Chapter 2 - Conceptual Framework for Financial Reporting PDF

# Conceptual Framework for Financial Reporting ## Learning Objectives After studying this chapter, you should be able to: - Describe the usefulness of a conceptual framework and the objective of financial reporting. - Identify the qualitative characteristics of accounting information and the basic...

# Conceptual Framework for Financial Reporting ## Learning Objectives After studying this chapter, you should be able to: - Describe the usefulness of a conceptual framework and the objective of financial reporting. - Identify the qualitative characteristics of accounting information and the basic elements of financial statements. - Review the basic assumptions of accounting. - Explain the application of the basic principles of accounting. ## Preview of Chapter 2 Users of financial statements can face difficult questions about the recognition and measurement of financial items. To help develop the type of financial information that can be used to answer these questions, financial accounting and reporting relies on a conceptual framework. This chapter examines the basic concepts underlying the conceptual framework. ## Conceptual Framework for Financial Reporting ### Conceptual Framework - Need for a conceptual framework. - Development of a conceptual framework. - Overview of the conceptual framework. - Basic objective. ### Fundamental Concepts - Qualitative characteristics of accounting information. - Basic elements. ### Assumptions - Economic entity. - Going Concern. - Monetary unit. - Periodicity. - Accrual basis. ### Measurement, Recognition, and Disclosure Concepts - Basic principles of accounting. - Cost constraint. - Summary of the structure. ## What is It? Accounting needs a framework-a conceptual framework-that helps guide the development of standards. To understand the importance of developing this framework, examine the following two situations. ## What Do the Numbers Mean? What's Your Principle? The need for a conceptual framework is highlighted by accounting scandals at Royal Ahold, Enron, Satyan Computer Services, and Carillion. Many argue that regulators should move towards principles-based rules. They believe that companies exploited the detailed provisions in rules-based pronouncements to manage accounting reports, rather than report the economic substance of transactions. For example, many of the off-balance-sheet arrangements of Enron relied on obscure accounting rules, allowing companies to structure transactions to achieve a desired accounting treatment. ## Development of a Conceptual Framework The IASB published the Conceptual Framework for Financial Reporting in 2018. This fully revised document replaced the section of the 2010 version of the Conceptual Framework that had been carried forward from the 1989 version, as well as addressed some changes introduced in 2010. The Conceptual Framework comprises eight chapters: - The Objective of General Purpose Financial Statements. - Qualitative Characteristics of Useful Financial Information. - Financial Statements and the Reporting Entity. - The Elements of Financial Statements. - Recognition and Derecognition. - Measurement. - Presentation and Disclosure. - Concepts of Capital and Capital Maintenance. ## Overview of the Conceptual Framework The illustration below provides an overview of the Conceptual Framework for Financial Reporting. | | | --- | |  | The first level identifies the objective of financial reporting — the purpose of financial reporting. The second level provides the qualitative characteristics that make accounting information useful and the elements of financial statements (assets, liabilities, and so on). The third level identifies the recognition, measurement, and disclosure concepts used in establishing and applying accounting standards and the specific concepts to implement the objective. These concepts include assumptions, principles, and a cost constraint that describe the present reporting environment. ## Basic Objective The objective of financial reporting is **the foundation of the Conceptual Framework**. Other aspects of the Conceptual Framework–qualitative characteristics, elements of financial statements, recognition, measurement, and disclosure—flow logically from the objective. ## Fundamental Concepts ### Learning Objective 2 Identify the qualitative characteristics of accounting information and the basic elements of financial statements. The objective (first level) focuses on the purpose of financial reporting. Building blocks that explain the qualitative characteristics of accounting information and define the elements of financial statements are provided. ### Qualitative Characteristics of Accounting Information *Should a company like Marks and Spencer (GBR) provide information in its financial statements on how much it costs to acquire is assets (historical cost basis), or how much the assets are currently worth (fair value basis)? Should Samsung (KOR) combine and show as one company the main segments of its business, or should it report Consumer Electronics, Information Technology & Mobile Communications, Device Solutions, and Harman as separate segments?* 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).* The IASB identified the qualitative characteristics of accounting information that distinguish better (more useful) information from inferior (less useful) information for decision-making purposes. The IASB identified a cost constraint as part of the Conceptual Framework. | | | --- | |  | ### Fundamental Quality – Relevance 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 – Faithful Representation Faithful representation is the second fundamental quality that makes accounting information useful for decision-making. Faithful representation and related ingredients of this fundamental quality are shown as follows: | | | --- | |  | ## 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 in the following diagram, are comparability, verifiability, timeliness, and understandability. | | | --- | |  | ## Cost Constraint In providing information with the qualitative characteristics that make it useful, companies must consider an overriding factor that limits (constrains) the reporting. This is referred to as the cost constraint. That is, companies must weigh the costs of providing the information against the benefits that can be derived from using it. ## What Do the Numbers Mean? Show Me the Earnings! Some young technology companies, in an effort to attract investors who will help them strike it rich, are using unconventional financial terms in their financial reports. As an example, instead of revenue, these privately held companies use terms such as "bookings," annual recurring revenues, or other numbers that often exceed actual revenue. Hortonworks Inc. (a U.S. software company) is a classic illustration. It forecast in March 2014 that it would have a strong $100 million in billings by year-end. It turns out the company was not talking about revenues but rather a non-U.S. GAAP number (referred to as an alternative performance measure, or APM) that it uses to gauge future business. This number looked a lot smaller after Hortonworks went public and reported financial results — just $46 million in revenues. | | | --- | |  | Another example is Uber Technologies (the sometimes controversial U.S. ride service). Uber noted that it was on target to reach $10 billion in bookings for 2014. Uber defines bookings as total fares paid by customers. But Uber keeps little of the money from these bookings. As shown in the following chart, Uber gets only 25 cents on each $1 of bookings. | | | --- | |  | ## 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 revenues — in which case, should we also consider the managers of a company as an asset? ## Elements of Financial Statements The elements directly related to the measurement of financial position are assets, liabilities, and equity. - **Asset**: A present economic resource controlled by the entity as a result of past events. (An economic resource is a right that has the potential to produce economic benefits). - **Liability**: A present obligation of the entity to transfer an economic resource as a result of past events. - **Equity**: The residual interest in the assets of the entity after deducting all its liabilities. ## Assumptions ### Learning Objective 3 Review the basic assumptions of accounting. The third level of the Conceptual Framework consists of concepts that implement the basic objectives of level one. These concepts explain how companies should recognize, measure, and report financial elements and events. Here, we identify the concepts as basic assumptions, principles, and a cost constraint. Not everyone uses this classification system, so focus your attention more on understanding the concepts than on how we classify and organize them. These concepts serve as guidelines in responding to controversial financial reporting issues. As indicated earlier, the Conceptual Framework specifically identifies only one assumption — the going concern assumption. Yet, we believe there are a number of other assumptions that are present in the reporting environment. As a result, for completeness, we discuss each of these five basic assumptions in turn: (1) economic entity, (2) going concern, (3) monetary unit, (4) periodicity, and (5) accrual basis. ## Measurement, Recognition, and Disclosure Concepts ### Learning Objective 4 Explain the application of the basic principles of accounting. We generally use four basic principles of accounting to record and report transactions: (1) measurement, (2) revenue recognition, (3) expense recognition, and (4) full disclosure. We look at each in turn. ### Measurement Principle We presently have a mixed-attribute system in which one of two measurement principles is used. Measurements are based on historic and current cost. Selection of which principle to follow generally reflects a trade-off between relevance and faithful representation. **Historical Cost** 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. **Current Value** Current value measures provide monetary information about assets, liabilities, and related income and expenses, using information updated to reflect conditions at the measurement date. - Because of the updating, current values of assets and liabilities reflect changes in amounts since the previous measurement date. Current value bases include: - Fair value. - Value in use for assets and fulfillment value for liabilities. - Current cost. **** ### Revenue Recognition Principle When a company agrees to perform a service or sell a product to a customer, it has a **performance obligation**. When the company satisfies this performance obligation, it recognizes revenue. The revenue recognition principle therefore requires that companies recognize revenue in the accounting period in which the performance obligation is satisfied. **To illustrate, assume that Klinke Cleaners cleans clothing on June 30 but customers do not claim and pay for their clothes until the first week of July. Klinke should record revenue in June when it performed the service (satisfied the performance obligation) rather than in July when it received the cash.** At June 30, Klinke would report a receivable on its statement of financial position and revenue in its income statement for the service performed. To illustrate the revenue recognition principle in more detail, assume that Airbus (DEU) signs a contract to sell airplanes to British Airways (GBR) for €100 million. To determine when to recognize revenue, Airbus uses the five steps shown in the illustration below: | | | --- | |  | ### Expense Recognition Principle Many revenue transactions pose few problems because the timing of performing the transaction is usually clear. However, recognizing expenses is often more difficult. Expenses are defined as outflows or other "using up" of assets or incurring of liabilities (or a combination of both) during the period that a company delivers or produces goods and/or services and earns revenues. In practice, the approach for recognizing expenses is, "Let the expense follow the revenues." This approach is the expense recognition principle. That is, by matching efforts (expenses) with accomplishment (revenues), the expense recognition principle is implemented using up of assets or incurring of liabilities. Some costs, however, are difficult to associate with revenue. As a result, some other approach must be developed. Often, companies use a "rational and systematic" allocation policy to apply the expense recognition principle. This type of expense recognition involves assumptions about the benefits that a company receives as well as the cost associated with those benefits. For example, a company like Nokia (FIN) allocates the cost of equipment over all of the accounting periods during which it uses the asset because the asset contributes to the generation of revenue throughout its useful life. Companies charge some costs to the current period as expenses (or losses) simply because they cannot determine a connection with revenue. Examples of these types of costs are officers' salaries and other administrative expenses. Costs are generally classified into two groups: product costs and period costs. Product costs, such as material, labor, and overhead, attach to the product. Companies carry these *product costs* into future periods if they recognize the revenue from the product in subsequent periods. Period costs, such as officers' salaries and other administrative expenses, attach to the period. Companies charge off such costs in the immediate period, even though benefits associated with these costs may occur in the future. Why? Because companies cannot determine a direct relationship between period costs and revenue. The illustration below summarizes these expense recognition procedures: | | | --- | |  | ### Full Disclosure Principle In deciding what information to report, companies follow the general practice of providing information that is of sufficient importance to influence the judgment and decisions of an informed user. Often referred to as the **full disclosure principle**, this practice recognizes that the nature and amount of information included in financial reports reflects a series of judgmental trade-offs. These trade-offs strive for (1) sufficient detail to disclose matters that make a difference to users, yet (2) sufficient condensation to make the information understandable, keeping in mind the costs of preparing and using it. Users find information about financial position, income, cash flows, and investments in one of three places: (1) within the main body of financial statements, (2) in the notes to those financial statements, or (3) as supplementary information. As discussed in Chapter 1, the financial statements are the statement of financial position, income statement (or statement of comprehensive income), statement of cash flows, and statement of changes in equity. They are a structured means of communicating financial information. As discussed earlier, an element is defined in terms of its recognition criteria; that is, an element is recognized when its definition meets the criteria. If an element should be recognized in the financial statements but is not because of existence or measurement uncertainty, companies should provide information about this through disclosure in the notes. Disclosure is not a substitute for proper accounting. As a noted accountant indicated, "Good disclosure does not cure bad accounting any more than an adjective or adverb can be used without, or in place of, a noun or verb. Thus, for example, cash-basis accounting for cost of goods sold is misleading, even if a company discloses accrual-basis amounts in the notes to the financial statements." The notes to financial statements generally amplify or explain the items presented in the main body of the statements. If the main body of the financial statements gives an incomplete picture of the performance and position of the company, the notes should provide the additional information needed. Information in the notes does not have to be quantifiable, nor does it need to qualify as an element. Notes can be partially or totally narrative. Examples of notes include descriptions of the accounting policies and methods used in measuring the elements reported in the statements, explanations of uncertainties and contingencies, and statistics and details too voluminous for presentation in the financial statements. The notes can be essential to understanding the company's performance and position. Supplementary information may include details or amounts that present a different perspective from that adopted in the financial statements. It may be quantifiable information that is high in relevance but low in reliability. For example, oil and gas companies typically provide information on proven reserves as well as the related discounted cash flows. Supplementary information may also include management's explanation of the financial information and its discussion of the significance of that information. For example, many business combinations have produced financing arrangements that demand new accounting and reporting practices and principles. In each of these situations, the same problem must be faced: making sure the company presents enough information to ensure that the reasonably prudent investor will not be misled. ## Cost Constraint In providing information with the qualitative characteristics that make it useful, companies must consider an overriding factor that limits (constrains) the reporting. This is referred to as the cost constraint. That is, companies must weigh the costs of providing the information against the benefits that can be derived from using it. ## Summary of the Structure The illustration below presents the Conceptual Framework for Financial Reporting discussed in this chapter. It is similar to Illustration 2.1 except that it provides additional information for each level. We cannot overemphasize the usefulness of this conceptual framework in helping to understand many of the problem areas that we examine in later chapters. | | | --- | |  |