Wiley CHAPTER 2 2 After studying this chapter, you should be able to: - PowerPoint Presentation

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Wiley

CHAPTER 2

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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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Chapter 2: Conceptual Framework Underlying Financial ReportingSlide4

Conceptual Framework Underlying 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:

Useful to users (e.g. investors, creditors, etc.), and

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 CharacteristicsThe Fundamental Qualitative Characteristics are:

Relevance

Makes a difference in a decision

Has predictive and feedback/confirmatory valueIncludes all material information (i.e. information that makes a difference to the decision-maker)Representational FaithfulnessComplete

NeutralFree from material error

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Enhancing Qualitative Characteristics

Enhancing Qualitative Characteristics are:

Comparability

Information measured and reported in a similar way (company to company, and year to year)Allows users to identify real economic similarities and differencesVerifiabilitySimilar results achieved if same methods are used

TimelinessUnderstandabilityAllows 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 characteristic 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: EquityEquity (net assets) represents residual interest in assets, after all liabilities are deducted

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Elements of Financial StatementsRevenues

Increases in economic resources, resulting from ordinary activities

Expenses

Decreases in economic resources, resulting from ordinary revenue-generating activitiesGainsIncreases in equity (net assets), resulting from incidental transactionsLosses and OCIDecreases in equity (net assets), resulting from incidental transactions

Other comprehensive incomeRevenues, 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

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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

Presentation and Disclosure

10. Full disclosure principle

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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:

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 accountabilityThe 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/DerecognitionEconomic 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

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 co-operation 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)

IFRS 15 contract based approach uses five-step approach to revenue recognition (See Chapter 6)

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Recognition/Derecognition

Matching Principle

Expenses are matched with revenues that they produceIllustrates 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 yearFor 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, real-time 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)

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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

The practice of providing information that is important enough to influence an informed user’s judgement and decisions

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:Provide sufficient detail of the occurrence

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:

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 issued an Exposure Draft relating to the conceptual framework in 2015. Some items included were:

Measurement

Presentation

Elements

Recognition

Reporting Entity

Objectives and qualitative characteristics

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Looking Ahead

It is hoped that the revised conceptual framework will be released in

2017

The IASB is currently working on two research projects

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Identifying and developing a set of disclosure principles

Clarification of the concept of materiality by adding key characteristics for materiality

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