1. Chapter 2 Conceptual Framework Underlying Financial Reporting
Prepared by:
Patricia Zima, CA Mohawk College of Applied Arts and Technology

2. Usefulness of a Conceptual Framework
The framework is like a constitution; it is a “coherent system of interrelated objectives”
Creates standards for the accounting profession
Increases financial statement users’ understanding of and confidence of financial reporting
Enhances comparability of financial statements of different companies

3. 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
This framework can be illustrated as follows:

4. 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
Financial statements provide information about:
An entity’s economic resources, obligations, and equity/net assets
Changes in an entity’s economic resources, obligations and equity/net assets
The economic performance of the entity

5. Conceptual Framework for Financial Reporting
Qualitative
Objectives
1st Level: Answers the ‘Why’ Question
2nd Level: The ‘Bridge’
Elements
3rd Level: Answers the ‘How’ Question
Foundation Principles and Conventions

6. Conceptual Framework–Qualitative Characteristics
The Qualitative Characteristics are as follows:
1. Understandability
2. Relevance
3. Reliability
4. Comparability
5. Consistency

7. Conceptual Framework–Qualitative Characteristics
Information is relevant if it:
-Has predictive value -Makes a difference
-Has feedback value -Is timely
Information is reliable if it:
Is verifiable; similar results achieved if use same measurement methods
Is a faithful representation of what actually happened
Reasonably free from bias; it is neutral
Tradeoffs of qualities:
Often must make a tradeoff between relevance (timeliness of financial information) and reliability of financial information
Needs of the users must be considered

8. Conceptual Framework–Qualitative Characteristics
Information is understandable if it:
Allows reasonably informed users to see the significance of the information
Provides “enough” information so that it is clear
Information is comparable if it:
Allows users to identify real similarities and differences for different companies
Has been measured and reported in a similar manner
Information is consistent if:
Similar events have the same accounting treatment from period to period

9. Conceptual Framework– Basic Elements
The CICA Handbook defines eight elements (or definitions) directly related to the measurement of performance of financial status of a company
The conceptual framework defines the basic elements that can be traced to the Balance Sheet and Income Statement
Helps users have a common understanding of financial statements

10. Conceptual Framework– Basic Elements
Balance Sheet
Assets: probable future economic benefit, as a result of a past transaction, and entity controls access to the benefit
Liabilities: probable future sacrifice of economic benefits, as a result of a past transaction, and there is little or no discretion to avoid obligation
Equity/Net Assets: residual interest
i.e. net worth (assets – liabilities)

11. Conceptual Framework– Basic Elements
Income Statement
Revenues: increases in economic resources, from an entity’s ordinary activities
Expenses: decreases in economic resources, from an entity’s ordinary revenue-generating activities
Gains: increases in equity (net assets) from incidental transactions
Losses: decreases in equity from incidental transactions
Other comprehensive income

12. Conceptual Framework–Foundational Concepts and Constraints
Foundational concepts and constraints help explain which, when, and how financial elements and events should be recognized, measured, and presented
They act as guidelines for developing rational responses to controversial financial reporting issues

13. Conceptual Framework–Foundational Concepts and Constraints
Economic entity
Going concern
Monetary unit
Periodicity
Historical cost
Revenue recognition
Matching
Full disclosure
Uncertainty
Cost-benefit
Materiality
Industry practice

14. Basic Foundational Concepts and Constraints
Economic Entity Assumption
(Also called Entity Concept)
The economic activity can be identified with a particular unit of accountability
The 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
For tax and legal purposes, considered a legal entity

15. Basic Foundational Concepts and Constraints
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

16. Basic Foundational Concepts and Constraints
Monetary Unit
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

17. Basic Foundational Concepts and Constraints
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 year
For 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 reliability
With technology, investors want more on-line, real-time financial information to ensure relevant information

18. Basic Foundational Concepts and Constraints
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 party
Initial 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) 21 21 22 22 22 22 22

19. Basic Foundational Concepts and Constraints
Historical Cost Principle (continued)
Estimate “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)
Bonds, notes, accounts payable and receivable recorded at “agreed upon exchange price or economic value” 21 21 22 22 22 22 22

20. Basic Foundational Concepts and Constraints
Revenue Recognition Principle
Revenue is recognized when:
Performance is achieved (earned)
Measurability is reasonably certain and
Collectibility is reasonably assured
(realized or realizable)
Basic presumptions of Revenue Recognition
Results from a reciprocal exchange and
The exchange includes an outside party
Revenue realized when products (goods or services), merchandise or assets are exchanged for cash (or claim to cash)

21. Basic Foundational Concepts and Constraints
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 buyer
Exceptions:
1. Continuous Earning Process
(Example: Long-term construction contract; revenue recognized as it is “earned” over life of contract)
2. Collectibility Issues
When measurement of revenues is uncertain due to collectibility issues or type of sale
(Example: Instalment sales contracts; revenue
recognized only on receipt of cash)

22. Basic Foundational Concepts and Constraints
Matching
Expenses are matched with revenues that they produce
Illustrates a “cause and effect relationship” between money spent to earn revenues and the revenues themselves
If the expense benefits the current and future periods, it is deferred
This 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) 23 23 24 24 24 24 24

23. Basic Foundational Concepts and Constraints
Matching (concept in transition)
Current concerns that matching allows for certain costs to be deferred on the balance sheet but that these costs do not meet the definition of an asset
Under the new IASB and FASB conceptual framework, if a cost/expenditure does not meet definition of an asset, it is “expensed” (matching is not followed)

24. Basic Foundational Concepts and Constraints
Full Disclosure Principle
Anything that is relevant to users’ decisions should be included in financial statements
Financial statements must report any information that could affect the judgement or decision of an informed user
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)

25. Basic Foundational Concepts and Constraints
Full Disclosure Principle (continued)
Disclosed information should:
Provide sufficient detail of the occurrence
Be sufficiently condensed enough to remain understandable
Full disclosure is not a substitute for proper accounting practice
Notes to financial statements are essential to understanding the enterprise’s performance and position

26. Management Discussion and Analysis (MD&A)
Management’s explanation of the financial information and the significance of the information
Publicly traded corporations are now required to include MD&A in their annual reports
Five key elements that should be included:
Company’s vision, core businesses, strategy
Key performance drivers
Capital and other resources to achieve
Historical and prospective results
Any risks

27. Basic Foundational Concepts and Constraints
Uncertainty
Recognition becomes difficult (or impossible) when there is uncertainty
Information reported is less likely to be uncertain if:
Events reported are likely or probable, and
They are measurable
Measurement uncertainty:
Difference between the recognized amount and another reasonably possible amount

28. Basic Foundational Concepts and Constraints
Cost-Benefit Relationship
The cost of providing information should not be greater than the benefits that are expected to come from providing the information
Costs and benefits are not always obvious or measurable
Some costs include:
Collecting and processing information
Auditing
Disclosure to competitors

29. Basic Foundational Concepts and Constraints
Materiality
Relates to an item’s impact on an entity’s overall financial operations
An item is material if including it or leaving it out influences a decision-maker
An item must make a difference, otherwise, it does not need to be disclosed
Both quantitative and qualitative factors should be considered in determining relative significance
General rule of thumb: if the item is 5% of income from continuing operations, it is considered material
Determination of materiality requires professional judgement and expertise

30. Basic Foundational Concepts and Constraints
Industry Practice
The nature of some industries may sometimes require departures from basic accounting theory
Must be consistent with primary sources of GAAP and conceptual framework

31. Issue Identification
All issues fall into one of the following categories:
Recognition
Measurement
Presentation
Disclosure

32. Choice in Accounting Decision-Making

33. Conceptual Framework Summary
Objectives
-Useful in investment & credit decisions
-Useful in making resource allocation decisions
-Useful in assessing management stewardship
Qualitative
Primary:
-Relevance
-Reliability
Secondary:
-Comparability
-Consistency
Elements
Assets and Liabilities
Equity/Net Assets
Revenues
Expenses
Gains and Losses
Other Comprehensive Income
Foundational Principles and Conventions
Assumptions
Economic entity
Going concern
Monetary unit
Periodicity
Principles
Historical cost
Revenue recognition
Matching
Full disclosure
Constraints
Uncertainty
Cost-benefit
Materiality
Industry practice

34. COPYRIGHT
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