Conceptual Framework u By the end of this class you should be familiar with …. u Activities of the firm u Major items in the Balance sheet and Income Statement (SFAC 6) u Qualitative characteristics of Accounting (SFAC 2) u Measurement and Recognition (SFAC 5) u Present Value and Cash Flow (SFAC 7)

Three Main Activities of a Firm u Financing –for example: Sale of stock –Sale of Bonds –Bank borrowing u Investing –for example:Purchase of Property, Plant and Equipment –Purchase of equity of debt securities u Operating –For example: Sale of goods and services –Purchases of inventory and services –Receipt of cash and payment of cash –How are these activities reflected in a set of financial statements

Balance Sheet u Assets = Liabilities + Owner’s Equity Also note: u Point in time - A snapshot u B/S Classifications

Elements of Financial Statements –SFAC 6 Assets u probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events u Three characteristics: – probable future benefit that in involves capacity, singly or in combination contribute future net cash flows – entity obtains any benefit and controls access to it – transaction has already occurred. Eg. Donations, Purchase, writing a contract, down payment, goodwill Observe asset can be acquired at no cost, may not be tangible, exchangeable, or legally enforceable but they are still assets if they satisfy the three characteristics

Elements of Financial Statements –SFAC 6 Liabilities u Probable and measurable future sacrifices of economic benefits arising from present obligations as a result of past transactions or events u Risk u Three characteristics: –Present duty or responsibility that entails settlement by probable future transfer or use of assets –Entity has little or no discretion to avoid future sacrifice –Transaction has already happened –Eg, loans, warranty, deferred tax, pension –Is identity of the person the entity is obligated to necessary to be a liability?

Elements of Financial Statements –SFAC 6 Owner’s Equity u Assets minus liabilities u captures the owner’s residual interest in the company u Two main accounts: –Contributed capital »Preferred Stock »Common Stock »Additional Paid-in-Capital –Retained Earnings

Remaining elements of Financial Statements-SFAC 6 u Investment by owners u Distribution by owners u Revenues u Gains u Expenses u Losses u Comprehensive Income – change in equity other investment by or distribution to owners

Recognition and Measurement Concept- SFAC 5 u Recognition-has to meet the following criteria –Definition – is an element per SFAC 6 –Measurability –Relevance –Reliability u Measurement – two choices –Choice of unit of measurement –Choice of an attribute to measure »Historical cost »Current cost – exit or replacement value »Net realizable value –mkt sec »Present value

Conceptual Underpinnings of F/S – Qualitative Characteristics u The general assumptions underlying financial statements u Basic measurement issues and how we deal with them u Accounting choices - –Good choice example »Because it fairly represents the firm’s unique operating activities –Bad choice example »Because it increases the earnings on which the bonus is paid

Assumptions Underlying U.S. Financial statements u Economic Entity –Determines the boundaries of the entity –Economic vs legal ownership: consolidated financial statements –Example:Minority Interest u Going Concern –Enterprise will continue to exist indefinitely provides basis for accrual accounting

Four Assumptions Underlying U.S. F/S u Economic Entity u Going Concern u Periodicity-Fiscal Period –Arbitrary time periods-usually one year- ensures timeliness of reporting »Con - loss in reliability –Home Depot’s Feb 2, year end u Monetary unit-Stable Dollar –Stable purchasing power –Problems of high inflation- Brazil –Note: not in IASC standards

Qualitative Characteristics u Reliability –Verifiability »Usefulness of Historical Cost »Form over Substance »Loss in relevance –Representational Faithfulness –Neutrality u Relevance –information capable of making a difference in decision making »Estimates –Predictive Value –Feedback value –Timeliness

Qualitative Characteristics- Secondary u Consistency –consistent application of accounting methods over time u Comparability –Cross-sectional by firms

Four Basic Principles u Historical cost –forms the basis of most elements of financial statements u However, to varying degrees all four measures of current cost, present value and net realizable value are used eg. –lower of cost or market –asset impairment u In highly inflationary economies the trade off of relevance and reliability often leads to greater use of non- historical cost measurements

Four Basic Principles - contd u Revenue Recognition –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

Four Basic Principles - contd u Matching Principle –Expenses must be matched against revenues earned in the period u Full disclosure- Footnotes

Constraints u Cost effectiveness –Benefits exceed costs u Materiality –judgment based u Conservatism –when in doubt, record in least favorably way for the company »International accounting standards refer to this as Prudence and specifically indicate that the concept should not be viewed as a license to create “hidden reserves” u Industry practices

SFAC #7 – Using Cash Flow Information and Present Value in Accounting Measurements u Statement provides a framework for using future cash flows as a basis for measuring an asset or a liability u Statement is limited to measurement issues and does not address recognition questions

Take-Home Points u Assumptions underlying the F/S –Economic Entity –Going Concern –Fiscal Period –Stable Dollar u Basic Principles –Reliability –Relevance –Matching –Revenue Recognition –Conservatism