Conceptual framework of an Accounting Board:
Defines the objective of financial statements
Identifies the qualitative characteristics that make information in financial statements useful
Defines the basic elements of financial statements
Specify how the elements are recognised and measured in financial statements.
The focus of this essay is on conceptual frameworks propounded by Accounting Standards Board (ASB), the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) and also the improvements proposed in the IASB and FASB Joint Discussion Paper.
ASB is a subsidiary company of the Financial Reporting Council (FRC) responsible for formulating Financial Reporting Standards.
FASB is an Accounting Board that establishes rules governing accounting practices throughout the US. The mission of the FASB is to establish and improve standards of financial accounting and reporting for the guidance and education of the public, including issuers, auditors, and users of financial information.
IASB is the youngest Accounting Board of the three. It was founded on April 1, 2001 as the successor of International Accounting Standards Committee (IASC) based in London, UK. IASB is responsible for setting International Accounting Standards. IASB has adopted many of the regulations of its predecessor. It uses IASCs 1989 ‘Framework for the Preparation and Presentation of Financial Statements’. Thus, IASB’s conceptual framework of accounting standards are outdated as the accounting standards prescribed by IASB reflect the accounting thought in1989. In contrast, ASB pronouncements are more contemporary.
IASB and FASB Joint Discussion Paper In October 2004, US FASB and the IASB accepted that their existing frameworks move in different directions and were not complete and up to date. They decided to develop a single common conceptual framework that converges and improves the existing individual conceptual frameworks of the boards. They published a consultative document in 2006 setting out their preliminary views on an enhanced conceptual framework.
Differences between Conceptual Frameworks
The conceptual frameworks put forward by the three Boards can be compared on the basis of:
Purpose of the framework
Objectives of financial statements
Elements of financial statements
Recognition and measurement criteria
These are examined in detail below:
Purpose of the Framework
The three conceptual frameworks have similar purpose. The purpose of each framework is described below:
ASB: The framework seeks to describe the fundamental approach propounded by ASB to strengthen the financial statements of profit-oriented entities. It provides a reference point to help ASB in developing new accounting standards and reviewing existing ones.
IASB: Like ASB, IASB’s framework also serves as a guide to the Board in developing accounting standards. It also acts as a guide to resolving accounting issues that are not addressed directly in an IAS or IFRS or Interpretation. With a revision to IAS 8 in 2003, the importance of conceptual framework has increased further.
The IASB framework applies to all business entities both in the private or public sector.
FASB: The purpose of the FASB framework is also to assist standard setters in developing and revising accounting standards. The framework does not override accounting standards, and therefore in this respect it has a lower status than specific accounting standards. The FASB framework applies to both business and not-for-profit entities in the private sector.
Despite the similar purpose of all frameworks, the emphasis of the framework differs from board to board. For instance, the IASB framework has a broader purpose than the FASB framework. The IASB framework not only assists IASB in developing or revising accounting standards but also assists preparers, auditors, and users of financial statements.
There is also a difference in the status of the frameworks. For instance, the IASB framework is considered at a higher level in its GAAP hierarchy than the FASB framework in the U.S. GAAP hierarchy. The management of entities preparing financial statements under IFRS is expressly required to follow the IASB framework.
IASB and FASB Joint Discussion Paper: The Discussion Paper states the purpose of conceptual framework to establish a common framework of the concepts that underlie financial reporting. The common framework is expected to suit the requirements of both FASB and IASB. However, this may lead to a problem. If the arguments contained in the discussion paper are adopted as the common framework, this will distance preparers and auditors as the framework will become theoretical and long and act only as a reference manual for standard setters.
Objectives of Financial Statements
Conceptual frameworks put forward by Accounting Boards put forward similar objectives of financial statement.
ASB: According to ASB “…the objective of financial statements is to provide information about the financial position, performance and the financial adaptability of an enterprise that is useful to a wide range of users” (1999:1)
FASB: The FASB framework specify objectives for business entities and non-business entities. According to FASB in SFAC 1 “…financial reporting is not an end in itself but is intended to provide information that is useful in making business and economic decisions”. (1978:9)
IASB: According to the IASB’s Framework for the Preparation and Presentation of Financial Statements “…the objective of financial statements is to provide information about the financial position, performance and changes in financial position of an enterprise that is useful to a wide range of users in making economic decisions.” (2001:12)Unlike FASB framework, the IASB framework has a more limited scope. It discusses objectives in the context of business entities only.
IASB and FASB Joint Discussion Paper: The discussion paper states that the objectives of financial reporting are to provide information:
Useful to present and potential investors and creditors and others in making investment, credit, and similar resource allocation decisions.
Useful in assessing cash flow prospects
About an entity’s resources, claims to those resources, and changes in resources and claims
Despite the similarity of objectives propounded by the various frameworks, the differences may arise due to the focus on users. The focus depends on the body producing the statements and establishing parameters.
The conceptual frameworks identify primarily four principal qualitative characteristics in common: Understandability Relevance, Reliability and Comparability. However there are differences in terms of what constitute ‘relevant’ and ‘reliable’ information and which characteristic is more important than others.
ASB: The ASB narrow down the scope of their conceptual framework by establishing parameters which clearly defines the inclusions and exclusions. It defines the qualitative characteristics of the information which merits inclusion, for example, relevance, reliability, and comparability. UK ASB treats information to be reliable if it is free from material errors. Though freedom from material error is included as a sub-quality of reliability, the framework excludes verifiability as an essential element for reliability of information.
The conceptual framework of ASB favours relevance over reliability if there is a conflict between relevance and reliability concept.
IASB: According to IASB, information is relevant when it influences the economic decisions of users and is reliable if it is free from material error and bias and can be depended upon by users to represent events and transactions faithfully.
IASB framework treats all four qualitative characteristics as primary qualitative characteristics. It treats materiality of information and its timeliness as a component of relevance. IASB does not give importance to one characteristic over the other. There is sometimes a tradeoff between relevance and reliability and judgement is required to provide the appropriate balance. IASB expects management to exercise prudence or conservatism to provide this balance.
FASB: Unlike IASB, FASB framework set out the qualitative characteristics in a hierarchy, treating understandability as a user-specific quality separate from the others, relevance and reliability as the primary qualities, and comparability as a secondary quality.
IASB and FASB Joint Discussion Paper: The discussion paper proposes replacing the qualitative characteristic of ‘reliability’ in the current frameworks with ‘faithful representation’. The paper also highlights areas where the qualitative characteristics of both IASB and FASB conceptual framework can be improved. For example, both frameworks emphasise neutrality, prudence or conservatism and expect that the exercise of prudence or conservatism does not allow the deliberate understatement of net assets and profits. However, the hard fact is that a concept of prudence or conservatism is inconsistent with the concept of neutrality.
Elements of Financial Statements
There are differences, though not major, between frameworks in relation to elements of financial statements
ASB: ASB classifies transactions and other events into 5 elements: assets, liabilities, ownership interests, gains and losses. Assets, liabilities and ownership interest are included in the Balance Sheet and gains and losses in the Profit
Financial Statements Analysis of Competitors
The two U.S. companies Lowe’s and Home Depot are two leading competitors on the DYI market who are both listed on the U.S. stock market. You are to carry out a financial statement analysis of these two companies covering the period 2002 to 2006. Specifically, you are to:
1. Analyze and evaluate the balance sheet for assets and liabilities that are not recorded.
Kohlbeck (2004) argues that, using the case of banks, few firms disclose the value of their intangible assets, and few provide any information enabling investors to make an informed judgement as to the value of these assets. As such, given that companies will tend to categorise and record the value of all their tangible assets, actually quantifying the value of any assets that are not recorded on the balance sheet is likely to be very difficult. Bodenhorn (1984) argues that non recorded assets can have a value assigned to them from the future value of the cash flows that they will generate. However, again companies rarely assign cash flows to intangible assets, such as branding, further making this difficult. As such, the analysis and evaluation will need to take on a qualitative nature.
Both Lowe’s (Shareholder.com, 2008) and Home Depot (SEC, 2008) provide details of cash and cash equivalents, short-term investments, and inventory in their current assets, and land, buildings, equipment, leasehold improvements and construction in progress in their fixed assets. However, Lowe’s does not include any trade receivables in their current assets. This could mean that the company does not have any trade receivables, or it could imply that the company is being prudent, and not recognising these receivables until they have been paid. In addition, Lowe’s does not record any goodwill, which could mean that the company has either not made any acquisitions, that it has only paid market value for them, or that it is not recording the goodwill as it does not see it as a reasonable asset: maybe the value of the goodwill will need to be downgraded. Neither company has recorded any asset value for brand value, employee skills and knowledge, or customer loyalty. Whilst this is in accordance with international accounting standards, it nevertheless fails to acknowledge what could be a significant source of value for the companies (Quick, 2002).
In terms of liabilities that are not recorded, the only potential items which may not have been recorded are pension liabilities, with neither company including them as an item of their annual reports. Whilst the FASB issues Statement No 158 in 2007, which made it a requirement for employers to move pension liabilities onto the balance sheet (Miller and Bahnson, 2007a), this requirement may not yet have impacted on these accounts. Other than this, modern accounting standards generally require that all liabilities be kept on balance sheet, hence there are unlikely to be any other liabilities which are not recorded by the balance sheets.
2. Analyze and evaluate the balance sheet for the current value of assets and liabilities.
When determining the current value of assets and liabilities, it is necessary to consider both their balance sheet value and their liquidity (Allen and Carletti, 2006). For example, if inventory has to be sold off quickly, it will rarely achieve its full valuation, and items such as goodwill will have no immediate current value. In contrast, banks can often call in loans and other liabilities at their full value. Applying this to the two balance sheets:
Cash and cash equivalents can be counted at full value
Short-term investments will be counted at 80% of value, to reflect losses and penalties on disposal
Receivables will be counted at 90%, as bad debts will likely increase in the event of a quick sale
Merchandise inventories will be counted at 20% to reflect the difficulty in disposing of them
Other current assets, deferred income taxes, and goodwill will be excluded, as they have no tangible saleable value.
Property and associated fixed assets will be counted at 50%.
Long term investments and notes will not be counted, as it may not be possible to recover this money in short order.
ItemBook valueCurrent value
Cash and cash equivalents281281
Deferred income taxes2470
Other current assets2980
Property, less accumulated depreciation21,36110,681
ItemBook valueCurrent value
Cash and Cash Equivalents445445
Other Current Assets1,2270
Net Property and Equipment27,47613,738
Whilst this analysis is somewhat basic, and the assumptions contained within it have not been rigorously tested, it demonstrates that, in the event that either company’s full liabilities became payable at short notice, both companies could have difficulty raising enough money to cover them. However, this is unlikely as both companies have a significant amount of their liabilities in the form of long term loans, which are unlikely to become due immediately.
3. Analyze and interpret the effect on financial results and ratios of the companies’ choices of accounting methods and assumptions made under these accounting methods.
In accordance with the US GAAP, both companies declare that they use estimates for determining the carrying value of assets and liabilities which cannot be otherwise determined (Miller and Bahnson, 2007b). As such, both companies acknowledge that the value they have applied to some of their assets and liabilities may be different from their actual value, which would depend on the circumstances in which these items were valued. This has had an effect on the financial results because, if the estimated value is incorrect, it will potentially have an impact on profits and net asset values, and hence affect all ratios which depend on these items.
Furthermore, the companies have both declared cash and cash equivalents to be made up of actual cash, cash in deposit accounts, and investments with maturity dates of less than three months from the date of purchase. In addition, they have classified payments made by credit or debit card around the time of preparation of the accounts as being cash equivalents, as they will generally be paid within two or three business days. This has impacted on the value of cash and cash equivalents, and also on the value of trade receivables and short term investments. As such, whilst it will not have affected the value of current assets, choosing different criteria would have led to a different value for cash and cash equivalents, and would thus have affected the quick ratio.
When recording merchandise inventory, both companies record the value of their inventory at the lower value of the cost to purchase or the market value, based on the first-in, first-out (FIFO) method of inventory accounting. As such, and as demonstrated by Bruns and Harmeling (1991), the value of inventory recorded in the financial accounts will be different than in another method, such as LIFO, was used to calculate the value of the inventory. This will affect the value of current assets, and also of total and net assets, thus affecting the majority of ratios related to the balance sheet. Lowe’s also records an inventory reserve, which is to be used to cover any loss associated with selling off inventory at less than its book value. This reserve will affect the value of inventory, and will also presumably affect the value of cash and cash equivalents if it is made up of liquid investments which are not held as such. As such, this may further affect several of the company’s ratios.
Finally, both companies use the straight line method to depreciate assets over their useful economic lives. As such, they will produce different values for fixed, total and net assets than they would under different methods of depreciation accounting, which will affect most ratios based on these values.
4. Interpret indicators and determine the companies’ earnings quality.
According to Richardson (2003) some of the primary indicators of a poor earnings quality include an increase in trade receivables; a link between growth in earnings and a reduction in the effective tax rate; capitalising interest payments; and a large number of significant one off items. In addition, an positive correlation between cash flow and earnings, as well as a higher gross margin, indicate a high quality of earnings (Bao and Bao, 2004).
Applying this to Lowe’s, there are no figures given for trade receivables in either of the past years. This can be taken to indicate that the company is not owed any significant receivables, thus implying a high quality of earnings. Over the past three years, there has been no noticeable change in the tax rate experienced, however, whilst post tax earnings grew from 2006 to 2007, they fell from 2007 to 2008, which may indicate further future falls in earnings. There is no evidence of a capitalisation in interest payments by the company, and nor are there any major one off items, with the profit and loss account remaining fairly consistent from year to year. Gross margin has also consistently increased, going from 34.2% to 34.64%. However, there has been a larger increase in general expenses, which has caused a fall in overall earnings. There has also been an increase in cash flow over the three years, further indicating high earnings quality.
Home Depot has experienced a significant fall in trade receivables over the past two years, and has had no significant change in its tax rate. However, its revenues have decreased over the past three years to a much greater degree than Lowe’s. Whilst part of this can be attributed to a fall in sales over the past two years, it is also due to a significant increase in selling and general expenses, which may also threaten earnings quality. Again, there is no evidence of capitalisation of interest payments or of major one off items. However, whilst Lowe’s has grown its gross margin, Home Depot has experienced no changes in margins, and its cash flows from operating have fallen more significantly than its earnings over the past two years. As such, Home Depot appears to have a much lower quality of earnings when compared to Lowe’s.
5. Discuss which of the two companies think produce more reliable financial reporting and discuss which of them you would choose to invest in. You have to use many ratios (the most common ratios), you have not a limited number of ratios to use in your analysis.
From the examination of the financial statements discussed above, there does not appear to be much difference between the reliability of the financial reporting methods of both companies. Both companies follow US GAAP regulations and standards, and both appear to interpret the rules in the same way. Both are publicly listed companies, and both sets of accounts include statements that they have followed accounting standards, been audited, and are Sarbanes-Oxley compliant. As such, the main differentiator between the two companies will need to be the ratio analysis of their financial accounts.
The ratio analysis, detailed in the appendix below, reveals that both of the companies are very similar in their financial performance, which is probably largely due to the fact that they operate in the same industry and very similar markets. In terms of liquidity, Home Depot has a better current ratio and quick ratio, due to its trade payables. However, Lowe’s has a better operating cash flow, a fact which was commented on in the previous section regarding earnings quality. Home Depot has a higher rate of turnover for all five ratios, indicating that it is better at using its inventory and assets to generate sales, however Lowe’s higher gross margin and net margin (return on sales) indicates that Lowe’s is better at generating profits from these sales. In addition, Lowe’s has a lower debt to equity and debt ratio, as well as higher interest cover, which indicates that Lowe’s is better placed to withstand any falls in revenue and profit, which were also remarked on in the earnings quality section.
As such, in conclusion, I would avoid investing in either of these companies based on the current falls in their earnings and the concerns about the wider performance of the US economy (Emerging Markets Monitor, 2008). However, if I were forced to choose between the two companies I would choose to invest in Lowe’s. This is because Lowe’s has shown itself to have better quality earnings, higher margins and lower debt ratios that Home Depot. As such, Lowe’s looks better placed to withstand any earnings shocks or economic issues in the US market and provide sustained long term value. In addition, Lowe’s is not carrying any goodwill or trade receivables on its balance sheet, which makes it less vulnerable to defaults from its debtors and enforced goodwill writedowns.
References Allen, F. and Carletti, E. (2006) Mark-to-Market Accounting and Liquidity Pricing. Working Papers — Financial Institutions Center at The Wharton School; Preceding p. 1-31.
Bao, B. H. and Bao, D. H. (2004) Income Smoothing, Earnings Quality and Firm Valuation. Journal of Business Finance