Intermediate Financial Accounting I Conceptual Framework Underlying Financial Reporting

Environment and Theoretical Structure of Financial Accounting2 Objectives of the Chapters (contd.)  Study the Conceptual framework underlying financial reports.

Environment and Theoretical Structure of Financial Accounting3 Conceptual Framework of Financial Reporting n What does the current accounting standard setting authority rely on to prescribe the accounting standards? n Conceptual Framework of Financial Reporting: A system of interactive objectives and fundamentals which can lead to a set of consistent standards in preparing financial reports.

Environment and Theoretical Structure of Financial Accounting4 Financial Reporting: A Theoretical Structure A Conceptual Framework for Financial Reporting Assumptions Entity Going- Concern Monetary unit Periodicity Constraints Cost/Benefit Industry Practices Objectives Qualitative Characteristic of Accounting Information Elements (SFAC No. 6) Recognition and Measurement Concepts Principles Cost & Fair Value Option Revenue Matching Full Disclosure SFAC No. 8, Ch. 1 SFAC No. 8, Ch.3 SFAC No.5 First Level Second Level Third level 4

Environment and Theoretical Structure of Financial Accounting5 SFAC No. 8 - Chapter 1 (Level One of The Conceptual Framework) n The objective of general-purpose financial reporting: Providing useful financial information of the reporting entity to existing and potential investors, lenders, and other creditors in making decisions regarding providing resources to the entity.

Environment and Theoretical Structure of Financial Accounting6 SFAC No. 8 –Chapter 1 (cont.) (Level One of The Conceptual Framework) n Those decisions involve buying, selling, or holding equity and debt instruments and providing or settling loans and other forms of credit.

Environment and Theoretical Structure of Financial Accounting7 SFAC No. 8 – Chapter 3 (Level Two of The Framework) n Qualitative (Characteristics of Accounting Information) I. Fundamental Qualities 1) Relevance a) Predictive value b) Confirmatory value c) Materiality 2 ) Faithful Representation a) Completeness b) Neutral c) Free from error

Environment and Theoretical Structure of Financial Accounting8 SFAC No. 8 (contd.) II. Enhancing Qualitative Characteristics 1) Comparability(including consistency) 2) Verifiability 3) Timeliness 4) Understandability

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Materiality (make a difference on decision) Materiality judgment should be made in the context of the nature and the amount of the item. Item. The rule of thumb of materiality: any item which is less than 5% of net income is immaterial. Environment and Theoretical Structure of Financial Accounting10

Environment and Theoretical Structure of Financial Accounting11 SFAC No. 5 (Level Three of The Conceptual Framework) n Measurement and Recognition Concepts I.Assumptions 1) Economic Entity 2) Going-concern (continuity) 3) Monetary unit 4) Periodicity (Period of time)

Environment and Theoretical Structure of Financial Accounting12 SFAC No. 5 (contd.) II.Principles 1) Historical cost principle and fair value option 2) Revenue recognition 3) Matching/Expense Recognition 4) Full Disclosure (i.e., footnote disclosure) III.Constraints 1) Cost-Benefit 2) Industry Practices

The Move Toward Fair Value  SFAS No. 157 establishes a framework for measuring fair values.  SFAS No. 159 gives companies the option to report some or all of their financial assets and liabilities at fair value. Environment and Theoretical Structure of Financial Accounting13

The Balance Sheet and Financial Disclosures 14 Fair Value Hierarchy (SFAS 157)  Level 1 (most reliable) measures are based on quoted prices for identical instruments in active markets.  Level 2 measures are based on quoted prices for similar instruments in active markets.  Level 3 (least reliable) measures are based on unobservable inputs such as company’s data or assumptions.

The Balance Sheet and Financial Disclosures 15 Fair Value Measurements Disclosure : Footnote 28 of GE 2008 Annual Report Level 1Level 2Level 3Fin. 39 Netting Net Bal. Assets Investment Securities$1,158$27,332$12,956 ___$41,446 Derivatives ___ 18,911 1,142 (7,411) 12,642 Others ,105 ____ 1,394 total $1,159 $46,531 15,203$(7,411)$55,482 Liabilities Derivatives $ 2$12,643$ 166 $(7,575)$ 5,236 Other ____ 1,031 ____ 1,031 Total$ 2$13,674$ 166 $(7,575)$6,267

Income Measurement And Profit Analysis16 Revenue Recognition Principle (SFAS No. 5) (-An Accrual Basis) n Revenue is recognized when it is earned and realized or realizable (SFAC 5, par. 83). n Earned : the entity has substantially accomplished what it must do to be entitled to compensation. n Realized: goods are exchanged for cash or claims. n Realizable: assets received as compensation are readily convertible into cash or claims to cash (i.e., measurable). n In general, these conditions are met at time of sale (delivery) or when services are rendered (SFAC 5, par. 84). n.n.

Income Measurement And Profit Analysis17 Revenue Recognition Principle n Other conditions for revenue recognition (Staff Accounting Bulletin No. 101(1999)): n Persuasive evidence of a sale. n Price is fixed or determinable. n Collectibility is reasonably assured. n Delivery has occurred or services have been rendered.

18 Expense Recognition (Matching) Principle – An Accrual Basis n If revenues are recognized in a period, all related expenses should be recognized in the same period. n The related expenses include: n Traceable costs: The contribution of these costs (i.e., product cots) can be traced to specific revenues, and therefore, are expensed when revenues (i.e., sales revenue) are recognized.

19 Expense Recognition (Matching) Principle – An Accrual Basis n Period costs: The contribution of these costs cannot be traced easily to specific revenues, and therefore, are expensed when they are consumed or occurred. (e.g. advertising exp., interest and rent exp.) n Allocated (or estimated) costs: Expenses such as depreciation expense, bad debt expense, etc. which contributions to revenues cannot be traced. These expenses are estimated and recognized at the end of a period.

Matching (Expenses with Revenues) Principle Traceable costs (i.e., product costs) vs. non- traceable costs (i.e., period costs): Environment and Theoretical Structure of Financial Accounting20