Chapter 2

INTERMEDIATE
ACCOUNTING
Chapter 2
Financial Reporting: Its Conceptual Framework
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Objectives
1. Explain the FASB Conceptual Framework.

2. Explain the general and specific objectives of general
purpose financial reporting.
3. Explain the qualitative characteristics of decision-useful
information as identified in the FASB and IASB joint
Conceptual Framework project.
4. Understand and apply the major principles and
assumptions of financial reporting and U.S. GAAP.
5. Describe the financial reporting model in the FASB
Conceptual Framework.
6. (Appendix 2.1) Understand the current status of the
ongoing project by the FASB and IASB to develop a joint
Conceptual Framework.
FASB Conceptual Framework
(Slide 1 of 2)
 The intent of FASB’s Conceptual Framework is to

establish a theoretical foundation of interrelated
objectives, concepts, and definitions that leads to
the establishment of consistent high-quality
financial accounting standards in accounting
practice, and the appropriate application of those
standards in accounting practice.
FASB Conceptual Framework
(Slide 2 of 2)
 The Conceptual Framework is intended to:

 Guide the FASB in establishing accounting standards
 Provide a frame of reference for financial statement
preparers and auditors for resolving accounting questions
in situations where a standard does not exist
 Establish objectives and conceptual guidelines that form
the bounds for judgment in the preparation of financial
statements
 Increase users’ understanding of and confidence in
financial reporting
 Enhance financial statement comparability across
companies and over time
Accounting Principles
 Accounting principles are fundamental theories,

truths and propositions that serve as the
foundation for financial accounting and financial
reporting.
 The most fundamental statements of these
principles come from FASB’s Statements of
Financial Accounting Concepts
 Also known as Concept Statements
 Generally broad and definitional
Accounting Concepts
 FASB’s Statements of Financial Accounting Concepts

are general proclamations that establish:
 Fundamental principles of accounting
 Objectives of financial reporting
 Qualities of useful financial accounting information
 Definitions of basic elements like assets and liabilities
 Types of economic transactions, events, and
arrangements to be recognized in financial statements
 Measurement attributes to use to measure and report
these transactions, events, and arrangements
 How transactions, events, and arrangements should be
presented and classified in financial statements
 Are the basis and objectives of GAAP
Accounting Standards
 Accounting standards
 Establish the authoritative guidance on how companies
should account for and report specific transactions,
events, and arrangements in their financial statements.
 Specific accounting standards in GAAP provide
guidance on when and how to recognize and measure
these elements in financial statements.
 Within accounting standards, rules exist, which are
specific implementation procedures.
Relationship of Principles, Concepts,
Standards, and Rules
Conceptual Framework: Brief History
 Statement of Financial Accounting Concepts No. 1

“Objectives of Financial Reporting by Business Enterprises”
(1978)
 Established primary objectives of financial accounting
“Qualitative Characteristics of Accounting Information”
(1980)
 Accounting projects define the accounting elements and identify
which elements should be recognized in financial statements,
when they should be reported, and how they should be
measured.
 Reporting projects deal with how elements of financial reports
are classified and presented, what information should be
provided, and where information should be presented.
Conceptual Framework: Current Status
 FASB and IASB are working closely together to

develop a common Conceptual Framework.
 Goal is to develop standards that are objectives-
based , internally consistent, and internationally
converged.
 Eight phase process with one phase complete and
three other phases in process
“Conceptual Framework for Financial Reporting” –
2010
Conceptual Framework Projects
What are the Objectives of Financial
Reporting? (Slide 1 of 2)
What are the Objectives of Financial
Reporting? (Slide 2 of 2)
Objective 1:
Information Useful in Decision Making
 Financial reporting should provide useful
information about the reporting entity for:
 Existing and potential investors – shareholders, equity
fund managers, and analysts
 Lenders – banks, lending institutions, bondholders, and
credit rating agencies
 Other creditors who make decisions about providing
resources to the entity – suppliers, customers, and
employees with claims
Objective 2: Information Useful to External
Users in Assessing Expected Returns
 Information needs of investors, lenders, and other
creditors
 Suppliers of financial capital are primarily interested
in the amounts, timing, and uncertainty of the
prospective cash flows they will receive.
 Need to assess the expected returns from buying, selling,
or holding a company’s equity, debt or other financial
instruments
 External users need financial information to form
expectations about the timing and amount of
prospective cash receipts and assess the risk involved.
Objective 3: Information Useful in Assessing
Company Cash Flows
 Financial reporting should provide information to
help external investors, lenders, and other
creditors in assessing the amounts, timing and
uncertainty of the prospective net cash inflows to
the company.
 Company’s ability to generate net cash inflows
determines both its ability to pay dividends and
interest and the market prices of its securities.
 These affect the cash flows to investors, lenders, and
creditors.
Information about Economic Resources and
Claims on the Company
 Financial reporting should provide information about a
company’s economic resources and the claims on the
company.
 This information is useful to external users for the
following reasons:
 To identify the company’s resources, obligations, financial
strengths and weaknesses, and to assess its liquidity and
solvency
 To specify the types of resources in which the company has
invested, as well as the types and timing on the claims of
the company
 To indicate the potential future cash flows from the
company’s resources and the ability of the resources to
satisfy the claims on the company
Information about Financial Performance Changes in
the Company’s Resources and Claims
 Financial reporting should provide information about

the financial performance which causes the company’s
resources and the claims on the company to change
during the period.
 Information concerning the company’s net income,
comprehensive income, and their components is useful
to external users in:
 Evaluating management’s performance
 Estimating the company’s “earning power” or other
amounts that are representative of persistent long-term
income-producing ability
 Predicting future income and net cash flows
 Assessing the risk of investing in or lending to the company
Accrual Accounting
 Accrual accounting measures and reports the

economic effects of a company’s transactions,
events, and circumstances on a company’s
economic resources and claims in the period in
which those effects occur, even if the related cash
receipts and payments occur in a different period.
 Provides a better basis for assessing the company’s
past and future performance than information solely
about cash receipts and payments.
Information about Cash Flow Changes in the
Company’s Resources and Claims
 Financial reporting should provide information about how
a company’s cash flows cause changes in the company’s
resources and claims.
 Cash flow information shows how a company obtains and
spends cash for its operating, investing, and financing
activities.
 Investors, lenders, and other creditors use cash flow
information about a company to:
 Help understand its operations and its cash-generating ability
 Evaluate its strategic sourcing and use of cash for financing and
investing activities
 Assess its liquidity and solvency
 Interpret other information about financial performance
Information about Management and the
Governing Board as they Relate to Resources
 Financial reporting should provide information about
how efficiently and effectively the company’s
management and governing board have discharged
their responsibilities to use the company’s resources.
 Referred to as management’s stewardship responsibility
 Management is responsible to the owners for:
 The custody and safekeeping of the resources
 Their efficient and profitable use
 Their protection against unfavorable economic
impacts, technological advances, and social changes
 Provided in Statement of Financial Accounting Concepts
No. 8
Types of Useful Information for Investors,
Lenders, and Other Creditors
 The following types of information are helpful in assessing
the amounts, timing, and uncertainty of expected future
cash flows to a company:
 Return on investment – measure of overall company
performance for equity shareholders
 Risk – the uncertainty or unpredictability of future profitability
of a company
 Financial flexibility – the ability of a company to use its
financial resources to adapt to change and to take advantage
of opportunities
 Liquidity – refers to how quickly a company can convert its
assets into cash to meet short-term obligations and cover
operating costs
 Operating capability – refers to the ability of a company to
produce goods and services for customers
What Qualities Make Accounting Information
Useful?
 Decision-useful information
 Defined by the joint Conceptual Framework in terms
of fundamental qualitative characteristics and
enhancing qualitative characteristics
 Qualitative characteristics guide standard setters
and financial statement preparers when choosing
among accounting alternatives
 Qualities distinguish more-useful from less-useful
information.
Qualitative Characteristics
Decision Usefulness
 Decision usefulness is the ultimate objective of

accounting information.
 It can be achieved if the information has a
sufficient degree of the fundamental
characteristics of relevance and faithful
representation.
Relevance
 Relevance – information that is capable of making

a difference in decisions made by financial
statement users
 Predictive Value – information that should help users
form expectations about the future
 Confirmatory Value – information that provides
feedback to confirm or correct prior predictions and
expectations
 Materiality – refers to the nature and magnitude of
an omission or misstatement of accounting information
that would influence the judgment of a reasonable
person relying on that information
Faithful Representation
 Faithful representation – when the words and numbers

accurately predict the economic substance of what
they purport to represent
 Complete representation – provides a user with full
disclosure of all information necessary to understand the
information being reported, with all necessary facts,
descriptions, and explanations
 Neutral representation – not biased, slanted, emphasized
or otherwise manipulated to achieve a predetermined
result or to influence users’ behavior in a particular
direction
 Free from error – the information is measured and
described as accurately as possible, using a process that
reflects the best available inputs
The Relation between Relevance and
Faithful Representation
 Accounting information is most useful when it is
both relevant and faithfully represented.
 Both characteristics should be maximized.
 To provide users with the most decision-useful
information possible
Process of Applying Fundamental Qualitative
Characteristics
Step 1 – Identify an economic transaction, event, or
arrangement that needs to be recognized in the
financial statements.
Step 2 – Identify the type of information about that
phenomenon that would be most relevant – material
and capable of making a difference in decision
makers’ predictions of future outcomes/or
confirmations of past predictions.
Step 3 – Determine whether that information can be faithfully
represented in a manner that is complete, neutral, and
free from error.
Step 4 – Determine whether the benefits of that information
are likely to exceed its cost. What are the possible
outcomes?
Enhancing Characteristics
(Slide 1 of 2)
 Comparability – enables users of accounting

information to identify and explain similarities and
differences between two or more sets of economic
facts
 Consistency – means that accounting methods and
procedures are applied in the same manner from
period to period
 Verifiability – accounting information is verifiable
when different knowledgeable and independent
observers can reach consensus that a particular
representation is faithful
Enhancing Characteristics
(Slide 2 of 2)
 Timeliness – accounting information is timely when it is

available to decision makers in time to influence their
decisions
 Understandability – the accounting information should
be comprehensible to users who have a reasonable
knowledge of business and economic activities and
who are willing to study the information carefully
What single, pervasive constraint bounds the qualitative
characteristics of the financial information disclosed in a
company’s financial reports?
Cost Constraint: Benefit > Costs
Accounting Assumptions and Principles
 Certain accounting assumptions and principles have

had an important impact on the development of
GAAP:
 Reporting Entity or Economic Entity Assumption
 Going Concern Assumption
 Period-of-Time Assumption
 Monetary Unit Assumption
 Mixed Attribute Measurement Model
 Recognition
 Accrual Accounting
 Conservatism
Reporting Entity or Economic Entity Assumption
 This assumption states that a business enterprise is

a legally and economically distinct entity so that
financial statements can be prepared and
reported specifically for that entity.
 For the purposes of financial accounting, the size
of a business is irrelevant.
 May vary from sole proprietorships to multi-national
corporations with subsidiary companies
What differences may exist between these types of
companies when reporting financial information?
Going Concern or Continuity Assumption
 The assumption is that the company will continue to

operate in the foreseeable future.
 Without substantial evidence to the contrary, the
company can be reasonably expected to operate
long enough to realize economic benefits from its
assets and satisfy its existing obligations.
Do companies that appear to be going

bankrupt meet the going concern assumption?
Why or why not?
Period-of-Time Assumption
 The period-of-time assumption requires that financial

statement users prepare and report financial
statements in an annual report with the SEC.
 Provides timely information to decision makers
 The annual reporting period is often referred to as
the accounting period or fiscal year which may or may
not mirror the calendar year.
 Some companies choose a fiscal year that more
closely approximates their annual business cycle, which
is the yearly period from lowest sales through highest
sales and back to lowest sales.
Monetary Unit Assumption
 Accountants generally use the national currency of

the reporting entity as the monetary unit of
measure in preparing financial statements.
Is the United States dollar considered to be a

stable monetary unit for preparing a company’s
financial statements? Why or why not?
Mixed Attribute Measurement Model
(Slide 1 of 2)
 This model seeks to measure assets, liabilities,

revenues, expenses, and other elements of the
financial statements with the most relevant and
faithful measurement available.
 What types of measurements would be included?
 Historical costs
 Allocated historical costs
 Fair values
 Present values of future cash flows
 Net realizable values
Mixed Attribute Measurement Model
(Slide 2 of 2)
 The economic activities and resources of a company

initially are measured using the exchange price or
historical cost at the time each transaction occurs.
 This cost is the most relevant and faithful representation of
the value of the exchange.
 The historical cost provides evidence that independent
parties have willingly agreed on the value of the items
exchanged at the time of the transaction.
 What are the qualities of historical cost?
 Relevance
 Representational faithfulness (Neutrality)
 Verifiability
 What are the differences between historical cost and fair
value?
Recognition
 Recognition is the process of formally recording and

reporting an item in the financial statements of a
company.
 A recognized item is shown in both words and
numbers, with the amount included in the financial
statement totals.
 To be recognized, an item must:
 Meet the definition of an element (asset, liability, etc.)
 Be measurable
 Be relevant
 Be representationally faithful
Accrual Accounting
 Accrual accounting is the process of measuring and

reporting the economic effects of transactions, events,
and arrangements in the period when those effects
occur, even though cash flows may occur in a different
period.
 Accruals – when economic effects are recognized in the
current period even though the cash flows will occur in a
later period
 Deferrals – when cash flows occur in the current period but
economic effects will be recognized in a later period
 What are some examples of accruals and deferrals?
Principles of Accrual Accounting
 The Revenue Recognition Principle – determines the

appropriate period in which a company creates
economic benefits and can recognize revenues in
income
 The Expense Recognition Principle – determines the
appropriate period in which a company has
consumed economic resources in conducting
business operations
 The Matching Principle – matches the expense to
the period in which the economic benefits are
consumed by generating revenues
Conservatism
 Conservatism is an approach that accountants use to

avoid overstating net assets and net income when
these amounts are uncertain.
 Results in the reporting of lower assets values or higher
liability values when those values are uncertain
 Conservatism is a practical approach accountants take
to avoid misleading investors, lenders, and other
creditors when valuations are uncertain.
 What is another name for conservatism?
 Prudence – conservatism is a prudent reaction to
uncertainty to ensure, to the extent possible, that the
uncertainties and risks inherent in the business situations
are adequately considered.
Sources of Information Used in External
Decision Making
Status of the Joint FASB and
IASB Conceptual Framework
 This project is split into eight phases:
1 – Objective and qualitative characteristics
2 – Elements and recognition
3 – Measurement
4 – Reporting entity
5 – Presentation and disclosure
6 – Framework for a GAAP hierarchy
7 – Applicability to the not-for-profit sector
8 – Remaining issues
 Each phase will involve extensive planning,
research, and deliberations.
Phase One:
Objective and Qualitative Characteristics
 Phase 1 is complete and resulted in the FASB and
IASB jointly issuing:
 Statement of Financial Accounting Concepts No. 8 -
“Conceptual Framework for Financial Reporting”
 Chapter 1 – “The Objective of General Purpose Financial
Reporting”
 Chapter 2 – “Qualitative Characteristics of Useful
Financial Information”
 These chapters supersede FASB Concepts
Statements No. 1 and No. 2.
Ongoing Phases
 The Boards have temporarily placed the Conceptual

Framework on hold while they focus on finalizing
convergence on several major specific standards.
 Three other active phases were put on hold.
 Phase Two: Elements and Recognition – exploring potential
ways to refine and improve definitions of assets and
liabilities
 Phase Three: Measurement – evaluating various
measurement techniques for assets and liabilities that
satisfy the objective and qualitative characteristics
 Phase Four: Reporting Entity – working on refining the
definition of a reporting entity and the appropriate
presentation in financial statements for a group entity

Chapter 2

Uploaded by

Copyright:

Available Formats

Chapter 2

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Chapter 2

Uploaded by

Copyright:

Available Formats

INTERMEDIATE

1. Explain the FASB Conceptual Framework.

 The intent of FASB’s Conceptual Framework is to

 The Conceptual Framework is intended to:

 Accounting principles are fundamental theories,

 FASB’s Statements of Financial Accounting Concepts

 Statement of Financial Accounting Concepts No. 1

 FASB and IASB are working closely together to

 Financial reporting should provide information about

 Accrual accounting measures and reports the

 Decision usefulness is the ultimate objective of

 Relevance – information that is capable of making

 Faithful representation – when the words and numbers

 Comparability – enables users of accounting

 Timeliness – accounting information is timely when it is

 Certain accounting assumptions and principles have

 This assumption states that a business enterprise is

 The assumption is that the company will continue to

Do companies that appear to be going

 The period-of-time assumption requires that financial

 Accountants generally use the national currency of

Is the United States dollar considered to be a

 This model seeks to measure assets, liabilities,

 The economic activities and resources of a company

 Recognition is the process of formally recording and

 Accrual accounting is the process of measuring and

 The Revenue Recognition Principle – determines the

 Conservatism is an approach that accountants use to

 The Boards have temporarily placed the Conceptual

You might also like