Chapter 2-1 CHAPTER CONCEPTUAL FRAMEWORK UNDERLYING FINANCIAL ACCOUNTING Intermediate Accounting 13th Edition Kieso, Weygandt, and Warfield Chapter 2-2 Learning Learning Objectives Objectives Describe the usefulness of a conceptual framework Describe the FASB’s efforts to construct a conceptual framework Understand the objectives of financial reporting Identify the qualitative characteristics of accounting information Define the basic elements of financial statements Describe the basic assumptions of accounting Explain the application of the basic principles of accounting Describe the impact that constraints have on reporting accounting information Chapter 2-3 Financial Financial Accounting Accounting and and Accounting Accounting Standards Standards Conceptual Framework Need Development Chapter 2-4 First Level: Basic Objectives Decision usefulness Information about economic resources Second Level: Fundamental Concepts Qualitative characteristics Basic elements Third Level: Recognition and Measurement Basic assumptions Basic principles Constraints Conceptual Conceptual Framework Framework The Need for a Conceptual Framework To develop a coherent set of standards and rules To solve new and emerging practical problems Chapter 2-5 LO Describe the usefulness of a conceptual framework Conceptual Conceptual Framework Framework Review: A conceptual framework underlying financial accounting is important because it can lead to consistent standards and it prescribes the nature, function, and limits of financial accounting and financial statements True Chapter 2-6 LO Describe the usefulness of a conceptual framework Conceptual Conceptual Framework Framework Review: A conceptual framework underlying financial accounting is necessary because future accounting practice problems can be solved by reference to the conceptual framework and a formal standard-setting body will not be necessary False Chapter 2-7 LO Describe the usefulness of a conceptual framework Development Development of of Conceptual Conceptual Framework Framework The FASB has issued six Statements of Financial Accounting Concepts (SFAC) for business enterprises SFAC No.1 - Objectives of Financial Reporting SFAC No.2 - Qualitative Characteristics of Accounting Information SFAC No.3 - Elements of Financial Statements (superceded by SFAC No 6) SFAC No.5 - Recognition and Measurement in Financial Statements SFAC No.6 - Elements of Financial Statements (replaces SFAC No 3) SFAC No.7 - Using Cash Flow Information and Present Value in Accounting Measurements Chapter 2-8 LO Describe the FASB’s efforts to construct a conceptual Objective framework Conceptual Conceptual Framework Framework The Framework is comprised of three levels: First Level = Basic Objectives Second Level = Qualitative Characteristics and Basic Elements Third Level = Recognition and Measurement Concepts The FASB and the IASB have agreed on a joint project to develop a common and improved conceptual framework Chapter 2-9 LO Describe the FASB’s efforts to construct a conceptual framework ASSUMPTIONS PRINCIPLES Economic entity Measurement Cost-benefit Going concern Revenue recognition Materiality Monetary unit Expense recognition Industry practice Periodicity Full disclosure Conservatism QUALITATIVE CHARACTERISTICS Relevance Reliability Comparability Illustration 2-7 Conceptual Framework for Financial Reporting Consistency Chapter 2-10 CONSTRAINTS Third level ELEMENTS Assets, Liabilities, and Equity Investments by owners Distribution to owners Comprehensive income Revenues and Expenses Gains and Losses OBJECTIVES Useful in investment and credit decisions Useful in assessing future cash flows About enterprise resources, claims to resources, and changes in them Second level First level LO Describe the FASB’s efforts to construct a conceptual framework Second Second Level: Level: Basic Basic Elements Elements Exercise 2-3: Identify the element or elements associated with items below Elements (f) Assets (f) Items characterized by (b) Liabilities future economic benefit (g) Equals increase in net Equity assets during the year, (c) Investment by owners after adding distributions (d) Distribution to owners to owners and subtracting investments by owners (g) (e) (c) Comprehensive income (h) Revenue (h) Arises from income statement activities that (h) Expenses constitute the entity’s (a) Gains ongoing major or central (a) Losses Chapter operations 2-27 LO Second Second Level: Level: Basic Basic Elements Elements Exercise 2-3: Identify the element or elements associated with items below Elements (f) Assets (i) Residual interest in the net assets of the enterprise (b) Liabilities (j) Increases assets through (i) Equity sale of product (c) Investment by owners (k) Decreases assets by (k) (d) Distribution to owners purchasing the company’s (l) (g) (e) (c) Comprehensive income own stock (l) Changes in equity during (j) (h) Revenue the period, except those (h) Expenses from investments by (a) Gains owners and distributions to (a) Losses owners Chapter 2-28 LO Second Second Level: Level: Basic Basic Elements Elements Review: According to the FASB conceptual framework, an entity’s revenue may result from a A decrease in an asset from primary operations b An increase in an asset from incidental transactions c An increase in a liability from incidental transactions d A decrease in a liability from primary operations (CPA adapted) Chapter 2-29 LO Define the basic elements of financial statements Third Third Level: Level: Recognition Recognition and and Measurement Measurement The FASB sets forth most of these concepts in its Statement of Financial Accounting Concepts No 5, “Recognition and Measurement in Financial Statements of Business Enterprises.” ASSUMPTIONS Chapter 2-30 PRINCIPLES CONSTRAINTS Economic entity Measurement Cost-benefit Going concern Revenue recognition Materiality Monetary unit Expense recognition Industry practice Periodicity Full disclosure Conservatism LO Describe the basic assumptions of accounting Third Third Level: Level: Assumptions Assumptions Economic Entity – company keeps its activity separate from its owners and other businesses Going Concern - company to last long enough to fulfill objectives and commitments Monetary Unit - money is the common denominator Periodicity - company can divide its economic activities into time periods Chapter 2-31 LO Describe the basic assumptions of accounting Third Third Level: Level: Assumptions Assumptions Brief Exercise 2-4: Identify which basic assumption of accounting is best described in each item below (a) The economic activities of KC Corporation are divided into 12-month periods for the purpose of issuing annual reports (b) Solectron Corporation, Inc does not adjust amounts in its financial statements for the effects of inflation (c) Walgreen Co reports current and noncurrent classifications in its balance sheet (d) The economic activities of General Electric and its subsidiaries are merged for accounting and reporting purposes Chapter 2-32 Periodicity Monetary Unit Going Concern Economic Entity LO Describe the basic assumptions of accounting Third Third Level: Level: Principles Principles Measurement – The most commonly used measurements are based on historical cost and fair value Issues: Historical cost provides a reliable benchmark for measuring historical trends Fair value information may be more useful Recently the FASB has taken the step of giving companies the option to use fair value as the basis for measurement of financial assets and financial liabilities Reporting of fair value information is increasing Chapter 2-33 LO Explain the application of the basic principles of accounting Third Third Level: Level: Principles Principles Revenue Recognition - generally occurs (1) when realized or realizable and (2) when earned Exceptions: Chapter 2-34 Illustration 2-4 Timing of Revenue Recognition LO Explain the application of the basic principles of accounting Third Third Level: Level: Principles Principles Expense Recognition - “Let the expense follow the revenues.” Chapter 2-35 Illustration 2-5 Expense Recognition LO Explain the application of the basic principles of accounting Third Third Level: Level: Principles Principles Full Disclosure – providing information that is of sufficient importance to influence the judgment and decisions of an informed user Provided through: Financial Statements Notes to the Financial Statements Supplementary information Chapter 2-36 LO Explain the application of the basic principles of accounting Third Third Level: Level: Principles Principles Brief Exercise 2-5: Identify which basic principle of accounting is best described in each item below Revenue (a) KC Corporation reports revenue in its income Recognitio statement when it is earned instead of when the cash is collected n (b) Yahoo, Inc recognizes depreciation expense for a machine over the 2-year period during which that machine helps the company earn revenue Expense Recognitio n (c) Oracle Corporation reports information about pending lawsuits in the notes to its financial statements Full Disclosure (d) Eastman Kodak Company reports land on its balance sheet at the amount paid to acquire it, even though the estimated fair market value is greater Chapter 2-37 Measurement LO Explain the application of the basic principles of accounting Third Third Level: Level: Constraints Constraints Cost Benefit – the cost of providing the information must be weighed against the benefits that can be derived from using it Materiality - an item is material if its inclusion or omission would influence or change the judgment of a reasonable person Industry Practice - the peculiar nature of some industries and business concerns sometimes requires departure from basic accounting theory Conservatism – when in doubt, choose the solution that will be least likely to overstate assets and income Chapter 2-38 LO Describe the impact that constraints have on reporting accounting information Third Third Level: Level: Constraints Constraints Brief Exercise 2-7: What accounting constraints are illustrated by the items below? (a) KC, Inc reports agricultural crops on its balance sheet at market value (b) Rafael Corporation does not accrue a contingent lawsuit gain of $650,000 (c) Willis Company does not disclose any information in the notes to the financial statements unless the value of the information to users exceeds the expense of gathering it (d) Favre Corporation expenses the cost of wastebaskets in the year they are acquired Chapter 2-39 Industry Practice Conservatism CostBenefit Materiality LO  The existing conceptual frameworks underlying U.S GAAP and iGAAP are very similar  The converged framework should be a single document, unlike the two conceptual frameworks that presently exist  The IASB framework makes two assumptions One assumption is that financial statements are prepared on an accrual basis; the other is that the reporting entity is a going concern  There is some agreement that the role of financial reporting is to assist users in decision making However, others note that another objective is to provide information on management’s performance, often referred to as stewardship Chapter 2-40 Copyright Copyright Copyright © 2009 John Wiley & Sons, Inc All rights reserved Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc The purchaser may make back-up copies for his/her own use only and not for distribution or resale The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein Chapter 2-41 .. .CHAPTER CONCEPTUAL FRAMEWORK UNDERLYING FINANCIAL ACCOUNTING Intermediate Accounting 13th Edition Kieso, Weygandt, and Warfield Chapter 2-2 Learning Learning Objectives... on reporting accounting information Chapter 2-3 Financial Financial Accounting Accounting and and Accounting Accounting Standards Standards Conceptual Framework Need Development Chapter 2-4 First... characteristics of accounting information Define the basic elements of financial statements Describe the basic assumptions of accounting Explain the application of the basic principles of accounting