Accounting: The Language of Business - Vol. 2 (Intermediate: Part 7)

When there is some fear about accounting and growth and the economy, food stocks are a decent place to be, ... 

Liz Miller

Financial Reporting Theory (Part A)

by

Charles Lamson

Introduction

Parts 1 through 6 of this volume provided a detailed discussion of the environment of financial accounting and the standard-setting process. Companies apply standards that are based on a conceptual framework that sets forth the theory of financial reporting.

Given diverse economic transactions, complex operating environments, and diverse industries, the standard setters require a logical and consistent basis for the development of the accounting standards. The conceptual framework provides a structure for developing new standards or revising existing standards. The framework ensures that standard-setters develop all portions of the authoritative literature on a uniform basis that can be justified by a well-defined theoretical foundation. Companies then apply the authoritative literature in preparing their financial statements.

Consider two companies that generate revenues in different ways like Facebook, Inc., the social media company, and Johnson & Johnson, the consumer healthcare, pharmaceutical, and medical device company. Facebook generates its revenues from advertising and fees for virtual currency and digital goods. Johnson & Johnson manufactures and sells a diverse range of health care products. Whereas Facebook primarily provides services and Johnson & Johnson manufactures and sells goods, both companies determine their costs associated with providing these services and goods based on the authoritative literature, which is grounded in the conceptual framework. Studying the conceptual framework of accounting will prepare you to understand the foundation of the guidance and associated financial reporting.

The conceptual framework defines the objective of financial reporting as providing financial information that is useful in making decisions about resource allocation. It identifies characteristics associated with high-quality financial information. The conceptual framework also defines the elements of the financial reporting system, such as assets and liabilities, and specifies the recognition and measurement criteria to be used in practice. Therefore, when investors and creditors analyze financial statements of companies such as Facebook or Johnson & Johnson, they understand how the financial statements were prepared, what each financial statement contains, and what each line item on the statement represents.

We will begin by discussing the purpose of a conceptual framework. The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) currently have two separate conceptual frameworks, which are partially converged. The two boards have converged to the same objective of financial reporting and the same qualitative characteristics. Other areas such as elements and recognition, measurement, and the reporting entity are not converged. For these areas, we will discuss similarities and differences between Generally Accepted Accounting Principles (GAAP or US GAAP) and International Financial Reporting Standards (IFRS).

Overview of the Conceptual Framework

A conceptual framework sets forth theory, concepts, and principles to ensure that accounting standards are coherent and uniform. The conceptual framework states that a purpose of the conceptual framework is to assist standard setters in developing and revising accounting standards. However, the conceptual framework does not override accounting standards.

Conceptual Framework Components

In the next several posts, we will examine the following conceptual framework components:

• Objective of financial reporting

• Characteristics associated with high-quality financial information

• Elements of the financial reporting system

• Recognition and measurement criteria

Throughout the rest of this volume, we will refer to this discussion of the conceptual framework. Sections in Vol. 2 "The Conceptual Framework Connection" provide a structure to guide our discussions and analyses by explicitly establishing the relevant conceptual underpinnings.

Exhibit 2.1 illustrates the relationship among the conceptual framework components. Specifically, the exhibit shows how the objective of financial reporting flows through the qualitative characteristics, elements, measurement and recognition, and constraints, leading to financial standards for preparing financial statements. In this way, the financial statements are designed to meet the objective of financial reporting.

Exhibit 2.1 also illustrates the use of the conceptual framework in developing new standards and justifying existing standards. When developing new standards, the standard-setters first determine if the proposed standard meets the objective of financial reporting. Next, the information provided by the new standard must possess the qualitative characteristics that make accounting information useful. The standard setters then consider the elements of the financial statements affected and the recognition and measurement concepts used to support the new standard. Before deciding to issue a new standard, the standard setters weigh constraints such as the cost and benefit of issuing the new standard, which may deter requiring the new standard. If the standard is issued, companies must disclose the changes in the financial statements.

The FASB is currently revising the conceptual framework. Exhibit 2.2 summarizes FASB's six-topic project initiated to revise its conceptual framework. The first topic on the objective of financial reporting and the qualitative characteristics has been completed. the FASB is currently working on elements, measurement, presentation, and disclosure. The other topic is inactive. At the current time, FASB and IASB are working independently on the conceptual framework.

Exhibit 2.3 provides a detailed overview of the current conceptual framework. In the next post, we will discuss the concept statements that comprise the current conceptual framework. 

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 23-25*

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