Chapter 2: Conceptual Framework Underlying Financial Reporting Flashcards
What is the Conceptual Framework?
A coherent system of interrelated objectives and fundamentals that are the foundation for developing standards and rules.
(Does not override specific IFRS)
Why is the Conceptual Framework needed?
- Create standards based on established concepts
- Provide assistance in solving new and emerging problems
- Increase users’ understanding of and confidence in financial reporting
- Enhance comparability among different companies’ financial statements
What are the levels of the Conceptual Framework?
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
What is the objective of financial reporting?
(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
What are general-purpose financial statements?
Basic statements that give information that meets the needs of key users
What are the Fundamental Qualitative Characteristics of accounting information?
(Part of the second level of the conceptual framework)
Relevance and Representational Faithfulness
Relevance
- 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
Representational Faithfulness
- 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
How do you ensure information has relevance and representational faithfulness?
- Identify the economic event or transaction
- Identify the type of information that would be relevant and can be faithfully represented
- Assess whether the information is available (cost/benefit)
What are the Enhancing Qualitative Characteristics of accounting information?
- Comparability
- Information is measured and reported in a similar way (company to company and year to year)
- Aids in making resource allocation decisions
- Verifiability
- Knowledgeable, independent users achieve similar results
- Timeliness
- Understandability
- Allows users with reasonable knowledge to understand the information
- Presented with sufficient quality and clarity
Trade-offs
- It is not always possible to have all fundamental and enhancing qualitative characteristics
- Trade-offs happen when one qualitative characteristic is sacrificed for another
Cost/Benefit
- Benefits of using the information should outweigh the costs of providing that information
- Led to simpler standards for private entities
What are the Elements of Financial Statements?
Basic elements include:
- Assets
- Liabilities
- Equity
- Revenues/Income
- Expenses
- Gains/Losses
Assets
- 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.
Liabilities
- 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
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
- Foundational principles also include assumptions
Recognition/Derecognition (Foundational Principles)
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
- Economic Entity Assumption (Entity Concept)
- Control
- Revenue Recognition Principle (ASPE)
- Matching Principle
Economic Entity Assumption (Entity Concept)
- 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?”
Control
- 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?
Revenue Recognition Principle
Revenues is recognized when the service or product is considered delivered to the customer — not when the cash is received.
Fully covered in Ch6
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 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
Measurement
- All elements must be measurable to be recognized
(Ch3 covered Measurement)
- Periodicity Assumption
- Monetary Unit Assumption
- Going Concern Assumption
- Historical Cost Principle
- Fair Value Principle
Measurement Uncertainty
When a value cannot be objectively measured
Existence Uncertainty
Does the asset or liability meet the recognition criteria
Outcome Uncertainty
Difficulty in determining future outflows and inflows
Periodicity Assumption
- 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
Monetary Unit Assumption
- 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)
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
Historical Cost Principle
- 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
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”
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.
Presentation and Disclosure (Full Disclosure Principle)
- 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
Management Discussion and Analysis
- 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
Financial Reporting Issues
- 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
- Principles-Based Approach
- Financial Engineering
- Fraudulent Financial Reporting
Principles-Based Approach
- 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
Financial Engineering
- 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
Fraudulent Financial Reporting
- 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
