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Chapter 2

Management and Organizational Studies 3360A/B Chapter Notes - Chapter 2: Conceptual Framework, Financial Statement, Measurement Uncertainty


Department
Management and Organizational Studies
Course Code
MOS 3360A/B
Professor
Stacey Hann
Chapter
2

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Chapter 2 Conceptual Framework Underlying Financial Reporting
Conceptual Framework
Conceptual framework coherent system of interrelated objectives and fundamentals
that can lead to consistent standards and that prescribes the nature, function, and limits of
financial accounting and financial statements
Creates standards for accounting profession
Increases financial statement users’ understanding of and confidence in financial
reporting
A reference of basic accounting theory for solving new and emerging practical problems
of reporting
Rationale for Conceptual Framework
Standard setting should build on established body of concepts and objectives
The result is a coherent set of standards and rules, because they have been built upon the
same foundation
By using the framework, you can solve new and emerging problems
Format of the Conceptual Framework
At the first level, the objectives identify accounting’s goals and purposes – these are the
conceptual framework’s building blocks
At the second level are the qualitative characteristics that make accounting information
useful and the elements of financial statements (assets, liabilities, equity, revenues,
expenses, gains, and losses)
At the third and final level are the foundational principles used in establishing and
applying accounting standards
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Objective of Financial Reporting (first level)
The objective of financial reporting is to provide information that is:
(a) Useful to users (e.g. investors, creditors, etc.)
(b) Decision relevant about how to allocate resources
Companies provide this information to users through financial statements
o The statements are intended to provide the most useful information possible in a
manner whereby benefits exceed costs to the different kinds of users
Fundamental Qualitative Characteristics (second level part I)
Relevance and representational faithfulness are fundamental qualities that make
accounting information useful for decision-making
Relevance
o To be relevant, accounting information must be capable of making a difference in
a decision
o Relevant information helps users make predictions about the final outcome of
past, present, and future events (that is it has predictive value)
o Relevant information also helps users confirm or correct their previous
expectations (that is it has feedback/confirmatory value)
o Materiality refers to how important a piece of information is
Often thought to be material if it would make a difference to the decision
maker
Materiality depends on both a relative amount and relative importance
“How big does an error have to be for a decision to be affected by it”
If information has material error, the error it too big to ignore
Representational Faithfulness
o Information must give a faithful picture of the facts and circumstances involved
o Information that is representationally faithful is complete, neutral, and free from
material error
o Completeness the idea that the statements should include all information
necessary to portray the underlying events and transactions
o Free from material error information must be reliable
Enhancing Qualitative Characteristics (second level part II)
Enhancing qualitative characteristics include comparability, verifiability, timeliness, and
understandability
Comparability
o Information that has been measured and reported in a similar way
o Enables users to identify the real similarities and differences
o Exists when knowledgeable users achieve similar results or reach consensus
regarding the accounting for a particular transaction
In other words, similar results achieved same methods used
o Numbers that are easy to verify with a reasonable degree of accuracy are often
referred to as “hard” numbers
o Numbers that have more measurement uncertainty are called “soft” numbers
Timeliness
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o Information should be available to decision makers before it loses its ability to
influence their decisions
o Quarterly reporting (issuance of financial information every 3 months) provides
information on a timelier basis
Oppose to having to wait until year end
Understandability
o Users need to have reasonable knowledge of business and financial accounting
matters in order to understand the information in financial statements
o The information must also be of quality so that it can be understood
o Allows reasonably informed users to see significance of the information
Verifiability
o High degree of consensus among various individuals
Trade-offs
It is not always possible for financial information to have all enhancing qualities you
must make a trade off
Refers to sacrificing one qualitative characteristic for another
E.g. comparability is temporarily sacrificed for better information in the future
Cost-benefit relationship the costs of providing information must be weighed against
the benefits that can be had from using the information
o Benefits of using information should outweigh costs of providing information
Elements of Financial Statements
Elements of financial statements include: assets, liabilities, equity, revenues, expenses,
gains and losses
Assets
Assets have three essential characteristics
o There is some economic benefit to the entity
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