Financial

Accounting
Theory and Analysis:
Text and Cases
12th Edition
Richard G. Schroeder
Myrtle W. Clark
Jack M. Cathey
Chapter 2

The Pursuit of the

Conceptual Framework
What is the conceptual framework?
 An attempt by the FASB to develop concepts useful in guiding the
Board in establishing standards and in providing a frame of
reference for resolving accounting issues

The Early Theorists

 Paton
 All changes in the value of assets and liabilities should be reflected in
the financial statements, and that such changes should be measured
on a current value basis. Also, basic assumptions or postulates
underlying the accounting process

 Canning
 Suggested a framework for asset valuations and measurement
based on future expectations as well as a model to match revenues
and expenses.
DR Scott and his Conceptual Framework
▪ Was viewed as an outsider
▪ But his writings have proven to be quite insightful
▪ Heavily influenced by the views of his colleague, the economist and
philosopher Thorstein Veblen
▪ Believed the industrial revolution caused managers to look for new
methods of maintaining organizational control
▪ As a result, scientific methods such as accounting and statistics
became organizational control tools
▪ Need for a normative theory of accounting
The Basis for Accounting Principles
▪ Orientation Postulate
▪ Accounting is based on a broad consideration of the current social, political, and
economic environment.

 The Pervasive Principle of Justice

 The second level in Scott’s conceptual framework was justice, which was seen as developing accounting
rules that offer equitable treatment to all users of financial statements.

 The Principles of Truth and Fairness

 Truth was seen as an accurate portrayal of the information presented. Fairness was viewed as
containing the attributes of objectivity, freedom from bias, and impartiality.

 The Principles of Adaptability and Consistency

 Adaptability was viewed as necessary because society and economic conditions change; consequently,
accounting must also change. However, need to balance adaptability with consistency by stating that
accounting rules should not be changed to serve the temporary purposes of management.

 Ahead of his time

Early Authoritative and Semi-authoritative
Organizational Attempts to Develop the
Conceptual Framework of Accounting
▪ Goal: provide guidance to the SEC
▪ Widely criticized by academics as
relying too heavily on the historic cost
model and the convention of
conservatism
▪ Highlighted the distinction between the
current operating performance and
all-inclusive concepts of income
Early Authoritative and Semi-authoritative
Organizational Attempts to Develop the Conceptual
Framework of Accounting
▪ Goal: provide guidance to the
SEC on best accounting practices
▪ Study did not accomplish its
objective
▪ Viewed as a defense of accepted
practices rather than an attempt
to develop a theory of
accounting
Early Authoritative and Semi-authoritative
Organizational Attempts to Develop the Conceptual
Framework of Accounting
 AAA benchmark study
by Paton and A. C. Littleton
 Continued to embrace the use of
historical cost
 Major contribution was the further
articulation of the entity theory
 Also described the matching concept
 Later cited as developing a theory that
has been used in many subsequent
authoritative pronouncements
The CAP and the Conceptual Framework
▪ Standard-setting bodies initially reluctant to deal with the
issue of accounting theory
▪ At its inception, the Committee on Accounting Procedure
(CAP) had considered developing a comprehensive set of
accounting principles
Dropped the idea because of the belief
that the SEC might not be patient
enough to allow the CAP enough time
to develop the project and, as a
consequence, might decide to develop
its own accounting standards
The CAP and the Conceptual Framework
▪ The Special Committee on Research Programs established to
review and make recommendations on the AICPA’s role in
establishing accounting principles.
▪ Proposed the establishment of the Accounting Principles Board (APB) to
replace the CAP.
▪ Also proposed the establishment of a research
division to assist the APB.
The APB and the Conceptual Framework
▪ Committee’s first charge to the APB’s research division
was to commission studies on the postulates and
principles that would serve as the foundation for future
authoritative pronouncements.
▪ This can be viewed as the first real attempt to establish a
conceptual framework of accounting by an authoritative body.
▪ The AICPA accepted the committee’s recommendations
and in 1959, the APB replaced the CAP.
▪ Postulates study
▪ Research study
Committee on Accounting Procedure (CAP)
▪ Hierarchy of postulates
▪ Group A: Economic and Political
▪ Based on the economic and political environment in which accounting exists.
▪ Represent descriptions of those aspects of the environment were
presumed to be relevant for accounting

▪ Group B: Accounting
▪ Focuses on the field of accounting.
▪ Designed to act as a foundation and assist in constructing
accounting principles.

▪ Group C: Imperatives
▪ Differs fundamentally from the first two groups.
▪ Not primarily descriptive statements; instead, they represent a set of normative statements
of what should be rather than statements of what is.

▪ Disastrous outcome
Early Authoritative and Semi-authoritative Organizational Attempts
to Develop the Conceptual Framework of Accounting

APB ASOBAT
ARS
No. 3
Statement 1966
No. 4
1962 Definition of Information
accounting system involving
Use of current Sophistication communication
values of users
Departure Economic income
Description of
from SEC’s Decision Usefulness
current practice
advocacy of
historical Not GAAP
cost

Standards for evaluating:

relevance, verifiability, freedom
from bias, quantifiability
 The Trueblood Committee
Charged with finding the following answers:

1. Who needs financial statements?

2. What information do they need?
3. How much of the needed information can be provided
by accountants?
4. What framework is needed to provide the needed
information?
The Trueblood Committee (Resulting Report)
Four information needs of users:
1. Making decisions concerning the use of limited resources
2. Effectively directing and controlling organizations
3. Maintaining and reporting on the custodianship of resources
4. Facilitating social functions and controls

 Objectives of financial reporting

Committee admitted difficulty in finding agreement

and therefore answers
(progress viewed as a first step)
Statement on Accounting Theory
and Theory Acceptance (SATTA)
▪ Rationale for the committee’s approach
▪ Fundamental changes since ASOBAT
▪ No one theory exists

▪ Approaches to accounting theory were condensed into

1. Classical  deductive and disconnected
2. Decision Usefulness  usefulness is a basic objective
3. Information Economics  specify information necessary to
make economic decisions

▪ Criticisms of the approaches to theory

Statement on Accounting Theory
and Theory Acceptance
▪ Committee suggested that the process of theorizing in accounting was more
revolutionary than evolutionary and turned to a perspective developed by Kuhn

▪ Kuhn suggested scientific progress proceeds in the following order:

1. Acceptance of a paradigm
2. Working with that paradigm by doing normal science
3. Becoming dissatisfied with that paradigm
4. Searching for a new paradigm
5. Accepting a new paradigm

▪ SATTA suggested that accounting theory at that time was in step 3 of this process
because a number of theorists had become dissatisfied with the matching approach
to specifying the content of financial reports
The Financial Accounting Standards Board
▪ Criticism of APB (predecessor)
▪ 1971: Board of Directors of AICPA appointed 2 committees:
▪ The Wheat Committee
▪ How to establish accounting principles
▪ The Trueblood Committee
▪ Objectives of financial statements

▪ The FASB was established

The FASB’s Conceptual Framework Project
▪ Objectives identify the goals and purposes of financial accounting
▪ Fundamentals are underlying concepts that help achieve those objectives.
▪ These concepts are designed to provide guidance in:
1. Selecting the transactions, events and circumstances to be accounted for
2. Determining how the selected transactions, events, and transactions should be measured
3. Determining how to summarize and report the results of events, transactions and
circumstances.
The Conceptual Framework
▪ The FASB originally developed six Statements of Financial
Accounting Concepts (SFAC)
▪ SFAC No.’s 1 & 2 were replaced by SFAC No. 8 (2010)

▪ The following slide provides an overview of the FASB’s

conceptual framework for financial accounting and
reporting
 OBJECTIVE
OBJECTIVES
SFAC No. 8

QUALITATIVE
ELEMENTS CHARACTERISTICS
SFAC No. 6
Revenue SFAC No’s. 5 & 8
FUNDAMENTALS Expense Relevance
Gain Faithful
Loss Representation
Asset
Liability
Equity

RECOGNITION, MEASUREMENT AND DISCLOSURE CONCEPTS

IMPLEMENTATION
ASSUMPTIONS PRINCIPLES CONSTRAINTS
GUIDELINES
Economic Entity Measurement Cost
Going Concern Revenue Recognition Industry Practices
Monetary Unit Expense Recognition
Periodicity Full Disclosure

The Conceptual Framework for Financial Accounting and Reporting

 Conceptual Framework
Level 3: identifies the implementation guidelines of recognition,
measurement, and disclosure used in establishing and applying
accounting standards and the specific concepts to put the objective
into practice. These guidelines include the assumptions, principles,
and constraints that describe the present reporting environment.

Level 2: outlines the fundamentals which are the qualitative

characteristics that make accounting information useful and the
elements of financial statements (assets, liabilities, etc.)

Level 1: identifies the objective of financial reporting—that is, the

purpose of financial reporting.
SFAC No. 8 (Chapter 1)
▪ Objective of general‐purpose financial reporting
▪ Provide financial information about the reporting entity that is
useful to present and potential equity investors, lenders, and
other creditors in making decisions about providing resources
to the entity.
▪ Decisions involve buying, selling, or holding equity and debt
instruments, and providing or settling loans and other forms
of credit.
▪ Information that is decision‐useful to capital providers may also
be useful to other users of financial reporting, who are not
capital providers.
SFAC No. 8 (Chapter 1)
▪ The objective of financial reporting is the foundation of the
conceptual framework.
▪ Other aspects of the framework (qualitative characteristics, elements
of financial statements, recognition, measurement, and disclosure)
all flow logically from the objective.
 Help to ensure that financial reporting achieves its objective.
SFAC No. 8 (Chapter 1)
▪ The second level of the Conceptual Framework contains
the fundamental concepts
▪ Provides
▪ Conceptual building blocks
▪ Includes qualitative characteristics
of accounting information and
elements of financial statements
SFAC No. 8 (Chapter 3)
▪ Identifies qualitative characteristics of accounting information
that distinguish
better (more useful) information
from
inferior (less useful) information for decision‐making purposes
▪ These characteristics may be
viewed as a hierarchy
Primary Users of Capital Providers
Accounting Information (Investors and Creditors)
and their characteristics

Pervasive Constraint Cost

Fundamental qualities Relevance Faithful Representation

Ingredients of
Fundamental Predictive Materiality Completeness Free
value from
Qualities
Confirmatory error
value Neutrality

Enhancing
Qualities Comparability Verifiability Timeliness Understandability
Primary Users of Financial Information

▪ Existing or potential investors, lenders and

other creditors
▪ Its capital providers
SFAC No. 8: Cost Constraint
▪ Cost - described as a pervasive constraint on the information
that can be provided by financial reporting
▪ The measurement, summarization, and reporting of financial
information imposes costs
▪ It is important that those costs are justified by the benefits
of reporting that information
SFAC No. 8: Cost Constraint
▪ This type of analysis is made on several levels.
▪ Companies must decide whether the benefits of providing financial
information outweigh the costs involved in collecting, processing,
verifying, and disseminating that information.
▪ Users of financial information must decide whether the benefits of
analyzing and interpreting the information provided outweigh their costs.
▪ Regulators must assess whether the benefits of reporting particular
information are likely to justify the costs incurred to provide and use that
information.

 This is termed cost-benefit analysis

SFAC No. 8: Qualitative Characteristics
▪ Distinguishing better (more useful) information from inferior
(less useful) information.
▪ These qualitative characteristics
▪ Either fundamental or enhancing characteristics
▪ Depending on how they affect the decision‐usefulness of information
▪ Fundamental qualities that make accounting information useful for
decision‐making
1. relevance and
2. faithful representation
SFAC No. 8: Relevance
▪ Relevant financial information is capable of making a
difference in the decisions made by users.
▪ Predictive value: can be used as an input to processes
employed by users to predict future outcomes
▪ Confirmatory value: it provides feedback
(confirms or changes) about previous evaluations
▪ Materiality: if omitting it or misstating it could
influence decisions that users make on the basis of the
financial information of a specific reporting entity
Proposed Change to Materiality Definition
▪ (September 2015) The FASB proposed changing the definition of
“materiality”
▪ As defined in SFAC No. 8:
▪ the threshold for recognizing the elements of accounting information
▪ Proposed change (define materiality as a legal concept)
▪ Information is material if there is a substantial likelihood that the omitted or
misstated item would have been viewed by a reasonable resource provider as
having significantly altered the total mix of information
▪ Consequently, the FASB was unable to specify or advise specifying a
uniform quantitative threshold for materiality or predetermine what could
be material in a particular situation
 Proposal was met with much disapproval
SFAC No. 8: Faithful Representation
▪ Financial reports represent economic phenomena
in words and numbers
▪ To be useful, financial information
▪ Must represent relevant phenomena
▪ Must faithfully represent the phenomena that it purports to represent

▪ A perfectly faithful representation has three characteristics:

1. Completeness
2. Neutrality
3. Free from error
SFAC No. 8: Faithful Representation
▪ A complete depiction should include all information necessary for a
user to understand the phenomenon being depicted
▪ A neutral depiction
▪ Without bias in the selection or presentation of financial information.
▪ Not slanted, weighted, emphasized, deemphasized, or otherwise manipulated
to increase the probability that information will be received favorably or
unfavorably by users
▪ Free from error
▪ There are no errors or omissions in the description of the phenomenon
▪ Process used to produce the reported information has been selected and
applied with no errors in the process

 Result will be a more faithful representation of financial results

SFAC No. 8: Enhancing Qualities
▪ Enhance the usefulness of information that is relevant and
faithfully represented
▪ Comparability enables users to identify and understand similarities and
differences among items
▪ Verifiability helps assure users that information faithfully represents the
economic phenomena it purports to represent
▪ Different knowledgeable and independent observers could reach consensus, although
not necessarily complete agreement
▪ Any particular depiction is a faithful representation
▪ Timeliness means having information available to decision makers in time to be
capable of influencing their decisions
▪ Understandability involves classifying, characterizing, and presenting
information clearly and concisely
Criticism of SFAC No. 8

▪ Young criticized FASB’s viewpoint that

financial statement users are “rational decision-makers”
▪ Other types of information that might be useful are omitted
▪ Accounting standard-setters failed to contact actual users of information
▪ Young’s critique of CFP was undertaken before SFAS No. 8 was
released

▪ Perhaps partially in response to this criticism, the phrases

“rational decision-makers” and “decision usefulness” are not used
SFAC No. 5: “Recognition and Measurement in
Financial Statements of Business Enterprises”
▪ Recognition criteria and guidance on what information should be
incorporated into financial statements and when this information
should be reported
▪ Defined comprehensive income as:
Revenues Earnings
Less: Expenses Plus or minus cumulative accounting adjustments
Plus: Gains Plus or minus other non-owner changes in equity
Less: Losses
= Earnings = Comprehensive Income
No. 5: “Recognition and Measurement in Financial
Statements of Business Enterprises
Measurement Issues
1. Definition (meets the definition of an element contained in SFAC No. 6)
2. Measurability (relevant attribute measurable with sufficient reliability)
3. Relevance (capable of making a difference in user decisions)
4. Reliability (information is representationally faithful, verifiable, and neutral
SFAC No. 5 Gaps
▪ Failure to define “earnings”
▪ No resolution on debate of current value versus historical cost
SFAC No. 6 “The Elements of Financial Statements”
▪ Defines ten elements of financial statements used to measure
the performance and position of economic entities
▪ Elements are discussed in more depth in Chapters 5 and 6
SFAC No. 7: “Using Cash Flow Information and
Present Value in Accounting Measurements”
▪ Accounting measurement is a very broad topic
▪ The FASB focused on a series of questions relevant to measurement
and amortization conventions that employ present value techniques
What are the objectives of using present value in the initial recognition of
assets and liabilities? And, do these objectives differ in subsequent fresh-
start measurements of assets and liabilities?
Does the measurement of liabilities at present value differ from the
measurement of assets?

How should the estimates of cash flows and interest rates be developed?
What are the objectives of present value when used in conjunction with the
amortization of assets and liabilities?
How should present value amortizations be used when the estimates of cash
flows change?
SFAC No. 7: “Using Cash Flow Information and
Present Value in Accounting Measurements”
Purpose is to capture economic difference between
sets of future cash flows

Present value measurements should include the following elements:

1. An estimate of the future cash flows
2. Expectations about variations in the timing of those cash flows

3. The time value of money represented by the risk-free rate of interest

4. The price for bearing the uncertainty

5. Other, sometimes unidentifiable, factors including illiquidity and

market imperfections
SFAC No. 7: “Using Cash Flow Information and
Present Value in Accounting Measurements”
▪ Approaches to present value
1. Traditional-Single cash flow single interest rate
2. Expected cash flow range

▪ Incorporating probabilities
▪ Objective is to estimate the value of the assets required currently to settle the liability
with the holder, or transfer the liability to an entity with a comparable credit standing

▪ Use of the interest method

Recent CFP Developments
▪ 2010 - FASB determines that because of the priority placed on
other projects, it cannot devote the time necessary to properly
address CFP issues in the near future.
▪ 2012 - IASB announces it will resume deliberations on the
CFP as an IASB-run project,
▪ 2014 - FASB reactivates the CFP and issued Exposure Draft
considering conceptual matters relating to the disclosures
contained in the footnotes to financial statements
Principles Based versus Rules Based
Accounting Standards
▪ Continuum ranging from
▪ highly rigid standards

 to general definitions of economics-based concepts

Example: Goodwill
▪ Previous practice:
▪ Goodwill is to be amortized over a 40 life until it is fully amortized

 New FASB rule:

 Goodwill is not amortized
 Instead, recorded goodwill is to be tested annually for
impairment and written down to its current fair value
Principles-Based Rules-Based

▪ Better able to cope  More workable in large,

with speed of change of complex economies &
business environment countries
▪ Less Voluminous  Less room for interpretation

▪ Encourages use of  Provides more guidance for

professional judgment with practical implementation
focus on what is right
▪ Seen as possibly  Less need for explanation in
discouraging financial financial statements
engineering
FASB Questions
1. Do you support the Board’s proposal for a principles-based approach to U. S. standard
setting?
Will that approach improve the quality and transparency of U. S. financial accounting and reporting?

2. Should the Board develop an overall reporting framework as in IAS 1?

If so, should that framework include a true and fair override?

3. Under what circumstances should interpretive and implementation guidance be

provided under a principles-based approach to U.S. standard setting?
Should the Board be the primary standard setter responsible for providing that guidance?

4. Will preparers, auditors, the SEC, investors, creditors, and other users of financial
information be able to adjust to a principles-based approach to U.S. standard setting?
If not, what needs to be done and by whom?

5. What other factors should the Board consider in assessing the extent to which it should
adopt a principles-based approach to U.S. standard setting?
6. What are the benefits and costs (including transition costs) of adopting a principles-
based approach to U.S. standard setting?
How might those benefits and costs be quantified?
Principles-Based versus Rules-Based Standards ???

▪ The AAA’s position

▪ Wrong question
▪ Should reflect economic substance, not form

▪ Dissenting opinion
▪ US standards should also include rules-based elements
Further Developments
▪ 2003 SEC study submitted to Congress
▪ Included recommendations to FASB

▪ 2004 FASB response to recommendations

1. Issuing Objectives-Oriented Standards
2. Conceptual Framework
3. One U.S. Standard Setter
4. GAAP Hierarchy
5. Access to Authoritative Literature
6. Comprehensive Review of Literature
International Convergence
▪ Norwalk Agreement
▪ September 2002: FASB & IASB pledged to
▪ Achieve compatibility
▪ Maintain compatibility
▪ 3 Major aspects:
1. Financial Statements Presentation Project
2. Conceptual Framework Project
3. Convergence Project
FASB-IASB Project
Financial Statement Presentation
▪ Establish common standard
▪ Goals
1. Understand past and present financial position
2. Understand changes and causes of changes
3. Evaluate future cash flows
 FASB-IASB Project
Financial Statement Presentation
▪ 3 Phases
▪ Phase A
1. What constitutes complete set of statements?
2. What are the requirements to present comparative information?
▪ Phase B  Fundamental issues for presentation of information
on the face of the financial statements
1. Developing principles for aggregating and disaggregating information in each financial
statement
2. Defining totals and subtotals to be reported on each financial statement
3. Deciding whether components of other comprehensive income/other recognized income and
expense should be recycled to profit or loss
4. Reconsidering SFAS No. 95, “Statement of Cash Flows” and IAS No. 7, “Cash Flow Statements”
 FASB-IASB Project
Financial Statement Presentation
▪ Phase C  Presentation of interim financial information
1. Which financial statements, if any, should be required in interim financial reports
2. Whether financial statements required in interim financial reports should be
allowed to be presented in a condensed format
3. What comparative periods, if any, should be required in interim financial reports
4. Whether guidance should differ for nonpublic companies and public companies
FASB-IASB Project
Financial Statement Presentation
▪ December 2005: Boards completed deliberations on Phase A
▪ March 2006: the IASB published its Phase A exposure draft
“Proposed Amendments to IAS 1 Presentation of
Financial Statements: A Revised Presentation”
▪ The FASB decided to consider phases A and B issues together and
therefore did not publish an exposure draft on Phase A.

▪ September 2007: the IASB issued a revised version of IAS No. 1

(Discussed in Chapter 3)
FASB-IASB Project
Financial Statement Presentation
▪ Phase B
▪ The Boards decided that each financial statement would contain two
primary sections: business and financing
▪ Guidelines adopted for displaying the items in each section:
▪ Business section would have two defined categories  operating and investing
▪ Categories require distinctions between
▪ business activities that are part of day‐to‐day business activities (operating category); and
▪ business activities that generate nonrevenue income

(Statements illustrated in Chapters 6 & 7)

FASB-IASB Project
Financial Statement Presentation
▪ July 2010: Exposure Draft released
▪ Engaged in extensive outreach activities
▪ After outreach concluded and results considered, the Boards
acknowledged that they did not have the capacity to devote
the time necessary to consider the information learned
during outreach activities
▪ No Phase B Exposure Draft has been issued at the time this
text went to print, and Phase C was never started
Conceptual Framework Project (8 Phases)
1. Objectives and qualitative characteristics
2. Definitions of elements, recognition and derecognition
3. Measurement
4. Reporting entity concept
5. Boundaries of financial reporting, and presentation and
disclosure
6. Purpose and status of framework
7. Application of framework to not-for-profit entities
8. Remaining issues, if any
Convergence Project
▪ Objectives
1. To have companies in different countries use the same
accounting procedures to measure and report their financial
position and results of operations
2. Eliminate differences between IFRS and U.S. GAAP
Convergence Project
▪ February 2006: Memorandum of Understanding (MOU)
▪ November 2009: Progress Report
▪ FASB issued four standards to bring consistency between U.S. GAAP and IAS
▪ April 2011: Quarterly Progress Report
▪ December 2011: Dampened Optimism
▪ Currently:
▪ Convergence project nearing completion; no new projects are expected to be undertaken
▪ Goal of developing a single set of worldwide accounting standards has not been achieved
and the use of IFRS in the United States is not anticipated in the near future
 End of Chapter 2
Prepared by Suzanne Sevin, CPA, and Kathryn Yarbrough, MBA

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