CHAPTER
12
CONCEPTUAL FRAMEWORK
OF ACCOUNTING



Generally accepted accounting principles are a
set of rules and practices that are recognized as a
general guide for financial reporting purposes.
Generally accepted means that these principles
must have substantial authoritative support.
The Canadian Institute of Chartered
Accountants (CICA) is responsible for
developing accounting principles in Canada.
CICA’S CONCEPTUAL
FRAMEWORK

The conceptual framework consists of:
– objective of financial reporting,
– qualitative characteristics of accounting
information,
– elements of financial statements, and
– recognition and measurement criteria
(assumptions, principles, and constraints).
OBJECTIVE OF FINANCIAL
REPORTING

The objective of financial reporting is to
provide information that is useful for
decision-making
QUALITATIVE CHARACTERISTICS
OF ACCOUNTING INFORMATION


The accounting alternative selected should be
one that generates the most useful financial
information for decision making.
To be useful, information should possess the
following qualitative characteristics:
1. understandability
2. relevance
3. reliability
4. comparability and consistency
UNDERSTANDABILITY


Information must be understandable by its
users.
Users are assumed to have a reasonable
comprehension of, and ability to study, the
accounting, business, and economic
concepts needed to understand the
information.
RELEVANCE



Accounting information is relevant if it
makes a difference in a decision.
Relevant information helps users forecast
future events (predictive value),
or
it confirms or corrects prior expectations
(feedback value).
Information must be available
to decision makers before it
loses its capacity to influence
their decisions (timeliness).
RELIABILITY



Reliability of information means that the
information is free of error and bias – it
can be depended on.
To be reliable, accounting information
must be verifiable – there must be proof
that it is free of error and bias.
The information must be a faithful
representation of what it purports to be – it
must be factual.
COMPARABILITY AND
CONSISTENCY


Comparability means that the information
should be comparable with accounting
information about other enterprises.
Consistency means that the same accounting
principles and methods should be used from
year to year within a company.
2000
2001
2003
RECOGNITION AND
MEASUREMENT CRITERIA




Recognition and measurement criteria used by accountants to
solve practical problems include assumptions, principles, and
constraints.
Assumptions provide a foundation for the accounting process.
Principles indicate how economic events should be reported in
the accounting process.
Constraints permit a company to modify generally accepted
accounting principles without reducing the usefulness of the
reported information.
Assumptions
Going concern
Monetary unit
Economic entity
Time period
Principles
Revenue recognition
Matching
Full disclosure
Cost
Constraint
s
Cost - benefit
Materiality
GOING CONCERN
ASSUMPTION
The going concern assumption assumes that the
enterprise will continue to operate in the
foreseeable future.
Implications: capital assets are recorded at cost
instead of liquidation value, amortization is used,
items are labeled as current or non-current.
MONETARY UNIT ASSUMPTION
The monetary unit assumption states that only
transaction data capable of being expressed in
terms of money should be included in the
accounting records of the economic entity.
 Also assumes unit of measure ($) remains
sufficiently stable over time. Ignores inflationary
and deflationary effects.

Should not be
included in
accounting records
Should be included
in accounting records
Customer satisfaction
Percentage of
international employees
Salaries paid
ECONOMIC ENTITY ASSUMPTION
The economic entity assumption states that
economic events can be identified with a
particular unit of accountability.
Example: Harvey’s activities
can be distinguished from
those of other food services
such as Swiss Chalet.
TIME PERIOD ASSUMPTION
The time period assumption states that the
economic life of a business can be divided
into artificial time periods.
Example: months, quarters, and years
2000
QTR 1
QTR 2
QTR 3
QTR 4
2001
JAN
MAY
SEPT
DEC
2003
FEB
MAR APR
JUN JUL
AUG
OCT
NOV
REVENUE RECOGNITION PRINCIPLE

The revenue recognition principle says
that revenue should be recognized in the
accounting period in which it is earned.
–
–
–
–
Production/sales essentially complete
Revenues measurable
Collection reasonably assured
Expenses determinable
REVENUE RECOGNITION

Revenue can be recognized:
1.
2.
3.
4.
At point of sale
During production
At completion of production
Upon collection of cash
REVENUE RECOGNTION
F.O.B.
(WITH TERMS OF SALE)
Destination
Shipping Point
Seller
Seller
Ownership
passes to the
buyer at the…
Public
Carrier
Co.
Buyer
F.O.B.
…so revenue
is recognized
as soon as the
goods leave
your business.
Ownership
does not pass
to the buyer
until the…
…so revenue
is not
recognized
until the goods
are delivered.
Public
Carrier
Co.
Buyer
PERCENTAGE-OF-COMPLETION
METHOD OF REVENUE
RECOGNITION
The percentage-of-completion method
recognizes revenue and income on the
basis of reasonable estimates of the
project’s progress toward completion.
 A project’s progress toward completion
is measured by comparing the costs
incurred in a year to total estimated
costs of the entire project.

ILLUSTRATION 12-4
FORMULA TO RECOGNIZE REVENUE
IN THE
PERCENTAGE-OF-COMPLETION METHOD
Cost Incurred
(Current Period)
Percent Complete
(Current Period)
÷

Total Estimated
Cost
Total Revenue
=
Percent Complete
(Current Period)
=
Revenue
Recognized
(Current Period)
The costs incurred in the current period are then
subtracted from the revenue recognized during the
current period to arrive at the gross profit.
INSTALMENT METHOD OF
REVENUE RECOGNITION



The cash basis is generally used only when it is
difficult to determine the revenue amount at
the time of a credit sale because collection is so
uncertain.
The instalment method, which uses the cash
basis, is a popular approach to revenue
recognition.
Under the instalment method gross profit is
recognized in the period in which the cash is
collected.
ILLUSTRATION 12-8
GROSS PROFIT FORMULAINSTALMENT METHOD
Under the instalment method, each cash collection
from a customer consists of
1. a partial recovery of the cost of goods sold, and
2. a partial gross profit from the sale.
 The formula to recognize gross profit is shown below.

Gross Profit

Sales
Revenue
Gross Profit
Margin

Cash Collections
from Customer
=
=
Gross Profit
Margin
Gross Profit
Recognized
during the period
MATCHING PRINCIPLE


Expense recognition is traditionally tied to
revenue recognition.
This practice – referred to as the matching
principle – dictates that expenses be
matched with revenues in the period in
which efforts are expended to generate
revenues.
MATCHING PRINCIPLE


Expired costs are costs that will generate
revenues only in the current period and are
therefore reported as operating expenses
on the income statement.
Unexpired costs are costs that will generate
revenues in future accounting periods and
are recognized as assets.
MATCHING PRINCIPLE
Unexpired costs become expenses through:
1. Cost of goods sold – Costs carried as
merchandise inventory are expensed as
cost of goods sold in the period when
the sale occurs – so there is a direct
matching of expenses with revenues.
2. Operating expenses – Unexpired costs
become operating expenses through use
or consumption or through the passage
of time.
FULL DISCLOSURE PRINCIPLE



The full disclosure principle requires that
circumstances and events that make a
difference to financial statement users be
disclosed.
Compliance with the full disclosure principle
is accomplished through
1. the data in the financial statements and
2. the notes that accompany the statements.
A summary of significant accounting policies
is usually the first note to the financial
statements.
COST PRINCIPLE


The cost principle dictates that assets are
recorded at their historic cost.
Cost is used because it is both relevant and
reliable.
1. Cost is relevant because it represents the
price paid, the assets sacrificed, or the
commitment made at the date of
acquisition.
2. Cost is reliable because it is objectively
measurable, factual, and verifiable.
CONSTRAINTS IN ACCOUNTING


Constraints permit a company to modify
generally accepted accounting principles without
reducing the usefulness of the reported
information.
The constraints are cost-benefit and materiality.
1. Cost-benefit means that the value of
information should be greater than the cost of
providing it.
2. Materiality relates to an item’s impact on a
firm’s overall financial condition and operations.