Chapter 2 - FASB Conceptual Framework

The objectives of general purpose financial reporting

to provide financial information about the reporting entity that is useful to existing and potential investors, lenders, and other creditors in making decisions about providing resources to the entity

Users of financial reports

* the primary users of general purpose financial reports are existing and potential investors, lenders, and other creditors
* other parties, such as regulators and members of the public other than investors, lenders, and other creditors, may also find general purpose financial reports useful; however these reports are not primarily directed to these other groups
* information that is useful for management may be provided to management without it being a part of the entity’s financial reporting package

These primary users are

* people who have a reasonable knowledge of business and economic activities
* people who will diligently review and analyze the financial information provided to them

Needs of the users of financial reports

decisions by existing and potential investors, lenders, and other creditors are dependent on the returns that they expect from providing investments or credit to the reporting entity; consequently, these capital providers need information to help them assess the prospects for future net cash inflows to an entity

To assess these factors net cash flows, capital providers need information about

* the resources of a reporting enterprise
* claims against the reporting entity
* how efficiently and effectively the reporting entity’s management and governing board have discharged their responsibility to use the entity’s resources

Information concerning a reporting entity’s economic resources and claims can help

users to identify the reporting entity’s strengths and weaknesses

Which can help users assess

* the reporting entity’s liquidity and solvency
* needs for additional financing
* how successful it is likely to be in obtaining that financing
* how future cash flows will be distributed among those with claims against the reporting entity

Reporting changes in a reporting entity’s economic resources can help users assess

* the reporting entity’s future cash flows
* the reporting entity’s financial performance which provides an indication of how well management has discharged its responsibilities to make efficient and effective use of the reporting entity’s resources

Note about the information about a reporting entity

the information about a reporting entity’s past financial performance and how its management discharged it responsibilities usually is helpful in predicting the entity’s future returns on its economic resources

Financial performance reflected by accrual accounting

future cash flows are better reflected by other things

Future cash flows are better reflected by

* changes in a reporting entity’s economic resources and claims during the current period based on accrual accounting THAN
* information solely about the cash receipts and payment during the current period

Note about financial performane reflected by accrual accounting

information about a reporting entity’s cash flows during the current period is also helpful for users when assessing the reporting entity’s ability to generate future net cash inflows

Characteristics and limitations of accounting information

* financial reports are based on estimates, judgments, and models rather than exact depictions
* general purpose financial reports do not and cannot provide all the information that existing and potential investors, lenders, and other creditors need
* those users need to consider pertinent information from other sources, for examples, general economic conditions and expectation, political events and political climate, and industry and company outlooks
* general purpose financial reports are not designed to show the value of a reporting entity but they provide information to help capital providers estimate the value of the reporting entity

Qualitative characteristics of useful financial information

* introduction
* fundamental qualitative characteristics
* enhancing qualitative characteristics
* a pervasive constraint
* other concepts from this chapter’s “basis for conclusions”

Introduction: qualitative characteristics of useful financial information

identify the types of information that are likely to be most useful to the existing and potential investors, lenders and other creditors for making decisions about the reporting entity on the basis of information in its financial report

The qualitative characteristics of useful financial information as well as the pervasive constraint of “cost” apply both to

* financial information provided in financial statements
* financial information provided in other ways

How there qualitative characteristics and cost contraint

may be applied different for different types of information

Note on concept statement

in the original concept statement written on this topic - concept statement #2 - FASB identified the “pervasive criterion” of accounting information to be “decision usefulness”

* although FASB did not mention this concept in concept statement #8, it is still arguable that the pervasive criterion of accounting information is “decision usefulness”

Fundamental qualitative characteristics

* relevance
* predictive value
* confirmatory value
* materiality
* faithful representation
* complete
* neutral
* free from error

Relevance

information provided in a set of financial statements is relevant if it is capable of making difference in the decisions made by users. financial information is capable of making a difference in decisions if it has

* predictive value
* confirmatory value
* materiality

Predictive value

information that can be used as an input to processes employed by users to predict future outcomes

Confirmatory value

information that provides feedback about previous evaluations (confirms or changes those evaluations)

Materiality

information is material if omitting it or misstating it could influence decisions that users make on the basis of the financial information of a specific reporting entity

Note on materiality

materiality is entity-specific. the board can not specify a uniform quantitative threshold for materiality to be used in every situation

Faithful representation

the manner in which transactions or events are represented in financial reports must faithfully agree with the true nature of the transaction-event; there are three parts

• complete

• neutral

• free from error

Note on faithful representation

this concept of faithful representation is very similar to the concept of “substance over form” that is used by the practicing accountant

Complete (completeness)

complete depiction includes all information necessary for user to understand the phenomenon being depicted, including all necessary descriptions and explanations

Neutral (nautrality)

a neutral depiction is without bias in the selection or presentation of financial information. it is not slanted, weighted, emphasized, deemphasized, or otherwise manipulation to increase the probability that financial information will be received favorably or unfavorably by users

Free from error (freedom from error)

faithful representation does not mean accurate in all respects. free from error means there are no errors or omission in the description of the phenomenon, and the process used to produce the reported information has been selected and applied with no errors in the process

Note on relevance and faithfully representation

information must be both relevant and faithfully represented if it is to be useful

Enhancing qualitative characteristics

• comparability

• verifiability

• timeliness

• understandability

Comparability

there are two aspects of comparability

• comparability between different enterprises

• comparability within one enterprise

Comparability between different enterprises

in the same industry; however one method for everyone is not the objective. FASB did note that permitting alternative accounting methods for the same economic phenomenon diminishes comparability

Comparability within one enterprise

from year to year; that is, ensuring that trends for a single enterprise from year to year have some meaning

Note about comparability

FASB noted that consistency and comparability do not mean the same thing; although it did note that “comparability is the goal. consistency helps to achieve that goal”

Verifability

information used to prepare a set of financial statements should be verifiable so that “different knowledgeable and independent observes” using the same measurement methods could reach consensus that a particular depiction is a faithful representation

Timeliness

the information provided in a set of financial statements should be available to decision makers in time to be capable of influencing their decisions

Understandability

classifying, characterizing, and presenting information clearly and concisely makes it understandable

Omitting phenomena that are inherently complex and cannot be made easy to understand might

make financial reports easier to understand; however, these reports would be incomplete and therefore, potentially misleading

Financial reports are prepared

for users who have a reasonable knowledge of business and economic activities and who review and analyze the information diligently; however, there are times when even a well-informed and diligent user may need to seek the aid of an advisor to understand information about complex economic phenomena

Note about enhancing qualitative characteristics

there is no order in which the enhancing qualitative characteristics should be considered by FASB. in addition, one enhancing qualitative characteristic may have to be diminished by FASB to maximize another qualitative characteristic

Note about qualitative characteristics overall

FASB distinguishes between qualitative characteristics that are “fundamental” (qualitative characteristics that are the most critical) and qualitative characteristics that are “enhancing” (qualitative characteristics that are less critical, but still highly desirable)

A pervasive constraint

cost is a pervasive constraint on the information that can be provided by financial reporting. the benefits of financial information to the user should exceed the reporting entity’s cost of providing that information

In the discussion paper and the exposure draft related to this chapter

FASB proposed that “materiality” would be a pervasive constraint in financial reporting. respondents to the exposure draft argued that materiality is an aspect of relevance because immaterial information does not affect a user’s decision. the board agreed with these views when it issued the chapter three of this concept document

Some respondents to the discussion paper and exposure draft argued

that “conservatism” should be included as a qualitative characteristic. FASB did not agree arguing that conservatism would be inconsistent with the concept of neutrality

Respondents to the discussion paper and exposure draft suggested other qualitative characteristics of financial information including:

• transparency

• high quality

• internal consistency

• true and fair view

• fair presentation

• credibility

FASB argues that these are different words to describe information that has the qualitative characteristics of relevance and representational faithfulness enhanced by comparability, verifiability, timeliness, and understandability. credibility is similar, but also implies trustworthiness of a reporting entity’s management

Other respondents to the discussion paper and exposure draft suggested other criteria for standard-setting decisions, and the board has at times cited some of those criteria as part of the rationale for some decisions. these criteria include:

• simplicity

• operationality

• practicability or practicality

• acceptability

FASB argues that these are not qualitative characteristics of financial information, but rather they are part of the overall weighing of benefits and costs of providing useful financial information

Elements of financial statements

• element definitions

• aspects of comprehensive income

• other accrual accounting and related concept definitions

Element definitions

• income statement items

• balance sheet items

• statement of owners’ equity items

Income statement items

• revenues

• expenses

• gains

• losses

Revenues

inflows or other enhancements of assets of an entity or settlement of its liabilities (or 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

Expenses

outflows or other using up of assets or incurrences of liabilities (or 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

Gains

increases in equity (net assets) 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

Losses

decreases in equity (net assets) 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

Balance sheet items

• assets

• liabilities

• equity

Assets

probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events

Liabilities

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

Equity

residual interest in the assets of an entity that remains after deducting its liabilities. in a business enterprise, the equity is the ownership interest

Statement of owners’ equity items

• investments by owners

• distribution to owners

• comprehensive income

Investments by owners

increases in net assets of a particular enterprise resulting from transfers to it from other entities of something of value to obtain or increase ownership interests (equity) in it. assets are most commonly received as investment by owners, but that which is received may also include services or satisfaction or conversion of liabilities of the enterprise

Distribution to owners

decreases in net assets of a particular enterprise resulting from transferring assets, rendering services, or incurring liabilities by the enterprise to owners. distributions to owners decrease ownership interests (equity) in an enterprise

Comprehensive income

the change in equity (net assets) of an entity during a period from transactions or events of non-owner sources. it includes all changes in equity during a period except those resulting from investments by owners and distributions to owners

Aspects of comprehensive income

• what is stated in the concept statement

• implications

What is stated in the concept statement

• “earnings” is considered to be a part of “net income”

• “net income” is considered to be a part of “comprehensive income”

Implications

• anything that is earnings will be reported on the income statement as part of net income

• there will be items included in “net income” that are not earnings (example: unrealized gain from revaluation or land held for resale)

• there will be items that are included in total comprehensive income that are not reported as “net income” (examples: “unrealized gains and losses” from holding “available-for-sale” securities and “cumulative translation adjustments” from translating the financial statement of a subsidiary from a foreign currency into american dollars)

Other accrual accounting and related concept definitions

• transactions

• event

• circumstance

• accrual accounting

• accrual

• deferral

• allocation: amortization is a type of allocation

• amortization: depreciation is a type of amortization

• realization: which no longer means recognition

• recognition: which now means to record

• matching

Recognition and measurement in financial statements of business enterprises

• a full set of financial statements

• necessary financial statements

• criteria for recognition on a financial statement

• other recognition and measurement considerations

• measurement attributes included in a set of financial statements

• necessary financial statements evaluations

A full set of financial statements

they should report:

• the financial position for the end of the period

• the earnings for the period

• the ”comprehensive income” for the period

• cash flows for the period

• investments by and distributions to the owners during the period

Necessary (required) financial statements

• statement of financial position (balance sheet)

• statement of earnings and comprehensive income (however, this statement currently is permitted to be split into two statements by audited companies)

• statement of cash flows

• statement of investments by and distributions to owners (however, this statement is not currently required of audited companies)

Criteria for recognition on a financial statement

• must be defined as an element of financial statements by SFAC #6

• must be measurable

• must be relevant

• must be reliable (which is no longer a qualitative characteristic of accounting information so this will likely be changed when this concept statement is revised as a chapter in concept statement no. 8)

Other recognition and measurement consideration

• some useful information is better provided by other means of financial reporting, such as footnotes or supplementary schedules

• financial statements are “general purpose” statements so they are not intended to satisfy the needs of all users

• financial statements must interrelate and complement one another

• a focus on the “bottom-line” net income figure must be avoided

• a degree of skepticism is needed in applying the recognition criteria

Measurement attributes included in a set of financial statements

• historical cost

• amortized cost (concept statement #5 does not mention “amortized cost”, yet many assets are reported in the financial statements at amortized cost)

• net realizable (settlement) value

• lower-of-cost-or-net-realizable-value

• par value or stated value (face value)

• present (discounted) value of future cash flows

• fair value

Note of measurement attributed included in a set of financial statements

many assets are required by FASB to be reported at fair value. anytime FASB requires an asset to be reported at fair value, it identifies for that asset what fair value is (ie current market value, current replacement cost, net realizable value, present value of future cash flows, etc.)

Necessary financial statements evaluations

• liquidity

• financial flexibility

• profitability

• risk

Note about necessary financial statements evaluations

concept statement #5 does not mention “operating efficiency” and although it is management that is usually most interested in operating efficiency, there are, at times, some external users who are also interested in this measurement

The historical framework of accounting (unofficial framework)

• assumptions

• principles

• accounting procedures

• accounting methods

• modifying conventions

Assumptions (postulates)

• economic entity

• monetary unit

• going concern

• periodicity

Economic entity

for any defined entity, even though not necessarily a legal entity, a set of accounting records can be maintained

Monetary unit

• accounting records will be maintained and measured in money

• money is a stable unit of measurement

Note about monetary unit

because money is not a stable unit of measurement, this assumption (and the principles built on it) are theoretically weaker than other assumptions and principles

Going conern

unless there is strong evidence to the contrary, the economic entity will continue in business indefinitely

Periodicity

• accountants must prepare financial statements that cover a specified period of time (month, quarter, year)

• accountants, with the use of estimates, are able to prepare these types of statements

• these period statements will be utilized by third parties in making investment and credit decisions

Principles (built on the assumptions)

• recognition

• matching

• measurement

• objectivity

• consistency

• full disclosure

Revenue recognition

• built on periodicity

• revenue should be recognized when it is “earned”, which is when it is “realized” or “realizable”

• some possible points of revenue recognition

Some possible points of revenue recognition

• before production begins

• during production

• after production, but before the sale

• at the point of sale

• when cash is collected

Before production begins

• this is no longer a point of revenue recognition

• in the past - in the oil and gas industry, revenue was reported as earned when the oil or gas was discovered, but this was not only reported as a supplemental disclosure. revenue on the income statement was based on oil and gas sold

During production

• this is the case for construction companies

• revenues are normally recorded throughout the period of construction

After production, but before the sale

• this is the case in some precious metal industries, such as gold mining, and also agricultural companies

• revenue is recorded when the gold is removed from the ground or crops are harvested

• this is done because since gold and agricultural commodities have an active marketplace and the current market price is set, there is no need to find a buyer nor is there a need to set a price, therefor, when the gold is out of the mine or the crops are harvested, the revenue is “realizable”

At the point of sale

• for almost all companies

• the point of sale is the point at which ownership of the item being sold changes hands

When cash is collected

• it is used at times for some installment sales

• it is only acceptable if

  • collectibility from the customer is uncertain

  • there is no basis for estimating bad debts

Matching

• built on periodicity

• costs (expenses) should be matched against:

  • the revenues that they produce

  • the time period over which the expense is incurred

Note about matching

the cost must always be allocated to the time periods in a “systematic and rational” manner

Measurement

• built on “monetary unit”, “going concern”, and “periodicity”

• we currently have a mix of measurement bases, the two most common are:

  • historical cost

  • fair value

Historical cost

assets and liabilities are shown at their historical cost values

Fair value

assets and liabilities are shown at their fair values, which might be current market value, current replacement cost, present value of future cash flows or net realizable value

Objectivity

• built on periodicity

• the most objective information available should be utilized when recording transactions or events

Consistency

• built on periodicity

• an accounting method, such as “straight-line depreciation” or “LIFO inventory valuation” once it is selected to be used, should be retained in following years so that there is the opportunity for comparability between the different period financial statements of the same entity, that is a reporting entity’s trends will have meaning

Full disclosure

• built on periodicity

• all information that would be of interest to the “prudent” financial statement user should be disclosed either:

  • in the body of the financial statements

  • as supplemental information (schedules, footnotes)

Accounting procedures (accounting practices)

• built on principles

• these procedures are what are referred to as “generally accepted accounting principles” (GAAP)

Examples of accounting procedures

• depreciation: built on matching

• amortization: built on matching

• the use of footnotes: built on full disclosure

• the allowance method of accounting for bad debt: built on matching

• the “percentage-of-completion” method of construction accounting: built on revenue recognition