Chapter 2: The Conceptual Framework

Chapter 2: The Chapter 2: The Conceptual FrameworkConceptual Framework

• Coherent system– Interrelated

• Objectives AND• Fundamentals

– Can lead to consistent standards– Prescribes for financial accounting &

FS • Nature• Function• Limits

• FASB began developing in 1976

Definition of Conceptual Definition of Conceptual FrameworkFramework

• Foundation for building a set of coherent accounting standards & rules

• Reference of basic accounting theory for solving emerging practical problems of financial reporting (more quickly)

Objectives of the Objectives of the Conceptual FrameworkConceptual Framework

• The FASB has issued seven Statements of Financial Accounting Concepts (SFACs)– Set forth major recognition & reporting

issues– Statement 4 pertains to reporting by

non-business entities• NFPs

– Other 6 statements pertain to reporting by business enterprises

Statements of Financial Statements of Financial Accounting ConceptsAccounting Concepts

• Statement 1

• Statement 2

• Statement 6

• Statement 4

• Statement 5

• Statement 7

• Objectives of Financial Reporting - Business

• Qualitative Characteristics

• Elements of Financial Statements (replaces 3)

• Objectives of Financial Reporting – Non business

• Recognition & Measurement Criteria

• Using Cash Flows

Brief TitleStatement

Statements of Financial Statements of Financial Accounting ConceptsAccounting Concepts

•Three different levels– First level = objectives

• Why – goals & purposes

– Second level = explains financial elements & characteristics of information• Bridges why & how

– Third level = incorporates recognition & measurement criteria• How – implementation of the framework

Overview of the Overview of the Conceptual FrameworkConceptual Framework

Conceptual Framework Conceptual Framework for Financial Reportingfor Financial Reporting

To provide information:• About economic resources, claims on

resources & changes in them• To individuals who reasonably

understand business & economic activities

• That is useful to – Those making investment & credit

decisions– Present & future investors, creditors in

assessing future cash flows

Basic Objectives of Basic Objectives of Financial ReportingFinancial Reporting

Hierarchy of Accounting Hierarchy of Accounting QualitiesQualities

• Overriding = understandability– Quality of info affects user decisions

• Primary qualities– Relevance– Reliability

• Secondary qualities – Comparability– Consistency

Qualitative Qualitative Characteristics of Characteristics of

Accounting InformationAccounting Information

• Relevance of information– “Information c capable of making a

difference in a decision context”

• Ingredients of relevant information are:• Timeliness• Predictive value• Feedback value

Primary Characteristic of Primary Characteristic of Accounting Information: Accounting Information:

RelevanceRelevance

• Information is reliable when it can be relied on to represent the true, underlying situation

• The ingredients of reliable information are:– Verifiability– Representational faithfulness– Neutrality (unbiased)

Primary Characteristic of Primary Characteristic of Accounting Information: Accounting Information:

ReliabilityReliability

• Neutrality in standard setting– Increasing attacks

• Don’t issue if cause undesirable economic effects– Accounting for goodwill

– Alternate view• Biased FS are not credible

Primary Characteristic of Primary Characteristic of Accounting Information: Accounting Information:

ReliabilityReliability

• Comparability– Similar measurement & reporting for different

enterprises

• Consistency– Application of same accounting treatment to

similar events by an enterprise period to period• Role of auditor, audit committee & SOX

Secondary Characteristics Secondary Characteristics of Accounting Informationof Accounting Information

• Moment in time– Assets– Liabilities– Equity– Investment by

Owners– Distributions to

Owners

• Period of time– Comprehensiv

e Income– Revenues– Expenses– Gains– Losses

Basic Elements of Basic Elements of Financial Statements Financial Statements

(SFAC #6)(SFAC #6)

ARTICULATION

Key figures in one correspond to balances in another!!!

BasicAssumptions

1. Economic entity 2. Going concern 3. Monetary

unit4. Periodicity

Principles

1. Historical cost

2. Revenue recognition

3. Matching4. Full

disclosure

Constraints

1. Cost benefit2. Materiality3. Industry

practices4. Conservatism

Recognition and Recognition and Measurement CriteriaMeasurement Criteria

• Activity identified with particular unit of accountability– Does not mean legal entity (parent &

subs)

• Recent reactions– FIN 46 & variable interest entities– Related party transactions

Basic AssumptionsBasic AssumptionsEconomic EntityEconomic Entity

• Long lived business– Bedrock for

• Historical cost principle• Depreciation & amortization

• Only inapplicable if liquidation imminent

Basic AssumptionsBasic AssumptionsGoing ConcernGoing Concern

• Money = common denominator of economic activity– Relevant– Simple– Universally available– Understandable– Useful

• Quantitative data is useful

Basic AssumptionsBasic AssumptionsMonetary UnitMonetary Unit

• Apprise users on timely basis– Quicker – more subject to error– Apparent tradeoff between relevance &

reliability today

• Economic activities divided into artificial time periods– Shorter period – more difficult to

determine income

Basic AssumptionsBasic AssumptionsPeriodicityPeriodicity

• Cost a reliable valuation technique• Suggested alternatives

– Fair value• At acquisition, cost = FV• Some amounts reported at FV

– Replacement cost– PV of future cash flows

Basic PrinciplesBasic PrinciplesHistorical CostHistorical Cost

• When– Realized

• Exchanged for cash/claims to cash

– Realizable• Assets readily convertible to cash/claims to cash

– Earned• All accomplished to be entitled to benefits

• Time of sale = uniform & reasonable

Basic PrinciplesBasic PrinciplesRevenue Recognition Revenue Recognition

• Exceptions to time of sale– During production

• LT construction contracts

– End of production• Mining, agriculture

– Upon receipt of cash• Installment sales

Basic PrinciplesBasic PrinciplesRevenue Recognition Revenue Recognition

• Match efforts & accomplishments– When reasonable & practicable

• Product costs = charge product– Carry to future if revenue recognized in

future• DM, DL, OH

• Period costs = charge currently– No direct relationship of cost & revenue

• Admin salaries & expenses

Basic PrinciplesBasic PrinciplesMatchingMatching

• Provide info– Of sufficient importance– To influence judgment & decisions– Of informed user

• Sufficient detail vs. condensed to be understandable

Basic PrinciplesBasic PrinciplesFull DisclosureFull Disclosure

• Financial statements– Formal & structured communication

device– Basic element criteria

• Measurable with sufficient certainty• Relevant• Reliable

Basic PrinciplesBasic PrinciplesFull DisclosureFull Disclosure

• Notes to FS– Amplify/explain FS items– Info does not need to be

• Quantifiable• Qualify as an element

• Supplemental info– Different perspective than FS– MD&A

Basic PrinciplesBasic PrinciplesFull DisclosureFull Disclosure

• Costs & benefits - not always evident or measurable

• Limiting reporting costs– Exclude info outside management expertise– Don’t require info that will harm competitive position– No forecasts required– Only info management knows (O/T FS)– Present elements only if users & management agree

they should be reported– No forward looking info required

ConstraintsConstraintsCost-BenefitCost-Benefit

• Item impact on overall financial operations– Must make a difference to decision maker– Separate & aggregate impacts

• Relative size & importance– Significant to other A, L, R, E, & NI– General rule – >5% NI– Consider qualitative & quantitative factors

• Internal & external parameters

ConstraintsConstraintsMaterialityMateriality

• Due to peculiar nature of industry– Public utilities– Agriculture

• Use ONLY if no related GAAP

ConstraintsConstraintsIndustry PracticesIndustry Practices

• Solution to LEAST LIKELY overstate assets & income– Does not mean UNDERSTATE

• GAAP examples– LOCOM– Accrued loss on purchase commitments

ConstraintsConstraintsConservatism Conservatism

• ExercisesE2-2 E2-3 E2-4E2-6 E2-7 E2-8

• CasesC2-6 C2-10

• Weyerhaeuser (page 58)

Exercises & CasesExercises & Cases