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Accounting Theory Conceptual Issues in a Political and Economic Environment 9th Edition Wolk

Chapter 7: The FASB’s Conceptual Framework Instructor Manual

CHAPTER HIGHLIGHTS
While the FASB’s conceptual framework may not be all that we would like it to be, the fact is
that it is “there” and has been used by the board members—though perhaps not as much as we
would like. Despite its shortcomings, the FASB’s conceptual framework has served as a model
for several other nations as well as the International Accounting Standards Committee. A minor,
but important point is that the FASB’s framework is intended to be used when setting standards ;
the IASB’s is used for setting standards and used by practice when the standards are unclear.
Another important point, the conceptual framework is a non-authorative source of U.S. GAAP.
It is not in the FASB Financial Accounting CodificationTM.

The chapter contains a fairly extensive discussion of the parts of the conceptual framework,
which are called Statements of Financial Accounting Concepts. These were preceded by a
discussion memorandum. The discussion memorandum was a massive study of the possible
valuation approaches that could be taken as well as orientations to the definitions of the main
financial statement categories. SFAC No. 1 largely echoed the Trueblood Report in terms of
setting out the objectives of accounting at the topmost level of the metatheoretical structure. It
did, however, strongly take the position that a common core of user needs exists despite the
heterogeneity of external user groups.

SFAC No. 2, in effect, created a structure of the qualitative characteristics of financial

accounting information. There are many difficult trade-offs that must eventually be made among
the hierarchy of concepts if operating standards are to be implemented on a viable basis. SFAC
No. 3 presented the definitions of ten “elements” of financial statements. These constitute a
considerable advance over previous definitions, though several other important issues have not
as yet been addressed.

SFAC No. 4 was concerned with objectives of financial reporting by nonbusiness organizations,
so it is beyond the scope of this text. Issues of recognition and measurement were to be dealt
with in SFAC No. 5. The question of relevant attributes to be measured for elements such as
assets, liabilities, and expenses was avoided by leaving it to future development and evolution.
This largely made the question of recognition sterile if meaningful attributes were not being
measured. In light of the dismal failure of SFAC No. 5, SFAC No. 6 turned out to be a slight
refinement of the definitions of the elements that had previously been given in SFAC No. 3. It
also extended the qualitative characteristics of SFAC No. 2 to nonbusiness organizations. After
a period of fifteen years since SFAC No. 6 appeared, SFAC No. 7 came out in 2000. It is
concerned with estimating fair value when this cannot be done at the point of recognition.
A decade later, SFAC No. 8 replaced SFAC No. 1 and No. 2. The qualitative characteristics
changed materiality from a pervasive constraint to one that is entity specific to relevance. Rather
than focusing on relevance and reliability, the new hierarchy focuses on relevance and faithful
representation. These changes resulted from the FASB-IASB convergence project on their
respective conceptual frameworks.

Two particularly interesting issues that are presented in the chapter are (1) the question of
representational faithfulness versus economic consequences and (2) an examination of the type
of instrument that the conceptual framework is. The first question lies at the heart of accounting:

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Chapter 7: The FASB’s Conceptual Framework Instructor Manual

can we actually come up with representationally faithful numbers, or is accounting basically a

log-rolling exercise where groups vie for the standards that they perceive will benefit them? The
second question, concerning the type of document the conceptual framework is, leads to issues
such as whether and how the framework could be changed or whether it is a completed document
that is basically historical in nature.

QUESTIONS
Q-1 Of what importance in a conceptual framework or metatheory are definitions of such
basic terms as assets, liabilities, revenues, and expenses?

Definitions can be helpful in a theoretical structure after higher parts of a conceptual framework
are formulated in order to help specify what qualifies (and does not qualify) as an asset, liability,
revenue, expense, gain, and loss. The definitions, thus, help to make the actual rules formulated
internally consistent by presenting verbal models for the components of financial statements.
The definitions, of course, must be consistent with the desired objectives expressed in the
metatheoretical structure.

Q-2 What is the relationship between the economic consequences of accounting standards
and the quality of neutrality presented in SFAC No. 8?

Accounting information must have distributional effects: it favors some parties at the expense of
others. That is the nature of economic consequences. Neutrality refers to a “let the chips fall
where they may” attitude insofar as accounting standards are concerned. Nevertheless, this is
supposed to be carried out in a context where the prime objective of financial statements is to
provide useful information to external users such as investors and creditors.

Q-3 Why must objectives be at the topmost level of a conceptual framework of accounting?

A conceptual framework is basically a normative and deductive type of undertaking. The main
thrust of the operating standards, while they may be affected by various types of constraints and
trade-offs, should be geared to attempting to carry out the user objectives. Indeed, the
constraints and trade-offs may well be influenced by the user objectives; the reverse, however,
should not occur.

Q-4 How does the freedom from bias mentioned in ASOBAT compare to the quality of
neutrality mentioned in SFAC No. 8?

The concepts are quite similar. Neutrality, however, refers to standard setters, whereas freedom
from bias, as discussed in ASOBAT, refers to preparers of financial statements.

Q-5 How does earnings as discussed in SFAC No. 5 differ from net income?

Earnings excludes the effect on prior years of any changes in accounting principles. These
appear with the extraordinary items under net income. Hence, earnings is more closely related to
the current operating performance notion than is net income.

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Q-6 What is comprehensive income?

Comprehensive income includes all changes in owners’ equity except for transactions with
owners. Included would be cumulative changes in accounting principles, foreign currency
translation adjustments, the effect of accounting errors, and benefits from realized tax loss
carryforwards of acquired firms (the latter two items are now classified as prior period
adjustments). Comprehensive income is thus the ultimate formulation of the all-inclusive
income concept. See Chapter 11 for how this was worked out in SFAS No. 130.

Q-7 Is neutrality consistent with the external user primary orientation of SFAC No. 1 and
the pervasive constraint (benefits > costs) of SFAC No. 8?

Rather than being inconsistent, the problem lies more in the nature of maintaining a delicate
balancing act. User primacy and the benefits > cost constraint both involve economic
consequences as well as providing information that is useful for decision making. Neutrality
means attempting to provide the most meaningful information for external users given the
pervasive constraint. Theoretically speaking, additional aspects of economic consequences
should be ignored (in reality, of course, they are not).

A simple example may help to demonstrate this point. Assume the FASB has decided that a
current value system is beneficial for external users and that benefits > costs. Two choices are
being examined: replacement cost and exit value (see Chapters 1 and 13). Security prices of
some firms might benefit from replacement cost and others from exit values. For example, firms
having highly specialized and immobile equipment would be subject to serious declines in
market values if exit prices are chosen rather than replacement costs. In turn, securities prices of
these firms could be adversely affected, so these firms would favor replacement costs. Firms not
having this problem would appear relatively better under exit values. The FASB’s main task is
with the comparative usefulness to external users and the cost of preparation, and not the
distributive effects discussed above.

Q-8 SFAC No. 6 is largely a repetition of SFAC No. 3. Discuss two possible reasons why
this repetition occurred.

One reason is that the failure of SFAC No. 5 created a desire to end on a happy note. One way to
accomplish this was to repeat a prior success, which is exactly what occurred since the
definitions of SFAC No. 3 were a marked improvement over those of APB Statement 4.
The second view is that of Paul Miller (1990), who saw SFAC No. 6 as an attempt to reassert the
primacy of SFAC Nos. 1-3, hence the maintenance of progress of those parts of the framework
rather than giving in to the “counter-reformation” of SFAC No. 5. While these views are not
dissimilar, the latter sees more of a progressive utopian spirit present at the FASB, while the
former is more in the spirit of resignation.

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Q-9 Very carefully explain why conflicts can exist between prediction of cash flows and
accountability. Can these conflicts be resolved?

Pensions provide a classic example of this problem. In order to determine pension expense,
future salaries must be estimated. While current management would estimate these, the future
salaries themselves are entirely executory. These future salaries, which would be higher than
present salaries, would be due to improvements in skills and promotions as well as inflation.
However, current management does not receive these benefits even though it is “responsible” for
them in the accountability sense. Hence, the use of accounting numbers for prediction of cash
flow and accountability purposes leads to a conflict in this situation.

Q-10 How does feedback value relate to predictive ability and accountability?

Feedback relates to comparing actual results against expectations. Even if the numbers involved
do not attempt to specifically predict future cash flows (see question 10 above), the numbers
should be useful, in a general sense, for prediction. Thus, if a firm has a target market share of
20 percent and it attains 23 percent, current management may appear to be doing a good job and
future prospects may thus look good. Feedback value, therefore, is primarily geared toward
accountability, although it can have secondary implications for predictive purposes.

Q-11 Is there a similarity between the codificational approach (Gaa) to standard setting and
the jurisprudential approach?

There is a similarity, but there are also differences. Both viewpoints are evolutionary but the
codificational approach is grounded more in terms of developing a rational process for arriving
at a conceptual framework and the resulting standards. This process will involve arriving at a
consensus among the affected parties. The jurisprudential view would attempt to attain
legitimacy through a stronger “logical” process than would codification: the use of cost-benefit
analysis or, where possible, deductive and/or inductive analysis for determining accounting
standards, thus giving them a quasi-legal status. Conceptual frameworks can be used with both
approaches.

Q-12 Verifiability is part of reliability in SFAC No. 2, but is now an enhancing qualitative
characteristic in SFAC No. 8. What effect does this reclassification have on the
importance of verifiability in the framework?

Verifiability involves the statistical concept of the degree of consensus among measurers,
whereas objectivity is concerned with the quality of evidence underlying accounting events. The
new hierarchy has raised the importance of verifiability in it.

Q-13 Conservatism is discussed in paragraphs 91–97 of SFAC No. 2. Why is its role in
SFAC No. 2 rather ambiguous? Why is conservatism absent from SFAC No. 8?

Conservatism is banished from the qualitative characteristics but appears outside of this
framework as a “convention.” Conservatism can easily be in conflict with important

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characteristics such as representational faithfulness if, for example, cost is below market. If it
has a role, it may be in the area of “quality of earnings”: for instance, recognizing a revenue or
expense if the measurement technique indicates that there is at least a 90 percent probability that
we are close to a mean, median, or modal value, but not if there is only a 50 percent probability.
This issue has received little attention in accounting.

BC3.27 Chapter 3 does not include prudence or conservatism as an aspect of faithful

representation because including either would be inconsistent with neutrality. Some respondents
to the Discussion Paper and Exposure Draft disagreed with that view. They said that the
framework should include conservatism, prudence, or both. They said that bias should not
always be assumed to be undesirable, especially in circumstances when bias, in their view,
produces information that is more relevant to some users. From SFAC No. 8.

Q-14 A study (discussed in the chapter) found a heavier emphasis placed on relevance rather
than reliability in disclosure standards by the FASB. Why do you think this is the case?

A heavier emphasis placed on relevance would most likely be the case because being outside the
body of the financial statements would lead to “lowering the bar” on reliability (or faithful
representation) which would increase the importance of relevance.

Q-15 Samuelson would use a property rights definition of assets (discussed in the chapter).
Do you think that SFAS No. 2 requiring immediate expensing of research and
development costs is an example of Samuelson’s property rights approach? Discuss.

While Samuelson’s view on assets is grounded in property rights, SFAS No. 2 is grounded in
verifiability issues rather than property rights. Property rights would indeed attach to research
and development though it may be hard to measure. Therefore, we do not believe that SFAS No.
2 would be an example of Samuelson’s approach.

Q-16 Would changing the asset definition in the conceptual framework to one concerned
with property rights have any other ramifications? Discuss.

In our opinion, Samuelson’s definition may lead to an exit value orientation for assets because it
is wealth oriented rather than being concerned with revenue generation.

Q-17 Is capital maintenance oriented toward proprietary theory or entity theory?

Capital maintenance is geared to both but it might be measured differently. Under proprietary
theory, capital maintenance might be geared to a broader definition of wealth for the owners of
the firm. Hence capital maintenance might be utilized using a general price level adjusted
measurement of income. On the other hand, from the firm’s standpoint, if the firm is interested
in replacing its presently owned assets with similar assets, replacement cost (entry value of
assets) might be used for income measurement. Purchasing power gains or losses (Chapters 1
and 13) might likewise be measured in general purchasing power terms for proprietary theory
purposes but might be measured in terms of the change in purchasing power of capital assets

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owned by the firm for entity theory purposes. These are by no means the only possibilities but
the point should be made that capital maintenance applies to both entity and proprietary theory.
It all depends on what you are trying to maintain in measuring income.

Q-18 Do you see any inconsistency in SFAC No. 1, which sees financial statements as
general purpose but geared primarily toward investors and creditors?

Yes, there is an inconsistency. Using a broader user base might have led to primacy of
accountability over cash flow prediction, for example.

Q-19 Do you see any inconsistency between the present value of assets and liabilities in
SFAC No. 7 since the latter is based on a firm-specific discount rate and the former
does not use a firm-specific rate? Discuss.

No, there is no inconsistency here. Assets have a value independent of the firm. Liability
valuation cannot be divorced from the firm because the firm’s specific credit standing affects the
value of the liability.

Q-20 Stewardship is absent from SFAC No. 8; why?

BC1.28 The Board decided not to use the term stewardship in this chapter because there would
be difficulties in translating it into other languages. Instead, the Board described what
stewardship encapsulates. Accordingly, the objective of financial reporting acknowledges that
users make resource allocation decisions as well as decisions as to whether management has
made efficient and effective use of the resources provided. From SFAC No. 8.

CASES, PROBLEMS, AND WRITING ASSIGNMENTS

1. Discuss as many of the potential trade-offs among the qualities mentioned in SFAC
No. 8 as you can and give either a general or a concrete example of each one.

The first trade-off concerns the possibility of different information needs of different user
groups. The benefits versus costs issue likewise involves a trade-off. There are several trade-off
possibilities in the area of relevance versus faithful representation. Review the hierarchy and
have students discuss each one in small groups.

2. Analyze three accounting standards promulgated by the FASB and show how
economic consequences (rather than representational faithfulness) influenced the
shaping of the standard (your professor may suggest particular standards for this case).

SFAS No. 15, on troubled debt restructuring (now superseded by SFAS No. 114), is a classic
example of economic consequences prevailing over representational faithfulness. In cases of
restructuring, no loss is recognized as long as the undiscounted amount of the restructured debt

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exceeds the present value of the existing debt. The use of the undiscounted amount, particularly
when being compared to a discounted amount, is virtually unprecedented in accounting (deferred
tax assets and liabilities are also undiscounted, but the context is entirely different). The
restructuring can thus be easily set up without the need to recognize a loss, which clearly appears
to have happened.

SFAS No. 13, on leases, while an improvement over APB Opinion Nos. 5 and 7, allows leases to
be structured in a fashion in which bringing the debt on the balance sheet can be avoided.
Obviously, title should not pass to the lessee, nor should bargain purchase options be present.
That leaves the 75 percent test and the 90 percent test. The 75 percent test is the easier to get
around. If an asset has a 20-year life, it should be leased for no more than 14 years, or estimated
life should be “refigured” to come out a bit higher. In the case of the 90 percent rule, having an
outside party guarantee the residual value gives the lessor and lessee the means to design the
lease so that the present value of minimum lease payments, excluding the guaranteed residual,
will be less than 90 percent of the fair market value of the property being leased.
In SFAS No. 87, the projected benefit obligation approach is used for the purpose of determining
service cost (and pension expense). However, for the purpose of determining the minimum
liability, the board somewhat inexplicably reverts to the accumulated benefit obligation which, of
course, would result in a lower minimum liability.

Daley and Tranter (1990) have an excellent discussion of the economic consequences issue.
They also illustrate economic consequence aspects of SFAS No. 12 on marketable securities.
The single best example of the economic consequences issues arises in APB Opinion Nos. 2 and
4 on the investment tax credit (also discussed by Daley and Tranter).

3. One of the principal problems of SFAC No. 2 and 8 is whether representational

faithfulness should predominate over economic consequences or the reverse relative to
drafting accounting standards. State the case as carefully as you can for each of the two
possibilities.

This is an interesting and challenging writing assignment concerning the articles discussed in the
chapter in the section on neutrality versus representational faithfulness. If the position is taken
that representational faithfulness does not exist (Daley and Tranter), then economic
consequences is preeminent and a standard-setting agency is simply mediating among competing
groups in a political fashion. This position is, we believe, overstated. An interesting possibility
might be to go with representational faithfulness where it can be measured with a high degree of
verifiability. Where representational faithfulness cannot be instituted with a high degree of
verifiability, then a system such as rigid uniformity (Chapter 9) might be instituted. A
conceptual framework would still be necessary to identify users—investors and creditors versus
an accountability orientation (Chapter 6), for example. This particular writing assignment
underlies many of our problems in the standard-setting arena.

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4. Part 1. Tucker Company has an asset in the form of a cash flow that it expects to
collect in three years. However, the amount of the cash flow is not certain. These are
the probabilities underlying the cash flow.
Amount Probability
$3,000 .30
$4,000 .30
$5,200 .40
The discount rate is 10%.

Required:
a. How should the asset be valued according to SFAC No. 7?
b. What other valuation is possible?
c. Which valuation do you prefer?

Part 2. Donahoe Company has a liability of $10,000 which is due in three years. The
discount rate applicable to the firm is 10%. Assume that the firm’s credit standing is
adversely affected by an untoward economic event. As a result, the discount rate
applicable to the firm goes up to 12%.
Required:
a. How does the value of the liability change?
b. If the firm’s financial condition worsens, does it make sense for the value of the
liabilities to decline? Explain.

Part 1:
a. $3,000 x.7513 x .3 = $ 676
4,000 x .7513 x .3 = 902
5,200 x .7513 x .4 = 1,563
$3,141
This is, perhaps, the best valuation: expected value.
b. $5,200 x .7513 = $3,907
This is the modal value
We prefer the expected value because it weights a wider number of possibilities so it seems more
representative.
Part 2:
It goes from $7,513 ($10,000 x .7513) to $7118 ($10,000 x. .7118).
Yes, because the worsening financial condition would lower the value of the liability to
outsiders.

5. In examining recognition and measurement, Sterling believes that measurement should

precede recognition whereas Archer believes that it is “logical” for recognition to
precede measurement. What is your position?

This is a “which came first,” the chicken or the egg, question. Do you recognize an economic
activity and then measure it or do you measure an activity and then recognize it when measured
results appear? We believe that ideally, the measurement processes would have been well
thought out before the activity occurs, triggering the monetary recognition of the economic

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activity when some measured activity occurs. However, when creative people produce activities
that have never been measured, does it make sense to not recognize the activity? By requiring
that measurements be in place before recognition, innovative practices may be delayed or
suppressed. You may want to discuss this in class. Does it matter? Should it matter?

CRITICAL THINKING AND ANALYSIS

1. Murphy, et al (2013) argue “living law” applies to conceptual frameworks. How does
this perspective affect current frameworks?

Murphy, Tim, Vincent O’Connell, and Ciarán Ó hÓgartaigh (January 2013). “Discourses
surrounding the evolution of the IASB/FASB Conceptual Framework: What they reveal about
the ‘living law’ of accounting,” Accounting, Organizations, and Society, 72-91.

The authors argue age-old stewardship (accountability) should not have been dropped from the
IASB-FASB’s financial reporting objective of the joint project revising the respective
Conceptual Frameworks. They also disagree with the limiting of users of financial reporting to
only investors and creditors. They make these arguments by applying “living law” to
accounting: “the moral or customary tradition of a particular community.”

The authors argue that the focus on ‘‘decision-usefulness,’’ from an investor/creditor

perspective, result in a usually artificial and inferior imitation of a “genuine story being told
about an entity.” Assuming their views are correct, perhaps the Conceptual Framework might be
tweaked to address their concerns. At a minimum, the morality of accounting’s obligations
(even though they are not in the written law, Conceptual Framework) needs to be communicated
to current and future accountants.

2. In SFAC No. 8, the objectives of financial reporting clearly take an entity perspective
rather than a proprietary one. If the FASB had taken the proprietary perspective, what
effect, if any, does it have on the resultant conceptual framework?

We argue that the resultant framework would not differ significantly. Those qualitative
characteristics of accounting should be universal.

3. Bradbury and Harrison (2015) study dissenting opinions in Financial Accounting

Standards Board (FASB) standards. What changes, if any, do these opinions suggest
need to be made in the conceptual framework?

Bradbury, Michael E. and Julie A. Harrison (June 2015). “The FASB’s Dissenting Opinions,”
Accounting Horizons, 363-375

This paper uses content analysis from qualitative research that is infrequently used by accounting
researchers. By grouping specific text, themes can then be counted (building quantitative

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Chapter 7: The FASB’s Conceptual Framework Instructor Manual

numbers that can then be summarized by frequency or percentages). Typically, this approach to
research requires considerably more time/hours to complete than the statistical models based on
samples.

This research examined all dissenting opinions in Financial Accounting Standards over the
period 1973 to 2009. They developed themes (note this is the qualitative part of the research)
relating to conceptual, logic, scope, outcome, and due process arguments. Conceptual arguments
were found to be the most frequent arguments used in dissenting opinions. This is an important
point to make.

The article does not lead to changes in the conceptual framework, but it does suggest that
dissenting opinions should use more of the wording from the qualitative characteristics in their
arguments. Many of the dissenting opinions used wording that was the in the spirit of a
qualitative characteristic, but it was inferred, not stated.

We suggest you have your students select a new Accounting Standard Update (ASU) and review
the dissenting opinions. Leases would be an excellent place to start. Go to FASB’s website.

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