Chapter 2

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Chapter
2








Page 2
-
1

Chapter 2

Conceptual Framework Underlying Financial Accounting

(Pages
30


52
)


Conceptual Framework


Four fundamental recognition criteria to be recognized in the financial statements:


1.

Definitions

The item meets the definition of an
element

of financi
al statements.

2.

Measurability

It has a relevant attribute (e.g., historical cost, current cost, etc.) which is
measurable with sufficient reliability.

3.

Relevance

The information is capable of making a difference in user decisions.

4.

Reliability

The in
formation is
representational
ly

faithful, verifiable, and neutral.





























N
eed for a Conceptual Framework



1.

Build on and relate to an established body of concepts and objectives.


2.

Provide a framework for solving new and emergin
g practical problems.

Chapter
2








Page 2
-
2


3.

Increase financial statement users’ understanding of and confidence in financial reporting
.


4.

Enhance comparability among companies’ financial statements.


First Level: Objectives

(as discussed in Chapter 1)


1.

U
seful

to prese
nt and potential
investors

and
creditors

in making investment and credit
decisions.



2.

Assessing the amounts, timing, and uncertainty of
future cash flows.



3.

Information about the economic
resources

of an enterprise, the
claims

to those resources, and

the effects of transactions, events, and circumstances that
change

its resources and claims to
those resources.


Second Level: Qualitative Characteristics and Elements.


The
overriding criterion for evaluating accounting information is that it must be
use
ful for decision
making.

To be useful, it must be
understandable.


Primary qualities

of useful accounting information

are Relevance and Reliability
.


Relevance
--
Accounting information is relevant if it is capable of making a difference in a decision.
Relev
ant information has
:

Predictive value

Feedback value

Timeliness


Reliability
--
Accounting information is reliable to the extent that users can depend on it to represent the
economic conditions or events that it purports to represent. Reliable information ha
s
:

Verifiability

Representational faithfulness

Neutrality


Secondary qualities

of useful accounting information

are Comparability and Consistency
.


Comparability

Accounting information that has been measured and reported
in a similar manner for
different c
ompanies is considered comparable
.


Consistency

Accounting information is consistent when a company applies the same accounting
treatment from period to period to similar accountable events
.


Brief Exercise 2
-
2 on page 55



Qualitative Characteristics

a)

Annual reports are audited


b)

Both use the FIFO cost flow assumption


c)

Used straight
-
line depreciation since it began operations


d)

Issues quarterly reports immediately after each quarter ends


Chapter
2








Page 2
-
3

Elements

(See text
page 39

for definitions.)

Assets

Liabilities

Equity

Investments by owners

Distributions to owners

Comprehensive income

Revenues

Expenses

Gains

Losses


Brief Exercise 2
-
3 on page 55



Account

Element


Account

Element

a)

Retained earnings


f)

Loss on sale of equipment


b)

Sales


g)

Inter
est payable


c)

APIC


h)

Dividends


d)

Inventory


i)

Gain on sale of investment


e)

Deprecia
t
i
on


j)

Issuance of common stock




Third Level: Recognition and Measurement Concepts.


ASSUMPTIONS


Economic entity assumption

economic activity can be identi
fied with a particular unit of accountability.


Going concern assumption

companies will have a long enough life to
justify the use of accruals and
deferrals.


Monetary unit assumption

the monetary unit (i.e., the dollar) is the most effec
tive means of
exp
ressing to interested parties changes in capital and exchanges of goods and services. A second
assumption is that the monetary unit remains reasonably stable.


Periodicity assumption

activities of an enterprise can be divided into artificial time periods.


Brief Exercise 2
-
4 on page 55



Assumption

a)

The economic activities of the corp. are divided into 12
-
month periods
for the purpose of issuing annual reports


b)

The corp. does not adjust amounts in its financial statements for the
effects of inflatio
n.


c)

The corp. reports current and noncurrent classifications in its balance
sheet.


d)

The economic activities of the corp. and it’s subsidiaries are merged for
accounting and reporting purposes.


Chapter
2








Page 2
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4

BASIC PRINCIPLES


Historical cost principle

definite
and objective, not subject to interpretation.

Fair value is increasingly being used in financial statement measurements.

Fair value information may be more useful for certain types of assets and liabilities.


Revenue recognition principle

revenue is recogn
ized when the earning process is virtually complete and
an exchange transaction has occurred. Exceptions to the revenue recognition principle include:


During production

e.g., long
-
term construction contracts.

End of production

e.g., agricultural products,

gold.

Receipt of cash

e.g., installment sales accounting.


Expense recognition principle

efforts (expenses) should be matched with accomplishments (revenues)
if feasible.

Practical rules for expense recognition: Analyze costs to determine whether a relati
onship exists
with revenue.

When direct relationship exists, expense costs against revenues in the period when the revenue is
recognized.

When relationship exists but is difficult to identify, allocate costs rationally and systematically to
expense in the
periods benefited.

When little if any relationship exists, expense as incurred.


Full disclosure principle

disclose

in financial statements any facts of sufficient
importance to influence
the judgment and decisions of an informed reader.


Brief Exercise 2
-
5 on page 55



Principle

a)

The corp. reports revenue in its income statement when it is earned
instead of when the cash is collected.


b)

The corp. recognizes depreciation expense for a machine over the 2
-
year
period during which that machine helps the

company earn revenue.


c)

The corp. reports information about pending lawsuits in the notes to its
financial statements.


d)

The corp. reports land on its balance sheet at the amount paid to acquire
it even thought he estimated fair value is greater.



CONSTRAINTS


Cost
-
benefit

the benefit to be derived from having accounting information should exceed the cost of
providing it. Frequently it is easier to assess the costs than it is to determine the benefits of
providing a particular item of information.


Materiality

if the amount is significant when compared with other items, sound and acceptable
standards should be followed.


The determination of materiality requires considerable judgment; a potential for abuse exists.

Chapter
2








Page 2
-
5

I
mmaterial items are recorded but n
eed not be separately disclosed.


Industry practice

peculiar nature of industry or business may result in variation.


Conservatism

when in doubt choose the solution that will be least likely to overstate assets and
income.


Brief Exercise 2
-
7 on page 55




Constraint

a)

G Farms reports agricultural crops on its balance sheet at fair value.


b)

R Corp. does not accrue a contingent lawsuit gain of $650,000.


c)

W Company does not disclose any information in the notes to the
financial statements unless the
value of the information to financial
statement users exceeds the expense of gathering it.


d)

F Corp. expense the cost of wastebaskets in the year they are acquired.





Key differences between iGAAP and GAAP relating to the conceptual framework includ
e:



I.

iGAAP assumes that financial statements are prepared on an accrual basis while the FASB framework
discusses accrual accounting extensively but does not identify it is as an assumption.


II.

iGAAP assumes that the reporting entity is a going concern
, but the FASB only briefly discusses the going
concern concept.



Homework to be submitted in Angel


Use
BE2
-
10

on page 56 to answer
questions 1


4
.


1. a)


2. b)


3. c)


4. d)



Use
E2
-
2

on page 57 to answer
questions 5


14


5 (a)



10 (f)


6 (
b)



11 (g)


7 (c)


12 (h)


8 (d)


13 (i)


9 (e)


14 (j)


Chapter
2








Page 2
-
6

Use
E2
-
3

on page 57 to answer
questions 15


26


1
5
(a)



2
1
(g)


1
6
(b)


2
2

(h)


1
7
(c)


2
3

(i)


1
8
(d)


2
4

(j)


1
9
(e)


25 (k)


2
0

(f
)


26 (l)




Use
E2
-
4

on pages 57
-
58 to answer
questi
ons
27
-

36



#

27
(a)


28
(b)


29
(c)


30
(d)


31
(e)


32
(f)


33
(g)


34
(h)


35
(i)


36
(j)



Use
E2
-
5

on page 58 to answer
questions
3
7
-

54


37 (a)


46 (j)


38 (b)


47 (k)


39 (c)


48 (l)


40 (d)


49 (m)


41 (e)


50 (n)


42 (f)


51 (o)


43 (g)


52 (p)


44 (h)


53 (q)


45 (i)


54 (r)