Bookkeeping • Advisory • Training
Accounting Concepts
The term "Accounting Concepts" represents the basic underlying ideas that form the foundation of accounting as a whole. These concepts include The Conceptual Framework that guides financial reporting, as well as The Accounting Equation and The Debit & Credit System that provide the mathematical backbone to the process of accounting.
Objective
Elements & Qualitative Characteristics
Principles, Assumptions, and Constraints
The Accounting Equation
Rights vs. Obligations (owns vs. owes)
The Debit & Credit System
Staying Balanced
The Conceptual Framework
Overview
In short, The Conceptual Framework is really just a set of ideas that guide "general-purpose" financial reporting.
It represents a summarized version of 7 FASB "concepts statements" that are intended to set the basis, or foundation, for developing accounting standards, which ultimately guide financial reporting.
The Conceptual Framework establishes what financial reporting is and what it should accomplish.
The Conceptual Framework first identifies the objective of financial reporting, and then it lays out some ideas that help us organize, shape, and create those reports.
• Objective of Financial Reporting
• Elements, and Qualitative Characteristics that Organize and Shape the Contents of Financial Reports
• Principles, Assumptions, and a Constraint that Guide the Creation of Financial Reports
The framework identifies why financial reports are needed, what financial reports are, and how to create them; and then, it also identifies some overarching ideas or considerations that affect financial reporting as a whole.
Objective
Why are financial reports needed? Who needs them, and for what purpose?
Financial Reports are Needed
To Provide Useful Information About a Reporting Entity...
Financial Reports are Needed By
Various People for Decision Making Purposes
The Conceptual Framework says that the objective of "general-purpose" financial reporting is to provide existing and potential investors, lenders, and creditors with useful information so they can make decisions about providing resources (or capital) to a reporting entity.
Of course, many other types of people can use general-purpose financial reports for many different reasons; however, since the FASB's focus is protecting the public interest, the primary users are identified as external in nature.
Elements & Qualitative Characteristics
Elements & Qualitative Characteristics organize and shape the contents of financial reports.
General-purpose financial reports contain a summary of financial items that convey the financial position and performance of a reporting entity…
• As classified (or categorized) by the 10 Elements of Financial Statements
• And possessing the overall Qualitative Characteristics of Useful Information
What are financial reports? What information is included in financial reports, and how is that information presented?
Financial Reports are
A Summary of Financial Items...
The Information Included
Conveys the Entity's Position & Performance...
The Information is Presented As Categorized by the
"Elements of Financial Statements" & As Possessing Qualitative Characteristics of Useful Information
General-purpose financial reports basically summarize what a company owns versus what they owe at some point in time (position), as well as how that information has changed over a period of time (performance).
This information is presented in an organized way using "Elements", and the information included needs to possess certain useful "Qualities".
The Conceptual Framework says that the information included in the financial statements must meet the definition of (and be categorized by) one of the 10 "Elements of Financial Statements", and it should possess the "Qualitative Characteristics of Useful Information".
What are the 10 Elements of Financial Statements?
The Conceptual Framework basically says that useful information conveys the financial position and performance of the reporting entity.
More specifically, it says that decision makers need information about the company's "economic resources, and claims against those resources, at a point in time" (Position); and, "changes to those resources and claims to resources over a period of time" (Performance).
In order to convey a company's financial position and performance, the Conceptual Framework identifies 10 "Elements of Financial Statements" that essentially classify or categorize financial items (events, transactions, or circumstances that affect a company's cash flow).
The first 3 Elements convey a reporting entity's position. Another way of thinking of it is that this conveys what the entity owns, controls, or has a right to use; and, it conveys what the entity owes or is obligated to provide to others.
Position: At a Point in Time ("Economic Resources and Claims Against Those Resources")
• Assets: Owns, Controls, or Has a Right to Use
• Liabilities: Owes or is Obligated to Provide to Non-Owners
• Equity: Owes or is Obligated to Provide to Owners
The remaining 7 Elements convey the company's position and performance. All of these Elements essentially "roll up" into Equity (see above). So, you can think of performance as a reflection of the changes to a company's position over time. Another way of thinking of it is that it summarizes the items that caused a change in the company's rights and obligations.
The term "Comprehensive Income" technically includes both Net Income and Other Comprehensive Income, which is certain "Unrealized Gains & Losses" that are not very common in the Small Business Environment. So, for the purposes of this training, you can really just think of this section as Net Income.
Net Income includes Revenues less Expenses, that are generally from normal operating activities, and Gains and Losses that are generally NOT from normal operating activities.
Investments by owners are usually, but not always, in the form of corporate stocks or non-corporate cash contributions to the entity, whereas distributions to owners are usually, but not always, in the form of corporate dividends or non-corporate cash draws from the entity.
Performance: Over a Period of Time ("Changes to Economic Resources and Claims Against Those Resources")
• Comprehensive Income: *Net Income (*plus certain Unrealized Gains & Losses)
• Revenues • Expenses: From normal operating activities
• Gains • Losses: NOT from normal operating activities
• Investments by Owners: Corporate Stocks or Non-Corporate Cash Contributions
• Distributions to Owners: Corporate Dividends or Non-Corporate Cash Draws
So, what does all of this mean? It just means that on financial reports, all financial information is going to be classified using one of these "10 Elements of Financial Statements". For example, the amount of cash a company has in the bank is classified as an Asset.
What are the Qualitative Characteristics of Useful Information?
In addition to being classified as one of the Elements of Financial Statements, useful information must also have certain Qualitative Characteristics (qualities required in order for information to be considered "useful").
The Conceptual Framework identifies 2 Fundamental Qualities (required) and 4 Enhancing Qualities (helpful, but not required).
2 Fundamental Qualities: (required)
1) Relevant: Meaningful to decision makers, which means having (or not having) the information could influence their decisions. Relevant information is:
• Materiality: Information is Material when it can influence decisions due to either the "Nature or Magnitude" (significance) of the information.
• Predictive and/or Confirmatory Value: Information has Predictive and/or Confirmatory Value when it can be used to try and predict, or confirm previously predicted, outcomes (such as changes in the entity's position or performance over time).
2) Reliable: Information that is Reliable has been "Faithfully Represented", meaning it conveys an accurate picture. Because it is difficult for financial reports to be 100% perfectly accurate in all respects, the qualities of "Faithful Representation" are instead meant to be "maximized". Reliable information is:
• Free from Error: There are "no errors or omissions in neither the presentation of information NOR the process used to select and present it". Meaning, for example, if a piece of information is an estimated value, then it should be clear that it is in fact "an estimate", AND the process for determining that estimated value should be free from error as well.
• Complete: The information includes all necessary information needed in order to understand what's being presented.
• Neutral: The information isn't biased; it hasn't been manipulated in order for it to be perceived as favorable or unfavorable.
4 Enhancing Qualities: (helpful, but not required)
1) Timely: Available to decision makers when they need it
2) Comparable: Can be used to compare the position and performance of different entities OR different periods of the same entity
3) Verifiable: Can be verified; thus, increasing reliability
4) Understandable: Clearly and concisely classified and characterized
To recap so far...
Financial reports summarize
What a company owns vs what owe (and how that has changed over time)
by categorizing "relevant and reliable" information into "Elements of Financial Statements"
Principles, Assumptions, and Constraints
Principles, Assumptions, and Constraints guide the creation of financial reports.
• Principles guide the recognition, measurement, and disclousre of financial items
• Assumptions & Constraints further guide the financial reporting process as a whole
Now that we know why financial reports are needed and what types of information they should include, we can get into how they are created.
How are financial reports created? When should information be included, and how should information be measured?
Financial Reports are created by
Recognizing, Measuring, and Otherwise Disclosing Financial Items
When they can be defined as a Relevant, Reliable, and Measurable Element of Financial Statements
Using a Relevant and Reliable Measurement Attribute
Financial reports are created by "recognizing, measuring, and otherwise disclosing" financial items.
In the simplest terms, "financial items" are the various events, transactions, and circumstances that affect an economic entity's future cash flow (i.e. the 10 Elements of Financial Statements). Recognition is an accounting term that essentially refers to the date an item is included, and measurement refers to the monetary value assigned to an item, and otherwise disclosing refers to providing additional explanations when needed.
• Financial Items: Events, transactions, or circumstances that affect an economic entity's future cash flow
• Recognition: Date Recorded as a Financial Item
• Measurement: Monetary Value of the recorded Financial Item
• Disclosure: Additional explanations when needed
So, when do you recognize financial items and how do you measure them?
The information is recognized when the item can be defined as a "Relevant, Reliable, and Measurable Element of Financial Statements". For example, an Asset would be recorded on the date that it is determined that the entity "owns, controls, or has the right to use" the asset (which is the definition of an Asset) as long as the asset was also determined to be relevant, reliable and measurable. It's a little more complicated than that, but that is the basic idea.
What are the Accounting Principles?
The Conceptual Framework identifies 4 Accounting Principles that guide how financial items are recognized, measured, and otherwise disclosed:
• Revenue Recognition Principle: Upon Satisfaction of a Performance Obligation
The Revenue Recognition principle basically says that revenue should be recognized when a performance obligation has been satisfied. A "performance obligation" is essentially a promise to provide goods or services; and so, revenue is generally recognized when the promise has been fulfilled.
• Expense Recognition (or Matching) Principle: When the benefit of operating revenue is derived
The Expense Recognition (or Matching) principle says that expenses should be recognized in the period that the entity derived the "benefit of the expense"; which just means, when the expense caused the entity to be able to make money, or generate revenue. So, in that way, expenses are thus "matched to revenue". There are basically two options: Either the expense is directly tied to products, so you recognize the expense when the product is sold; or, the expense is tied to operations as a whole, so you recognize the expense in the period it enables the entity to operate (often times, when the expense is incurred).
~Product Costs: Expenses tied to Products; so, recognized when the product is sold
~Period Costs: Expenses tied to Operations; so, recognized when the cost is incurred
• Measurement Principle: Measurement attribute is a Relevant and Reliable monetary value
The Measurement Principle says that in order to include a financial item you must be able to assign a Relevant and Reliable monetary value to it. The Conceptual Framework acknowledges the use of a "Mixed-Attribute System", which just means there is more than one way to measure financial items. For the most part, items are at least initially measured at "historical cost", which is the amount of cash (or its equivalent) paid or received at the time of acquisition. Historical cost is considered the most reliable because it is generally verifiable. However, it may be more useful to measure certain items with a less reliable but MORE RELEVANT measurement attribute; such as one that conveys the items future cash flows better. So, in addition to Historical Cost, certain items can be measured using other attributes depending on the nature of the item being measured.
Most reliable:
~Historical Cost: Amount of cash (or its equivalent) paid/received at time of acquisition
May be more relevant for certain items:
~Fair Market Value: Price of an orderly transaction between market participants
~Net Realizable Value: Estimate of cash conversion
~Net Present Value: Current amount of future sums of money
~Replacement Cost: Exchange at today's price
• Full Disclosure Principle: Provides further explanation when needed
The Full Disclosure Principle is basically the concept that the information provided in the financial statements may need some additional explanations in order to make it useful. General-purpose financial reports include a full set of financial statements PLUS disclosure notes and supplemental information that essentially do three things:
1) Further explain the line items included in the financial statements
2) Provide relevant information about the company as a whole
3) Provide relevant information about events, conditions, or circumstances that can affect the company's cash flow
What are the Accounting Assumptions and Constraints?
The Conceptual Framework identifies 4 Accounting Assumptions and a Constraint that guides the financial reporting process as a whole.
The 4 Accounting Assumptions need to be true in order for financial reporting to be useful for decision making.
• Entity Assumption: Separate and Distinct
It is assumed that the entity is separate and distinct from its owners and other entities. In order to determine what financial items should be included in the financial reports, you must first be able to clearly define what the entity is (as separate from other things).
• Going Concern Assumption: The Entity will Continue to Operate
It is assumed that the entity has a "going concern", which just means that the entity weill continue to operate until there is some reason to think otherwise. This assumption is important because the recognition and measurement principles are based on the idea that the entity will continue to operate; and, if it won't, then financial items are recognized and measured differently.
• Unit of Measure Assumption: Stable and Consistent
It is assumed that the financial items will be measured in a stable and consistent monetary unit (like the U.S. dollar) without adjustment for inflation. Using the same non-adjusted unit of measure increases comparability and usefulness.
• Time Period Assumption: Consistent and Regular
It is assumed that the financial reports will be issued on a consistent and regular basis, using consistent and regular time periods (such as month, quarter, and year). Again, this allows for comparability and thus usefulness.
The Accounting Constraint acknowledges that the whole process of financial reporting is limited, meaning there are constraints to the information that can be presented.
• Cost-Benefit Constraint: Benefits should justify the costs
There are costs associated with creating financial reports, and those costs should not outweigh the benefits of using financial reports.
Pulling it all together: The Conceptual Framework Summarized
General-Purpose Financial Reports
Contain a Full Set of Financial Statements, plus Disclosure Notes & Supplemental Information
That Summarize and Explain Relevant, Reliable, & Measurable Elements of the Financial Statements
While Taking into Consideration the Assumptions and Constraints of Financial Reporting
In summary, the Conceptual Framework says:
• The purpose of general-purpose financial reporting is to provide existing and potential investors, lenders, and creditors with useful information so they can make decisions about providing resources (or capital) to a reporting entity.
• The information these users find useful conveys the entity's financial position at a point in time as well as their financial performance over a period of time.
• The information is best summarized using the "10 Elements of Financial Statements".
• The information must have the fundamental qualities of being relevant and reliable, but it's even better if it also has the additional enhancing qualities of being timely, comparable, verifiable, and understandable.
• The revenue, expense, measurement, and disclosure principles guide how items are recognized, measured, and otherwise disclosed.
• The entity, going concern, unit of measure, and time period assumptions and the cost-benefit constraint should be taken into consideration for the entire financial reporting process.