CHAPTER REVIEW Kieso 13e

1. Chapter 2 outlines the development of a conceptual framework for financial accounting and reporting by the FASB. The entire conceptual framework is affected by the environmental aspects discussed in Chapter 1. It is composed of basic objectives, fundamental concepts, and operational guidelines. These notions are discussed in Chapter 2 and should enhance your understanding of the topics covered in intermediate accounting. Conceptual Framework 2. (S.O. 1)A conceptual framework in accounting is important because it can lead to consistent standards and it prescribes the nature, function, and limits of financial accounting and financial statements. The benefits its development will generate can be characterized as follows: (a) it should be easier to promulgate a coherent set of standards and rules; and (b) practical problems should be more quickly solved. 3. (S.O. 2)The FASB recognized the need for a conceptual framework upon which a con-sistent set of financial accounting standards could be based. The FASB has issued six Statements of Financial Accounting Concepts (SFAC) that relate to financial reporting. They are listed and described briefly below: SFAC No. 1.Objectives of Financial Reporting by Business Enterprises presents the goals and purposes of accounting. SFAC No. 2.Qualitative Characteristics of Accounting Information examines the characteristics that make accounting information useful. SFAC No. 3.Elements of Financial Statements of Business Enterprises defines the broad classifications of items found in financial statements. SFAC No. 5.Recognition and Measurement in Financial Statements of Business Enterprises gives guidance on what information should be formally incorporated into financial statements and when. SFAC No. 6.Elements of Financial Statements replaces SFAC No. 3 and expands its scope to include not-for-profit organizations. SFAC No. 7.Using Cash Flow Information and Present Value in Accounting Measurements, provides a framework for using expected future cash flows and present values as a basis for measurement.

Basic Objectives 4. (S.O. 3)SFAC No. 1 describes the objectives of financial reporting as the presentation of information that is useful (a) in making investment and credit decisions, (b) in assessing cash flow prospects, and (c) in learning about economic resources, claims to those resources, and changes in them. SFAC No. 2 identifies the primary and secondary qualitative characteristics of accounting information that distinguish better (more useful) information from inferior (less useful) information for decision-making purposes.

Primary Qualities 5. (S.O. 4)The primary qualities that make accounting information useful for decision making are relevance and reliability. Relevance.Accounting information is relevant if it is 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. Reliability.Accounting information is reliable to the extent that it is verifiable, is a faithful representation, and is reasonably free of error and bias. To be reliable, accounting information must possess three key characteristics: (a) verifiability, (b) representational faithfulness, and (c) neutrality. Secondary Qualities 6. The secondary qualities identified are comparability and consistency. Comparability.Accounting information that has been measured and reported in a similar manner for different companies is considered comparable. Consistency.Accounting information is consistent when a company applies the same accounting treatment to similar events from period to period. Basic Elements 7. (S.O. 5)An important aspect of developing an accounting theoretical structure is the body of basic elements or definitions. Ten basic elements that are most directly related to measuring the performance and financial status of a business enterprise are formally defined in SFAC No. 6. These elements, as defined below, are further discussed and interpreted throughout the text. Assets.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 events. Equity.Residual interest in the assets of an entity that remains after deducting its liabilities. In a business enterprise, the equity is the ownership interest. Investments by Owners.Increases in net assets of a particular enterprise resulting from transfers to it from other entities of something of value to obtain or increase ownership interests (or equity) in it. Assets are most commonly received as investments by owners, but that which is received may include services or satisfaction or conversion of liabilities of the enterprise. Distributions to Owners.Decreases in net assets of a particular enterprise resulting from transferring assets, rendering services, or incurring liabilities by the enterprise to owners. Distributions to owners decrease ownership interests (or equity) in an enterprise. Comprehensive Income.Change in equity (net assets) of an entity during a period from transactions and other events and circumstances from nonowner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners. Revenues.Inflows or other enhancements of assets of an entity or settlement of its liabilities (or a combination of both) during a period from delivering or producing goods, rendering services, or other activities that constitute the entitys ongoing major or central operations. Expenses.Outflows or other using up of assets or incurrences of liabilities (or a combination of both) during a period from delivering or producing goods, rendering services, or carrying out other activities that constitute the entitys ongoing major or central operations. Gains.Increases in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity during a period except those that result from revenues or investments by owners. Losses.Decrease in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity during a period except those that result from expenses or distributions to owners.

Basic Assumptions 8. (S.O. 6)In the practice of financial accounting, certain basic assumptions are important to an understanding of the manner in which data are presented. The following four basic assumptions underlie the financial accounting structure: Economic Entity Assumption.The economic activities of a company can be accumulated and reported in a manner that assumes the company is separate and distinct from its owners or other business units. Going Concern Assumption.In the absence of contrary information, a company is assumed to have a long life. The current relevance of the historical cost principle is dependent on the going-concern assumption. Monetary Unit Assumption.Money is the common denominator of economic activity and provides an appropriate basis for accounting measurement and analysis. The monetary unit is assumed to remain relatively stable over the years in terms of purchasing power. In essence, this assumption disregards any inflation or deflation in the economy in which the company operates. Periodicity Assumption.The life of a company can be divided into artificial time periods for the purpose of providing periodic reports on the economic activities of the company. As you progress through the remaining chapters in the text, the reasoning behind these assumptions should become more apparent. Basic Principles 9. (S.O. 7)Certain basic principles are followed by accountants in recording the transactions of a business entity. These principles relate basically to how assets, liabilities, revenues, and expenses are to be identified, measured, and reported. The following is a brief review of the basic principles considered in Chapter 2 of the text: Historical Cost Principle.Acquisition cost is considered a reliable basis upon which to account for assets and liabilities of a company. Historical cost has an advantage over other valuationsit is thought to be reliable. Recently, the FASB appears to support greater use of fair value measurements in the financial statements. Fair value information may be more useful than historical cost for certain types of assets and liabilities and in certain industries. Revenue Recognition Principle.Revenue is recognized (1) when realized or relizable and (2) when earned. Recognition at the time of sale provides a uniform and reasonable test. Certain variations in the revenue recognition principle include: certain long-term construction contracts, end-of-production recognition, and

recognition upon receipt of cash. Expense Recognition Principle.Recognition of expenses is related to net changes in assets and earning revenues. The expense recognition principle is implemented in accordance with the definition of expense by matching efforts (expenses) with accomplishment (revenues). Full Disclosure Principle.In the preparation of financial statements, the accountant should include sufficient information to permit the knowledgeable reader to make an informed judgment about the financial condition of the company in question. Constraints 10. (S.O. 8)Although accounting theory is based upon certain assumptions and the application of basic principles, there are some exceptions to these assumptions. These exceptions, often called constraints, sometimes justify departures from basic accounting theory. The constraints presented in Chapter 2 are the following: Cost-Benefit Relationship.This constraint relates to the notion that the benefits to be derived from providing certain accounting information should exceed the costs of providing that information. The difficulty in cost-benefit analysis is that the costs and especially the benefits are not always evident or measurable. Materiality.In the application of basic accounting theory, an amount may be considered less important because of its size in comparison with revenues and expenses, assets and liabilities, or net income. Deciding when an amount is material in relation to other amounts is a matter of judgment and professional expertise. The accounting for immaterial items need not follow GAAP. Industry Practices.Basic accounting theory may not apply with equal relevance to every industry that accounting must serve. The fair presentation of financial position and results of operations for a particular industry may require a departure from basic accounting theory because of the peculiar nature of an event or practice common only to that industry. Conservatism.When in doubt, an accountant should choose a solution that will be least likely to overstate assets and income. The conservatism constraint should be applied only when doubt exists. An intentional understatement of assets or income is not acceptable accounting.