CHAPTER

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Conceptual Framework Underlying Financial Reporting
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Conceptual Framework Underlying Financial Reporting

Conceptual Framework Rationale Development Objective of Financial Reporting Qualitative characteristics of useful information Elements of financial statements

Foundational Principles Recognition / derecognition Measurement Presentation and disclosure

Financial Reporting Issues Principlesbased approach Financial engineering Fraudulent financial reporting

IFRS / Private GAAP Comparison Looking ahead

Chapter Overview
Conceptual framework
What is conceptual framework Why conceptual framework

Financial reporting issues

Rule-based vs. Principle-based Financial engineering and fraudulent financial reporting
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Conceptual Framework
1st Level:

Objectives
2nd Level:

Quality

Elements
3rd Level:

Foundational Principles

Conceptual Framework (p.63, Illustration 2-9)

Why Conceptual Framework

Practical (In real world)
Providing ground rules
To develop GAAP To resolve real-world accounting issues

Not override current GAAP

Educational (For students)

To provide a framework to analyze accounting issues in financial reporting Case Analysis: e.g. CA2-1 (p.85)
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Conceptual Framework Development

AcSB, IASB and FASB have their own individual framework These frameworks differ in various respects, are incomplete, and are not up to date IASB and FASB are currently working on a joint project to develop a common conceptual framework
The project finished Phase A Objectives and Qualitative Characteristics in Sep 2010 The project was paused thereafter The Framework described in the text reflects IASB and FASBs joint efforts to date

Level 1: Objectives of Financial Reporting

(IASB and FASB Exposure Draft) The objective is to communicate information that is useful to users in making their resource allocation decisions

Provide useful information to users in decision making

Qualitative Characteristics Elements

Level 2: Qualitative Characteristics and Elements

Qualitative characteristics
To assess quality of financial reporting (high quality vs. low quality) Include Fundamental and Enhanced

Elements
To establish language that is common to users and preparers of financial reports.
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Fundamental Qualitative Characteristics

1.Relevance
Makes a difference in a decision Has predictive and feedback/confirmatory value

2.Representational Faithfulness
Complete Neutral Reasonably free from error or bias

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Enhancing Qualitative Characteristics

1. Comparability Information measured and reported in similar way (company to company, and year to year) Allows users to identify real economic similarities and differences 2. Verifiability Similar results achieved if same methods are used 3. Timeliness 4. Understandability Allows reasonably informed users to see the significance of the information Provides enough information so that it is clear
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Trade-offs and Constraints

Trade-offs Trade-offs happen when one qualitative characteristics is sacrificed for another Each situation/case must be evaluated separately based on the facts available and the needs of the users Constraints Cost-benefit constraint Materiality constraint: 5% rule? How to determine materiality?
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e.g. relevance and reliability

Materiality
Relates to an items impact on an entitys overall financial operations

Both quantitative and qualitative factors should be considered in determining relative significance

Quantitative (General rule of thumb): if the item is 5% of income from continuing operations, it is considered material Qualitative: An item is material if including it or leaving it out influences a decision-maker Determination of materiality requires professional judgement and expertise

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Real-world Cases
Which qualitative characteristic of accounting information is not followed?

LIVENT provide real information to internal users yet false and misleading information to external users In 2006, NORTEL announced it would be delaying the filing of its annual reports In 2006, NORTEL announced yet again that it would be restating its results for the past four years. The restatement was in addition to the two previous restatements ENRON arranged complex business activities to make it difficult to understand the nature of underlying transactions ENRON uses carefully chosen words in the notes of its annual report to make the note difficulty to read Worldcom recorded large amount of expenses as Pre-14 Paid Expenses

Exercises
BE2-1 BE2-2

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Level 2: Elements
Basic elements of financial statements include the following:
Assets Liabilities Equity Revenues Expenses Gains Losses

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Elements of Financial Statements: Assets

Assets have two key characteristics:
They involve a present economic resource Entity has a right or access to those resources where others do not

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Elements of Financial Statements: Liabilities

Liabilities have two key characteristics:
They represent an economic obligation or burden Entity has a present obligation

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Exercise: Revenue or Liability?

The company received $500 cash from a customer on December 30th, 2010 for service to be performed on January 1, 2011. Should the $500 be recognized as revenue on December 31st, 2010?

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Exercise: BE2-4, BE2-5

Constructive Obligation (p.49): - Are obligations that arise through past or present practice that signals the company acknowledge a potential economic burden - Voluntary, not required by law

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Exercise: BE2-4, BE2-5

Constructive Organization (p.49): - Are obligations that arise through past or present practice that signals the company acknowledge a potential economic burden - Voluntary, not required by law
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Other Elements
Revenues
Expenses
Increases in economic resources resulting from ordinary activities Decreases in economic resources resulting from ordinary activities Increases in equity (net assets) resulting from incidental transactions

Gains

Losses

Decreases in equity (net assets) resulting from incidental transactions

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Level 3: Foundational Principles (Exercise: E2-4)

Recognition Economic entity Control Revenue recognition Matching (in transition) Measurement Going concern Monetary unit Periodicity Historical cost Fair value Presentation and Disclosure Full disclosure principle

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-Whether to recognize; Where to recognize

Recognition

Economic entity
Vs. legal entity

Control
Scope of consolidation

Revenue recognition
Can revenue be recognized before or after goods delivery?

Matching (Next slide)

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Matching
Expenses should be matched with revenue If expense benefits the current and future period, it can be deferred as an asset
Examples: amortization; CGS vs. Sales revenue

Current trend is to de-emphasize matching (I/S view) to emphasize B/S view

Serious problems as a result of poor matching (Livent Inc. deferred charges) If in conflict, B/S view (whether the deferred charge qualifies the definition of asset) dominants I/S view (whether the expenditure bring in future benefits)
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Exercise Asset or Expense? (Matching)

Decide if the following spending should be classified as asset, based on the definition of assets
The firm spent $20,000 on pre-operating expenses The first spent 1 million in advertising The firm spent $500,000 to purchase a machine and incurred follow charges during the year The machine broke down and the company paid $2,000 to repair it. The company paid another $500 per year to service the machine. The company installed an upgrade to the machine that would prolong its useful life for 5 more years and would increase its productivity.
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Measurement - What amount to record

Going concern

Going-concern-based value vs. liquidation value

Assume use of monetray unit as measurement stick Assume the unit of measure remains reasonably stable

Monetary unit

Periodicity
Artificial split of time period Related to Timeliness Historical cost vs. Fair value (next slide)
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Fair Value
Fair value has been 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

Subsequent to initial recognition, historical cost and fair value often differ Fair value is often considered more relevant for certain assets/liabilities (e.g. financial instruments) IFRS allows the use of fair value measurement in more situations than private entity GAAP
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Fair Value (continued)

Fair value is a market-based measure

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Fair Value Three Levels

Level 1: Quoted market price Level 2: Quoted prices for similar assets Level 3: Use entitys own assumptions to estimate based on a valid model. Which gives the most reliable valuation?
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Fair Value Three Levels

Level 1: Quoted market price Level 2: Quoted prices for similar assets Level 3: Use entitys own assumptions to estimate based on a valid model.
Which gives the most reliable valuation?

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Models for Measuring Fair Value (Exercise: BE2-11)

Discounted Cash Flow Models (Appendix 2A)
Traditional approach
FV=sum of PV (FCF) The rate to discount FCF is risk-adjusted The FCF is risk-free Used when cash flows are fairly certain

Expected cash flow approach

FV=sum of PV (FCF) The rate to discount FCF is risk-free The FCF is risk-adjusted (by applying probability) Used when cash flows are uncertain

Options pricing models (Ch16)

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Full Disclsure
Disclosed information should:
1.Provide sufficient detail of the occurrence 2.Be sufficiently condensed to remain understandable, and appropriate in terms of costs of preparing/using it

Full disclosure is not a substitute for proper accounting practice Notes to financial statements are essential to understanding the enterprises performance and position MD&A: Mandatory for listed firms
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Financial Reporting Issues: Principle-based vs. Rule-based

Canadian GAAP is principles-based Therefore, selecting and interpreting accounting principles and rules relies on application of professional judgment Example: Finance lease or operating lease? (i.e. Whether the leased asset should be recognized as PP&E)
Rule-based: One criteria is the lease term is at least 75% of useful life of the leased asset Principle-based: when substantial future economic benefits is generated by the use of the leased asset

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Financial Reporting Issues: Financial Engineering vs. Fraudulent reporting

Financial engineering is a process whereby a business arrangement or transaction is legally structured such that it meets the companys financial reporting objective (e.g., to maximize earnings, minimize a debt to equity ratio or other). Any illegal structuring of financial statements is considered fraudulent financial reporting. Legally a firm is required to comply with GAAP, so material non-compliance with GAAP is illegal
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Choice in Accounting Decision-Making

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