Presentation on theme: "BY HERICK ONDIGO SCHOOL OF BUSINESS,UON 2012"— Presentation transcript:
1 BY HERICK ONDIGO SCHOOL OF BUSINESS,UON 2012 CONCEPTUAL FRAMEWORK UNDERLYING FINANCIAL ACCOUNTING & FINANCIAL REPORTINGBYHERICK ONDIGO SCHOOL OF BUSINESS,UON2012
2 Presentation Objectives At the end of the presentation, you should:Describe the usefulness of a conceptual framework.Understand the objectives of financial reporting.Identify the qualitative characteristics of accounting information.Define the basic elements of financial statements.Describe the basic assumptions of accounting.Explain the application of the basic principles of accounting.Describe the impact that constraints have on reporting accounting information.1. On the topic, “Challenges Facing Financial Accounting,” what did the AICPA Special Committee on Financial Reporting suggest should be included in future financial statements?Non-financial Measurements (customer satisfaction indexes, backlog information, and reject rates on goods purchases).Forward-looking InformationSoft Assets (a company’s know-how, market dominance, marketing setup, well-trained employees, and brand image).Timeliness (no real time financial information)
3 Conceptual Framework Presentation overview First Level: Basic ObjectivesSecond Level: Fundamental ConceptsThird Level: Recognition and MeasurementDefinitionUsefulnessRationale/NeedDecision usefulnessInformation about economic resourcesQualitative characteristicsBasic elementsBasic assumptionsBasic principlesConstraintsService Cost - Actuaries compute service cost as the present value of the new benefits earned by employees during the year. Future salary levels considered in calculation.Interest on Liability - Interest accrues each year on the PBO just as it does on any discounted debt.Actual Return on Plan Assets - Increase in pension funds from interest, dividends, and realized and unrealized changes in the fair market value of the plan assets.Amortization of Unrecognized Prior Service Cost - The cost of providing retroactive benefits is allocated to pension expense in the future, specifically to the remaining service-years of the affected employees.Gain or Loss - Volatility in pension expense can be caused by sudden and large changes in the market value of plan assets and by changes in the projected benefit obligation. Two items comprise the gain or loss:difference between the actual return and the expected return on plan assets and,amortization of the unrecognized net gain or loss from previous periods
4 DefinitionA conceptual framework may be described as "a unified and generally accepted set of theories and principles that provide a foundation from which specific practices and methods can be deduced".In other words it is a fundamental set of principles, somewhat like a "constitution", or a coherent system of thought about a discipline.In the case of accounting, it relates to that basic set of unifying principles, if any, that underlies accounting practice.
5 Definition cont…Such a set of concepts would be influential in determining how the discipline deals with issues such as:How transactions should be accounted forWhich events should be accounted forWhat set of user-requirements financial accounting should aim to satisfyHow financial information should be communicated to users
6 Usefulness of a Conceptual Framework The framework is like a constitution; it is a “coherent system of interrelated objectives” that prescribe the nature, functions & limits of financial Accounting & Financial Reporting.Creates standards for the accounting professionIncreases financial statement users’ understanding of and confidence in financial reportingEnhances comparability of financial statements of different companies
7 Need/Rationale of the Conceptual Framework The framework is the foundation for building a set of accounting standards and rulesThe framework is a reference of basic accounting theory for solving new and emerging practical problems of reporting
8 First level –Objectives To provide information:Useful to those making investment and credit decisionsUseful in making resource allocation decisionsUseful in assessing management stewardshipFinancial statements provide information about:An entity’s economic resources, obligations, and equity/net assetsChanges in an entity’s economic resources, obligations and equity/net assetsThe economic performance of the entity
9 First level –Objectives Financial reporting should therefore provide information that:(a) is useful to present and potential investors and creditors and other users in making rational investment, credit, and similar decisions.(b) helps present and potential investors and creditors and other users in assessing the amounts, timing, and uncertainty of prospective cash receipts.(c) portrays the economic resources of an enterprise, the claims to those resources, and the effects of transactions, events, and circumstances that change its resources and claims to those resources.
10 Second Level –Qualitative Characteristics The Qualitative Characteristics are: Characteristics of accounting information that distinguish better (more useful) information from inferior (less useful) information for decision-making purposes.”These are:1. Relevance2. Reliability3. Understandability4. Comparability
11 Second Level –Qualitative Characteristics Information is relevant if it:- Makes a difference-Has predictive value -Is timely-Has feedback valueInformation is reliable if it:- is free from error or biasIs verifiable; similar results achieved if use same measurement methodsIs a faithful representation of what actually happenedReasonably free from bias; it is neutralComplete- No intentional omissions to misleadSubstance over form- Accounted for in accordance with their substance and economic reality not merely their legal, contrived or paper form
12 Second Level –Qualitative Characteristics Tradeoffs of qualities:Accountants often must make a tradeoff between relevance (timeliness of financial information) and reliability (verifiability) of financial informationNeeds of the users must be considered in reaching a decision
13 Second Level –Qualitative Characteristics Information is understandable if it:Allows informed users to see the significance of the information(Abilities of users considered)Provides “enough” (Aggregation & classification) so that it is clearA company may present highly relevant and reliable information, however it is useless to those who do not understand it.
14 Second Level –Qualitative Characteristics Information is comparable if it: Allows users to identify real similarities & differences for same & different companies (including disclosures)Has been measured and reported in a similar manner (consistent)Information is consistent if: Similar events have the same accounting treatment within the period & from period to periodThere should be adequate disclosures to aid comparability
15 Second level- Basic Elements Ten elements (or definitions) directly relates to the measurement of performance or financial status/position of a companyThe conceptual framework defines the basic elements that can be traced to the Statement of Financial Position & Statement of IncomeHelps users have a common understanding of financial statements
16 Second level- Basic Elements Statement of Financial PositionAssets: probable future economic benefit that arise as a result of a past transaction and entity controls access to the benefitLiabilities: probable future sacrifice of economic benefits that arise as a result of a past transaction, and there is little or no discretion to avoid obligationEquity/Net Assets: residual interesti.e. net worth (assets – liabilities)
17 Conceptual Framework– Basic Elements Statement of IncomeRevenues: increases in economic resources, from an entity’s ordinary activitiesExpenses: decreases in economic resources, from an entity’s ordinary revenue-generating activitiesGains: increases in equity (net assets) from incidental transactionsLosses: decreases in equity from incidental transactionsNet Income- Net increase/decrease in owners equity resulting from the operating activitiesNet income= Revenues+ Gains- Expenses-Losses
18 Second Level: Basic Elements Ten interrelated elements that relate to measuring the performance and financial status of a business enterprise.“Moment in Time”“Period of Time”AssetsLiabilitiesEquityInvestment by ownersDistribution to ownersComprehensive incomeRevenueExpensesGainsLosses
19 Third level-Recognition and measurement Guidelines The guidelines -concepts and constraints help explain which, when, and how financial elements and events should be recognized, measured, and presentedThey act as guidelines for developing rational responses to controversial financial reporting issues
20 Third level-Recognition and measurement Guidelines Economic entityGoing concernMonetary unitPeriodicityHistorical costRevenue recognitionMatchingFull disclosurePrudence/conservatismCost-benefitMaterialityIndustry practice/uniqueness/perculiarity
21 Third Level –Assumptions 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 entitiesDoes not necessarily refer to a legal entityFor tax and legal purposes, considered a legal entity
22 Third Level –Assumptions Going Concern AssumptionAssumption that a business enterprise will continue to operate in the foreseeable futureThere is an expectation of continuing long enough to meet their objectives and commitmentsManagement must look out at least 12 months from balance sheet dateIf 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
23 Third Level –Assumptions Monetary UnitMoney is the common unit of measure of economic transactionsUse of a monetary unit is relevant, simple and understandable, universally available, and usefulThe Monetary Unit 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
24 Third Level –Assumptions Periodicity AssumptionEconomic activity of an entity can be divided into artificial time periods for reporting purposesMost 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)Trade-off between relevance and reliabilityWith technology, investors want more on-line, real-time financial information to ensure relevant information
25 Third Level -Principles Historical Cost PrincipleThree basic assumptions of historical costRepresents a value at a point in timeResults from a reciprocal exchange(i.e. a two-way exchange)Exchange includes an outside partyInitial recognition: for non-financial assets, record at all costs incurred to get the asset “ready” for sale or for use (e.g. includes transportation and installation costs)21212222222222
26 Historical Cost Principle cont Measurement – The most commonly used measurements are based on historical cost and fair value.Issues:Historical cost provides a reliable benchmark for measuring historical trends.Fair value information may be more useful/relevant for decision making.Recently the accounting profession has taken the step of giving companies the option to use fair value as the basis for measurement of financial assets and financial liabilities.Reporting of fair value information is increasing.
27 Third Level -Principles We use Estimated “fair value” for:1. Non-monetary transactions (as no cash/monetary consideration exchanged)2. Non-reciprocal transactions (e.g. donations)3. Related party transactions – not acting at “arm’s length” (use exchange value or cost)21212222222222
28 Third Level -Principles Revenue Recognition PrincipleRevenue is recognized when:Performance is achieved (earned)Measurability is reasonably certain andCollectability is reasonably assured(realized or realizable)Basic presumptions of Revenue RecognitionResults from a reciprocal exchange andThe exchange includes an outside partyRevenue is realized when products (goods or services), merchandise or assets are exchanged for cash (or claim to cash)
29 Third Level -Principles Revenue Recognition Principle (continued)Revenue is recognized when the earning process is substantially complete – normally when the risks and rewards of ownership have passed to the buyerExceptions:1. Continuous Earning Process/During Production(Example: Long-term construction contract; revenue recognized as it is “earned” over life of contract)2. Collectability Issues/Receipt of CashWhen measurement of revenues is uncertain due to collectability issues or type of sale(Example: Installment sales contracts; revenuerecognized only on receipt of cash)
30 Third Level -Principles Revenue Recognition Principle (continued) 3.End of Production:- where there is a ready market where unlimited quantity can be sold at a standard price, revenue can be recognized before sale. 4. Cost recovery:- for highly speculative projects the outcomes of which are highly unpredictable, the first amounts received can be considered a recovery of cost.
31 Third Level -Principles Revenue Recognition - generally occurs (1) when realized or realizable and (2) when earned.Exceptions:Timing of Revenue Recognition
32 Third Level -Principles Matching PrincipleExpenses are matched with revenues that they produceWhere there is “a direct cause and effect relationship” between money spent to earn revenues and the revenues themselves (e.g. cost of goods sold),If the expense benefits the current and future periods, it is deferred (as an asset e.g. prepaid rent)23232424242424
33 Third Level -Principles Matching Principle (cont..)The asset’s cost is then systematically and rationally matched to future revenues (i.e. cost allocated over all accounting periods during which asset is used, e.g. amortization/depreciation or simply apportionment).Where no future economic benefit is expected from an expenditure a loss is recognized immediately.
34 Expense Recognition cont.. “Let the expense follow the revenues.”Expense Recognition
35 Third Level -Principles Full Disclosure PrincipleAnything that is relevant to users’ decisions should be included in financial statementsFinancial statements must report any information that could affect the judgment or decision of an informed userDisclosure may be made:Within the main body of the financial statementsAs notes to the financial statementsAs supplementary information, including Management Discussion and Analysis (MDA)
36 Third Level -Principles Full Disclosure – implies providing information that is of sufficient importance to influence the judgment and decisions of an informed user.Provided through:Financial StatementsNotes to the Financial StatementsSupplementary information
37 Third Level -Principles Full Disclosure Principle (continued)Disclosed information should:Provide sufficient detail of the occurrenceBe sufficiently condensed enough to remain understandableFull disclosure is not a substitute for proper accounting practiceNotes to financial statements are essential to understanding the enterprise’s performance and position
38 Third Level -Constraints Uncertainty/Prudence/ConservatismRecognition becomes difficult (or impossible) when there is uncertaintyInformation reported is less likely to be uncertain if:Events reported are likely or probable, andThey are measurableWhen in doubt, choose the solution that will be least likely to overstate assets and income.
39 Third Level -Constraints MaterialityRelates to an item’s impact on an entity’s overall financial operationsan item is material if its inclusion or omission would influence or change the judgment of a reasonable person.An item must make a difference, otherwise, it does not ,it needs not to be disclosed or accounted for in a conceptually required mannerBoth quantitative and qualitative factors should be considered in determining relative significanceGeneral rule of thumb: if the item is 5% of income from continuing operations, it is considered materialDetermination of materiality requires professional judgment and expertise
40 Third Level -Constraints Cost- Benefit constraintThe financial reporting must be cost effectiveThe cost of providing the information must be weighed against the benefits that can be derived from using it.The benefits must exceed the cost
41 constraints Industry Practice/uniqueness or peculiarity the peculiar nature of some industries and business concerns sometimes requires departure from basic accounting theory’Treatment Must be consistent with primary sources of GAAP and conceptual frameworkThe profession is attempting to eliminate such differences through issuance of financial repotting standards (IFRS’s)
42 Third Level: Assumptions- Brief Exercise Identify which basic assumption of accounting is best described in each item below.The economic activities of BCOM Corporation are divided into 12-month periods for the purpose of issuing annual reports.(b) BCOM Company. does not adjust amounts in its financial statements for the effects of inflation.(c) BCOM Co. reports current and noncurrent classifications in its balance sheet.(d) The economic activities of BCOM and its subsidiaries are merged for accounting and reporting purposes.PeriodicityMonetaryUnitGoing ConcernEconomicEntity
43 Third Level: Principles- Brief Exercise: Identify which basic principle of accounting is best described in each item below.(a) BCOM Corporation reports revenue in its income statement when it is earned instead of when the cash is collected.(b) BCOM co. recognizes depreciation expense for a machine over the 2-year period during which that machine helps the company earn revenue.(c) BCOM Co reports information about pending lawsuits in the notes to its financial statements.(d) BCOM Co. reports land on its balance sheet at the amount paid to acquire it, even though the estimated fair market value is greater.RevenueRecognitionExpense RecognitionFullDisclosureHistorical cost
44 Third Level: Constraints- Brief Exercise What accounting constraints are illustrated by the items below?(a) BCOM co. reports agricultural crops on its financial statements at market value.(b) BCOM Company does not accrue a contingent lawsuit gain of sh.6,500,000.(c) BCOM Company does not disclose any information in the notes to the financial statements unless the value of the information to users exceeds the expense of gathering it.(d) BCOM co. expenses the cost of wastebaskets in the year they are acquired.IndustryPracticeConservatismCost-BenefitMateriality