Conceptual Framework for Financial Reporting

The conceptual framework shows the basic objectives of financial reporting. It also describes the financial reporting elements and concepts. The conceptual framework of generally accepted accounting principles is set by the Financial Accounting Standards Board (FASB).

This is Intermediate Accounting Chapter 2. For more Intermediate Accounting topics, see Intermediate Accounting Study Guide.

Contents

Accounting Conceptual Framework

The Financial Accounting Standards Board (FASB) defined the objectives and concepts of financial reporting in the United States. The FASB issued Statements of Financial Accounting Concepts to define the accounting conceptual framework.

A conceptual framework in accounting is important because accounting standards should relate to established concepts.

The financial reporting conceptual framework has 3 levels:

Level 1: Basic Objective of Financial Reporting

Level 2: Qualities and Elements of Financial Reporting

Level 3: Financial Reporting Concepts

Level 1: Basic Objective of Financial Reporting

The basic objective of financial reporting is to provide information about the entity that is useful to investors, lenders, and other creditors in making decisions about the entity. Financial users need reasonable financial literacy.

Level 2: Qualities and Elements of Financial Reporting

Companies should provide useful information for decisions. Accounting qualities have two types: fundamental qualities and enhancing qualities.

The elements are the basic components of the financial statements.

Fundamental Qualities

The fundamental qualities of accounting information are:

Relevance
Faithful representation

Relevance

Relevance includes information that is capable of making a difference in a decision. Relevance has three components:

predictive value
confirmatory value
materiality

Predictive value helps users form expectations about the future.

Confirmatory value confirms expectations based on previous experience

Materiality means large enough to affect users’ decisions. Information that is too small to make a difference is immaterial.

Faithful representation

Faithful representation matches the economic reality. It has three components:

completeness
neutrality
free from error

Completeness provides all necessary information.

Neutrality requires information to be unbiased.

Free from error shows information that is accurate.

Enhancing Qualities

Enhancing qualities complement the fundamental qualities and include five components:

comparability
consistency
verifiability
understandability

Comparability requires that companies report information in a similar manner. The financial statements should be easy to compare.

Consistency means a company should use the same accounting methods each period.

Verifiability means independent professionals using the same methods would arrive at similar results.

Timeliness requires that information is provided before it loses relevance.

Understandability means reasonably informed users should be able to understand the information.

Basic Elements

The basic elements of financial statements are defined in Statements on Financial Accounting Concepts (SFAC) Number 6. These 10 basic elements are:

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

Assets are probable future economic benefits owned by an entity because of past transactions or events. Assets are economic resources owned by an entity.

Liabilities are probable future sacrifices of economic benefits arising from present obligations. Claims by the creditors. These are debts and are called payables.

Equity is the residual interest in the assets of an entity that remains after deducting its liabilities. In a business, equity is the ownership interest. Equity is also called net assets.

Investments by owners are increases in net assets of an entity resulting from transfers from the owners. Assets are received as investments by owners. Also, investments can include services from the owners or payment of liabilities by the owners. Investment by owners increases the net assets or equity of the entity.

Distributions to owners are decreases in net assets resulting from transferring assets, rendering services, or incurring liabilities by the entity to owners. Distributions to owners decrease equity or net assets in an entity.

Comprehensive income is a change in equity or net assets of an entity from transactions from nonowner sources. A typical example is unrealized gains or losses on available for sale investments.

Revenues are receiving assets, enhancements of assets, or reduction of its liabilities from selling goods or providing services. This is from an entity’s normal operations.

Expenses are consuming assets or incurrences of liabilities from selling goods or services from the entity’s normal operations.

Gains are increases in equity or net assets from other transactions besides normal operations. These transactions would not normally be revenues or investments by owners.

Losses are decreases in equity or net assets from other transactions besides normal operations. These transactions would not normally be losses or distributions to owners.

Level 3: Financial Reporting Concepts

Assumptions

Financial reporting includes four basic assumptions:

economic entity assumption
going concern assumption
monetary unit assumption
periodicity assumption

Economic entity assumption assumes a company is separate and distinct from its owners.

Going concern assumption states that a company is presumed to have a long life unless there is evidence to the contrary.

Monetary unit assumption assumes that all transactions can be shown in a single monetary unit. A company could have transactions in many different currencies, however, financial statements are shown in one currency. The monetary unit is assumed to remain relatively stable over the years.

Periodicity Assumption assumes that an entity’s economic life can be divided into months, quarters, and years to provide financial reports.

Principles

Accounting principles relate to how assets, liabilities, revenues, and expenses are identified, measured, and reported. Financial reporting includes six principles:

measurement principle
historical cost principle
fair value principle
revenue recognition principle
expense recognition principle (matching principle)
full disclosure principle

Measurement principle shows accounting has several mixed measurements. This includes both historical cost and fair value principle.

Historical cost principle records the actual purchase price of an asset even if it occurred years ago. Historical cost has an advantage over other valuations because it is verifiable.

Fair value principle shows the price that would be received to sell an asset or paid to transfer a liability in a transaction between market participants at the measurement date. GAAP has increasingly allowed the use of fair value measurements in financial statements.

Revenue recognition principle requires revenue to be recognized at the time in which the revenue is earned.

Expense recognition principle or matching principle requires matching expenses with the revenues that they produced in the same time period.

Product costs, such as material, labor, and overhead, attach to the product and are recognized in the same period the products are sold.

Period costs, such as officers’ salaries and other administrative expenses, attach to the period and are recognized in the period incurred.

Full disclosure principle requires an entity to provide sufficient information to be useful to reasonably informed decision makers.

Cost Constraint

There is one constraint over the financial accounting principles and concepts.

cost constraint

Cost Constraint means the benefits from providing accounting information should exceed the costs of providing that information. The difficulty is the costs and the benefits are not always clear or measurable. This is also called cost-benefit analysis.