Conceptual Framework of

Financial Reporting by
Business Enterprises
Pg 37-48
8/6/15

Objectives and Qualitative

Characteristics
Conceptual Framework Outline
FASBs Statements of Financial Accounting Concepts comprise the
conceptual framework for financial accounting.
Does not constitute GAAP, but provides consistent direction for the development of
specific GAAp.
The conceptual framework is a constitution for developing specific GAAP

Parts of the conceptual framework

Objective of financial reporting

Qualitative characteristics of accounting information
Accounting assumptions
Basic accounting principles
Cost constraint
Elements of financial statements

 Objective of financial reporting

The objective of general purpose financial reporting is to
provide information about the entity useful to current and
future investors and creditors in making decisions as capital
providers
Useful information includes:
The amount, timing, and uncertainty of an entitys cash flows
Ability of the entity to generate future net cash inflows
An entitys economic resources (assets) and claims to those resources
(liabilities) which provides insight into the entitys financial strengths
and weaknesses, and its liquidity and solvency
The effectiveness with which management has met its stewardship
responsibilities
The effect of transactions and other events that change an entitys
economic resources and the claims to those resources.

 Qualitative Characteristics of Accounting Information

For financial statement information to be useful, it should have several
qualitative characteristics.
Two primary characteristics
Relevance
Predictive value
Confirmatory value
Materiality
Faithful representation
Completeness
Neutrality
Free from error

Four enhancing characteristics

Comparability
Verifiability
Timeliness
understandability

 Primary Qualitative Characteristics

For information to be useful for decision making, it must be
both relevant and a faithful representation of the economic
phenomena that it represents
Relevance information is relevant if it makes a difference to decision
makers in their role as capital providers.
Predictive value
Assists capital providers in forming expectations about future events
Confirmatory value
Confirms or changes past (or present) expectations based on previous
evaluations
Materiality
Information that is material will impact a users decision.
Somewhat pervasive throughout the objectives of financial reporting
Financial statements should present material information
FASB believes that materiality is an entity specific attribute, material
information is relevant to the user
Materiality is an attribute of relevance

 Primary Qualitative Characteristics

For information to be useful for decision making, it must be
both relevant and a faithful representation of the economic
phenomena that it represents
Faithful representation: Information faithfully represents an economic
condition or situation when the reported measure and the condition or
situation are in agreement
Replaces reliability as a primary qualitative characteristic
Completeness:
Includes all data necessary to be faithfully representative
Neutral:
Free from any bias intended to attain a prespecified result, or to
encourage or discourage certain behavior
Free from error:
No omissions or errors

Relevance and faithful representation may conflict

In these cases, a trade off is made favoring one over the other

 Enhancing Characteristics
Complementary to the primary characteristics
Enhance the decision usefulness of financial reporting
information that is relevant and faithfully represented
Comparability
The quality of information that enables users to identify similarities and
difference between sets of information
Consistency in application of recognition and measurement methods over
time enhances comparability

Verifiability
Different knowledgeable and independent observers could reach similar
conclusions based on the information

Timeliness
Received in time to make a difference to the decision maker
Can also enhance the faithful representation of information

Understandability
User comprehends it within the decision context at hand

Assumptions, Accounting Principles

Accounting Assumptions
Entity assumption
There is a separate accounting entity for each business organization

Going concern assumption

A business is assumed to have an indefinite life
Also called the continuity assumption, supports the historical principle for many assets
Income measurement is based on historical cost of assets because assets provide value through use,
rather than disposal

Without the going concern principle, historical cost would not be an appropriate valuation basis

Unit of measure assumption

Assets, liabilities, equities, revenues, expenses, gains, losses and cash flows are measured in
terms of the monetary unit of the country in which the business is operated
Price level changes cause the application of this assumption to weaken the relevance of certain
disclosures

 Unit of measure assumption

Capital maintenance and departures from the unit of measure
assumption
Concept of capital maintenance is related to the unit of measure
assumption
Capital is maintained when the firm has positive earnings for the year,
assuming no changes in price levels
When a firm has income, it has recognized revenue sufficient enough to
replace all the resources used in generating that revenue (return on
capital), and has the resources left over in addition.
That income could be distributed as dividends without eroding the net
assets (capital) existing at the beginning of the year
GAAP is based on the concept of financial capital maintenance.
As long as dividends do not exceed earnings, and earnings is not
negative, financial capital has been maintained.

Alternative concept of capital maintenance is physical capital

maintenance.
Earnings cannot be recognized until the firm has provided for the physical
capital used up during the period.

 Time period assumption

The indefinite life of a business is broken into smaller time frames,
typically a year, for evaluation purposes and reporting purposes.
For accounting information to be relevant, it must be timely.
The reliability of information often must be sacrificed to provide
relevant disclosures.
The use of estimates is required for timely reporting but also implies a
loss of reliability

 Accounting Principles
Measurement
At the time of origin, assets and liabilities are recorded at the market value of the item on the date
of acquisition, usually the cash equivalent
Referred to as historical cost

Other assets such as plant assets and intangibles are disclosed at historical cost less accumulated
depreciation or amortization
Given the going concern assumption, revaluation to market value is inappropriate for plant assets, because
the value of these assets is derived through use, rather than from disposal

Measurement attributes other than historical cost used to represent items on financial
statements
Net realizable value:
used to approximate liquidation value or selling price.
The net value to be received after the costs of sale are deducted from the current market value

Current replacement cost

Represents how much you would have to pay to replace an asset
Current market value

Fair value
Also referred to as current market value
The price that would be received to sell an asset (or the price to settle a liability) in an orderly transaction
from the perspective of a market participant at the measurement date.

 Amortized cost
Historical cost less the accumulated amortization or depreciation of the asset

Net present value

The value determined from discounting the expected future cash flows

Revenue Recognition Principle

Addresses three important issues related to revenues.
Revenue defined
Increases in assets or the extinguishment of liabilities stemming form the delivery of goods or services- the
main activities of the firm

When to recognize revenue

Revenues are recognized when the entity completes its performance obligation to a customer and the revenue
is earned and realized (or realizable)
The performance obligation is completed when the goods or services are delivered (revenue earned) and
cash or promise of cash is received (realized).
Five steps to allocate the components of revenue
Identify the contract with the customer
Identify if there is more than one performance obligation
Determine the transaction price
Allocate the transaction price to the separate performance oblications
Recognize revenue when each performance obligation is satisfied

Measure Revenue
How to measure revenue
Revenues are measured at the cash equivalent amount of the good or service provided

 Expense recognition principle

Addresses when to recognize expenses
Sometimes referred to as the matching principle
Matching principle
Recognize expenses only when expenditures help to produce revenues
Revenues are recognized when earned and realized or realizable; the related expenses are
recognized
Expenses that are directly related to revenues can be readily matched with revenues they
help produce
COGS and sales commissions are expenses that are directly associated and therefore
matched with revenue.
Other expenses are allocated based on the time period or benefit provided
depreciation and amortization
Other expenses are recognized in the period incurred when there is no determinable
relationship between expenditures and revenues
Advertising costs

Full disclosure principle

Financial statements should present all information needed by an informed reader to
make an economic decision
Sometimes referred to as the adequate disclosure principle

Constraints and Present Value

Cost Constraint
The cost constraint on GAAP limits recognition and disclosure if the cost of
providing the information exceeds its benefit
Firms may not omit disclosures if they are material and mandated by GAAP

Note: Conservatism
No longer a constraint, not a qualitative characteristic
Also called prudence
The reporting o less optimistic amounts under conditions of uncertainty or when GAAP
provides a choice from among recognition or measurement methods
Conservatism is a guideline that is used to limit the reporting of aggressive accounting information
used to avoid misleading internal and external users of the financial statements
If estimates of an outcome are not equally likely, the preferred approach is to report the most likely
estimate, rather than the more conservative estimate, if the latter is less likely.
It should be noted that overly conservative estimates can be misleading and cause over reporting
in subsequent periods

 Financial Statements, Recognition Criteria, Elements

A full set of financial statements should include the following
Financial position at year end
Balance sheet

Earnings for the year

Income statement

Comprehensive income for the year- total non owner changes

Statement of comprehensive income

Cash flows during the year

Statement of cash flows

Investments by and distributions to owners during the year

Statement of owners equity

Recognition and Measurement criteria

Definition- the definition of a financial statement element is met
Measurability- there is an attribute to be measured, such as historical cost
Relevance- the information presented in the financial report is capable of influencing
decisions
The information is timely, had predictive ability, provides feedback value, and is material

Faithful representation- the information is complete, neutral, and free from material error

 Financial Statements, Recognition Criteria, Elements

Elements of Financial Statements- Ten elements
Assets
Resources that have probably future economic benefits resulting from past transactions, controlled by management

Liabilities
Probable future sacrifices of economic benefits arising from present obligations of an entity to transfer assets or
provide services to other entities as a result of pas transactions or events

Equity
Residual interest in the firms assets

Investments by owners
Increases in net assets of an entity

Distributions to owners
Decreases in net assets of an entity

Comprehensive income
Accounting income (transaction bases) plus certain holding gains and losses and other items
Includes all changes in equity other than investments by and distributions to owners

Revenues
Increases in assets or settlements of liabilities

Expenses
Decreases in assets or incurrences of liabilities

Gains
Increases in equity or net assets

Losses
Decreases in equity or net assets

 Using Cash Flow information and present value in accounting

measurements
Addresses the use of present value measurements
Does not constitute GAAP but is used in the development of GAAP
Measurement issues
Addresses only measurement issues, not recognition
Applies to initial recognition, fresh start measurements, and amortization
technique based on future cash flows
Fresh start measurement- establishes a new carrying value after an initial recognition
and is unrelated to previous amounts

If the fair value of an asset or liability is available, there is no need to use present
value measurement

Present value measure

When a present value measure is used:
The result should be as close as possible to fair value if such a value could be obtained
The expected cash flow approach is preferred, because present value measurements
should reflect the uncertainties inherent in the estimated cash flows

 Using Cash Flow information and present value in accounting

measurements
Capture Economic differences
A present value measurement that fully captures the economic differences between various
estimates of future cash flows would include the following

An estimate of future cash flows

Expectations about variations in amount or timing of those cash flows
Time value of money as measured by the risk free rate of interest
The price for bearing the uncertainty inherent in the asset or liability
Any other relevant factors

Two approaches of computing present value

Traditional approach
Uses the interest rate to capture all the uncertainties and risks inherent in a cash flow measure

Expected cash flow approach

Uses a risk free rate as the discount rate

Expected cash flow approach

Uses expectations about all possible cash flows instead of a single most likely cash flow.
Believed to provide a better estimate of fair value because it directly incorporates the uncertainty
in estimated future cash flows
Has been incorprated into Accounting for Asset Retirement Obligations.