Prepared by:

Patricia Zima, CAMohawk College of Applied Arts and Technology

Chapter 2Chapter 2 Conceptual Framework Conceptual Framework Underlying Underlying

Financial Reporting Financial Reporting

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Conceptual Framework Conceptual Framework Underlying Financial ReportingUnderlying Financial Reporting

Conceptual Conceptual FrameworkFramework

• Rationale Rationale

• DevelopmentDevelopment

First Level:First Level:

Basic Basic ObjectivesObjectives

Second Level:Second Level:

Fundamental Fundamental ConceptsConcepts

• Qualitative Qualitative characteristicscharacteristics

• Basic elementsBasic elements

Third Level: Third Level: Foundational Foundational Concepts and Concepts and ConventionsConventions• Economic entityEconomic entity• Going concernGoing concern• Monetary unitMonetary unit• PeriodicityPeriodicity• Historical costHistorical cost• Revenue recognitionRevenue recognition• MatchingMatching• Full disclosureFull disclosure• UncertaintyUncertainty• Cost-benefitCost-benefit• MaterialityMateriality• Industry practiceIndustry practice

Financial Financial Reporting Reporting IssuesIssues•Accounting Accounting ChoicesChoices• Issue Issue IdentificationIdentification• Financial Financial EngineeringEngineering•Fraudulent Fraudulent Financial Financial ReportingReporting•InternationalInternational

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Usefulness of a Conceptual Usefulness of a Conceptual FrameworkFramework

• The framework is like a constitution; it is a “coherent system of interrelated objectives”

• Creates standards for the accounting profession

• Increases financial statement users’ understanding of and confidence of financial reporting

• Enhances comparability of financial statements of different companies

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Objectives of the Conceptual Objectives of the Conceptual FrameworkFramework

• The framework is the foundation for building a set of accounting concepts and objectives

• The framework is a reference of basic accounting theory for solving new and emerging practical problems of reporting

• This framework can be illustrated as follows:

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Conceptual Framework for Conceptual Framework for Financial ReportingFinancial Reporting

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Conceptual Framework – Conceptual Framework – ObjectivesObjectives

To provide information:

• Useful to those making investment and credit decisions

• Useful in making resource allocation decisions

• Useful in assessing management stewardship

• Financial statements provide information about:

• An entity’s economic resources, obligations, and equity/net assets

• Changes in an entity’s economic resources, obligations, and equity/net assets

• The economic performance of the entity

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Conceptual Framework–Conceptual Framework–Qualitative CharacteristicsQualitative Characteristics

The Qualitative Characteristics are as follows:

1. Understandability

2. Relevance

3. Reliability

4. Comparability

5. Consistency

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Conceptual Framework – Conceptual Framework – Qualitative CharacteristicsQualitative Characteristics

Information is relevant if it:

-Has predictive value -Makes a difference

-Has feedback value -Is timely Information is reliable if it:

• Is verifiable; similar results achieved if same measurement methods are used

• Is a faithful representation of what actually happened

• Reasonably free from bias; it is neutral Tradeoffs of qualities:• Often must make a tradeoff between relevance (timeliness of

financial information) and reliability of financial information• Needs of the users must be considered

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Conceptual Framework –Conceptual Framework –Qualitative CharacteristicsQualitative Characteristics

Information is understandable if it: • Allows reasonably informed users to see the

significance of the information• Provides “enough” information so that it is clear

Information is comparable if it:• Allows users to identify real similarities and

differences for different companies• Has been measured and reported in a similar

manner Information is consistent if:

• Similar events have the same accounting treatment from period to period

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Conceptual Framework – Conceptual Framework – Basic ElementsBasic Elements

• The CICA Handbook defines eight elements (or definitions) directly related to the measurement of performance of financial status of a company

• The conceptual framework defines the basic elements that can be traced to the Balance Sheet and Income Statement

• Helps users have a common understanding of financial statements

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Conceptual Framework – Conceptual Framework – Basic ElementsBasic Elements

Balance Sheet

Assets: probable future economic benefit, as a result of a past transaction, and entity controls access to the benefit

Liabilities: probable future sacrifice of economic benefits, as a result of a past transaction, and there is little or no discretion to avoid obligation

Equity/Net Assets: residual interest

i.e. net worth (assets – liabilities)

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Conceptual Framework – Conceptual Framework – Basic ElementsBasic Elements

Income Statement

Revenues: increases in economic resources, from an entity’s ordinary activities

Expenses: decreases in economic resources, from an entity’s ordinary revenue-generating activities

Gains: increases in equity (net assets) from incidental transactions

Losses: decreases in equity from incidental transactions

Other comprehensive income

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Conceptual Framework – Conceptual Framework – Foundational Concepts and Foundational Concepts and

ConstraintsConstraints• Foundational concepts and

constraints help explain which, when, and how financial elements and events should be recognized, measured, and presented

• They act as guidelines for developing rational responses to controversial financial reporting issues

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Conceptual Framework – Conceptual Framework – Foundational Concepts and Foundational Concepts and

ConstraintsConstraints• Economic entity • Going concern • Monetary unit• Periodicity• Historical cost• Revenue recognition• Matching• Full disclosure• Uncertainty• Cost-benefit• Materiality• Industry practice

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Economic Entity Assumption (Also called Entity Concept)

• The economic activity can be identified with a particular unit of accountability

• The business activity is separate and distinct from its owners (and any other business unit)

• An individual, departments or divisions of an entity, or an entire industry may be considered separate entities

• Does not necessarily refer to a legal entity• For tax and legal purposes, considered a legal

entity

Basic Foundational Concepts Basic Foundational Concepts and Constraintsand Constraints

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Going Concern Assumption• Assumption that a business enterprise will

continue to operate in the foreseeable future• There is an expectation of continuing long

enough to meet their objectives and commitments

• Management must look out at least 12 months from balance sheet date

• If liquidation of the company is assumed to be likely, use liquidation accounting (at net realizable value)

• Full disclosure is required of any material uncertainties of continuing as a going concern

Basic Foundational Concepts Basic Foundational Concepts and Constraintsand Constraints

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Monetary Unit• Money is the common unit of measure of

economic transactions• Use of a monetary unit is relevant, simple and

understandable, universally available, and useful• In Canada and the United States, the dollar is

assumed to remain relatively stable in value (effects of inflation/deflation are ignored i.e. price-level change is ignored)

• Monetary unit is relevant only as long as it is assumed that quantitative data are useful in communicating economic information

Basic Foundational Concepts Basic Foundational Concepts and Constraintsand Constraints

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Basic Foundational Concepts Basic Foundational Concepts and Constraintsand Constraints

Periodicity Assumption • Economic activity of an entity can be divided

into artificial time periods for reporting purposes• Most common: one month, one quarter, and one

year• For shorter time periods, more difficult to

determine proper net income (i.e. the more likely errors become due to more estimates)

• Trade-off between relevance and reliability• With technology, investors want more on-line,

real-time financial information to ensure relevant information

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Historical Cost Principle• Three basic assumptions of historical cost

• Represents a value at a point in time• Results from a reciprocal exchange

(i.e. a two-way exchange)• Exchange includes an outside party

• Initial recognition: for non-financial assets, record all costs incurred to get the asset “ready” for sale or for use (e.g. includes transportation and installation costs)

Basic Foundational Concepts Basic Foundational Concepts and Constraintsand Constraints

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Historical Cost Principle (continued)• Estimate “fair value” for:

1. Non-monetary transactions (as no cash/monetary consideration exchanged)

2. Non-reciprocal transactions (e.g. donations)

3. Related party transactions – not acting at “arm’s length” (use exchange value or cost)

• Bonds, notes, accounts payable, and receivable recorded at “agreed upon exchange price or economic value”

Basic Foundational Concepts Basic Foundational Concepts and Constraintsand Constraints

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Revenue Recognition Principle• Revenue is recognized when:

• Performance is achieved (earned)• Measurability is reasonably certain and• Collectibility is reasonably assured

(realized or realizable)• Basic presumptions of Revenue Recognition

• Results from a reciprocal exchange and• The exchange includes an outside party

• Revenue realized when products (goods or services), merchandise, or assets are exchanged for cash (or claim to cash)

Basic Foundational Concepts Basic Foundational Concepts and Constraintsand Constraints

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Revenue Recognition Principle (continued)• Revenue is recognized when the earning process is

substantially complete – normally when the risks and rewards of ownership have passed to the buyer

• Exceptions: 1. Continuous Earning Process(Example: Long-term construction contract; revenue

recognized as it is “earned” over life of contract)2. Collectibility IssuesWhen measurement of revenues is uncertain due to

collectibility issues or type of sale(Example: Instalment sales contracts; revenue recognized only on receipt of cash)

Basic Foundational Concepts Basic Foundational Concepts and Constraintsand Constraints

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Matching• Expenses are matched with revenues that they

produce

• Illustrates a “cause and effect relationship” between money spent to earn revenues and the revenues themselves

• If the expense benefits the current and future periods, it is deferred

• This asset’s cost is then systematically and rationally matched to future revenues (i.e. cost allocated over all accounting periods during which asset is used, e.g. amortization)

Basic Foundational Concepts Basic Foundational Concepts and Constraintsand Constraints

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Basic Foundational Concepts Basic Foundational Concepts and Constraintsand Constraints

Matching (concept in transition)• Current concerns are that matching allows for

certain costs to be deferred on the balance sheet but that these costs do not meet the definition of an asset

• Under the new IASB and FASB conceptual framework, if a cost/expenditure does not meet definition of an asset, it is “expensed” (matching is not followed)

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Full Disclosure Principle• Anything that is relevant to users’ decisions should

be included in financial statements

• Financial statements must report any information that could affect the judgement or decision of an informed user

• Disclosure may be made:

• Within the main body of the financial statements

• As notes to the financial statements

• As supplementary information, including Management Discussion and Analysis (MD&A)

Basic Foundational Concepts Basic Foundational Concepts and Constraintsand Constraints

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Full Disclosure Principle (continued)

• Disclosed information should:

1. Provide sufficient detail of the occurrence

2. Be sufficiently condensed enough to remain understandable

• Full disclosure is not a substitute for proper accounting practice

• Notes to financial statements are essential to understanding the enterprise’s performance and position

Basic Foundational Concepts Basic Foundational Concepts and Constraintsand Constraints

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Management Discussion and Management Discussion and Analysis (MD&A)Analysis (MD&A)

• Management’s explanation of the financial information and the significance of the information

• Publicly traded corporations are now required to include MD&A in their annual reports

• Five key elements that should be included:

1. Company’s vision, core businesses, strategy

2. Key performance drivers

3. Capital and other resources to achieve

4. Historical and prospective results

5. Any risks

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Uncertainty•Recognition becomes difficult (or impossible)

when there is uncertainty• Information reported is less likely to be

uncertain if:• Events reported are likely or probable, and• They are measurable

•Measurement uncertainty:• Difference between the recognized amount

and another reasonably possible amount

Basic Foundational Concepts Basic Foundational Concepts and Constraintsand Constraints

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Cost-Benefit Relationship• The cost of providing information should not

be greater than the benefits that are expected to come from providing the information

• Costs and benefits are not always obvious or measurable

• Some costs include:

1. Collecting and processing information

2. Auditing

3. Disclosure to competitors

Basic Foundational Concepts Basic Foundational Concepts and Constraintsand Constraints

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Basic Foundational Concepts Basic Foundational Concepts and Constraintsand Constraints

MaterialityRelates to an item’s impact on an entity’s overall

financial operationsAn item is material if including it or leaving it out

influences a decision-makerAn item must make a difference, otherwise, it does not

need to be disclosedBoth quantitative and qualitative factors should be

considered in determining relative significanceGeneral rule of thumb: if the item is 5% of income from

continuing operations, it is considered materialDetermination of materiality requires professional

judgement and expertise

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Industry Practice• The nature of some industries may

sometimes require departures from basic accounting theory

• Must be consistent with primary sources of GAAP and conceptual framework

Basic Foundational Concepts Basic Foundational Concepts and Constraintsand Constraints

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Issue IdentificationIssue Identification

All issues fall into one of the following categories:

1. Recognition

2. Measurement

3. Presentation

4. Disclosure

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Choice in Accounting Choice in Accounting Decision-MakingDecision-Making

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