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EXTERNAL FINANCIAL REPORTING
I. OBJECTIVES OF EXTERNAL FINANCIAL REPORTING
The intention of the Financial Accounting Standards Board (FASB) is to create a coherent system of interrelated accounting objectives and fundamentals that can lead to consistent standards and principles. This is to be implemented through a series of Statements of Financial Accounting Concepts. These are pronouncements which are intended by the FASB to set forth objectives and fundamentals that will be used as a basis for future development of financial accounting and reporting standards.
A. Information on Resources and Obligations
The FASB’s SFAC No. 1 (superseded by SFAC No. 8) establishes the objectives of general purpose external financial reporting. The following objectives were established:
1. Investment Decisions: Financial reporting should provide information that is useful to existing and potential investors, lenders, and creditors, and other users in making rational investment, credit and similar decisions.
2. Cash Receipts: Financial reporting should provide information to help present and potential investors and creditors and other users in assessing the amounts, timing, and uncertainty of prospective cash receipts from dividends or interest and the proceeds from the sale, redemption, or maturity of securities and loans.
3. Resources: Financial reporting should provide information about the economic resources of an enterprise (assets), the claims to those resources (obligations of the enterprise to transfer resources to other entities and owner’s equity), and the effects of transactions, events, and circumstances that change resources and claims to those resources.
It is assumed that users of financial statements will read them with reasonable diligence and have some understanding of basic business reports. An expert knowledge level is not assumed.
B. Basic Concepts And Accounting Principles Underlying Financial Accounting
1. Accounting Entity: Accounting information pertains to entities, which are circumscribed areas of interest. In financial accounting, the entity is the specific business enterprise. The enterprise is identified in its financial statements.
2. Going Concern: An accounting entity is viewed as theoretically continuing in operation in the absence of evidence to the contrary.
3. Time Periods: The financial accounting process provides information about the economic activities of an enterprise for specified time periods that are shorter than the life of the enterprise. Normally, the time periods are of equal length to facilitate comparisons. The time period is identified in the financial statements.
4. Measurement: Financial accounting measures monetary attributes of economic resources and obligations and changes in them. The unit of measure is identified in the financial statements. Transactions are recorded using historical cost information.
5. Approximation: Financial accounting measurements that involve allocations among relatively short periods of time and among complex and joint activities are necessarily made on the basis of estimates.
6. Judgments: Financial accounting necessarily involves informed judgment. This precludes reducing all of the financial accounting process to a set of inflexible rules.
7. General-Purpose Financial Information: Financial accounting presents general-purpose financial information that is designed to serve the common needs of owners, creditors, managers, and other users, with primary emphasis on the needs of present and potential owners and creditors.
8. Substance Over Form: Financial accounting emphasizes the economic substance of events, even though the legal form may differ from the economic substance and suggest different treatment.
9. Conservatism: Historically, managers, investors, and accountants have generally preferred that possible errors in measurement be in the direction of understatement rather than overstatement of net income and net assets. These rules may result in stated net income and net assets at amounts lower than would otherwise result from applying the pervasive measurement principles.
C. Recognition and Measurement In Financial Statements of Business Enterprises
1. Recognition Criteria: Guidance for recognizing revenues and gains is based on their being:
a. Realized or Realizable: Revenues and gains are generally not recognized (recorded) as components of earnings until realized or realizable. There are exceptions to this general rule such as in the long-term construction contract area where a portion of the revenue may be recognized (recorded) each year through the life of the contract despite the actual sale taking place later (using the percentage of completion contract accounting method).
b. Earned: Revenues are not recognized until earned. Revenues are considered to have been earned when the entity has substantially accomplished what it must do to be entitled to the benefits represented by the revenues. For gains, being earned is generally less significant than being realized or realizable.
2. Expenses: Guidance for expenses and losses is intended to recognize:
a. Consumption of Benefit: Expenses are generally recognized when an entity’s economic benefits are consumed in revenue-earning activities or otherwise.
b. Loss or Lack of Benefit: Expenses or losses are recognized if it becomes evident that previously recognized future economic benefits of assets have been reduced or eliminated, or that liabilities have been incurred or increased, without associated economic benefits.
3. Financial Statements: A full set of financial statements for a period should show:
a. Financial position at the end of the period.
b. Earnings for the period.
c. Comprehensive income for the period.
d. Cash flows during the period.
e. Investments by and distributions to owners during the period.
4. Not Transaction Value: A statement of financial position does not purport to show the market or sale value of a business enterprise.
5. Comprehensive Income: The concept of earnings set forth in the Statement is similar to net income for a period in present practice; however, it excludes certain accounting adjustments of earlier periods that are recognized in the current period - cumulative effect of a change in accounting principles is an example.
a. Broad Measure: Comprehensive income is a broad measure of the effects of transactions and other events on an entity, comprising all recognized changes in equity (net assets) of the entity during a period from transactions and other events and circumstances except those resulting from investments by owners and distributions to owners.
b. Differences: Earnings and comprehensive income are not the same because certain gains and losses are included in comprehensive income but are excluded from earnings.
c. ASC Topic 220 Requirement: Accounting Standards Codification (ASC) Topic 220 requires that all component items of comprehensive income be reported in a financial statement that is displayed “with the same prominence” as other financial statements. No specific format is prescribed. However, total comprehensive income for the period must be displayed. The Statement requires that a company (1) classify items of other comprehensive income by their nature in a financial statement, and (2) display the accumulated balance of other comprehensive income (i.e. the items that bypass the income statement) separately from retained earnings and additional paid-in capital in the equity section of the balance sheet.
D. Elements of Financial Statements
1. Purpose: Statement of Financial Accounting Concepts No. 6 defines 10 elements of financial statements: 7 elements of financial statements of both business enterprises and not-for-profit organizations -- assets, liabilities, equity (business enterprises) or net assets (not-for-profit organizations), revenues, expenses, gains and losses -- and 3 elements of financial statements of business enterprises only -- investments by owners, distributions to owners, and comprehensive income.
2. Definitions of Elements
a. Assets: Assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.
b. Liabilities: Liabilities are probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.
c. Equity or Net Assets: Equity or net assets is the residual interest in the assets of an entity that remains after deducting its liabilities.
d. Characteristics of Investments by and Distributions to Owners: Investments by owners and distributions to owners are transactions between an enterprise and its owners as outsiders.
e. Comprehensive Income of Business Enterprises: Comprehensive income is the change in equity of a business enterprise during a period from transactions and other events from nonowner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners. The financial capital concept is the traditional view and emphasizes capital maintenance with measurement through financial statements. Comprehensive income as defined is a return on financial capital.
f. Revenues: Revenues are inflows or other enhancements of assets of an entity or settlements of its liabilities (or a combination of both) from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations.
g. Expenses: Expenses are outflows or the using up of assets or incurring of liabilities (or a combination of both). These are incurred in delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major or central operations.
h. Gains and Losses: Gains are increases in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity except those that result from major revenues or investment by owners. Losses are decreases in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity except those that result from major expenses or distributions to owners.
Example: According to the FASB conceptual framework, an entity’s revenue may result from
a. A decrease in an asset from primary operations.
b. An increase in an asset from incidental transactions.
c. An increase in a liability from incidental transactions.
d. A decrease in a liability from primary operations.
Answer: SFAC No. 6 defines revenues as inflows or other enhancements of assets of an entity or settlement of its liabilities from delivering or producing goods, rendering services, or other activities that constitute the entity’s major or central operations. Item /d/ is the correct answer because this is an example of a deferred revenue that is being recognized in the current period as revenue. Item /a/ involves a decrease in assets, not an increase. Items /b/ and /c/ both relate to incidental transactions.
3. Accrual Accounting and Related Concepts: Items that qualify under the definitions of elements of financial statements and that meet criteria for recognition and measurement are accounted for and included in financial statements by the use of accrual accounting procedures.
a. Accrual Accounting: Accrual accounting attempts to record the financial effects on an entity of transactions and other events and circumstances that have significant consequences for the entity in the periods in which those transactions, events and circumstances occur rather than only in the periods in which cash is received or paid by the entity. Accrual accounting attempts to recognize non-cash events and liability-imposing circumstances as they occur and involves not only accruals but also deferrals, including allocations and amortizations.
b. Realization and Recognition: Realization in the most precise sense means the process of converting noncash resources and rights into money and is most frequently used in accounting and financial reporting to refer to sales of assets for cash or claims to cash. The term realized, therefore, identifies revenues or gains on assets exchanged or sold or liabilities reduced. Recognition is the process of formally recording or incorporating an item in the financial statements of an entity.
c. Recognition, Matching and Allocation: Matching of costs and revenues is simultaneous or combined recognition of the revenues and expenses that result directly and jointly from the same transactions. Many expenses, however, are not related directly to particular revenues but can be related to a period on the basis of transactions or events occurring in that period or by allocation. Some costs that cannot be directly related to particular revenues are incurred to obtain benefits that are exhausted in the period in which the costs are incurred, such as building rents.