Standards and the Conceptual Framework Underlying Financial Accounting

Standards and the Conceptual Framework Underlying Financial Accounting CHAPTERS 1 & 2

Who sets the standards? US � FASB - Financial Accounting Standards Board � GAAP – Generally Accepted Accounting Principles International � IASB – International Accounting Standards Board � IFRS – International Financial Reporting Standards [also known as i. GAAP]

Conceptual Framework �The IASB and the FASB have agreed to work on a joint project to develop a common conceptual framework – where differences will be resolved. �Currently, US GAAP and i. GAAP follow a very similar conceptual framework.

ASSUMPTIONS PRINCIPLES CONSTRAINTS 1. Economic entity 1. Measurement 1. Cost-benefit 2. Going concern 2. Revenue recognition 2. Materiality 3. Monetary unit 3. Expense recognition 3. Industry practice 4. Periodicity 4. Full disclosure 4. Conservatism QUALITATIVE CHARACTERISTICS Relevance Reliability Comparability Illustration 2 -7 Conceptual Framework for Financial Reporting Consistency Third level ELEMENTS Assets, Liabilities, and Equity Investments by owners Distribution to owners Comprehensive income Revenues and Expenses Gains and Losses OBJECTIVES 1. Useful in investment and credit decisions 2. Useful in assessing future cash flows 3. About enterprise resources, claims to resources, and changes in them Second level First level LO 2 Describe the FASB’s efforts to construct a conceptual framework.

Basic Objectives of Reporting To provide information that is: • Understandable • Useful to those making investment and credit decisions • Helpful to users to assess the amounts, timing, and certainty or uncertainty of future cash flows • About economic resources, the claims to those resources, and the changes in them.

Qualitative Characteristics Primary Qualities Relevance – capable of making a difference in a decision - Predictive value - Feedback value - Timeliness

Qualitative Characteristics Primary Qualities Reliability – assurance that information has integrity to the extent that it is -Verifiable -a Faithful Representation -Free of Error and Bias

Qualitative Characteristics Secondary Qualities Comparability – Information that has been measured and reported in a similar manner for different enterprises is considered comparable. Consistency – applying the same accounting treatment to similar events, from period to period.

Basic Elements of Financial Statements Assets – probable future economic benefits Liabilities – probable future sacrifices of economic benefits Equity – residual interest in the assets of an entity that remains after deducting its liabilities (also referred to as the ownership interests).

Basic Elements of Financial Statements Comprehensive Income – Includes all changes in equity (presented on the Stmt of Owners’ Equity) during a period except those resulting from investments by owners and distributions to owners. ex) Net Income +/+/+/- Unrealized Gains/Losses Foreign Currency Translations Minimum Pension Liability Adjustment

Basic Elements of Financial Statements Revenues – Inflows or other enhancements of assets of an entity or settlement of its liabilities occurring from ongoing major or central operations of the business Expenses – Outflows or other using up of assets or incurrences of liabilities occurring from ongoing major or central operations of a business

Basic Elements of Financial Statements Gains – Increases in equity (net assets) from peripheral or incidental transactions of an entity Losses – Decreases in equity (net assets) from peripheral or incidental transactions of an entity (ex. Gains/Losses from sale of an operational asset, or gains/losses from settlement of a lawsuit)

Basic Assumptions 1. Economic Entity Assumption – economic activity can be identified with a particular unit of accountability. The activity of a business enterprise can be kept separate and distinct from its owners and any other business unit.

Basic Assumptions 2. Going Concern Assumption – most accounting methods assume that the business enterprise will have a long life. Depreciation and amortization policies are just one example where we must assume a business permanence in the future to justify the policies as appropriate. Only where liquidation appears imminent is the assumption inapplicable.

Basic Assumptions 3. Monetary Unit Assumption – money is the common denominator of economic activity and provides an appropriate basis for accounting measurement and analysis. We assume that the unit of monetary measure remains relatively stable and do not adjust for inflation from one year to the next

Basic Assumptions 4. Periodicity Assumption – implies that the ongoing economic activities of an enterprise can be divided into artificial time periods. It is most common to break the financial accounting cycle into months, quarters, and years.

Basic Principles 1. Historical Cost Principle – GAAP requires that most assets and liabilities be accounted for and reported on the basis of acquisition price. Using historical cost, as opposed to other valuations such as fair value or replacement cost, provides users with a stable, reliable, and consistent benchmark that can be relied upon to establish historical trends.

Basic Principles 2. Revenue Recognition Principle – Revenues are recognized when a) realized or realizable b) earned Realized – revenues are realized when goods or services are exchanged for cash or claims to cash Realizable – revenues are realizable when assets received or held are readily convertible into cash or claims to cash Earned – revenues are earned when the entity has substantially accomplished what it must do to be entitled to the benefits represented by the revenues.

Basic Principles 3. Matching Principle – dictates that efforts (expenses) be matched with accomplishments (revenues) whenever it is reasonable and practical to do so. Expenses are recognized in the period the work (service) or product actually makes its contribution to revenue, thereby, “matching” expenses to revenues they helped create in the appropriate period. ex) the allowance method to account for bad debt or depreciation methods

Basic Principles 4. Full Disclosure Principle – sufficient information must be provided to a) disclose matters that make a difference to users b) make the information understandable Information may be disclosed a) within the main body of financial statements b) in the notes to those statements c) as supplementary information

Constraints 1. Cost-Benefit Relationship – The costs of providing the information must be weighed against the benefits that can be derived from using the information. Examples of costs to provide particular information that must be considered include costs for a) collecting and processing b) auditing c) potential litigation d) disclosure to competitors Benefits are generally more difficult to quantify than costs.

Constraints 2. Materiality – An item is material if its inclusion or omission would influence or change the judgment of a reasonable person. Information is considered immaterial or irrelevant if would have no impact on a decision maker. The size and importance of disclosing certain information will be relative from one company to another. What’s material to Joe’s Discount Tire may be immaterial to Firestone.

Constraints 3. Industry Practice – The peculiar nature of some industries and business concerns sometimes requires departure from basic theory. Ex. ) In the public utility industry, non-current assets are reported first on the balance sheet to highlight the industry’s capital-intensive nature.

Constraints 4. Conservatism – when in doubt, choose the solution that will be least likely to overstate assets and income. When in doubt, or when subjective estimates are necessary, refrain from overstatement of net income and net assets.

Review According to the FASB conceptual framework, the objectives of financial reporting for business enterprises are based on? a. Generally accepted accounting principles b. Reporting on management’s stewardship. c. The need for conservatism. d. The needs of the users of the information. The current proposed converged framework adopts the FASB’s focus on investors and creditors. LO 3

Ø The existing conceptual frameworks underlying U. S. GAAP and i. GAAP are very similar. Ø The converged framework should be a single document, unlike the two conceptual frameworks that presently exist. Ø The IASB framework makes two assumptions. One assumption is that financial statements are prepared on an accrual basis; the other is that the reporting entity is a going concern. Ø There is some agreement that the role of financial reporting is to assist users in decision making. However, others note that another objective is to provide information on management’s performance, often referred to as stewardship.