Conceptual Framework for Financial Reporting

Chapter 2: Conceptual Framework for Financial Reporting

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


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:

  1. Relevance – information that is capable of making a difference in a decision. Relevance has three components:
    1. Predictive value — helps users form expectations about the future.
    2. Confirmatory value — confirms expectations based on previous experience
    3. Materiality — large enough to affect users’ decisions; information too small to make a difference is immaterial
  2. Faithful representation — matches the economic reality. It has three components:
    1. Completeness — provides all necessary information
    2. Neutrality — unbiased
    3. Free from error — accurate

Enhancing Qualities

Enhancing qualities complement the fundamental qualities and include:

  1. Comparability — different companies report information in a similar manner
  2. Consistency — the same company uses the same accounting methods from period to period
  3. Verifiability — independent professionals using the same methods arrive at similar results
  4. Timeliness — information is provided before it loses relevance
  5. Understandability — reasonably informed users should be able to understand the information

Basic Elements

The basic elements of financial statements are defined in SFAC No. 6. These 10 basic elements are:

  1. Assets. Probable future economic benefits owned by an entity as a result of past transactions or events.
  2. Liabilities. Probable future sacrifices of economic benefits arising from present obligations. Claims by the creditors. These are debts and are called payables.
  3. Equity. Residual interest in the assets of an entity that remains after deducting it’s liabilities. In a business, the equity is the ownership interest. Equity is also called net assets.
  4. Investments by Owners. Increases in net assets of an entity resulting from transfers from the owners. Assets are most commonly received as investments by owners. Also, investments can include services from the owners or payment of liabilities by the owners. Investment by owners increase the net assets or equity of the entity.
  5. Distributions to Owners. 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.
  6. Comprehensive Income. Change in equity or net assets of an entity from transactions from non owner sources. A typical example is unrealized gains or losses on available for sale investments.
  7. Revenues. Receiving assets, enhancements of assets, or reduction of its liabilities from selling goods or providing services. This is from an entity’s normal operations.
  8. Expenses. Consuming assets or incurrences of liabilities from selling goods or services from the entity’s normal operations.
  9. Gains. Increases in equity or net assets from other transactions besides normal operations. These transactions would not normally be revenues or investments by owners.
  10. Losses. 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

The following four basic assumptions underlie financial reporting:

  1. Economic Entity Assumption. The company is separate and distinct from its owners.
  2. Going Concern Assumption. A company is assumed to have a long life, unless there is evidence to the contrary.
  3. Monetary Unit Assumption. All transactions can be shown in a single monetary unit. The monetary unit is assumed to remain relatively stable over the years.
  4. Periodicity Assumption. The economic life of an entity can be divided into months, quarters, and years to provide periodic financial reports.

Principles

Accounting principles relate to how assets, liabilities, revenues, and expenses are identified, measured, and reported.

  1. Measurement Principle. Accounting has several mixed measurements. This includes both historical cost and fair value principle.
  2. Historical Cost Principle. 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.
  3. Fair Value Principle. 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 the financial statements.
  4. Revenue Recognition Principle. Revenue is recognized at the time in which the revenue is earned.
  5. Expense Recognition Principle or Matching Principle. The matching expenses with the revenues that they produced in the same time period.
    1. Product costs, such as material, labor, and overhead, attach to the product, and are recognized in the same period the products are sold.
    2. Period costs, such as officers’ salaries and other administrative expenses, attach to the period, and are recognized in the period incurred.
  6. Full Disclosure Principle. The entity should provide sufficient information to be useful to reasonably informed decision makers.

Cost Constraint

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

  1. Cost Constraint. The 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.

Conceptual Framework Video


Intermediate Accounting Study Guide

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

Jeff Mankin

Jeff Mankin teaches financial literacy. His website is FinallyLearn.com.

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