CMA Part2-Unit11

391STUDY UNIT ELEVENFRAMEWORKCONCEPTUALThis study unit is one of nine that are devoted to external financial reporting,a major topic that has been assigned a relative weight of25%of Part2.Study Unit11primarily addresses the conceptual framework,which consists of a set of fundamental principles on which the further development of accounting and reporting standards is based.The conceptual framework is described in the Statements of Financial Accounting Concepts(SFACs)issued by the FASB.It is a coherent set of interrelated objectives and fundamental concepts promulgated by the FASB.Study Unit11also covers such related subjects as revenue recognition and limits on financial information.Below is a reprint of the IMA’s Learning Outcome Statements that apply to Study Unit11.After studying the outlines and answering the multiple-choice questions,you will have the skills necessary to address the topics covered in the following:Learning Outcome Statements for Study Unit11Part2–Sections E.1.Objectives of external financial reporting;and E.2.Financial accounting fundamentalsThe candidate should be able to:q identify the objectives of external financial reporting,i.e.,providing information on resources and obligations,comprehensive income,and cash flowq identify and demonstrate an understanding of basic accounting assumptions and conventions,including going concern,historical cost,accrual accounting,and conservatismq demonstrate an understanding of recognition and measurement conceptsq differentiate between realization and recognitionq identify financial statement elements for each of the financial statementsPart2–Section E.4.Recognition,measurement,valuation,and disclosureRevenues and expensesq apply the revenue recognition principle to various types of transactionsq identify issues involved with revenue recognition at point of sale,including sales with buyback agreements,sales when right of return exists,and trade loading(or channelstuffing)q identify instances where revenue is recognized before deliveryq distinguish between percentage-of-completion and completed-contract methods for recognizing revenueq apply the percentage-of-completion and the completed-contract methodsq compare and contrast the recognition of costs of construction,progress billings,collections, and gross profit recognized under the two long-term contract accounting methodsq demonstrate an understanding of the proper accounting for losses on long-term contracts q identify instances where revenue is recognized after delivery392SU11:Conceptual Frameworkq recognize the situations in which each of the following revenue recognition methods would be used:installment sales method,cost recovery method,and deposit methodq demonstrate an understanding of the accounting procedures under the installment method, the cost recovery method,and the deposit methodq define gains and losses and indicate the proper financial statement presentationq recognize the issues and concerns that have been identified with respect to revenue recognition practices11.1CONCEPTUAL FRAMEWORK UNDERLYING FINANCIAL ACCOUNTING1.Objectives of Financial Reporting by Business Enterprises(SFAC1)a.Scope of financial reporting.The objectives extend to all means of general purposeexternal financial reporting by business enterprises(financial reporting).They are aresponse to the needs of external users who lack the authority to prescribe theinformation they need.1)Financial statements,including the notes and parenthetical disclosures,arecrucial to financial reporting because they communicate accounting informationto external parties,but the scope of financial reporting is much broader.It alsoembraces“other means of communicating information that relates,directly orindirectly,to the information provided by the accounting system.”a)Examples are disclosures required by authoritative pronouncements assupplementary information,annual reports,prospectuses,other filingswith the SEC,news releases,and letters to shareholders.2)Financial statements are often audited by independent accountants,but theinformation included in financial reporting is often not subject to outside scrutinythat would enhance its reliability or credibility.b.Characteristics and limitations of information1)Most information provided by financial reporting is financial in nature andquantified in nominal units of money,but as the general purchasing power ofthe unit of measure changes,financial statements expressed in nominalmonetary units become less comparable and useful.2)Financial reporting is ordinarily focused on individual entities.3)Information supplied by financial reporting involves estimation,classification,summarization,judgment,and allocation.4)Most forms of financial reporting reflect historical transactions,events,andcircumstances(forecasts and projections are examples to the contrary).5)Financial reporting requires the incurrence of costs,and the cost-benefitcriterion must be considered in weighing the extent of financial reporting.6)Financial reporting is not the only source of information required by economicdecision makers.c.Objectives–General considerations1)Although focused on investment and credit decisions,the objectives areintended to apply to information that is useful to anyone interested in the relatedenterprise’s ability to meet its obligations or reward its investors.2)Financial reporting should provide“evenhanded,neutral,or unbiasedinformation”to facilitate business and economic decisions but not to determinewhat those decisions should be.SU11:Conceptual Framework393d.Objective–Information useful in investment and credit decisions1)Financial reporting should provide information that is useful to current andpotential investors and creditors and other users in making rational investment,credit,and other similar decisions.2)The information should be comprehensible to those who have a reasonableunderstanding of business and economic activities and who are willing to studythe information with reasonable diligence.e.Objective–Information useful in assessing cash flow prospects1)Financial reporting should provide information to help current and potentialinvestors,creditors,and other users in assessing the amounts,timing,anduncertainty of prospective cash receipts from dividends or interest and theproceeds from the sale,redemption,or maturity of securities or loans.2)Financial reporting should also provide information to help investors,creditors,and other users assess the amounts,timing,and uncertainty of prospective netcash inflows to the related enterprise.3)Investing,lending,and similar activities are undertaken to obtain not merely areturn of cash expended but also a return proportionate to the risk.Thus,information should be useful in assessing risk.f.Objective–Information about enterprise resources,claims to those resources,and changes in them1)Financial reporting furnishes information that helps to identify the financialstrengths and weaknesses of an enterprise,to assess its liquidity and solvency,and to evaluate its performance during a period.However,financial accountingdoes not directly measure the value of an enterprise,although it may provideinformation to those who wish to do so.2)According to SFAC1,“The primary focus of financial reporting is informationabout an enterprise’s performance provided by measures of earnings and itscomponents.”a)Although such information concerns the past,investors and creditorscommonly use it to evaluate an enterprise’s rmation aboutpast performance is most valuable when the going-concern assumptionis appropriate,that is,when an enterprise is expected to continue inoperation for an indefinite time.b)Measures of earnings and its components are of special interest tothose concerned with an enterprise’s cash flow potential.However,cash-basis financial statements for a short period,such as a year,areless valuable for this purpose than accrual-basis statements.3)Although the primary focus is on earnings,information about cash flows is usefulfor understanding operations,evaluating financing activities,assessing liquidityand solvency,and interpreting earnings information.4)Financial reporting should provide information about management’sstewardship of resources,including their efficient and profitable use.a)However,it does not separate management performance from enterpriseperformance.The latter is affected by many factors other thanmanagement’s activities.Thus,financial reporting does not directlyprovide information about management performance.5)Financial reporting should include management’s explanations andinterpretations.394SU11:Conceptual Framework2.Qualitative Characteristics of Accounting Information(SFAC2)a.SFAC2describes the qualities or characteristics of accounting information that makeit useful for decision making.These qualities apply to information of both businessenterprises and not-for-profit organizations.1)SFAC2presents the hierarchy of accounting qualities in the following table:b.Decision makers.Decision making has a central role in financial reporting,anddecision makers must ultimately determine what information is useful.1)Information becomes more beneficial as it is understood by a greater number ofusers.2)Understandability(a user-specific quality)depends on both the characteristicsof users(such as prior training and knowledge)and those of the information(reliability,relevance,etc.).c.Relevance.The primary decision-specific qualities are relevance and reliability.Relevance is“the capacity of information to make a difference in a decision byhelping users to form predictions about the outcomes of past,present,and futureevents or to confirm or correct prior expectations.”1)The two principal ingredients of relevance are feedback value and predictivevalue.a)Feedback value is defined as“the quality of information that enablesusers to confirm or correct prior expectations.”SU11:Conceptual Framework395b)Predictive value is“the quality of information that helps users to increasethe likelihood of correctly forecasting the outcome of past or currentevents.”2)SFAC2describes timeliness as an ancillary aspect of relevance.a)Timeliness means“having information available to a decision makerbefore it loses its capacity to influence decisions.”d.Reliability.The other primary decision-specific quality is reliability.Reliability is“thequality of information that assures that information is reasonably free from error andbias and faithfully represents what it purports to represent.”1)Representational faithfulness is“correspondence or agreement between ameasure or description and the phenomenon that it purports to represent.”2)Verifiability is“the ability through consensus among measures to ensure thatinformation represents what it purports to represent or that the chosen methodof measurement has been used without error or bias.”3)Neutrality is“absence in reported information of bias intended to attain apredetermined result or to induce a particular mode of behavior.”a)Neutrality interacts with the other ingredients of reliability.e.Secondary and interactive qualities1)Comparability is“the quality of information that enables users to identifysimilarities in and differences between two sets of economic phenomena.”a)Comparability interacts with the primary decision-specific qualities toenhance the usefulness of accounting information.b)Comparability is not a quality of information in the same sense asrelevance and reliability.Rather,it is a quality of the relationship amongitems of information.2)Consistency is“conformity from period to period with unchanging policies andprocedures.”a)Consistency restricts companies from changing accounting methods,unless they can demonstrate that the newly adopted method is preferableto the old method.The nature and effect of the accounting change,aswell as the justification for it,must be disclosed in the financial statementsfor the period in which the change is made.f.Materiality is the threshold for recognition.Materiality is“the magnitude of anomission or misstatement of accounting information that,in the light of surroundingcircumstances,makes it probable that the judgment of a reasonable person relyingon the information would have been changed or influenced by the omission ormisstatement.”1)The importance of materiality is emphasized by the exemption of immaterialitems from the application of GAAP.2)Judgments about materiality are primarily quantitative but are affected byqualitative concerns about the nature of particular items and the circumstancesin which the judgments are made.a)Because the unique circumstances affecting materiality judgments differsubstantially,general standards of materiality ordinarily have not beenpromulgated.g.Costs and benefits is the pervasive constraint.Like other goods,financialinformation will not often be sought unless its benefits exceed its costs.However,these costs and benefits cannot be objectively quantified.396SU11:Conceptual Framework3.Elements of Financial Statements(SFAC6)a.SFAC6applies to business enterprises and not-for-profit entities.The elementsdefined are those that relate to measuring the performance and status of an entitybased on information provided by accrual accounting.b.The following elements reflect resources and claims thereto at a moment in time:1)Assets are“probable future economic benefits obtained or controlled by aparticular entity as a result of past transactions or events.”a)A valuation allowance changes the carrying amount of an asset.It is not aseparate asset or a liability.2)Liabilities are“probable future sacrifices of economic benefits arising frompresent obligations of a particular entity to transfer assets or provide services toother entities in the future as a result of past transactions or events.”a)A valuation account,e.g.,bond premium or discount,changes the carryingamount of a liability.3)Equity or net assets is“the residual interest in the assets of an entity thatremains after deducting its liabilities.”a)Equity of a business enterprise,in contrast with the net assets of anonprofit entity,is changed by investments by,and distributions to,owners.c.The following elements describe transactions,events,and circumstances duringintervals of time(the first three apply only to business enterprises):1)Investments by owners are“increases in equity of a particular businessenterprise resulting from transfers to it from other entities of something valuableto obtain or increase ownership interests(or equity)in it.”2)Distributions to owners are“decreases in equity of a particular businessenterprise resulting from transferring assets,rendering services,or incurringliabilities by the enterprise to owners.”a)A distribution to owners decreases equity(the ownership interest).3)Comprehensive income is“the change in equity of a business enterprise duringa period from transactions and other events and circumstances from nonownersources.”It excludes changes in equity resulting from investments by anddistributions to owners.a)Comprehensive income and the financial statements are based on thefinancial capital maintenance concept;comprehensive income is areturn on,not a return of,financial capital.b)Comprehensive income differs from measures of net income in currentpractice because it encompasses certain changes in equity recognized inthe equity section of the balance sheet but not in the income statement,e.g.,changes in the fair values of available-for-sale securities,foreigncurrency translation adjustments,and the excess of an additionalminimum pension liability over any unrecognized prior service cost.c)Comprehensive income also differs from earnings as defined in SFAC5.Moreover,adding to the terminological confusion,earnings is sometimesused in current practice as a synonym for net income.Earnings is similarto net income except that it excludes the cumulative effects of certainaccounting adjustments of prior periods,e.g.,the cumulative effect of achange in accounting principle.SU11:Conceptual Framework397d)SFAS130,Reporting Comprehensive Income,requires that all itemsrecognized under current standards as components of comprehensiveincome be reported in a financial statement displayed with the sameprominence as the other statements.4)Revenues are“inflows or other enhancements of assets of an entity orsettlements of its liabilities(or a combination of both)from delivering orproducing goods,rendering services,or other activities that constitute theentity’s ongoing major or central operations.”5)Expenses are“outflows or other using up of assets or incurrences of liabilities(or a combination of both)from delivering or producing goods,renderingservices,or carrying out other activities that constitute the entity’s ongoingmajor or central operations.”6)Gains(losses)are increases(decreases)in equity“from peripheral or incidentaltransactions of an entity and from all other transactions and other events andcircumstances affecting the entity except those that result from revenues(expenses)or investments by(distributions to)owners.”4.Recognition and Measurement Concepts(SFAC5)a.Recognition criteria determine whether and when items should be incorporated intothe financial statements,either initially or as changes in existing items.1)Four fundamental recognition criteria apply to all recognition issues.However,each is subject to the pervasive cost-benefit constraint and themateriality threshold.a)The item must meet the definition of an element of financial statements.b)It must have a relevant attribute measurable with sufficient reliability(measurability).c)The information about it must be capable of making a difference in userdecisions(relevance).d)The information must be representationally faithful,verifiable,and neutral(reliability).2)Revenue recognition principle.According to the revenue recognitionprinciple,revenues and gains should be recognized when(1)realized orrealizable and(2)earned.a)Revenues and gains are realized when goods or services have beenexchanged for cash or claims to cash.b)Revenues and gains are realizable when goods or services have beenexchanged for assets that are readily convertible into cash or claims tocash.c)Revenues are earned when the earning process has been substantiallycompleted and the entity is entitled to the resulting benefits or revenues.i)Gains ordinarily do not involve an earning process.Thus,thesignificant criterion for recognition of gains is being realized orrealizable.d)The two conditions are usually met when goods are delivered or servicesare rendered,that is,at the time of sale,which is customarily the time ofdelivery.398SU11:Conceptual Frameworke)As a reflection of the profession’s conservatism,expenses and losseshave historically been subject to less stringent recognition criteria thanrevenues and gains.i)Expenses and losses are not subject to the realization criterion.ii)Rather,expenses and losses are recognized when a consumptionof economic benefits occurs during the entity’s primary activitiesor when an impairment of the ability of existing assets to providefuture benefits has occurred.•An expense or loss may also be recognized when a liabilityhas been incurred or increased without the receipt ofcorresponding benefits;a probable and reasonably estimablecontingent loss is an example.iii)Long-lived assets,such as equipment,buildings,and intangibleassets,are depreciated or amortized over their useful lives.Natural resources are depleted–usually on a units-of-productionbasis.3)The following are exceptions to the basic revenue recognition rules:a)Revenues from long-term contracts may be recognized using thepercentage-of-completion method.i)This method allows for revenue to be recognized before delivery atvarious stages of the contract although the entire job is notcomplete.b)Completion-of-production or a change in prices is an appropriate basisfor recognition before delivery if products or other assets are readilyrealizable,e.g.,precious metals and some agricultural products.c)Recognition of revenues or gains or losses is appropriate in nonmonetarytransactions,including exchanges and nonreciprocal transactions(e.g.,contributions received or given).However,fair values must bereasonably determinable.d)If the collectibility of assets is relatively uncertain,revenues and gains maybe recognized after delivery as cash is received using the installmentsales method or the cost recovery method.e)Revenues from,for example,interest and rent,may be recognized basedon the passage of time.4)Recognition of revenues,expenses,gains,losses,and changes in related assetsand liabilities involves,among other things,the application of the pervasiveexpense recognition principles:associating cause and effect,systematicand rational allocation,and immediate recognition.a)SFAC6defines matching,a term that has been given a variety ofmeanings in accounting literature,as essentially synonymous withassociating cause and effect.i)Matching“is simultaneous or combined recognition of the revenuesand expenses that result directly and jointly from the sametransactions or other events.”Such a direct relationship is foundwhen revenue for sales of goods is recognized in the same periodas the cost of goods sold.SU11:Conceptual Framework399b)Systematic and rational allocation procedures do not directly relatecosts and revenues but are applied when a causal relationship is“generally,but not specifically,identified.”i)This expense recognition principle is appropriate when an assetprovides benefits over several periods(its estimated useful life),theasset is used up as a result of events affecting the entity,and theexpense resulting from such wastage is indirectly(not directly andtraceably)related to specific revenues and particular periods.Theusual example is depreciation.c)Immediate recognition is the applicable principle when costs cannot bedirectly or feasibly related to specific revenues and their benefits are usedup in the period in which they are incurred.Utilities expense is a commonexample.b.Different measurement attributes of assets and liabilities are used in currentpractice.1)Historical cost is the acquisition price of an asset and is ordinarily adjustedsubsequently for amortization(which includes depreciation)or otherallocations.It is the relevant attribute for plant assets and most inventories.2)Historical proceeds is the cash or equivalent that is actually received when anobligation was created and may be subsequently amortized.It is the relevantattribute for liabilities incurred to provide goods or services to customers.Anexample is a magazine subscription.3)Current(replacement)cost is the cash or equivalent that would have to be paidfor a current acquisition of the same or an equivalent asset.Inventory valued atthe lower of cost or market may reflect current cost.4)Current market value(exit value)is the cash or equivalent realizable by sellingan asset in an orderly liquidation(not in a forced sale).It is used to measuresome marketable securities,e.g.,those held by investment companies,orassets expected to be sold at below their carrying amount.Certain liabilities,such as those incurred by writers of options who do not own the underlyingassets,are also measured at current market value.More commonly,currentmarket value is used when the lower-of-cost-or-market rule is applied toinventories and marketable securities.5)Net realizable value is the cash or equivalent expected to be received for anasset in the due course of business,minus the costs of completion and sale.Itis used to measure short-term receivables and some inventories,for example,damaged realizable value is distinct from liquidation value,which is the appropriate valuation of assets and liabilities when thegoing-concern assumption no longer holds.6)Net settlement value is the cash or equivalent that the entity expects to pay tosatisfy an obligation in the due course of business.It is used to measure suchitems as trade payables and warranty settlement value ignorespresent value considerations.The amounts that will be realized in a liquidationare usually less than those that would have been received in the due course ofbusiness.7)Present value is in theory the most relevant method of measurement because itincorporates time value of money concepts.Determination of the present valueof an asset or liability requires discounting at an appropriate interest rate therelated future cash flows expected to occur in the due course of business.Inpractice,it is currently used only for long-term receivables and payables(butsee SFAC7).400SU11:Conceptual Frameworkc.Nominal units of money are expected to continue as the measurement scale incurrent practice.1)The use of monetary units unadjusted for changes in purchasing power is notideal,but it has the virtue of simplicity and does not result in excessivedistortion if inflation or deflation is relatively low.ing Cash Flow Information and Present Value in Accounting Measurements(SFAC7)a.Accounting measurements ordinarily use an observable amount determined by marketforces,but,absent such a measurement,estimated cash flows often serve as ameasure of an asset or a liability.Thus,SFAC7establishes a framework that usescash flows for measurements at initial recognition,for fresh-start measurements,andfor applications of the interest method of allocation.1)An estimated cash flow is a future amount,whether paid or received.2)A fresh-start measurement occurs in a period subsequent to initial recognition.It results in a carrying amount not based on prior amounts or accountingtreatments.An example is the reporting of trading securities at fair value ateach balance sheet date.3)An interest method of allocation uses present value in the absence of afresh-start measurement to calculate the periodic change in the carryingamount of an asset or liability.b.SFAC7also states principles for the use of present value,especially when theamounts of future cash flows or their timing are uncertain,and describes the objectiveof present value.1)Present value is a current measure of an estimated cash flow after discounting.Hence,the present value of$1due or payable in n periods and discounted atinterest rate i is$1÷(1+i)n.c.The scope of SFAC7is limited to measurement matters.It does not concernrecognition issues or determine when fresh-start measurements should be used.d.The objective of present value measurement is to distinguish the economicdifferences between sets of future cash flows that may vary in amount,timing,anduncertainty.e.For initial recognition and fresh-start purposes,present value is based on anobservable measurement attribute.Absent observed transaction prices,the presentvalue measurement should encompass the elements of a market price if one existed(fair value).1)Fair value is the amount at which an“asset(or liability)could be bought(orincurred)or sold(or settled)in a current transaction between willing parties,thatis,other than in a forced or liquidation sale.”f.The market finally determines asset and liability values.However,if management’sestimates are the sole source of information,the objective is still to estimate the likelymarket price if a market existed.g.A measurement based on present value should reflect uncertainty so thatvariations in risks are incorporated.Accordingly,the following are the necessaryelements of a present value measurement:1)Estimates of future cash flows2)Expected variability of their amount and timing3)The time value of money(risk-free interest rate)4)The price of uncertainty inherent in an asset or liability5)Other factors,such as lack of liquidity or market imperfections。