Chapter 2 - Financial Reporting:Its Conceptual Framework

Conceptual Framework

Developed by the FASB as a theoretical foundation of interrelated objectives, concepts, principles, and definitions that leads to the establishment of consistent high-quality financial accounting standards and the appropriate application of those standards in accounting practice.

Monetary Unit Assumption

Financial statement elements can be expressed in terms of the national currency of the reporting entity, like the dollar for U.S. companies. The assumption that the national currency of the reporting company is used in preparing financial statements.

Period-of-Time Assumption

Financial statement users need timely information to evaluate a company's financial position, profitability, and cash flows on an ongoing basis; accordingly, companies prepare and report periodic financial statements, usually each year (and some firms report each quarter). The assumption companies operate under in that they prepare and report financial statements at the end of each year and include them in an annual report and in annual filings with the SEC.

Complete Representation

Full disclosure of all the information necessary to understand the information being reported in the financial statements, with all the necessary facts, descriptions and explanations.

Accounting Principles

Fundamental theories, truths, and propositions that serve as the foundation for financial accounting and financial reporting.

Statements of Financial Accounting Concepts (Concepts Statements)

General proclamations that establish fundamental principles of accounting, objectives of financial reporting, qualities of useful financial accounting information, definitions of basic elements of accounting, and other important aspects of financial accounting.

Stewardship

How efficiently and effectively the company's management and governing board have discharged their responsibilities to use the company's resources.

Accounting Standards

Professional standards (U.S. GAAP and IFRS) for how companies should account for and report revenues, expenses, assets, liabilities, and equities that provide the concepts, rules, guidance, and methods that principals and agents need to measure and report financial statements that are relevant and representationally faithful.

Recognition

Recognition is the process of formally recording and reporting an item in the financial statements of a company. To be recognized, an item must meet the definition of an element (such as an asset, liability, revenue, expense, etc.), be measurable, be relevant, and be faithfully represented.

Return on Investment

Serves as useful information to investors, lenders, and other creditors in providing a measure of overall company profitability and performance.

Financial reporting should provide information about:

economic resources and the claims on the company; changes in the company's economic resources and claims resulting from the company's financial performance and cash flows during a specified period of time; how the management of a company has discharged its stewardship responsibility

To establish the Conceptual Framework, the FASB has issued a number of Concepts Statements that establish:

fundamental principles of accounting objectives of financial reporting qualities of useful financial accounting information definitions of basic elements like assets and liabilities types of economic transactions, events, and arrangements to be recognized in financial statements measurement attributes to use to measure and report these transactions, events, and arrangements how transactions, events, and arrangements should be presented and classified in financial statements

Verifiable

Aspect of accounting information that means when different knowledgeable and independent observers can reach consensus (but not necessarily complete agreement), a particular representation is faithful.

Liquidity

A characteristic of an asset that refers to how quickly a company can convert that asset into cash to meet short-term obligations and cover operating costs.

Cost Constraint

A constraint on identifying what information should be disclosed in financial reports and is based on the costs of collecting, processing, auditing, and communicating the information and possibly the risk of losing a competitive advantage by disclosing such information.

Accounting Standards Updates

A new standard issued by the FASB.

Relevance

A primary attribute of accounting information that indicates it is capable of making a difference in decisions made by financial statement users. Financial information is capable of making a difference if the information is capable of helping users predict future outcomes and/or confirm or correct prior expectations, and the information is material in nature and amount.

Accounting Standards Codification

A searchable electronic database that integrates and topically organizes U.S. GAAP into one coherent body of literature.

Faithful Representation

Accounting information is a faithful representation of the underlying economic transactions, events, and arrangements when the words and numbers accurately depict the economic substance of what they purport to represent. To be a faithful representation, the information must be complete, neutral, and free from error.

Timely

Accounting information that is available to decision makers in time to influence their decisions.

Reporting Entity Assumption

Accounting measures and reports economic activities for a particular economic entity, which is distinct from the owners of the entity. The accounting assumption that the business enterprise being accounted for is legally and economically distinct.

Mixed Attribute Measurement Model

Accounting strives to measure assets, liabilities, revenues, expenses, and other elements of the financial statements with the most relevant and faithful measurement available; therefore, financial statement elements are measured and reported using a mixture of measurement attributes.

Accrual Accounting

Accruals and deferrals measure and report the economic effects of transactions, events, and circumstances on a company's economic resources and claims in the period when those effects occur, even though the cash consequences may occur in a different period. This involves the application of both revenue and expense recognition principles.

Expense Recognition Principle

An application of accrual accounting that determines the appropriate period in which a company has consumed economic resources in conducting business operations.

Confirmatory Value

An attribute of accounting information that provides feedback to confirm or correct prior predictions and expectations.

Predictive Value

An attribute of accounting information that should help users form expectations about the future.

Prudence

An attribute of the accounting practice of conservatism where the uncertainties and risks inherent in business situations are adequately considered.

Comparability

Aspect of accounting information that enables users to identify and explain similarities and differences between two or more sets of economic facts.

Consistency

Aspect of accounting information that means accounting methods and procedures are applied in the same manner from period to period.

Understandability

Aspect of accounting information that means it should be comprehensible to users who have a reasonable knowledge of business and economic activities and who are willing to study the information carefully.

Free from Error

Aspect of accounting information that means the information is presented as accurately as possible, using a process that reflects the best available inputs.

How do concepts statements, principles, standards, and rules differ (because they serve different purposes)?

Concepts Statements and principles are broad and definitional. Standards are authoritative statements that comprise GAAP and are applications of concepts and principles to different types of transactions, events, and arrangements. Rules are specific implementation procedures within accounting standards.

Going Concern Assumption (Continuity Assumption)

It is assumed that a company will continue to operate in the foreseeable future unless substantial evidence to the contrary exists.

Rules

Specific implementation guidelines through which financial statement preparers apply accounting standards to measure and report a company's financial statements.

Explain the FASB's Conceptual Framework.

The FASB Conceptual Framework is a theoretical foundation of interrelated objectives, concepts, principles, and definitions that enable the establishment and application of consistent financial accounting standards. It provides a logical structure to guide standard setters, financial statement preparers, auditors, and financial statement users.

Describe the financial reporting model in the FASB's Conceptual Framework.

The FASB's Conceptual Framework outlined the financial reporting model, identifying five basic financial statements as core sources of useful information: balance sheet income statement comprehensive income statement statement of cash flows statement of shareholders' equity Under GAAP, the financial statements should also include the notes to explain the policies, methods, and estimates the company used to measure and report the financial statement elements, as well as any required supplementary information.

Operating Capability

The ability of a company to produce goods and services for customers.

Financial Flexibility

The ability of a company to use its financial resources to adapt to change and to take advantage of opportunities.

Economic Entity Assumption

The accounting assumption that the business enterprise being accounted for is legally and economically distinct.

Historical Cost

The amount paid initially to acquire an asset.

Accounting Period

The annual reporting period whether calendar year or fiscal year.

Materiality

The nature and magnitude of an omission or misstatement of accounting information that would influence the judgment of a reasonable person relying on that information.

Decision Usefulness

The overall qualitative characteristic that is the ultimate objective of accounting information.

Generally Accepted Accounting Principles (GAAP)

The principles, concepts, guidelines, methods, and practices that regulated companies in the U.S. are required to use in preparing and reporting the accounting information in financial statements for use by external stakeholders and decision makers.

Revenue Recognition Principle

The process of formally measuring and reporting revenue in a company's financial statements.

Risk

The uncertainty or unpredictability of the future results of a company.

Business Cycle

The yearly period from lowest sales through highest sales and back to lowest sales.

Accruals

Transactions, events, or arrangements in which the cash flows occur after the related expenses are incurred or revenues are earned.

Deferrals

Transactions, events, or arrangements in which the cash flows occur before the related expenses are incurred or revenues are earned.

Neutral Representation

Unbiased measurement and presentation of the financial statements and amounts.

Conservatism

When accounting valuations are uncertain and alternative accounting valuations for assets or liabilities are equally possible, the accountant should select the one that is least likely to overstate the company's assets and income in the current period.