Its Conceptual Framework 2 hapter Financial Reporting: Its Conceptual Framework 1 1 1 1

Objectives 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. 2 2 2 4

Objectives 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.

Charges Given to the FASB To develop a conceptual framework of accounting theory.

Charges Given to the FASB To establish standards (GAAP) for financial accounting practices.

FASB 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.

Relationship of Conceptual Framework and Standard-Setting Process Objectives and Concepts Terms to standard setting Identify goals and purpose of accounting Guide the selection of events to be accounted for, the measurement of these events, and the means of summarizing and communicating the information to external users, Purpose Statements of Financial Accounting Concepts Documents

Relationship of Conceptual Framework and Standard-Setting Process From conceptual framework Standards Establish methods and procedures for measuring, summarizing, and communicating financial accounting information to external users. Statements of Financial Accounting Standards From conceptual framework

Conceptual Framework Projects for Financial Accounting and Reporting Objective Project Accounting Projects Reporting Projects Qualitative Characteristics Project continued

Conceptual Framework Projects for Financial Accounting and Reporting Accounting Projects Reporting Projects Qualitative Characteristics Project Elements Recognition Measurement Financial Statements and Financial Reporting Income Cash Flow and Liquidity

Objectives 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

Objectives of Financial Reporting 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

Objectives of Financial Reporting 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

Objectives of Financial Reporting Provide information about a company’s comprehensive income and its components. Provide information about a company’s economic resources, obligations, and owners’ equity. Provide information about a company’s cash flows. Specific Objectives

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

Other Issues Second, financial statements and other means of financial reporting should include explanations and interpretations by management to help external users.

Other Issues Third, the FASB made no decision concerning the qualitative characteristics that accounting information should possess in order to be included in financial reports.

Objectives 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

Objectives in Other Countries 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

Objectives in Other Countries In France, accounting rules essentially are controlled by law and are influenced by income tax rules. The French legal system makes the officers of a company personally responsible, to a great extent, for the consequences of business bankruptcy. France

Interrelationship of Final Reports, Useful Information, and Decision Making Return on Investment Risk Financial Flexibility Liquidity Operating Capability Buy Hold Sell Extend Continue Deny (Credit) Communication Documents Financial Reports External Decision Making Types of Useful Information

Hierarchy of Qualitative Characteristics Accounting Information Benefits>Costs Understandability Pervasive Constraint Decision Usefulness User-Specific Quality Relevance Overall Quality Continued next slide Primary Decision-Specific Qualities

Hierarchy of Qualitative Characteristics Relevance Relevance Comparability (including Consistency Predictive Value Feedback Value Timeli-ness Verifi-ability Representa-tional faithfulness Neu-trality Secondary and Interactive Qualities Ingredients of Primary Qualities Materiality

Hierarchy of Qualitative Characteristics Accounting information is relevant if it can make a difference in a decision.

Hierarchy of Qualitative Characteristics Accounting information is reliable when it is reasonably free from error and bias, and faithfully represents what it is intended to represent.

Hierarchy of Qualitative Characteristics Comparability of accounting information enables users to identify and explain similarities and differences between two or more sets of economic facts.

Constraints to the Hierarchy Are benefits greater than costs?

Constraints to the Hierarchy Materiality The nature of the item. The relative size rather than absolute size of an item.

Assumptions and Conventions Entity 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.

Assumptions and Conventions Continuity 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.

Assumptions and Conventions Period 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.

Assumptions and Conventions Historical Cost Usually, the exchange price is retained in the accounting records as the value of an item until it is removed from the records. Market Value $13,500 Replacement Cost $13,000 Cost $16,000

Assumptions and Conventions Historical Cost Which amount should be used? Cost $16,000

Assumptions and Conventions Monetary 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. The FASB encourages companies to prepare supplemental disclosures about the impact of changing prices.

Assumptions and Conventions Realization 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.

Assumptions and Conventions Matching and Accrual Accounting 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. 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.

Assumptions and Conventions Conservatism 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)

It also is called a statement of financial position. Balance Sheet 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.

Balance Sheet Elements of a balance sheet: 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.

Income Statement An income statement is a financial statement that summarizes the results of a company’s operations.

Continued on next slide Income Statement The elements of the income statement are: 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. Continued on next slide

Income Statement The elements of the income statement are: 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.

Income Statement Expenses decrease the equity of the company Revenues increase the equity of the company

Statement of Cash Flows A statement of cash flows summarizes the cash inflows and outflows of a company for a period.

Statement of Cash Flows The elements of a statement of cash flows are: 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 Changes in Equity A statement of changes in equity summarizes the changes in a company’s equity for a period.

Statement of Changes in Equity A statement of changes in equity contains two elements: 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.

Business Reporting Financial and nonfinancial data. Framework of the Model 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.

C 2 hapter The End

C 2-2: Identify the assumption or convention The business, rather than its owners, is the reporting unit. Entity

C 2-2: Identify the assumption or convention Depreciation costs are expensed in the periods of use rather than at the time the asset is acquired. Matching

C 2-2: Identify the assumption or convention Accounting measurements are reported in dollars. Monetary unit

C 2-2: Identify the assumption or convention The year is the normal reporting unit. Period of time

C 2-2: Identify the assumption or convention In the absence of evidence to the contrary, the business will operate long enough to carry out its existing commitments. Continuity

C 2-2: Identify the assumption or convention Revenue is usually recognized at the time of sale. Realization

C 2-2: Identify the assumption or convention Exchange price is retained in the accounting records. Historical cost

C 2-2: Identify the assumption or convention An accounting alternative is selected that is least likely to overstate assets and income. Conservatism Return to Slide 37