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Financial Accounting
Daga Sandra

CHAPTER 2 CONCEPTUAL FRAMEWORK – the “constitution” – coherent system of interrelated objectives and fundamentals that can lead to consistent standards and that prescribes the nature, function and limits of financial accounting and financial statements  Increases the comparability of different companies’ financial statements  With existing framework of basic theory it is possible to solve new and emerging practice problems quickly 1) First Level – Objectives – identify accounting’s goals and purposes 2) Second Level - Qualitative Characteristics (what makes accounting information useful) and Elements of Financial Statements (assets, liabilities, equity, revenues, expenses) 3) Third Level – Foundational Principles – used to establish and apply accounting standards Fundamental Qualitative Characteristics Relevance – information has a capability of making a difference in a decision. It has predictive value and feedback/confirmatory value Faithful representation – Reflects the underlying economic substance of an event or transaction (transparency). The information is complete, neutral and free from material error or bias Completeness – statements should include all information necessary to portray the underlying events and transactions Neutrality – information cannot be selected to favour one set of stakeholders over another Enhancing Qualitative Characteristics Comparability – enables users to identify the real similarities and differences in economic phenomena Verifiability – when knowledgeable, independent users achieve similar results or reach consensus regarding the accounting for a particular transaction Timeliness – information must be timely or it loses its relevance Understand ability – users need to have reasonable knowledge of business and financial accounting maters in order to understand information in financial statements Constraints Materiality – relates to an item’s impact on a firm’s overall financial operations  Information is material if including it or leaving it out will change the judgement of a reasonable person  Materially is relative to its size  5% or more of income from continuing operations (after tax) is considered material  Any sensitive number on the financial statements (ratios involving management compensation) should be considered  Both quantitative and qualitative factors must be considered in determining whether an item is material Cost versus Benefits – the cost of providing the information must be weight against the benefits that can be had from using the information ELEMNTS OF FINANCIAL STATEMENT Assets – 1) They involve present economic resources 2) The entity has a right or access to these resources where others do not (i.e legal rights) Liabilities 1) They represent an economic burden or obligation 2) The entity has a present obligation (which is enforceable) Equity – the residual interest in the assets of an entity that remains after deducting its liabilities. Ownership interest Revenues – increase in economic resources, either by inflows or other enhancements of an entity’s assets or settlement of its liabilities, which result from an entity’s ordinary activities Expenses – decrease in economic resources, either by outflows or reduction of assets or by the incurrence of liabilities from an entity’s ordinary revenue-generating activities Gains – increases in equity (net assets) from an entity’s peripheral or incidental transactions Losses – decrease in equity (net assets) from an entity’s peripheral or incidental transactions FOUNDATIONAL PRINCIPLES These concepts help explain which, when and how financial elements and events should be recognized, measured, and presented/disclosed. Recognition/ Derecognition Measurement Presentation and Disclosure 1. Economic Entity 5. Periodicity 10. Full Disclosure 2. Control 6.Monetary unit 3. Revenue Recognition and 7. Going Concern Realization 4. Matching 8. Historical Cost 9. Fair Value Recognition/Derecognition Recognition – deals with the act of including something on the entity’s balance sheet or income statement 1. They meet the respective definition of an element, and 2. They are measurable Derecognition – deals with the act of taking something off the balance sheet or income statement 1. Economic Entity – allows us to identify an economic activity with a particular unit of accountability  For tax and legal purposes the legal entity is relevant unit  Consolidated Financial Statements combine parent and subsidiary legal entity for reporting as it gives a complete perspective of the economic entity 2. Control - concept in determining which entities to consolidate and include in the financial statements i. There is power to direct the entity’s activity. The reporting entity must be able to make strategic decisions for the entity ii. Only ONE entity has the power to direct the activities iii. Power need not be exercised or absolute. For example, the government may still have control over the entity through regulations iv. Reporting entity should have access to the benefits from the entity  It is important to first define the entity for financial reporting purposes 3. Revenue Recognition and Realization  Risk and rewards have passed or the earning process
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