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Chapter 2 Conceptual Frameworks. Provide the structure for building a set of coherent accounting standards. Levels: “Why” - Provides objectives of financial reporting

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chapter 2 conceptual frameworks
Chapter 2Conceptual Frameworks
  • Provide the structure for building a set of coherent accounting standards.
  • Levels:
      • “Why” - Provides objectives of financial reporting
      • “Bridges levels 1 and 3” - Defines qualitative characteristics of accounting information and the elements of financial statements
      • “How/implementation” - Explains recognition and measurement criteria
  • US and IFRS similar, but are not exactly the same
  • Convergence project underway, not yet approved
level 1 objectives of financial reporting
Per SFAC 1-2, 4-7

Provide information that is useful to those making investment & credit decisions.

Helpful to present and potential investors, creditor and other users in assessing the amounts, timing and uncertainty of future cash flows; and

About economic resources, the claims to those resources and the changes in them.

Per IASB Framework (April 1989)

The objective of f/s’s is to provide information about the financial position, performance and changes in financial position of an entity that is useful to a wide range of users in making economic decisions.

Users are present & potential investors, employees, lenders, suppliers & other trade creditors, customers, gov’ts & their agencies & the general public.

Level 1: Objectives of Financial Reporting

US GAAP

IFRS

level 2 qualitative characteristics
Primary characteristics

Relevance

Predictive value

Feedback value

Timeliness

Reliability

Verifiability

Representational faithfulness

Neutrality

Secondary Characteristics

Comparability

Consistency

Understandability

Relevance

Predictive value

Confirmatory value

Materiality

Reliability

Faithful representation

Substance over form

Neutrality

Prudence

Completeness

Comparability

Level 2: Qualitative Characteristics

US GAAP

IFRS

relevance and reliability tradeoff example
Example: Suppose a biotech firm spends $1,000,000 on research and development expenditures. How could the firm record the expenditures?

CR Cash

DR Expense?

DR R&D Asset?

For each alternative consider:

What is the relevance/reliability tradeoff?

How can the treatment be theoretically supported?

Does US or IFRS allow?

Relevance and Reliability – Tradeoff Example
level 2 qualitative characteristics con t
Constraints

Cost/Benefit

Materiality

Industry Practices

Conservatism

Constraints on relevant & reliable info

Timeliness

Balance between benefit and cost

Balance between qualitative characteristics

Level 2: Qualitative Characteristics con’t

US GAAP

IFRS

how to cheat with conservatism
Scumbag Corp. pays a bonus to the CFO of $10,000 if the company earns net income over $1 million in any given year.

Draft f/s for 2004 show net income of $1.5 million dollars

However, the CFO argues that slowing sales indicate that inventory may be overvalued, and advocates the following journal entry:

Dr. Cost of Goods Sold (overvalued goods) 400,000

Cr. Inventory 400,000

What would this entry do? Cause COGS to be 400K lower in following year

Sometimes this practice is called the “cookie jar”

What if projected net income in 2005 was $800,000 (before this journal entry was made)?

How to Cheat with Conservatism
level 2 elements of financial statements
Assets

Liabilities

Equity

Investment by Owners

Distributions to Owners

Comprehensive Income

Revenues

Expenses

Gains

Losses

Asset

Liabilities

Equity

Income

Expenses

Capital Maintenance

result from revaluation of assets and liabilities

Level 2: Elements of Financial Statements

US GAAP

IFRS

slide10

Element Definitions

(a) Arises from peripheral or incidental transactions.

(b) Obligation to transfer resources arising from a past transaction.

(c) Increases ownership interest.

(d) Declares and pays cash dividends to owners.

(e) Increases in net assets in a period from nonowner sources.

(f) Items characterized by future economic benefit.

(g) Equals increase in net assets during the year, after adding distributions to owners and subtracting investments by owners.

(h) Arises from income statement activities that constitute the entity’s ongoing major or central operations.

(i) Residual interest in the net assets of the enterprise.

(j) Increases assets through sale of product.

(k) Decreases assets by purchasing the company’s own stock.

  • Changes in equity during the period, except those from investments by owners and distributions to owners.
level 3 basic assumptions principles
Assumptions

Economic Entity

Going concern

Monetary Unit

Periodicity

Principles

Measurement

Historical Cost

Fair value

Revenue Recognition

Expense Recognition

Full disclosure

Underlying Assumptions

Accrual Basis

Going concern

Principles

Measurement

Historical cost

Current cost

Realizable value

Fair value

Revenue Recognition

Expense Recognition

Full disclosure

Level 3: Basic Assumptions, Principles

US GAAP

IFRS

level 3 principles
Measurement: Consider this example under US GAAP and IFRS.

If a firm bought land in 1950 for $10K and still owned it in 2009, would it appear on the 2009 financial statements at $10K even if it is now worth $1 million?

How is your answer justified by the conceptual framework?

Level 3: Principles
level 3 principles13
Revenue Recognition – Criteria

Earned – seller substantially completed what it must do to be entitled to keep resources received from the transaction.

Realized or realizable –buyer provided resources or resources to be received are readily convertible to some other asset.

Revenue is generally at the point of sale. Exceptions:

During production – long term construction contracts (% Completion Method)

(2) End of production – when ready market at quoted price exists (mining and agriculture)

(3) Upon receipt of cash – when collections uncertain at time of sale (Installment sales method)

Level 3: Principles
level 3 principles14
Matching

Idea: Record expense in same period as the revenue it helped generate.

To do:

Determine revenue recognition

Choices to match expenses

Direct (COGS)

Rational allocation (rent)

Immediate

Level 3: Principles
level 3 principles15
Full Disclosure –Nature and amount of information included in financial reports reflects a series of judgmental trade-offs (between providing sufficient detail and keeping information understandable).

Financial statements

Notes to financial statements

Supplementary information

Level 3: Principles
professional ethics and principles based accounting
Readings:

“Study Pursuant to Section 108(d) of the Sarbanes-Oxley Act of 2002 on…Principles-Based Accounting System”

Kapnick (1974) and Wyatt (2004)

Questions:

What is meant by principles vs. rules based accounting?

Why did Congress want this examined?

What are the benefits and concerns with principles based accounting?

Are judgment and professional ethics more or less important under principles based accounting?

Professional Ethics and Principles Based Accounting
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