The Accounting Concept

Reasons for a Conceptual Framework

A conceptual framework is a system of ideas and objectives that lead to the creation of a consistent set standards.

Learning Objectives

Explain the purpose of the conceptual framework in accounting

Key Takeaways

Key Points

  • The main reasons for developing an agreed conceptual framework are that it provides a framework for setting accounting standards, a basis for resolving accounting disputes, fundamental principles which then do not have to be repeated in accounting standards.
  • The Financial Accounting Standards Board ( FASB ) is a private, not-for-profit organization whose mission is “to establish and improve standards of financial accounting and reporting for the guidance and education of the public, including issuers, auditors, and users of financial information.
  • Created in 1973, FASB replaced the Committee on Accounting Procedure (CAP) and the Accounting Principles Board (APB) of the American Institute of Certified Public Accountants (AICPA).
  • FASB’s Conceptual Framework, a project begun in 1973 to develop a sound theoretical basis for the development of accounting standards in the United States. From 1978 to 2010 the FASB released eight concept statements.

Key Terms

  • FASB: The Financial Accounting Standards Board (FASB) is a private, not-for-profit organization whose primary purpose is to developgenerally accepted accounting principles (GAAP) within the United States in the public’s interest.

Conceptual Framework

A conceptual framework can be defined as a system of ideas and objectives that lead to the creation of a consistent set of rules and standards. Specifically in accounting, the rule and standards set the the nature, function and limits of financial accounting and financial statements.

The main reasons for developing an agreed conceptual framework are that it provides:

  • a framework for setting accounting standards;
  • a basis for resolving accounting disputes;
  • fundamental principles which then do not have to be repeated in accounting standards.

History

Prior to 1929, no group—public or private—was responsible for accounting standards. After the 1929 stock market crash, the Securities and Exchange Act of 1934 was passed. This resulted in the U.S. Securities and Exchange Commission (SEC) supervising public companies. The Securities and Exchange Commission (SEC) designated the FASB as the organization responsible for setting accounting standards for public companies in the U.S.

The Financial Accounting Standards Board (FASB) is a private, not-for-profit organization whose mission is “to establish and improve standards of financial accounting and reporting for the guidance and education of the public, including issuers, auditors, and users of financial information. ” Created in 1973, FASB replaced the Committee on Accounting Procedure (CAP) and the Accounting Principles Board (APB) of the American Institute of Certified Public Accountants (AICPA).

FASB’s Conceptual Framework, a project begun in 1973 to develop a sound theoretical basis for the development of accounting standards in the United States. From 1978 to 2010 the FASB released eight concept statements.

  1. OBJECTIVES OF FINANCIAL REPORTING BY BUSINESS ENTERPRISES (SFAC No. 1) 1978
  2. QUALITATIVE CHARACTERISTICS OF ACCOUNTING INFORMATION (SFAC No. 2)1980
  3. ELEMENTS OF FINANCIAL STATEMENTS OF BUSINESS ENTERPRISES (SFAC No. 3)1980
  4. OBJECTIVES OF FINANCIAL REPORTING BY NONBUSINESS ORGANIZATIONS (SFAC No. 4) 1980
  5. RECOGNITION AND MEASUREMENT IN FINANCIAL STATEMENTS OF BUSINESS ENTERPRISES (SFAC No. 5)1984
  6. ELEMENTS OF FINANCIAL STATEMENTS; a replacement of FASB Concepts Statement N. 3, also incorporating an amendment of FASB Concepts Statement No. 2 (SFAC N. 6) 1985
  7. USING CASH FLOW INFORMATION AND PRESENT VALUE IN ACCOUNTING MEASUREMENTS (SFAC No. 7) 2000
  8. No. 8. CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING, a replacement of SFAC No. 1 and No. 2 2010

Why is the Framework Necessary

With a sound conceptual framework in place the FASB is able to issue consistent and useful standards. In addition, without an existing set of standards, it isn’t possible to resolve any new problems that emerge.

The framework also increases financial statement users’ understanding of and confidence in financial reporting and makes it easier to compare different companies’ financial statements.

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Laying a Foundation for Building: U.S. Navy Petty Officer 3rd Class Channing Connelly, right, uses a laser-guided level to check for proper frame elevation as other Seabees adjust a frame board while working on a building foundation at a patrol base in Mahawil, Iraq, Feb. 4, 2009.

Objectives of Accounting

The objective of business financial reporting is to provide information that is useful for making business and economic decisions.

Learning Objectives

Describe the objectives of accounting, distinguishing between Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS)

Key Takeaways

Key Points

  • Specifically, the information should be useful to investors and lenders, be helpful in determining a company’s cash flows, and report the company’s assets, liabilities, and owner’s equity and the changes in them.
  • Financial accountants produce financial statements based on the accounting standards in a given jurisdiction.
  • Generally Accepted Accounting Principles refer to the standard framework of guidelines for financial accounting used in any given jurisdiction.
  • International Financial Reporting Standards (IFRS) are designed as a common global language for business affairs so that company accounts are understandable and comparable across international boundaries.

Key Terms

  • Assets: Any property or object of value that one possesses, usually considered as applicable to the payment of one’s debts.
  • International Accounting Standards Board: an independent, accounting standard-setting body
  • liabilities: An amount of money in a company that is owed to someone and has to be paid in the future, such as tax, debt, interest, and mortgage payments.

Objectives of Accounting

The Financial Accounting Standards Boards Statements of Financial Accounting Concepts No. 1 states the objective of business financial reporting, which is to provide information that is useful for making business and economic decisions. Specifically, the information should be useful to investors and lenders, be helpful in determining a company’s cash flows, and report the company’s assets, liabilities, and owner’s equity and the changes in them.

With these objectives in mind, financial accountants produce financial statements based on the accounting standards in a given jurisdiction. These standards may be the generally accepted accounting principles of a respective country, which are typically issued by a national standard setter, or International Financial Reporting Standards, which are issued by the International Accounting Standards Board.

U.S GAAP

Generally Accepted Accounting Principles refer to the standard framework of guidelines for financial accounting used in any given jurisdiction; generally known as accounting standards or Standard accounting practice. These include the standards, conventions, and rules that accountants follow in recording and summarizing, and in the preparation of financial statements.

IFRS

International Financial Reporting Standards (IFRS) are designed as a common global language for business affairs so that company accounts are understandable and comparable across international boundaries. They are a consequence of growing international shareholding and trade and are particularly important for companies that have dealings in several countries. They are progressively replacing the many different national accounting standards.The rules to be followed by accountants to maintain books of accounts which is comparable, understandable, reliable and relevant as per the users internal or external.

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Project Managers: Gary Roughead talks with project managers while touring Pacific Beacon.

Fundamental Concepts in Accounting

In order to prepare the financial statements, it is important to adhere to certain fundamental accounting concepts.

Learning Objectives

State the fundamental concepts and objectives of financial reporting

Key Takeaways

Key Points

  • Going Concern, unless there is evidence to the contrary, it is assumed that a business will continue to trade normally for the foreseeable future.
  • Accruals and Matching, revenue earned must be matched against expenditure when it was incurred.
  • The objectives of financial reporting is to provide information that is relevant and useful.
  • Accounting concepts deal with the standards and laws required to satisfy the needs of investors, employees, and other stakeholders.

Key Terms

  • entity: That which has a distinct existence as an individual unit. Often used for organisations which have no physical form.
  • going concern assumption: the business is going to be operated for non-predefined period
  • revenue: Income that a company receives from its normal business activities, usually from the sale of goods and services to customers.

Fundamental Concepts in Accounting

Financial statements are prepared according to agreed upon guidelines. In order to understand these guidelines, it helps to understand the objectives of financial reporting. The objectives of financial reporting, as discussed in the Financial Accounting standards Board (FASB) Statement of Financial Accounting Concepts No. 1, are to provide information that

  • Is useful to existing and potential investors and creditors and other users in making rational investment, credit, and similar decisions;
  • Helps existing and potential investors and creditors and other users to assess the amounts, timing, and uncertainty of prospective net cash inflows to the enterprise;
  • Identifies the economic resources of an enterprise, the claims to those resources, and the effects that transactions, events, and circumstances have on those resources.

Preparing Financial Statements

In order to prepare the financial statements, it is important to adhere to certain fundamental accounting concepts.

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Accounting Concepts in a Diagram: This is a diagram of details for principles, concepts, and constraints within the field of Financial Accounting.

  • Going Concern, unless there is evidence to the contrary, it is assumed that a business will continue to trade normally for the foreseeable future.
  • Accruals and Matching, revenue earned must be matched against expenditure when it was incurred
  • Prudence, if there are two acceptable accounting procedures choose the one gives the less optimistic view of profitability and asset values.
  • Consistency, similar items should be accorded similar accounting treatments.
  • Entity, a business is an entity distinct from its owners.
  • Money Measurement, accounts only deal with items to which monetary values can be attributed.
  • Separate Valuation each asset or liability must be valued separately.
  • Materiality, only items material in amount or in their nature will affect the true and fair view given by a set of accounts.
  • Historical Cost, tTransactions are recorded at the cost when they occurred.
  • Realization, revenue and profits are recognized when realized.
  • Duality, every transaction has two effects.

Importance of Recognition and Measurement

In accounting, recognition of revenues and expenses is based on the matching principle.

Learning Objectives

Explain the difference between accruals and deferrals

Key Takeaways

Key Points

  • Accrued revenue: Revenue is recognized before cash is received.
  • Deferred revenue: Revenue is recognized after cash is received.
  • Accrued expense: Expense is recognized before cash is paid out.
  • Deferred expense: Expense is recognized after cash is paid out.

Key Terms

  • recognition: In accounting recognition is the act of including a transaction of a financial statement-either the income statement or the balance sheet.
  • mismatch: Something that does not match; something dissimilar, inappropriate or unsuitable.
  • disclosure: In accounting the transaction is not included on the financial statements but reported in the notes to the financial statement.

Revenue Recognition Principle

The revenue recognition principle and the matching principle are two cornerstones of accrual accounting. They both determine the accounting period, in which revenues and expenses are recognized. According to the revenue recognition principle, revenues are recognized when they are realized or realizable and earned—usually when goods are transferred or services rendered—regardless of when cash is received. In contrast, cash accounting revenues are recognized when cash is received regardless of when goods or services are sold. Cash can be received before or after obligations are met—when goods or services are delivered. Related revenues as two types of accounts:

  • Accrued revenue: Revenue is recognized before cash is received.
  • Deferred revenue: Revenue is recognized after cash is received.
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Revenues and Expenses: This graph shows the growth of the revenues, expenses, and net assets of the Wikimedia Foundation from june 2003 to june 2006.

Accruals and Deferrals: Timing of Recognition vs. Cash Flow

Two types of balancing accounts exist to avoid fictitious profits and losses. These might occur when cash is not paid out in the same accounting period in which expenses are recognized. According to the matching principle in accrual accounting, expenses are recognized when obligations are incurred—regardless of when cash is paid out. In contrast to recognition is disclosure. An item is disclosed when it is not included in the financial statements, but appears in the notes of the financial statements. Cash can be paid out in an earlier or later period than the period in which obligations are incurred. Related expenses result in the following two types of accounts:

  • Accrued expense: Expense is recognized before cash is paid out.
  • Deferred expense: Expense is recognized after cash is paid out.

Accrued expenses are a liability with an uncertain timing or amount; the uncertainty is not significant enough to qualify it as a provision. One example would be an obligation to pay for goods or services received from a counterpart, while the cash is paid out in a later accounting period—when its amount is deducted from accrued expenses. Accrued expenses shares characteristics with deferred revenue. One difference is that cash received from a counterpart is a liability to be covered later; goods or services are to be delivered later—when such income item is earned, the related revenue item is recognized, and the same amount is deducted from deferred revenues.

Deferred expenses, or prepaid expenses or prepayment, are an asset. These expenses include cash paid out to a counterpart for goods or services to be received in a later accounting period—when fulfilling the promise to pay is actually acknowledged, the related expense item is recognized, and the same amount is deducted from prepayments. Deferred expenses share characteristics with accrued revenue. One difference is that proceeds from a delivery of goods or services are an asset to be covered later, when the income item is earned and the related revenue item is recognized; cash for the items is received in a later period—when its amount is deducted from accrued revenues.

The Matching Principle

The matching principle is a culmination of accrual accounting and the revenue recognition principle. They both determine the accounting period, in which revenues and expenses are recognized. According to the principle, expenses are recognized when obligations are:

  • Incurred (usually when goods are transferred or services rendered—e.g. sold)
  • Offset against recognized revenues, which were generated from those expenses (related on the cause-and-effect basis), regardless of when cash is paid out. In cash accounting, on the other hand, expenses are recognized when cash is paid out, regardless of when obligations are incurred through transfer of goods or rendition of services.

If no cause-and-effect relationship exists (e.g., a sale is impossible), costs are recognized as expenses in the accounting period they expired—when have been used up or consumed. Prepaid expenses are not recognized as expenses, but as assets until one of the qualifying conditions is met resulting in a recognition as expenses. If no connection with revenues can be established, costs are recognized immediately as expenses (e.g., general administrative and research and development costs).

Prepaid expenses, such as employee wages or subcontractor fees paid out or promised, are not recognized as expenses (cost of goods sold), but as assets (deferred expenses), until the actual products are sold.

The matching principle allows better evaluation of actual profitability and performance. It reduces noise from the timing mismatch between when costs are incurred and when revenue is realized. Keep in mind that recent standards have moved away from matching expenses and revenues in favor of “balance sheet” model of reporting.