What Is the GAAP Conceptual Framework?

The Generally Accepted Accounting Principles (GAAP) Conceptual Framework is a system of objectives that provides the foundation for financial accounting and reporting. Developed by the Financial Accounting Standards Board (FASB), this framework is not an accounting standard itself but the constitution that guides the FASB in creating consistent and logical standards. It provides a basis for reasoning through complex financial reporting issues, ensuring new standards are built on a stable foundation.

The framework’s purpose is to give structure to the standard-setting process, helping the FASB develop principles without re-debating basic ideas. This structure also benefits those who prepare, audit, and use financial reports by providing a frame of reference for understanding and applying the standards.

Objective of Financial Reporting

The objective of general-purpose financial reporting, as outlined in the FASB’s Concepts Statement No. 8, is to provide financial information about a company that is useful to its primary users. These users are existing and potential investors, lenders, and other creditors who cannot demand information directly from the entity. The framework is built around the information needs of these groups as they make economic decisions.

These decisions involve providing resources to the entity, such as buying or selling its stocks and bonds, or providing loans. To make these assessments, users need information that helps them evaluate the amounts, timing, and uncertainty of the company’s future net cash inflows. This information allows them to gauge the company’s ability to generate cash and provide a return to its resource providers.

To meet this objective, financial reports should provide data about the entity’s economic resources and the claims against those resources, including assets, liabilities, and equity. Reports must also show how these resources and claims have changed over a period, detailing the effects of transactions that constitute the company’s financial performance.

Qualitative Characteristics of Useful Financial Information

For financial information to be useful, it must possess certain qualitative characteristics. These attributes are divided into two categories: fundamental and enhancing. The benefit of providing the information should justify the cost of doing so, which is a constraint on these characteristics.

Fundamental Qualitative Characteristics

The two fundamental qualities are relevance and faithful representation. Relevance means the information can make a difference in a user’s decision, which is achieved if it has predictive or confirmatory value. Materiality is an aspect of relevance; information is material if omitting or misstating it could influence a user’s decision.

Faithful representation requires that financial information depicts the economic phenomena it claims to represent. To achieve this, the information must be complete, neutral, and free from error. Complete means it includes all data necessary for a user to understand the phenomenon, neutral means it is free from bias in its selection, and free from error means the process used to produce it was applied correctly.

Enhancing Qualitative Characteristics

Enhancing characteristics support the usefulness of information that is already relevant and faithfully represented. They are not absolute requirements but are highly desirable. These include:

• Comparability: Allows users to identify similarities and differences among items, either between companies or across time periods for the same company.
• Verifiability: Means that different knowledgeable observers could reach a consensus that a depiction is a faithful representation.
• Timeliness: Refers to having information available to decision-makers before it loses its capacity to influence their decisions.
• Understandability: Requires that information is classified and presented clearly and concisely.

Elements of Financial Statements

The conceptual framework defines ten interrelated elements that are the building blocks of financial statements. These elements are the classes of items that financial statements measure and report. They are organized into categories reflecting an entity’s financial position and its performance over time.

Elements of Financial Position

The elements describing financial position are assets, liabilities, and equity, which are presented on the balance sheet. An asset is a present right of an entity to an economic benefit; for example, cash, inventory, and equipment are assets because they can be used to generate future revenue. A liability is a present obligation to transfer an economic benefit, like the accounts payable owed to a supplier. Equity is the residual interest in the assets of an entity after deducting its liabilities, representing the ownership interest.

Elements of Transactions with Owners

Two elements describe transactions with owners. Investments by owners are increases in equity from transfers of value, such as cash, to obtain or increase ownership interests, like purchasing newly issued stock. Distributions to owners are decreases in equity from transferring assets to owners, with a cash dividend being a common example. These are segregated from performance elements because they are capital transactions.

Elements of Financial Performance

The remaining elements describe a company’s financial performance and are reported on the income statement. Comprehensive income is the change in a business’s equity during a period from non-owner sources, including all changes except for investments by and distributions to owners. Revenues are inflows of assets from an entity’s ongoing central operations, while expenses are outflows of assets from these same operations.

For a retailer, revenue is generated from selling merchandise, and expenses include the cost of that merchandise and employee salaries. Gains are increases in equity from peripheral or incidental transactions, such as selling equipment for a profit. Losses are decreases in equity from similar peripheral transactions, like a loss from a lawsuit settlement.

Recognition and Measurement in Financial Statements

The framework also provides guidance on when and how items should be recorded. An item is recognized in the financial statements if it meets an element’s definition, is measurable, and can be depicted with faithful representation. Derecognition occurs when the item no longer meets these criteria. These concepts are applied using a set of underlying assumptions and principles.

Foundational Assumptions

Four assumptions provide a foundation for the financial accounting process:

• Economic entity assumption: A company’s financial activities are kept separate from those of its owners.
• Going concern assumption: A business is presumed to continue operating for the foreseeable future.
• Monetary unit assumption: Only transaction data that can be expressed in money is included in accounting records.
• Periodicity assumption: The economic life of a business can be divided into artificial time periods, like a month or quarter, for timely reporting.

Core Principles

Building on these assumptions are several principles that direct how transactions are recorded:

• Measurement principle: Dictates how assets and liabilities are valued, using bases like historical cost or fair value.
• Revenue recognition principle: Dictates that revenue is recognized when a company transfers goods or services to a customer.
• Expense recognition principle: Directs that expenses be matched with revenues in the period they are incurred to generate those revenues.
• Full disclosure principle: Requires companies to disclose all circumstances and events that would make a difference to financial statement users.