LUNAR INTERNATIONAL COLLEGE

SCHOOL OF GRADUATE STUDIES

MASTERS OF BUSINESS
ADMINISTRATION
(MBA)

Chapter
2-1
Chapter
2-2
 CHAPTER ONE
The Environment OF FINANCIAL
ACCOUNTING

Chapter
2-3
 Chapter
Chapter Outline
Outline
 Accounting from Users Perspective
 Types of Accounting Information
 Conceptual Framework for Financial Reporting
 The Development of a Conceptual Framework of
Accounting
 Framework for the Preparation and Presentation of
Financial Statements

Chapter
2-4
 Chapter
Chapter 11 Learning
Learning Objectives
Objectives
 Explain the need of accounting from users perspective.
 Define the accounting concepts.
 Identify the types accounting information.
 Describe the usefulness of a conceptual framework.
 Describe efforts to construct a conceptual framework.
 Understand the objective of financial reporting.
 Identify the qualitative characteristics of accounting information.
 Define the basic elements of financial statements.
 Describe the basic assumptions of accounting.
 Explain the application of the basic principles of accounting.
 Describe the impact that the cost constraint has on reporting
accounting information.

Chapter
2-5
 Chapter
Chapter Description
Description
 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.
 In this chapter, we mainly discuss the basic
concepts underlying the conceptual framework.

Chapter
2-6
 Accounting
Accounting from
from Users
Users
Perspective
Perspective

Chapter
2-7
 Accounting
Accounting from
from Users
Users Perspective
Perspective
 Owners (Investors): In larger companies there
is separation of ownership from management.
 To decide when to buy, hold and sell shares.
 To understand the adequacy of return from the
investment, at present and in the future.
 BOD:
 To assess the stewardship or accountability of
management.

Chapter
2-8
 Cont…
Cont…
 Management: Concerned with running the
business and using assets to generate profit.
 To manage the entity on day-to-day basis.
 To add value to shareholders.

 Employees:
 to assess the ability of the entity to pay salary
(wage) and provide other benefits to its
employees.
 To assess the continuity of employment and
issues associated with the working environment.

Chapter
2-9
 Cont…
Cont…
 Lenders:
 To assess the security for amounts lent to the
entity.
 To measure the vulnerability of the entity to
different risks.
 Suppliers or trade creditors:
 To assess the continuity of supply.
 To assess the ability of the firm to pay for
supplies delivered on credit terms.

Chapter
2-10
 Cont…
Cont…
 Governments and their Agencies:
 To determine taxation policies.
 To conduct governmental planning.
 To prepare and use national income statistics.
 To regulate the activities of entities.

 Public interest:
 Impact on local economy
 Environmental concerns.

Chapter
2-11
 Definition
Definition of
of Accounting
Accounting

Chapter
2-12
 What
What is
is Accounting?
Accounting?
 There is no single ‘official’ definition of
accounting, the definition by American
Accounting Association is widely quoted one.
 According to this association, accounting is
defined as:
 “Accounting is the process of identifying,
measuring and communicating financial
information about an entity to permit informed
judgements and decisions by users of the
information.”

Chapter
2-13
 Cont…
Cont…
 Taking the definition word by word, it leads to
the following questions:
 What is the process?
 How is financial information identified?
 How is financial information measured?
 How is financial information communicated?
 What is an entity?
 Who are the users of financial information?
 What types of judgments and decisions do these
users make?

Chapter
2-14
 Types
Types of
of Business
Business Entity
Entity

Chapter
2-15
 Types
Types of
of Accounting
Accounting
Information
Information

Chapter
2-16
 Types
Types of
of Accounting
Accounting Information
Information

Types
Types of
of Accounting
Accounting
Information
Information
Managerial
Managerial Accounting
Accounting Financial
Financial Accounting
Accounting
Information
Information for
for decision
decision Published
Published financial
financial
making,
making, planning,
planning, and
and statements
statements and
and other
other
controlling
controlling an
an organization’s
organization’s financial
financial reports.
reports.
operations.
operations.

Internal External
Users Users
Chapter
2-17
 Cont…
Cont…

Chapter
2-18
 The
Thecompany’s
company’saccountants
accountants
prepare
prepareboth
boththe
thefinancial
financialand
and …and
…andthetheinformation
information
the
themanagerial
managerialaccounting
accounting comes
comesfrom
fromthe
thesame
same
reports…
reports… information
informationsystem.
system.

Chapter
2-19
1
 The
The Conceptual
Conceptual Framework
Framework for
for
Financial
Financial Reporting
Reporting

Chapter
2-20
 Cont…
Cont…
 The most widely applicable conceptual
framework is the framework for the preparation
and presentation of financial statements
produced by the:
1) Generally Accepted Accounting Principles
(GAAP)
2) International Financial Reporting Standards
(IFRS).

Chapter
2-21
 Conceptual
Conceptual Framework
Framework for
for
Financial
Financial Reporting
Reporting

Third Level:
Second Level: Recognition,
Conceptual First Level:
Fundamental Measurement, &
Framework Basic Objective Disclosure
Concepts
Concepts
Need Qualitative Basic
Development characteristics assumptions
Overview Basic elements Basic principles
Cost Constraints
Summary of the
Structure

Chapter
2-22
 Need
Need for
for aa Conceptual
Conceptual Framework
Framework
 A conceptual framework establishes the
concepts that underlie financial reporting.

The Need for a Conceptual Framework

To issue more useful and consistent
pronouncements over time, and a coherent set of
standards should result.
To more quickly solve new and emerging practical
problems by referring to an existing framework
of basic theory.
Chapter
2-23
 Development
Development of
of aa Conceptual
Conceptual Framework
Framework
 The IASB issued “Conceptual Framework for
Financial Reporting 2010” (the Conceptual
Framework) in 2010.
 It superseded the Framework for the Preparation
and Presentation of Financial Statements.
 The Conceptual Framework is a work in progress
in that the IASB has not yet completed updating
the previous version of it.

Chapter
2-24
 Cont..
Cont..
 The most widely applicable conceptual
framework is the framework for the preparation
and presentation of financial statements
produced by the International Accounting
Standards Board (IASB).

Chapter
2-25
 Cont…
Cont…
 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 (not yet issued)
 Chapter 3: Qualitative Characteristics of Useful
Financial Information
 Chapter 4: The Framework (this material was
developed prior to the creation of the IASB but is
considered part of the Conceptual Framework until
changed or updated).

Chapter
2-26
 Cont…
Cont…
 Chapter Four comprised of the following:
1) Underlying assumption—the going concern
assumption, monetary unit assumption etc.
2) The elements of financial statements;
3) Recognition of the elements of financial
statements;
4) Measurement of the elements of financial
statements; and
5) Concepts of capital and capital maintenance.

Chapter
2-27
 Overview
Overview of
of the
the Conceptual
Conceptual Framework
Framework

The Framework is comprised of three levels:

First Level = Basic Objectives
Second Level = Qualitative Characteristics and
Basic Elements
Third Level = Recognition, Measurement
Concepts and Disclosure Concepts.

Chapter
2-28
 ASSUMPTIONS PRINCIPLES CONSTRAINTS
1. Economic entity 1. Measurement 1. Cost-benefit
2. Going concern 2. Revenue recognition
Third
3. Monetary unit 3. Expense recognition level: The
4. Periodicity 4. Full disclosure "how"—
5. Accruals implement
ation
QUALITATIVE
CHARACTERISTICS ELEMENTS
1.Fundamental 1.Assets
qualities 2.Liabilities
3.Equity Second level:
2.Enhancing 4.Income Bridge between
qualities 5.Expenses
levels 1 and 3
Illustration 1-6
Conceptual OBJECTIVE
Framework for Provide information
Financial about the reporting
entity that is useful
Reporting to present and potential First level: The
equity investors, "why"—purpose
lenders, and other
creditors in their of accounting
capacity as capital
Chapter providers.
2-29
 First
First Level:
Level: Basic
Basic Objective
Objective
 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.

Chapter
2-30
 First
First Level:
Level: Basic
Basic Objective
Objective
 Those decisions involve buying, selling, or
holding equity and debt instruments, and
providing or settling loans and other forms of
credit.
 Information that is decision-useful to capital
providers may also be helpful to other users of
financial reporting who are not capital
providers.

Chapter
2-31
 Second
Second Level:
Level: Fundamental
Fundamental Concepts
Concepts
 The second level provides conceptual building
blocks that explain the qualitative characteristics of
accounting information and define the elements of
financial statements.
 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).

Chapter
2-32
 Second
Second Level:
Level: Fundamental
Fundamental Concepts
Concepts

Qualitative Characteristics
 “The IASB identified the Qualitative
Characteristics of accounting information that
distinguish better (more useful) information from
inferior (less useful) information for decision-
making purposes.”
 In addition, the IASB identified a cost constraint
as part of the Conceptual Framework.
 The characteristics may be viewed as a hierarchy.

Chapter
2-33
 Second
Second Level:
Level: Fundamental
Fundamental Concepts
Concepts

Illustration 1-7
Hierarchy of
Accounting
Qualities

Chapter
2-34
 Second
Second Level:
Level: Fundamental
Fundamental Concepts
Concepts
 The qualitative characteristics are either
fundamental or enhancing characteristics,
depending on how they affect the decision-
usefulness of information.
 Regardless of classification, each qualitative
characteristic contributes to the decision-usefulness of
financial reporting information.
 However, providing useful financial information
is limited by a pervasive constraint on financial
reporting—cost should not exceed the benefits of a
reporting practice.
Chapter
2-35
 Second
Second Level:
Level: Fundamental
Fundamental Concepts
Concepts

Fundamental Quality – Relevance

 To be relevant, accounting information must be

capable of making a difference in a decision when
it has predictive value, confirmatory value, or both.

Chapter
2-36
 Second
Second Level:
Level: Fundamental
Fundamental Concepts
Concepts
 Financial information has:
1. Predictive value, exist if it has value as an input
to predictive processes used by investors to
form their own expectations about the future.
 Accounting information should be helpful to external
decision makers by increasing their ability to make
predictions about the outcome of future events
 For example, information about the current level and
structure of asset holdings help users to assess the
entity’s ability to exploit opportunities and react to
adverse situations

Chapter
2-37
 2. Confirmatory value, exist if it helps users
confirm or correct prior expectations.
3. Materiality - Information is material if omitting it or
misstating it could influence decisions that users make on
the basis of the reported financial information

Chapter
2-38
 Second
Second Level:
Level: Fundamental
Fundamental Concepts
Concepts

Fundamental Quality – Faithful Representation

 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.
 To be a faithful representation, information must be
complete, neutral, and free of material error.

Chapter
2-39
 Second
Second Level:
Level: Fundamental
Fundamental Concepts
Concepts
 Attributes of Faithful Representation
1. 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.
2. Neutrality - means that a company cannot select
information to favor one set of interested parties
over another.
 Preparers of financial reports must not attempt to induce a
predetermined outcome or a particular mode of behavior

Chapter
2-40
 Second
Second Level:
Level: Fundamental
Fundamental Concepts
Concepts
3. Free from Error - an information item that is free from
error will be a more accurate (faithful) representation of a
financial item.

Enhancing Quality – Consistency

 It 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.
Chapter
2-41
 Second
Second Level:
Level: Fundamental
Fundamental Concepts
Concepts

Enhancing Quality – Verifiability

 It occurs when independent measurers, using
the same methods, obtain similar results.

Enhancing Quality – Timeliness

 Having relevant information available sooner
can enhance its capacity to influence decisions,
and a lack of timeliness can rob information of
its usefulness.

Chapter
2-42
 Second
Second Level:
Level: Fundamental
Fundamental Concepts
Concepts

Enhancing Quality – Understandability

 It 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.

Chapter
2-43
 Second
Second Level:
Level: Elements
Elements

Chapter
2-44
 Third
Third Level:
Level: Recognition
Recognition and
and Measurement
Measurement

The third level of the Conceptual Framework consists of

concepts that implement the basic objectives of level
one.

ASSUMPTIONS PRINCIPLES Cost CONSTRAINTS

1. Economic entity 1. Measurement 1. Cost-benefit
2. Going concern 2. Revenue recognition
3. Monetary unit 3. Expense recognition
4. Periodicity 4. Full disclosure
5. Accrual Bases

Chapter
2-45
 Third
Third Level:
Level: Assumptions
Assumptions

Economic Entity – company keeps its activity

separate from its owners and other businesses.

Going Concern - company to last long enough to fulfill

objectives and commitments.

Monetary Unit - money is the common denominator.

Periodicity (time period) - company can divide its
economic activities into time periods.

Accrual Basis of Accounting - transactions that

change a company’s financial statements are
recorded in the periods in which the events occur.
Chapter
2-46
 Third
Third Level:
Level: Principles
Principles

Measurement – The most commonly used measurements

are based on historical cost and fair value.
Selection of which principle to follow generally reflects
a trade-off between relevance and faithful
representation.
1) Historical Cost – the price, established by the
exchange transaction, is the “cost”.
Issues:
 IFRS requires that companies account for and report many assets and
liabilities on the basis of acquisition price (historical cost principle).
 The advantage of cost is that it is generally thought to be a faithful
representation of the amount paid for a given item.
Chapter
2-47
 Third
Third Level:
Level: Principles
Principles

2) 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.”
Issues:

Fair value is therefore a market-based measure.

Recently, IFRS has increasingly called for use of fair
value measurements in the financial statements.

Chapter
2-48
 Third
Third Level:
Level: Principles
Principles

Revenue Recognition – companies recognize revenue in

the accounting period in which the performance
obligation is satisfied.

Expense Recognition – recognition of expenses is

related to net changes in assets and earning revenues.
In practice, the approach for recognizing expenses is,
“Let the expense follow the revenues.”

Chapter
2-49
 Third
Third Level:
Level: Principles
Principles

Full Disclosure – providing information that is of

sufficient importance to influence the judgment and
decisions of an informed user.
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 statements, or
3)as supplementary information.

Chapter
2-50
 Third
Third Level:
Level: Constraints
Constraints

Cost Benefit – the cost of providing the information

must be weighed against the benefits that can be
derived from using it.

Chapter
2-51
 End of Chapter One

Questions…???

Chapter
2-52