CH 02
CH 02
CH 02
CHAPTER
CONCEPTUAL FRAMEWORK
A conceptual framework establishes the concepts that underlie financial reporting.
A conceptual framework is a coherent system of concepts that flow from an objective.
The objective identifies the purpose of financial reporting. The other concepts provide
guidance on (1) identifying the boundaries of financial reporting; (2) selecting the transactions, other events, and circumstances to be represented; (3) how they should be recognized and measured; and (4) how they should be summarized and reported.1
Proposed Conceptual Framework for Financial Reporting: Objective of Financial Reporting and
Qualitative Characteristics of Decision-Useful Financial Reporting Information (Norwalk, Conn.:
FASB, May 29, 2008), page ix. Recall from our discussion in Chapter 1 that while the
conceptual framework and any changes to it pass through the same due process (discussion
paper, public hearing, exposure draft, etc.) as do the IFRSs, the framework is not an IFRS.
That is, the framework does not define standards for any particular measurement or
disclosure issue, and nothing in the framework overrides any specific IFRS.
2
C. Horngren, Uses and Limitations of a Conceptual Framework, Journal of Accountancy
(April 1981), p. 90.
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to an existing framework of basic theory. For example, Sunshine Mining (USA) sold
two issues of bonds. It can redeem them either with $1,000 in cash or with 50 ounces of
silver, whichever is worth more at maturity. Both bond issues have a stated interest rate
of 8.5 percent. At what amounts should Sunshine or the buyers of the bonds record them?
What is the amount of the premium or discount on the bonds? And how should Sunshine
amortize this amount, if the bond redemption payments are to be made in silver (the
future value of which is unknown at the date of issuance)? Consider that Sunshine cannot
know, at the date of issuance, the value of future silver bond redemption payments.
It is difficult, if not impossible, for the IASB to prescribe the proper accounting
treatment quickly for situations like this or like those represented in our opening story.
Practicing accountants, however, must resolve such problems on a daily basis. How?
Through good judgment and with the help of a universally accepted conceptual framework, practitioners can quickly focus on an acceptable treatment.
23
ILLUSTRATION 2-1
Framework for Financial
Reporting
Third level:
The "how"
implementation
ASSUMPTIONS
PRINCIPLES
QUALITATIVE
CHARACTERISTICS
of
accounting
information
CONSTRAINTS
ELEMENTS
of
financial
statements
OBJECTIVE
of
financial
reporting
lenders, and other creditors in making decisions in their capacity as capital providers.
Information that is decision-useful to capital providers may also be useful to other
users of financial reporting, who are not capital providers.4
As indicated in Chapter 1, to provide information to decision-makers, companies
prepare general-purpose financial statements. General-purpose financial reporting
helps users who lack the ability to demand all the financial information they need from
an entity and therefore must rely, at least partly, on the information provided in financial reports. However, an implicit assumption is that users need reasonable knowledge
of business and financial accounting matters to understand the information contained
in financial statements. This point is important. It means that financial statement preparers assume a level of competence on the part of users. This assumption impacts the
way and the extent to which companies report information.
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that explain the qualitative characteristics of accounting information and define the
elements of financial statements.5 That is, the second level forms a bridge between the
why of accounting (the objective) and the how of accounting (recognition, measurement,
and financial statement presentation).
Primary users of
accounting information
Constraints
COST
Pervasive criterion
Fundamental
qualities
Ingredients of
fundamental
qualities
Enhancing
qualities
MATERIALITY
DECISION-USEFULNESS
RELEVANCE
Predictive
value
Comparability
FAITHFUL REPRESENTATION
Confirmatory
value
Verifiability
Completeness
Timeliness
Neutrality
Understandability
Fundamental QualityRelevance
Relevance is one of the two fundamental qualities that make accounting information
useful for decision-making. Relevance and related ingredients of this fundamental quality are shown below.
Fundamental
quality
Ingredients of the
fundamental
quality
RELEVANCE
Predictive
value
Confirmatory
value
Fundamental
quality
Ingredients of the
fundamental
quality
FAITHFUL REPRESENTATION
Completeness
Neutrality
Faithful representation means that the numbers and descriptions match what really existed or happened. Faithful representation is a necessity because most users have
neither the time nor the expertise to evaluate the factual content of the information. For
example, if Siemens AGs (DEU) income statement reports sales of 60,510 million
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when it had sales of 40,510 million, then the statement fails to faithfully represent the
proper sales amount. To be a faithful representation, information must be complete,
neutral, and free of material error.
Completeness. Completeness means that all the information that is necessary for faithful representation is provided. An omission can cause information to be false or misleading and thus not be helpful to the users of financial reports. For example, when
Citigroup (USA) fails to provide information needed to assess the value of its subprime
loan receivables (toxic assets), the information is not complete and therefore not a faithful representation of their values.
Neutrality. Neutrality means that a company cannot select information to favor one
set of interested parties over another. Unbiased information must be the overriding
consideration. For example, in the notes to financial statements, tobacco companies
such as KT & G Corporation (KOR) should not suppress information about the numerous lawsuits that have been filed because of tobacco-related health concernseven
though such disclosure is damaging to the company.
Neutrality in rule-making has come under increasing attack. Some argue that the
IASB should not issue pronouncements that cause undesirable economic effects on an
industry or company. We disagree. Accounting rules (and the standard-setting process)
must be free from bias, or we will no longer have credible financial statements. Without
credible financial statements, individuals will no longer use this information. An analogy demonstrates the point: In the United States, many individuals bet on boxing matches
because such contests are assumed not to be fixed. But nobody bets on wrestling matches.
Why? Because the public assumes that wrestling matches are rigged. If financial information is biased (rigged), the public will lose confidence and no longer use it.
Free from Error. An information item that is free from error will be a more accurate
(faithful) representation of a financial item. For example, if UBS (CHE) misstates its loan
losses, its financial statements are misleading and not a faithful representation of its
financial results. However, faithful representation does not imply total freedom from
error. This is because most financial reporting measures involve estimates of various types
that incorporate managements judgment. For example, management must estimate the
amount of uncollectible accounts to determine bad debt expense. And determination of
depreciation expense requires estimation of useful lives of plant and equipment.
Enhancing Qualities
Enhancing qualitative characteristics are complementary to the fundamental qualitative
characteristics. These characteristics distinguish more-useful information from less-useful
information. Enhancing characteristics, shown below, are comparability, verifiability,
timeliness, and understandability.
Fundamental
qualities
Ingredients of
fundamental
qualities
Enhancing
qualities
RELEVANCE
Predictive
value
Comparability
FAITHFUL REPRESENTATION
Confirmatory
value
Verifiability
Completeness
Timeliness
Neutrality
Understandability
Comparability. Information that is measured and reported in a similar manner for different companies is considered comparable. Comparability enables users to identify the real
1. Two independent auditors count Anheuser-Busch InBev NVs (BEL) inventory and
arrive at the same physical quantity amount for inventory. Verification of an amount
for an asset therefore can occur by simply counting the inventory (referred to as direct
verification).
2. Two independent auditors compute Anheuser-Busch InBev NVs (BEL) inventory
value at the end of the year using the FIFO method of inventory valuation. Verification may occur by checking the inputs (quantity and costs) and recalculating the
outputs (ending inventory value) using the same accounting convention or methodology (referred to as indirect verification).
Timeliness. Timeliness means having information available to decision-makers before
it loses its capacity to influence decisions. Having relevant information available sooner
can enhance its capacity to influence decisions, and a lack of timeliness can rob information of its usefulness. For example, if Lenovo (CHN) waited to report its interim results
until nine months after the period, the information would be much less useful for
decision-making purposes.
Understandability. Decision-makers vary widely in the types of decisions they make,
how they make decisions, the information they already possess or can obtain from
other sources, and their ability to process the information. For information to be useful, there must be a connection (linkage) between these users and the decisions they
make. This link, understandability, is the quality of information that lets reasonably
informed users see its significance. Understandability is enhanced when information
is classified, characterized, and presented clearly and concisely.
For example, assume that Tomkins plc (GBR) issues a three-months report that
shows interim earnings have declined significantly. This interim report provides relevant and faithfully represented information for decision-making purposes. Some users,
upon reading the report, decide to sell their shares. Other users, however, do not
understand the reports content and significance. They are surprised when Tomkins
6
Surveys indicate that users highly value consistency. They note that a change tends to
destroy the comparability of data before and after the change. Some companies assist users
to understand the pre- and post-change data. Generally, however, users say they lose the
ability to analyze over time. IFRS guidelines (discussed in Chapter 22) on accounting changes
are designed to improve the comparability of the data before and after the change.
7
In the United States, these provisions are specified in Reports on Audited Financial
Statements, Statement on Auditing Standards No. 58 (New York: AICPA, April 1988), par. 34.
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declares a smaller year-end dividend and the share price declines. Thus, although
Tomkins presented highly relevant information that was a faithful representation, it was
useless to those who did not understand it.
Thus, users of financial reports are assumed to have a reasonable knowledge of
business and economic activities. In making decisions, users also should review and
analyze the information with reasonable diligence. Information that is relevant and
faithfully represented should not be excluded from financial reports solely because it
is too complex or difficult for some users to understand without assistance.8
Basic Elements
An important aspect of developing any theoretical structure is the body of basic elements
or definitions to be included in it. Accounting uses many terms with distinctive and
specific meanings. These terms constitute the language of business or the jargon of
accounting.
One such term is asset. Is it merely something we own? Or is an asset something
we have the right to use, as in the case of leased equipment? Or is it anything of value
used by a company to generate revenuesin which case, should we also consider the
managers of a company as an asset?
As this example and the lottery ticket example in the opening story illustrate, it is
necessary, therefore, to develop basic definitions for the elements of financial statements. The IASB Framework defines the five interrelated elements that most directly
relate to measuring the performance and financial status of a business enterprise. We
list them below for review and information purposes; you need not memorize these definitions at this point. We will explain and examine each of these elements in more detail
in subsequent chapters.
The elements directly related to the measurement of financial position are assets,
liabilities, and equity. These are defined as follows:
ASSET. A resource controlled by the entity as a result of past events and from
which future economic benefits are expected to flow to the entity.
LIABILITY. A present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources
embodying economic benefits.
EQUITY. The residual interest in the assets of the entity after deducting all its
liabilities.
The elements of income and expenses are defined as follows:
INCOME. Increases in economic benefits during the accounting period in the form
of inflows or enhancements of assets or decreases of liabilities that result in increases
in equity, other than those relating to contributions from equity participants.
EXPENSES. Decreases in economic benefits during the accounting period in the
form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants.
As indicated, the IASB classifies the elements into two distinct groups. [2] The first
group of three elementsassets, liabilities, and equitydescribes amounts of resources
8
Basic Assumptions
Five basic assumptions underlie the financial accounting structure: (1) economic entity,
(2) going concern, (3) monetary unit, (4) periodicity, and (5) accrual basis. Well look
at each in turn.
Recently, the IASB has proposed to link the definition of an entity to its financial reporting
objective. That is, a reporting entity is described as a circumscribed area of business activity
of interest to present and potential equity investors, lenders, and other capital providers. See
IASB/FASB Exposure Draft ED/2010/2: Conceptual Framework for Financial Reporting, The Reporting
Entity (March 2010) at http://www.iasb.org/Current+Projects/IASB+Projects/Conceptual+Framework/
Conceptual+Framework.htm.
10
The concept of the entity is changing. For example, defining the outer edges of companies
is now harder. Public companies often consist of multiple public subsidiaries, each with joint
ventures, licensing arrangements, and other affiliations. Increasingly, companies form and
dissolve joint ventures or customer-supplier relationships in a matter of months or weeks.
These virtual companies raise accounting issues about how to account for the entity. See
Steven H. Wallman, The Future of Accounting and Disclosure in an Evolving World: The Need
for Dramatic Change, Accounting Horizons (September 1995). The IASB is addressing these
issues in the entity phase of its conceptual framework project (see http://www.iasb.org/
Current+Projects/IASB+Projects/Conceptual+Framework/Conceptual+Framework.htm) and in
its project on consolidations (see http://www.iasb.org/Current%20Projects/IASB%20Projects/
Consolidation/Consolidation.htm).
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IFRS Supplement
Periodicity Assumption
To measure the results of a companys activity accurately, we would need to wait until
it liquidates. Decision-makers, however, cannot wait that long for such information.
Users need to know a companys performance and economic status on a timely basis
so that they can evaluate and compare companies, and take appropriate actions. Therefore, companies must report information periodically.
The periodicity (or time period) assumption implies that a company can divide
its economic activities into artificial time periods. These time periods vary, but the most
common are monthly, quarterly, and yearly.
The shorter the time period, the more difficult it is to determine the proper net
income for the period. A months results usually prove less reliable than a quarters results, and a quarters results are likely to be less reliable than a years results. Investors
desire and demand that a company quickly process and disseminate information. Yet
the quicker a company releases the information, the more likely the information will
include errors. This phenomenon provides an interesting example of the trade-off
between relevance and faithful representation in preparing financial data.
11
There is a separate IFRS (IFRS No. 29, Financial Reporting in Hyperinflationary Economies)
that provides guidance on how to account for adjustments to the purchasing power of the
monetary unit. [3]
Measurement Principles
We presently have a mixed-attribute system in which one of two measurement principles is used. These two principles are the cost principle and the fair value principle.
Selection of which principle to follow generally reflects a trade-off between relevance
and faithful representation. Here, we discuss each measurement principle.
Cost Principle. IFRS requires that companies account for and report many assets and
liabilities on the basis of acquisition price. This is often referred to as the historical cost
principle. Cost has an important advantage over other valuations: It is generally
thought to be a faithful representation of the amount paid for a given item.
To illustrate this advantage, consider the problems if companies select current selling
price instead. Companies might have difficulty establishing a value for unsold items.
Every member of the accounting department might value the assets differently. Further,
how often would it be necessary to establish sales value? All companies close their
accounts at least annually. But some compute their net income every month. Those companies would have to place a sales value on every asset each time they wished to determine income. Critics raise similar objections against current cost (replacement cost, present
value of future cash flows) and any other basis of valuation except historical cost.
What about liabilities? Do companies account for them on a cost basis? Yes, they
do. Companies issue liabilities, such as bonds, notes, and accounts payable, in exchange
for assets (or services), for an agreed-upon price. This price, established by the exchange transaction, is the cost of the liability. A company uses this amount to record
the liability in the accounts and report it in financial statements. Thus, many users prefer
historical cost because it provides them with a verifiable benchmark for measuring
historical trends.
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U.S. GAAP
PERSPECTIVE
Both the IASB and FASB
have similar measurement
principles, based on
historical cost and fair value.
However, U.S. GAAP has a
concept statement to guide
estimation of fair values
when market-related data is
not available (Statement of
Financial Accounting
Concepts No. 7, Using Cash
Flow Information and Present
Value in Accounting). The
IASB is considering a
proposal to provide expanded
guidance on estimating fair
values when market-related
data is not available.
U.S. GAAP
PERSPECTIVE
Under U.S. GAAP, revenue is
recognized when realized
(when the company receives
cash or claims to cash) and
earned (when the company
substantially accomplishes
what it must do to be
entitled to the benefits
represented by the
revenues).
Fair Value Principle. Fair value is defined as the amount for which an asset could be
exchanged, a liability settled, or an equity instrument granted could be exchanged, between
knowledgeable, willing parties in an arms length transaction. Fair value is therefore
a market-based measure. IFRS has increasingly called for use of fair value measurements
in the financial statements. This is often referred to as the fair value principle. Fair value
information may be more useful than historical cost for certain types of assets and liabilities and in certain industries.
For example, companies report many financial instruments, including derivatives, at
fair value. Certain industries, such as brokerage houses and mutual funds, prepare their
basic financial statements on a fair value basis. Similarly, in the agricultural industry, biological assets, such as crops and livestock, are measured on the basis of net realizable value.
Net realizable value generally approximates fair value for these assets. In these situations,
there is a ready and active market for these assets. Thus, the unique nature of these industries calls for a departure from historical cost in favor of fair value measurement.
At initial acquisition, historical cost equals fair value. In subsequent periods, as
market and economic conditions change, historical cost and fair value often diverge.
Thus, fair value measures or estimates often provide more relevant information about
the expected future cash flows related to the asset or liability. For example, when longlived assets decline in value, a fair value measure determines any impairment loss. In
this case, fair value measurement, it is argued, provides better insight into the value of
a companys asset and liabilities (its financial position) and a better basis for assessing
future cash flow prospects.
The IASB has also taken the additional step of giving companies the option to use
fair value (referred to as the fair value option) as the basis for measurement of financial assets and financial liabilities. [5] The Board considers fair value more relevant than
historical cost in these situations because it reflects the current cash equivalent value
of financial instruments. As a result companies now have the option to record fair value
in their accounts for most financial instruments, including such items as receivables,
investments, debt securities, and financial liabilities.
Some oppose the movement to fair value measurement. They argue that measurement based on fair value introduces increased subjectivity into accounting reports,
when fair value information is not readily available. For example, it is easy to arrive at
fair values when markets are liquid with many traders, but fair value answers are not
readily available in other situations. For example, how do you value the mortgage-backed
assets held by Socit Gnrale (FRA) and Barclays (GBR) if the market for these securities essentially disappears? In these situations, companies may rely on valuation models based on discounted expected cash flows to arrive at fair value measurements.
Obviously, a great deal of expertise and sound judgment is needed to arrive at measures
that are representationally faithful.12
As indicated above, we presently have a mixed-attribute system that permits the
use of historical cost and fair value. Although the historical cost principle continues to
be an important basis for valuation, recording and reporting of fair value information
is increasing.
The IASB is considering a proposal to provide guidance on estimating fair values when
market-related data is not available. Similar to fair value guidance in U.S. GAAP, these
measurements may be developed using expected cash flow and present value techniques.
See IASB Exposure Draft ED/2009/5, Fair Value Measurement (London, U.K.: IASB, May 2009).
213
Generally, an objective test, such as a sale, indicates the point at which a company
recognizes revenue. The sale provides an objective and verifiable measure of revenue
the sales price. Any basis for revenue recognition short of actual sale opens the door
to wide variations in practice. Recognition at the time of sale provides a uniform and
reasonable test.13
However, as Illustration 2-3 shows, exceptions to the rule exist. We discuss these
exceptions in the following sections.
ILLUSTRATION 2-3
Timing of Revenue
Recognition
End
of production
During
production
Time
of sale
Time cash
received
Revenue should be recognized in the accounting period in which it is probable that future
economic benefits will flow to the company and reliable measurement of the amount of revenue
is possible (generally at point of sale).
During Production. A company can recognize revenue before it completes the job in
certain long-term construction contracts. In this method, a company recognizes revenue
periodically, based on the percentage of the job it has completed. Although technically
a transfer of ownership has not occurred, it is probable that future economic benefits
will flow to the company. If it is not possible to obtain dependable estimates of cost and
progress, then a company delays revenue recognition until it completes the job.
At End of Production. At times, a company may recognize revenue after completion
of the production cycle but before the sale takes place. This occurs if products or other
assets are salable in an active market at readily determinable prices without significant
additional cost. An example is the mining of certain minerals. Once a company mines
the mineral, a ready market at a quoted price exists. The same holds true for harvested
assets in the agricultural industry.
Upon Receipt of Cash. Receipt of cash is another basis for revenue recognition. Companies use the cash-basis approach only when collection is uncertain at the time of sale.
One form of the cash basis is the installment-sales method. Here, a company requires payment in periodic installments over a long period of time. Its most common
use is in retail, such as for farm and home equipment and furnishings. Companies frequently justify the installment-sales method based on the high risk of not collecting an
account receivable. In some instances, this reasoning may be valid. Generally, though,
if a sale has been completed, the company should recognize the sale; if bad debts are
expected, the company should record them as separate estimates.
To summarize, a company records revenue in the period in which it is probable
that future economic benefits will flow to the company and reliable measurement of
the amount of revenue is possible. Normally, this is the date of sale. But circumstances
may dictate application of the percentage-of-completion approach, the end-of-production
approach, or the receipt-of-cash approach.
13
The FASB and IASB are working on a joint revenue recognition project, which will likely
change from revenue recognition criteria based on completing the earnings process to
criteria more aligned with changes in assets and liabilities. See http://www.fasb.org/project/
revenue_recognition.shtml.
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Type of Cost
Relationship
Recognition
Product costs:
Material
Labor
Overhead
Period costs:
Salaries
Administrative costs
No direct relationship
between cost
and revenue.
Expense as incurred.
This approach is commonly referred to as the matching principle. However, there is some
debate about the conceptual validity of the matching principle. A major concern is that
matching permits companies to defer certain costs and treat them as assets on the statement
of financial position. In fact, these costs may not have future benefits. If abused, this principle
permits the statement of financial position to become a dumping ground for unmatched costs.
Constraints
In providing information with the qualitative characteristics that make it useful, companies must consider two overriding factors that limit (constrain) the reporting. These
constraints are: (1) cost and (2) materiality.
Cost Constraint
Too often, users assume that information is free. But preparers and providers of accounting information know that it is not. Therefore, companies must consider the cost
constraint: They must weigh the costs of providing the information against the benefits that can be derived from using it. Rule-making bodies and governmental agencies
use cost-benefit analysis before making final their informational requirements. In order
to justify requiring a particular measurement or disclosure, the benefits perceived to
be derived from it must exceed the costs perceived to be associated with it.
A corporate executive made the following remark to a standard-setter about a proposed rule: In all my years in the financial arena, I have never seen such an absolutely
ridiculous proposal. . . . To dignify these actuarial estimates by recording them as
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IFRS Supplement
assets and liabilities would be virtually unthinkable except for the fact that the FASB
has done equally stupid things in the past. . . . For Gods sake, use common sense just
this once.15 Although extreme, this remark indicates the frustration expressed by members of the business community about rule-making, and whether the benefits of a given
pronouncement exceed the costs.
The difficulty in cost-benefit analysis is that the costs and especially the benefits
are not always evident or measurable. The costs are of several kinds: costs of collecting
and processing, of disseminating, of auditing, of potential litigation, of disclosure to
competitors, and of analysis and interpretation. Benefits to preparers may include
greater management control and access to capital at a lower cost. Users may receive
better information for allocation of resources, tax assessment, and rate regulation. As
noted earlier, benefits are generally more difficult to quantify than are costs.
The implementation of the provisions of the Sarbanes-Oxley Act in the United States
illustrates the challenges in assessing costs and benefits of standards. One study estimated
the increased costs of complying with the new internal-control standards related to the
financial reporting process to be an average of $7.8 million per company. However, the
study concluded that . . . quantifying the benefits of improved more reliable financial
reporting is not fully possible.16
Despite the difficulty in assessing the costs and benefits of its rules, the IASB attempts
to determine that each proposed pronouncement will fill a significant need and that
the costs imposed to meet the standard are justified in relation to overall benefits of the
resulting information. In addition, they seek input on costs and benefits as part of their
due process.
Materiality Constraint
The materiality constraint concerns an items impact on a companys overall financial
operations. An item is material if its inclusion or omission would influence or change
the judgment of a reasonable person. As noted in the IASB Framework: Information
is material if its omission or misstatement could influence the decisions that users make
on the basis of an entitys financial information. . . . When considering whether financial
information is a faithful representation of what it purports to represent, it is important
to take into account materiality because material omissions or misstatements will result
in information that is incomplete, biased, or not free from error.17 It is immaterial, and
therefore irrelevant, if it would have no impact on a decision-maker. In short, it must
make a difference or a company need not disclose it.
The point involved here is of relative size and importance. If the amount involved
is significant when compared with the other revenues and expenses, assets and liabilities,
or net income of the company, sound and acceptable standards should be followed in
reporting it. If the amount is so small that it is unimportant when compared with other
items, applying a particular standard may be considered of less importance.
It is difficult to provide firm guidelines in judging when a given item is or is not
material. Materiality varies both with relative amount and with relative importance.
For example, the two sets of numbers in Illustration 2-5 indicate relative size.
During the period in question, the revenues and expenses, and therefore the net
incomes of Company A and Company B, are proportional. Each reported an unusual gain.
In looking at the abbreviated income figures for Company A, it appears insignificant
whether the amount of the unusual gain is set out separately or merged with the regular
15
16
Charles Rivers and Associates, Sarbanes-Oxley Section 404: Costs and Remediation of
Deficiencies, letter from Deloitte and Touche, Ernst and Young, KPMG, and PricewaterhouseCoopers to the SEC (April 11, 2005).
17
Company A
Company B
Sales
Costs and expenses
10,000,000
9,000,000
100,000
90,000
1,000,000
10,000
Unusual gain
20,000
217
ILLUSTRATION 2-5
Materiality Comparison
5,000
operating income. The gain is only 2 percent of the net income. If merged, it would not
seriously distort the net income figure. Company B has had an unusual gain of only
5,000. However, it is relatively much more significant than the larger gain realized
by A. For Company B, an item of 5,000 amounts to 50 percent of its income from
operations. Obviously, the inclusion of such an item in ordinary operating income
would affect the amount of that income materially. Thus we see the importance of
the relative size of an item in determining its materiality.
Companies and their auditors generally adopt the rule of thumb that anything
under 5 percent of net income is considered immaterial. However, much can depend
on specific rules. For example, one market regulator indicates that a company may use
this percentage for an initial assessment of materiality, but it must also consider other
factors.18 For example, companies can no longer fail to record items in order to meet
consensus analysts earnings numbers, preserve a positive earnings trend, convert a
loss to a profit or vice versa, increase management compensation, or hide an illegal
transaction like a bribe. In other words, companies must consider both quantitative
and qualitative factors in determining whether an item is material.
Thus, it is generally not feasible to specify uniform quantitative thresholds at which an
item becomes material. Rather, materiality judgments should be made in the context of the
nature and the amount of an item. Additional examples are provided in Illustration 2-6.
1. Disclosure of the effects of an accounting change might lead to a company violating a debt
covenant, even though the amount is small in magnitude. Such a situation may justify a
lower materiality threshold than if the companys financial condition were stronger.
2. A misclassification of an asset as equipment that should have been classified as plant may
not be material because it does not affect classification on the statement of financial position (that is, the line item plant and equipment is the same regardless of the misclassification). However, a misclassification of the same amount might be material if it changed
the classification of an asset from plant or equipment to inventory.
3. Similar to the example above, an error of 10,000 in the amount of uncollectible receivables is more likely to be material if the total amount of receivables is 100,000 than if
it is 1,000,000. In addition, even though an individual item may be immaterial, it may
be considered material when added to other immaterial items.
Materiality factors into a great many internal accounting decisions, too. Examples
of such judgments that companies must make include: the amount of classification
required in a subsidiary expense ledger, the degree of accuracy required in allocating
expenses among the departments of a company, and the extent to which adjustments
should be made for accrued and deferred items. Only by the exercise of good judgment
18
Materiality, SEC Staff Accounting Bulletin No. 99 (Washington, D.C.: SEC, 1999).
19
ILLUSTRATION 2-6
Materiality Examples
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IFRS Supplement
and professional expertise can reasonable and appropriate answers be found, which
is the materiality constraint sensibly applied.20
ASSUMPTIONS
1.
2.
3.
4.
5.
PRINCIPLES
Economic entity
Going concern
Monetary unit
Periodicity
Accrual
1.
2.
3.
4.
Measurement
Revenue recognition
Expense recognition
Full disclosure
QUALITATIVE
CHARACTERISTICS
1. Fundamental qualities
A. Relevance
(1) Predictive value
(2) Confirmatory value
B. Faithful representation
(1) Completeness
(2) Neutrality
(3) Free from error
2. Enhancing qualities
(1) Comparability
(2) Verifiability
(3) Timeliness
(4) Understandability
CONSTRAINTS
1. Cost
2. Materiality
Third level:
The "how"
implementation
ELEMENTS
1.
2.
3.
4.
5.
Assets
Liabilities
Equity
Income
Expenses
OBJECTIVE
Provide information
about the reporting
entity that is useful
to present and potential
equity investors,
lenders, and other
creditors in their
capacity as capital
providers.
20
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AUTHORITATIVE LITERATURE
Authoritative Literature References
[1] Framework for the Preparation and Presentation of Financial Statements (London, U.K.: IASB, 2001).
[2] Framework for the Preparation and Presentation of Financial Statements (London, U.K.: IASB, 2001),
paras. 49, 70.
[3] International Accounting Standard No. 29, Financial Reporting in Hyperinflationary Economies (London, U.K.:
IASB, 2001).
[4] Framework for the Preparation and Presentation of Financial Statements (London, U.K.: IASB, 2001),
par. 22.
[5] International Accounting Standard 39, Financial Instruments: Recognition and Measurement (London, U.K.:
International Accounting Standards Committee Foundation, March 1999), par. 9.
[6] International Accounting Standard 18, Revenue (London, U.K.: International Accounting Standards Committee
Foundation, 2001), par. 1.
[7] Framework for the Preparation and Presentation of Financial Statements (London, U.K.: IASB, 2001),
paras. 8388.
QUESTIONS
1. Briefly describe the two fundamental qualities of useful accounting information.
BRIEF EXERCISES
BE2-1
1. Relevance
2. Faithful representation
3. Predictive value
4. Confirmatory value
5.
6.
7.
8.
Comparability
Completeness
Neutrality
Timeliness
(a) Quality of information that permits users to identify similarities in and differences between two
sets of economic phenomena.
(b) Having information available to users before it loses its capacity to influence decisions.
(c) Information about an economic phenomenon that has value as an input to the processes used by
capital providers to form their own expectations about the future.
(d) Information that is capable of making a difference in the decisions of users in their capacity as
capital providers.
(e) Absence of bias intended to attain a predetermined result or to induce a particular behavior.
BE2-2
1.
2.
3.
4.
5.
6.
7.
8.
Faithful representation
Relevance
Neutrality
Confirmatory value
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IFRS Supplement
(a) Quality of information that assures users that information represents the economic phenomena
that it purports to represent.
(b) Information about an economic phenomenon that changes past or present expectations based on
previous evaluations.
(c) The extent to which information is accurate in representing the economic substance of a transaction.
(d) Includes all the information that is necessary for a faithful representation of the economic phenomena that it purports to represent.
(e) Quality of information that allows users to comprehend its meaning.
BE2-3 Identify which qualitative characteristic of accounting information is best described in each item
below. (Do not use relevance and faithful representation.)
(a)
(b)
(c)
(d)
The annual reports of Best Buy Co. (USA) are audited by certified public accountants.
Motorola (USA) and Nokia (FIN) both use the FIFO cost flow assumption.
Starbucks Corporation (USA) has used straight-line depreciation since it began operations.
Heineken Holdings (NLD) issues its quarterly reports immediately after each quarter ends.
BE2-4 What accounting assumption, principle, or constraint would Marks and Spencer plc (M&S) (GBR)
use in each of the situations below?
(a) M&S records expenses when incurred, rather than when cash is paid.
(b) M&S was involved in litigation over the last year. This litigation is disclosed in the financial
statements.
(c) M&S allocates the cost of its depreciable assets over the life it expects to receive revenue from
these assets.
(d) M&S records the purchase of a new Dell (USA) PC at its cash equivalent price.
BE2-5
1.
2.
3.
4.
5.
6.
EXERCISES
E2-1 (Usefulness, Objective of Financial Reporting, Qualitative Characteristics) Indicate whether the
following statements about the conceptual framework are true or false. If false, provide a brief explanation supporting your position.
(a) The fundamental qualitative characteristics that make accounting information useful are relevance
and verifiability.
(b) Relevant information has predictive value, confirmatory value, or both.
(c) Conservatism, a prudent reaction to uncertainty, is considered a constraint of financial reporting.
(d) Information that is a faithful representation is characterized as having predictive or confirmatory value.
(e) Comparability pertains only to the reporting of information in a similar manner for different
companies.
(f) Verifiability is solely an enhancing characteristic for faithful representation.
(g) In preparing financial reports, it is assumed that users of the reports have reasonable knowledge
of business and economic activities.
E2-2 (Qualitative Characteristics) The Framework identifies the qualitative characteristics that make
accounting information useful. Presented below are a number of questions related to these qualitative
characteristics and underlying constraints.
Neutrality
Completeness
Timeliness
Verifiability
Understandability
Comparability
Instructions
Identify the appropriate qualitative characteristic(s) to be used given the information provided below.
(a) Qualitative characteristic being employed when companies in the same industry are using the
same accounting principles.
(b) Quality of information that confirms users earlier expectations.
(c) Imperative for providing comparisons of a company from period to period.
(d) Ignores the economic consequences of a standard or rule.
(e) Requires a high degree of consensus among individuals on a given measurement.
(f) Predictive value is an ingredient of this fundamental quality of information.
(g) Qualitative characteristics that enhance both relevance and faithful representation.
(h) Neutrality and completeness are ingredients of this fundamental quality of accounting
information.
(i) Two fundamental qualities that make accounting information useful for decision-making purposes.
(j) Issuance of interim reports is an example of what enhancing ingredient?
E2-4 (Elements of Financial Statements) Five interrelated elements that are most directly related to
measuring the performance and financial status of an enterprise are provided below.
Assets
Liabilities
Equity
Income
Expenses
Instructions
Identify the element or elements associated with the nine items below.
(a) Obligation to transfer resources arising from a past transaction.
(b) Increases ownership interest.
(c) Declares and pays cash dividends to owners.
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IFRS Supplement
(d) Increases in net assets in a period from non-owner sources.
(e) Items characterized by service potential or future economic benefit.
(f) Equals increase in assets less liabilities during the year, after adding distributions to owners and
subtracting investments by owners.
(g) Residual interest in the assets of the enterprise after deducting its liabilities.
(h) Increases assets during a period through sale of product.
(i) Decreases assets during the period by purchasing the companys own shares.
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Instructions
oifrs
ies
Refer to M&Ss financial statements and the accompanying notes to answer the following questions.
(a) Using the notes to the consolidated financial statements, determine M&Ss revenue recognition
policies.
(b) Give two examples of where historical cost information is reported in M&Ss financial statements and
related notes. Give two examples of the use of fair value information reported in either the financial
statements or related notes.
(c) How can we determine that the accounting principles used by M&S are prepared on a basis consistent with those of last year?
(d) What is M&Ss accounting policy related to Refunds and loyalty schemes? Why does M&S include
the accounting for Refunds and loyalty schemes in its Critical accounting estimates and judgements?
Instructions
Access the IASB Framework at the IASB website (http://eifrs.iasb.org/ ). When you have accessed the
documents, you can use the search tool in your Internet browser to prepare responses to the following
items. (Provide paragraph citations.)
(a) How is materiality defined in the Framework?
(b) Briefly discuss how materiality relates to (1) the relevance of financial information, and (2) completeness.
(c) Your aunt observes that under IFRS, the financial statements are prepared on the accrual basis.
According to the Framework, what does the accrual basis mean?
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