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The Need for a Conceptual Framework § To develop a coherent set of standards and rules § To solve new and emerging practical problems

Conceptual Framework

The Framework is comprised of three levels:

First Level = Basic Objectives Second Level = Qualitative Characteristics and Basic Elements Third Level = Recognition and Measurement Concepts

Chapter 1: Objectives: (1) Useful in investment and credit decisions (2) Useful in assessing future cash flows (3) Useful in assessing enterprise resources, claims to resources and changes in them

Chapter 2

Conceptual Framework for Financial Reporting

Chapter 1: Objectives: (1) Useful in investment and credit decisions (2) Useful in assessing future cash flows (3) Useful in assessing enterprise resources, claims to resources and changes in them

Chapter 2

Conceptual Framework for Financial Reporting

Chapter 1: Objectives: (1) Useful in investment and credit decisions (2) Useful in assessing future cash flows (3) Useful in assessing enterprise resources, claims to resources and changes in them

Chapter 2

Conceptual Framework for Financial Reporting

Level 2: Qualitative Characteristics

Level 2: Qualitative Characteristics

Relevance – Accounting information must be capable of making a difference in a decision

Predictive Value – Information has value as an input to predictive processes used by investors or creditors to form their own expectations about the future. Example: Investors interested in purchasing stock in a company would analyze its current resources (assets) and claims to those resources (liabilities and stockholders’ equity), its dividend payments, and its past performance to predict the amount, timing, and uncertainty future cash flows.

Level 2: Qualitative Characteristics

Relevance – Accounting information must be capable of making a difference in a decision

Confirmatory Value – Helps users confirm or correct prior expectations. Example: Information about the current level and structure of assets and liabilities helps users predict its ability to take advantage of opportunities and react to situations. The same information helps confirm or correct users’ past predictions about that ability.

Level 2: Qualitative Characteristics

Relevance – Accounting information must be capable of making a difference in a decision  

Materiality – Information is material if omitting it or misstating it could influence a user’s decision. Materiality is determined on a company-by- company basis based on the nature and/or magnitude of the items.

Level 2: Qualitative Characteristics

Relevance – Accounting information must be capable of making a difference in a decision  

Materiality – Information is material if omitting it or misstating it could influence a user’s decision. Materiality is determined on a company-by- company basis based on the nature and/or magnitude of the items.

Level 2: Qualitative Characteristics

Relevance – Accounting information must be capable of making a difference in a decision  

Materiality – Information is material if omitting it or misstating it could influence a user’s decision. Materiality is determined on a company-by- company basis based on the nature and/or magnitude of the items.

2% of Income from operations 50% of income from operations

Level 2: Qualitative Characteristics

Faithful Representation – Numbers and descriptions match what really existed or happened.

Completeness – All the information that is necessary for faithful representation is provided For example, when a company fails to provide information needed to assess the value receivables, the information is not complete and therefore not a faithful representation of their values.

Level 2: Qualitative Characteristics

Faithful Representation – Numbers and descriptions match what really existed or happened.

Neutrality – Company cannot select information to favor one set of interested parties over another. For example, tobacco companies should not suppress information about the numerous lawsuits that have been filed because of tobacco related health concerns, even though such disclosure is damaging to the company.

Level 2: Qualitative Characteristics

Faithful Representation – Numbers and descriptions match what really existed or happened.

Free from error

Level 2: Qualitative Characteristics

Enhancing Qualities Comparability – Information is measured and reported in a similar manner for different companies or different years (over time). Verifiability – Verifiability occurs when independent measurers, using the same methods, obtain similar results. Timeliness – Having information do decision makers before it loses its capacity to influence decisions Understandability – Quality of information that lets reasonably informed users see its significance.    

Chapter 1: Objectives: (1) Useful in investment and credit decisions (2) Useful in assessing future cash flows (3) Useful in assessing enterprise resources, claims to resources and changes in them

Chapter 2

Conceptual Framework for Financial Reporting

Chapter 1: Objectives: (1) Useful in investment and credit decisions (2) Useful in assessing future cash flows (3) Useful in assessing enterprise resources, claims to resources and changes in them

Chapter 2

Conceptual Framework for Financial Reporting

Level 2: Elements of Financial Statements

Level 2: Elements of Financial Statements

Stock Purchases

Dividends

Level 2: Elements of Financial Statements

NI + OCI

Level 2: Elements of Financial Statements

NI + OCI

Level 2: Elements of Financial Statements Brief Exercise 2-6: For each item below, indicate to which category of elements of financial statements it belongs. (a) Retained earnings (b) Sales (c) Additional paid-in capital (d) Inventory (e) Depreciation (Expense) (f) Loss on sale of equipment (g) Interest payable (h) Dividends (i) Gain on sale of investment (j) Issuance of common stock

Chapter 1: Objectives: (1) Useful in investment and credit decisions (2) Useful in assessing future cash flows (3) Useful in assessing enterprise resources, claims to resources and changes in them

Chapter 2

Conceptual Framework for Financial Reporting

Chapter 1: Objectives: (1) Useful in investment and credit decisions (2) Useful in assessing future cash flows (3) Useful in assessing enterprise resources, claims to resources and changes in them

Chapter 2

Conceptual Framework for Financial Reporting

Basic Assumptions a. Economic entity assumption—economic activity can be identified with a particular unit of accountability. 1) That is, a company keeps its activity separate and distinct from its owners and any other business units. 2) We can distinguish activities between different companies, and/or between different divisions/ segments. b. Going concern assumption—companies will have a long life. c. Monetary unit assumption—the monetary unit (i.e., the dollar) is the common denominator of economic activity and provides the most effec-tive means of expressing to interested parties changes in capital and exchanges of goods and services. d. Periodicity assumption—activities of an enterprise can be divided into artificial time periods.

Level 3: Recognition and Measurement Concepts

Basic Principles of Accounting Measurement principle—GAAP permits the use of a mixed attribute system that allows for historical cost and fair value bases.

Historical cost principle. Report assets and liabilities on the basis of acquisition price. Fair value principle. Report assets and liabilities as the current market-value of the asset/ liability.

Revenue recognition principle— Revenue is recognized at the time in which the performance obligation is satisfied, regardless of when cash is received Expense recognition principle (matching principle) – efforts (expenses) should be matched with accomplishments (revenues). Record cost of generating revenues (expenses) in the same period as those revenues are earned. Full disclosure principle—revealing in financial statements any facts of sufficient importance to influence the judgment and decisions of an informed reader. Example: Notes and supplementary information in financial reporting.

Level 3: Recognition and Measurement Concepts

Conceptual Framework for Financial Reporting

Exercise 2-9 Presented below are a number of business transactions that occurred during the current year for Gonzales, Inc. In each of the situations, discuss the appropriateness of the journal entries in terms of generally accepted accounting principles. (a) The president of Gonzales, Inc. used his expense account to purchase a new Suburban solely for personal use. The following journal entry was made. Miscellaneous Expense 29,000 Cash 29,000 (b) Merchandise inventory that cost $620,000 is reported on the balance sheet at $690,000, the expected selling price less estimated selling costs. The following entry was made to record this increase in value. Inventory 70,000 Sales Revenue 70,000 (c) The company is being sued for $500,000 by a customer who claims damages for personal injury apparently caused by a defective product. Company attorneys feel extremely confident that the company will have no liability for damages resulting from the situation. Nevertheless, the company decides to make the following entry. Loss from Lawsuit 500,000 Liability for Lawsuit 500,000

Presented below is information related to Cramer, Inc. Instructions Comment on the appropriateness of the accounting procedures followed by Cramer, Inc. (a) Depreciation expense on the building for the year was $60,000. Because the building was

increasing in value during the year, the controller decided to charge the depreciation expense to retained earnings instead of to net income. The following entry is recorded.

Retained Earnings 60,000 Accumulated Depreciation—Buildings 60,000

(b) Materials were purchased on January 1, 2014, for $120,000 and this amount was entered in the Materials account. On December 31, 2014, the materials would have cost $141,000, so the following entry is made.

Inventory 21,000 Gain on Inventories 21,000

(c) During the year, the company purchased equipment through the issuance of common stock. The stock had a par value of $135,000 and a fair value of $450,000. The fair value of the equipment was not easily determinable. The company recorded this transaction as follows.

Equipment 135,000 Common Stock 135,000

(d) During the year, the company sold certain equipment for $285,000, recognizing a gain of $69,000. Because the controller believed that new equipment would be needed in the near future, she decided to defer the gain and amortize it over the life of any new equipment purchased.

(e) An order for $61,500 has been received from a customer for products on hand. This order was shipped on January 9, 2015. The company made the following entry in 2014.

Accounts Receivable 61,500 Sales Revenue 61,500