Accounting Theory History and Conceptual Framework

Accounting Theory
History and Conceptual Framework
I. History of Financial Accounting: Reporting to outside users financial matters.
A. Why do we need financial accounting?
It’s an operation of the economy. Capital resources are allocated through
the financial markets. The allocation process consists of a large number of
decisions by capital providers. These decisions are based on some form of
financial information. Some of this information is provided by financial
B. Development of Standards—Generally accepted accounting principles
(GAAP) are accounting principles that have substantial authoritative support. The
SEC actually has the power to establish GAAP but has allowed the accounting
profession itself to establish GAAP and self-regulate.
1. Before 1900, little organized financial reporting existed. Accounting
was all internal accounting.
2. 16th Amendment (1913) says business owners should report net
income; therefore rules are needed to calculate this figure.
3. 1929: Stock Market Crash
4. 1933: Securities Act established the SEC. This organization was given
the power to regulate accounting rules. The purpose of the SEC is to
protect investors.
5. 1939: Committee on Accounting Procedure (CAP)—a part-time
committee of the AICPA that promulgated Accounting Research Bulletins
(ARB), which was GAAP from 1939 until 1959.
6. 1959: Practicing CPA’s issued 51 Accounting Research Bulletins—
like FASBs. However they did not have to be followed.
7. 1959: Accounting Principles Board (APB), another part-time
committee of the AICPA, issued 31 opinions (APBO) and APB
Interpretations, which determined GAAP from 1959 until 1973.
8. 1964: Companies were finally required to follow APB’s.
9. 1973 to 2009: Financial Accounting Standards Board (FASB) is the
authoritative standard setting body. It is an independent full-time
organization. They issued 168 standards as well as opinions, bulletins,
a. Statements of Financial Accounting Standards (SFAS): These
statements establish GAAP and define the specific methods and
procedures for various accounting issues. Each statement is issued
after extensive research, discussion memoranda, exposure drafts,
and public comments.
b. FASB Interpretations: Clarify GAAP by addressing issues that
may be conflicting or ambiguous and may establish GAAP.
c. Technical Bulletins: May expand or further clarify GAAP
because of problems that may exist in accounting or reporting
under the standard or interpretation.
d. Statements of Financial Accounting Concepts (SFAC):
Intended to establish the objectives and concepts in developing
accounting and reporting standards. They do not establish GAAP.
10. 2002: Sarbanes-Oxley Act of 2002 was enacted as a reaction to a
number of major corporate accounting scandals including Enron and
WorldCom. The act creates a government regulated Public Company
Oversight Board (PCAOB) charged with overseeing, regulating,
inspecting, and disciplining accounting firms in their roles as auditors of
public companies. Stress the independence of auditors.
11. July 1, 2009: FASB Accounting Standards Codification is the single
official source of authoritative, nongovernmental U.S. generally accepted
accounting principles. Accounting and financial reporting practices not
included in the Codification are not GAAP. Modifications to the
Codification are issued by FASB via Accounting Standards Updates (not
authoritative). All new GAAP and SEC amendments are fully integrated
into the existing structure of the Codification.
*Under IFRS, entities are directed to refer to and consider the applicability
of the concepts in the Framework when developing accounting policies in
the absence of a standard or interpretation that specifically applies to an
item. Under U.S. GAAP, the Conceptual Framework cannot be applied to
specific accounting issues.
C. Hierarchy of Sources of GAAP—The sole source is currently the FASB
Codification. Accounting and financial reporting practices not included in the
Codification are not GAAP. FASB updates the Accounting Standards
Codification for new U.S. GAAP issued by the FASB and for amendments to
the SEC content with Accounting Standards Updates. These Updates are not
authoritative literature. All new GAAP and SEC amendments are fully
integrated into the existing structure of the Codification.
II. International Accounting Standards Board (IASB)
A. Established in 2001 to develop a single set of high-quality, global accounting
B. Issues International Financial Reporting Standards (IFRS)—“International
GAAP.” At least 9/12 IASB members must approve an IFRS for issuance.
C. Framework for the Preparation and Presentation of Financial Statements
(Framework)—developed by the IASB to assist in developing future IFRSs
and evaluating existing IFRSs.
D. International Convergence—the IASB and FASB have been working together
towards international convergence of accounting standards since 2002. The
goal of the convergence project is a single set of high-quality, international
accounting standards that companies can use from both domestic and crossborder financial reporting.
III. Conceptual Framework of Financial Accounting: A coherent set of interrelated
objectives and fundamental concepts; define accounting rules and boundaries.
 Guide the FASB in establishing accounting standards
 Provide a frame of reference for resolving accounting questions for which
no standard exists
 Determine the bounds for judgment in the preparation of financial
 Increase users’ understanding of and confidence in financial reporting.
 Enhance comparability
A. SFAC 1: Objectives of Financial Reporting—Disclosing the
entity’s performance with the focus being on the information
needs of external users.
1. Users of Financial Information
a. Present and potential investors/creditors
b. Assumes users have reasonable understanding of
economic and business situations.
2. Information
a. Useful for decision making
b. Helpful in assessing future cash flows
c. Relates to economic resources (assets), claims
against resources (liabilities), and inflows and
outflows of resources.
3. The objectives are stated with the understanding that the
financial information is:
a. Reported at the entity level (not industry or
b. Full of estimates
c. Reflects financial effects of transactions
d. Only 1 of many sources
B. SFAC 2: Qualitative Characteristics of Useful Accounting
1. Characteristics that make financial information useful
a. Relevance—makes a difference; has predictive or
feedback value and is timely
b. Reliable—free from error and bias and represents
what it intends to represent. It’s verifiable, neutral,
and has representational faithfulness.
i. Verifiable—when measures can form a
consensus that the selected method has been
used w/o error or bias.
ii. Neutral—an absence of bias intended to
attain a predetermined result or to influence
behavior in a particular direction.
iii. Representational Faithfulness: A
relationship exists btwn the reported
accounting measurements or descriptions
and the economic resources, the obligations,
and the transactions and events causing
changes in these items.
c. Tradeoff between the 2: liquidation value vs. fair
value (give up reliability for relevance).
d. Comparability vs. Consistency:
i. Comparability—enables users to identify
and explain similarities and differences
between 2+ sets of economic fact.
ii. Consistency—conformity from period to
period with accounting policies and
procedures remaining unchanged.
iii. Constraints are materiality—threshold of
measurement—and cost vs. benefit
C. SFAC 5: Recognition and Measurement in the Financial
Statements—what and when information should be incorporated
in the financial statements
1. Financial Statements
a. Statement of Financial Position (Balance Sheet)
b. Statement of Earnings (Income Statement)
c. Statement of Comprehensive Income
d. Statement of Cash Flows
e. Statement of Changes in Owners’ Equity
2. Measurement Bases
a. Historical Cost (historical proceeds)—PP&E and
most inventory
b. Current Cost (Replacement Costs)—some inventory
c. Fair Value (Current Market Value)
d. Net Realizable Value (Settlement Value)—Sales
e. Present Value of Future Cash Flows—LT
receivables and payables
3. Assumptions
a. Entity—personal transactions are separate from
those of business.
b. Going Concern—the entity will continue to operate
c. Monetary Unit
d. Periodicity
e. Historical Cost
f. Revenue Recognition—recognize revenue when it
is earned and realized or realizable.
g. Matching Principle—why do we incur expenses?
To generate revenue.
h. Accrual Accounting—revenues are recognized
when they are earned and expenses are recognized
in the same period as the related revenue
i. Full Disclosure Principle—users are given
information that would make a difference in the
decision process but not too much that it impedes
analyzing what is important.
j. Conservatism Principle—when selecting GAAP
methods, the method that is least likely to overstate
assets, revenues, and gains and understate liabilities,
expenses and losses should be selected.
i. Recognize revenues/gains when the earrings
process is complete.
ii. Recognize expenses/losses immediately.
*IASB Framework outlines only 2 assumptions—accrual
basis accounting and going concern.
D. SFAC 6: Elements of Financial Reporting—Elements are the
building blocks with which financial statements are constructed.
1. Classes of items the financial statements comprise: A = L +
a. Items that affect equity:
i. Increase: Revenue, Gains, Investments by
ii. Decrease: Expenses, Losses, Distributions to
b. Comprehensive Income—changes in equity from nonowner sources. All differences between beginning balance
sheet and ending balance sheet other than transactions with
owners (net income plus other comprehensive income)
i. Unrealized holding gains/losses on available
for sale securities
ii. Excess of additional liability over
unrecognized prior service costs
iii. Cumulative translation adjustment
c. Ten Elements that provide information required in the
objectives stated in SFAC No. 1
i. Comprehensive Income—excludes items ix and x
ii. Revenues—inflows, enhancements of assets, or
reduction of liabilities. Record at gross amounts.
iii. Expenses—outflows, uses of assets, or incurring
iv. Gains—increases in equity from peripheral
transactions and other events except revenue
and investments from owners.
v. Losses—decreases in equity from peripheral
transactions and other events except epenses
and distributions to owners.
vi. Assets—probable future economic benefits
vii. Liabilities—probable future sacrifices
viii. Equity—the residual of assets and liabilities
ix. Investments by Owners
x. Distributions to Owners
*IASB Framework outlines the following elements of
financial statements: assets, liabilities, equity, income
(including revenue and gains), expenses (including
expenses and losses), and capital maintenance adjustments.
Capital maintenance adjustments are increases and
decreases in equity that arise from the revaluation or
restatement of assets and liabilities. The IASB Framework
does not include the concept of comprehensive income.
E. SFAC 7: Using Cash Flow Information and Present Value in
Accounting Measurements—provides a framework for
accountants to employ when using future cash flows as a
measurement basis for assets and liabilities—applies only to
measurement issues for assets and liabilities that are determined
using future cash flows only. The objective in valuing an asset
or liability using present value is to approximate fair value of that
asset or liability.
1. Determine the present value of future cash flows
2. Consider uncertainty and timing of cash flows
3. Example: Lease payment (certain—use traditional PV
approach with interest rate) vs. Pending lawsuit
(uncertain—use expected cash flows approach). If future
cash flow ranges from $100,000 to $300,000, with a 10%
probability it will be $100, 60% probability it will be
$200,000 and a 30% probability it will be $300,000,
expected cash flow would be $220,000 (.10 X
$100,000)+(.6 X $200,000)+(.3 X $300,000). This
approach is often used in measuring pensions and postretirement benefits.
*The IASB Framework does not consider the use of cash flow
information and present value in accounting measurements.