Intermediate Accounting, Tenth Canadian Edition · Web viewThese notions should enhance your understanding of the topics covered in intermediate accounting. LEARNING OBJECTIVES 1

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CHAPTER 2CONCEPTUAL FRAMEWORK UNDERLYING

FINANCIAL REPORTING

CHAPTER OBJECTIVES

Chapter 2 focuses on the conceptual framework underlying financial accounting. The objectives of the chapter are to (1) provide a framework for, and an understanding of, basic financial accounting theory; (2) describe the usefulness of, and attempts to construct, a conceptual framework; (3) define the objectives, qualitative characteristics, and basic elements of accounting; and (4) discuss the foundational principles (economic entity, control, revenue recognition and realization, matching, periodicity, monetary unit, going concern, historical cost, fair value and full disclosure) and the constraints of accounting (cost-benefit and materiality). These notions should enhance your understanding of the topics covered in intermediate accounting.

LEARNING OBJECTIVES1. Indicate the usefulness and describe the main components of a conceptual

framework for financial reporting.

2. Identify the qualitative characteristics of accounting information.

3. Define the basic elements of financial statements.

4. Describe the foundational principles and constraints of accounting.

5. Explain the factors that contribute to choice and/or bias in financial reporting decisions.

6. Discuss current trends in standard setting for the conceptual framework.

Instructor’s Manual 2-1Copyright © 2016 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission of this page is strictly prohibited.


CHAPTER REVIEW

Conceptual Framework

1. A conceptual frameworkin accounting is a coherent system of interrelated objectives and fundamentals that can lead to consistent standards and that prescribe the nature, function, and limits of financial accounting and financial statements. The benefits its development will generate can be characterized as follows:

a. The standard setters (AcSB, IASB, FASB) will be able to issue more useful and consistent standards in the future.

b. Problems in practice should be solved more rapidly and consistently by reference to a framework of basic theory.

c. Understanding of and confidence in the financial reporting process by financial statement users will be increased.

d. Comparability with respect to the financial statements of various companies will be enhanced.

2. The 1980 CICA(now referred to as CPA Canada) research study Corporate Reporting: Its Future Evolution represents the first major Canadian document related to the development of a conceptual framework. It discussed the objectives of financial statements and suggested criteria for the development of financial accounting standards. In 1987, Conceptual Framework for Financial Reporting was published by the Accounting Standards Authority of Canada to assist in standard setting, education, and preparation of financial statements. In 1988, Section 1000 on "Financial Statement Concepts" was incorporated into the CICA Handbook (now referred to as the CPA Canada Handbook) to be used by the AcSB to develop standards and to help preparers and auditors of financial statements in exercising professional judgement. While these documents were written with the tradition and environment of Canadian financial accounting in mind, the conclusions expressed regarding the composition of a conceptual framework closely paralleled those derived by the FASB in the U.S.

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. The AcSB has indicated it will likely adopt the framework for private enterprises as well.



First Level: Basic Objectives

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.

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.

4. For ASPE, Section 1000 of the CPA Canada Handbook states that the objective of financial statements is to communicate information that is useful to investors, creditors, and others in making resource allocation decisions, including assessing management stewardship. As such, financial statements are to provide information that is (1) useful for making investment, credit, and other decisions; (2) useful in making resource allocation decisions. General purpose financial statements are intended to meet the needs of key users, creditors and investors.

Second Level: Fundamental Concepts

5. The fundamental qualitative characteristics that make information useful are relevance and representational faithfulness (or faithful representation). Added to this list is consistency, which the CPA Canada Handbook recognizes as enhancing comparability. A brief description of each of these characteristics is given below.

a. Relevance: Accounting information is relevant if it can influence the decisions of users (i.e., 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.Representational faithfulness: 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. Completeness means all information that portrays the events and transactions has been included and no pertinent information has been excluded. Neutrality means that information or accounting procedures are unbiased and that they have not been selected with an eye to favouring one group of stakeholders over another. Information that is free from material error or bias means that the information must be reliable. It does not mean total freedom from all 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. Complicating this is that management estimates and judgement are often required, making it even more important to ensure information is complete, neutral, and free from material error or bias.



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

b. Verifiability: Verifiability exists when knowledgeable, independent preparers or users, using the same methods, achieve similar results or reach a consensus regarding the accounting for a particular transaction.

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.

Trade-offs of qualitative characteristics may be necessary in the presentation of financial information, but they should not render the information irrelevant. Similarly, constraints of materiality and cost-benefit must be considered when preparing financial information. Something is considered material if leaving it out would make a difference in the decision process. A particular measurement or disclosure may not be warranted if the cost of providing it outweighs the benefits that accrue to the users.

Basic Elements

7. Knowledge of the specific meaning of certain basic elements is essential for an understanding of financial accounting. However, the specific meaning that accountants attach to these basic elements sometimes differs from their meaning in a non-accounting context. These elements, as defined below, are further discussed and interpreted throughout the text. Presented below are the definitions for assets and liabilities using the current proposed definitions.

Assets: Assets have three essential characteristics – (1) There is some economic benefit to the entity and (2) The entity has control over that benefit and (3) The benefits result from a past transaction or event.

Liabilities: Liabilities also have three essential characteristics – (1) they represent a present duty or responsibility and (2) The duty or responsibility obligates the entity, leaving it little or no discretion to avoid it and (3) The transaction or event results from a past transaction or event.



Equity/Net Assets: Residual interest in the assets of an entity that remains after deducting its liabilities. In a business enterprise, the equity is the ownership interest.

Revenues: Increases in economic resources during the accounting period, either by inflows or other enhancements of assets or settlement of liabilities, resulting from the ordinary activities of an entity.

Expenses: Decreases in economic resources during the accounting period, either by outflows or the reduction of assets or the incurrence of liabilities, resulting from an entity’s ordinary revenue generating activities.

Gains: Increases in equity (net assets) from peripheral or incidental transactions and events affecting an entity and from all other transactions, events, and circumstances affecting the entity except those that result from revenues or equity contributions.

Losses: Decreases in equity from peripheral or incidental transactions and events affecting an entity and from all other transactions, events, and circumstances affecting the entity except those that result from expenses or distributions to owners.

Note that Other Comprehensive Income (OCI) could theoretically be excluded as a separate financial statement element as it includes elements already discussed (revenues, expenses, gains and losses) except that they are included in comprehensive income but excluded from net income. Comprehensive income includes both net income and other comprehensive income. Therefore, OCI could be considered just a subclassification on the income statement.

The following would be included as OCI in the comprehensive income statement:

Unrealized holding gains and losses on certain securities; Changes in the revaluation surplus when using the revaluation method to

account for capital assets; Certain gains and losses related to the translation of foreign operations,

and cash flow hedges; Certain gains and losses related to remeasurement of defined benefit

benefit plans and liabilities measure at fair value.

Note: IFRS does not require companies to use the terms “comprehensive income” or “other comprehensive income.” The concepts of comprehensive income and other comprehensive income do not exist under ASPE. Items would either be booked through net income or straight to shareholders’ equity.



Third Level: Foundational Principles

8. In the practice of financial accounting, certain foundational principles are important to an understanding of the manner in which data are assembled and presented. The following principles underlie the financial accounting structure and can be loosely grouped under headings of recognition/derecognition; measurement; and presentation and disclosure.

Recognition/derecognition

Recognition/derecognition is concerned with those elements that should be included/removed from a company’s balance sheet or income statement. When determining what should be included or excluded, the following principles should be considered:

a. Economic Entity Assumption: The economic activities of an entity can be accumulated and reported in a manner that assumes that the entity is separate and distinct from its owners or other business units.

b.Control: If one reporting entity alone has the ability to direct the activities of another entity, even if they don’t exercise this option, and if they have access to the benefits of that entity, then the reporting entity has control, and the financial statement elements of both entities should be consolidated and reported on the controlling entity’s financial statements.

c. Revenue Recognition: Revenue is generally recognized when (1) risks and rewards have passed or the earnings process is substantially complete, (2) measurement is reasonably certain, and (3) collectibility is reasonably assured (realized or realizable).

This is an income statement approach in that it focuses more on the earnings process. ASPE continues to follow this.

The new IFRS 15 standard entitled Revenue from Contracts with Customers is effective for fiscal years beginning on or after January 1, 2018, although earlier application is allowed. This new standard follows a five-step approach in determining when revenue is recognized:

1. Identify the contract with the customer2. Identify the performance obligations in the contract (promises to

transfer goods and/or services that are distinct).3. Determine the transaction price. 4. Allocate the transaction price to each performance obligation.5. Recognize revenue when each performance obligation is satisfied.

This new IFRS approach is a balance sheet approach.



d. Matching: Accountants attempt to match the expenses incurred to earn revenues with the revenues earned during a fiscal period. Use of accrual accounting procedures assists the accountant in allocating revenues and expenses among the fiscal periods that compose the life of a business enterprise. However, matching is an income statement focused concept whereas IASB and FASB accounting standard setters are more concerned with defining what constitutes assets and liabilities to ensure that costs that do not meet the definition of assets are not set up on the balance sheet. As a result, these costs would be expensed in the period in which they are incurred, regardless of when the revenue with which they are associated occurs.

Measurement

Elements are recognized in a financial statement if they meet the definition of an element and are measurable. Because measurement is complicated by the use of accrual accounting and estimates, accountants must determine an acceptable amount of uncertainty surrounding measurement with the use of measurement tools, and give sufficient disclosure to indicate the uncertainty that exists. The following principles are relevant to measurement issues:

a. Periodicity: The economic activities of an entity can be divided into artificial time periods for the purpose of providing periodic reports.

b. Monetary Unit.: Since money (dollars) is the common denominator by which economic activity is conducted, it is assumed that money provides an appropriate basis for accounting measurement and analysis. Additionally, it is generally assumed that the unit of measure—the dollar—remains reasonably stable in terms of purchasing power (stable dollar assumption).

c. Going Concern: In the absence of contrary information, it is assumed that a business entity will continue in operation for the foreseeable future and will be able to realise assets and discharge liabilities in the normal course of operations. This would not be the case if there was intent to liquidate the net assets of the company, to cease operations, or to cease trading in the company’s shares.

d. Historical Cost: GAAP requires that most transactions and events be recognized at the amount of cash or cash equivalents paid or received or the fair value ascribed to them when they took place. Historical acquisition cost is more reliable than other suggested valuation methods. However, in the interest of relevancy, there has been a movement toward a mixed valuation model that uses amortized cost, net realizable value or fair value, or a combination of the lower of cost and net realizable value, or lower of cost and fair value.

e. Fair Value: Thisis an emerging principle that may be more useful than historical cost for certain types of assets and liabilities, and for certain industries. Fair value is defined as “the price that would be received or the



paid to transfer a liability in an orderly transaction between market participants at the measurement date.” Standard setters have given companies the option to use fair value for most financial instruments (cash, investments, receivables, and payables) to promote the use of fair value. Certain IFRS standards further allow the use of fair value for non-financial assets such as investment properties, and property, plant and equipment.

Presentation and Disclosure

Presentation and disclosure indicates that anything that is relevant to decisions of the users should be included in the financial statements and should be disclosed. The principle relevant to this is:

Full Disclosure:In the preparation of financial statements, the accountant should include sufficient information to permit the reader to reach an informed decision about the financial condition and results of operation of the enterprise in question. This often results in a trade-off for preparers and users to ensure the information is detailed enough to make a difference to users but condensed enough to be understandable within the constraint of cost-benefits.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.

Factors Contributing to Choice in Financial Accounting

9. Many factors contribute to choice in financial reporting. The choices made should ensure financial information is of high quality. The accountant should be aware of factors that may affect the choices made to ensure the most appropriate choices are made. These factors include the following:

a. Canadian GAAP (both ASPE and IFRS) is principles-based meaning the flexibility allowed requires the application of professional judgement, consistently applied;

b. The need to meet contractual and regulatory requirements (such as debt covenants)

c. Management bonuses based on earningsd. Capital markets focus on earnings and earnings per share.

10. Practice of financial engineering. Financial engineering is a process whereby a business arrangement or transaction is legally structured such that it meets the company’s financial reporting objective (e.g., to maximize earnings, minimize a debt to equity ratio or other).



11. Factors that contribute to fraudulent financial reporting. Good financial reporting should be a result of well-reasoned and supported analysis that is grounded in a conceptual framework. Fraudulent financial reporting, however, often results from pressures from individuals or the company. These pressures may arise from various sources, including worsening company, industry, or economic conditions; unrealistic internal budgets and financial statement focal points arising from contractual, regulatory or capital market expectation; and/or weak internal controls and governance.

The basic theory outlined in Chapter 2 is critical to a thorough understanding of the financial accounting process. In subsequent chapters, many problem areas are examined that use, build upon, and expand the framework developed in Chapter 2.

12. Compare IFRS to ASPE:Both IFRS and ASPE are principles-based so fundamentally similar. The IASB and FASB are continuing to work on a joint project to complete a common conceptual framework. The Exposure Draft relating to this conceptual framework was issued in 2015. In Canada, it is the intent to use this framework for private enterprises as well. Standard setters continue to work on definitions for financial statement elements, recognition and measurement criteria, and presentation and disclosure issues.



LECTURE OUTLINE

TEACHING TIP

Illustration 2-1Intermediate Accounting Kieso et al. 11ce might be put up first to show the relationship between objectives, characteristics, elements, and foundational principles. The relationship between the three levels could be emphasized.

2. Need for a Conceptual Framework

2. Coherence in rules and standards2. Quicker solutions to new and emerging practical problemsby reference to an existing framework of basic theory2. Increased user understanding of and confidence in financial reporting2. Enhanced comparability among companies' financial statements

2. Conceptual Framework for Financial Reporting

a. Objectivesb. Qualitative characteristicsc. Elements

Basic foundational concepts and constraints of accounting.

TEACHING TIP

Describe the components of the conceptual framework as shown in Illustration 2-1and Illustration 2-5from the text. You may wish to point out that the pyramid can be viewed as "upside down" in a sense. That is, the objectives of the first level form the characteristics and elements of the second level, which in turn support the basic foundational principles of the third level. The foundational principles used in establishing and applying accounting standards include 3 major groupings: Recognition/derecognition; measurement; and presentation and disclosure. These principles constitute an accepted theoretical base, both under IFRS and ASPE, upon which the qualitative characteristics, elements, and objectives have been developed.

2. First Level: Objectives(Recall that these were discussed in Chapter 1.)

a. Information that is useful in making rational investment, credit, and other decisions

b. Information to help in making resource allocation decisionsc. Information that is useful in assessing management stewardship



4. Second Level: Qualitative Characteristics and Elements

Qualitative Characteristics: The overriding criterion for evaluating accounting information is that it be useful for decision making. To be useful, it must be understandable.

i. Fundamental Qualities:

Relevance: Accounting information is relevant if it is capable of making a difference in a decision. Relevant information has

(a) Predictive value(b) Feedback value

Representational Faithfulness: For accounting information to be useful, the numbers and descriptions contained in the financial statements must be transparent and faithfully represent what really existed or happened. To be a faithful representation, information must be:

(a) Complete (b) Neutral (c) Free from material error or bias

ii. Enhancing Qualities:

Comparability: Information that is measured and reported in a similar manner for different companies is considered comparable. Consistency is when a company applies the same accounting treatment to similar events, period to period.

Verifiability: Verifiability exists when knowledgeable, independent preparers or users achieve similar results or reach a consensus regarding the accounting for a particular transaction.

Timeliness: Information that is not provided in a timely manner loses its ability to influence the decisions of users.

Understandability: This quality or ability is relevant to both users and preparers of financial information. A user has the responsibility to obtain a reasonable knowledge of accounting information and business to use financial information to make decisions. Preparers have the responsibility to prepare information that is understandable to a reasonably informed user.



TEACHING TIP

Discuss how trade-offs of qualitative characteristics and materiality and cost-benefit constraints may affect the presentation of financial information. Use the Brief Exercises as a quick tool to review the concepts.

iii. Elements

(a) Assets (emphasize existing standards with proposed standards for both assets and liabilities, as students coming from an introductory accounting course may not be familiar with the proposed standards).

(b) Liabilities(c) Equity (consists of investments by owners, less distributions to

owners)(d) Revenues.(e) Expenses.(f) Gains.(g) Losses.

In the above list:Items (a)–(c) are elements at a moment in time.Items (d)–(g) are elements during a period of time.

Explain how Other comprehensive income fits into the Elements components.

5. Third Level: Recognition, Measurement, and Presentation and Disclosure Principles

Recognition—the process of including an item in the financial statements of an entity.

Measurement—the process of determining the amount at which an item isrecognized in the financial statements.

Presentation and Disclosure—the process of including information that is relevant to decisions of the users

Recognition, measurement, and presentation and disclosure in accounting are influenced by basic foundational principles and constraints.



a. Recognition/Derecognition—Elements are recognized in a financial statement if they meet the definition of an element and are measurable. Relevant principles include:

Economic entity—assumes economic activity can be identified with a particular unit of accountability.

Control—requires that financial statement elements of another entity be combined if one entity controls another

Revenue recognition—revenue generally recognized when (1) risks and rewards have passed or the earnings process is substantially complete, (2) measurement is reasonably certain, and (3) collectibility is reasonably assured (realized or realizable).

Matching—efforts(expenses)should be matched with accomplishments (revenues) whenever it is reasonable and practical to do so. Practicalrules for expense matching:

When direct association, costs are expensed against related revenues.

When association exists but is difficult to determine, use rational and systematic allocation.

When little if any association, expense.

When a cost does not meet the definition of an asset, expense

However, note that accounting standard setters are moving toward a balance sheet emphasis by ensuring that the balance sheet elements are property recognized and measured as a basis for measuring income which will have only an incidental relationship to the matching concept.

b. Measurement Principles—if an element is recognized, how much should it be recorded at. Measurement principles include:

Periodicity—activities of an enterprise can be divided into artificial time periods.

Monetary unit—money is the common denominator by which economic activity is conducted and thus provides an appropriate basis for accounting measurement, aggregation, and analysis. A supporting assumption is that the monetary unit remains reasonably stable. Note that during periods of high inflation (e.g., the 1970s) this assumption is very tenuous.

Going concern—assumes business enterprises will continue in operation for the foreseeable future and will be able to realize assets and discharge liabilities in the normal course of operations.

Historical cost—most transactions and events are recognized at the amount of cash or cash equivalents paid or received or the fair value ascribed to them when they took place. A major advantage of historical cost is that it is verifiable.



Fair value—Increasingly the historical cost measurement principle is giving way to other valuations, such as fair value, when this value is more relevant (such as for financial assets and liabilities).

c. Presentation and Disclosure Principles are concerned with where on the key financial statements should an item be shown (such as debt or equity) and how much detail should be given in the financial reports? Any transactions or balances that affect key numbers or ratios by a material amount become important and significant.The major principle here is:

Full disclosure principle—revealing in financial statements any facts of sufficient importance to influence the judgement and decisions of an informed reader. (Develop concept of a reasonably prudent investor.) Use of notes and supplementary information in financial reporting.

6. Factors that contribute to choice in financial reporting decisions. Many factors contribute to choice in financial reporting, including the following:

GAAP in Canada is principles-based and therefore requires the use of professional judgement. Principles-based GAAP provides consistency, flexibility, and neutrality, though principles-based GAAP is sometimes subject to criticism.

The need to meet contractual and regulatory requirements (such as debt covenants)

Management bonuses based on earnings Capital markets focus on earnings and earnings per share Measurement uncertainty (such as accrual accounting, and

complexity of business transactions).

7. Financial Engineering. This is often done by creating complex legal arrangements and financial instruments that meet the company’s desired objectives within GAAP; e.g., a company raising debt financing might want the instrument structured such that it meets the GAAP definition of equity versus debt. In this way, the debt to equity ratio is not affected. Since Enron, this practice has been curtailed.

8. Fraudulent Financial Reporting. Pressures may arise from the economic or business environment, unrealistic budgets, analysts’ expectations, and others. These pressures cause the management to use the financial statements to portray something that doesn’t exist. If the situations are not controlled, major problems may arise. In order to minimize fraudulent financial reporting, various controls and solid governance structures may be put in place by a company, including:

a vigilant, knowledgeable top management; an independent audit committee; an internal audit function; and other internal controls at lower levels.



9. Discuss similarity between IFRS and ASPE. Both IFRS and ASPE are principles-based and so are fundamentally similar. The IASB and FASB are continuing to work on a joint project to complete a common conceptual framework. In Canada, it is the intent to use this framework for private enterprises as well. Standard setters continue to work on definitions for financial statement elements, recognition and measurement criteria, and presentation and disclosure issues.



ILLUSTRATION 2-1

CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING



ILLUSTRATION 2-2

EXPANDED CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING



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Intermediate Accounting, Tenth Canadian Edition · Web viewThese notions should enhance your understanding of the topics covered in intermediate accounting. LEARNING OBJECTIVES 1