prepared by: dragan stojanovic, ca rotman school of management, university of toronto chapter 2...

Prepared by:Dragan Stojanovic, CA

Rotman School of Management, University of Toronto

Chapter 2Chapter 2 Conceptual Framework Underlying Conceptual Framework Underlying

Financial Reporting Financial Reporting

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Conceptual Framework Conceptual Framework Underlying Financial ReportingUnderlying Financial Reporting

Conceptual Conceptual FrameworkFramework• Rationale • Development

Objective of Objective of Financial Financial ReportingReporting• Qualitative characteristics of useful information • Elements of financial statements

Foundational Foundational PrinciplesPrinciples• Recognition / derecognition•Measurement•Presentation and disclosure

Financial Financial Reporting Reporting IssuesIssues• Principles-based approach•Financial engineering•Fraudulent financial reporting

IFRS / Private IFRS / Private GAAP GAAP ComparisonComparison• Looking ahead

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Usefulness of a Conceptual Usefulness of a Conceptual FrameworkFramework

• 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 in financial reporting

• Enhances comparability of financial statements of different companies

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Objectives of the Conceptual Objectives of the Conceptual FrameworkFramework

• 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 Conceptual Framework for Financial ReportingFinancial Reporting

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• The overall objective of financial reporting is to provide information that is:1. useful to users (e.g. Investors, creditors, etc), and2. 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

Objective of Financial Objective of Financial ReportingReporting

Fundamental Qualitative Fundamental Qualitative CharacteristicsCharacteristics

The Fundamental Qualitative Characteristics are:1.Relevance

– Makes a difference in a decision– Has predictive and feedback/confirmatory value

2.Representational Faithfulness– Complete– Neutral– Reasonably free from error or bias

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Enhancing Qualitative Enhancing Qualitative CharacteristicsCharacteristics

Enhancing Qualitative Characteristics are:1. Comparability

– Information measured and reported in similar way (company to company, and year to year)

– Allows users to identify real economic similarities and differences2. Verifiability

– Similar results achieved if same methods are used3. Timeliness4. Understandability

– Allows reasonably informed users to see the significance of the information

– Provides “enough” information so that it is clear

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• Trade-Offs– It is not always possible to have all fundamental and enhancing

qualitative characteristics– Trade-offs happen when one qualitative characteristics is sacrificed

for another• Constraints

– Materiality• If leaving or including information would influence/change the

judgement of a reasonable person, then that information is considered material

• Quantitative guidelines for materiality are usually made based on income from continuing operations, assets and liabilities, or revenues

– Cost versus Benefits• Benefits of using the information should outweigh the costs of providing

that information

Tradeoffs and ConstraintsTradeoffs and Constraints

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• Basic elements of financial statements include the following: – Assets– Liabilities– Equity– Revenues– Expenses– Gains– Losses

Elements of Financial Elements of Financial StatementsStatements

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• Assets have two key characteristics: – They involve a present economic resource– Entity has a right or access to those resources where

others do not

Elements of Financial Elements of Financial Statements: AssetsStatements: Assets

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• Liabilities have two key characteristics: – They represent an economic obligation or burden– Entity has a present obligation

Elements of Financial Elements of Financial Statements: LiabilitiesStatements: Liabilities

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• Equity (net assets) represents residual interest in assets, after all liabilities are deducted

Elements of Financial Elements of Financial Statements: EquityStatements: Equity

Elements of Financial Elements of Financial StatementsStatements

• Revenues– Increases in economic resources resulting from ordinary activities

• Expenses– Decreases in economic resources resulting from ordinary activities

• Gains– Increases in equity (net assets) resulting from incidental

transactions• Losses

• Decreases in equity (net assets) resulting from incidental transactions

– Other comprehensive income• Revenues, 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 PrinciplesFoundational 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 PrinciplesFoundational Principles

Recognition / Recognition / DerecognitionDerecognition1. Economic entity2. Control3. Revenue recognition and realization4. Matching

MeasurementMeasurement5. Periodicity6. Monetary unit7. Going concern8. Historical cost9. Fair value

Presentation Presentation and and DisclosureDisclosure10. Full disclosure

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• Recognition– Process of including an item on entity’s balance

sheet or income statement– Elements of financial statements have

historically been recognized when: 1. they meet the definition of an element (e.g.

asset)2. they are probable, and 3. they are reliably measurable

• Derecognition– Process of ‘removing’ something from the

balance sheet or income statement

Recognition/DerecognitionRecognition/Derecognition

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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


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Economic Entity Assumption


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Control• Important factor in determining entities to be

consolidated and included in the economic entity• Some concepts of control include:

– Having power to direct entity’s activities– Not sharing this power– Power doesn’t need to be absolute, or even

exercised– Access to benefits


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Revenue Recognition Principle• Revenue is recognized when:

• Risks and rewards have passed or the earnings process is substantially complete

• Measurability is reasonably certain and• Collectibility is reasonably assured (realized or

realizable)• Revenue realized when products (goods or services),

merchandise, or assets are exchanged for cash (or claim to cash)

• Alternative contract-based view also emerging


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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 (and

meets the definition of asset), it is deferred• This asset’s cost is then systematically and rationally

matched to future revenues • There is a decreasing emphasis on matching in emerging

accounting standards


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• 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

MeasurementMeasurement

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MeasurementMeasurement 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)

• With technology, investors want more on-line, real-time financial information to ensure relevant information

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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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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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Historical Cost Principle• Three basic assumptions of historical cost

• Represents a value at a point in time (generally fair value at transaction date)

• Results from a reciprocal exchange (i.e. a two-way exchange)

• Exchange includes an outside 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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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)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”


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Fair Value Principle• Fair value has been defined 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 private entity GAAP


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Fair Value Principle (continued)Fair value is a market-based measure


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Full Disclosure Principle• Anything that is relevant to users’ decisions should

be included in financial statements• 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)

Presentation and DisclosurePresentation and Disclosure

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Full Disclosure Principle (continued)• Disclosed information should:

1. Provide sufficient detail of the occurrence2. 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

Presentation and DisclosurePresentation and Disclosure

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Management Discussion and Management Discussion and Analysis (MD&A)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:1. Company’s vision, core businesses, strategy2. Key performance drivers3. Capital and other resources4. Historical and prospective results5. Any risks

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Expanded Conceptual Expanded Conceptual FrameworkFramework

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Financial Reporting IssuesFinancial Reporting Issues

• Canadian GAAP is 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 Choice in Accounting Decision-MakingDecision-Making

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Looking AheadLooking Ahead

• IASB and FASB are currently working on a joint project to develop a common conceptual framework

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prepared by: dragan stojanovic, ca rotman school of management, university of toronto chapter 2...

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