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Chapter 2

MGAC01H3 Chapter Notes - Chapter 2: Income Statement, Comprehensive Income, Conceptual Framework


Department
Financial Accounting
Course Code
MGAC01H3
Professor
Daga
Chapter
2

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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

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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
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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 consensus regarding the accounting for a particular transaction
Timeliness: timeliness is information that is made available to decision-makers before it loses its
ability to influence their decisions
Understandability: 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
Constraints
Materiality: materiality relates 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 judgement
of a reasonable person
Elements of Financial Statements
Assets
Assets have two essential characteristics: they involve present economic resources (scarce and
capable of producing cash flows) and the entity has a right or access to these resources where
others do not (restricted and enforceable)
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