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What is the Conceptual Framework? (9m:58s)

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Slides 1-2 (:37s) Welcome to Introduction to Accounting for a User’s Perspective.
What is the Conceptual Framework and how does it provide guidance and structure to financial reporting?

In late 2004, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) began the Conceptual Framework-Joint Project for Financial Reporting. The objective of the project was to develop an overall vision of what financial reporting should accomplish and describe its objectives, its limitations, its component pieces to hopefully lead to the development of consistent accounting standards in the future.

Slide 3 (:25s) Here is a listing of the phases that the Framework project originally expected to complete.

However, in 2010 after completing Phase A, the FASB and IASB abandoned the joint project. Later, in September 2012, the IASB restarted the project, from phases B on, but without the FASB’s direct involvement.

Slide 4 (:33s) FASB’s completion of Phase A resulted in Statement of Financial Accounting Concepts No. 8 (SFAC No. 8) which includes Chapters 1 and 3 of the Conceptual Framework for Financial Reporting. That statement indicates that the Framework is expected to provide guidance and structure to the standard setting process that will result in significant benefits to:

1)      standard setters.
2)      world economies and markets.
3)      users’ of financial statements.

Slide 5 (:21s) 1) Benefits to standard setters. The Framework is expected to help standard setters develop more consistent standards, standards that don’t contradict each other. The Framework should also help them by providing a common foundation upon which to base their opinions and justify their reasoning for such new standards. Slide 6 (:15s) 2) Benefits to world economies and markets. The Framework was created to serve the public interest by providing information that users within capital markets can use to help them make capital lending and investing decisions.

Slide 7 (:25s) 3) Benefits to users’ of financial statements. The users of US GAAP-basis financial statements should also benefit by understanding the Framework because they will better understand the purpose and intent of the financial statements and the accounting elements included in them. This increased understanding should enhance users’ abilities to use and trust the financial statements they analyze.

Slide 8 (:23s) Please note that the Framework is not part of US GAAP so you won’t find it in the FASB Accounting Standards Codification. US GAAP is enforceable but the Framework is not. In the future, the FASB may choose to modify current US GAAP to better align with the Framework, but such alignment is not required.

Slide 9 (:21s) I do not expect you to memorize the various phases of the Framework project. Just be aware that the FASB and IASB worked jointly to complete Phase A after which the joint project was discontinued, then, a couple years later the IASB restarted the project on its own.

Slide 10 (:36s) So what did the FASB and IASB accomplish in Phase A? Phase A resulted in the FASB issuing Chapters 1 and 3 of the Conceptual Framework for Financial Reporting. Chapter 1 focuses on describing the objective of general purpose financial reporting. In other words, who is financial reporting for and what are its goals? Chapter 3 focuses on describing the qualitative characteristics of useful financial information. In other words, what makes financial reporting helpful to users?

Slide 11 (:55s) Per Chapter 1 of the Framework, the objective of financial reporting is to provide investors and creditors information about the reporting entity that would help them make investing, lending and other credit decisions. In addition, it pointed out that financial reporting information is only one piece of the information puzzle that investors and creditors need access to in order to make good investing and lending decisions. Other pieces of the investing and lending puzzle are general economic data, political data, industry data, and other company data. Another caveat from Chapter 1 is that a company’s financial statements do not provide the current fair market value of the entity, but they do provide information that investors and creditors can use, combined with other non-financial information, to help them estimate the current value of the entity.

Slide 12 (:30s): Finally, Chapter 1 indicates that general purpose financial reports should provide information about an entity’s resources (i.e. assets) and claims against those resources (i.e. liabilities and equity). They should also include information summarizing the transactions that caused an entity’s resources, and related claims, to increase or decrease from one period to the next, for example revenues, expenses, loans, owner contributions, dividends, etc.

Slide 13 (:15s) Chapter 3 of the Framework discusses the “Qualitative Characteristics of Useful Information” in which it indicates that in order for information to be useful, it must be relevant and faithfully represented.

Slide 14 (:56s) Relevance. Relevant information must be capable of making a difference in the financing decisions of investors or creditors by either helping them predict a future financial outcome (i.e. predictive value) or helping confirm a previous evaluation (i.e. confirmatory value). For example, if an entity’s statement of cash flows indicates that the entity will likely run out of cash within the next year, such information would be considered to have “predictive value”. On the other hand, financial information indicating that an entity’s prior estimates of an amount, such as the cost to complete a long-term contract, were accurate (or inaccurate), would be said to have “confirmatory value” because it helps to confirm or reject financial information previously provided. A pregnancy test kit is a non-financial example of something that has “confirmatory value”.

Slide 15 (:29s) Faithful representation. In order for financial information to be a faithful representation, it needs to be:

complete - no key information is left out
neutral – it is not biased in a favorable or unfavorable manner toward one result or another
free from error – no important descriptions were left out and the process to develop the information was properly selected and applied. It does not mean the information is perfectly accurate.

Slide 16 (1m:46s) Materiality. In addition to determining whether a piece of financial information has the qualities of useful information, it is also essential to determine if it is “material” to the decision at hand. A piece of information is considered “material” if leaving it out or misstating it could influence a user’s investing or lending decision about an entity. Useful information can be material for quantitative or qualitative reasons.

Quantitatively material: Information is “quantitatively material” if, in numeric terms, it is sufficiently large to influence the decision of a financial user. For example, if a company had a clerical error that resulted in a $5 M overstatement of Net Income, we wouldn’t know whether such overstatement is quantitatively material or not until we know how much Net Income it reported. If the Company’s reported Net Income is $100 M, a $5 M error (or 5%) is probably quantitatively material and would influence a user’s financial decisions. However if the company’s reported Net Income was $1 B, a $5 M error (or .5%) probably is not quantitatively material.
Qualitatively material: On the other hand, items can be material for qualitative reasons, such as fraud. For example, if users knew that Company A’s CEO committed fraud to include the $5 M misstatement in the $1 B of Net Income, such information could concern a user enough to influence his decision and therefore would be considered to be qualitatively material.

Slide 17a (:34s) When financial information possesses both fundamental qualitative characteristics of useful financial information, relevance and faithful representation, and it is also material, it should be provided to users. In addition, Chapter 3 of the Framework notes that useful financial information becomes even more useful if it possesses the enhancing qualitative characteristics of comparability, verifiability, timeliness, and understandability:

Slide 17b (:23s)Comparability: Information is more useful to users when they can compare similarly measured information for two different companies during the same accounting period or at the same date, or similarly measured information from the same company but during two different accounting periods or at two different dates.
Slide 17c (:21s)Verifiability: Verifiability relies on the term to “verify”, which effectively means that several independent and knowledgeable people would agree that how the information is presented is close enough. They may not agree 100% but their opinions would line up reasonably close to each other
Slide 17d (:20s)Timeliness: Timeliness means that the users are able to access the information with sufficient time for the information to be capable of influencing the users’ decisions. As you can imagine, just like an apple ages and becomes less useful, so too does financial information age and becomes less useful.
Slide 17e (:16s)Understandability – Understandability really is that, the information can be understood by the user’s because it is classified, characterized, and presented in a clear and concise manner to make it understandable.

Slide 18 (:28s) In summary, the Framework is designed to benefit standard setters, world economies and markets by providing guidance and structure to the financial reporting, standard-setting process. The Framework is not enforceable, but it does help users understand what the objectives of financial reporting are, what the key characteristics of useful information are and what characteristics enhance the information to make it more useful. Additional work on the Framework still needs to be done to complete all phases.