Chapter 2: Conceptual Framework Underlying Financial Accounting
(definition on page 28)
Need for Conceptual Framework
Development of Conceptual Framework
FASB began working on the conceptual framework in 1976. FASB
has issued 6
Statements of Financial Accounting Concepts (SFACs).
SFAC No. 1
, “Objectives of Financial Reporting by Business Enterprises,” presents
goals and purposes of accounting. (
See First Level: Basic Objectives
SFAC No. 2
, “Qualitative Characteris
tics of Accounting Information,” examines the
characteristics that make accounting information useful. (
See Second Level:
in Illustration 2
1 on page 30
; also, refer to
on page 32
SFAC No. 3
, “Elements of Financial
Statements of Business Enterprises,” provides
definitions of items in financial statements, such as assets, liabilities, revenues, and
SFAC No. 4
, “Objectives of Financial Reporting by Nonbusiness Organizations”
SFAC No. 5
, “Recognition and Measu
rement in Financial Statements of Business
Enterprises,” sets forth fundamental recognition and measurement criteria and
guidance on what information should be formally incorporated into financial
statements and when. (
See Third Level: Recognition and Mea
1 on page 30
SFAC No. 6
, “Elements of Financial Statements,” replaces SFAC No. 3 and expands
its scope to include not
Statement of Financial Position
(i.e., Balance Sheet): Include assets, lia
Earnings for the Period
: Does not include prior period adjustments (Stockholders’
Equity Statement) or changes in accounting principles.
: any change in Net Assets (Assets
Cash Flows during period
a) Operations, b) Financing, c) Investing
Investments and Distributions to Owners
: Statement of Stockholders’ Equity:
Beginning Capital + Investment + Earning
Dividends = Ending Capital
SFAC No. 7
, “Using Cash Flow Information and Present Val
ue in Accounting
Measurements,” provides a framework for using expected future cash flows and
present values as a basis for measurement.
: See Illustration 2
1 on page 30.
2, E1, 2, 3
First Level: Basic Objectives (SFAC No. 1)
: Identify th
e goals and purposes of accounting.
Decision usefulness is key to the conceptual framework. General
statements provide the most useful information possible at minimal cost to
users need to have a reasonable knowledge of business and financial accounting
measures to u
nderstand financial statements.
Second Level: Fundamental Concepts (SFAC No. 2)
: (See Illustration 2
Qualitative Characteristics of Accounting Informatio
: make accounting information
useful. (Need to determine which alternative provides the most useful information for
Decision Makers (Users) and Understandability
: Information should be of such
it is understandable to users.
Two Dimensions of Usefulness:
relevance and reliability. T
he qualities that
distinguish ‘better’ (more useful) information from ‘inferior’ (less useful)
information are primar
ily the qualities of relevance and reliability, with some
ics that those qualities imply.
Primary Qualities: Relevance and Reliability
Relevant info has:
Reliable information has:
Secondary Qualities: Comparability and Consistency
: Accounting information that has been measured and reported in a
similar manner for differen
t enterprises is considered comparable.
: Accounting information is consistent when an entity applies the
same accounting treatment from period to period to similar accountable events.
(e.g., assets, liab
ilities, etc.): FASB considers these ten elements to be
most closely related to financial measurement of an enterprise. Defined in
The first group of three elements (assets, liabilities, and equity) describes amounts of
claims to resources at a
moment in time
. The other seven elements
describe transactions, events, and circumstances that affect an enterprise during a
List is included on page
future economic benefits obta
ined or controlled by a particular
entity as a result of past transactions or events.
: Probable future sacrifices of economic benefits arising from present
obligations of a particular entity to transfer assets or provide services to other entit
in the future as a result
of past transactions or events.
: Residual interest in the assets of an entity that remains after deducting its
liabilities. In a business enterprise, the equity is the ownership interest.
Investments by Owners
reases in net assets of a particular enterprise resulting
from transfers to it from other entities of something of value to obtain or increase
ownership interests (or equity) in it. Owners most commonly receive assets as
investments, but that which is rec
eived may also include services or satisfaction or
liabilities of the enterprise.
Distributions to Owners
: Decreases in net assets of a particular enterprise resulting
from transferring assets, rendering services, or incurring liabilities by
the enterprise to
owners. Distributions to owners decrease ownership interest
s (or equity) in an
: Change in equity (net assets) of an entity during a period
from transactions and other events and circumstances from nonown
er sources. It
includes all changes in equity during a period except those resulting from investments
rs and distributions to owners.
: 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 central operations.
: Increases in equity (net assets) from peripheral or incidental transactions
entity during a period except those that result from revenues or investments by
: Decreases in equity (net assets) from peripheral or incidental transactions of
an entity and from all other transactions and other events and circumstances affe
the entity during a period except those that result from expenses or distributions to
Third Level: Recognition and Measurement Concepts
: used in establishing and applying
accounting standards (i.e., concepts that implement the basic objective
s of level one.)
Consists of concepts
how financial elements and events should be recognized,
measured, and reported by the accounting system. Focus on understanding the concepts not
on classification (i.e., assumptions, principles, constra
Economic Entity Assumption
Going Concern Assumption
This approach is used in financial statements as opposed to a liquidation approach.
Monetary Unit Assumption
: Record in terms of dollars
The monetary unit is r
elevant, simple, universally available, understandable, and
useful. A second assumption (often called the Stable Dollar concept) is that the
monetary unit remains reasonably stable (i.e.,
every $1 is of equal worth.)
s are demanding more rapid information. Thus, financial statement users
off between relevance and reliability.
Basic Principles of Accounting
: Four basic principles to record transactions.
Historical Cost Principle
: Revenue is recognized (i.e., recorded in the
ts) when the earnings process is
virtually complete and an exchange
transaction has occurred. In other words, revenue is generally recognized (1) when
realized or realiz
able and (2) when earned.
Recognition at the time of sale provides a uniform and reasonable test. Generally, if a
sale has been completed, it should be recognized; if bad debts are expected, they
should be reco
rded as separate estimates.
Exceptions to the revenue recognition principle include
During Production (or Percentage of Completion Method)
: Revenue is allowed
before the contract is completed in certain long
term construction contracts. The
cess is considered substantially completed at various stages as
construction progresses, even though ownership has not been transferred. Must
have good estimates
to be able to use this method.
At End of Production
: Revenue might be recognized after the p
has ended but before the sale takes place. For example, revenue may be
recognized for commodities (e.g., agricultural products) and precious metals (e.g.,
gold) upon completion because of established markets and prices.
Upon Receipt of Cas
: Recognize revenue when cash is received. One form is
Installment Sales Method
. Here, payment is required in periodic installments
over a long period time (e.g., retail, farm/home equipment.) Revenue is
recognized as each cash installment is rece
ived. This is justified because the risk
of not collecting is high.
This assumes cause/effect relationship (gives users more usable information in
determining future cash flow.) A major concern is that matching permits certain c
to be deferred and treated as assets on the balance sheet when in fact these costs may
not have future benefits (e.g., improvements to assets.)
Relates to how we measure earnings:
Direct Matching (cause and effect)
ic and rational allocation
Matching Process Summarized
: First, see if direct relationship exists
between cost and revenue. If so, use direct matching. If not, determine if a
systematic and rational allocation method be used. If s
o, use the method. If
not, immediately expense.
Full Disclosure Principle
Recognizes that nature and amount of information in financial reports reflects a series
of judgmental trade
offs. Certain footnotes (FN) are required. FN explain items
ented within financial statements. FN do not have to be quantifiable or an
element. Supplementary information (such as oil and gas reserve info) is provided.
Information should be understandable to a reasonably prudent investor.
Items should meet four
fundamental recognition criteria to be recognized
: Q10, 14, 16, 20, 21
; E 6
Frequently it is easier to ass
ess the costs than it is to determine the benefits of
particular item of information.
: The magnitude of an omission or misstatement of accounting
information that, in light of surrounding circumstances, makes it probable that the
udgment of a reasonable person relying on the information would have been changed
or influenced by the omission or misstatement.
The concept of materiality is an EXTREMELY difficult concept. Materiality
varies both with relative amount and with relative
importance. (See Illustration 2
Companies and their auditors for the most part have adopted the general rule of
thumb that anything under 5 percent of net income is considered immaterial.
However, both quantitative and qualitative factors must be co
determining whether an item is material.
The SEC had indicated that companies must consider each misstatement
separately and the aggregat
e effect of all misstatements.
: Peculiar nature of industry or business may result i
(e.g., utility industry lists non
current assets first b/c of capital intensive nature of
industry; agricultural industry lists crops at market value b/c difficult to quantify cost
Summary of the
: See Illustration 2
: E 4, 5