Key Things to Know
Key Things To Know
The Statements of Financial Accounting Concepts (SFAC) provide the following:
The objective of financial reporting:
To provide financial information that is useful to capital providers:
1) about the reporting entity
2) useful to existing and potential investors and creditors
3) useful for making decisions about allocating resources
4) the definition of the elements:
Asset, liability, equity, investments by owners, distributions to owners, revenues, expenses, gains, losses, comprehensive income.
5) the qualitative characteristics, constraints, recognition, measurement and disclosure concepts users can rely on when using financial information to make decisions.
Recognition of Elements on the Financial Statements
According to Statements of Financial Accounting Concepts Statement, an item should be recognized on the basic financial statements when it meets all of the following four criteria (subject to cost/benefit and materiality):
Definition: The item meets the definition of an element of financial statements.
Measurability: The item can be measured with sufficient reliability.
Relevance: The information is capable of making a difference in a decision.
Reliability: The information is true and can be relied upon.
Conceptual Framework Overview
Recognition, Measurement, and Disclosure Concepts
- Economic entity
- Going concern
- Monetary unit
- Revenue recognition
- Expense recognition
- Measurement (mixed attribute)
- Full disclosure
- Cost effectiveness
- Predictive value
- Confirmatory value
Faithful Representation / Reliable
- Free from error
Recognition, Measurement, and Disclosure Concepts
The following assumptions can be made by users when reading the financial statements:
Economic Entity Assumption
Each business is its own legal entity and only transactions of the entity are reported on the financial statements.
The activities of the business must be reported separately from activities of owners.
Owners’ personal transactions are not included on the company’s financial statements.
Financial statements report the economic activities of a business in separate periods of time.
The period of time is usually a month, quarter, or year.
Going Concern Assumption
Users may assume a company will remain in business, assets will be used, and liabilities will be repaid as part of future ongoing business unless stated otherwise.
A going concern warning must be presented if it is highly unlikely the company will continue to do business.
A company’s management team and the auditors generally make this determination.
Monetary Unit Assumption
Economic activity is expressed in nominal units of money (dollars.)
Accountants assume the dollar is reasonably stable over time and amounts are not adjusted for inflation or deflation.
The rate of inflation in the United States has historically been too low to impact decisions made by investors and creditors.
Accountants conform to the following principles when presenting financial information:
Revenue is recognized when goods or services are transferred to customers (customer controls) at the amount the company expects to be entitled to receive in exchange for the goods or services.
No revenue is recognized if receipt of payment is not probable.
Revenue recognition criteria help to make sure a company doesn’t record revenue before it has performed all of the obligation to the buyer and the buyer has the ability to pay.
Reporting revenue on the income statement also results in an increase to an asset or a decrease to unearned (deferred) revenue in the same period.
Expenses must be recorded and reported in the same period the revenue is generated in order to report earnings for a specific period of time.
Expenses are not always incurred directly to support specific revenue.
Acceptable methods used to record expenses are as follows:
Exact Cause and Effect Relationship:
The expense occurs as part of the revenue process.
Examples: cost of goods sold and sales commission as a percent of sales
Associate the Expense with Revenues in the Same Time Period:
The expense occurs during the same time period the revenue is generated.
Examples: interest expense, rent expense, and salary expense
Systematic and Rational Allocation over time:
The cost of using long-term assets is allocated to each period assets are used.
Example: depreciation and amortization expense
In the Period Incurred:
No direct connection to the specific revenues earned during the period.
Example: Advertising expenses, research and development expenses
All items presented on the financial statements must be presented with an amount.
The chosen measurement should provide the greatest relevance and reliability.
Companies will use a combination of the following measurement techniques provided by SFAC 5:
Assets are initially reported at historical cost (the amount paid.)
Historical cost can be verified and is reliable.
For liabilities, the “cost” is the value of the asset received in exchange for the liability.
Cost is based on an exchange between independent parties
Net Realizable Value:
the net amount of cash the asset is expected to convert into during normal business operations
The cost to replace the asset
Present Value of Future Cash Flows:
Approximation of fair value given a specific rate of interest
Market approach: valued of instruments traded on a market exchange
Income approach: the present value of earnings or cash flows
Cost approach: the cost of replacing the asset (buy or reproduce)
All information that would influence a user’s decision must be reported on the financial statements or stated in the footnotes.
Footnotes must be provided with financial statements.
FASB provides general guidance on the type and detail of information that must be disclosed in the footnotes.
Common footnote disclosures that are important for users to take notice of are as follows:
Subsequent Event Disclosures:
Subsequent events are significant events that occur after the company’s year-end and before the financial statements and footnotes are released to the public.
Examples of subsequent events are significant debt issuances, losses from natural disasters, and mergers or acquisitions.
Related Party Disclosures:
Related parties are owners, management, families of owners and management, affiliated companies and other parties that may have influence on the company.
Users should be aware of related party transactions because favorable treatment may occur or the economic substance may differ from the legal form in transactions with related parties.
Irregularities and Illegal Acts:
Intentional mistakes in reported financial information and other violations of the law.
Preparing and presenting financial information has a cost.
Accountants have agreed that the benefit of providing information must exceed the cost of gathering and presenting information.
Example of cost effectiveness applied:
Listing the names of every customer of a company is too costly.
Companies are required to disclose when more than one customer accounts for 10% or more of total sales so investors can assess the risk of future earnings.
Financial information presented must be capable of making a difference in a decision as evidenced by the following:
Assisting the user in predicting future performance (predictive value)
Assisting the user in evaluating past performance (feedback/confirmatory value)
Information would affect a users’ decision is not omitted or misstated. (materiality)
More on Materiality
GAAP requires that all information with an amount large enough to influence the judgment of a reasonable person must be presented either on the financial statements or in the footnotes.
Material information is always relevant; both refer to information that makes a difference in a decision.
Materiality is different from relevance because it refers specifically to the amount presented.
A transaction with a value that is not large enough to matter is not required to be reported and accounted for in accordance with GAAP.
The following examples illustrate materiality:
1) A company with total assets of $100 million could have an accounting error of $10,000 on the balance sheet. The amount of $10,000 is not a material amount.
2) Earnings per share is reported at $2.10. Investors are expecting earnings per share to be $2.11. One cent is material to investors because the fact that the company did not meet expectations could influence the decision of an investor.
Materiality is generally determined based on how the amount compares to total assets or net income on a percentage basis.
As a general rule, a typical investor or creditor is likely to be impacted by an error related to an amount:
- on the balance sheet that is 5 % or more of the reported total assets
- on the income statement that is 3 % or more of total net income.
Financial information is material if omitting it or misstating it could impact a user’s decision. Whether an amount is material is subject to the judgment of the accountant and the auditor.
Faithful Representation / Reliable
Users of financial information must be able to rely on and have confidence in the information. Reliable financial information consists of the following:
1) Represents the economic position as it really is (faithful representation)
The financial information is complete and free from material error.
2) Presented in a manner that would not sway the user’s opinion (neutrality/conservatism)
Relevance versus Reliability
The accountant often must determine whether relevance or reliability is more important to the user.
Recording assets at historical cost is reliable; however, it is not relevant if the fair market value has changed significantly since the asset was purchased.
Reporting assets at fair market value is relevant; however, it is subjective and not always reliable.
United States GAAP generally holds that reliability is more important than relevance when reporting asset values.
Accounting estimates rarely end up being the actual value.
However, United States GAAP generally supports that it is more important for transactions to be recorded timely than to wait until the actual amount is known.
Comparability allows users to identify similarities and differences from one year to the next
(for a single company) and from one company to another (when comparing more than one company.)
Comparability is accomplished by using
- standard formats
- common account names
- and comparable valuation methods (i.e. historical cost or fair market value.)
Accounting methods are disclosed in the footnotes to allow users to identify any inconsistencies between companies.
A public company is required to present two years of information on the balance sheet and three years of information on the other three financial statements.
FASB often provides a choice of methods to use when accounting for transactions.
Accountants cannot change a method of accounting unless there is a significant change in the way the business operates that justifies the change.
Examples of an acceptable reason for changing a method is the acquisition of another company and a change is made for consistency in the new company and new guidance is provided by FASB.
A description of methods used by the company and the impact of all material changes in methods must be stated in the footnotes.
Verifiability is met when independent knowledgeable business people reach the same conclusion about whether or not the information is an accurate representation of financial results.
Some items and values can be directly verified with documentation of the exchange.
Other items and values are estimated and projections and models are reviewed for reasonableness.
Information is timely if it is provided periodically and is available to users in time to be used to make decisions.
Financial information is understandable when users are able to comprehend the information in the context of the decision being made.
Users are assumed to have a reasonable understanding of business transactions.
The Fair Value Option
GAAP provides the option to report some or all of the financial assets and financial liabilities at fair market value.
Financial assets and financial liabilities convert directly into known amounts of cash.
Examples of financial assets and liabilities are notes receivable, investments, derivatives, notes payable, and other long-term liabilities.
Financial assets and financial liabilities selected to be reported at fair market value report changes in fair market value for the current period as a gain or loss on the income statement.
FASB provided the fair value option to companies to allow for consistency with other investments and derivatives required to be reported at fair market value.
Companies are allowed to select the types of financial assets or liabilities they report at fair market value.
A company may not switch back to reporting the selected items at historical cost once the fair value option is elected.
Three levels of fair value:
Level 1: Quoted prices in active markets
Level 2: Based on direct or indirect observable inputs – similar assets or liabilities
Level 3: Unobservable inputs – best information available to project future cash flows