Session 2 Pervasive Principles in Preparing Financial Statements 1 Learning Points Know about FASB s Conceptual Framework Learn about the Objectives of Financial Reporting Understand the Qualitative characteristics of decision-useful information Know about the Financial reporting model 2 Copyright 2017 IASeminars Ltd. 1
Recent Focus on 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. In addition future standards: Should be built on an improved and consistently applied conceptual framework Clearly state the accounting objective Minimize exceptions Avoid the use of bright-line tests 3 Objectives of the FASB The FASB was given two primary objectives To develop a conceptual framework of accounting theory. To establish standards (GAAP) for financial accounting practices. 4 Copyright 2017 IASeminars Ltd. 2
FASB Conceptual Framework Conceptual Framework is comprised of eight Statements of Financial Accounting Concepts (SFACs). SFAC No. 1 Objectives of Financial Reporting by Business Enterprises SFAC No. 2 Qualitative Characteristics of Accounting Information SFAC No. 3 Elements of Financial Statements of Business Enterprises SFAC No. 4 Objectives of Financial Reporting by Nonbusiness Orgs. SFAC No. 5 Recognition and Measurement in F/S of Bus. Enterprises SFAC No. 6 Elements of F/S, a replacement of SFAC No. 3 SFAC No. 7 Using Cash Flow Information and Present Value in Accounting Measurements SFAC No. 8 Conceptual Framework for Financial Reporting Chapter 1 Chapter 2 Chapter 3 The Objective of General Purpose Financial Reporting Not Complete Qualitative Characteristics of Useful FinancialInformation (SFAC No. 8 replaces SFAC No. 1 & 2) 5 FASB Conceptual Framework Instructor Notes In response to the ad-hoc nature of CAP and APB standards, the Conceptual Framework was meant 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. 6 Copyright 2017 IASeminars Ltd. 3
Joint FASB/IASB Conceptual Framework Project As seen from the previous slide, several concept statements have been replaced. The Boards are working on a Joint FASB/IASB Conceptual Framework Project Project has Eight different phases, however the Project is moving slowly and only the first portion is complete Released Statement of Financial Accounting Concepts No. 8 has 3 chapters: Chapter 1 The Objective of General Purpose Financial Reporting Chapter 2 Not Complete [The Reporting Entity] Chapter 3 Qualitative Characteristics of Useful Financial Information (SFAC No. 8 replaces SFAC No. 1 & 2) Phase 2 of the Joint Project examines the definitions of accounting elements which would replace SFAC No. 6 7 SFAC #8 Objectives of Financial Reporting by Business Enterprises Objectives as defined in concept statement 8 are to: 1. Provide information that is useful to present and potential investors, creditors, and other sophisticated external users for making decisions about economic activities (i.e., decision useful). 2. Provide these users information about the (a) amount, (b) timing, and (c) uncertainty of the cash flows received from the firm. 3. More specifically, provide these users information about: The firm s economic resources and claims to those resources. i.e., assets = claims on assets = liabilities + stockholders equity Changes in the firm s economic resources and claims i.e., comprehensive income and cash flows 8 Copyright 2017 IASeminars Ltd. 4
2013 Cengage Learning EXHIBIT Course 2003e: US GAAP Essentials SFAC #8 Objectives of Financial Reporting by Business Enterprises Instructor Notes Types of useful information identified by the FASB: 1. Return on investment provides a measure of overall company performance. 2. Risk the uncertainty or unpredictability surrounding a company s future results. 3. Financial flexibility the ability of a company to use its financial resources to adapt to change. 4. Liquidity refers to how quickly a company can convert its assets into cash to pay its bills. 5. Operating capability the ability of a company to maintain a given physical level of operations. 9 SFAC #8 Qualitative Characteristics of Accounting Information 2.4 Objective Qualitative Characteristics of Decision-Useful Financial Information Decision-Useful Financial Information Fundamental Qualitative Characteristics Relevance Predictive Value Confirmatory Value Materiality Faithful Representation Completeness Neutrality Free from Error Enhancing Qualitative Characteristics Comparability (including Consistency) Verifiability Timeliness Understandability Cost Constraint Benefits > Costs 10 Copyright 2017 IASeminars Ltd. 5
SFAC #8 Qualitative Characteristics of Accounting Information Instructor Notes Hierarchy of qualitative characteristics Decision usefulness is the ultimate objective of accounting information. For the information to be decision useful to investors, lenders and other creditors, the information must have a SUFFICIENT DEGREE of (1) relevance and (2) faithful representation. 11 SFAC #8 Qualitative Characteristics of Accounting Information Comparability Verifiability Timeliness Understandability 12 Copyright 2017 IASeminars Ltd. 6
Concept statement 5 The concept statement lays out: The basic assumptions underlying financial statements The basic principles (e.g., conservatism) The principle of accrual accounting which involves Revenue Recognition Principle Revenue is recognized when the earnings process is complete and collection has occurred or reasonably certain to occur. Expense Recognition Principle Expenses are recognized during a period due to: (a) cause and effect, for example sales commissions (b) systematic and rational allocation, for example depreciation (c) immediate consumption for example salary expense 13 CON 5 Recognition and Measurement in Financial Statements of Business Enterprises Basic Assumptions Reporting Entity Going Concern Monetary Unit Period of time Basic Principles Mixed Attributes Model Recognition Conservatism 14 Copyright 2017 IASeminars Ltd. 7
Accounting Assumptions and Principles Accrual Accounting: Revenue Recognition Principle Expense Recognition 15 Accounting Assumptions and Principles Instructor Notes Accrual Accounting The accrual accounting is the process of measuring and reporting the economic effects of transactions, events and arrangements IN THE PERIOD in which they occur even though the cash flows may occur in a different period. Accrual accounting involves 2 important principles: 1. Revenue Recognition Principle Revenue is recognized when the earnings process is complete and collection has occurred or reasonably certain to occur. 2. Expense Recognition Principle Expenses are recognized during a period due to: a) cause and effect, for example sales commissions b) systematic and rational allocation, for example depreciation c) immediate consumption for example salary expense 16 Copyright 2017 IASeminars Ltd. 8
Concept statement 6 The concept statement lays out: Defines all the elements recognized in financial statements (e.g., assets and liabilities) 17 10 Elements of Financial Statements Assets Equity (net assets) Expenses Losses Liabilities Revenues Gains Comprehensive income Distributions to owners Investments by owners 18 Copyright 2017 IASeminars Ltd. 9
CON 6: Key Definitions Asset Liability Probable future economic benefits Obtained or controlled by the enterprise As a result of past transactions or events Probable future economic benefit sacrifices A present obligation of the enterprise to transfer assets or services in the future As a result of past transactions or events Equity Revenues A residual interest Inflows or enhancements of assets or decreases of liabilities From delivering or producing goods, rendering services, or other activities constituting the entity s ongoing major and central operations 19 CON 6: Key Definitions continued Expenses Gains/(Losses) Outflows or using up of assets or incurrence of liabilities From delivering or producing goods, rendering services, or other activities constituting the entity s ongoing major and central operations Increases (decreases) in equity from peripheral or incidental transactions other than from revenues/(expenses) or owner investments/(distributions) Comprehensive income Change in equity during a period from transactions & other events, from sources other than owner investments or distributions Owners Investments/ (Distributions) Increases in equity resulting from ownership transfers for the purpose of increasing ownership interest Decreases in equity resulting from transferring assets, rendering services or incurring liabilities to owners 20 Copyright 2017 IASeminars Ltd. 10
CON 7: Present Value This concept statement provide guiding principles on computing present value (used in many cases as a proxy for fair value) Present value measurements must include Estimate of future cash flows or series of cash flows at different times Expectations about variations in the amount or timing of cash flows Time value of money, represented by the risk-free rate of interest Risk premium the price for bearing uncertainty inherent in the asset or liability Other factors such as illiquidity and market imperfections 21 Discounted Cash Flow Components Estimate of cash flows can be a: Single point estimate that is the mean of all expected cash flows; OR Expected value calculation that is probability weighted for discrete cash flow estimates The expected value calculation takes into account Possible variations in amount/timing Risk-free interest rate plus a Premium to risk-free rate for uncertainty is used to discount future cash flows Other factors, e.g. illiquidity, that market participants would reflect in pricing cash flows Adjustment in this case is usually to the premium to the risk free rate for uncertainty 22 Copyright 2017 IASeminars Ltd. 11