Chapter 2: Conceptual Framework Flashcards
Assets
Probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events
Objective of Financial Reporting
To provide financial information about the reporting entity that is useful to present and potential equity investors, lenders, and other creditors in making decisions about providing resources to the entity.
Financial Reporting/ Financial Accounting
The identification, measurement and communication of financial information about economic entities to potential users
Basic Assumptions of Financial Accounting
- Economic Entity Assumption
- Going Concern Assumption
- Monetary Unit Assumption
- Periodicity
(set out in SFAC No. 5)
Economic Entity Assumption
That economic activity can be identified with a particular unit of accountability.
Activity is kept separate from that of other business units.
Reporting entity does not need to be a specific legal entity (could simply be separate departments)
Going Concern Assumption
Assumption that the company will have a long life (continuance)
Not a functional assumption if it’s apparent that liquidation is imminent (Liquidation basis accounting) Depreciation and amortization only make sense if entity is a going concern
Monetary Unit Assumption
Assumes money as the common denominator of economic activity, providing a basis for measurement.
Ignores inflation/ deflation (assumes stable dollar)
Periodicity Assumption
Assumes that a company can divide its economic activities into artificial time periods (monthly, yearly, quarterly).
Shorter period data, however, tends to be less verifiable and more error prone. Trade off between timeliness and accuracy.
Basic Principles of Accounting
Used to record and report transactions
- Measurement
- Revenue Recognition
- Expense Recognition (matching)
- Full disclosure
Measurement Principle
Current system permits use of various measurement bases.
- Historical cost principle (acquisition price. highly verifiable)
- Fair value principle (market based)
- price that would be received for the sale of an asset at the measurement date.- more useful for certain types of assets
- measures impairment cost
Revenue Recognition Principle
Companies must recognize revenue in the accounting period in which the performance obligation is satisfied.
Steps:
1) Identify the contracts with the customer
2) Identify the separate performance obligations in the contract
3) Determine the transaction price
4) Allocate the transaction price to separate obligations
5) Recognize the revenue when the obligation is satisfied
Expense Recognition Principle
"Let the expenses follow the revenues" Matching efforts (expenses) with revenues (accomplishments) to implement matching principle.
Allocation policy that involves “rational and systemic “ assumptions about benefits the company receives for the cost associated with the benefits.
Product costs vs. Period Costs
Full Disclosure Principle
Information that is of sufficient importance to influence the judgement and decisions of an informed user must be disclosed.
- Disclose all important information
- but sufficiently condensed to remain understandable.
Cost Constraint
AKA Cost-Benefit Relationship
- weighing the cost of providing the information against the benefits to be derived from using it. Benefit must exceed the cost
Qualitative Characteristics of Accounting Information
Fundamental Qualities
- Relevance
- predictive value
- confirmatory value
- materiality
- Faithful Representation
- completeness
- neutrality
- free from error
Enhancing Qualities
- Comparability
- Verifiability
- Timeliness
- Understandability
Relevance
Must be decision-useful
Has predictive value, confirmatory value or both
Also Materiality
Predictive value
Helps users predict future profits / cash flows
Confirmatory Value
Helps users confirm or correct prior expectations
Materiality
Information is material if omitting it or misstating it would influence the decisions that users make.
- nature of transaction (qualitative)
- magnitude of transaction relative to company size
(generally anything under 3% of net income is immaterial but it depends)
Faithful Representation
The numbers and descriptions match what really existed or happened
- completeness
- neutrality
- free from error (though some estimates must occur and will not always be accurate)
Completeness
All information necessary for faithful representation is provided.
No omissions that changes the view of events
Neutrality
A company cannot select information to favor one set of interested parties over another
(No suppressing potentially damaging information)
Enhancing Qualities
Qualities that complement fundamental qualities and distinguish more useful information from less useful
- comparability
- verifiability
- timeliness
- understanability
Comparability
Enables comparisons between companies
Consistency enables comparability between periods for the same company
Verifiability
If an independent measurer uses the same methods on the same information they will achieve similar results
Direct verification (ex: counting inventory)
Indirect verification (ex: checking inputs and recalculating outputs)
Timeliness
Information is available to decision makers before it loses its capacity to influence decisions (relevance)
Understandability
Quality of information that lets (reasonably informed) users readily see its significance
Assisted by classifying, characterization and clarity
Cannot exclude complex information simply because it is complex.
Pro-forma measures
Non-GAAP
standard measures that companies adjust for unusual or non-recurring items to make them more comparable
- practice is subject to misuse
Public companies are required to reconcile these numbers to GAAP so users can see how they achieved the results
Period costs
No direct relationship between these costs and revenue
Expensed as costs are incurred
Product Costs
Have a direct relationship to revenue
Recognized in period revenue is recognized (Cost of Goods sold - including labor)
Fair Value Hierarchy
Least to most subjective
Level 1: observable inputs that reflect quoted prices for identical assets/ liabilities in active markets
Level 2: inputs other than level 1 inputs, but that are observable for the asset/ liability directly or through corroboration with observable data
Level 3: un-observable inputs (assumptions)
Fair Value Option
FASB gave companies the option to use fair value as a basis of measurement for financial assets and liabilities
companies must disclose not only the fair value measurement but the hierarchy level of the measurement
(2007?)
How companies (are supposed to) choose an accounting method
Depending on which alternative provides the most useful information for decision making purposes
(“decision-usefulness”)
Overview of FASB Conceptual Framework
1st level - objective of financial reporting
2nd level - qualitative characteristics of accounting information and elements of financial statements
3rd level - establishes how to implement the objective of financial reporting with: assumptions, principles, and constraints
Conservatism
aka prudence
When in doubt chose the solution that is least likely to overstate assets/ income and/or understate liabilities/ expenses.
Somewhat in conflict with neutrality
understatement in one period = overstatement in the next
Process for a company to switch accounting methods
1) must demonstrate that the new method is preferable (more closely matches reality)
2) must disclose nature and effect of change, and justification for change in financial statements
SAFC no. 8
chapter 1: “the objective of general purpose financial reporting”
- goals and purposes of accounting
chapter 3: “Qualitative characteristics of useful financial information”
- what makes accounting information useful
chapter 8: “notes to financial statements”
SAFC no. 7
“Using cash flow information and present value in accounting measurements”
- framework for using expected future cash flows and present value as basis for measurement
SAFC no. 6
“Elements of Financial Statements”
- definitions of items in financial statements
- for profit and not-for-profit orgs
SAFC no. 5
“Recognition and measurement in financial statements of business enterprises”
Guidance on where and when to incorporate information into financial statments
Basic elements of financial statements
Elements that measure performance and financial status
Amounts of resources and claims to resources at a moment in time.
- assets, liabilities, equity
Transaction events and circumstances affecting a company during a period of time
- investments by owners
- distributions to owners
- comprehensive income
- revenues
- expenses
- gains
- losses
Liabilities
Probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events
Equity
Residual interest in the assets of an entity that remains after deducting its liabilities.
in a business enterprise the equity is the ownership interest
Investments by owners
Increases in net assets of a particular enterprise resulting from transfers to it from other entities of something of value to obtain or increase ownership interests (equity) in it.
Assets are most commonly received as investments by owners, but that which is received may also include services or satisfaction or conversion of liabilities of the enterprise.
Distributions to owners
Decreases in net assets of a particular enterprise resulting from transferring assets, rendering services or incurring liabilities oy the enterprise to owners.
Distributions to owners decrease ownership interests (equity) in an enterprise
Comprehensive Income
Change in equity (net assets) of an entity during a period from transactions and other events and circumstances from non-owner sources.
Includes all changes in equity during a period EXCEPT those resulting from investments by owners and distributions to owners.
Revenues
Inflows or other enhancements of assets of an entity or settlement of its liabilities (or a combination of both) during a period from delivering or producing goods, rendering services or other activities that constitute the entities ongoing major or central operations
Expenses
Outflows or other using up of assets or incurrances of liabilities (or a combination of both) during a period from delivering or producing goods, rendering services or carrying out other activities that constitute the entity’s major or central operations.
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 revenues or investments by owners.
Monetary Unit Assumption & Inflation globally
Some countries with persistent inflation use “constant currency” financial reports using a price level index to adjust for inflation
Conceptual framework IASB
IASB issued its own conceptual framework which results in some differences from FASB/ GAAP
Qualifications for an item to be recognized in financial statments
- Must meet the definition of a basic element
- Must be measurable with sufficient certainty
- Be reliable
- Be relevant
FASB
Financial Accounting Standards Board
- privately funded board
- responsible for the creation and governance of accounting standards
SEC
Securities and Exchange Commission
- government entity
- has the power to mandate guidelines where no accounting principles exist
- oversees FASB
- oversees Markets
