2. 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

3. 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

4. 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

5. 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

6. Conceptual Framework for Financial Reporting
LO1

7. 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

8. 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

9. 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

10. 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

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

12. 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

13. 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

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

15. 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

16. 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

17. 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

18. 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

19. 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

20. Recognition/Derecognition
Economic Entity Assumption
LO4

21. 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

22. 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

23. 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

24. 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

25. 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

26. 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

27. 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

28. 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

29. 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

30. 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

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

32. 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

33. 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

34. 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

35. Expanded Conceptual Framework

36. 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

37. Choice in Accounting Decision-Making
LO5

38. 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

39. 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

40. 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

41. COPYRIGHT
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