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Conceptual Framework
By the end of this class you should be familiar with ….
Activities of the firm Major items in the Balance sheet
and Income Statement (SFAC 6) Qualitative characteristics of
Accounting (SFAC 2) Measurement and Recognition
(SFAC 5) Present Value and Cash Flow
(SFAC 7)
Three Main Activities of a Firm
Financing– for example: Sale of stock
– Sale of Bonds– Bank borrowing
Investing– for example:Purchase of Property, Plant and
Equipment– Purchase of equity of debt securities
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
Assets = Liabilities + Owner’s Equity
Also note: Point in time - A snapshot B/S Classifications
Elements of Financial Statements –SFAC 6 Assets
probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events
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
Probable and measurable future sacrifices of economic benefits arising from present obligations as a result of past transactions or events
Risk 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
Assets minus liabilities captures the owner’s residual
interest in the company Two main accounts:
– Contributed capital» Preferred Stock
» Common Stock
» Additional Paid-in-Capital
– Retained Earnings
Remaining elements of Financial Statements-SFAC 6
Investment by owners Distribution by owners Revenues Gains Expenses Losses Comprehensive Income –
change in equity other investment by or distribution to owners
Recognition and Measurement Concept- SFAC 5
Recognition-has to meet the following criteria– Definition – is an element per SFAC 6– Measurability – Relevance– Reliability
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
The general assumptions underlying financial statements
Basic measurement issues and how we deal with them
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
Economic Entity– Determines the boundaries of the
entity – Economic vs legal ownership:
consolidated financial statements– Example:Minority Interest
Going Concern – Enterprise will continue to exist
indefinitely provides basis for accrual accounting
Four Assumptions Underlying U.S. F/S
Economic Entity Going Concern
Periodicity-Fiscal Period – Arbitrary time periods-usually one
year- ensures timeliness of reporting
» Con - loss in reliability
– Home Depot’s Feb 2, year end Monetary unit-Stable Dollar
– Stable purchasing power– Problems of high inflation- Brazil– Note: not in IASC standards
Qualitative Characteristics
Reliability– Verifiability
» Usefulness of Historical Cost» Form over Substance» Loss in relevance
– Representational Faithfulness– Neutrality
Relevance– information capable of making a
difference in decision making» Estimates
– Predictive Value– Feedback value– Timeliness
Qualitative Characteristics- Secondary
Consistency– consistent application of
accounting methods over time Comparability
– Cross-sectional by firms
Four Basic Principles
Historical cost – forms the basis of most elements of
financial statements
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
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
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
Matching Principle– Expenses must be matched
against revenues earned in the period
Full disclosure- Footnotes
Constraints
Cost effectiveness– Benefits exceed costs
Materiality– judgment based
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”
Industry practices
SFAC #7 – Using Cash Flow Information and Present Value in Accounting Measurements
Statement provides a framework for using future cash flows as a basis for measuring an asset or a liability
Statement is limited to measurement issues and does not address recognition questions
Take-Home Points
Assumptions underlying the F/S– Economic Entity– Going Concern– Fiscal Period– Stable Dollar
Basic Principles– Reliability– Relevance– Matching – Revenue Recognition– Conservatism