Objectives, Qualitative Characteristics

I.Conceptual Framework Outline

A.The FASB's Statements of Financial Accounting Concepts, as amended, comprise the

conceptual framework for financial accounting. The framework does not constitute
GAAP but rather provides consistent direction for the development of specific GAAP.
The conceptual framework is a "constitution" for developing specific GAAP.

B.A listing of the parts of the conceptual framework follows. This outline lists the major
subsections of the framework in a progression leading from definitions and general
concepts to specific accounting principles, the ultimate purpose of the framework.

1.Objective of financial reporting;

2.Qualitative characteristics of accounting information;

3.Accounting assumptions;

4.Basic accounting principles;

5.Accounting constraints;

6.Elements of financial statements.

II.Objective of Financial Reporting

A.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.

B.Useful information includes information about:

1.The amount, timing, and uncertainty of an entity's cash flows;

2.Ability of the entity to generate future net cash inflows;

3.An entity's economic resources (assets) and claims to those resources

(liabilities) which provides insight into the entity's financial strengths and
weaknesses, and its liquidity and solvency;

4.The effectiveness with which management has met its stewardship

responsibilities;

5.The effect of transactions and other events that change an entity's economic
resources and the claims to those resources.
III.Qualitative Characteristics of Accounting Information

A.For financial statement information to be useful, it should have several qualitative

characteristics. There are two primary characteristics and four enhancing
characteristics, each of which has subcomponents. The following diagram shows the
primary and enhancing characteristics and their components, as contributing to the
objective of financial reporting.
Objective of financial reporting: decision usefulness
Primary qualitative characteristics
1. Relevance 2. Faithful representation
a. Predictive value a. Completeness
b. Confimatory value b. Neutrality
 c. Free from material error
Enhancing qualitative characteristics
1. Comparability
2. Verifiability
3. Timeliness
4. Understandability

B.Primary characteristics (relevance, faithful representation) -- For

information to be useful for decision making, it must both be relevant and be a
faithful representation of the economic phenomena that it represents.

1.Relevance (primary characteristic) -- Information is relevant if it makes

a difference to decision makers in their role as capital providers. Information
is relevant when it has predictive value, confirmatory value, or both.

a.Predictive value -- Information has predictive value if it assists

capital providers in forming expectations about future events.

b.Confirmatory value -- Information has confirmatory value if it

confirms or changes past (or present) expectations based on previous
evaluations. For example, if reported earnings for a period bears out
market expectations, then it has confirmatory value.

2.Faithful representation (primary characteristic) -- Information

faithfully represents an economic condition or situation when the reported
measure and the condition or situation are in agreement. Financial
information that faithfully represents an economic phenomenon portrays the
economic substance of the phenomenon. Information is representationally
faithful when it is complete, neutral and free from material error. Faithful
representation replaces reliability as a primary qualitative characteristic.

a.Completeness: information is complete if it includes all data necessary

to be faithfully representative.

b.Neutral: information is neutral when it is free from any bias intended to

attain a prespecified result, or to encourage or discourage certain
behavior.

c.Free from material error: information is free from material error if it is

accurate and truthful.

C.Enhancing characteristics -- These are complementary to the primary

characteristics and enhance the decision usefulness of financial reporting information
that is relevant and faithfully represented.

1.Comparability -- The quality of information that enables users to identify

similarities and differences between sets of information. Consistency in
application of recognition and measurement methods over time enhances
comparability.

2.Verifiability -- Information is verifiable if different knowledgeable and

independent observers could reach similar conclusions based on the
information.

3.Timeliness -- Information is timely if it is received in time to make a

difference to the decision maker. Timeliness can also enhance the faithful
representation of information.
 4.Understandability -- Information is understandable if the user
comprehends it within the decision context at hand. Users are assumed to
have a reasonable understanding of business and accounting and are willing
to study the information with reasonable diligence.

D.Relevance and faithful representation may conflict -- In such cases, a trade-

off is made favoring one or the other.

Example:

1. Relevance over faithful representation. The pervasive use of accounting estimates

(depreciation, bad debt expense, pension estimates) is an example of emphasizing
relevance over faithful representation. Firms are providing estimates, rather than certain
amounts. Reasonable approximations, although they cannot be perfectly reliable, are
preferred by financial statement users to either (1) perfect information issued too late to
make a difference, or (2) no information at all.

2. Faithful representation over relevance. In the opinion of many, the use of

historical cost as a valuation base is an example of emphasizing faithful representation
over relevance. Historical cost is very reliable because it is based on objectively verifiable
past information. However, historical cost is considered to be less current and therefore
less relevant than market value.

Note:
Candidates should be able to identify the components of relevance and faithful
representation. It helps to remember that there is more than one component to both
qualities.
Assumptions, Accounting Principles
I.Accounting Assumptions

A.Entity Assumption -- We assume there is a separate accounting entity for each

business organization.

Example:

The owners and the corporation are separate. The owners own shares in the corporation;
they do not own the assets of the firm. The corporation owns the assets. The financial
statements represent the corporation, not the owners. A firm cannot own itself. Treasury
shares are not assets to the firm - no one owns treasury shares. A firm can sue and be
sued. If a firm is sued, the owners are not liable.

B.Going Concern Assumption --

1.In the absence of information to the contrary, a business is assumed to have

an indefinite life, that is, it will continue to be a going concern. Therefore, we
do not show items at their liquidation or exit values.

2.This assumption, also called the continuity assumption, supports the historical
cost principle for many assets. Income measurement is based on historical
cost of assets because assets provide value through use, rather than disposal.
Thus, net income is the difference between revenue and the historical cost of
assets used in generating that revenue. Without the going concern principle,
historical cost would not be an appropriate valuation basis.

Example:

Prepaid assets, such as prepaid rent, would not be assets without the assumption of
continuity.

C.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.

Example:

The amounts of all assets are added together even though amounts recorded at
different times represent different purchasing power levels.
 1.Capital maintenance and departures from the unit of measure
assumption --

a.The concept of capital maintenance is related to the unit of measure

assumption. Capital is said to be 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 to replace all the
resources used in generating that revenue (return of capital), and has
resources left over in addition (income, which is return on capital). 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.

b.An alternative concept of capital maintenance is "physical" capital

maintenance. This concept holds that earnings cannot be recognized
until the firm has provided for the physical capital used up during the
period. To measure the capital used up, changes in price level must be
considered.

Example:

A firm uses up $5,000 worth of supplies in providing its service during the year,
but to replace those supplies for use next year, $5,500 will have to be paid (10%
increase in specific price of supplies). The "financial" capital maintenance model
uses the $5,000 cost of supplies as the measure of revenue needed to maintain
capital. If revenue for the current period is $5,000 and the firm had no other
expenses, earnings would be zero and capital would just be maintained. The
"physical" capital model would require revenue of $5,500 for capital to be
maintained.

GAAP does not require adjustments for price level changes and thus applies the
"financial" capital maintenance concept in financial reports.

D.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 the
information often must be sacrificed to provide relevant disclosures. The use of
estimates is required for timely reporting but also implies a possible loss of reliability.
II.Accounting Principles

A.Historical Cost -- Assets and liabilities are recorded at historical cost, that is, their
cash equivalent amount at time of origination. This value is the market value of the
item on the date of acquisition. For many assets, this value is not changed even
though market value changes. 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.

B.Revenue Recognition Principle -- This principle addresses three important issues

 related to revenues.

1.Defined Revenue -- What is revenue: revenues are increases in assets or

extinguishment of liabilities stemming from delivery of goods or from providing
services -- the main activities of the firm.

2.When to Recognize Revenue -- When to recognize revenue: Revenues are

recognized when they are realized. Realization occurs in the accounting period
in which three conditions are met:

a.Goods or services have been provided (seller performance is

substantially complete);

b.Collectibility of cash is assured - revenue is realizable (buyer

performance is complete or assured);

c.Expenses of providing goods and services can be determined. This

criterion becomes important when service or production is provided
over an extended period of time.

3.The second condition: collectibility of cash, plays a key role in several specific
methods of revenue recognition. When uncertainty exists with respect to the
ultimate collection of cash, several alternative methods of revenue recognition
are available. Two important methods are the installment method and cost
recovery method.

4.Measure Revenue -- How to measure revenue: Revenues are measured at

the cash equivalent amount of the good or service provided.

Example:

An equipment dealer sells equipment and accepts stock of the purchasing firm in return.
The equipment does not have a ready market value, but the stock accepted has a current
market value of $30,000 on the NASDAQ exchange. The equipment dealer records
revenue in the amount of $30,000.

C.Matching Principle -- This principle addresses when to recognize expenses.

1.The matching principle says: recognize expenses only when expenditures help
to produce revenues. Revenues are recognized when earned and realized or
realizable; the related expenses are recognized, and the revenues and
expenses are "matched" to determine net income or loss.

2.Expenses that are directly related to revenues can be readily matched with
revenues they help produce.

3.Cost of goods sold and sales commissions are expenses that are directly
associated and therefore matched with revenue. Other expenses are allocated
based on the time period of benefit provided. Depreciation and amortization
are examples. Such expenses are not directly matched with revenues. Still
other expenses are recognized in the period incurred when there is no
determinable relationship between expenditures and revenues. Advertising
 costs are an example.

D.Full Disclosure Principle -- Financial statements should present all information

needed by an informed reader to make an economic decision. This principle is
sometimes referred to as the adequate disclosure principle.

Example:

An aircraft manufacturer enters into a contract to build 200 airplanes for an airline
company. As of the balance sheet date, production has not begun. Thus, there is no
recognition of this contract in the accounts. However, a footnote should explain the
financial aspects of the contract. This information is potentially of greater interest than
many items recognized in the accounts.
Constraints and Present Value
I.Accounting Constraints
Accounting constraints provide exceptions to the strict application of GAAP. These
constraints refer to a condition for which the normal measurement and recognition rules are
modified. Accounting constraints are also called modifying conventions. The two accounting
constraints are cost materiality and cost effectiveness.

A.Materiality -- Transactions that are material in amount will be accounted for in

strict accordance with the appropriate accounting procedures. Those that are
immaterial in amount will be handled in the most expedient way possible. In effect,
for transactions of small dollar amount, GAAP may be suspended. However, GAAP
has not specified general quantitative materiality thresholds (such as 5 or 10%).
Professional judgment is required. Materiality decisions are affected by both the
relative dollar amount of an item and also its nature.

Example:

A firm may expense immediately an expenditure of office calculators because of the small
purchase price. Strict adherence to GAAP would require that the cost be capitalized and
depreciated because the calculators will benefit more than the current period.

However, there is no materiality threshold for illegal activities and related party
transactions. All such transactions must be disclosed properly.
B.Cost Effectiveness -- This constraint on GAAP limits recognition and disclosure if
the cost of providing the information exceeds its benefit. The FASB typically
discusses how it considered the cost and benefits of new accounting standards in its
"Basis for Conclusions" section of accounting updates. However, firms may not omit
disclosures if they are material and mandated by GAAP.

Example:
A firm would not report its entire inventory subsidiary ledger in the footnotes or financial
statements. The reporting of total inventory cost is sufficient. Reporting more detailed
information is not worth the cost of doing so.
C.Conservatism -- Conservatism is no longer a constraint and also is not a
qualitative characteristic. Conservatism (also called prudence) is the reporting of less
optimistic amounts (lower income, net assets) under conditions of uncertainty or
when GAAP provides a choice from among recognition or measurement methods.

1.Conservatism is sometimes a preferred reporting strategy to avoid inflating

expectations of capital providers. Some firms may report conservatively, for
example, to avoid lawsuits.

2.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.

3.Conservatism is in conflict with neutrality, one of the ingredients of faithful

representation.
 Example:

1. The use of LIFO during inflationary periods is considered a conservative choice because
cost of goods sold is maximized and gross margin and ending inventory minimized,
relative to other inventory valuation methods.

2. Choosing shorter useful lives for depreciable equipment is conservative because

depreciation will be recognized over a shorter period, income will be smaller during that
period, and net assets also will be smaller in amount.
II.Financial Statements, Recognition Criteria, Elements

A.A full set of financial statements should include the following --

1.Financial Position at year-end (balance sheet);

2.Earnings for the year (income statement);

3.Comprehensive Income for the year - total nonowner changes (statement of

comprehensive income);

4.Cash Flows during the year (statement of cash flows);

5.Investments by and Distributions to Owners during the year (statement of

owner's equity).

B.Recognition and measurement criteria -- In relation to measurement and

recognition of items in a financial report, the following criteria must be met:

1.Definition -- The definition of a financial statement element is met;

2.Measurability -- There is an attribute to be measured, such as historical

cost;

3.Relevance -- The information to be presented in the financial report is

capable of influencing decisions. The information is timely, has predictive
ability, and provides feedback value;

4.Reliability -- The information is representationally faithful, verifiable, and

neutral. (Note that reliability has been replaced by faithful representation.)

C.Elements of Financial Statements -- Ten elements that appear in a financial

report.

1.Assets -- Resources that have probable future benefits to the firm,

controlled by management, resulting from past transactions. Note the three
aspects of this definition.

2.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 past transactions or events.

3.Equity -- Residual interest in the firm's assets, also known as net assets.
Equity is primarily comprised of past investor contributions and retained
 earnings.

4.Investments by Owners -- Increases in net assets of an entity from

transfers to it by existing owners or parties seeking ownership interest.

5.Distributions to Owners -- Decreases in net assets of an entity from the

transfer of assets, provision of services, or incurrence of liabilities by the
enterprise to owners.

6.Comprehensive Income -- Accounting income (transaction based) plus

certain holding gains and losses and other items. It includes all changes in
equity other than investments by owners and distributions to owners.

7.Revenues -- Increases in assets or settlements of liabilities of an entity by

providing goods or services.

8.Expenses -- Decreases in assets or incurrences of liabilities of an entity by

providing goods or services. Expenses provide a benefit to the firm.

9.Gains -- Increases in equity or net assets from peripheral or incidental

transactions.

10.Losses -- Decreases in equity or net assets from peripheral or incidental

transactions. Losses provide no benefit to the firm.
III.Using Cash Flow Information and Present Value in Accounting Measurements
The concept statement addresses the use of present value measurements. Like all concepts
statements, it does not constitute GAAP but is used in the development of GAAP.

A.Measurement Issues --

1.This Statement addresses only measurement issues, not recognition. The

statement applies to initial recognition, fresh-start measurements, and
amortization techniques based on future cash flows. A fresh-start
measurement establishes a new carrying value after an initial recognition and
is unrelated to previous amounts (e.g., mark-to-market accounting and
recognition of asset impairments).

2.If the fair value of an asset or liability is available, there is no need to use
present value measurement. If not, present value is often the best available
technique to estimate what fair value would be if it existed in the situation.

B.Present Value Measure -- When a present value measure is used:

1.The result should be as close as possible to fair value if such a value could be
obtained;

2.The expected cash flow approach is preferred because present value

measurements should reflect the uncertainties inherent in the estimated cash
flows.

C.Capture Economic Differences -- A present value measurement that fully

captures the economic differences between various estimates of future cash flows
would include the following:

1.An estimate of future cash flows;

 2.Expectations about variations in amount or timing of those cash flows;

3.Time value of money as measured by the risk-free rate of interest;

4.The price for bearing the uncertainty inherent in the asset or liability;

5.Any other relevant factors.

D.Two Approaches -- The statement contrasts two approaches to computing

present value:

1.The traditional approach incorporates factors 2-5 above in the discount

rate and uses a single most-likely cash flow in the computation. The
traditional approach uses the interest rate to capture all the uncertainties and
risks inherent in a cash flow measure. This is the approach that continues to
be applied in some present value applications in financial accounting.

2.The expected cash flow approach uses a risk-free rate as the discount
rate. The other 4 factors above are used to determine the risk adjusted
expected cash flow.

E.Expected Cash Flow Approach -- The expected cash flow approach uses
expectations about all possible cash flows instead of a single most-likely cash flow.
Both uncertainty as to timing and amount can be incorporated into the calculation.
The Board believes that the expected cash flow approach is likely to provide a better
estimate of fair value than a single value because it directly incorporates the
uncertainty in estimated future cash flows.

Example:

1. (Example of uncertain amount) The amount of a cash flow may vary as follows:
$200, $400, or $600 with probabilities of 10%, 60%, and 30%, respectively. The
expected cash flow is $440 = $200(.10) + $400(.60) + $600(.30). The expected
cash flow approach uses a range of cash flows with probabilities attached. Thus,
the uncertainties of the cash flows themselves are reflected in the distribution of
cash flows. Present value may then be applied to the expected cash flow amount,
depending on the timing of the cash flow.

2. (Example of uncertain timing) A $100 cash flow might be received in 1, 2, or 3

years with probabilities of 10%, 60%, and 30%, respectively. Assuming an
interest rate of 5%, the expected present value = $100(pv1, .05, 1)(.10) +
$100(pv1, .05, 2)(.60) + $100(pv1, .05, 3)(.30). [(pv1, .05, 1) is the symbol for
the present value of a single payment of $1, due in 1 year discounted at 5%.]
1.Different rates of interest may also be used in each of the single present
value terms to reflect different risk for the different timing of cash flow.

F.The expected cash flow approach has been incorporated into Accounting for Asset
Retirement Obligations.