Overview: Conceptual Framework of Accounting

2-1
 Conceptual Framework
for Financial Reporting

LEARNING OBJECTIVES
After studying this chapter, you should be able to:

1. Describe the usefulness of a 5. Define the basic elements of financial

conceptual framework. statements.

2. Describe efforts to construct a conceptual 6. Describe the basic assumptions of

framework. accounting.

3. Understand the objective of financial 7. Explain the application of the basic principles
reporting. of accounting.

4. Identify the qualitative characteristics of 8. Describe the impact that the cost constraint
accounting information. has on reporting accounting information.

2-2
 CONCEPTUAL FRAMEWORK

Conceptual Framework establishes the concepts that

underlie financial reporting.

Need for a Conceptual Framework

► Rule-making should build on and relate to an established
body of concepts.
► Enables IASB to issue more useful and consistent
pronouncements over time.

2-3 LO 1
 WHAT’S YOUR PRINCIPLE?

The need for a conceptual framework is highlighted by accounting scandals

such as those at Royal Ahold (NLD), Enron (USA), and Satyan Computer
Services (IND). To restore public confidence in the financial reporting process,
many have argued that regulators should move toward principles-based rules.
They believe that companies exploited the detailed provisions in rules-based
pronouncements to manage accounting reports, rather than report the
economic substance of transactions. For example, many of the off–balance-
sheet arrangements of Enron avoided transparent reporting by barely achieving
3 percent outside equity ownership, a requirement in an obscure accounting
rule interpretation. Enron’s financial engineers were able to structure
transactions to achieve a desired accounting treatment, even if that accounting
treatment did 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.
2-4 LO 1
 Conceptual Framework
for Financial Reporting

LEARNING OBJECTIVES
After studying this chapter, you should be able to:

1. Describe the usefulness of a conceptual 5. Define the basic elements of financial

framework. statements.

2. Describe efforts to construct a 6. Describe the basic assumptions of

conceptual framework. accounting.

3. Understand the objective of financial 7. Explain the application of the basic principles
reporting. of accounting.

4. Identify the qualitative characteristics of 8. Describe the impact that the cost constraint
accounting information. has on reporting accounting information.

2-5
 CONCEPTUAL FRAMEWORK

Development of a Conceptual Framework

Presently, the Conceptual Framework is comprises of the following.
• Chapter 1: The Objective of General Purpose Financial Reporting
• Chapter 2: The Reporting Entity (not yet issued)
• Chapter 3: Qualitative Characteristics of Useful Financial Information
• Chapter 4: The Framework, comprised of the following:
1. Underlying assumption—the going concern assumption;
2. The elements of financial statements;
3. Recognition of the elements of financial statements;
4. Measurement of the elements of financial statements; and
5. Concepts of capital and capital maintenance.

2-6 LO 2
 CONCEPTUAL FRAMEWORK

Overview of the Conceptual Framework

Three levels:
 First Level = Objectives of Financial Reporting
 Second Level = Qualitative Characteristics and
Elements of Financial Statements
 Third Level = Recognition, Measurement, and
Disclosure Concepts.

2-7 LO 2
 ASSUMPTIONS PRINCIPLES CONSTRAINTS
1. Economic entity 1. Measurement 1. Cost
2. Going concern 2. Revenue recognition
Third level
3. Monetary unit 3. Expense recognition
The "how"—
4. Periodicity 4. Full disclosure implementation
5. Accrual

QUALITATIVE
CHARACTERISTICS ELEMENTS
1. Fundamental 1. Assets
qualities 2. Liabilities Second level
2. Enhancing 3. Equity Bridge between
qualities 4. Income
levels 1 and 3
5. Expenses
ILLUSTRATION 2-7
Conceptual Framework
for Financial Reporting OBJECTIVE
Provide information
about the reporting
entity that is useful
to present and potential First level
equity investors, The "why"—purpose
lenders, and other of accounting
creditors in their
capacity as capital
2-8 providers.
 Conceptual Framework
for Financial Reporting

LEARNING OBJECTIVES
After studying this chapter, you should be able to:

1. Describe the usefulness of a conceptual 5. Define the basic elements of financial

framework. statements.
2. Describe efforts to construct a conceptual 6. Describe the basic assumptions of
framework. accounting.

3. Understand the objective of financial 7. Explain the application of the basic principles
reporting. of accounting.

4. Identify the qualitative characteristics of 8. Describe the impact that the cost constraint
accounting information. has on reporting accounting information.

2-9
 FIRST LEVEL: BASIC OBJECTIVE

OBJECTIVE
“To provide financial information about the reporting entity
that is useful to present and potential equity investors,
lenders, and other creditors in making decisions about
providing resources to the entity.

 Provided by issuing general-purpose financial statements.

 Assumption is that users need reasonable knowledge of business
and financial accounting matters to understand the information.

2-10 LO 3
 Conceptual Framework
for Financial Reporting

LEARNING OBJECTIVES
After studying this chapter, you should be able to:

1. Describe the usefulness of a conceptual 5. Define the basic elements of financial

framework. statements.
2. Describe efforts to construct a conceptual 6. Describe the basic assumptions of
framework. accounting.
3. Understand the objective of financial 7. Explain the application of the basic principles
reporting. of accounting.

4. Identify the qualitative characteristics 8. Describe the impact that the cost constraint
of accounting information. has on reporting accounting information.

2-11
SECOND LEVEL: FUNDAMENTAL CONCEPTS

Qualitative Characteristics of Accounting

Information
IASB identified the Qualitative Characteristics of
accounting information that distinguish better (more useful)
information from inferior (less useful) information for
decision-making purposes.

2-12 LO 4
SECOND LEVEL: FUNDAMENTAL CONCEPTS

ILLUSTRATION 2-2
Hierarchy of Accounting
Qualities

2-13 LO 4
 Relevance

ILLUSTRATION 2-7
Conceptual Framework
for Financial Reporting

2-14 LO 4
SECOND LEVEL: FUNDAMENTAL CONCEPTS

Fundamental Quality—Relevance

To be relevant, accounting information must be capable of making

a difference in a decision.

2-15 LO 4
SECOND LEVEL: FUNDAMENTAL CONCEPTS

Fundamental Quality—Relevance

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.
2-16 LO 4
SECOND LEVEL: FUNDAMENTAL CONCEPTS

Fundamental Quality—Relevance

Relevant information also helps users confirm or correct prior

expectations.

2-17 LO 4
SECOND LEVEL: FUNDAMENTAL CONCEPTS

Fundamental Quality—Relevance

Information is material if omitting it or misstating it could influence

decisions that users make on the basis of the reported financial
information.
2-18 LO 4
 Faithful Representation

ILLUSTRATION 2-7
Conceptual Framework
for Financial Reporting

2-19 LO 4
SECOND LEVEL: FUNDAMENTAL CONCEPTS

Fundamental Quality—Faithful Representation

Faithful representation means that the numbers and descriptions

match what really existed or happened.

2-20 LO 4
SECOND LEVEL: FUNDAMENTAL CONCEPTS

Fundamental Quality—Faithful Representation

Completeness means that all the information that is necessary for

faithful representation is provided.

2-21 LO 4
SECOND LEVEL: FUNDAMENTAL CONCEPTS

Fundamental Quality—Faithful Representation

Neutrality means that a company cannot select information to favor

one set of interested parties over another.

2-22 LO 4
SECOND LEVEL: FUNDAMENTAL CONCEPTS

Fundamental Quality—Faithful Representation

An information item that is free from error will be a more accurate

(faithful) representation of a financial item.

2-23 LO 4
SECOND LEVEL: FUNDAMENTAL CONCEPTS

Enhancing Qualities

Information that is measured and reported in a similar manner for

different companies is considered comparable.

2-24 LO 4
SECOND LEVEL: FUNDAMENTAL CONCEPTS

Enhancing Qualities

Verifiability occurs when independent measurers, using the same

methods, obtain similar results.

2-25 LO 4
SECOND LEVEL: FUNDAMENTAL CONCEPTS

Enhancing Qualities

Timeliness means having information available to decision-makers

before it loses its capacity to influence decisions.

2-26 LO 4
SECOND LEVEL: FUNDAMENTAL CONCEPTS

Enhancing Qualities

Understandability is the quality of information that lets reasonably

informed users see its significance.

2-27 LO 4
 Conceptual Framework
for Financial Reporting

LEARNING OBJECTIVES
After studying this chapter, you should be able to:

1. Describe the usefulness of a conceptual 5. Define the basic elements of financial

framework. statements.
2. Describe efforts to construct a conceptual 6. Describe the basic assumptions of
framework. accounting.
3. Understand the objective of financial 7. Explain the application of the basic principles
reporting. of accounting.
4. Identify the qualitative characteristics of 8. Describe the impact that the cost constraint
accounting information. has on reporting accounting information.

2-28
 Basic Elements

ILLUSTRATION 2-7
Conceptual Framework
for Financial Reporting

2-29 LO 5
 SECOND LEVEL: BASIC ELEMENTS
Elements of Financial Statements

Asset A resource controlled by the entity as a

result of past events and from which
future economic benefits are expected to
Liability flow to the entity.

Equity

Income

Expenses
2-30 LO 5
 SECOND LEVEL: BASIC ELEMENTS
Elements of Financial Statements

Asset
A present obligation of the entity arising
from past events, the settlement of which
Liability
is expected to result in an outflow from the
entity of resources embodying economic
Equity benefits.

Income

Expenses
2-31 LO 5
 SECOND LEVEL: BASIC ELEMENTS
Elements of Financial Statements

Asset

Liability

Equity The residual interest in the assets of the

entity after deducting all its liabilities.

Income

Expenses
2-32 LO 5
 SECOND LEVEL: BASIC ELEMENTS
Elements of Financial Statements

Asset

Liability

Equity Increases in economic benefits during the

accounting period in the form of inflows or
enhancements of assets or decreases of
Income
liabilities that result in increases in equity,
other than those relating to contributions
Expenses from equity participants.
2-33 LO 5
 SECOND LEVEL: BASIC ELEMENTS
Elements of Financial Statements

Asset

Liability

Equity Decreases in economic benefits during the

accounting period in the form of outflows
Income or depletions of assets or incurrences of
liabilities that result in decreases in equity,
other than those relating to distributions to
Expenses
equity participants.
2-34 LO 5
 SECOND LEVEL: BASIC ELEMENTS
Exercise 2-4: Identify the qualitative characteristic(s) to be used
given the information provided. Characteristics
(a) Qualitative characteristic being Relevance
displayed when companies in the Faithful representation
same industry are using the same Predictive value
accounting principles.
Confirmatory value
(b) Quality of information that confirms Neutrality
users’ earlier expectations.
Materiality
(c) Imperative for providing comparisons Timeliness
of a company from period to period.
Verifiability
(d) Ignores the economic consequences Understandability
of a standard or rule.
Comparability
2-35 LO 5
 SECOND LEVEL: BASIC ELEMENTS
Exercise 2-4: Identify the qualitative characteristic(s) to be used
given the information provided. Characteristics
(e) Requires a high degree of consensus Relevance
among individuals on a given Faithful representation
measurement. Predictive value
(f) Predictive value is an ingredient of this Confirmatory value
fundamental quality of information. Neutrality
(g) Four qualitative characteristics that Materiality
enhance both relevance and faithful Timeliness
representation.
Verifiability
(h) An item is not reported because its Understandability
effect on income would not change a
Comparability
decision.
2-36 LO 5
 SECOND LEVEL: BASIC ELEMENTS
Exercise 2-4: Identify the qualitative characteristic(s) to be used
given the information provided. Characteristics
(i) Neutrality is a key ingredient of this Relevance
fundamental quality of accounting Faithful representation
information. Predictive value
(j) Two fundamental qualities that make Confirmatory value
accounting information useful for Neutrality
decision-making purposes.
Materiality
(k) Issuance of interim reports is an Timeliness
example of what enhancing
Verifiability
ingredient?
Understandability
Comparability
2-37 LO 5
 Conceptual Framework
for Financial Reporting

LEARNING OBJECTIVES
After studying this chapter, you should be able to:

1. Describe the usefulness of a conceptual 5. Define the basic elements of financial

framework. statements.
2. Describe efforts to construct a conceptual 6. Describe the basic assumptions of
framework. accounting.
3. Understand the objective of financial 7. Explain the application of the basic principles
reporting. of accounting.
4. Identify the qualitative characteristics of 8. Describe the impact that the cost constraint
accounting information. has on reporting accounting information.

2-38
THIRD LEVEL: RECOGNITION, MEASUREMENT,
AND DISCLOSURE CONCEPTS

These concepts explain how companies should recognize,

measure, and report financial elements and events.

Recognition, Measurement, and Disclosure Concepts

ASSUMPTIONS PRINCIPLES CONSTRAINTS
1. Economic entity 1. Measurement 1. Cost
2. Going concern 2. Revenue recognition
3. Monetary unit 3. Expense recognition
4. Periodicity 4. Full disclosure
5. Accrual

ILLUSTRATION 2-7
Conceptual Framework for
Financial Reporting

2-39 LO 6
 THIRD LEVEL: ASSUMPTIONS

Basic Assumptions
Economic Entity – company keeps its activity separate from its
owners and other business unit.

Going Concern - company to last long enough to fulfill

objectives and commitments.

Monetary Unit - money is the common denominator.

Periodicity - company can divide its economic activities into

time periods.

Accrual Basis of Accounting – transactions are recorded in the

periods in which the events occur.
2-40 LO 6
 THIRD LEVEL: ASSUMPTIONS

BE2-8: Identify which basic assumption of accounting is best

described in each item below.
(a) The economic activities of FedEx Corporation
(USA) are divided into 12-month periods for the Periodicity
purpose of issuing annual reports.
(b) Total S.A. (FRA) does not adjust amounts in its Monetary
financial statements for the effects of inflation. Unit
(c) Barclays (GBR) reports current and non-current
classifications in its statement of financial Going Concern
position.
(d) The economic activities of Tokai Rubber
Industries (JPN) and its subsidiaries are Economic
merged for accounting and reporting purposes. Entity

2-41 LO 6
 Conceptual Framework
for Financial Reporting

LEARNING OBJECTIVES
After studying this chapter, you should be able to:

1. Describe the usefulness of a conceptual 5. Define the basic elements of financial

framework. statements.
2. Describe efforts to construct a conceptual 6. Describe the basic assumptions of
framework. accounting.
3. Understand the objective of financial 7. Explain the application of the basic
reporting. principles of accounting.
4. Identify the qualitative characteristics of 8. Describe the impact that the cost constraint
accounting information. has on reporting accounting information.

2-42
 THIRD LEVEL: BASIC PRINCIPLES

Measurement Principles
 Historical Cost is generally thought to be a faithful
representation of the amount paid for a given item.

 Fair value is defined 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.”

 IASB has given companies the option to use fair value as the
basis for measurement of financial assets and financial
liabilities.
2-43 LO 7
 THIRD LEVEL: BASIC PRINCIPLES

Measurement Principles
IASB established a fair value hierarchy that provides insight into
the priority of valuation techniques to use to determine fair value.
ILLUSTRATION 2-4

2-44 LO 7
 THIRD LEVEL: BASIC PRINCIPLES

Revenue Recognition
When a company agrees to perform a service or sell a product to
a customer, it has a performance obligation.

Requires that companies recognize revenue in the accounting

period in which the performance obligation is satisfied.

2-45 LO 7
THIRD
LEVEL:
BASIC
PRINCIPLES
Illustration: Assume
the Airbus (DEU) signs
a contract to sell
airplanes to British
Airways (GRB) for
€100 million. To
determine when to
recognize revenue,
Airbus uses the five
steps for revenue
recognition shown at
right.
ILLUSTRATION 2-5
The Five Steps of
2-46
Revenue Recognition
 THIRD LEVEL: BASIC PRINCIPLES

Expense Recognition - Outflows or “using up” of assets

or incurring of liabilities during a period as a result of delivering
or producing goods and/or rendering services. ILLUSTRATION 2-6
Expense Recognition

“Let the expense follow the revenues.”

2-47 LO 7
 THIRD LEVEL: BASIC PRINCIPLES

Full Disclosure
Providing information that is of sufficient importance to
influence the judgment and decisions of an informed user.
Provided through:
 Financial Statements
 Notes to the Financial Statements
 Supplementary information

2-48 LO 7
 THIRD LEVEL: BASIC PRINCIPLES

BE2-9: Identify which basic principle of accounting is best

described in each item below.
(a) Parmalat (ITA) reports revenue in its income Revenue
statement when it delivered goods instead of when Recognition
the cash is collected.
(b) Google (USA) recognizes depreciation expense for Expense
a machine over the 2-year period during which that
Recognition
machine helps the company earn revenue.
(c) KC Corp. (USA) reports information about pending
Full
lawsuits in the notes to its financial statements.
Disclosure
(d) Fuji Film (JPN) reports land on its statement of
financial position at the amount paid to acquire it,
even though the estimated fair market value is Measurement
greater.
2-49 LO 7
 Conceptual Framework
for Financial Reporting

LEARNING OBJECTIVES
After studying this chapter, you should be able to:

1. Describe the usefulness of a conceptual 5. Define the basic elements of financial

framework. statements.
2. Describe efforts to construct a conceptual 6. Describe the basic assumptions of
framework. accounting.
3. Understand the objective of financial 7. Explain the application of the basic principles
reporting. of accounting.
4. Identify the qualitative characteristics of 8. Describe the impact that the cost
accounting information. constraint has on reporting
accounting information.

2-50
 THIRD LEVEL: COST CONSTRAINT

Cost Constraint
Companies must weigh the costs of providing the information
against the benefits that can be derived from using it.

 Rule-making bodies and governmental agencies use cost-

benefit analysis before making final their informational
requirements.
 In order to justify requiring a particular measurement or
disclosure, the benefits perceived to be derived from it
must exceed the costs perceived to be associated with it.

2-51 LO 8
 THIRD LEVEL: COST CONSTRAINT

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 Material
earnings year. The impact of this adjustment is
equal to 3% of net income.
(b) Damon Co. expenses all capital equipment
Likely not
under €2,500 on the basis that it is immaterial.
material
The company has followed this practice for a
number of years.

2-52 LO 8
Summary of
the Structure

ILLUSTRATION 2-7
Conceptual Framework
for Financial Reporting

2-53 LO 8
 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.

2-54
 GLOBAL ACCOUNTING INSIGHTS

Relevant Facts
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).

2-55
 GLOBAL ACCOUNTING INSIGHTS

Relevant Facts
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.

2-56
 GLOBAL ACCOUNTING INSIGHTS

Relevant Facts
Similarities
• 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.

Differences
• 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.
2-57
 GLOBAL ACCOUNTING INSIGHTS

Relevant Facts
Differences
• 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).

2-58
 GLOBAL ACCOUNTING INSIGHTS

Relevant Facts
Differences
• 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.

2-59
 GLOBAL ACCOUNTING INSIGHTS

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.

2-60
 GLOBAL ACCOUNTING INSIGHTS

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.

2-61