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Chapter 2

Chapter 2 – Conceptual Framework underlying financial reporting.docx

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Department
Financial Accounting
Course
MGAC01H3
Professor
Daga
Semester
Summer

Description
Chapter 2 – Conceptual Framework underlying financial reporting Learning Objectives:  Describe the usefulness of a conceptual framework  A conceptual framework is needed to (1) create standards that build on an established body of concepts and objectives, (2) provide a framework for solving new and emerging practical problems, (3) increase financial statement users’ understanding of and confidence in financial reporting, and (4) enhance comparability among different companies’ financial statements  Describe the main components of a conceptual framework for financial reporting  The first level deals with the objective of financial reporting. The second level includes the qualitative characteristics of useful information and elements of financial statements. The third level includes foundational principles and conventions  Understand the objective of financial reporting  The objective of financial reporting is to provide information that is useful to individuals making investment and credit decisions  Identify the qualitative characteristics of accounting information  The overriding criterion by which accounting choices can be judged is decision usefulness; that is, the goal is to provide the information that is the most useful for decision-making, Fundamental characteristics include relevance and faithful representation. These two characteristics must be present. Enhancing characteristics include comparability, verifiability, timeliness, and understandability. There may be trade-offs.  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.  Describe the foundational principles of accounting  Economic Entity: the assumption that the activity of the business can be kept separate from its owners and any other business unit  Control: entity has the power to make decisions  Revenue recognition: revenue is recognized when it is earned, measureable, and collectable (realizable)  Matching: costs incurred in earning revenues are booked in the same period as the revenue earned  Periodicity: the entity’s economic activities can be divided into artificial time periods to facilitate timely reporting  Monetary unit: money is the common denominator that businesses’ operate with  Going concern: assumption that business will have a long life  Historical costs: assets and liabilities to be accounted for and reported based on their acquisition price (GAAP)  Fair-value principle: assets and liabilities are valued at fair value, that is, an exit price and viewed from a market perspective  Full disclosure principle: providing information that is important enough to influence an informed user’s judgement and decisions  Explain the factors that contribute to choice and/or bias in financial reporting decisions  Many factors play a role  GAAP is the leading contributor  Financial engineering: structuring a business arrangement to meet the company’s financial reporting objectives  Discuss current trends in standard setting for the conceptual framework Conceptual Framework  Conceptual framework: coherent system of interrelated objectives and fundamentals that can lead to consistent standards and that prescribes that nature, function, and limits of financial accounting and financial statements Rationale for Conceptual Framework  Standard setting should build on an established body of concepts and objectives. Having a developed framework will allow standard setters to issue additional useful and consistent standards over time  Allows to solve new and emerging practical problems more quickly Development of the Conceptual Framework Objective of Financial Reporting Qualitative Characteristics of useful information  Fundamental Qualitative Characteristics Relevance: to be relevant, accounting information must be capable of making a difference in a decision. Relevant information also helps users confirm or correct their previous expectations; it has feed-back/confirmatory value Representational faithfulness: information that is representationally faithful is complete, neutral, and free from material error or bias. Completeness means that statements should include all information necessary to portray the underlying events and transactions. Neutrality means that information cannot be selected to favour one set of stakeholders over another. If the accounting results in users changing their decisions, then by definition, the information is decision-relevant. Freedom from material error/bias means that the information must be reliable  Enhancing Qualitative Characteristics Comparability: comparability enables users to identify the real similarities and differences in economic phenomena because they have not been obscured by accounting methods that cannot be compared Verifiability: verifiability exists when knowledgeable, independent users achieve similar results or reach con
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