CONCEPTUAL FRAMEWORK UNDERLYING FINANCIAL ACCOUNTING FINANCIAL REPORTING BY

CONCEPTUAL FRAMEWORK UNDERLYING FINANCIAL ACCOUNTING & FINANCIAL REPORTING BY HERICK ONDIGO SCHOOL OF BUSINESS, UON 2012

Presentation Objectives At the end of the presentation, you should: 1. Describe the usefulness of a conceptual framework. 2. 3. Understand the objectives of financial reporting. Identify the qualitative characteristics of accounting information. Define the basic elements of financial statements. Describe the basic assumptions of accounting. Explain the application of the basic principles of accounting. Describe the impact that constraints have on reporting accounting information. 4. 5. 6. 7.

Conceptual Framework Presentation overview Conceptual Framework Definition Usefulness Rationale/Need First Level: Objectives Basic Decision usefulness Information about economic resources Second Level: Fundamental Concepts Qualitative characteristics Basic elements Third Level: Recognition and Measurement Basic assumptions Basic principles Constraints

Definition • A conceptual framework may be described as "a unified and generally accepted set of theories and principles that provide a foundation from which specific practices and methods can be deduced". • In other words it is a fundamental set of principles, somewhat like a "constitution", or a coherent system of thought about a discipline. • In the case of accounting, it relates to that basic set of unifying principles, if any, that underlies accounting practice. 4

Definition cont… • Such a set of concepts would be influential in determining how the discipline deals with issues such as: v How transactions should be accounted for v. Which events should be accounted for v. What set of user-requirements financial accounting should aim to satisfy v. How financial information should be communicated to users 5

Usefulness of a Conceptual Framework • The framework is like a constitution; it is a “coherent system of interrelated objectives” that prescribe the nature, functions & limits of financial Accounting & Financial Reporting. • Creates standards for the accounting profession • Increases financial statement users’ understanding of and confidence in financial reporting • Enhances comparability of financial statements of different companies 6

Need/Rationale of the Conceptual Framework • The framework is the foundation for building a set of accounting standards and rules • The framework is a reference of basic accounting theory for solving new and emerging practical problems of reporting 7

First level –Objectives To provide information: • Useful to those making investment and credit decisions • Useful in making resource allocation decisions • Useful in assessing management stewardship • Financial statements provide information about: • An entity’s economic resources, obligations, and equity/net assets • Changes in an entity’s economic resources, obligations and equity/net assets • The economic performance of the entity 8

First level –Objectives Financial reporting should therefore provide information that: (a) is useful to present and potential investors and creditors and other users in making rational investment, credit, and similar decisions. (b) helps present and potential investors and creditors and other users in assessing the amounts, timing, and uncertainty of prospective cash receipts. (c) portrays the economic resources of an enterprise, the claims to those resources, and the effects of transactions, events, and circumstances that change its resources and claims to those resources.

Second Level –Qualitative Characteristics The Qualitative Characteristics are: Characteristics of accounting information that distinguish better (more useful) information from inferior (less useful) information for decision-making purposes. ” These are: 1. Relevance 2. Reliability 3. Understandability 4. Comparability 10

Second Level –Qualitative Characteristics ü Information is relevant if it: - Makes a difference -Has predictive value -Is timely -Has feedback value ü Information is reliable if it: - is free from error or bias • Is verifiable; similar results achieved if use same measurement methods • Is a faithful representation of what actually happened • Reasonably free from bias; it is neutral • Complete- No intentional omissions to mislead • Substance over form- Accounted for in accordance with their substance and economic reality not merely their legal, contrived or paper form 11

Second Level –Qualitative Characteristics ü Tradeoffs of qualities: • Accountants often must make a tradeoff between relevance (timeliness of financial information) and reliability (verifiability) of financial information • Needs of the users must be considered in reaching a decision 12

Second Level –Qualitative Characteristics ü Information is understandable if it: • Allows informed users to see the significance of the information(Abilities of users considered) • Provides “enough” (Aggregation & classification) so that it is clear • A company may present highly relevant and reliable information, however it is useless to those who do not understand it. 13

Second Level –Qualitative Characteristics ü Information is comparable if it: Allows users to identify real similarities & differences for same & different companies (including disclosures) • Has been measured and reported in a similar manner (consistent) • Information is consistent if: Similar events have the same accounting treatment within the period & from period to period • There should be adequate disclosures to aid comparability 14

Second level- Basic Elements • Ten elements (or definitions) directly relates to the measurement of performance or financial status/position of a company • The conceptual framework defines the basic elements that can be traced to the Statement of Financial Position & Statement of Income • Helps users have a common understanding of financial statements 15

Second level- Basic Elements Statement of Financial Position Assets: probable future economic benefit that arise as a result of a past transaction and entity controls access to the benefit Liabilities: probable future sacrifice of economic benefits that arise as a result of a past transaction, and there is little or no discretion to avoid obligation Equity/Net Assets: residual interest i. e. net worth (assets – liabilities) 16

Conceptual Framework– Basic Elements Statement of Income Revenues: increases in economic resources, from an entity’s ordinary activities Expenses: decreases in economic resources, from an entity’s ordinary revenue-generating activities Gains: increases in equity (net assets) from incidental transactions Losses: decreases in equity from incidental transactions Net Income- Net increase/decrease in owners equity resulting from the operating activities Net income= Revenues+ Gains- Expenses-Losses 17

Second Level: Basic Elements Ten interrelated elements that relate to measuring the performance and financial status of a business enterprise. • “Moment in Time” • “Period of Time” Assets Investment by owners Liabilities Distribution to owners Equity Comprehensive income Revenue Expenses Gains Losses

Third level-Recognition and measurement Guidelines • The guidelines -concepts and constraints help explain which, when, and how financial elements and events should be recognized, measured, and presented • They act as guidelines for developing rational responses to controversial financial reporting issues 19

Third level-Recognition and measurement Guidelines 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. Economic entity Going concern Monetary unit Periodicity Historical cost Revenue recognition Matching Full disclosure Prudence/conservatism Cost-benefit Materiality Industry practice/uniqueness/perculiarity 20

Third Level –Assumptions Economic Entity Assumption (Also called Entity Concept) • The economic activity can be identified with a particular unit of accountability • The business activity is separate and distinct from its owners (and any other business unit) • An individual, departments or divisions of an entity, or an entire industry may be considered separate entities • Does not necessarily refer to a legal entity • For tax and legal purposes, considered a legal entity 21

Third Level –Assumptions Going Concern Assumption • Assumption that a business enterprise will continue to operate in the foreseeable future • There is an expectation of continuing long enough to meet their objectives and commitments • Management must look out at least 12 months from balance sheet date • If liquidation of the company is assumed to be likely, use liquidation accounting (at net realizable value) • Full disclosure is required of any material uncertainties of continuing as a going concern 22

Third Level –Assumptions Monetary Unit • Money is the common unit of measure of economic transactions • Use of a monetary unit is relevant, simple and understandable, universally available, and useful • The Monetary Unit is assumed to remain relatively stable in value (effects of inflation/deflation are ignored i. e. price-level change is ignored) • Monetary unit is relevant only as long as it is assumed that quantitative data are useful in communicating economic information 23

Third Level –Assumptions Periodicity Assumption • Economic activity of an entity can be divided into artificial time periods for reporting purposes • Most common: one month, one quarter, and one year • For shorter time periods, more difficult to determine proper net income (i. e. the more likely errors become due to more estimates) • Trade-off between relevance and reliability • With technology, investors want more on-line, real-time financial information to ensure relevant information 24

Third Level -Principles Historical Cost Principle • Three basic assumptions of historical cost 1. Represents a value at a point in time 2. Results from a reciprocal exchange (i. e. a two-way exchange) 3. Exchange includes an outside party • Initial recognition: for non-financial assets, record at all costs incurred to get the asset “ready” for sale or for use (e. g. includes transportation and installation costs) 25

Historical Cost Principle cont • Measurement – The most commonly used measurements are based on historical cost and fair value. • Issues: Historical cost provides a reliable benchmark for measuring historical trends. Fair value information may be more useful/relevant for decision making. Recently the accounting profession has taken the step of giving companies the option to use fair value as the basis for measurement of financial assets and financial liabilities. Reporting of fair value information is increasing.

Third Level -Principles • We use Estimated “fair value” for: 1. Non-monetary transactions (as no cash/monetary consideration exchanged) 2. Non-reciprocal transactions (e. g. donations) 3. Related party transactions – not acting at “arm’s length” (use exchange value or cost) 27

Third Level -Principles Revenue Recognition Principle • • • Revenue is recognized when: 1. Performance is achieved (earned) 2. Measurability is reasonably certain and 3. Collectability is reasonably assured (realized or realizable) Basic presumptions of Revenue Recognition 1. Results from a reciprocal exchange and 2. The exchange includes an outside party Revenue is realized when products (goods or services), merchandise or assets are exchanged for cash (or claim to cash) 28

Third Level -Principles Revenue Recognition Principle (continued) • Revenue is recognized when the earning process is substantially complete – normally when the risks and rewards of ownership have passed to the buyer • Exceptions: 1. Continuous Earning Process/During Production (Example: Long-term construction contract; revenue recognized as it is “earned” over life of contract) 2. Collectability Issues/Receipt of Cash When measurement of revenues is uncertain due to collectability issues or type of sale (Example: Installment sales contracts; revenue recognized only on receipt of cash) 29

Third Level -Principles Revenue Recognition Principle (continued) 3. End of Production: - where there is a ready market where unlimited quantity can be sold at a standard price, revenue can be recognized before sale. 4. Cost recovery: - for highly speculative projects the outcomes of which are highly unpredictable, the first amounts received can be considered a recovery of cost. 30

Third Level -Principles • Revenue Recognition - generally occurs (1) when realized or realizable and (2) when earned. • Exceptions: Timing of Revenue Recognition

Third Level -Principles Matching Principle • Expenses are matched with revenues that they produce • Where there is “a direct cause and effect relationship” between money spent to earn revenues and the revenues themselves (e. g. cost of goods sold), • If the expense benefits the current and future periods, it is deferred (as an asset e. g. prepaid rent) 32

Third Level -Principles Matching Principle (cont. . ) • The asset’s cost is then systematically and rationally matched to future revenues (i. e. cost allocated over all accounting periods during which asset is used, e. g. amortization/depreciation or simply apportionment). • Where no future economic benefit is expected from an expenditure a loss is recognized immediately. 33

Expense Recognition cont. . “Let the expense follow the revenues. ” Expense Recognition

Third Level -Principles Full Disclosure Principle • • • Anything that is relevant to users’ decisions should be included in financial statements Financial statements must report any information that could affect the judgment or decision of an informed user Disclosure may be made: 1. Within the main body of the financial statements 2. As notes to the financial statements 3. As supplementary information, including Management Discussion and Analysis (MDA) 35

Third Level -Principles • Full Disclosure – implies providing information that is of sufficient importance to influence the judgment and decisions of an informed user. • Provided through: Financial Statements Notes to the Financial Statements Supplementary information

Third Level -Principles Full Disclosure Principle (continued) • • • Disclosed information should: 1. Provide sufficient detail of the occurrence 2. Be sufficiently condensed enough to remain understandable Full disclosure is not a substitute for proper accounting practice Notes to financial statements are essential to understanding the enterprise’s performance and position 37

Third Level -Constraints Uncertainty/Prudence/Conservatism • Recognition becomes difficult (or impossible) when there is uncertainty • Information reported is less likely to be uncertain if: • Events reported are likely or probable, and • They are measurable • When in doubt, choose the solution that will be least likely to overstate assets and income. 38

Third Level -Constraints Materiality • Relates to an item’s impact on an entity’s overall financial operations • an item is material if its inclusion or omission would influence or change the judgment of a reasonable person. • An item must make a difference, otherwise, it does not , it needs not to be disclosed or accounted for in a conceptually required manner • Both quantitative and qualitative factors should be considered in determining relative significance • General rule of thumb: if the item is 5% of income from continuing operations, it is considered material • Determination of materiality requires professional 39 judgment and expertise

Third Level -Constraints • Cost- Benefit constraint • The financial reporting must be cost effective • The cost of providing the information must be weighed against the benefits that can be derived from using it. • The benefits must exceed the cost 40

constraints Industry Practice/uniqueness or peculiarity § the peculiar nature of some industries and business concerns sometimes requires departure from basic accounting theory’ § Treatment Must be consistent with primary sources of GAAP and conceptual framework § The profession is attempting to eliminate such differences through issuance of financial repotting standards (IFRS’s) 41

Third Level: Assumptions- Brief Exercise Identify which basic assumption of accounting is best described in each item below. (a) The economic activities of BCOM Corporation are divided into 12 -month periods for the purpose of issuing annual reports. (b) BCOM Company. does not adjust amounts in its financial statements for the effects of inflation. (c) BCOM Co. reports current and noncurrent classifications in its balance sheet. (d) The economic activities of BCOM and its subsidiaries are merged for accounting and reporting purposes. • Periodicity • Monetary • Unit • Going Concern • Economic • Entity

Third Level: Principles- Brief Exercise: Identify which basic principle of accounting is best described in each item below. • (a) BCOM Corporation reports revenue in its income statement when it is earned instead of when the cash is collected. • (b) BCOM co. recognizes depreciation expense for a machine over the 2 -year period during which that machine helps the company earn revenue. • (c) BCOM Co reports information about pending lawsuits in the notes to its financial statements. • (d) BCOM Co. reports land on its balance sheet at the amount paid to acquire it, even though the estimated fair market value is greater. • Revenue • Recognition • Expense Recognition • Full • Disclosure • Historical cost

Third Level: Constraints- Brief Exercise What accounting constraints are illustrated by the items below? (a) BCOM co. reports agricultural crops on its financial statements at market value. • Industry • Practice (b) BCOM Company does not accrue a contingent lawsuit gain of sh. 6, 500, 000. • Conservatism (c) BCOM Company does not disclose any information in the notes to the financial statements unless the value of the information to users exceeds the expense of gathering it. • Cost. Benefit (d) BCOM co. expenses the cost of wastebaskets in the year they are acquired. • Materiality

END OF PRESENTATION THANK YOU 45