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Harvard Business School 9-101-118 June 27,2001, A Conceptual Framework for Financial Reporting ‘One of the initial tasks the newly formed Financial Accounting Standards Board (FASB) set for itself was to produce a conceptual framework for financial accounting and reporting. The conceptual framework was to be a coherent system of interrelated objectives and fundamentals that ‘was expected to lead to consistent standards that prescribe the nature, function, and limits of financial accounting and reporting. It was to be the constitution that would govem the Board's setting of accounting standards.! Since that time, the FASB has adopted a number of Statements of Financial Accounting Concepts? These statements have proviced the FASB with explicit conceptual criteria to resolve accounting issues. The following outline provides a brief look at FASB's current conceptual framework. 1. Objectives of financial statements: ‘The main objective of financial statements is to provide information useful for the entity's stakeholders in making business and economic decisions. Among the firm’s stakeholders are ‘owners, potential investors and creditors, suppliers, customers, employees, labor unions, ‘management, directors, financial analysts and advisors, taxing and regulatory authorities, legislators, teachers and students, and the public. Users of financial statements are assumed to be reasonably knowledgeable in business and willing to spend the time studying the financial statements with reasonable diligence. Financial reporting is expected to provide information about an enterprise's financial performance during an accounting period, with a focus on earnings and its components, Calculated according to accrual accounting. Financial statements should provide information about the economic resources of an enterprise, assets, claims on those resources, liabilities, and circumstances that will affect assets and liabilities in the future. Financial statements should provide information useful for assessing the timing, amounts, and uncertainty of 2 Pelham Gore, The FASB Conceptual Framework Project 1973-1985 - An Analysis, Manchester University Press, 1992, 2 Financial Accounting Standards Board, FASB Statements of Concepss, www, 3 FASB Statement of Financial Accounting Concept No. 1—Objesives of Financial Reporting by Business Enterprises, November 1978 ‘Professor David F. Hawkins and Teaching Fellow Jacob Cohen |.D. prepared this note asthe bass for class discussion rather ‘thax to ilustrate ether effective or neffectce handling ofan administrative situation. Copyright © 2001 by the President and Fellows of Harvard College. To order copies or request permission to reprodiice materials, call 1-800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to http://www hbsp harvard.ed. No part of this publication may be reproduced, stored in. a retrieval system, used in a spreadsheet, or transmitted in any form or by any mesns—electronic, mechanical, photocopying, recording, or otherwise—without the permission of Harvard Business School. 101-110 ‘A Conceptual Framework for Financial Reporting future cash flows to creditors and investors. Although financial accounting is not designed to measure directly the value ofa business entity, the information it provides may be helpful in estimating the firm's value. Assumptions of financial accounting:* ‘There are a number of basic assumptions that underlie financial accounting. They reflect the scope of financial accounting and set limits on financial reporting. The principal assumptions are the following: Separate entity: The owners and the corporation are separate legal entities. Financial statements report on an entity's financial position and performance, which is distinctly separate from that of its owners. The importance of this distinction plays a role in shareholders’ limited lability protection. The concept of limited liability argues that creditors cannot sue the shareholders for wrong doings of the corporation, given that the corporation and its shareholders are separate legal entities. The lability of shareholders is limited to their investment in the corporation. Going concem: Unless evidence suggests to the contrary, accountants assume the corporation will continue to operate into the foreseeable future and not be subject to liquidation. This assumption supports the historical cost principle, where net income is calculated as revenues less the historical cost of resources consumed in generating the revenue. For example, the cost of a 747 airplane is allocated over the life of the plane as a depreciation expense entry. But for a going concern assumption, allocating the costs in this ‘manner would not make any sense. Ifa firm believes it will not continue operating, into the foreseeable future, liquidation accounting characterized by the use of net realizable values rather than historical costs would be required. ‘Accounting period: This assumption recognizes the need for providing financial accounting information on a periodic and timely basis so that it will be useful in the decision making process. Accounting measures activities for a specific inverval of time. The Securities and Exchange Commission requires publicly traded companies to file quarterly reports, 10-Q, in addition toan annual report, 10-K. Typically, companies report their financial statements on a calendar year-end basis. However, companies can opt to report on a fisca-year end basis other than 12/31 to avoid closing books during high activity periods. For example, many ‘companies in the retail industry often chose a fiscal year end of January 31 in order to capture all the sales made during the holiday season. Unit of Measure:$ Monetary units are used for the measurement and reporting of economic activities. Companies prepare financial statements in the currency of the country in which they are incorporated and assume that its purchasing power does not change. This means, for US companies, that total assets and the components of net income reflect dollars of different purchasing power, which results in totals that ace sometimes less than meaningful. ‘This flaw is especially true during times of high inflation or deflation. To partially solve this problem, inflation adjusted financial statements are mandatory in high inflation countries. 4 FASB Statement of Financial Accounting Concept No. 6- Hlements of Financial Statements, a replacement of ASB Concept Statement No. 3, December 1565. 5 FASB Statement of Financial Accounting Concept No. 5 ~ Recognition and Measurement in Financial Statements of Business Enterprises, December 1984 ‘A Conceptual Framework for Financial Reporting ro118 Desired characteristics of financial accounting information:® ‘There are four desired characteristics of financial amounting information. Relevance and reliability are both deemed to be primary characteristics. Comparability and consistency are bboth deemed secondary characteristics of financial accounting information. The following is a description of all four. Relevance: Relevant accounting information is information capable of making an impact in a financial statement’s user decision process. Information is deemed relevant if it helps in forming predictions as to outcomes of future events, and in providing feedback regarding prior expectations. Information usually has both feedback value and predictive value, owing to the fact that knowledge about the outcomes of past actions will generally improve a decision-maker’s ability in predicting the results of similar future actions. An ancillary ‘element of relevance is that the information be timely. It requires that the information be ‘provided to the decision-maker before it loses its ability to influence decisions. Reliability: A primary quality of information is that it be reliable for stakeholders using the financial statements. Reliability describes the quality of information that makes it credible and representatively faithful. To be reliable, information should be verifiable. Verifiability is ‘a quality that may be demonstrated by securing a high degree of consensus among. independent measurers using the same measurement method. Also, to be reliable, information must be neutral and unbiased. Neutrality means that the primary concern in formulating and implementing standards should be the relevance and reliability of the information that results, and not its effect on particular parties. Comparability: The quality of information that makes it possible to compare data for the ‘same firm across periods, and to compare data from different firms. Users do not study firms in isolation; rather they compare data across time periods and across firms. To foster comparability, firms typically report 2 years of balance sheet information and 3 years of income statements and cash flow statements, in eack annual report. ‘These statements are called comparative financial statements. For example, the 2001 annual report would contain balance sheets for 2001 and 2000, and income statements for 2001, 2000 and 1999. Furthermore, the footnotes often disclose 5 and 10-year summaries of important financial data within each of these three statements. This disclesure is important for analyzing trends within the company’s performance. The comparative information is much more valuable than information limited only to the current year. Year to year changes in sales, net income, total assets and other amounts are often important for making predictions of future amounts. ‘Consistency: The use of the same accounting measurement and recognition principles across periods. Without consistency, comparability would be compromised and trend analysis ‘would be meaningless. For example, ifa firm used different depreciation methods each year, how would a user be able to analyze the changes in net income from year to year? Hence, itis important that companies follow consistent accourting policies from period to period. However, if a company has a good faith bona fide reason for changing its accounting ‘measurement or for converting to a principle that better captures its true economics, then the company is encouraged to make the switch and disclose its reasons and effect on the financial statements in its footnotes. © FASB Statement of Financial Accounting Concept No. 2 - Qualitative Characteristics of Accounting Information, May 1980 3