dfa5038 chapter 5.ppt

8/2/2019 DFA5038 Chapter 5.ppt

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Chapter5Conceptual Framework

UnderlyingFinancial Accounting


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Study ObjectivesStudy Objectives

Study ObjectivesStudy Objectives

1. Describe the usefulness of a conceptual framework.2. Describe the FASBs efforts to construct a conceptual

framework.

3. Understand the objectives of financial reporting.

4. Identify the qualitative characteristics of accountinginformation.

5. Define the basic elements of financial statements.

1. Describe the basic assumptions of accounting.2. Explain the application of the basic principles of

accounting.

3. Describe the impact that constraints have on reporting

accounting information.


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ConceptualConceptual

FrameworkFramework

ConceptualConceptual

FrameworkFramework

RationaleRationale

DevelopmentDevelopment

QualitativeQualitative

characteristicscharacteristics

Basic elementsBasic elements

First LevelFirst Level

Basic ObjectivesBasic Objectives

First LevelFirst Level

Basic ObjectivesBasic Objectives

Conceptual Framework Underlying Financial AccountingConceptual Framework Underlying Financial Accounting

Conceptual Framework Underlying Financial AccountingConceptual Framework Underlying Financial Accounting

Third LevelThird Level

Recognition andRecognition and

MeasurementMeasurement

Third LevelThird Level

Recognition andRecognition and

MeasurementMeasurement

Second LevelSecond Level

FundamentalFundamental

ConceptsConcepts

Second LevelSecond Level

FundamentalFundamental

ConceptsConcepts

BasicBasic

assumptionsassumptions

Basic principlesBasic principles

ConstraintsConstraints


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IntroductionIntroduction

IntroductionIntroduction

Users of financial statements need relevant and

reliable information

To provide such information, the profession has

developed a set of principles and guidelines calledConceptual Framework

The framework is to be the foundation for building a

set of coherent accounting standards and rulesAlso to be a reference of basic accounting theory

for solving emerging practical problems of reporting


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Statements of Financial AccountingStatements of Financial AccountingConceptsConcepts

Statements of Financial AccountingStatements of Financial AccountingConceptsConcepts

The Financial Accounting Standards Board (FASB)

has issued seven Statements of Financial Accounting

Concepts (SFAC) to-date

These statements set forth major recognition andreporting issues

SFAC No. 4 pertains to reporting by non-business

entities

The other six statements pertain to reporting by

business enterprises


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SFAC No. 1 >>> Objectives of Financial Reporting (Business)

SFAC No. 2 >>> Qualitative Characteristics of AccountingInformation

SFAC No. 3 >>> Elements of Financial Statements (Business)

SFAC No. 4 >>> Objectives of Financial Reporting (Non-Business)

SFAC No. 5 >>> Recognition and Measurement Criteria inFinancial Statements

SFAC No. 6 >>> Elements of Financial Statements (replacesSFAC No. 3)

SFAC No. 7 >>> Using Cash Flows information and Present

Value in Accounting Measurements

Statements of Financial Accounting ConceptsStatements of Financial Accounting Concepts

Statements of Financial Accounting ConceptsStatements of Financial Accounting Concepts


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Overview of the Conceptual FrameworkOverview of the Conceptual FrameworkOverview of the Conceptual FrameworkOverview of the Conceptual Framework

The Framework has three levels : Objectives,elements and criteria

First level consists of objectives to identify goalsand purposes of accounting

Second level consists of qualitative characteristicsthat make accounting information useful andelements of financial statements

Third level incorporates recognition andmeasurement criteria used in establishing andapplying accounting standards, including assumptions,principles and constraints


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Overview of the Conceptual FrameworkOverview of the Conceptual FrameworkOverview of the Conceptual FrameworkOverview of the Conceptual Framework

Objectives

QualitativeCharacteristics Elements

Recognition and Measurement Concepts

of financialreporting

ofaccountinginformation

offinancial

statements

assumptions principles constraints

Level 1

Level 2

Level 3


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First Level : Basic ObjectivesFirst Level : Basic ObjectivesFirst Level : Basic ObjectivesFirst Level : Basic Objectives

The basic objectives of financial reporting are toprovide information that is :-

1. Useful to those making investment and creditdecisions who have a reasonable understanding of

business and economic activities

2. Helpful to present and future investors, creditorsand other users in assessing future cash flows

3. About economic resources, the claims on thoseresources and the changes in them


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Second Level : Qualitative CharacteristicsSecond Level : Qualitative CharacteristicsSecond Level : Qualitative CharacteristicsSecond Level : Qualitative Characteristics

The FASB has identified the qualitativecharacteristics of accounting information thatdistinguish better (more useful) information frominferior (less useful) information for decision

making purposes

Primary qualities are relevance and reliability ofaccounting information

Secondary qualities are comparability andconsistency of reported information


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Primary Qualities- RelevancePrimary Qualities- RelevancePrimary Qualities- RelevancePrimary Qualities- Relevance

To be relevant, accounting information must be capableof making a difference in a decision

For information to be relevant, it should havepredictive or feedback value, and it must be presentedon a timely basis

Predictive value helps users make predictions aboutultimate outcome of past, present and future events

Feedback value helps users confirm or correct priorexpectations

Timeliness available to decision makers before it losesits capacity to influence their decisions


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Primary Qualities- ReliabilityPrimary Qualities- ReliabilityPrimary Qualities- ReliabilityPrimary Qualities- Reliability

Information is reliable when it can be relied on torepresent the true situation

For accounting information to be reliable, it should beverifiable, is a faithful representation, and it isreasonably free of error and bias

Verifiability when given the same information andusing the same measurement methods, independentusers can obtain the same results

Representational faithfulness when it represents whatreally existed or happened

Neutrality when it is factual, truthful and unbiased


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Secondary Qualities- ComparabilitySecondary Qualities- ComparabilitySecondary Qualities- ComparabilitySecondary Qualities- Comparability

Comparability and consistency of reported information

Information about an enterprise is more useful if it canbe compared with similar information about anotherenterprise (comparability) and with similar information

about the same enterprise at other points in time(consistency)

For information to be comparable, it must be

1. Measured and reported in a similar manner fordifferent enterprises

2. Useful to users in identifying real similarities anddifferences between enterprises


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Secondary Qualities- ConsistencySecondary Qualities- ConsistencySecondary Qualities- ConsistencySecondary Qualities- Consistency

Entity is considered to be consistent in its use ofaccounting standards when it applies the sameaccounting treatment to similar events from periodto period

Companies can change methods, if the changeresults in better reporting

Disclosure for change :-

1. Nature of the change2. Effect of the change

3. Justification for the change


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Hierarchy of Accounting QualitiesHierarchy of Accounting QualitiesHierarchy of Accounting QualitiesHierarchy of Accounting Qualities

Pervasive Criterion

What are the characteristics?

Primary Qualities

Secondary Qualities

User Specific Qualities

Constraints

Decision Makers

Cost-Benefit & Materiality

Understandability

Comparability & Consistency

Relevance & Reliability

Decision Usefulness


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Ingredients of Primary QualitiesIngredients of Primary QualitiesIngredients of Primary QualitiesIngredients of Primary Qualities


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Basic Elements of Financial StatementsBasic Elements of Financial StatementsBasic Elements of Financial StatementsBasic Elements of Financial Statements

Assets: Probable futureeconomic benefits resultingfrom past transactions

Liabilities: Probable futuresacrifices of economicbenefits resulting from pasttransactions

Equity: Residual interest inassets after deductingliabilities or ownershipinterest

Investment by Owners:Increases in net assets

Distributions to Owners:

Decreases in net assets

Comprehensive Income: Allchanges in equity from non-owner sources

Revenues: Inflows fromentitys ongoing operations Expenses: Outflows from

entitys ongoing operations Gains: Increases in equity

from incidental transactions Losses: Decreases in equity

from incidental transactions

Balance Sheet Income Statement


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Third Level : Recognition and Measurement ConceptsThird Level : Recognition and Measurement ConceptsThird Level : Recognition and Measurement ConceptsThird Level : Recognition and Measurement Concepts

Consists of concepts that implement the basicobjectives of level one

These concepts explain which, when and howfinancial elements and events should be recognized,measured and reported by the accounting system

According to SFAC No. 5 (Recognition andMeasurement in Financial Statements of Business

Enterprises), to be recognized, an item must1. meet the definition of an element of financial

statements as defined in SFAC No. 6; and

2. must be measureable


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Third Level : Recognition and Measurement ConceptsThird Level : Recognition and Measurement ConceptsThird Level : Recognition and Measurement ConceptsThird Level : Recognition and Measurement Concepts


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Basic Assumptions


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Basic Assumptions : Economic Entity AssumptionBasic Assumptions : Economic Entity AssumptionBasic Assumptions : Economic Entity AssumptionBasic Assumptions : Economic Entity Assumption

The economic entity can be identified with aparticular unit of accountability

The activity of a business enterprise is

separate and distinct from its owners

Entitys assets and other financial elements areseparate from the owners

The economic entity assumption is anaccounting concept and not a legal construct


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Basic Assumptions : Going Concern AssumptionBasic Assumptions : Going Concern AssumptionBasic Assumptions : Going Concern AssumptionBasic Assumptions : Going Concern Assumption

The business is assumed to continueindefinitely unless terminated by owners

The basis of recoding financial elements is

historical cost accounting

Liquidation accounting (based on net realizablevalue) is not followed unless so indicated


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Basic Assumptions : Going Concern AssumptionBasic Assumptions : Going Concern AssumptionBasic Assumptions : Going Concern AssumptionBasic Assumptions : Going Concern Assumption

The financial statements are normally prepared onthe assumption that an entity is a going concern and

will continue in operation for the foreseeable futureHence, it is assumed that the entity has neither theintention nor the need to liquidate or curtailmaterially the scale of its operations

If such an intention or need exists, the financialstatements may have to be prepared on a differentbasis, and, if so, the basis used is disclosed

According to MASB (Malaysian Accounting Standards Board)


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Basic Assumptions : Monetary UnitBasic Assumptions : Monetary UnitBasic Assumptions : Monetary UnitBasic Assumptions : Monetary Unit

Money is the common unit of measure ofeconomic transactions

The use of monetary unit is relevant, simple,

universally available, understandable and useful

Price level changes (inflation and deflation) areignored in accounting, leading to the assumption

that the dollar remains relatively stable


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Basic Assumptions : Periodicity (Time Period)Basic Assumptions : Periodicity (Time Period)Basic Assumptions : Periodicity (Time Period)Basic Assumptions : Periodicity (Time Period)

Economic activities of an entity can be dividedinto artificial time periods (monthly, quarterly,

yearly) for reporting purposes

The shorter the time period, the more difficultit becomes to determine the proper net incomefor the period

Investors usually demand that accountinginformation be quickly processed but the fasterit is released, the more it is subject to error


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Basic Assumptions : Accrual BasisBasic Assumptions : Accrual BasisBasic Assumptions : Accrual BasisBasic Assumptions : Accrual Basis

In order to meet their objectives, financialstatements are prepared on the accrual basis of

accountingUnder this basis, the effects of transactions andother events are recognized when they occur (andnot as cash or its equivalent is received or paid); and

They are recorded in the accounting records andreported in the financial statements of the periodsto which they relate



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Basic Assumptions : Accrual BasisBasic Assumptions : Accrual BasisBasic Assumptions : Accrual BasisBasic Assumptions : Accrual Basis

Financial statements prepared on the accrual basisinform users not only of past transactions involving

the payment and receipt of cash, but also ofobligations to pay cash in the future and ofresources that represent cash to be received in thefuture

Hence, they provide the type of information aboutpast transactions and other events that is mostuseful to users in making economic decisions



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Basic Principles


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Basic Principles : Historical Cost PrincipleBasic Principles : Historical Cost PrincipleBasic Principles : Historical Cost PrincipleBasic Principles : Historical Cost Principle

Most assets and liabilities are recorded at itsacquisition price

Cost has an important advantage over other

valuations : it is reliableUser of financial statements may find fair valueinformation useful for certain types of assets andliabilities

The current system is a mixed attributeincorporating historical cost, fair value, lower ofcost or market, and other valuation bases


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Basic Principles : Revenue Recognition PrincipleBasic Principles : Revenue Recognition PrincipleBasic Principles : Revenue Recognition PrincipleBasic Principles : Revenue Recognition Principle

Revenue is recognized when it is realized orrealizable, and earned

Revenue is realized when goods or services are

exchanged for cash or claims to cashRevenue is realizable when assets received or heldare readily convertible into cash or claims to cash

Revenue is earned when the entity hassubstantially accomplished what it must do to beentitled to the benefits represented by therevenues


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Basic Principles : Revenue Recognition PrincipleBasic Principles : Revenue Recognition PrincipleBasic Principles : Revenue Recognition PrincipleBasic Principles : Revenue Recognition Principle

Usually, revenue is recognized at the time of saleHowever, there are exceptions :

1. During Production : In long-term constructioncontracts, revenue is recognized periodically based on

the percentage of job completed

2. End of Production (After production but beforesales) : Where active markets exist for the productand there are no significant additional cost

3. Receipt of cash : Used when it is impossible toestablish the revenue amount at the time of salebecause of the uncertainty of collection. E.g. Ininstallment sales methods, payment is required in

periodic installments > risk of uncollectible


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Basic Principles : Matching PrincipleBasic Principles : Matching PrincipleBasic Principles : Matching PrincipleBasic Principles : Matching Principle

Efforts (expenses) are to be matched withaccomplishment (revenues)

Expenses are matched to the revenues they help togenerate

Costs that are related to the revenue are expensed andmatched against the revenue in the period the revenue isrecognized

When there is no connections between costs andrevenues, an allocation of cost based on some systematicbasis might be appropriate, e.g. The cost of fixed assetsis allocated throughout its useful life because the assetcontributes to the generation of revenue


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Basic Principles : Matching PrincipleBasic Principles : Matching PrincipleBasic Principles : Matching PrincipleBasic Principles : Matching Principle

If the allocation method is not desirable, then the cost isexpensed off immediately

Costs are generally classified into two groups :-

1. Product Costs : Material, labour and overhead attach tothe product and carried into future periods if therevenue from the product is recognized in subsequentperiods

2. Period Costs : Officers salaries and other administrativeexpenses are charged off immediately even thoughbenefits associated with these costs occur in the future,because there is no direct relationship between cost andrevenue


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Basic Principles : Full Disclosure PrincipleBasic Principles : Full Disclosure PrincipleBasic Principles : Full Disclosure PrincipleBasic Principles : Full Disclosure Principle

Providing information that is of sufficient importance toinfluence the judgment and decisions of an informed user

Disclosure can be made : Within the main body of financial statements

- The item should meet the definition of a basic element,be measurable with sufficient certainty and be relevantand reliable

In the notes to financial statements

- Generally explain the items presented in the main bodyof the financial statements

As supplementary information- May include information that is high in relevance but low

in reliability, or that is helpful but not essential


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Constraints


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ConstraintsConstraintsConstraintsConstraints

In providing information with the qualitativecharacteristics that make it useful, two overridingconstraints must be considered :

1. Cost-Benefit Relationship, and

2. Materiality

Two less dominant yet important constraints thatare part of the reporting environment are

1. Industry Practices, and2. Conservatism


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Constraints : Cost-Benefit RelationshipConstraints : Cost-Benefit RelationshipConstraints : Cost-Benefit RelationshipConstraints : Cost-Benefit Relationship

The cost of providing information should notoutweigh the benefit derived from theinformation

However, costs and especially benefits are notalways obvious or measurable

Sound judgment must be used in providing

information


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Constraints : MaterialityConstraints : MaterialityConstraints : MaterialityConstraints : Materiality

Materiality refers to an items significance to afirms overall financial operations

An item must make a difference to be material and

to be disclosed

It is also a matter of relative significance of theelement

E.g. If the amount involved is significant comparedwith other revenues and expenses, assets andliabilities, or net income of the entity, then soundand acceptable standards should be allowed


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Constraints : Industry PracticesConstraints : Industry PracticesConstraints : Industry PracticesConstraints : Industry Practices

An entity may follow the general practices inthe firms industry, which sometimes requiresdeparture from basic accounting theory

If application of accounting theory results instatements that are not comparable orconsistent, then industry practices must beexamined for possible explanations


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Constraints : ConservatismConstraints : ConservatismConstraints : ConservatismConstraints : Conservatism

Conservatism suggests that when in doubt, thepreparer should always choose a conservativesolution

This solution will be least likely to overstateassets and income

However, bear in mind that conservatism does

not suggest that net assets or net income to bedeliberately understated


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Malaysia AccountingStandard Board

(MASB)http://www.masb.org.my/


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LEMBAGA PIAWAIAN PERAKAUNAN MALAYSIA

MALAYSIAN ACCOUNTING STANDARDS BOARD

Framework for the Preparation and

Presentation of Financial Statements

http://www.masb.org.my/index.php?option=com_content&view=article&id=150&Itemid=24


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End of Chapter 5

All the Best in

Your Exam

dfa5038 chapter 5.ppt

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