Conceptual Framework for Financial Reporting

LEARNING OBJECTIVES

1. Describe the usefulness of a conceptual framework.

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

CHAPTER REVIEW

Conceptual Framework

2. (S.O. 1) A conceptual framework in accounting is important because it

can lead to consistent standards and it prescribes the nature, function,
and limits of financial accounting and financial statements. The benefits
its development will generate can be characterized as follows: (a) it
should be easier to promulgate a coherent set of standards and rules;
and (b) practical problems should be more quickly solved.

3. (S.O. 2) The IASB recognized the need for a conceptual framework upon
which a consistent set of financial accounting standards could be
based. The FASB and the IASB are currently working on a joint project
to develop a common conceptual framework that provides a sound
foundation for developing future accounting standards. The framework
will consist of three levels. The first level identifies the objective of
financial reporting. The second level provides the qualitative
characteristics that make accounting information useful and the
elements of financial statements. The third level identifies the
assumptions, principles and constraints that describe the reporting
environment.

Copyright © 2011 John Wiley & Sons, Inc.   Kieso Intermediate: IFRS Edition, Instructor’s Manual 2-1
First Level: Basic Objective

4. (S.O. 3) The objective of financial reporting is the foundation of the

Framework. The objective of general-purpose financial reporting is to
provide financial information about the reporting entity that is useful to
present and potential equity investors, lenders, and other creditors in
making decisions in their capacity as capital providers.

5. An implicit assumption is that users need reasonable knowledge of

business and financial accounting matters to understand the
information contained in financial statements. This means that financial
statement preparers assume a level of competence on the part of users,
which impacts the way and the extent to which companies present
information.

Second Level: Fundamental Concepts

6. (S.O. 4) The fundamental qualities that make accounting information

useful for decision making are relevance and faithful representation.

a. Relevance: Accounting information is relevant if it is capable of

making a difference in a decision. Financial information is capable of
making a difference when it has predictive value, confirmatory value,
or both.

b. Faithful Representation: Means that the numbers and descriptions

contained in the financial statements match what really existed or
happened. To be a faithful representation, information must be
complete, neutral, and free of material error.

(1) Completeness: The financial statements include all the

information that is necessary for faithful representation of the
economic phenomena that it purports to represent.
(2) Neutrality: Information is neutral if it is unbiased, i.e., it is not
presented in a manner that favors one set of interested parties
over another.
(3) Free from error: Does not mean total freedom from error. It means
that the information presented is as accurate as possible, given
any estimates are based on the best information available at the
time.

7. The enhancing qualities are complementary to the fundamental

qualitative characteristics. They include comparability, verifiability,
timeliness, and understandability.

a. Comparability: Information that is measured and reported in a similar

manner for different companies is considered comparable. It enables
users to identify the real similarities and differences in economic

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 events between companies. Consistency is present when a company
applies the same accounting treatment to similar events, from period
to period.

b. Verifiability: Occurs when independent measurers, using the same

methods, obtain similar results.

c. Timeliness: Means having information available to decision-makers

before it loses its capacity to influence decisions.

d. Understandability: Is the quality of information that lets reasonably

informed users to see the connection between their decisions and
the information contained in the financial statements.
Understandability is enhanced when information is classified,
characterized, and presented clearly and concisely.

8. (S.O. 5) The IASB classifies the elements of the financial statements

into two groups. The first group describes amounts of resources and
claims to resources at a moment in time. The second group describes
transactions, events and circumstances that affect a company during a
period time.

a. Resources and claims to resources at a moment in time.

(1) Asset: A resource controlled by the entity as a result of past

events and from which future economic benefits are expected to
flow to the entity.

(2) Liability: A present obligation of the entity arising from past

events, the settlement of which is expected to result in an outflow
from the entity of resources embodying economic benefits.

(3) Equity: The residual interest in the assets of the entity after
deducting all its liabilities.

b. Transactions, events, and circumstances that affect a company

during a period of time.

(1) Income: Increases in economic benefits during the accounting

period in the form of inflows or enhancements of assets or
decreases of liabilities that result in increases in equity, other
than those relating to contributions from equity participants.

(2) Expenses: Decreases in economic benefits during the accounting

period in the form of outflows or depletions of assets or
incurrences of liabilities that result in decreases in equity, other
than those relating to distributions to equity participants.

Third Level: Recognition, Measurement, and Disclosure Concepts

Copyright © 2011 John Wiley & Sons, Inc.   Kieso Intermediate: IFRS Edition, Instructor’s Manual 2-3
9. (S.O. 6) In the practice of financial accounting, certain basic
assumptions are important to an understanding of the manner in which
information is presented. The following five basic assumptions underlie
the financial accounting structure.

a. Economic Entity Assumption: Means that economic activity can be

identified with a particular unit of accountability. In other words, a
company keeps its activity separate and distinct from its owners and
any other business unit.

b. Going Concern Assumption: In the absence of information to the

contrary, a company is assumed to have a long live. The legitimacy of
the cost principle is dependent upon the going concern assumption.

c. Monetary Unit Assumption: Money is the common denominator of

economic activity and provides an appropriate basis for accounting
measurement and analysis. The monetary unit is assumed to remain
relatively stable over the years in terms of purchasing power.
Therefore, this assumption disregards any inflation or deflation in
the economy in which the company operates.

d. Periodicity Assumption: The life of a company can be divided into

artificial time periods for the purpose of providing periodic reports
on the economic activities of the company.

e. Accrual Basis of Accounting: Transactions that change a company’s

financial statements are recorded in the periods in which the events
occur. The cash basis of accounting is prohibited under IFRS
because it violates both the revenue recognition principle and the
expense recognition principle.

10. (S.O. 7) The basic principles of accounting are used to record and report
assets, liabilities, equity, revenues, and expenses. The four basic
principles of accounting are:

a. Measurement Principles: We currently have two acceptable

measurement principles: cost and fair value. Choosing which
principle to follow generally reflects the trade off between relevance
and faithful representation.

(1) Cost Principle: IFRS requires many assets and liabilities be

reported at their acquisition price, or cost, sometimes referred to
as historical cost. It is thought to be a faithful representation of
the amount paid for a given item. Many users favor the cost
principle because it is verifiable.
(2) Fair Value: Is a market based measure. At acquisition historical
cost and fair value are identical. In subsequent periods, as
market and economic conditions change, the two diverge. It is
felt that where fair value information is available, it provides
more relevant information about the expected future cash flows

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 related to an asset or liability. The IASB allows companies the
option to use fair value, the fair value option, as the basis for
measurement of financial assets and financial liabilities.

b. Revenue Recognition Principle: Revenue is recognized (1) when

realized or realizable and (2) when earned. Recognition at the time of
sale provides a uniform and reasonable test. Certain variations in the
revenue recognition principle include: certain long-term construction
contracts, end-of-production recognition, and recognition upon
receipt of cash.

c. Expense Recognition Principle: Recognition of expenses is related to

net changes in assets and earning revenues. The expense
recognition principle is implemented in accordance with the
definition of expense by matching efforts (expenses) with
accomplishment (revenues). Some costs are difficult to associate
with revenues and must be allocated to expense based on a “rational
and systematic” policy. Product costs are expense when the units
they are attached to are sold. Period costs are expense as incurred.

d. Full Disclosure Principle: Financial statements should include

sufficient information to permit a knowledgeable user to make an
informed decision about the financial condition of the company in
question. Users can find information (1) within the main body of the
financial statements, (2) in the notes to those statements, or (3) as
supplementary information.

11. (S.O. 8) In providing information with the qualitative characteristics that
make it useful, companies, must consider two overriding factors that
limit the reporting: the cost-benefit relationship and materiality.

a. Cost-Benefit Relationship: This constraint relates to the notion that

the benefits to be derived from providing certain accounting
information should exceed the costs of providing that information.
The difficulty in cost-benefit analysis is that the costs and especially
the benefits are not always evident or measurable.

b. Materiality: In the application of basic accounting theory, an amount may be

considered less important because of its size in comparison with revenues and
expenses, assets and liabilities, or net income. Deciding when an amount is
material in relation to other amounts is a matter of judgment and professional
expertise. Companies must consider both quantitative and qualitative factors in
determining whether an item is material.

Copyright © 2011 John Wiley & Sons, Inc.   Kieso Intermediate: IFRS Edition, Instructor’s Manual 2-5