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

4

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.

18

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.

19

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