Ch.

1: Conceptual Framework
Intermediate Accounting I
Spring 2017

Nafis Rahman
The conceptual framework of the IFRS
§ Coverage
• Objectives of financial reporting (skim through)
• Fundamental properties
• Other enhancing qualitative characteristics
• Conservatism
• Cost effectiveness
• Elements (skim through)
• Underlying Assumptions
• Recognition of the elements of Financial Statements
• Multiple Measurement Attributes employed in IFRS (later)

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The conceptual framework of the IFRS

• The main objective of financial reporting is to provide useful

information for investment and lending decisions (IFRS OB2,
2012)

• The conceptual framework is the statement of generally

accepted theoretical principles that can be used as
references.
– an essential part of IFRS because IFRS
• emphasizes the general concepts and principles
• provides a limited amount of guidance and fewer
illustrations and examples.

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Objectives of financial reporting

Buying
stocks/bonds Dividends Selling stocks/bonds
Originating loans Interest Collecting principal
(time 0) (time 1, 2, 3, …) (time T)

Shareholders and creditors want to know the

amount, timing, and uncertainty of future
cash flows during the investment horizon.
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 Fundamental qualitative
characteristics
§ Useful information must have
A. Relevance
B. Representational faithfulness

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 Fundamental qualitative
characteristics
A. Relevance
§ Relevant information has the ability to
influence investors’ investment decisions.
§ It has
1. Predictive value
2. Confirmative value
3. Materiality

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 Fundamental qualitative
characteristics
A. Relevance
1. Predictive value
§ Used as an input to predict future cash
flows during the investment horizon

Example: Prospective investors are interested in

purchasing common stocks in a real estate
investment trust. They may use past and current
dividends as an input to predict future dividends.

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 Fundamental qualitative
characteristics
A. Relevance
2. Confirmative value
§ Used to confirm or correct prior
assessment of future cash flows

Example: Year-end financial statements confirm

or change (update) investors’ past expectations
based on previous assessment of future cash
flows.

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 Fundamental qualitative
characteristics
A. Relevance
3. Materiality
§ An item is material if its omission or
misstatement influences investors’
decisions.
• Accountants must consider both quantitative
and qualitative factors.
ü IFRS does not specify uniform quantitative
thresholds at which an item becomes material.
ü Accountants should exercise professional
judgement and experience.
(Continued) 9
 Fundamental qualitative
characteristics
A. Relevance
3. Materiality
a) An example of a quantitative factor
• Items of less than 5 percent of net income are
considered immaterial.
b) Examples of qualitative factors
• An illegal transaction like a bribe
• Earnings management
— Omitting an expense preserves a growing trend of
earnings or is essential for meeting the analysts’
forecasts of earnings, etc.

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 Fundamental qualitative
characteristics
B. Representational faithfulness
§ The extent to which financial information
reflects the underlying transactions,
resources, and claims of an enterprise.
§ It comprises of three concepts
1. Completeness
2. Neutrality
3. Freedom from errors

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 Fundamental qualitative
characteristics
B. Representational faithfulness
1. Completeness
§ Requires inclusion of all material items in
the financial statements.

Example: Société Générale failed to provide

information needed to assess the value of its
subprime loan receivables. The omission of this
information made the loan receivables disclosure
misleading.

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 Fundamental qualitative
characteristics
B. Representational faithfulness
2. Neutrality
§ The extent to which information is free
from bias
• Reported income, assets, and liabilities
should be equal to true values on average.

Example: British American Tobacco have suppressed

information about lawsuits pertaining to tobacco-
related health concerns because such disclosure is
damaging to the company.
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 Fundamental qualitative
characteristics
B. Representational faithfulness
3. Freedom from errors
§ There are no errors in describing the
amount or the process used to report the
amount.
• Some inaccuracy in estimates is OK if they are
described clearly and accurately.
Example: Omitting depreciation of office building in
the previous year's financial statements is a prior
period accounting error. Such error must be corrected
retrospectively in the financial statements.
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 Question 1: Earnings restatement

For the last three years, Enron has reported a

sequence of earnings per share (EPS) that
systematically beats the consensus analysts’ forecasts.
Reported EPS Analysts’ EPS forecasts
Year 1 $4.30 $4.00
Year 2 $4.73 $4.40
Year 3 $5.20 $4.90

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 Question 1: Earnings restatement
In Year 4, the U.S. Security Exchange Committee
requested Enron to restate the Year 2 and Year 3
earnings per share (EPS) and disclose them.
Previous EPS Restated EPS Difference
Year 1 $4.30 $4.30 $0.00
Year 2 $4.73 $3.87 $0.86
Year 3 $5.20 $3.48 $1.72

Required:
1. Evaluate the representational faithfulness of
previously reported EPS.
2. Evaluate the relevance of restated EPS. 16
 Question 1: Solution

Required 1: Representational faithfulness of

previously reported EPS
• The restated EPS is less than the previously
reported EPS, suggesting that the latter is
upwardly biased.
• The upward bias may be due to the omission of
expenses and losses or the inflation of revenues
and gains.

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 Question 1: Solution

Required 2: Relevance of restated EPS

• Confirmative value
– The earnings restatement corrects investors’
prior assessment of earnings growth.
• The previously reported EPS is growing over time,
a good sign of the firm’s cash-generating ability.
• The restated EPS is declining over time, a bad sign
of the firm’s cash-generating ability.

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 Question 1: Solution

Required 2: Relevance of restated EPS

• Predictive value
– Without significant change in management
and control, poor firm performance is likely
to recur.

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 Question 1: Solution

Required 2: Relevance of restated EPS

• Materiality
– Restated earnings are significantly less than
pre-restatement earnings.
– It is now clear to investors that the stocks
have been significantly overvalued!

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 Enhancing qualitative characteristics

§ Characteristics that are not essential but

desirable
1. Comparability
2. Verifiability
3. Timeliness
4. Understandability

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 Enhancing qualitative characteristics

1. Comparability
§ The ability to compare the financial statements of
a company in different periods or of different
companies
a. The convergence of accounting standards to
IFRS enables investors to compare the
financial statements of foreign firms more
easily.

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 Enhancing qualitative characteristics

1. Comparability
b. Consistency: Companies are required to use
accounting policies in a consistent manner
across periods.
– If an accounting policy is changed, the nature and
effect of the policy change, as well as the justification
for it, must be disclosed in the financial statements
for the period in which the company made the
change.

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 Enhancing qualitative characteristics

2. Verifiability
• The degree to which different people would
agree with the chosen representation in the
financial reports

Example: Two independent auditors count Tata

Motors’ inventory and arrive at the same physical
quantity amount for inventory.

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 Enhancing qualitative characteristics

3. Timeliness
• How soon information becomes available to
investors in their decision process.

Example: If Lenovo waited to report its interim

results until nine months after the end of the
reporting period, the interim report would be much
less useful for decision-making purposes.

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Question 2: Timeliness vs. Relevance

Equity analysts analyze information from various

sources together with financial statements for prior
periods to forecast earnings per share (EPS) for
future periods. Investors can rely on EPS forecasts
for equity valuation even before firms announce
actual EPS. Why are firms required to report actual
EPS later even though investors can use the EPS
forecasts?
Note: Respond to this question by explaining the
confirmatory value of actual EPS.
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 Question 2: Solution

• Reported EPS reflects actual performance during a

reporting period.
• Reported EPS confirms and corrects investors’ prior
assessment of firm performance based on the
analysts’ forecasts of EPS.
• While the analyst reports are more timely, they are
necessarily not accurate.

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 Enhancing qualitative characteristics

4. Understandability
§ The ease with which investors are able to
comprehend financial reports.
• Understandability requires the information presented
in financial reports to be concise, complete and clear in
presentation.
• Investors appreciate this property
• Research shows that among the foreign firms listed in
the US, those that make their statements more easy to
read can attract more US investors--Lundholm, Rogo,
Zhang (2014)
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 Conservatism

As practitioners, accountants generally require greater

verification before recognizing good news than bad news
• Losses more quickly recognized than gains in net income, and
net assets tend to be biased downward
• Inconsistent with neutrality concept

Example: valuing inventory at lower-of-cost-or-market method

Useful in undoing the potential intentions of the management

to be overly optimistic in their outlook for the company.
• Can lead to some protection against lawsuits from investors/
creditors
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 Conservatism

Research shows that investors can see through (and act

accordingly) this conservative bias in the accounting
system—Basu (1997)

Stock market sensitivity to good news is greater than

stock market sensitivity to bad new
• Stock market movement (upward) for a 2% increase in
income is greater than the stock price movement (downward)
for a 2% decrease in income.

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 Cost Effectiveness
Full Disclosure Principle: All information useful to decision
makers should be provided in the financial statements
Constraint: The benefit of disclosing the information
should be greater than the cost of disclosing
• Cost of gathering and processing the information on the
preparer’s part
• Costs of interpretation on the receiver’s part (reading the
information can be time consuming)
• Cost of adverse economic consequences to the company for
revealing sensitive information (such as operating segment data).

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 Elements of financial statements

Assets
Liability
Equity (also known as net assets)
Income
--revenue , gain,
--expenses, loss

You should be familiar with these things

already!!!
 Underlying Assumptions

• Going Concern assumption

• Economic Entity Assumption
• Periodicity Assumption
• Monetary Unit Assumptions
 Recognition

• Recognition is the process of incorporating

information into financial statements
• General recognition criteria
– An item that meets the definition of an element of
financial statements should be recognized if:
i. it is probable that any future economic
benefit associated with the item will flow to
or from the entity; and
ii. the item has a cost or value that can be
measured with reliability.
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 Question 3: Recognition

Determine whether to recognize an asset or liability in

each of the following cases given the definition of an
asset and a liability.
(a) FBE Co. has purchased a patent for $20,000. The
patent gives the company sole use of a
manufacturing process which will save it $3,000 a
year for the next five years.
(b) FBE Co. borrowed $20,000 from a bank to purchase
the patent. It promised to pay the amount in next
year with an annual interest rate of 10%.
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 Question 3: Solution
(a) FBE should recognize the patent as an asset.
1. Definition of an asset
• Resource: Right of possess and use patent
• Past event: Purchase
• Controlled by FBE Co.
• Expected economic benefits: Cost savings
2. Recognition criteria
• Probable of the flows of expected economic benefits
– The use of the patent will save $3,000 a year for the next
five years. (“Probable” è Probability > 50%.)
• Reliable measurement of cost or value
– The price of the patent at the date of purchase ($20,000) is
verifiable.
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 Question 3: Solution

(b) FBE should recognize the loan as a liability.

1. Definition of a liability
• Obligation: Paying $20,000 with 10% interest
• Past event: Borrowing
• The outflow of expected economic benefits: Interest and
principal payment
2. Recognition criteria
• The payment of interest and principal (required by a loan
contract) is probable.
• The amount of loan (specified by a loan contract) is measured
reliably.
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 Measurement

• Measurement is the process of associating

numerical amounts with the elements of
financial statements
• Measurement techniques
– Historical Cost (the most verifiable)
– Net Realizable Value (discuss later)
– Current Costs (discuss later)
– Present value of future cash flow (discuss later)
– Fair value or current market value
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