7126dc02_33-66 3/28/00 10:09 AM Page 33 CHAPTER 2 Conceptual Framework Underlying Financial Accounting LEARNING T here Are Profits... And There Are Profits OBJECTIVES Accounting in Hollywood affects two parties dramatically. The first is the After studying this chapter, you numerous actors, writers, and producers who sign “net profit contracts” on should be able to: highly successful projects but never receive a share of the profits. With the big ³ Describe the usefulness of studios’ ability to allocate overhead costs creatively, “net profits” often fail to a conceptual framework. materialize. As a result, large-grossing productions like Forrest Gump, · Describe the FASB’s Batman, J.F.K., Alien, Ghostbusters, and Coming to America have never efforts to construct a conceptual framework. produced a “net profit.” Thus, several stars have brought lawsuits against the » movie studios in an attempt to uncover the creative measurement of “net loss.” Understand the objectives of financial reporting. Whether that issue will ever be resolved is anybody’s guess. ¿ Identify the qualitative Investors are another party affected by Hollywood accounting. For example, characteristics of major motion picture studios have been allowed to capitalize advertising and accounting information. marketing costs and amortize these costs against revenues over the life of the ´ Define the basic elements film. As a result, many investors have suggested that the studios’ profit of financial statements. numbers were overstated. Under a new GAAP standard, these costs now must ² Describe the basic be amortized over no more than three months; in many cases, they have to assumptions of be expensed immediately. Similarly, the costs related to abandoned projects accounting. often were allocated to overhead and spread out over the lives of the ¶ Explain the application of successful projects. Not anymore. These costs now must be expensed as they the basic principles of are incurred. Here is a rough estimate of the amounts of capitalized accounting. advertising costs some major studios will have to write off: º Describe the impact that constraints have on Studio (Parent Company) Capitalized Advertising reporting accounting (in millions) information. Columbia Tri-Star (Sony) $200 Paramount (Viacom) 200 20th Century Fox (News Corp) 150 Why the more conservative approach? A lot has to do with a stricter application of the definitions of assets and expenses. While many argue that advertising and marketing costs have future service potential, difficulty in reliably measuring these benefits suggests they are not assets. Therefore, a very short amortization period or immediate charge-off is justified. These new guidelines will not fix the problem of vanishing profits that are used to determine what film stars receive, but investors will now be better able to understand what is happening to the performance of companies in this industry. 33 7126dc02_33-66 3/28/00 10:09 AM Page 34 PREVIEW OF CHAPTER 2 As indicated in the opening story about Hollywood accounting, users of financial state- ments need relevant and reliable information. To help develop this type of financial information, accountants use a conceptual framework that guides financial accounting and reporting. This chapter discusses the basic concepts underlying this conceptual framework. The content and organization of this chapter are as follows: CONCEPTUAL FRAMEWORK UNDERLYING FINANCIAL ACCOUNTING Second Level: Conceptual First Level: Third Level: Fundamental Framework Basic Objectives Recognition and Concepts Measurement • Rationale • Qualitative • Basic • Development characteristics assumptions • Basic elements • Basic principles • Constraints CONCEPTUAL FRAMEWORK A conceptual framework is like a constitution: It is “a coherent system of interrelated objectives and fundamentals that can lead to consistent standards and that prescribes the nature, function, and limits of financial accounting and financial statements.”1 Many have considered the Board’s real contribution—and even its continued existence—to depend on the quality and utility of the conceptual framework. Need for Conceptual Framework Why is a conceptual framework necessary? First, to be useful, standard setting should build on and relate to an established body of concepts and objectives. A soundly de- OBJECTIVE ³ veloped conceptual framework should enable the FASB to issue more useful and con- Describe the usefulness sistent standards over time. A coherent set of standards and rules should be the re- of a conceptual sult, because they would be built upon the same foundation. The framework should framework. increase financial statement users’ understanding of and confidence in financial re- porting, and it should enhance comparability among companies’ financial statements. Second, new and emerging practical problems should be more quickly solved by reference to an existing framework of basic theory. To illustrate an emerging problem: Unique debt instruments were issued by companies in the early 1980s as a response to high interest and inflation rates. These included shared appreciation mortgages (debt in which the lender receives equity participation), zero coupon bonds (debt issued at a deep discount with no stated interest rate), and commodity-backed bonds (debt that 1”Conceptual Framework for Financial Accounting and Reporting: Elements of Financial Statements and Their Measurement,” FASB Discussion Memorandum (Stamford, Conn.: FASB, 1976), page 1 of the “Scope and Implications of the Conceptual Framework Project” section. 34 7126dc02_33-66 3/28/00 10:09 AM Page 35 Conceptual Framework • 35 may be repaid in a commodity). For example, Sunshine Mining (a silver mining com- pany) sold two issues of bonds that it would redeem either with $1,000 in cash or with 50 ounces of silver, whichever was worth more at maturity. Both bond issues had a stated interest rate of 8.5%. At what amounts should the bonds have been recorded by Sun- shine or the buyers of the bonds? What is the amount of the premium or discount on the bonds and how should it be amortized, if the bond redemption payments are to be made in silver (the future value of which was unknown at the date of issuance)? It is difficult, if not impossible, for the FASB to prescribe the proper accounting treatment quickly for situations like this. Practicing accountants, however, must resolve such problems on a day-to-day basis. Through the exercise of good judgment and with the help of a universally accepted conceptual framework, it is hoped that practitioners will be able to dismiss certain alternatives quickly and then to focus upon a logical and acceptable treatment. Development of Conceptual Framework Over the years numerous organizations, committees, and interested individuals devel- oped and published their own conceptual frameworks. But no single framework was universally accepted and relied on in practice. Perhaps the most successful was Ac- counting Principles Board Statement No. 4, “Basic Concepts and Accounting Principles Un- derlying Financial Statements of Business Enterprises,” which described existing prac- OBJECTIVE · tice but did not prescribe what practice ought to be.2 Recognizing the need for a generally Describe the FASB’s accepted framework, the FASB in 1976 issued a massive three-part Discussion Memo- efforts to construct a randum entitled Conceptual Framework for Financial Accounting and Reporting: Elements of conceptual framework. Financial Statements and Their Measurement. It set forth the major issues that must be ad- dressed in establishing a conceptual framework that would be a basis for setting ac- counting standards and for resolving financial reporting controversies. Since the publi- cation of that document, the FASB has issued six Statements of Financial Accounting Concepts that relate to financial reporting for business enterprises.3 They are: INTERNATIONAL ³ SFAC No. 1, “Objectives of Financial Reporting by Business Enterprises,” presents INSIGHT the goals and purposes of accounting. The IASC has issued a concep- · tual framework that is broadly SFAC No. 2, “Qualitative Characteristics of Accounting Information,” examines the consistent with that of the U.S. characteristics that make accounting information useful. » SFAC No. 3, “Elements of Financial Statements of Business Enterprises,” provides definitions of items in financial statements, such as assets, liabilities, revenues, and expenses. ¿ SFAC No. 5, “Recognition and Measurement in Financial Statements of Business Enterprises,” sets forth fundamental recognition and measurement criteria and guidance on what information should be formally incorporated into financial state- ments and when. ´ SFAC No. 6, “Elements of Financial Statements,” replaces SFAC No. 3 and expands its scope to include not-for-profit organizations. ᕦ SFAC No. 7, “Using Cash Flow Information and Present Value in Accounting Mea- surements,” provides a framework for using expected future cash flows and pres- ent values as a basis for measurement. Illustration 2-1 provides an overview of the conceptual framework.4 At the first level, the objectives identify the goals and purposes of accounting and are the build- 2”Basic Concepts and Accounting Principles Underlying Financial Statements of Business Enterprises,” APB Statement No. 4 (New York: AICPA, 1970). 3The FASB has also issued a Statement of Financial Accounting Concepts that relates to non- business organizations: Statement of Financial Accounting Concepts No. 4, “Objectives of Financial