Chapter 1

Conceptual Framework

Textbook Pages 16-31

Dr. Nafis Rahman

Intermediate Accounting 1
Spring 2020

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 The Conceptual Framework
• Provides structure and direction to financial accounting and
reporting and underlying foundation for IFRS.
• Purpose is to provide guidance to:
– IASB in the development of accounting standards;
– Preparers in formulating accounting policies when no IFRS
exists or when IFRS allows accounting choice; and
– Users to better understand and apply the IFRS.
• Revised Conceptual Framework was published by the IASB in
March 2018 and improved on certain aspects of the 2010
conceptual framework and the 1989 framework (issued by
IASB’s predecessor, the IASC).

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 Conceptual Framework
Objective of financial reporting: To provide financial
information that is useful to capital providers

Recognition,
Measurement,
Qualitative and Presentation
Elements and Disclosure
Characteristics
Capital and
Capital Maintenance
Financial
Constraints Statements Continued

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 Objective of financial reporting
Recognition
Provides relevance
Qualitative and faithful
Characteristics Elements
representation
Fundamental Financial Position
Assets Measurement
Relevance
Liabilities Measurement bases
Faithful representation
Equity Presentation and
Enhancing
Comparability Performance Disclosure
Verifiability Income
Capital and
Timeliness Expenses
Capital Maintenance
Understandability
Concepts
Financial Statements
Statement of financial position
Statement of profit or loss and
Constraint other comprehensive income
Other statements and disclosures
Cost
Underlying assumption (going concern)
effectiveness
Reporting entity (boundary of entity)
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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.
 IFRS does not specify uniform quantitative
thresholds at which an item becomes material.
 Accountants should exercise professional
judgement and experience.

(Continued) 1-9
 Fundamental qualitative
characteristics
A. Relevance
3. Materiality
a) An example of a quantitative factor
• Generally, an item that is less than 5 percent of net
income is 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. 1-14
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.
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 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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 Qualitative Characteristics of
Financial Reporting Information

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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. It should be in a language investors understand
• Investors appreciate this property
• Research shows that the US investors shy away from
investing in firms located in Quebec (the French speaking
Province of Canada). This bias against Quebec firm
increases with the proportion of French language usage in
the firm disclosures—Lundholm, Rahman (your Prof ),
Rogo 2018.
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 Elements of Financial Statements
• An asset is an economic resource that a company has
control over and that arises from past events.
• The definition of a liability consists of three components:
present obligation, obligation to transfer economic
resources, and past events.
• Equity comprises the remaining interest in a company’s
assets after deducting liabilities.
• Income (revenues and gains) comes about from increment
in assets or reduction in liabilities and leads to increases in
equity, except those pertaining to shareholder contribution.
• Expenses (including losses) come about from reduction in
assets or increment in liabilities and result in decreases in
equity, except those pertaining to shareholder distributions.

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 Financial Statements
• Primary means of communicating financial information to
external parties.
Statement of Financial Position: presents organized list of
assets, liabilities, and equity at a point in time.
Statement of Profit or Loss and Other Comprehensive
Income: summarizes the income-generating activities that
caused shareholders’ equity to change and that were not a
result of transactions with owners. Presented either in a single,
continuous statement, or in two separate but consecutive
statements.
Statement of Cash Flows: summarizes and classifies the
transactions that caused cash to change.
Statement of Changes in Equity: discloses the events that
caused shareholders’ equity accounts to change.

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 Underlying Assumptions
Going concern assumption (stated in the Conceptual Framework
as the assumption underlying preparation and presentation of
financial statements) presumes a business entity will continue to
operate indefinitely.
Economic entity assumption presumes economic events can be
identified specifically with a particular economic entity.
Periodicity assumption allows a company’s life to be divided into
artificial time periods to provide timely information.
Monetary unit assumption requires financial statement elements to
be measured in nominal units of money.

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 Recognition, Measurement, and
Presentation and Disclosure
• Recognition refers to the process of incorporating
information into the financial statements.
• Measurement is the process of associating numerical
amounts with the elements.
• Presentation and Disclosure refer to the process of
including additional pertinent information in the financial
statements and accompanying notes.

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 Recognition Criteria
• An item should be recognized in the basic financial
statements if it meets the definition of the item and the
following two conditions:
– Recognition provides relevant information about the item.
– Recognition provides faithful representation of the item.
• Uncertainty in the existence and measurement of assets and
liabilities and low probability of inflow or outflow of benefits are
some factors that indicate recognition does not result in
relevant information.

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 Revenue and Expense Recognition
• Under IFRS 15, revenue is recognized at a point in time or
over a period, depending on when seller fulfills performance
obligations of transferring control of goods or services to
customers for the amount seller expects to be entitled to
receive in exchange for those goods or services.
• In practice, expenses are reported in the same period as the
related revenue if there is a direct causal relationship
between revenue and expense, or related to a particular
period, allocated over several periods, or expensed as
incurred (if there is no causal relationship).

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 Measurement
• There are two main categories of measurement bases:
historical cost and current value.
• Current value is further categorized into value in use (for
assets), fulfillment value (for liabilities), and fair value.
• The measurement bases are:
Historical cost: original transaction value adjusted for
depreciation and amortization.
Value in use (for assets) and fulfillment value (for
liabilities): present value of future cash flows, discounted for
the time value of money.
Fair value: the transaction price for selling an asset or for
transferring a liability, for a transaction that occurs between
market participants.

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 Fair Value
• Fair value bases measurements on the price that would be
received to sell assets or transfer liabilities in an orderly
market transaction.
• Fair value can be measured using:
- Market approach: valuation based on market information.
- Income approach: estimates future amounts and then
mathematically converts those amounts to a single present
value.
- Cost approach: estimates the amount that would be
required to buy or construct an asset of similar quality and
condition.

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 Fair Value Hierarchy
Level Inputs Example
1 Quoted market prices in active Quoted share price from the
Most markets for identical assets or stock exchange on which the
Desirable liabilities. security is traded.

2 Quoted prices for similar assetsFair value of building used as

or liabilities in active or inactive
noncash consideration:
markets and inputs that are quoted market price for
derived from observable market similar buildings recently sold
data. or price per square foot from
observable market data.
3 Unobservable inputs that reflect Fair value of asset retirement
Least the entity’s own assumptions obligations (AROs) using
Desirable about the assumptions market present value of expected
participants would use in pricing cash flows estimated using
the asset or liability. the entity’s own data.

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 Fair Value Option
• Fair Value Option: IFRS gives a company the option, in
some circumstances, to choose whether to report financial
assets and liabilities at fair value.
– Financial assets and liabilities are cash and other assets
and liabilities that convert directly into known amounts of
cash. For example, shares and bonds of other companies,
notes receivable and payable, bonds payable, and
derivative securities.
– Provides companies a way to reduce volatility in reported
earnings without having to comply with complex hedge
accounting standards.

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