1. Prepared by: Dragan Stojanovic, CA Rotman School of Management, University of Toronto Chapter 2 Conceptual Framework Underlying Financial Reporting

2. 2 Conceptual Framework Underlying Financial Reporting Conceptual Framework Rationale Development 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 / Private GAAP Comparison Looking ahead

3. 3 Conceptual Framework Underlying Financial Reporting Conceptual Framework Rationale Development 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 / Private GAAP Comparison Looking ahead

4. 4 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 in financial reporting Enhances comparability of financial statements of different companies

5. 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

6. 6 Conceptual Framework for Financial Reporting

7. 7 Conceptual Framework Underlying Financial Reporting Conceptual Framework Rationale Development 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 / Private GAAP Comparison Looking ahead

8. 8 The overall objective of financial reporting is to provide information that is: 1.useful to users (e.g. Investors, creditors, etc), and 2.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 Objective of Financial Reporting

9. Fundamental Qualitative Characteristics The Fundamental Qualitative Characteristics are: 1.Relevance –Makes a difference in a decision –Has predictive and feedback/confirmatory value 2.Representational Faithfulness –Complete –Neutral –Reasonably free from error or bias 9

10. Enhancing Qualitative Characteristics Enhancing Qualitative Characteristics are: 1.Comparability –Information measured and reported in similar way (company to company, and year to year) –Allows users to identify real economic similarities and differences 2.Verifiability –Similar results achieved if same methods are used 3.Timeliness 4.Understandability –Allows reasonably informed users to see the significance of the information –Provides “enough” information so that it is clear 10

11. 11 Trade-Offs –It is not always possible to have all fundamental and enhancing qualitative characteristics –Trade-offs happen when one qualitative characteristics is sacrificed for another Constraints –Materiality If leaving or including information would influence/change the judgement of a reasonable person, then that information is considered material Quantitative guidelines for materiality are usually made based on income from continuing operations, assets and liabilities, or revenues –Cost versus Benefits Benefits of using the information should outweigh the costs of providing that information Tradeoffs and Constraints

12. 12 Basic elements of financial statements include the following: –Assets –Liabilities –Equity –Revenues –Expenses –Gains –Losses Elements of Financial Statements

13. 13 Assets have two key characteristics: –They involve a present economic resource –Entity has a right or access to those resources where others do not Elements of Financial Statements: Assets

14. 14 Liabilities have two key characteristics: –They represent an economic obligation or burden –Entity has a present obligation Elements of Financial Statements: Liabilities

15. 15 Equity (net assets) represents residual interest in assets, after all liabilities are deducted Elements of Financial Statements: Equity

16. Elements of Financial Statements Revenues –Increases in economic resources resulting from ordinary activities Expenses –Decreases in economic resources resulting from ordinary 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) 16

17. 17 Conceptual Framework Underlying Financial Reporting Conceptual Framework Rationale Development 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 / Private GAAP Comparison Looking ahead

18. 18 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

19. 19 Foundational Principles Recognition / Derecognition 1. Economic entity 2. Control 3. Revenue recognition and realization 4. Matching Measurement 5. Periodicity 6. Monetary unit 7. Going concern 8. Historical cost 9. Fair value Presentation and Disclosure 10. Full disclosure

20. 20 Recognition –Process of including an item on entity’s balance sheet or income statement –Elements of financial statements have historically been recognized when: 1.they meet the definition of an element (e.g. asset) 2.they are probable, and 3.they are reliably measurable Derecognition –Process of ‘removing’ something from the balance sheet or income statement Recognition/Derecognition

21. 21 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 Recognition/Derecognition

22. 22 Economic Entity Assumption Recognition/Derecognition

23. 23 Control Important factor in determining entities to be consolidated and included in the economic entity Some concepts of control include: –Having power to direct entity’s activities –Not sharing this power –Power doesn’t need to be absolute, or even exercised –Access to benefits Recognition/Derecognition

24. 24 Revenue Recognition Principle Revenue is recognized when: Risks and rewards have passed or the earnings process is substantially complete Measurability is reasonably certain and Collectibility is reasonably assured (realized or realizable) Revenue realized when products (goods or services), merchandise, or assets are exchanged for cash (or claim to cash) Alternative contract-based view also emerging Recognition/Derecognition

25. 25 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 (and meets the definition of asset), it is deferred This asset’s cost is then systematically and rationally matched to future revenues There is a decreasing emphasis on matching in emerging accounting standards Recognition/Derecognition

26. 26 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 Measurement

27. 27 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

28. 28 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 Measurement

29. 29 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 Measurement

30. 30 Historical Cost Principle Three basic assumptions of historical cost Represents a value at a point in time (generally fair value at transaction date) 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) Measurement

31. 31 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) Bonds, notes, accounts payable, and receivable recorded at “agreed upon exchange price or economic value” Measurement

32. 32 Fair Value Principle Fair value has been defined 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 private entity GAAP Measurement

33. 33 Fair Value Principle (continued) Fair value is a market-based measure Measurement

34. 34 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) Presentation and Disclosure

35. 35 Full Disclosure Principle (continued) Disclosed information should: 1.Provide sufficient detail of the occurrence 2.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 Presentation and Disclosure

36. 36 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 4.Historical and prospective results 5.Any risks

37. 37 Expanded Conceptual Framework

38. 38 Conceptual Framework Underlying Financial Reporting Conceptual Framework Rationale Development 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 / Private GAAP Comparison Looking ahead

39. 39 Financial Reporting Issues Canadian GAAP is 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

40. 40 Choice in Accounting Decision-Making

41. 41 Conceptual Framework Underlying Financial Reporting Conceptual Framework Rationale Development 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 / Private GAAP Comparison Looking ahead

42. 42 Looking Ahead IASB and FASB are currently working on a joint project to develop a common conceptual framework

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