The Conceptual Framework of Accounting

Levels in the Accounting Framework

The discipline of accounting can be broken down into a framework with three general levels. First is the conceptual framework which outlines the theory behind accounting rules. Second is a set of basic generally accepted accounting principles (Basic GAAP) that helps guide decision making when applying GAAP. Basic GAAP includes principles (such as the cost principle or the entity assumption) which are introduced to most accountanting students right at the start. Thirdly, is the FASB Accounting Standards Codification - the complete source of authoritative GAAP, including specific rules set out by FASB and the SEC. For example, the accounting standards codification outlines how depreciation based on the declining balance method is performed. Fourthly, and lastly, is a set of generally accepted industry standards that arise from practice. Firm's within the same industry typical mimic eachothers significant accounting policies that are chosen. This makes financial reports more consistent between firms, thus aiding in their comparability and making them more useful for users. 

                                                                                   

The Conceptual Framework

The conceptual framework of accounting is outlined in a series of "Concept Statements" put forth by the FASB. These statements are not 'GAAP' per say, and existing GAAP in certain areas may conflict with the conceptual framework outlined by the Board. The conceptual framework is the theory behind US GAAP. It is important to learn because US GAAP allows significant leeway for accountants to make decisions about how to apply GAAP in different circumstances. Understanding the theory behind US GAAP will allow accountants, and accounting students, to develop useful decision making skills for when they encounter this ambiguity. Similarly, it is tempting for students to view accounting rules as inevitable, and convert "what is" into "what ought to be." The SEC allows accountants to depart from GAAP when its strict application could be misleading, thus an accountant cannot blindly apply the rules of GAAP without understanding the theory behind it.

The Objective of Financial Reporting

According to the FASB, financial statements aim to provide useful information to one primary user group of financial statements: these are investors, lenders and other creditors who need financial information to make resource allocation decisions (FASB CON8 OB1). There are many different potential users of financial statements, with competing information needs. However, we must focus on making general purpose financial reports useful to this one primary group to allow for a clearly defined conceptual framework. 

In order for information to be useful to investors it must have two fundamental qualitative characteristics: relevance and reliability  (FASB CON8 QC17). We also try to maximize four enhancing characteristics: comparability, timeliness, understandability, and verifiability. Accounting information is then subject to two constraints: materiality (which affects relevance) and the cost vs. benefits of preparing accounting information. Ultimately, we use the conceptual framework to guide us in applying GAAP to the four elements of the financial statements: recognition, measurement, presentation, and disclosure. 
 
                        

Fundamental Qualitative Characteristics

Relevance: Relevant financial information is information that is capable in making a difference in the decisions made by investors, lenders and other creditors (FASB CON8 QC6). To be relevant, information must had a predictive value (can predict future outcomes) and must have a confirmatory value (it provides feedback) (FASB CON8 QC6). 

Reliability: "To be reliable, information about an item must be representationally faithful, verifiable, and neutral, [and] reliability may affect the timing of recognition [when] the first available information about an event ... is sometimes too uncertain to be recognized" (FASB CON5-20). In FASB Concept Statement No. 8 (which replaced Concept Statements 1 and 2), reliability is replaced by "faithful representation." Faithful representation is described as information that is complete, neutral and free from error (FASB CON8 QC12). 

Enhancing Qualitative Characteristics

There are four enhancing qualitative characteristics of financial information: comparability, verifiability, timeliness, and understandability (FASB CON9 QC19). Accountants try to maximize these characteristics in financial information. 

Comparability: Because financial statements provide information that needed by primary users to make capital allocation decisions, it should be able to be compared with similar information about other entities, and with similar information about the same entity for another period or another date (FASB CON8 QC20). "Consistency, although related to comparablity ... refers to the use of the same methods for the same items, eithr from period to period within a reporting entity or in a single period across entities. Comparability is the goal, consistency helps to achieve that" FASB CON8 QC22). Comparability makes financial information more relevant. 

Verifiability: Verifiability means that different people looking at the same information either directly (by looking at a contract, or counting cash), or indirectly (by knowing the inputs to a model, formula or other technique) would come to a consensus that the financial information presented was correct (FASB CON8 QC27). As a result, normally it is necessary for a business to disclose the underlying assumptions, the methods of compiling the information, and other factors and circumstances that support the information (FASB CON8 QC28). Verifiability makes financial information more reliable. 

Timeliness: Financial information should be availabe to investors, lenders and creditors in time for it to be capable of influencing their decisions. Timeliness makes financial information more relevant (FASB CON8 QC28). 

Understandability: "Classifying, characterizing, and presenting information clearly and concisely makes it understandable. Understandability makes financial information more relevant. Sometimes there is a trade-off between accurate representing complex accounting, or simplifying it to make it more understandable (but perhaps less accurate). In this case, we should always ensure that financial information is accurate, even if a user of a financial statement must seek an advisors help to understand them fully (FASB CON8 QC32).

Constraints 

Materiality: Materiality is a threshold that information about an economc phenomenon must pass in order to be recognized or disclosed on the financial statements. Materiality means that information that is included is capable of influencing a decision made by a primary user of the financial statements. When items are non-material, the accountant is allowed to depart from GAAP.

Cost-Benefit of Information: The FASB recongizes that there are cost contraints to reporting financial information, and that the costs of preparing financial statements are typically incurred by its shareholders. There is therefore a cost-benefit analysis for producing accounting information: what is the cost of providing accurate financial information, and what is its related benefit to primary users? (FASC CON8 QC39)

Elements of the Financial Statements

We apply the GAAP to the four elements of the financial statements:

Recognition: Recognition is the process of incorporating information about an asset, liability, revenue, expense or the like into the financial statements. 

Measurement: Measurement looks at how we value, and how we allocate, the items we want to recognize on the financial statements. 

Presentation: Presentation addresses how we prepare and present the balance sheet, income statement, statement of owner's equity, and cash flow statement. 

Disclosure: Many items are material but are not recognized on the financial statements. Disclosure looks at what type of additional information we need to provide along with the financial statements in order to help the users of the financial statements make decisions. Typical things that are disclosed in the notes to the financial statements include sgnificant accounting policies and lawsuits.