Wiley - Chapter 2: Conceptual Framework Underlying Financial Accounting

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Chapter 2-1 The Need for a Conceptual Framework To develop a coherent set of standards and rules To solve new and emerging practical problems Conceptual Framework Conceptual Framework

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Intermediate Accounting, 13th Edition,Donald E. Kieso, Jerry J. Weygandt, Terry D. Warfield

Transcript of Wiley - Chapter 2: Conceptual Framework Underlying Financial Accounting

Page 1: Wiley - Chapter 2: Conceptual Framework Underlying Financial Accounting

Chapter 2-1

The Need for a Conceptual Framework

To develop a coherent set of standards and rules

To solve new and emerging practical problems

Conceptual FrameworkConceptual FrameworkConceptual FrameworkConceptual Framework

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The FASB has issued seven Statements of Financial Accounting Concepts (SFAC) for business enterprises.

Development of Conceptual Development of Conceptual FrameworkFramework

Development of Conceptual Development of Conceptual FrameworkFramework

SFAC No.1 -Objectives of Financial Reporting.

SFAC No.2 - Qualitative Characteristics of Accounting Information.

SFAC No.3 - Elements of Financial Statements.

SFAC No.5 -Recognition and Measurement in Financial Statements.

SFAC No.6 - Elements of Financial Statements (replaces SFAC No. 3).

SFAC No.7 -Using Cash Flow Information and Present Value in Accounting Measurements.

SFAC No.8 - The Objective of General Purpose Financial Reporting and Qualitative Characteristics of Useful Financial Information (replaces SFAC No. 1 and No. 2)

LO 2

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The Framework is comprised of three levels:

First Level = Basic Objectives

Second Level = Qualitative Characteristics and Basic Elements

Third Level = Recognition, Measurement, and Disclosure Concepts.

Conceptual FrameworkConceptual FrameworkConceptual FrameworkConceptual Framework

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Financial reporting should provide information that: Financial reporting should provide information that: Financial reporting should provide information that: Financial reporting should provide information that:

(a) is useful to present and potential investors and (a) is useful to present and potential investors and creditors in making decisions about providing creditors in making decisions about providing resources to the reporting entity. resources to the reporting entity.

(a) is useful to present and potential investors and (a) is useful to present and potential investors and creditors in making decisions about providing creditors in making decisions about providing resources to the reporting entity. resources to the reporting entity.

(b) help existing and potential investors, lenders, and (b) help existing and potential investors, lenders, and other creditors assess the prospects for future net other creditors assess the prospects for future net cash inflows to an entitycash inflows to an entity

(b) help existing and potential investors, lenders, and (b) help existing and potential investors, lenders, and other creditors assess the prospects for future net other creditors assess the prospects for future net cash inflows to an entitycash inflows to an entity

(c) portrays the economic resources of an enterprise, the (c) portrays the economic resources of an enterprise, the claims to those resources, and the effects of claims to those resources, and the effects of transactions, events, and circumstances that change transactions, events, and circumstances that change its resources and claims to those resources. its resources and claims to those resources.

(c) portrays the economic resources of an enterprise, the (c) portrays the economic resources of an enterprise, the claims to those resources, and the effects of claims to those resources, and the effects of transactions, events, and circumstances that change transactions, events, and circumstances that change its resources and claims to those resources. its resources and claims to those resources.

First Level: Basic ObjectivesFirst Level: Basic ObjectivesFirst Level: Basic ObjectivesFirst Level: Basic Objectives

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Financial reporting should provide information that: Financial reporting should provide information that: Financial reporting should provide information that: Financial reporting should provide information that:

(d) Provide information on the stewardship role of (d) Provide information on the stewardship role of management and the governing board.management and the governing board.

(d) Provide information on the stewardship role of (d) Provide information on the stewardship role of management and the governing board.management and the governing board.

(e) portray circumstances that change its resources for (e) portray circumstances that change its resources for reasons other than financial performance (e.g. reasons other than financial performance (e.g. additional ownership shares)additional ownership shares)

(e) portray circumstances that change its resources for (e) portray circumstances that change its resources for reasons other than financial performance (e.g. reasons other than financial performance (e.g. additional ownership shares)additional ownership shares)

First Level: Basic ObjectivesFirst Level: Basic ObjectivesFirst Level: Basic ObjectivesFirst Level: Basic Objectives

It’s also stated that: It’s also stated that: It’s also stated that: It’s also stated that:

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Qualitative Characteristics

“The FASB identified the Qualitative Characteristics of accounting information that distinguish better (more useful) information from inferior (less useful) information for decision-making purposes.”

Second Level: Fundamental Second Level: Fundamental ConceptsConcepts

Second Level: Fundamental Second Level: Fundamental ConceptsConcepts

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Second Level: Qualitative Second Level: Qualitative CharacteristicsCharacteristics

Second Level: Qualitative Second Level: Qualitative CharacteristicsCharacteristics

Fundamental (Primary) Qualities:

Relevance – making a difference in a decision.

Predictive valueConfirmatory (Feedback) value

Faithful RepresentationComplete - includes all information necessary for a user to understand the phenomenon being depictedNeutral - free of biasFree from error - in the description, and the selection and application of process used to produce the reported information

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Second Level: Qualitative Second Level: Qualitative CharacteristicsCharacteristics

Second Level: Qualitative Second Level: Qualitative CharacteristicsCharacteristics

Primary Qualities:

Materialityan item is material if its inclusion or omission would influence decisions that users make based upon the financial information.

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Second Level: Qualitative Second Level: Qualitative CharacteristicsCharacteristics

Second Level: Qualitative Second Level: Qualitative CharacteristicsCharacteristics

Enhancing (Secondary) Qualities:

Comparability – Information that is measured and reported in a similar manner for different companies or the same company across time is considered comparable.

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Second Level: Qualitative Second Level: Qualitative CharacteristicsCharacteristics

Second Level: Qualitative Second Level: Qualitative CharacteristicsCharacteristics

Enhancing (Secondary) Qualities:

Verifiability - different knowledgeable and independent observers could reach consensus that a particular depiction is a faithful representation

Timeliness - having information available to decision makers in time to be capable of influencing their decisions.

Understandability – Classifying, characterizing, and presenting information clearly and concisely.

(assumes a reasonable knowledge of business and economic activities and diligent analysis)

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Process of applying the Fundamental Qualitative Characteristics1. Identify an economic phenomenon that could be useful to users.

2. Identify the type of information about that phenomenon that would be most relevant.

3. Determine whether that information is available and can be faithfully represented.

4. If available, application is complete. If not, repeat process with next most relevant type of information.

Second Level: Qualitative Second Level: Qualitative CharacteristicsCharacteristics

Second Level: Qualitative Second Level: Qualitative CharacteristicsCharacteristics

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Investment by Investment by ownersowners

Distribution to Distribution to ownersowners

Comprehensive Comprehensive incomeincome

RevenueRevenue

ExpensesExpenses

GainsGains

LossesLosses

Second Level: ElementsSecond Level: ElementsSecond Level: ElementsSecond Level: Elements

Concepts Statement No. 6 defines ten interrelated elements that relate to measuring the performance and financial status of a business enterprise.

AssetsAssets

LiabilitiesLiabilities

EquityEquity

“Moment in Time” “Period of Time”

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Third Level: Recognition and Third Level: Recognition and MeasurementMeasurement

Third Level: Recognition and Third Level: Recognition and MeasurementMeasurement

The FASB sets forth most of these concepts in its Statement of Financial Accounting Concepts No. 5, “Recognition and Measurement in Financial Statements of Business Enterprises.”

ASSUMPTIONSASSUMPTIONS

1.1. Economic entityEconomic entity

2.2. Going concernGoing concern

3.3. Monetary unitMonetary unit

4.4. PeriodicityPeriodicity

PRINCIPLESPRINCIPLES

1.1. MeasurementMeasurement

2.2. Revenue recognitionRevenue recognition

3.3. Expense recognitionExpense recognition

4.4. Full disclosureFull disclosure

CONSTRAINTSCONSTRAINTS

1.1. Cost-benefitCost-benefit

2.2. MaterialityMateriality

3.3. Industry practiceIndustry practice

4.4. ConservatismConservatism

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Economic Entity – company keeps its activity separate from its owners and other businesses.

- Economic vs legal ownership: consolidated financial statements

Going Concern - company to last long enough to fulfill objectives and commitments.

Monetary Unit - money is the common denominator.

- Dollar is considered as stable across time

Periodicity - company can divide its economic activities into time periods.

Third Level: AssumptionsThird Level: AssumptionsThird Level: AssumptionsThird Level: Assumptions

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Measurement – The most commonly used measurements are based on historical cost and fair value.

Historical cost– the price, established by the exchange transaction, is the “cost”.

provides a reliable benchmark for measuring historical trends.

FASB issued SFAS 157 & 159 related to Fair Value Measurements

Reporting of fair value information is increasing.

Maybe more relevant

Third Level: PrinciplesThird Level: PrinciplesThird Level: PrinciplesThird Level: Principles

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Revenue Recognition - generally occurs (1) when realized or realizable and (2) when earned.

More detailed criteria

The earnings process is complete or essentially complete.

The amount of revenue can be objectively measured

The major portion of costs has been incurred, and the remaining is reasonably estimable

Cash collection is reasonably assured

Third Level: PrinciplesThird Level: PrinciplesThird Level: PrinciplesThird Level: Principles

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Expense Recognition - “Let the expense follow the revenues.”

Third Level: PrinciplesThird Level: PrinciplesThird Level: PrinciplesThird Level: Principles

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Full Disclosure – providing information that is of sufficient importance to influence the judgment and decisions of an informed user.

Provided through:

Financial Statements

Notes to the Financial Statements

Supplementary information

Third Level: PrinciplesThird Level: PrinciplesThird Level: PrinciplesThird Level: Principles

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Cost Benefit – the cost of providing the information must be weighed against the benefits that can be derived from using it.

Materiality - an item is material if its inclusion or omission would influence decisions that users make based upon the financial information.

Industry Practice - the peculiar nature of some industries and business concerns sometimes requires departure from basic accounting theory.

Conservatism – when in doubt, choose the solution that will be least likely to overstate assets and income.

Third Level: ConstraintsThird Level: ConstraintsThird Level: ConstraintsThird Level: Constraints

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The existing conceptual frameworks underlying U.S. GAAP and iGAAP are very similar. (Especially after SFAC No. 8). Differences:

IASB elevates conceptual framework to iGAAP

Element descriptions are different under IFRS than U.S. GAAP

Name changes: Ex. Prudence replaces conservatism.

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See Exercise 2-4, CA 2-7See Exercise 2-4, CA 2-7See Exercise 2-4, CA 2-7See Exercise 2-4, CA 2-7

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CA 2-7CA 2-7CA 2-7CA 2-7