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Chapter 2

MGAC01H3 Chapter Notes - Chapter 2: Revenue Recognition, Financial Statement, Income Statement

Financial Accounting
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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
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
2. Control
3. Revenue recognition and realization
4. Matching
5. Periodicity
6. Monetary unity
7. Going concern
8. Historical cost
9. Fair value
10. Full disclosure
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
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