2 After studying this chapter, you should be able to: CONCEPTUAL FRAMEWORK UNDERLYING FINANCIAL REPORTING After studying this chapter, you should be able to: Indicate the usefulness and describe the main components of a conceptual framework for financial reporting Identify the qualitative characteristics of accounting information Define the basic elements of financial statements Describe the foundational principles of accounting Explain the factors that contribute to choices and/or bias in financial reporting decisions Discuss current trends in standard setting for the conceptual framework

Conceptual Framework Underlying Financial Reporting Rationale Development Information asymmetry revisited Objective of Financial Reporting Qualitative characteristics of useful information Elements of financial statements Foundational Principles Recognition / derecognition Measurement Presentation and disclosure Financial Reporting Issues Principles-based approach Financial engineering Fraudulent financial reporting IFRS / ASPE Comparison Looking ahead

Usefulness of a Conceptual Framework The framework is like a constitution; it is a “coherent system of interrelated objectives” Aids in creation of standards for the accounting profession Increases financial statement users’ understanding of and confidence in financial reporting Enhances comparability of financial statements of different companies LO1

Objectives of the Conceptual Framework 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 LO1

Conceptual Framework for Financial Reporting LO1

Objective of Financial Reporting The overall objective of financial reporting is to provide information that is: useful to users (e.g. investors, creditors, etc.), and decision relevant (resource allocation) Resource allocation decisions are assumed to include assessment of management stewardship (i.e. management role in maximizing shareholder value) Conceptual building blocks (second level) include: qualitative characteristics, and elements of financial statements LO1

Fundamental Qualitative Characteristics The Fundamental Qualitative Characteristics are: Relevance Makes a difference in a decision Has predictive and feedback/confirmatory value Includes all material information (i.e. information that makes a difference to the decision-maker) Representational Faithfulness Complete Neutral Free from material error L02

Enhancing Qualitative Characteristics Enhancing Qualitative Characteristics are: Comparability Information measured and reported in similar way (company to company, and year to year) Allows users to identify real economic similarities and differences Verifiability Similar results achieved if same methods are used Timeliness Understandability Allows reasonably informed users to see the significance of the information Provides “enough” information so that it is clear LO2

Trade-offs and Cost/Benefit It is not always possible to have all fundamental and enhancing qualitative characteristics Trade-offs happen when one qualitative characteristics is sacrificed for another Cost versus Benefits Benefits of using the information should outweigh the costs of providing that information LO2

Elements of Financial Statements Basic elements of financial statements include the following: Assets Liabilities Equity Revenues Expenses Gains Losses LO3

Elements of Financial Statements: Assets Assets have three key characteristics: They involve some economic benefit to the entity Entity has a control over that benefit Benefit results from a past transaction or event LO3

Elements of Financial Statements: Liabilities Liabilities have three key characteristics: They represent a present duty or responsibility Entity is obligated and has little or no discretion to avoid the duty or responsibility Obligation results from a past transaction or event LO3

Elements of Financial Statements: Equity Equity (net assets) represents residual interest in assets, after all liabilities are deducted LO3

Elements of Financial Statements Revenues Increases in economic resources resulting from ordinary activities Expenses Decreases in economic resources resulting from ordinary revenue- generating activities Gains Increases in equity (net assets) resulting from incidental transactions Losses Decreases in equity (net assets) resulting from incidental transactions Other comprehensive income Revenues, expenses, gains, and losses that are recognized in comprehensive income, but are not included in net income (e.g. unrealized holding gains and losses on certain securities) LO3

Foundational Principles Foundational concepts and constraints help explain which, when, and how financial elements and events should be recognized/derecognized, measured, and presented/disclosed They act as guidelines for developing rational responses to controversial financial reporting issues LO4

Foundational Principles Recognition / Derecognition 1. Economic entity assumption 2. Control 3. Revenue recognition and realization principle 4. Matching principle Measurement 5. Periodicity assumption 6. Monetary unit assumption 7. Going concern assumption 8. Historical cost principle 9. Fair value principle Presentation and Disclosure 10. Full disclosure principle LO4

Recognition/Derecognition Process of including an item on entity’s balance sheet or income statement Elements of financial statements have historically been recognized when: they meet the definition of an element (e.g. asset) they are probable, and they are reliably measurable Derecognition Process of ‘removing’ something from the balance sheet or income statement LO4

Recognition/Derecognition 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 Legal entity concept is used for tax and legal purposes LO4

Recognition/Derecognition Economic Entity Assumption LO4

Recognition/Derecognition Control Important factor in determining entities to be consolidated and included in the economic entity Some concepts of control include: Under IFRS Having power over investee Exposure, or rights, to variable returns from involvement with investee; and Ability to use power over investee to affect amount of investor’s returns Under ASPE Continuing power to determine strategic decisions without the co- operation of others LO4

Recognition/Derecognition Revenue Recognition Principle Revenue is recognized when: Risks and rewards have passed or the earnings process is substantially complete Revenue is measurable and Revenue is collectible (realized or realizable) Revenues are realized when products (goods or services), merchandise, or assets are exchanged for cash (or claims to cash) Alternative contract-based view also emerging LO4

Recognition/Derecognition Matching Principle 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 future periods and meets the definition of asset, it is recorded as an asset This asset’s cost is then systematically and rationally matched to future revenues LO4

Measurement All elements must be measurable to be recognized Because of accrual accounting, many elements of financial statements require the use of estimates (and include uncertainty) Therefore, we must determine the level of uncertainty that is acceptable for recognition use appropriate measurement tools, and disclose sufficient information to indicate/describe the uncertainty LO4

Measurement 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) With technology, investors want more on-line, real-time financial information to ensure relevant information LO4

Measurement Monetary Unit Assumption 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 LO4

Measurement 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 LO4

Measurement 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 arm’s-length 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) LO4

Measurement Historical Cost Principle (continued) Measurement is especially challenging for : 1. Non-monetary transactions (as no cash/monetary consideration exchanged) 2. Non-monetary, non-reciprocal transactions (e.g. donations) 3. Related party transactions – not acting at “arm’s length” (use exchange value or cost) Applies also to financial instruments (e.g. bonds, notes, accounts payable, and receivable) LO4

Measurement Fair Value Principle Fair value has been defined (under IFRS) as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date” Subsequent to initial recognition, historical cost and fair value often differ Fair value is often considered more relevant for certain assets/liabilities (e.g. financial instruments) IFRS allows the use of fair value measurement in more situations than ASPE LO4

Measurement Fair Value Principle (continued) Fair value (under IFRS) is a market-based measure LO4

Presentation and Disclosure Full Disclosure Principle Anything that is relevant to users’ decisions should be included in financial statements 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) LO4

Presentation and Disclosure Full Disclosure Principle (continued) Disclosed information should: Provide sufficient detail of the occurrence Be sufficiently condensed to remain understandable, and appropriate in terms of costs of preparing/using it Full disclosure is not a substitute for proper accounting practice Notes to financial statements are essential to understanding the enterprise’s performance and position L04

Management Discussion and Analysis (MD&A) Management’s explanation of the financial information and the significance of the information Five key elements that should be included: Company’s vision, core businesses, and strategy Key performance drivers Capital and other resources Historical and prospective results Risks LO4

Expanded Conceptual Framework

Financial Reporting Issues IFRS and ASPE are principles-based Therefore, selecting and interpreting accounting principles and rules relies on application of professional judgment Legally structuring transactions so that they meet the company’s financial reporting objectives (while complying with GAAP) is known as financial engineering When pressures for reaching specific financial reporting objectives are high, risk of fraudulent financial reporting increases

Choice in Accounting Decision-Making LO5

Looking Ahead IASB and FASB are currently working on a joint project to develop a common conceptual framework Proposed conceptual framework redefines major elements such as assets and liabilities LO6

Proposed Definition: Assets Under the proposed framework assets have two key characteristics: They involve a present economic resource Entity has a right or access to those resources where others do not LO6

Elements of Financial Statements: Liabilities Under the proposed framework liabilities have two key characteristics: They represent a present economic obligation Entity is the obligor (obligation is enforceable) LO6

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