CONCEPTUAL FRAMEWORK 69

Reading from left to right, General Mills’ stock price increased by 8.15% between January 1 and
September 30, 2011. The highest price at which General Mills’ common stock sold in the pre-
ceding 52 weeks was $40.00 per share; the lowest price was $34.54. The current annual dividend
yield is 3.2% based on the day’s closing price of the stock. The P-E ratio is 15, also based on
the closing price. The closing price—that is, the price of the last trade for the day—was $38.49,
which was $.42 lower than the last trade on Thursday, September 29. That means that the closing
price on September 29 was ($38.49 + $.42) = $38.91, and shareholders lost $.42 on each share
they held on September 30.
Keep in mind that transactions in publicly traded shares are between individual investors in
the stock, not between the corporation and the individuals. Thus, a “typical trade” results in the
selling of, for example, 100 shares of General Mills stock held by Ms. Johnson in Minneapolis to
Mr. Ruiz in Atlanta for $3,849 in cash. These parties would ordinarily transact the trade through
their respective stockbrokers. The trade would not directly affect General Mills, except that it
would change its records of shareholders to show that Ruiz, not Johnson, holds the 100 shares.

Summary Problem for Your Review

PROBLEM
On January 31, 2011, the first trading day after the Sunday, January 30 year end, The Home Depot
stock sold at about $36.80 per share. The company had net income of $3,338 million for the fiscal
year ending January 30, 2011, had an average of 1,648 million common shares outstanding during
the year, and paid common dividends of $.945 per share. Calculate and interpret the following:

Earnings per share Dividend-yield ratio

Price-earnings ratio Dividend-payout ratio

SOLUTION (in millions of dollars)

Earnings per share = $3,338 , 1,648 = $2.03
Price@earnings ratio = $36.80 , $2.03 = 18.1
Dividend@yield ratio = $.945 , $36.80 = 2.6%
Dividend@payout ratio = $.945 , $2.03 = 46.6%

The Home Depot had net income of $2.03 for each share of its common stock. Its market price
was 18.1 times its earnings. This is higher than the S&P 500 average P-E ratio as of January 1,
2011, and shows that investors expect continuing growth in The Home Depot’s earnings. Home
Depot paid out 46.6% of its income in dividends, which results in a 2.6% return for investors as
of January 30, 2011. The dividend-yield ratio for the year ended January 30, 2011, is consistent
with the historical average for Home Depot over the last 5 years. The dividend-payout ratio has
been volatile over the last 5 years, ranging from a high of 56.9% in the fiscal year ended January
31, 2010, to a low of 24.1% for fiscal year ended January 28, 2007. Home Depot is apparently
trying to maintain a record of steadily increasing dividend amounts despite fluctuating earnings.

Conceptual Framework
As we learned in Chapter 1, financial statements are based on a set of generally accepted account-
OBJECTIVE 7
ing principles (GAAP) as determined by the Financial Accounting Standards Board (FASB) in
the United States and the International Accounting Standards Board (IASB) in most of the rest of Explain how the concep-
tual framework guides the
the world. How do these boards decide what is acceptable and what is unacceptable in financial
standard setting process and
reporting? Ideally, GAAP would be based on an agreed-upon objective of financial reporting, a how accounting regulators
set of overriding concepts, principles derived from the concepts, and rules for implementing the trade off relevance and faith-
principles. Both the FASB and IASB have attempted to achieve this by developing conceptual ful representation in setting
frameworks. Although there are some differences in the FASB and IASB conceptual frameworks, accounting standards.
the similarities are much greater than the differences. Further, the two standard setting bodies are
working together on a common framework to serve as the basis for developing worldwide stan-
dards. We will focus primarily on the FASB framework, but the discussion would be similar for
70 CHAPTER 2 • MEASURING INCOME TO ASSESS PERFORMANCE

the IASB framework. Understanding the conceptual framework will help you understand why
companies prepare financial statements the way they do.
Why is a conceptual framework necessary? When the FASB or IASB sets standards for finan-
cial reporting, they must make many judgments. Consider the accounting for the expiration of
prepaid expenses. In the case of prepaid rent, it is easy to identify when the prepaid asset provides
a benefit to the company. Rent becomes an expense in the period in which a company uses the
rented facilities or equipment. However, some of the most difficult issues in accounting center on
when a prepaid asset expires and becomes an expense. For example, some accountants believe that
companies should first record research costs as an asset on the balance sheet and then gradually
expense these costs in some systematic manner over a period of years. After all, companies engage
in research activities because they expect them to create future benefits. However, both the IASB
and the FASB have ruled that such costs have vague future benefits that are difficult to measure
reliably. Therefore, companies must treat research costs as expenses when incurred. They do not
appear on the balance sheet as assets. In contrast, under IFRS (but not U.S. GAAP) development
costs that meet very specific criteria are considered assets and appear on the balance sheet.
Other difficult questions faced by the FASB and IASB include the following: Should com-
panies record an expense when they issue stock options to executives? If so, how should the
company measure the expense? How should companies measure and disclose the expense for
retirement benefits? Should companies show assets and liabilities at historical cost or current
market value? The list could go on and on. The existence of a conceptual framework helps stan-
dard setters when faced with such difficult questions.
What factors do the FASB and IASB consider when setting standards? They start with the
objective of financial reporting objective of financial reporting—to provide information that is useful to present and poten-
To provide information that is useful tial investors and creditors and others in making investment, credit, and similar resource alloca-
to present and potential investors tion decisions. Financial information is most useful to decision makers when it possesses certain
and creditors and others in mak- qualitative characteristics, subject to practical constraints. As depicted in Exhibit 2-9, the concep-
ing investment, credit, and similar
tual framework identifies characteristics of information that lead to improved decision making.
resource allocation decisions.
We next discuss these characteristics.

EXHIBIT 2-9
Qualities That Increase the Value of Information

Decision
Usefulness

Relevance Faithful
Representation

Predictive Confirmatory Free from

Complete Neutral
Value Value Material Error

Comparability Verifiability Timeliness Understandability

 CONCEPTUAL FRAMEWORK 71

Characteristics of Decision-Useful Information

Relevance and faithful representation are the two main qualities that make accounting informa-
tion useful for decision making. Relevance refers to whether the information makes a difference relevance
to the decision maker. If information has no impact on a decision, it is not relevant to that deci- The capability of information to
sion. The two attributes that can make information relevant are predictive value and confirmatory make a difference to the decision
value. Information has predictive value if users of financial statements can use the information maker.
to help them form their expectations about the future. Information has confirmatory value if it predictive value
can confirm or contradict existing expectations. Information that confirms expectations means A quality of information that allows
that they become more likely to occur. Information that contradicts expectations will likely lead it to help users form their expecta-
decision makers to change those expectations. tions about the future.
Users of financial statements want assurance that management has accurately and truth- confirmatory value
fully reported its financial results. Consequently, in addition to relevance, accountants want A quality of information that allows
information to exhibit faithful representation—that is, information should truly capture the it to confirm or contradict existing
economic substance of the transactions, events, or circumstances it describes. Faithful represen- expectations.
tation requires information to be complete, neutral, and free from material errors. Information is faithful representation
complete if it contains all the information necessary to faithfully represent an economic phenom- A quality of information that ensures
enon. It is neutral if it is free from bias—that is, the information is not slanted to influence behav- that it captures the economic sub-
ior in a particular direction. Finally, information should be free from material errors. This does stance of the transactions, events, or
not mean the complete absence of errors. Much accounting information is based on estimates circumstances it describes. It requires
that are, by definition, imperfect. Being free from material errors simply means that estimates are information to be complete, neutral,
based on appropriate inputs, which in turn are based on the best information available. and free from material errors.
Accounting is filled with trade-offs between relevance and faithful representation. Consider
the $4.0 billion balance sheet value of Weyerhaeuser Company’s timberlands, which the com-
pany shows at historical cost. Some of the land was purchased more than 50 years ago. The bal-
ance sheet value faithfully represents the historical cost of the timberlands, but the cost of land
50 years ago is not very relevant to today’s decisions. In contrast, the current value of the land is
more relevant, but estimates of this current value are subjective and would be more difficult to
represent faithfully. Which quality is more important? That answer depends on the specific deci-
sion being made. However, the most desirable information has both qualities: It is relevant and
faithfully represents the phenomenon of interest. The prevailing view in the United States is that
many current market value estimates, especially for property, plant, and equipment, are not suffi-
ciently reliable to be included in the accounting records, even though they may be more relevant.
However, under IFRS, companies can use current market values for such assets.
As you can see on the bottom of Exhibit 2-9, four characteristics can enhance both relevance
and faithful representation. The first such characteristic is comparability—requiring all compa- comparability
nies to use similar concepts and measurements and to use them consistently. It requires account- A characteristic of information
ing systems to treat like phenomena the same and unlike phenomena differently. Comparability produced when all companies use
helps decision makers identify similarities in and differences between the phenomena being rep- similar concepts and measurements
resented. Note that comparability requires consistency, using the same accounting policies and and use them consistently.
procedures from period to period. Information is more useful if decision makers can compare it consistency
with similar information about other companies or with similar information for other reporting Using the same accounting policies
periods. For example, financial results of two companies are hard to compare if the companies and procedures from period to
used different methods of accounting for the value of their inventory. Further, we cannot make period.
useful comparisons over time if a company constantly changes its accounting methods.
The second enhancing characteristic is verifiability, which means that information can be verifiability
checked to ensure it is correct. That is, knowledgeable and independent observers would agree A characteristic of information that
that the information presented has been appropriately measured. For example, the historical cost can be checked to ensure it is correct.
of an item is verifiable because we can check the records to verify that the amounts are correct. timeliness
In contrast, some estimates and appraisals are not easily verifiable. A characteristic of information
Timeliness is obviously desirable. Information must reach decision makers while it can still that requires information to reach
influence their decisions. Information that is not available until after decision makers act is of decision makers while it can still
little value. influence their decisions.
Finally, information should be understandable. Understandability requires accountants to understandability
present information clearly and concisely. It does not require oversimplification of the data. That A characteristic of information that
might fail to reveal important information. Complex phenomena sometimes require complex requires information to be presented
reporting. However, it is important to avoid unnecessary complexity. clearly and concisely.
72 CHAPTER 2 • MEASURING INCOME TO ASSESS PERFORMANCE

Constraints
When setting standards that provide decision-useful information, there are practical constraints
that must be considered. One is the cost-effectiveness constraint. Accounting should improve
decision making. This is a benefit. However, accounting information is an economic good that is
cost-effectiveness constraint costly to produce and use. The cost-effectiveness constraint requires that standard setting bod-
Requirement that standard setting ies must choose rules whose decision-making benefits exceed the costs of providing the informa-
bodies choose rules whose decision- tion. The FASB and IASB safeguard the cost effectiveness of their standards by (1) ensuring a
making benefits exceed the costs of standard does not “impose costs on the many for the benefit of a few,” and (2) seeking alternative
providing the information. ways of handling an issue that are “less costly and only slightly less efficient.”
The cost of providing information to the investing public includes expenses incurred by both
companies and investors. Companies incur expenses for data collecting and processing, auditing,
and educating employees. In addition, disclosure of sensitive information can lead to lost com-
petitive advantages or increased labor union pressures. Investors’ expenses include the costs of
education, analysis, and interpretation.
The benefits of accounting information are often harder to pinpoint than the costs. For
example, countries with emerging market economies often need to create an infrastructure of
financial markets and relevant information to guide their economic development. However, the
specific benefits of any particular proposal are harder to articulate than the general benefits of
an intelligent system of accounting rules and procedures. While it can be difficult to explicitly
identify and measure costs and benefits, standard setters attempt to weigh the cost effectiveness
of a standard before its issuance.

Other Basic Concepts And Conventions

In addition to items in the conceptual framework, there are some basic concepts and conventions
OBJECTIVE 8
that are implicit in all financial statements. Now it is time to make some of these underlying
Explain how the following assumptions explicit. In this section, we discuss the entity, going concern, materiality, stable
concepts affect financial
monetary unit, periodicity, and reliability concepts and conventions.
statements: entity, going
concern, materiality, stable
monetary unit, periodicity, The Entity Concept
and reliability. The first basic concept or principle in accounting is the entity concept. As you learned in Chapter 1,
an accounting entity is an organization or a section of an organization that stands apart from other
organizations and individuals as a separate economic unit. Accounting draws sharp boundaries
around each entity to avoid confusing its affairs with those of other entities.
An example of an entity is Berkshire Hathaway Inc., an enormous entity that encompasses
many smaller entities. Just a few of the companies that are part of the Berkshire Hathaway
corporate entity are insurance companies such as GEICO, General Re, United States Liability
Insurance Group, National Indemnity Company; food companies such as International Dairy
Queen and See’s Candies; jewelry companies such as Ben Bridge Jeweler, Helzberg Diamonds,
and Borsheims Fine Jewelry; and numerous companies in the furniture, clothing, and other
industries. Managers want accounting reports that are confined to their particular entities.
The entity concept helps the accountant relate events to a clearly defined area of account-
ability. For example, do not confuse business entities with personal entities. A purchase of gro-
ceries for merchandise inventory is an accounting transaction of a grocery store (the business
entity), but the store owner’s purchase of a DVD player with a personal check is a transaction of
the owner (the personal entity).

Going Concern Convention

going concern (continuity) The going concern (continuity) convention is the assumption that an entity will persist indefi-
A convention that assumes that an nitely. This notion implies that a company will use its existing resources, such as plant assets,
entity will persist indefinitely. to fulfill its general business needs rather than sell them in tomorrow’s real estate or equipment
markets. For a going concern, it is reasonable to use historical cost to record long-lived assets.
The opposite view of this going concern convention is an immediate liquidation assumption,
whereby a company values all items on its balance sheet at the amounts appropriate if the entity were
to be liquidated in piecemeal fashion within a few days or months. Companies use this liquidation
approach to valuation only when the probability is high that the company will be liquidated.
 OTHER BASIC CONCEPTS AND CONVENTIONS 73

Materiality Convention
How does an accountant know what to include on the financial statements? There are a lot of
rules and regulations about what must appear in those statements. However, some items are
insignificant enough that they need not be reported. The materiality convention asserts that an materiality
item should be included in a financial statement if its omission or misstatement would tend to A convention that asserts that
mislead the reader of the financial statements under consideration. an item should be included in a
Most large items, such as buildings and machinery, are clearly material. Smaller items, though, financial statement if its omission or
misstatement would tend to mislead
may not be so clear-cut. Many acquisitions that a company theoretically should record as assets are
the reader of the financial state-
immediately expensed because of their low dollar value. For example, coat hangers may last indefi-
ments under consideration.
nitely but never appear in the balance sheet as assets. Many corporations require the immediate
expensing of all outlays under a specified minimum, such as $1,000, regardless of the useful life of
the asset acquired. The resulting $1,000 understatement of assets and stockholders’ equity is con-
sidered too insignificant to be of concern. In fact, the FASB regularly includes the following state-
ment in its standards: “The provisions of this statement need not be applied to immaterial items.”
When is an item material? There will probably never be a universal, clear-cut answer. What
is trivial to General Electric may be material to a local clothing boutique. A working rule is that
an item is material if its proper accounting is likely to affect the decision of an informed user
of financial statements. In sum, materiality is an important convention, but it is difficult to use
anything other than prudent judgment to tell whether an item is material.

Stable Monetary Unit

The monetary unit (called the dollar in the United States, the yen in Japan, the euro in the European
Union, and various names elsewhere) is the principal means for measuring financial statement
elements. It is the common denominator for quantifying the effects of a wide variety of transac-
tions. Accountants record, classify, summarize, and report in terms of the monetary unit. The abil-
ity to use historical-cost accounting depends on a stable monetary unit. A stable monetary unit is stable monetary unit
simply one that is not expected to change in value significantly over time—that is, a 2013 dollar A monetary unit that is not expected
has about the same value as a 2000 dollar. Although this is not precisely correct, with low levels of to change in value significantly over
time. For example, the dollar in the
inflation, the changes in the value of the monetary unit do not cause great problems.
United States, the yen in Japan, and
the euro in the European Union.
The Periodicity Convention
Earlier in the chapter we discussed the accounting time period. Recall that companies with publicly
traded securities must file financial reports with the SEC on a quarterly and annual basis. However,
companies frequently prepare monthly or even daily financial statements for internal use. For infor-
mation to be useful, users must receive it on a timely basis. The periodicity convention requires periodicity convention
that a company break up its economic activity into artificial time periods that will provide timely Related to the information charac-
information to users. teristic of timeliness, this convention
requires that a company break up
The Reliability Concept its economic activity into artificial
time periods that will provide timely
Users of financial statements want assurance that management did not fabricate the numbers. information to users.
Consequently, accountants regard reliability as an essential characteristic of measurement.
Reliability is a quality of information that assures decision makers that the information captures reliability
the conditions or events it purports to represent. It is similar to representational faithfulness but A quality of information that assures
also requires recording of data only when there is convincing evidence that can be verified by decision makers that the information
independent auditors. captures the conditions or events it
purports to represent.
The accounting process focuses on reliable recording of events that affect an organization.
Although many events may affect a company—including wars, elections, and general economic
booms or depressions—accountants recognize only specified types of events as being reliably
recorded as accounting transactions.
Suppose a top executive of ExxonMobil is killed in an airplane crash. The accountant would
not record this event. Now suppose that ExxonMobil discovers that an employee has embezzled
$1,000 in cash. The accountant would record this event. The death of the executive may have
greater economic or financial significance for ExxonMobil than does the embezzlement, but the
monetary effect is hard to measure in any reliable way.
The conceptual framework and these other concepts guide both standard setters and accountants.
The standard setters use them to decide GAAP—principles that meet the concepts are preferred—and
accountants use them to decide among alternative ways of recording and reporting transactions.