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Lecture 2

BU387 Lecture 2: Chapter 2 Notes

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Floria Niu

Chapter 2 – Conceptual Framework Underlying Financial Reporting Conceptual Framework • Conceptual framework - a system of interrelated objectives and fundamentals that can lead to consistent standards and that prescribes the nature, function, and limits of financial accounting and financial statements • 1.) Recognition • 2.) Measurement • 3.) Presentation • 4.) Disclosure • 5.) Valuation Why is a conceptual framework necessary? 1. To be useful, standard setting should build on an established body of concepts and objectives. Useful and consistent standards can be additionally added over time. The result is a coherent set of standards and rules, as they have all been built upon the same foundation. 2. By referring to an existing framework, it should be possible to solve new and emerging practical problems more quickly. The following diagram shows an overview of a conceptual framework. At the first level, the objectives identify accounting’s goals and purposes: these are the conceptual framework’s building blocks. At the second level are the qualitative characteristics that make accounting information useful and the elements of financial statement (assets, liabilities, equity, revenues, expenses, gains and losses). At the third and final level are the foundational principles used in establishing and applying accounting standards. First Level: The “why” – goals and purposes of accounting OBJECTIVES of financial reporting Second Level: Bridge Qualitative between levels 1 and 3 Characteristics Elements of financial of accounting statements information Third Level: The “how” - implementation Foundational Principles Level 1: Objective of Financial Reporting • Objective is to communicate information that is useful to investors, credits, and other users Left of Level 2: Fundamental Qualitative Characteristics • Relevance and representational faithfulness are fundamental qualities that make accounting information useful for decision making o Relevance – the piece of information must have an impact on a decision to be relevant, must be useful ▪ Predictive value – information that helps people make predictions about the past, present, or future ▪ Feedback value – information helps users confirm or correct prior expectations o Representational faithfulness ▪ Transparent – reflects what really happened (should be true) ▪ Completeness – idea that the statements should include all information necessary to portray the underlying events and transaction ▪ Neutrality – information cannot be selected to favour one side of interested parties over another ▪ Free of material error – means that information must be reliable, truthful, unbiased Left of Level 2: Enhancing Qualitative Characteristics • Comparability – information that been measured and reported in a similar way is considered comparable, e.g. FASB allows LIFO where IFRS does not, so during raising prices, company using LIFO will have a net income that is lower than companies not using LIFO • Verifiability – the information should be correct and the conclusion should be consistent • Timeliness – information should be available to decision makers before it loses its ability to influence their decision • Understandability – the information must be of sufficient quality and clarity so users can understand it Trade-Offs • Cost vs. Benefit – the costs of providing the information must be weighed against the benefits that can be had from using the information o Costs may be from auditing, collecting and processing, distributing, potential litigation, disclosure of proprietary information to competitors, analysis and interpretation Right of Level 2: Elements of financial Statements • Assets have three essential characteristics: o There is some economic benefit to th
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