CH 02

Financial Accounting Theory and Analysis
Text and Cases
Fourteenth Edition
Richard G. Schroeder, Myrtle W. Clark, Jack M. Cathey
Chapter 2
The Pursuit of the Conceptual Framework

What is the Conceptual Framework?
• The Conceptual Framework Project (CFP) is contained in the various FASB
Statements of Financial Accounting Concepts (SFACs)
• It was an attempt by the FASB to develop concepts useful in guiding the
Board in establishing standards and in providing a frame of reference for
resolving accounting issues
Copyright ©2023 John Wiley & Sons, Inc. 2-2

The Early Theorists
• Paton
o All changes in the value of assets and liabilities should be reflected in the financial
statements, and that such changes should be measured on a current value basis
o Also, basic assumptions or postulates underlying the accounting process
• Canning
o Suggested a framework for asset valuations and measurement based on future
expectations as well as a model to match revenues and expenses

DR Scott and his Conceptual Framework
• Was viewed as an outsider
o But his writings have proven to be quite insightful
• Heavily influenced by the views of his colleague, the economist and
philosopher Thorstein Veblen
• Believed the industrial revolution caused managers to look for new
methods of maintaining organizational control
o As a result, scientific methods such as accounting and statistics became
organizational control tools
• Need for a normative theory of accounting

DR Scott and his Conceptual Framework Continued
• In his first important work, The Cultural Significance of Accounts, Scott argued
that accounting theory was not a progression toward a static ideal but rather a
process of continually adapting to an evolving environment
o The notion of adaptation later became one of Scott’s principles in his conceptual
framework
• Scott’s next important work was a response to the American Accounting
Association’s (AAA) “A Tentative Statement of Principles Underlying Corporate
Financial Statements”
o He criticized the AAA monograph as having a too-narrow view of accounting in that it
addressed only accounting’s transaction function
• In 1941, Scott unveiled his conceptual framework in “The Basis for Accounting
Principles”
The Basis for Accounting Principles
• Orientation Postulate
o Accounting is based on a broad consideration of the current social, political and
economic environment
• The Pervasive Principle of Justice
o The second level in Scott’s conceptual framework was justice, which was seen as
developing accounting rules that offer equitable treatment to all users of financial
statements

The Basis for Accounting Principles Continued
• The Principles of Truth and Fairness
o Truth was seen as an accurate portrayal of the information presented
o Fairness was viewed as containing the attributes of objectivity, freedom from bias,
and impartiality
• The Principles of Adaptability and Consistency
o Adaptability was viewed as necessary because society and economic conditions
change; consequently, accounting must also change
o However, need to balance adaptability with consistency by stating that accounting
rules should not be changed to serve the temporary purposes of management

Early Authoritative and Semiauthoritative Attempts to Develop
the Conceptual Framework of Accounting
• “A Tentative Statement of Accounting Principles Affecting Annual Corporate
Reports”
• A Statement of Accounting Principles, written by Thomas H. Sanders, Henry
Rand Hatfield, and Underhill Moore
• Introduction to Corporate Accounting Standards

“A Tentative Statement of Accounting Principles Affecting Annual
Corporate Reports”
• Released in 1936 by the American Accounting Association
• Goal was to provide guidance to the SEC
• Widely criticized by academics as relying too heavily on the historic cost
model and the convention of conservatism
• Highlighted the distinction between the current operating performance and
all-inclusive concepts of income

A Statement of Accounting Principles
• Released in 1938 by the American Institute of Accountants (AIA)
• Written by Thomas H. Sanders, Henry Rand Hatfield, and Underhill Moore
• Goal was to provide guidance to the SEC on best accounting practices
• Study did not accomplish its objective
• Viewed as a defense of accepted practices rather than an attempt to
develop a theory of accounting

Introduction to Corporate Accounting Standards
• Released in 1940 by the AAA
• Written by Paton and A. C. Littleton
• Continued to embrace the use of historical cost
• Major contribution was the further articulation of the entity theory
• Also described the matching concept
• Later cited as developing a theory that has been used in many subsequent
authoritative pronouncements

The CAP and the Conceptual Framework
• Standard-setting bodies initially reluctant to deal with
the issue of accounting theory
• At its inception, the Committee on Accounting Procedure (CAP) had considered
developing a comprehensive set of accounting principles
• Dropped the idea because of the belief that the SEC might not be patient
enough to allow the CAP enough time to develop the project and, therefore,
might decide to develop its own accounting standards
• The Special Committee on Research Programs was established to review and
make recommendations on the AICPA’s role in establishing accounting principles
o Proposed the establishment of the Accounting Principles Board (APB) to replace the CAP
o Also proposed the establishment of a research division to assist the APB
The APB and the Conceptual Framework
• Committee’s first charge to the APB’s research division was to commission
studies on the postulates and principles that would serve as the foundation
for future authoritative pronouncements
o This can be viewed as first real attempt to establish a conceptual framework of
accounting by an authoritative body
• The AICPA accepted the Committee’s recommendations and in 1959, the
CAP was replaced by the APB
o Postulates study
o Research study

Committee on Accounting Procedure (CAP)
• Hierarchy of postulates
• Group A: Economic and Political
o Based on the economic and political environment in which accounting exists
o Represent descriptions of those aspects of the environment presumed to be relevant for
accounting
• Group B: Accounting
o Focuses on the field of accounting; Designed to act as a foundation and assist in
constructing accounting principles
• Group C: Imperatives
o Differs fundamentally from the first two groups
o Not primarily descriptive statements; instead, they represent a set of normative statements
of what should be rather than statements of what is
Group A: Economic and Political Environmental Postulates
• A-1. Quantification
• A-2. Exchange
• A-3. Entities
• A-4. Time Period (Including Specification of the Time Period)
• A-5. Unit of Measure (Including Identification of the Measuring Unit)

Group B: Accounting Postulates
• B-1. Financial Statements (Related to A-1)
• B-2. Market Prices (Related to A-2)
• B-3. Entities (Related to A-3)
• B-4. Tentativeness (Related to A-4)

Group C: Imperative Postulates
• C-1. Continuity (Including the Correlative Concept of Limited Life)
• C-2. Objectivity
• C-3. Consistency
• C-4. Stable Unit
• C-5. Disclosure

Committee on Accounting Procedure (CAP) Continued
• The general reaction to the release of ARS No. 1 was that the results were
self-evident and consequently didn’t serve any useful purpose
• The principles study argued for the use of current values in accounting
measurements
o The authors advocated different methods of determining current value for various
balance sheet items such as replacement cost for inventories and plant and
equipment and the use of discounted present values for receivables and payables
• The APB was again faced with the same problems that daunted its
predecessor

A Statement of Basic Accounting Theory
• Published by the AAA in 1966
• This monograph defined accounting as “the process of identifying,
measuring and communicating economic information to permit informed
judgments and decision by users of the information
• Consequently, the committee adopted a decision-usefulness approach and
identified four standards to be used in evaluating accounting information
1. Relevance – it is useful in making the decision at hand7
2. Verifiability – there is consensus among measurers
3. Freedom from bias – there is neutrality in the preparation of financial statements
4. Quantifiability – it has the ability to be measured

The Trueblood Committee
• This committee was charged by the AICPA with proposing fundamental
objectives of financial statements to guide the improvement of financial
reporting
• It was to find the answers to four questions
1. Who needs financial statements?
2. What information do they need?
3. How much of the needed information can be provided by accountants?
4. What framework is needed to provide the needed information?

The Trueblood Committee (Resulting Report)
• Four information needs of users:
1. Making decisions concerning the use of limited resources
2. Effectively directing and controlling organizations
3. Maintaining and reporting on the custodianship of resources
4. Facilitating social functions and controls
• Objectives of financial reporting
• Committee admitted difficulty in finding agreement and therefore, answers
o Progress viewed as a first step

Trueblood Objectives for Financial Reporting
1. The basic objective of financial statements is to provide information useful
for making economic decisions
2. An objective of financial statements is to serve primarily those users who
have limited authority, ability, or resources to obtain information and who
rely on financial statements as their principal source of information about
an enterprise’s economic activities
3. An objective of financial statements is to provide information useful to
investors and creditors for predicting, comparing, and evaluating potential
cash flows in terms of amount, timing, and related uncertainty
4. An objective of financial statements is to provide users with information for
predicting, comparing, and evaluating enterprise earning power
Trueblood Objectives for Financial Reporting Continued
5. An objective of financial statements is to supply information useful in
judging management’s ability to use enterprise resources effectively in
achieving its primary enterprise goal
6. An objective of financial statements is to provide factual and
interpretative information about transactions and other events that is
useful for predicting, comparing, and evaluating enterprise earning power
7. An objective is to provide a statement of financial position useful for
8. An objective is to provide a statement of periodic earnings useful for
Trueblood Objectives for Financial Reporting Continued
9. Another objective is to provide a statement of financial activities useful for
10. An objective of financial statements is to provide information useful for the
predicting process
11. An objective of financial statements for governmental and not-for-profit
organizations is to provide information useful for evaluating the effectiveness
of the management of resources in achieving the organization’s goals
12. An objective of financial statements is to report on the enterprise’s activities
affecting society that can be determined and described or measured and that
are important to the role of the enterprise in its social environment

Statement on Accounting Theory and Theory Acceptance
• Rationale for the committee’s approach
o Fundamental changes since ASOBAT
o No one theory exists
• Approaches to accounting theory were condensed into
1. Classical  deductive and disconnected
2. Decision Usefulness  usefulness is a basic objective
3. Information Economics  specify information necessary to make economic
decisions

Criticisms of the Approaches to Theory
1. The problem with relating theory to practice
2. Allocation problem
3. The difficulty with normative standards
4. The difficulties in interpreting security price behavior research
5. The problem of cost–benefit considerations accounting theories
6. Limitations of data expansion

Statement on Accounting Theory and Theory Acceptance
Continued
• Committee suggested that the process of theorizing in accounting was more

revolutionary than evolutionary and turned to a perspective developed by Kuhn
• Kuhn suggested scientific progress proceeds in the following order:
1. Acceptance of a paradigm
2. Working with that paradigm by doing normal science
3. Becoming dissatisfied with that paradigm
4. Searching for a new paradigm
5. Accepting a new paradigm
• SATTA suggested that accounting theory at that time was in step 3 of this
process because a number of theorists had become dissatisfied with the
matching approach to specifying the content of financial reports
The FASB’s Conceptual Framework Project
• Objective was to identify the goals and purposes of financial accounting
• Fundamentals are underlying concepts that help achieve the objectives
• Concepts are designed to provide guidance in:
1. Selecting transactions, events and circumstances to be accounted for
2. Determining how selected transactions, events and transactions should be
measured
3. Determining how to summarize and report results of events, transactions and
circumstances

The FASB’s Conceptual Framework Project Continued
• Initially, the CFP was developed solely by the FASB who initially issued
seven SFACs
• At the same time the International Standards Board was developing its own
CFP
• In October 2004, the FASB and IASB announced a joint project
1. Focused on changes in the environment since the original frameworks were issued,
as well as omissions in the original frameworks
2. Gaged priority to addressing and deliberating those issues within each phase that
were likely to yield benefits to the Boards in the short term
3. Initially considered concepts applicable to private-sector business entities

Eight Phases of the CFP
1. Objectives and qualitative characteristics
2. Definitions of elements, recognition, and derecognition
3. Measurement
4. Reporting entity concept
5. Boundaries of financial reporting, and presentation and disclosure
6. Purpose and status of the framework
7. Application of the framework to not-for-profit entities
8. Remaining issues, if any

Eight Statements of Financial Accounting Concepts (SFACs)
• No. 1: “Objectives of Financial Reporting by Business Enterprises” (superseded);
• No. 2: “Qualitative Characteristics of Accounting Information” (superseded);
• No. 3: “Elements of Financial Statements of Business Enterprises” (superseded);
• No. 4:“Objectives of Financial Reporting by Nonbusiness Organizations”
• No. 5: “Recognition and Measurement in Financial Statements of Business
Enterprises”
• No. 6: “Elements of Financial Statements” (replaced SFAC No. 3);
• No. 7: “Using Cash Flow Information and Present Value in Accounting
Measurements”
• No. 8: Conceptual Framework for Financial Reporting (Chapters 1 and 3)
o Replaces SFAC No. 1 and SFAC No. 2, and marks the completion
The FASB’s Conceptual Framework for Financial Accounting and
Reporting

Conceptual Framework
• Level 3
o Identifies the implementation guidelines of recognition, measurement, and disclosure
used in establishing and applying accounting standards and the specific concepts to put
the objective into practice.
o These guidelines include the assumptions, principles, and constraints that describe the
present reporting environment
• Level 2
o Outlines the fundamentals which are the qualitative characteristics that make
accounting information useful and the elements of financial statements
• Level 1
o Identifies the objective of financial reporting—that is, the purpose of financial reporting

Statement of Financial Accounting Concepts No. 8
• Chapter 1: The Objective of General Purpose Financial Reporting
• Chapter 2: Reserved for the Chapter on the Reporting Entity
• Chapter 3: Qualitative Characteristics of Useful Financial Information
• Chapter 4: Elements of Financial Statements
• Chapter 5: Future Undisclosed Topic
• Chapter 6 Measurement
• Chapter 7: Presentation
• Chapter 8: Notes to Financial Statements

Chapter 1: The Objective of General Purpose Financial Reporting
• Chapter 1 of SFAC No. 8 states: “The objective of general purpose financial

reporting1 is to provide financial information about the reporting entity
that is useful to existing and potential investors, lenders, and other
creditors in making decisions about providing resources to the entity
• The objective of financial reporting is the foundation of the conceptual
framework
• The second level of the Conceptual Framework contains the fundamental
concepts
o Conceptual building blocks
o Includes qualitative characteristics of accounting information and elements of
financial statements
Chapter 2: Reserved for the Chapter on the Reporting Entity
• In November 2010 The FASB and IASB discussed some of the issues raised
in comment letters on the Exposure Draft, Conceptual Framework for
Financial Reporting: The Reporting Entity
• They concluded that significant time will be required to satisfactorily
address those issues
• No further work on this phase of the conceptual framework had been
undertaken by the FASB

Chapter 3: Qualitative Characteristics of Useful Financial
Information
• Identifies qualitative characteristics of accounting information that
distinguish better (more useful) information from inferior (less useful)
information for decision‐making purposes
• These characteristics may be viewed as a hierarchy

The Qualitative Characteristics of Accounting Information

Chapter 3: Primary Users of Financial Information
• The primary users of financial information are existing or potential
investors, lenders, and other creditors, that is, its capital providers
• In other words, capital providers

Chapter 3: Cost Constraint
• A pervasive constraint on the information that can be provided by financial
reporting
• Measurement, summarization and reporting of financial information imposes
costs
• It is important that those costs are justified by the benefits
• Analysis is made on several levels
o Companies must decide whether the benefits of providing financial information outweigh
the costs involved in collecting, processing, verifying and disseminating that information
o Users of financial information must decide whether benefits of analyzing, and interpreting
provided information outweigh their costs
o Regulators must assess whether the benefits of reporting particular information are likely to
justify the costs incurred to provide and use that information
Chapter 3: Qualitative Characteristics
• Distinguishing better (more useful) information from inferior (less useful)
information
• Qualitative Characteristics are Either “fundamental” or “enhancing”
depending on how they affect the decision‐usefulness of information
• Fundamental qualities that make accounting information useful for
decision‐making:
1. Relevance and
2. Faithful representation

Chapter 3: Relevance
• Relevant financial information is capable of making a difference in the
decisions made by users
• Predictive value: can be used as an input to processes employed by users
to predict future outcomes
• Confirmatory value: it provides feedback (confirms or changes) about
previous evaluations
• Materiality: if omitting it or misstating it could influence decisions that
users make on the basis of the financial information of a specific reporting
entity

Chapter 4: Elements of Financial Statements
• Chapter 4 amended the definitions of the financial statements elements
that should be applied in developing standards for both businesses and not-
for-profit entities and supersedes SFAC No. 6
• The elements of financial statements are discussed in more detail in
Chapters 6 and 7

Proposed Change to Materiality Definition (2015)
• The FASB proposed changing the definition of “materiality”
o As defined in SFAC No. 8: threshold for recognizing elements of accounting
information
• Proposed change (define materiality as a legal concept)
o Information is material if there is a substantial likelihood that the omitted or
misstated item would have been viewed by a reasonable resource provider as having
significantly altered the total mix of information
• Consequently, the FASB was unable to specify or advise specifying a
uniform quantitative threshold for materiality or predetermine what could
be material in a particular situation
• Proposal was met with much disapproval and was ultimately abandoned
Chapter 6 Measurement
• The progress on Chapter 6 of SFAC No. 8 has been extremely slow
• In June 2014 the FASB began a discussion on how to proceed with
developing concepts related to measurement, including:
1. Agreeing on the meanings of key terms and what the objectives and qualitative
characteristics imply for measurement
2. Identifying appropriate types of measurements
3. Determining which measurements to use in specific circumstances
• Subsequently the Board discussed the topic of measurement in a series of
meetings and reached several conclusions

Measurement Conclusions
1. The following general categories of methods should be discussed in a
proposed Concepts Statement chapter
a. Prices in transactions in which the entity participated
b. Current prices observed or estimated by the entity
c. Discounted or undiscounted estimates of future cash flows other than estimates of
market prices
2. There is a need to describe or explain the following
a. The level of relevance for achieving the objective of financial reporting of market
exit prices for assets that are not expected to be sold
b. The level of information about market participants’ views that is provided by
market prices estimated by management

Measurement Conclusions Continued
c. Why regularly adjusting to market exit prices is not the appropriate way to determine
changes in carrying amounts of inventories that will be so
d. How using different methods of determining changes in carrying amounts affects the
understandability of a set of financial statements
e. The reasons for using systematic allocation for assets and liabilities
f. Why providing information to assess the performance of the reporting entity or its
management is not an objective of financial reporting
3. It is necessary to describe or explain the following
a. Estimating market prices and cost-based amounts
b. The effect on understandability of using different methods of determining carrying
amount
c. The relationship of information about management performance to the objective of
financial reporting
4. There are two alternatives for determining what should be included in the
initial carrying amounts of assets, liabilities, and equity
5. The following aspects are related to initial measurement
a. There are three categories of initial measurement: entry price, exit price, and
estimated future cash flows
b. Exit price is appropriate as an initial carrying amount of an asset when the
subsequent measure of the asset will be at exit price
c. For transactions in which something other than cash is exchanged, the initial
measure of an asset may be based on the exit price for the asset transferred
d. The overall objective in identifying costs should be to capture the costs incurred to
bring the asset to the location and condition necessary for it to be capable of
operational
e. The following categories help identify the types of costs that should be included in
an initial carrying amount consistent with the objective in the previous bullet:
i. Government-imposed charges
ii. Costs of services related to the acquisition of the asset and readying the asset for use
iii. Costs to participate in the market for the asset
f. Gains and losses on cash flow hedges are neither part of the entry price of assets
nor a cost to be included in initial carrying amounts of assets based on the objective
and categories described above

Chapter 7: Presentation
• Its stated objective is to provide a foundation for future standards that enhance
resource providers’ abilities to assess prospects for future cash flows by addressing
how to:
a. Group individual recognized items into line items and subtotals
b. Clarify the relationships between an entity’s assets, liabilities, and equity
• Useful elements in financial statements:
o Information about an entity’s assets, liabilities, and equity and their relationships to each
other
o Information about revenues, expenses, gains, and losses reflects the extent to which, and the
ways in which, the equity of an entity increased or decreased
o Information about an entity’s cash receipts and payments
o Information about investments by and distributions to owners reflects the extent to and ways
in which the equity of an entity increased or decreased
The Individual Items to Include in Each Line Item
a. The event that caused an item to be recognized, for example, a transaction, a change in
circumstances or conditions, an accounting adjustment like systematic allocation, or an
accounting change
b. The activity with which an item is associated
c. Similarities and differences in the frequency with which similar components of comprehensive
income are expected to result in similar amounts to be recognized in the future
d. The expected time until realization or settlement of an asset or a liability
e. The expected form (for example, cash or shares) of realization or settlement of an asset, a
liability, or in certain circumstances an equity instrument
f. The types of changes in economic conditions that can affect the cash flows related either to an
existing asset or a liability or to similar revenues, expenses, and gains or losses in the future
g. Similarities and differences in measurement methods

Chapter 8: Notes to Financial Statements
• The notes should contain information about the following matters:
a. Financial statement line items
b. The reporting entity
c. Past events and current conditions and circumstances that have not been recognized that
can affect an entity’s cashflows
• Chapter 8 also lists four limitations for the requirement to provide information in
notes to financial statements:
a. The Board should only require information that is relevant to existing and potential users of
the financial statements of a broad range of entities
b. The cost constraint applies
c. The Board should consider potential unintended adverse consequences
d. Including some types of future-oriented information in the notes may have negative effects
on the cash flow prospects
Statement of Financial Accounting Concepts No. 5: “Recognition
and Measurement in Financial Statements of Business Enterprises”
• SFAC No. 5 states that an item, and information about it, should meet four recognition
criteria and be recognized at the time these criteria are met
1. Definitions: The item meets the definition of an element
2. Measurability: It has a relevant attribute, measurable with sufficient reliability
3. Relevance: The information about the item is capable of making a difference in user decisions
4. Faithful representation: Financial reports represent economic phenomena in words and numbers
• It notes that items currently reported in financial statements are measured by different
attributes:
a. Historical cost
b. Current cost
c. Current market value
d. Net realizable value
e. Present value of future cash flows
SFAC No. 5 Gaps
• Failure to define “earnings”
• No resolution on debate of current value versus historical cost

Statement of Financial Accounting Concepts No. 7: “Using Cash
Flow Information and Present Value in Accounting Measurements”
• SFAC No. 7 provides a framework for using future cash flows as the basis for
accounting measurements at the time of the initial recognition of assets
• Accounting measurement is a very broad topic
• The FASB focused on a series of questions relevant to measurement and
amortization conventions that employ present-value techniques
1. What are the objectives of using present value in the initial recognition of assets and
liabilities?
2. Does the measurement of liabilities at present value differ from the measurement of assets?
3. How should the estimates of cash flows and interest rates be developed?
4. What are the objectives of present value when used in conjunction with the amortization of
assets and liabilities?
5. How should present-value amortizations be used when the estimates of cash flows change?
Present Value Measurements Should Include the Following
a) An estimate of the future cash flows
b) Expectations about variations in the timing of those cash flows
c) The time value of money represented by the risk-free rate of interest
d) The price for bearing the uncertainty
e) Other, sometimes unidentifiable, factors including illiquidity and market
imperfections

SFAC No. 7 Continued
• Approaches to present value
1. Traditional-Single cash flow single interest rate
2. Expected cash flow range
• Incorporating probabilities
o Objective is to estimate the value of the assets required currently to settle the
liability with the holder, or transfer the liability to an entity with a comparable credit
standing
• Use of the interest method

Example
Years Amount PV
• A business is faced with a
Best-case 5 $1,000,000 $783,526
liability to be measured
Most likely 10 $2,000,000 $1,227,826
• Most likely payment is $2 million Worst-case 25 $50,000,000 $2,953,028
in 10 years Total $4,964,380
• Best-case might be settled for $1 Divided by 3 $1,654,794
million in five years
• Works-case is $50 million in 25
years
• Assume a 5% risk-free discount
rate and a flat yield curve
Example Continued
Years PV P Extension
• Management has estimated
5 $783,526 0.30 $235.058
probabilities
10 $1,227,826 0.60 $736,696
• E.g., not assuming they are equal
25 $2,953,028 0.10 $295.303
• These estimations result in Expected present value $1,267,057
probabilities of 30%, 60%, and
10%
• We incorporate these
probabilities

SFAC No. 7 Continued
• The most relevant measure of a liability must incorporate the credit
standing of the entity obligated to pay
• The FASB noted that the purpose of all accounting allocations is to report
changes in the value, utility, or substance of assets and liabilities over time
• Under current U.S. GAAP, the interest method of allocation is considered
more relevant than other methods when it is applied to assets containing
one or more of the following characteristics:
a) The transaction giving rise to the asset or liability involves borrowing or lending.
b) A particular set of estimated future cash flows is closely associated with the asset or
liability.
c) The measurement at initial recognition was based on present value
Methods to Address Changes in Estimated Cash Flows
• Prospective: Computes a new effective interest rate based on future cash
flows
• Catch-up: Adjusts carrying amount to the present value of the revised cash
flows
• Retrospective: Computes a new interest rate based on to-date cash flows
and expected future cash flows

Criticism of the CFP
• Not all accountants view the CFP in a favorable light
• Critical perspective accounting theorists argue that accountants have been
unduly influenced by utility-based, marginalist economics
• Young criticized the FASB’s viewpoint that financial statement users are
“rational decision-makers” who are only interested in economic events
o She argues that other purposes for accounting could have been selected and that by
selecting a different purpose, it might have been possible to investigate how
accounting could contribute to reporting on an economic accountability that is more
broadly defined to encompass the moral dimensions of economic life
• Young asserts that accounting standard setters fail to consult actual users as
new accounting standards are developed
Principles-Based Versus Rules-Based Accounting Standards
• Continuum ranging from highly rigid standards to general definitions
of economics-based concepts
• Harvey Pitt, former chairman of the SEC, in testimony before the SEC,
highlighted this issue by stating: “The development of rule-based
accounting standards has resulted in the employment of financial
engineering techniques designed solely to achieve accounting objectives
rather than to achieve economic objectives”
• The Sarbanes-Oxley Act of 2002 attempted to address this concern by
requiring the SEC to examine the feasibility of a principles-based accounting
system

Example: Goodwill
• The previously acceptable practice for handling goodwill
o Goodwill is to be amortized over a period not to exceed 40 years
• At the opposite end of the continuum is the FASB ASC’s 350-20-35-1 rule
o Goodwill shall not be amortized
o Instead, goodwill shall be tested for impairment at a level of reporting referred to as
a reporting unit

Benefits of Each Approach
Principles-based set of standards Rules-based set of standards
Better able to cope with speed of change of More workable in large, complex economies
business environment and countries
Less voluminous Less room for interpretation
Encourages use of professional judgment Provides more guidance for practical
with a focus on what is right implementation
Seen as possibly discouraging financial Less need for explanation in financial
engineering statements

FASB Questions
1. Do you support the Board’s proposal for a principles-based approach to U.
S. standard setting?
o Will that approach improve the quality and transparency of
U. S. financial accounting and reporting?
2. Should the Board develop an overall reporting framework as in IAS 1?
o If so, should that framework include a true and fair override?
3. Under what circumstances should interpretive and implementation
guidance be provided under a principles-based approach to U.S. standard
setting?
o Should the Board be the primary standard setter responsible for providing that
guidance?
FASB Questions Continued
4. Will preparers, auditors, the SEC, investors, creditors, and other users of
financial information be able to adjust to a principles-based approach to
U.S. standard setting?
o If not, what needs to be done and by whom?
5. What other factors should the Board consider in assessing the extent to
which it should adopt a principles-based approach to U.S. standard
setting?
6. What are the benefits and costs (including transition costs) of adopting a
principles-based approach to U.S. standard setting?
o How might those benefits and costs be quantified?

Characteristics American Accounting Association Committee
believes Concepts-Based Standards Should Possess
1. For concepts-based standards, the economic substance, not the form, of a
particular transaction should guide its financial reporting
2. Concepts-based standards should include descriptions of the transactions that
are the subject of the standard
3. Concepts-based standards should include a general discussion of the linkage
between the economics of transactions and the financial statements
4. Concepts-based standards may include implementation guidance and
examples
5. The FASB should be careful when creating names in concepts-based standards
6. Disclosure requirements related to a description of the economics of the
transaction being reported should be included
Submission to Congress
• In 2003, the SEC submitted a study to Congress with the following
recommendations:
1. The FASB should issue objectives-oriented standards
2. The FASB should address deficiencies in the conceptual framework
3. The FASB should be the only organization setting authoritative accounting guidance in the
United States
4. The FASB should continue its convergence efforts
5. The FASB should work to redefine the U.S. GAAP hierarchy
6. The FASB should increase access to authoritative literature
7. The FASB should perform a comprehensive review of its literature to identify standards that
are more rules based and adopt a transition plan to change those standards
• In July 2004, the FASB responded to the study’s recommendations and noted that
several of its recommendations were already being implemented
International Convergence
• Norwalk Agreement
• September 2002: FASB & IASB pledged to
o Achieve compatibility
o Maintain compatibility
• Three major aspects:
1. Financial Statements Presentation Project
2. Conceptual Framework Project
3. Convergence Project

The FASB–IASB Financial Statement Presentation Project
• Establish common standard
• Goals
1. Understand past and present financial position
2. Understand changes and causes of changes
3. Evaluate future cash flows
• Three phases

Three Phases of The FASB–IASB Financial Statement Presentation
Project
• Phase A
1. What constitutes complete set of statements?
2. What are the requirements to present comparative information?
• Phase B: Fundamental issues for presentation of information on the face of
the financial statements
1. Developing principles for aggregating and disaggregating information in each financial
statement
2. Defining totals and subtotals to be reported on each financial statement
3. Deciding whether components of other comprehensive income/other recognized
income and expense should be recycled to profit or loss
4. Reconsidering SFAS No. 95, “Statement of Cash Flows” and IAS No. 7, “Cash Flow
Statements”
Project Continued
• Phase C  Presentation of interim financial information
1. Which financial statements, if any, should be required in interim financial reports
2. Whether financial statements required in interim financial reports should be allowed to
be presented in a condensed format
3. What comparative periods, if any, should be required in interim financial reports
4. Whether guidance should differ for nonpublic companies and public companies
• December 2005: Boards completed deliberations on Phase A March 2006: the
IASB published its Phase A exposure draft Proposed Amendments to IAS 1
Presentation of Financial Statements: A Revised Presentation”
o The FASB decided to consider phases A and B issues together and therefore did not
publish an exposure draft on Phase A
• September 2007: the IASB issued a revised version of IAS No. 1
Project Continued
• Phase B
o The Boards decided that each financial statement would contain
two primary sections: business and financing
o Guidelines adopted for displaying the items in each section
o Business section would have two defined categories: operating and investing
o Categories require distinctions between business activities that are part of day‐to‐day
business activities and business activities that generate nonrevenue income
• July 2010: Exposure Draft released
• After outreach concluded and results considered, the Boards acknowledged that
they did not have the capacity to devote the time necessary to consider the
information learned during outreach activities
• No Phase B Exposure Draft has been issued and Phase C has never been started
Conceptual Framework Project
1. Objectives and qualitative characteristics
2. Definitions of elements, recognition and de-recognition
3. Measurement
4. Reporting entity concept
5. Boundaries of financial reporting, and presentation and disclosure
6. Purpose and status of framework
7. Application of framework to not-for-profit entities
8. Remaining issues, if any

Convergence Project
• Objectives
1. To have companies in different countries use the same accounting procedures to measure and report
their financial position and results of operations
2. Eliminate differences between IFRS and U.S. GAAP
• February 2006: Memorandum of Understanding (MOU)
• November 2009: Progress Report
• FASB issued four standards to bring consistency between U.S. GAAP and IAS
• April 2011: Quarterly Progress Report
• December 2011: Dampened Optimism
• Convergence project nearing completion and no new projects are expected to be undertaken
o Goal of developing a single set of worldwide accounting standards has not been achieved; use of IFRS in
the United States is not anticipated in the near future

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Financial Accounting Theory and Analysis

Text and Cases

The Pursuit of the Conceptual Framework

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• Committee suggested that the process of theorizing in accounting was more

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• Chapter 1 of SFAC No. 8 states: “The objective of general purpose financial

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