2nd

2nd Lecture
Lecture

Chapter
Chapter 22
Conceptual
Conceptual Framework
Framework for
for Financial
Financial
Reporting
Reporting

Dr. Rawan Hamed

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 PREVIEW OF CHAPTER 2

Intermediate Accounting
IFRS
Kieso, Weygandt, and Warfield
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 CONCEPTUAL
CONCEPTUALFRAMEWORK
FRAMEWORKFOR
FORFINANCIAL
FINANCIALREPORTING
REPORTING

Conceptual Framework establishes the concepts that underlie

financial reporting.

Why do we need a Conceptual Framework?

 Rule-making should build on and relate to an established

body of concepts.
 Enables IASB to issue more useful and consistent
pronouncements over time and a coherent set of
standards
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 DEVELOPMENT
DEVELOPMENTOF
OFAACONCEPTUAL
CONCEPTUALFRAMEWORK
FRAMEWORK

Presently, the Conceptual Framework comprises an

introduction and four chapters as follows:
Chapter 1: The Objective of General Purpose Financial
Reporting
Chapter 2: The Reporting Entity
Chapter 3: Qualitative Characteristics of Useful Financial
Information
Chapter 4: The Framework, comprised of the following:
1. Underlying assumption—the going concern assumption;
2. The elements of financial statements;
3. Recognition of the elements of financial statements;
4. Measurement of the elements of financial statements; and
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5. Concepts of capital and capital maintenance.
 ASSUMPTIONS PRINCIPLES CONSTRAINTS
1. Economic entity 1. Measurement 1. Cost
2. Going concern 2. Revenue recognition
Third level
3. Monetary unit 3. Expense recognition
The "how"—
4. Periodicity 4. Full disclosure implementation
5. Accrual
Recognition, Measurement,
& Disclosure Concepts.
QUALITATIVE
CHARACTERISTICS ELEMENTS
1. Fundamental 1. Assets
qualities 2. Liabilities Second level
2. Enhancing 3. Equity Bridge between
qualities 4. Income
levels 1 and 3
5. Expenses
ILLUSTRATION 2-7
Conceptual Framework
for Financial Reporting OBJECTIVE
Provide information
about the reporting
entity that is useful
to present and potential First level
equity investors, The "why"—purpose
lenders, and other of accounting
creditors in their
capacity as capital
2-5 providers.
 FIRST
FIRST LEVEL:
LEVEL: BASIC
BASIC OBJECTIVE
OBJECTIVE
OBJECTIVE
“To provide financial information about the reporting entity that is
useful to (capital providers) present and potential equity
investors, lenders, and other creditors in making decisions about
providing resources to the entity.
Information that is decision-useful to capital providers may also be
useful to other users of financial reporting, who are not capital
providers.

 Provided by issuing general-purpose financial statements.

 Assumption is that users need reasonable knowledge of business
and financial accounting matters to understand the information
contained in financial statements.
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SECOND
SECOND LEVEL:
LEVEL: FUNDAMENTAL
FUNDAMENTALCONCEPTS
CONCEPTS

Qualitative Characteristics of Accounting Information

IASB (International Accounting Standard Board) identified the
Qualitative Characteristics of accounting information that distinguish
better (more useful) information from inferior (less useful)
information for decision-making purposes.

How does a company choose an acceptable accounting method, the

amount and types of information to disclose, and the format in which to
present it?
The answer:
By determining which alternative provides the most useful
information for decision making purposes (decision-usefulness).

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SECOND
SECOND LEVEL:
LEVEL: FUNDAMENTAL
FUNDAMENTAL CONCEPTS
CONCEPTS

ILLUSTRATION 2-2
Hierarchy of
Accounting Qualities

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SECOND LEVEL: FUNDAMENTAL CONCEPTS
Fundamental Quality—Relevance

To be relevant, accounting information must be capable of making a

difference in a decision.
 Financial information has predictive value if it has value as an input to
predictive processes used by investors to form their own expectations
about the future.
 Relevant information also helps users confirm or correct prior
expectations.
 Information is material if omitting it or misstating it could influence
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SECOND LEVEL: FUNDAMENTAL CONCEPTS
Fundamental Quality—Faithful Representation

Faithful representation means that the numbers and descriptions match what
really existed or happened.
 Completeness means that all the information that is necessary for faithful
representation is provided.
 Neutrality means that a company cannot select information to favor one set
of interested parties over another.
 An information item that is free from error will be a more accurate
(faithful) representation of a financial item.
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SECOND LEVEL: FUNDAMENTAL CONCEPTS
Enhancing Qualities

Information that is measured and reported in a similar manner for different companies
is considered comparable. Another type of comparability, consistency, is present when
a company applies the same accounting treatment to similar events, from period to
period.
 Verifiability occurs when independent measurers, using the same methods, obtain

similar results.
 Timeliness means having information available to decision-makers before it loses

its capacity to influence decisions.

 Understandability is the quality of information that lets reasonably informed users
see its significance.
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 SECOND LEVEL: BASIC ELEMENTS
Elements of Financial Statements
A resource controlled by the entity as a result of past events
and from which future economic benefits are expected to flow
Asset
to the entity.

A present obligation of the entity arising from past events, the

Liability 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.

Increases in economic benefits during the accounting period in

Income 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.

Decreases in economic benefits during the accounting period

Expenses
in the form of outflows or depletions of assets or incurrences
of liabilities that result in decreases in equity, other than those
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THIRD
THIRD LEVEL:
LEVEL: RECOGNITION,
RECOGNITION, MEASUREMENT,
MEASUREMENT,
AND
AND DISCLOSURE
DISCLOSURE CONCEPTS
CONCEPTS

These concepts explain how companies should recognize,

measure, and report financial elements and events.

Recognition, Measurement, and Disclosure Concepts

ASSUMPTIONS PRINCIPLES CONSTRAINTS
1. Economic entity 1. Measurement 1. Cost
2. Going concern 2. Revenue recognition
3. Monetary unit 3. Expense recognition
4. Periodicity 4. Full disclosure
5. Accrual

ILLUSTRATION 2-7
Conceptual Framework for
Financial Reporting

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 THIRD
THIRD LEVEL:
LEVEL: BASIC
BASICASSUMPTIONS
ASSUMPTIONS
Economic Entity – company keeps its activity separate from its owners and
other business unit.

Going Concern - company to last long enough to fulfill objectives and

commitments. No liquidation is presumed in the near future.

Monetary Unit - money is the common denominator (measure of value).The

monetary unit is relevant, simple, universally available, understandable,
& useful. However, it ignores the effect of inflation.
Periodicity - company can divide its economic activities into time periods.
This enables the co. to report information periodically
(monthly/quarterly/yearly).

Accrual Basis of Accounting – transactions are recorded in the periods in

which the events occur. Regardless of when cash is collected or paid.
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 THIRD
THIRD LEVEL:
LEVEL: BASIC
BASIC PRINCIPLES
PRINCIPLES

Measurement Principles
 Historical Cost is generally thought to be a faithful
representation of the amount paid for a given item.

 Fair value is defined as “the price that would be received to

sell an asset or paid to transfer a liability in an orderly
transaction between market participants at the measurement
date.”

 IFRS has given companies the option to use fair value as the
basis for measurement of financial assets and financial
liabilities.
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 A system of “mixed-attribute” is applied, that permits
the use of Historical Cost & Fair Value.

 Although the Historical Cost principle continues to

be an important basis for valuation,

 Recording & reporting of Fair Value information is

increasing, where it is believed it would enhance
consistency & comparability.
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 THIRD
THIRD LEVEL:
LEVEL: BASIC
BASIC PRINCIPLES
PRINCIPLES

Revenue Recognition
When a company agrees to perform a service or sell a product to
a customer, it has a performance obligation.

Requires that companies recognize revenue in the accounting

period in which the performance obligation is satisfied.

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 THIRD
THIRD LEVEL:
LEVEL: BASIC
BASIC PRINCIPLES
PRINCIPLES

Expense Recognition - Outflows or “using up” of assets

or incurring of liabilities during a period as a result of delivering
or producing goods and/or rendering services. ILLUSTRATION 2-6
Expense Recognition

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“Let the expense follow the revenues.”
Expense recognition maintains that
companies recognize expenses Not when
payment occurs, but when the work or the
product actually contributes to
revenues.
i.e.
The companies tie expense recognition to
revenue recognition

Matching efforts (expenses) with

accomplishments (revenues)
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 THIRD LEVEL: BASIC PRINCIPLES

Full Disclosure
Providing information that is of sufficient importance to
influence the judgment and decisions of an informed user.
Provided through:
 Financial Statements
 Notes to the Financial Statements
 Supplementary information

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 THIRD LEVEL: COST CONSTRAINT

Cost Constraint
Companies 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.

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 Exercises
Relevance and Faithful representation
are the two Fundamental qualities that
make accounting information useful for
decision making.
True

To be faithfully represented, accounting

information must be capable of making a
difference in a decision.

False
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E (2-1): Indicate whether the following statements about the
Conceptual Framework are true or false.
(a) Accounting rule-making that relies on a body of concepts will
result in useful and consistent pronouncements.
(b) General-purpose financial reports are most useful to company
insiders in making strategic business decisions.
(c) Accounting standards based on individual conceptual frameworks
generally will result in consistent and comparable accounting
reports.
(d) Capital providers are the only users who benefit from general-
purpose financial reporting.
(e) Accounting reports should be developed so that users without
knowledge of economic & business can become informed about
the financial results of a company.
(f) The objective of financial reporting is the foundation from which
the other aspects of the framework logically result.
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 (a) True
(b) False. 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. Managers and
company insiders generally do not meet these criteria.
(c) False. Standard-setting that is based on personal conceptual frameworks will
lead to different conclusions about identical or similar issues than it did
previously. As a result, standards will not be con­sistent with one another and past
decisions may not be indicative of future ones.
(d) False. The objective of general purpose financial reporting is to provide financial
information about the reporting entity that is useful to present and potential
equity investors, lenders, and other creditors in making decisions in their
capacity as capital providers. However, that information may also be useful to
other users of financial reporting who are not capital providers.
(e) False. An implicit assumption is that users need reasonable knowledge of
business and financial accounting matters to understand the information
contained in financial statements. It means that financial statement preparers
assume a level of com­petence on the part of users.
(f) True.

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E2.2 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.

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 (a) False.
(b) True.
(c) False.
(d) False.
(e) False. While comparability does pertain to the reporting of information
in a similar manner for different companies, it also refers to the consistency of
information, which is present when a company applies the same accounting
treatment to similar events, from period to period. Through such application the
company shows consistent use of accounting standards and this permits valid
comparisons from one period to the next.
(f) False. Verifiability is an enhancing characteristic for both relevance
and faithful representation. Verifiability occurs when independent measurers,
using the same methods obtain similar results.

(g) True.

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E2-3: Presented below are a number of questions related to the qualitative characteristics
and underlying constraints.
(a) What is the quality of information that enables users to confirm or correct prior
expectations?
(b) Identify the overall or pervasive constraint developed in the conceptual framework.
(c) A noted accountant once remarked, “If it becomes accepted or expected that accounting
principles are determined or modified in order to secure purposes other than economic
measurement, we assume a grave risk that confidence in the credibility of our financial
information system will be undermined.” Which qualitative characteristic of accounting
information should ensure that such a situation will not occur? (Do not use faithful
representation.)
(d) Muruyama Group. switches from FIFO to average cost & then back to FIFO over a 2-year
period. Which qualitative characteristic of accounting information is not followed?
(e) Assume that the profession permits the savings and loan industry to defer losses on
investments it sells, because immediate recognition of the loss may have adverse
economic consequences on the industry. Which qualitative characteristic of accounting
information is not followed? (Do not use relevance or faithful representation.)
(f) What are the two fundamental qualities that make accounting information useful for decision
making?
(g) Watteau Inc. does not issue its first-quarter report until after the second quarter’s results are
reported. Which qualitative characteristic of accounting is not followed? (Do not use
relevance.)
(h) Predictive value is an ingredient of which of the two fundamental qualities that make
accounting information useful for decision-making purposes?
(i) Duggan, Inc. is the only company in its industry to depreciate its plant assets on a straight-line
basis. Which qualitative characteristic of accounting information may not be present?
(j) Nadal Company has attempted to determine the replacement cost of its inventory. Three
different appraisers arrive at substantially different amounts for this value. The president,
nevertheless, decides to report the middle value for external reporting purposes. Which
qualitative characteristic of information is lacking in these data?
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(a) Confirmatory Value.
(b) Cost Constraint.
(c) Neutrality.
(d) Consistency (note the overall qualitative
characteristic is comparability; consistency is
considered part of comparability).
(e) Neutrality.
(f) Relevance and Faithful representation.
(g) Timeliness.
(h) Relevance.
(i) Comparability.
(j) Verifiability.
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Exercise 2-4: Identify the qualitative characteristic(s) to be used given
the information provided.

Characteristics
(a) Qualitative characteristic being
displayed when companies in the same Comparability
industry are using the same
accounting principles.

(b) Quality of information that confirms Confirmatory value

users’ earlier expectations.

(c) Imperative for providing comparisons Comparability

of a company from period to period. (Consistency)

(d) Ignores the economic consequences of

a standard or rule. Neutrality
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 Exercise 2-4: Identify the qualitative characteristic(s) to be used given
the information provided.

Characteristics
(e) Requires a high degree of consensus Verifiability
among individuals on a given
measurement.

(f) Predictive value is an ingredient of this

fundamental quality of information. Relevance

(g) Four qualitative characteristics that

Comparability, Verifiability,
enhance both relevance and faithful
Timeliness, Understandability
representation.

(h) An item is not reported because its effect

on income would not change a decision. Materiality

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 Exercise 2-4: Identify the qualitative characteristic(s) to be used given
the information provided.

Characteristics
(i) Neutrality is a key ingredient of this Faithful representation
fundamental quality of accounting
information.

(j) Two fundamental qualities that make

accounting information useful for Relevance, Faithful
decision-making purposes. representation

(k) Issuance of interim reports is an example

of what enhancing ingredient? Timeliness

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E2-5 Identify the element or elements associated with the
items below:

a. Obligation to transfer resources arising from a past

transaction.
b. Increases ownership interest by issuance of shares.
c. Declares and pays cash dividends to owners.
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
company’s own shares.
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 (a) Liabilities.
(b) Equity.
(c) Equity.
(d) Income.
(e) Assets.
(f) Income.
(g) Equity.
(h) Income.
(i) Equity.

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E2-6: Identify the accounting assumption, principle, or constraint that
describes each situation below.

(a) Allocates expenses to revenues in the proper period.

(b) Indicates that fair value changes subsequent to purchase
are not recorded in the accounts.
(c) Ensures that all relevant financial information is reported.
(d) Rationale why plant assets are not reported at liquidation
value.
(e) Generally records revenue at the point of sale.
(f) Indicates that personal and business record keeping should
be separately maintained.
(g) Separates financial information into time periods for
reporting purposes.
(h) Permits the use of fair value valuation in certain situations.
(i) Assumes that the Yen is the “measuring stick” used to report
on financial performance of a Japanese company.

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a. Expense recognition principle.
b. Historical cost principle.
c. Full disclosure principle.
d. Going concern assumption.
e. Revenue recognition principle
f. Economic entity assumption.
g. Periodicity assumption.
h. Fair value principle
i. Monetary unit assumption.

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 BE2-8: Identify which basic assumption of accounting is best
described in each item below.

(a) The economic activities of FedEx Corporation

(USA) are divided into 12-month periods for the Periodicity
purpose of issuing annual reports.
(b) Total S.A. (FRA) does not adjust amounts in its
financial statements for the effects of inflation. Monetary
Unit
(c) Barclays (GBR) reports current and non-current
classifications in its statement of financial Going Concern
position.
(d) The economic activities of Tokai Rubber
Industries (JPN) and its subsidiaries are merged Economic
for accounting and reporting purposes. Entity
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 BE2-9: Identify which basic principle of accounting is
best described in each item below.

(a) Parmalat (ITA) reports revenue in its income Revenue

statement when it delivered goods instead of when Recognition
the cash is collected.
(b) Google (USA) recognizes depreciation expense for Expense
a machine over the 2-year period during which that
Recognition
machine helps the company earn revenue.
(c) KC Corp. (USA) reports information about pending
Full
lawsuits in the notes to its financial statements.
Disclosure
(d) Fuji Film (JPN) reports land on its statement of
financial position at the amount paid to acquire it,
even though the estimated fair market value is Measurement
greater.
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