INTERMEDIATE ACCOUNTING-Unit02
INTERMEDIATE ACCOUNTING-Unit02
INTERMEDIATE ACCOUNTING-Unit02
com
CHAPTER
2 Conceptual Framework
for Financial Reporting
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1 Describe the usefulness of a conceptual framework. 5 Define the basic elements of financial statements.
2 Describe efforts to construct a conceptual 6 Describe the basic assumptions of accounting.
framework.
7 Explain the application of the basic principles
3 Understand the objective of financial reporting. of accounting.
4 Identify the qualitative characteristics of accounting 8 Describe the impact that the cost constraint has on
information. reporting accounting information.
What Is It?
Everyone agrees that accounting needs a framework—a conceptual framework, so to speak—that will help
guide the development of standards. To understand the importance of developing this framework, let’s see
how you would respond in the following two situations.
1. Should Phil N. Tropic recognize his lottery ticket as an asset in his financial statements?
2. Assuming that Phil N. Tropic recognizes the lottery ticket as an asset, at what amount should it be
reported? Some possible answers are $150, $100, and $90.
www.downloadslide.com
CONCEPTUAL FOCUS
> This chapter summarizes conceptual elements
Situation 2: The $20 Million that will be referred to throughout subsequent
chapters.
Question
The Hard Rock Mining Company has just completed the first
INTERNATIONAL FOCUS
year of operations at its new strip mine, the Lonesome Doe.
> Read the Global Accounting Insights on pages
Hard Rock spent $10 million for the land and $20 million in
preparing the site for mining operations. The mine is expected 47–49 for a discussion of convergence efforts in
to operate for 20 years. Hard Rock is subject to environmental developing a common conceptual framework.
statutes requiring it to restore the Lonesome Doe mine site on
completion of mining operations.
Based on its experience and industry data, as well as cur-
rent technology, Hard Rock forecasts that restoration will cost
about $10 million when it is undertaken. Of those costs, about
$4 million is for restoring the topsoil that was removed in prepar-
ing the site for mining operations (prior to opening the mine); the
rest is directly proportional to the depth of the mine, which in
turn is directly proportional to the amount of ore extracted.
Conceptual Framework
for Financial Reporting
27
www.downloadslide.com
28 Chapter 2 Conceptual Framework for Financial Reporting
CONCEPTUAL FRAMEWORK
A conceptual framework establishes the concepts that underlie financial reporting.
LEARNING OBJECTIVE 1
A conceptual framework is a coherent system of concepts that flow from an objec-
Describe the usefulness of a
conceptual framework.
tive. The objective identifies the purpose of financial reporting. The other concepts
provide guidance on (1) identifying the boundaries of financial reporting; (2) select-
ing the transactions, other events, and circumstances to be represented; (3) how they should
be recognized and measured; and (4) how they should be summarized and reported.1
“As our professional careers unfold, each of us develops a technical conceptual framework.
Some individual frameworks are sharply defined and firmly held; others are vague and
weakly held; still others are vague and firmly held. . . . At one time or another, most of us have
felt the discomfort of listening to somebody buttress a preconceived conclusion by building
a convoluted chain of shaky reasoning. Indeed, perhaps on occasion we have voiced such
thinking ourselves. . . . My experience . . . taught me many lessons. A major one was that most
of us have a natural tendency and an incredible talent for processing new facts in such a way
that our prior conclusions remain intact.”2
1
Recall from our discussion in Chapter 1 that while the Conceptual Framework and any changes
See the Authoritative to it pass through the same due process (discussion paper, preliminary views, public hearing,
Literature section exposure draft, etc.) as do the IFRSs, the Conceptual Framework is not an IFRS. That is, the
(page 50). Conceptual Framework does not define standards for any particular measurement or disclosure
issue, and nothing in the Conceptual Framework overrides any specific IFRS. [1]
2
C. Horngren, “Uses and Limitations of a Conceptual Framework,” Journal of Accountancy
(April 1981), p. 90.
www.downloadslide.com
Conceptual Framework 29
Practicing accountants, however, must resolve such problems on a daily basis. How?
Through good judgment and with the help of a universally accepted conceptual frame-
work, practitioners can quickly focus on an acceptable treatment.
The need for a conceptual framework is highlighted by transparent reporting by barely achieving 3 percent out-
accounting scandals such as those at Royal Ahold (NLD), side equity ownership, a requirement in an obscure
Enron (USA), and Satyan Computer Services (IND). To accounting rule interpretation. Enron’s financial engineers
restore public confidence in the financial reporting process, were able to structure transactions to achieve a desired
many have argued that regulators should move toward accounting treatment, even if that accounting treatment
principles-based rules. They believe that companies did not reflect the transaction’s true nature. Under principles-
exploited the detailed provisions in rules-based pronounce- based rules, hopefully top management’s financial reporting
ments to manage accounting reports, rather than report the focus will shift from demonstrating compliance with rules
economic substance of transactions. For example, many of to demonstrating that a company has attained financial
the off–balance-sheet arrangements of Enron avoided reporting objectives.
Chapters 1 and 3 were recently completed. However, much work still needs to be
done on the remaining parts of the Conceptual Framework. The IASB has given priority
to its completion as the Board recognizes the need for such a document to serve its set of
diverse users. It should be emphasized that the Conceptual Framework is not an IFRS and
therefore an IFRS always takes precedence even if it appears to be in conflict with the
Conceptual Framework. Nonetheless, the Conceptual Framework should provide guid-
ance in many situations where an IFRS does not cover the issue under consideration.3 [2]
3
Working together, the IASB and the FASB developed converged concepts statements on the
objective of financial reporting and qualitative characteristics of accounting information. The
Boards are working on their own schedules to address the remaining elements of the conceptual
framework project. The IASB has issued a discussion paper exploring additional possible
changes to the Conceptual Framework for Financial Reporting. The discussion paper seeks
input on issues such as the definitions of assets and liabilities, measurement, recognition,
presentation and disclosure, and other comprehensive income. See http://www.ifrs.org/Current-
Projects/IASB-Projects/Conceptual-Framework/Pages/Conceptual-Framework-Summary.aspx.
www.downloadslide.com
30 Chapter 2 Conceptual Framework for Financial Reporting
ILLUSTRATION 2-1
Conceptual Framework
for Financial Reporting
Recognition, Measurement, and Disclosure Concepts Third level:
The "how"—
implementation
QUALITATIVE
ELEMENTS
CHARACTERISTICS Second level: Bridge between
of
of levels 1 and 3
financial
accounting
statements
information
The first level identifies the objective of financial reporting—that is, the purpose of
financial reporting. The second level provides the qualitative characteristics that make
accounting information useful and the elements of financial statements (assets, liabili-
ties, and so on). The third level identifies the recognition, measurement, and disclosure
concepts used in establishing and applying accounting standards and the specific con-
cepts to implement the objective. These concepts include assumptions, principles, and a
cost constraint that describe the present reporting environment. We examine these three
levels of the Conceptual Framework next.
ILLUSTRATION 2-2
Hierarchy of Accounting
Primary users of CAPITAL PROVIDERS (Investors and Creditors)
Qualities accounting information AND THEIR CHARACTERISTICS
Constraint COST
Pervasive criterion
DECISION-USEFULNESS
Ingredients of Free
fundamental Predictive Confirmatory
Materiality Completeness Neutrality from
qualities value value
error
Enhancing
qualities Comparability Verifiability Timeliness Understandability
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 RELEVANCE
quality
Ingredients of the
fundamental Predictive Confirmatory
Materiality
quality value value
During the period in question, the revenues and expenses, and therefore the net incomes
of Company A and Company B, are proportional. Each reported an unusual gain. In
looking at the abbreviated income figures for Company A, it appears insignificant
whether the amount of the unusual gain is set out separately or merged with the regular
operating income. The gain is only 2 percent of the operating income. If merged, it would
not seriously distort the income figure. Company B has had an unusual gain of only
$5,000. However, it is relatively much more significant than the larger gain realized by
Company A. For Company B, an item of $5,000 amounts to 50 percent of its income from
operations. Obviously, the inclusion of such an item in operating income would affect the
amount of that income materially. Thus, we see the importance of the relative size of an
item in determining its materiality.
Companies and their auditors generally adopt the rule of thumb that anything
under 5 percent of net income is considered immaterial. However, much can depend on
specific rules. For example, one market regulator indicates that a company may use this
percentage for an initial assessment of materiality, but it must also consider other fac-
tors. For example, companies can no longer fail to record items in order to meet consen-
sus analysts’ earnings numbers, preserve a positive earnings trend, convert a loss to a
profit or vice versa, increase management compensation, or hide an illegal transaction
like a bribe. In other words, companies must consider both quantitative and qualita-
tive factors in determining whether an item is material.
Thus, it is generally not feasible to specify uniform quantitative thresholds at
which an item becomes material. Rather, materiality judgments should be made in
the context of the nature and the amount of an item. Materiality factors into a great
many internal accounting decisions, too. Examples of such judgments that compa-
nies must make include the amount of classification required in a subsidiary expense
ledger, the degree of accuracy required in allocating expenses among the depart-
ments of a company, and the extent to which adjustments should be made for ac-
crued and deferred items. Only by the exercise of good judgment and professional
expertise can reasonable and appropriate answers be found, which is the materiality
concept sensibly applied.
www.downloadslide.com
34 Chapter 2 Conceptual Framework for Financial Reporting
Fundamental
FAITHFUL REPRESENTATION
quality
Ingredients of the
fundamental Completeness Neutrality Free from error
quality
Faithful representation means that the numbers and descriptions match what re-
ally 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. For
example, if Siemens AG’s (DEU) income statement reports sales of €60,510 million
when it had sales of €40,510 million, then the statement fails to faithfully represent the
proper sales amount. To be a faithful representation, information must be complete,
neutral, and free of material error.
Completeness. Completeness means that all the information that is necessary for faith-
ful representation is provided. An omission can cause information to be false or mis-
leading and thus not be helpful to the users of financial reports. For example, when
Société Générale (FRA) fails to provide information needed to assess the value of its
subprime loan receivables (toxic assets), the information is not complete and therefore
not a faithful representation of their values.
Neutrality. Neutrality means that a company cannot select information to favor one set
of interested parties over another. Providing neutral or unbiased information must be
the overriding consideration. For example, in the notes to financial statements, tobacco
companies such as British American Tobacco (GBR) should not suppress information
about the numerous lawsuits that have been filed because of tobacco-related health
concerns—even though such disclosure is damaging to the company.
Neutrality in rule-making has come under increasing attack. Some argue that the
IASB should not issue pronouncements that cause undesirable economic effects on an
industry or company. We disagree. Accounting rules (and the standard-setting process)
must be free from bias, or we will no longer have credible financial statements. Without
credible financial statements, individuals will no longer use this information. An anal-
ogy demonstrates the point: Many individuals bet on boxing matches because such con-
tests are assumed not to be fixed. But nobody bets on wrestling matches. Why? Because
the public assumes that wrestling matches are rigged. If financial information is biased
(rigged), the public will lose confidence and no longer use it.
Free from Error. An information item that is free from error will be a more accurate
(faithful) representation of a financial item. For example, if UBS (CHE) misstates its loan
losses, its financial statements are misleading and not a faithful representation of its
financial results. However, faithful representation does not imply total freedom from
error. This is because most financial reporting measures involve estimates of various
types that incorporate management’s judgment. For example, management must estimate
the amount of uncollectible accounts to determine bad debt expense. And determination of
depreciation expense requires estimation of useful lives of plant and equipment, as well as
the residual value of the assets.
www.downloadslide.com
Second Level: Fundamental Concepts 35
The importance of faithful representation is illustrated by the Olympus then dug the hole deeper; it developed a plan
fraud at Olympus Corporation (JPN). Here’s what hap- to “sell” the losing investments, at original cost, to shell
pened, as revealed in a recent report on the fraud by an companies set up by Olympus for that purpose. Under
investigative committee. In transactions dating back nearly lenient accounting rules, those shell companies would not
20 years, Olympus was hiding losses related to export sales. have to be consolidated with Olympus, so the losses could
The losses arose when the exchange rate between the dollar remain hidden. That all ended when the investigation un-
and yen moved in an unfavorable direction for Olympus, covered the sham adjustments and the losses were finally
which negatively impacted investments related to the export revealed.
sales. However, the losses were not reported; that is, the The scandal highlights the importance of accounting
financial statements were not faithful representations. rules that result in faithful representation of company perfor-
How could such a loss be hidden? At the time, account- mance and financial position. That is, until accounting rule-
ing rules in Japan, as well as in other countries, allowed in- makers finally started to require fair value accounting for
vestments to be carried at cost. Theoretically, there should some financial instruments in 1997—seven years after the
eventually have been a write-down, but there never was. Rather, fraud began—covering up the losses was easy. Furthermore,
management hoped that with additional risky investments, subsequent rule changes (in the wake of the Enron (USA)
the losses could somehow be made up. They were not, and scandal) forced companies to stop hiding losses in off-
eventually the losses grew to more than $1 billion. Olympus balance-sheet entities. Indeed, the Olympus scandal might
seems to have been content to sit on the losses until 1997, never have occurred if the accounting kept a focus on faithful
when accounting rules changed and some investments had to representation.
be marked to market.
Source: F. Norris, “Deep Roots of Fraud at Olympus,” The New York Times (December 8, 2011).
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 below, are comparability, verifiability, time-
liness, and understandability.
Ingredients of Free
fundamental Predictive Confirmatory
Materiality Completeness Neutrality from
qualities value value
error
Enhancing
qualities Comparability Verifiability Timeliness Understandability
Comparability. Information that is measured and reported in a similar manner for dif-
ferent companies is considered comparable. Comparability enables users to identify the
real similarities and differences in economic events between companies. For example, his-
torically the accounting for pensions in Japan differed from that in the United States. In
Japan, companies generally recorded little or no charge to income for these costs. U.S.
companies recorded pension cost as incurred. As a result, it is difficult to compare and
evaluate the financial results of Toyota (JPN) or Honda (JPN) to General Motors (USA)
or Ford (USA). Investors can only make valid evaluations if comparable information is
available.
www.downloadslide.com
36 Chapter 2 Conceptual Framework for Financial Reporting
Verifiability. Verifiability occurs when independent measurers, using the same meth-
ods, obtain similar results. Verifiability occurs in the following situations.
1. Two independent auditors count Tata Motors’ (IND) inventory and arrive at the
same physical quantity amount for inventory. Verification of an amount for an asset
therefore can occur by simply counting the inventory (referred to as direct verification).
2. Two independent auditors compute Tata Motors’ inventory value at the end of the
year using the FIFO method of inventory valuation. Verification may occur by
checking the inputs (quantity and costs) and recalculating the outputs (ending in-
ventory value) using the same accounting convention or methodology (referred to
as indirect verification).
4
Surveys indicate that users highly value consistency. They note that a change tends to destroy
the comparability of data before and after the change. Some companies assist users to understand
the pre- and post-change data. Generally, however, users say they lose the ability to analyze over
time. IFRS guidelines (discussed in Chapter 22) on accounting changes are designed to improve
the comparability of the data before and after the change.
www.downloadslide.com
Second Level: Fundamental Concepts 37
information with reasonable diligence. Information that is relevant and faithfully repre-
sented should not be excluded from financial reports solely because it is too complex or
difficult for some users to understand without assistance.5
Basic Elements
An important aspect of developing any theoretical structure is the body of basic
5 LEARNING OBJECTIVE
elements or definitions to be included in it. Accounting uses many terms with
Define the basic elements of
distinctive and specific meanings. These terms constitute the language of busi-
financial statements.
ness 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?
As this example and the lottery ticket example in the opening story illustrate, it is
necessary, therefore, to develop basic definitions for the elements of financial state-
ments. The Conceptual Framework defines the five interrelated elements that most di-
rectly relate to measuring the performance and financial status of a business enterprise.
We list them below for review and information purposes; you need not memorize these
definitions at this point. We will explain and examine each of these elements in more
detail in subsequent chapters.
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.
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.
EQUITY. The residual interest in the assets of the entity after deducting all its liabilities.
INCOME. Increases in economic benefits during the accounting period in the form of in-
flows or enhancements of assets or decreases of liabilities that result in increases in equity,
other than those relating to contributions from equity participants.
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.
As indicated, the IASB classifies the elements into two distinct groups. [5] The first
group of three elements—assets, liabilities, and equity—describes amounts of resources
and claims to resources at a moment in time. The second group of two elements
describes transactions, events, and circumstances that affect a company during a period
of time. The first class, affected by elements of the second class, provides at any time the
cumulative result of all changes. This interaction is referred to as “articulation.” That is,
key figures in one financial statement correspond to balances in another.
5
The Conceptual Framework for Financial Reporting, “Chapter 3, Qualitative Characteristics of
Useful Financial Information” (London, U.K.: IASB, September 2010), paras. QC30–QC31.
www.downloadslide.com
38 Chapter 2 Conceptual Framework for Financial Reporting
Basic Assumptions
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 complete-
ness, 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.
6
In 2010, the IASB issued an exposure draft entitled “Conceptual Framework for Financial
Reporting—The Reporting Entity.” The IASB proposal indicates that a reporting entity has three
features: (1) economic activities have been, are being, or will be conducted; (2) those activities
can be distinguished from those of other entities; and (3) financial information about the entity’s
economic activities has the potential to be of value in making decisions about providing resources
to that entity. See IASB, “Conceptual Framework for Financial Reporting—The Reporting Entity,”
Exposure Draft (March 2010).
7
The concept of the entity is changing. For example, defining the “outer edges” of companies is
now harder. Public companies often consist of multiple public subsidiaries, each with joint
ventures, licensing arrangements, and other affiliations. Increasingly, companies form and
dissolve joint ventures or customer-supplier relationships in a matter of months or weeks. These
“virtual companies” raise accounting issues about how to account for the entity. See Steven H.
Wallman, “The Future of Accounting and Disclosure in an Evolving World: The Need for Dramatic
Change,” Accounting Horizons (September 1995). The IASB is addressing these issues in the entity
phase of its conceptual framework project (see http://www.iasb.org/Current1Projects/IASB1Projects/
Conceptual1Framework/Conceptual1Framework.htm) and in its project on consolidations
(see http://www.iasb.org/Current%20Projects/IASB%20Projects/Consolidation/Consolidation.htm).
www.downloadslide.com
Third Level: Recognition, Measurement, and Disclosure Concepts 39
Periodicity Assumption
To measure the results of a company’s activity accurately, we would need to wait until
it liquidates. Decision-makers, however, cannot wait that long for such information.
Users need to know a company’s performance and economic status on a timely basis so
that they can evaluate and compare companies, and take appropriate actions. Therefore,
companies must report information periodically.
The periodicity (or time period) assumption implies that a company can divide its
economic activities into artificial time periods. These time periods vary, but the most
common are monthly, quarterly, and yearly.
The shorter the time period, the more difficult it is to determine the proper net
income for the period. A month’s results usually prove less reliable than a quarter’s
8
As noted in the Conceptual Framework (Chapter 4, par. 63), this approach reflects adoption of
a financial capital approach to capital maintenance under which the change in capital or a
company’s net assets is measured in nominal monetary units without adjusting for changes in
prices. [6] There is a separate IFRS (IFRS No. 29, “Financial Reporting in Hyperinflationary
Economies”) that provides guidance on how to account for adjustments to the purchasing
power of the monetary unit. [7]
www.downloadslide.com
40 Chapter 2 Conceptual Framework for Financial Reporting
results, and a quarter’s results are likely to be less reliable than a year’s results. Investors
desire and demand that a company quickly process and disseminate information. Yet
the quicker a company releases the information, the more likely the information will
include errors. This phenomenon provides an interesting example of the trade-off
between relevance and faithful representation in preparing financial data.
The problem of defining the time period becomes more serious as product cycles
shorten and products become obsolete more quickly. Many believe that, given technol-
ogy advances, companies need to provide more online, real-time financial information
to ensure the availability of relevant information.
Measurement Principles
We presently have a “mixed-attribute” system in which one of two measurement prin-
ciples is used. 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. Here, we discuss each measurement principle.
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 sell-
ing 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
www.downloadslide.com
Third Level: Recognition, Measurement, and Disclosure Concepts 41
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.
Fair Value. 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.” Fair value is therefore a market-based measure. [9] Recently, IFRS
has increasingly called for use of fair value measurements in the financial statements.
This is often referred to as the fair value principle. Fair value information may be more
useful than historical cost for certain types of assets and liabilities and in certain indus-
tries. For example, companies report many financial instruments, including derivatives,
at fair value. Certain industries, such as brokerage houses and mutual funds, prepare
their basic financial statements on a fair value basis. At initial acquisition, historical cost
equals fair value. In subsequent periods, as market and economic conditions change,
historical cost and fair value often diverge. Thus, fair value measures or estimates often
provide more relevant information about the expected future cash flows related to the
asset or liability. For example, when long-lived assets decline in value, a fair value mea-
sure determines any impairment loss.
The IASB believes that fair value information is more relevant to users than histori-
cal cost. Fair value measurement, it is argued, provides better insight into the value of a
company’s assets and liabilities (its financial position) and a better basis for assessing
future cash flow prospects. Recently, the Board has taken the additional step of giving
companies the option to use fair value (referred to as the fair value option) as the basis
for measurement of financial assets and financial liabilities. [10] The Board considers
fair value more relevant than historical cost because it reflects the current cash equiva-
lent value of financial instruments. As a result, companies now have the option to
record fair value in their accounts for most financial instruments, including such items
as receivables, investments, and debt securities.
Use of fair value in financial reporting is increasing. However, measurement based on
fair value introduces increased subjectivity into accounting reports when fair value infor-
mation is not readily available. To increase consistency and comparability in fair value
measures, the IASB established a fair value hierarchy that provides insight into the priority
of valuation techniques to use to determine fair value. As shown in Illustration 2-4, the fair
value hierarchy is divided into three broad levels.
ILLUSTRATION 2-4
Level 1: Observable inputs that reflect quoted Least Subjective
prices for identical assets or liabilities in
Fair Value Hierarchy
active markets.
Level 2: Inputs other than quoted prices
included in Level 1 that are observable for
the asset or liability either directly or through
corroboration with observable data.
Level 3: Unobservable inputs (for example,
a company’s own data or assumptions). Most Subjective
www.downloadslide.com
42 Chapter 2 Conceptual Framework for Financial Reporting
9
For major groups of assets and liabilities, companies must disclose (1) the fair value measurement
and (2) the fair value hierarchy level of the measurements as a whole, classified by Level 1, 2, or 3.
Given the judgment involved, it follows that the more a company depends on Level 3 to
determine fair values, the more information about the valuation process the company will need
to disclose. Thus, additional disclosures are required for Level 3 measurements; we discuss these
disclosures in more detail in subsequent chapters.
10
The framework shown in Illustration 2-5 is based on the recent standard on revenue recognition.
www.downloadslide.com
Third Level: Recognition, Measurement, and Disclosure Concepts 43
ILLUSTRATION 2-5
The Five Steps of
A contract is an agreement between two parties
Step 1: Identify the contract that creates enforceable rights or obligations. In
Revenue Recognition
with the customers. this case, Airbus has signed a contract to deliver
Aairplanes
contract to British Airways.
Step 4: Allocate the transaction In this case, Airbus has only one performance
price to the separate performance obligation—to deliver airplanes to British Airways.
obligations.
11
This approach is commonly referred to as the matching principle. However, there is some
debate about the conceptual validity of the matching principle. A major concern is that matching
permits companies to defer certain costs and treat them as assets on the statement of financial
position. In fact, these costs may not have future benefits. If abused, this principle permits the
statement of financial position to become a “dumping ground” for unmatched costs.
www.downloadslide.com
44 Chapter 2 Conceptual Framework for Financial Reporting
allocation policy to apply the expense recognition principle. This type of expense recog-
nition 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 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.
Illustration 2-6 summarizes these expense recognition procedures.
ILLUSTRATION 2-6
Type of Cost Relationship Recognition
Expense Recognition
Procedures for Product Product costs: Direct relationship between Recognize in period of revenue
• Material cost and revenue. (matching).
and Period Costs
• Labor
• Overhead
Period costs: No direct relationship Expense as incurred.
• Salaries between cost
• Administrative costs and revenue.
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 meth-
ods used in measuring the elements reported in the statements, explanations of uncer-
tainties 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 differ-
ent 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 dis-
counted 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 situa-
tions, the same problem must be faced: making sure the company presents enough in-
formation to ensure that the reasonably prudent investor will not be misled.12
We discuss the content, arrangement, and display of financial statements, along
with other facets of full disclosure, in Chapters 4, 5, and 24.
Cost Constraint
In providing information with the qualitative characteristics that make it useful,
companies must consider an overriding factor that limits (constrains) the report- 8 LEARNING OBJECTIVE
ing. This is referred to as the cost constraint. That is, companies must weigh the Describe the impact that the cost
constraint has on reporting accounting
costs of providing the information against the benefits that can be derived from information.
using it. Rule-making bodies and governmental agencies use cost-benefit analy-
sis before making final their informational requirements. In order to justify requiring a
particular measurement or disclosure, the benefits perceived to be derived from it must
exceed the costs perceived to be associated with it.
A corporate executive made the following remark to a standard-setter about a pro-
posed rule: “In all my years in the financial arena, I have never seen such an absolutely
ridiculous proposal. . . . To dignify these ‘actuarial’ estimates by recording them as as-
sets and liabilities would be virtually unthinkable except for the fact that the FASB has
done equally stupid things in the past. . . . For God’s sake, use common sense just this
once.”13 Although extreme, this remark indicates the frustration expressed by members
of the business community about accounting standard-setting, and whether the benefits
of a given pronouncement exceed the costs.
The difficulty in cost-benefit analysis is that the costs and especially the benefits
are not always evident or measurable. The costs are of several kinds: costs of collect-
ing and processing, of disseminating, of auditing, of potential litigation, of disclosure
12
To provide guidance for management disclosures, the IASB issued an IFRS practice statement
entitled “Management Commentary—A Framework for Presentation.” The IASB notes that this
practice statement is neither an IFRS nor part of the Conceptual Framework. However, the
guidance is issued on the basis that management commentary meets the definition of other
financial reporting as referenced in the Conceptual Framework.
13
“Decision-Usefulness: The Overriding Objective,” FASB Viewpoints (October 19, 1983), p. 4.
www.downloadslide.com
46 Chapter 2 Conceptual Framework for Financial Reporting
Sometimes, in practice, it has been acceptable to invoke the The role of conservatism or prudence may not be fully
additional constraint of prudence or conservatism as a justifi- settled. Recently, the European Parliament (EP) called for the
cation for an accounting treatment under conditions of uncer- IASB to reintroduce a specific reference to “prudence” in its
tainty. Prudence or conservatism means when in doubt, Conceptual Framework. The EP argues that such a tenet puts
choose the solution that will be least likely to overstate assets pressure on accountants to err on the side of caution when
or income and/or understate liabilities or expenses. The Con- scrutinizing losses. The lawmakers argue that a prudence
ceptual Framework indicates that prudence or conservatism guideline could help avoid a repeat of the 2007–2009 finan-
generally is in conflict with the quality of neutrality. This is cial crisis in which European taxpayers had to put billions
because being prudent or conservative likely leads to a bias in of euros into struggling banks. Some in the Parliament are
the reported financial position and financial performance. linking continued funding for the IFRS to a change in the
In fact, introducing biased understatement of assets (or prudence guidelines.
overstatement of liabilities) in one period frequently leads to In response, IASB chairman Hans Hoogervorst de-
overstating financial performance in later periods—a result scribed the Parliament’s stance as “highly worrisome,” not-
that cannot be described as prudent. This is inconsistent with ing that pressuring the IASB on this issue will raise concern
neutrality, which encompasses freedom from bias. Accord- about its independence. Thus, just as the use of prudence can
ingly, the Conceptual Framework does not include prudence lead to a lack of neutrality of the reported numbers, the EP’s
or conservatism as desirable qualities of financial reporting stand on prudence could negatively impact the perceived
information. neutrality of the IASB’s standard-setting process.
Source: H. Jones, “IASB Accounting Body Rejects EU Parliament’s Funding Conditions,” Reuters (October 14, 2013), http://uk.reuters.com/article/2013/
10/14/uk-accounting-iasb-idUKBRE99D0KQ20131014.
14
Charles Rivers and Associates, “Sarbanes-Oxley Section 404: Costs and Remediation of
Deficiencies,” letter from Deloitte and Touche, Ernst and Young, KPMG, and Pricewaterhouse-
Coopers to the SEC (April 11, 2005).
www.downloadslide.com
Global Accounting Insights 47
ILLUSTRATION 2-7
Conceptual Framework
Recognition, Measurement, and Disclosure Concepts
for Financial Reporting
QUALITATIVE
CHARACTERISTICS ELEMENTS
1. Fundamental qualities
A. Relevance 1. Assets
(1) Predictive value 2. Liabilities
(2) Confirmatory value 3. Equity
(3) Materiality 4. Income Second level: Bridge
B. Faithful representation 5. Expenses between levels 1 and 3
(1) Completeness
(2) Neutrality
(3) Free from error
2. Enhancing qualities
(1) Comparability
(2) Verifiability
(3) Timeliness
(4) Understandability
OBJECTIVE
Provide information
about the reporting
entity that is useful
to present and potential
equity investors,
lenders, and other
creditors in their First level: The "why"—
capacity as capital
providers.
purpose of accounting
Relevant Facts
Following are the key similarities and differences between they agreed on the objective of financial reporting and a
U.S. GAAP and IFRS related to the Conceptual Framework common set of desired qualitative characteristics. These
for Financial Reporting. were presented in the Chapter 2 discussion. Note that prior
Similarities to this converged phase, the Conceptual Framework gave
• In 2010, the IASB and FASB completed the first phase of a more emphasis to the objective of providing information
jointly created conceptual framework. In this first phase, on management’s performance (stewardship).
www.downloadslide.com
48 Chapter 2 Conceptual Framework for Financial Reporting
• The existing conceptual frameworks underlying U.S. apply fair value to property, plant, and equipment; natural
GAAP and IFRS are very similar. That is, they are orga- resources; and, in some cases, intangible assets.
nized in a similar manner (objective, elements, qualitative • U.S. GAAP has a concept statement to guide estimation of
characteristics, etc.). There is no real need to change many fair values when market-related data is not available (State-
aspects of the existing frameworks other than to converge ment of Financial Accounting Concepts No. 7, “Using Cash
different ways of discussing essentially the same concepts. Flow Information and Present Value in Accounting”). The
• The converged framework should be a single document, IASB has not issued a similar concept statement; it has
unlike the two conceptual frameworks that presently exist. issued a fair value standard (IFRS 13) that is converged
It is unlikely that the basic structure related to the concepts with U.S. GAAP.
will change. • The monetary unit assumption is part of each framework.
• Both the IASB and FASB have similar measurement prin- However, the unit of measure will vary depending on the
ciples, based on historical cost and fair value. In 2011, the currency used in the country in which the company is in-
Boards issued a converged standard on fair value measure- corporated (e.g., Chinese yuan, Japanese yen, and British
ment so that the definition of fair value, measurement tech- pound).
niques, and disclosures are the same between U.S. GAAP • The economic entity assumption is also part of each frame-
and IFRS when fair value is used in financial statements. work although some cultural differences result in differences
in its application. For example, in Japan many companies
Differences have formed alliances that are so strong that they act similar
• Although both U.S. GAAP and IFRS are increasing the use to related corporate divisions although they are not actually
of fair value to report assets, at this point IFRS has adopted part of the same company.
it more broadly. As examples, under IFRS, companies can
LIABILITIES. Probable future sacrifices of economic benefits arising from present obliga-
tions of a particular entity to transfer assets or provide services to other entities in the future
as a result of past transactions or events.
EQUITY. Residual interest in the assets of an entity that remains after deducting its liabili-
ties. In a business enterprise, the equity is the ownership interest.
Source: “Elements of Financial Statements,” Statement of Financial Accounting Concepts No. 6 (Stamford, Conn.:
FASB, December 1985), pp. ix and x.
On the Horizon
The IASB and the FASB face a difficult task in attempting to the sacrifice? Should a single measurement method, such as
update, modify, and complete a converged conceptual frame- historical cost or fair value, be used, or does it depend on
work. There are many challenging issues to overcome. For whether it is an asset or liability that is being measured? We
example, how do we trade off characteristics such as highly are optimistic that the new converged conceptual framework
relevant information that is difficult to verify? How do we de- will be a significant improvement over its predecessors and
fine control when we are developing a definition of an asset? will lead to standards that will help financial statement users
Is a liability the future sacrifice itself or the obligation to make to make better decisions.
[8] The Conceptual Framework for Financial Reporting, “Chapter 1: The Objective of General Purpose Financial Report-
ing” (London, U.K.: IASB, 2010), par. OB 17.
[9] International Financial Reporting Standard 13, Fair Value Measurement (London, U.K.: IASB, 2011), par. 9.
[10] International Financial Reporting Standard 9, “Financial Instruments, Chapter 4: Classification” (London, U.K.: IASB
2010), paras. 4.1.5–4.1.6 and 4.2.2–4.2.3.
[11] The Conceptual Framework for Financial Reporting, “Chapter 4, The 1989 Framework: The Remaining Text”
(London, U.K.: IASB, 2010), paras. 4.37–4.39.
QUESTIONS
1. What is a conceptual framework? Why is a conceptual 13. What is the basic accounting problem created by the mon-
framework necessary in financial accounting? etary unit assumption when there is significant inflation?
2. What is the primary objective of financial reporting? What appears to be the IASB position on a stable monetary
unit?
3. What is meant by the term “qualitative characteristics of
accounting information”? 14. The chairman of the board of directors of the company for
which you are chief accountant has told you that he has
4. Briefly describe the two fundamental qualities of useful little use for accounting figures based on historical cost. He
accounting information. believes that fair values are of far more significance to the
5. How are materiality (and immateriality) related to the board of directors than “out-of-date costs.” Present some
proper presentation of financial statements? What factors arguments to convince him that accounting data should
and measures should be considered in assessing the mate- still be based on historical cost.
riality of a misstatement in the presentation of a financial 15. What is the definition of fair value?
statement?
16. What is the fair value option? Explain how use of the fair
6. What are the enhancing qualities of the qualitative charac- value option reflects application of the fair value principle.
teristics? What is the role of enhancing qualities in the
Conceptual Framework? 17. Briefly describe the fair value hierarchy.
7. According to the Conceptual Framework, the objective of 18. Explain the revenue recognition principle.
financial reporting for business enterprises is based on the 19. What is a performance obligation, and how is it used to
needs of the users of financial statements. Explain the level determine when revenue should be recognized?
of sophistication that the IASB assumes about the users of
20. What are the five steps used to determine the proper time
financial statements.
to recognize revenue?
8. What is the distinction between comparability and con-
sistency? 21. Selane Eatery operates a catering service specializing in
business luncheons for large corporations. Selane requires
9. Why is it necessary to develop a definitional framework customers to place their orders 2 weeks in advance of the
for the basic elements of accounting? scheduled events. Selane bills its customers on the tenth
10. What are the basic elements of the Conceptual Frame- day of the month following the date of service and requires
work? Briefly describe the relationship between the that payment be made within 30 days of the billing date.
“moment in time” and “period of time” elements. Conceptually, when should Selane recognize revenue re-
lated to its catering service?
11. What are the five basic assumptions that underlie the
financial accounting structure? 22. Mogilny Company paid $135,000 for a machine. The
Accumulated Depreciation account has a balance of $46,500
12. The life of a business is divided into specific time periods,
at the present time. The company could sell the machine
usually a year, to measure results of operations for each
today for $150,000. The company president believes that
such time period and to portray financial conditions at the
the company has a “right to this gain.” What does the pres-
end of each period.
ident mean by this statement? Do you agree?
(a) This practice is based on the accounting assumption
23. Three expense recognition methods (associating cause and
that the life of the business consists of a series of time
effect, systematic and rational allocation, and immediate
periods and that it is possible to measure accurately
recognition) were discussed in the chapter under the ex-
the results of operations for each period. Comment on
pense recognition principle. Indicate the basic nature of
the validity and necessity of this assumption.
each of these expense recognition methods and give two
(b) What has been the effect of this practice on account-
examples of each.
ing? What is its relation to the accrual basis of account-
ing? What influence has it had on accounting entries 24. Under what conditions should an item be recognized in
and practices? the financial statements?
www.downloadslide.com
52 Chapter 2 Conceptual Framework for Financial Reporting
25. Briefly describe the types of information concerning finan- 27. Describe the major constraint inherent in the presentation
cial position, income, and cash flows that might be pro- of accounting information.
vided (a) within the main body of the financial statements, 28. What are some of the costs of providing accounting infor-
(b) in the notes to the financial statements, or (c) as supple- mation? What are some of the benefits of accounting
mentary information. information? Describe the cost-benefit factors that should
be considered when new accounting standards are being
26. In January 2015, Janeway Inc. doubled the amount of its
proposed.
outstanding shares by selling an additional 10,000 shares
to finance an expansion of the business. You propose that 29. Do the IASB and U.S. GAAP conceptual frameworks differ
this information be shown by a footnote to the statement in terms of fair value measurement? Explain.
of financial position as of December 31, 2015. The presi- 30. How do the FASB and IASB conceptual frameworks differ
dent objects, claiming that this sale took place after in terms of the elements of financial statements?
December 31, 2015, and, therefore, should not be shown. 31. What are some of the challenges to the FASB and IASB in
Explain your position. developing a converged conceptual framework?
BRIEF EXERCISES
4 BE2-1 Match the qualitative characteristics below with the following statements.
1. Relevance 5. Comparability
2. Faithful representation 6. Completeness
3. Predictive value 7. Neutrality
4. Confirmatory value 8. Timeliness
(a) Quality of information that permits users to identify similarities in and differences between
two sets of economic phenomena.
(b) Having information available to users before it loses its capacity to influence decisions.
(c) Information about an economic phenomenon that has value as an input to the processes
used by capital providers to form their own expectations about the future.
(d) Information that is capable of making a difference in the decisions of users in their capacity
as capital providers.
(e) Absence of bias intended to attain a predetermined result or to induce a particular behavior.
4 BE2-2 Match the qualitative characteristics below with the following statements.
1. Timeliness 5. Faithful representation
2. Completeness 6. Relevance
3. Free from error 7. Neutrality
4. Understandability 8. Confirmatory value
(a) Quality of information that assures users that information represents the economic phenom-
ena that it purports to represent.
(b) Information about an economic phenomenon that changes past or present expectations
based on previous evaluations.
(c) The extent to which information is accurate in representing the economic substance of a
transaction.
(d) Includes all the information that is necessary for a faithful representation of the economic
phenomena that it purports to represent.
(e) Quality of information that allows users to comprehend its meaning.
4 BE2-3 Discuss whether the changes described in each of the situations below require recognition in the
audit report as to consistency. (Assume that the amounts are material.)
(a) The company changed its inventory method to FIFO from weighted-average, which had been
used in prior years.
(b) The company disposed of one of the two subsidiaries that had been included in its consolidated
statements for prior years.
(c) The estimated remaining useful life of plant property was reduced because of obsolescence.
(d) The company is using an inventory valuation method that is different from those used by all
other companies in its industry.
www.downloadslide.com
Brief Exercises 53
4 BE2-4 Identify which qualitative characteristic of accounting information is best described in each item
below. (Do not use relevance and faithful representation.)
(a) The annual reports of Best Buy Co. (USA) are audited by certified public accountants.
(b) Motorola (USA) and Nokia (FIN) both use the FIFO cost flow assumption.
(c) Starbucks Corporation (USA) has used straight-line depreciation since it began operations.
(d) Heineken Holdings (NLD) issues its quarterly reports immediately after each quarter ends.
5 BE2-5 Explain how you would decide whether to record each of the following expenditures as an asset or
an expense. Assume all items are material.
(a) Legal fees paid in connection with the purchase of land are €1,500.
(b) Eduardo, Inc. paves the driveway leading to the office building at a cost of €21,000.
(c) A meat market purchases a meat-grinding machine at a cost of €3,500.
(d) On June 30, Monroe and Meno, medical doctors, pay 6 months’ office rent to cover the month of
July and the next 5 months.
(e) Smith’s Hardware Company pays €9,000 in wages to laborers for construction on a building to
be used in the business.
(f) Alvarez’s Florists pays wages of €2,100 for November to an employee who serves as driver of
their delivery truck.
5 BE2-6 For each item below, indicate to which category of elements of financial statements it belongs.
(a) Retained earnings. (e) Depreciation. (h) Dividends.
(b) Sales. (f) Loss on sale of equipment. (i) Gain on sale of investment.
(c) Share Premium. (g) Interest payable. (j) Issuance of ordinary shares.
(d) Inventory.
6 BE2-7 If the going concern assumption is not made in accounting, discuss the differences in the amounts
shown in the financial statements for the following items.
(a) Land.
(b) Depreciation expense on equipment.
(c) Inventory.
(d) Prepaid insurance.
6 BE2-8 Identify which basic assumption of accounting is best described in each of the following items.
(a) The economic activities of FedEx Corporation (USA) are divided into 12-month periods for the
purpose of issuing annual reports.
(b) Total S.A. (FRA) does not adjust amounts in its financial statements for the effects of inflation.
(c) Barclays (GBR) reports current and non-current classifications in its statement of financial position.
(d) The economic activities of Tokai Rubber Industries (JPN) and its subsidiaries are merged for
accounting and reporting purposes.
7 BE2-9 Identify which basic principle of accounting is best described in each item below.
(a) Parmalat (ITA) reports revenue in its income statement when it delivers goods instead of when
the cash is collected.
(b) Google (USA) recognizes depreciation expense for a machine over the 2-year period during
which that machine helps the company earn revenue.
(c) Oracle Corporation (USA) reports information about pending lawsuits in the notes to its finan-
cial statements.
(d) Fuji Film (JPN) reports land on its statement of financial position at the amount paid to acquire
it, even though the estimated fair value is greater.
7 BE2-10 Vande Velde Company made three investments during 2015. (1) It purchased 1,000 shares of Sastre
Company, a start-up company. Vande Velde made the investment based on valuation estimates from an
internally developed model. (2) It purchased 2,000 shares of Fuji Film (JPN), which trades on the Nikkei.
(3) It invested $10,000 in local development authority bonds. Although these bonds do not trade on an ac-
tive market, their value closely tracks movements in U.S. Treasury bonds. Rank these three investments in
terms of the verifiability of fair value.
4 BE2-11 Presented below are three different transactions related to materiality. Explain whether you would
classify these transactions as material.
(a) Blair Co. has reported a positive trend in earnings over the last 3 years. In the current year, it
reduces its bad debt expense to ensure another positive earnings year. The impact of this
adjustment is equal to 3% of net income.
www.downloadslide.com
54 Chapter 2 Conceptual Framework for Financial Reporting
(b) Hindi Co. has a gain of €3.1 million on the sale of plant assets and a €3.3 million loss on the sale
of investments. It decides to net the gain and loss because the net effect is considered immaterial.
Hindi Co.’s income for the current year was €10 million.
(c) Damon Co. expenses all capital equipment under €2,500 on the basis that it is immaterial. The
company has followed this practice for a number of years.
6 7 BE2-12 What accounting assumption, principle, or constraint would Marks and Spencer plc (M&S) (GBR)
8 use in each of the situations below?
(a) M&S records expenses when incurred, rather than when cash is paid.
(b) M&S was involved in litigation over the last year. This litigation is disclosed in the financial
statements.
(c) M&S allocates the cost of its depreciable assets over the life it expects to receive revenue from
these assets.
(d) M&S records the purchase of a new Lenovo (CHN) PC at its cash equivalent price.
3 4 BE2-13 Fill in the blanks related to the following statements.
8 1. Financial reporting imposes ______; the benefits of financial reporting should justify those _____.
2. The information provided by ______ ______ ______ ______ focuses on the needs of all capital
providers, not just the needs of a particular group.
3. A depiction of economic phenomena is ______ if it includes all the information that is necessary
for faithful representation of the economic phenomena that it purports to represent.
4. ______ is the quality of information that allows users to comprehend its meaning.
5. ______ is the quality of information that permits users to identify similarities in and differences
between two sets of economic phenomena.
6. Information about economic phenomena has _____ _____ if it confirms or changes past or present
expectations based on previous evaluations.
EXERCISES
1 3 E2-1 (Usefulness, Objective of Financial Reporting) Indicate whether the following statements about
the Conceptual Framework are true or false. If false, provide a brief explanation supporting your position.
(a) Accounting rule-making that relies on a body of concepts will result in useful and consistent
pronouncements.
(b) General-purpose financial reports are most useful to company insiders in making strategic busi-
ness decisions.
(c) Accounting standards based on individual conceptual frameworks generally will result in consis-
tent and comparable accounting reports.
(d) Capital providers are the only users who benefit from general-purpose financial reporting.
(e) Accounting reports should be developed so that users without knowledge of economics and busi-
ness can become informed about the financial results of a company.
(f) The objective of financial reporting is the foundation from which the other aspects of the frame-
work logically result.
1 3 E2-2 (Usefulness, Objective of Financial Reporting, Qualitative Characteristics) Indicate whether the
4 following statements about the Conceptual Framework are true or false. If false, provide a brief explana-
tion supporting your position.
(a) The fundamental qualitative characteristics that make accounting information useful are relevance
and verifiability.
(b) Relevant information has predictive value, confirmatory value, or both.
(c) Conservatism, a prudent reaction to uncertainty, is considered a constraint of financial reporting.
(d) Information that is a faithful representation is characterized as having predictive or confirmatory
value.
(e) Comparability pertains only to the reporting of information in a similar manner for different
companies.
(f) Verifiability is solely an enhancing characteristic for faithful representation.
(g) In preparing financial reports, it is assumed that users of the reports have reasonable knowledge
of business and economic activities.
www.downloadslide.com
Exercises 55
4 8 E2-3 (Qualitative Characteristics) The Conceptual Framework identifies the qualitative characteristics
that make accounting information useful. Presented below are a number of questions related to these qual-
itative characteristics and underlying constraint.
(a) What is the quality of information that enables users to confirm or correct prior expectations?
(b) Identify the overall or pervasive constraint developed in the Conceptual Framework.
(c) A noted accountant once remarked, “If it becomes accepted or expected that accounting principles
are determined or modified in order to secure purposes other than economic measurement, we
assume a grave risk that confidence in the credibility of our financial information system will be
undermined.” Which qualitative characteristic of accounting information should ensure that such
a situation will not occur? (Do not use faithful representation.)
(d) Muruyama Group switches from FIFO to average-cost and then back to FIFO over a 2-year period.
Which qualitative characteristic of accounting information is not followed?
(e) Assume that the profession permits the savings and loan industry to defer losses on investments
it sells, because immediate recognition of the loss may have adverse economic consequences on
the industry. Which qualitative characteristic of accounting information is not followed? (Do not
use relevance or faithful representation.)
(f) What are the two fundamental qualities that make accounting information useful for decision-making?
(g) Watteau Inc. does not issue its first-quarter report until after the second quarter’s results are re-
ported. Which qualitative characteristic of accounting is not followed? (Do not use relevance.)
(h) Predictive value is an ingredient of which of the two fundamental qualities that make accounting
information useful for decision-making purposes?
(i) Duggan, Inc. is the only company in its industry to depreciate its plant assets on a straight-line
basis. Which qualitative characteristic of accounting information may not be present?
(j) Nadal Company has attempted to determine the replacement cost of its inventory. Three different
appraisers arrive at substantially different amounts for this value. The president, nevertheless,
decides to report the middle value for external reporting purposes. Which qualitative characteris-
tic of information is lacking in these data? (Do not use reliability or representational faithfulness.)
4 E2-4 (Qualitative Characteristics) The qualitative characteristics that make accounting information
useful for decision-making purposes are as follows.
Relevance Neutrality Verifiability
Faithful representation Completeness Understandability
Predictive value Timeliness Comparability
Confirmatory value Materiality Free from error
Instructions
Identify the appropriate qualitative characteristic(s) to be used given the information provided below.
(a) Qualitative characteristic being displayed when companies in the same industry are using the
same accounting principles.
(b) Quality of information that confirms users’ earlier expectations.
(c) Imperative for providing comparisons of a company from period to period.
(d) Ignores the economic consequences of a standard or rule.
(e) Requires a high degree of consensus among individuals on a given measurement.
(f) Predictive value is an ingredient of this fundamental quality of information.
(g) Four qualitative characteristics that enhance both relevance and faithful representation.
(h) An item is not reported because its effect on income would not change a decision.
(i) Neutrality is a key ingredient of this fundamental quality of accounting information.
(j) Two fundamental qualities that make accounting information useful for decision-making purposes.
(k) Issuance of interim reports is an example of what enhancing ingredient?
5 E2-5 (Elements of Financial Statements) Five interrelated elements that are most directly related to
measuring the performance and financial status of an enterprise are provided below.
Assets Income
Liabilities Expenses
Equity
Instructions
Identify the element or elements associated with the following nine items.
(a) Obligation to transfer resources arising from a past transaction.
(b) Increases ownership interest by issuance of shares.
(c) Declares and pays cash dividends to owners.
(d) Increases in net assets in a period from non-owner sources.
www.downloadslide.com
56 Chapter 2 Conceptual Framework for Financial Reporting
(b) Equipment purchases of €170,000 were partly financed during the year through the issuance of a
€110,000 notes payable. The company offset the equipment against the notes payable and reported
plant assets at €60,000.
(c) Weller has reported its ending inventory at €2,100,000 in the financial statements. No other infor-
mation related to inventories is presented in the financial statements and related notes.
(d) The company changed its method of valuing inventories from weighted-average to FIFO. No
mention of this change was made in the financial statements.
7 E2-9 (Accounting Principles—Comprehensive) Presented below are a number of business transactions
that occurred during the current year for Gonzales, Inc.
Instructions
In each of the situations, discuss the appropriateness of the journal entries.
(a) The president of Gonzales, Inc. used his expense account to purchase a new Suburban solely for
personal use. The following journal entry was made.
Miscellaneous Expense 29,000
Cash 29,000
(b) Merchandise inventory that cost €620,000 is reported on the statement of financial position at
€690,000, the expected selling price less estimated selling costs. The following entry was made to
record this increase in value.
Inventory 70,000
Sales Revenue 70,000
(c) The company is being sued for €500,000 by a customer who claims damages for personal injury
apparently caused by a defective product. Company attorneys feel extremely confident that the
company will have no liability for damages resulting from the situation. Nevertheless, the com-
pany decides to make the following entry.
Loss from Lawsuit 500,000
Liability for Lawsuit 500,000
(d) Because the general level of prices increased during the current year, Gonzales, Inc. determined
that there was a €16,000 understatement of depreciation expense on its equipment and decided to
record it in its accounts. The following entry was made.
Depreciation Expense 16,000
Accumulated Depreciation—Equipment 16,000
(e) Gonzales, Inc. has been concerned about whether intangible assets could generate cash in case of
liquidation. As a consequence, goodwill arising from a purchase transaction during the current
year and recorded at €800,000 was written off as follows.
Retained Earnings 800,000
Goodwill 800,000
(f) Because of a “fire sale,” equipment obviously worth €200,000 was acquired at a cost of €155,000.
The following entry was made.
Equipment 200,000
Cash 155,000
Sales Revenue 45,000
Instructions
Comment on the appropriateness of the accounting procedures followed by Wang Group.
(a) Depreciation expense on the building for the year was ¥60,000. Because the building was increas-
ing in value during the year, the controller decided to charge the depreciation expense to retained
earnings instead of to net income. The following entry is recorded.
Retained Earnings 60,000
Accumulated Depreciation—Buildings 60,000
(b) Materials were purchased on January 1, 2015, for ¥120,000 and this amount was entered in the
Materials account. On December 31, 2015, the materials would have cost ¥141,000, so the following
entry is made.
Inventory 21,000
Gain on Inventories 21,000
www.downloadslide.com
58 Chapter 2 Conceptual Framework for Financial Reporting
(c) During the year, the company purchased equipment through the issuance of ordinary shares. The
shares had a par value of ¥135,000 and a fair value of ¥450,000. The fair value of the equipment was
not easily determinable. The company recorded this transaction as follows.
Equipment 135,000
Share Capital 135,000
(d) During the year, the company sold certain equipment for ¥285,000, recognizing a gain of ¥69,000.
Because the controller believed that new equipment would be needed in the near future, she de-
cided to defer the gain and amortize it over the life of any new equipment purchased.
(e) An order for ¥61,500 has been received from a customer for products on hand. This order was
shipped on January 9, 2015. The company made the following entry in 2014.
Accounts Receivable 61,500
Sales Revenue 61,500
C O N C E P T S F O R A N A LY S I S
CA2-1 (Conceptual Framework—General) Wayne Cooper has some questions regarding the theoretical
framework in which IFRS is established. He knows that the IASB has attempted to develop a conceptual
framework for accounting theory formulation. Yet, Wayne’s supervisors have indicated that these theo-
retical frameworks have little value in the practical sense (i.e., in the real world). Wayne did notice that
accounting rules seem to be established after the fact rather than before. He thought this indicated a lack
of theory structure but never really questioned the process at school because he was too busy doing the
homework.
Wayne feels that some of his anxiety about accounting theory and accounting semantics could be
alleviated by identifying the basic concepts and definitions accepted by the profession and considering
them in light of his current work. By doing this, he hopes to develop an appropriate connection between
theory and practice.
Instructions
(a) Help Wayne recognize the purpose of a conceptual framework.
(b) Identify the benefits that arise from a conceptual framework.
CA2-2 (Conceptual Framework—General) The IASB’s Conceptual Framework for Financial Reporting
sets forth the objective and fundamentals that will be the basis for developing financial accounting and
reporting standards. The objective identifies the purpose of financial reporting. The fundamentals are the
underlying concepts of financial accounting that guide the selection of transactions, events, and circumstances
to be accounted for; their recognition and measurement; and the means of summarizing and communicating
them to interested parties.
The characteristics or qualities of information discussed in the Conceptual Framework are the con-
cepts that make information useful and the qualities to be sought when accounting choices are made.
Instructions
(a) Identify and discuss the benefits that can be expected to be derived from the Conceptual Frame-
work.
(b) What is the most important quality for accounting information as identified in the Conceptual
Framework? Explain why it is the most important.
(c) Briefly discuss the importance of any three of the fundamental characteristics or enhancing quali-
ties of accounting information.
CA2-3 (Objective of Financial Reporting) Homer Winslow and Jane Alexander are discussing various
aspects of the Conceptual Framework. Homer indicates that this pronouncement provides little, if any,
guidance to the practicing professional in resolving accounting controversies. He believes that the Concep-
tual Framework provides such broad guidelines that it would be impossible to apply the objective(s) to
present-day reporting problems. Jane concedes this point but indicates that objective(s) are still needed to
provide a starting point for the IASB in helping to improve financial reporting.
Instructions
(a) Indicate the basic objective established in the Conceptual Framework.
(b) What do you think is the meaning of Jane’s statement that the IASB needs a starting point to
resolve accounting controversies about how to improve financial reporting?
www.downloadslide.com
Concepts for Analysis 59
CA2-4 (Qualitative Characteristics) Accounting information provides useful information about business
transactions and events. Those who provide and use financial reports must often select and evaluate ac-
counting alternatives. The Conceptual Framework examines the characteristics of accounting information
that make it useful for decision-making. It also points out that various limitations inherent in the measure-
ment and reporting process may necessitate trade-offs or sacrifices among the characteristics of useful
information.
Instructions
(a) Describe briefly the following characteristics of useful accounting information.
(1) Relevance. (4) Comparability (consistency).
(2) Faithful representation. (5) Neutrality.
(3) Understandability.
(b) For each of the following pairs of information characteristics, give an example of a situation in
which one of the characteristics may be sacrificed in return for a gain in the other.
(1) Relevance and faithful representation. (3) Comparability and consistency.
(2) Relevance and consistency. (4) Relevance and understandability.
(c) What criterion should be used to evaluate trade-offs between information characteristics?
CA2-5 (Revenue Recognition Principle) After the presentation of your report on the examination of the
financial statements to the board of directors of Piper Publishing Company, one of the new directors ex-
presses surprise that the income statement assumes that an equal proportion of the revenue is earned with
the publication of every issue of the company’s magazine. She feels that the “crucial event” in the process
of recognizing revenue in the magazine business is the cash sale of the subscription. She says that she does
not understand why most of the revenue cannot be recognized in the period of the sale.
Instructions
Discuss the propriety of timing the recognition of revenue in Piper Publishing Company’s accounts with
respect to the following.
(a) The cash sale of the magazine subscription.
(b) The publication of the magazine every month.
(c) Both events, by recognizing a portion of the revenue with the cash sale of the magazine subscrip-
tion and a portion of the revenue with the publication of the magazine every month.
CA2-6 (Expense Recognition Principle) An accountant must be familiar with the concepts involved in
determining earnings of a business entity. The amount of earnings reported for a business entity is de-
pendent on the proper recognition, in general, of revenue and expense for a given time period. In some
situations, costs are recognized as expenses at the time of product sale. In other situations, guidelines
have been developed for recognizing costs as expenses or losses by other criteria.
Instructions
(a) Explain the rationale for recognizing costs as expenses at the time of product sale.
(b) What is the rationale underlying the appropriateness of treating costs as expenses of a period in-
stead of assigning the costs to an asset? Explain.
(c) In what general circumstances would it be appropriate to treat a cost as an asset instead of as an
expense? Explain.
(d) Some expenses are assigned to specific accounting periods on the basis of systematic and rational
allocation of asset cost. Explain the underlying rationale for recognizing expenses on the basis of
systematic and rational allocation of asset cost.
(e) Identify the conditions under which it would be appropriate to treat a cost as a loss.
CA2-7 (Expense Recognition Principle) Daniel Barenboim sells and erects shell houses, that is, frame
structures that are completely finished on the outside but are unfinished on the inside except for flooring,
partition studding, and ceiling joists. Shell houses are sold chiefly to customers who are handy with tools
and who have time to do the interior wiring, plumbing, wall completion and finishing, and other work
necessary to make the shell houses livable dwellings.
Barenboim buys shell houses from a manufacturer in unassembled packages consisting of all lum-
ber, roofing, doors, windows, and similar materials necessary to complete a shell house. Upon com-
mencing operations in a new area, Barenboim buys or leases land as a site for his local warehouse,
field office, and display houses. Sample display houses are erected at a total cost of $30,000 to $44,000
including the cost of the unassembled packages. The chief element of cost of the display houses is the
unassembled packages, inasmuch as erection is a short, low-cost operation. Old sample models are
torn down or altered into new models every 3 to 7 years. Sample display houses have little salvage
value because dismantling and moving costs amount to nearly as much as the cost of an unassembled
package.
www.downloadslide.com
60 Chapter 2 Conceptual Framework for Financial Reporting
Instructions
(a) A choice must be made between (1) expensing the costs of sample display houses in the
periods in which the expenditure is made and (2) spreading the costs over more than one
period. Discuss the advantages of each method.
(b) Would it be preferable to amortize the cost of display houses on the basis of (1) the pas-
sage of time or (2) the number of shell houses sold? Explain.
CA2-8 (Qualitative Characteristics) Recently, your Uncle Carlos Beltran, who knows that you
always have your eye out for a profitable investment, has discussed the possibility of your pur-
chasing some corporate bonds. He suggests that you may wish to get in on the “ground floor” of
this deal. The bonds being issued by Neville Corp. are 10-year debentures which promise a 40%
rate of return. Neville manufactures novelty/party items.
You have told Neville that, unless you can take a look at its financial statements, you
would not feel comfortable about such an investment. Believing that this is the chance of a
lifetime, Uncle Carlos has procured a copy of Neville’s most recent, unaudited financial state-
ments which are a year old. These statements were prepared by Mrs. Andy Neville. You peruse
these statements, and they are quite impressive. The statement of financial position showed a
debt to equity ratio of 0.10 and, for the year shown, the company reported net income of
€2,424,240.
The financial statements are not shown in comparison with amounts from other years. In ad-
dition, no significant note disclosures about inventory valuation, depreciation methods, loan
agreements, etc. are available.
Instructions
Write a letter to Uncle Carlos explaining why it would be unwise to base an investment decision
on the financial statements that he has provided to you. Be sure to explain why these financial
statements are neither relevant nor a faithful representation.
CA2-9 (Expense Recognition Principle) Anderson Nuclear Power Plant will be “mothballed” at
the end of its useful life (approximately 20 years) at great expense. Accountants Ana Alicia and Ed
Bradley argue whether it is better to allocate the expense of mothballing over the next 20 years or
ignore it until mothballing occurs.
Instructions
Answer the following questions.
(a) What stakeholders should be considered?
(b) What ethical issue, if any, underlies the dispute?
(c) What alternatives should be considered?
(d) Assess the consequences of the alternatives.
(e) What decision would you recommend?
CA2-10 (Cost Constraint) A Special Committee on Financial Reporting proposed the following
constraints related to financial reporting.
1. Business reporting should exclude information outside of management’s expertise or for
which management is not the best source, such as information about competitors.
2. Management should not be required to report information that would significantly harm
the company’s competitive position.
3. Management should not be required to provide forecasted financial statements. Rather,
management should provide information that helps users forecast for themselves the com-
pany’s financial future.
4. Other than for financial statements, management need report only the information it knows.
That is, management should be under no obligation to gather information it does not have,
or does not need, to manage the business.
5. Companies should present certain elements of business reporting only if users and manage-
ment agree they should be reported—a concept of flexible reporting.
6. Companies should not have to report forward-looking information unless there are effec-
tive deterrents to unwarranted litigation that discourages companies from doing so.
Instructions
For each item, briefly discuss how the proposed constraint addresses concerns about the costs and
benefits of financial reporting.
www.downloadslide.com
Using Your Judgment 61
date of the price adjustment. Possible changes in these estimates could result in revisions to the sales in
future periods.
Revenue from contracts involving solutions achieved through modification of complex telecommuni-
cations equipment is recognized on the percentage of completion basis when the outcome of the contract
can be estimated reliably. Recognized revenues and profits are subject to revisions during the project in the
event that the assumptions regarding the overall project outcome are revised. Current sales and profit
estimates for projects may materially change due to the early stage of a longterm project, new technology,
changes in the project scope, changes in costs, changes in timing, changes in customers’ plans, realization
of penalties, and other corresponding factors.
Instructions
(a) Briefly discuss how Nokia’s revenue recognition policies are consistent with the revenue recogni-
tion principle. Evaluate both:
1. Sales.
2. Revenue from contracts.
(b) Briefly discuss how estimates inherent in Nokia’s revenue recognition policies can result in reported
revenue numbers that are not relevant and faithful representations.
(c) Assume that Nokia’s competitors use similar revenue recognition policies for their sales. What are
some of the judgments inherent in applying those policies that could raise concerns with respect to
the qualitative characteristic of comparability?
Professional Research
Your aunt recently received the annual report for a company in which she has invested. The report notes
that the statements have been prepared in accordance with IFRS. She has also heard that certain terms have
special meanings in accounting relative to everyday use. She would like you to explain the meaning of
terms she has come across related to accounting.
www.downloadslide.com
Using Your Judgment 63
Instructions
Access the Conceptual Framework at the IASB website (http://eifrs.iasb.org/ ) (you may register for free
eIFRS access at this site). When you have accessed the documents, you can use the search tool in your
Internet browser to prepare responses to the following items. (Provide paragraph citations.)
(a) How is “materiality” defined in the Conceptual Framework?
(b) Briefly discuss the role of completeness as it relates to faithful representation.
(c) Your aunt observes that under IFRS, the financial statements are prepared on the accrual basis.
According to the Conceptual Framework, what does the “accrual basis” mean?
Professional Simulation
In this simulation, you are asked to address questions regarding the Conceptual Framework. Prepare
responses to all parts.
© KWW_Professional _Simulation
A friend of yours is one of seven shareholders in a small start-up company. He is evaluating information
about the company that was discussed at a recent shareholders’ meeting. No mention of these facts was
made in the financial statements or the related notes. Given your accounting background, he thought you
would know the appropriate treatment of these items.
1. The company is concerned that one of its patents will be worthless in the event of liquidation. As a
result, this intangible asset was written off through the following entry.
2. The company is being sued for $150,000 by a customer claiming damages caused by a defective
product. The attorney for the company is confident that the company will have no liability for damages.
To be safe, the company made the following entry.
3. The company president used her expense account to purchase a new Hummer solely for her personal
use. The following entry was made.
For each situation, prepare a brief explanation for the appropriate accounting and related disclosure
required for each of the items.
Your friend had an extensive discussion with other shareholders on the subject of materiality. He argues
for a strict quantitative definition of materiality, while the other shareholders believe that both quantitative
and qualitative indicators should be considered in evaluating whether an item is material. Access the
Conceptual Framework at the IASB website (http://eifrs.iasb.org/ ). When you have accessed the documents,
use the search tool in your Internet browser to determine how the Conceptual Framework defines and
operationalizes materiality. (Provide paragraph citations.)