Chapter 2 Conceptual Frameworks for Financial Reporting

Chapter 2 Conceptual Frameworks for Financial Reporting

Copyright © 2014 Pearson Canada Inc. 2-14 Chapter 2 Conceptual Frameworks for Financial Reporting

• Problems

P2-1. Suggested solution:

Three reasons for having a conceptual framework for accounting standards include the

following:

• The framework helps to organize the numerous concepts that financial statement

preparers and users have found to be important.

• The framework provides general guidance for standard setters when they deliberate new

standards or changes to existing standards.

• The framework helps financial statement preparers to choose among accounting

alternatives when such alternatives exist.

P2-2. Suggested solution:

Concept Demand Supply

• User needs √
• Measurement criteria √
• Assumptions for the preparation of financial statements √
• Objectives of financial reporting √
• Definitions of the elements of financial statements √
• Recognition criteria √
• Constraints √
• Desirable qualitative characteristics √

P2-3. Suggested solution:

Concept Qualitative characteristics Assumption Constraint

• Understandability √
• Going concern √
• Relevance √
• Benefits vs. costs √
• Verifiability √
• Representational faithfulness √
• Comparability √
• Financial capital maintenance √

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Chapter 2 Conceptual Frameworks for Financial Reporting

Copyright © 2014 Pearson Canada Inc. 2-15

P2-4. Suggested solution:

Concept Representational faithfulness Recognition Measurement

• Current cost √
• Completeness √
• Historical cost √
• Revenue recognition √
• Probable and measurable future

flows of resources √

• Neutrality √
• Present value √
• Realizable value √

P2-5. Suggested solution:

An asset is:

– a resource controlled by an entity – as a result of past events , and – from which future economic benefits are expected to flow to the entity.

P2-6. Suggested solution:

A liability is:

– 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 economic resources embodying economic benefits .

P2-7. Suggested solution:

• Equity is defined as assets net of liabilities. It is not independently defined because the

balance sheet and double-entry bookkeeping requires A = L + E.

• Income involves increases in equity (other than from capital transactions with owners).

Since equity is defined in terms of assets and liabilities, income ultimately involves increases in assets or decreases in liabilities.

• Expenses involve decreases in equity (other than from capital transactions with owners).

Since equity is defined in terms of assets and liabilities, expenses ultimately involve decreases in assets or increases in liabilities.

Chapter 2 Conceptual Frameworks for Financial Reporting

Copyright © 2014 Pearson Canada Inc. 2-16

P2-8. Suggested solution:

Reasons for the lack of general acceptance of the current cost accounting model include:

Cost and benefits constraint: The cost to collect current cost information and to prepare current cost financial statements outweighs the likely benefits. Developing a system to produce current cost information for firms’ assets and liabilities on an ongoing basis is an expensive undertaking.Auditors will also need to develop methods to independently verify the current cost data, which also entails substantial costs.

Understandability: Current cost arguably provides better information to users for decision making, in particular regarding the maintenance of physical capital. However, the complexity of the calculations and even the principle of current cost are difficult to understand, such that only the very sophisticated reader will be able to understand the financial statements. This lack of understanding could be so significant as to render the information useless, or at least significantly impair the benefits of having such information.

Predictive value: Virtually all prediction models involve extrapolation from past patterns.Historical cost accounting reflects the past and is verifiable, providing a solid base for trend analysis.

Articulation: Historical cost accounting produces internally consistent data that are articulated among the financial statements. Current cost accounting information is not necessarily articulated.

P2-9. Suggested solution:

• Considering the qualitative characteristics, investments in employees should not be

recorded as assets for several reasons. First, the benefits of the training lack verifiability; different people will come up with vastly different estimates of the value of training.Second, the amount would lack representational faithfulness due to the incompleteness and biasedness of the figures. The amounts are likely to be incomplete because there are many different activities that could improve the value of employees and it is not practical to track these activities. Due to the lack of verifiability of the value of employees, the amounts are likely to be biased to serve management’s interests.

• Considering the elements of financial statement and the recogni tion, of those elements,

there are several reasons for not recording assets for the investment in employees. First, the employees are not under the full control of the company since they can seek employment elsewhere, so they cannot be considered to be assets of the company.Second, since there are outflows of resources associated with employee training, those outflows should be reflected as expenses. Third, even if one argues that investments in employees are assets, they cannot be recognized on the financial statements—the future benefits associated with better trained employees may be probable, but those benefits are not measurable with a sufficient degree of accuracy.

Chapter 2 Conceptual Frameworks for Financial Reporting

Copyright © 2014 Pearson Canada Inc. 2-17

P2-10. Suggested solution:

It is true that financial statements are complicated by accounting methods, such as the method of accounting for deferred income taxes, financial instruments, and so on. However, some of these complexities cannot be avoided. The business environment and business transactions are themselves more complex. Since the financial statements try to reflect these business events, it is inevitable that the financial statements will be more complex. Thus, it is not accounting methods per se that make financial statements difficult to understand.

Financial statements are not directed at the average person, so they cannot be criticized on the grounds that they are beyond the comprehension of the “average person.” Instead, they are intended for users with a reasonable understanding of financial statements. The question then becomes: should additional explanations be provided for users who have a reasonable understanding of financial information? The answer depends on what type of information the “explanation” will contain.

Usefulness of additional information

Explanations could be of three types:

 They could make information that is now in the financial statements easier to understand by explaining technical accounting terms and concepts used. They could provide more detail on information that is already contained in the financial statements. For example, certain dollar amounts might be broken down in more detail, or the significance of certain amounts might be spelled out. They could provide new information not now included in financial statements.

Additional information for the latter two categories may relate to the past or future. Future- oriented information would obviously be of considerable interest to someone with, say, a cash flow prediction objective. The difficulty, obviously, is that such information is very subjective and could be subject to biases. Auditors would find it difficult to provide any assurance on such future-oriented information.

It can be argued that additional information is already being provided in some financial statement packages (i.e., the remainder of the annual report outside of the financial statements). This information can include factual background relating to the year’s results, or it can include subjective projections of the company’s future.

There is significant evidence in support of the idea that capital markets are informationally efficient, thereby lessening the need for information that merely clarifies the financial statements or accounting methods used. However, even in efficient markets there will be a role for information that is not currently presented in the financial statements, to the extent that such information is not available elsewhere. The obvious disadvantage is that information disclosed could also be useful to competitors or other interest groups, to the detriment of the reporting company.

We should also consider whether providing more information would overload users and whether the incremental benefit is worth the incremental cost of the information. One of the additional costs is the potential delay in the reporting time.