MGT2250 The Conceptual Framework of Accounting PDF

MGT2250 The Conceptual Framework of Accounting Copyright ©2022 John Wiley & Sons, Canada, Ltd. Conceptual Framework A conceptual framework is needed to Create standards based on established concepts Increase users’ understanding of and confidence in financial reporting Enha...

MGT2250 The Conceptual Framework of Accounting Copyright ©2022 John Wiley & Sons, Canada, Ltd. Conceptual Framework A conceptual framework is needed to Create standards based on established concepts Increase users’ understanding of and confidence in financial reporting Enhance comparability of different companies’ financial statements Solve new and emerging practical problems more quickly Development of the Conceptual Framework Objective of Financial Reporting The objective of financial reporting is to communicate information that is: useful to investors, creditors, and other users Useful in making decisions about how to allocate resources Fundamental Qualitative Characteristics of Useful Information (1) Relevance Has predictive value—helps users make predictions about past, present and future events Has feedback/confirmatory value—helps users confirm or correct previous expectations Is material—how important the information is; would it make a difference to the decision-maker? (2) Representational Faithfulness are fundamental qualities that make accounting information useful for decision-making. Fundamental: Representational Faithfulness Economic substance over legal form Transparency Represents economic reality Include all information needed to portray underlying events and transactions Completeness (e.g., level of detailed included) Information does not favour one set of interested parties over another; Neutrality supported by the concept of conservatism/prudence. Economic consequences argument: neutrality in standard setting Freedom from Reliability; arises from good information systems and strong internal error controls Enhancing Qualitative Characteristics Information is measured and reported in a similar way—company to Comparability company and year to year (e.g., same accounting policies) Verifiability Knowledgeable, independent users achieve similar results Timeliness Information is available in sufficient time to influence decisions Information must be of sufficient quality and clarity (onus on the Understandability preparer) so reasonably informed users (onus on the user) can see its significance Financial Statements Elements of Financial Statements Basic elements of financial statements most directly related to measuring performance and financial status: Assets Liabilities The basic elements of financial statements are Equity defined so users have a Revenues/Income common understanding of the Expenses main items presented on the financial statements. Gains/Losses Balance Sheet Cashflow Statement Income Statement Assets Assets Examples of Assets Cash Inventory Property, Plant, and Equipment Assets Assets have three essential characteristics: 1.They represent a present economic resource—a right to use an asset that produces economic benefit or that has the potential to produce economic benefits 2.Entity has control over that resource—entity’s ability to decide how to use the asset and receive economic benefits (through legal ownership or a contractual or other right) 3.Resource results from a past transaction or event The conceptual framework defines the asset as the right as opposed to the physical asset. Liabilities Liabilities Examples of Liabilities Bank indebtedness Trades Payable Income Tax Payable Liabilities Liabilities have three essential characteristics: 1.They represent a present duty or responsibility—and there is no practical ability to avoid them 2.Entity is obligated to transfer an economic resource 3.Obligation results from a past transaction or event Both financial and non-financial liabilities Equity A residual interest in an entity that remains after deducting liabilities from assets Also known as net worth In business, equity is the ownership interest and is normally Common and preferred shares Retained earnings Accumulated other comprehensive income (IFRS)  Golden Rule of Accounting Assets = Liabilities + Equity + Revenues + Expenses Balance Sheet Income Statement Revenues & Expenses Elements of Financial Statements: Other Element ASPE IFRS Revenues/ Revenue is defined as increases in Income is defined as increases in Income economic resources, which result from assets or decreases in liabilities, that ordinary operations. result in increases to equity, other than those relating to contributions from shareholders. Expenses Decreases in economic resources that No distinction between ordinary result from ordinary revenue-generating revenue-generating activities and activities. losses. Focuses on decreases in assets or increases in liabilities, that result in decreases in equity. Gains/ Increases/decreases in equity from an Revenues and gains are grouped Losses entity’s peripheral or incidental together under Income (they are not transactions except revenues/expenses separately defined), and expenses and owner’s activity. and losses are grouped together under Expenses. Items Included in Financial Statements: IFRS ASPE Statement of financial performance Income statement Or Statement of profit and loss and statement of other comprehensive income* OCI does not exist Statement of financial position Balance sheet Statement of changes in shareholders’ equity Statement of retained earnings Statement of cash flows Cash flow statement *Other comprehensive income (OCI) includes all changes in equity except for net income and owner’s investments and distributions. Comprehensive income includes net income and other comprehensive income. Journal Entry Double Entry Accounting System Transaction refers to any business action that directly impacts the basic financial elements (i.e. assets, liabilities, equity, revenue, and expenses) An account tracks the changes in assets, liabilities, or equity by recording increases and decreases in the balance E.g. Cash, Accounts Receivable, Prepaid Expenses, Etc. In an accounting system, we record the impact of transaction on an account through a journal entry Double Entry Accounting System In looking at a specific account, such as cash, it can be split into left and right sides to separate the increases and decreases to the account. There are two sides of the account called Debit and Credit Debit – left side of an account Credit – right side of an account Account Debit Credit Double Entry Accounting System Whether a Debit or Credit increases or decreases an account depends on the type of financial element the account represents Accounts that are considered Assets are increased by DEBITS as assets are on the left side of the accounting equation Accounts that are considered Liabilities and Equity are increased by CREDITS because they are on the right side of the accounting equation To reduce the account, the opposites is done. For example, assets are decreased by credits and liabilities and equity are decreased by debits Assets Liabilities Equity Debit Credit Debit Credit Debit Credit Increase Decrease Decrease Increase Decrease Increase  Debit / Credit Exercise Accounts Increase Decrease Accounts Payable Dividends Declared Salary Expense Property Plant, and Equipment Loan Payable  Debit / Credit Exercise Accounts Increase Decrease Accounts Payable Credit Debit Dividends Declared Debit Credit Salary Expense Debit Credit Property Plant, and Debit Credit Equipment Loan Payable Credit Debit  Journal Entry Process of recording the impact of transactions on the financial statement elements is called journalizing. Elements of Journal Entry Include At least one debit account, At least on credit account, Date of the transaction Specific description of the transaction Both the debit and credit side must equal All accounts that are debited are usually listed before credits General Format Date Description Debit Credit June 3 Dr. Property, Plant, Equipment $XXX,XXX Cr. Cash $XXX,XXX Used cash to purchase assets Foundational Principles Foundational Principles Recognition/Derecognition Measurement Presentation/Disclosure 1. Economic entity assumption 5. Periodicity 10. Full disclosure assumption principle 2. Control 6. Monetary unit assumption 3. Revenue recognition and 7. Going concern realization principles assumption 4. Matching principle 8. Historical cost principle 9. Fair value principle and value in use Recognition/ Derecognition Recognition/Derecognition Part 1 Derecognition: taking something off statement of financial position e.g. when asset control is given up Recognition is the act of including something on the statement of financial position or income statement Under ASPE, elements of financial statements are recognized when they Meet the definition of an element Are probable Are reliably measurable Under IFRS, the element must Meet the definition of an element Provide relevant information that faithfully represents the underlying transaction or event Recognition/Derecognition Part 2 IFRS encompasses the principle of usefulness when determining recognition Information is not considered useful if there is significant uncertainty as to existence or measurement— so probability and measurability criteria are not included as separate IFRS recognition criteria Derecognition is the act of taking something off the statement of financial position or income statement For assets: when control is given up For liabilities: when the obligation is extinguished 1. Economic Entity Assumption Also called entity concept Means an economic activity can be identified with a particular unit of accountability, e.g., a company, a division, an individual An economic entity is not always a legal entity Legal entities can be merged into an economic entity for financial reporting purposes (consolidated financial statements) Defining factor for an economic entity is “Who has control?” 2. Control Control is an important concept when determining asset recognition ASPE IFRS Control is the continuing power to Investor has control over an investee determine strategic decisions without the when it has: cooperation of others. 1. power over the investee 2. rights to returns from its In some situations, the focus is on whether involvement with the investor the other entity is “demonstrably distinct” 3. ability to affect the amount of the from the other company. Criteria consist of investors’ returns. 1. whether the entity can be unilaterally dissolved by the company Control is assessed through exposure 2. whether others have more than 10% to the risks and rewards of the entity— ownership. not just ownership of shares. 3. Revenue Recognition Principle (ASPE) Revenue recognized when Covered in future lectures 1. risk & reward have passed. earning process is complete (significant acts performed, no continueing involvement) 2. revenue is measurable 3. revenue is collectible 4. Matching Principle e.g. cost of a long-lived asset needs to be allocated over all accounting periods during which the asset is used bc it contributes to revenue all through its useful life Cause and effect relationship between money spent to earn revenues and the revenues themselves The effort (expenditure) is matched to the accomplishments (revenues) Product costs are held in inventory until the costs (cost of goods sold) are recorded at the same time as the revenue (sale) PPE costs, which benefit future periods, are matched to future revenues through depreciation However, period costs are recognized immediately even if some of the benefits are realized in the future—expenditures that do not meet the definition of an asset are expensed Measurement Measurement Uncertainty Because of accrual accounting, measuring many elements of financial statements requires the use of estimates Estimates give rise to uncertainty—uncertainty affects faithful representation Measurement uncertainty: when a value cannot be objectively measured due to Existence uncertainty: difficulty in determining whether an asset or liability exists or not Outcome uncertainty: difficulty in determining future outflows and inflows Measurement Basis Measurement basis must provide relevant information that faithfully represents the transaction or event Common choices: historical cost (including amortized cost); and current cost (fair value, value in use or fulfilment value) Key for accountants when choosing a basis: Determine an acceptable level of uncertainty Use measurement tools that deal with uncertainty Disclose enough information to signal the uncertainty Underlying assumptions: periodicity, unit of measure and going concern 5. Periodicity Assumption Economic activity of an entity can be divided into artificial time periods for reporting purposes Most common: one month, one quarter, and one year For shorter time periods, more difficult to determine proper net income (i.e. more likely errors occur due to more estimates) With technology and AI, investors use more online, real- time financial information to ensure relevant information—continuous reporting 6. Monetary Unit Assumption Money is the common unit of measure of economic transactions Use of a monetary unit is relevant, simple and understandable, universally available, and useful In Canada and the United States, the dollar is assumed to remain relatively stable in value (effects of inflation/ deflation are ignored i.e. price-level change is ignored) Monetary unit is relevant as long as it is assumed that quantitative data are useful in communicating economic information 7. Going Concern Assumption Assumption that a business enterprise will continue to operate in the foreseeable future There is an expectation of continuing long enough to meet objectives and commitments Management must look out at least 12 months from balance sheet date If liquidation of the company is assumed to be likely, use liquidation accounting (at net realizable value) Measuring financial statement elements at historical cost would have limited usefulness if liquidation were assumed to be likely 8. Historical Cost Principle (Part 1) Transactions are measured at the amount of cash (or equivalents) paid or received, or the fair value of the initial transaction Three basic assumptions of historical cost Represents a value at a point in time Results from a reciprocal exchange (i.e. a two-way exchange) Exchange includes an outside arm’s-length party Sometimes the historical cost principle cannot be applied in determining a value 8. Historical Cost Principle (Part 2) Times when historical cost cannot be used … Nonmonetary or barter transactions (no cash or monetary consideration) Nonmonetary, non-reciprocal transaction (no exchange) Related party transactions In these types of situations, an attempt may be made to estimate the fair value Principle also applies to financial instruments when issued in exchange for assets or services; the price becomes the “cost” of the instrument 8. Historical Cost Principle (Part 3) Initially, historical cost usually equals fair value Over time, this value may lose its predictive value Calls for subsequent remeasurement Can be based on different measurement values, but that means measurement uncertainty With no external exchange, value may be subjective Trend is toward using a mixed valuation model: primarily historical cost moving to a market valuation model Market valuation uses fair value measures 9. Fair Value Principle At acquisition, historical cost = fair value Subsequently, with market and economical conditions changing, the values diverge Fair value (current value, market-based) measures provide more relevant information than historical cost for some assets and liabilities Fair value reflects the current cash equivalent Fair-value option—to encourage using fair value There is an option to use fair value for most financial instruments (non-strategic investments) Financial instruments are measured at fair value with gains and losses booked to income  Fair Value Principle (IFRS) IFRS defines fair value 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” An exit price and a market-based measure Explicitly allowed for some non-financial assets (investment properties, PPE) Required for some assets (biological)  Fair Value Principle (ASPE) ASPE defines fair value as “amount of consideration that would be agreed upon in an arm’s length transaction between knowledgeable, willing parties who are under no compulsion to act.” Definition under ASPE Does not refer to an orderly market (as does I FRS) Does not stipulate the price as an exit price Does not refer to non-financial assets or PPE, but acknowledges use for certain industries (e.g., agriculture, mining) Market-Based versus Entity-Specific Value Fair value is a market-based measure as opposed to an entity-specific value Market-based value How market participants would value the item in question More objective and must be applied under IFRS for fair value situations Entity-specific value (value in use) Present value of the future cash flows expected from the asset More relevant for operating assets but is subjective Fair Value versus Value in Use Value in use is an entity-specific value (perspective of the entity) Defined as the present value of the future cash flows expected from use of the asset Presentation and Disclosure 10. Full Disclosure Principle Only principle associated with presentation and disclosure General practice of providing information that is important enough to influence an informed user’s judgement and decisions Recognizes a series of judgemental trade-offs Detailed enough to disclose matters that make a difference to users? Condensed enough to make the information understandable? Avoid information overload too much info --> user unable to process it Presentation and Disclosure Information about an entity is presented in three places Main body of financial statements—formalized structured way of communicating financial information Notes to the financial statements—amplify or explain items presented in the main body of the statements Supplementary documents including the Management Discussion and Analysis (MD&A) Report—includes details or amounts that present a different perspective Full disclosure is not a substitute for proper accounting Notes to the Financial Statements Additional information needed to complete the picture of performance and position Information does not have to be quantifiable; could include Descriptions of policies and methods Explanations of uncertainties and contingencies Details too voluminous to include in the statements According to guidance from IFRS conceptual framework for effective communication Entity-specific over general information Duplication inhibits usefulness of information Management Discussion and Analysis Six disclosure principles for the MD&A Provide a view through management’s eyes Supplement and complement information in the financial statements Provide fair, complete, and balanced information that is material to decision-makers Outline key trends, risks, and uncertainties that may affect the company in the future Explain management’s plan for long- and short-term goals Be understandable, relevant, comparable, verifiable, timely Management Discussion and Analysis cont. information that is high in relevance but lwo in reliability helpful but not essential info Provides management’s explanation of financial information and a discussion of its significance Includes forward-looking information Five key elements included to give users greater insight into the business Core businesses Objectives and strategies Capability to deliver results Results and outlook Key performance measures and indicators Expanded Conceptual Framework