1 Financial Reporting: Its Conceptual Framework Financial Reporting: Its Conceptual Framework C...

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Financial Reporting:

Its Conceptual Framework

Financial Reporting:

Its Conceptual Framework

Chapter2

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Explain the FASB conceptual framework. Understand the relationship among the

objectives of financial reporting. Identify the general objective of financial

reporting. Describe the three specific objectives of

financial reporting.

ObjectivesObjectives

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

Explain the qualities of useful accounting information.

Understand the accounting assumptions and conventions that influence GAAP.

Define the elements of financial statements.

ObjectivesObjectives

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Charges Given to the FASBCharges Given to the FASB

To develop a conceptual

framework of accounting theory.

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Charges Given to the FASBCharges Given to the FASB

To establish standards (GAAP)

for financial accounting practices.

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FASB Conceptual FrameworkFASB 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.

• 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.

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Relationship of Conceptual Framework and Standard-Setting Process


Conceptual Framework

Objectives and ConceptsObjectives and ConceptsTerms

Identify goals and Identify goals and purpose of accountingpurpose of accounting

Guide the selection of events to Guide the selection of events to be accounted for, the be accounted for, the

measurement of these events, and measurement of these events, and the means of summarizing and the means of summarizing and communicating the information communicating the information

to external users,to external users,

Purpose

Statements of Financial Statements of Financial Accounting ConceptsAccounting Concepts

Documents

to standard setting

to standard setting

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Standard Setting

Statements of Financial Accounting Standards

Standards

Establish methods and procedures for measuring,

summarizing, and communicating financial accounting information to

external users.

From conceptual framework

From conceptual framework

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Conceptual Framework Projects for Financial Accounting and ReportingConceptual Framework Projects for Financial Accounting and Reporting

Objective Objective ProjectProject

Accounting Accounting ProjectsProjects

Reporting Reporting ProjectsProjects

continued continued continued

Qualitative Characteristics Qualitative Characteristics ProjectProject

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Conceptual Framework Projects for Financial Accounting and ReportingConceptual Framework Projects for Financial Accounting and Reporting

Accounting Accounting ProjectsProjects

Reporting Reporting ProjectsProjects

Qualitative Characteristics Qualitative Characteristics ProjectProject

Elements

Recognition

Measurement

Financial Statements and Financial

Reporting

Income

Cash Flow and Liquidity

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Objectives of Financial ReportingObjectives of Financial Reporting

Provide information that is useful to present and potential investors, creditors, and other

users in making rational investment, credit, and similar

decisions.

General Objective

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Provide information that is useful to present and potential investors

creditors, and other users in assessing the amounts, timing, and

uncertainty of prospective cash receipts from dividends and interest,

and the proceeds from the sale, redemption, or maturity of securities

or loans.

Derived External User Objective

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Provide information to help investors, creditors, and others in

assessing the amounts, timing, and uncertainty of prospective

net cash inflows to related company.

Derived Company Objective

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Specific Objectives

Provide information about a company’s economic resources, obligations, and owners’ equity.

Provide information about a company’s economic resources, obligations, and owners’ equity.

Provide information about a company’s comprehensive income and its components.

Provide information about a company’s comprehensive income and its components.

Provide information about a company’s

cash flows.

Provide information about a company’s

cash flows.

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Other IssuesOther Issues

First, financial reporting should provide information about how the management of a company has discharged its stewardship

responsibility.

First, financial reporting should provide information about how the management of a company has discharged its stewardship

responsibility.

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Second, financial statements and other means of financial

reporting should include explanations and interpretations

by management to help external users.

Second, financial statements and other means of financial

reporting should include explanations and interpretations

by management to help external users.

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Third, the FASB made no decision concerning the

qualitative characteristics that accounting information should possess in order to be included

in financial reports.

Third, the FASB made no decision concerning the

qualitative characteristics that accounting information should possess in order to be included

in financial reports.

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Objectives in Other CountriesObjectives in Other Countries

German accounting principles are affected by

legal and income tax requirements. German accounting emphasizes

information for creditors and has a conservative

balance sheet orientation.

German accounting principles are affected by

legal and income tax requirements. German accounting emphasizes

information for creditors and has a conservative

balance sheet orientation. German

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Swedish companies use “income smoothing” in their financial statements to make profits seem uniform from

year to year. Some consider such income smoothing to

contribute to economic stability.

Swedish companies use “income smoothing” in their financial statements to make profits seem uniform from

year to year. Some consider such income smoothing to

contribute to economic stability.

Sweden

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In France, accounting rules In France, accounting rules essentially are controlled by essentially are controlled by law and are influenced by law and are influenced by

income tax rules. The income tax rules. The French legal system makes French legal system makes the officers of a company the officers of a company

personally responsible, to a personally responsible, to a great extent, for the great extent, for the

consequences of business consequences of business bankruptcy.bankruptcy.

In France, accounting rules In France, accounting rules essentially are controlled by essentially are controlled by law and are influenced by law and are influenced by

income tax rules. The income tax rules. The French legal system makes French legal system makes the officers of a company the officers of a company

personally responsible, to a personally responsible, to a great extent, for the great extent, for the

consequences of business consequences of business bankruptcy.bankruptcy.

France

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Interrelationship of Final Reports, Useful Information, and Decision Making

Interrelationship of Final Reports, Useful Information, and Decision Making

Financial Reports

Return on Investment

Risk

Financial Flexibility

Liquidity

Operating Capability

Buy Hold Sell

Extend Continue

Deny (Credit)

Communication Documents

Types of Useful Information

External Decision Making

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RelevanceRelevance RelevanceRelevance

Hierarchy of Qualitative CharacteristicsHierarchy of Qualitative Characteristics

Accounting Information

Benefits>CostsBenefits>Costs

Understandability

Decision Usefulness

Pervasive Pervasive ConstraintConstraint

Pervasive Pervasive ConstraintConstraint

User-User-Specific Specific QualityQuality

User-User-Specific Specific QualityQualityOverall Overall QualityQuality

Overall Overall QualityQuality

Primary Decision-Specific QualitiesPrimary Decision-Specific Qualities

Continued next slide

Continued next slide

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Ingredients of Primary QualitiesIngredients of Primary Qualities

RelevanceRelevance RelevanceRelevance


Predictive Value

Feedback Value

Timeli-ness

Verifi-ability

Representa-tional

faithfulness

Neu-trality

Secondary Secondary and and

Interactive Interactive QualitiesQualities

MaterialityMateriality

Comparability (including Consistency

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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.

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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.

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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.

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Constraints to the HierarchyConstraints to the Hierarchy

Are benefits greater

than costs?

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• 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.

Constraints to the HierarchyConstraints to the Hierarchy

Materiality

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Assumptions and ConventionsAssumptions and Conventions

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.

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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.

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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.

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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.

Cost$16,000

Cost$16,000

Replacement Cost

$13,000

Replacement Cost

$13,000

Market Value

$13,500

Market Value

$13,500

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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

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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 The FASB encourages companies to prepare companies to prepare

supplemental disclosures about supplemental disclosures about the impact of changing prices.the impact of changing prices.

The FASB encourages The FASB encourages companies to prepare companies to prepare

supplemental disclosures about supplemental disclosures about the impact of changing prices.the impact of changing prices.

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Realization and RecognitionRealization and Recognition

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

rights to cash. Recognition is the process of formally recording and reporting an item in

the financial statements of a company.

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

rights to cash. Recognition is the process of formally recording and reporting an item in

the financial statements of a company.

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Matching and Accrual AccountingMatching and Accrual Accounting

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.

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.

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.

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ConservatismConservatism

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.

Click here to review assumptions and conventions (C2-2)

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Balance SheetBalance Sheet

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.

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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.

Balance SheetBalance SheetElements of a balance sheet:

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Income StatementIncome Statement

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.

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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.

Expenses are outflows or other using up of assets of a company or incurrences of liabilities during a period that are the company’s ongoing major operation.


The elements of the income statement are:

Continued on next slideContinued on next slide

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Gains are increases in equity from peripheral or incidental transactions of a company and from all other transactions and other events and circumstances affecting the company, except those that result from revenues or investments by owners.

Losses are decreases in equity from peripheral or incidental transactions of a company, except those that result from expenses or distribution to owners.


The elements of the income statement are:

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Revenues increase the equity of the

company

Expenses decrease the equity of the

company

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Statement of Cash FlowsStatement of Cash Flows

A statement of cash flows summarizes the cash

inflows and outflows of a company for a period.

A statement of cash flows summarizes the cash

inflows and outflows of a company for a period.

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Operating cash flows are the flows of cash from acquiring, selling, and delivering goods for sale, as well as providing services.

Investing cash flows are the flows of cash from acquiring and selling investments, property, plant, and equipment, as well as from lending money and collecting on loans.

Financing cash flows are the flows of cash to and from the owners and long-term creditors.

Statement of Cash FlowsStatement of Cash FlowsThe elements of a statement of cash flows are:

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Statement of Changes in EquityStatement of Changes in Equity

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.

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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.

Statement of Changes in EquityStatement of Changes in EquityA statement of changes in equity contains two elements:

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Business ReportingBusiness Reporting

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

nonfinancial data. Forward-looking information. Information about management and

shareholders. Background about the company.

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

nonfinancial data. Forward-looking information. Information about management and

shareholders. Background about the company.

Framework of the Model

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Chapter2

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C 2-2: Identify the assumption or convention


The business, rather than its owners, is the reporting unit.

EntityEntity

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Depreciation costs are expensed in the periods of use rather than at the time the asset is acquired.

MatchingMatching

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Accounting measurements are reported in dollars.

Monetary unitMonetary unit

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The year is the normal reporting unit.

Period of timePeriod of time

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In the absence of evidence to the contrary, the business will operate long enough to carry out its existing commitments.

ContinuityContinuity

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Revenue is usually recognized at the time of sale.

RealizationRealization

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Exchange price is retained in the accounting records.

Historical costHistorical cost

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An accounting alternative is selected that is least likely to overstate assets and income.

ConservatismConservatism

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