Ch. 2 Flashcards
the conceptual framework identifies two fundamental qualitative characteristics as essential:
relevance and faithful representation
what constraints account acknowledge that there are practical limitations and resource constraints to providing financial information?
materiality and cost versus benefits
Materiality
refers to how important a piece of information is, or an item’s impact on the company’s overall financial operations.
Cost versus benefits
weighs the cost of providing the information against the benefits of doing so.
example of materiality constraint:
consider the cost of an item that will ben- efit operations for five years. Normally, it would be recorded as an asset and depreciated (expensed) over the related five-year period as dictated by the matching principle. However, if the item is a recycling container that cost $20, the amount is deemed to be immaterial and insignificant and the whole amount is handled with expedience; that is, it is expensed in the period when the container is purchased. This departure from the matching principle is justified by the materiality constraint because expensing the recycling container, instead of recording it as an asset and depreciating it, would not change the financial statements to an extent that would cause a reasonable person to change a decision they are making.
The 10 foundational principles can be grouped into three categories:
1) In the recognition/derecognition category are: economic entity assumption, control, revenue recognition and realization principle, and matching principle.
2) In the measurement category are: periodicity assumption, monetary unit assumption, going concern assumption, historical cost principle, and fair value principle.
3) In the presentation and disclosure category is: full disclosure principle.
Recognition
refers to the process of formally recording or incorporating an item in the accounts and financial statements of an entity.
Derecognition
refers to the process of formally removing an item from the accounts and financial statements of an entity.
Revenue recognition and realization principle is …
applied before the matching principle is applied.
gives guidance to determining what revenues to recognize in a given period.
The Matching Principle
gives guidance as to what expenses to recognize during the period. It states that expenses should be recognized in the same period in which related related revenues are recognized, whenever reasonable and possible.
Contract-based approach to revenue recognition emphasizes …
the statement of financial position, and focuses more on contractual rights and performance obligations created by entering into a contract with a customer.
There are three common methods of expense recognition:
1) cause and effect (matched against revenue in the period)
2) systematic and rational allocation, and
3) immediate expense recognition
Economic Entity Assumption
allows us to identify an economic activity or transaction with an economic entity (such as a corporation), an requires that only the activities or transactions of the economic entity
Relevance
the information is capable of making a difference in a decision.
Predictive value
the information helps users make predictions about the outcome of past, present, and future events.
Feedback value
the information helps to confirm or correct prior expectations.
Representational faithfulness
there is correspondence or agreement between the accounting numbers and descriptions and the resources or events that the numbers and descriptions purport to represent.
Completeness
Financial statements should include all information necessary to portray the underlying events and transactions.
Neutrality
information is not selected to favour one set of interested parties over another and is to be free from bias toward a predetermined result.
Free from error or bias
information must be reliable.
Comparability (consistency)
information is to be measured and reported in a similar manner for different enterprises, and a company is to apply the same methods to similar accountable events from period to period.
Verifiability
This is demonstrated when a high degree of consensus can be secured among independent measures using the same measurement methods.
Timeliness
information must be available to decision-makers before it loses its ability to influence their decisions.
Understandability
Information provided by financial reporting should be comprehensible to those who have a reasonable understanding of business and economic activities and are willing to study the information with reasonable diligence.
Assets
Present economic resources that have some economic benefit to the entity, where the entity has control over that benefit, and where the benefits result from a past transaction or event.
Liabilities
Present economic burdens that represent a present duty or responsibility, where the duty or responsibility obligates the entity, leaving it little or no discretion to avoid it, and where the duty or responsibility results from a past transaction or event.
Equity/net assets
Residual interest in an entity that remains after deducting its liabilities from its assets. In a business enterprise, the equity is the ownership interest.
Revenues
increases in economic resources, either by inflows or other enhancements of an entity’s assets or by settlement of its liabilities, resulting from ordinary activities of the entity.
Expenses
Decreases in economic resources, either by outflows or reductions of assets or by incurrence of liabilities, resulting from an entity’s ordinary revenue-generating activities.
Gains
Increases in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity during a period, except those that result from revenues or investments by owners.
Losses
Decreases in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity during a period, except those that result from expenses or distributions to owners.
Control principle
the principle that other economic entities under a parent entity’s control are generally included in the parent’s economic entity.
Revenue recognition and realization principal
the principle that dictates when revenue should be recognized (recorded in the revenue account).
under the traditional EARNINGS APPROACH TO REVENUE RECOGNITION, revenues are recognized when (3):
(1) risks and rewards have passed and/or the earnings process is substantially complete
(2) the revenue is measurable, and
(3) the revenue is collectible (realized or realizable)
Revenues are REALIZED when
products (goods or services, merchandise, or other assets) are exchanged for cash or claims to cash.
Revenues are REALIZABLE when
assets received or held are readily convertible into cash or claims to cash.
When are assets REALIZABLE and readily convertible?
Assets are readily convertible when they are saleable or interchangeable in an active market at readily determinable prices with- out significant additional cost. The earnings process is substantially complete when the entity has substantially accomplished what it must do to be entitled to the benefits represented by the revenues.
Contract-based approach to revenue recognition
there is greater emphasis on the statement of financial position, and the contractual rights (assets) and performance obligations (liabilities) created by entering into a contract with a customer.
Contract based approach follows a five-step approach to revenue recognition:
1) identify the contract with the customer
2) identify the performance obligations in the contract
3) determine the transaction price
4) allocate the transaction price to each performance obligation, and
5) recognize revenue when each performance obligation (liability) is satisfied.
Periodicity Assumption
the assumption that the economic life of a business can be divided into artificial time periods. Although some companies choose to subdivide the entity’s life into months or quarters, others report financial state, emts only annually.
Monetary unit assumption
The assumption that only transaction data capable of being expressed in terms of money should be included in the accounting records of the economic entity. All transactions and events can be measured in terms of a common denominator: units of money. A corollary is the added assumption that the unit of mea- sure remains constant from one period to the next. (Some people call the corollary the “stable dollar assumption.”)
Going concern assumption
The assumption that the enterprise will continue in operation long enough to carry out its existing objectives and commitments. It assumes the entity will continue in operation long enough to recover the cost of its assets. This assumption serves as a basis for other principles such as the historical cost principle. Because of this assumption, liquidation values of assets are not relevant (in most cases). Management must assess the company’s ability to continue as a going concern and take into account all available informa- tion, looking out at least 12 months from the statement of financial position date.
Historical cost principle
The principle that an asset should initially be recorded at acquisition cost, measured by the amount of cash (or cash equivalents) that was paid or received or the fair value that was attributed to the transaction when it took place. Acqui- sition cost of an asset includes all costs necessary to acquire the item and get it in the place and condition ready for its intended use.
Fair Value Principle
The principle that in certain situations and industries, recording certain assets and liabilities at fair value may be more useful than recording them at his- torical cost, where fair value is actually an exit price (a price to sell or transfer the asset or liability) as of the measurement date.
Full Disclosure Principle
The principle that information should be provided when it is important enough to influence the judgement and decisions of an informed user. An entity is to disclose, through the data contained in the financial statements and the information in the notes that accompany the statements, all information necessary to make the statements not misleading. To be recognized in the main body of the financial statements, an item should meet the definition of one of the basic elements, be measur- able with sufficient certainty, and be relevant and faithfully representative. The notes to financial statements generally amplify or explain the items presented in the body of the statements. Information in the notes does not have to be quantifiable. Overall, a balance between sufficient detail and sufficient condensation of information should be achieved; entity-specific information is more useful than general information; and duplication of information reduces its usefulness.
