This chapter covers conceptual framework, fundamental accounting principles, accounting assumptions and the elements of financial statements.
The Conceptual Framework for Financial Reporting
The Elements of Financial Statements
Accounting Assumptions and Principles
Chapter 2 outlines the development of a conceptual framework for financial reporting. The conceptual framework is composed of a basic objective, fundamental concepts, and recognition, measurement, and disclosure concepts. Each of these topics is discussed in Chapter 2 and should enhance your understanding of the topics covered in intermediate accounting.
A conceptual framework in accounting is important because rule-making should be built on and relate to an established body of concepts. The benefits of a soundly developed conceptual framework are as follows: (a) it should be easier to issue a coherent set of standards and rules; and (b) practical problems should be more quickly solved.
The FASB’s conceptual framework is developed in a series of concept statements (collectively the Conceptual Framework). The conceptual framework has the following 3 levels:
- First level: The objective of financial reporting, the “why” or purpose of accounting.
- Second level: The qualitative characteristics and the elements of financial statements, which form a bridge between the 1st and 3rd levels.
- Third level: Recognition, measurement, and disclosure concepts, the “how” or implementation.
First Level: Basic Objective
The basic objective of financial reporting is the foundation of the conceptual framework and requires that general-purpose financial reporting provide 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. In order to understand general-purpose financial reporting, users need reasonable knowledge of business and financial matters.
Second Level: Fundamental Concepts
Companies must decide what type of information to disclose and how to disclose it. These choices are determined by which method or alternative provides the most decision-useful information. The qualitative characteristics of accounting information distinguish better and more useful information from inferior and less useful information.
The fundamental qualities of accounting information are:
- Relevance – information that is capable of making a difference in a decision. Comprised of
- Predictive value means that the information can help users form expectations about the future.
- Confirmatory value means that the information validates or refutes expectations based on previous evaluations.
- Materiality means that information is material if omitting it or misstating it could influence decisions that users make on the basis of the reported financial information.
Faithful representation – numbers and descriptions match what really happened or existed. Comprised of Completeness means that all necessary information is provided. Neutrality means that the information is unbiased. Free from error means that the information is accurate.
- Enhancing qualities complement the fundamental qualities and include:
- Comparability means that companies record and report information in a similar manner. Consistency is another type of comparability and means the company uses the same accounting methods from period to period.
- Verifiability means that independent people using the same methods arrive at similar conclusions.
- Timeliness means that information is available before it loses its relevance.
- Understandability means that reasonably informed users should be able to comprehend the information that is clearly classified and presented.
An important aspect of developing an accounting theoretical structure is the body of basic elements or definitions. Ten basic elements that are most directly related to measuring the performance and financial status of a business enterprise are formally defined in SFAC No. 6. These elements, as defined below, are further discussed and interpreted throughout the text.
Assets. Probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.
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 (or equity) in it. Assets are most commonly received as investments by owners, but that which is received may 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 by the enterprise to owners. Distributions to owners decrease ownership interests (or 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 nonowner sources. It 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 entity’s ongoing major or central operations.
Expenses. Outflows or other using up of assets or incurrences 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 ongoing 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 expenses or distributions to owners.
In the practice of financial accounting, certain basic assumptions are important to an understanding of the manner in which data are presented. The following four basic assumptions underlie the financial accounting structure:
Economic Entity Assumption. Economic activity can be identified with a particular unit of accountability in a manner that assumes the company is separate and distinct from its owners or other business units.
Going Concern Assumption. In the absence of contrary information, a company is assumed to have a long life. The current relevance of the historical cost principle is dependent on the going-concern assumption.
Monetary Unit Assumption. Money is the common denominator of economic activity and provides an appropriate basis for accounting measurement and analysis. The monetary unit is assumed to remain relatively stable over the years in terms of purchasing power. In essence, this assumption disregards any inflation or deflation in the economy in which the company operates.
Periodicity Assumption. The economic activities of a company can be divided into artificial time periods for the purpose of providing the company’s periodic reports.
Certain basic principles are followed by accountants in recording and reporting the transactions of a business entity. These principles relate to how assets, liabilities, revenues, and expenses are to be identified, measured, and reported.
Measurement Principle. A ‘mixed-attribute’ system permits the use of various measurement bases.
Historical Cost Principle. Acquisition cost is considered a reliable basis upon which to account for assets and liabilities of a company. Historical cost has an advantage over other valuations, as it is thought to be verifiable.
Fair Value Principle. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in on orderly transaction between market participants at the measurement date. Recently, GAAP has increasingly called for the use of fair value measurements in the financial statements.
Revenue Recognition Principle. Revenue is recognized at the time in which the performance obligation is satisfied.
Expense Recognition Principle. Recognition of expenses is related to net changes in assets and earning revenues. The expense recognition principle is implemented in accordance with the definition of expense by matching efforts (expenses) with accomplishment (revenues).
Product costs, such as material, labor, and overhead, attach to the product, and are recognized in the same period the products are sold.
Period costs, such as officers’ salaries and other administrative expenses, attach to the period, and are recognized in the period incurred.
Full Disclosure Principle. In the preparation of financial statements, the accountant should include sufficient information to influence the judgment and decision of an informed user. A series of judgmental tradeoffs must occur.
Although accounting theory is based upon certain assumptions and the application of basic principles, there are some exceptions to these assumptions. One exception is often called a constraint, and sometimes justifies departures from basic accounting theory.
Cost Constraint. The cost constraint (or cost-benefit relationship) relates to the notion that the benefits to be derived from providing certain accounting information should exceed the costs of providing that information. The difficulty in cost-benefit analysis is that the costs and especially the benefits are not always evident or measurable.