1. Prepared by: Gabriela H. Schneider, CMA Northern Alberta Institute of Technology INTERMEDIATE ACCOUNTING Seventh Canadian Edition KIESO, WEYGANDT, WARFIELD, YOUNG, WIECEK

2. C H A P T E R 2 Conceptual Framework Underlying Financial Reporting

3. 1. Describe the usefulness of a conceptual framework. 2. Describe the main components of the conceptual framework for financial reporting. 3. Understand the objective of financial reporting. 4. Identify the qualitative characteristics of accounting information. Learning Objectives

4. 5. Define the basic elements of financial statements. 6. Describe the basic assumptions of accounting. 7. Explain the application of the basic principles of accounting. 8. Describe the impact that constraints have on reporting accounting information. Learning Objectives

5. 9. Explain the factors that contribute to choice in financial reporting decisions. 10. Identify the four types of financial reporting issues and what makes certain issues more important than others. 11. Explain the practice of financial engineering. 12. Identify factors that contribute to fraudulent financial reporting.

6. Conceptual Framework Underlying Financial Reporting Conceptual Framework RationaleDevelopment First Level: Basic Objectives Second Level: Fundamental Concepts Qualitative characteristics Basic elements Third Level: Foundational Principles and Conventions Basic assumptions Basic principles Constraints Financial Reporting Issues Making Accounting Choices Issue Identification Financial Engineering Fraudulent Financial Reporting

7. Conceptual Framework Users of financial statements need relevant and reliable informationUsers of financial statements need relevant and reliable information To provide such information, the profession has developed a set of principles and guidelinesTo provide such information, the profession has developed a set of principles and guidelines These principles and guidelines are collectively called the Conceptual FrameworkThese principles and guidelines are collectively called the Conceptual Framework In short, the Framework is like a constitution for the professionIn short, the Framework is like a constitution for the profession

8. Objectives of the Conceptual Framework The Framework is the foundation for building a set of coherent accounting standards and rulesThe Framework is the foundation for building a set of coherent accounting standards and rules The Framework is a reference of basic accounting theory for solving emerging practical problems of reportingThe Framework is a reference of basic accounting theory for solving emerging practical problems of reporting This framework can be illustrated as followsThis framework can be illustrated as follows

9. Conceptual Framework for Financial Reporting Foundation Principles and Conventions 3 rd Level: Answers the ‘How’ Question Elements Qualitative Objectives Objectives 2 nd Level: The ‘Bridge 2 nd Level: The ‘Bridge’ 1 st Level: Answers the ‘Why’ Question

10. Conceptual Framework–Objectives To provide information : useful to those making investment and credit decisionsuseful to those making investment and credit decisions useful in making resource allocation decisionsuseful in making resource allocation decisions useful in assessing management stewardshipuseful in assessing management stewardship to individuals who reasonably understand business and economic activitiesto individuals who reasonably understand business and economic activities

11. Conceptual Framework–Qualitative Characteristics UnderstandabilityUnderstandability RelevanceRelevance ReliabilityReliability ComparabilityComparability ConsistencyConsistency

12. Conceptual Framework–Qualitative Characteristics Information is Relevant if it:Information is Relevant if it: –has predictive value –has feedback value –is timely Information is Reliable if it:Information is Reliable if it: –is verifiable; independent users can arrive at the same conclusion –is a faithful representation of what actually happened –is neutral; free from bias Information is Comparable if it:Information is Comparable if it: –allows users to identify real economic similarities and differences Information is Consistent if:Information is Consistent if: –similar events have the same accounting treatment from period to period –when the treatment changes, full disclosure is made

13. Conceptual Framework– Basic Elements Section 1000 of the CICA Handbook defines seven elements directly related to the measurement of performance of financial status of an enterpriseSection 1000 of the CICA Handbook defines seven elements directly related to the measurement of performance of financial status of an enterprise These elements can be traced to the Balance Sheet and Income StatementThese elements can be traced to the Balance Sheet and Income Statement

14. Conceptual Framework– Basic Elements Balance Sheet Assets: probable future economic benefit Liabilities: probable future sacrifice of economic benefits Equity/Net Assets: residual interest (Assets – Liabilities)

15. Conceptual Framework– Basic Elements Income Statement Revenues: increases in economic resources Expenses: decreases in economic resources Gains: increases in equity Losses: decreases in equity Other comprehensive income

16. Conceptual Framework–Foundational Principles and Conventions Explain which, when, and how financial elements and events should be recognized, measured, and presentedExplain which, when, and how financial elements and events should be recognized, measured, and presented These concepts are categorized as:These concepts are categorized as: basic assumptionsbasic assumptions principlesprinciples constraintsconstraints

17. BasicAssumptions 1.Economic entity 2.Going concern 3.Monetary unit 4.Periodicity Principles of Accounting Accounting 1.Historical cost 2.Revenue recognition 3.Matching 4.Full disclosure Constraints 1.Uncertainty 2.Cost benefit 3.Materiality 4.Industry Practice Conceptual Framework–Foundational Principles and Conventions

18. Economic Entity AssumptionEconomic 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 Basic Assumptions

19. Going Concern AssumptionGoing 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 Basic Assumptions

20. Monetary UnitMonetary 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 –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 Basic Assumptions

21. Periodicity (Time Period) AssumptionPeriodicity (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 reliabilityTrade-off between relevance and reliability –Technology, accountability, and investors who are more aware are driving the demand for more on-line, real-time financial information

22. Historical Cost PrincipleHistorical Cost Principle –Three basic presumptions of historical cost 1.Represents a value at a point in time 2.Results from a reciprocal exchange 3.Exchange includes an outside party –Assets and liabilities are recorded at acquisition price –Financial information is reliable Basic Principles of Accounting

23. Historical Cost Principle (continued) –Recording transactions at other than historical cost results in a net income materially affected by opinion –A “mixed attribute” system reports historical cost, fair value, and lower of cost or market values Basic Principles of Accounting

24. Revenue Recognition PrincipleRevenue Recognition Principle –Revenue is recognized when: It is performance achieved (earned)It is performance achieved (earned) Measurability is reasonably certain andMeasurability is reasonably certain and Collectibility reasonably assured (realizability )Collectibility reasonably assured (realizability ) –Basic presumptions of Revenue Recognition Result from a reciprocal exchangeResult from a reciprocal exchange Exchange includes an outside partyExchange includes an outside party Basic Principles of Accounting

25. Revenue Recognition Principle (continued) –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

26. Revenue Recognition Principle (continued) –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 Considered as a continuous earnings process Reliable cost and progress estimates must be achieved Reliable cost and progress estimates must be achieved Basic Principles of Accounting

27. Revenue Recognition Principle –Exceptions (continued) 2 End of Production: revenue is recognized end of production and before sale occurs Sale and price are certain 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) An example - instalment sales contracts (revenue is recognized only on receipt of cash) Basic Principles of Accounting

28. Matching PrincipleMatching 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 Basic Principles of Accounting

29. Full Disclosure PrincipleFull 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 statementsWithin the main body of the financial statements As notes to those statementsAs notes to those statements As supplementary information, including Management Discussion and Analysis (MD&A)As supplementary information, including Management Discussion and Analysis (MD&A) Basic Principles of Accounting

30. Full Disclosure Principle (continued) –Disclosed information should: Provide sufficient detail of the occurrence; and at the same timeProvide sufficient detail of the occurrence; and at the same time Be sufficiently brief enough to remain understandableBe sufficiently brief enough to remain understandable –Full disclosure is not a replacement for well- founded accounting practice Basic Principles of Accounting

31. Management Discussion and Analysis (MD&A) Management’s explanation of the financial information and its significanceManagement’s explanation of the financial information and its significance Publicly traded corporations are now required to include MD&A in their annual reportsPublicly traded corporations are now required to include MD&A in their annual reports

32. Management Discussion and Analysis (MD&A) Six general principles (CICA MD&A Guidance on Preparation and Disclosure)Six general principles (CICA MD&A Guidance on Preparation and Disclosure) 1.Allows readers to view company through management eyes 2.Complement and supplement financial statements 3.Be reliable, complete, fair, and balanced 4.Have a forward-looking perspective 5.Focus on management’s strategy for increasing investor value 6.Be written in plain language

33. Management Discussion and Analysis (MD&A) Five key elements to be included (CICA MD&A Guidance on Preparation and Disclosure)Five key elements to be included (CICA MD&A Guidance on Preparation and Disclosure) 1.Company’s vision, core businesses, and strategy 2.Key performance indicators 3.Resources (capabilities) to reach targets 4.Results 5.Outline of risks

34. UncertaintyUncertainty –Recognition becomes difficult (or impossible) when there is uncertainty –Information reported is less likely to be uncertain if: Events reported are likely or probably, andEvents reported are likely or probably, and They are measurableThey are measurable –Measurement Uncertainty Difference between the recognized amount and another reasonably possible amountDifference between the recognized amount and another reasonably possible amount Constraints

35. Cost-Benefit RelationshipCost-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 Constraints

36. Constraints MaterialityMateriality –Refers to an item’s impact on a user’s decision An item must make a difference to be material and be disclosedAn item must make a difference to be material and be disclosed It is a matter of the relative significance of the elementIt is a matter of the relative significance of the element Both quantitative and qualitative factors are to be considered in determining relative significanceBoth quantitative and qualitative factors are to 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

37. Industry PracticesIndustry Practices –The nature of some industries may sometimes require departures from basic accounting theory –Must be consistent with primary sources of GAAP and conceptual framework Constraints

38. Conceptual Framework Summary Objectives -Useful in investment & credit decisions -Useful in making resource allocation decisions -Useful in assessing management stewardship Elements Assets and Liabilities Equity/Net Assets Revenues Expenses Gains and Losses Other Comprehensive IncomeQualitative Primary: -Relevance -Reliability Secondary: -Comparability -Consistency Foundational Principles and Conventions Assumptions Economic entity Going concern Monetary unit PeriodicityPrinciples Historical cost Revenue recognition Matching Full disclosure Constraints Uncertainty Cost-benefit Materiality Industry practice

39. Financial Reporting Choices Factors contributing to reporting choices:Factors contributing to reporting choices: 1.Principles-based GAAP, use of professional judgement 2.Measurement uncertainty 3.Business transaction complexity

40. Issue Identification RecognitionRecognition MeasurementMeasurement PresentationPresentation DisclosureDisclosure

41. Financial Engineering and Fraudulent Financial Reporting Various shades of greyVarious shades of grey Well reasoned and supported analysis paramountWell reasoned and supported analysis paramount

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