INTERMEDIATE
ACCOUNTING
Seventh Canadian Edition
KIESO, WEYGANDT, WARFIELD, YOUNG, WIECEK
Prepared by:
Gabriela H. Schneider, CMA
Northern Alberta Institute of Technology
CHAPTER
2
Conceptual Framework
Underlying Financial Reporting
Learning Objectives
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
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
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.
Conceptual Framework Underlying
Financial Reporting
Conceptual First Level:
Framework Basic
Rationale Objectives
Development
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
Conceptual Framework
• Users of financial statements need relevant
and reliable information
• To provide such information, the profession
has developed a set of principles and
guidelines
• These principles and guidelines are
collectively called the Conceptual
Framework
• In short, the Framework is like a constitution
for the profession
Objectives of the Conceptual
Framework
• The 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 reporting
• This framework can be illustrated as follows
Conceptual Framework for
Financial Reporting
1st Level: Answers the ‘Why’ Question
Objectives
2nd Level:
Qualitative
The ‘Bridge’
Elements
3rd Level: Answers the ‘How’ Question
Foundation Principles and Conventions
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
• to individuals who reasonably understand
business and economic activities
Conceptual Framework–Qualitative
Characteristics
• Understandability
• Relevance
• Reliability
• Comparability
• Consistency
Conceptual Framework–Qualitative
Characteristics
• Information is Relevant if it:
– has predictive value
– has feedback value
– is timely
• 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:
– allows users to identify
real economic similarities
and differences
• Information is Consistent if:
– similar events have the
same accounting
treatment from period to
period
– when the treatment
changes, full disclosure is
made
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 enterprise
• These elements can be traced to
the Balance Sheet and Income
Statement
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)
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
Conceptual Framework–Foundational
Principles and Conventions
• Explain which, when, and how financial
elements and events should be
recognized, measured, and presented
• These concepts are categorized as:
• basic assumptions
• principles
• constraints
Conceptual Framework–Foundational
Principles and Conventions
Basic
Assumptions
Principles of
Accounting
1. Economic
entity
2. Going
concern
3. Monetary unit
4. Periodicity
1. Historical cost
2. Revenue
recognition
3. Matching
4. Full
disclosure
Constraints
1.
2.
3.
4.
Uncertainty
Cost benefit
Materiality
Industry
Practice
Basic Assumptions
• Economic 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
• Going 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
• 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
– 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
• Periodicity (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 reliability
– Technology, accountability, and investors who
are more aware are driving the demand for
more on-line, real-time financial information
Basic Principles of Accounting
•
Historical 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
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
• Revenue Recognition Principle
– Revenue is recognized when:
• It is performance achieved (earned)
• Measurability is reasonably certain and
• Collectibility reasonably assured (realizability)
– Basic presumptions of Revenue Recognition
• Result from a reciprocal exchange
• Exchange includes an outside party
Basic Principles of Accounting
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
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
• Reliable cost and progress estimates must be
achieved
Basic Principles of Accounting
Revenue Recognition Principle
– Exceptions (continued)
2
3
End of Production: revenue is recognized end of
production and before sale occurs
• Sale and price are certain
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)
Basic Principles of Accounting
• Matching 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
• Full 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 statements
• As notes to those statements
• As supplementary information, including
Management Discussion and Analysis (MD&A)
Basic Principles of Accounting
Full Disclosure Principle (continued)
– Disclosed information should:
• Provide sufficient detail of the occurrence; and at the
same time
• Be sufficiently brief enough to remain understandable
– Full disclosure is not a replacement for wellfounded accounting practice
Management Discussion and
Analysis (MD&A)
•
•
Management’s explanation of the
financial information and its
significance
Publicly traded corporations are now
required to include MD&A in their
annual reports
Management Discussion and
Analysis (MD&A)
• 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
Management Discussion and
Analysis (MD&A)
•
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
Constraints
• Uncertainty
– Recognition becomes difficult (or impossible)
when there is uncertainty
– Information reported is less likely to be
uncertain if:
• Events reported are likely or probably, and
• They are measurable
– Measurement Uncertainty
• Difference between the recognized amount and
another reasonably possible amount
Constraints
• Cost-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
• Materiality
– Refers to an item’s impact on a user’s decision
• An item must make a difference to be material and be
disclosed
• It is a matter of the relative significance of the element
• Both 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
Constraints
• Industry 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
Conceptual Framework Summary
Objectives
-Useful in investment & credit decisions
-Useful in making resource allocation decisions
-Useful in assessing management stewardship
Qualitative
Primary:
-Relevance
-Reliability
Secondary:
-Comparability
-Consistency
Elements
Assets and Liabilities
Equity/Net Assets
Revenues
Expenses
Gains and Losses
Other Comprehensive Income
Foundational Principles and Conventions
Assumptions
Economic entity
Going concern
Monetary unit
Periodicity
Principles
Historical cost
Revenue
recognition
Matching
Full disclosure
Constraints
Uncertainty
Cost-benefit
Materiality
Industry practice
Financial Reporting Choices
•
Factors contributing to reporting choices:
1. Principles-based GAAP, use of professional
judgement
2. Measurement uncertainty
3. Business transaction complexity
Issue Identification
•
•
•
•
Recognition
Measurement
Presentation
Disclosure
Financial Engineering and
Fraudulent Financial Reporting
• Various shades of grey
• Well reasoned and supported analysis
paramount
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