Intermediate Financial Accounting I Conceptual Framework Underlying Financial

Intermediate Financial Accounting I Conceptual Framework Underlying Financial Reporting

Objectives of the Chapters (contd. ) § Study the Conceptual framework underlying financial reports. Environment and Theoretical Structure of Financial Accounting 2

Conceptual Framework of Financial Reporting n n What does the current accounting standard setting authority rely on to prescribe the accounting standards? Conceptual Framework of Financial Reporting: A system of interactive objectives and fundamentals which can lead to a set of consistent standards in preparing financial reports. Environment and Theoretical Structure of Financial Accounting 3

Financial Reporting: A Theoretical Structure A Conceptual Framework for Financial Reporting SFAC No. 8, First Level Ch. 1 Objectives Qualitati ve Elements Second Level SFAC No. 8, Ch. 3 Characteris (SFAC No. 6) tic of Accounting Recognition and Information Measurement Concepts Third level SFAC No. 5 Assumptions • Entity • Going. Concern • Monetary unit • Periodicity Principles Constraints • Cost & Fair • Cost/Benefit Value Option • Industry Practices • Revenue • Matching • Full Disclosure Environment and Theoretical Structure of Financial Accounting 4

SFAC No. 8 - Chapter 1 (Level One of The Conceptual Framework) n • The objective of general-purpose financial reporting: Providing useful financial information of the reporting entity to existing and potential investors, lenders, and other creditors in making decisions regarding providing resources to the entity. Environment and Theoretical Structure of Financial Accounting 5

SFAC No. 8 –Chapter 1 (cont. ) (Level One of The Conceptual Framework) n Those decisions involve buying, selling, or holding equity and debt instruments and providing or settling loans and other forms of credit. Environment and Theoretical Structure of Financial Accounting 6

SFAC No. 8 – Chapter 3 (Level Two of The Framework) n Qualitative (Characteristics of Accounting Information) I. Fundamental Qualities 2) Faithful Representation 1) Relevance a) Completeness a) Predictive value b) Confirmatory value b) Neutral c) Materiality c) Free from error Environment and Theoretical Structure of Financial Accounting 7

SFAC No. 8 (contd. ) II. Enhancing Qualitative Characteristics 1) Comparability(including consistency) 2) Verifiability 3) Timeliness 4) Understandability Environment and Theoretical Structure of Financial Accounting 8

Environment and Theoretical Structure of Financial Accounting 9

Materiality (make a difference on decision) • • Materiality judgment should be made in the context of the nature and the amount of the item. Item. The rule of thumb of materiality: any item which is less than 5% of net income is immaterial. Environment and Theoretical Structure of Financial Accounting 10

SFAC No. 5 (Level Three of The Conceptual Framework) n Measurement and Recognition Concepts I. Assumptions 1) Economic Entity 2) Going-concern (continuity) 3) Monetary unit 4) Periodicity (Period of time) Environment and Theoretical Structure of Financial Accounting 11

SFAC No. 5 (contd. ) II. Principles 1) Historical cost principle and fair value option 2) Revenue recognition 3) Matching/Expense Recognition 4) Full Disclosure (i. e. , footnote disclosure) III. Constraints 1) Cost-Benefit 2) Industry Practices Environment and Theoretical Structure of Financial Accounting 12

The Move Toward Fair Value § § SFAS No. 157 establishes a framework for measuring fair values. SFAS No. 159 gives companies the option to report some or all of their financial assets and liabilities at fair value. Environment and Theoretical Structure of Financial Accounting 13

Fair Value Hierarchy (SFAS 157) § Level 1 (most reliable) measures are based on quoted prices for identical instruments in active markets. § Level 2 measures are based on quoted prices for similar instruments in active markets. § Level 3 (least reliable) measures are based on unobservable inputs such as company’s data or assumptions. The Balance Sheet and Financial Disclosures 14

Fair Value Measurements Disclosure : Footnote 28 of GE 2008 Annual Report Level 1 Level 2 Level 3 Fin. 39 Netting Net Bal. $1, 158 $27, 332 $12, 956 ___ $41, 446 ___ 18, 911 1, 142 (7, 411) 12, 642 1 288 1, 105 ____ 1, 394 $1, 159 $46, 531 15, 203 $ 2 $12, 643 ____ 2 Assets Investment Securities Derivatives Others total $(7, 411) $55, 482 166 $(7, 575) $ 5, 236 1, 031 ____ 1, 031 $13, 674 $ 166 Liabilities Derivatives Other Total $ $ $(7, 575) The Balance Sheet and Financial Disclosures $6, 267 15

Revenue Recognition Principle (SFAS No. 5) (-An Accrual Basis) n n n Revenue is recognized when it is earned and realized or realizable (SFAC 5, par. 83). Earned : the entity has substantially accomplished what it must do to be entitled to compensation. Realized: goods are exchanged for cash or claims. Realizable: assets received as compensation are readily convertible into cash or claims to cash (i. e. , measurable). In general, these conditions are met at time of sale (delivery) or when services are rendered (SFAC 5, par. 84). Income Measurement And Profit Analysis 16

Revenue Recognition Principle Other conditions for revenue recognition (Staff Accounting Bulletin No. 101(1999)): n Persuasive evidence of a sale. n Price is fixed or determinable. n Collectibility is reasonably assured. n Delivery has occurred or services have been rendered. n Income Measurement And Profit Analysis 17

Expense Recognition (Matching) Principle – An Accrual Basis n n n If revenues are recognized in a period, all related expenses should be recognized in the same period. The related expenses include: Traceable costs: The contribution of these costs (i. e. , product cots) can be traced to specific revenues, and therefore, are expensed when revenues (i. e. , sales revenue) are recognized. 18

Expense Recognition (Matching) Principle – An Accrual Basis n n Period costs: The contribution of these costs cannot be traced easily to specific revenues , and therefore, are expensed when they are consumed or occurred. (e. g. advertising exp. , interest and rent exp. ) Allocated (or estimated) costs: Expenses such as depreciation expense, bad debt expense, etc. which contributions to revenues cannot be traced. These expenses are estimated and recognized at the end of a period. 19

Matching (Expenses with Revenues) Principle • Traceable costs (i. e. , product costs) vs. nontraceable costs (i. e. , period costs): Environment and Theoretical Structure of Financial Accounting 20