Chapter 2 Conceptual Frameworks

1. Chapter 2Conceptual Frameworks • Provide the structure for building a set of coherent accounting standards. • Levels: • “Why” - Provides objectives of financial reporting • “Bridges levels 1 and 3” - Defines qualitative characteristics of accounting information and the elements of financial statements • “How/implementation” - Explains recognition and measurement criteria • US and IFRS similar, but are not exactly the same • Convergence project underway, not yet approved

2. General Conceptual Framework

3. 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. 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. Level 1: Objectives of Financial Reporting US GAAP IFRS

4. U.S. Conceptual Framework Level 2: Hierarchy of Qualitative Characteristics

5. Primary characteristics Relevance Predictive value Feedback value Timeliness Reliability Verifiability Representational faithfulness Neutrality Secondary Characteristics Comparability Consistency Understandability Relevance Predictive value Confirmatory value Materiality Reliability Faithful representation Substance over form Neutrality Prudence Completeness Comparability Level 2: Qualitative Characteristics US GAAP IFRS

6. 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? Relevance and Reliability – Tradeoff Example

7. Constraints Cost/Benefit Materiality Industry Practices Conservatism Constraints on relevant & reliable info Timeliness Balance between benefit and cost Balance between qualitative characteristics Level 2: Qualitative Characteristics con’t US GAAP IFRS

8. 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)? How to Cheat with Conservatism

9. Assets Liabilities Equity Investment by Owners Distributions to Owners Comprehensive Income Revenues Expenses Gains Losses Asset Liabilities Equity Income Expenses Capital Maintenance result from revaluation of assets and liabilities Level 2: Elements of Financial Statements US GAAP IFRS

10. 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. • Changes in equity during the period, except those from investments by owners and distributions to owners.

11. Assumptions Economic Entity Going concern Monetary Unit Periodicity Principles Measurement Historical Cost Fair value Revenue Recognition Expense Recognition Full disclosure Underlying Assumptions Accrual Basis Going concern Principles Measurement Historical cost Current cost Realizable value Fair value Revenue Recognition Expense Recognition Full disclosure Level 3: Basic Assumptions, Principles US GAAP IFRS

12. 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

13. 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: 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

14. 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

15. 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

16. Level 3 Principles - Full Disclosure

17. 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? Professional Ethics and Principles Based Accounting