Conceptual Framework Underlying Financial Reporting

Thursday, January 9, 2020 9:45 PM

Conceptual Framework Underlying Financial Reporting

Conceptual Framework
- Coherent system of interrelated objectives and fundamentals that are the foundation for
developing standards and rules
- A conceptual framework is needed to:
1. Create standards based on established concepts
2. Provide assistance in solving new and emerging practical problems
3. Increase users’ understanding of and confidence in financial reporting
4. Enhance comparability among different companies’ financial statements

- New framework by IASB in March 2018 (effective Jan 1, 2020)

- It deals with:
○ Objective of general-purpose financial reporting
○ Qualitative characteristics of useful information
○ Financial statements and the reporting entity
○ Elements of the financial statements
○ Recognition, derecognition, measurement
○ Presentation and disclosure
○ Concepts of capital and capital maintenance
- Conceptual framework does not override specific IFRS

Objective of Financial Reporting

- The overall objective of financial reporting is to communicate information that is:
1. Useful to users (Example: investors, creditors, etc.), and
2. Useful in making decisions about how to allocate resources
- Resource allocation decisions are assumed to include assessment of management stewardship
(that is, how well management is using entity resources to create and sustain value)
- General-purpose financial statements—basic statements that give information that meets the needs
of key users

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 of key users

Fundamental Qualitative Characteristics

1. Relevance
• Information that makes a difference in decision making
 Has predictive and feedback/confirmatory value
• Materiality
 Includes all material information (i.e. information that makes a difference to the
decision-maker)
 Consider impact on any sensitive numbers
 Qualitative factors must be considered
2. Representational Faithfulness
• Economic substance over legal form
• Transparency—representing economic reality
 Completeness—include all pertinent information
 Neutrality (1)—information does not favor one interested party over another
Neutrality (2)—in standard setting
 Freedom from error—reliability; management must make estimates and use judgement

To ensure information has relevance and representational faithfulness, follow three steps:
1. Identify the economic event or transaction
2. Identify the type of information that would be relevant and can be faithfully represented
3. Assess whether the information is available (cost/benefit)

Enhancing Qualitative Characteristics [VCUT]

1. Comparability (Consistency)
- Information is measured and reported in a similar way (company to company and year to
year)
- Aids in making resource allocation decisions
2. Verifiability
- Knowledgeable, independent users achieve similar results; Does not guarantee accuracy
3. Timeliness
- Information needs to be current
- Deadlines
4. Understandability
- Allows users with reasonable knowledge to understand the information
- Presented with sufficient quality and clarity
- Assumes that in complex transactions/information, users consult with an advisor

Trade-offs and Cost/Benefit

- Trade-Offs
- It is not always possible to have all fundamental and enhancing qualitative characteristics
- Trade-offs happen when one qualitative characteristic is sacrificed for another
- Cost-Benefits Relationship
- Benefits of using the information should outweigh the costs of providing that information
- Led to simpler standards for private entities

Elements of Financial Statements

- Basic elements of financial statements include the following:
• Assets
• Liabilities
• Equity
• Revenues/Income
• Expenses
• Gains/Loses

ASSETS
- Represent a present economic resource—a right to use an asset that produces economic benefit or
that has the potential to produce economic benefits

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ASSETS
- Represent a present economic resource—a right to use an asset that produces economic benefit or
that has the potential to produce economic benefits
- Entity has control over that resource—entity’s ability to decide how to use the asset and receive
economic benefits (legal ownership)
- Resource results from a past transaction or event
- Includes tangibles and intangibles as well as contractual rights

The conceptual framework defines the asset as the right as opposed to the physical asset.

LIABILITIES
- They represent a present duty or responsibility (there is no practical ability to avoid them)
• May arise through contractual obligations or statutory requirements
• Constructive obligations—the company acknowledges a potential economic burden
• Equitable obligations—arise from moral or ethical considerations
- Entity is obligated to transfer an economic resource
- Obligation results from a past transaction or event

EQUITY
- Residual interest that remains in an entity after deducting its liabilities from its assets
- Also known as “net worth”
- Represents ownership interest
- Normally consists of shares, retained earnings, and under I F R S, accumulated other
comprehensive income

OTHER ELEMENTS

Items Included in Financial Statements:

*Othercomprehensive income (O C I) includes all changes in equity except for net income and
owner’s investments and distributions.
Comprehensive income includes net income and other comprehensive income.
Foundational Principles
- Foundational concepts and constraints help explain which, when, and how financial elements and
events should be recognized/derecognized, measured, and presented/disclosed
- They act as guidelines for developing rational responses to controversial financial reporting issues
- Foundational principles also include assumptions

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 Foundational principles also include assumptions

Recognition/Derecognition
- Recognition under new IFRS Conceptual Framework
○ Elements of financial statements are recognized when:
1. They meet the definition of an element (e.g. asset)
2. They provide users with relevant information that faithfully represents the underlying
transaction or event.
○ No probability or measurement criteria
○ If there is significant uncertainty as to existence or measurement, or low probability of
occurrence, information may not be useful anyway
1. Economic Entity Assumption (Entity Concept)
- Means an economic activity can be identified with a particular unit of accountability, e.g. a
company, a division, an individual
- Not necessarily a legal entity
- Legal entities can be merged into an economic entity for financial reporting purposes
(consolidated financial statements)
- Defining factor for an economic entity is “Who has control?”
2. Control
- Control is an important factor in determining entities to be consolidated and included in an
economic entity
- Criteria under IFRS:
1. Having power over investee
2. Exposure, or rights, to variable returns from involvement with investee; and
3. Ability to use power over investee to affect amount of investor’s returns
- Criteria under ASPE:
1. Continuing power to determine strategic decisions without others
2. Demonstrably distinct
• Can the entity be unilaterally dissolved by the company?
• Do others have a more than 10% ownership interest?
3. A. Revenue Recognition Principle (ASPE)
- Revenue is recognized when:
 Risks and rewards have passed or the earnings process is substantially complete
 Revenue is measurable, and
 Revenue is collectible (realized or realizable)
- Revenues are realized when products (goods or services), merchandise, or assets are
exchanged for cash (or claims to cash)
B. Revenue Recognition Principle (IFRS)
- Follows a 5-step approach:
1. Identify the contract with the customer
2. Identify the performance obligations in the contract
3. Determine the transaction price
4. Allocate the price to each performance obligation
5. Recognize revenue when each performance obligation is satisfied
- Collectible revenues are recognized when control over goods and services passes to the

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 - Collectible revenues are recognized when control over goods and services passes to the
customer
- Balance sheet approach; covered fully in Chapter 6
4. Matching Principle
- Expenses are matched with revenues that they produce
- Illustrates a “cause and effect relationship” between money spent to earn revenues, and the
revenues themselves
- If the expense benefits future periods and meets the definition of asset, it is recorded as an
asset
- This asset’s cost is then systematically and rationally matched to future revenues through
amortization/depreciation

Measurement
- All elements must be measurable to be recognized
- Because of accrual accounting, measuring many elements of financial statements requires the use of estimates
- Estimates give rise to uncertainty
○ Measurement uncertainty: when a value cannot be objectively measured
○ Existence uncertainty: does the asset or liability meet the recognition criteria
○ Outcome uncertainty: difficulty in determining future outflows and inflows
- Therefore, we must:
○ Determine the level of uncertainty that is acceptable for recognition
○ Use appropriate measurement tools, and
○ Disclose sufficient information to indicate/describe the uncertainty
- Need to determine the measurement basis
- Measurement bases must provide relevant information that faithfully represents the event
- New IFRS CF specifies historical costs or current values
- Current values: fair value, value in use, current cost

Of the ten foundational principles five are associated with measurement of an entity’s resources.

5. 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 (minimum)
- For shorter time periods, more difficult to determine proper net income (i.e. its more likely errors occur due to more
estimates)
- With technology, investors want more on-line, real-time financial information to ensure relevant information
6. Monetary Unit Assumption
- Money is the common unit of measure of economic transactions
- Use of a monetary unit is relevant, simple and understandable, universally available, and useful
- In Canada and the United States, the dollar 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
7. 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
8. Historical Cost Principle
- Transactions are measured at the amount of cash (or equivalents) paid, or the fair value of initial transaction
- Three basic assumptions of historical cost
 Represents a value at a point in time
 Results from a reciprocal exchange (i.e. a two-way exchange)
 Exchange includes an outside arm’s-length party
- Initial recognition for non-financial assets: record all costs incurred to get the asset “ready” for sale or for its intended
use (e.g. includes transportation and installation costs) also called “laid-down costs”
- Measurement is especially challenging for:
1. Non-monetary transactions (as no cash/monetary consideration exchanged)

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 1. Non-monetary transactions (as no cash/monetary consideration exchanged)
2. Non-monetary, non-reciprocal transactions (e.g. donations)
3. Related party transactions – not acting at “arm’s length” (use exchange value or cost)
- In these types of situations, an attempt may be made to estimate the fair value
- Applies also to short-term financial instruments (e.g. bonds, notes, accounts payable, and receivables)
9. Fair Value Principle
- Fair value has been defined under IFRS 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 has been defined under ASPE as:
“amount of consideration that would be agreed upon in an arm’s length transaction between knowledgeable,
willing parties who are under no compulsion to act.”
Does not refer to an orderly market, nor does it stipulate that the price is an exit price.
- Fair value option—financial instruments are measured at fair value with gains and losses booked to income.

For subsequent re-measurement—trend is moving from a mixed valuation model to a market valuation
model

Presentation and Disclosure

10. Full Disclosure Principle
- This is the only principle associated with presentation and disclosure.
- Follow general practice of providing information that is important enough to influence an
informed user’s judgement and decisions—it is useful
- Disclosed information should:
1. Provide sufficient detail of the occurrence
2. Be sufficiently condensed to remain understandable, and appropriate in terms of costs
of preparing/using it
- Always a trade-off: Is it detailed enough? Is it condensed enough?
- Disclosure may be made:
 Within the main body of the financial statements
 As notes to the financial statements
 As supplementary information, including Management Discussion and Analysis (M
D&A)
- Full disclosure is not a substitute for proper accounting practice
- Notes to financial statements are essential to understanding the enterprise’s performance
and position
- New IFRS Conceptual Framework provides general guidance
1. Entity specific information over general information
2. Duplication inhibits usefulness
- Management Discussion and Analysis
 Management’s explanation of the financial information and the significance of the
information
 Six disclosure principles:
1. Provide a view through management’s eyes
2. Supplement and complement information in the F/S
3. Provide fair, complete, and balanced information that is material to decision-
makers
4. Outline key trends, risks, and uncertainties that may affect the company in the
future and provide information on the quality of earnings and cashflow

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 future and provide information on the quality of earnings and cashflow
5. Explain management’s plan for long- and short-term goals
6. Be understandable, relevant, comparable, verifiable, timely
 Five key elements:
1. Core business
2. Objectives and strategy
3. Capability to deliver results
4. Results and outlook
5. Key performance measures and indicators
 Under IFRS there is a general trend towards increased disclosure to achieve greater
transparency

Expanded Conceptual Framework

Financial Reporting Issues

- IFRS and ASPE are principles-based
- It means selecting and interpreting accounting principles and rules relies on application of
professional judgment
- Legally structuring transactions so that they meet the company’s financial reporting objectives
(while complying with G A A P) is known as financial engineering
- When pressures for reaching specific financial reporting objectives are high, risk of fraudulent
financial reporting increases
1. Principles-Based Approach
- IFRS and ASPE are principles-based; grounded in the conceptual framework
- Benefits of this approach? Consistency and flexibility
- First principles
- Some think principles-based GAAP is too flexible
- In the absence of specific GAAP guidance, policies should be developed through exercising

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 - In the absence of specific GAAP guidance, policies should be developed through exercising
professional judgement and applying the conceptual framework
2. Financial Engineering
- Process of legally structuring a business arrangement so that it meets the company’s financial
reporting objectives.
- Structured financing—creating instruments so the financial reporting objectives are within
GAAP
- Financial engineering could result in biased information
- Now viewed as potential fraudulent activity
3. Fraudulent Financial Reporting
- Changes in the economic or business environment could trigger manipulation of financial
information
- Negative influence of budgets may lead to inappropriate decisions
- Weak internal controls and governance

Activity of IASB
- March 2018, released new conceptual framework
- Working on:
- The definition of materiality
- Applying materiality
- Development of a framework for disclosures
- Upcoming
- Primary Financial Statement Project

P2-3
1. Recorded Loss on Disposal even though sale hasn't occurred yet
----> Could be correct if asset is impaired
----> If the company uses the Revaluation method
----> Must be appraised by a certified assessor (or with another evidence)
2. Inventory was recorded at NRV ($690,000), should be recorded at the lower of cost and net
realizable value
Sale was recorded to adjust amount recorded for inventory
3. Not appropriate to accrue the liability (should not have been recorded)
4. Should not adjust for inflation
Depreciation does not measure value, it should be matched against existing asset
5. Should not base records in a liquidation perspective
----> Goodwill can only be reduced if impaired (with impairment test). Debit to Retained
Earnings is incorrect
6. Should have been recorded at cost. Gain should not have been recorded

2-11
1. Periodicity, Comparability. The company only prepares statements when there is a
downturn, when it would be easier to prepare them
2. Historical cost, Relevance. The inventory wasn't charged for the manufacturing costs
incurred to make them but copied prices from suppliers
3. Historical Cost, Matching. Freight-in wasn't included in the computation of the cost of
inventory even if they were material
4. Revenue Recognition, Representational Faithfulness. The entire franchise fee was
recognized when it was collected even though it was still not fully earned due to
obligations outstanding to the franchisee
5. Full disclosure, Representational faithfulness
6. Economic entity
7. Control, Full Disclosure, Comparability
8. Matching?, Representational faithfulness

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8. Matching?, Representational faithfulness
9. Full disclosure, Neutrality

Recognition
1. Meet the definition of an element
2. Probable
3. Reliably measurable

BRE-X MINERALS
where On this property find bowling courses you have to go out and explore and you have to
take samples of the earth and dig around and do this and test it so they did this for 2 years
they said we found gold and they actually said that they found evidence of a significant and
they were saying that there was three million and you can do the math on this because at this
time I think it was treated like gold goes up and down $500,000 per oz multiplied by
30,000,000 ounces that's a lot of money so in 1995 soon guess what happened to their stock
crazy it went from share like crazy 1990 six 97 they may continue exploring taking more
samples and every time they took a sample they said we think there's more I think there's
more people so then eventually estimates of 200 million based on the work they were doing
more testing more testing the other thing that also happened in 19 95 is they went from the
Alberta Stock Exchange to the Toronto Stock Exchange because their their capitalization was
coming up big the value of their stock was getting huge so they actually got Stock Exchange
which is image in Stock Exchange respark exchange rate now they were there playing with all
the big players so they're not playing in the big leagues reported more stock price stock price
$280 per share so think about this we're talking about a company then 3 years previously is
trading for like 5 cents a share is now trading for $280 share end mysterious story this is
when people started going crazy buying this stock which is like a present this is when you had
little ladies never ever bought stock in their life cashing in their life savings to buy stock you
had some municipal organizations like municipal pension plans investments like this was
insane everyone was trying to get in on this because they thought there's property and
everyone is going crazy investing investing and making the price go up like nuts so of course
they were 96 period is all about exploration in trying to build up but at one point serious
stock exchanges serious regulations do you have the action gets incredible minded people in
here too develop this project original founders doing this right so the company calls into
credible mining companies morning and these guys decided well we're gonna do our own
tests because we're incredible mining companies need to test this reserve so this is March 19
1997 Michael founders mysteriously falls out of a helicopter over the Indonesian jungle OK so
pause no the helicopter was in the air so he's pretty dead OK . Medium ignore body was
buried March 19th one week later March 26 report which was the incredible mining company
that was brought into the system or in Maine public announcement that based on their tests
of the property there is insignificant amounts of gold mouses what do you suppose happened
to my company's stock it was at $280 a share it went like that in fact after this announcement
what is Stock Exchange actually have to close for a day because they've crashed in Toronto
Stock Exchange computer because everybody who only reassures was trying to sell this came
up so they actually crash the Stock Exchange book start it up and they start up the next day
and of course now it's like $10 a share or something it just plummeted on May 4th the other
company that was involved with announce that normally there's not there's actually no gold
and what they announced was that mean original samples that had been used Alas why is he
well 2 reasons first of all that's where his money was money to be in Calgary where he lived
Thomas Bahamas because Canada in the Bahamas do not have an extradition treaty for
criminals which means that

David Walsh
John Felderhof
Michael de Guzman

1989 - Bre-X Founded in Calgary

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1989 - Bre-X Founded in Calgary
1993 - Purchased property in Indonesia
1995 - Announced found gold (30 Million ounces)
1996-97 - Est. 200 Million ounces
- Stock price $280/share
March 19, 1997 - de Guzman falls out of helicopter
March 26, 1997 - Free McMoran announces insignificant gold
May 4, 1997 - Strathcoma says no gold
November 3, 1997 - bankrupt, Share losses $3 billion
1998 - David Walsh dies in bahamas
1999 - Felderhof trial begins
2007 - Trial ends, Felderhof not guilty
2014 - Civil suit dismissed, all assets consumed by lawyers

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