Chapter 2: Conceptual Framework Underlying Financial Reporting​

Question 1

What is the Conceptual Framework?

Answer 1

A coherent system of interrelated objectives and fundamentals that are the foundation for developing standards and rules.
(Does not override specific IFRS)

Question 2

Why is the Conceptual Framework needed?

Answer 2

1. Create standards based on established concepts​
2. Provide assistance in solving new and emerging problems​
3. Increase users’ understanding of and confidence in financial reporting​
4. Enhance comparability among different companies’ financial statements​

Question 3

What are the levels of the Conceptual Framework?

Answer 3

1st level: identifies goals and purposes​ of accounting
2nd level: qualitative characteristics of accounting information, elements of financial statements
3rd level: principles used in establishing and applying accounting standards​

Question 4

What is the objective of financial reporting?

Answer 4

(First level of the conceptual framework)
The overall objective of financial reporting is to communicate information that is:​
- Useful to users (Example: investors, creditors, etc.), and​
- Useful in making decisions about how to allocate resources​

Question 5

What are general-purpose financial statements?

Answer 5

Basic statements that give information that meets the needs of key users​

Question 6

What are the Fundamental Qualitative Characteristics​ of accounting information?

Answer 6

(Part of the second level of the conceptual framework)
Relevance and Representational Faithfulness

Question 7

Relevance

Answer 7

• Information that makes a difference in decision making​
• Has predictive and feedback/confirmatory value​
• Materiality​
  
  • Includes all material information (i.e. information that makes a difference to the decision-maker)​
  • Consider impact on any sensitive numbers​
  • Qualitative factors must be considered​

Question 8

Representational Faithfulness

Answer 8

• Economic substance over legal form​
  
  • Ex.​ Legal: lease​, Substance: an asset and a loan
• Transparency—representing economic reality​
• Completeness—include all pertinent information​
• Neutrality (1)—information does not favour one interested party over another​
• Neutrality (2)—in standard setting​
• Freedom from error—reliability; management must make estimates and use judgement​

Question 9

How do you ensure information has relevance and representational faithfulness?

Answer 9

1. Identify the economic event or transaction​
2. Identify the type of information that would be relevant and can be faithfully represented​
3. Assess whether the information is available (cost/benefit)​

Question 10

What are the Enhancing Qualitative Characteristics​ of accounting information?

Answer 10

1. Comparability​
   
   • Information is measured and reported in a similar way (company to company and year to year)​
   • Aids in making resource allocation decisions​
2. Verifiability​
   
   • Knowledgeable, independent users achieve similar results​
3. Timeliness​
4. Understandability​
   
   • Allows users with reasonable knowledge to understand the information​
   • Presented with sufficient quality and clarity​

Question 11

Trade-offs

Answer 11

• It is not always possible to have all fundamental and enhancing qualitative characteristics​
• Trade-offs happen when one qualitative characteristic is sacrificed for another​

Question 12

Cost/Benefit

Answer 12

• Benefits of using the information should outweigh the costs of providing that information​
• Led to simpler standards for private entities​

Question 13

What are the Elements of Financial Statements​?

Answer 13

Basic elements include:​
- Assets​
- Liabilities
- Equity
- Revenues/Income​
- Expenses
- Gains/Losses​

Question 14

Assets

Answer 14

• Represent a present economic resource—a right to use an asset that produces (or has the potential to produce) economic benefit
• Entity has control over that resource—entity’s ability to decide how to use the asset and receive economic benefits (legal ownership)​
• Resource results from a past transaction or event​
• Includes tangibles and intangibles as well as contractual rights​

The conceptual framework defines the asset as the right as opposed to the physical asset.​

Question 15

Liabilities

Answer 15

• They represent a present duty or responsibility (there is no practical ability to avoid them)​
  
  • May arise through contractual obligations or statutory requirements​
  • Constructive obligations—the company acknowledges a potential economic burden​
  • Equitable obligations—arise from moral or ethical considerations​
• Entity is obligated to transfer an economic resource​
• Obligation results from a past transaction or event​

Question 16

Foundational Principles

Answer 16

• 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​
• Foundational principles also include assumptions​

Question 17

Recognition/Derecognition (Foundational Principles)

Answer 17

Recognition under new IFRS Conceptual Framework​
- Elements of financial statements are recognized when: ​
1. They meet the definition of an element (e.g. asset)​
2. They provide users with relevant information that faithfully represents the underlying transaction or event.​
- No probability or measurement criteria​
- If there is significant uncertainty as to existence or measurement, or low probability of occurrence, information may not be useful anyway​

1. Economic Entity Assumption (Entity Concept)
2. Control
3. Revenue Recognition Principle (ASPE)
4. Matching Principle​

Question 18

Economic Entity Assumption (Entity Concept)

Answer 18

• Means an economic activity can be identified with a particular unit of accountability, e.g. a company, a division, an individual​
• Not necessarily a legal entity​
• Legal entities can be merged into an economic entity for financial reporting purposes (consolidated financial statements)​
• Defining factor for an economic entity is “Who has control?”​

Question 19

Control

Answer 19

• Control is an important factor in determining entities to be consolidated and included in an economic entity​
• Criteria under IFRS:​
  1. Having power over investee​
  2. Exposure, or rights, to variable returns from involvement with investee
  3. Ability to use power over investee to affect amount of investor’s returns​
• Criteria under ASPE:​
  1. Continuing power to determine strategic decisions without others​
  2. Demonstrably distinct:​
  - Can the entity be unilaterally dissolved by the company?​
  - Do others have a more than 10% ownership interest?​

Question 20

Revenue Recognition Principle

Answer 20

Revenues is recognized when the service or product is considered delivered to the customer — not when the cash is received.

Fully covered in Ch6

Question 21

Matching Principle​

Answer 21

• 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 future periods and meets the definition of asset, it is recorded as an asset​
• This asset’s cost is then systematically and rationally matched to future revenues through amortization/depreciation​

Question 22

Measurement

Answer 22

• All elements must be measurable to be recognized​
  (Ch3 covered Measurement)

5. Periodicity Assumption​
6. Monetary Unit Assumption​
7. Going Concern Assumption​
8. Historical Cost Principle
9. Fair Value Principle​

Question 23

Measurement Uncertainty

Answer 23

When a value cannot be objectively measured​

Question 24

Existence Uncertainty

Answer 24

Does the asset or liability meet the recognition criteria​

Question 25

Outcome Uncertainty

Answer 25

Difficulty in determining future outflows and inflows​

Question 26

Periodicity Assumption​

Answer 26

• Economic activity of an entity can be divided into artificial time periods for reporting purposes​
• For shorter time periods, more difficult to determine proper net income (i.e. its more likely errors occur due to more estimates)​
• With technology, investors want more on-line, real-time financial information to ensure relevant information​

Question 27

Monetary Unit Assumption​

Answer 27

• Money is the common unit of measure of economic transactions​
• The dollar is assumed to remain relatively stable in value (effects of inflation/deflation are ignored i.e. price-level change is ignored)​

Question 28

Going Concern Assumption​

Answer 28

• 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​

Question 29

Historical Cost Principle

Answer 29

• Transactions are measured at the amount of cash (or equivalents) paid, or the fair value of initial transaction​
• 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 arm’s-length party​

Question 30

Fair Value Principle​

Answer 30

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”​

Fair value has been defined under ASPE as​
- “amount of consideration that would be agreed upon in an arm’s length transaction between knowledgeable, willing parties who are under no compulsion to act.”​
- Does not refer to an orderly market, nor does it stipulate that the price is an exit price.​

Fair value option—financial instruments are measured at fair value with gains and losses booked to income.​

Question 31

Presentation and Disclosure (Full Disclosure Principle)

Answer 31

• Follow general practice of providing information that is important enough to influence an informed user’s judgement and decisions—it is useful​
• 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​
• Always a trade-off: Is it detailed enough? Is it condensed enough?​
• 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)​
• Full disclosure is not a substitute for proper accounting practice​
• Notes to financial statements are essential to understanding the enterprise’s performance and position​
• New IFRS Conceptual Framework provides general guidance​
  1. Entity specific information over general information​
  2. Duplication inhibits usefulness​

Question 32

Management Discussion and Analysis​

Answer 32

• Management’s explanation of the financial information and the significance of the information​
• Six disclosure principles:​
  1. Provide a view through management’s eyes​
  2. Supplement and complement information in the F/S​
  3. Provide fair, complete, and balanced information that is material to decision-makers​
  4. Outline key trends, risks, and uncertainties that may affect the company in the future and provide information on the quality of earnings and cashflow​
  5. Explain management’s plan for long- and short-term goals​
  6. Be understandable, relevant, comparable, verifiable, timely​

Five key elements:
1. Core business​
2. Objectives and strategy​
3. Capability to deliver results​
4. Results and outlook​
5. Key performance measures and indicators​

Question 33

Financial Reporting Issues

Answer 33

• IFRS and ASPE are principles-based​
• It means 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​

1. Principles-Based Approach​
2. Financial Engineering​
3. Fraudulent Financial Reporting​

Question 34

Principles-Based Approach​

Answer 34

• IFRS and ASPE are principles-based; grounded in the conceptual framework​
• Benefits of this approach? Consistency and flexibility​
• First principles​
• Some think principles-based GAAP is too flexible​
• In the absence of specific GAAP guidance, policies should be developed through exercising professional judgement and applying the conceptual framework​

Question 35

Financial Engineering​

Answer 35

• Process of legally structuring a business arrangement so that it meets the company’s financial reporting objectives.​
• Structured financing—creating instruments so the financial reporting objectives are within GAAP​
• Financial engineering could result in biased information​
• Now viewed as potential fraudulent activity​

Question 36

Fraudulent Financial Reporting​

Answer 36

• Changes in the economic or business environment could trigger manipulation of financial information​
• Negative influence of budgets may lead to inappropriate decisions​
• Weak internal controls and governance​