Chapter 2 - The Conceptual Framework

Topics Definitions Examples

Definitions

 

Examples

 

The Conceptual Framework - Topics:

 

The Conceptual Framework

 

The conceptual framework consists of six Statements of Financial Accounting Concepts (SFAC) comprising a set of objectives (SFAC 1 [Business Enterprises] and 4 [Non-business Organizations]), characteristics of information (SFAC 2) principles  (SFAC 5) constraints (SFAC 2), and elements (SFAC3, 6) that are meant to help the rule makers (Financial Accounting Standards Board [FASB] develop good financial accounting standards. Understanding the conceptual framework should also help information providers (management and accountants) to provide "good" information in cases where no official rules have been developed.

Businesses and accountants (and a lot of other people) spend lots of time and money on preparing annual reports, press conferences, press releases, briefings for financial analysts, etc. All of this is supposed to provide information.

Objectives of Financial Information (SFAC 1 and 4): About whom, for whom, and for what purpose? These are critical questions that need to be answered before one can begin to develop any rules (standards). SFAC 1 attempts to answer these questions for business enterprises, while SFAC 2 does the same for non-business enterprises (for example charitable organizations) We concentrate on business enterprises in this course.  In the U.S., financial accounting is designed to prove information for  investors to help them decide whether to buy stock, sell stock or keep stock they already own.  Now for the hard part: What information do investors want and what characteristics must it have to be useful to them?

 

Information

Types of Information.  To understand what information investors want, it is necessary to understand what their ultimate investment objective is.  What do you think?  If you give it a little thought, you will quickly realize that "they are in it for the money".  In other words, they want to get cash.  Maybe not right now, but certainly sometime.   Knowing this leads to the next question.  Under what circumstances will investors get money from stocks or bonds?  There are only two possibilities:  1.   they may receive dividends (from stocks) or interest (from bonds) and 2.  They may sell  the stocks or bonds  (hopefully for more than what they paid for it) or the bonds are retired (paid off).  Ok, that was not so bad.  Under what condition will this happy event (getting dividends or interest, selling stocks or bonds for more than the price originally paid) occur?  Why, only if the corporation makes money.   In accounting we talk a lot about income, about revenues and expenses, but in the end, it must result in money - cash flow.  Therefore, it is believed that investors most of all want information that will enable them to predict a company's future cash flow.     

 

Important Characteristics of Information

 

To make information "decision useful" it must possess certain characteristics.  Some of these are general (they apply to information in any context) others are specific to accounting.

General Characteristics (SFAC 2: The most important are :  Decision Usefulness and  Understandability.   The world is filled with information and we are constantly making decisions based on the information we have.  Assuming rational  behavior (a heroic assumption), we use information that can help improve our decision.  In other words, we factor decision useful information into the decision and ignore other, irrelevant information.  Of course, we can only do this if (a) the decision useful information is available to us and (b) we can understand it.  For information to be decision useful  it must be relevant , reliable and comparable.  Relevance and reliability are of crucial importance, but, unfortunately, they are not always compatible.  This results in a lot of problems for accounting information providers and rule makers.  We will come back to these terms again and again during the semester.  You may get sick and tired of them, but they won't go away.  We constantly need to evaluate whether accounting information meets the relevance/reliability criteria.  More often than not we must make a trade-off in favor of one or the other.  Sometimes the trade-off decision has been made.  For example, the historical cost of a piece of land is reliable information (it can easily be verified).  But is it relevant to a banker who is trying to assess its value as security for a loan?  Maybe, maybe not:  If the land was bought fifty years ago, it is probably irrelevant and a current evaluation must be made.  The banker relies instead on a current appraisal of the property.   That is highly relevant but, it is not completely reliable (the appraiser is only making an educated guess, after all). Quite often decision making requires comparison of information items.  In that case it is essential that information be comparable (think of apples and oranges!)

It is difficult, if not impossible to always (or even most of the time) have equally high degrees of relevance, reliability and comparability in accounting information.  What to do?  This is where the Full Disclosure principle comes into play.  If you know how an information item was developed and what its limitations are, you can still use it, even if it is not "perfect in every way". 

 

Constraints on Accounting Information (SFAC 2):

  • Cost/Benefit
  • Materiality
  • Conservatism (historical cost). 

Is more information always better?  No.  Information is costly and the benefit derived from it should exceed the cost of producing and using it. Sometimes an information item is simply not important enough to make a difference to a decision - it is immaterial.   And finally, in the U.S., it is considered important that accounting information be conservative (it is better to understate than to overstate).   There is also a rather strong requirement to stick with historical cost, even though it understates values over time and becomes irrelevant.

 

Important Accounting Principles (SFAC 2 and 5)

 

Recognition - Realization - Measurement
  • Recognition and realization refer to revenues, expenses, gains and losses. What does realization mean?  It means actually getting (or paying) cash.  Under Cash accounting recognition ("putting it on the books") occurs when cash is received (paid).  In other words, recognition and realization are effectively the same.  This is nice and simple, but we don't like that.  Instead we use accrual accounting.  Under accrual accounting revenue (or gain) is recognized when earned.  This may be before or after or at the same time as cash is received.     Expenses (losses) are recognized when incurred.  Again this may be before, after, or at the same time as cash is paid. 
  • Measurement - Accounting information almost invariably is restricted to those items that can be measured in monetary terms.  In the U.S. that means if you can't put a dollar price on it, we don't talk about it. Mind, that dollar price maybe an estimate (we issued a warranty, we do not know if or when we will have to repair the item or how much it will cost to repair it.  But, based on past experience we can estimate (guess at) the amount.  We must report it as warranty expense. 

 

Accrual Accounting versus Cash Accounting

 

 We use accrual accounting (which is much more complicated than cash accounting) because it assures full employment for accounting .      No.  We use it because of the need to provide periodic reports on how a corporation is doing to investors, creditors and other interested parties.  It was decided that these people want information that will help them 1.  assess the amount, timing and riskiness of future cash flows and   2.  evaluate the financial position of the firm.  Ok, how are we going to do that, if the company is expected to continue indefinitely (going concern assumption).   Because of this, for example, a company will buy a plant for $60 million that is expected to last for thirty years.  The money is spent in the first year.  Under cash accounting this results  in $ 60 million in expense in year one and zero expense in years 2 through 30.  This causes a problem, if you are trying to predict how the company will do in the future.  If you look at year one, things look terrible - little income and an enormous ($60 million) amount of expense.  So you don't buy stock in the company.  But what if you looked at the company in any of the following years?  You would be very impressed - no expense from the plant, only revenue.   You would be likely to pay too much for it.  Under accrual accounting, using proper revenue and expense recognition rules, each year in which the plant operates (helps earn revenue) will be charged  with a portion of the cost of the plant.  as a result, each year will show the same amount of expense relating to the plant.  This makes for much better (relevant) information.   

Financial Statements and their Elements (SFAC 3, superceded by SFAC 6)

Under the Securities and Exchange Act of 1934 ('34 law) corporations are required to provide current and prospective investors with financial statements at regular intervals (annual and quarterly reports).     Corporations are also required to file reports with the Securities and Exchange Commission (SEC) annually on Form 10K and quarterly on Form 10Q.  These reports consist of the following:
  1. The Income Statement - it consists of revenues, expenses, gains and losses
  2. The Statement of Changes in Stockholders Equity - shows contributions, dividends paid and net income for the period
  3. The Balance Sheet - it consists of assets, liabilities and stockholders' equity
  4. The Statement of Cash Flow - it shows where the company's cash came from and where it went - operations, investing and financing activities
  5. Notes to the financial statements - extremely important! (remember Full Disclosure) it is virtually impossible to understand "the numbers" without reading the accompanying notes.
  6. Management Discussion and Analysis (MD&A)
  7. The auditors report - the financial statements are prepared by management and are management's responsibility.  The auditors examine the financial statements and underlying evidence and express an opinion on their "fairness".  Auditors are cannot change the content of the statements. If they disagree with anything they are required to inform management of this and, if management refuses to make any required corrections, the auditors will take appropriate action. 
 
What do investors wish to do (with information about the firm)? Information How does it help?
predict future cash flows
  • their amounts (how much)
  • their timing (when)
  • their uncertainty (how risky)
 Income Statement provides information about the company's earnings future cash flows
evaluate the company's financial position and its stewardship Balance Sheet provides information about assets, liabilities and stockholders' equity they affect future cash flow
evaluate the company's cash flow Cash Flow Statement shows where the company got money and how it was spent this also affects future cash flow

 

Income Statement Elements
Item Definition Example
Revenue income earned from normal operations of the firm Computer store sells a computer
Expense costs incurred in order to earn revenues Computer store recognizes cost of the computer sold above
Gains positive income resulting from infrequent or unusual activities Computer company sells a delivery truck for more than its book value
Losses negative income resulting from infrequent or unusual activities Computer company sells a delivery truck for less than its book value

 

Balance Sheet Elements
Item Definition Example
Assets Cash or things or right to cash, etc. owned and/or controlled by the firm
  • cash
  • inventory
  • accounts receivable
Liabilities claims against the firm by creditors
  • accounts payable
  • salaries payable
  • deposits
Stockholders' Equity

 

 Claims by owners (a) contributed capital
  • Stock (par value)
  • additional paid in capital
Sum of all income less all dividends paid retained earnings

 

Statement of Cash Flow
Activity Definition Example
Operating cash received less cash paid in normal operations
  • revenue collected
  • paid for inventory
  • paid for salaries
Investing cash received from sale of assets  less cash paid for assets ( non-operating activities)
  • paid for new factory
  • received cash from sale of delivery truck
Financing cash received from creditors or owners less cash paid to creditors or owners
  • sold stock
  • paid dividends
  • borrowed money from bank
  • paid bank loan

 

Revenue is recognized when the earnings process is essentially complete

Necessary conditions:

  Example (at or before cash received)
  1. A transaction has occurred
  •   A refrigerator has been sold
  1. all costs have been incurred or remaining costs are minor and can be estimated
  • The cost of the refrigerator has been incurred
  • the company offers a warranty  (minor future costs can be estimated)
  1. cash has been received or is likely to be received
  • the customer has paid or
  • the customer has promised to pay (account receivable)
all conditions have been met revenue can be recognized
 
  Example (after  cash received)
  1. A transaction has occurred
  • Customer paid in advance for services
Costs have not yet been incurred No services have been performed yet
cash has been received the customer has paid
all conditions have not been met revenue can not be recognized

 

 

Expenses are recognized when incurred

1.  Matched with Revenue: (cause and effect)

  Example (a refrigerator was sold, revenue was recognized)
a.  the refrigerator had been purchased and paid for in an earlier period or it will be paid later cost of goods sold expense recognized when refrigerator is sold
b.  a warranty was issued, cash may or may not have to be paid in the future (repair may or may not be needed) warranty expense is estimated and  recognized when refrigerator is sold
c.  salesperson receives commission on the sale (cash paid) salary expense when refrigerator is sold
 
2.  Allocated over time: (cause and effect difficult or impossible to determine) Example: Depreciation
cash was paid when equipment purchased each year a portion of the cost is recognized as depreciation expense
 
3. Immediate Recognition (no future benefits expected) Example: 1. Administrative expenses,     2. Loss
a. cash will be paid next period employees have worked, salary expense recognized
b. cash had been paid nobody will buy pet rocks.  they are written off as a loss

 

 

  • Objective: You want to surf, swim and  work on your tan.
  • Decision to be made: Should you go to the beach?

Elements

Relevance (the information relates to the decision)

Example

possible conflict with reliability

Predictive ability information helps predict whether the objective will be reached KNX traffic and weather report: temperatures in the high 80's, minor accident on PCH Is it true?  Maybe the "minor" accident turns out to be an overturned tanker
Timeliness the information is received in time to help make the decision You want to go to the beach at 11 am.  The hear the traffic and weather report at 10:45 am a forecast is an educated "guess".  Only after the fact will you know today's temperature for sure.
Feedback value the information helps evaluate a past decision,  improves the current decision "Minor" accident on PCH caused two hour delay in getting to "your" beach  
       

Elements

 Reliability  ( the information  is true)

Examples

possible conflict with relevance

Verifiability the measurement  can be duplicated independently . Other weather stations arrive at the same temperature estimate You don't have the time to get three weather reports
Representational faithfulness The information gives a "true" picture of the item of interest The current temperature is determined with an accurate thermometer, not the Richter scale "100% correct"  information is hard to find in time.   You  have to make a decision.  Slightly inaccurate is better than flying completely blind
Neutrality The information provider  has no hidden agenda KNX doesn't care if you go to the beach because of their weather report The accident was "minor" according to Neptune's Net.   They want customers.  Can you trust the report? Should you ignore it?
  Comparability    
consistency (across information providers) can two (or more) items legitimately be compared? KVEN predicts 30 degree weather for Ventura.  KNX predicts 85 degrees for Long Beach.  You drive south.  Later you find out that KVEN reported in Celsius, KNX in Fahrenheit. Was it really colder in Ventura? The two reports were not comparable.
consistency (over time) can two (or more) items legitimately be compared? KNX reports yesterday's high temperature as 85 degrees and today's as 30 degrees.  Wow! The temperature sure dropped overnight! Or did KNX decide to join the rest of the world and switched to Celsius without telling you?
  Full Disclosure  
provide sufficient detail about how information item was developed to make it useful E.g., If KNX switched from Fahrenheit to Celsius and announced that 85 degree Fahrenheit is about 30 degree Celsius, then the information is comparable and useful.

 

For example, you are trying to decide whether to go to the beach to work on your tan. Useful Information: The weather report (some people like to walk in the rain, but if you are trying to work on your tan, a rain forecast is not a positive bit of information).  Information about beach closures due to sewage contamination.  PCH is closed because (fill in the disaster blank).  You have three finals within the next two days.  You are scheduled for skin cancer treatment for the 14th time. All of these are information items that can (and should) help you make a rational and informed decision. They are decision useful.  Other information is (or should) be irrelevant to this particular decision. Useless Information: President Yeltzin has just fired another prime minister.  The unemployment rate in Ohio is 5.2%.  The U.S. air force made a fantastic drop of emergency medical equipment in Antarctica to enable a scientist to treat her own cancer. Remember, you are trying to decide to go to the beach. None of  the information items  in this section are useful.

Knowing which kind of information is likely to be useful is good.  Getting it is even better, but you must be able to understand it! Understandability is critical! If you have just arrived from Dagestan (yes it exists) and do not know English, then you can listen to KNX traffic and weather until you are green and you still would not know that a major storm front is moving in (expected to drop 18 inches in one hour) and that another part of Malibu has decided to slide across PCH into the ocean right where you wanted to go.  Notice that you are the "problem" in this case.  The reason the information is not helpful is because do not understand English.   This characteristic is user specific.  

As you can see, we are simply talking common sense here.  You already knew all of this didn't you?

 

Information about whom: The rules developed by the FASB apply to corporations, although they may also be used to provide information about other types of business organizations (single proprietorships and partnerships). More specifically, the rules are designed for publicly traded corporations. While accounting standards are developed by the FASB, they can only be enforced by the Securities and Exchange Commission (SEC) which has the legal right to establish and enforce rules for corporations.

 

Information for whom: Accounting information is supposed to be useful for a variety of users: owners (stockholders), creditors, managers, and "other interested parties". That sounds nice, but in reality, a PRIMARY USER group has to be identified (not everybody wants or needs or can use the same information). In the U.S., accounting information is designed primarily for investors (current or prospective owners). To narrow it down a bit more, the information is designed for short term or "active" investors (otherwise known as speculators).  Furthermore, U.S. financial accounting information is designed for "reasonably sophisticated" users. That means they are willing to spend the time and effort to learn a fair bit about accounting rules. As you will find out, a lot of accounting rules are pretty complicated. What if Uncle Billy-Bob and Aunt Myrtle don't know anything about accounting? Well, they are supposed to get themselves into a mutual fund and do their gambling in Las Vegas.

As regards other "reasonably sophisticated" information users such as creditors and managers:  they are assumed to be able to use the same information as investors.

 

Information for what purpose: Once you know who will use information, you then need to know what the information is to be used for. Since we have already decided that financial accounting information is about a business entity and for investors, that part is actually pretty easy:

Investors need information about a business entity to decide whether to buy stock, sell stock or keep stock they already own.