Chapter 2 Notes Conceptual Framework conceptual framework a coherent system of concepts that flow form an objective o establishes the concepts that underlie financial reporting o objective identify the purpose of financial accounting o other concepts provide guidance on identifying the boundaries of financial reporting selecting the transactions other events and circumstances to be represented how they should be recognized and measured how they should be summarized and reported Need for a Conceptual Framework why do we need a conceptual framework o allows the FASB to issue more useful and consistent pronouncements over time resulting in a coherent set of standards o should be able to more quickly solve new and emerging practical problems by referring to the existing framework Development of a Conceptual Framework 1976 the FASB begins to develop a conceptual framework that would be the basis for setting accounting rules and for resolving financial reporting controversies o has since issued 7 Statements of Financial Accounting Concepts Overview of the Conceptual Framework 1st level identifies the objective of financial reporting o the purpose of financial reporting nd 2 level provides the qualitative characteristics that make accounting information useful as well as the elements of financial statements i e assets liabilities etc 3rd level identifies the recognition measurement and disclosure concepts used in establishing and applying accounting standards and how to implement the objective o assumptions o principles o cost constraint First Level Basic Objective objective of financial reporting to provide financial info about the reporting entity that is useful to present and potential users i e investors creditors etc in making decisions about providing resources to the entity o general purpose financial reporting helps users who lack the ability to demand all the financial information they need from an entity therefore must rely on the information provided in financial reports financial statement preparers still assume a level of competence on the part of users Second Level Fundamental Concepts provides concepts that explain the qualitative characteristics of accounting information and define the elements of financial statements o forms a bridge between the why objective of accounting and the how recognition measurement and financial statement presentation Qualitative Characteristics of Accounting Information companies must determine which alternative of accounting methods provides the most useful information for decision making purposes FASB identified the qualitative characteristics of accounting that distinguish more useful information from less useful information Fundamental Quality Relevance accounting information that has relevance must o be capable of making a difference in a decision o must have predictive value confirmatory value materiality or a combination of all three predictive value when financial information has value as an input to predictive processes used by investors to form their own expectations about the future confirmatory value when financial information helps users confirm or correct prior expectations materiality when information could influence decisions that users make on the basis of reported financial information if it is omitted or misstated o determined by company both the nature and or magnitude of the items for which the information relates must be considered in the context of the company o the information must make a difference or the company does not have to disclose it o difficult because it requires both the relative size and importance of information o general rule of thumb anything under 5 of net income is considered immaterial Fundamental Quality Faithful Representation faithful representation the numbers and descriptions in information match what really existed happened o necessary because most users do not have the time to verify info in the financial statements o 3 ingredients completeness neutrality free from error completeness all information that is necessary for faithful representation is provided o omission can cause false or misleading information neutrality a company cannot select information to favor one set of interested parties over another o accounting rules must be free from bias or else financial statements will lose credibility free from error o financial information that is free from error will be a more accurate presentation of a company s financial position o does not have to have total freedom from error most financial reporting measures involve estimates of various types Enhancing Qualities enhancing qualities distinguish more useful information from less useful information o include comparability verifiability timeliness understandability comparability enables users to identify the real similarities and differences in economic events between companies o info that is measured and reported in a similar manner for different companies o consistency present when a company applies the same accounting treatment to similar events from period to period in order for a company to switch accounting methods they must demonstrate that the new method is better than the old one after approval the company must disclose the nature and effect of the change as well as justification verifiability occurs when independent measurers using the same methods obtain similar results o verification for an amount of an asset can occur simply by counting the inventory direct verification o verification can occur by checking the inputs quantity and costs and recalculating the outputs ending inventory value using the same accounting methods indirect verification timeliness having information available to decision makers before it loses its capacity to influence decisions o can enhance information s capacity to influence decisions understandability the quality of information that lets reasonably informed users see its significance o enhanced when info is classified characterized and presented clearly and concisely Basic Elements definitions to be included in the conceptual framework list of definitions asset probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events liabilities probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or