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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
According to MASB (Malaysian Accounting Standards Board)
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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
According to MASB (Malaysian Accounting Standards Board)
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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