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Chapter 2: Conceptual Framework Underlying Financial Accounting
1) Conceptual Framework: (definition on page 28)
a Need for Conceptual Framework
i)
ii)
iii)
iv)
b Development of Conceptual Framework
FASB began working on the conceptual framework in 1976. FASB has issued 6
Statements of Financial Accounting Concepts (SFACs).
i) SFAC No. 1, “Objectives of Financial Reporting by Business Enterprises,” presents
goals and purposes of accounting. (See First Level: Basic Objectives.)
ii) SFAC No. 2, “Qualitative Characteristics of Accounting Information,” examines the
characteristics that make accounting information useful. (See Second Level:
Fundamental Concepts in Illustration 2-1 on page 30; also, refer to Illustration 2-2
on page 32.)
iii) SFAC No. 3, “Elements of Financial Statements of Business Enterprises,” provides
definitions of items in financial statements, such as assets, liabilities, revenues, and
expenses.
iv) SFAC No. 4, “Objectives of Financial Reporting by Nonbusiness Organizations”
v) SFAC No. 5, “Recognition and Measurement in Financial Statements of Business
Enterprises,” sets forth fundamental recognition and measurement criteria and
guidance on what information should be formally incorporated into financial
statements and when. (See Third Level: Recognition and Measurement Concepts in
Illustration 2-1 on page 30.)
vi) SFAC No. 6, “Elements of Financial Statements,” replaces SFAC No. 3 and expands
its scope to include not-for-profit organizations.
(1) Statement of Financial Position (i.e., Balance Sheet): Include assets, liabilities,
and equity.
(2) Earnings for the Period: Does not include prior period adjustments (Stockholders’
Equity Statement) or changes in accounting principles.
(3) Comprehensive Income: any change in Net Assets (Assets – Liabilities)
(4) Cash Flows during period: 3 sources – a) Operations, b) Financing, c) Investing
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(5) Investments and Distributions to Owners: Statement of Stockholders’ Equity:
Beginning Capital + Investment + Earnings – Dividends = Ending Capital
vii) SFAC No. 7, “Using Cash Flow Information and Present Value in Accounting
Measurements,” provides a framework for using expected future cash flows and
present values as a basis for measurement.
Note: See Illustration 2-1 on page 30.
Homework: Q2, E1, 2, 3
2) First Level: Basic Objectives (SFAC No. 1): Identify the goals and purposes of accounting.
Objectives provide information:
a
b
c
Decision usefulness is key to the conceptual framework. General-purpose financial
statements provide the most useful information possible at minimal cost to users. Of
course, users need to have a reasonable knowledge of business and financial accounting
measures to understand financial statements.
3) Second Level: Fundamental Concepts (SFAC No. 2): (See Illustration 2-2, p32.)
a Qualitative Characteristics of Accounting Information: make accounting information
useful. (Need to determine which alternative provides the most useful information for
decision-making purposes – decision usefulness.)
i) Decision Makers (Users) and Understandability: Information should be of such
quality that it is understandable to users.
(1) Understandability:
(2) Decision Usefulness:
Two Dimensions of Usefulness: relevance and reliability. The qualities that
distinguish ‘better’ (more useful) information from ‘inferior’ (less useful)
information are primarily the qualities of relevance and reliability, with some
other characteristics that those qualities imply.
ii) Primary Qualities: Relevance and Reliability:
(1) Relevance.
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Relevant info has:
(a) Predictive value:
(b) Feedback value:
(c) Timeliness:
(2) Reliability:
Reliable information has:
(a) Verifiability:
(b) Representational faithfulness:
(c) Neutrality:
iii) Secondary Qualities: Comparability and Consistency:
(1) Comparability: Accounting information that has been measured and reported in a
similar manner for different enterprises is considered comparable.
(2) Consistency: Accounting information is consistent when an entity applies the
same accounting treatment from period to period to similar accountable events.
Homework: Q3, 4, 6
b Basic Elements (e.g., assets, liabilities, etc.): FASB considers these ten elements to be
most closely related to financial measurement of an enterprise. Defined in Concepts Stmt
No. 6:
The first group of three elements (assets, liabilities, and equity) describes amounts of
resources and claims to resources at a moment in time. The other seven elements
describe transactions, events, and circumstances that affect an enterprise during a period
of time.
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Following List is included on page 35.
i) Assets: Probable future economic benefits obtained or controlled by a particular
entity as a result of past transactions or events.
ii) Liabilities: Probable future sacrifices of economic benefits arising from present
obligations of a particular entity to transfer assets or provide services to other entities
in the future as a result of past transactions or events.
iii) Equity: Residual interest in the assets of an entity that remains after deducting its
liabilities. In a business enterprise, the equity is the ownership interest.
iv) Investments by Owners: Increases in net assets of a particular enterprise resulting
from transfers to it from other entities of something of value to obtain or increase
ownership interests (or equity) in it. Owners most commonly receive assets as
investments, but that which is received may also include services or satisfaction or
conversion of liabilities of the enterprise.
v) Distributions to Owners: Decreases in net assets of a particular enterprise resulting
from transferring assets, rendering services, or incurring liabilities by the enterprise to
owners. Distributions to owners decrease ownership interests (or equity) in an
enterprise.
vi) Comprehensive Income: Change in equity (net assets) of an entity during a period
from transactions and other events and circumstances from nonowner sources. It
includes all changes in equity during a period except those resulting from investments
by owners and distributions to owners.
vii) Revenues: Inflows or other enhancements of assets of an entity or settlement of its
liabilities (or a combination of both) during a period from delivering or producing
goods, rendering services, or other activities that constitute the entity’s ongoing major
or central operations.
viii) Gains: Increases in equity (net assets) from peripheral or incidental transactions
of an entity during a period except those that result from revenues or investments by
owners.
ix) Losses: Decreases in equity (net assets) from peripheral or incidental transactions of
an entity and from all other transactions and other events and circumstances affecting
the entity during a period except those that result from expenses or distributions to
owners.
4) Third Level: Recognition and Measurement Concepts: used in establishing and applying
accounting standards (i.e., concepts that implement the basic objectives of level one.)
Consists of concepts which explain how financial elements and events should be recognized,
measured, and reported by the accounting system. Focus on understanding the concepts not
on classification (i.e., assumptions, principles, constraints)
a Basic Assumptions:
i) Economic Entity Assumption:
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ii) Going Concern Assumption:
This approach is used in financial statements as opposed to a liquidation approach.
iii) Monetary Unit Assumption: Record in terms of dollars.
The monetary unit is relevant, simple, universally available, understandable, and
useful. A second assumption (often called the Stable Dollar concept) is that the
monetary unit remains reasonably stable (i.e., every $1 is of equal worth.)
iv) Periodicity Assumption:
Investors are demanding more rapid information. Thus, financial statement users
must consider the trade-off between relevance and reliability.
b Basic Principles of Accounting: Four basic principles to record transactions.
i) Historical Cost Principle:
ii) Revenue Recognition Principle: Revenue is recognized (i.e., recorded in the
financial statements) when the earnings process is virtually complete and an exchange
transaction has occurred. In other words, revenue is generally recognized (1) when
realized or realizable and (2) when earned.
Realized:
Realizable:
Earned:
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Recognition at the time of sale provides a uniform and reasonable test. Generally, if a
sale has been completed, it should be recognized; if bad debts are expected, they
should be recorded as separate estimates.
Exceptions to the revenue recognition principle include:
(1) During Production (or Percentage of Completion Method): Revenue is allowed
before the contract is completed in certain long-term construction contracts. The
earnings process is considered substantially completed at various stages as
construction progresses, even though ownership has not been transferred. Must
have good estimates to be able to use this method.
(2) At End of Production: Revenue might be recognized after the production cycle
has ended but before the sale takes place. For example, revenue may be
recognized for commodities (e.g., agricultural products) and precious metals (e.g.,
gold) upon completion because of established markets and prices.
(3) Upon Receipt of Cash: Recognize revenue when cash is received. One form is
the Installment Sales Method. Here, payment is required in periodic installments
over a long period time (e.g., retail, farm/home equipment.) Revenue is
recognized as each cash installment is received. This is justified because the risk
of not collecting is high.
iii) Matching Principle:
This assumes cause/effect relationship (gives users more usable information in
determining future cash flow.) A major concern is that matching permits certain costs
to be deferred and treated as assets on the balance sheet when in fact these costs may
not have future benefits (e.g., improvements to assets.)
Relates to how we measure earnings:
(1) Direct Matching (cause and effect):
(2) Indirect Matching:
(a) Systematic and rational allocation:
(b) Period Costs:
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Matching Process Summarized: First, see if direct relationship exists
between cost and revenue. If so, use direct matching. If not, determine if a
systematic and rational allocation method be used. If so, use the method. If
not, immediately expense.
iv) Full Disclosure Principle:
Recognizes that nature and amount of information in financial reports reflects a series
of judgmental trade-offs. Certain footnotes (FN) are required. FN explain items
presented within financial statements. FN do not have to be quantifiable or an
element. Supplementary information (such as oil and gas reserve info) is provided.
Information should be understandable to a reasonably prudent investor.
Items should meet four fundamental recognition criteria to be recognized in the
financial statements:
(1) Definitions:
(2) Measurability:
(3) Relevance:
(4) Reliability:
Homework: Q10, 14, 16, 20, 21; E 6
c
Constraints:
i) Cost-Benefit Relationship:
Frequently it is easier to assess the costs than it is to determine the benefits of
providing a particular item of information.
ii) Materiality: The magnitude of an omission or misstatement of accounting
information that, in light of surrounding circumstances, makes it probable that the
judgment of a reasonable person relying on the information would have been changed
or influenced by the omission or misstatement.
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(1) The concept of materiality is an EXTREMELY difficult concept. Materiality
varies both with relative amount and with relative importance. (See Illustration 25.)
(2) Companies and their auditors for the most part have adopted the general rule of
thumb that anything under 5 percent of net income is considered immaterial.
However, both quantitative and qualitative factors must be considered in
determining whether an item is material.
(3) The SEC had indicated that companies must consider each misstatement
separately and the aggregate effect of all misstatements.
iii) Industry Practices: Peculiar nature of industry or business may result in variation
(e.g., utility industry lists non-current assets first b/c of capital intensive nature of
industry; agricultural industry lists crops at market value b/c difficult to quantify cost
of individual crops.)
iv) Conservatism:
d Summary of the Structure: See Illustration 2-6.
Homework: E 4, 5