Intermediate Financial Accounting I
Conceptual Framework Underlying Financial
Reporting
Environment and Theoretical Structure of Financial Accounting 2
Objectives of the Chapters (contd.)
Study the Conceptual framework underlying financial reports.
Environment and Theoretical Structure of Financial Accounting 3
Conceptual Framework of Financial Reporting What does the current accounting
standard setting authority rely on to prescribe the accounting standards?
Conceptual Framework of Financial Reporting: A system of interactive objectives and fundamentals which can lead to a set of consistent standards in preparing financial reports.
Environment and Theoretical Structure of Financial Accounting 4
Financial Reporting: A Theoretical StructureA Conceptual Framework for Financial Reporting
Assumptions•Entity•Going-Concern
•Monetary unit•Periodicity
Constraints•Cost/Benefit•Industry Practices
Objectives
Qualitative Characteristic of Accounting
InformationElements (SFAC No. 6)
Recognition and Measurement Concepts
Principles•Cost & Fair Value Option•Revenue•Matching•Full Disclosure
SFAC No. 8, Ch. 1
SFAC No. 8, Ch.3
SFAC No.5
First Level
Second Level
Third level
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Environment and Theoretical Structure of Financial Accounting 5
SFAC No. 8 - Chapter 1 (Level One of The Conceptual Framework) The objective of general-purpose
financial reporting:
Providing useful financial information of the reporting entity to existing and potential investors, lenders, and other creditors in making decisions regarding providing resources to the entity.
Environment and Theoretical Structure of Financial Accounting 6
SFAC No. 8 –Chapter 1 (cont.)(Level One of The Conceptual Framework) Those decisions involve buying, selling,
or holding equity and debt instruments and providing or settling loans and other forms of credit.
Environment and Theoretical Structure of Financial Accounting 7
SFAC No. 8 – Chapter 3 (Level Two of The Framework) Qualitative (Characteristics of Accounting Information)
I. Fundamental Qualities
1) Relevancea) Predictive valueb) Confirmatory valuec) Materiality
2) Faithful Representation
a) Completeness
b) Neutral
c) Free from error
Environment and Theoretical Structure of Financial Accounting 8
SFAC No. 8 (contd.)
II. Enhancing Qualitative Characteristics
1) Comparability(including consistency)
2) Verifiability
3) Timeliness
4) Understandability
Environment and Theoretical Structure of Financial Accounting 9
Materiality (make a difference on decision) Materiality judgment should be made in the
context of the nature and the amount of the item. Item.
The rule of thumb of materiality: any item which is less than 5% of net income is immaterial.
Environment and Theoretical Structure of Financial Accounting 10
Environment and Theoretical Structure of Financial Accounting 11
SFAC No. 5 (Level Three of The Conceptual Framework) Measurement and Recognition Concepts
I.Assumptions
1) Economic Entity
2) Going-concern (continuity)
3) Monetary unit
4) Periodicity (Period of time)
Environment and Theoretical Structure of Financial Accounting 12
SFAC No. 5 (contd.)II. Principles
1) Historical cost principle and fair value option
2) Revenue recognition 3) Matching/Expense Recognition4) Full Disclosure (i.e., footnote
disclosure)
III. Constraints1) Cost-Benefit2) Industry Practices
The Move Toward Fair Value
SFAS No. 157 establishes a framework for measuring fair values.
SFAS No. 159 gives companies the option to report some or all of their financial assets and liabilities at fair value.
Environment and Theoretical Structure of Financial Accounting 13
The Balance Sheet and Financial Disclosures 14
Fair Value Hierarchy (SFAS 157)
Level 1 (most reliable) measures are based on quoted prices for identical instruments in active markets.
Level 2 measures are based on quoted prices for similar instruments in active markets.
Level 3 (least reliable) measures are based on unobservable inputs such as company’s data or assumptions.
The Balance Sheet and Financial Disclosures 15
Fair Value Measurements Disclosure : Footnote 28 of GE 2008 Annual Report
Level 1 Level 2 Level 3 Fin. 39 Netting
Net Bal.
Assets
Investment Securities $1,158 $27,332 $12,956 ___ $41,446
Derivatives ___ 18,911 1,142 (7,411) 12,642
Others 1 288 1,105 ____ 1,394
total $1,159 $46,531 15,203 $(7,411) $55,482
Liabilities
Derivatives $ 2
$12,643 $ 166 $(7,575) $ 5,236
Other ____ 1,031 ____ ____ 1,031
Total $ 2 $13,674 $ 166 $(7,575) $6,267
Income Measurement And Profit Analysis 16
Revenue Recognition Principle (SFAS No. 5) (-An Accrual Basis) Revenue is recognized when it is earned and
realized or realizable (SFAC 5, par. 83). Earned : the entity has substantially accomplished
what it must do to be entitled to compensation. Realized: goods are exchanged for cash or claims. Realizable: assets received as compensation are
readily convertible into cash or claims to cash (i.e., measurable).
In general, these conditions are met at time of sale (delivery) or when services are rendered (SFAC 5, par. 84).
.
Income Measurement And Profit Analysis 17
Revenue Recognition Principle Other conditions for revenue
recognition (Staff Accounting Bulletin No. 101(1999)):
Persuasive evidence of a sale. Price is fixed or determinable. Collectibility is reasonably assured. Delivery has occurred or services
have been rendered.
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Expense Recognition (Matching) Principle – An Accrual Basis
If revenues are recognized in a period, all related expenses should be recognized in the same period.
The related expenses include:
Traceable costs: The contribution of these costs (i.e., product cots) can be traced to specific revenues, and therefore, are expensed when revenues (i.e., sales revenue) are recognized.
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Expense Recognition (Matching) Principle – An Accrual Basis
Period costs: The contribution of these costs cannot be traced easily to specific revenues , and therefore, are expensed when they are consumed or occurred. (e.g. advertising exp., interest and rent exp.)
Allocated (or estimated) costs: Expenses such as depreciation expense, bad debt expense, etc. which contributions to revenues cannot be traced. These expenses are estimated and recognized at the end of a period.
Matching (Expenses with Revenues) Principle Traceable costs (i.e., product costs) vs. non-
traceable costs (i.e., period costs):
Environment and Theoretical Structure of Financial Accounting 20