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MGAC01H3 (34)
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Chapter 2

Chapter 2 Notes

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University of Toronto Scarborough
Financial Accounting

Chapter 2 Conceptual Framework Underlying Financial Reporting Notes Conceptual Framework • a conceptual framework is like a constitution: it is a “coherent system of interrelated objectives and fundamentals tat can lead to consistent standards and that prescribes the nature, function, and limits of financial accounting and financial statements” Objective of Financial Reporting • objective of financial reporting is to communicate info that is useful to investors, creditors, and other users in making their resource decisions (assessing management stewardship) about economic resources and claims on them, as well as financial performance • the statements are extended to provide the most useful information possible in a manner whereby benefits exceed costs to the users Qualitative Characteristics of Useful Information Fundamental Qualitative Characteristics • relevance and representational faithfulness (sometimes referred to as faithful representation) are fundamental qualities that make accounting information useful for decision-making; these two characteristics must be present • to be relevant, accounting information must be capable of making a difference in a decision • relevant info helps users make predictions about the final outcome of past, present, and future events; i.e., it has predictive value • relevant info also helps users confirm or correct their previous expectations; it has feedback/confirmatory value • accounting info is representational faithful to the extent that it reflects the underlying economic substance of an event/transaction • this notion of representing economic reality is sometimes referred to as transparency • information that is representational faithful is complete, neutral, and free from material error or bias • completeness refers to the fact that the statements should include all info necessary to portray the underlying events and transactions • neutrality means that information cannot be selected to favour one set of stakeholders over another • freedom from material error/bias means that the information must be reliable Enhancing Qualitative Characteristics • enhancing qualitative characteristics include comparability, verifiability, timeliness, and understandability • comparability enables users to identify the real similarities and differences in economic phenomena because these have not been obscured by accounting methods that cannot be compared • verifiability exists when knowledgeable, independent users achieve similar results regarding accounting for a particular transaction • information must be available to decision-makers before it loses its ability to influence their decisions • users need to have reasonable knowledge of business and financial accounting matters in order to understand the information in financial statements; however, financial information must also be of sufficient quality and clarity that it allows reasonably informed users to see its significance—this is the information’s understandability Constraints • materiality refers to an item’s impact on a firm’s overall financial operations • information is material if including it or leaving it out would influence or change the judgment of a reasonable person • many companies and their auditors have historically adopted the general rule of thumb that any item representing 5% or more of income from continuing operations (after tax) is considered material, however, this is not a hard and fast rule • the item’s impact on other factors—any sensitive number on the financial statements—should also be considered • in addition, both quantitative and qualitative factors must be considered in determining whether an item is material • the cost-benefit relationship must be considered: the costs of providing the info must be weighted against the benefits that can be had from using the info; in order to justify requiring a particular measurement or disclosure, the costs must be justified by the benefits • the difficulty is that the costs and, especially, the benefits are not always evident or measurable Foundational Principles Recognition/De-Recognition Measurement Presentation and Disclosure 1. Economic entity 5. Periodicity 10. Full disclosure 2. Control 6. Monetary unity 3. Revenue recognition and realization 7. Going concern 4. Matching 8. Historical cost 9. Fair value Recognition/De-Recognition • recognition deals with the act of including something on the entity’s balance sheet or income statements • historically, elements of financial statements have been recognized when: (1) they meet the definition of an element (e.g., liability); (2) they are probable; and (3) they are reliably measurable • presently, a model requires recognition of these elements when: (1) they meet the respective definition; and (2) they are measurable • de-recognition deals with the act of taking something off the balance sheet or income statement Economic Entity Assumption • economic entity assumption (or entity concept) identifies an economic activity with a particular unit of accountability • for tax and legal purposes, the legal entity is the relevant unit for a company • for GAAP (which considers a broader definition when preparing consolidated financial statements), a parent and its subsidiaries are separate legal entities, but merging their activities for accounting and reporting purposes gives more meaningful information • thus, the consolidated financial statements are prepared from the perspective of the economic entity, which allows the company to recognize and group together the assets, liabilities, and other elements that are under the parent’s control into one set of statements Control • control is an important concept in determining which entities to consolidate and include in the financial statements • there are several components to the concept of control: 1) There is 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 decisions for the entity. 2) Only one entity has the power to direct the activities of the entity in question. Control precludes the sharing of power. 3) Power need not be exercised or absolute. There is no requirement to have unrestricted, total control or power over the entity. In addition, as long as the reporting entity has the ability to control the other entity, it need not exercise that control. 4) The reporting entity should have access to the benefits from the entity. Revenue Recognition and Realization • revenue has generally been recognized when the following 3 conditions are met: 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) • under the alternative contract-based view, any contract between the entity and a customer is recognized when: (1) the entity becomes party to the contract; and (2) the resulting rights and obligations are measurable, including credit risk • the resulting revenues are recognized when: (1) control over the goods passes; and (2) performance obligations are settled Matching • the practice of matching costs with the revenues that they produce is called matching • costs are often classified into two groups: product costs and period costs • product costs such as material, labour, and overhead attach to the product and are carried into future periods as inventory (if not sold) since inventory meets the definition of an asset; which period costs such as officers’ salaries and other administrative expenses are recognized immediately—even though the benefits associated with these costs occur in the future—because no direct relationship between cost and revenue can be established and, more importantly, because the costs do not meet the definition of an asset Measurement Periodicity Assumption • periodicity assumption (or time period assumption) implies that firm’s economic activities can be divided into artificial time periods • the shorter the time period, the more difficult it becomes to determine the proper net income for the period • investors want and demand information that has been quickly processed and distributed; yet the more quickly the information is released, the more likely errors become because there are not estimates made to accrue costs and revenues in accrual accounting Monetary Unit Assumption • the monetary unit assumption means that money is the common denominat
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