Chapter 5

Conceptual Framework Underlying Financial Accounting

Study Objectives Study Objectives

1. Describe the usefulness of a conceptual framework. 2. Describe the FASBs efforts to construct a conceptual framework. 3. 4. 5. 1. Understand the objectives of financial reporting. Identify the qualitative characteristics of accounting information. Define the basic elements of financial statements. Describe the basic assumptions of accounting.

2. Explain the application of the basic principles of accounting. 3. Describe the impact that constraints have on reporting accounting information.

Conceptual Framework Underlying Financial Accounting Conceptual Framework Underlying Financial Accounting

Conceptual Framework

First Level Basic Objectives

Second Level Fundamental Concepts Qualitative characteristics Basic elements

Third Level Recognition and Measurement Basic assumptions Basic principles Constraints

Rationale Development

Introduction Introduction
Users of financial statements need relevant and reliable information To provide such information, the profession has developed a set of principles and guidelines called Conceptual Framework The framework is to be the foundation for building a set of coherent accounting standards and rules Also to be a reference of basic accounting theory for solving emerging practical problems of reporting

Statements of Financial Accounting Statements of Financial Accounting Concepts Concepts

The Financial Accounting Standards Board (FASB) has issued seven Statements of Financial Accounting Concepts (SFAC) to-date These statements set forth major recognition and reporting issues SFAC No. 4 pertains to reporting by non-business entities The other six statements pertain to reporting by business enterprises

Statements of Financial Accounting Concepts Statements of Financial Accounting Concepts

SFAC No. 1 >>> Objectives of Financial Reporting (Business) SFAC No. 2 >>> Qualitative Characteristics of Accounting Information SFAC No. 3 >>> Elements of Financial Statements (Business) SFAC No. 4 >>> Objectives of Financial Reporting (NonBusiness) SFAC No. 5 >>> Recognition and Measurement Criteria in Financial Statements SFAC No. 6 >>> Elements of Financial Statements (replaces SFAC No. 3) SFAC No. 7 >>> Using Cash Flows information and Present Value in Accounting Measurements

Overview of the Conceptual Framework Overview of the Conceptual Framework

The Framework has three levels : Objectives, elements and criteria First level consists of objectives to identify goals and purposes of accounting Second level consists of qualitative characteristics that make accounting information useful and elements of financial statements Third level incorporates recognition and measurement criteria used in establishing and applying accounting standards, including assumptions, principles and constraints

Overview of the Conceptual Framework Overview of the Conceptual Framework

Recognition and Measurement Concepts
assumptions principles constraints

Level 3

Qualitative Characteristics
of accounting information

Elements
of financial statements

Level 2

Objectives
of financial reporting

Level 1

First Level : Basic Objectives First Level : Basic Objectives

The basic objectives of financial reporting are to provide information that is :1.

Useful to those making investment and credit decisions who have a reasonable understanding of business and economic activities Helpful to present and future investors, creditors and other users in assessing future cash flows About economic resources, the claims on those resources and the changes in them

2. 3.

Second Level : Qualitative Characteristics Second Level : Qualitative Characteristics

The FASB has identified the qualitative characteristics of accounting information that distinguish better (more useful) information from inferior (less useful) information for decision making purposes Primary qualities are relevance and reliability of accounting information Secondary qualities are comparability consistency of reported information and

Primary Qualities- Relevance Primary Qualities- Relevance

To be relevant, accounting information must be capable of making a difference in a decision For information to be relevant, it should have predictive or feedback value, and it must be presented on a timely basis Predictive value helps users make predictions about ultimate outcome of past, present and future events Feedback value helps users confirm or correct prior expectations Timeliness available to decision makers before it loses its capacity to influence their decisions

Primary Qualities- Reliability Primary Qualities- Reliability

Information is reliable when it can be relied on to represent the true situation For accounting information to be reliable, it should be verifiable, is a faithful representation, and it is reasonably free of error and bias Verifiability when given the same information and using the same measurement methods, independent users can obtain the same results Representational faithfulness when it represents what really existed or happened Neutrality when it is factual, truthful and unbiased

Secondary Qualities- Comparability Secondary Qualities- Comparability

Comparability and consistency of reported information Information about an enterprise is more useful if it can be compared with similar information about another enterprise (comparability) and with similar information about the same enterprise at other points in time (consistency) For information to be comparable, it must be
1. 2.

Measured and reported in a similar manner for different enterprises Useful to users in identifying real similarities and differences between enterprises

Secondary Qualities- Consistency Secondary Qualities- Consistency

Entity is considered to be consistent in its use of accounting standards when it applies the same accounting treatment to similar events from period to period Companies can change methods, if the change results in better reporting
1. 2. 3.

Disclosure for change :Nature of the change Effect of the change Justification for the change

Hierarchy of Accounting Qualities Hierarchy of Accounting Qualities

Decision Makers Constraints User Specific Qualities Pervasive Criterion Primary Qualities Secondary Qualities What are the characteristics? Cost-Benefit & Materiality Understandability Decision Usefulness Relevance & Reliability Comparability & Consistency

Ingredients of Primary Qualities Ingredients of Primary Qualities

Basic Elements of Financial Statements 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 interest in assets after deducting liabilities 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 nonowner sources Revenues: Inflows from entitys ongoing operations Expenses: Outflows from entitys ongoing operations Gains: Increases in equity from incidental transactions Losses: Decreases in equity from incidental transactions

Third Level :: Recognition and Measurement Concepts Third Level Recognition and Measurement Concepts
Consists of concepts that implement the basic objectives of level one These concepts explain which, when and how financial elements and events should be recognized, measured and reported by the accounting system According to SFAC No. 5 (Recognition and Measurement in Financial Statements of Business Enterprises), to be recognized, an item must
1. 2.

meet the definition of an element of financial statements as defined in SFAC No. 6; and must be measureable

Third Level :: Recognition and Measurement Concepts Third Level Recognition and Measurement Concepts

Basic Assumptions

Basic Assumptions : Economic Entity Assumption Basic Assumptions : Economic Entity Assumption
The economic entity can be identified with a particular unit of accountability The activity of a business enterprise is separate and distinct from its owners Entitys assets and other financial elements are separate from the owners The economic entity assumption is an accounting concept and not a legal construct

Basic Assumptions : Going Concern Assumption Basic Assumptions : Going Concern Assumption
The business is assumed to continue indefinitely unless terminated by owners The basis of recoding financial elements is historical cost accounting Liquidation accounting (based on net realizable value) is not followed unless so indicated

Basic Assumptions : Going Concern Assumption Basic Assumptions : Going Concern Assumption
According to MASB (Malaysian Accounting Standards Board) The financial statements are normally prepared on the assumption that an entity is a going concern and will continue in operation for the foreseeable future Hence, it is assumed that the entity has neither the intention nor the need to liquidate or curtail materially the scale of its operations If such an intention or need exists, the financial statements may have to be prepared on a different basis, and, if so, the basis used is disclosed

Basic Assumptions : Monetary Unit Basic Assumptions : Monetary Unit

Money is the common unit of measure of economic transactions The use of monetary unit is relevant, simple, universally available, understandable and useful Price level changes (inflation and deflation) are ignored in accounting, leading to the assumption that the dollar remains relatively stable

Basic Assumptions : Periodicity (Time Period) Basic Assumptions : Periodicity (Time Period)
Economic activities of an entity can be divided into artificial time periods (monthly, quarterly, yearly) for reporting purposes The shorter the time period, the more difficult it becomes to determine the proper net income for the period Investors usually demand that accounting information be quickly processed but the faster it is released, the more it is subject to error

Basic Assumptions : Accrual Basis Basic Assumptions : Accrual Basis

According to MASB (Malaysian Accounting Standards Board) In order to meet their objectives, financial statements are prepared on the accrual basis of accounting Under this basis, the effects of transactions and other events are recognized when they occur (and not as cash or its equivalent is received or paid); and They are recorded in the accounting records and reported in the financial statements of the periods to which they relate

Basic Assumptions : Accrual Basis Basic Assumptions : Accrual Basis

According to MASB (Malaysian Accounting Standards Board) Financial statements prepared on the accrual basis inform users not only of past transactions involving the payment and receipt of cash, but also of obligations to pay cash in the future and of resources that represent cash to be received in the future Hence, they provide the type of information about past transactions and other events that is most useful to users in making economic decisions

Basic Principles

Basic Principles : Historical Cost Principle Basic Principles : Historical Cost Principle
Most assets and liabilities are recorded at its acquisition price Cost has an important advantage over other valuations : it is reliable User 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, lower of cost or market, and other valuation bases

Basic Principles : Revenue Recognition Principle Basic Principles : Revenue Recognition Principle
Revenue is recognized when it is realized or realizable, and earned Revenue is realized when goods or services are exchanged for cash or claims to cash Revenue is realizable when assets received or held are readily convertible into cash or claims to cash Revenue is earned when the entity has substantially accomplished what it must do to be entitled to the benefits represented by the revenues

Basic Principles : Revenue Recognition Principle Basic Principles : Revenue Recognition Principle
Usually, revenue is recognized at the time of sale However, there are exceptions :
1.

During Production : In long-term construction contracts, revenue is recognized periodically based on the percentage of job completed End of Production (After production but before sales) : Where active markets exist for the product and there are no significant additional cost Receipt of cash : Used when it is impossible to establish the revenue amount at the time of sale because of the uncertainty of collection. E.g. In installment sales methods, payment is required in periodic installments > risk of uncollectible

2.

3.

Basic Principles : Matching Principle Basic Principles : Matching Principle

Efforts (expenses) are accomplishment (revenues) to be matched with

Expenses are matched to the revenues they help to generate Costs that are related to the revenue are expensed and matched against the revenue in the period the revenue is recognized When there is no connections between costs and revenues, an allocation of cost based on some systematic basis might be appropriate, e.g. The cost of fixed assets is allocated throughout its useful life because the asset contributes to the generation of revenue

Basic Principles : Matching Principle Basic Principles : Matching Principle

If the allocation method is not desirable, then the cost is expensed off immediately Costs are generally classified into two groups :1.

Product Costs : Material, labour and overhead attach to the product and carried into future periods if the revenue from the product is recognized in subsequent periods Period Costs : Officers salaries and other administrative expenses are charged off immediately even though benefits associated with these costs occur in the future, because there is no direct relationship between cost and revenue

2.

Basic Principles : Full Disclosure Principle Basic Principles : Full Disclosure Principle
Providing information that is of sufficient importance to influence the judgment and decisions of an informed user Disclosure can be made : Within the main body of financial statements - The item should meet the definition of a basic element, be measurable with sufficient certainty and be relevant and reliable

In the notes to financial statements - Generally explain the items presented in the main body of the financial statements As supplementary information - May include information that is high in relevance but low in reliability, or that is helpful but not essential

Constraints

Constraints Constraints
In providing information with the qualitative characteristics that make it useful, two overriding constraints must be considered : Cost-Benefit Relationship, and Materiality Two less dominant yet important constraints that are part of the reporting environment are Industry Practices, and Conservatism

1. 2.

1. 2.

Constraints : Cost-Benefit Relationship Constraints : Cost-Benefit Relationship

The cost of providing information should not outweigh the benefit derived from the information However, costs and especially benefits are not always obvious or measurable Sound judgment must be used in providing information

Constraints : Materiality Constraints : Materiality

Materiality refers to an items significance to a firms overall financial operations An item must make a difference to be material and to be disclosed It is also a matter of relative significance of the element E.g. If the amount involved is significant compared with other revenues and expenses, assets and liabilities, or net income of the entity, then sound and acceptable standards should be allowed

Constraints : Industry Practices Constraints : Industry Practices

An entity may follow the general practices in the firms industry, which sometimes requires departure 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 Constraints : Conservatism

Conservatism suggests that when in doubt, the preparer should always choose a conservative solution This solution will be least likely to overstate assets and income However, bear in mind that conservatism does not suggest that net assets or net income to be deliberately understated

http://www.masb.org.my/

Malaysia Accounting Standard Board (MASB)

LEMBAGA PIAWAIAN PERAKAUNAN MALAYSIA MALAYSIAN ACCOUNTING STANDARDS BOARD Framework for the Preparation and Presentation of Financial Statements
http://www.masb.org.my/index.php?option=com_content&view=article&id=150&Itemid=24

End of Chapter 5 All the Best in Your Exam