CHAPTER TWO

CONCEPTUAL FRAMEWORK
UNDERLYING FINANCIAL REPORTING
 Usefulness of a Conceptual
Framework
• The framework is like a constitution; it is a
“coherent system of interrelated objectives”
• Creates standards for the accounting
profession
• Increases financial statement users’
understanding of and confidence of financial
reporting
• Enhances comparability of financial
statements of different companies
Objectives of the Conceptual
Framework
• The framework is the foundation for
building a set of accounting concepts and
objectives
• The framework is a reference of basic
accounting theory for solving new and
emerging practical problems of reporting
• This framework can be illustrated as
follows:
Conceptual Framework for
Financial Reporting
 Conceptual Framework –
Objective of Financial Reporting
To provide information:
• Useful to those making investment and credit
decisions
• Useful in making resource allocation decisions
• Useful in assessing management stewardship
• Financial statements provide information about:
• An entity’s economic resources, obligations, and
equity/net assets
• Changes in an entity’s economic resources,
obligations, and equity/net assets
• The economic performance of the entity
Conceptual Framework–Qualitative
Characteristics - IFRS STANDARD

The Fundamental Qualitative Characteristics are as

follows:
1. Relevance – info should be relevant
2. Faithful representation – info must be
reliable
Conceptual Framework –
Qualitative Characteristics
 Information is relevant if it:
-Has predictive value-makes a difference in
decision-making of users and/or,
-Has confirmatory value if it provides feedback
about previous evaluations.
• Financial information may have both predictive
and confirmatory value e.g. revenue information
• Must consider materiality; specific to an entity.
Conceptual Framework –
Qualitative Characteristics
 Information that faithfully represents the economic
phenomena of a transaction possess the following
characteristics:
-Complete
-include all information necessary for a user to
understand the transaction being depicted
-Neutral
-transaction depicted without bias...
-Free from Error
-does not imply 100% accuracy but the process used
to produce the reported information has been selected
and applied with no errors in the process
Conceptual Framework–Qualitative
Characteristics - IFRS STANDARD

The Enhancing Qualitative Characteristics include:

1. Comparability
2. Verifiability
3. Timeliness
4. Understandability
Conceptual Framework –
Enhancing Qualitative Characteristics
 Information is comparable if:
• Allows users to identify similarities and
differences in how transactions are
reported (e.g. different inventory valuation
methods should be similar)
 Information is verifiable if it:
• Enables users to either directly or indirectly
assess the reasonableness of
representations included in the financial
information so different people would all be
able to understand/verify
Conceptual Framework –Qualitative
Characteristics
 Information is timely if it:
• Enables users to use the information to
make decisions within a reasonable
timeframe
 Information is understandable if it:
• Provides clear/concise information for
users who have a reasonable knowledge of
business and economic activities, users are
assumed to have knowledge
Conceptual Framework –
Basic Elements
• The CICA Handbook defines seven
elements (or definitions) directly
related to the measurement of
performance of financial status of a
company (IASB defines five)
• The conceptual framework
defines the basic elements that
can be traced to the Balance
Sheet and Income Statement
• Helps users have a common
understanding of financial
statements
Conceptual Framework –
Basic Elements
Balance Sheet

Assets: economic resources controlled

by an entity as a result of past
transaction or events and from which
future economic benefits may be
obtained
Conceptual Framework –
Basic Elements
Liabilities: (per IASB) a present obligation
of an entity arising from past
transactions or events, the settlement of
which result in the transfer or use of
assets, provision of services or other
yielding of economic benefits in the
future (legal or constructive)
Conceptual Framework –
Basic Elements
Equity: residual interest in the net assets
of the entity
equity may be sub-classified
• i.e. net worth (assets – liabilities)
Conceptual Framework –
Basic Elements
Income Statement
Revenues (Income): increases in economic
resources, from an entity’s ordinary activities
•Sale of goods
•Rendering of services
•Use by others of entity resources yielding
rent, interest, royalties or dividends
Conceptual Framework –
Basic Elements
Income Statement
Expenses: decreases in economic
resources, from an entity’s ordinary
revenue-generating activities or service
delivery activities
Conceptual Framework –
Basic Elements
Gains:
• Increases in equity/net assets from
peripheral or incidental transactions
Losses:
• Decreases in equity/net assets from
peripheral or incidental transactions
Conceptual Framework – Foundational
Concepts and Constraints

• Foundational concepts and

constraints help explain which,
when, and how financial
elements and events should be
recognized, measured, and
presented

• They act as guidelines for

developing rational responses to
controversial financial reporting
issues
Conceptual Framework – Foundational
Concepts and Constraints
RECOGNITION
• Occurs when an increase in future economic
benefits (income) or decrease in future
economic benefit (expense) can be reliably
measured with sufficient degree of certainty.
DERECOGNITION
• Removed from the accounts of the entity
CONTROL
• Entity controls access to benefit
• Directs the activities of another entity; entities
consolidated and presented as one.
Conceptual Framework –Foundational
Concepts and Constraints
IAS 1
• Companies following IFRS are required
to make an explicit and unreserved
statement in the notes to the financial
statements that it is compliance with (all
the requirements of) IFRSs (IAS 1.16)
Basic Foundational Concepts
and Constraints
• Accrual accounting requires estimates
• Measurement Model: Currently Mixed Model

IFRS (mixed model) ASPE

Historical Cost Primary-Historic
Current Cost (FV) Replacement
Realizable (settlement) Realizable
Fair value Fair value
Present Value Present Value
 Basic Foundational Concepts
and Constraints-Measurement
Historical Cost
• Based on valuation at a point in time
• Highly verifiable, may not have much relevance
Fair Value
• More widely used in IFRS
• Defined as: “Amount by which an asset could be
exchanged or a liability settled between knowledgeable
and willing parties acting at arms length”.
• Definition in IFRS 13 (effective January 1, 2013): “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”
Basic Foundational Concepts
and Constraints
Economic Entity Assumption (ASPE)
(Also called Entity Concept)
• The economic activity can be identified with a
particular unit of accountability
• The business activity is separate and distinct from
its owners (and any other business unit)
• An individual, departments or divisions of an entity,
or an entire industry may be considered separate
entities
• Does not necessarily refer to a legal entity
• For tax and legal purposes, considered a legal entity
 Basic Foundational Concepts
and Constraints
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
Basic Foundational Concepts
and Constraints
Accrual Basis
• Accepted basis of accounting
 Basic Foundational Concepts
and Constraints
Monetary Unit (ASPE)
• 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)
• Monetary unit is relevant only as long as it is
assumed that quantitative data are useful in
communicating economic information
 Basic Foundational Concepts
and Constraints
Periodicity (Frequency of Reporting)
Assumption
• Economic activity of an entity can be divided
into artificial time periods for reporting
purposes
• Most common: month, quarter & year
• For shorter time periods, more difficult to
determine proper net income (i.e. the more likely
errors become due to more estimates)
• Trade-off between relevance and reliability
• With technology, investors want more on-line,
real-time financials to ensure relevant info
Basic Foundational Concepts
and Constraints
Matching (ASPE)
• Expenses are matched with revenues
• Illustrates a “cause and effect relationship” between
money spent to earn revenues and the revenues
themselves
• If the expense benefit future periods, it is deferred
and then is systematically and rationally matched to
future revenues (e.g. cost allocated over all
accounting periods during which asset is used -
amortization)
• Does not permit the recognition of an asset that does
not meet the def’n of an asset.
 Basic Foundational Concepts
and Constraints
Full Disclosure Principle (ASPE)
• Include info relevant to users’ decisions in
financial statements
• F/S must report any info that could affect the
judgement or decision of an informed user
• Disclosure may be made:
• Within the main body of the financial
statements
• As notes to the financial statements
• As supplementary information
Basic Foundational Concepts
and Constraints
Full Disclosure Principle (continued)
• Disclosed information should:
1. Provide sufficient detail of the
occurrence
2. Be sufficiently condensed enough to
remain understandable
• Full disclosure is not a substitute for
proper accounting practice
• Notes to financial statements are
essential to understanding the
enterprise’s performance and position
Basic Foundational Concepts
and Constraints
Measurement
• Recognition becomes difficult (or
impossible) when there is uncertainty
• Information reported is less likely to be
uncertain if:
• Events reported are likely or probable,
and
• They are measurable
• Measurement uncertainty:
• Difference between the recognized amt
and another reasonably possible amt
 Management Discussion and
Analysis (MD&A)
• Management’s explanation of the financial
information & the significance of the info
• Publicly traded corporations are required to
include MD&A in their annual reports
• Five key elements that should be included:
1. Company’s vision, core businesses, strategy
2. Key performance drivers
3. Capital and other resources to achieve
4. Historical and prospective results
5. Any risks
Basic Foundational Concepts
and Constraints
Cost-Benefit Relationship
• The cost of providing information should
not be greater than the benefits that are
expected to come from providing the
information
• Costs and benefits are not always obvious
or measurable
• Some costs include:
1. Collecting and processing information
2. Auditing
3. Disclosure to competitors
 Basic Foundational Concepts
and Constraints

Materiality

Relates to an item’s impact on an entity’s overall
financial operations

An item is material if including it or leaving it out
influences a decision-maker

An item must make a difference, otherwise, it does
not need to be disclosed

Both quantitative and qualitative factors should be
considered in determining relative significance

Determination of materiality requires professional
judgement and expertise
Basic Foundational Concepts
and Constraints
How have standards changed:
Industry Practice
• The nature of some industries may sometimes
require departures from basic accounting
theory
• Must be consistent with primary sources of
GAAP and conceptual framework
Industry practice NO longer accepted as a
rationale to change accounting principles
Issue Identification

All issues fall into one of the following

categories:
1. Recognition
2. Measurement
3. Presentation
4. Disclosure
Choice in Accounting
Decision-Making
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