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KIESO WEYGANDT WARFIELD YOUNG WIECEK - MCCONOMY

INTERMEDIATE
ACCOUNTING
VOLUME 1
ELEVENTH CANADIAN EDITION

Prepared by:
Darrin Ambrose CPA, CMA, MBA
University of Calgary

CHAPTER 2
CONCEPTUAL FRAMEWORK
UNDERLYING FINANCIAL REPORTING

Wiley

Chapter 2: Conceptual Framework


Underlying Financial Reporting
After studying this chapter, you should be able to:
1. Indicate the usefulness and describe the main components of a
conceptual framework for financial reporting
2. Identify the qualitative characteristics of accounting information
3. Define the basic elements of financial statements
4. Describe the foundational principles of accounting
5. Explain the factors that contribute to choices and/or bias in
financial reporting decisions
6. Discuss current trends in standard setting for the conceptual
framework
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Conceptual Framework Underlying


Financial Reporting

Usefulness of a Conceptual Framework


The framework is like a constitution; it is a
coherent system of interrelated objectives
Aids in creation of 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 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

Conceptual Framework for Financial


Reporting

Objective of Financial Reporting


The overall objective of financial reporting is to provide
information that is:
1. useful to users (e.g. investors, creditors, etc.), and
2. 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

Fundamental Qualitative Characteristics


The Fundamental Qualitative Characteristics are:
1. Relevance
Makes a difference in a decision
Has predictive and feedback/confirmatory value
Includes all material information (i.e. information that makes a
difference to the decision-maker)

2. Representational Faithfulness
Complete
Neutral
Free from material error
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Enhancing Qualitative Characteristics


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
differences
2. Verifiability
Similar results achieved if same methods are used
3. Timeliness
4. 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 and Cost/Benefit


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

Cost versus Benefits


Benefits of using the information should outweigh the costs of
providing that information

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Elements of Financial Statements


Basic elements of financial statements
include the following:

Assets
Liabilities
Equity
Revenues
Expenses
Gains
Losses
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Elements of Financial Statements: Assets


Assets have three key characteristics:
They involve some economic benefit to the
entity
Entity has a control over that benefit
Benefit results from a past transaction or
event

13

Elements of Financial Statements: Liabilities


Liabilities have three key characteristics:
They represent a present duty or
responsibility
Entity is obligated and has little or no
discretion to avoid the duty or responsibility
Obligation results from a past transaction or
event

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Elements of Financial Statements: Equity


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

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Elements of Financial Statements


Revenues
Increases in economic resources resulting from ordinary activities

Expenses

Decreases in economic resources resulting from ordinary revenuegenerating 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 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 Principles

Recognition /
Derecognition

1. Economic entity
assumption
2. Control
3. Revenue recognition
and realization principle
4. Matching principle

Measurement
5. Periodicity assumption
6. Monetary unit
assumption
7. Going concern
assumption
8. Historical cost principle
9. Fair value principle

Presentation and
Disclosure
10. Full disclosure
principle

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Recognition/Derecognition

Recognition

Process of including an item on entitys balance


sheet or income statement
Elements of financial statements have historically
been recognized when:
1.
2.
3.

they meet the definition of an element (e.g. asset)


they are probable, and
they are reliably measurable

Derecognition

Process of removing something from the balance


sheet or income statement
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Recognition/Derecognition
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
Legal entity concept is used for tax and legal purposes

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Recognition/Derecognition
Economic Entity Assumption

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Recognition/Derecognition
Control
Important factor in determining entities to be
consolidated and included in the economic entity
Some concepts of control include:
Under IFRS
1.
2.
3.

Having power over investee


Exposure, or rights, to variable returns from involvement with
investee; and
Ability to use power over investee to affect amount of investors
returns

Under ASPE
. Continuing power to determine strategic decisions without the cooperation of others

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Recognition/Derecognition
Revenue Recognition Principle

Revenue is recognized when:

Risks and rewards have passed or the earnings


process is substantially complete
Revenue is measurable and
Revenue is collectible (realized or realizable)

Revenues are realized when products (goods or


services), merchandise, or assets are exchanged for
cash (or claims to cash)
Alternative contract-based view also emerging

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Recognition/Derecognition
Matching Principle
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 future periods and meets the
definition of asset, it is recorded as an asset
This assets cost is then systematically and rationally
matched to future revenues

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Measurement
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

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Measurement
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, realtime financial information to ensure relevant
information

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Measurement
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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Measurement
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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Measurement
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 arms-length 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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Measurement
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 arms
length (use exchange value or cost)
Applies also to financial instruments (e.g. bonds, notes,
accounts payable, and receivable)
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Measurement
Fair Value Principle

Fair value has been defined (under IFRS) 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 ASPE
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Measurement
Fair Value Principle (continued)
Fair value (under IFRS) is a market-based measure

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Presentation and Disclosure


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)

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Presentation and Disclosure


Full Disclosure Principle (continued)

Disclosed information should:


1. Provide sufficient detail of the occurrence
2. 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 enterprises performance and
position

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Management Discussion and Analysis


(MD&A)

Managements explanation of the financial information


and the significance of the information
Five key elements that should be included:
1.
2.
3.
4.
5.

Companys vision, core businesses, and strategy


Key performance drivers
Capital and other resources
Historical and prospective results
Risks

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Expanded Conceptual Framework

36

Financial Reporting Issues

IFRS and ASPE are principles-based


Therefore, selecting and interpreting accounting
principles and rules relies on application of professional
judgment
Legally structuring transactions so that they meet the
companys 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
Decision-Making

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Looking Ahead
IASB issued an Exposure Draft relating to
the conceptual framework in 2015. Some
items included were:

Measurement
Presentation
Elements
Recognition
Reporting Entity
Objectives and qualitative characteristics
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Looking Ahead
It is hoped that the revised conceptual
framework will be released in 2016
The IASB is currently working on two
research projects:
Identifying and developing a set of disclosure
principles
Clarification of the concept of materiality by
adding key characteristics for materiality
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