Accounting theory

WHAT IS SFAC?
Statement of Financial Accounting Concepts (SFAC) A document issued by
the Financial Accounting Standards Board (FASB) covering broad
financial reporting concepts. The purpose of the SFAC document is to
provide a general overview of accounting concepts, definitions and
ideas. It is seen as a prelude to the statement of financial accounting
standards.
A Statement of Financial Accounting Concepts does not establish
generally accepted accounting standards.

Statements of Financial Accounting Concepts:
No. 1. OBJECTIVES OF FINANCIAL REPORTING BY BUSINESS ENTERPRISES (SFAC No. 1)
1978
No. 2. QUALITATIVE CHARACTERISTICS OF ACCOUNTING INFORMATION (SFAC No. 2)
1980
No. 3. ELEMENTS OF FINANCIAL STATEMENTS OF BUSINESS ENTERPRISES (SFAC No. 3)
1980
No. 4. OBJECTIVES OF FINANCIAL REPORTING BY NONBUSINESS ORGANIZATIONS (SFAC
No. 4) 1980
No. 5. RECOGNITION AND MEASUREMENT IN FINANCIAL STATEMENTS OF BUSINESS
ENTERPRISES (SFAC No. 5)
1984
No. 6. ELEMENTS OF FINANCIAL STATEMENTS; a replacement of FASB Concepts Statement
N. 3, also incorporating an amendment of FASB Concepts Statement No. 2 (SFAC N. 6)
1985
No. 7. USING CASH FLOW INFORMATION AND PRESENT VALUE IN ACCOUNTING
MEASUREMENTS (SFAC No. 7)
2000
No. 8. CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING, a replacement of SFAC No.
1 and No. 2

2010

SFAC NO 1: OBJECTIVES OF FINANCIAL
REPORTING BY BUSINESS ENTERPRISES
SFAC No. 1 is concerned with the objectives of business financial
reporting.
Its overall purpose is to provide information that is useful for making
business and economic decisions.
The statement is a direct descendant of the Trueblood Report and is
generally a boiled-down version of that report, with some necessary
value judgments as well as some redundant statements scattered
throughout.
SFAC No. 1 maintains that financial statements must be general purpose in
nature rather than geared toward specific needs of a particular user
group, although investors, creditors, and their advisers are singled out
among external users.

Several important value judgments are made throughout the report:
 Information is not costless to provide, so benefits of usage should exceed costs of
production.
 Accounting reports are by no means the only source of information about enterprises.
 Accrual accounting is extremely useful in assessing and predicting earning power and
cash flows of an enterprise.
 The information provided should be helpful, but users make their own predictions and
assessments.

SFAC NO 2: QUALITATIVE CHARACTERISTICS OF
ACCOUNTING INFORMATION
SFAC No. 2 deals with qualitative characteristics of accounting information.
The term qualitative characteristics is used in APB Statement 4, but the
concepts discussed here proceed directly from ASOBAT.

PRINCIPLES
Relevance
Relevance is a quality carried forward from ASOBAT and is rather
awkwardly expressed in SFAC No. 2 as being “capable of making a
difference in a decision by helping users to form predictions about the
outcomes of past, present, and future events or to confirm or correct
expectations.

Relevance has two main aspects and one minor:
 Predictive value, as in previous documents, refers to usefulness of inputs for
predictions, such as cash flows or earning power, rather than being an actual prediction
itself.
 Feedback value concerns “confirming or correcting their [decision makers] earlier
expectations.” It thus refers to assessing where the firm presently stands and overlaps
with how well management has carried out its functions.
 Timeliness is really a constraint on both of the other aspects of relevance. To be
relevant, information must be timely, which means that it must be “available to decision
makers before it loses its capacity to influence decisions.” There is a conflict between
timeliness and the other aspects of relevance because information can be more
complete and accurate if the time constraint is relaxed.

Reliability
Reliability is composed of three parts: verifiability, representational
faithfulness, and neutrality.
 Verifiability in SFAC No. 2 refers, as in previous documents, to the degree of
consensus among measurers. It is thus concerned with measurement theory.
 Representational faithfulness, likewise, pertains to measurement theory. It refers to the
idea that the measurement itself should correspond with the phenomenon it is
attempting to measure.

Neutrality refers to the belief that the policy-setting process is primarily concerned
with relevance and reliability rather than the effect a standard or rule has on a
specific user group or the enterprise itself. In other words, neutrality is
concerned with financial statements “telling it like it is” rather than the way a
particular interest group, such as management or stockholders, might like it to
be. Neutrality is the only qualitative characteristic that pertains wholly to the
attitude of Board members as opposed to being more directly concerned with
specific aspects of the information itself. The purpose of neutrality is a
conscious attempt to ward off interference by groups having an important
interest in financial statements and the accounting standards underlying them.

SFAC NO 5: RECOGNITION AND MEASUREMENT
IN FINANCIAL STATEMENTS OF BUSINESS
ENTERPRISES
The statement was to deal with the difficult issues of recognition and
measurement.
Scope of the statement:
 Earnings and Comprehensive Income
One of the principal concerns of SFAC No. 5 was the format and
presentation of changes in owners’ equity that do not arise from transactions
with owners.
Today, only two items that are now classified as prior period adjustments
enter into a comprehensive income statement, earnings and comprehensive
income.

 Recognition Criteria
Recognition criteria refers to when an asset, liability, expense, revenue,
gain, or loss is recorded in the accounts.
 Definitions. The item meets the definition of an element of financial
statements.
 Measurability. It has a relevant attribute measurable with sufficient reliability.
 Relevance. The information about it is capable of making a difference in
user decisions.
 Reliability. The information is representationally faithful, verifiable, and
neutral.

 Measurement Attributes
The five measurement attributes:
1. Historical cost
2. Current cost (replacement cost)
3. Current market value (exit value)
4. Net realizable value (selling cost less any costs to complete or
dispose)
5. Present (discounted) value of future cash flows

SFAC NO 6: ELEMENTS OF FINANCIAL
STATEMENTS
SFAC No. 6 is a replacement (not a revision) of SFAC No. 3. Its added to the
conceptual framework from the perspective of business enterprises.
SFAC No. 6 includes the definitions of 10 elements of financial statements
(assets, liabilities, equity, investments, distributions, comprehensive,
revenues, expenses, gains, and losses.)
SFAC No. 6 (paras. 150–151 and 169) mentions a small and limited number
of transactions involving owners’ equity that are nonreciprocal in
nature. These include receipts of cash by the firm with (presumably) no
strings attached or with no presumed necessity to transfer assets in the
future. Nonreciprocity is extremely rare and should not be used as a
basis for transaction avoidance.

SFAC N0 7: USING CASH FLOW INFORMATION
AND PRESENT VALUE IN ACCOUNTING
MEASUREMENTS
Two important points should be immediately made about SFAC No. 7.
First, in light of the importance of the Trueblood Committee Report
with its emphasis on the importance of cash flows, Second, this
statement concerns specific measurement issues rather than
broader conceptual-type issues; hence it can be viewed as a subset
of SFAC No. 5. SFAC No. 7 applies to situations in which present
market-determined amounts such as cash received or paid and
current cost or market value are not available at the point of
recognition. Instead estimated future cash flows are used for asset
or liability measurement.
In SFAC No. 7, the Board recognized that present valuation methods
were inconsistently applied in various standards.
SFAC No. 7 applies only to initial recognition and not subsequent
revaluations, which it terms “fresh-start measurements. To
understand that term, know that the SFAC is divided into two parts:
asset measurement and liability measurement.

PRESENT VALUE ASSET MEASUREMENT
The most important point about asset measurement is that present value
measurements are intended to simulate fair value rather than the
particular present value of the asset to the firm itself.
For example, the asset might have a higher value to the firm because it
holds special manufacturing processes or other preferences that
increase the value of the asset to the particular enterprise.53 Thus any
value accruing to the particular firm because the simulated fair value
is less than the present value of the asset to the firm is to be realized
in the form of cost savings during usage rather than in higher initial
valuation. Hence if the firm does not know the specific market value of
a particular asset, it strives for that discount rate, which leads as
closely as possible to estimated fair value.

PRESENT VALUE LIABILITY MEASUREMENT
The key point about liability measurement is that the discount rate
must be tied to the credit standing of the firm. The carrying
value of the original liability is tied to the firm’s credit standing.
Notice that this means that if the firm’s credit standing
deteriorates, the valuation of the liability decreases (because a
poorer credit standing means that the applicable discount rate
rises). Hence any firm acquiring the liability from the original
creditor pays less to acquire the liability owing to the debtor’s
worsening credit standing.

SFAC NO. 8: CONCEPTUAL FRAMEWORK FOR
FINANCIAL REPORTING
Qualitative Characteristics of Useful Financial Information, results from FASB’s
collaborative work with the IASB and their respective qualitative
characteristics.
Relevance continues to be one of the two fundamental qualitative characteristics
of useful information; however, “faithful representation” replaces “reliability”
as the second. Relevance influences user decisions, this is a subtle shift
from SFAC No 2’s emphasis on making a difference in decisions. Predictive
and confirmatory values determine relevance.
Information that is faithfully represented is complete, neutral, and free from
error. When reporting financial information, the FASB recommends a 3-step
process: (1) identification of the economic phenomenon, (2) determination of
the most relevant information and that it can be faithfully represented, and
(3) determination of the information’s availability and that it can be faithfully
represented. Note that in SFAC No 2’s hierarchy, verifiability was closely
associated with representational faithfulness, but is now one of four
“enhancing qualitative characteristics.”

SFAC NO. 8
The new framework groups comparability, verifiability, timeliness, and
understandability as enhancing qualitative characteristics. This
result simplifies the framework while improving the usefulness of
information that is relevant and faithfully represented. The boards
considered other concepts (e.g., true and fair view, transparency,
quality) for inclusion in the framework, but determined they were
not qualitative characteristics.
Perhaps the key document in the series is SFAC No. 8, the replacement
of SFAC No. 2. The principal qualitative characteristics are now
relevance and faithful representation. The pervasive constraint that
benefits should exceed their costs is an economic consideration
affecting FASB’s neutrality when setting standards.
The eight SFACs that comprise the conceptual framework were
completed between 1978 and 2010. The document is an
evolutionary one because the objectives were rooted in the
Trueblood Report and the qualitative characteristics that stemmed
from ASOBAT via APB Statement 4.

Accounting theory

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Accounting theory