Chapter 2

Conceptual Framework

Wiley 1
Objectives of the Conceptual Framework

Conceptual framework: basic objectives and

fundamentals underlying accounting standards and
practices
The framework is the foundation for building a set of
accounting concepts and objectives of accounting
standards
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 Financial
Reporting

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Objective of Financial Reporting

The overall objective of financial reporting (first level) is

to provide information that is:
1. useful to users (e.g. investors, creditors, etc.), and
2. decision relevant (resource allocation)
Conceptual building blocks (second level) include:
. qualitative characteristics, and
. elements of financial statements

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Fundamental Qualitative Characteristics

The Fundamental Qualitative Characteristics are:

1. Relevance
Makes a difference in a decision
Has predictive and feedback/confirmatory value
(e.g., separate income between continued and discontinued
operations; comparison of actual and predicted earnings per share)
2. Representational Faithfulness
Complete (all pertinent information is
included), e.g., leased assets
Neutral (not favor one over another)
Free from material error (reliable)
e.g., accounting estimate

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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). e.g., switch from FIFO to Weighted Average inventory
cost method?
Allows users to identify real economic similarities and differences
2. Verifiability
Similar results achieved if same methods are used. e.g. Is cash verifiable?
3. Timeliness: e.g., quarterly reporting
4. Understandability
Allows reasonably informed users to see
the significance of the information
Information should be of sufficient quality
and clarity, e.g., preparation of financial
statements

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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 e.g., relevance vs. representational
faithfulness)
Cost versus Benefits
Benefits of using the information should outweigh the costs of
providing that information
e.g. disclosure of proprietary information to competitors vs. full
disclosure principle

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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

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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

e.g. Share Capital, Contributed Surplus, Retained Earnings,

Accumulated Other Comprehensive Income

Under IFRS, comprehensive income = net income +other

comprehensive income (OCI),
e.g., unrealized gain or loss on FV(fair value)-OCI investments.
On Oct 1, purchased 1000 shares at $10 per share recorded as
FV-OCI investments. On Dec 31, the share price was $12 per
shares. Unrealized gain=(12-10)x1000= $2,000 reported as OCI

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Elements of Financial Statements

Revenues
Increases in economic resources resulting from
ordinary activities, e.g., sell products
Expenses
Decreases in economic resources resulting from
ordinary revenue-generating activities
Gains
Increases in equity (net assets) resulting from
incidental transactions. e.g., disposal of fixed assets
Losses
Decreases in equity (net assets) resulting from
incidental transactions

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Foundational Principles

Recognition / Measurement Presentation and

Derecognition 5. Periodicity assumption Disclosure
1. Economic entity 6. Monetary unit 10. Full disclosure
assumption assumption principle
2. Control 7. Going concern
3. Revenue recognition assumption
and realization principle 8. Historical cost principle
4. Matching principle 9. Fair value 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. they meet the definition of an element (e.g., asset)
2. they are probable (e.g., more than 50% chance for losses),
and
3. 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 business activity is separate and distinct from its
owners (and any other business unit), e.g., store
owners personal assets?
An individual, departments or divisions of an entity, or
an entire industry may be considered separate entities
Does not necessarily refer to a separate legal entity
e.g., proprietorship (not separate), partnership (not
separate), corporation (separate)

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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
Consolidation of financial statements of parent and
subsidiaries
An investor has control over an investee
e.g., investors shareholding (>50%), majority of board
representation

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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, i.e., different concepts: realization vs.
recognition

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Recognition/Derecognition

Matching Principle
Expenses are matched with revenues that they produce
e.g., accrued warranty expense
If the expense benefits the future periods and meets the
definition of asset, it is recorded as an asset, e.g., self-
construction of a building
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), e.g., allowance for
doubtful accounts
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, real-
time 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)

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Measurement

Going Concern Assumption

Assumption that a business enterprise will continue to
operate for the foreseeable future
e.g. historical cost principal
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),
net realizable value vs. historical cost
Full disclosure is required of any material
uncertainties of continuing as a going concern

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Measurement

Historical Cost Principle: assets or liabilities are

measured at the historical cost
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 (price
reflecting true value)
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

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Measurement

Fair Value Principle: assets or liabilities are subsequently

measured at current fair value
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
(historical cost is fair value of the asset when it was acquired)
Fair value is often considered more relevant for certain assets/liabilities
(e.g. financial instruments), e.g., a short-term share investment:,
purchased 1000 shares at $10 per share on Oct 1, share price declined to
$8 per share on Dec 31, how much is the investment reported on Oct 1
and Dec 31?)
IFRS allows the use of fair value measurement in more situations than
ASPE

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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
Notes to financial statements are essential to
understanding the enterprises performance and
position (e.g., descriptions of accounting policies,
explanations of contingencies, details that are too
voluminous to include in the statements)

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Management Discussion and Analysis
(MD&A)

Management can explain financial information via

MD&A (e.g., current and future performance)
Five key elements that should be included:
1. core businesses
2. objectives and strategy
3. capability to deliver results
4. results and outlook
5. risk analysis

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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 to meet the companys
financial reporting objectives (while complying with
GAAP) is known as financial engineering (e.g.,
structure an instrument as equity rather than debt)
When pressures for reaching specific financial reporting
objectives are high, risk of fraudulent financial reporting
increases

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CA 2-2

Bennett Environment Inc. (p. 72)

Business: treating and neutralizing
contaminated soil
Publicly listed on the TSX
Users: investors
Constrains: IFRS

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CA 2-2

Analyze accounting issues:

1. Accounting for transportation costs
Two options:
a. Expense
b. Capitalize: definition of assets, it brings
future benefit as it is reimbursable

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CA 2-2

2. Lawsuit
Three options:
a. Recognize a liability: definition of liability,
probable and measurable
b. Just disclose this issue: uncertainty on
probability and measurement
c. Do nothing

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Exercises

What are your recommendations on these

two issues in CA2-2?

Examples of foundational principles, E2-7

on p. 67

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