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University of Waterloo
Accounting & Financial Management
AFM 291
Kareen Brown

CHAPTER 2 CONCEPTUAL FRAMEWORK UNDERLYING FINANCIAL REPORTING 1. Describe the usefulness of a conceptual framework.  Conceptual framework is a coherent 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  First, to be useful, standard setting should build on an established body of concepts and objectives o Useful and consistent standards over time, resulting in coherent set of standards and rules from the same foundation o Increase financial statement users’ understanding of and confidence in financial reporting o Enhance the comparability of different companies’ financial statements  Second, able to solve new and emerging practical problems more quickly 2. Describe the main components of the conceptual framework for financial reporting.  First level, the objectives identify accounting’s goals and purposes (building blocks)  Second level, qualitative characteristics that make accounting info. useful and the elements of financial statements (assets, liabilities, equity, revenues, expenses…)  Final level, foundational principles used in establishing and applying accounting standards (includes assumptions, principles, and constraints) 3. Understand the objective of financial reporting. (FIRST LVL: BASIC OBJECTIVES)  To communicate info. that is useful to investors, credits, and other users in making their resource allocation decisions (including assessing management stewardship) about economic resources and claims on them, and the financial performance  Provide general-purpose financial statements, intended to provide the most useful info. whereby benefits exceed costs to the different kinds of users  All about goals and purposes 4. Identify the qualitative characteristics of accounting information. (SECOND LVL: FUNDAMENTAL CONCEPTS)  Qualitative characteristics of accounting information o Determine which alternative gives the most useful info. for decision-making purposes o Decision-makers (users) and understandability—the quality that allows reasonably informed users to see info.’s significance o Fundamental Qualitative Characteristics: - Relevance • must be capable of making a difference in a decision • has predictive value • has feedback/confirmatory value - Representational faithfulness • reflects the underlying economic substance of an event or transaction • Transparency which represents the economic reality • Completeness that statements include all info. necessary to portray the underlying events and transactions; • Neutrality that does not favor one set of stakeholders over another • Management best estimate • Freedom from material error/bias—info. must be reliable o Enhancing Qualitative Characteristics: - Comparability: enables users to identify the real similarities and differences in economic phenomena; resource allocation decisions involve evaluations of alternatives and a valid evaluation can only be made if comparable info. is available - Consistency: when an entity uses the same accounting treatment for similar events from period to period; the nature and effect of an accounting change must be disclosed in financial statements for the period - Verifiability - Timeliness: usually quarterly reporting system used - Understandability o Trade-Offs o Constraints - Materiality relates to an item’s impact on a firm’s overall financial operations - Generally 5% or more of income from continuing operations (after tax) is considered material - Sensitive numbers, quantitative, and qualitative factors must be considered - Cost versus Benefits: costs of providing the info. must be weighed against the benefits that can be had from using the info. (cost ex. Collecting and processing, distributing, auditing, potential litigation, analysis and interpretation, and disclosure to competitors) 5. Define the basic elements of financial statements.  The basic elements of financial statements are (1) assets, (2) liabilities, (3) equity, (4) revenues, (5) expenses, (6) gains, and (7) losses  Make sure to read over this sections regarding each account  Additional element is other comprehensive income (includes net income and all other changes in equity except for owners’ investments and distributions i.e. unrealized holding gains and losses on certain securities, those related to foreign exchange instrument) 6. Describe the basic foundational concepts and constraints of accounting. (THIRD LVL: FOUNDATIONAL CONCEPTS AND CONSTRAINTS)  Explain which, when and how financial elements and events should be recognized, measured, and presented by the accounting system 1. Recognition/derecognition: a. Deals with the act of including something on the entity’s balance sheet or income statement (or whether to consolidate investments in other entities at macro level) b. Requires recognition of these elements when: they meet the respective definition & they are measurable c. Derecognition deals with the act of taking something off the balance sheet or income statement • Economic Entity Assumption (or entity concept)—that economic activity can be identified with a particular unit of accountability (i.e. company, division, individual) oLegal entity is relevant unit for the company oConsolidated financial statements are prepared from the perspective of the economic entity, allowing the company to group together the assets, liabilities, and other financial statement elements that are under the parent’s control into one set of statements • Control oDetermine which entities to consolidate and include in the financial statement oThings under the entity’s control are generally included in the economic activity and the consolidated financial statements oComponents: i. Power to direct the entity’s activities: in order to include the entity in the consolidated financial statements, the reporting entity must be able to make strategic decision for the entity ii. Only one entity has the power to direct the activities of the entity in question: precludes the sharing of power iii. Power need not be exercised or absolute iv. Reporting entity should have access to the benefits from the entity d. Many companies use Special Purpose Entities (SPE) or Variable Interest Entities (VIE) i. To hold leases, pension funds, or perhaps certain investment • Revenue Recognition—three given conditions: (1) risks and rewards have passed or the earnings process is substantially complete (2) measurability is reasonably certain (3) collectability is reasonably assured (realized or realizable) oUnder alternative contract-based view, any contract between the entity and a customer is recognized when: ii. The entity becomes party to the contract iii. The resulting rights and obligations are measurable, including credit risk oThe resulting revenues are recognized when: iv. Control over the goods passes and v. Performance obligations are settled • Matching Principle—illustrates the cause and effect of relationship between the money spent to earn revenues and the revenues themselves oMatch the costs with the revenues that they produce oIllustrates cause and effect relationship between money spent and earned oWhen there’s a variance between the recognized amount and another reasonably possible amount = measurement uncertainty oProduct cost: material, labor, and overhead costs carried into future periods as inventory; Period cost: other administrative expenses (i.e. salaries) 2. Measurement: a. Elements are recognized in the financial statements if they meet the definition of elements and are measurable • Going Concern Assumption—a
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