1 Chapter 2 â Conceptual framework CONCEPTUAL FRAMEWORK ...
Chapter 2 – Conceptual framework CONCEPTUAL FRAMEWORK
Conceptual framework: A coherent system of interrelated objectives and fundamentals that can lead to consistent standards and that prescribes the nature, function, and limits of financial accounting and financial statements Rationale for conceptual framework o Standard setting should build on an established body of concepts and objectives. Resulting in a coherent set of standards and rules. Such framework should increase financial statement users understanding of and confidence in financial reporting (as well of comparability of different companies) o Should be possible to solve new and emerging practical problems more quickly Doing so by using good judgment and with the help of a universally accepted conceptual framework. Development of the conceptual framework
OBJECTIVE OF FINANCIAL REPORTING
Qualitative characteristics of useful information o Determining which alternative gives the most useful information for decision making purposes (decision usefulness) o Fundamental qualitative characteristics Relevance capability of making a difference in a decision
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It needs predictive value: information that helps users make predictions about the final outcome of past/present/future events Feedback value: information that helps users confirm or correct their previous expectations Representational faithfulness: information that reflects the underlying economic substance of an event or transaction (transparency) Information that is complete, neutral and free from material error or bias Enhancing qualitative characteristics o Comparability: information that enables users to identify the real similarities and differences in economic phenomena. o Verifiability: where knowledgeable, independent users achieve similar results or reach consensus regarding the accounting for a particular transaction o Timeliness: information must be available to decision makers before it loses its ability to influence their decision o Understandability: Users need to have reasonable knowledge of business financial accounting in order to understand the information in financial statements Financial information must be of sufficient quality and clarity that it allows reasonably informed users to see its significance Users have the responsibility to review and analyze the information with reasonable diligence Tradeoffs it is not always possible for financial information to have all the enhancing qualities of useful information Contraints things to consider o Materiality: An items impact on a firm’s overall financial operations. Information that would influence or change the jusgement of a reasonable person. Rule of thumb: any item representing 5% or more of income from continuing operations after tax is considered material Both qualitative and quantitative factors must be considered in determining whether an item is material o Cost versus Benefit: the costs of providing the information must be weighed against the benefits that can be had from using the information Elements of financial statements o Assets: Something that involve present economic resources that the entity has a right or access to where others do not o Liabilities: represent and economic burden/obligation that is enforceable Contructive obligations: obligations that arise though past or present practice that signals that the company acklowledges a potential economic burden (I stand by my product) Performance obligations: where an entity agrees to provide a future service or delivery o Equity: residual interest in the assets of an entity that remains after deducting liabilities
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o o o
o
Revenues: increases in economic resources, either by inflows or other enhancements of an entity’s assets or by settlement of its liabilities Expenses: decreases in economic resources, either by outflows or reductions of assets or by incurrence of liabilities from an entity’s ordinary revenue generating activities Gains/Losses Gains: increase in equity from an enitty’s peripheral or incidental transactions Losses: decreases in equity from an entity’s peripheral or incidental transactions Comprehensive income: It includes net income and all other changes in equity except for owners investments and distributions Unrealized holding gains and losses on certain securities…
FOUNDATIONAL PRINCIPLES
Help explain which, when, and how financial elements and events should be recognized, measures and presented/disclosed by accounting systems Recognition/derecognition must meet the definition of an element on financial statements as well as be probable and measurable o Economic entity assumption: allows us to identify an economic activity with a particular unit of accountability The activities of the entity are to be kept separate from the activities of its owner and all other economic entities o Control: there is power to the entity’s activities; only one entity has the power to direct the activities; power need not be exercised or absolute; the reporting entity should have access to the benefits from the entity o Revenue recognition and realization when is revenue recognized Passing of risks and rewards or the earnings process is substantially complete Measurability is reasonably certain Collectability is reasonably assured Revenues are realizable when they(assets) can be readily converted into cash o Matching: dictating that effort be matched with accomplishment whenever it is reasonable and can be done. Illustrating the cause and effect relationship between the money spent to earn revenues and the revenues themselves Product costs: costs attached to the product (labour, material and overhead) that are carried into future periods of inventory until sold Period costs: costs that are recognized immediately. (administration costs…) Measurement determine an acceptable level of uncertainty, use measurement tools that help deal with the uncertainty, and disclose enough information to signal the uncertainty o Periodicity assumption: implies that an enterprises economic activities can be divided into artificial time periods (one month, one quarter, one year) Shorter time periods = more difficulty in determining the proper net income (more assumptions to be made)
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o
Monetary unit assumption: money is the common denominator of economic activity and is an appropriate basis for accounting measurement and analysis o Going concern assumption: a business enterprise will continue to operate for the foreseeable future. Long enough to fulfill their objectives and commitment o Historical cost principle: represents a value at a point in time; results from a reciprocal exchange; the exchange includes and outside party o Fair value principle: 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 Market based measure (selling price) Presentation and disclosure o Full disclosure principle: anything that is relevant to decisions should be included in the financial statements Information that is detailed enough to disclose matters that make difference to users Information that is condensed enough to make the information understandable and also appropriate in terms of the costs of preparing and using it
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Conceptual framework: A coherent system of interrelated objectives and fundamentals that can lead to consistent standards and that prescribes the nature, function, and limits of financial accounting and financial statements Rationale for conceptual framework o Standard setting should build on an established body of concepts and objectives. Resulting in a coherent set of standards and rules. Such framework should increase financial statement users understanding of and confidence in financial reporting (as well of comparability of different companies) o Should be possible to solve new and emerging practical problems more quickly Doing so by using good judgment and with the help of a universally accepted conceptual framework. Development of the conceptual framework
OBJECTIVE OF FINANCIAL REPORTING
Qualitative characteristics of useful information o Determining which alternative gives the most useful information for decision making purposes (decision usefulness) o Fundamental qualitative characteristics Relevance capability of making a difference in a decision
1
It needs predictive value: information that helps users make predictions about the final outcome of past/present/future events Feedback value: information that helps users confirm or correct their previous expectations Representational faithfulness: information that reflects the underlying economic substance of an event or transaction (transparency) Information that is complete, neutral and free from material error or bias Enhancing qualitative characteristics o Comparability: information that enables users to identify the real similarities and differences in economic phenomena. o Verifiability: where knowledgeable, independent users achieve similar results or reach consensus regarding the accounting for a particular transaction o Timeliness: information must be available to decision makers before it loses its ability to influence their decision o Understandability: Users need to have reasonable knowledge of business financial accounting in order to understand the information in financial statements Financial information must be of sufficient quality and clarity that it allows reasonably informed users to see its significance Users have the responsibility to review and analyze the information with reasonable diligence Tradeoffs it is not always possible for financial information to have all the enhancing qualities of useful information Contraints things to consider o Materiality: An items impact on a firm’s overall financial operations. Information that would influence or change the jusgement of a reasonable person. Rule of thumb: any item representing 5% or more of income from continuing operations after tax is considered material Both qualitative and quantitative factors must be considered in determining whether an item is material o Cost versus Benefit: the costs of providing the information must be weighed against the benefits that can be had from using the information Elements of financial statements o Assets: Something that involve present economic resources that the entity has a right or access to where others do not o Liabilities: represent and economic burden/obligation that is enforceable Contructive obligations: obligations that arise though past or present practice that signals that the company acklowledges a potential economic burden (I stand by my product) Performance obligations: where an entity agrees to provide a future service or delivery o Equity: residual interest in the assets of an entity that remains after deducting liabilities
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o o o
o
Revenues: increases in economic resources, either by inflows or other enhancements of an entity’s assets or by settlement of its liabilities Expenses: decreases in economic resources, either by outflows or reductions of assets or by incurrence of liabilities from an entity’s ordinary revenue generating activities Gains/Losses Gains: increase in equity from an enitty’s peripheral or incidental transactions Losses: decreases in equity from an entity’s peripheral or incidental transactions Comprehensive income: It includes net income and all other changes in equity except for owners investments and distributions Unrealized holding gains and losses on certain securities…
FOUNDATIONAL PRINCIPLES
Help explain which, when, and how financial elements and events should be recognized, measures and presented/disclosed by accounting systems Recognition/derecognition must meet the definition of an element on financial statements as well as be probable and measurable o Economic entity assumption: allows us to identify an economic activity with a particular unit of accountability The activities of the entity are to be kept separate from the activities of its owner and all other economic entities o Control: there is power to the entity’s activities; only one entity has the power to direct the activities; power need not be exercised or absolute; the reporting entity should have access to the benefits from the entity o Revenue recognition and realization when is revenue recognized Passing of risks and rewards or the earnings process is substantially complete Measurability is reasonably certain Collectability is reasonably assured Revenues are realizable when they(assets) can be readily converted into cash o Matching: dictating that effort be matched with accomplishment whenever it is reasonable and can be done. Illustrating the cause and effect relationship between the money spent to earn revenues and the revenues themselves Product costs: costs attached to the product (labour, material and overhead) that are carried into future periods of inventory until sold Period costs: costs that are recognized immediately. (administration costs…) Measurement determine an acceptable level of uncertainty, use measurement tools that help deal with the uncertainty, and disclose enough information to signal the uncertainty o Periodicity assumption: implies that an enterprises economic activities can be divided into artificial time periods (one month, one quarter, one year) Shorter time periods = more difficulty in determining the proper net income (more assumptions to be made)
3
o
Monetary unit assumption: money is the common denominator of economic activity and is an appropriate basis for accounting measurement and analysis o Going concern assumption: a business enterprise will continue to operate for the foreseeable future. Long enough to fulfill their objectives and commitment o Historical cost principle: represents a value at a point in time; results from a reciprocal exchange; the exchange includes and outside party o Fair value principle: 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 Market based measure (selling price) Presentation and disclosure o Full disclosure principle: anything that is relevant to decisions should be included in the financial statements Information that is detailed enough to disclose matters that make difference to users Information that is condensed enough to make the information understandable and also appropriate in terms of the costs of preparing and using it
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