Chapter 2 Conceptual Framework Underlying Financial Reporting Notes
Chapter 2 Conceptual Framework Underlying Financial Reporting Notes Conceptual Framework •
a conceptual framework is like a constitution: it is a “coherent system of interrelated objectives and fundamentals tat can lead to consistent standards and that prescribes the nature, function, and limits of financial accounting and financial statements”
Objective of Financial Reporting • •
objective of financial reporting is to communicate info that is useful to investors, creditors, and other users in making their resource decisions (assessing management stewardship) about economic resources and claims on them, as well as financial performance the statements are extended to provide the most useful information possible in a manner whereby benefits exceed costs to the users
Qualitative Characteristics of Useful Information Fundamental Qualitative Characteristics • relevance and representational faithfulness (sometimes referred to as faithful representation) are fundamental qualities that make accounting information useful for decision-making; these two characteristics must be present • to be relevant, accounting information must be capable of making a difference in a decision • relevant info helps users make predictions about the final outcome of past, present, and future events; i.e., it has predictive value • relevant info also helps users confirm or correct their previous expectations; it has feedback/confirmatory value • accounting info is representational faithful to the extent that it reflects the underlying economic substance of an event/transaction • this notion of representing economic reality is sometimes referred to as transparency • information that is representational faithful is complete, neutral, and free from material error or bias • completeness refers to the fact that the statements should include all info necessary to portray the underlying events and transactions • neutrality means that information cannot be selected to favour one set of stakeholders over another • freedom from material error/bias means that the information must be reliable Enhancing Qualitative Characteristics • enhancing qualitative characteristics include comparability, verifiability, timeliness, and understandability • comparability enables users to identify the real similarities and differences in economic phenomena because these have not been obscured by accounting methods that cannot be compared • verifiability exists when knowledgeable, independent users achieve similar results regarding accounting for a particular transaction • information must be available to decision-makers before it loses its ability to influence their decisions • users need to have reasonable knowledge of business and financial accounting matters in order to understand the information in financial statements; however, financial information must also be of sufficient quality and clarity that it allows reasonably informed users to see its significance—this is the information’s understandability Constraints • materiality refers to an item’s impact on a firm’s overall financial operations • information is material if including it or leaving it out would influence or change the judgment of a reasonable person • many companies and their auditors have historically adopted the general rule of thumb that any item representing 5% or more of income from continuing operations (after tax) is considered material, however, this is not a hard and fast rule • the item’s impact on other factors—any sensitive number on the financial statements—should also be considered • in addition, both quantitative and qualitative factors must be considered in determining whether an item is material • the cost-benefit relationship must be considered: the costs of providing the info must be weighted against the benefits that can be had from using the info; in order to justify requiring a particular measurement or disclosure, the costs must be justified by the benefits • the difficulty is that the costs and, especially, the benefits are not always evident or measurable
Foundational Principles 1. 2. 3. 4.
Recognition/De-Recognition Economic entity Control Revenue recognition and realization Matching
5. 6. 7. 8. 9.
Measurement Periodicity Monetary unity Going concern Historical cost Fair value
Presentation and Disclosure 10. Full disclosure
Recognition/De-Recognition • •
recognition deals with the act of including something on the entity’s balance sheet or income statements historically, elements of financial statements have been recognized when: (1) they meet the definition of an element (e.g., liability); (2) they are probable; and (3) they are reliably measurable • presently, a model requires recognition of these elements when: (1) they meet the respective definition; and (2) they are measurable • de-recognition deals with the act of taking something off the balance sheet or income statement Economic Entity Assumption • economic entity assumption (or entity concept) identifies an economic activity with a particular unit of accountability • for tax and legal purposes, the legal entity is the relevant unit for a company • for GAAP (which considers a broader definition when preparing consolidated financial statements), a parent and its subsidiaries are separate legal entities, but merging their activities for accounting and reporting purposes gives more meaningful information
•
thus, the consolidated financial statements are prepared from the perspective of the economic entity, which allows the company to recognize and group together the assets, liabilities, and other elements that are under the parent’s control into one set of statements Control • control is an important concept in determining which entities to consolidate and include in the financial statements • there are several components to the concept of control: 1) There is power to direct the entity’s activities. In order to include the entity in the consolidated financial statements, the reporting entity must be able to make strategic decisions for the entity. 2) Only one entity has the power to direct the activities of the entity in question. Control precludes the sharing of power. 3) Power need not be exercised or absolute. There is no requirement to have unrestricted, total control or power over the entity. In addition, as long as the reporting entity has the ability to control the other entity, it need not exercise that control. 4) The reporting entity should have access to the benefits from the entity. Revenue Recognition and Realization • revenue has generally been recognized when the following 3 conditions are met: 1) risks and rewards have passed or the earnings process is substantially complete 2) measurability is reasonably certain 3) collectability is reasonably assured (realized or realizable) • under the alternative contract-based view, any contract between the entity and a customer is recognized when: (1) the entity becomes party to the contract; and (2) the resulting rights and obligations are measurable, including credit risk • the resulting revenues are recognized when: (1) control over the goods passes; and (2) performance obligations are settled Matching • the practice of matching costs with the revenues that they produce is called matching • costs are often classified into two groups: product costs and period costs • product costs such as material, labour, and overhead attach to the product and are carried into future periods as inventory (if not sold) since inventory meets the definition of an asset; which period costs such as officers’ salaries and other administrative expenses are recognized immediately—even though the benefits associated with these costs occur in the future—because no direct relationship between cost and revenue can be established and, more importantly, because the costs do not meet the definition of an asset
Measurement Periodicity Assumption • periodicity assumption (or time period assumption) implies that firm’s economic activities can be divided into artificial time periods • the shorter the time period, the more difficult it becomes to determine the proper net income for the period • investors want and demand information that has been quickly processed and distributed; yet the more quickly the information is released, the more likely errors become because there are not estimates made to accrue costs and revenues in accrual accounting Monetary Unit Assumption • the monetary unit assumption means that money is the common denominator of economic activity and is an appropriate basis for accounting measurement and analysis, which implies that the monetary unit is the most effective way of expressing to interested parties changes in capital and exchanges of goods and services • the monetary unit is relevant, simple, universally available, understandable, and useful Going Concern Assumption • the going concern assumption is the assumption that a business enterprise will continue to operate for the foreseeable future • the historical cost principle would have limited usefulness if liquidation were assumed to be likely • if a liquidation approach were adopted, current versus noncurrent classification of assets and liabilities would lose much significance • the only time when the assumption does not apply is when there is intent to liquidate the company’s net asset and cease operations or cease trading in the company’s shares or when the company has no realistic alternative but to liquidate or cease operations Historical Cost Principle • transactions are initially measured at the amount of cash (or cash equivalents) that was paid or received or the fair value that was ascribed to the transactions when they took place—this is often called the historical cost principle • the historical cost principle generally has 3 underlying assumptions: (1) it represents a value at a point in time; (2) it results from a reciprocal exchange (i.e., a two-way exchange); and (3) the exchange includes an outside party Fair Value Principle • fair value information may be more useful than historical cost for certain types of assets and liabilities and in certain industries • fair value is defined 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” • fair value is an exit price, which refers to a selling price
Presentation and Disclosure
Full Disclosure Principle • the principle recognizes that the nature and amount of information included in financial reports reflects a series of judgmental tradeoffs, which aim for information that is: detailed enough to disclose matters that make a difference to users, but condensed enough to make the information understandable, and also appropriate in terms of the costs of preparing and using it • info about a company’s financial position, income, cash flows, and investments can be found in 1 of 3 places: (1) in the main body of financial statements; (2) in the notes; and (3) as supplementary information, including the Management Discussion and Analysis
• •
the financial statements are a formalized, structured way of communicating financial information information in the notes does not have to be quantifiable, nor does it need to qualify as an element
•
there are 5 key elements that should be included in the MD & A: (1) the company’s vision, core businesses, and strategy; (2) key performance drivers; (3) capabilities (capital and other resources) to achieve the desired results; (4) results (historical and prospective); and (5) risks that may shape and/or affect the achievement of results
Summary of Learning Objectives 1. Describe the usefulness of a conceptual framework.
2. 3. 4.
5. 6.
7.
8. 9.
A conceptual framework is needed to (1) create standards that build on an established body of concepts and objectives, (2) provide a framework for solving new and emerging practical problems, (3) increase financial statement users’ understanding of and confidence in financial reporting, and (4) enhance comparability among different companies’ financial statements. Describe the main components of a conceptual framework for financial reporting. The first level deals with the objective of financial reporting. The second level includes the qualitative characteristics of useful information and elements of financial statements. The third level includes foundational principles and conventions. Understand the objective of financial reporting. The objective of financial reporting is to provide information that is useful to individuals making investment and credit decisions. Identify the qualitative characteristics of accounting information. The overriding criterion by which accounting choices can be judged is decision usefulness; that is, the goal is to provide the information that is the most useful for decision-making. Fundamental characteristics include relevance and faithful representation. These two characteristics must be present. Enhancing characteristics include comparability, verifiability, timeliness, and understandability. There may be trade-offs. Define the basic elements of financial elements. Basic elements of financial statements are (1) assets, (2) liabilities, (3) equity, (4) revenues, (5) expenses, (6) gains, and (7) losses. Describe the foundational principles of accounting. (1) Economic entity: the assumption that the activity of a business enterprise can be kept separate and distinct from its owners and any other business unit. (2) Control: the entity has the power to make decisions and reap the benefits. (3) Revenue recognition: revenue is generally recognized when it is (a) earned, (b) measurable, and (c) collectible (realizable). (4) Matching assists in the measurement of income by ensuring that costs (relating to long-lived assets) incurred in earning revenues are booked in the same period as the revenues earned. (5) Periodicity: the assumption that an enterprise’s economic activities can be divided into artificial time periods to facilitate timely reporting. (6) Monetary unit: the assumption that money is the common denominator by which economic activity is conducted, and that the monetary unit gives an appropriate basis for measurement and analysis. (7) Going concern: the assumption that the business enterprise will have a long life. (8) Historical cost principle: existing GAAP requires that many assets and liabilities be accounted for and reported based on their acquisition price. Many assets are later revalued. (9) Fair value principle: assets and liabilities are valued at fair value, that is, an exit price and viewed from a market participant perspective. (10) Full disclosure principle: accountants follow the general practice of providing information that is important enough to influence an informed user’s judgment and decisions. Explain the factors that contribute to choice and/or bias in financial reporting decisions. Choice is the result of many things, including GAAP’s basis of principles, measurement uncertainty, and increasingly complex business transactions. The conceptual framework is the foundation that GAAP is built on. If there is no primary source of GAAP for a specific decision, then professional judgment must be used, making sure that the accounting policies chosen are consistent with the primary sources of GAAP and the conceptual framework. Financial engineering is the process of legally structuring a business arrangement or transaction so that it meets the company’s financial reporting objective. This is a dangerous practice since it often results in biased information. Fraudulent financial reporting often results from pressures on individuals or the company. These pressures may come from various sources, including worsening company, industry, or economic conditions; unrealistic internal budgets; and financial statement focal points related to contractual, regulatory, or capital market expectations. Weak internal controls and governance also contribute to fraudulent financial reporting. Discuss current trends in standard setting for the conceptual framework. The IASB and FASB will continue to work toward a common conceptual framework. The project on objectives and qualitative characteristics is essentially complete. The Boards are focusing on defining elements and the recognition/measurement frameworks. Understand in greater detail how fair value is measured. Fair value measurement is a market-based approach with incorporates the specific attributes of the asset/liability being measured, the valuation premise (how the asset/liability is to be used), the most advantageous market, and the availability of data. Since market prices are not always available, valuation models are used to measure the value. Inputs to these models are either observable in the market or not. Observable inputs are most useful since they are more objective. The fair value hierarchy establishes three levels of inputs, with level one being the highest/best type of input (based on market prices which are observable). Because level three inputs are more subjective, additional disclosures are required. Valuation models include discounted cash flow and options pricing models.
a conceptual framework is like a constitution: it is a “coherent system of interrelated objectives and fundamentals tat can lead to consistent standards and that prescribes the nature, function, and limits of financial accounting and financial statements”
Objective of Financial Reporting • •
objective of financial reporting is to communicate info that is useful to investors, creditors, and other users in making their resource decisions (assessing management stewardship) about economic resources and claims on them, as well as financial performance the statements are extended to provide the most useful information possible in a manner whereby benefits exceed costs to the users
Qualitative Characteristics of Useful Information Fundamental Qualitative Characteristics • relevance and representational faithfulness (sometimes referred to as faithful representation) are fundamental qualities that make accounting information useful for decision-making; these two characteristics must be present • to be relevant, accounting information must be capable of making a difference in a decision • relevant info helps users make predictions about the final outcome of past, present, and future events; i.e., it has predictive value • relevant info also helps users confirm or correct their previous expectations; it has feedback/confirmatory value • accounting info is representational faithful to the extent that it reflects the underlying economic substance of an event/transaction • this notion of representing economic reality is sometimes referred to as transparency • information that is representational faithful is complete, neutral, and free from material error or bias • completeness refers to the fact that the statements should include all info necessary to portray the underlying events and transactions • neutrality means that information cannot be selected to favour one set of stakeholders over another • freedom from material error/bias means that the information must be reliable Enhancing Qualitative Characteristics • enhancing qualitative characteristics include comparability, verifiability, timeliness, and understandability • comparability enables users to identify the real similarities and differences in economic phenomena because these have not been obscured by accounting methods that cannot be compared • verifiability exists when knowledgeable, independent users achieve similar results regarding accounting for a particular transaction • information must be available to decision-makers before it loses its ability to influence their decisions • users need to have reasonable knowledge of business and financial accounting matters in order to understand the information in financial statements; however, financial information must also be of sufficient quality and clarity that it allows reasonably informed users to see its significance—this is the information’s understandability Constraints • materiality refers to an item’s impact on a firm’s overall financial operations • information is material if including it or leaving it out would influence or change the judgment of a reasonable person • many companies and their auditors have historically adopted the general rule of thumb that any item representing 5% or more of income from continuing operations (after tax) is considered material, however, this is not a hard and fast rule • the item’s impact on other factors—any sensitive number on the financial statements—should also be considered • in addition, both quantitative and qualitative factors must be considered in determining whether an item is material • the cost-benefit relationship must be considered: the costs of providing the info must be weighted against the benefits that can be had from using the info; in order to justify requiring a particular measurement or disclosure, the costs must be justified by the benefits • the difficulty is that the costs and, especially, the benefits are not always evident or measurable
Foundational Principles 1. 2. 3. 4.
Recognition/De-Recognition Economic entity Control Revenue recognition and realization Matching
5. 6. 7. 8. 9.
Measurement Periodicity Monetary unity Going concern Historical cost Fair value
Presentation and Disclosure 10. Full disclosure
Recognition/De-Recognition • •
recognition deals with the act of including something on the entity’s balance sheet or income statements historically, elements of financial statements have been recognized when: (1) they meet the definition of an element (e.g., liability); (2) they are probable; and (3) they are reliably measurable • presently, a model requires recognition of these elements when: (1) they meet the respective definition; and (2) they are measurable • de-recognition deals with the act of taking something off the balance sheet or income statement Economic Entity Assumption • economic entity assumption (or entity concept) identifies an economic activity with a particular unit of accountability • for tax and legal purposes, the legal entity is the relevant unit for a company • for GAAP (which considers a broader definition when preparing consolidated financial statements), a parent and its subsidiaries are separate legal entities, but merging their activities for accounting and reporting purposes gives more meaningful information
•
thus, the consolidated financial statements are prepared from the perspective of the economic entity, which allows the company to recognize and group together the assets, liabilities, and other elements that are under the parent’s control into one set of statements Control • control is an important concept in determining which entities to consolidate and include in the financial statements • there are several components to the concept of control: 1) There is power to direct the entity’s activities. In order to include the entity in the consolidated financial statements, the reporting entity must be able to make strategic decisions for the entity. 2) Only one entity has the power to direct the activities of the entity in question. Control precludes the sharing of power. 3) Power need not be exercised or absolute. There is no requirement to have unrestricted, total control or power over the entity. In addition, as long as the reporting entity has the ability to control the other entity, it need not exercise that control. 4) The reporting entity should have access to the benefits from the entity. Revenue Recognition and Realization • revenue has generally been recognized when the following 3 conditions are met: 1) risks and rewards have passed or the earnings process is substantially complete 2) measurability is reasonably certain 3) collectability is reasonably assured (realized or realizable) • under the alternative contract-based view, any contract between the entity and a customer is recognized when: (1) the entity becomes party to the contract; and (2) the resulting rights and obligations are measurable, including credit risk • the resulting revenues are recognized when: (1) control over the goods passes; and (2) performance obligations are settled Matching • the practice of matching costs with the revenues that they produce is called matching • costs are often classified into two groups: product costs and period costs • product costs such as material, labour, and overhead attach to the product and are carried into future periods as inventory (if not sold) since inventory meets the definition of an asset; which period costs such as officers’ salaries and other administrative expenses are recognized immediately—even though the benefits associated with these costs occur in the future—because no direct relationship between cost and revenue can be established and, more importantly, because the costs do not meet the definition of an asset
Measurement Periodicity Assumption • periodicity assumption (or time period assumption) implies that firm’s economic activities can be divided into artificial time periods • the shorter the time period, the more difficult it becomes to determine the proper net income for the period • investors want and demand information that has been quickly processed and distributed; yet the more quickly the information is released, the more likely errors become because there are not estimates made to accrue costs and revenues in accrual accounting Monetary Unit Assumption • the monetary unit assumption means that money is the common denominator of economic activity and is an appropriate basis for accounting measurement and analysis, which implies that the monetary unit is the most effective way of expressing to interested parties changes in capital and exchanges of goods and services • the monetary unit is relevant, simple, universally available, understandable, and useful Going Concern Assumption • the going concern assumption is the assumption that a business enterprise will continue to operate for the foreseeable future • the historical cost principle would have limited usefulness if liquidation were assumed to be likely • if a liquidation approach were adopted, current versus noncurrent classification of assets and liabilities would lose much significance • the only time when the assumption does not apply is when there is intent to liquidate the company’s net asset and cease operations or cease trading in the company’s shares or when the company has no realistic alternative but to liquidate or cease operations Historical Cost Principle • transactions are initially measured at the amount of cash (or cash equivalents) that was paid or received or the fair value that was ascribed to the transactions when they took place—this is often called the historical cost principle • the historical cost principle generally has 3 underlying assumptions: (1) it represents a value at a point in time; (2) it results from a reciprocal exchange (i.e., a two-way exchange); and (3) the exchange includes an outside party Fair Value Principle • fair value information may be more useful than historical cost for certain types of assets and liabilities and in certain industries • fair value is defined 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” • fair value is an exit price, which refers to a selling price
Presentation and Disclosure
Full Disclosure Principle • the principle recognizes that the nature and amount of information included in financial reports reflects a series of judgmental tradeoffs, which aim for information that is: detailed enough to disclose matters that make a difference to users, but condensed enough to make the information understandable, and also appropriate in terms of the costs of preparing and using it • info about a company’s financial position, income, cash flows, and investments can be found in 1 of 3 places: (1) in the main body of financial statements; (2) in the notes; and (3) as supplementary information, including the Management Discussion and Analysis
• •
the financial statements are a formalized, structured way of communicating financial information information in the notes does not have to be quantifiable, nor does it need to qualify as an element
•
there are 5 key elements that should be included in the MD & A: (1) the company’s vision, core businesses, and strategy; (2) key performance drivers; (3) capabilities (capital and other resources) to achieve the desired results; (4) results (historical and prospective); and (5) risks that may shape and/or affect the achievement of results
Summary of Learning Objectives 1. Describe the usefulness of a conceptual framework.
2. 3. 4.
5. 6.
7.
8. 9.
A conceptual framework is needed to (1) create standards that build on an established body of concepts and objectives, (2) provide a framework for solving new and emerging practical problems, (3) increase financial statement users’ understanding of and confidence in financial reporting, and (4) enhance comparability among different companies’ financial statements. Describe the main components of a conceptual framework for financial reporting. The first level deals with the objective of financial reporting. The second level includes the qualitative characteristics of useful information and elements of financial statements. The third level includes foundational principles and conventions. Understand the objective of financial reporting. The objective of financial reporting is to provide information that is useful to individuals making investment and credit decisions. Identify the qualitative characteristics of accounting information. The overriding criterion by which accounting choices can be judged is decision usefulness; that is, the goal is to provide the information that is the most useful for decision-making. Fundamental characteristics include relevance and faithful representation. These two characteristics must be present. Enhancing characteristics include comparability, verifiability, timeliness, and understandability. There may be trade-offs. Define the basic elements of financial elements. Basic elements of financial statements are (1) assets, (2) liabilities, (3) equity, (4) revenues, (5) expenses, (6) gains, and (7) losses. Describe the foundational principles of accounting. (1) Economic entity: the assumption that the activity of a business enterprise can be kept separate and distinct from its owners and any other business unit. (2) Control: the entity has the power to make decisions and reap the benefits. (3) Revenue recognition: revenue is generally recognized when it is (a) earned, (b) measurable, and (c) collectible (realizable). (4) Matching assists in the measurement of income by ensuring that costs (relating to long-lived assets) incurred in earning revenues are booked in the same period as the revenues earned. (5) Periodicity: the assumption that an enterprise’s economic activities can be divided into artificial time periods to facilitate timely reporting. (6) Monetary unit: the assumption that money is the common denominator by which economic activity is conducted, and that the monetary unit gives an appropriate basis for measurement and analysis. (7) Going concern: the assumption that the business enterprise will have a long life. (8) Historical cost principle: existing GAAP requires that many assets and liabilities be accounted for and reported based on their acquisition price. Many assets are later revalued. (9) Fair value principle: assets and liabilities are valued at fair value, that is, an exit price and viewed from a market participant perspective. (10) Full disclosure principle: accountants follow the general practice of providing information that is important enough to influence an informed user’s judgment and decisions. Explain the factors that contribute to choice and/or bias in financial reporting decisions. Choice is the result of many things, including GAAP’s basis of principles, measurement uncertainty, and increasingly complex business transactions. The conceptual framework is the foundation that GAAP is built on. If there is no primary source of GAAP for a specific decision, then professional judgment must be used, making sure that the accounting policies chosen are consistent with the primary sources of GAAP and the conceptual framework. Financial engineering is the process of legally structuring a business arrangement or transaction so that it meets the company’s financial reporting objective. This is a dangerous practice since it often results in biased information. Fraudulent financial reporting often results from pressures on individuals or the company. These pressures may come from various sources, including worsening company, industry, or economic conditions; unrealistic internal budgets; and financial statement focal points related to contractual, regulatory, or capital market expectations. Weak internal controls and governance also contribute to fraudulent financial reporting. Discuss current trends in standard setting for the conceptual framework. The IASB and FASB will continue to work toward a common conceptual framework. The project on objectives and qualitative characteristics is essentially complete. The Boards are focusing on defining elements and the recognition/measurement frameworks. Understand in greater detail how fair value is measured. Fair value measurement is a market-based approach with incorporates the specific attributes of the asset/liability being measured, the valuation premise (how the asset/liability is to be used), the most advantageous market, and the availability of data. Since market prices are not always available, valuation models are used to measure the value. Inputs to these models are either observable in the market or not. Observable inputs are most useful since they are more objective. The fair value hierarchy establishes three levels of inputs, with level one being the highest/best type of input (based on market prices which are observable). Because level three inputs are more subjective, additional disclosures are required. Valuation models include discounted cash flow and options pricing models.
