Chapter 2 - Conceptual framework underlying financial reporting

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Management and Organizational Studies
Management and Organizational Studies 3360A/B
Michelle Loveland

Conceptual Framework A conceptual framework is like a constitution: it is a "coherent system of interrelated objectives and fundamentals that can lead to consistent standards and that prescribes the nature, function, and limited of financial accounting and financial statements." Rationale for Conceptual Framework Standard setting should build on an established body of concepts and objectives. Such a framework should increase financial statement users' understanding of and confidence in financial reporting, and that it enhance the comparability of different companies' financial statements. By referring to an existing framework, it should be possible to solve new and emerging practical problems more quickly. Development of Conceptual Framework 1976 FASB issued a three-part discussion memorandum entitled "Conceptual Framework for Financial Accounting and Reporting: Elements of financial statement and their measurement." Figure 2-1 on pg. 39 First level (Objectives) - Accountings Goals and Purposes: These are the conceptual framework building blocks. Second Level (Qualitative characteristics) - Qualitative (a) accounting information useful and the elements (b) of financial statements. Third Level (Foundational principles) - Used in establishing and applying accounting standards. Objective of Financial Reporting General Purpose Financial Statements: useful information presented to ket users in a manner whereby benefits exceed costs. (a) Qualitative Characteristics of useful information Decision Usefulness Fundamental Qualitative Characteristics Relevance Makes a difference in a decision It has Predictive Value It has feedback/confirmatory value Materiality: How important a piece of information is. Representational faithfulness Reflects the underlying economic substance of an event or transaction. Referred to as transparency. Is complete, neutral, and free from material error. Completeness: Should include all information necessary to portray the underlying events and transactions. Neutrality: Information cannot be selected to favour one set of interested parties over another. Management Best Estimate: To portray the economic reality of realized or unrealized revenues. Freedom from material error means that the information must be reliable. Enhancing Qualitative Characteristics Includes comparability, verifiability, timeliness, and understandability. Comparability: Enables users to identify the real similarities and differences in economic phenomena. Verifiability: When knowledgeable, independent users achieve similar results or reach consensus regarding the account for a particular transaction. Timeliness: Information should be 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. Tradeoffs: A tradeoff exists when a company decides to temporarily sacrifice of financial reporting in order to more effectively present information. Cost versus Benefits: The cost of providing the information must be weighed against the benefits that can be had from using the information. (b) Elements of Financial Statements Assets There is some economic benefit to the entity. The entity has control over that benefit. The benefits result from a past transaction or event. Liabilities They represent a present duty or responsibility. The duty or responsibility obligates the entity, leaving it little or no discretion to avoid it. the transaction or event results form a past transaction or event. Constructive Obligations: are obligations that arise through past or present practice that signals that the company acknowledges a potential economic burden. Example: Warranties. Equitable Obligations: arise due to moral or ethical considerations. Example: Care given to an employee who is being downsized… May be further categorized as financial (regarding contractual obligations to deliver cash or other financial assets), or non-financial (everything else). Equity Is a residual interest in an entity that remains after deducting its liabilities from its assets. Equity is the ownership interest. Revenues Increases in economic resources. Result from ordinary activities. Expenses Decreases in economic resources. Result from an entity's ordinary revenue-generating-activities Gains/Losses Gains are increases in equity (net assets) from an entity's peripheral or incidental transactions. Losses are decreases in equity (net assets) from an entity's peripheral or incidental transactions. (example, a real-estate company who usually collects rent from its properties, but then decides to sell their buildings for a gain or loss.) The financial statements include the following items: Income statement and/or statement of comprehensive income Statement of financial position Statement of retained earnings or changes in shareholders' equity Statement of cash flows Comprehensive income: A relatively new income concept and includes more than the traditional notion of net income. It includes net income and other comprehensive income. Other Comprehensive income is made up of revenues, expenses, gains, and losses that are recognized in comprehensive income, but excluded from net income. Example: Unrealized holding gains and losses on certain securities and property, plant, and equipment (revaluation method). Certain gains and losses related to foreign exchange instruments, foreign operations, and certain types of hedges. Certain gains and losses related to remeasurement of defined benefit plans and liabilities measured at fair value. **Comprehensive income does not exist under ASPE.** Foundational Principles * The third level of the conceptual framework. These concepts explain which, when, and how financial elements and events should be recognized, measured, and presented/disclosed by the accounting system. The 10 foundational principles and assumptions: 1. Economic entity assumption 2. Control 3. Revenue recognition and realization principles 4. Matching principle 5. Periodicity assumption 6. Monetary unit assumption 7. Going concern assumption 8. Historical cost principle 9. Fair value principle 10. Full disclosure principle Recognition/Derecognition Recognition deals wight he act of including something on the entity's statement of financial position or income statement. Historically, elements of financial statements have been recognized when: They meet the definition of an element (for example, a liability), They are probably, and They are reliably measurable. Under IFRS, "probable" is defined as "more likely that not" (interpreted as greater than 50%. Under ASPE, it is defined as "likely". Greater losses and liabilities likely to occur under IFRS due to the perceived lower threshold. Derecognition is the act of taking something off the statement of financial position or income statement. Economic Entity Assumption and Control Allows us to identify an economic activity with a particular unit of accountability. Legal Entity. Parent and subsidiary companies are separate legal entities, for for accurate reporting standards, they are considered the same Economic Entity. Allow the company to group particular financial statement elements
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