1 2

Conceptual Framework For Financial

CHAPTER 2 Reporting

First Level: Second Level: Third Level:

Conceptual
Conceptual Framework Framework Basic Objective
Fundamental
Concepts
Recognition and
Measurement
for Financial Reporting • Need • Decision • Qualitative • Basic
usefulness characteristics assumptions
• Development
• Information • Basic elements • Basic
• Overview
about principles
economic
• Constraints
resources

3 4

Objectives LO1: Conceptual Framework

1. Describe the usefulness of a conceptual framework. Conceptual Framework establishes the concepts
2. Describe efforts to construct a conceptual framework.
that underlie financial reporting.
3. Understand the objective of financial reporting.
4. Identify the qualitative characteristics of accounting
Need for a Conceptual Framework
information.
5. Define the basic elements of financial statements. Rule-making should build on and relate to an
6. Describe the basic assumptions of accounting. established body of concepts.
7. Explain the application of the basic principles of
accounting. Enables IASB to issue more useful and
8. Describe the impact that constraints have on reporting consistent pronouncements over time.
accounting information.
 5 6
WHAT’S YOUR PRINCIPLE?
LO2: Development of a Conceptual
The need for a conceptual framework is highlighted by accounting
scandals such as those at Royal Ahold (NLD), Enron (USA), and Framework
Satyan Computer Services (IND). To restore public confidence in IASB and FASB are working on a joint project to
the financial reporting process, many have argued that regulators
should move toward principles-based rules. They believe that develop a common conceptual framework
companies exploited the detailed provisions in rules-based Framework will build on existing IASB and FASB
pronouncements to manage accounting reports, rather than report
the economic substance of transactions. For example, many of the frameworks.
off–balance-sheet arrangements of Enron avoided transparent Project has identified the objective of financial
reporting by barely achieving 3 percent outside equity ownership, a
requirement in an obscure accounting rule interpretation. Enron’s reporting (Chapter 1) and the qualitative
financial engineers were able to structure transactions to achieve a characteristics of decision-useful financial
desired accounting treatment, even if that accounting treatment did reporting information.
not reflect the transaction’s true nature. Under principles-based
rules, hopefully top management’s financial reporting focus will
shift from demonstrating compliance with rules to demonstrating
that a company has attained financial reporting objectives.

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Development of a Conceptual Framework
Overview of the Conceptual Framework
Presently, the Conceptual Framework is comprises of the
following. Three levels:
• Chapter 1: The Objective of General Purpose Financial
Reporting First Level = Objectives of Financial Reporting
• Chapter 2: The Reporting Entity (not yet issued)
Second Level = Qualitative characteristics and
• Chapter 3: Qualitative Characteristics of Useful Financial
Information elements of financial statements
• Chapter 4: The Framework, comprised of the following:
Third Level = Recognition, measurement, and
1.Underlying assumption—the going concern assumption;
2.The elements of financial statements; disclosure concepts
3.Recognition of the elements of financial statements;
4.Measurement of the elements of financial statements; and
5.Concepts of capital and capital maintenance.
LO 2
 ASSUMPTIONS PRINCIPLES CONSTRAINTS
10
1. Economic entity
2. Going concern
1. Measurement
2. Revenue recognition
1. Cost
LO3: First Level: Basic Objective
Third level
3. Monetary unit 3. Expense recognition The "how"—
4. Periodicity 4. Full disclosure implementation
“To provide financial information about the reporting
5. Accrual

QUALITATIVE
entity that is useful to present and potential equity
CHARACTERISTICS ELEMENTS
1. Fundamental 1. Assets investors, lenders, and other creditors in making
qualities 2. Liabilities Second level
2. Enhancing 3. Equity Bridge between decisions in their capacity as capital providers.”
qualities 4. Income
levels 1 and 3
5. Expenses
ILLUSTRATION 2-7
Conceptual Framework
Provided by issuing general-purpose financial
for Financial Reporting OBJECTIVE
Provide information
statements.
about the reporting
entity that is useful
to present and potential
Assumption is that users have reasonable
First level
equity investors,
lenders, and other
The "why"—purpose knowledge of business and financial accounting
of accounting
creditors in their
capacity as capital matters to understand the information.
providers.

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Investors Creditors LO4: Second Level: Fundamental Concepts

Decision
ILLUSTRATION
2-2 Hierarchy of
Return Accounting
Qualities

Risk

Return Risk?
When? How much? Uncertainty
 13 14
SECOND LEVEL: FUNDAMENTAL CONCEPTS
Qualitative Characteristics of Accounting
Relevance
Information
IASB identified the Qualitative Characteristics of
accounting information that distinguish better
(more useful) information from inferior (less useful)
information for decision-making purposes.
ILLUSTRATION 2-7
Conceptual Framework
for Financial Reporting

LO 4

15 16
SECOND LEVEL: FUNDAMENTAL CONCEPTS Primary Characteristic - Relevance
Fundamental Quality - Relevance 1. Predictive value – Financial information has
predictive value if it has value as an input to
predictive processes used by investors to form their
own expectations about the future.

2. Confirmatory value – Relevant information helps users

____________________ their prior expectations
3. Materiality- Information is material if omitting it or
misstating it could influence decisions that users
make on the basis of the reported financial
To be relevant, accounting information must be capable
information.
of ______________________in a decision.
Information with no bearing on a decision is irrelevant.
 17 18

Confirmatory value
3. Materiality - an item is material if its inclusion or
omission would influence or change the judgment
of a reasonable person.
It must make a difference or a company need not
disclose it.
Actual earnings - The importance of the item.
Expected earnings $900,000 - The relative size of an item.
$1,200,000
Deciding “materiality” needs judgment and
professional expertise.
$300,000
Companies must consider both quantitative and
qualitative factors in determining whether an item
is material.

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Second Level: Fundamental Concepts
Fundamental Quality – Faithful Representation
Faithful Representation
The _______________________contained in the financial
statements ________________________________.
To be a faithful representation, information must be
complete, neutral, and free of material error.
ILLUSTRATION 2-7
Conceptual Framework
for Financial Reporting
Fundamental Faithful Representation
quality

Free from
Ingredients Completeness Neutrality
error
LO 4
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Fundamental Quality – Faithful Representation Second Level: Fundamental Concepts
1. Completeness: The financial statements include all the Enhancing Qualities
information that is necessary for faithful representation of
distinguish more-useful information from less-useful
the economic phenomena that it purports to represent.
information.
2. Neutrality: that a company cannot select information to
are complementary to fundamental qualitative characteristics
favor one set of interested parties over another
- Information is neutral if it is unbiased, i.e., it is not
Fundamental Relevance Faithful representation
_____________________________________________.
3. Free from error: An information item that is free from
error will be a more accurate (faithful) representation
of a financial item. Predictive Confirmator Complete Free from
Value y value Materiality Neutrality
- Does not mean total freedom from error. It means that the -ness error
information presented is _______________________, given Enhancing
any estimates are based on the best information available at
the time. Comparability Verifiability Timeliness Understandability

23
Enhancing Qualities
• Comparability: Information that is measured and
reported in a ___________________________ is
considered comparable.
- It enables users to identify the real similarities and
differences in economic events between companies.
- Consistency is present when a company applies
________________________________________.
• Verifiability: Occurs when independent
measurers, using the same methods, obtain similar
results.
24
Enhancing Qualities
• Timeliness: Means having information available to
decision-makers
________________________________________
• Understandability:
- Is the quality of information that lets reasonably
informed users see its significance.
- Classifying, characterizing, and presenting
information clearly and concisely makes information
understandable
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Second Level: Fundamental Concepts LO5: Second Level: Basic Elements

Two groups:
I. Resources and claims to resources at a moment in time.
ILLUSTRATION 1. Asset: A resource controlled by the entity as a result of
2-2 Hierarchy of
Accounting past events and from which future economic benefits are
Qualities expected to flow to the entity.
2. Liability: 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.
3. Equity: The residual interest in the assets of the entity
after deducting all its liabilities.

LO 4

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Second Level: Basic Elements
Hierarchy of Accounting Qualities
II. Transactions, events and circumstances that affect a
company during a period of time.
Capital providers and their
1. ___________: Increases in economic benefits during Users
characteristics
the accounting period in the form of inflows or
enhancements of assets or decreases of liabilities that
result in increases in equity, other than those relating to Constraints Cost<Benefit
contributions from equity participants.
2. Expenses: Decreases in economic benefits during the
accounting period in the form of outflows or depletions of Pervasive criterion Decision Usefulness
assets or incurrences of liabilities that result in decreases
in equity, other than those relating to distributions to
equity participants.
Relevance Faithful Representation
 29 30
Exercise 2-4: Identify the qualitative characteristic(s) to be
Hierarchy of Qualitative Characteristics used given the information provided.

(a) Qualitative characteristic being Characteristics

Relevance Faithful Representation displayed when companies in the Relevance
same industry are using the same Faithful
accounting principles. representation
Free (b) Quality of information that Predictive value
Predictive Confirmat Complete confirms users’ earlier
Materiality Neutrality from Confirmatory value
Value ory Value ness expectations.
error Neutrality
(c) Imperative for providing
comparisons of a company from Materiality
Ingredients of Fundamental Qualities period to period. Timeliness
(d) Ignores the economic Consistency
Comparability Verifiability Timeliness Understandability consequences of a standard or Understandability
rule. Comparability LO 5

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Exercise 2-4: Identify the qualitative characteristic(s) to be
used given the information provided. Exercise 2-4: Identify the qualitative characteristic(s) to be used
Characteristics given the information provided. Characteristics
(e) Requires a high degree of Relevance (i) Neutrality is a key ingredient of Relevance
consensus among individuals Faithful this fundamental quality of Faithful
on a given measurement. representation accounting information. representation
Predictive value Predictive value
(f) Predictive value is an ingredient (j) Two fundamental qualities that
of this fundamental quality of Confirmatory value Confirmatory value
make accounting information
information. Neutrality Neutrality
useful for decision-making
Materiality Materiality
(g) Four qualitative characteristics purposes.
Timeliness Timeliness
that enhance both relevance
and faithful representation. Verifiability (k) Issuance of interim reports is an Verifiability
Understandability example of what enhancing Understandability
(h) An item is not reported because ingredient? LO 5
Comparability Comparability
its effect on income would not
change a decision.
LO 5
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Third Level: Recognition, Measurement, LO6: Third Level: Assumptions

and Disclosure Concepts 1. Economic Entity Assumption
- Economic activity can be identified with a particular unit of
These concepts explain how companies should accountability.
recognize, measure, and report financial elements - Company keeps its activity separate from its owners and
and events. other business unit
- Does the entity concept necessarily refer to a legal
Recognition, Measurement, and Disclosure Concepts entity?
ASSUMPTIONS PRINCIPLES CONSTRAINT
1. Economic 1. Measurement 1. Cost
entity 2. Revenue 2. Materiality
2. Going concern recognition
3. Monetary unit 3. Expense
recognition
4. Periodicity
4. Full disclosure
5. Accrual

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Third Level: Assumptions Basic Assumptions

2. Going Concern Assumption: In the absence of
information to the contrary, a company is assumed
to have a long life.
- company to last long enough to fulfill objectives
and commitments
- The legitimacy of the historical cost principle is
dependent upon the going concern assumption.
3. Monetary Unit - money is the common
denominator.
• Money is the common denominator of economic
activity and provides an appropriate basis for
accounting measurement and analysis.
• The monetary unit is assumed to remain
relatively stable over the years in terms of
purchasing power.
Therefore, this assumption disregards any
inflation or deflation in the economy in which the
company operates.
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Basic Assumptions Third Level: Assumptions

4. Periodicity (time period)
The life of a company can be divided into artificial time 1. Economic activity can be identified with
a particular unit of accountability. Economic
periods for the purpose of providing periodic reports on
Company keeps its activity separate from Entity
the economic activities of the company.
-company can divide its economic activities into time
its owners and other businesses.
2. Company will continue to operate in the Monetary
periods.
near future, unless substantial evidence to Unit
the contrary exists.
3. Money is the common denominator. The
5. Accrual Basis of Accounting – transactions are
monetary unit is assumed to remain
recorded in the periods in which the events occur.
reasonably stable.
Periodicity
rather than when the cash receipt or payment occurs.
4. The life of an enterprise is divided into
- The cash basis of accounting is prohibited under IFRS equal interval (same length of time
period). Company can divide its economic Going
activities into time periods. Concern

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BE2-8: Identify which basic assumption of
accounting is best described in each item below. LO7: Third Level: Principles
(a) The economic activities of FedEx 1. Measurement Principle
Corporation (USA) are divided into 12-
month periods for the purpose of issuing Periodicity (1). Historical Cost Principle
annual reports. IFRS requires many assets and liabilities be reported
(b) Total S.A. (FRA) does not adjust amounts Monetary at their acquisition price, or cost, sometimes referred
in its financial statements for the effects of Unit to as historical cost.
inflation.
It is thought to be a faithful representation of the
(c) Barclays (GBR) reports current and Economic amount paid for a given item.
noncurrent classifications in its statement of Entity
financial position. Many users favor the cost principle because it is
(d) The economic activities of Tokai Rubber verifiable.
Going Concern
Industries (JPN) and its subsidiaries are
merged for accounting and reporting
purposes.
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Third Level: Principles THIRD LEVEL: BASIC PRINCIPLES

(2). Fair value Measurement Principles

is “the amount for which an asset could be IASB established a fair value hierarchy that provides
insight into the priority of valuation techniques to use to
exchanged, a liability settled, or an equity
determine fair value.
instrument granted could be exchanged, between
ILLUSTRATION 2-4
knowledgeable, willing parties in an arm’s length
transaction.”
• ___________________: IASB has taken the step
of giving companies the option to use fair value as
the basis for measurement of financial assets and
financial liabilities.

43 44
Third Level: Principles Five steps of revenue recognition
IASB and FASB
2. Revenue Recognition
-When a company agrees to perform a service or sell 1. Identify the contract with customers
a product to a customer, it has a a performance 2. Identify the separate performance obligations
obligation. in the contract
- Revenue is recognized in the period in which the 3. Determine the transaction price
______________________is satisfied..
4. Allocate the transaction price to the separate
performance obligations

Revenue is to be recognized when it is probable that 5. Recognize revenue when each performance
future economic benefits will flow to the company obligation is satisfied
and reliable measurement of the amount of
revenue is possible.
 45 46
THIRD THIRD LEVEL: BASIC PRINCIPLES
LEVEL:
BASIC 3. Expense Recognition Principle
PRINCIPLES - outflows or “using up” of assets or incurring of
liabilities during a period as a result of delivering or
Illustration: Assume producing goods and/or rendering services.
the Airbus (DEU) signs
a contract to sell - The expense recognition principle is implemented
airplanes to British
Airways (GRB) for €100
in accordance with the definition of expense by
million. To determine matching _______________________________.
when to recognize
revenue, Airbus uses
the five steps for
revenue recognition
shown at right.
ILLUSTRATION 2-5
The Five Steps of Revenue
Recognition

47 48

Expense Recognition Principle Product costs are ______________________, and

are expensed when the units they are attached to are
Three rules: sold.
1. Association of ____________________ Period costs (expenses) are expenses as incurred.
2. ________________________________________
Some costs are difficult to associate with revenues and
must be allocated to expense based on a “rational
and systematic” policy.
3. _______________________as expense in the
period in which it is incurred

“Let the expense follow the revenues.”

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THIRD LEVEL: BASIC PRINCIPLES Example: Measurement
4. Full Disclosure Principle –Financial statements
should include sufficient information to permit a Market Value
knowledgeable user to make an informed decision about $13,500
the financial condition of the company in question.
- providing information that is of sufficient importance Replacement Cost
to influence the judgment and decisions of an informed Cost $13,000
user. $16,000
- Provided through: Which amount should be used?
1. Financial Statements
Cost $16,000
2. Notes to the Financial Statements
3. Supplementary information

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BE2-9: Identify which basic principle of LO8: THIRD LEVEL: COST CONSTRAINT
accounting is best described in each item below.
Companies must weigh the costs of providing the
(a) Parmalat (ITA) reports revenue in its income information against the benefits that can be derived
statement when it delivered goods instead Revenue
from using it.
of when the cash is collected. Recognition
– Rule-making bodies and governmental agencies use
(b) Google (USA) recognizes depreciation
cost-benefit analysis before making final their
expense for a machine over the 2-year Expense informational requirements.
period during which that machine helps the Recognition
company earn revenue. – In order to justify requiring a particular measurement
(c) KC Corp. (USA) reports information about or disclosure, the benefits perceived to be derived
Full
pending lawsuits in the notes to its financial from it must exceed the costs perceived to be
Disclosure
statements. associated with it.
(d) Fuji Film (JPN) reports land on its
statement of financial position at the amount Cost principle
paid to acquire it, even though the estimated
fair market value is greater.
 53 54

Example: What accounting constraints are

illustrated by the items below?

(a) Willis Company does not disclose

any information in the notes to the Materiality
financial statements unless the
value of the information to users
exceeds the expense of gathering Summary of
it. the Structure

(b) Beckham Corporation expenses

Cost-benefit
the cost of wastebaskets in the
year they are acquired.

55
GLOBAL ACCOUNTING INSIGHTS
THE CONCEPTUAL FRAMEWORK
The IASB and the FASB have been working together to develop
a common conceptual framework. This framework is based on
the existing conceptual frameworks underlying U.S. GAAP and
IFRS. The objective of this joint project is to develop a
conceptual framework consisting of standards that are
principles-based and internally consistent, thereby leading to the
most useful financial reporting.
56
THE CONCEPTUAL FRAMEWORK
Following are the key similarities and differences between U.S.
GAAP and IFRS related to the Conceptual Framework for
Financial Reporting.
Similarities
•In 2010, the IASB and FASB completed the first phase of a
jointly created conceptual framework. In this first phase, they
agreed on the objective of financial reporting and a common set
of desired qualitative characteristics. These were presented in
the Chapter 2 discussion. Note that prior to this converged
phase, the Conceptual Framework gave more emphasis to the
objective of providing information on management’s
performance (stewardship).
 57
Similarities
•The existing conceptual frameworks underlying U.S. GAAP and IFRS
are very similar. That is, they are organized in a similar manner
(objective, elements, qualitative characteristics, etc.). There is no real
need to change many aspects of the existing frameworks other than
to converge different ways of discussing essentially the same
concepts.
•The converged framework should be a single document, unlike the
two conceptual frameworks that presently exist. It is unlikely that the
basic structure related to the concepts will change.
•Both the IASB and FASB have similar measurement principles,
based on historical cost and fair value. In 2011, the Boards issued a
converged standard on fair value measurement so that the definition
of fair value, measurement techniques, and disclosures are the same
between U.S. GAAP and IFRS when fair value is used in financial
statements.
59
About The Numbers
While the conceptual framework that underlies U.S. GAAP is very
similar to that used to develop IFRS, the elements identified and
their definitions under U.S. GAAP are different.
On the Horizon
The IASB and the FASB face a difficult task in attempting to update,
modify, and complete a converged conceptual framework. There are
many challenging issues to overcome. For example, how do we
trade off characteristics such as highly relevant information that is
difficult to verify? How do we define control when we are developing
a definition of an asset? Is a liability the future sacrifice itself or the
obligation to make the sacrifice? Should a single measurement
method, such as historical cost or fair value, be used, or does it
depend on whether it is an asset or liability that is being measured?
We are optimistic that the new converged conceptual framework will
be a significant improvement over its predecessors and will lead to
standards that will help financial statement users to make better
decisions.
Differences 58
•Although both U.S. GAAP and IFRS are increasing the use of fair value to
report assets, at this point IFRS has adopted it more broadly. As examples,
under IFRS, companies can apply fair value to property, plant, and
equipment; natural resources; and, in some cases, intangible assets.
•U.S. GAAP has a concept statement to guide estimation of fair values when
market-related data is not available (Statement of Financial Accounting
Concepts No. 7, “Using Cash Flow Information and Present Value in
Accounting”). The IASB has not issued a similar concept statement; it has
issued a fair value standard (IFRS 13) that is converged with U.S. GAAP.
•The monetary unit assumption is part of each framework. However, the unit
of measure will vary depending on the currency used in the country in which
the company is incorporated (e.g., Chinese yuan, Japanese yen, and British
pound).
•The economic entity assumption is also part of each framework although
some cultural differences result in differences in its application. For example,
in Japan many companies have formed alliances that are so strong that they
act similar to related corporate divisions although they are not actually part of
the same company.
60
BE2-11: Determine whether you would classify
these transactions as material.
(a) In the current year, Blair Co. reduces
its bad debt expense to ensure another
positive earnings year. The impact of
this adjustment is equal to 3% of net
income.
(b) Damon Co. expenses all capital
equipment under €2,500 on the basis
that it is immaterial. The company has
followed this practice for a number of
years.
 61
Practice:
Identify which qualitative characteristic accounting
information or constraint is best describe in each item below.
1. The annual reports of Best Buy Co. are audited by
certificated public accountants.
2. Black & Decker and Connondale Corporation both
use the FIFO cost flow assumption.
3. Starbucks Corporation has used straight-line
depreciation since it began operations.
4. Motorola issues its quarterly reports immediately after
each quarter ends.
63
Assumptions
1. The economic activities of FedEx Corporation are
divided into 12-month periods for the purpose of
issuing annual reports.
2. Solectron Corporation, Inc. does not adjust
amounts in its financial statements for the effects
of inflation.
3. Walgreen Co. report current and noncurrent
classifications in its statement of financial position.
4. The economic activities of General Electric and its
subsidiaries are merged for accounting and
reporting purposes.
62
5. Wildcat Company does not disclose any information
in the notes to the financial statements unless the
value of the information to the financial statement
users exceeds the expense of gathering it.
6. Sun Devil Corporation expenses the cost of
wastebaskets in the year they are acquired.
64
Principles
1. Norfolk Southern Corporation reports revenue in its
income statement when it is earned instead of when
the cash is collected.
2. Yahoo, Inc., recognizes depreciation expense for a
machine over 2-year period during which that machine
helps the company earn revenue.
3. Oracle Corporation reports information about pending
lawsuits in the notes to its financial statements.
4. Eastman Kodak Company reports land on its statement
of financial position at the amount paid to acquire it,
even though the estimated fair market value is greater.