Unidad 2

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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.
Situation 1: “Taking a Long Shot . . . ”

To supplement donations collected from its general community solicitation, Tri-Cities United Charities
holds an Annual Lottery Sweepstakes. In this year’s sweepstakes, United Charities is offering a grand
prize of $1,000,000 to a single winning ticket holder. A total of 10,000 tickets have been printed, and
United Charities plans to sell all the tickets at a price of $150 each.
Since its inception, the Sweepstakes has attracted area-wide interest, and United Charities has
always been able to meet its sales target. However, in the unlikely event that it might fail to sell a suffi-
cient number of tickets to cover the grand prize, United Charities has reserved the right to cancel the
Sweepstakes and to refund the price of the tickets to holders.
In recent years, a fairly active secondary market for tickets has developed. This year, buying–selling
prices have varied between $75 and $95 before stabilizing at about $90.
When the tickets first went on sale this year, multimillionaire Phil N. Tropic, well-known in Tri-
Cities civic circles as a generous but sometimes eccentric donor, bought one of the tickets from United
Charities, paying $150 cash.
How would you answer the following questions?
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.
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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.
How would you answer the following questions?

1. Should Hard Rock recognize a liability for site restoration in conjunction with the opening of the
Lonesome Doe Mine? If so, what is the amount of that liability?
2. After Hard Rock has operated the Lonesome Doe Mine for 5 years, new technology is introduced that
reduces Hard Rock’s estimated future restoration costs to $7 million, $3 million of which relates to
restoring the topsoil. How should Hard Rock account for this change in its estimated future liability?
The answer to the questions on the two situations depends on how assets and liabilities are defined and how
they should be valued. Hopefully, this chapter will provide you with a framework to resolve questions like these.
Source: Adapted from Todd Johnson and Kim Petrone, The FASB Cases on Recognition and Measurement, Second
Edition (New York: John Wiley and Sons, Inc., 1996).
As our opening story indicates, users of financial statements can face

PREVIEW OF CHAPTER 2 difficult questions about the recognition and measurement of financial
items. To help develop the type of financial information that can be
used to answer these questions, financial accounting and reporting relies on a conceptual framework. In this
chapter, we discuss the basic concepts underlying the conceptual framework, as follows.
Conceptual Framework
Third Level: Recognition,

Conceptual First Level: Second Level:
Measurement, and
Framework Basic Objective Fundamental Concepts
Disclosure Concepts
• Need • Qualitative characteristics • Basic assumptions
• Development • Basic elements • Basic principles
• Overview • Cost constraint
• Summary of the structure
27
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
Need for a Conceptual Framework

Why do we need a conceptual framework? First, to be useful, rule-making should build
on and relate to an established body of concepts. A soundly developed conceptual frame-
work thus enables the IASB to issue more useful and consistent pronouncements over
time, and a coherent set of standards should result. Indeed, without the guidance pro-
vided by a soundly developed framework, standard-setting ends up being based on indi-
vidual concepts developed by each member of the standard-setting body. The following
observation by a former standard-setter highlights the problem.
“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
In other words, standard-setting that is based on personal conceptual frameworks

will lead to different conclusions about identical or similar issues than it did previously.
As a result, standards will not be consistent with one another, and past decisions may
not be indicative of future ones. Furthermore, the framework should increase financial
statement users’ understanding of and confidence in financial reporting. It should en-
hance comparability among companies’ financial statements.
Second, as a result of a soundly developed conceptual framework, the profession
should be able to more quickly solve new and emerging practical problems by referring
to an existing framework of basic theory. For example, assume that Aphrodite Gold Ltd.
(AUS) sold two issues of bonds. It can redeem them either with $2,000 in cash or with
5 ounces of gold, whichever is worth more at maturity. Both bond issues have a stated inter-
est rate of 8.5 percent. At what amounts should Aphrodite or the buyers of the bonds record
them? What is the amount of the premium or discount on the bonds? And how should
Aphrodite amortize this amount, if the bond redemption payments are to be made in gold
(the future value of which is unknown at the date of issuance)? Consider that Aphrodite
cannot know, at the date of issuance, the value of future gold bond redemption payments.
It is difficult, if not impossible, for the IASB to prescribe the proper accounting
treatment quickly for situations like this or like those represented in our opening story.
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.
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.
What do the numbers mean? WHAT’S YOUR PRINCIPLE?
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.
Development of a Conceptual Framework

The IASB issued “Conceptual Framework for Financial Reporting 2010” (the Con-
2 LEARNING OBJECTIVE
ceptual Framework) in 2010. The Conceptual Framework is a work in progress in
Describe efforts to construct a
that the IASB has not yet completed updating the previous version of it. Presently, conceptual framework.
the Conceptual Framework comprises an introduction and four chapters as follows.
• Chapter 1: The Objective of General Purpose Financial Reporting

• Chapter 2: The Reporting Entity (not yet issued)
• Chapter 3: Qualitative Characteristics of Useful Financial Information
• Chapter 4: The Framework (this material was developed prior to the creation of the
IASB but is considered part of the Conceptual Framework until changed or up-
dated), comprised of the following:
1. Underlying assumption—the going concern assumption;
2. The elements of financial statements;
3. Recognition of the elements of financial statements;
4. Measurement of the elements of financial statements; and
5. Concepts of capital and capital maintenance.
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.
Overview of the Conceptual Framework

Illustration 2-1 provides an overview of the IASB’s Conceptual Framework for Financial
Reporting, also referred to simply as the Conceptual Framework.
ILLUSTRATION 2-1
Recognition, Measurement, and Disclosure Concepts Third level:
The "how"—
implementation
ASSUMPTIONS PRINCIPLES CONSTRAINT
QUALITATIVE
ELEMENTS
CHARACTERISTICS Second level: Bridge between
of
of levels 1 and 3
financial
accounting
statements
information
OBJECTIVE First level: The "why"—purpose

of of accounting
financial
reporting
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.
FIRST LEVEL: BASIC OBJECTIVE

The objective of financial reporting is the foundation of the Conceptual Frame-
LEARNING OBJECTIVE 3 work. Other aspects of the Conceptual Framework—qualitative characteristics,
Understand the objective of financial
elements of financial statements, recognition, measurement, and disclosure—
reporting.
flow logically from the objective. Those aspects of the Conceptual Framework
help to ensure that financial reporting achieves its objective.
Second Level: Fundamental Concepts 31
The objective of general-purpose financial reporting is to provide financial informa-

tion about the reporting entity that is useful to present and potential equity investors,
lenders, and other creditors in making decisions about providing resources to the
entity. [3] Those decisions involve buying, selling, or holding equity and debt instru-
ments, and providing or settling loans and other forms of credit. Information that is
decision-useful to capital providers may also be helpful to other users of financial re-
porting who are not capital providers.
As indicated in Chapter 1, to provide information to decision-makers, companies
prepare general-purpose financial statements. General-purpose financial reporting
helps users who lack the ability to demand all the financial information they need from
an entity and therefore must rely, at least partly, on the information provided in financial
reports. However, an implicit assumption is that users need reasonable knowledge of
business and financial accounting matters to understand the information contained in
financial statements. This point is important. It means that financial statement preparers
assume a level of competence on the part of users. This assumption impacts the way and
the extent to which companies report information.
SECOND LEVEL: FUNDAMENTAL CONCEPTS

The objective (first level) focuses on the purpose of financial reporting. Later,
we will discuss the ways in which this purpose is implemented (third level).
Identify the qualitative characteristics
What, then, is the purpose of the second level? The second level provides
of accounting information.
conceptual building blocks that explain the qualitative characteristics of
accounting information and define the elements of financial statements. [4]
That is, the second level forms a bridge between the why of accounting (the objec-
tive) and the how of accounting (recognition, measurement, and financial statement
presentation).
Qualitative Characteristics of Accounting Information

Should companies like Marks and Spencer plc (GBR) or Samsung Electronics Ltd.
(KOR) provide information in their financial statements on how much it costs them to
acquire their assets (historical cost basis) or how much the assets are currently worth (fair
value basis)? Should PepsiCo (USA) combine and show as one company the four main
segments of its business, or should it report PepsiCo Beverages, Frito Lay, Quaker Foods,
and PepsiCo International as four separate segments?
How does a company choose an acceptable accounting method, the amount and
types of information to disclose, and the format in which to present it? The answer: By
determining which alternative provides the most useful information for decision-
making purposes (decision-usefulness). The IASB identified the qualitative character-
istics of accounting information that distinguish better (more useful) information from
inferior (less useful) information for decision-making purposes. In addition, the IASB
identified a cost constraint as part of the Conceptual Framework (discussed later in the
chapter). As Illustration 2-2 (on page 32) shows, the characteristics may be viewed as a
hierarchy.
As indicated by Illustration 2-2, qualitative characteristics are either fundamental or
enhancing characteristics, depending on how they affect the decision-usefulness of
information. Regardless of classification, each qualitative characteristic contributes to
the decision-usefulness of financial reporting information. However, providing useful
financial information is limited by a pervasive constraint on financial reporting—cost
should not exceed the benefits of a reporting practice.
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
Fundamental RELEVANCE FAITHFUL REPRESENTATION

qualities
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
Materiality
quality value value
To be relevant, accounting information must be capable of making a difference in a

decision. Information with no bearing on a decision is irrelevant. Financial information is
capable of making a difference when it has predictive value, confirmatory value, or both.
Financial information has predictive value if it has value as an input to predictive
processes used by investors to form their own expectations about the future. For exam-
ple, if potential investors are interested in purchasing ordinary shares in Nippon (JPN),
they may analyze its current resources and claims to those resources, its dividend pay-
ments, and its past income performance to predict the amount, timing, and uncertainty
of Nippon’s future cash flows.
Relevant information also helps users confirm or correct prior expectations; it has
confirmatory value. For example, when Nippon issues its year-end financial statements,
it confirms or changes past (or present) expectations based on previous evaluations. It
follows that predictive value and confirmatory value are interrelated. For example, in-
formation about the current level and structure of Nippon’s assets and liabilities helps
users predict its ability to take advantage of opportunities and to react to adverse situa-
tions. The same information helps to confirm or correct users’ past predictions about
that ability.
Materiality is a company-specific aspect of relevance. Information is material if

omitting it or misstating it could influence decisions that users make on the basis of the
reported financial information. An individual company determines whether informa-
tion is material because both the nature and/or magnitude of the item(s) to which the
information relates must be considered in the context of an individual company’s finan-
cial report. Information is immaterial, and therefore irrelevant, if it would have no
impact on a decision-maker. In short, it must make a difference or a company need not
disclose it.
Assessing materiality is one of the more challenging aspects of accounting because
it requires evaluating both the relative size and importance of an item. However, it is
difficult to provide firm guidelines in judging when a given item is or is not material.
Materiality varies both with relative amount and with relative importance. For example,
the two sets of numbers in Illustration 2-3 indicate relative size.
Company A Company B ILLUSTRATION 2-3

Materiality Comparison
Sales $10,000,000 $100,000
Costs and expenses 9,000,000 90,000
Income from operations $ 1,000,000 $ 10,000
Unusual gain $ 20,000 $ 5,000
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.
Fundamental Quality—Faithful Representation

Faithful representation is the second fundamental quality that makes accounting infor-
mation useful for decision-making. Faithful representation and related ingredients of
this fundamental quality are shown below.
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.
What do the numbers mean? UNFAITHFUL—FOR 20 YEARS

U
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.
Fundamental RELEVANCE FAITHFUL REPRESENTATION

qualities
Ingredients of Free
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.
Another type of comparability, consistency, is present when a company applies the

same accounting treatment to similar events, from period to period. Through such
application, the company shows consistent use of accounting standards. The idea of con-
sistency does not mean, however, that companies cannot switch from one accounting
method to another. A company can change methods, but it must first demonstrate that
the newly adopted method is preferable to the old. If approved, the company must then
disclose the nature and effect of the accounting change, as well as the justification for it,
in the financial statements for the period in which it made the change.4 When a change in
accounting principles occurs, the auditor generally refers to it in an explanatory para-
graph of the audit report. This paragraph identifies the nature of the change and refers
the reader to the note in the financial statements that discusses the change in detail.
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).
Timeliness. Timeliness means having information available to decision-makers before

it loses its capacity to influence decisions. Having relevant information available sooner
can enhance its capacity to influence decisions, and a lack of timeliness can rob informa-
tion of its usefulness. For example, if Lenovo Group (CHN) waited to report its interim
results until nine months after the period, the information would be much less useful
for decision-making purposes.
Understandability. Decision-makers vary widely in the types of decisions they make,

how they make decisions, the information they already possess or can obtain from other
sources, and their ability to process the information. For information to be useful, there
must be a connection (linkage) between these users and the decisions they make. This
link, understandability, is the quality of information that lets reasonably informed
users see its significance. Understandability is enhanced when information is classified,
characterized, and presented clearly and concisely.
For example, assume that Tomkins plc (GBR) issues a three-months’ report that
shows interim earnings have declined significantly. This interim report provides rele-
vant and faithfully represented information for decision-making purposes. Some users,
upon reading the report, decide to sell their shares. Other users, however, do not under-
stand the report’s content and significance. They are surprised when Tomkins declares
a smaller year-end dividend and the share price declines. Thus, although Tomkins pre-
sented highly relevant information that was a faithful representation, it was useless to
those who did not understand it.
Users of financial reports are assumed to have a reasonable knowledge of business
and economic activities. In making decisions, users also should review and analyze the
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.
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
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.
ELEMENTS OF FINANCIAL STATEMENTS

The elements directly related to the measurement of financial position are assets, liabilities,
and equity. These are defined as follows.
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.
The elements of income and expenses are defined as follows.
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.
THIRD LEVEL: RECOGNITION, MEASUREMENT,

AND DISCLOSURE CONCEPTS
The third level of the Conceptual Framework consists of concepts that imple-
LEARNING OBJECTIVE 6 ment the basic objectives of level one. These concepts explain how companies
Describe the basic assumptions
should recognize, measure, and report financial elements and events. Here, we
of accounting.
identify the concepts as basic assumptions, principles, and a cost constraint. Not
everyone uses this classification system, so focus your attention more on under-
standing the concepts than on how we classify and organize them. These concepts
serve as guidelines in responding to controversial financial reporting issues.
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.
Economic Entity Assumption

The economic entity assumption means that economic activity can be identified with
a particular unit of accountability. In other words, a company keeps its activity sepa-
rate and distinct from its owners and any other business unit.6 At the most basic level,
the economic entity assumption dictates that Sappi Limited (ZAF) record the company’s
financial activities separate from those of its owners and managers. Equally important,
financial statement users need to be able to distinguish the activities and elements of
different companies, such as Volvo (SWE), Ford (USA), and Volkswagen AG (DEU). If
users could not distinguish the activities of different companies, how would they know
which company financially outperformed the other?
The entity concept does not apply solely to the segregation of activities among
competing companies, such as Toyota (JPN) and Hyundai (KOR). An individual,
department, division, or an entire industry could be considered a separate entity if we
choose to define it in this manner. Thus, the entity concept does not necessarily refer
to a legal entity. A parent and its subsidiaries are separate legal entities, but merging
their activities for accounting and reporting purposes does not violate the economic
entity assumption.7
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).
Third Level: Recognition, Measurement, and Disclosure Concepts 39
Going Concern Assumption

Most accounting methods rely on the going concern assumption—that the company
will have a long life. Despite numerous business failures, most companies have a fairly
high continuance rate. As a rule, we expect companies to last long enough to fulfill their
objectives and commitments.
This assumption has significant implications. The historical cost principle would be
of limited usefulness if we assume eventual liquidation. Under a liquidation approach,
for example, a company would better state asset values at fair value than at acquisition
cost. Depreciation and amortization policies are justifiable and appropriate only if we
assume some permanence to the company. If a company adopts the liquidation approach,
the current/non-current classification of assets and liabilities loses much of its significance.
Labeling anything a long-lived or non-current asset would be difficult to justify. Indeed,
listing liabilities on the basis of priority in liquidation would be more reasonable.
The going concern assumption applies in most business situations. Only where
liquidation appears imminent is the assumption inapplicable. In these cases a total
revaluation of assets and liabilities can provide information that closely approximates
the company’s fair value. You will learn more about accounting problems related to a
company in liquidation in advanced accounting courses.
Monetary Unit Assumption

The monetary unit assumption means that money is the common denominator of eco-
nomic activity and provides an appropriate basis for accounting measurement and anal-
ysis. That is, the monetary unit is the most effective means of expressing to interested
parties changes in capital and exchanges of goods and services. Application of this
assumption depends on the even more basic assumption that quantitative data are use-
ful in communicating economic information and in making rational economic decisions.
Furthermore, accounting generally ignores price-level changes (inflation and defla-
tion) and assumes that the unit of measure—euros, dollars, or yen—remains reasonably
stable. We therefore use the monetary unit assumption to justify adding 1985 pounds to
2015 pounds without any adjustment. It is expected that the pound or other currency,
unadjusted for inflation or deflation, will continue to be used to measure items recognized
in financial statements. Only if circumstances change dramatically (such as high inflation
rates similar to that in some South American countries) will “inflation accounting” be
considered.8
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]
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.
Accrual Basis of Accounting

Companies prepare financial statements using the accrual basis of accounting. Accrual-
basis accounting means that transactions that change a company’s financial statements
are recorded in the periods in which the events occur. [8] For example, using the accrual
basis means that companies recognize revenues when it is probable that future eco-
nomic benefits will flow to the company and reliable measurement is possible (the rev-
enue recognition principle). This is in contrast to recognition based on receipt of cash.
Likewise, under the accrual basis, companies recognize expenses when incurred (the
expense recognition principle) rather than when paid.
An alternative to the accrual basis is the cash basis. Under cash-basis accounting,
companies record revenue only when cash is received. They record expenses only when
cash is paid. The cash basis of accounting is prohibited under IFRS. Why? Because it
does not record revenue according to the revenue recognition principle (discussed in the
next section). Similarly, it does not record expenses when incurred, which violates the
expense recognition principle (discussed in the next section).
Financial statements prepared on the accrual basis inform users not only of past
transactions involving the payment and receipt of cash but also of obligations to pay
cash in the future and of resources that represent cash to be received in the future. Hence,
they provide the type of information about past transactions and other events that is
most useful in making economic decisions.
Basic Principles of Accounting

We generally use four basic principles of accounting to record and report trans-
LEARNING OBJECTIVE 7 actions: (1) measurement, (2) revenue recognition, (3) expense recognition, and
Explain the application of the basic
(4) full disclosure. We look at each in turn.
principles of accounting.
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
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
As Illustration 2-4 indicates, Level 1 is the least subjective because it is based on

quoted prices, like a closing share price in the Financial Times. Level 2 is more subjective
and would rely on evaluating similar assets or liabilities in active markets. At the most
subjective level, Level 3, much judgment is needed, based on the best information avail-
able, to arrive at a relevant and representationally faithful fair value measurement.9
It is easy to arrive at fair values when markets are liquid with many traders, but fair
value answers are not readily available in other situations. For example, how do you
value the mortgage assets of a subprime lender such as New Century (USA) given that
the market for these securities has essentially disappeared? A great deal of expertise and
sound judgment will be needed to arrive at appropriate answers. IFRS also provides
guidance on estimating fair values when market-related data is not available. In gen-
eral, these valuation issues relate to Level 3 fair value measurements. These measure-
ments may be developed using expected cash flow and present value techniques, as
described in Chapter 6.
As indicated above, we presently have a “mixed-attribute” system that permits the
use of historical cost and fair value. Although the historical cost principle continues to
be an important basis for valuation, recording and reporting of fair value information is
increasing. The recent measurement and disclosure guidance should increase consis-
tency and comparability when fair value measurements are used in the financial state-
ments and related notes.
Revenue Recognition Principle

When a company agrees to perform a service or sell a product to a customer, it has a
performance obligation. When the company satisfies this performance obligation, it
recognizes revenue. The revenue recognition principle therefore requires that compa-
nies recognize revenue in the accounting period in which the performance obligation is
satisfied.
To illustrate, assume that Klinke Cleaners cleans clothing on June 30 but customers
do not claim and pay for their clothes until the first week of July. Klinke should record
revenue in June when it performed the service (satisfied the performance obligation)
rather than in July when it received the cash. At June 30, Klinke would report a receiv-
able on its statement of financial position and revenue in its income statement for the
service performed. To illustrate the revenue recognition principle in more detail, as-
sume that Airbus (DEU) signs a contract to sell airplanes to British Airways (GBR) for
€100 million. To determine when to recognize revenue, Airbus uses the five steps shown
in Illustration 2-5.10
Many revenue transactions pose few problems because the transaction is initiated
and completed at the same time. However, when to recognize revenue in other certain
situations is often more difficult. The risk of errors and misstatements is significant.
Chapter 18 discusses revenue recognition issues in more detail.
Expense Recognition Principle

Expenses are defined as outflows or other “using up” of assets or incurring of liabilities
(or a combination of both) during a period as a result of delivering or producing goods
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.
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.
Airbus has only one performance obligation—to

Step 2: Identify the separate
deliver airplanes to British Airways. If Airbus also
performance obligations in
agreed to maintain the planes, a separate
the contract.
performance obligation is recorded for this promise.
Transaction price is the amount of consideration

that a company expects to receive from a customer
Step 3: Determine the transaction
in exchange for transferring a good or service. In
price.
this case, the transaction price is
straightforward—it is €100 million.
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.
Airbus recognizes revenue of €100 million for the

Step 5: Recognize revenue when
sale of the airplanes to British Airways when it
each performance obligation
satisfies its performance obligation—the delivery
is satisfied.
of the airplanes to British Airways.
and/or rendering services. It follows then that recognition of expenses is related to

net changes in assets and earning revenues. In practice, the approach for recognizing
expenses is, “Let the expense follow the revenues.” This approach is the expense recog-
nition principle.
To illustrate, companies recognize expenses not when they pay wages or make a
product, but when the work (service) or the product actually contributes to revenue.
Thus, companies tie expense recognition to revenue recognition. That is, by matching
efforts (expenses) with accomplishment (revenues), the expense recognition principle
is implemented in accordance with the definition of expense (outflows or other using
up of assets or incurring of liabilities).11
Some costs, however, are difficult to associate with revenue. As a result, some
other approach must be developed. Often, companies use a “rational and systematic”
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.
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.
Full Disclosure Principle

In deciding what information to report, companies follow the general practice of
providing information that is of sufficient importance to influence the judgment and
decisions of an informed user. Often referred to as the full disclosure principle, it rec-
ognizes that the nature and amount of information included in financial reports reflects
a series of judgmental trade-offs. These trade-offs strive for (1) sufficient detail to dis-
close matters that make a difference to users, yet (2) sufficient condensation to make the
information understandable, keeping in mind costs of preparing and using it.
Users find information about financial position, income, cash flows, and invest-
ments in one of three places: (1) within the main body of financial statements, (2) in the
notes to those statements, or (3) as supplementary information.
As discussed in Chapter 1, the financial statements are the statement of financial
position, income statement (or statement of comprehensive income), statement of cash
flows, and statement of changes in equity. They are a structured means of communicat-
ing financial information. An item that meets the definition of an element should be
recognized if (a) it is probable that any future economic benefit associated with the item
will flow to or from the entity; and (b) the item has a cost or value that can be measured
with reliability. [11]
Disclosure is not a substitute for proper accounting. As a noted accountant indi-
cated, “Good disclosure does not cure bad accounting any more than an adjective or
adverb can be used without, or in place of, a noun or verb.” Thus, for example, cash-
basis accounting for cost of goods sold is misleading, even if a company discloses
accrual-basis amounts in the notes to the financial statements.
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.
to competitors, and of analysis and interpretation. Benefits to preparers may include

greater management control and access to capital at a lower cost. Users may receive
better information for allocation of resources, tax assessment, and rate regulation. As
noted earlier, benefits are generally more difficult to quantify than are costs.
The implementation of the provisions of the Sarbanes-Oxley Act in the United States
illustrates the challenges in assessing costs and benefits of standards. One study esti-
mated the increased costs of complying with the new internal-control standards related
to the financial reporting process to be an average of $7.8 million per company. How-
ever, the study concluded that “. . . quantifying the benefits of improved more reliable
financial reporting is not fully possible.”14
Despite the difficulty in assessing the costs and benefits of its rules, the IASB at-
tempts to determine that each proposed pronouncement will fill a significant need and
that the costs imposed to meet the standard are justified in relation to overall benefits
of the resulting information. In addition, they seek input on costs and benefits as part of
their due process.
What do the numbers mean? LET’S BE PRUDENT

L
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.
Summary of the Structure

Illustration 2-7 presents the Conceptual Framework for Financial Reporting discussed
in this chapter. It is similar to Illustration 2-1 (on page 30) except that it provides
additional information for each level. We cannot overemphasize the usefulness of this
conceptual framework in helping to understand many of the problem areas that we
examine in later chapters.
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).
Global Accounting Insights 47
ILLUSTRATION 2-7
Recognition, Measurement, and Disclosure Concepts
ASSUMPTIONS PRINCIPLES CONSTRAINT

1. Economic entity 1. Measurement 1. Cost
2. Going concern 2. Revenue recognition
3. Monetary unit 3. Expense recognition Third level:
4. Periodicity 4. Full disclosure The "how"—
5. Accrual
implementation
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
GLOBAL ACCOUNTING INSIGHTS

THE CONCEPTUAL FRAMEWORK
The IASB and the FASB have been working together to de- develop a conceptual framework consisting of standards that
velop a common conceptual framework. This framework is are principles-based and internally consistent, thereby lead-
based on the existing conceptual frameworks underlying ing to the most useful financial reporting.
U.S. GAAP and IFRS. The objective of this joint project is to
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).

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Situation 1: “Taking a Long Shot . . . ”

How would you answer the following questions?

How would you answer the following questions?

As our opening story indicates, users of financial statements can face

Third Level: Recognition,

Need for a Conceptual Framework

In other words, standard-setting that is based on personal conceptual frameworks

What do the numbers mean? WHAT’S YOUR PRINCIPLE?

Development of a Conceptual Framework

• Chapter 1: The Objective of General Purpose Financial Reporting

Overview of the Conceptual Framework

ASSUMPTIONS PRINCIPLES CONSTRAINT

OBJECTIVE First level: The "why"—purpose

FIRST LEVEL: BASIC OBJECTIVE

The objective of general-purpose financial reporting is to provide financial informa-

SECOND LEVEL: FUNDAMENTAL CONCEPTS

Qualitative Characteristics of Accounting Information

Fundamental RELEVANCE FAITHFUL REPRESENTATION

To be relevant, accounting information must be capable of making a difference in a

Materiality is a company-specific aspect of relevance. Information is material if

Company A Company B ILLUSTRATION 2-3

Unusual gain $ 20,000 $ 5,000

Fundamental Quality—Faithful Representation

What do the numbers mean? UNFAITHFUL—FOR 20 YEARS

Fundamental RELEVANCE FAITHFUL REPRESENTATION

Another type of comparability, consistency, is present when a company applies the

Timeliness. Timeliness means having information available to decision-makers before

Understandability. Decision-makers vary widely in the types of decisions they make,

ELEMENTS OF FINANCIAL STATEMENTS

The elements of income and expenses are defined as follows.

THIRD LEVEL: RECOGNITION, MEASUREMENT,

Economic Entity Assumption

Going Concern Assumption

Monetary Unit Assumption

Accrual Basis of Accounting

Basic Principles of Accounting

As Illustration 2-4 indicates, Level 1 is the least subjective because it is based on

Revenue Recognition Principle

Expense Recognition Principle

Airbus has only one performance obligation—to

Transaction price is the amount of consideration

Airbus recognizes revenue of €100 million for the

and/or rendering services. It follows then that recognition of expenses is related to

Full Disclosure Principle

to competitors, and of analysis and interpretation. Benefits to preparers may include

What do the numbers mean? LET’S BE PRUDENT

Summary of the Structure

ASSUMPTIONS PRINCIPLES CONSTRAINT

GLOBAL ACCOUNTING INSIGHTS

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