Chapter 2: Conceptual Framework Underlying Financial Reporting

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.

Objective of Conceptual Framework

  • Create standards that build on an established body concepts and objectives.
  • Provide a framework for solving new and emerging practical problems.
  • Increase financial statement users’ understanding of and confidence in financial reporting.
  • Enhance comparability among different companies’ financial statements.

Development of the Conceptual Framework

First Level \rightarrow Objectives of Financial Reporting

Second Level \rightarrow Qualitative Characteristics and Elements of Financial Statements

Third Level \rightarrow Foundational Principles for establishing/applying standards.


Information Asymmetry

A well-written conceptual framework based on sound principles may address adverse selection or moral hazard.


Fundamental Qualitative Characteristics

Relevance

  • Accounting information must be capable of making a difference in a decision.
  • It may have predictive value or feedback/confirmatory value.
  • Materiality – How important a piece of information is to the decision maker.
  • Depends on quantitative and qualitative factors.

Representational Faithfulness

  • Accounting info faithfully reflects or represents the underlying economic substance of an event or transaction. (Known as transparency)
  • Completeness – Statements include all info necessary to portray underlying events and transactions.
  • Neutrality – Info cannot be selected to favour one set of interested parties over another.
  • Freedom from Material Error – Info is reliable.


Enhancing Qualitative Characteristics

Comparability

  • Lets users identify the real similarities and differences in economic phenomena.
  • Resource allocation decisions involve evaluations of alternatives.

Verifiability

  • Knowledgeable, independent users achieve similar results or reach consensus regarding accounting for a particular transaction.
  • i.e. cash is confirmed with the bank.
  • Easy to verify – Hard numbers
  • Difficult to verify – Soft numbers

Timeliness

  • Info is available to decision-makers before it loses its ability to influence their decisions.

Understandability

  • Financial information must be of sufficient quality and clarity to allow reasonably informed users to see its significance.


Trade-Offs

  • Fundamental qualities need to exist but enhancing qualities may be traded off for each other.
  • i.e. sacrifice comparability to get more relevant info in a new standard.

Cost-Benefit Relationship

  • Analyzes costs of providing info against benefits that can be had from using the info.
  • Costs include: collecting/distributing, distributing, auditing, litigation, disclosure of info to competitors, analysis & interpretation.


Assets

  • There is economic benefit to the entity.
  • The entity has control over that benefit.
  • The benefits result from a past transaction or event.


Liabilities

  • They represent a present duty or responsibility.
  • The duty or responsibility obligates the entity, leaving it little or no discretion to avoid it.
  • The transaction or event results from a past transaction or event.
  • Constructive Obligations – Arise through past or present practice that signal that the company acknowledges a potential economic burden,
  • Equitable Obligations Arise due to moral or ethical obligations.


Equity

  • A residual interest in an entity that remains after deducting its liabilities from its assets.
  • Net worth” – The equity is the ownership interest.
  • Consists of common or ordinary shares, preferred shares, retained earnings, and accumulated other comprehensive income (IFRS only)


Revenues

  • Increases in economic resources, either by inflows or other enhancements of assets or settlement of liabilities.
  • Results from ordinary activities.


Expenses

  • Decreases in economic resources, either by outflows or reductions of assets or by the incurrence of liabilities.
  • Results from ordinary revenue-generating activities.


Gains

Increases in equity (net assets) from an entity’s peripheral or incidental transactions and from all other transactions and other events affecting the entity during a period, except those that result from revenues or investments.


Losses

Decreases in equity (net assets) from an entity’s peripheral or incidental transactions and from all other transactions and other events affecting the entity during a period, except those that result from expenses or distributions.


Financial Statements

Includes

  • Income Statement and/or statement of comprehensive income (IFRS only)
  • Statement of Financial Position
  • Statement of Retained Earnings (ASPE) or Changes in Shareholders’ Equity (IFRS)
  • Statement of Cash Flows
  • Comprehensive income includes net income and other comprehensive income (all other changes in equity besides investments and distributions).
  • i.e. unrealized holding gains and losses, changes in revaluation surplus, gains and losses related to translation of foreign operations


Foundational Principles

  • Third level consists of principles that implement the basic objectives.
  • Help explain which, when, and how financial elements and events should be recognized, measured, and presented/disclosed by the accounting system.


Recognition/Derecognition

Recognition - Act of including something on the entity’s statement of financial position or income statement.

  • Meet the definition of an element, are probable, and are reliably measured.

Derecognition - Act of taking something off the statement of financial position or income statement.

1. Economic Entity Assumption

  • 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 benefits are be exposed to losses.

3. Revenue Recognition and Realization Principles

  • Recognized when it is earned, measurable, and collectible (realizable).

4. Matching Principle

  • Assumption assists in measurement of income by ensuring that costs incurred in earning revenues are booked in the same period as the revenues earned.


Measurement

  • Accrual accounting requires soft number estimates in statement preparation, so elements must have a measurement method to be recognized.
  • Measurement Uncertainty – Option pricing or discounted cash flow models, these may undermine reliability.

5. Periodicity Assumption

  • Assumes that an enterprise’s economic activities can be divided into artificial time periods for timely reporting.

6. Monetary Unit Assumption

  • Assumes that money is the common denominator for economic activity, and the monetary unit gives an appropriate basis for measurement/analysis.

7. Going Concern Assumption

  • Assumes that the business will have a long life.

8. Historical Cost Principle

  • Existing GAAP - Assets and liabilities are accounted for and reported as their acquisition price.
  • Initial Recognition Value includes laid-down costs.
  • Sometimes we cannot use historical cost due to non-monetary transactions, such as non-reciprocal, barter, or related party transactions
  • Subsequent Re-measurement – Cost is initially fair value, but changes over time in terms of predictive value.

9. Fair Value Principle

  • Assets and liabilities are valued at fair value (selling price) and are viewed from a market participant perspective.


Presentation and Disclosure

10. Full Disclosure Principle

  • Accounts follow the practice of providing info important enough to influence an informed user’s judgement and decisions.


Financial Reporting Issues

  • Accounting is influenced by decisions made by individuals who often act in self-interest or in the interests of the company.
  • Bias may cause wealth and value destruction.


Principles-Based Approach

  • Decisions are theoretically consistent, and flexible.
  • Critics argue there is too much choice and that it lacks comparability.
  • An entity should adopt policies consistent with GAAP guidance and developed through professional judgement and the conceptual framework.


Financial Engineering

  • Process of legally structuring a business arrangement or transaction so that it meets the company’s financial reporting objective.
  • Dangerous, it often results in biased info.


Fraudulent Financial Reporting

  • Good financial reporting should be the result of well-reasoned and supported analysis grounded in a conceptual framework.
  • Economic or Business Environment – Sudden drops in revenue or market share pressures companies to “prop up” revenues.
  • Purging the statement of financial position makes positive impact of future earnings look better.
  • Other Pressures – Bonuses and jobs depend on meeting budget targets, pressuring a negative influence to accounting decisions.
  • Prevention Tactics: Vigilant top management, independent audit committee, internal audit function, strong internal control systems.


IFRS/ASPE Comparison

  • Fundamentally similar as they are both principles-based.
  • IASB issued new guidance on objectives and qualitative characteristics.


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