Download The FASB's Conceptual Framework and more Study notes Accounting in PDF only on Docsity!
I
n Chapter 6, we examined a number of committee reports and documents emanating from the American Institute of Certified Public Accountants (AICPA), Accounting Principles Board (APB), and the American Accounting Association (AAA). The chronology of these documents is extremely impor- tant. The first one (ASOBAT, A Statement of Basic Accounting Theory ) appeared shortly after ARSs 1 and 3 (the Moonitz and Sprouse and Moonitz postulates and principles studies) and the last one (SATTA, Statement of Accounting Theory and Theory Acceptance ) appeared just prior to publica- tion of the first part of the conceptual framework. Since all of the Chapter 6
The FASB’s Conceptual
Framework
C H A P T E R
After reading this chapter, you should be able to:
- Recognize the linkage between the conceptual framework and the documents discussed in Chapter 6.
- Understand the components of the conceptual framework.
- Comprehend the trade-off problems that standard setters face.
- Appreciate the conflict between representational faithfulness and economic consequences.
- Assess empirical research on the conceptual framework.
- View the conceptual framework from the codificational standpoint and the jurisprudential view.
L e a r n i n g O b j e c t i v e s
224 – ♦ – ACCOUNTING THEORY
documents became available just prior to the FASB’s conceptual framework project, they played an important role in its development. There are two important points to keep in mind as we examine the con- tents of the conceptual framework. First, the project can be viewed as an evolutionary document with important parts drawing heavily on the works just discussed. Second, while much criticism can (and will) be directed toward the conceptual framework, the document can be improved so that it may yet provide a sound underpinning for future accounting standards. The conceptual framework consists of eight different statements. Statement No. 7 came out in 2000, 15 years after Statement No. 6, then Statement No. 8 was not published until a decade later. Each of these eight parts is referred to as a statement of financial accounting concepts (SFAC), and our discussion of these parts proceeds chronologically. The eight SFACs and the year of publication by the FASB are: Statements of Financial Accounting Concepts: No. 1. OBJECTIVES OF FINANCIAL REPORTING BY BUSINESS ENTERPRISES (SFAC No. 1) 1978 No. 2. QUALITATIVE CHARACTERISTICS OF ACCOUNTING INFORMATION (SFAC No. 2) 1980 No. 3. ELEMENTS OF FINANCIAL STATEMENTS OF BUSINESS ENTERPRISES (SFAC No. 3) 1980 No. 4. OBJECTIVES OF FINANCIAL REPORTING BY NONBUSINESS ORGANIZATIONS (SFAC No. 4) 1980 No. 5. RECOGNITION AND MEASUREMENT IN FINANCIAL STATEMENTS OF BUSINESS ENTERPRISES (SFAC No. 5) 1984 No. 6. ELEMENTS OF FINANCIAL STATEMENTS; a replacement of FASB Concepts Statement N. 3, also incorporating an amendment of FASB Concepts Statement No. 2 (SFAC N. 6) 1985 No. 7. USING CASH FLOW INFORMATION AND PRESENT VALUE IN ACCOUNTING MEASUREMENTS (SFAC No. 7) 2000 No. 8. CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING, a replacement of SFAC No. 1 and No. 2 2010 In this chapter, we provide a chronological overview of the SFACs and discuss some of the potential problem areas. These include problems between two of the objectives and the question of whether representational
226 – ♦ – ACCOUNTING THEORY
problem that should be given a very prominent place in the normative objectives of a metatheoretical structure. It was not considered extensively, if at all, in any of the other documents discussed in Chapter 6. Statements of Financial Accounting Concepts The SFACs constitute the finished portion of the conceptual framework project. These statements are analogous to APB Statement 4 in one respect: Like that document, these statements do not establish generally accepted accounting principles (GAAP) and are not intended to invoke Rule 203 of the Rules of Conduct of the AICPA (which prohibits departures from GAAP). This weakness may be disappointing, but it nonetheless provides some important benefits. First of all, the possibility of a crisis arising from a failure to comply with the statements is avoided. Second, the process of arriving at a workable and utilitarian metatheoretical-type structure must be acknowl- edged as a slow, evolutionary process. Statement No. 1 SFAC No. 1^4 is concerned with the objectives of business financial reporting. Its overall purpose is to provide information that is useful for making business and economic decisions (para. 9). The statement is a direct descendant of the Trueblood Report and is generally a boiled-down version of that report, with some necessary value judgments as well as some redun- dant statements scattered throughout. SFAC No. 1 reiterates the user orien- tation of the documents reviewed in Chapter 6. Although it acknowledges the heterogeneity of external user groups, it states that a common core characteristic of all outside users is their interest in the prediction of the amounts, timing, and uncertainties of future cash flows. Hence, SFAC No. 1 maintains that financial statements must be gen- eral purpose in nature rather than geared toward specific needs of a particu- lar user group, although investors, creditors, and their advisers are singled out among external users.^5 While it is difficult to tell what changes might have occurred, if any, a broader user focus embracing customers, employees, and the general public might have given the Board a broader outlook. The report also takes the posi- tion that it is assumed that users of financial statements are knowledgeable about financial information and reporting, an apparent departure from the Trueblood Report’s statement assuming “limited ability” of users. (We already noted the potential qualification of the literal meaning of that phrase in Chapter 6.) As in the Trueblood Report, users are assumed to have limited authority.
The FASB’s Conceptual Framework – ♦ – 227 The statement also notes the importance of stewardship in terms of assessing how well management has discharged its duties and obligations to owners and other interested groups. The notion of stewardship goes beyond the narrow interpretation of proper custodianship of the firm’s resources and moves toward accountability, a preferable term. Several important value judgments are made throughout the report:
- Information is not costless to provide, so benefits of usage should exceed costs of production.
- Accounting reports are by no means the only source of information about enterprises.
- Accrual accounting is extremely useful in assessing and predicting earning power and cash flows of an enterprise.
- The information provided should be helpful, but users make their own predictions and assessments. Finally, the document does not specify what statements should be used, much less what their format should be. It does mention, however, that financial reporting should provide information relative to the firm’s economic resources, obligations, and owners’ equity (para. 41). Also dis- cussed is how firm performance is provided by measurements of earnings and its components (para. 43) as well as how cash is acquired and dis- bursed (para. 49). Hence, SFAC No. 1 is an extremely cautious invocation of the Trueblood Committee objectives and it maintains a high level of generality. Statement No. 2 (subsequently replaced by SFAC No. 8) SFAC No. 2 deals with qualitative characteristics of accounting informa- tion. The term qualitative characteristics is used in APB Statement 4, but the concepts discussed here proceed directly from ASOBAT. Exhibit 7.1, which comes from SFAC No. 2, best illustrates the document. Decision makers stand at the apex of the diagram, a position indicative of the orientation of the financial accounting function to serve the decision needs of users. With regard to users, SFAC No. 1 previously established that financial statements should be aimed at a common core of similar informa- tion needs. Users are also presumed to be knowledgeable about financial statements and information; hence, understandability is recognized in Exhibit 7.1 as a “user-specific quality.” However, even if users are assumed to be knowledgeable, information itself can have different degrees of compre- hensibility. The quality of understandability is a characteristic influenced by
Exhibit 7. A Hierarchy of Accounting Qualities Decision Makers and Their Characteristics (for example, understanding or prior knowledge)^ Benefits
Costs Materiality Understandability DecisionUsefulness Representational Faithfulness Verifiability Predictive Value Feedback Value Timeliness Comparability (IncludingConsistency) Reliability Neutrality Relevance Users of AccountingInformationPervasive ConstraintUser-SpecificQualities PrimaryDecision-SpecificQualitiesIngredients ofPrimary QualitiesSecondary andInteractive QualitiesThreshold forRecognition SOURCE: FASB Concepts Statement No. 2, Qualitative Characteristics of Accounting Information , page 15. FASB material is copyrighted by the Financial Accounting Foundation, 401 Merritt 7, Norwalk, CT 06856, USA, and is reproduced with permission.
230 – ♦ – ACCOUNTING THEORY
competitors, although the traffic is likely to flow in both directions on this issue. A more graphic example of this problem pertains to SFAS No. 5 on loss contingencies. If an enterprise is having legal problems with a customer and a loss is both “probable” and the amount of the loss can be “reasonably estimated,” then the firm is required to make the appropriate entries. However, booking the loss in this fashion is a virtual admission of guilt that could, in effect, be a self-fulfilling prophecy. Another indirect cost pertains to the understandability of information that is listed as a separate qualitative characteristic. Most evidence indicates that the additional disclosures required by SFAS No. 33 were not well understood by users. Since the information was relatively costly to pro- duce, the pervasive constraint was not met because the benefits were negated owing to the lack of understandability. Another problem that arises here concerns information overload: the ability of individuals and the mar- ket to absorb and use information. Notice that the pervasive constraint goes beyond the firm itself when understandability is factored into the pervasive constraint equation. The benefits and the costs of information, both direct and indirect, involve economic consequences, which are discussed in Chapter 4. Many other economic consequences of accounting information arise that are extremely difficult to evaluate. Some are quite legitimate and desirable. For example, the intention of SFAS No. 106, Employers’ Accounting for Post retirement Benefits Other Than Pensions, is to book postretirement health care costs of employees as they accrue rather than handling these costs on a cash basis, as was done prior to the standard. We can certainly make a good case that this is useful information for predictive or accountability purposes for all user groups. However, a valuation problem arises: Should we value the expense and liability at currently existing costs or attempt to estimate what the costs will be when they are actually incurred (discounting to present value is appropriate in both cases)? If we use future costs, which are most likely considerably higher than present costs, several consequences are possible:
- Management bonuses might be adversely affected if they are based on reported income.
- The evaluation of management’s accountability might be down- graded owing to lower reported income.
- Dividends to shareholders might be adversely affected due to lower income negatively impacting on debt-equity ratios.
- Bondholders could be better protected as a result of (1) and (3).
232 – ♦ – ACCOUNTING THEORY
Possible Inconsistency Between Predictive Value and Feedback Value. Predictive value and feedback value, which are qualitative character- istics, derive from the objectives of providing information useful for pre- dicting cash flows and accountability. In going from the Trueblood Report to SFAC No. 1 and then to SFAC No. 2, slightly more detail and specificity were added in each succeeding document. Throughout these three docu- ments, the importance of decision making by outside users is stressed.^9 Obviously, predictive ability is very closely related to decision making. However, SFAC No. 2 notes that stewardship (feedback) is also involved with decision making: The (stewardship) measurement confirms expectations or shows how far actual achievements diverged from them. The confirmation or divergence becomes the basis for a decision—which often is a decision to leave things alone. To say that stewardship reporting is an aspect of accounting’s decision-making role is simply to say that its purpose is to guide actions that may need to be taken in relation to the steward on... the action that is being monitored.^10 Hence, feedback value really involves two user objectives: (1) assessing how well management has done, which is stated as confirming or discon- firming expectations relative to its accountability, and (2) decision making. Predictive value may utilize, to some extent, how well management has performed during the current period.^11 However, conflicts between predic- tive value and feedback value can arise. One example of this type of conflict is in defined benefit pension accounting.^12 SFAS No. 87 made a sharp departure from its predecessor, APB Opinion No. 8. Periodic pension cost measurement is determined by multi- plying factors based on service of covered employees earned to date (years of service) and annual salary. The latter is the point of contention. Most pen- sion plans base the annual salary on either the employee’s final salary just prior to retirement or on an average of annual salaries over the employee’s last few years of service prior to retirement. In APB Opinion No. 8, pension cost was based on currently existing sala- ries. SFAS No. 87, however, changed the cost factor to an estimate of final salary or final average salary, whichever was in force in the firm’s pension contract, and which was used to determine actual pension payments.^13 Future salaries are, of course, dependent on future events such as general and specific inflation, employee advancement, and improved quality of employee services (with or without promotion). Future management, not current management, determines the actual decision relative to promotion
The FASB’s Conceptual Framework – ♦ – 233 and amount of future salaries. Present management is thus being asked to determine a present expense by estimating future salaries, a factor that is clearly beyond current management’s control. Furthermore, employee advancement and improved quality of employee services are totally execu- tory in nature: Neither party, employees or employer, has performed its part of the contract by either performing the required future services or paying for them.^14 The FASB justified its choice of the future salary orientation of the pen- sion cost measurement in SFAS No. 87 on the grounds that prediction of future cash flows is the paramount objective of financial reporting.^15 However, from the standpoint of accountability, the future salary orientation simply does not work. How can present management estimate—and be held accountable for—expenses that are based on future costs, which cur- rent management (a) does not actually determine, and (b) cannot there- from receive the benefits? In addition to the accountability problem, there are also verifiability problems relative to estimating future salaries as well as a very obvious agency theory problem, particularly if management bonuses are based on current income. In summary, pension accounting provides an example in which measurements that can be useful for predictions of cash flows are defi- nitely suboptimal relative to accountability purposes. If pension cost measurements are based on currently existing salaries (as they are in APB Opinion No. 8 and SFAS No. 35), the measurement is useful for both accountability and predictive purposes (although not as useful for prediction of cash flows as the SFAS No. 87 requirements).^16 The exam- ple of defined benefit pension accounting is a very good one for illus- trating the importance of objectives of financial reporting and the potential conflicts that can be present.^17 However, we believe that most conflicts between predictive value and feedback value can be reason- ably, if not optimally, solved. Reliability Reliability is composed of three parts: verifiability, representational faith- fulness, and neutrality. Verifiability. Verifiability in SFAC No. 2 refers, as in previous documents, to the degree of consensus among measurers. It is thus concerned with measurement theory. Unlike aspects of relevance, there is a quantifiable element to verifiability. However, it is unquestionably difficult to measure,
The FASB’s Conceptual Framework – ♦ – 235 like it is” rather than the way a particular interest group, such as manage- ment or stockholders, might like it to be. Neutrality is the only qualitative characteristic that pertains wholly to the attitude of Board members as opposed to being more directly concerned with specific aspects of the information itself. The purpose of neutrality, as seen by Wyatt and Brown, is a conscious attempt to ward off interference by groups having an impor- tant interest in financial statements and the accounting standards underly- ing them.^19 As we soon see, the role of neutrality generates a great deal of controversy. Representational Faithfulness Versus Economic Consequences One of the central issues regarding the conceptual framework is whether representational faithfulness or economic consequences should underlie the promulgation of accounting standards. Representational faith- fulness is part of the conceptual framework, whereas economic conse- quences is not. Several articles examined this important issue. Sole Emphasis on Representational Faithfulness. Ruland clearly favors exclusive emphasis on representational faithfulness as an obligation of the FASB in drafting standards.^20 He sees representational faithfulness as suffi- cient justification for accounting standards. If economic consequences is the criterion for standard setting, outcomes of accounting policy making have to be carefully determined but could by no means be certain.^21 The Complementary Roles of Representational Faithfulness and Economic Consequences. Ingram and Rayburn take a dualistic position relative to the roles of representational faithfulness and economic conse- quences in the standard-setting process.^22 Unfortunately, difficulties are inherent in achieving representational faithfulness. For example, the defini- tion of assets in SFAC No. 6 is not complete enough to enable us to deter- mine a unique amount for the cost of an oil producer’s petroleum field holdings. Under the full cost approach, a country or even a continent is considered a cost center. The components of the definition in SFAC No. 6 are, thus, necessary, but not sufficient, to fully define assets.^23 Even moving to current valuation does not eliminate the problem of levels of aggregation in achieving representational faithfulness (an oil well as opposed to an oil field with many wells or even wider aggregational units, such as countries or continents). Hence, in Ingram and Rayburn’s view, faithfulness of represen- tation is often a matter of employing measurement rules (or calculation rules, as Sterling would have it) rather than “mapping reality”—that is,
236 – ♦ – ACCOUNTING THEORY
determining a “true” figure from the representational faithfulness stand- point. Because it cannot employ an easily ascertainable means to objective truth, the standard-setting process necessarily entails a consideration of economic consequences: how users, preparers, and other parties are affected by prospective accounting standards. Ingram and Rayburn con- clude that representational faithfulness and economic consequences are not either/or alternatives in the standard-setting process; rather, they are com- plementary to each other.^24 The Preeminence of the Economic Consequences View. Daley and Tranter’s position relative to faithful representations and economic conse- quences is at the opposite pole from Ruland’s.^25 They see economic conse- quences embodied in the conceptual framework—like the camel gaining access to the tent by slipping its nose under the flap—despite the FASB’s attempt to give representational faithfulness primacy in setting accounting standards. The underlying reason for Daley and Tranter’s conclusion is that the FASB cannot be neutral in assessing the relevance and reliability of accounting information given the pervasive constraint of the benefits/costs trade-off. Daley and Tranter view the benefits/costs trade-off as covering a broad gamut of economic consequence issues. For example, they state that: This process of weighing costs and benefits on differing sectors of our society is not neutral. It cannot be. In the case of marketable equities securities the decision was clearly that the interests of the insurance industry outweighed the general benefits to financial statement users [italics added] of moving to flow-through account- ing, even though this method has much support in the conceptual framework.^26 However, Ruland interprets the benefits/costs trade-off as a materiality threshold for assessing the usefulness of an accounting standard: Benefits to users should be greater than the costs of preparation.^27 Moreover, the discus- sion of the pervasive constraint of benefits/ costs in SFAC No. 2 focuses mainly on such issues as the fact that the preparer initially bears the cost of collecting, processing, and disseminating information to users and makes only limited mention of distributional effects on different user groups (for example, the benefit of off-balance-sheet financing for investors as opposed to creditors).^28 In one sense, Daley and Tranter are certainly correct. The benefits/costs trade-off unquestionably involves economic consequences involving the
238 – ♦ – ACCOUNTING THEORY
Comparability and Consistency These qualities are defined essentially the same way that they are defined in Chapter 5. We view these characteristics as being output oriented. Hence, comparability and consistency should be the result of a viable con- ceptual framework rather than part of the theoretical structure itself. More is said about comparability in Chapter 9. Materiality Materiality is also discussed in much the same fashion as in Chapter 5. The question that must be raised relative to materiality is whether an item is large enough to influence users’ decisions. Materiality is recognized as being a quantitative characteristic, and some progress is being made in that area as is discussed in Chapter 5. Materiality is also a relative concept rather than an absolute one, an aspect that most research in this area has stressed. Statement No. 3 SFAC No. 3 defines ten (10) elements of financial statements. It is obviously a resolution of the definitions presented in the discussion memorandum for the conceptual framework project. Since these definitions were amended in SFAC No. 6, they are presented in the discussion of that document. Several observations are worth making, particularly about what SFAC No. 3 does not include. First of all, it barely mentions the three views of financial accounting (revenue-expense, asset-liability, and non-articulated) as put forth in the discussion memorandum. It also does not specify the type of capital maintenance concept to employ. Likewise, it does not address matters of recognition (realization) and measurement as well as “display” in financial statements. Thus, the definitions in the statement seem to be a “first screen” in determining the content of financial statements. It is clear that much work remained to be done in prescribing the properties of these various elements, not to mention their arrangement in financial statements. SFAC No. 3 also reveals a reversal of terminology.^32 Throughout the discussion memorandum and SFAC No. 1, the word earnings supplanted the more commonly used income. However, in SFAC No. 2, earnings disap- peared and income was used in paragraphs 90 and 94. Finally, SFAC No. 3 made the reversal official by designating income as the term to indicate the comprehensive or total change in net assets occurring during the period as a result of operations. Earnings was reserved as a possible component of
income, to be specified at a later date (see the discussion of SFAC No. 5 ).
The FASB’s Conceptual Framework – ♦ – 239 Statement No. 4 SFAC No. 4 is concerned with objectives of nonbusiness financial report- ing. Nonbusiness organizations are characterized by
- receipts of significant amounts of resources from providers who do not expect to receive either repayment or economic benefits propor- tionate to resources provided;
- operating purposes that are primarily other than to provide goods or services at a profit... ;
- absence of defined ownership interests that can be sold, trans- ferred, or redeemed, or that convey entitlement to a share of residual distribution of resources in the event of liquidation of the organization.^33 SFAC No. 4 also notes that nonbusiness organizations do not have a single indicator of the entity’s performance comparable to income measure- ment in the profit sector.^34 Since the emphasis in this text is on the profit sector, SFAC No. 4 is outside the scope of this manuscript. Statement No. 5 The long-awaited SFAC No. 5 finally appeared in December 1984, exactly four years after SFAC No. 4. Since this statement was to deal with the difficult issues of recognition and measurement, it was clear that it would be the linchpin for the success or failure of the entire project. The statement let the cat out of the bag immediately in Paragraph 2, which made it quite clear that there would be no extensive attempt to come to grips with the issues of recognition and measurement: The recognition criteria and guidance in this Statement are gener- ally consistent with current practice and do not imply radical change. Nor do they foreclose the possibility of future change in practice. The Board intends future change to occur in the gradual, evolutionary way that has characterized past change.^35 The statement’s reliance on the evolutionary process made David Solomons angry; he termed it a “cop-out.”^36 He was also disappointed with the Board’s failure to deal with executory contracts in terms of either their possible inclusion within the body of the statement, their disclosure in foot- notes, or their total ommission.^37
Exhibit 7. Delineation of Formats for Presenting Financial Information All Information Useful for Investment, Credit, and Similar Decisions (Concepts Statement 1, paragraph 22; partly quoted in Note 6) Financial Reporting (Concepts Statement 1, paragraphs 5–8) Area Directly Affected by Existing FASB StandardsBasic Financial Statements (in AICPA Auditing Standards Literature) Scope of Recognition and Measurement Concepts Statements Notes to Financial Statements (& parenthetical disclosures) Examples: •^ Accounting Policies
-^ Contingencies -^ Inventory Methods -^ Number of Shares ofStock Outstanding -^ Alternative Measures(market values ofitems carried athistorical cost) Supplementary Information Other Means of Financial Reporting Other Information Examples: •^ Changing PricesDisclosure (FASBStatement 33 asamended) -^ Oil and GasReserves Information(FASB Statement 69) Examples: •^ ManagementDiscussion andAnalysis -^ Letters toStockholders Examples: •^ Discussion ofCompetition andOrder Backlog in SECForm 10-K (underSEC Reg. S-K) -^ Analysts’ Reports -^ Economic Statistics -^ News Articles aboutCompany -^ Statement of FinancialPosition -^ Statements of Earningsand ComprehensiveIncome -^ Statement of Cash Flows -^ Financial Statements Statement of Investmentsby and Distributionsto Owners SOURCE: FASB Concepts Statement No. 5, Recognition and Measurement in Financial Statements of Business Enterprises, pages 5, 13, and 16. FASB mate
rial is copyrighted by the Financial Accounting Foundation, 401 Merritt 7, Norwalk, CT 06856, USA, and is reproduced with permission.
242 – ♦ – ACCOUNTING THEORY
measurement problem. Using earnings was, more or less, an attempt to maintain the status quo of income, and the possibility was open in the future to include unrealized holding gains in comprehensive income.^39 More is said about comprehensive income in Chapter 12. Recognition Criteria Recognition criteria refers to when an asset, liability, expense, revenue, gain, or loss is recorded in the accounts. The fundamental recognition crite- ria from earlier parts of the conceptual framework are
- Definitions. The item meets the definition of an element of financial statements.
- Measurability. It has a relevant attribute measurable with sufficient reliability.
- Relevance. The information about it is capable of making a difference in user decisions.
- Reliability. The information is representationally faithful, verifiable, and neutral. In applying recognition criteria to revenue and gain situations, recogni- tion requires that the asset received has been realized or is realizable and that the revenue should be earned, as discussed in Chapter 5. Likewise, recognition criteria for expenses and losses arise as the asset is used up or when no further benefits are expected (para. 85). Recognition methods for expenses include matching with revenues, write-off during the period when cash is expended, or liabilities incurred for very short-lived expense items, or other systematic and rational procedures (para. 86). Although resorting to previous statements logically closed the circle, SFAC No. 5 needed to do much more work on recognition criteria than its two-page coverage. To take one example, the definitions of elements from SFAC No. 3 and SFAC No. 6 are clearly superior to previous definitions. They are necessary in and of themselves, but not sufficient. Solomons notes that the definition of a liability is difficult to apply to pensions: Quite apart from the measurement problems resulting from uncer- tainties, what is an employer’s present obligation to the participants in a pension plan? Is it the (discounted) amount of all future payments to all eligible employees, past and present? Or is it the amount that would be payable if the plan is discontinued at the bal- ance sheet date? Or is it the amount of benefits vested at the balance sheet date? Or is it only the amounts currently due and payable to those who have already retired at the balance sheet date?^40
