Chapter 2

Conceptual Frameworks
• Provide the structure for building a set of coherent
accounting standards.
• Levels:
1. “Why” - Provides objectives of financial reporting
2. “Bridges levels 1 and 3” - Defines qualitative
characteristics of accounting information and the
elements of financial statements
3. “How/implementation” - Explains recognition and
measurement criteria
• US and IFRS similar, but are not exactly the same
• Convergence project underway, not yet approved
General Conceptual Framework
 Level 1:
Objectives of Financial Reporting
US GAAP
Per SFAC 1-2, 4-7
• Provide information that is useful
to those making investment &
credit decisions.
• Helpful to present and potential
investors, creditor and other
users in assessing the amounts,
timing and uncertainty of future
cash flows; and
• About economic resources, the
claims to those resources and the
changes in them.
IFRS
Per IASB Framework (April 1989)
• The objective of f/s’s is to provide
information about the financial
position, performance and changes
in financial position of an entity
that is useful to a wide range of
users in making economic
decisions.
• Users are present & potential
investors, employees, lenders,
suppliers & other trade creditors,
customers, gov’ts & their agencies
& the general public.
 U.S. Conceptual Framework Level 2:
Hierarchy of Qualitative Characteristics
 Level 2:
Qualitative Characteristics
US GAAP IFRS
Primary characteristics Understandability
• Relevance Relevance
– Predictive value
• Predictive value
– Feedback value
– Timeliness • Confirmatory value
• Reliability • Materiality
– Verifiability Reliability
– Representational • Faithful representation
faithfulness
• Substance over form
– Neutrality
• Neutrality
Secondary Characteristics
• Prudence
• Comparability
• Completeness
• Consistency
Comparability
 Relevance and Reliability –
Tradeoff Example

Example: Suppose a biotech firm spends $1,000,000 on

research and development expenditures. How could the
firm record the expenditures?
 CR Cash
 DR Expense?
 DR R&D Asset?
For each alternative consider:
 What is the relevance/reliability tradeoff?
 How can the treatment be theoretically supported?
 Does US or IFRS allow?
 Level 2:
Qualitative Characteristics con’t
US GAAP IFRS
Constraints Constraints on relevant &
• Cost/Benefit reliable info
• Materiality
• Timeliness
• Industry Practices
• Balance between benefit and cost
• Conservatism
• Balance between qualitative
characteristics
 How to Cheat with Conservatism

Scumbag Corp. pays a bonus to the CFO of $10,000 if

the company earns net income over $1 million in any
given year.
– Draft f/s for 2004 show net income of $1.5 million dollars
– However, the CFO argues that slowing sales indicate that
inventory may be overvalued, and advocates the following
journal entry:
Dr. Cost of Goods Sold (overvalued goods) 400,000
Cr. Inventory 400,000
– What would this entry do? Cause COGS to be 400K lower
in following year
• Sometimes this practice is called the “cookie jar”
– What if projected net income in 2005 was $800,000 (before
this journal entry was made)?
 Level 2:
Elements of Financial Statements
US GAAP IFRS
Assets Asset
Liabilities Liabilities
Equity Equity
Investment by Owners
Distributions to Owners Income
Comprehensive Income Expenses
Revenues Capital Maintenance
Expenses • result from revaluation of assets
Gains and liabilities
Losses
 Element Definitions
(a) Arises from peripheral or incidental
transactions.
(b) Obligation to transfer resources
arising from a past transaction.
(c) Increases ownership interest.
(d) Declares and pays cash dividends
to owners.
(e) Increases in net assets in a period
from nonowner sources.
(f) Items characterized by future
economic benefit.
(g) Equals increase in net assets
during the year, after adding
distributions to owners and
subtracting investments by
owners.
(h) Arises from income statement
activities that constitute the
entity’s ongoing major or
central operations.
(i) Residual interest in the net
assets of the enterprise.
(j) Increases assets through sale
of product.
(k) Decreases assets by purchasing
the company’s own stock.
(l) Changes in equity during the
period, except those from
investments by owners and
distributions to owners.
 Level 3: Basic Assumptions,
Principles
US GAAP IFRS
Assumptions Underlying Assumptions
• Economic Entity • Accrual Basis
• Going concern • Going concern
• Monetary Unit
• Periodicity Principles
Principles • Measurement
• Measurement – Historical cost
– Historical Cost – Current cost
– Fair value – Realizable value
• Revenue Recognition – Fair value
• Expense Recognition • Revenue Recognition
• Full disclosure • Expense Recognition
• Full disclosure
 Level 3:
Principles

Measurement: Consider this example under US

GAAP and IFRS.

If a firm bought land in 1950 for $10K and still owned
it in 2009, would it appear on the 2009 financial
statements at $10K even if it is now worth $1 million?
How is your answer justified by the conceptual
framework?
 Level 3:
Principles
Revenue Recognition – Criteria
 Earned – seller substantially completed what it must do to be
entitled to keep resources received from the transaction.
 Realized or realizable –buyer provided resources or resources
to be received are readily convertible to some other asset.

Revenue is generally at the point of sale. Exceptions:

(1) During production – long term construction contracts (%
Completion Method)
(2) End of production – when ready market at quoted price exists
(mining and agriculture)
(3) Upon receipt of cash – when collections uncertain at time of sale
(Installment sales method)
 Level 3:
Principles

Matching
 Idea: Record expense in same period as the
revenue it helped generate.
 To do:
 Determine revenue recognition
 Choices to match expenses
 Direct (COGS)
 Rational allocation (rent)
 Immediate
 Level 3:
Principles
Full Disclosure –Nature and amount of
information included in financial reports
reflects a series of judgmental trade-offs
(between providing sufficient detail and
keeping information understandable).
 Financial statements
 Notes to financial statements
 Supplementary information
Level 3 Principles - Full Disclosure
 Professional Ethics and Principles
Based Accounting
Readings:
 “Study Pursuant to Section 108(d) of the Sarbanes-Oxley
Act of 2002 on…Principles-Based Accounting System”
 Kapnick (1974) and Wyatt (2004)
Questions:
 What is meant by principles vs. rules based accounting?
 Why did Congress want this examined?
 What are the benefits and concerns with principles based
accounting?
 Are judgment and professional ethics more or less
important under principles based accounting?