Conceptual Framework Underlying Financial Accounting

Conceptual Framework Underlying Financial Accounting
Chapter 2 Intermediate Accounting 12th Edition Kieso, Weygandt, and Warfield Prepared by Coby Harmon, University of California, Santa Barbara

Chapter 2 Learning Objectives
Describe the usefulness of a conceptual framework. Describe the FASB’s efforts to construct a conceptual framework. Understand the objectives of financial reporting. Identify the qualitative characteristics of accounting information. Define the basic elements of financial statements. Describe the basic assumptions of accounting. Explain the application of the basic principles of accounting. Describe the impact that constraints have on reporting accounting information.

Conceptual Framework Conceptual framework:
First Level: Basic Objectives Second Level: Fundamental Concepts Third Level: Recognition and Measurement Need Development Decision usefulness Information about economic resources Qualitative characteristics Basic elements Basic assumptions Basic principles Constraints The basic concepts underlying the conceptual framework are showing in the slide. Qualitative characteristics: examines the characteristics that make accounting information useful. Basic elements provides definitions if items in financial statements such as assets, etc. Conceptual framework: a coherent system of interrelated objectives and fundamentals that can lead to consistent rules, and that prescribes the nature, function, and limits of financial accounting and financial elements.

Conceptual Framework The Need for a Conceptual Framework
To develop a coherent set of standards and rules To solve new and emerging practical problems To increase financial statements users’ understanding and confidence in financial reporting . Enhance comparability among companies' financial statements . Why do we need a conceptual framework? LO 1 Describe the usefulness of a conceptual framework.

Development of Conceptual Framework
Many organizations developed and published their conceptual framework but no single framework was universal accepted and relied on in practice. In 1976, the FASB began to develop conceptual framework that would be a basis for (1) setting accounting rules and for (2) resolving financial reporting controversies. LO 2 Describe the FASB’s efforts to construct a conceptual framework. Objective 2

True or False (Review):
Conceptual Framework True or False (Review): A conceptual framework underlying financial accounting is important because it can lead to consistent standards and it prescribes the nature, function, and limits of financial accounting and financial statements. LO 1 Describe the usefulness of a conceptual framework.

Conceptual Framework True
Review: A conceptual framework underlying financial accounting is important because it can lead to consistent standards and it prescribes the nature, function, and limits of financial accounting and financial statements. True LO 1 Describe the usefulness of a conceptual framework.

Conceptual Framework Review:
A conceptual framework underlying financial accounting is necessary because future accounting practice problems can be solved by reference to the conceptual framework and a formal standard-setting body will not be necessary. LO 1 Describe the usefulness of a conceptual framework.

Conceptual Framework False
Review: A conceptual framework underlying financial accounting is necessary because future accounting practice problems can be solved by reference to the conceptual framework and a formal standard-setting body will not be necessary. False LO 1 Describe the usefulness of a conceptual framework.

Conceptual Framework The Framework is comprised of three levels:
First Level = Basic Objectives Second Level = Qualitative Characteristics and Basic Elements Third Level = Recognition and Measurement Concepts. Goal and purposes To make accounting information useful Used in applying and publishing accounting standards. these concepts include assumptions, principles and constraints. LO 2 Describe the FASB’s efforts to construct a conceptual framework.

Recognition & measurement
ASSUMPTIONS Economic entity Going concern Monetary unit Periodicity PRINCIPLES Historical cost Revenue recognition Matching Full disclosure CONSTRAINTS Cost-benefit Materiality Industry practice Conservatism Third level Recognition & measurement QUALITATIVE CHARACTERISTICS Relevance Reliability Comparability Consistency ELEMENTS Assets, Liabilities, and Equity Investments by owners Distribution to owners Comprehensive income Revenues and Expenses Gains and Losses Second level: Fundamental concepts Illustration 2-6 Conceptual Framework for Financial Reporting First level: objectives are to provide information that is (1)useful Third level discuss the ways these goals are implemented The second level forms a bridge between why of accounting (objectives) and how of accounting (recognition and measurement) OBJECTIVES 1. Useful in investment and credit decisions 2. Useful in assessing future cash flows 3. About enterprise resources, claims to resources, and changes in them First level LO 2 Describe the FASB’s efforts to construct a conceptual framework.

Review: Conceptual Framework
What are the Statements of Financial Accounting Concepts intended to establish? Generally accepted accounting principles in financial reporting by business enterprises. The meaning of “Present fairly in accordance with generally accepted accounting principles.” The objectives and concepts for use in developing standards of financial accounting and reporting. The hierarchy of sources of generally accepted accounting principles. (CPA adapted) LO 2 Describe the FASB’s efforts to construct a conceptual framework.

First Level: Basic Objectives
Financial reporting should provide information that: (a) is useful to present and potential investors and creditors and other users in making rational investment, credit, and similar decisions. (b) helps present and potential investors and creditors and other users in assessing the amounts, timing, and uncertainty of prospective cash receipts. (c) portrays the economic resources of an enterprise, the claims to those resources, and the effects of transactions, events, and circumstances that change its resources and claims to those resources. LO 3 Understand the objectives of financial reporting.

Review: Conceptual Framework
According to the FASB conceptual framework, the objectives of financial reporting for business enterprises are based on? Generally accepted accounting principles Reporting on management’s stewardship. The need for conservatism. The needs of the users of the information. (CPA adapted) LO 3 Understand the objectives of financial reporting.

Second Level: Fundamental Concepts
Question: How does a company choose an acceptable accounting method, the amount and types of information to disclose, and the format in which to present it? Answer: By determining which alternative provides the most useful information for decision-making purposes (decision usefulness). LO 4 Identify the qualitative characteristics of accounting information.

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.” LO 4 Identify the qualitative characteristics of accounting information.

Second Level: Qualitative Characteristics
Illustration 2-2 Hierarchy of Accounting Qualities LO 4 Identify the qualitative characteristics of accounting information.

Understandability A company may present highly relevant and reliable information, however it was useless to those who do not understand it. LO 4 Identify the qualitative characteristics of accounting information.

Relevance and Reliability
ASSUMPTIONS Economic entity Going concern Monetary unit Periodicity PRINCIPLES Historical cost Revenue recognition Matching Full disclosure CONSTRAINTS Cost-benefit Materiality Industry practice Conservatism Third level Relevance and Reliability QUALITATIVE CHARACTERISTICS Relevance Reliability Comparability Consistency ELEMENTS Assets, Liabilities, and Equity Investments by owners Distribution to owners Comprehensive income Revenues and Expenses Gains and Losses Second level Illustration 2-6 Conceptual Framework for Financial Reporting OBJECTIVES 1. Useful in investment and credit decisions 2. Useful in assessing future cash flows 3. About enterprise resources, claims to resources, and changes in them First level LO 4 Identify the qualitative characteristics of accounting information.

Primary Qualities: Relevance – making a difference in a decision. Predictive value Feedback value Timeliness Reliability Verifiable Representational faithfulness Neutral - free of error and bias Information is relevant when it influences the economic decisions of users. when It helps them to predict outcomes by evaluating past, present or future economic events (Predictive value) or even confirming, or correcting, their past evaluations (feedback value). Relevant info must be available to decision makers before it loses the capacity to influence their decisions. It has timeliness. For information to be relevant, it needs predictive value, feedback value, presented on a timely basis. Verifiability: when independent bodies obtain similar results using the same methods. Representational faithfulness: means that the numbers and descriptions match what is really existed or happened Neutral: means company cannot select information to favor one set of interested parties over another LO 4 Identify the qualitative characteristics of accounting information.

Review: Relevance and reliability are the two primary qualities that make accounting information useful for decision making. To be reliable, accounting information must be capable of making a difference in a decision. LO 4 Identify the qualitative characteristics of accounting information.

Review: Relevance and reliability are the two primary qualities that make accounting information useful for decision making. True To be reliable, accounting information must be capable of making a difference in a decision. False LO 4 Identify the qualitative characteristics of accounting information.

Comparability and Consistency
ASSUMPTIONS Economic entity Going concern Monetary unit Periodicity PRINCIPLES Historical cost Revenue recognition Matching Full disclosure CONSTRAINTS Cost-benefit Materiality Industry practice Conservatism Third level Comparability and Consistency QUALITATIVE CHARACTERISTICS Relevance Reliability Comparability Consistency ELEMENTS Assets, Liabilities, and Equity Investments by owners Distribution to owners Comprehensive income Revenues and Expenses Gains and Losses Second level Illustration 2-6 Conceptual Framework for Financial Reporting OBJECTIVES 1. Useful in investment and credit decisions 2. Useful in assessing future cash flows 3. About enterprise resources, claims to resources, and changes in them First level LO 4 Identify the qualitative characteristics of accounting information.

Secondary Qualities: Comparability – Information that is measured and reported in a similar manner for different companies is considered comparable. Consistency - When a company applies the same accounting treatment to similar events from period to period. The company shows consistent use of accounting standards. Information about a company is more useful if decision makers can compare it with similar information about another company، or about the same company at different points in time. These qualities are comparability and consistency. comparability enables users to identify the real similarities and differences in economic events between companies. Consistency: the idea from consistency does not mean that companies cannot switch from one accounting method to another. A company can change methods but it must demonstrate that the newly adopted method is preferable to the old. If approved, the company must then disclose the nature and effect of the accounting change in the financial statement for the period in which the change is made. Additionally, The auditor refers to the change in the audit report. LO 4 Identify the qualitative characteristics of accounting information.

Review: Adherence to the concept of consistency requires that the same accounting principles be applied to similar transactions for a minimum of five years before any change in principle is adopted. False LO 4 Identify the qualitative characteristics of accounting information.

Elements Illustration 2-6 Conceptual Framework for Financial Reporting
ASSUMPTIONS Economic entity Going concern Monetary unit Periodicity PRINCIPLES Historical cost Revenue recognition Matching Full disclosure CONSTRAINTS Cost-benefit Materiality Industry practice Conservatism Third level Elements QUALITATIVE CHARACTERISTICS Relevance Reliability Comparability Consistency ELEMENTS Assets, Liabilities, and Equity Investments by owners Distribution to owners Comprehensive income Revenues and Expenses Gains and Losses Second level Illustration 2-6 Conceptual Framework for Financial Reporting OBJECTIVES 1. Useful in investment and credit decisions 2. Useful in assessing future cash flows 3. About enterprise resources, claims to resources, and changes in them First level LO 5 Define the basic elements of financial statements.

Second Level: Elements
Concepts Statement No. 6 defines ten interrelated elements that relate to measuring the performance and financial status of a business enterprise (see page 39). “Moment in Time” “Period of Time” Assets Liabilities Equity Investment by owners Distribution to owners Comprehensive income Revenue Expenses Gains Losses Transactions, events & circumstances that affect a company Amounts of Resources and claims to them LO 5 Define the basic elements of financial statements.

Definitions: 1.Assets: Rights or resources controlled by an entity as a result of past transaction or events and from which future economic benefits are expected to flow to the entity . 2.Liability: Obligations to transfer economic benefits as a result of past transactions or events. 3.Equity (ownership interest): Residual interest in the assets of an entity after deducting its liabilities.

4.Investment by owners: Increases in net assets (equity) of a particular enterprise resulting from transfer to it from other entities e.g. receiving services or conversion of liabilities. Assets are most commonly received as investments by owners. 5.Distributions to owners: Decreases in net assets (equity) of a particular enterprise resulting from transferring assets, rendering services or incurring liabilities by the enterprise to owners. 6.Comprehensive income: Change in equity (net assets) of an entity during a period from transactions or other events from non-owner sources. It includes all changes in equity expect those resulting from investments by owners and distributions to owners. 4 & 5 transactions from one side only. 6. Comprehensive income comes from central and incidental activities e.g. revenues, expenses, gains and loss.

7.Revenue: Increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity. It mainly comes from producing & selling goods, rendering services or other activities that constitute the entity’s central operations. 8.Expenses: Decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or increases of liabilities that result in decreases in equity e.g. delivering or producing goods or other activity that constitute the entity’s central operations.

9.Gains: Increases in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions, events and circumstances affecting the entity during a period except those that result from revenue or investments by owners. 10.Losses: Decreases in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions, events and circumstances affecting the entity during a period except those that result from expenses or distribution by owners. *peripheral or incidental transactions such as selling a fixed asset (use in production)، damage or theft. * e.g. when Burger king restaurant sell a land or building

Exercise 2-3 Identify the element or elements associated with items below. Elements (a) Arises from peripheral or incidental transactions. (b) Obligation to transfer resources arising from a past transaction. (c) Increases ownership interest. (d) Declares and pays cash dividends to owners. (e) Increases in net assets in a period from nonowner sources. Assets Liabilities Equity Investment by owners Distribution to owners Comprehensive income Revenue Expenses Gains Losses LO 5 Define the basic elements of financial statements.

Exercise 2-3 Identify the element or elements associated with items below. Elements Assets Liabilities Equity Investment by owners Distribution to owners Comprehensive income Revenue Expenses Gains Losses (f) Items characterized by future economic benefit. (g) Equals increase in net assets during the year, after adding distributions to owners and subtracting investments by owners. (h) Arises from income statement activities that constitute the entity’s ongoing major or central operations. LO 5 Define the basic elements of financial statements.

Exercise 2-3 Identify the element or elements associated with items below. Elements (i) Residual interest in the net assets of the enterprise. (j) Increases assets through sale of product. (k) Decreases assets by purchasing the company’s own stock. (l) Changes in equity during the period, except those from investments by owners and distributions to owners. Assets Liabilities Equity Investment by owners Distribution to owners Comprehensive income Revenue Expenses Gains Losses LO 5 Define the basic elements of financial statements.

Exercise 2-3 Identify the element or elements associated with items below. Elements (a) Arises from peripheral or incidental transactions. (b) Obligation to transfer resources arising from a past transaction. (c) Increases ownership interest. (d) Declares and pays cash dividends to owners. (e) Increases in net assets in a period from non-owner sources. Assets Liabilities Equity Investment by owners Distribution to owners Comprehensive income Revenue Expenses Gains Losses (b) (c) (d) (e) (c) (a) (a) LO 5 Define the basic elements of financial statements.

Exercise 2-3 Identify the element or elements associated with items below. Elements (f) Assets Liabilities Equity Investment by owners Distribution to owners Comprehensive income Revenue Expenses Gains Losses (f) Items characterized by future economic benefit. (g) Equals increase in net assets during the year, after adding distributions to owners and subtracting investments by owners. (h) Arises from income statement activities that constitute the entity’s ongoing major or central operations. (b) (c) (d) (g) (e) (c) (h) (h) (a) (a) LO 5 Define the basic elements of financial statements.

Exercise 2-3 Identify the element or elements associated with items below. Elements (i) Residual interest in the net assets of the enterprise. (j) Increases assets through sale of product. (k) Decreases assets by purchasing the company’s own stock. (l) Changes in equity during the period, except those from investments by owners and distributions to owners. (f) Assets Liabilities Equity Investment by owners Distribution to owners Comprehensive income Revenue Expenses Gains Losses (b) (i) (c) (k) (d) (l) (g) (e) (c) (j) (h) (h) (a) (a) LO 5 Define the basic elements of financial statements.

Review: According to the FASB conceptual framework, an entity’s revenue may result from A decrease in an asset from primary operations. An increase in an asset from incidental transactions. An increase in a liability from incidental transactions. A decrease in a liability from primary operations. (CPA adapted) LO 5 Define the basic elements of financial statements.

Third Level: Recognition and Measurement
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.” ASSUMPTIONS Economic entity Going concern Monetary unit Periodicity PRINCIPLES Historical cost Revenue recognition Matching Full disclosure CONSTRAINTS Cost-benefit Materiality Industry practice Conservatism LO 6 Describe the basic assumptions of accounting.

Third Level: Assumptions
Economic Entity – company keeps its activity separate from its owners and other businesses. Going Concern - company to last long enough to fulfill objectives and commitments. Monetary Unit - money is the common denominator (e.g. Saudi Riyals in Saudi Arabia). Periodicity - company can divide its economic activities into time periods. LO 6 Describe the basic assumptions of accounting.

Third Level: Assumptions
Brief Exercise 2-5 Identify which basic assumption of accounting is best described in each item below. The economic activities of FedEx Corporation are divided into 12-month periods for the purpose of issuing annual reports. (b) Solectron Corporation, Inc. does not adjust amounts in its financial statements for the effects of inflation. (c) Walgreen Co. reports current and noncurrent classifications in its balance sheet. (d) The economic activities of General Electric and its subsidiaries are merged for accounting and reporting purposes. Periodicity Monetary Unit Going Concern Economic Entity LO 6 Describe the basic assumptions of accounting.

Third Level: Principles
Historical Cost – the price, established by the exchange transaction, is the “cost”. Issues: Historical cost provides a reliable benchmark for measuring historical trends. Fair value information may be more useful. FASB issued SFAS 15X, “Fair Value Measurements (2005).” Reporting of fair value information is increasing. LO 7 Explain the application of the basic principles of accounting.

Revenue Recognition - generally occurs (1) when realized or realizable and (2) when earned. Exceptions: During Production. At End of Production Upon Receipt of Cash LO 7 Explain the application of the basic principles of accounting.

Matching - efforts (expenses) should be matched with accomplishment (revenues) whenever it is reasonable and practicable to do so. “Let the expense follow the revenues.” Illustration Expense Recognition LO 7 Explain the application of the basic principles of accounting.

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 LO 7 Explain the application of the basic principles of accounting.

Brief Exercise 2-7 Identify which basic principle of accounting is best described in each item below. (a) Norfolk Southern Corporation reports revenue in its income statement when it is earned instead of when the cash is collected. (b) Yahoo, Inc. recognizes depreciation expense for a machine over the 2-year period during which that machine helps the company earn revenue. (c) Oracle Corporation reports information about pending lawsuits in the notes to its financial statements. (d) Eastman Kodak Company reports land on its balance sheet at the amount paid to acquire it, even though the estimated fair market value is greater. Revenue Recognition Matching Full Disclosure Historical Cost LO 7 Explain the application of the basic principles of accounting.

Third Level: Constraints
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 or change the judgment of a reasonable person. 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. LO 8 Describe the impact that constraints have on reporting accounting information.

Third Level: Constraints
Brief Exercise 2-9 What accounting constraints are illustrated by the items below? (a) Zip’s Farms, Inc. reports agricultural crops on its balance sheet at market value. (b) Crimson Tide Corporation does not accrue a contingent lawsuit gain of $650,000. (c) Wildcat Company does not disclose any information in the notes to the financial statements unless the value of the information to users exceeds the expense of gathering it. (d) Sun Devil Corporation expenses the cost of wastebaskets in the year they are acquired. Industry Practice Conservatism Cost-Benefit Materiality LO 8 Describe the impact that constraints have on reporting accounting information.

Chapter Excercises BE 2-1, BE2-4, BE2-5 BE2-7 , BE 2-9 E2-1, E2-3, E2-5

Copyright Copyright © 2006 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.

Conceptual Framework Underlying Financial Accounting

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