Chapter 2- Conceptual Framework of Financial Reporting

Basic Objective of Financial Reporting

To provide financial information about the reporting entity that is useful to present and potential investors, lenders, and other creditors in making decisions about providing resources to the entity.

Purpose of Qualitative Characteristics

to distinguish better (more useful) information from inferior information for decision making purposes.

2 Fundamental Qualities are:

Relevance and Faithful Representation

Ingredients of Relevance

Predictive Value, Confirmatory Value, and Materiality

Relevance means:

accounting information must be capable of making a difference in a decision.

Predictive Value

has value as an input to predictive processes used by investors to form their own expectations about the future.

Confirmatory Value

has value that helps users confirm or correct prior expectations.

Materiality

information has this quality if omitting it or misstating it could influence decisions that users make on the basis of the reported financial information.

Faithful Representation

the numbers and descriptions match what really existed or happened.

Ingredients of Faithful Representation

Completeness, Neutrality, and Free from Error.

Completeness

all the information that is necessary for faithful representation is provided.

Neutrality

A company cannot select information to favor one set of interested parties over another. (unbiased)

Free from Error

self-explanatory (error free)

Complementary to the fundamental qualitative characteristics

Enhancing Qualities

What are the Enhancing Qualities?

Comparability/Consistency, Verifiability, Timeliness, Understandability

Comparability

Information that is measured and reported in a similar manner for different companies.

Consistency

present when a company applies the same accounting treatment to similar events, from period to period.

Verifiability

occurs when independent measurers, using the same methods, obtain similar results.

Timeliness

having information available to decision makers before it loses its capacity to influence decisions.

Understandability

the quality of information that lets reasonably informed users see its significance. Enhanced when information is classified, characterized, and presented clearly and concisely.

Basic Elements of Financial Statements

Assets, Liabilities, Equity, Investment by Owners, Distribution to Owners, Comprehensive Income, Revenues, Expenses, Gains, Losses.

Assets

Probably future economics benefits obtained or controlled by a particular entity as a result of past transactions or events.

Liabilities

Probably 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.

Investment 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 interest (or equity) in it. Assets are most commonly received as investments by owners, but that wh

Distribution to Owners

Decreases in net assets of a particular enterprise resulting from transferring assets, rendering services, or incurring liabilities by the enterprise to owners. Distribution 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

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 centr

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 ope

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 owner

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 own

4 Basic Assumptions that underlie the financial accounting structure are:

Economic Entity, Going Concern, Monetary Unit, Periodicity

Economic Entity Assumption

the economic activity can be identified with a particular unit of accountability. ( Company keeps its activity separate and distinct from its owners and any other business unit)

Going Concern Assumption

that the company will have a long-life and fulfill their objectives and commitments.

Monetary Unit Assumption

means that money is the common denominator of economic activity and provides an appropriate basis for accounting measurement and analysis.

Periodicity Assumption

implies that a company can divide its economic activities into artificial time periods (monthly, quarterly, yearly)

Basic Principles of Accounting

Measurement Principle, Revenue Recognition Principle, Expense Recognition Principle, and Full Disclosure Principle.

Measurement Principle

We presently have a "mixed attribute" system that permits the use of various measurement bases. The most commonly used are based on historical cost and fair value.

Historical Cost

accounting for and reporting assets or liabilities on the basis of acquisition price.

Fair Value

the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. (market value)

Revenue Recognition Principle

Revenue is recognized when earned.

Expense Recognition Principle

The recognition of expenses is related to net changes in assets and earning revenues.

Full Disclosure Principle

Providing information that is of sufficient importance to influence the judgments and decisions of an informed user.

Cost Constraint

weighing the costs of providing the information against the benefits that can be derived from using it.

Industry Practices

The peculiar nature of some industries and business concerns sometimes requires departure from basic theory.