chapter 2: the conceptual framework

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Chapter 2: The Chapter 2: The Conceptual Framework Conceptual Framework

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Page 1: Chapter 2: The Conceptual Framework

Chapter 2: The Chapter 2: The Conceptual FrameworkConceptual Framework

Page 2: Chapter 2: The Conceptual Framework

• Coherent system– Interrelated

• Objectives AND• Fundamentals

– Can lead to consistent standards– Prescribes for financial accounting &

FS • Nature• Function• Limits

• FASB began developing in 1976

Definition of Conceptual Definition of Conceptual FrameworkFramework

Page 3: Chapter 2: The Conceptual Framework

• Foundation for building a set of coherent accounting standards & rules

• Reference of basic accounting theory for solving emerging practical problems of financial reporting (more quickly)

Objectives of the Objectives of the Conceptual FrameworkConceptual Framework

Page 4: Chapter 2: The Conceptual Framework

• The FASB has issued seven Statements of Financial Accounting Concepts (SFACs)– Set forth major recognition & reporting

issues– Statement 4 pertains to reporting by

non-business entities• NFPs

– Other 6 statements pertain to reporting by business enterprises

Statements of Financial Statements of Financial Accounting ConceptsAccounting Concepts

Page 5: Chapter 2: The Conceptual Framework

• Statement 1

• Statement 2

• Statement 6

• Statement 4

• Statement 5

• Statement 7

• Objectives of Financial Reporting - Business

• Qualitative Characteristics

• Elements of Financial Statements (replaces 3)

• Objectives of Financial Reporting – Non business

• Recognition & Measurement Criteria

• Using Cash Flows

Brief TitleStatement

Statements of Financial Statements of Financial Accounting ConceptsAccounting Concepts

Page 6: Chapter 2: The Conceptual Framework

•Three different levels– First level = objectives

• Why – goals & purposes

– Second level = explains financial elements & characteristics of information• Bridges why & how

– Third level = incorporates recognition & measurement criteria• How – implementation of the framework

Overview of the Overview of the Conceptual FrameworkConceptual Framework

Page 7: Chapter 2: The Conceptual Framework

Conceptual Framework Conceptual Framework for Financial Reportingfor Financial Reporting

Page 8: Chapter 2: The Conceptual Framework

To provide information:• About economic resources, claims on

resources & changes in them• To individuals who reasonably

understand business & economic activities

• That is useful to – Those making investment & credit

decisions– Present & future investors, creditors in

assessing future cash flows

Basic Objectives of Basic Objectives of Financial ReportingFinancial Reporting

Page 9: Chapter 2: The Conceptual Framework

Hierarchy of Accounting Hierarchy of Accounting QualitiesQualities

Page 10: Chapter 2: The Conceptual Framework

• Overriding = understandability– Quality of info affects user decisions

• Primary qualities– Relevance– Reliability

• Secondary qualities – Comparability– Consistency

Qualitative Qualitative Characteristics of Characteristics of

Accounting InformationAccounting Information

Page 11: Chapter 2: The Conceptual Framework

• Relevance of information– “Information c capable of making a

difference in a decision context”

• Ingredients of relevant information are:• Timeliness• Predictive value• Feedback value

Primary Characteristic of Primary Characteristic of Accounting Information: Accounting Information:

RelevanceRelevance

Page 12: Chapter 2: The Conceptual Framework

• Information is reliable when it can be relied on to represent the true, underlying situation

• The ingredients of reliable information are:– Verifiability– Representational faithfulness– Neutrality (unbiased)

Primary Characteristic of Primary Characteristic of Accounting Information: Accounting Information:

ReliabilityReliability

Page 13: Chapter 2: The Conceptual Framework

• Neutrality in standard setting– Increasing attacks

• Don’t issue if cause undesirable economic effects– Accounting for goodwill

– Alternate view• Biased FS are not credible

Primary Characteristic of Primary Characteristic of Accounting Information: Accounting Information:

ReliabilityReliability

Page 14: Chapter 2: The Conceptual Framework

• Comparability– Similar measurement & reporting for different

enterprises

• Consistency– Application of same accounting treatment to

similar events by an enterprise period to period• Role of auditor, audit committee & SOX

Secondary Characteristics Secondary Characteristics of Accounting Informationof Accounting Information

Page 15: Chapter 2: The Conceptual Framework

• Moment in time– Assets– Liabilities– Equity– Investment by

Owners– Distributions to

Owners

• Period of time– Comprehensiv

e Income– Revenues– Expenses– Gains– Losses

Basic Elements of Basic Elements of Financial Statements Financial Statements

(SFAC #6)(SFAC #6)

ARTICULATION

Key figures in one correspond to balances in another!!!

Page 16: Chapter 2: The Conceptual Framework

BasicAssumptions

1. Economic entity 2. Going concern 3. Monetary

unit4. Periodicity

Principles

1. Historical cost

2. Revenue recognition

3. Matching4. Full

disclosure

Constraints

1. Cost benefit2. Materiality3. Industry

practices4. Conservatism

Recognition and Recognition and Measurement CriteriaMeasurement Criteria

Page 17: Chapter 2: The Conceptual Framework

• Activity identified with particular unit of accountability– Does not mean legal entity (parent &

subs)

• Recent reactions– FIN 46 & variable interest entities– Related party transactions

Basic AssumptionsBasic AssumptionsEconomic EntityEconomic Entity

Page 18: Chapter 2: The Conceptual Framework

• Long lived business– Bedrock for

• Historical cost principle• Depreciation & amortization

• Only inapplicable if liquidation imminent

Basic AssumptionsBasic AssumptionsGoing ConcernGoing Concern

Page 19: Chapter 2: The Conceptual Framework

• Money = common denominator of economic activity– Relevant– Simple– Universally available– Understandable– Useful

• Quantitative data is useful

Basic AssumptionsBasic AssumptionsMonetary UnitMonetary Unit

Page 20: Chapter 2: The Conceptual Framework

• Apprise users on timely basis– Quicker – more subject to error– Apparent tradeoff between relevance &

reliability today

• Economic activities divided into artificial time periods– Shorter period – more difficult to

determine income

Basic AssumptionsBasic AssumptionsPeriodicityPeriodicity

Page 21: Chapter 2: The Conceptual Framework

• Cost a reliable valuation technique• Suggested alternatives

– Fair value• At acquisition, cost = FV• Some amounts reported at FV

– Replacement cost– PV of future cash flows

Basic PrinciplesBasic PrinciplesHistorical CostHistorical Cost

Page 22: Chapter 2: The Conceptual Framework

• When– Realized

• Exchanged for cash/claims to cash

– Realizable• Assets readily convertible to cash/claims to cash

– Earned• All accomplished to be entitled to benefits

• Time of sale = uniform & reasonable

Basic PrinciplesBasic PrinciplesRevenue Recognition Revenue Recognition

Page 23: Chapter 2: The Conceptual Framework

• Exceptions to time of sale– During production

• LT construction contracts

– End of production• Mining, agriculture

– Upon receipt of cash• Installment sales

Basic PrinciplesBasic PrinciplesRevenue Recognition Revenue Recognition

Page 24: Chapter 2: The Conceptual Framework

• Match efforts & accomplishments– When reasonable & practicable

• Product costs = charge product– Carry to future if revenue recognized in

future• DM, DL, OH

• Period costs = charge currently– No direct relationship of cost & revenue

• Admin salaries & expenses

Basic PrinciplesBasic PrinciplesMatchingMatching

Page 25: Chapter 2: The Conceptual Framework

• Provide info– Of sufficient importance– To influence judgment & decisions– Of informed user

• Sufficient detail vs. condensed to be understandable

Basic PrinciplesBasic PrinciplesFull DisclosureFull Disclosure

Page 26: Chapter 2: The Conceptual Framework

• Financial statements– Formal & structured communication

device– Basic element criteria

• Measurable with sufficient certainty• Relevant• Reliable

Basic PrinciplesBasic PrinciplesFull DisclosureFull Disclosure

Page 27: Chapter 2: The Conceptual Framework

• Notes to FS– Amplify/explain FS items– Info does not need to be

• Quantifiable• Qualify as an element

• Supplemental info– Different perspective than FS– MD&A

Basic PrinciplesBasic PrinciplesFull DisclosureFull Disclosure

Page 28: Chapter 2: The Conceptual Framework

• Costs & benefits - not always evident or measurable

• Limiting reporting costs– Exclude info outside management expertise– Don’t require info that will harm competitive position– No forecasts required– Only info management knows (O/T FS)– Present elements only if users & management agree

they should be reported– No forward looking info required

ConstraintsConstraintsCost-BenefitCost-Benefit

Page 29: Chapter 2: The Conceptual Framework

• Item impact on overall financial operations– Must make a difference to decision maker– Separate & aggregate impacts

• Relative size & importance– Significant to other A, L, R, E, & NI– General rule – >5% NI– Consider qualitative & quantitative factors

• Internal & external parameters

ConstraintsConstraintsMaterialityMateriality

Page 30: Chapter 2: The Conceptual Framework

• Due to peculiar nature of industry– Public utilities– Agriculture

• Use ONLY if no related GAAP

ConstraintsConstraintsIndustry PracticesIndustry Practices

Page 31: Chapter 2: The Conceptual Framework

• Solution to LEAST LIKELY overstate assets & income– Does not mean UNDERSTATE

• GAAP examples– LOCOM– Accrued loss on purchase commitments

ConstraintsConstraintsConservatism Conservatism

Page 32: Chapter 2: The Conceptual Framework

• ExercisesE2-2 E2-3 E2-4E2-6 E2-7 E2-8

• CasesC2-6 C2-10

• Weyerhaeuser (page 58)

Exercises & CasesExercises & Cases