5-1 Chapter 2: The Conceptual Framework CHAPTER 2

5-2 Accounting theory provides a logical framework for accounting practice. Structure of Accounting Theory Formal Approach

5-3 Accounting theory provides a logical framework for accounting practice. ASSUMPTIONS Structure of Accounting Theory Formal Approach

5-4 Accounting theory provides a logical framework for accounting practice. ASSUMPTIONS PRINCIPLES Structure of Accounting Theory Formal Approach

5-5 Accounting theory provides a logical framework for accounting practice. ASSUMPTIONS PRINCIPLES RULES Structure of Accounting Theory Formal Approach

5-6 The Conceptual Framework elements l Goals l Assumptions l Principles l Information characteristics 6

5-7 “Objectives of Financial Reporting By Business Enterprises” l Report on enterprise resources, claims against resources and changes in them l Report economic resources, obligations and owners equity l Report enterprise performance and earnings l Evaluate liquidity, solvency, and flow of funds l Explain and interpret financial information 7

5-8 l Each business has an identity separate from its owners. l The business is the accounting entity. u Financial statements report only the activities, resources, and obligations of that business. l Each business has an identity separate from its owners. l The business is the accounting entity. u Financial statements report only the activities, resources, and obligations of that business. Assumptions 1-Business Entity “Idea”

5-92-Going-Concern l In the absence of evidence to the contrary, we assume that a business will continue to exist indefinitely. u For example, a company is more likely to acquire long-term assets if it can assume that the company will continue to exist indefinitely. l It is fundamental to the matching principle. l In the absence of evidence to the contrary, we assume that a business will continue to exist indefinitely. u For example, a company is more likely to acquire long-term assets if it can assume that the company will continue to exist indefinitely. l It is fundamental to the matching principle.

MONEY MEASUREMENT l Business entities measure economic events and transactions in monetary units. u In the United States, the unit of measurement is the dollar. In Jordan the unit of measurement is JD l Business entities measure economic events and transactions in monetary units. u In the United States, the unit of measurement is the dollar. In Jordan the unit of measurement is JD

5-11 l Assumes that the dollar maintains a relatively stable value. u In countries with high inflation, this assumption may not be valid. l Assumes that the dollar maintains a relatively stable value. u In countries with high inflation, this assumption may not be valid. Stable Dollar or Stable Monetary Unit

5-12 l Assumes that the dollar maintains a relatively stable value. u In countries with high inflation, this assumption may not be valid. l Accountants do not adjust the accounts for the changing value of the dollar (i.e., inflation) l Assumes that the dollar maintains a relatively stable value. u In countries with high inflation, this assumption may not be valid. l Accountants do not adjust the accounts for the changing value of the dollar (i.e., inflation) Stable Dollar or Stable Monetary Unit

5-13 l Continuous business activity is divided into arbitrary time periods as exemplified by this time line. l Business activity is best reported in annual, quarterly or monthly periods. l Continuous business activity is divided into arbitrary time periods as exemplified by this time line. l Business activity is best reported in annual, quarterly or monthly periods. 4-Periodicity

5-14 l Substance Over Form The substance of a transaction or economic event is more important than its legal form. Main principles

5-15principles l Substance Over Form The substance of a transaction or economic event is more important than its legal form. e.g., next semester, we will study that even though parent and subsidiary companies are legally separate entities, GAAP says that a set of consolidated financial statements must be prepared as if they were one company, i.e., one economic entity.

5-16 Other Major Principles/Ideas ¶Historical Cost ·Matching ¸Revenue Recognition ¹Expense Recognition ºGain and Loss Recognition »Full Disclosure ¶Historical Cost ·Matching ¸Revenue Recognition ¹Expense Recognition ºGain and Loss Recognition »Full Disclosure

5-17 ¶Historical Cost ·Matching ¸Revenue Recognition ¹Expense Recognition ºGain and Loss Recognition »Full Disclosure ¶Historical Cost ·Matching ¸Revenue Recognition ¹Expense Recognition ºGain and Loss Recognition »Full Disclosure All transactions are recorded at their historical cost at the time of the transaction. Major Principles/Ideas

5-18 ¶ Cost ·Matching ¸Revenue Recognition ¹Expense Recognition ºGain and Loss Recognition »Full Disclosure ¶ Cost ·Matching ¸Revenue Recognition ¹Expense Recognition ºGain and Loss Recognition »Full Disclosure The most important principle. It provides the basis for accrual accounting. Major Principles/Ideas

5-19 ¶Exchange-Price or Historical Cost ·Matching ¸Revenue Recognition ¹Expense Recognition ºGain and Loss Recognition »Full Disclosure ¶Exchange-Price or Historical Cost ·Matching ¸Revenue Recognition ¹Expense Recognition ºGain and Loss Recognition »Full Disclosure Revenues are recorded when they are earned (i.e., realized). When does this happen? When title passes. Revenues are recorded when they are earned (i.e., realized). When does this happen? When title passes. Major Principles/Ideas

5-20 Exceptions to Revenue Recognition Principle  Cash basis of revenue recognition  Installment basis of revenue recognition (Need only know concept, not how to apply)  Percentage-of-completion basis of revenue recognition  Revenue recognition at completion of production (Need only know concept, not how to apply)  Cash basis of revenue recognition  Installment basis of revenue recognition (Need only know concept, not how to apply)  Percentage-of-completion basis of revenue recognition  Revenue recognition at completion of production (Need only know concept, not how to apply)

5-21 ¶Historical Cost ·Matching ¸Revenue Recognition ¹Expense Recognition ºGain and Loss Recognition »Full Disclosure ¶Historical Cost ·Matching ¸Revenue Recognition ¹Expense Recognition ºGain and Loss Recognition »Full Disclosure Expenses should be recorded as they are incurred in the process of earning revenues. Major Principles/Ideas

5-22 ¶Historical Cost ·Matching ¸Revenue Recognition ¹Expense Recognition ºGain and Loss Recognition »Full Disclosure ¶Historical Cost ·Matching ¸Revenue Recognition ¹Expense Recognition ºGain and Loss Recognition »Full Disclosure The rules are different for recognition of gains and losses. Major Principles/Ideas

5-23 Gain and Loss Recognition l Gains are recognized/recorded at the time they are realized. sold For example, an increase in the value of land cannot be recognized as a gain until the land is actually sold. l Gains are recognized/recorded at the time they are realized. sold For example, an increase in the value of land cannot be recognized as a gain until the land is actually sold.

5-24 Gain and Loss Recognition l Gains are recognized/recorded at the time they are realized. sold For example, an increase in the value of land cannot be recognized as a gain until the land is actually sold. l Losses are recognized when they become apparent. For example, a decrease in the value of inventory would be recognized as a loss when it becomes apparent. l Gains are recognized/recorded at the time they are realized. sold For example, an increase in the value of land cannot be recognized as a gain until the land is actually sold. l Losses are recognized when they become apparent. For example, a decrease in the value of inventory would be recognized as a loss when it becomes apparent.

5-25 ·Matching ¸Revenue Recognition ¹Expense Recognition ºGain and Loss Recognition »Full Disclosure ·Matching ¸Revenue Recognition ¹Expense Recognition ºGain and Loss Recognition »Full Disclosure Disclose in the financial statements or related notes, all information important enough to influence a stakeholder. Major Principles/Ideas

5-26 Cost-Benefit Consideration Optional information should be included in the primary financial statements only if the benefits of providing it exceed the costs. For example, providing a listing of every sales transaction may be interesting, but the cost of providing that information to every shareholder might bankrupt the company. Optional information should be included in the primary financial statements only if the benefits of providing it exceed the costs. For example, providing a listing of every sales transaction may be interesting, but the cost of providing that information to every shareholder might bankrupt the company.

5-278-Materiality l An item is material if knowledge of the item would affect the decision of an informed user, therefore, this is a somewhat nebulous concept. l Material items must be reported. l An item can be material either in amount or in nature. Materiality in amount is relative to the size of the amounts on a company’s fin. stmts. (e.g. $50,000,000 may not be material …) l An item is material if knowledge of the item would affect the decision of an informed user, therefore, this is a somewhat nebulous concept. l Material items must be reported. l An item can be material either in amount or in nature. Materiality in amount is relative to the size of the amounts on a company’s fin. stmts. (e.g. $50,000,000 may not be material …)

5-289-Conservatism Transactions should be recorded so that net assets and net income are not overstated. Anticipate losses, but do not anticipate gains. Transactions should be recorded so that net assets and net income are not overstated. Anticipate losses, but do not anticipate gains.

5-29 “Qualitative Characteristics of Accounting Information l Addresses the question: What makes accounting information useful? l Develops a Hierarchy of Accounting Qualities 29

5-30 A Hierarchy of Accounting Qualities Users of Accounting Information Pervasive Constraint User-specific qualities Primary Decision-specific qualities Ingredients of primary qualities Secondary and interactive qualities Threshold for recognition Decision makers and their characteristics (for example, understanding of prior knowledge Benefits > Costs Understandability Decision Usefulness Relevance Reliability Timelines Verifiability Representational faithfulness Predictive value Feedback value Neutrality Comparability (including Consistency Materiality 30

5-31 The Conceptual Framework of the international accounting standards committee ( IASC) The Conceptual Framework of the international accounting standards committee ( IASC) l It Was formed in 1973 to develop worldwide accounting standards it was an independent private – sector body, whose objectives was to achieve uniformity in accounting principle that are used for worldwide financial reporting u The original board members of IASC were the accounting bodies of 9 countries :Australia, Canada, France, Japan, Mexico, Germany Netherlands, United Kingdom, United States Objectives IASC formulate and publish in the public interest accounting standards to be observed in the presentation of financial statements and promote their worldwide acceptance and observance 2-work generally for the improvement and harmonization of regulations, accounting standards and procedures …

5-32 From IASC to IASB IASC Board IASB Board volunteers, constituencies full-time, independent approve IAS approve IFRS Consultative Group Standards Advisory Council Advisory Council Trustees Oversight, funding appoint Board oversight funding

5-33IASC The original board members of IASC were the accounting bodies of 9 countries 1) Australia 2) Canada 3) France 4) Japan 5) Mexico 6) Netherlands 7) United Kingdom 8) United States 9) Germany

5-34 Objectives IASC u formulate and publish in the public interest accounting standards to be observed in the presentation of financial statements and promote their worldwide acceptance and observance u work generally for the improvement and harmonization of regulations, accounting standards and procedures …

5-35 Overview of the Restructured IASB

5-36 Components of the new structure:  International Accounting Standards Board (IASB) – has sole responsibility for establishing International Financial Reporting Standards (IFRSs).  IFRS Foundation (IFRSF) – oversees the work of the IASB, the structure, and strategy, and has fundraising responsibility.  IASCF Monitoring Board – oversees the IFRSF Trustees, participates in the Trustee nomination process, and approves appointments to the Trustees.  IFRS Interpretations Committee (IFRIC) – develops interpretations for approval by the IASB.  IFRS Advisory Council (SAC) – advises the IASB and the IFRSF.  Working Groups – expert task forces for individual agenda projects. *The Trustees announced that these name changes will be implemented as soon as practicable.

5-37 Due process steps. Formal due process for projects normally, but not necessarily, involves the following steps. study national accounting requirements and practice and exchange views about the issues with national standard-setters; consults the Standards Advisory Council about the advisability of adding the topic to the IASB's agenda; form an advisory group (generally called a 'working group') to advise the IASB and its staff on the project; publish for public comment a discussion document; publish for public comment an exposure draft approved by vote of at least nine IASB members, including any dissenting opinions held by IASB members (in exposure drafts, dissenting opinions are referred to as 'alternative views') consider all comments received within the comment period on discussion documents and exposure drafts consider the desirability of holding a public hearing and the desirability of conducting field tests Issue a final IFRS by at least votes of at least nine IASB members and include in the published standard any dissenting opinions;* and publish within a standard a basis for conclusions, explaining, among other things, the steps in the IASB's due process and how the IASB dealt with public comments on the exposure draft. IFRS Due Process IFRSF IASB IFRSC

5-38 Use of IAS/IFRS l IAS as national standards u Croatia, Cyprus, Jordan, Kuwait, Romania, Nepal Serbia, peru u EU from 2005 l IAS as basis for national standards u China, Denmark, Switzerland, l Harmonisation/convergence projects u Australia, USA, Japan, Hong Kong, South Africa, Sweden, UK, Egypt