Financial Reporting: Its Conceptual Framework C hapter 2 An electronic presentation by Norman Sunderman Angelo State University An electronic presentation by Norman Sunderman Angelo State University COPYRIGHT © 2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Intermediate Accounting 10th edition Nikolai Bazley Jones

2 Objectives Oriented Principles  The SEC has recommended that future accounting standards should not follow a rules-base or principles based only approach, but should be objectives-oriented.  Should be built on an improved and consistently improved conceptual framework  Clearly state the accounting objective  Minimize exceptions  Avoid the use of bright-line tests

3 To develop a conceptual framework of accounting theory. Charges Given to the FASB

4 To establish standards (GAAP) for financial accounting practices. Charges Given to the FASB

5  To guide the FASB in establishing accounting standards.  To provide a frame of reference for resolving accounting questions in situations where a standard does not exist.  To determine the bounds for judgment in the preparation of financial statements.  To increase users’ understanding of and confidence in financial reporting.  To enhance comparability. FASB Conceptual Framework

6 General Objective Provide information that is useful to present and potential investors, creditors, and other users in making rational investment, credit, and similar decisions. Objectives of Financial Reporting

7 Derived External User Objective Provide information that is useful to present and potential investors creditors, and other users in assessing the amounts, timing, and uncertainty of prospective cash receipts from dividends and interest, and the proceeds from the sale, redemption, or maturity of securities or loans. Objectives of Financial Reporting

8 Derived Company Objective Provide information to help investors, creditors, and others in assessing the amounts, timing, and uncertainty of prospective net cash inflows to related company. Objectives of Financial Reporting

9 Specific Objectives Provide information about a company’s economic resources, obligations, and owners’ equity. Provide information about a company’s comprehensive income and its components. Provide information about a company’s cash flows. Objectives of Financial Reporting

10 First, financial reporting should provide information about how the management of a company has discharged its stewardship responsibilities. Other Issues

11 Second, financial statements and other means of financial reporting should include explanations and interpretations to management to help external users understand the financial information provided. Other Issues

12 Providing this critical information is known as full disclosure. Other Issues

13 Accounting information is relevant if it can make a difference in a decision. Hierarchy of Qualitative Characteristics

14 Accounting information is reliable when it is reasonably free from error and bias, and faithfully represents what it is intended to represent. Hierarchy of Qualitative Characteristics

15 Comparability of accounting information enables users to identify and explain similarities and differences between two or more sets of economic facts. Hierarchy of Qualitative Characteristics

16 Are benefits greater than costs? Constraints to the Hierarchy

17  The nature of the item.  The relative size rather than absolute size of an item.  The nature of the item.  The relative size rather than absolute size of an item. Materiality Constraints to the Hierarchy

18 Entity The entity assumption assumes that a proprietorship, partnership, or corporation’s financial activities are distinguished from other financial organizations in keeping its own financial records and reports. Assumptions and Conventions

19 Continuity This assumption assumes that the company will continue to operate in the near future, unless substantial evidence to the contrary exists. This assumption is also known as the going-concern assumption. Assumptions and Conventions

20 Period of Time In accordance with the period-of-time assumption, a company prepares financial statements at the end of each year and includes them its annual report. The period-of-time assumption is the basis for the adjusting entry process at period-end. Assumptions and Conventions

21 Market Value $13,500 Market Value $13,500 Cost $16,000 Cost $16,000 Replacement Cost $13,000 Replacement Cost $13,000 Historical Cost Usually, the exchange price is retained in the accounting records as the value of an item until it is removed from the records. Assumptions and Conventions

22 Historical Cost Which amount should be used? Cost $16,000 Cost $16,000 Assumptions and Conventions

23 Monetary Unit This assumption states that there must be some basis for measuring exchange of goods or services. Currently the dollar is considered to be a stable monetary unit for preparing a company’s financial statements. Assumptions and Conventions

24 Realization and Recognition Realization is the process of converting noncash resources and rights into cash or rights to cash. Recognition is the process of formally recording and reporting an item in the financial statements of a company. Assumptions and Conventions

25 Accrual accounting is the process of relating the financial effects of transactions, events, and circumstances having cash consequences to the period in which they occur rather than to when the cash receipt or payment occurs. The matching principle states that to determine the income of a company for an accounting period, the company computes the total expense involved in obtaining the revenues of the period and relates these total expenses to the total revenues recorded in the period. Matching and Accrual Accounting Assumptions and Conventions

26 Conservatism The conservatism convention states that when alternative accounting valuations are equally possible, the accountant should select the one that is least likely to overstate assets and income in the current period. Assumptions and Conventions

27 A balance sheet is a financial statement that summarizes the financial position of a company on a particular date. It also is called a statement of financial position. Balance Sheet

28  Assets are the probable future economic benefits obtained and controlled by a company as a result of past transactions or events.  Liabilities are the probable future sacrifices of economic benefits arising from present obligations of a company to transfer assets or provide services in the future as a result of past transactions or events.  Equity is the owners’ residual interest in the net assets of a company. Elements of a balance sheet: Balance Sheet

29 An income statement is a financial statement that summarizes the results of a company’s operations. Income Statement

30  Revenues are inflows or other enhancements of assets of a company or settlement of its liabilities during a period from delivering or producing goods, rendering services, or other activities that are the company’s ongoing major operation. Revenues increase the equity of a company. ContinuedContinued The elements of the income statement are: Income Statement

31  Expenses are outflows or other using up of assets of a company or incurrences of liabilities during a period from delivering or producing goods, rendering services, or carrying out other activities that are the company’s ongoing major operation. Expenses decrease the equity of a company. ContinuedContinued The elements of the income statement are: Income Statement

32  Gains are increases in the equity of a company from peripheral or incidental transactions and from all other transactions and other events and circumstances affecting the company, except those that result from revenues or investments by owners. Gains increase the equity of a company. ContinuedContinued The elements of the income statement are: Income Statement

33  Losses are decreases in the equity of a company, from peripheral or incidental transactions except those that result from expenses or distribution to owners. Losses decrease the equity of a company. The elements of the income statement are: Income Statement

34 Revenues increase the equity of the company Expenses decrease the equity of the company Income Statement

35 A statement of cash flows is a financial statement that summarizes the cash inflows and outflows of a company for a period. Statement of Cash Flows

36  Operating cash flows are the flows of cash from acquiring, selling, and delivering goods for sale, as well as providing services.  Investing cash flows are the flows of cash from acquiring and selling investments, property, plant, and equipment, as well as from lending money and collecting on loans.  Financing cash flows are the flows of cash to and from the owners and long-term creditors. The elements of a statement of cash flows are: Statement of Cash Flows

37 A statement of changes in equity summarizes the changes in a company’s equity for a period. Statement of Changes in Equity

38  Investments by owners are increases in equity resulting from transfers of something valuable to the company from other entities in order to obtain or increase ownership interest.  Distribution to owners are decreases in equity of a company caused by transferring assets, rendering services, or incurring liabilities to owners. A statement of changes in equity contains two elements: Statement of Changes in Equity

39 IASB Framework  In 2004, the FASB and the IASB added to their respective agendas a project to develop a common conceptual framework.  Promote harmonization of future accounting standards that are principles based

40 C hapter 2 Task Force Image Gallery clip art included in this electronic presentation is used with the permission of NVTech Inc.