ACCOUNTING OBJECTIVES,

CONVENTIONS, AND
STANDARDS- THEIR
IMPLICATIONS FOR ANALYSIS
Chapter 3 of Fin-4201 Financial Analysis
Fourth Year / Eight Semesters
Major-Finance

Muhammad Majidul Haq Patwary, FRM

AVP and Senior Manager, The City Bank Limited
Objectives of Accounting
In 1973, The Objectives of Financial Statements Study Group
[True Blood Committee] reported that basic objective of Financial
Statement is to provide information useful for making economic
decisions. Two other significant objectives are as under:
1. An objective of financial statements is to provide information
useful to investors and creditors for predicting, comparing,
and evaluating potential cash flows to them in terms of
amount, timing, and related uncertainty.
2. Another objective is to provide users with information for
predicting, comparing, and evaluating enterprise’s earning
power.
However, the objectives clearly expressed by the study group
can be attained only in stages and over time.
The FASB Conceptual Framework (CF)
• In the mid-1970s, the FASB embarked on its CF project
purpose of which was establishment of a coherent system of
interrelated objectives and concepts that are expected to
lead to consistent financial accounting and reporting.
• These concepts are expected to guide the selection of
events to be accounted for, the measurement of these
events, as well as the means of their summarization and
their communication to interested users.
• CF should enable users to obtain increased
understanding of and confidence in Financial reporting.
• Without conceptual underpinnings, measures provided by
accounting and financial reporting are essentially matters of
judgment and personal opinion.
Organization of the CF
• To implement the development of the CF, the FASB
established a program to issue Statement of Financial
Accounting Concepts (SFAC) which is different from
SFASs.
• The Purpose of SFACs is to set forth fundamentals on
which financial accounting and reporting standards should
be based and these should serve the Board in developing
standards of financial accounting and reporting.
• Till date FAS has issued six SFACs in different times.
SFAC 1 in 1978, SFAC 2 SFAC 3 and SFAC 4 in 1980,
SFAC 5 in 1984, SFAC 6 in 1985.
SFAC 1 & 2
• In SFAC 1 “ Objectives of Financial reporting by Business
Enterprises”, the Board establishes the objectives of general purpose
external financial reporting by business enterprises. It states that
financial reporting can best serves investors and creditors to predict
the amount, timing, and uncertainty of future cash flows to them by
facilitating the prediction of the amount, timing, and uncertainty of
future cash flows to the business entity. Moreover, financial reporting
should provide information about the economic resources, and the
effects of transactions events, and circumstances that change its
resources and claims to those resources.
• SFAC 2, “Quantitative characteristics of Accounting Information” is
designed to examine the characteristics of accounting information
that make it useful. Qualities of Accounting information are Relevance
and reliability, those could be demonstrated with hierarchy of
accounting qualities.
Hierarchy of Accounting Qualities
SFAC 3
• SFAC 3, “Elements of Financial Statements of Business Enterprises”
defines the following 10 elements of financial statements of business
enterprises:
1. Assets are future economic benefits obtained or controlled by a
particular entity as a result of past transactions or events.
2. Liabilities are probable future sacrifices of economic benefits
arising from present obligations of a particular entity to transfer
assets or provide services to other entities in the future as a result
of past transactions or events.
3. Equity is the residual interest in the assets of an entity that remains after
deducting its liabilities.
4. Investment by owners are increases in net assets of a particular
enterprise resulting from transfer to it from other entities of something
valuable to obtain or increase equity.
5. Distributions to owners are decreases in net assets of a particular
enterprise resulting from transferring assets, rendering services, or
SFAC 3…. Cont…..
6. Comprehensive income is the change in equity (net assets) of an enterprise
during a period from transactions and other events and circumstances from
non-owner sources. Comprehensive income results from Exchange
transaction and other events as mentioned above, enterprises productive
activities, and price changes, casualties, and other effects.
7. Revenues are inflows or other enhancements of assets of an entity or
settlements of its liabilities (or a combine of both) during a period of economic
activities that constitute the entity's ongoing major or central operations.
8. Expenses are outflows or other using up of assets or incurrences of liabilities
(or a combination of both) during a period of economic activities that
constitute the entity's ongoing major or central operations.
9. Gains are increases in equity (net assets) from Peripheral or incidental
transactions during a period except those results from revenues or
investments by owners.
10. Losses are decreases in equity (net assets) from Peripheral or incidental
transactions during a period except those results from expenses or
distribution to owners.
Other concepts that underline the above 10 elements are Accrual, Deferral,
Allocation, Realization, Recognition.
SFAC 4 & 5
• SFAC 4 deals with objectives of financial reporting by nonbusiness
organizations and is outside the scope of our course.
• SFAC 5, “Recognition and Measurement in Financial Statements of
Business Enterprises” basically endorses present practices while
allowing for gradual, evolutionary change. The statement emphasizes
that a full set of FSs should show:
A. Financial Position at the end of the period
B. Earnings for the period
C. Comprehensive Income for the period
D. Cash flows during the period
E. Investment by and distributions to owners during the period.
Earnings is net income as currently reported and comprehensive
income is sum of earnings, cumulative effect adjustments, and certain
other changes in net assets such as decline in the value of a security.
SFAC 5 & 6
• SFAC 5: To be included in FSs, the recognition of an item
is required when all of the following four criteria are met:
1. The item must meet the definition of an element of FSs
as defined by SFAC 3
2. The item must be measurable
3. The item is relevant, i.e. the information about it is
capable of making a difference in user decisions.
4. The information about the item is reliable, i.e. it is
representationally faithful, verifiable, and neutral.
• SFAC 6 modified SFAC 3 as to make it applicable to non
business organization as well
Implications for Analysis
• The analyst must understand that Accounting is not
science but rather a service activity [social science].
• Analysts should be understanding of the accounting
profession’s efforts in its attempts to establish a sound CF
and should be supportive of its goals, which are,
ultimately, in the analysts' best interests
Accounting Principles or Standards
• An accounting standard is a common set of principles,
standards and procedures that define the basis of
financial accounting policies and practices. Accounting
standards improve the transparency of financial reporting
in all countries. In the United States, the Generally
Accepted Accounting Principles form the set of accounting
standards widely accepted for preparing financial
statements. International companies follow the
International Financial Reporting Standards, which are set
by the International Accounting Standards Board and
serve as the guideline for non-U.S. GAAP companies
reporting financial statements.
How Accounting Standards are Established?
• The American Institute of Accountants, which is now known as
the American Institute of Certified Public Accountants, and the
New York Stock Exchange attempted to launch the first
accounting standards in the 1930s. Following this attempt
came the Securities Act of 1933 and the Securities Exchange
Act of 1934, which created the Securities and Exchange
Commission. Accounting standards have also been established
by the Governmental Accounting Standards Board for
accounting principles for all state and local governments.
Tremendous growth of leasing after world ward II has moved
the accounting profession to reconsider accounting for leases
and changes it significantly. Accounting principles have been
long in developing and are subject to continuous innovation,
modification, and changes.
Pervasive Human Factor and Accounting Risk
• While the objective of accounting is to supply information
for making economic decision, we must recognize that in
fact many interested parties engaged in the accounting
function have more specific (and more narrow or selfish)
objective in mind.
• Accounting Risk: The risk results from the human nature
factor as well as from the impression inherent in the basic
accounting process. It is also due to existence of
alternative accounting principals.
Questions & Answers
Thank You