acc 301 ch. 2 pp slides

Financial Reporting: Its Conceptual

Framework

Chapter2

An electronic presentation by Norman Sunderman Angelo State University

An electronic presentation by Norman Sunderman Angelo State University

COPYRIGHT © 2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.

Intermediate AccountingIntermediate Accounting 10th edition 10th edition

Nikolai Bazley JonesNikolai Bazley Jones

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1. Explain the FASB conceptual framework.

2. Understand the relationship among the objectives of financial reporting.

3. Identify the general objective of financial reporting.

4. Describe the three specific objectives of financial reporting.

ContinuedContinuedContinuedContinued

Objectives

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5. Discuss the types of useful information for investment and credit decision making.

6. Explain the qualities of useful accounting information.

7. Understand the accounting assumptions and conventions that influence GAAP.

8. Define the elements of financial statements.

Objectives

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Objectives Oriented Principles

The SEC has recommended that future accounting standards should not follow a rules-base or principles based only approach, but should be objectives-oriented.

Should be built on an improved and consistently improved conceptual framework

Clearly state the accounting objectiveMinimize exceptionsAvoid the use of bright-line (percentage) tests

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To develop a conceptual

framework of accounting theory.

Charges Given to the FASB

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To establish standards (GAAP)

for financial accounting practices.

Charges Given to the FASB

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To guide the FASB in establishing accounting standards.

To provide a frame of reference for resolving accounting questions in situations where a standard does not exist.

To determine the bounds for judgment in the preparation of financial statements.

To increase users’ understanding of and confidence in financial reporting.

To enhance comparability.

FASB Conceptual Framework- serves as a conceptual underpinning that provides a unified and consistent structure and direction to financial

accounting and reporting

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Relationship of Conceptual Framework and Standard-Setting

Process

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Conceptual Framework Projects for Financial Accounting and Reporting

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Objectives of Financial Reporting—TO PROVIDE INFORMATION THAT SATISFIES THE

FOLLOWING OBJECTIVESGeneral Objective

• Useful

Derived External User Objective– assess their (THE USER) prospective cash receiptsDerived Company Objective– assess the net cash inflows to the companySpecific Objectives – provide information about a

company’s– economic resources, obligations, owners’ eq.– comprehensive income and its components– cash flows

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General ObjectiveProvide information that is

useful to present and potential investors, creditors, and other users in making their rational investment,

credit, and similar decisions.

Objectives of Financial Reporting

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Derived External User Objective (relates to external users’ needs) (they made this investment to increase their cash

inflows)Provide information that is useful to present and potential

investors creditors, and other users in assessing the amounts, timing, and uncertainty of

prospective cash receipts from dividends and interest, and the proceeds from the

sale, redemption, or maturity of securities or loans.(investors need financial information to help set their expectations of their future cash receipts….they are

interested in not only the return of their investment, but also, a return on their investment.)


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Derived Company ObjectiveProvide information to help investors, creditors, and

others in assessing the amounts, timing, and uncertainty of prospective

net cash inflows to related company.(In reality, the investor’s cash receipts are affected by

the cash flows of the company)


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Specific Objectives---RELATE TO THE TYPES OF INFORMATION THAT A COMPANY

SHOULD PROVIDE IN ITS FINANCIAL REPORTS

Provide information about a company’s economic

resources, obligations, and owners’ equity.

Provide information about a company’s economic

resources, obligations, and owners’ equity.

Provide information about a company’s comprehensive

income and its components.

Provide information about a company’s comprehensive

income and its components.

Provide information about a company’s

cash flows.

Provide information about a company’s

cash flows.


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Accrual Accounting

The measurement of comprehensive income should relate or match the costs or sacrifices of a com.’s operations to the benefits from its operations.

Under accrual accounting, the financial effects of a com.’s transactions having cash consequences are related to the period in which they occur instead of to when the cash receipt or cash payment takes place.

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First, financial reporting should provide information

about how the management of a company has dischargeddischarged its stewardshipstewardship responsibilitiesresponsibilities.

First, financial reporting should provide information

about how the management of a company has dischargeddischarged its stewardshipstewardship responsibilitiesresponsibilities.

Other Issues – the FASB raised these other issues in Other Issues – the FASB raised these other issues in its SFAC#1its SFAC#1

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Second, financial statements and other means of financial reporting should include explanationsexplanations and

interpretationsinterpretations of management to help external users understand

the financial information provided. (KNOWN AS FULL

DISCLOSURE)

Second, financial statements and other means of financial reporting should include explanationsexplanations and

interpretationsinterpretations of management to help external users understand

the financial information provided. (KNOWN AS FULL

DISCLOSURE)

Other Issues

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The FASB first step in developing its conceptual framework was to

establish the objectives of financial reporting. These objectives will be guidelines for providing financial information for investment and

credit decisions. These guidelines will help in the efficient operation of the capital markets and in promoting

the efficient allocation of scarce resources.

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Types of Useful Information A company’s financial reports should provide information to help

external users asses the amounts, timing, and uncertainty about

its future net cash inflows. The FASB has identified five

types of information as being useful in meeting this specific objective.

1. Return on investment 2. Risk 3. Financial flexibility 4. Liquidity 5. Operating capability

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Return on Investment

Provides a measure of overall company performance e.g. the comprehensive income….

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Risk

The uncertainty or unpredictability of the future results of a company.

The greater the risk of an investment, the higher the rate of return expected by investors or the higher rate of interest charged by creditors.

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Financial Flexibility

The ability of a company to use its financial

resources to adapt to change.Important because it enhances a company

to respond to unexpected needs and opportunities.

Reduces the risk of failure in the

event of a shortage in net cash flows from operations.

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Liquidity

Refers to how quickly a company can convert its assets into cash to pay its bills.

Liquidity reflects an asset’s nearness to cash.An indication of a company’s ability to meet its obligations

when they come due.A more liquid company is likely to have a superior

ability to adapt to unexpected needs and opportunities.

A more liquid company is likely to have a lower risk of failure.

Liquid assets often offer lower rates of return than nonliquid assets.

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Operating Capability

Refers to the ability of a company to maintain a given physical level of operations.

This level of operating capability may be indicated by– The quantity of goods & services produced

– The physical capacity of the fixed assetsOperating capability helps users to understand a

company’s past performance and predict its future performance.

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Financial Reports

Return on Investment

Risk

Financial Flexibility

Liquidity

Operating Capability

•Buy•Hold• Sell

• Extend Credit

• Continue Credit

• Deny Credit

Communication Documents

Types of Useful InformationExternal Decision Making

Interrelationship of Final Reports, Useful Information and

Decision Making

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Qualitative Characteristics of Useful Accounting Information

SFAC #2 is to specify the qualitative characteristics or “ingredients” that accounting information should have.

Hierarchy of qualitative characteristics is bounded by two constraints

• Benefits > costs• The dollar amount of the info. Must be material (large enough to

make a difference in decision making)

Hierarchy is not designed to assign priorities among the qualitative characteristics…accounting info. Must have each of the qualitative characteristics to a minimum degree

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Understandability

Accounting information should be understandable to users who have

• A reasonable knowledge of business and economic activities

• Are willing to study the information carefully

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Decision Usefulness

The overall qualitative characteristic to be used in judging the quality of accounting information.

Decision Usefulness can be separated into the primary qualities of

• Relevance

• Reliability

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Relevance

Accounting information is relevant if it can make a difference in a decision

Can the accounting information help the users • Predict the outcome past, present, and future events

• Confirm or correct prior expectations

To be relevant, accounting information should have either

– Predictive value- help forecast

– Feedback value-help to confirm or correct prior expectations

– Be timely- available before it loses its ability to influence decisions

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Reliability

Information is free from error and bias, and faithfully represents what it is intended to represent

To be reliable, information must be• Verifiable – measurement results can be duplicated by

different measurers (accountants)

• Neutral- accounting info., is neutral when it is not biased to attain a predetermined result. In other words, accounting information is not to be influenced in a predetermined direction.

• Possess representational faithfulness- there is a relationship b/w the reported accounting measurements and the economic resources, obligations, and transactions

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Consistency and Comparability

Information about a company is more useful if it can be compared with similar information from other companies or with similar information from past periods within the company

• Intercompany comparison

• Intracompany comparison

Consistency- conformity from period to period, with accounting policies and procedures remaining unchanged

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Constraints to the Hierarchy Benefits greater than costs –

• Accounting information is a commodity• Cost are passed onto consumers• The FASB must have reasonable assurance that the costs of implementing a

standard will not exceed the benefits

Materiality– A quantitative threshold constraint– Refers to the magnitude of an omission or misstatement of accounting info.

–would the judgment of a reasonable person relying on the information have been influenced by the omission or misstatement…..is the amount large enough to make a difference

– No quantitative guidelines for materiality

• Materiality involves judgment• Consider the nature of the item (did this item arise from abnormal

circumstances)

• Consider the relative size of the item, rather than the absolute size– Some co. establish a percentage threshold of 5% of NI and 5% of total assets

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Primary Decision-Specific QualitiesPrimary Decision-Specific Qualities

RelevanceRelevance ReliabilityReliability

Accounting Information

Benefits>CostsBenefits>Costs

UnderstandabilityUnderstandability

Decision Usefulness

Pervasive Pervasive ConstraintConstraint

Pervasive Pervasive ConstraintConstraint


Hierarchy of Qualitative Characteristics

User-User-Specific Specific QualityQuality

User-User-Specific Specific QualityQualityOverall Overall QualityQuality

Overall Overall QualityQuality

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Ingredients of Primary QualitiesIngredients of Primary Qualities

RelevanceRelevance ReliabilityReliability

Predictive Value

Predictive Value

Feedback Value

Timeli-ness

Verifi-ability

Representa-tional

faithfulness

Neu-trality

Secondary and

Interactive Qualities

MaterialityMateriality

Comparability (including Consistency

Threshold for

Recognition

Threshold for

Recognition


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Accounting information is relevant if it can make a difference in a decision.

Accounting information is relevant if it can make a difference in a decision.


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Accounting information is reliable when it is reasonably free from error and bias, and faithfully represents what it

is intended to represent.

Accounting information is reliable when it is reasonably free from error and bias, and faithfully represents what it

is intended to represent.


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Comparability of accounting information enables users to

identify and explain similarities and differences between two or

more sets of economic facts.

Comparability of accounting information enables users to

identify and explain similarities and differences between two or

more sets of economic facts.


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Are benefits greater

than costs?

Constraints to the Hierarchy

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The nature of the item.The relative size rather

than absolute size of an item.

The nature of the item.The relative size rather

than absolute size of an item.

Materiality

Constraints to the Hierarchy

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EntityEntity

The entity assumption assumes that a proprietorship, partnership, or corporation’s

financial activities are distinguished from other financial organizations in keeping its own

financial records and reports. Each organization is distinguished from its owners. The personal

transactions are kept separate from those of the business enterprise.

The entity assumption assumes that a proprietorship, partnership, or corporation’s

financial activities are distinguished from other financial organizations in keeping its own

financial records and reports. Each organization is distinguished from its owners. The personal

transactions are kept separate from those of the business enterprise.

Assumptions and Conventions

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ContinuityContinuity

This assumption assumes that the company will continue to operate in the near future, unless substantial evidence to the contrary exists. This assumption is also known as the going-concern assumption. The continuity assumption is necessary for many of the accounting procedures used. Example: If a company is not regarded as a going concern, it should not depreciate its fixed assets over their expected useful lives nor should it record its inventory at its cost, b/c the receipt of future economic benefits from these items is uncertain. (continued)

This assumption assumes that the company will continue to operate in the near future, unless substantial evidence to the contrary exists. This assumption is also known as the going-concern assumption. The continuity assumption is necessary for many of the accounting procedures used. Example: If a company is not regarded as a going concern, it should not depreciate its fixed assets over their expected useful lives nor should it record its inventory at its cost, b/c the receipt of future economic benefits from these items is uncertain. (continued)


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Continuity (cont)

-does not imply permanence-implies that a co. will operate long enough

to carry out its existing commitments-if a co. appears to be going bankrupt, it

must report its financial statements on a liquidation basis

• All assets and liabilities valued at the amounts estimated to be collected or paid when they are sold or liquidated

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Period of TimePeriod of Time

In accordance with the period-of-time assumption, a company prepares financial statements at the end of each year and includes them its annual report. The period-of-time assumption is the basis for the

adjusting entry process at period-end. If the co. did not prepare FS on a certain time basis, there would be no reason to determine the time frame affected

by particular transactions.

In accordance with the period-of-time assumption, a company prepares financial statements at the end of each year and includes them its annual report. The period-of-time assumption is the basis for the

adjusting entry process at period-end. If the co. did not prepare FS on a certain time basis, there would be no reason to determine the time frame affected

by particular transactions.


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Historical Cost The exchange price at the time each transaction occurs. -a company delays recording gains//losses resulting from value

changes of assets or liabilities until another exchange occurs. -historical cost is reliable -source documents are available to confirm the recorded amount -HC information may not be completely relevant for all decisions, but

it does have reliability -in certain situations, the use of valuation methods other than

historical cost to report the fair value of selected items in FS is required b/c they provide more relevant information for the decision

-concerns for measurement problems in alternative valuation methods -fasb encourages companies to disclose supplemental current value

information in their annual reports

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Market Value

$13,500

Market Value

$13,500Cost

$16,000

Cost$16,000

Replacement Cost

$13,000

Replacement Cost

$13,000

Historical CostHistorical Cost

Usually, the exchange price is retained in the accounting records as the value of an item until it is removed from the records.

Usually, the exchange price is retained in the accounting records as the value of an item until it is removed from the records.


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Historical CostHistorical Cost

Which amount Which amount should be used?should be used?Which amount Which amount should be used?should be used?

Cost$16,000

Cost$16,000


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Monetary UnitMonetary Unit

This assumption states that there must be some basis for measuring exchange of goods

or services. Currently the dollar is considered to be a stable monetary unit for preparing a

company’s financial statements.

This assumption states that there must be some basis for measuring exchange of goods

or services. Currently the dollar is considered to be a stable monetary unit for preparing a

company’s financial statements.

The FASB encourages companies to prepare supplemental disclosures about the impact of

changing prices.

The FASB encourages companies to prepare supplemental disclosures about the impact of

changing prices.


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Monetary Unit (cont.)

- used to be gold that was accepted in exchange for goods & services

-monetary unit is different for almost every nation-accountants generally adopt the national

currency of the reporting company and the unit of measure in FS

-the dollar is considered to be a stable monetary unit for preparing a company’s FS

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Realization and RecognitionRealization and Recognition

Realization is the process of converting noncash resources and rights into cash or rights to cash.

Recognition is the process of formally recording and reporting

an item in the financial statements of a company.

Realization is the process of converting noncash resources and rights into cash or rights to cash.

Recognition is the process of formally recording and reporting

an item in the financial statements of a company.


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Recognition

-shown in both words and numbersTo be recognized, an item must

• Meet the definition of an element

• Be measurable• Be relevant• Be reliable

Revenues should be recognized when

1. realization has taken place

2. they have been earned

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Realization

-the process of converting noncash resources and rights Into Cash or rights to cash

-fasb suggests that revenues are considered to be earned when a co. has substantially completed what it must do to be entitled to the benefits (assets) generated by the revenues---this is usually the point of sale

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Recognizing revenue

-at times a co. may not recognize (record) revenue at the same time as realization

--a co. may recognize revenue• DURING PRODUCTION

– PERCENTAGE OF COMPLETION METHOD– PROPORTIONAL PERFORMANCE

• AT THE END OF PRODUCTION– A FIXED SELLING PRICE AND THERE IS NO LIMIT ON THE

AMOUNT THAT IT CAN SELL

• AFTER THE SALE– IF THE ULTIMATE COLLECTIBILITY IS UNCERTAIN

» USE THE INSTALLMENT MEHTOD» USE THE COST RECOVERY METHOD

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Accrual accounting is the process of relating the financial effects of

transactions, events, and circumstances having cash consequences to the period in which they occur rather than to when the

cash receipt or payment occurs.

Accrual accounting is the process of relating the financial effects of

transactions, events, and circumstances having cash consequences to the period in which they occur rather than to when the

cash receipt or payment occurs.

The matching principle states that to determine the income of a company for an accounting period, the company computes the total expense involved in obtaining the revenues of the period and relates these total expenses to the total revenues recorded

in the period. INTENT IS TO MATCH THE

SACRIFICES AGAINST THE BENEFITS, OR THE

EFFORTS AGAINST THE ACCOMPLISHMENTS

The matching principle states that to determine the income of a company for an accounting period, the company computes the total expense involved in obtaining the revenues of the period and relates these total expenses to the total revenues recorded

in the period. INTENT IS TO MATCH THE

SACRIFICES AGAINST THE BENEFITS, OR THE

EFFORTS AGAINST THE ACCOMPLISHMENTS

Matching and Accrual AccountingMatching and Accrual Accounting


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MATCH EXPENSES AGAINST REVENUES ON THE BASIS OF THREE PRINCIPLES

1. ASSOCIATION OF CASUE & EFFECT• Sales commissions• Product cost included in CGS

2. SYSTEMATIC AND RATIONAL ALLOCATION

• Depreciation• amortization

3. IMMEDIATE RECOGNITION• Period costs

– salaries

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ConservatismConservatism

The conservatism convention states that when alternative accounting valuations are

equally possible, the accountant should select the one that is least likely to

overstate assets and income in the current period.

The conservatism convention states that when alternative accounting valuations are

equally possible, the accountant should select the one that is least likely to

overstate assets and income in the current period.


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Financial Statement

Fasb has identified sources from which users might obtain information for decision making

Fasb has identified four specific FS and the elements of each

Page 52 –Sources of Information Used in External Decision Making

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A balance sheet is a financial statement that

summarizes the financial position of a company on

a particular date.

A balance sheet is a financial statement that

summarizes the financial position of a company on

a particular date.

It also is called a statement of

financial position.

It also is called a statement of

financial position.

Balance Sheet

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Assets are the probable future economic benefits obtained and controlled by a company as a result of past transactions or events. ECONOMIC RESOURCES

Liabilities are the probable future sacrifices of economic benefits arising from present obligations of a company to transfer assets or provide services in the future as a result of past transactions or events. ECONOMIC OBLIGATIONS

Equity is the owners’ residual interest in the net assets of a company.

Elements of a balance sheet:

Balance Sheet

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An income statement is a financial statement that summarizes the results

of a company’s operations. A company’s operations are called the earnings process which include its

purchasing, producing, selling, delivering, servicing, and administrating activities.

An income statement is a financial statement that summarizes the results

of a company’s operations. A company’s operations are called the earnings process which include its

purchasing, producing, selling, delivering, servicing, and administrating activities.

Income Statement

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1. Revenues are inflows or other enhancements of assets of a company or settlement of its liabilities during a period from delivering or producing goods, rendering services, or other activities that are the company’s ongoing major operation. Revenues increase the equity of a company.


The four elements of the income statement are:

Income Statement

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2. Expenses are outflows or other using up of assets of a company or incurrences of liabilities during a period from delivering or producing goods, rendering services, or carrying out other activities that are the company’s ongoing major operation. Expenses decrease the equity of a company.


The elements of the income statement are:

Income Statement

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3. Gains are increases in the equity of a company from peripheral or incidental transactions and from all other transactions and other events and circumstances affecting the company, except those that result from revenues or investments by owners. Gains increase the equity of a company.



Income Statement

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4. Losses are decreases in the equity of a company, from peripheral or incidental transactions except those that result from expenses or distribution to owners. Losses decrease the equity of a company.


Income Statement

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Expenses decrease the equity of the

company. May be thought of as

measures of the efforts to achieve

the revenues

Income Statement

Revenues increase the equity of the company. May be thought

of as measures of the accomplishments of a co. during

its accounting period.

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Gains/Losses

-gains are similar to revenues-gains relate to a company’s secondary

activities, not to its primary operations-losses are similar to expenses-losses relate to a company’s secondary

activities

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A statement of cash flows is a financial statement that

summarizes the cash inflows and outflows of a company for a

period.

A statement of cash flows is a financial statement that

summarizes the cash inflows and outflows of a company for a

period.

Statement of Cash Flows

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Operating cash flows are the flows of cash from acquiring, selling, and delivering goods for sale, as well as providing services.

Investing cash flows are the flows of cash from acquiring and selling investments, property, plant, and equipment, as well as from lending money and collecting on loans.

Financing cash flows are the flows of cash to and from the owners and long-term creditors.

The elements of a statement of cash flows are:

Statement of Cash Flows

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A statement of changes in equity summarizes the changes in a company’s

equity for a period.

A statement of changes in equity summarizes the changes in a company’s

equity for a period.

Statement of Changes in Equity

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Investments by owners are increases in equity resulting from transfers of something valuable to the company from other entities in order to obtain or increase ownership interest.

Distribution to owners are decreases in equity of a company caused by transferring assets, rendering services, or incurring liabilities to owners.

A statement of changes in equity contains two elements:

Statement of Changes in Equity

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1. Financial and nonfinancial data.1. FS and related disclosures2. High level operating data and performance measures

2. Management’s analysis of the financial and nonfinancial data.1. Reasons for changes2. The identity and past effect of key trends

3. Forward-looking information.1. Assessment of opportunities and risks2. Management plans3. Comparison of actual business performance to plans

4. Information about management and shareholders.1. Directors, management, compensation, major shareholders2. Transactions and relationship among related parties

5. Background about the company.1. Broad objectives and strategies2. Scope of business3. Industry structure

Framework of the Model – 5 categories

Model of Business Reporting—the information that a company provides to help users with capital allocation

decision about the company…goal of the model is provide a foundation for future improvement in business reporting—a

recommendation by AICPA

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IASB Framework

In 2004, the FASB and the IASB added to their respective agendas a project to develop a common conceptual framework.

Promote harmonization of future accounting standards that are principles based

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Question 1

The conceptual framework, which is intended to provide a theoretical foundation for consistent accounting standards, has been essentially completed, with seven Statements of Financial Accounting Concepts issued.

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SFACs

Statement No. 1 "Objectives of Financial Reporting by Business Enterprises,"

Statement No. 2 "Qualitative Characteristics of Accounting Information,"

Statement No. 3 "Elements of Financial Statements of Business Enterprises," (replaced by Statement No. 6 "Elements of Financial Statements"),

Statement No. 4 "Objectives of Financial Reporting by Nonbusiness Organizations,"

Statement No. 5 "Recognition and Measurement in Financial Statements of Business Enterprises,” and Statement No. 7 “Using Cash Flow Information and Present Value in Accounting Measurements.”

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Question 2

The most general objective is that financial reporting should provide useful information for present and potential investors, creditors, and other external users in making rational investment, credit, and similar decisions.

Investors include both equity security holders (stockholders) and debt security holders (bondholders), while creditors include suppliers, customers and employees with claims, individual lenders, and lending institutions.

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question 3The "derived external user objective" is to provide

information that is useful to external users in assessing the amounts, timing, and uncertainty of prospective cash receipts. This objective is important because individuals and institutions make cash outflows for investing and lending activities primarily to increase their cash inflows. Financial information is needed to help establish expectations about the timing and amount of prospective cash receipts (e.g., dividends, interest, proceeds from resale or repayment) and assess the risk involved.

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Question 4

The "derived company objective" is to provide information to help investors, creditors, and others in assessing the amounts, timing, and uncertainty of prospective net cash inflows to the related company. Information about (1) a company's economic resources, obligations, and owners' equity; (2) a company's comprehensive income and its components; and (3) a company's cash flows should be reported to satisfy the "derived company objective.“

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Question 5 Information about the "economic resources and claims to

those resources" of a company is useful to external users for four reasons:

1. To identify the company's financial strengths and weaknesses and to assess its liquidity;

2. To provide a basis to evaluate information about the company's performance during a period;

3. To provide direct indications of the cash flow potentials of some resources and the cash needed to satisfy obligations; and

4. To indicate the potential cash flows that are the joint result of combining various resources in the company's operations.

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Question 5 cont.

Information about the "comprehensive income and its components" of a company is useful to external users in:

1. Evaluating management's performance;2. Estimating the "earning power" or other

amounts that are representative of its long-term income producing ability;

3. Predicting future income; and4. Assessing the risk of investing in or lending

to the company.

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Question 5 cont.

Information about the cash flows of a company is useful to external users:

1. To help understand its operations;2. To evaluate its financing and investing

activities;3. To assess its liquidity; andTo interpret the comprehensive income

information provided.

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Question 6

The terms are defined as follows: (a) return on investment provides a measure of overall company performance, (b) risk is the uncertainty or unpredictability of the future results of a company, (c) financial flexibility is the ability of a company to use its financial resources to adapt to change, (d) liquidity refers to how quickly a company can convert its assets into cash to pay its bills, and (e) operating capability refers to the ability of a company to maintain a given physical level of operations.

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Question 7

Decision usefulness is the overall qualitative characteristic of useful accounting information. The two primary qualities of decision usefulness are relevance and reliability.

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Question 8

information is relevant if it can make a difference in a decision by helping users predict the outcomes of past, present, and future events or confirm or correct prior expectations. To be relevant, accounting information must be timely and must have either predictive value or feedback value, or both. Predictive value is present when the information helps decision makers forecast the outcome of past or present events more accurately. Feedback value is present when the accounting information enables decision makers to confirm or correct prior expectations. Timeliness is having information available to decision makers before it loses its capacity to influence decisions.

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Question 9

Accounting information is reliable if it is reasonably free from error and bias and faithfully represents what it purports to represent. To be reliable the information must be verifiable, neutral, and possess representational faithfulness. Verifiability is the ability of accountants to agree that the selected method has been used without error or bias. Representational faithfulness is the degree of correspondence between the reported accounting measurements and the economic resources, obligations, and the transactions and events causing changes in these items. Neutrality is present when information is not biased to influence behavior in a particular direction. Neutrality also implies a completeness of information.

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Question 10

The secondary quality of useful accounting information is comparability. Comparability of accounting information enables users to identify and explain similarities and differences between two (or more) sets of economic phenomena. Comparability is enhanced by consistency. Consistency means conformity from period to period with unchanging accounting policies and procedures. Without consistency, it would be difficult to determine whether differences in results were caused by economic differences or simply differences in accounting methods.

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Question 11

Materiality refers to the magnitude of an omission or misstatement of accounting information that makes it likely the judgment of a reasonable person relying on the information would have been influenced by the omission or misstatement. Materiality is closely linked to relevance. Both characteristics are defined in terms of the influences that affect a decision maker. However, relevance deals with the need that the users may have for that information, while materiality occurs because the amount is large enough to make a difference.

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Question 12

The continuity assumption (or going-concern assumption) is the assumption that a company will continue to operate in the near future, unless substantial evidence to the contrary exists. This assumption is important in financial accounting because it is necessary for many of the accounting procedures used by the company. For example, its assets which are depreciated and its method of recording inventory may be affected if the future economic benefits from these items are uncertain.

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Question 13

The period-of-time assumption is the assumption that a company has adopted the year, either calendar or fiscal, as the reporting period. This assumption is important to financial accounting because it is the basis for the adjusting entry process in accounting. If a company's financial statements were not prepared on a yearly (or shorter time) basis, there would be no reason to determine the time frame affected by particular transactions.

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Question 14

Historical cost is the exchange price that is retained in the accounting records as the value of an economic resource. Reliability provides the rationale behind the use of historical cost; it possesses representational faithfulness, neutrality, and verifiability (i.e., source documents are usually available to substantiate the recorded amount).

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Question 15

Recognition the process of formally recording and reporting an item in the financial statements of a company. Realization is the process of converting noncash resources and rights into cash or rights to cash. Two factors provide guidance for revenue recognition. Revenues should be recognized when: (1) realization has taken place, and (2) the revenues have been earned. Revenues are considered to be earned when a company has substantially completed what it must do to be entitled to the benefits generated by the revenues. Thus, revenue is usually recognized at the point of sale.

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Question 16

Accrual accounting is the process of relating the financial effects of transactions, events, and circumstances having cash consequences to the period in which they occur instead of when the cash receipt or payment occurs. This process is related to the matching principle, which states that to determine the income of a company for an accounting period the company computes the total expenses involved in obtaining the revenues of the period and relates these total expenses to (matches them against) the total revenues recorded in the period.

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Question 17

The three principles for matching expenses against revenues are:

1. Associating cause and effect;2. Systematic and rational allocation;

and3. Immediate recognition.

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Question 18

Conservatism states that when alternative accounting valuations are equally possible, the accountant should select the alternative which is least likely to overstate the company’s assets and income in the current period. Conservatism, however, can conflict with neutrality. Conservative financial statements may be unfair to present stockholders and biased in favor of future stockholders because the net valuation of the company may not fully include future expectations. The result may be a relatively lower current market price of the company's common stock.

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Question 19

A balance sheet (or statement of financial position) is a financial statement that shows the financial position of a company on a particular date (usually the end of the accounting period). There are three elements of a balance sheet: (a) assets, (b) liabilities, and (c) equity.

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Question 20

An income statement is a financial statement that shows the results of a company's operations (i.e., net income) for a period of time (generally a one-year or one-quarter accounting period). There are four elements of an income statement: (a) revenues, (b) expenses, (c) gains, and (d) losses.

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Question 21

A statement of cash flows is a financial statement that shows the cash inflows and outflows of a company for a period of time (generally one year or one-quarter). There are three elements of a statement of cash flows: (a) operating cash flows, (b) investing cash flows, and (c) financing cash flows.

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Question 22

statement of changes in equity shows the changes in a company's equity for a period of time (generally one year or one-quarter). There are two elements of a statement of changes in equity: (a) investments by owners, and (b) distributions to owners.

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question 23 The IASB Framework states that the objective of financial

statements is to provide information about the financial position, performance, and changes in financial position of a company that is useful to a wide range of users in making economic decisions. The Framework has two underlying assumptions; that a company is a going concern and uses accrual accounting. It identifies four qualitative characteristics of financial statements–understandability, relevance (including materiality), reliability ( including faithful presentation, substance over form, neutrality, prudence, and completeness), and comparability. Three constraints on relevant and reliable information are identified; they include timeliness, balance between benefit and cost, and balance between the qualitative characteristics. The Framework calls for financial statements that present a true and fair view of the company and a fair presentation of the company’s activities.

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Chapter2

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