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Chapter 2

MGT220H5 Chapter 2: Chapter 2 (Conceptual Framework Underlying Financial Reporting) - MGT220 (2018)

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Christopher Small

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Prof. Small MGT220
Chapter 2 Conceptual Framework Underlying Financial Reporting
Chapter 2 Conceptual Framework
Underlying Financial Reporting
What is a Conceptual Framework?
Like a constitution; its a coherent system of interrelated objectives & fundamentals that can lead to
consistent standards and that prescribes the nature, function, and limits of financial accounting &
statements.Theres no universally accepted conceptual framework.
Why have a conceptual framework?
Standard setting should build on an established body of concepts & objectives. This allows for
useful, consistent & coherent standards over time. The framework should increase understanding,
confidence & comparability. It should help with solving new practical problems.
What is the Objective of Financial Reporting?
To communicate information that’s useful to investors, creditors & other users. Its helps on deciding
on how to allocate resources (including assessing management stewardship).
What are General-Purpose Financial Statements?
The 4 basic financial statements. These basic statements give information that meets the needs of key
users. Statements are intended to provide the most useful information possible in a manner whereby
benefits exceed costs to the different kinds of users.
The general objective of accounting is providing information that has decision usefulness
(information that’s useful for decision-making purposes).
What are the 2 Fundamental Qualitative Characteristics?
o Relevance: Accounting information must be able to make a difference in a decision, otherwise its irrelevant.
Relevant information has predictive value, that allows one to forecast the future.
It also has feedback/confirmatory value, as it allows one to correct/confirm previous expectations.
Materiality is like relevance but more about specific amounts; at what amount will information influence
decision-making? For a small company, a $1000 loss is material, but for a multi-billion company, it’s possible
that it isnt. There are some loose standards (such as 5% on pre-tax income from continuing operations, or 1%
for non-profits). But generally, it’s based on quantitative & qualitative factors.
o Representational Faithfulness: Accounting information must represent the underlying economic substance
of an event. This is sometimes known as transparency. Basically, by reading the numbers, will users know what’s
happening behind them?
Completeness: The idea that the statements include all information necessary to portray the underlying event.
Neutrality: Information can’t be selected to favour one set of interested parties over another, or that it cant be
manipulated in any way.
Freedom from Material Error: Information must be reliable.
What are the 4 Enhancing Qualitative Characteristics?
o Comparability: Enables users to identify the real similarities & differences in economic phenomena.

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Prof. Small MGT220
Chapter 2 Conceptual Framework Underlying Financial Reporting
o Verifiability: Knowledgeable & independent users should be able to achieve similar results or reach consensus
regarding the accounting for an event. Numbers that are easy to verify are known as hard numbers, others that have
uncertain measurement are called soft numbers.
o Timeliness: Information should be available to decision-makers before it loses its ability to influence decisions.
o Understandability: Information must be of sufficient quality/clarity that allows reasonably informed users to
see its significance.
Its not always possible for financial information to have all the enhancing qualities of useful
information (but it still must have all the fundamental qualitative characteristics). For example, a new
standard might be applied to all statements going forward. This new standard makes comparisons to
previous years difficult, even though the change in standard is justified.
What is meant by the Cost-Benefit Relationship?
Accounting for information has costs associated with it:
o Collecting & Processing
o Distributing
o Auditing
o Potential Litigation
o Disclosure of proprietary information to competitors
o Analysis & Interpretation
Because of this, the costs of providing the information must be weighed against the benefits that can
be had from using the information.
What are the Elements of Financial Statements?
3 Essential Characteristics:
o There is some economic benefit to the entity.
o The entity has control over that benefit (even if its leased).
o The benefits result from a past transaction or event.
A liability has a negative economic value & requires one to give up economic resources to settle the
obligation. There are financial & non-financial liabilities.
3 Essential Characteristics:
o They represent a present duty or responsibility.
o The duty or responsibility obligates the entity, leaving it little or no discretion to avoid it.
o The transaction or event results from a past transaction or event.
2 Types of Obligations:
o Constructive Obligations: Obligations that arise through past or present practice that signal that the company
acknowledges a potential economic burden. For example, a company might announce that they’ll replace defective
products even though it’s not part of any sales contracts.
o Equitable Obligations: These arise due to moral or ethical considerations. For example, re-training an employee
that’s being downsized.
Equity is a residual interest in an entity that remains after deducting its liabilities from its assets (its
net worth). In a business enterprise, the equity is the ownership interest & consists of shares.
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