Chapter 2

Prepared by:Gabriela H. Schneider, CMA; Grant MacEwan College

INTERMEDIATEINTERMEDIATEACCOUNTINGACCOUNTING

Sixth Canadian Edition

KIESO, WEYGANDT, WARFIELD, IRVINE, SILVESTER, YOUNG, WIECEK

C H A P T E R

22

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.

Conceptual Framework Underlying Financial Reporting

Conceptual Framework

Rationale

Development

First Level: Basic

Objectives

Second Level: Fundamental

Concepts

Qualitative characteristics

Basic Elements

Third Level: Recognition

and Measurement

Basic assumptions

Basic principles

Constraints

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 to be the foundation for building a set of coherent accounting standards and rules

• The Framework is to be 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

Recognition and Measurement Recognition and Measurement ConceptsConcepts

3rd Level: Answers the ‘How’ Question

2nd Level: The ‘Bridge’

QualitativQualitativee

ElementsElements

ObjectivesObjectives

1st Level: Answers the ‘Why’ Question

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

•Primary qualities are Relevance and Reliability of accounting information

•Secondary qualities are comparability and consistency of reported information

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 representationally faithful; it represents (reports) what actually happened

– is neutral; is 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

– if 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 Balance Sheet and Income Statement


Balance SheetAssets: probable future economic benefit

Liabilities: probable future sacrifice of economic benefits

Equity/Net Assets: residual interest (Assets – Liabilities)


Income StatementRevenues: increases in economic resources

Expenses: decreases in economic resources

Gains: increases in equity

Losses: decreases in equity

Conceptual Framework – Recognition and Measurement

Concepts

• Explain which, when, and how financial elements and events should be recognized, measured and reported

• These concepts are categorized as:

•basic assumptions•principles•constraints

BasicAssumptions

1. Economic entity

2. Going concern

3. Monetary unit

4. Periodicity

Principles of Accounting

1. Historical cost

2. Revenue recognition

3. Matching4. Full

disclosure

Constraints

1. Cost Benefit2. Materiality3. Industry

practices4. Conservatis

m

Conceptual Framework – Recognition and Measurement

Concepts

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, and 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 aware investors are driving the demand for more on-line, real-time financial information

Basic Assumptions

Historical Cost Principle– Assets and liabilities are recorded at acquisition

price– Financial information is reliable (a primary

characteristics of information)– Recording transactions at other than historical cost

results in a net income materially affected by opinion

– Users of financial statements may find current fair value information to be useful as well

– 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 earned

and the amount can be objectively determined

– 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



– 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

2 End of Production: revenue is recognized end of production and before sale occurs

Sale and price are certain

3 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)

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


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

• Disclosed information should:– provide sufficient detail of the occurrence; and at the same time– be sufficiently brief enough to remain understandable

• Full disclosure should not be seen as a replacement for well-founded accounting practice


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

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 between 5-10% of net income it is considered material

• Determination of materiality requires professional judgement and expertise

Industry Practices• The nature of some industries may

sometimes require departures from basic accounting theory

• If application of accounting theory results in statements that are not comparable or consistent, then industry practices must examined for possible explanations

Constraints

Conservatism• When in doubt, choose a conservative

solution

• This solution will be least likely to overstate assets and income

• Conservatism does not suggest that net assets or net income be deliberately understated– Simply a mechanism to discourage the

overstatement of net income and net assets

Constraints

Conceptual Framework for Financial Reporting

Recognition and Measurement ConceptsRecognition and Measurement Concepts

QualitativeQualitative ElementsElements

ObjectivesObjectives

AssumptionsAssumptionsEconomic EntityGoing concernMonetary unitPeriodicity

PrinciplesPrinciplesHistorical costRevenue recognitionMatchingFull disclosure

ConstraintsConstraintsCost-benefitMaterialityIndustry PracticeConservatism

AssetsLiabilitiesEquity/Net AssetsRevenuesExpensesGains and Losses

Primary:-Relevance-ReliabilitySecondary:

-Comparability-Consistency

-useful in investment & credit decisions-useful in making resource allocation decisions-useful in assessing management stewardship

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Copyright © 2002 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by CANCOPY (Canadian Reprography Collective) is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his / her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.

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Chapter 2