Basic Concepts & Financial Statements  

Section 1  

Basic Concepts & Financial Statements  

 FASB Standards & Frameworks  

Financial Reporting Frameworks  

Financial reporting frameworks (FRFs) may be general purpose frameworks or special purpose  

frameworks. Publicly held entities are required to submit their F/S to the SEC prepared in  

accordance with a general-purpose framework, either GAAP or IFRS. Nonpublic entities, however,  

have a greater number of choices and select a framework that fairly balances the needs of their F/S  

users and the cost of providing information. Like public entities, nonpublic entities may prepare  

their F/S under either GAAP or IFRS; however, they also may use a special purpose framework.  

A financial reporting framework (FRF) includes:  

Recognition criteria that determine what will appear on financial statements (F/S) and  

when it will appear.  

Measurement criteria that determine the amount at which it will be reported.  

Presentation criteria that determine where it will appear on the F/S.  

Disclosure criteria that determine what information and how much information must be  

provided to F/S users.  

General Purpose Frameworks  

There are currently two general purpose frameworks:  

U.S. Generally Accepted Accounting Principles (GAAP)  

International Financial Reporting Standards (IFRS)  

Special Purpose Frameworks  

A special purpose framework is an FRF other than GAAP or IFRS. Statements prepared under a  

special purpose framework must have modified titles showing the basis of accounting—for  

example, “Consolidated Statements of Assets, Liabilities and Equity (FRF for SMEs Basis).” There  

are numerous special purpose frameworks:  

• Cash Basis  

O Revenues are recognized when they are received, regardless of when they are  

earned.  

O Expenses are recognized when they are paid, regardless of when they are incurred.  

Fixed assets are expensed and not capitalized.  

One could also use the modified cash basis, which is considered a sort of hybrid  

approach between cash and accrual, where assets could be capitalized and taxes  

and inventory could be accrued.  

• Tax Basis  

O Revenues and expenses are recognized for financial reporting purposes in the  

same periods and in the same amount as they are recognized when the entity is  

preparing its income tax return.  

The tax basis could be cash-basis or accrual-basis.  

O Basic Concepts & Financial Statements  

• Contractual Basis  

O May be required to be used by a party to a contract.  

O Generally designed to assist users in determining whether or not terms of the  

contract, and other requirements related to it, are being adhered to.  

• Regulatory Basis  

May be imposed by a governmental regulatory agency to which the entity is  

required to report.  

FRF for SMEs (Financial Reporting Framework for Small- and Medium-Sized Entities)  

O With the exception of the cash basis of accounting and in some cases the tax basis, both general  

purpose frameworks and most special purpose frameworks apply the accrual basis of accounting.  

Under the accrual basis, revenues are recognized in the periods in which they are earned,  

regardless of when they are received; and expenses are recognized in the periods in which they  

are incurred, regardless of when they are paid.  

A closely related topic is the statement of cash flows, a statement required to be presented  

along with every complete set of F/S prepared in conformity with GAAP. In order to prepare a  
statement of cash flows, however, the amounts of revenue and expense items determined  

under the accrual basis are generally known and the amounts of cash received and paid must be  

determined, a common area of testing on the exam. The process to be applied, discussed  

in the chapter related to Statement of Cash Flows, is basically the reverse of the procedure used  

to convert from cash to accrual.  

Alternative Accounting Approaches for Nonpublic Entities  

In order to reduce the cost of financial reporting for nonpublic entities, and to bring the cost more  

in line with the benefits derived by users of F/S, the FASB created the Private Company Council  

(PCC). The PCC is charged with evaluating existing GAAP to determine if there are requirements,  

including disclosures, from which nonpublic entities should be exempt; or simplified accounting  

approaches that may be applied to transactions or F/S elements that will reduce the cost of  

reporting without diminishing the relative value of the information provided.  

The PCC has developed alternative accounting approaches for goodwill; certain interest rate swaps  

(a common form of derivative); for the recognition of identifiable intangible assets acquired in a  

business combination; and for potential variable interest entities (VIEs). These alternative  

accounting approaches may only be applied by a nonpublic entity. In order to do so, the entity will  

elect the alternative accounting treatment by including information in its Summary of Significant  

Accounting Policies.  

• In the period of adoption, the entity will indicate that it is adopting the alternative  

treatment and the primary differences between it and the previous requirements.  

It will also be disclosed in subsequent periods, since it represents a choice among  

acceptable alternative accounting treatments.  

• An entity electing to adopt the alternative accounting approaches is still preparing its F/S in  

accordance with GAAP since the pronouncements of the PCC are incorporated into the ASC. As  

indicated, they apply to nonpublic entities, which are all of those entities that are not considered  

public entities. The FASB defines public entities as those that:  

 Submit F/S to the SEC, either as a result of a requirement to do so or do so voluntarily.  

 Are regulated under the 1934 Securities Exchange Act.  
 Issue securities that are traded or have securities that are listed on an exchange.  
 Are required to apply GAAP and have securities that are not restricted as to transfer.  
FASB Accounting Standards Codification (ASC)  

U.S. Generally Accepted Accounting Principles (GAAP) is developed by the Financial Accounting  

Standards Board (FASB), who is authorized to establish accounting standards by the Securities and  

Exchange Commission (SEC). The FASB Accounting Standards Codification (ASC) is the single  

source of authoritative GAAP for nongovernmental entities. This replaced all previously issued  

non-SEC accounting literature. The goal was to create one cohesive set of accounting standards.  

The Codification reorganized thousands of GAAP pronouncements into approximately 90  

accounting topics (see Research Appendix for more specifics). This is expected to improve the ease  

of researching GAAP issues.  

Topic Groups  

Presentation  

Assets  

Numbered  

200-299  

300-399  

400-499  

500-599  

600-699  

700-799  

800-899  

900-999  

Liabilities  

Equity  

Revenues  

Expenses  

Broad Transactions  

Industry  
GAAP hierarchy now consists of two levels:  

•Authoritative (in ASC) — updated with Accounting Standards Updates (ASUs), but which are  

not in themselves authoritative.

•Nonauthoritative (not in ASC)  

Emerging Issues Task Force (EITF) was created in 1984 by the FASB to reach a consensus on how  

to account for new and unusual financial transactions that have the potential for creating differing  

financial reporting practices. The FASB works on long-term problems, while the EITF deals with  

short-term emerging issues.  

FASB Conceptual Framework for Accounting  

The FASB periodically issues Statements on Financial Accounting Concepts (SFACs). SFACs are  

not applications of GAAP to specific situations, but instead represent the conceptual framework  

that guides the development of financial accounting and reporting standards. The conceptual  

framework defines the objectives and concepts that underlie financial reporting (per SFAC 8).  

Section 1  

Basic Concepts & Financial Statements  

The Objectives of financial reporting (which focus on the USERS of F/S) are:  

1. Primary Objective - To provide information that is useful to existing and potential  

investors, lenders, and other creditors (ie, users) in making decisions about providing  

resources to the entity.  

2. Information about a reporting entity’s economic resources and claims against the entity  

(ie, financial position) – Balance Sheet (B/S).  

3. Changes in economic resources and claims.  

4. Financial performance reflected by accrual accounting – provides a better basis for  

assessing the entity’s past and future performance than does cash basis – Income  

Statement (I/S).  

5. Financial performance reflected by past cash flow – Statement of Cash Flows  

6. Changes in economic resources and claims NOT resulting from financial performance (eg,  

issuing additional stock) – Statement of Changes in Owners’ Equity.  

We can achieve our objectives if F/S have certain Primary Qualitative Characteristics that makes  

information USEFUL. In order to be useful, information must have BOTH Relevance & Faithful  

Representation.  

•Relevance– Information is capable of making a difference in a user’s decision-making process if it has

one or both of the following components:  

o Predictive value – Helps decision makers predict or forecast future results.  

o Confirmatory value (Feedback value) – Confirms or corrects prior predictions.  

•Faithful Representation – The information depicts what it purports to represent. The 3 components

are:  

o Free from Error – No errors or omissions in the information.  

o Neutrality (w/o bias) – The information is free from bias.  
o Completeness – Adequate or full disclosure of all necessary information.  

Enhancing Qualitative Characteristics that relate to both Relevance and Faithful Representation  

Comparability – Same principles being used with business enterprises in similar Industry.  

Consistency – Same accounting methods in different periods.  

Understandability – Classifying, characterizing and presenting information clearly and concisely.  

O Timeliness – Information is available to a decision maker when it is useful to make the  

decision.  

Verifiability – Different sources agree on an amount through either direct or indirect verification.  

Constraints that override the usefulness of information:  

•Cost/benefit – Cost of obtaining and presenting the information shouldn’t exceed the  

benefit.  

•Materiality – Capable of making a difference in the user’s decision-making process if  

omitted or misstated (auditor’s judgment). Considered an entity-specific aspect similar to  

Relevance that applies at the individual entity level.  

Elements of Financial Statements  

Full set of Financial Statements  

 Statement of Position (Balance sheet)  

 Statement of Earnings Financial & Comprehensive Income (Income statement)  
 Statement of Cash Flows  
 Statement of Changes in Owners’ Equity (Statement of Investments by and Distributions to  

Owners)  

10 Key Elements (SFAC 6)  

The F/S elements need to be useful. There are 10 key elements that make up all the F/S. The first 3  

are the basic elements:  

Assets – An economic resource that has a probable future benefit, one can obtain the  

benefit, and the transaction creating the benefit has already occurred.  

Liabilities – An economic obligation in which one needs to use or transfer an asset, it can’t  

be avoided and the transaction has already occurred.  

Equity or Net Assets – Assets left over after deducting liabilities. 

Equity consists of 3 elements:  

Investments by owners (ie, contributions)  

Distributions to owners (ie, dividends)  

Comprehensive Income – All changes in equity other than “owner” sources.  

Comprehensive income has 4 elements:  

Revenues – Inflows from an entity’s primary operations.  

Expenses – Outflows due to an entity’s primary operations.  

Gains – Increases in equity from incidental transactions.  

Losses – Decreases in equity from incidental transactions.  

Note, however, that comprehensive income is separated into the following two categories on the  

income statement (discussed further later):  

•Net income  

•Other Comprehensive Income (DENT):  

O Derivative cash flow hedges  

Excess adjustment of Pension PBO and FV of plan assets at year end  

Net unrealized gains or losses on “available-for-sale” securities  

Translation adjustments for foreign currency  

When deciding what will be included in income (comprehensive or net income), the capital  

maintenance concept being used needs to be known.  

•Physical capital maintenance concept – Only recognize an event when an asset is sold or  

a liability is settled (measures the effects of price changes in nominal or constant dollars).  

Financial capital maintenance concept – Recognize an event as a change in the value of  

an asset or liability occurs (recognize holding gains and losses – current GAAP).  

•Current accounting methods emphasize the physical capital approach with fixed assets, which are  

not adjusted to market value, but emphasize the financial capital approach with most marketable  

securities, which are reported at market value, except in limited cases. Part of the reason relates to  

the Enhancing Qualitative Characteristics of Verifiability: market values of fixed assets are difficult  

to verify and adjustments based on management estimates are subject to biases, while the active  

market for investment securities provides numbers that are verifiable and not subject to  

management bias, hence meeting the Enhancing Qualitative Characteristic of Verifiability.  

Elements of Financial Statements  

The Financial statement elements need to be Useful. There are 10 key elements that make up all  

the financial statements.  

A full set of financial statements includes:  

▪Statement of Financial Position (Balance sheet)  

▪Statement of Earnings & Comprehensive Income (Income statement)  

▪Statement of Cash Flows  

▪Statement of Changes in Owners’ Equity (statement of Investments by and Distributions to  

Owners)  

Basic Concepts & Framework for Accounting & IFRS  

General Accounting Rules & Concepts  

Accounting rules and concepts that go along with the key elements:  

▪Consistency – Same principle each year.  

▪Conservatism – Considering all risks inherent in the business (accruing a contingent loss).  

▪Cost/Benefit – Costs don’t exceed benefits to be derived.  

▪Matching – Recognize a cost as an expense in the same period as the benefit (usually a revenue) is
recognized.  

▪Allocation – Spreading a cost over more than one period.  

▪Full Disclosure – Providing all useful info in the F/S.  

▪Recognition – Booking an item in the F/S.  

▪Realization – Converting noncash resources into cash or a claim to cash.  

When to Recognize Financial Statement Elements (SFAC 5)  

▪Meets definition – The item meets the definition of an element (asset, liability, etc.).  

▪Measurable – Element is capable of being measured in monetary terms.  

▪Relevant – The item is capable of making a difference in user decisions.  

▪Reliable – The information is faithfully represented and verifiable (ie, useful).  

Measurement in Monetary Terms  

▪Historical cost – Amount paid (eg, PP&E).  

▪Replacement (current) cost – Cost to replace an item (eg, inventory).  

▪Fair Value (FV) – The price that would be received to sell an asset or paid to transfer a  

liability in an orderly transaction between market participants at the measurement date  

(ASC 820)—aka, Fair Market Value (FMV).  

▪Net realizable value (NRV) – Amount expected to be converted into (eg, A/R).  

▪Present Value (PV) – Discounted cash flows due to the time value of money (used for  

notes receivable, bonds payable, leases).  

Fair Value Measurement  

ASC 820 defines fair value as “the price that would be received to sell an asset or paid to transfer a  

liability in an orderly transaction between market participants at the measurement date (at exit  

price)” – also called “mark-to-market.”  

Fair value measurements are required for certain assets and liabilities (investments, derivatives,  

asset impairments, asset retirement obligations, goodwill, business combinations, troubled debt  

restructuring).  
Applying the fair value measurement approach involves the following six steps:  

1. Identify the asset or liability to be measured.  

2. Determine the principal or most advantageous market (highest and best

3. Determine the valuation premise.

4.Determine the appropriate valuation technique (market, income, or cost approach).

5.Obtain inputs for valuation. (Level 1, Level 2, or Level 3)

6.Calculate the fair value of the asset.