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Unformatted text preview: Conceptual Framework Underlying Financial Accounting Chapter 2 Intermediate Accounting 12th Edition Kieso, Weygandt, and Warfield Chapter 2-1 Prepared by Coby Harmon, University of California, Santa Barbara Chapter 2 Learning Objectives 1. 2. 3. 4. 5. 6. 7. 8. Describe the usefulness of a conceptual framework. Describe the FASB's efforts to construct a conceptual framework. Understand the objectives of financial reporting. Identify the qualitative characteristics of accounting information. Define the basic elements of financial statements. Describe the basic assumptions of accounting. Explain the application of the basic principles of accounting. 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 Qualitative characteristics Basic elements Third Level: Recognition and Measurement Basic assumptions Basic principles Constraints Chapter 2-3 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 2-4 LO 1 Describe the usefulness of a conceptual framework. Development of Conceptual Framework The FASB has issued six Statements of Financial Accounting Concepts (SFAC) for business enterprises. SFAC No.1 Objectives of Financial Reporting SFAC No.2 Qualitative Characteristics of Accounting Information SFAC No.3 Elements of Financial Statements (superceded by SFAC No. 6) SFAC No.4 Nonbusiness Organizations SFAC No.5 SFAC No.7 Recognition and Measurement in Financial Statements Using Cash Flow Information and Present Value in Accounting Measurements SFAC No.6 Elements of Financial Statements (replaces SFAC No. 3) Chapter 2-5 LO 2 Describe the FASB's efforts to construct a conceptualObjective 2 framework. Conceptual Framework The Framework is comprised of three levels: First Level = Basic Objectives Second Level = Qualitative Characteristics and Basic Elements Third Level = Recognition and Measurement Concepts. Chapter 2-6 LO 2 Describe the FASB's efforts to construct a conceptual framework. ASSUMPTIONS 1. Economic entity 2. Going concern 3. Monetary unit 4. Periodicity PRINCIPLES 1. Historical cost 2. Revenue recognition 3. Matching 4. Full disclosure CONSTRAINTS 1. Cost-benefit 2. Materiality 3. Industry practice 4. Conservatism Third level QUALITATIVE CHARACTERISTICS Relevance Reliability Comparability Consistency ELEMENTS Assets, Liabilities, and Equity Investments by owners Distribution to owners Comprehensive income Revenues and Expenses Gains and Losses Second level Illustration 2-6 2-6 Conceptual Framework for Financial Reporting 1. 2. 3. Chapter 2-7 OBJECTIVES Useful in investment and credit decisions Useful in assessing future cash flows About enterprise resources, claims to resources, and changes in them First level LO 2 Describe the FASB's efforts to construct a conceptual framework. Conceptual Framework Review: What are the Statements of Financial Accounting Concepts intended to establish? a. b. c. d. Generally accepted accounting principles in financial reporting by business enterprises. The meaning of "Present fairly in accordance with generally accepted accounting principles." The objectives and concepts for use in developing standards of financial accounting and reporting. The hierarchy of sources of generally accepted accounting principles. (CPA adapted) LO 2 Describe the FASB's efforts to construct a conceptual framework. Chapter 2-8 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 2-9 LO 3 Understand the objectives of financial reporting. Conceptual Framework Review: According to the FASB conceptual framework, the objectives of financial reporting for business enterprises are based on? a. b. c. d. Generally accepted accounting principles Reporting on management's stewardship. The need for conservatism. The needs of the users of the information. (CPA adapted) Chapter 2-10 LO 3 Understand the objectives of financial reporting. Second Level: Fundamental Concepts Question: How does a company choose an acceptable accounting method, the amount and types of information to disclose, and the format in which to present it? Answer: Chapter 2-11 LO 4 Identify the qualitative characteristics of accounting information. Second Level: Fundamental Concepts Qualitative Characteristics "The FASB identified the Qualitative Characteristics of accounting information that distinguish better (more useful) information from inferior (less useful) information for decisionmaking purposes." Chapter 2-12 LO 4 Identify the qualitative characteristics of accounting information. Second Level: Qualitative Characteristics Illustration 22 Illustration 22 Hierarchy of Accounting Qualities Chapter 2-13 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 2-14 LO 4 Identify the qualitative characteristics of accounting information. ASSUMPTIONS 1. Economic entity 2. Going concern 3. Monetary unit 4. Periodicity PRINCIPLES 1. Historical cost 2. Revenue recognition 4. Full disclosure CONSTRAINTS 1. Cost-benefit 2. Materiality 3. Matching 3. Industry Relevance and Reliabilitypractice 4. Conservatism Third level QUALITATIVE CHARACTERISTICS Relevance Reliability Comparability Consistency ELEMENTS Assets, Liabilities, and Equity Investments by owners Distribution to owners Comprehensive income Revenues and Expenses Gains and Losses Second level Illustration 2-6 2-6 Conceptual Framework for Financial Reporting 1. 2. 3. Chapter 2-15 OBJECTIVES Useful in investment and credit decisions Useful in assessing future cash flows About enterprise resources, claims to resources, and changes in them 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 2-16 LO 4 Identify the qualitative characteristics of accounting information. Second Level: Qualitative Characteristics Review (True or False): Relevance and reliability are the two primary qualities that make accounting information useful for decision making. To be reliable, accounting information must be capable of making a difference in a decision. Chapter 2-17 LO 4 Identify the qualitative characteristics of accounting information. ASSUMPTIONS 1. Economic entity 2. Going concern 3. Monetary unit 4. Periodicity PRINCIPLES 1. Historical cost 2. Revenue recognition 4. Full disclosure CONSTRAINTS 1. Cost-benefit 2. Materiality 3. Matching 3. Industry practice Comparability and Consistency 4. Conservatism Third level QUALITATIVE CHARACTERISTICS Relevance Reliability Comparability Consistency ELEMENTS Assets, Liabilities, and Equity Investments by owners Distribution to owners Comprehensive income Revenues and Expenses Gains and Losses Second level Illustration 2-6 2-6 Conceptual Framework for Financial Reporting 1. 2. 3. Chapter 2-18 OBJECTIVES Useful in investment and credit decisions Useful in assessing future cash flows About enterprise resources, claims to resources, and changes in them 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. treatment to similar events from period to period. Consistency When a company applies the same accounting Chapter 2-19 LO 4 Identify the qualitative characteristics of accounting information. ASSUMPTIONS 1. Economic entity 2. Going concern 3. Monetary unit 4. Periodicity PRINCIPLES 1. Historical cost 2. Revenue recognition 3. Matching CONSTRAINTS 1. Cost-benefit 2. Materiality 3. Industry practice 4. Conservatism Elements Third level 4. Full disclosure QUALITATIVE CHARACTERISTICS Relevance Reliability Comparability Consistency ELEMENTS Assets, Liabilities, and Equity Investments by owners Distribution to owners Comprehensive income Revenues and Expenses Gains and Losses Second level Illustration 2-6 2-6 Conceptual Framework for Financial Reporting 1. 2. 3. Chapter 2-20 OBJECTIVES Useful in investment and credit decisions Useful in assessing future cash flows About enterprise resources, claims to resources, and changes in them First level LO 5 Define the basic elements of financial statements. Second Level: Elements Concepts Statement No. 6 defines ten interrelated elements that relate to measuring the performance and financial status of a business enterprise. "Moment in Time" Assets Liabilities Equity "Period of Time" Investment by owners Distribution to owners Comprehensive income Revenue Expenses Gains Losses LO 5 Define the basic elements of financial statements. Chapter 2-21 Second Level: Elements Exercise 2-3 Identify the element or elements associated with items below. (a) Arises from peripheral or incidental transactions. Elements Assets Liabilities Equity Investment by owners Distribution to owners Comprehensive income Revenue Expenses Gains Losses (b) Obligation to transfer resources arising from a past transaction. (c) Increases ownership interest. (d) Declares and pays cash dividends to owners. (e) Increases in net assets in a period from nonowner sources. Chapter 2-22 LO 5 Define the basic elements of financial statements. Second Level: Elements Exercise 2-3 Identify the element or elements associated with items below. Elements (f) Items characterized by future economic benefit. Assets Liabilities Equity Investment by owners Distribution to owners Comprehensive income Revenue Expenses Gains Losses (g) Equals increase in net assets during the year, after adding distributions to owners and subtracting investments by owners. (h) Arises from income statement activities that constitute the entity's ongoing major or central operations. Chapter 2-23 LO 5 Define the basic elements of financial statements. Second Level: Elements Exercise 2-3 Identify the element or elements associated with items below. (i) Residual interest in the net assets of the enterprise. (j) Increases assets through sale of product. Elements Assets Liabilities Equity Investment by owners Distribution to owners Comprehensive income Revenue Expenses Gains Losses (k) Decreases assets by purchasing the company's own stock. (l) Changes in equity during the period, except those from investments by owners and distributions to owners. Chapter 2-24 LO 5 Define the basic elements of financial statements. Second Level: Elements Review: According to the FASB conceptual framework, an entity's revenue may result from a. b. c. d. A decrease in an asset from primary operations. An increase in an asset from incidental transactions. An increase in a liability from incidental transactions. A decrease in a liability from primary operations. (CPA adapted) Chapter 2-25 LO 5 Define the basic elements of financial statements. Third Level: Recognition and Measurement The FASB sets forth most of these concepts in its Statement of Financial Accounting Concepts No. 5, "Recognition and Measurement in Financial Statements of Business Enterprises." ASSUMPTIONS 1. Economic entity 2. Going concern 3. Monetary unit 4. Periodicity PRINCIPLES 1. Historical cost 2. Revenue recognition 3. Matching 4. Full disclosure CONSTRAINTS 1. Cost-benefit 2. Materiality 3. Industry practice 4. Conservatism Chapter 2-26 LO 6 Describe the basic assumptions of accounting. Third Level: Assumptions Economic Entity company keeps its activity separate from its owners and other businesses. and commitments. Going Concern company to last long enough to fulfill objectives Monetary Unit money is the common denominator. Periodicity company can divide its economic activities into time periods. Chapter 2-27 LO 6 Describe the basic assumptions of accounting. Third Level: Assumptions Brief Exercise 2-4 Identify which basic assumption of accounting is best described in each item below. (a) The economic activities of FedEx Corporation are divided into 12month periods for the purpose of issuing annual reports. (b) Solectron Corporation, Inc. does not adjust amounts in its financial statements for the effects of inflation. (c) Walgreen Co. reports current and noncurrent classifications in its balance sheet. (d) The economic activities of General Electric and its subsidiaries are merged for accounting and reporting purposes. Chapter 2-28 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. FASB issued SFAS 15X, "Fair Value Measurements (2005)." Reporting of fair value information is increasing. Chapter 2-29 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 2-30 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. "Let the expense follow the revenues." Illustration 2-4 Recognition Expense Chapter 2-31 LO 7 Explain the application of the basic principles of accounting. Third Level: Principles Full Disclosure providing information that is of sufficient Provided through: Financial Statements Notes to the Financial Statements Supplementary information importance to influence the judgment and decisions of an informed user. Chapter 2-32 LO 7 Explain the application of the basic principles of accounting. Third Level: Principles Brief Exercise 2-5 Identify which basic principle of accounting is best described in each item below. (a) Norfolk Southern Corporation reports revenue in its income statement when it is earned instead of when the cash is collected. (b) Yahoo, Inc. recognizes depreciation expense for a machine over the 2year period during which that machine helps the company earn revenue. (c) Oracle Corporation reports information about pending lawsuits in the notes to its financial statements. (d) Eastman Kodak Company reports land on its balance sheet at the amount paid to acquire it, even though the estimated fair market value is greater. Chapter 2-33 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. influence or change the judgment of a reasonable person. Materiality an item is material if its inclusion or omission would Industry Practice the peculiar nature of some industries and business concerns sometimes requires departure from basic accounting theory. least likely to overstate assets and income. Conservatism when in doubt, choose the solution that will be Chapter 2-34 LO 8 Describe the impact that constraints have on reporting accounting information. Third Level: Constraints Brief Exercise 2-6 What accounting constraints are illustrated by the items below? (a) Zip's Farms, Inc. reports agricultural crops on its balance sheet at market value. (b) Crimson Tide Corporation does not accrue a contingent lawsuit gain of $650,000. (c) Wildcat Company does not disclose any information in the notes to the financial statements unless the value of the information to users exceeds the expense of gathering it. (d) Sun Devil Corporation expenses the cost of wastebaskets in the year they are acquired. Chapter 2-35 LO 8 Describe the impact that constraints have on reporting accounting information. Wrap Up Remember to do your homework before the next class Questions? Chapter 2-36 ...
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This note was uploaded on 04/02/2008 for the course ACIS 3115 taught by Professor Cmeasterwood during the Spring '08 term at Virginia Tech.

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