1. Prepared by: Gabriela H. Schneider, CMA; Grant MacEwan College INTERMEDIATE ACCOUNTING INTERMEDIATE ACCOUNTING Sixth Canadian Edition KIESO, WEYGANDT, WARFIELD, IRVINE, SILVESTER, YOUNG, WIECEK

2. C H A P T E R 2 Conceptual Framework Underlying Financial Reporting

3. Learning Objectives 1. Describe the usefulness of a conceptual framework. 2. Describe the main components of the conceptual framework for financial reporting. 3. Understand the objective of financial reporting. 4. Identify the qualitative characteristics of accounting information.

4. Learning Objectives 5. Define the basic elements of financial statements. 6. Describe the basic assumptions of accounting. 7. Explain the application of the basic principles of accounting. 8. Describe the impact that constraints have on reporting accounting information.

5. Conceptual Framework Underlying Financial Reporting Conceptual Framework Rationale Development First Level: Basic Objectives Second Level: Fundamental Concepts Qualitative characteristics Basic Elements Third Level: Recognition and Measurement Basic assumptions Basic principles Constraints

6. Conceptual Framework Users of financial statements need relevant and reliable information To provide such information, the profession has developed a set of principles and guidelines These principles and guidelines are collectively called the Conceptual Framework In short, the Framework is like a constitution for the profession

7. Objectives of the Conceptual Framework The Framework is to be the foundation for building a set of coherent accounting standards and rules The Framework is to be a reference of basic accounting theory for solving emerging practical problems of reporting. This framework can be illustrated as follows:

8. Conceptual Framework for Financial Reporting Recognition and Measurement Concepts 3rd Level: Answers the ‘How’ Question 2 nd Level: The ‘Bridge’ QualitativeElements Objectives 1 st Level: Answers the ‘Why’ Question

9. Conceptual Framework – Objectives To provide information : useful to those making investment and credit decisions useful in making resource allocation decisions useful in assessing management stewardship to individuals who reasonably understand business and economic activities.

10. Conceptual Framework – Qualitative Characteristics Primary qualities are Relevance and Reliability of accounting information Secondary qualities are comparability and consistency of reported information

11. Conceptual Framework – Qualitative Characteristics Information is relevant if it: –has predictive value –has feedback value –is timely Information is reliable if it: –is verifiable; independent users can arrive at the same conclusion –is representationally faithful; it represents (reports) what actually happened –is neutral; is free from bias Information is comparable if it: –allows users to identify real economic similarities and differences Information is consistent if: –similar events have the same accounting treatment from period to period –if the treatment changes, full disclosure is made

12. Conceptual Framework – Basic Elements Section 1000 of the CICA Handbook defines seven elements directly related to the measurement of performance of financial status of an enterprise These elements can be traced to Balance Sheet and Income Statement

13. Conceptual Framework – Basic Elements Balance Sheet Assets: probable future economic benefit Liabilities: probable future sacrifice of economic benefits Equity/Net Assets: residual interest (Assets – Liabilities)

14. Conceptual Framework – Basic Elements Income Statement Revenues: increases in economic resources Expenses: decreases in economic resources Gains: increases in equity Losses: decreases in equity

15. Conceptual Framework – Recognition and Measurement Concepts Explain which, when, and how financial elements and events s hould be recognized, measured and reported These concepts are categorized as: basic assumptions principles constraints

16. Basic Assumptions 1.Economic entity 2.Going concern 3.Monetary unit 4.Periodicity Principles of Accounting 1.Historical cost 2.Revenue recognition 3.Matching 4.Full disclosure Constraints 1.Cost Benefit 2.Materiality 3.Industry practices 4.Conservatism Conceptual Framework – Recognition and Measurement Concepts

17. Economic Entity Assumption – The economic entity can be identified with a particular unit of accountability – The business activity is separate and distinct from its owners – The entity’s assets and other financial elements are not commingled with those of the owners – The economic entity assumption is an accounting concept, and not a legal construct – Departments or divisions of an entity may be considered separate entities Basic Assumptions

18. Going Concern Assumption –The business is assumed to continue indefinitely unless terminated by owners –Expectation of continuing long enough to meet their objectives and commitments –The basis of recording financial elements is historical accounting –If liquidation of the enterprise is assumed to occur, then liquidation accounting is more appropriate –Liquidation accounting (net realizable value) is not followed unless liquidation of the enterprise appears imminent Basic Assumptions

19. Monetary Unit –Money is the common unit of measure of economic transactions –Use of a monetary unit is relevant, and simple and understandable, universally available, and useful –The dollar is assumed to remain relatively stable in value (effects of inflation/deflation are ignored –Monetary unit is relevant only as long as it is assumed that quantitative data is the driving force behind users decision making Basic Assumptions

20. Periodicity (Time Period) Assumption –Economic activity of an entity may be artificially divided into time periods for reporting purposes –Shorter time periods are subject to errors but may be more timely Trade-off between relevance and reliability –Technology, accountability and aware investors are driving the demand for more on-line, real-time financial information Basic Assumptions

21. Historical Cost Principle –Assets and liabilities are recorded at acquisition price –Financial information is reliable (a primary characteristics of information) –Recording transactions at other than historical cost results in a net income materially affected by opinion –Users of financial statements may find current fair value information to be useful as well –A “mixed attribute” system reports historical cost, fair value, and lower of cost or market values Basic Principles of Accounting

22. Revenue Recognition Principle –Revenue is recognized when it is earned and the amount can be objectively determined –Revenue is recognized at the date of sale (objective test) Date of sale provides an objective and verifiable measure of revenue Applicable with a discrete earnings process and one critical event Basic Principles of Accounting

23. –There are exceptions; revenue may be recognized: 1 During Production: revenue is recognized prior to contract completion in certain long-term construction contracts  Considered as a continuous earnings process  Reliable cost and progress estimates must be achieved 2 End of Production: revenue is recognized end of production and before sale occurs  Sale and price are certain 3 Receipt of cash: when sales figure cannot be established due to collection uncertainty  An example - instalment sales contracts (revenue is recognized only on receipt of cash)

24. Matching Principle Expenses in one period are matched to revenues recognized in the same period There should be a logical, rational association of revenues and expenses If the expense benefits the current and future periods, it is recorded as an asset This asset cost is then systematically and rationally matched to future revenues Basic Principles of Accounting

25. Full Disclosure Principle Financial statements must report any information that could reasonably be seen to affect the judgement or decision of an informed user Disclosure may be made: –within the main body of the financial statements –as notes to those statements –as supplementary information Disclosed information should: –provide sufficient detail of the occurrence; and at the same time –be sufficiently brief enough to remain understandable Full disclosure should not be seen as a replacement for well-founded accounting practice Basic Principles of Accounting

26. Cost-Benefit Relationship –The cost of providing information should not outweigh the benefit derived –Costs and benefits are not always obvious or quantifiable –Sound judgement must be used in providing information Constraints

27. Materiality Refers to an item’s impact on a user’s decision –An item must make a difference to be material and be disclosed –It is a matter of the relative significance of the element –Both quantitative and qualitative factors are to be considered in determining relative significance General rule of thumb: if the item is between 5-10% of net income it is considered material Determination of materiality requires professional judgement and expertise

28. Industry Practices The nature of some industries may sometimes require departures from basic accounting theory If application of accounting theory results in statements that are not comparable or consistent, then industry practices must examined for possible explanations Constraints

29. Conservatism When in doubt, choose a conservative solution This solution will be least likely to overstate assets and income Conservatism does not suggest that net assets or net income be deliberately understated –Simply a mechanism to discourage the overstatement of net income and net assets Constraints

30. Conceptual Framework for Financial Reporting Recognition and Measurement Concepts QualitativeElements Objectives Assumptions Economic Entity Going concern Monetary unit PeriodicityPrinciples Historical cost Revenue recognition Matching Full disclosureConstraints Cost-benefit Materiality Industry Practice Conservatism Assets Liabilities Equity/Net Assets Revenues Expenses Gains and Losses Primary: -Relevance -Reliability Secondary: -Comparability -Consistency -useful in investment & credit decisions -useful in making resource allocation decisions -useful in assessing management stewardship

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