “the attributes that make financial reporting information useful”, and as “complementary concepts that each contribute to the usefulness of financial reporting information.”

16. Objective and Qualitative Characteristics Fundamental Qualitative Characteristics: – Relevance – Faithful Representation

17. Objective and Qualitative Characteristics Relevance: “is capable of making a difference in the decisions made by users in their capacity as capital providers.”

18. Objective and Qualitative Characteristics Faithful Representation (replaces “reliable” in the ‘old’ conceptual framework): “[W]hen the depiction of an economic phenomenon is complete, neutral, and free from material error.”

19. Objective and Qualitative Characteristics Enhancing Qualitative Characteristics (are complementary to the fundamental qualitative characteristics): –Comparability –Verifiability –Timeliness –Understandability

20. Objective and Qualitative Characteristics Comparability: “enables users to identify similarities in and differences between two sets of economic phenomena.”

21. Objective and Qualitative Characteristics Verifiability: “[H]elps assure users that information faithfully represents the economic phenomena that it purports to represent.”

22. Objective and Qualitative Characteristics Timeliness: “Available to decision makers before it loses its capacity to influence decisions.”

23. Objective and Qualitative Characteristics Understandability: “Enables users to comprehend its meaning.”

24. Objective and Qualitative Characteristics Constraints: –Materiality –Cost

25. Elements and Recognition Purpose: “To refine and converge the Boards’ frameworks”: – “Revise and clarify the definitions of asset and liability”; – “Resolve differences regarding other elements and their definitions”;

26. Elements and Recognition (continued from previous slide) – “Revise the recognition criteria concepts to eliminate differences and provide a basis for resolving issues such as derecognition and unit of account.”

27. Elements and Recognition Current GAAP definition of an asset: “Probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.”

28. Elements and Recognition Concerns with the current definition of asset: – “Some users misinterpret...‘probable’ to mean that there must be a high likelihood of future economic benefits for the definition to be met; this excludes asset items with a low likelihood of future economic benefits.”

29. Elements and Recognition Concerns with the current definition of asset: – Emphasizes “the future flow of economic benefits, instead of focusing on the item that presently exists, an economic resource.”

30. Elements and Recognition Concerns with the current definition of asset: – “Some users misinterpret...‘control’ and use it in the same sense as that used for... consolidation accounting. The term should focus on whether the entity has some rights or privileged access to the economic resource.”

31. Elements and Recognition Concerns with the current definition of asset: – ‘Places undue emphasis on identifying the past transactions or events that gave rise to the asset, instead of focusing on whether the entity had access to the economic resource at the balance sheet date.”

32. Elements and Recognition The following definition of an “asset” has been suggested: – “ An asset of an entity is a present economic resource to which the entity has a right or other access that others do not have.”

33. Elements and Recognition “Present”: “On the date of the financial statements both the economic resource exists and the entity has the right or other access that others do not have.”

34. Elements and Recognition An “economic resource” is something that is scarce and capable of producing cash inflows or reducing cash outflows, directly or indirectly, alone or together with other economic resources. Economic resources that arise from contracts and other binding arrangements are unconditional promises and other abilities to require provision of economic resources, including through risk protection.”

35. Elements and Recognition “A “right or other access that others do not have” enables the entity to use the economic resource and its use by others can be precluded or limited. A right or other access that others do not have is enforceable by legal or equivalent means.”

36. Elements and Recognition The current definition of a liability is “Probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.”

37. Elements and Recognition Concerns about the definition of “liability” are comparable to those with the definition of “asset”: Misinterpretation of the term “probable”; “Emphasis on future outflow of benefits instead of focus on the item that presently exists”; and “undue emphasis on past events instead of the economic obligation that exists at the balance sheet date.”

38. Elements and Recognition There is the additional concern that it is unclear how the current definition of ‘liability’ applies to contractual obligations.

39. Elements and Recognition The suggested new definition of a ‘liability’ is: – “ A ‘liability’ of an entity is a present economic obligation for which the entity is the obligor.”

40. Elements and Recognition “Present” means that on the date of the financial statements both the economic obligation exists and the entity is the obligor.”

41. Elements and Recognition An “ ‘economic obligation’ is an unconditional promise or other requirement to provide or forgo economic resources, including through risk protection.”

42. Elements and Recognition An entity is the “obligor” if “it is required to bear the economic obligation, and the economic obligation is enforceable by legal or equivalent means.”

43. Elements and Recognition The FASB and IASB are considering the definition of ‘revenue’ and its criteria for recognition as a separate project.

44. Elements and Recognition The FASB and IASB agree “that it is helpful to analyze contracts...to identify whether they contain unconditional and conditional obligations” as they relate to the suggested definitions of assets and liabilities.

45. Elements and Recognition Neither the current framework of the FASB nor of the IASB includes criteria to when an item should be derecognized.

46. Elements and Recognition The IASB is studying the concept of ‘derecognition.’ The initial focus of the IASB’s study is financial assets. The IASB will later widen the study to non- financial assets.

47. Measurement Purpose: “To select a set of measurement bases that satisfy the objectives and qualitative characteristics of financial reporting.”

48. Measurement On January 14 of this year, the FASB and IASB discussed which possible measurement methods should be included in the conceptual framework and tentative decided to include three categories:

49. Measurement 1. “Actual or estimated current prices”; 2. “Actual past entry prices adjusted for interest accruals, depreciation, amortization, impairments, etc.”; 3.Other “prescribed computations based on discounted or undiscounted estimates of future cash flows”.

50. Measurement The two boards have identified five factors that might be considered in selecting a measurement basis:

51. Measurement 1. Value / flow weighting and separation (“the relative importance to users about the current value of the asset or liability vs. information about the cash flows generated by the item, as well as the ease and precision with which the flows can be separated from the value changes.”);

52. Measurement 2. Confidence level: “The confidence level that can be placed on alternative measurements as representations of the asset or liability being measured (an indication of faithful representation.)”

53. Measurement 3. The measurement of similar items (comparability): “Items of a similar nature should be measured the same way”.

54. Measurement 4. The measurement of items that generate cash flows together (understandability): “Items that generate cash together flows as a unit should be measured the same way.”

55. Measurement 5. Cost-benefit: “An assessment of the benefits that would be derived from alternative measurements to the costs of preparing those measurements.”

56. Measurement SFAS 157, Fair Value Measurements, “defines fair value and establishes a framework for applying the fair value measurement objective in GAAP.”

57. Reporting Entity Purpose: “To determine what constitutes a reporting entity for the purposes of financial reporting.”

58. Reporting Entity The FASB and IASB jointly issued their preliminary views, Conceptual Framework for Financial Reporting: The Reporting Entity on May 29, 2008. Comments that the FASB and IASB received in response are published on their respective websites.

59. Towards a New Conceptual Framework Revenue Recognition Project: FASB and IASB formally agreed to embark on the joint project in 2002.

60. Revenue Recognition Project Purpose: “To develop coherent conceptual guidance for revenue recognition and a comprehensive Statement on revenue recognition based on those concepts.”

61. Revenue Recognition Project “In particular, the project is intended to improve financial reporting by: – 1. Converging U. S. and international standards on revenue recognition; – 2. Eliminating inconsistencies in the existing conceptual guidance on revenue recognition;”

62. Revenue Recognition Project “In particular, the project is intended to improve financial reporting by: – 3. Providing conceptual guidance that would be useful in addressing future revenue recognition issues; –4. Eliminating inconsistencies in existing standards-level authoritative literature and accepted practices;”

63. Revenue Recognition Project “In particular, the project is intended to improve financial reporting by: – 5. Filling voids in revenue recognition guidance that have developed over time; – 6. Establishing a single, comprehensive standard on revenue recognition.”

64. Revenue Recognition Project Before the Norwalk Agreement, the FASB had begun a project that “would lead to a new comprehensive accounting standard on revenue recognition and also would amend the related guidance on revenues and liabilities in certain of the FASB concepts statements.”

65. Revenue Recognition Project “Comprehensive guidance on revenue recognition has not been previously developed in the United States...There currently are more than 140 pieces of authoritative literature that relate to revenue recognition.” – The FASB Report, December 24, 2002

66. Revenue Recognition Project Consider: According to SFAC 5, Recognition and Measurement in Financial Statements of Business Enterprises, revenues should be recognized when realized or realizable, and when earned.

67. Revenue Recognition Project However, in SFAC6, Elements of Financial Statements, revenues are defined in terms of changes of assets and liabilities. So, what happens if revenue is earned and realized, but has not resulted in a change in assets or liabilities? (SFAC 5 overrides SFAC 6, resulting in a deferred revenue liability - even if no obligation exists.)

68. Revenue Recognition Project The FASB and IASB are jointly considering such questions as: – “ Should revenue recognition be subject to criteria over and above the asset and liability recognition criteria?” – “Is the earnings process useful as a basis for revenue recognition?” – “Is the distinction between revenues and gains useful?”

69. Revenue Recognition Project The FASB and IASB are leaning towards recognizing revenue as the result of an increase in assets relative to liabilities, as opposed to the result of realization and earnings.

70. Revenue Recognition Project Under the “assets and liabilities” approach to recognizing revenue, “changes in assets and liabilities that have occurred are analyzed to determine the source of those changes.”

71. Revenue Recognition Project An increase in assets must be the result of one of four causes: 1. A decrease in other assets; 2. An increase in liabilities; 3. An investment by owners; 4. Income (including revenue).

72. Revenue Recognition Project Here’s why the FASB and IASB are concerned about recognizing revenue based on realization and earnings: Consider a retailer who sells tv sets with extended warranties. When should the retailer recognize revenue from selling the extended warranties?

73. Revenue Recognition Project If the retailer is responsible for honoring the warranty, no revenue should be recognized until the retailer’s obligation has been fulfilled - until the warranty revenue has been earned. The warranty obligation represents a liability of unearned revenue until the obligation has been fulfilled.

74. Revenue Recognition Project However, if the retailer outsources the servicing of the tv’s under the extended warranties, then the retailer has “earned” the revenue from the extended warranties when they are sold.

75. Revenue Recognition Project An “assets and liabilities” approach to recognizing revenue will prevent situations in which the recognition of revenue is contingent on whether services to be performed under a contract will be outsourced.

76. Revenue Recognition Project On December 19, 2008, the FASB and IASB released a discussion draft on revenue recognition.

77. Revenue Recognition Project The discussion draft is available on the FASB’s website. The FASB invites comments from the Accounting profession through June 19.

78. Towards a New Conceptual Framework On September 11, 2008, the FASB and IASB reaffirmed the 2006 Memorandum of Understanding.

79. Towards a New Conceptual Framework The FASB and IASB “again affirmed their commitment to developing a common set of high-quality standards.”

80. Towards a New Conceptual Framework “The boards are aware that that continued progress toward convergence [sic] is a factor that the Securities and Exchange Commission will consider in evaluating its recent proposal to permit or require use of IFRS’s in the U.S.”

81. More Information http://www.fasb.org/intl http://www.iasb.org