Chapter 2: The Conceptual

Framework
 Chapter 2
Conceptual Framework Underlying
Financial Accounting
After studying this chapter, you should be able to:
1 Describe the usefulness of a conceptual framework.
2 Describe the FASB’s efforts to construct a
conceptual framework.
3 Understand the objectives of financial reporting.
4 Identify the qualitative characteristics of accounting
information.
5 Define the basic elements of financial statements.
 Chapter 2
Conceptual Framework Underlying
Financial Accounting
After studying the chapter, you should be able to:

6 Describe the basic assumptions of accounting.

7 Explain the applications of the basic
principles of accounting.
8 Describe the impact that constraints have on
reporting accounting information.
 Introduction
• Users of financial statements need relevant and
reliable information.
• To provide such information, the profession
has developed a set of principles and guidelines.
• These principles and guidelines are
collectively called the Conceptual Framework.
• In short, the Framework is like a constitution
for the profession.
 Objectives of the Conceptual
Framework
• The Framework is to be the foundation for
building a set of coherent accounting
standards and rules.
• The Framework is to be a reference of basic
accounting theory for solving emerging
practical problems of reporting.
Statements of Financial Accounting
Concepts
• The FASB has issued seven Statements of
Financial Accounting Concepts (SFACs) to
date .
• These statements set forth major recognition
and reporting issues.
• Statement 4 pertains to reporting by
nonbusiness entities.
• The other six statements pertain to reporting
by business enterprises.
 Statements of Financial Accounting
Statement Concepts
Brief Title
Brief Title
• Statement 1 • Objectives of Financial
Reporting (Business)
• Statement 2 • Qualitative Characteristics
• Elements of Financial
• Statement 6 Statements (replaces 3)
• Objectives of Financial
• Statement 4
Reporting (Nonbusiness)
• Statement 5 • Recognition and
Measurement Criteria
• Statement 7 • Using Cash Flows
 Overview of the Conceptual
Framework (1 of 2)
• The Framework has three levels: objectives,
elements and criteria.
• The first level consists of objectives.
• The second level explains financial
statement elements and characteristics of
information
• The third level incorporates recognition and
measurement criteria.
Overview of the Conceptual Framework (2
of 2)
Level 3: Recognition and
Implemen- Measurement Concepts
tation

Level 2: Elements of
Qual Financial Statements and
Elements
Charac. Qualitative Characteristics
of Accounting Information

Objectives Level 1: Objectives of

Financial Reporting
 Basic Objectives of Financial
Reporting
To provide
To provide information
information::

1) that
1) that isis uuseful to those
sefulto those making
making investment
investment and
and
credit decisions
credit decisions whowho reasonably
reasonably understand
understand
business and
business and
2) that
2) that isis useful
usefulto to present
present and
and future
futureinvestors,
investors,
creditors in
creditors assessing future
in assessing future cash
cash flows
flows
3) about
3) economic resources
about economic resources,,thethe claims
claims on
on
those resources
those resources and and changes
changes inin them
them
 Qualitative Characteristics of
Accounting Information
• Primary qualities are relevance and
reliability of accounting
information.
• Secondary qualities are
comparability and consistency of
reported information.
 Qualitative Characteristics of
Accounting Information: Relevance
Relevance of information means “information
capable of making a difference in a decision
context.” To be relevant:
 The information must be timely.
 The information should have predictive value: (be
helpful in making predictions about ultimate
outcomes of past, present and future events).
 The information should have feedback value
(helps users to confirm prior expectations.)
 Primary Characteristic: Reliability

• Information is reliable, when it can be

relied on to represent the true, underlying
situation.
• To be reliable, information must be:
* verifiable
* representationally faithful, and
* neutral
 Primary Characteristic: Reliability

• Information is verifiable, when, given the

same information, independent users can
arrive at similar conclusions.
• Information is faithful, when it represents
what really existed or happened.
• Information is neutral, when it is free from
bias.
 Secondary Characteristics
• Secondary characteristics are: comparability and
consistency of reported information.
• For information to be comparable, it must be:
 measured and reported in a similar manner for different
enterprises.
 useful in the allocation of resources to the areas of
greatest benefit.
 useful to users in identifying real differences between
enterprises.
 Secondary Characteristics
• Accounting information is consistent, if the same
accounting principles are applied in a similar
manner from one period to the next.
• Accounting principles may be changed, if the
change results in better reporting.
• If principles are changed, the justification for, and
the nature and effect of the change, must be
disclosed.
 Hierarchy of Accounting Qualities
Decision Makers What are their characteristics?

Constraints Cost benefit & Materiality

User specific Qualities Understandability

Pervasive Criterion Decision Usefulness

Primary Qualities Relevance & Reliability

Secondary Qualities Comparability & Consistency

 Ingredients of Primary Qualities
Relevance Reliability

Predictive Feedback Represent.

Verifiability Neutrality
Faithfulness
Value Value

Timeliness
 Basic Elements of Financial Statements
Balance Sheet
• Assets: Probable future
economic benefits resulting
from past transactions
• Liabilities: Probable future
sacrifices of economic benefits
resulting from past transactions
• Equity: Residual or ownership
interest
• Investment by Owners:
Increases in net assets
• Distributions to Owners:
Decreases in net assets
Income Statement
• Comprehensive Income: All
changes in equity from non-
owner sources
• Revenues: Inflows from
entity’s ongoing operations
• Expenses: Outflows from
entity’s ongoing operations
• Gains: Increases in equity from
incidental transactions
• Losses: Decreases in equity
from incidental transactions
 Recognition and Measurement
Criteria
Basic
Principles Constraints
Assumptions

1. Economic 1. Historical cost 1. Cost Benefit

entity 2. Revenue 2. Materiality
2. Going recognition 3. Industry
concern 3. Matching practices
3. Monetary 4. Full 4. Conservatism
Unit disclosure
4. Periodicity
Basic Assumptions
 Basic Assumptions
Economic Entity Assumption
• The economic entity can be identified with a
particular unit of accountability.
• The business is separate and distinct from its
owners.
• Entity’s assets and other financial elements are not
commingled with those of the owners.
• The economic entity assumption is an accounting
concept, and not a legal construct.
 Basic Assumptions
Going Concern Assumption
• The business is assumed to continue
indefinitely unless terminated by owners.
• The basis of recording financial elements is
historical accounting.
• Liquidation accounting (based on liquidation
values) is not followed unless so indicated.
 Basic Assumptions
Monetary Unit
• Money is the common unit of measure of
economic transactions.
• Use of a monetary unit is relevant, simple to
understand and universally available.
• Price level changes are ignored in
accounting, leading to the assumption that
the dollar remains relatively stable.
 Basic Assumptions
Periodicity (Time Period) Assumption
• Economic activity of an entity may be
artificially divided into time periods for
reporting purposes.
• Shorter time periods are subject to revisions but
may be more timely.
Basic Principles
 The Cost Principle
Historical Cost Principle
• Transaction is recorded at its acquisition price.
• It is not changed to reflect market price.
• The principle applies to most assets and liabilities.
• Users of financial statements may find fair value
information useful for certain types of assets and
liabilities.
• The current system is a “mixed attribute” incorporating
historical cost, fair value, and certain other
valuation bases.
22
 The Revenue Recognition Principle
Revenue Recognition Principle
• Revenue is recognized when it is realized or
realizable and earned and the amount can be
objectively determined.
• Revenue is recognized at time of sale. There are
exceptions:
1) During production: In long-term construction revenue is
recognized periodically based on % of job completed.
2) End of production: Where active markets exist for the
product and there are no significant future costs..
3) Receipt of cash: Used when there is uncertainty of
collection. In installment sales contracts payment is required
in periodic installments.
 The Matching Principle
• Expenses are matched to the revenues they help
generate.
• There should be a logical, rational association of
revenues and expenses.
• If a cost does not benefit future periods, it is
recorded in the current period as an expense.

24
 The Full Disclosure Principle
• Financial statements must report what a
reasonable person would need to know to make
an informed decision.
• Disclosure may be made:
 within the body of the financial statements,
 as notes to those statements, or
 as supplementary information.
Constraints
 Constraints: The Cost Benefit Rule

Cost-Benefit Relationship
• The cost of providing information should not
outweigh the benefit derived.
• Costs and benefits are not always obvious or
measurable.
• Sound judgment must be used in providing
information.
 Constraints: Materiality
Materiality refers to an item’s importance to a
firm’s overall financial operations.
• An item must make a difference to be material and
be disclosed.
• It is a matter of the relative significance of the
element.
• Both quantitative and qualitative factors are to be
considered in determining relative significance.
 Constraints: Industry Practices
Industry Practices
• The nature of some industries sometimes
require departures from basic accounting
theory.
• If application of accounting theory results in
statements that are not comparable or
consistent, then industry practices must be
examined for possible explanations.
 Constraints: Conservatism
• Conservatism suggests that the preparer,
when in doubt, choose a conservative
solution.
• This solution will be least likely to overstate
assets and income.
• Conservatism does not suggest that net
assets or net income be deliberately
understated.
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