Transcript Intermediate Accounting, Eighth Canadian Edition

Chapter 2
Conceptual Framework Underlying
Financial Reporting
Prepared by:
Patricia Zima, CA
Mohawk College of Applied Arts and Technology
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 of 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
• This framework can be illustrated as follows:
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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
•
Financial statements provide information about:
•
An entity’s economic resources, obligations, and
equity/net assets
•
Changes in an entity’s economic resources,
obligations and equity/net assets
•
The economic performance of the entity
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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
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Conceptual Framework–Qualitative
Characteristics
The Qualitative Characteristics are as follows:
1. Understandability
2. Relevance
3. Reliability
4. Comparability
5. Consistency
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Conceptual Framework–Qualitative
Characteristics
 Information is relevant if it:
-Has predictive value
-Makes a difference
-Has feedback value
-Is timely
 Information is reliable if it:
• Is verifiable; similar results achieved if use same
measurement methods
• Is a faithful representation of what actually happened
• Reasonably free from bias; it is neutral
 Tradeoffs of qualities:
• Often must make a tradeoff between relevance (timeliness of
financial information) and reliability of financial information
• Needs of the users must be considered
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Conceptual Framework–Qualitative
Characteristics
 Information is understandable if it:
• Allows reasonably informed users to see the
significance of the information
• Provides “enough” information so that it is clear
 Information is comparable if it:
• Allows users to identify real similarities and
differences for different companies
• Has been measured and reported in a similar
manner
 Information is consistent if:
• Similar events have the same accounting
treatment from period to period
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Conceptual Framework–
Basic Elements
• The CICA Handbook defines eight
elements (or definitions) directly
related to the measurement of
performance of financial status of a
company
• The conceptual framework defines
the basic elements that can be
traced to the Balance Sheet and
Income Statement
• Helps users have a common
understanding of financial
statements
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Conceptual Framework–
Basic Elements
Balance Sheet
Assets: probable future economic benefit,
as a result of a past transaction, and entity
controls access to the benefit
Liabilities: probable future sacrifice of
economic benefits, as a result of a past
transaction, and there is little or no
discretion to avoid obligation
Equity/Net Assets: residual interest
i.e. net worth (assets – liabilities)
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Conceptual Framework–
Basic Elements
Income Statement
Revenues: increases in economic resources,
from an entity’s ordinary activities
Expenses: decreases in economic resources,
from an entity’s ordinary revenue-generating
activities
Gains: increases in equity (net assets) from
incidental transactions
Losses: decreases in equity from incidental
transactions
Other comprehensive income
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Conceptual Framework–Foundational
Concepts and Constraints
• Foundational concepts and
constraints help explain which,
when, and how financial elements
and events should be recognized,
measured, and presented
• They act as guidelines for
developing rational responses to
controversial financial reporting
issues
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Conceptual Framework–Foundational
Concepts and Constraints
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
Economic entity
Going concern
Monetary unit
Periodicity
Historical cost
Revenue recognition
Matching
Full disclosure
Uncertainty
Cost-benefit
Materiality
Industry practice
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Basic Foundational Concepts
and Constraints
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
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Basic Foundational Concepts
and Constraints
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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Basic Foundational Concepts
and Constraints
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
• 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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Basic Foundational Concepts
and Constraints
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)
• Trade-off between relevance and reliability
• With technology, investors want more on-line,
real-time financial information to ensure relevant
information
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Basic Foundational Concepts
and Constraints
Historical Cost Principle
•
Three basic assumptions of historical cost
1. Represents a value at a point in time
2. Results from a reciprocal exchange
(i.e. a two-way exchange)
3. Exchange includes an outside party
•
Initial recognition: for non-financial assets, record
at all costs incurred to get the asset “ready” for
sale or for use (e.g. includes transportation and
installation costs)
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Basic Foundational Concepts
and Constraints
Historical Cost Principle (continued)
•
•
Estimate “fair value” for:
1. Non-monetary transactions (as no
cash/monetary consideration exchanged)
2. 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”
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Basic Foundational Concepts
and Constraints
Revenue Recognition Principle
•
•
•
Revenue is recognized when:
1. Performance is achieved (earned)
2. Measurability is reasonably certain and
3. Collectibility is reasonably assured
(realized or realizable)
Basic presumptions of Revenue Recognition
1. Results from a reciprocal exchange and
2. The exchange includes an outside party
Revenue realized when products (goods or services),
merchandise or assets are exchanged for cash (or
claim to cash)
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Basic Foundational Concepts
and Constraints
Revenue Recognition Principle (continued)
•
Revenue is recognized when the earning process is
substantially complete – normally when the risks and
rewards of ownership have passed to the buyer
• Exceptions:
1. Continuous Earning Process
(Example: Long-term construction contract; revenue
recognized as it is “earned” over life of contract)
2. Collectibility Issues
When measurement of revenues is uncertain due to
collectibility issues or type of sale
(Example: Instalment sales contracts; revenue
recognized only on receipt of cash)
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Basic Foundational Concepts
and Constraints
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, it is deferred
• This asset’s cost is then systematically and
rationally matched to future revenues (i.e. cost
allocated over all accounting periods during which
asset is used, e.g. amortization)
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Basic Foundational Concepts
and Constraints
Matching (concept in transition)
• Current concerns that matching allows for
certain costs to be deferred on the balance
sheet but that these costs do not meet the
definition of an asset
• Under the new IASB and FASB conceptual
framework, if a cost/expenditure does not meet
definition of an asset, it is “expensed” (matching
is not followed)
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Basic Foundational Concepts
and Constraints
Full Disclosure Principle
•
•
•
Anything that is relevant to users’ decisions should
be included in financial statements
Financial statements must report any information
that could affect the judgement or decision of an
informed user
Disclosure may be made:
1. Within the main body of the financial statements
2. As notes to the financial statements
3. As supplementary information, including
Management Discussion and Analysis (MD&A)
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Basic Foundational Concepts
and Constraints
Full Disclosure Principle (continued)
•
•
•
Disclosed information should:
1. Provide sufficient detail of the occurrence
2. Be sufficiently condensed enough to remain
understandable
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
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 to achieve
4. Historical and prospective results
5. Any risks
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Basic Foundational Concepts
and 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 probable, and
• They are measurable
• Measurement uncertainty:
• Difference between the recognized amount
and another reasonably possible amount
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Basic Foundational Concepts
and Constraints
Cost-Benefit Relationship
•
•
•
The cost of providing information should not
be greater than the benefits that are expected
to come from providing the information
Costs and benefits are not always obvious or
measurable
Some costs include:
1. Collecting and processing information
2. Auditing
3. Disclosure to competitors
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Basic Foundational Concepts
and Constraints
Materiality
• Relates to an item’s impact on an entity’s overall
financial operations
• An item is material if including it or leaving it out
influences a decision-maker
• An item must make a difference, otherwise, it does
not need to be disclosed
• Both quantitative and qualitative factors should 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
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Basic Foundational Concepts
and Constraints
Industry Practice
• The nature of some industries may
sometimes require departures from basic
accounting theory
• Must be consistent with primary sources of
GAAP and conceptual framework
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Issue Identification
All issues fall into one of the following categories:
1. Recognition
2. Measurement
3. Presentation
4. Disclosure
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Choice in Accounting
Decision-Making
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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
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