INTERMEDIATE ACCOUNTING
TENTH CANADIAN EDITION
Kieso • Weygandt • Warfield • Young • Wiecek • McConomy
CHAPTER 2
Conceptual Framework
Underlying Financial
Reporting
Prepared by:
Dragan Stojanovic, CA
Rotman School of Management,
University of Toronto
CHAPTER 2
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
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Conceptual Framework Underlying
Financial Reporting
Conceptual
Framework
• 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
IFRS / ASPE
Financial
Comparison
Reporting
Issues
• Looking ahead
• Principlesbased approach
•Financial
engineering
•Fraudulent
financial
reporting
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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
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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
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Conceptual Framework for Financial
Reporting
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Objective of Financial Reporting
• 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
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Fundamental Qualitative Characteristics
The Fundamental Qualitative Characteristics are:
1. 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)
2. Representational Faithfulness
– Complete
– Neutral
– Free from material error
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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
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Trade-offs and Cost/Benefit
• 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
• Cost versus Benefits
– Benefits of using the information should outweigh the costs of
providing that information
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Elements of Financial Statements
• Basic elements of financial statements
include the following:
–
–
–
–
–
–
–
Assets
Liabilities
Equity
Revenues
Expenses
Gains
Losses
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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
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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
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Elements of Financial Statements:
Equity
• Equity (net assets) represents residual
interest in assets, after all liabilities are
deducted
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Elements of Financial Statements
• Revenues
– Increases in economic resources resulting from ordinary activities
• Expenses
– Decreases in economic resources resulting from ordinary revenuegenerating 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)
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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
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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
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Presentation and
Disclosure
10. Full disclosure
principle
17
Recognition/Derecognition
•
Recognition
–
–
Process of including an item on entity’s balance
sheet or income statement
Elements of financial statements have historically
been recognized when:
1.
2.
3.
•
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
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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
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Recognition/Derecognition
Economic Entity Assumption
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Recognition/Derecognition
Control
• Important factor in determining entities to be
consolidated and included in the economic entity
• Some concepts of control include:
– Under IFRS
1.
2.
3.
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 cooperation of others
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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
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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
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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
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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, realtime financial information to ensure relevant
information
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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
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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
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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)
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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)
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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
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Measurement
Fair Value Principle (continued)
Fair value (under IFRS) is a market-based
measure
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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)
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Presentation and Disclosure
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
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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:
1.
2.
3.
4.
5.
Company’s vision, core businesses, and strategy
Key performance drivers
Capital and other resources
Historical and prospective results
Risks
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Expanded Conceptual Framework
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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
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Choice in Accounting
Decision-Making
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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
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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
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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)
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