Chapter 2Conceptual Framework Underlying Financial

Reporting

September 18/20, 2013

Objective of a Conceptual Framework

• The objective of a conceptual framework is to facilitate the consistent and logical formulation of standards and provide a basis for the use of judgment in resolving accounting issues. (Preface to CICA Handbook –Accounting)

First Level: Objective of Financial Reporting• IFRS: “The objective of general purpose financial reporting is

to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity.” (IFRS OB2)

• ASPE: “The objective of financial statements is to communicate information that is useful to investors, creditors and other users ("users") in making their resource allocation decisions and/or assessing management stewardship.” (HB 1000.12)

• Both standards emphasize similar objectives and management stewardship is embedded in IFRS OB16.

Second Level: Qualitative Characteristics

• IFRS:– Fundamental Characteristics

• Relevance • Representational Faithfulness

– Enhancing Characteristics: help determine which of two ways should be used to depict a phenomenon if both are considered equally relevant and faithfully represented

• Comparability• Verifiability• Timeliness• Understandability

Second Level: Qualitative Characteristics

• ASPE:• Understandability• Relevance• Reliability (similar to Representational Faithfulness)• Comparability

Relevance

• Relevant financial information is capable of making a difference in the decisions made by users.

• Essential Properties:– Predictive value: Financial information has predictive

value if it can be used as an input to processes employed by users to predict future outcomes.

– Confirmatory value: provides feedback about (confirms or changes) previous evaluations.

– Materiality: Information is material if omitting it or misstating it could influence decisions that users make on the basis of financial information about a specific reporting entity.

ExamplesWhich qualitative characteristic is best described here?1. Financial analysts forecast revenue growth by using 5-year

revenue figures contained in My Little Pony’s Inc.’s annual report.

2. In January 2013, CFO of Jabba Corp. issued earnings forecast for the fiscal year. In December 2013, the financial statements show that Jabba Corp. has missed the forecast by $0.5/share.

3. Hendrix Inc. has earnings of $2.5/share in fiscal year 2013. However, the company was involved in litigation with Vinyasa Ltd. over a product malfunction. If Hendrix loses the lawsuit, the company may have to pay up to $4 million in damages, equivalent to $0.75/share. Hendrix has disclosed this litigation in the financial statements.

Representational Faithfulness

• Transactions and events affecting the entity are presented in financial statements in a manner that is in agreement with the actual underlying transactions and events. Thus, transactions and events are accounted for and presented in a manner that conveys their substance rather than necessarily their legal or other form.

Representational Faithfulness• Three Properties:

– Complete: includes all information necessary for a user to understand the phenomenon being depicted, including all necessary descriptions and explanations.

– Neutral: without bias in the selection or presentation of financial information

– Free from error: no errors or omissions in the description of the phenomenon, and the process used to produce the reported information has been selected and applied with no errors in the process.

Reliability (ASPE)

• Reliability is achieved through all the attributes underlying representational faithfulness and with the addition of Conservatism:– Use of conservatism in making judgments under

conditions of uncertainty affects the neutrality of financial statements in an acceptable manner. When uncertainty exists, estimates of a conservative nature attempt to ensure that assets, revenues and gains are not overstated and, conversely, that liabilities, expenses and losses are not understated.

ExamplesWhich qualitative characteristic is best described here?1. EB Energy Inc. appreciates that financial information may be

misrepresented or misinterpreted if all pertinent information is not included.

2. Wright Industries management did not take into consideration of any bonus plan implications when developing all estimates and assumptions to prepare its financial information.

3. Sandy Inc. ensures that transactions over a certain amount are reviewed by at least two senior level executives before recording in the books.

4. Graham Crackers Corp. recorded the highest possible amount of loss expected to result from the lawsuit.

5. Graham Crackers Corp. recorded the highest possible amount of loss expected to result from the lawsuit, even though it is confident that either it will win the lawsuit or it owe a much smaller amount.

Enhancing Qualities• Comparability:

– Between entities: information about a reporting entity is more useful if it can be compared with similar information about other entities

– Within an entity: use of the same methods for the same items, from period to period within a reporting entity.

• Verifiability:– different knowledgeable and independent observers

could reach consensus, although not necessarily complete agreement, that a particular depiction is a faithful representation. I.e. other people can use similar methods and come to similar conclusions.

Enhancing Qualities

• Timeliness: For information to be useful for decision making, it must be received by the decision maker before it loses its capacity to influence decisions.

• Understandability: Classifying, characterizing and presenting information clearly and concisely makes it understandable. Financial reports are prepared for users who have a reasonable knowledge of business and economic activities and who review and analyze the information diligently.

Examples

Which qualitative characteristic is best described here?1. When Foster Inc. changed its inventory valuation

method from LIFO to FIFO in 2013, it also restated its inventory balance in 2010 and 2011 using FIFO.

2. Bailey Corp. discloses all inputs and the process it uses to estimate the fair value of its properties.

3. On top of producing annual financial statements, Jabba Inc. also produces quarterly financial statements.

4. Skywalker Corp. used plain and precise language to describe the sale of its assets in the financial statements.

Trade-Offs

• It is not always possible to have all fundamental and enhancing qualitative characteristics

• Trade-offs happen when one qualitative characteristics is sacrificed for another.

• E.g. Should Land and Buildings be recorded using current market value or the original cost?– Current market value increases predictive value and

therefore relevance.– Cost is more verifiable than current market value.– A trade-off between relevance (or predictive value)

and reliability (or verifiability).

Benefits vs. Cost constraints on Useful Information

• The benefits expected to arise from providing information in financial statements should exceed the cost of doing so.

• Costs of Financial Reporting:– collecting, processing, verifying and disseminating financial

information.– Users ultimately bear the cost through reduced rate of return.

• Benefits:– efficient functioning of capital markets– lower cost of capital– Investors made more informed decisions

Second Level: Elements of Financial Statements

• Assets• Liabilities• Equity• Income:

– Revenues – from ordinary activities– Gains- from peripheral transactions

• Expense:– Expenses – from ordinary activities– Losses – from peripheral transactions

Assets

• An asset is 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.

• Control: The entity has the rights to the future economic benefits arising directly, or indirectly from the use of the resource.

• Future economic benefits: The potential to contribute, directly or indirectly, to the flow of cash and cash equivalents to the entity, beyond the current fiscal year that the resource is acquired.

• Past events: Transactions or events expected to occur in the future do not in themselves give rise to assets.

Roger’s financial statements

Roger’s financial statements

Liabilities

• A liability is 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.

• Present Obligation: An obligation is a duty or responsibility, maybe legally enforceable, or one that the entity has little discretion to avoid.

• The outlflow of resources can take form of cash, assets, services, etc.

Roger’s financial statements

Roger’s financial statements

Roger’s financial statements

Equity

• Equity is the residual interest in the assets of the entity after deducting all its liabilities.

Roger’s financial statements

Examples

Identify whether the events below give rise to an asset, liability, equity, or none of the above:1. Maxwell Ltd. hires a manager work for the company.2. The Blue Jays signs a new player with a multiple year contract.3. Galaxy Inc. sell mobile phones with attached 3-year extended

warranty plans.4. An oil spill occurs where there is no regulation that requires

clean up.5. Obi-Wan Corp. sells shares to an investor and the company

agrees to buy back the shares at the price equal to the minimum of the original costs or market value 5 years later.

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.

• Revenues:– arises in the course of the ordinary activities of an entity.

E.g. sales, fees, interest, dividends, royalties and rent.• Gains:

– arises from peripheral activities. E.g. sale of non-current assets.

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.

• Expenses arise from ordinary business e.g. cost of sales, wages and depreciation.

• Losses arise from peripheral activities e.g. disasters such as fire and flood, sale of non-current assets.

Roger’s financial statements

Examples

Identify whether the events below give rise to revenue, gain, expense, or loss:• William Inc., disposes of one of its buildings and the

proceed is higher than cost.– William Inc. is a computer software company.– William Inc. is a homebuilder

• George Inc. disposes of some of its equity investments and the proceed is lower than cost.– George Inc. is an investment company.– George Inc. is a manufacturing company

Comprehensive Income (IFRS only)

• Includes other gains/losses that are not included in net income such as unrealized holding gains/losses on investments, land and buildings etc.

• These gains and losses do not flow through net income and are regarded as changes in equity.

• When the assets are disposed of, the unrealized gains/losses will then be transferred to net income.

Third Level: Foundational Principles

• Foundational concepts and constraints help identify:– When and which items should be recorded

(Recognition and Derecognition) – How should the items be recorded (Measurement)– Where should the items be disclosed (Presentation

and Disclosure)

• Every transaction must be analyzed through these three processes

Recognition and Derecognition

• Recognition and Derecognition answer question of “When” and “Which” items should be recorded in the financial statements.

• An item should be recognized if:– It meets the definition of an element

(asset/liability/equity/income/expense); and– it is probable that any future economic benefit associated

with the item will flow to or from the entity; and– the item has a cost or value that can be measured with

reliability.• An item should be derecognized (removed from the financial

statements) if it stops to meet the above criteria.

Recognition and Derecognition• Let’s step back to think about the three criteria for

recognition of an item in the financial statements, especially criteria 2 and 3.

• Which Qualitative Characteristics will be violated if criteria 2 and 3 are not adhered to?

ExampleConsider the following two scenarios:1. Carz Inc. purchased a photocopier for use in its

business from a backstreet vendor for $3,000. The photocopier broke down immediately at first use and could not be repaired.

2. Smurfz Corp. purchased a photocopier from a national business supplies store for $3,000. The photocopier worked fine and greatly improved productivity in the office.

Recognition and Derecognition

• There are FOUR foundational principles:– Economic entity assumption– Control– Revenue recognition and realization principles– Matching principle

Recognition and Derecognition: Economic Entity Assumption

• The economic activity can be identified with a particular unit of accountability, i.e. the reporting unit

• The business activity is separate and distinct from its owners (and any other business unit)• e.g. the owner purchases a car for his own use

would not be recorded in the financial statements of the entity he owns.

• Does not necessarily refer to a legal entity• Legal entity concept is used for tax and legal

purposes

Recognition and Derecognition: Economic Entity Assumption

Recognition and Derecognition: Control

• The concept of control is important to determine whether entities should be included (consolidated) into the economic entity.

• Control under IFRS:1. Having power over investee2. Exposure, or rights, to variable returns from

involvement with investee; and3. Ability to use power over investee to affect amount

of investor’s returns• Control under ASPE:

– Continuing power to determine strategic decisions without the co-operation of others

Recognition and Derecognition: Control

• Why are the Economic Entity Assumption and concept of Control so important?

• Take the example of Enron:– Enron set up companies called “Special Purpose Entities (SPEs) by

manipulating the rules.– Enron sold assets to the SPEs and recorded gains on Enron’s books.– The SPEs held large amount of debt to finance the purchase of assets

from Enron.– BUT Enron did not consolidate the financial statements of these SPEs

into its financial statements, therefore investors were not aware of the inflated income and the huge amount of debt that Enron was hiding.

– Under IFRS and ASPE’s concept of control, these SPEs most likely would have been consolidated.

Roger’s Financial Statements

Recognition and Derecognition: Revenue Recognition Principle

• Revenue is recognized when an increase in future economic benefits related to an increase in an asset (e.g. cash or accounts receivable) or a decrease of a liability (e.g. debt or accounts payable) has arisen that can be measured reliably.

• Generally speaking revenue can be recognized when:1. It is earned, meaning risks and rewards of ownership have

passed (in the case of selling goods); and/or the earnings process is substantially complete (in the case of service);

2. the revenue can be measured; and3. The revenue is collectible

Roger’s Revenue Recognition Policy

Roger’s Revenue Recognition Policy

Exercise

When should revenue should be recognized?E2-10:1. Air Yukon sells you an advance purchase

airline ticket in September for your flight home at Christmas.

2. Better Buy Ltd. Sells you a home theatre on a “no money down, no interest, and no payments for one year” promotional deal.

Recognition and Derecognition: Matching principle

• While Revenue Recognition principle determines when revenues are recognized, matching principle determines when expenses are recognized.

• Expenses are recognized in the income statement on the basis of a direct association between the costs incurred and the earning of specific items of income. I.e. expenses are matched with the income they produce.

• When the expenditure produce future economic benefits beyond the fiscal year, it is recognized as an asset, and the asset’s cost is then systematically and rationally matched to future revenues.

Roger’s expense policy

ExercisesDescribe which foundational principle has been violated: E2-54. Quick & Health, a fast-food company, sells franchises for $100,000, accepting a $5,000 down payment and a25-year note for the remainder. Quick & Healthy promises for three years to assist in site selection, building, and management training. Quick & Healthy records the full $100,000 franchise fee as revenue when the contract is signed.6. Maurice Morris, owner of Rare Bookstore., bought a computer for his own use. He paid for the computer by writing a cheque on the bookstore chequing account and charged the Office Equipment account.7. Brock Inc. decides that it will be selling its subsidiary, Breck Inc., in a few years. Brock has excluded Breck’s activities from its consolidated financial results.8. Wilhelm Corp. expensed the purchase of new manufacturing equipment.

Measurement• Measurement answers the question of “How” an item should

be recognized in the financial statements, i.e. the basis of determining the monetary amount that should be put on the balance sheet and income statement.

• All elements must be measurable to be recognized• Because of accrual accounting, many elements of financial

statements require the use of estimates (and include uncertainty)

• Therefore, we must– determine the level of uncertainty that is acceptable for

recognition– use appropriate measurement tools, and – disclose sufficient information to indicate/describe the

uncertainty

Measurement

• Four main basis of measurement:– Historical Cost: The original amount at the time of the

transaction. Most common measurement basis.– Current Cost: The amount that need to be paid to replace

existing assets. Most common during periods of high inflation– Realizable (Settlement) Value: The amount that will be

obtained (paid) from selling (settling) an asset (liability), during normal course of business. E.g. Inventory is measured as lower of cost or net realizable value.

– Present Value: The amount is calculated as the present discounted value of the future net cash inflows or outflows. E.g. Marketable securities are measured at fair value.

Measurement

• There are FIVE foundational principles:– Periodicity assumption– Monetary unit assumption– Going concern assumption– Historical cost principle– Fair value principle

Measurement: Periodicity Assumption• The accuracy of measurement is a function of time:

• Imagine that an entity only reports financial information at the end of its life. All revenues, expenses, assets and liabilities are known for certainty, thus there is no room for error.

• However, such financial information is of limited use – violates the relevance principle.

• The Periodicity Assumption assumes that economic activity of an entity can be divided into artificial time periods for reporting purposes• achieve a balance between representational faithfulness and

relevance• Most common: one month, one quarter, and one year• For shorter time periods, more difficult to determine proper net

income • With technology, investors want more on-line, real-time financial

information to ensure relevant information• IFRS requires at least annual reporting.

Measurement: Monetary Unit Assumption

• Money is the common denominator of economic activity, e.g. on the balance sheet, we do not report the number of inventory units on hand, rather, we report the value of the inventory.

• In Canada and the United States, the dollar is assumed to remain reasonably stable, i.e. no need to adjust the entire set of financial statements with the rate of inflation.

Measurement: Going Concern Assumption

• Recall that historical cost is the most common basis of measurement. This is based on the 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, i.e. at least 12 months from balance sheet date

• If the company will likely cease operation within 12 months, liquidation is assumed to be likely, use liquidation accounting (at net realizable value = selling price – cost to sell)

• Full disclosure is required of any material uncertainties of continuing as a going concern

Measurement: Historical Cost Principle

• Three basic assumptions of historical cost– Represents a value at a point in time– Results from a reciprocal exchange

(i.e. a two-way exchange)– Exchange includes an outside arm’s-length party

• Example of non-reciprocal exchange, government grant and donations, no cost involved.

• Non-arm’s length transaction: difficult to determine cost in an objective manner.

• Sometimes it is also difficult to apply historical cost principle when the transaction in non-monetary: e.g. exchange of goods and services.

Measurement: Historical Cost Principle

• Initial recognition and measurement: for non-financial assets, record all costs incurred to get the asset “ready” for sale or for use (e.g. includes transportation and installation costs)

• Subsequent measurement: • many assets are measured at amortized cost, e.g.

part of the cost is amortized or depreciated to match the revenue the asset generates (Matching Principle)

• Test for impairment: lower of cost or fair value. (Conservatism)

• May lose relevance (predictive value)

Measurement: Fair Value Principle

• IFRS defines Fair Value as:– A market based measurement: 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. We call this the EXIT PRICE.

– There may not be a ready market price for every asset: the need to use a model to estimate fair value.

– There three levels of inputs in a model: Level 1 being the most objective and Level 3 being the most subjective.

– Fair value under ASPE is less restrictive (no reference to an orderly market) and is used not as often as in IFRS.

Market Model Income Model

Use market priceEstimate future cash flows, discounted, and/or risk adjusted

Level 1 inputs

Quoted prices in active market for identical asset Risk-free interest rate

e.g. second hand iPhone4s may have an active market and reliable market price e.g. T-bill rate

Level 2 inputs

Quoted prices for similar or identical asset in an inactive market

Risk-adjusted interest rate recently charged by a creditor

e.g. second hand iPhone 3GS may not have an active market

Level 3 inputs

Management estimate of what a potential purchaser would pay for the asset

Internal generated estimate of incremental interest rate

e.g. a market may not even exist for the no-name iPhone like device

Roger’s financial statements

Exercises

Which foundational principle and qualitative characteristic has been violated?E2-5 1. The treasurer of Sweet Grapes Corp. would like to prepare financial statements only during downturns in the company’s wine production, which occur periodically when the grape crop fails. The company would never allow more than 30 months to pass without statements being prepared.2. Tower Manufacturing Ltd. decided to make its own widgets because it was cheaper than buying from a supplier. In an attempt to make its statements more comparable with those of its competitors, Tower charged its inventory account for what it felt the widgets would have cost if they had been purchased form a supplier.

Exercise

• E2-9 If going concern assumption did not apply in accounting, how would this affect the amounts shown in the financial statements for the following items:

1. Land 2. Depreciation expense3. Inventory 4. Prepaid insurance

Presentation and Disclosure: Full Disclosure Principle

• It answers the question of “Where” an item should be put on the financial statements, i.e. in an aggregated number, as a separate line item in the financial statements, or in the notes disclosure?

• Full Disclosure Principle:– Anything that is relevant to decision should be included in

financial statements, include notes disclosure

• An art of balance: detailed enough to disclose matters that make a difference but condensed enough to make the information understandable in a cost effective manner.

Full Disclosure Principle• Disclosure may be made:

– Within the main body of the financial statements– As notes to the financial statements – As supplementary information, including Management

Discussion and Analysis (MD&A): non-audited.• MD&A: Management’s explanation of the financial

information and the significance of the information• Five key elements that should be included:

1. Company’s vision, core businesses, and strategy

2. Key performance drivers

3. Capital and other resources

4. Historical and prospective results

5. Risks

Exercises

Discuss whether the company has followed acceptable accounting and disclosure practices:E2-8 2. Equipment purchases of $270K were partly financed during the year by issuing a $110K note payable. The company offset the equipment against the note payable and reported plant assets at $160K.4. The company has reported its ending inventory at $2.7 million in the financial statements. No other information on inventories is presented in the financial statements and related notes.