Concepts Underlying

Financial Accounting

Chapter
2

Chapter
2-1
 Chapter 2 Learning Objectives
1. Describe the usefulness of a conceptual framework.
2. Describe the MASB’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.
6. Describe the basic assumptions of accounting.
7. Explain the application of the basic principles of
accounting.
8. Describe the impact that constraints have on reporting
accounting information.

Chapter
2-2
 Conceptual Framework

Second Level: Third Level:

Conceptual First Level:
Fundamental Recognition and
Framework Basic Objectives Measurement
Concepts

Need Qualitative Basic

Development characteristics assumptions
Basic elements Basic principles
Constraints

Chapter
2-3
 What is the conceptual framework?

…a coherent system of interrelated

objectives and fundamentals that is
expected to lead to consistent
standards and that prescribes the
nature, function and limits of financial
accounting and reporting.
Chapter
2-4
 Conceptual Framework

The Need for a Conceptual Framework

To develop a coherent set of standards and rules
To solve new and emerging practical problems

Chapter
2-5 LO 1 Describe the usefulness of a conceptual framework.
  Benefits:

 consistent,logical reporting requirements

 greater compliance
 enhanced accountability
 fewer specific standards
 enhanced understandability of reporting
requirements

Chapter
2-6
 MASB DP1, Framework for the
Preparation and
Presentation of Financial Statements

Chapter
2-7
 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
2-8 LO 2 Describe the MASB’s efforts to construct a conceptual framework.
 ASSUMPTIONS PRINCIPLES CONSTRAINTS
2. Economic entity 2. Historical cost 2. Cost-benefit
3. Going concern 3. Revenue recognition 3. Materiality Third
4. Monetary unit 4. Matching 4. Industry practice level
5. Periodicity 5. Full disclosure 5. Conservatism

QUALITATIVE
CHARACTERISTICS ELEMENTS
Relevance Assets, Liabilities, and Equity
Investments by owners
Reliability Distribution to owners Second level
Comparability Comprehensive income
Revenues and Expenses
Consistency Gains and Losses
Illustration 2-
6 Conceptual OBJECTIVES
Framework for 1. Useful in investment
Financial 2.
and credit decisions
Useful in assessing
Reporting future cash flows First level
3. About enterprise
resources, claims to
resources, and
changes in them LO 2 Describe the MASB’s
Chapter efforts to construct a
2-9 conceptual framework.
 First Level: Basic Objectives

Financial reporting should provide information that:

(a) is useful to present and potential investors and creditors
and other users in making rational investment, credit, and
similar decisions.
(b) helps present and potential investors and creditors and
other users in assessing the amounts, timing, and
uncertainty of prospective cash receipts.
(c) portrays the economic resources of an enterprise, the
claims to those resources, and the effects of
transactions, events, and circumstances that change its
resources and claims to those resources.

Chapter
2-10 LO 3 Understand the objectives of financial reporting.
 Objectives of financial reporting is to provide
useful information:

* investors, creditors and other users

* to help them in assessing the amounts, timing and

uncertainty of prospective cash receipts, redemption or
maturity of debentures or loan.

* economic resources of the enterprise, the claim to

those resources and the effects of transactions,
events and circumstances that change its resources
and claims to those resources.

Chapter
2-11
• Objectives of financial statements:

* provide information about the financial position,

performance and changes in financial position

* to show results of stewardship

* the accountability of management for the resources

entrusted to it

Chapter
2-12
 Second Level: Fundamental Concepts

Qualitative Characteristics
“The MASB identified the Qualitative Characteristics
of accounting information that distinguish better
(more useful) information from inferior (less useful)
information for decision-making purposes.”

Chapter
2-13 LO 4 Identify the qualitative characteristics of accounting information.
 Second Level: Qualitative Characteristics

Illustration 2-2
Hierarchy of
Accounting
Qualities

Chapter
2-14 LO 4 Identify the qualitative characteristics of accounting information.
 Second Level: Fundamental Concepts

Understandability
A company may present highly relevant and reliable
information, however it was useless to those who do
not understand it.

Chapter
2-15 LO 4 Identify the qualitative characteristics of accounting information.
 ASSUMPTIONS PRINCIPLES CONSTRAINTS
2. Economic entity 2. Historical cost 2. Cost-benefit
3. Going concern 3. Revenue recognition 3. Materiality Third
Relevance
4. Monetary unit and Reliability
4. Matching 4. Industry practice level
5. Periodicity 5. Full disclosure 5. Conservatism

QUALITATIVE
CHARACTERISTICS ELEMENTS
Relevance Assets, Liabilities, and Equity
Investments by owners
Reliability Distribution to owners Second level
Comparability Comprehensive income
Revenues and Expenses
Consistency Gains and Losses
Illustration 2-
6 Conceptual OBJECTIVES
Framework for 1. Useful in investment
Financial 2.
and credit decisions
Useful in assessing
Reporting future cash flows First level
3. About enterprise
resources, claims to
resources, and
changes in them LO 4 Identify the qualitative
Chapter characteristics of
2-16 accounting information.
 Second Level: Qualitative Characteristics

Primary Qualities:
Relevance – making a difference in a decision.
Predictive value
Feedback value
Timeliness
Reliability
Verifiable
Representational faithfulness
Neutral - free of error and bias

Chapter
2-17 LO 4 Identify the qualitative characteristics of accounting information.
 ASSUMPTIONS PRINCIPLES CONSTRAINTS
2. Economic entity 2. Historical cost 2. Cost-benefit
3. Going concern 3. Revenue recognition 3. Materiality Third
Comparability
4. Monetary unit and Consistency
4. Matching 4. Industry practice level
5. Periodicity 5. Full disclosure 5. Conservatism

QUALITATIVE
CHARACTERISTICS ELEMENTS
Relevance Assets, Liabilities, and Equity
Investments by owners
Reliability Distribution to owners Second level
Comparability Comprehensive income
Revenues and Expenses
Consistency Gains and Losses
Illustration 2-
6 Conceptual OBJECTIVES
Framework for 1. Useful in investment
Financial 2.
and credit decisions
Useful in assessing
Reporting future cash flows First level
3. About enterprise
resources, claims to
resources, and
changes in them LO 4 Identify the qualitative
Chapter characteristics of
2-18 accounting information.
 Second Level: Qualitative Characteristics

Secondary Qualities:
Comparability – Information that is measured and
reported in a similar manner for different companies
is considered comparable.
Consistency - When a company applies the same
accounting treatment to similar events from period
to period.

Chapter
2-19 LO 4 Identify the qualitative characteristics of accounting information.
 ASSUMPTIONS PRINCIPLES CONSTRAINTS
2. Economic entity 2. Historical cost 2. Cost-benefit
3. Going concern 3. Revenue recognition 3. Materiality Third
4. Monetary unit Elements
4. Matching 4. Industry practice level
5. Periodicity 5. Full disclosure 5. Conservatism

QUALITATIVE
CHARACTERISTICS ELEMENTS
Relevance Assets, Liabilities, and Equity
Investments by owners
Reliability Distribution to owners Second level
Comparability Comprehensive income
Revenues and Expenses
Consistency Gains and Losses
Illustration 2-
6 Conceptual OBJECTIVES
Framework for 1. Useful in investment
Financial 2.
and credit decisions
Useful in assessing
Reporting future cash flows First level
3. About enterprise
resources, claims to
resources, and
changes in them LO 5 Define the basic
Chapter elements of financial
2-20 statements.
Elements of financial statements

• Balance sheet
* assets
* liabilities
* equity

• Income statement
* income
* expenses

Chapter
2-21
Assets

-a resource controlled by the enterprise as a result of past

transactions or events and from which future economic benefits
are expected to flow to the enterprise.

-ownership or legal rights

Liabilities

- present obligation of the enterprise arising from past

transactions or events, the settlement of which is expected to
result in an outflow from the enterprise of resources embodying
economic benefits.
Chapter
2-22
Income

-increase in economic benefits during the accounting period in

the form of inflows or enhancements of assets or decreases of
liabilities that result in increase in equity, other than those
relating to contributions from equity participants.

Expenses

- decreases in economic benefits during the accounting period in

the form of outflows or depletions of assets or incurrence of
liabilities that result in decrease in equity, other than those
relating to distributions to equity participants.

Equity

- Chapter
residual interest in the assets of an enterprise after deducting
all2-23
its liabilities.
 Second Level: Elements
There are ten interrelated elements that relate to
measuring the performance and financial status of a
business enterprise.
“Moment in Time” “Period of Time”
Assets Investment by owners
Liabilities Distribution to owners
Equity Comprehensive income
Revenue
Expenses
Gains
Losses
Chapter
2-24 LO 5 Define the basic elements of financial statements.
 Third Level: Recognition and Measurement

ASSUMPTIONS PRINCIPLES CONSTRAINTS

2. Economic entity 2. Historical cost 2. Cost-benefit
3. Going concern 3. Revenue recognition 3. Materiality
4. Monetary unit 4. Matching 4. Industry practice
5. Periodicity 5. Full disclosure 5. Conservatism

Chapter
2-25 LO 6 Describe the basic assumptions of accounting.
 Third Level: Assumptions

Economic Entity – company keeps its activity

separate from its owners and other businesses.

Going Concern - company to last long enough to fulfill

objectives and commitments.

Monetary Unit - money is the common denominator.

Periodicity - company can divide its economic
activities into time periods.

Chapter
2-26 LO 6 Describe the basic assumptions of accounting.
 Third Level: Principles

Historical Cost – the price, established by the

exchange transaction, is the “cost”.
Issues:
Historical cost provides a reliable benchmark for
measuring historical trends.
Fair value information may be more useful.

Chapter
2-27 LO 7 Explain the application of the basic principles of accounting.
 Third Level: Principles

Revenue Recognition - generally occurs (1) when

realized or realizable and (2) when earned.
Exceptions:
During Production.
At End of Production
Upon Receipt of Cash

Chapter
2-28 LO 7 Explain the application of the basic principles of accounting.
 Third Level: Principles

Matching - efforts (expenses) should be matched

with accomplishment (revenues) whenever it is
reasonable and practicable to do so.

Illustration 2-4 Expense

Recognition

Chapter
2-29 LO 7 Explain the application of the basic principles of accounting.
 Third Level: Principles

Full Disclosure – providing information that is of

sufficient importance to influence the judgment and
decisions of an informed user.
Provided through:
Financial Statements
Notes to the Financial Statements
Supplementary information

Chapter
2-30 LO 7 Explain the application of the basic principles of accounting.
 Third Level: Constraints
Cost Benefit – the cost of providing the information
must be weighed against the benefits that can be
derived from using it.
Materiality - an item is material if its inclusion or
omission would influence or change the judgment of
a reasonable person.
Industry Practice - the peculiar nature of some
industries and business concerns sometimes requires
departure from basic accounting theory.
Conservatism – when in doubt, choose the solution
that will be least likely to overstate assets and
income.
Chapter LO 8 Describe the impact that constraints have
2-31 on reporting accounting information.