Fundamentals of Intermediate Accounting

Weygandt, Kieso, and Warfield

Chapter 2: The Conceptual

Framework
Prepared by
Bonnie Harrison, College of Southern Maryland
LaPlata, Maryland
 Chapter 2
Conceptual Framework Underlying
Financial Accounting



   
½ rescribe the usefulness of a conceptual framework.
 rescribe the FASB¶s efforts to construct a
conceptual framework.
 Understand the objectives of financial reporting.
 Identify the qualitative characteristics of accounting
information.
 refine the basic elements of financial statements.
 Chapter 2
Conceptual Framework Underlying
Financial Accounting


    

 rescribe the basic assumptions of accounting.

 Explain the applications of the basic
principles of accounting.
 rescribe the impact that constraints have on
reporting accounting information.
 Introduction
 sers of financial statements need Õ

Õ

information.

o provide such information, the profession
has developed a set of
Õ

 
 .

hese principles and guidelines are
collectively called the 

Õ Õ
 n short, the Framework is like a 
for the profession.
 —    


Õ Õ
 The Framework is to be the

 for
building a set of coherent accounting
standards and rules.
 The Framework is to be a 




  for solving emerging
practical problems of reporting.
˜  
 



he FASB has issued   ˜   of
Financial Accounting Concepts (SFACs) to
date .

hese statements set forth major Õ  
Õ
Õ issues.
 Statement 4 pertains to reporting by
   entities.

he other six statements pertain to reporting
by   enterprises.
 ˜  
 
Statement


Brief Title
 Statement 1  bjectives of Financial
Reporting (Business)
 Statement 2 
ualitative Characteristics
 Elements of Financial
 Statement 6 Statements (replaces 3)
 bjectives of Financial
 Statement 4
Reporting (Nonbusiness)
 Statement 5  Recognition and
Measurement Criteria
 Statement 7  Using Cash Flows
 —verview of the Conceptual
Framework (1 of 2)
 The Framework has   objectives,
elements and criteria.
 The first level consists of 
.
 The second level explains financial
statement  and characteristics of
information
 The third level incorporates 

 and


.
—verview of the Conceptual Framework (2
of 2)
Level 3: Recognition and
Implemen- Measurement Concepts
tation

Level 2: ðlements of
Qual Financial Statements and
ðlements
Charac.
ualitative Characteristics
of Accounting Information

—
ectives Level 1: —
ectives of

Financial Reporting
 O
 

!


"

To provide information:

1) that is useful to those making



 decisions who  
business and
2) that is useful to present and future investors,
creditors in 

 
#
3) about 
, the claims on
those resources and changes in them
 è

$ 




%


 rimary qualities are  and



 of accounting
information.
 Secondary qualities are


 and 
 of
reported information.
 è

$ 




%

"
Relevance of information means ³information
capable of making a difference in a decision
context.´ To be relevant:
r The information must be 


 ..
r The information should have 




:: (be
helpful in making predictions about ultimate
outcomes of past, present and future events).
r The information should have
&
(helps users to 


'




'
.)
.)
 )
 $ 

"




 Information is 
, when it can be
relied on to represent the true, underlying
situation.
 (



:
* verifiable
* representationally faithful, and
* neutral
 Primary Characteristic: Reliability

 Information is verifiable, when, given the

same information, independent users can
arrive at similar conclusions.
 Information is faithful, when it represents
what really existed or happened.
 Information is neutral, when it is free from
bias.
 Secondary Characteristics
 Secondary characteristics are: comparability and
consistency of reported information.
 For information to be 



  measured and reported in a similar manner for different
enterprises.
  useful in the allocation of resources to the areas of
greatest benefit.
  useful to users in identifying real differences between
enterprises.
 Secondary Characteristics
 Accounting information is consistent, if the same
accounting principles are applied in a similar
manner from one period to the next.
 Accounting principles may be changed, if the
change results in better reporting.
 If principles are changed, the justification for, and
the nature and effect of the change, must be
disclosed.
 j
 
 
è


recision Makers What are their characteristics?

Constraints Cost enefit & Materiality

User specific Qualities Understanda ility

Pervasive Criterion Decision Usefulness

rimary
ualities Relevance & Reliability

Secondary
ualities Comparability & Consistency

 %

)
 è


Relevance Reliability

redictive Feedback Represent.

Verifiability Neutrality
Value Value Faithfulness

Timeliness
 O
*
!

+
Balance Sheet
 Assets: robable future
economic benefits resulting
from past transactions
 Liabilities: robable future
sacrifices of economic benefits
resulting from past transactions
 Equity: Residual or ownership
interest
 Investment by wners:
Increases in net assets
 ristributions to wners:
recreases in net assets
Income Statement
 Comprehensive Income: All
changes in equity from non-
owner sources
 Revenues: Inflows from entity¶s
ongoing operations
 Expenses: utflows from
entity¶s ongoing operations
 ains: Increases in equity from
incidental transactions
 Losses: recreases in equity
from incidental transactions
 "

,
$


Basic
rinciples Constraints
Assumptions

½ ðconomic ½ istorical cost ½ Cost Benefit

entity 2 Revenue 2 Materiality
2
oing recognition 3 Industry
concern 3 Matching practices
3 Monetary 4 Full 4 Conservatism
Unit disclosure
4 Periodicity
Basic Assumptions
 Basic Assumptions
Economic Entity Assumption
 Yhe economic entity can e identified with a
particular unit of accounta ility
 Yhe usiness is separate and distinct from its
owners
 ðntity¶s assets and other financial elements are not
commingled with those of the owners
 Yhe economic entity assumption is an accounting
concept, and not a legal construct
 Basic Assumptions
oing Concern Assumption
 The business is assumed to continue




unless terminated by owners.
 The basis of recording financial elements is



.
 Liquidation accounting (based on liquidation
values) is not followed unless so indicated.
 Basic Assumptions
Monetary Unit
 Money is the common unit of measure of
economic transactions
 Use of a monetary unit is relevant, simple to
understand and universally availa le
 Price level changes are ignored in
accounting, leading to the assumption that
the dollar remains relatively sta le.
 Basic Assumptions
eriodicity (Time eriod) Assumption
 Economic activity of an entity may be




 divided into time periods for
reporting purposes.
 Shorter time periods are subject to revisions but
may be more timely.
Basic rinciples
 ( $)


Historical Cost rinciple
 Transaction is recorded at its acquisition price.
 It is not changed to reflect market price.
 The principle applies to most assets and liabilities.
 Users of financial statements may find fair value
information useful for certain types of assets and
liabilities.
 The current system is a ³mixed attribute´ incorporating
historical cost, fair value, and certain other
valuation bases.
22
 ( ""

)


Revenue Recognition rinciple
 Revenue is recognized when it is realized or
realizable and earned  
objectively 
-
 Revenue is recognized at time of sale. There are
'
:
½ During production: In long-term construction revenue is
recognized periodically based on % of job completed.
2 ðnd of production: Where active markets exist for the
product and there are no significant future costs..
3 Receipt of cash: Used when there is uncertainty of
collection. In installment sales contracts payment is required
in periodic installments.
 ( ,
)


 Expenses are matched to the revenues they help
generate.
 There should be a logical, 


 of
revenues and expenses.
 If a cost does not benefit future periods, it is
recorded in the current period as an expense.

24
 ( !.
)


 Financial statements must report what a
 would need to know to make
an informed decision.
 risclosure may be made:
* within the  of the financial statements,
* as  to those statements, or
* as  information.
Constraints
 $
( $O

"

Cost--Benefit Relationship
Cost
 The cost of providing information should not
outweigh the benefit derived.
 Costs and benefits are not always obvious or
measurable.
 Sound judgment must be used in providing
information.
 $
,


Materiality refers to an item¶s importance to a
firm¶s overall financial operations.
 An item must &


 to be material and
be disclosed.
 It is a matter of the 




 of the
element.
 Both /

/

 factors are to be
considered in determining relative significance.
 Constraints: Industry ractices
Industry Practices
 The nature of some industries sometimes
require departures from basic accounting
theory.
 If application of accounting theory results in
statements that are not comparable or
consistent, then industry practices must be
examined for possible explanations.
 Constraints: Conservatism
 Conservatism suggests that the preparer,
when in doubt, choose a 


.
 This solution will be 
& to overstate
assets and income.
 Conservatism  that net
assets or net income be deliberately
understated.
 C RIHT
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