Conceptual Framework of Fin Reporting

Question 1

Outline of the Conceptual Framework of Financial Reporting: will not be tested, but helps me see the big picture.

Answer 1

• 1. Objective of financial reporting.
• 2. Qualitative characteristics of accounting information.
• 3. Accounting assumptions.
• 4. Accounting principles.
• 5. Cost constraint.
• 6. Elements of financial statements.

Question 2

What is the role of the Conceptual Framework?

Answer 2

• It does not constitute GAAP
• It only provides guideline for the development of GAAP
• It is a “constitution” for developing GAAP

Question 3

Accounting information must have the following characteristics:

Primary Qualitative Characteristics

►Roger is PC, he is also Materialistic.

►He is never on FENCe.

►It helps to remember that there are 3 components to both Relevance & Faithful Representation.

Enhancing Qualitative Characteristics

►CUT like a V.

Answer 3

Primary Qualitative Characteristics

Relevance

• Predictive Value - Helps in making predictions about future events.
• Confirmatory Value - Helps in confirming past predictions.
• Materiality - Significant enough to influence decision making.

Faithful Representation

• Free from Error - No omissions or errors.
• Neutral - Free of bias.
• Completeness - Includes all data necessary to be faithfully representative.

Enhancing Qualitative Characteristics

• Comparability - Enables users to identify similarities and differences between sets of information.
• Understandability - Users can comprehend it with reasonable effort and diligence.
• Timeliness - Information must be received in time to make a difference.
• Verifiability - Different knowledgeable and independent observers can reach similar conclusions.

►NOTE: Enhancing characteristics relate to both Relevance & Faithful Representation.

Question 4

Relevance and Faithful Representation may conflict. In such cases, a trade-off is made favoring one or the other. Give examples of:

• Relevance over Faithful Representation.
• Faithful Representation over Relevance.

Answer 4

• Accounting estimates (depreciation, bad debt expense, pension estimates). Firms are providing estimates, rather than certain amounts. Although they cannot be perfectly reliable, are preferred over (1) perfect information issued too late to make a difference (2) no information at all.
• Historical cost emphasizes Faithful Representation over Relevance. Historical cost is very reliable because it is based on past information. But, historical cost is less current and therefore less relevant than market value.

Question 5

What are Objectives of Financial Reporting?

Answer 5

Decision usefulness. To provide information about the entity to current and future users of the financial statements who are making credit and investment decisions.

Question 6

Who is the Target Audience of Financial Statements?

Answer 6

Decision makers; mainly potential investors, creditors, and regulators.

Question 7

What are the 4 assumptions in the Conceptual Framework?

►Entire GUT

Answer 7

• E: Entity assumption - There is a separate accounting entity for each business organization. The owners and the company are separate. The owners own shares in the company, but they do not own the assets. The company owns the assets. The financial statements represent the company, not the owners. Another example is a parent-subsidiary relationship within a company.
• G: Going concern also called continuity assumption - A business is assumed to have an indefinite life. Going concern supports the historical cost principle. Prepaid assets would not be assets without the assumption of continuity.
• U: Unit of measure assumption - Accounts are measured in terms of the monetary unit of the country in which the business is operated.
• T: Time period assumption - The indefinite life of a business is broken into smaller time frames, typically a year, for evaluation purposes and reporting purposes.

Question 8

• What does the Historical Cost principle state?
• Why Going Concern supports Historical Cost Pinciple?

Answer 8

• At the time of origination, assets and liabilities are recorded at the market value of the item on the date of acquisition, usually the cash equivalent . This origination value is referred to as historical cost.

For many assets and liabilities, this value is not changed even though market value changes. Other assets, such as plant assets and intangibles, are disclosed at historical cost less accumulated depreciation or amortization.

• Given the going concern assumption, revaluation to market value is inappropriate for plant assets, because the value of these assets is derived through use, rather than from disposal.

Question 9

• What are revenues?
• How do we measure revenues?
• When should a company recognize revenues?

Answer 9

• Increases in assets or extinguishment of liabilities resulting from delivery of goods or providing services – the primary activities of the firm.
• Revenues are measured as the cash equivalent amount of the good or service provided.
• Revenues are recognized when the entity completes its performance obligation to a customer and the revenue is earned and realized (or realizable).

Earned means the obligation is completed (the goods or services are delivered).

Realized means cash or promise of cash is received.

Question 10

When does realization occur in the accounting period?

Answer 10

(1) Goods or services have been provided, (2) Collectability of cash is assured, (3) Expenses of providing goods and services can be determined.

Question 11

What is the matching principle?

Answer 11

• The matching principle says:

Recognize expenses only when expenditures help to produce revenues. Revenues are recognized when earned and realized or realizable; and the revenues and expenses are “matched” to determine net income or loss.

• Not all expenses are directly related to revenues. Cost of goods sold and sales commissions are expenses that are directly associated and therefore matched with revenue.
• Other expenses are allocated based on the time period of benefit provided. Depreciation and amortization are examples. Such expenses are not directly matched with revenues.

Question 12

• What is the full disclosure principle?
• Give example.

Answer 12

• Financial statements should present all information needed by users to make a decision. Also referred to as the adequate disclosure principle.
• An aircraft manufacturer enters into a contract to build 200 airplanes for an airline company. As of the balance sheet date, production has not begun. Thus, there is no recognition of this contract in the accounts. However, a footnote should explain the financial aspects of the contract. This information is potentially of greater interest than many items recognized in the accounts.

Question 13

What is the concept of Capital Maintenance?

Answer 13

Capital is said to be maintained when the firm has positive earnings for the year, assuming no changes in price levels.

Question 14

What is the constraint to setting accounting standards?

Answer 14

Cost effectiveness or cost-benefit. This constraint on GAAP limits recognition and disclosure if the cost of providing the information exceeds its benefit.

Example: Companies don’t report entire inventory subsidiary ledger in the footnotes or financial statements. They only report the total amount of inventory, because reporting more detailed information is not worth the cost of doing so.

►NOTE: companies may not omit disclosures if they are material and mandated by GAAP.

Question 15

What are the 4 criteria that must be met to be recognized and measured in a financial report?

Answer 15

1. Defintion - The definition of a financial statement element is met.
2. Measureability - There is an attribute to be measured, such as historical cost.
3. Relevance - The information has predictive value, confirmatory value, and is material.
4. Faithful Representation - The information is free from material error, neutral, and complete.

Question 16

What does a fresh start measurement do?

Answer 16

Establishes a new carrying value after an initial recognition and is unrelated to previous amounts (e.g., mark-to-market accounting and recognition of asset impairments).

Question 17

• What is Conservatism?
• Give examples of Conservatism: AFUA & Loss Contingency

►NOTE: Conservatism is no longer a constraint and is not a qualitative characteristic.

Answer 17

• Conservatism, also called prudence, is the reporting of less optimistic amounts (lower income & net assets) under conditions of uncertainty or when GAAP provides a choice from among recognition or measurement methods.
  
  • If estimates of an outcome are not equally likely, the preferred approach is to report the most likely estimate, rather than the more conservative estimate, if the latter is less likely.
  • It should be noted that overly conservative estimates can be misleading and cause over reporting in subsequent periods.
• 2 examples:
  • Loss contingencies that are probable and estimable are recognized. But gain contingencies are not recognized. This is a classic example of conservatism, which suppresses positive information but requires the reporting of negative information when the negative outcome is likely.
  • The allowance for uncollectible accounts is an estimate, but an overly conservative accrual of the allowance will lead to lower net income, but would over report income in subsequent years.

Question 18

List the 10 elements that appear in the financial statements.

Answer 18

1. Revenues - Increases in equity or settlements of liabilities by providing goods or services (primary activities).
2. Expenses - Decreases in equity or incurrences of liabilities by providing goods or services. Expenses provide a benefit to the firm.
3. Gains - Increases in equity from peripheral or incidental transactions.
4. Losses - Decreases in equity from peripheral or incidental transactions. Losses provide no benefit to the firm.
5. Comprehensive Income = NI + OCI. Comp Inc reports all changes in equity stemming from transactions with nonowners (means transactions other than investments by owners and distributions to owners).
6. Assets - Resources that have probable future economic benefits to the firm, controlled by management, resulting from past transactions. Note the 3 aspects of this definition.
7. Liabilities - Probable future sacrifices of economic benefits arising from present obligations to transfer assets or provide services to other entities as a result of past transactions or events.
8. Equity - Residual interest in the firm’s assets, also known as Net Assets. Equity is primarily comprised of past investor contributions and retained earnings.
9. Investments by Owners - Increases in net assets from transfers by owners or parties seeking ownership interest.
10. Distributions to Owners - Decreases in net assets from transfers by the firm to owners.

Question 19

• 2 approaches to compute present value.
• When to use present value measurement?
• When a present-value measure is used:
  
  • The result should be ______________ if such a value could be obtained.
  • The ________________ approach is preferred. It provides a better estimate of fair value than a single most-likely cash flow, because it directly incorporates the uncertainty in estimated future cash flows.
• The Expected Cash Flow Approach has been incorporated into _________________.

Answer 19

• 2 approaches to compute present value:
  
  • Traditional Approach also referred to as Discounted Cash Flows - The risk and uncertainty is incorporated into the discount rate. Uses a single most-likely cash flow in the computation. This approach continues to be applied in some present value applications.
  • Expected Cash Flow Approach - The risk and uncertainty is incorporated into the risk-adjusted expected cash flows. Uses expectations about all possible cash flows instead of a single cash flow. Both uncertainty as to timing and amount can be incorporated into the calculation.

NOTE: The risk and uncertainty is incorporated into either the discount rate or the cash flows—not both!!!

• When the fair value of an asset or liability is not available, present value is often the best available technique to estimate what fair value would be if it existed in the situation. But if the fair value is available, there is no need to use present value measurement.
• As close as possible to fair value; expected cash flow approach.
• Accounting for Asset Retirement Obligations.