Conceptual Framework for Financial Reporting -Chapter 2 Intermediate Accounting, by Keiso-Warfield-Weygandt

C ONCEPTUAL F RAMEWORK U NDERLYING F INANCIAL R EPORTING Conceptual Framework -Rationale -Development First Level: -Basic Objectives Second Level: Fundamental Concepts -Qualitative characteristics -Basic Elements Third Level: Recognition and Measurement -Basic assumptions -Basic principles -Constraints

C ONCEPTUAL F RAMEWORK Users of financial statements need relevant and reliable information To provide such information, the profession has developed a set of principles and guidelines These principles and guidelines are collectively called the Conceptual Framework In short, the Framework is like a constitution for the profession

O BJECTIVES OF THE C ONCEPTUAL F RAMEWORK The Framework is to be the foundation for building a set of coherent accounting standards and rules The Framework is to be a reference of basic accounting theory for solving emerging practical problems of reporting. This framework can be illustrated as follows: (PTO>>)

C ONCEPTUAL F RAMEWORK FOR F INANCIAL R EPORTING Recognition and Measurement Concepts 3rd Level: Answers the question-‘How?’ 2 nd Level: The ‘Bridge’ QualitativeElements Objectives 1 st Level: Answers the question- ‘Why?’

C ONCEPTUAL F RAMEWORK – O BJECTIVES To provide information : useful to those making investment and credit decisions useful in making resource allocation decisions useful in assessing management stewardship to individuals who reasonably understand business and economic activities.

C ONCEPTUAL F RAMEWORK – Q UALITATIVE C HARACTERISTICS Primary qualities are Relevance and Reliability of accounting information Secondary qualities are comparability and consistency of reported information

C ONCEPTUAL F RAMEWORK – Q UALITATIVE C HARACTERISTICS Information is relevant if it: has predictive value has feedback value is timely Information is reliable if it: is verifiable; independent users can arrive at the same conclusion is representationally faithful; it represents (reports) what actually happened is neutral; is free from bias Information is comparable if it: allows users to identify real economic similarities and differences Information is consistent if: similar events have the same accounting treatment from period to period if the treatment changes, full disclosure is made

C ONCEPTUAL F RAMEWORK – B ASIC E LEMENTS Seven elements directly related to the measurement of performance of financial status of an enterprise AssetsRevenues Liability Expenses Owners’ Equity Gain Loss

C ONCEPTUAL F RAMEWORK – R ECOGNITION AND M EASUREMENT C ONCEPTS Explain which, when, and how financial elements and events s hould be recognized, measured and reported These concepts are categorized as: basic assumptions principles constraints

Basic Assumptions 1.Economic entity 2.Going concern 3.Monetary unit 4.Periodicity Principles of Accounting 1.Historical cost 2.Revenue recognition 3.Matching 4.Full disclosure Constraints 1.Cost Benefit 2.Materiality 3.Industry practices 4.Conservatism C ONCEPTUAL F RAMEWORK – R ECOGNITION AND M EASUREMENT C ONCEPTS

B ASIC A SSUMPTIONS Economic Entity Assumption The economic entity can be identified with a particular unit of accountability The business activity is separate and distinct from its owners The entity’s assets and other financial elements are not commingled with those of the owners The economic entity assumption is an accounting concept, and not a legal construct Departments or divisions of an entity may be considered separate entities

B ASIC A SSUMPTIONS Going Concern Assumption The business is assumed to continue indefinitely unless terminated by owners Expectation of continuing long enough to meet their objectives and commitments The basis of recording financial elements is historical accounting If liquidation of the enterprise is assumed to occur, then liquidation accounting is more appropriate Liquidation accounting (net realizable value) is not followed unless liquidation of the enterprise appears imminent

B ASIC A SSUMPTIONS Monetary Unit Money is the common unit of measure of economic transactions Use of a monetary unit is relevant, and simple and understandable, universally available, and useful The dollar is assumed to remain relatively stable in value (effects of inflation/deflation are ignored Monetary unit is relevant only as long as it is assumed that quantitative data is the driving force behind users decision making

B ASIC A SSUMPTIONS Periodicity (Time Period) Assumption Economic activity of an entity may be artificially divided into time periods for reporting purposes Shorter time periods are subject to errors but may be more timely Trade-off between relevance and reliability Technology, accountability and aware investors are driving the demand for more on-line, real-time financial information

B ASIC P RINCIPLES OF A CCOUNTING Historical Cost Principle Assets and liabilities are recorded at acquisition price Financial information is reliable (a primary characteristics of information) Recording transactions at other than historical cost results in a net income materially affected by opinion Users of financial statements may find current fair value information to be useful as well

B ASIC P RINCIPLES OF A CCOUNTING Revenue Recognition Principle Revenue is recognized when it is earned and the amount can be objectively determined Revenue is recognized at the date of sale (objective test) Date of sale provides an objective and verifiable measure of revenue Applicable with a discrete earnings process and one critical event

Basic Principles of Accounting –There are exceptions; revenue may be recognized: 1 During Production: revenue is recognized prior to contract completion in certain long-term construction contracts  Considered as a continuous earnings process  Reliable cost and progress estimates must be achieved 2 End of Production: revenue is recognized end of production and before sale occurs  Sale and price are certain 3 Receipt of cash: when sales figure cannot be established due to collection uncertainty  An example - instalment sales contracts (revenue is recognized only on receipt of cash)

B ASIC P RINCIPLES OF A CCOUNTING Matching Principle Expenses in one period are matched to revenues recognized in the same period There should be a logical, rational association of revenues and expenses If the expense benefits the current and future periods, it is recorded as an asset This asset cost is then systematically and rationally matched to future revenues

B ASIC P RINCIPLES OF A CCOUNTING Full Disclosure Principle Financial statements must report any information that could reasonably be seen to affect the judgement or decision of an informed user Disclosure may be made: within the main body of the financial statements as notes to those statements as supplementary information Disclosed information should: provide sufficient detail of the occurrence; and at the same time be sufficiently brief enough to remain understandable

Cost-Benefit Relationship –The cost of providing information should not outweigh the benefit derived –Costs and benefits are not always obvious or quantifiable –Sound judgement must be used in providing information C ONSTRAINTS

Materiality Refers to an item’s impact on a user’s decision –An item must make a difference to be material and be disclosed –It is a matter of the relative significance of the element –Both quantitative and qualitative factors are to be considered in determining relative significance Determination of materiality requires professional judgment and expertise

C ONSTRAINTS Industry Practices The nature of some industries may sometimes require departures from basic accounting theory If application of accounting theory results in statements that are not comparable or consistent, then industry practices must examined for possible explanations

C ONSTRAINTS Conservatism When in doubt, choose a conservative solution This solution will be least likely to overstate assets and income Conservatism does not suggest that net assets or net income be deliberately understated Simply a mechanism to discourage the overstatement of net income and net assets

C ONCEPTUAL F RAMEWORK FOR F INANCIAL R EPORTING Recognition and Measurement Concepts QualitativeElements Objectives Assumptions Economic Entity Going concern Monetary unit Periodicity Principles Historical cost Revenue recognition Matching Full disclosure Constraints Cost-benefit Materiality Industry Practice Conservatism Assets Liabilities Equity/Net Assets Revenues Expenses Gains and Losses Primary: -Relevance -Reliability Secondary: -Comparability -Consistency -useful in investment & credit decisions -useful in making resource allocation decisions -useful in assessing management stewardship