Prepared by: Patricia Zima, CA Mohawk College of Applied Arts and Technology Chapter 2 Conceptual Framework Underlying Financial Reporting

2 Conceptual Framework Underlying Financial Reporting Conceptual Framework Rationale Rationale Development Development First Level: Basic Objectives Second Level: Fundamental Concepts Qualitative characteristics Qualitative characteristics Basic elements Basic elements Third Level: Foundational Concepts and Conventions Economic entity Economic entity Going concern Going concern Monetary unit Monetary unit Periodicity Periodicity Historical cost Historical cost Revenue recognition Revenue recognition Matching Matching Full disclosure Full disclosure Uncertainty Uncertainty Cost-benefit Cost-benefit Materiality Materiality Industry practice Industry practice Financial Reporting Issues Accounting ChoicesAccounting Choices Issue Identification Issue Identification Financial Engineering Financial Engineering Fraudulent Financial ReportingFraudulent Financial Reporting InternationalInternational

3 Usefulness of a Conceptual Framework 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

4 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 This framework can be illustrated as follows:

5 Conceptual Framework for Financial Reporting

6 Conceptual Framework – Objectives 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

7 Conceptual Framework–Qualitative Characteristics The Qualitative Characteristics are as follows: 1. Understandability 2. Relevance 3. Reliability 4. Comparability 5. Consistency

8 Conceptual Framework – Qualitative 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

9 Conceptual Framework – Qualitative 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

10 Conceptual Framework – Basic 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

11 Conceptual Framework – Basic 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)

12 Conceptual Framework – Basic 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

13 Conceptual Framework – Foundational Concepts and Constraints 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

14 Conceptual Framework – Foundational Concepts and Constraints Economic entity Going concern Monetary unit Periodicity Historical cost Revenue recognition Matching Full disclosure Uncertainty Cost-benefit Materiality Industry practice

15 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 and Constraints

16 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 and Constraints

17 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 and Constraints

18 Basic Foundational Concepts and 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

19 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 and Constraints

20 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 and Constraints

21 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 and Constraints

22 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 Issues When 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 and Constraints

23 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 and Constraints

24 Basic Foundational Concepts and 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)

25 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 and Constraints

26 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 and Constraints

27 Management Discussion and 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

28 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 and Constraints

29 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 and Constraints

30 Basic Foundational Concepts and Constraints Materiality Relates to an item’s impact on an entity’s overall financial operations An item is material if including it or leaving it out influences a decision-maker An item must make a difference, otherwise, it does not need to be disclosed Both quantitative and qualitative factors should be considered in determining relative significance General rule of thumb: if the item is 5% of income from continuing operations, it is considered material Determination of materiality requires professional judgement and expertise

31 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 and Constraints

32 Issue Identification All issues fall into one of the following categories: 1.Recognition 2.Measurement 3.Presentation 4.Disclosure

33 Choice in Accounting Decision-Making

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