chapter 1 conceptual framework underlying financial accounting

Chapter 1

Conceptual Framework Conceptual Framework Underlying Financial AccountingUnderlying Financial Accounting

1. Explain the FASB conceptual framework.

2. Understand the relationship among the objectives of financial reporting.

3. Identify the general objective of financial reporting.

4. Describe the three specific objectives of financial reporting.

ContinuedContinuedContinuedContinued

5. Discuss the types of useful information for investment and credit decision making.

6. Explain the qualities of useful accounting information.

7. Understand the accounting assumptions and conventions that influence GAAP.

8. Define the elements of financial statements.

How do we determine the amount of

information to

supply in general-purpose financial statements?

In what format? Under what assumptions, principles, and

constraints?

The FASB’s Conceptual FrameworkThe FASB’s Conceptual FrameworkThe FASB’s Conceptual FrameworkThe FASB’s Conceptual Framework

To guide the FASB in establishing accounting standards.

To provide a frame of reference for resolving accounting questions in situations where a standard does not exist.

To determine the bounds for judgment in the preparation of financial statements.

To increase users’ understanding of and confidence in financial reporting.

To enhance comparability.


The FASB’a role is to . . .◦ Establish consensus on topical accounting issues.◦ Interpret accounting principles.◦ Keep accounting practice as standardized as

possible.


Accounting standards should be consistent with the framework.

New problems can be effectively resolved with reference to the framework.

User can benefit from a more comprehensive understanding of the accounting information in financial statements.


To develop a conceptual

framework of accounting theory.

To establish standards (GAAP)

for financial accounting practices.

General ObjectiveProvide information that is

useful to present and potential investors, creditors, and other

users in making rational investment, credit, and similar

decisions.

Objectives of Financial Reporting by Business Enterprises

Target audience . . .◦ External users of financial information◦ Have a reasonable understanding of business and

economic activities and are willing to study the information

SFAC No. 1SFAC No. 1SFAC No. 1SFAC No. 1

Provide information that . . .◦ Is useful in making rational investment, credit and

other related decisions.◦ Helps assess the amount, timing and uncertainty

of future cash flows.◦ Is accurate in reporting the economic resources of

the business.◦ Provide information about a company’s

comprehensive income and its components.

SFAC No. 1SFAC No. 1Financial Reporting ObjectivesFinancial Reporting Objectives

SFAC No. 1SFAC No. 1Financial Reporting ObjectivesFinancial Reporting Objectives

Financial Reports

Return on Investment

Risk

Financial Flexibility

Liquidity

Operating Capability

•Buy•Hold• Sell

• Extend Credit

• Continue Credit

• Deny Credit

Communication Documents

Types of Useful Information External Decision Making

Primary Decision-Specific QualitiesPrimary Decision-Specific Qualities

RelevanceRelevance ReliabilityReliability

Accounting Information

Benefits>CostsBenefits>Costs

UnderstandabilityUnderstandability

Decision Usefulness

Pervasive Pervasive ConstraintConstraint

Pervasive Pervasive ConstraintConstraint


User-User-Specific Specific QualityQuality

User-User-Specific Specific QualityQuality

Overall Overall QualityQuality

Overall Overall QualityQuality

Ingredients of Primary QualitiesIngredients of Primary Qualities

RelevanceRelevance ReliabilityReliability

Predictive Value

Predictive Value

Feedback Value

Timeli-ness

Verifi-ability

Representa-tional

faithfulness

Neu-trality

Secondary and

Interactive Qualities

MaterialityMateriality

Comparability (including Consistency

Threshold for

Recognition

Threshold for

Recognition

Accounting information is relevant if it can make a difference in a decision.

Accounting information is relevant if it can make a difference in a decision.


Qualitative Characteristics of Accounting Information

Primary Quality . . . Relevance.1. Timeliness

2. Predictive value

3. Feedback value


Accounting information is reliable when it is reasonably free from error and bias, and faithfully represents what it

is intended to represent.

Accounting information is reliable when it is reasonably free from error and bias, and faithfully represents what it

is intended to represent.



Primary Quality . . . Reliability.1. Representational faithfulness

2. Verifiability

3. Neutrality



Secondary QualitiesComparability and Consistency


Comparability of accounting information enables users to

identify and explain similarities and differences between two or

more sets of economic facts.

Comparability of accounting information enables users to

identify and explain similarities and differences between two or

more sets of economic facts.


Recognition and Measurement in Financial Statements of Business Enterprises

1. Recognition criteria

2. Measurement criteria

3. Environmental assumptions

4. Implementation principles

5. Implementation constraints

6. General-purpose financial statements


Recognition is the process of formally recording and reporting an item in the financial statements of a

company.

Recognition is the process of formally recording and reporting an item in the financial statements of a

company.


Definition

Measurability

Relevance

Reliability

SFAC No. 3SFAC No. 3Recognition CriteriaRecognition Criteria

SFAC No. 3SFAC No. 3Recognition CriteriaRecognition Criteria

Continued use of different attributes (historical cost, current cost, market value, etc.).

All monetary measurement based on nominal units of money.

SFAC No. 4SFAC No. 4Measurement CriteriaMeasurement Criteria

SFAC No. 4SFAC No. 4Measurement CriteriaMeasurement Criteria

Separate entity assumption

Continuity assumption

Unit-of-measure assumption

Time period assumption

SFAC No. 4SFAC No. 4Environmental AssumptionsEnvironmental Assumptions


EntityEntity

The entity assumption assumes that a proprietorship, partnership, or

corporation’s financial activities are distinguished from other financial organizations in keeping its own financial records and reports.

The entity assumption assumes that a proprietorship, partnership, or

corporation’s financial activities are distinguished from other financial organizations in keeping its own financial records and reports.



ContinuityContinuity

This assumption assumes that the company will continue to

operate in the near future, unless substantial evidence to

the contrary exists. This assumption is also known as the

going-concern assumption.

This assumption assumes that the company will continue to

operate in the near future, unless substantial evidence to

the contrary exists. This assumption is also known as the

going-concern assumption.



Period of TimePeriod of Time

In accordance with the period-of-time assumption, a company prepares

financial statements at the end of each year and includes them its annual

report. The period-of-time assumption is the basis for the adjusting entry

process at period-end.

In accordance with the period-of-time assumption, a company prepares

financial statements at the end of each year and includes them its annual

report. The period-of-time assumption is the basis for the adjusting entry

process at period-end.



Monetary UnitMonetary Unit

This assumption states that there must be some basis for measuring exchange of goods

or services. Currently the dollar is considered to be a stable monetary unit for preparing a

company’s financial statements.

This assumption states that there must be some basis for measuring exchange of goods

or services. Currently the dollar is considered to be a stable monetary unit for preparing a

company’s financial statements.

The FASB encourages companies to prepare supplemental disclosures about the impact of

changing prices.

The FASB encourages companies to prepare supplemental disclosures about the impact of

changing prices.



Cost principle

Realization principle

Matching concept

Full disclosure principle

SFAC No. 4SFAC No. 4Implementation PrinciplesImplementation Principles


Market Value

$13,500

Market Value

$13,500Cost

$16,000

Cost$16,000

Replacement Cost

$13,000

Replacement Cost

$13,000

Historical CostHistorical Cost

Usually, the exchange price is retained in the accounting records as the value of an item until it is removed from the records.

Usually, the exchange price is retained in the accounting records as the value of an item until it is removed from the records.



Historical CostHistorical Cost

Which amount Which amount should be used?should be used?Which amount Which amount should be used?should be used?

Cost$16,000

Cost$16,000

SFAC No.4SFAC No.4Implementation PrinciplesImplementation Principles

SFAC No.4SFAC No.4Implementation PrinciplesImplementation Principles

Realization is the process of converting noncash resources and rights into cash or rights to cash.

Realization is the process of converting noncash resources and rights into cash or rights to cash.



Realization principle: Two conditions must be met if therevenue principle is to be satisfied.

ReasonableAssurance of

Collection

SubstantialCompletion of

Earning Process



Accrual accounting is the process of relating the financial effects of

transactions, events, and circumstances having cash consequences to the period in which they occur rather than to when the

cash receipt or payment occurs.




Matching PincipleMatching Pinciple









The matching principle states that to determine the income of a company for

an accounting period, the company computes the total expense involved in

obtaining the revenues of the period and relates these total expenses to the total revenues recorded in the period.

The matching principle states that to determine the income of a company for

an accounting period, the company computes the total expense involved in

obtaining the revenues of the period and relates these total expenses to the total revenues recorded in the period.

Matching PrincipleMatching Principle



•Parenthetical Comments

•Disclosure Notes

•Supplemental Financial Statements

•Parenthetical Comments

•Disclosure Notes

•Supplemental Financial Statements

Full Disclosure PrincipleFull Disclosure Principle



Cost-benefit constraint

Materiality constraint

Conservatism constraint

Industrial peculiarities

SFAC No. 5SFAC No. 5Implementation ConstraintsImplementation Constraints


Are benefits greater

than costs?

Cost-benefit Constraint



The nature of the item. The relative size rather

than absolute size of an item.

The nature of the item. The relative size rather

than absolute size of an item.

Materiality



The conservatism convention states that when alternative accounting valuations are

equally possible, the accountant should select the one that is least likely to overstate

assets and income in the current period.

The conservatism convention states that when alternative accounting valuations are

equally possible, the accountant should select the one that is least likely to overstate

assets and income in the current period.

Conservatism



1. Statement of Financial Position (Balance Sheet)

2. Earnings (Income Statement)

3. Cash Flows (Statement of Cash Flows)

4. Investment by and Distributions to Owners (Statement of Changes in Equity)

General-Purpose Financial StatementsGeneral-Purpose Financial StatementsGeneral-Purpose Financial StatementsGeneral-Purpose Financial Statements

Elements of Financial Statements of Business Enterprises

Defines 10 elements of financial statements:◦ Revenues, Expenses, Gains, Losses, Assets,

Liabilities, Equity, Investment by owners, Distributions to owners and Comprehensive income.

All

10


A balance sheet is a financial statement that

summarizes the financial position of a company on

a particular date.

A balance sheet is a financial statement that

summarizes the financial position of a company on

a particular date.

It also is called a statement of

financial position.

It also is called a statement of

financial position.

Assets are the probable future economic benefits obtained and controlled by a company as a result of past transactions or events.

Liabilities are the probable future sacrifices of economic benefits arising from present obligations of a company to transfer assets or provide services in the future as a result of past transactions or events.

Equity is the owners’ residual interest in the net assets of a company.

Elements of a balance sheet:

An income statement is a financial statement that

summarizes the results of a company’s operations.

An income statement is a financial statement that

summarizes the results of a company’s operations.

Revenues are inflows or other enhancements of assets of a company or settlement of its liabilities during a period from delivering or producing goods, rendering services, or other activities that are the company’s ongoing major operation. Revenues increase the equity of a company.


The elements of the income statement are:

Expenses are outflows or other using up of

assets of a company or incurrences of liabilities

during a period from delivering or producing

goods, rendering services, or carrying out other

activities that are the company’s ongoing major

operation. Expenses decrease the equity of a

company.



Gains Gains are increases in the equity of a company

from peripheral or incidental transactions and

from all other transactions and other events and

circumstances affecting the company, except

those that result from revenues or investments

by owners. Gains increase the equity of a

company.



Losses Losses are decreases in the equity of a company,

from peripheral or incidental transactions except

those that result from expenses or distribution to

owners. Losses decrease the equity of a

company.


Revenues increase the equity of the

company

Expenses decrease the equity of the

company

A statement of changes in equity summarizes the changes in a company’s

equity for a period.

A statement of changes in equity summarizes the changes in a company’s

equity for a period.

Investments by owners are increases in equity resulting from transfers of something valuable to the company from other entities in order to obtain or increase ownership interest.

Distribution to owners are decreases in equity of a company caused by transferring assets, rendering services, or incurring liabilities to owners.

A statement of changes in equity contains two elements:

Comprehensive income includes all changes in equity during a

period except those resulting form investments by owners and

distributions to owners.

Comprehensive income includes all changes in equity during a

period except those resulting form investments by owners and

distributions to owners.

1. Financial and nonfinancial data.

2. Management’s analysis of the financial and nonfinancial data.

3. Forward-looking information.

4. Information about management and shareholders.

5. Background about the company.

Framework of the Model

Chapter1

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chapter 1 conceptual framework underlying financial accounting

Documents

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financial accounting

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financial reporting

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accounting standards

accounting assumptions