CHAPTER 2

Conceptual Framework for Financial

Reporting

LEARNING OBJECTIVES

1. Describe the usefulness of a conceptual framework.

2. Describe efforts to construct a conceptual framework.
3. Understand the objective of financial reporting.
4. Identify the qualitative characteristics of accounting information.
5. Define the basic elements of financial statements.
6. Describe the basic assumptions of accounting.
7. Explain the application of the basic principles of accounting.
8. Describe the impact that the cost constraint has on reporting accounting
information.

Copyright © 2018 John Wiley & Sons, Inc.   Kieso Intermediate: IFRS 3e, Instructor’s Manual 2-1
CHAPTER REVIEW
1. Chapter 2 outlines the development of a conceptual framework for financial accounting and
reporting by the IASB. The entire conceptual framework is affected by the environmental
aspects discussed in Chapter 1. It is composed of the basic objective, fundamental concepts,
and operational guidelines. These notions are discussed in Chapter 2 and should enhance
your understanding of the topics covered in intermediate accounting.

Conceptual Framework

2. (L.O. 1) A conceptual framework is important as a coherent system of concepts that

flow from an objective and the objective identifies the purpose of financial reporting. By
building upon an established body of concepts, a soundly developed conceptual
framework leads to more useful and consistent pronouncements over time and allows the
accounting profession to solve new and emerging practical problems more quickly.

3. (L.O. 2) Although the IASB issued the Conceptual Framework for Financial Reporting in
2010, it remains a work in process. The framework consists of three levels. The first level
identifies the objective of financial reporting. The second level provides the qualitative
characteristics that make accounting information useful and the elements of financial
statements. The third level identifies the assumptions, principles and constraints that
describe the reporting environment. Working together the IASB and the FASB developed
the converged concept statements on the objective of financial reporting and qualitative
characteristics of accounting information. Both Boards are now working on their own
individual schedules to address the remaining elements of the framework.

First Level: Basic Objective

4. (L.O. 3) The objective of financial reporting is the foundation of the Conceptual

Framework. 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 about providing resources to
the entity.

5. An implicit assumption is that users need reasonable knowledge of business and financial
accounting matters to understand the information contained in financial statements. This
means that financial statement preparers assume a level of competence on the part of
users, which impacts the way and the extent to which companies report information.

Second Level: Fundamental Concepts

6. (L.O. 4) The second level bridges the “why” or objective of accounting with the “how of
accounting that addresses recognition, measurement and financial presentation. The
fundamental qualities that make accounting information useful for decision making are
relevance and faithful representation.

a. Relevance: Accounting information is relevant if it is capable of making a difference

in a decision. Financial information is capable of making a difference when it has

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 predictive value, confirmatory value, or both. If the monetary size of an item could
influence a user’s discussion, then the item is material and must be disclosed.

(1) Predictive Value: Financial information has value as an input to predictive

processes used by potential investors in forming their expectations of a
company’s future.

(2) Confirmatory Value: Financial information that helps users confirm or correct
prior expectations.

(3) Materiality: Materiality is a company-specific aspect of relevance. Information is

material if omitting or misstating would make a difference in users’ decisions. It
requires evaluating both the relative size and importance of an item. While
companies and auditors adopt a general rule of thumb is that anything under 5
percent of net income is considered immaterial, this depends upon specific rules;
companies must consider both quantitative and qualitative factors when
determining materiality thresholds.

b. Faithful Representation: Means that the numbers and descriptions contained in the
financial statements match what really existed or happened. To be a faithful
representation, information must be complete, neutral, and free from error.

(1) Completeness: The financial statements include all the information that is
necessary for faithful representation of the economic phenomena that it purports
to represent.
(2) Neutrality: Information is neutral if it is unbiased, i.e., it is not presented in a
manner that favors one set of interested parties over another.
(3) Free from error: Does not mean total freedom from error. It means that the
information presented is as accurate as possible, given that any estimates are
based on the best information available at the time.

7. The enhancing qualities are complementary to the fundamental qualitative characteristics.

They include comparability, verifiability, timeliness, and understandability.

a. Comparability: Information that is measured and reported in a similar manner for

different companies is considered comparable. It enables users to identify the real
similarities and differences in economic events between companies. Another type of
comparability is consistency, which is present when a company applies the same
accounting treatment to similar events, from period to period.

b. Verifiability: Occurs when independent measurers, using the same methods, obtain
similar results.

c. Timeliness: Means having information available to decision-makers before it loses its

capacity to influence decisions.

d. Understandability: Is the quality of information that lets reasonably informed users

see the connection between their decisions and the information contained in the

Copyright © 2018 John Wiley & Sons, Inc.   Kieso Intermediate: IFRS 3e, Instructor’s Manual 2-3
 financial statements. Understandability is enhanced when information is classified,
characterized, and presented clearly and concisely.

8. (L.O. 5) The IASB classifies the elements of the financial statements into two groups. The
first group describes amounts of resources and claims to resources at a moment in time.
The second group describes transactions, events and circumstances that affect a
company during a period time.

a. Resources and claims to resources at a moment in time.

(1) 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.

(2) 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.

(3) Equity: The residual interest in the assets of the entity after deducting all its
liabilities.

b. Transactions, events, and circumstances that affect a company during a period of time.

(1) 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.

(2) 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.

Third Level: Recognition, Measurement, and Disclosure Concepts

9. (L.O. 6) In the practice of financial accounting, certain basic assumptions are important to
an understanding of the manner in which information is presented. The following five
basic assumptions underlie the financial accounting structure.

a. Economic Entity Assumption: Means that economic activity can be identified with a
particular unit of accountability. In other words, a company keeps its activity separate
and distinct from its owners and any other business unit.

b. Going Concern Assumption: In the absence of information to the contrary, a

company is assumed to have a long life. The legitimacy of the cost principle is
dependent upon the going concern assumption, whereby depreciation and
amortization policies are justified and appropriate only if there is some permanence to
the company’s continuance.

c. Monetary Unit Assumption: Money is the common denominator of economic

activity and provides an appropriate basis for accounting measurement and analysis.
The monetary unit is assumed to remain relatively stable over the years in terms of

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 purchasing power. Therefore, this assumption disregards any inflation or deflation in
the economy in which the company operates.

d. Periodicity Assumption: The life of a company can be divided into artificial time
periods for the purpose of providing periodic reports on the economic activities of the
company.

e. Accrual Basis of Accounting: Transactions that change a company’s financial

statements are recorded in the periods in which the events occur. The cash basis of
accounting is prohibited under IFRS because it violates both the revenue recognition
principle and the expense recognition principle.

10. (L.O. 7) The basic principles of accounting are used to record and report transaction. The
four basic principles of accounting are:

a. Measurement Principles: We currently have two acceptable measurement

principles: historical cost and fair value. Choosing which principle to follow generally
reflects the trade off between relevance and faithful representation.

(1) Historical Cost: IFRS requires many assets and liabilities be reported at their
acquisition price, or cost, sometimes referred to as historical cost. Using cost has
an important advantage: It is thought to be a faithful representation of the amount
paid for a given item. Many users favor historical cost because it provides a
verifiable benchmark for measuring historical trends.

(2) Fair Value: Is a market-based measure. At acquisition, historical cost and fair
value are identical. In subsequent periods, as market and economic conditions
change, the two values may diverge. It is felt that where fair value information is
available, it provides more relevant information about the expected future cash
flows related to an asset or liability. The IASB allows companies the option to use
fair value, known as the fair value option, for the measurement basis of financial
assets and financial liabilities.

b. Revenue Recognition Principle: When a company agrees to perform a service or

sell a product it has a performance obligation. Therefore, revenue is recognized in
the period in which the performance obligation is satisfied.

c. Expense Recognition Principle: Recognition of expenses is related to the

consumption of assets or incurring of liabilities. The expense recognition principle is
implemented in accordance with the definition of expense by matching efforts
(expenses) with accomplishments (revenues). Some costs are difficult to associate
with revenues and must be allocated to expense based on a “rational and systematic”
allocation policy. Product costs, like materials, labor, and overhead, are expensed
when the units they are attached to are sold. Period costs, like officers’ salaries or
other administrative expenses, are expensed as incurred.

d. Full Disclosure Principle: Financial statements should include sufficient information

to permit a knowledgeable user to make an informed decision about the financial
condition of the company in question. Users can find financial information (1) within

Copyright © 2018 John Wiley & Sons, Inc.   Kieso Intermediate: IFRS 3e, Instructor’s Manual 2-5
 the main body of the financial statements, (2) in the notes to those statements, or (3)
as supplementary information.

11. (L.O. 8) In providing information with the qualitative characteristics that make it useful,
companies, must consider an overriding factor that limits the reporting. This is referred to
as the cost constraint.

a. Cost-Benefit Relationship: Rule-making bodies and governmental agencies use

cost-benefit analysis before making final their informational requirements. The
difficulty in cost-benefit analysis is that the costs and especially the benefits are not
always evident or measurable.

(1) Costs: 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.

(2) Benefits: Benefits to preparers may include greater management control and
access to capital at a lower cost. User benefits may include receiving
better information for allocation of resources, tax assessment, and rate
regulation.

b. The IASB seeks input on costs and benefits of new standards during the due process
procedure and attempts to determine that the costs imposed by each proposed
pronouncement is justified by the overall benefits of the financial information gained.

LECTURE OUTLINE

The material in this chapter can usually be covered in two class sessions. The first class
session can be used for lecture and discussion of the concepts presented in the chapter. The
second class session can be used to develop student’s understanding of these concepts by
applying them to specific accounting situations. Students frequently believe that they understand
the concepts but have difficulty correctly identifying improper accounting procedures in
practical situations. Apparently, students are not alone in this difficulty.

A. (L.O. 1) Need for a Conceptual Framework.

1. Build on and relate to an established body of concepts.

2. Issue more useful and consistent pronouncements over time.
3. Increase financial statement users’ understanding of and confidence in financial reporting.
4. Enhance comparability among companies’ financial statements.
5. Provide a framework for quickly solving new and emerging practical problems.
B. (L.O. 2) Development of a Conceptual Framework with three levels.

C. (L.O. 3) First Level: Basic Objective. (Recall that this was discussed in Chapter 1).

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 1. Financial information that is useful to present and potential equity investors, lenders
and other creditors in making decisions about providing resources to the entity.

2. Financial information that is helpful to capital providers may also be useful to other
users of financial reporting who are not capital providers.

D. (L.O. 4) Second Level: Fundamental Concepts.

1. Qualitative characteristics. The overriding criterion for evaluating accounting information

is that it must be useful for decision making.

a. Fundamental qualities of useful accounting information.

(1) Relevance. Accounting information is relevant if it is capable of making

a difference in a decision. Relevant information includes:
(a) Predictive value.
(b) Confirmatory value.
(c) Materiality

(2) Faithful Representation. For accounting information to be useful, the

numbers and descriptions contained in the financial statements must faithfully
represent what really existed or happened. To be a faithful representation,
information must be:

(a) Complete

(b) Neutral

(c) Free from error

b. Enhancing qualities of useful information distinguish more useful information from

less useful information.

(1) Comparability. Information that is measured and reported in a similar

manner for different companies is considered comparable. Consistency,
another type of comparability, is when a company applies the same
accounting treatment to similar events, from period to period.

(2) Verifiability. When independent measurers, using the same methods, obtain
similar results.

(3) Timeliness. Having information available to decision-makers before it loses

its capacity to influence decisions.

(4) Understandability. When information lets reasonably informed users see the
connection between their decisions and the information contained in the
financial statements.

Copyright © 2018 John Wiley & Sons, Inc.   Kieso Intermediate: IFRS 3e, Instructor’s Manual 2-7
 2. (L.O. 5) Elements. (See text page 37 for definitions.) Items a-c are elements at
a moment in time. Items d and e are elements during a period of time.

a. Asset.
b. Liability.
c. Equity.
d. Income.
e. Expenses.

E. (L.O. 6) Third Level: Recognition, Measurement, and Disclosure Concepts.

1. Basic Assumptions.

a. Economic entity assumption—economic activity can be identified with a particular

unit of accountability.
b. Going concern assumption—companies will have a long enough life to justify
depreciation and amortization.

c. Monetary unit assumption—the monetary unit (i.e., the euro) is the most
effective means of expressing to interested parties changes in capital and
exchanges of goods and services. A second assumption is that the monetary unit
ignores price-level changes, like inflation and deflation.

d. Periodicity assumption—activities of an enterprise can be divided into artificial

time periods.

e. Accrual basis of accounting—revenues are recognized when earned and

expenses are recognized when incurred.

2. (L.O. 7) Basic Principles of Accounting.

a. Measurement principles

(1) Historical Cost Principle. Objective and verifiable.

(2) Fair value. A market-based measure. The IASB allows companies to choose
the fair value option to measure financial assets and financial liabilities,
because they believe it to better assess future cash flows.

b. Revenue recognition principle—revenue is recognized in the accounting period

in which the performance obligation is satisfied.

c. Expense recognition principle—efforts (expenses) should be matched with

accomplishments (revenues), if feasible.

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 Practical rules for expense recognition: Analyze costs to determine whether a
relationship exists with revenue.

(a) When a direct relationship exists, then expense costs against revenues
in the period when the revenue is recognized.

(b) When a relationship exists but is difficult to identify, then allocate costs
rationally and systematically to expenses in the periods benefited.

(c) When little if any relationship exists, expense costs as incurred.

d. Full disclosure principle—revealing in financial statements any facts of sufficient

importance to influence the judgment and decisions of an informed reader. (Develop
concept of reasonably prudent investor.) Discuss the use of the notes to the
financial statements and the supplementary information presented in financial
reports.

3. (L.O. 8) Cost Constraint: Financial information benefits must outweigh the costs of
producing the information.

a. Cost-benefit relationship—the benefit to be derived from having accounting

information should exceed the cost of providing it. Frequently it is easier to assess
the costs than it is to determine the benefits of providing a particular item of
information.

b. The IASB’s due process procedure solicits cost-benefit information for proposed
pronouncements.

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