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Chapter 2

Chapter 2. Conceptual Framework Underlying Financial Accounting. Conceptual Framework. Coherent set of principles to establish accounting standards; solve new problems. FASB established conceptual framework beginning with 1976 Discussion Memorandum. Level 1: objectives of financial reporting.

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Chapter 2

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  1. Chapter 2 Conceptual Framework Underlying Financial Accounting

  2. Conceptual Framework • Coherent set of principles to establish accounting standards; solve new problems. • FASB established conceptual framework beginning with 1976 Discussion Memorandum. • Level 1: objectives of financial reporting. • Level 2: qualitative characteristics; elements. • Level 3: recognition & measurement.

  3. Statements of Financial Accounting Concepts (SFACs) • SFAC No.1 - Objectives of Financial Reporting • SFAC No.2 - Qualitative Characteristics of Accounting Information • SFAC No.3 - Elements of Financial Statements (superseded by SFAC No. 6) • SFAC No.4 - Nonbusiness Organizations • SFAC No.5 - Recognition and Measurement in Financial Statements • SFAC No.6 - Elements of Financial Statements (replaces SFAC No. 3) • SFAC No.7 - Using Cash Flow Information and Present Value in Accounting Measurements

  4. Objectives • Financial reporting should provide information that: • is useful to present and potential investors and creditors and other users in making rational investment, credit, and similar decisions. • helps present and potential investors and creditors and other users in assessing the amounts, timing, and uncertainty of prospective cash receipts. • portrays the economic resources of an enterprise, the claims to those resources, and the effects of transactions, events, and circumstances that change its resources and claims to those resources.

  5. Qualitative Characteristics • Distinguish better (more useful) information from inferior (less useful) information for decision-making purposes.

  6. Primary Qualities • Relevance– making a difference in a decision. • Predictive value • Feedback value • Timeliness • Reliability • Verifiable • Representational faithfulness • Neutral - free of error and bias

  7. Secondary Qualities • Comparability– Information that is measured and reported in a similar manner for different companies is considered comparable. • Consistency - When a company applies the same accounting treatment to similar events from period to period.

  8. Elements • Concepts Statement No. 6defines ten interrelated elements that relate to measuring the performance and financial status of a business enterprise. • Moments in Time: Assets: probable future economic benefits Liabilities: probable future sacrifices Equity: residual interest

  9. Elements: Periods of Time • Investment by owners • Distribution to owners • Comprehensive income • Revenue • Expenses • Gains • Losses

  10. Assumptions • Economic Entity– company keeps its activity separate from its owners and other businesses. • Going Concern - company to last long enough to fulfill objectives and commitments. • Monetary Unit - money is the common denominator. • Periodicity - company can divide its economic activities into time periods.

  11. Principles of Accounting • Historical cost (primary focus since 1940s; conceptual framework suggests importance of fair value) • Revenue recognition • Matching (consistent with historical cost) • Full disclosure (related to transparency)

  12. Historical Cost • The price, established by the exchange transaction, is the “cost”. • Issues: • Historical cost provides a reliable benchmark for measuring historical trends. • Fair value information may be more useful. • FASB issued SFAS 15X, “Fair Value Measurements (2005).” • Reporting of fair value information is increasing.

  13. Revenue Recognition • Revenue Recognition - generally occurs (1) when realized or realizable and (2) when earned. • Exceptions: • During Production. • At End of Production • Upon Receipt of Cash

  14. Matching • - efforts (expenses) should be matched with accomplishment (revenues) whenever it is reasonable and practicable to do so. “Let the expense follow the revenues.” • Product costs • Period costs (e.g., marketing, administrative costs)

  15. Full Disclosure • Full Disclosure – providing information that is of sufficient importance to influence the judgment and decisions of an informed user. • Provided through: • Financial Statements • Notes to the Financial Statements • Supplementary Information

  16. Constraints • Cost Benefit– the cost of providing the information must be weighed against the benefits that can be derived from using it. • Materiality - an item is material if its inclusion or omission would influence or change the judgment of a reasonable person. • Industry Practice - the peculiar nature of some industries and business concerns sometimes requires departure from basic accounting theory. • Conservatism – when in doubt, choose the solution that will be least likely to overstate assets and income.

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