Conceptual Framework for Financial Reporting, Objective, Assumption, Constraint, Elements

Question 1

According to standard setters, what is the conceptual framework? What does it ensure?

Answer 1

The conceptual framework is “a coherent system of interrelated objectives and fundamentals that can lead to consistent standards and that prescribes the nature, function, and limits of financial accounting statements.” In other words, the conceptual framework of accounting guides decisions about what to present in financial statements, alternative ways of reporting economic events, and appropriate ways of communicating this information.

The conceptual framework ensures that existing standards are clear and consistent, provides guidance in responding to new issues and developing new standards, assists accountants in the application of accounting standards, and increases financial statement user’s understanding of and confidence in the financial statements.

Question 2

Why don’t all countries use the same conceptual framework or set of accounting standards? Why was IASB formed?

Answer 2

They can, and do, differ significantly from country to country. This lack of uniformity has arisen over time because of differences in legal systems, in processes for developing standards, in government requirements, and in economic environments.

The International Accounting Standards Board (IASB)- the standard-setting body responsible for developing International Financial Reporting Standards- was formed to try to reduce these areas of difference and unify global standard setting. Currently, nearly 125 countries either require or permit the use of IFRS. p.71 for the rest.

Question 3

What 5 of many selected portions of the conceptual framework ?

Answer 3

Objective of financial reporting, Underlying assumption, cost constraint, Elements of financial statements, Qualitative characteristics of useful financial information, and Measurement and recognition criteria of the elements of financial statements.

~Take note that some of these conceptual frameworks are still being finalized.

Question 4

What is the Objective of Financial Reporting? Who are the main users of financial reporting?

Answer 4

It is to provide financial information about a company that is useful to existing and potential investors, lenders, and other creditors in making decisions about providing resources to the company. Those decisions involve buying, selling, or holding equity and debt instruments and providing or settling loans and other forms of credit.

Although a wide variety of users rely on financial reporting, investors, lenders, and other creditors are identified as the main users of financial reporting.

Question 5

What is the economic entity concept? What is an economic (reporting) entity?

Answer 5

The concept that the accounting for n economic entity’s activities be kept separate and distinct from the accounting for the activities of its owner and all other economic entities.

An economic (reporting entity) could be one company or a collection of companies consolidated under common ownership.

Question 6

Businesses require cash to start up, maintain operations and grow. Cash or capital comes from?

Answer 6

Cash or capital comes from investors, lenders, and the company’s revenue-generating activities.

Question 7

To make decisions about allocating capital (such as about investing or lending), users look for what information? How do they assess this ability? Financial statements must give what sorts of information?

Answer 7

Users look for information in the financial statements about a company’s ability to earn a profit and generate future cash flows.

To assess this ability, users read the financial statements to determine whether or not management acquired and used the company’s resources in the best way possible.

Consequently, financial statements must give info about:

1. Economic resources (assets) and claims on the economic resources (liabilities and equity)
2. Changes in economic resources and in claims on the economic resources
3. Economic performance

Question 8

Financial statements are prepared using the Accrual basis of Accounting. Define and provide an example.

Answer 8

Under the accrual basis of accounting, the effects of transactions on a company’s economic resources and claims are recorded in the period when a transaction occurs and not when cash is received or paid. For example, a law firm would record revenue in the accounting period when the legal services are provided to the client and not necessarily in the accounting period when the client pays for the services.

Question 9

UNDERLYING ASSUMPTION:

A key assumption, the Going Concern Assumption, creates a foundation for the financial reporting process. Define it.

Answer 9

The going concern assumption assumes that the company will continue operating for the foreseeable future; that is, long enough to carry out its existing objectives and commitments. Although there are many business failures, if a business has a history of profitable operations and access to financial resources, it is reasonable to assume that it will continue operating long enough to carry out its existing objectives and commitments.

Question 10

UNDERLYING ASSUMPTION:

If the company is a going concern then? If it’s not a going concern, then?

Answer 10

If a company is assumed to be a going concern, then financial statement users will find it useful for the company to report assets, such as buildings and equipment, at their cost minus accumulated depreciation (carrying amount).

If the company is not a going concern, then the carrying amount will not be relevant. Instead, the financial statement user would want to know what the assets can be sold for or their net realizable value. Furthermore, if the company is not a going concern, the classification of assets and liabilities as current or non-current would not matter. Labelling anything as non-current would be difficult to justify. The only time the going concern assumption should not be used is when liquidation is likely. If it cannot be assumed that the company is a going concern, this needs to be explicitly stated in the financial statement.s

Question 11

COST CONSTRAINT:

What is the cost constraint?

Answer 11

The cost constraint is a pervasive constraint that ensures the value of the information provided is greater than the cost of providing it. That is, the benefits of financial reporting information should justify the costs. For example, in the section on the qualitative characteristics of useful financial information, we will recognize that to be useful, the financial information must be complete. To achieve completeness, accountants could record or disclose every financial event that occurs and every uncertainty that exists.

Question 12

COST CONSTRAINT:

Why did the AcSB applied this constraint? How do ASPE conceptual framework refer to this constraint?

Answer 12

The AcSB applied this constraint when it adopted IFRS for public companies and ASPE for private companies. Users of private companies’ financial statements generally require less information that users of public companies’ financial statements. The aboard recognized that the cost to private companies of providing financial statements prepared under IFRS was greater than the benefits. Consequently, the board developed ASPE, which is simpler and requires less disclosure than IFRS.

The ASPE conceptual framework refers to this constraint as the benefit versus const constraint.

Question 13

ELEMENTS OF FINANCIAL STATEMENTS:

The elements of financial statements include? Define each.

Answer 13

Assets, liabilities, equity, revenues and expenses.

Assets: an asset is a resource controlled by a business as a result of a past event that is expected to provide future economic benefits to the company.

Liabilities: A liability is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits.

Equity: Equity is the residual interest in the assets of the entity after deducting all its liabilities (Assets - Liabilities = Equity)

Revenues: Revenue is an increase in assets or a decrease in liabilities that results in an increase in equity, other than those relating to contributions from owners, including both revenue and gains. Under IFRS, revenue also includes gains. Revenue arises in the course of the company’s ordinary activities, while gains may or may not arise from ordinary activities.

Expenses: Expenses are decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to owners. Under IFRS, expenses also includes losses. Expenses arise from the company’s ordinary activities. Losses may or may not arise from the company’s ordinary activities.
(Decreases of assets or increases in liabilities that result in decreases in equity [other than owner’s withdrawals], including losses).

Under ASPE, gains and losses are defined in separate categories from revenues and expenses, but the basic definitions are similar to those under IFRS.

Question 14

Describe the conceptual framework of accounting and explain how it helps financial reporting.

Answer 14

The conceptual framework is a coherent system of interrelated objectives and fundamentals that can lead to consistent standards and that prescribe the nature, function, and limits of financial accounting statements. It guides choices about what to present in financial statements, decisions about alternative ways of reporting economic events, and the selection of appropriate ways of communicating such information.

Question 15

Is the conceptual framework applicable to companies reporting under IFRS, under ASPE, or both?

Answer 15

The conceptual framework is applicable to companies reporting under IFRS and ASPE.

Question 16

What is the main objective of financial reporting?

Although there are many users of financial statements, why does the objective identify the specific users?

Answer 16

The main objective of financial reporting is to provide information that is useful for decision-making. More specifically, the conceptual framework states that the objective of general purpose financial reporting is to provide financial information that is useful to present and potential investors, lenders, and other creditors in making decisions about a business.

The objective identifies the specific users to ensure that all possible points of view are included in fulfilling the needs of users.

Question 17

Explain the going concern assumption.

How does the going concern assumption support the use of the cost basis of accounting and the classification of assets and liabilities as current and non-current?

Answer 17

Going Concern: The company will continue operating for the foreseeable future – long enough to achieve its goals and respect its commitments. The going concern assumption is necessary because many accounting principles require us to assume that a company is going to continue to operate in the future. For example, if a company was not going to continue to operate into the future, depreciation of long-lived assets would not be justifiable and appropriate.

The going concern assumption supports reporting the cost of an asset because if a company is not going to sell its assets, cost (the amount given up to acquire the asset) becomes more relevant than fair values. When a company is no longer a going concern, assets would be valued at fair or liquidation values rather than at historical cost. The timing of when the asset will be converted to cash or used in operations and when liabilities are to be paid determines their classification on the statement of financial position. Since the business is expected to remain in operation for the foreseeable future, these elements can continue to be reported in accordance with their respective current or non-current classifications.

Question 18

Describe the cost constraint on financial reporting.

Answer 18

The cost constraint means that the costs of obtaining the accounting information should not exceed the benefits derived from it. For example, a small company could issue interim statements monthly instead of quarterly, but the benefits provided to users would probably be outweighed by the additional costs associated with preparing and presenting the extra information.

Question 19

Isabelle believes that the same GAAP should be used by every company, whether large or small and whether public or private. Do you agree? Explain.

Answer 19

I disagree. The costs of applying IFRS to small or non-publicly traded companies exceed the benefits. As a result, a simplified version of GAAP has been developed and set in place for these companies, referred to as ASPE.

Question 20

Identify and explain the two fundamental qualitative characteristics of accounting information.

Answer 20

The fundamental qualitative characteristics are relevance and faithful representation.

Accounting information has relevance if it makes a difference in a decision. Relevant information has predictive value or confirmatory value. Faithful representation shows the economic reality of events rather than just their legal form. Faithful representation is achieved if the information is complete, neutral and free from material error. Complete information includes all information necessary to show the economic reality of the transaction. Accounting information is neutral if it is free from bias intended to attain a predetermined result or encourage a particular behaviour. Accounting estimates must also be based on the best available information and be reasonably accurate to be considered free from material error.

Question 21

Explain the concept of materiality.

How is materiality related to the qualitative characteristic of relevance?

Answer 21

The concept of materiality means that an item may be so small that failure to follow generally accepted accounting principles will not influence the decision of a reasonably prudent investor or creditor. For example, the expensing of a $20 calculator would not be in accordance with GAAP since the calculator will probably have a useful life beyond one year. However, the cost is so insignificant that it will have no impact on users’ decisions and therefore, this GAAP deviation is not considered to be material.

In order to be relevant to a financial statement user, a transaction or amount must make a difference to the user when making a decision. If an omission or misstatement does not influence a user, it is said to be immaterial or not material. Materiality is not only a matter of size, but also has to do with the nature of the omission or misstatement (for instance, illegal acts).

Question 22

Identify and explain the four enhancing qualitative characteristics of accounting information.

Answer 22

The four enhancing qualitative characteristics are comparability, verifiability, timeliness and understandability.

Accounting information about a company is most useful when it can be compared with accounting information about other companies. Comparability results when different companies use the same accounting principles. Comparability is easier when accounting policies are used consistently by a business from one accounting period to the next. Information is verifiable if two knowledgeable and independent people would agree that it faithfully represents the economic reality. The usefulness of accounting information is enhanced when it is provided on a timely basis, when it is still highly useful for decision-making. Information in financial statements must be capable of being understood by users. Understandability is enhanced by classified, clear, and concise presentation. It is assumed that the average user has a reasonable understanding of accounting concepts and procedures, and general business and economic conditions.

Question 23

The qualitative characteristics should be applied in a certain order. Identify the order and explain why it matters.

Answer 23

The two fundamental qualitative characteristics should be applied first before the four enhancing characteristics. Relevance should be applied first, followed by faithful representation. Relevance is applied first to identify which information would impact a user’s decision. Faithful representation is applied second to ensure the relevant information represents its substance. Comparability, verifiability, timeliness and understandability enhance the communication of information that is relevant and representationally faithful.

Question 24

Identify the differences between the qualitative characteristics identified in the conceptual framework for IFRS and the conceptual framework for ASPE.

Answer 24

While the conceptual framework for IFRS identifies two fundamental and four enhancing characteristics, the framework for ASPE identifies four principal qualitative characteristics: understandability, relevance, reliability, and comparability. ASPE also recognizes conservatism as a qualitative characteristic of financial information.

Question 25

Explain how the cost constraint relates to the quality of completeness.

Answer 25

In general terms, in order for financial information to be useful, it must be complete. To achieve completeness, accountants could record or disclose every financial event that occurs and every uncertainty that exists. However, providing this information increases reporting costs. The benefits of providing more information, in some cases, may be less than the costs

Question 26

The controller of Mustafa Corporation rounded all dollar figures in the company’s financial statements to the nearest thousand dollars. “It’s not important for our users to know how many pennies we spend,” she said. Do you believe rounded financial figures can provide useful information for decision-making? Explain why or why not.

Answer 26

Yes. Rounded figures provide enough information to be useful for decision-making and are less distracting to the reader than are too many digits in a number. In fact, including specific dollar figures can imply a false sense of accuracy that is simply not the case in financial statements where estimates and other judgements are made.

Question 27

Why is revenue recognition a difficult concept to apply in practice?

Answer 27

The revenue recognition criteria state that revenue is recognized when there is an increase in an asset or a decrease in a liability due to profit-generating activities. The application of these criteria involves judgement. In addition, activities that generate revenues have become a lot more innovative and complex than in the past, making the point where revenues meet these guidelines much harder to determine.

Question 28

Describe the general criteria for revenue recognition.

Answer 28

The revenue recognition criteria state that revenue is recognized when there is an increase in an asset or a decrease in a liability due to profit-generating activities.

Question 29

What are the five conditions that must be met for revenue to be recognized from the sale of goods?

Answer 29

The five conditions that must be met for revenue to be recognized include:
• the risks and rewards of ownership must be transferred;
• the seller does not have control over the goods;
• the amount of revenue can be reliably measured;
• collection must be reasonably assured; and
• costs can be reliably measured.

Question 30

A customer of JRT Company ordered merchandise inventory on December 15, 2013. The order was packed on December 31 and shipped on January 2, 2014. JRT’s year end is December 31. Erin, the accountant, recorded the sales revenue in the December 31, 2013, income statement. She said, “We might as well recognize the revenue at December 31, we know the order was shipped. What difference do a couple of days make?” Do you agree? Explain.

Answer 30

I disagree. The risks and rewards of ownership did not get transferred to the buyer until the customer took possession of the shipment. This transfer did not legally occur in 2013 and so the sale should not have been included in the December 31, 2013 income statement. There exists an added risk to recording the sale in December which could bring about an error. Since the goods were not shipped as of the end of the fiscal year, they would be included in the physical count of inventory. Consequently, the inventory would be included on JRT’s balance sheet as well as the accounts receivable from the sale. This error has a significant effect on gross profit and profit for the year, making the results misleading to any reader.

Question 31

On March 24, 2014, Greenthumb Landscaping Services received $10,000 for five months of landscaping service to be provided May through September 2014. Greenthumb’s year end is April 30. (a) How should the $10,000 received be reported in the April 30, 2014, financial statements? Explain. (b) Assuming Greenthumb prepares monthly financial statements, how should the $10,000 be accounted for from May through September? Explain.

Answer 31

(a) The $10,000 cash receipt on March 24, 2014 should be recorded as unearned revenue as no landscaping services have yet been performed. The unearned revenue should appear as a current liability on Greenthumb’s balance sheet at April 30, 2014.
(b) Since Greenthumb’s practice is to prepare monthly financial statements, the revenue from providing landscaping services should be allocated to the month in which the services are performed. In this case the amount of $10,000 will be allocated to the five month period from May through September 2014 at the rate of $2,000 per month.

Question 32

(a) How is revenue recognized in long-term service and construction contracts?
(b) Describe the three steps in the percentage-of-completion method.

Answer 32

Revenue from long-term service and construction contracts should be recognized as the revenue is earned, as long as the revenue recognition criteria are met.

The three steps in the percentage-of-completion method include:

1. Progress toward completion is measured often by comparing the costs incurred in a period with the total estimated costs for the entire project. This indicates the percentage of the work that is complete.
2. This percentage is multiplied by the total revenue for the project, to determine the amount of revenue to be recognized for the period.
3. The costs incurred are then subtracted from the revenue recognized to arrive at the gross profit for the current period.

Question 33

Explain how revenue should be recognized if a sales transaction includes both the sale of goods and a service component.

Answer 33

When goods are sold together with a service component, the amount collected from the sale must be divided between the two sources of revenue. The revenue from the sale of the goods should be recognized at the point of sale, while the service component must be recognized over the period in which the services are delivered.

Question 34

A company has a return policy that allows customers to return goods within 30 days of purchase and receive a full refund. Should the company recognize revenue when the goods are sold or when the 30-day return period expires? Explain.

Answer 34

Unless the company can reasonably and reliably estimate the amount of the returns it expects following the sale, in order to accrue the returns at the point of sale, the company should postpone the recognition of the sale until the return period has expired. Failing to do so would be in violation of the revenue recognition criteria.

Question 35

Describe when expenses should be recognized.

Answer 35

Expenses should be recognized when there is a decrease in an asset or increase in a liability, excluding transactions with owners. The timing of expenses recognition on the income statement depends on the nature of the expense. If there is a direct association between the cost and revenue, the expense is recognized on the income statement in the same period as the related revenue. Where there is no direct relationship between expense and revenue, a rational and systematic allocation process is adopted. In addition, for expenditures that do not qualify for recognition as assets, or previously recognized assets that cease to have future benefits, expenses are recognized immediately.

Question 36

Explain how the qualitative characteristics of relevance and faithful representation relate to the cost and fair value measurement bases of accounting.

Answer 36

In order to be relevant for decision making, the measurement of elements of financial statements need to reflect amounts that are reliable. For assets that are intended to be sold, the current fair value of the assets becomes the most relevant measurement as it approximates the current amount of cash that could be obtained on the sale of the asset. On the other hand, for assets held for use by the corporation, the value at resale is not as relevant to the financial statement user. In that case the cost of the assets is the better measurement for reporting the financial statement element. For example, inventory will become cost of goods sold when sold. It is relevant to compare the actual cost of the inventory to the amount of the revenue generated from its sale. Using the cost basis of accounting gives a faithful representation of the transaction that has occurred from the sale of inventory.

Question 37

Identify two situations that might lead management to overstate profits. Identify two ways the profit could be overstated by applying the recognition criteria incorrectly.

Answer 37

Profits might be overstated on purpose by management to satisfy the owners’ expectations of performance or to allow certain members of the management to earn a bonus which is based on profits. For example, the seller might recognize sales revenues for goods that are shipped FOB destination when the goods are shipped instead of when the customer receives the goods. This would overstate revenues if the goods were shipped just prior to the company’s fiscal year end and received by the customer after the year end. Another means of overstating profits is to recognize revenue from the sale of extended warranties when the cash is collected instead of when the work is performed.