Question

Assume that the FASB is considering revising an important accounting standard.

Required:

1. what constraint applies to the FASB's consideration of whether to require companies to provide new imformation?

2. In what concepts statement is that constraint discussed?

3. What are some of the possible costs that could result from a revision of an accounting standard?

what does the FASB do in order to assess possible benefits and costs of a proposed revision of an accounting standard?

Answer 1

Ans 1)

The constraints of accounting refer to the limitations to providing financial information. Financial reporting must follow generally accepted accounting principles, or GAAP. The constraints of accounting permit certain variations from the basic accounting principles in reporting a company's financial information. Such variations are not considered a violation of the GAAP because of the recognized constraints of accounting.

Costs and Benefits

One major constraint of accounting is the costs of providing financial information. Financial reporting is not cost free because companies must spend time and money to collect, process, analyze and disseminate relevant information. In deciding what to include in a financial reporting, companies must weigh the costs of providing particular information against the benefits that can be derived from using the information. Therefore, companies may not require particular accounting measurements or disclosures if the costs of implementing them exceed the benefits accrued to users of the information.

Materiality

While the cost-benefit constraint of accounting may limit the scope of the financial information provided in an effort to control reporting costs, the materiality constraint allows companies to omit certain information that is immaterial and won't have an impact or influence on information users. In other words, companies must include all information that has a material impact on their overall financial performance. Companies determine the materiality of information based on its relative size and importance. When the amount involved is relatively small or the nature of the information at issue is unimportant, companies may resort to the materiality constraint not to report the information.

Industry Practices

While cost-benefit and materiality are the two overriding accounting constraints, industry practices are a less dominant constraint but also part of the reporting environment. Particular industry practices in financial reporting may cause departure from basic accounting standards for companies in certain industries. For example, contrary to recording asset value at historical cost as required by GAAP, companies in the agricultural business may report corps at their market value because it's difficult to estimate original corps cost. The constraint of industry practices allows companies to deviate from some prescribed reporting standards on certain financial information.

Conservatism

Similar to industry practices, conservatism is another less prevalent accounting constraint but should be observed in financial reporting when applicable. Conservatism means that when in doubt about how to report an accounting issue, choose the method that least likely overstates assets and income or understates liabilities and losses. Sometimes companies may find difficult situations in which simply following GAAP may not yield the best reporting results. For example, GAAP doesn't require the accrual of losses on a likely future purchase of inventories, but if the planned purchase is a firm commitment, it's conservative to accrue the losses now from any future price increases.

Ans 2)  

THE COST-BENEFIT ANALYSIS INTEGRATED THROUGHOUT THE FASB’S STANDARD-SETTING PROCESS

In order to make better decisions about whether, when, and where to allocate investment capital, high-quality financial reporting is a prerequisite. Since 1973, the Financial Accounting Standards Board (FASB) has worked to strengthen U.S. capital markets by setting accounting standards that provide investors with the information they need for decision–making.

FASB standards, known collectively as nongovernmental Generally Accepted Accounting Principles or GAAP, are essential to the efficient functioning of the U.S. economy. Investors, creditors, donors, and other users of financial reports require credible, transparent, comparable, and unbiased financial information. As an independent setter of accounting standards, FASB is focused on the needs of financial statement users for neutral information and fair presentation: FASB is not attempting to influence behavior or to achieve a particular outcome.

Financial reporting comes at a cost—the cost to prepare, provide, and audit the information. For that reason, projects are only added to the FASB’s agenda when current financial reporting information is not portraying an objective and complete reflection of the underlying economics. Furthermore, an associated principle guiding the FASB is to issue standards only when the expected improvement in the quality of the information provided to users—the benefit—justifies the cost of preparing and providing that information. The FASB strives to improve financial reporting in the most cost–effective manner.

HOW DOES THE FASB GATHER INFORMATION ABOUT POTENTIAL COSTS AND BENEFITS OF STANDARDS?

An independent standard-setting process is critical to producing high-quality accounting standards, because it relies on the collective judgment of experts, and it is informed by the input of all interested parties through a thorough and deliberative process. The FASB sets accounting standards through processes that are open and allow for extensive input from all stakeholders. These stakeholders represent a broad range of capital market participants, including investors, analysts, donors to nonprofit organizations, financial statement preparers, auditors, academics, and other interested parties.

Throughout the stages of a project, the FASB’s procedures, which are called “due process,” are specifically designed to generate feedback about costs and benefits of a proposed new standard. Stakeholders are asked about the most faithful way to portray a transaction or economic phenomenon, as well as the most cost-effective ways to implement any changes. Before being implemented, every proposal is exposed for public commentary and discussed with numerous informed stakeholders. Technical decisions by the Board are made in public meetings after careful consideration of the input from stakeholders. The chart below illustrates the many elements that play into the Board’s decision-making process.

Should The Constraint On Variable Consideration Be Applied At The Contract Level Or Performance Obligation Level?

Contract level. In its 2020 Q&A, the Financial Accounting Standards Board (FASB) addressed whether the magnitude of a potential reversal should be assessed at the level of the performance obligation or at the level of the contract. While the standard does not specifically address this issue, the Basis for Conclusions paragraph 234 clearly states that the unit of account for determining the transaction price in a contract is the contract (ASU 2014-09). As the constraint is primarily a transaction price issue, the FASB agreed that the contract should be seen as the unit of account for the constraint as well (FASB, Question 30). In other words, when considering the magnitude of a potential reversal of variable consideration, the assessment should be based on the total consideration of the whole contract, not just on amounts specific to the variable consideration or to the specific performance obligation.

Can The Most Likely Amount And Expected Value Approaches Be Used In The Same Contract?

While the two approaches should not be applied simultaneously to the same source of variable consideration within a contract (or aggregate group of similar contracts), they may be applied separately to different sources of variable consideration within the same contract (BC202). For example, if a contract includes both a bonus for early completion of a project (which scales with the number of days ahead of schedule) and a quality bonus if a project exceeds certain specifications, a company may use the expected value approach for the early completion bonus and the most likely approach for the quality bonus.

Is Consideration Variable If The Price Per Unit Is Fixed But The Units Are Variable?

In its 2020 Q&A, the FASB addresses the issue of whether variable consideration is present if a contract includes an undefined quantity of outputs, but the price is fixed (FASB, Question 41). For example, assume a transaction processor charges $0.001 per processed transaction but does not have a fixed quantity of transactions that must be processed. The staff cited the following statement from ASC 606-10-32-6: “The promised consideration also can vary if an entity’s entitlement to the consideration is contingent on the occurrence or nonoccurrence of a future event.” With this in mind, the staff concluded that the transaction price would be variable if the nature of the promise is to perform an unknown quantity of tasks throughout the contract period and the consideration is contingent on the quantity completed.

How Did The FASB Decide On The Constraint?

In the Basis for Conclusions of Accounting Standards Update (ASU) 2014-09, the FASB indicates that the constraint was strongly influenced by the large number of respondents to Exposure Drafts who indicated that the most useful revenue figure would be one that would not reverse in a future period. The FASB noted that the constraint introduces a definite downward bias into revenue numbers. However, it felt this treatment was appropriate in trying to avoid significant reversals of revenue, making the revenue numbers more useful (BC206-BC207). However, while the FASB and respondents did not wish to include revenue likely to reverse, not including variable consideration in transactions prices could seriously understate revenues, which would still lead to reporting less relevant and useful data. This interplay led to the constraint.

Specifying a level of confidence (i.e., use of the language “probable” [US Generally Accepted Accounting Principles (GAAP)] and “highly probable” [International Financial Reporting Standards (IFRS)]) also received significant attention from the FASB. While the staff initially considered not specifying a level of confidence at all, preparers and auditors indicated that constraining estimates would be very difficult and would result in a great deal of diversity in practice if no guidance were given on the necessary level of confidence. Thus, the criterion of meeting a level of confidence is intended to facilitate preparation and reduce diversity in practice. The specific level of confidence to be used was also discussed, and the FASB decided to use wording already present and defined in other standards for clarity.

Conclusion

Estimating variable consideration requires significant judgment by preparers and auditors. ASC 606 requires companies to include variable consideration in the transaction price of each contract only to the extent that it is not probable that a significant reversal of revenue will occur for that amount. Companies are required to determine both the likelihood and the magnitude of potential reversals to correctly determine what amounts should be constrained. The constraint requires the most judgment when variable amounts are near the “probable” threshold.

Ans 3)

COST–BENEFIT DIFFERS FROM AN ANALYSIS OF ECONOMIC CONSEQUENCES

The economic consequences of a new financial reporting standard are separate and distinct from an analysis of costs and benefits relating to the adoption of a new standard. The role of financial reporting is not to deter-mine or influence what capital allocation decisions should be made or what actions should be taken by management. Rather, the role of financial reporting is to promote decisions that are well-informed and to provide investors information they need to make those decisions. The FASB’s objective in developing accounting standards is to show a complete and unbiased picture of a company’s financial position and performance. Better information (which could be favorable or unfavorable for a particular organization) is expected to change capital allocation decisions, but the Board does not try to influence the outcome of those decisions.