Conceptual Framework CHAPTER 2

for Financial Reporting

LEARNING
LEARNING OBJECTIVES
OBJECTIVES
After studying this chapter, you should be able to:
1. Describe the usefulness of a 3. Review the basic
conceptual framework and the assumptions of accounting.
objective of financial reporting. 4. Explain the application of the
2. Identify the qualitative basic principles of
characteristics of accounting accounting.
information and the basic
elements of financial
statements.

2-1
 PREVIEW OF CHAPTER 2

2-2
 LEARNING OBJECTIVE 1
Conceptual
Conceptual Framework
Framework Describe the usefulness of a
conceptual framework and the
objective of financial reporting.

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
 Conceptual
Conceptual Framework
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.

2-4 LO 1
 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.

2-5 LO 1
 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
3. Equity Bridge between
2. Enhancing
qualities 4. Income levels 1 and 3
5. Expenses

OBJECTIVE
Provide information
about the reporting
entity that is useful First level
ILLUSTRATION 2.7 to present and potential
Conceptual Framework for The "why"—purpose
equity investors,
Financial Reporting of accounting
lenders, and other
creditors in their
capacity as capital
2-6 providers.
 Basic
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.

2-7 LO 1
 LEARNING OBJECTIVE 2
Fundamental Concepts Identify the qualitative
characteristics of accounting
information and the elements
of financial statements.
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.

2-8 LO 2
 Qualitative Characteristics

ILLUSTRATION 2.2
Hierarchy of Accounting
Qualities

2-9 LO 2
 Relevance
Relevance

ILLUSTRATION 2.7
Conceptual Framework for
Financial Reporting

2-10 LO 2
 Qualitative Characteristics
Fundamental Quality—Relevance

To be relevant, accounting information must be capable of making

a difference in a decision.
Financial information is capable of making a difference in decisions if
it has predictive value or confirmatory value

2-11 LO 2
 Qualitative Characteristics

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.
2-12 LO 2
 Qualitative Characteristics

Fundamental Quality—Relevance

Relevant information also helps users confirm or correct prior

expectations.

2-13 LO 2
 Qualitative Characteristics

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.
2-14 LO 2
 Faithful
Faithful Representation
Representation

ILLUSTRATION 2.7
Conceptual Framework for
Financial Reporting

2-15 LO 2
 Qualitative Characteristics

Fundamental Quality—Faithful Representation

Faithful representation means that the numbers and descriptions

match what really existed or happened.

2-16 LO 2
 Qualitative Characteristics

Fundamental Quality—Faithful Representation

Completeness means that all the information that is necessary for

faithful representation is provided.

2-17 LO 2
 Qualitative Characteristics

Fundamental Quality—Faithful Representation

Neutrality means that a company cannot select information to favor

one set of interested parties over another.

2-18 LO 2
 Qualitative Characteristics

Fundamental Quality—Faithful Representation

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

(faithful) representation of a financial item.

2-19 LO 2
 Qualitative Characteristics

Enhancing Qualities

Information that is measured and reported in a similar manner for

different companies is considered comparable.

2-20 LO 2
 Qualitative Characteristics

Enhancing Qualities

Verifiability occurs when independent measurers, using the same

methods, obtain similar results.

2-21 LO 2
 Qualitative Characteristics

Enhancing Qualities

Timeliness means having information available to decision-makers

before it loses its capacity to influence decisions.

2-22 LO 2
 Qualitative Characteristics

Enhancing Qualities

Understandability is the quality of information that lets reasonably

informed users see its significance.
These four qualitative characteristics enhance the usefulness of
2-23 LO 2
information but they cannot make non-useful information useful
 Basic
Basic Elements
Elements

ILLUSTRATION 2.7
Conceptual Framework for
Financial Reporting

2-24 LO 2
 Basic Elements
Elements of Financial Statements

Asset A present economic resource controlled

by the entity as a result of past events

Liability An economic resource is a right that

has the potential to produce economic
benefits
Equity

Income

Expenses
2-25 LO 2
 Basic Elements
Elements of Financial Statements

Asset
A present obligation of the entity to
transfer an economic resource as a
Liability
result of past events

Equity

Income

Expenses
2-26 LO 2
 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
2-27 LO 2
 Basic Elements
Elements of Financial Statements

Asset

Liability

Equity Increases in assets, or decreases in

liabilities, that result in increases in
Income equity, other than those relating to
contributions from holders of equity
claims
Expenses
2-28 LO 2
 Basic Elements
Elements of Financial Statements

Asset

Liability

Equity

Income Decreases in assets, or increases in

liabilities, that result in decreases in
equity, other than those relating to
Expenses
distributions to holders of equity claims
2-29 LO 2
 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
2-30 LO 2
 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.
2-31 LO 2
 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
2-32 LO 2
 Recognition, LEARNING OBJECTIVE 3
Review the basic
Measurement, and assumptions of accounting.

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
2-33 LO 3
 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.

2-34 LO 3
 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

2-35 LO 3
 Basic Principles of LEARNING OBJECTIVE 4
Explain the application of the
Accounting basic principles of accounting.

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.
2-36 LO 4
 Basic Principles of Accounting

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

2-37 LO 4
 Basic Principles of Accounting

Revenue Recognition Principle

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.

2-38 LO 4
Basic
Principles of
Accounting
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
2-39
Revenue Recognition
 Basic Principles of Accounting

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 Procedures for Product and Period Costs

2-40 LO 4
 Basic Principles of Accounting

Full Disclosure Principle

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

2-41 LO 4
 Basic Principles of Accounting

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.
2-42 LO 4
 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.

2-43 LO 4
 Cost Constraint

BE2-11: Determine whether you would classify these

transactions as material.
(a) Blair Co. has reported a positive trend in
earnings over the last 3 years. In the current Material
year, it reduces its bad debt expense to ensure
another positive earnings year. The impact of
this adjustment is equal to 3% of net income. b.
(b) Hindi SE has a gain of €3.1 million on the sale of
plant assets and a €3.3 million loss on the sale
Material
of investments. It decides to net the gain and
loss because the net effect is considered
immaterial. Hindi SE’s income for the current
2-44
year was €10 million.
LO 4
 Cost Constraint

BE2-11: Determine whether you would classify these

transactions as material.
(c) Damon SpA 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.

2-45 LO 4
Summary of
the Structure

ILLUSTRATION 2.7
Conceptual Framework for
Financial Reporting

2-46 LO 2