Concepts Underlying Financial Accounting
Chapter
2
Chapter 2-1
Chapter 2 Learning Objectives 1.
Describe the usefulness of a conceptual framework.
2. Describe the MASB’s efforts to construct a conceptual framework. 3. Understand the objectives of financial reporting. 4. Identify the qualitative characteristics of accounting information. 5. Define the basic elements of financial statements. 6. Describe the basic assumptions of accounting. 7. Explain the application of the basic principles of accounting. 8. Describe the impact that constraints have on reporting accounting information. Chapter 2-2
Conceptual Framework
Conceptual Framework
Need Development
First Level: Basic Objectives
Second Level: Fundamental Concepts
Third Level: Recognition and Measurement
Qualitative characteristics
Basic assumptions
Basic elements
Basic principles Constraints
Chapter 2-3
What is the conceptual framework?
…a
coherent system of interrelated objectives and fundamentals that is expected to lead to consistent standards and that prescribes the nature, function and limits of financial accounting and reporting. Chapter 2-4
Conceptual Framework The Need for a Conceptual Framework To develop a coherent set of standards and rules To solve new and emerging practical problems
Chapter 2-5
LO 1 Describe the usefulness of a conceptual framework.
Benefits: consistent,
logical reporting requirements greater compliance enhanced accountability fewer specific standards enhanced understandability of reporting requirements
Chapter 2-6
MASB DP1, Framework for the Preparation and Presentation of Financial Statements
Chapter 2-7
Conceptual Framework The Framework is comprised of three levels:
Chapter 2-8
•
First Level = Basic Objectives
•
Second Level = Qualitative Characteristics and Basic Elements
•
Third Level = Recognition and Measurement Concepts.
LO 2 Describe the MASB’s efforts to construct a conceptual framework.
ASSUMPTIONS
PRINCIPLES
2. Economic entity
2. Historical cost
2. Cost-benefit
3. Going concern
3. Revenue recognition
3. Materiality
4. Monetary unit
4. Matching
4. Industry practice
5. Periodicity
5. Full disclosure
5. Conservatism
QUALITATIVE CHARACTERISTICS Relevance Reliability Comparability
Illustration 26 Conceptual Framework for Financial Reporting
Consistency
1. 2. 3.
Chapter 2-9
CONSTRAINTS
Third level
ELEMENTS Assets, Liabilities, and Equity Investments by owners Distribution to owners Comprehensive income Revenues and Expenses Gains and Losses
OBJECTIVES Useful in investment and credit decisions Useful in assessing future cash flows About enterprise resources, claims to resources, and changes in them
Second level
First level
LO 2 Describe the MASB’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. Chapter 2-10
LO 3 Understand the objectives of financial reporting.
Objectives
of financial reporting is to provide useful information: * investors, creditors and other users * to help them in assessing the amounts, timing and uncertainty of prospective cash receipts, redemption or maturity of debentures or loan. * economic resources of the enterprise, the claim to those resources and the effects of transactions, events and circumstances that change its resources and claims to those resources.
Chapter 2-11
• Objectives of financial statements: * provide information about the financial position, performance and changes in financial position * to show results of stewardship * the accountability of management for the resources entrusted to it
Chapter 2-12
Second Level: Fundamental Concepts Qualitative Characteristics “The MASB identified the Qualitative Characteristics of accounting information that distinguish better (more useful) information from inferior (less useful) information for decision-making purposes.”
Chapter 2-13
LO 4 Identify the qualitative characteristics of accounting information.
Second Level: Qualitative Characteristics
Illustration 2-2 Hierarchy of Accounting Qualities
Chapter 2-14
LO 4 Identify the qualitative characteristics of accounting information.
Second Level: Fundamental Concepts Understandability A company may present highly relevant and reliable information, however it was useless to those who do not understand it.
Chapter 2-15
LO 4 Identify the qualitative characteristics of accounting information.
ASSUMPTIONS
PRINCIPLES
CONSTRAINTS
2. Economic entity
2. Historical cost
2. Cost-benefit
3. Going concern
3. Revenue recognition
3. Materiality
5. Full disclosure
5. Conservatism
4. Matching 4. Industry practice Relevance and Reliability
4. Monetary unit 5. Periodicity
QUALITATIVE CHARACTERISTICS Relevance Reliability Comparability
Illustration 26 Conceptual Framework for Financial Reporting
Consistency
1. 2. 3.
Chapter 2-16
Third level
ELEMENTS Assets, Liabilities, and Equity Investments by owners Distribution to owners Comprehensive income Revenues and Expenses Gains and Losses
OBJECTIVES Useful in investment and credit decisions Useful in assessing future cash flows About enterprise resources, claims to resources, and changes in them
Second level
First level
LO 4 Identify the qualitative characteristics of accounting information.
Second Level: Qualitative Characteristics Primary Qualities: Relevance – making a difference in a decision. Predictive value Feedback value Timeliness
Reliability Verifiable Representational faithfulness Neutral - free of error and bias Chapter 2-17
LO 4 Identify the qualitative characteristics of accounting information.
ASSUMPTIONS
PRINCIPLES
CONSTRAINTS
2. Economic entity
2. Historical cost
2. Cost-benefit
3. Going concern
3. Revenue recognition
3. Materiality
5. Full disclosure
5. Conservatism
4. Matching 4. Industry practice Comparability and Consistency
4. Monetary unit 5. Periodicity
QUALITATIVE CHARACTERISTICS Relevance Reliability Comparability
Illustration 26 Conceptual Framework for Financial Reporting
Consistency
1. 2. 3.
Chapter 2-18
Third level
ELEMENTS Assets, Liabilities, and Equity Investments by owners Distribution to owners Comprehensive income Revenues and Expenses Gains and Losses
OBJECTIVES Useful in investment and credit decisions Useful in assessing future cash flows About enterprise resources, claims to resources, and changes in them
Second level
First level
LO 4 Identify the qualitative characteristics of accounting information.
Second Level: Qualitative Characteristics 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.
Chapter 2-19
LO 4 Identify the qualitative characteristics of accounting information.
ASSUMPTIONS
PRINCIPLES
2. Economic entity
2. Historical cost
2. Cost-benefit
3. Going concern
3. Revenue recognition
3. Materiality
4. Monetary unit
4. Matching
4. Industry practice
5. Periodicity
5. Full disclosure
5. Conservatism
Elements
QUALITATIVE CHARACTERISTICS Relevance Reliability Comparability
Illustration 26 Conceptual Framework for Financial Reporting
Consistency
1. 2. 3.
Chapter 2-20
CONSTRAINTS
Third level
ELEMENTS Assets, Liabilities, and Equity Investments by owners Distribution to owners Comprehensive income Revenues and Expenses Gains and Losses
OBJECTIVES Useful in investment and credit decisions Useful in assessing future cash flows About enterprise resources, claims to resources, and changes in them
Second level
First level
LO 5 Define the basic elements of financial statements.
Elements of financial statements
• Balance sheet * assets * liabilities * equity
• Income statement * income * expenses
Chapter 2-21
Assets -a resource controlled by the enterprise as a result of past transactions or events and from which future economic benefits are expected to flow to the enterprise. -ownership or legal rights Liabilities - present obligation of the enterprise arising from past transactions or events, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits. Chapter 2-22
Income -increase in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increase in equity, other than those relating to contributions from equity participants. Expenses - decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrence of liabilities that result in decrease in equity, other than those relating to distributions to equity participants. Equity - Chapter residual interest in the assets of an enterprise after deducting all2-23 its liabilities.
Second Level: Elements There are ten interrelated elements that relate to measuring the performance and financial status of a business enterprise. “Moment in Time” Assets Liabilities Equity
Chapter 2-24
“Period of Time” Investment by owners Distribution to owners Comprehensive income Revenue Expenses Gains Losses
LO 5 Define the basic elements of financial statements.
Third Level: Recognition and Measurement
ASSUMPTIONS
Chapter 2-25
PRINCIPLES
CONSTRAINTS
2. Economic entity
2. Historical cost
2. Cost-benefit
3. Going concern
3. Revenue recognition
3. Materiality
4. Monetary unit
4. Matching
4. Industry practice
5. Periodicity
5. Full disclosure
5. 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. Periodicity - company can divide its economic activities into time periods.
Chapter 2-26
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.
Chapter 2-27
LO 7 Explain the application of the basic principles of accounting.
Third Level: Principles Revenue Recognition - generally occurs (1) when realized or realizable and (2) when earned. Exceptions: During Production. At End of Production Upon Receipt of Cash
Chapter 2-28
LO 7 Explain the application of the basic principles of accounting.
Third Level: Principles Matching - efforts (expenses) should be matched with accomplishment (revenues) whenever it is reasonable and practicable to do so.
Illustration 2-4 Recognition
Chapter 2-29
Expense
LO 7 Explain the application of the basic principles of accounting.
Third Level: Principles 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
Chapter 2-30
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.
Chapter 2-31
LO 8 Describe the impact that constraints have on reporting accounting information.