No class 1/15 (MLK holiday)

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Class 2 Announcements

• No class 1/15 (MLK holiday)
• Take-home quiz due Wednesday 1/17
• Quiz 1 Monday (1/22)

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Conceptual Framework

• The Framework is to be the foundation for
  building a set of coherent accounting standards
  and rules.
• The Framework is to be a reference of basic
  accounting theory for solving emerging practical
  problems of reporting.
• There is a joint FASB/IASB project to revise the
  conceptual framework

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Conceptual Framework

• The FASB has issued seven Statements of Financial
  Accounting Concepts (SFACs) to date (Statements 1
  through 7.)
• These statements set forth major recognition and
  reporting issues.
• Statement 4 pertains to reporting by non-business
  entities.
• The other six statements pertain to reporting by
  business enterprises.

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Statements of Financial Accounting Concepts
Brief Title
Statement

• Statement 1
• Statement 2
• Statement 6
• Statement 4
• Statement 5
• Statement 7

• Objectives of Financial Reporting (Business)
• Qualitative Characteristics
• Elements of Financial Statements (replaces 3)
• Objectives of Financial Reporting (Non-business)
• Recognition and Measurement Criteria
• Using Cash Flows

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Conceptual Framework
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Conceptual Framework Level 1 Objectives

• Objectives of financial reporting (Level 1)
• To provide useful information to reasonably
  informed individuals for the purposes of making
  investment, credit and similar decisions.
• Information should be useful in predicting
  amounts, timing and uncertainty of future cash
  flows of a company.
• Information should also be useful in describing
  the economic resources of a company, the claims
  on those resources, and changes in the resources
  and claims.

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Hierarchy of Accounting Characteristics
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Conceptual Framework Level 2 Fundamental
Concepts

• Usefulness
• Understandability
• Primary Qualities
• Relevance
• Reliability
• Secondary Qualities
• Comparability
• Consistency

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Conceptual Framework Level 2 Fundamental
Concepts Primary Qualities

• Relevance reported financial information should
  be capable of influencing the decisions of users
  of the information. Ingredients
• Predictive value (helps users predict outcome of
  past, present, and future events)
• Feedback value (aka confirmatory or corrective
  value)
• Timeliness available before loses capacity to
  influence a decision
• Reliability when information represent the
  true, underlying situation. Ingredients
• Verifiable (when measurers, using same methods
  get similar results)
• Faithfully represent what it purports to
  represent
• Neutral (unbiased)

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Relevance and Reliability - Tradeoffs

• Example Suppose a biotech firm spends
  1,000,000 on research and development
  expenditures. Should the firm record the
  expenditures as an asset?
• Does the situation fit the definition of an
  asset?
• According to GAAP, what is the amount of asset
  reported?
• Suppose the firm sells all rights related to the
  RD to a pharmaceutical company for 6,000,000.
  Should the pharmaceutical company report an asset?

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Relevance and Reliability - Tradeoffs

• Improvements in the relevance of information
  (specifically, timeliness) increase the risk that
  information will be less reliable.
• It takes time to compile financial statements,
  make adjusting entries, and perform the audit

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Conceptual Framework Level 2 Fundamental
Concepts Secondary Qualities

• Secondary Qualities
• Comparability financial information should be
  measured and reported so that users of the
  information may make meaningful comparisons
  across businesses at one point in time
• Consistency The same accounting methods should
  be used to measure similar transactions and
  events across time for one business

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Conceptual Framework Level 2 Qualitative
Characteristics Decision Usefulness

• Many companies promise certain post-retirement
  benefits other than pensions to their employees.
  Examples include medical coverage, dental
  coverage, and life insurance. Prior to 1993,
  companies accounted for such post-retirement
  benefits by recording nothing while the employee
  worked for the company and expensing the cost of
  the medical claims as they were paid during the
  employees retirement.
• An alternative to this practice is recognizing
  the estimated liability (and expense) while the
  employee works for the company and reducing the
  liability as the medical claims are paid during
  the employees retirement.
• Assess the relative relevance and reliability for
  investor and creditor decision making of these 2
  alternative methods for recognizing a companys
  obligation it its employees for post-retirement
  benefits.

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Conceptual Framework Level 2 Qualitative
Characteristics Decision Usefulness
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Level 2 Basic Elements of Financial Statements

• Assets
• Liabilities
• Equity
• Investment by Owners
• Distributions to Owners

• Comprehensive Income
• Revenues
• Expenses
• Gains
• Losses

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Level 2 Elements of Financial Statements

• Assets
• Firm expects to receive future economic benefits
• Controlled by firm
• Results from past transactions or events
• Liabilities
• Firm expects to pay future economic obligations
• Firm is obligated to pay (no discretion to avoid
  it)
• Results from past transactions or events
• Equity Claims against the excess of assets over
  liabilities. Generally arises from
• Contributed capital
• Retained earnings profits that have not been
  distributed as dividends to shareholders

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Level 2 Elements of Financial Statements

• Investments by Owners
• Increase in net assets resulting from
  transferring assets to the firm for an ownership
  interest
• (investments may also be in the form of a
  reduction in liabilities for ownership interest).
• Distributions to Owners
• Decrease in net assets resulting from
  transferring assets, rendering services, or
  incurring liabilities by the firm to owners (e.g.
  dividends).
• Comprehensive Income
• Includes all changes in equity during a period
  except those resulting from investments by and
  distributions to owners. Certain types of
  transactions change the equity of a firm, but do
  not affect net income. Required by FAS130.

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Level 2 Elements of Financial Statements

• Revenues
• Increases in assets or decreases in liabilities
• From ongoing, ordinary operations
• Gains
• Increases in assets or decreases in liabilities
• From peripheral transactions or events
• Expenses
• Decreases in assets or increases in liabilities
• From ongoing, ordinary operations
• Losses
• Decreases in assets or increases in liabilities
• From peripheral transactions or events

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Level 3 Recognition and Measurement Criteria
Basic Assumptions
Principles
Constraints
1. Historical cost 2. Revenue
recognition 3. Matching 4. Full disclosure
1. Cost benefit 2. Materiality 3. Industry
practices 4. Conservatism
1. Economic entity 2. Going concern
3. Monetary unit 4. Periodicity
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Level 3 Recognition and Measurement Basic
Assumptions

1. Economic Entity the entity that is providing
   information should be well defined. In many
   cases, financial statements of many related (but
   legally separate) entities are combined and
   financial statements of consolidated entity are
   provided.
2. Going Concern It is assumed that a firm will
   remain in business unless something suggests
   otherwise. Certain accounting methods (e.g.
   depreciating an asset over time) are not
   appropriate when this assumption is violated.

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Level 3 Recognition and Measurement Basic
Assumptions

1. Monetary Unit Financial information should be
   express in monetary terms since this is the most
   universal medium of exchange.
2. Periodicity (Time Period) Economic activities
   of a firm are divided (perhaps somewhat
   artificially) into time periods. Estimates,
   accruals, and adjustments are often needed to
   accomplish this.

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Level 3 Recognition and Measurement - Principles

• Historical Cost GAAP requires that most assets
  and liabilities be accounted for and reported on
  the basis of acquisition price.
• Ex If a firm bought land in 1950 for 10K and
  still owned it in 2006, would it appear on the
  2006 financial statements at 10K even if it is
  now worth 1 million?
• Is historical cost more relevant or reliable?

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Level 3 Recognition and Measurement - Principles

• 2. Revenue Recognition Revenue should be
  reported when it is
• (1) earned and
• (2) realized or realizable
• When is Revenue is earned?
• When is Revenue realized?
• When is Revenue realizable ?

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Level 3 Recognition and Measurement - Principles

• 2. Revenue Recognition Revenue should be
  reported when it is
• (1) earned (based on accounting standards)
• (2) realized or realizable (based on economic
  facts)
• Revenue is earned when a firm has substantially
  completed what it must do to be entitled to keep
  resources received from the transaction. Revenue
  is realized when resources are received, and
  realizable when resources to be received are
  readily convertible to some other asset.

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Level 3 Recognition and Measurement - Principles

• 2. Revenue Recognition Generally recognized at
  time of sale. Exceptions
• During production long term construction
  contracts ( Completion Method)
• (2) End of production when ready market at
  quoted price exists (mining and agriculture)
• (3) Upon receipt of cash when collections
  uncertain at time of sale (Installment sales
  method)

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Level 3 Recognition and Measurement - Principles

• Matching Once a firm has established its
  criteria for recognizing revenue, it should
  record expenses so that resources consumed in
  generating revenues are expensed in the same
  accounting period as the related revenue is
  recognized (only 1 way match expense to
  revenue, not the other way around)
• If the link between an expense and revenue is
  unclear, recognize the expense when incurred. Ex
  
• In 2004, bought 10K inventory and paid firm CEO
  600K.
• In 2005, sold the inventory for 30K and paid the
  firm CEO 750K
• 2004 record 0 revenue and 600K salary expense
• 2005 record 30K revenue 10K COGS, and 750K
  salary expense

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Level 3 Recognition and Measurement - Principles

• 4. Full Disclosure Nature and amount of
  information included in financial reports
  reflects a series of judgmental trade-offs
  (between providing sufficient detail and keeping
  information understandable). Users find financial
  information in 3 places
• Financial statements
• Notes to financial statements
• Supplementary information

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Level 3 Principles - Full Disclosure
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Level 3 Recognition and Measurement - Constraints

1. Cost/Benefit In order to justify requiring a
   particular measurement or disclosure, the
   benefits perceived to be derived from it must
   exceed the costs perceived to be associated with
   it.

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Cost and Benefits of Disclosure

• Costs
• Cost of collecting, processing and distributing
  information
• Litigation risk associated with releasing
  inaccurate information
• Potential to provide private information to
  competitors
• Some information may lead to undesired scrutiny
  (e.g. executive compensation)

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Cost and Benefits of Disclosure

• Benefits
• Comply with SEC requirements (publicly traded
  companies)
• Reduce investors uncertainty about a companys
  opportunities and risks, leading to reduction in
  cost of capital
• Help attract employees, suppliers, and customers
  (other stakeholders)
• Lack of disclosure may lead to interpretation
  that undisclosed information is unfavorable

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Level 3 Recognition and Measurement - Constraints

• Materiality A concept suggesting that
  accounting treatment for relatively minor items
  doesnt matter. Relatively minor items are those
  that would not influence the decisions made by
  readers of the financial statements. Companies
  must consider each misstatement separately and
  the aggregate effect of all misstatements
• Ex say 3M misestimated its bad debt by 10 in
  2006. Should they reissue their financial
  statements?
• Quantitative and qualitative factors must be
  considered

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Level 3 Recognition and Measurement - Constraints

• Constraints
• Industry Practices The peculiar nature of some
  industries and business concerns sometimes
  requires departure from basic theory.
• Ex Public utility companies report non-current
  assets first on balance sheet real estate
  companies can report real estate investments
  first on balance sheet
• Conservatism when uncertainty exists about an
  event, an unfavorable outcome is usually
  reflected in the financial statements
  immediately, whereas recording a possible
  favorable outcome is usually deferred until the
  favorable outcome actually occurs (choose
  solution that will least likely overstate assets
  and income)

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How to Cheat with Conservatism

• Scumbag Corp. pays a bonus to the CFO of 10,000
  if the company earns net income over 1 million
  in any given year.
• Draft f/s for 2004 show net income of 1.5
  million dollars
• However, the CFO argues that slowing sales
  indicate that inventory may be overvalued, and
  advocates the following journal entry
• Dr. Cost of Goods Sold (overvalued goods)
  400,000
• Cr. Inventory
  400,000
• What would this entry do?
• Sometimes this practice is called the cookie
  jar
• What if projected net income in 2005 was 800,000
  (before this journal entry was made)?