CHAPTER 2
Conceptual Framework for Financial
Reporting
LEARNING OBJECTIVES
1. Describe the usefulness of a conceptual framework.
2. Describe efforts to construct a conceptual framework.
3. Understand the objective of financial reporting.
CHAPTER REVIEW
1. Chapter 2 outlines the development of a conceptual framework for financial accounting and
reporting by the IASB. The entire conceptual framework is affected by the environmental
Conceptual Framework
2. (L.O. 1) A conceptual framework is important as a coherent system of concepts that
flow from an objective and the objective identifies the purpose of financial reporting. By
3. (L.O. 2) Although the IASB issued the Conceptual Framework for Financial Reporting in
2010, it remains a work in process. The framework consists of three levels. The first level
identifies the objective of financial reporting. The second level provides the qualitative
First Level: Basic Objective
4. (L.O. 3) The objective of financial reporting is the foundation of the Conceptual
Framework. The objective of general-purpose financial reporting is to provide financial
5. An implicit assumption is that users need reasonable knowledge of business and financial
accounting matters to understand the information contained in financial statements. This
users, which impacts the way and the extent to which companies report information.
Second Level: Fundamental Concepts
6. (L.O. 4) The second level bridges the “why” or objective of accounting with the “how of
accounting that addresses recognition, measurement and financial presentation. The
fundamental qualities that make accounting information useful for decision making are
relevance and faithful representation.
a. Relevance: Accounting information is relevant if it is capable of making a difference
in a decision. Financial information is capable of making a difference when it has
predictive value, confirmatory value, or both. If the monetary size of an item could
influence a user’s discussion, then the item is material and must be disclosed.
(1) Predictive Value: Financial information has value as an input to predictive
(3) Materiality: Materiality is a company-specific aspect of relevance. Information is
material if omitting or misstating would make a difference in users’ decisions. It
b. Faithful Representation: Means that the numbers and descriptions contained in the
financial statements match what really existed or happened. To be a faithful
representation, information must be complete, neutral, and free from error.
(1) Completeness: The financial statements include all the information that is
necessary for faithful representation of the economic phenomena that it purports
7. The enhancing qualities are complementary to the fundamental qualitative characteristics.
They include comparability, verifiability, timeliness, and understandability.
a. Comparability: Information that is measured and reported in a similar manner for
different companies is considered comparable. It enables users to identify the real
financial statements. Understandability is enhanced when information is classified,
characterized, and presented clearly and concisely.
8. (L.O. 5) The IASB classifies the elements of the financial statements into two groups.
The first group describes amounts of resources and claims to resources at a moment in
time. The second group describes transactions, events and circumstances that affect a
company during a period time.
a. Resources and claims to resources at a moment in time.
(1) Asset: A resource controlled by the entity as a result of past events and from
which future economic benefits are expected to flow to the entity.
b. Transactions, events, and circumstances that affect a company during a period of time.
(1) Income: Increases in economic benefits during the accounting period in the form
of inflows or enhancements of assets or decreases of liabilities that result in
Third Level: Recognition, Measurement, and Disclosure Concepts
9. (L.O. 6) In the practice of financial accounting, certain basic assumptions are important to
an understanding of the manner in which information is presented. The following five
basic assumptions underlie the financial accounting structure.
a. Economic Entity Assumption: Means that economic activity can be identified with a
10. (L.O. 7) The basic principles of accounting are used to record and report transaction. The
four basic principles of accounting are:
a. Measurement Principles: We currently have two acceptable measurement
principles: historical cost and fair value. Choosing which principle to follow generally
reflects the trade off between relevance and faithful representation.
(1) Historical Cost: IFRS requires many assets and liabilities be reported at their
acquisition price, or cost, sometimes referred to as historical cost. Using cost has
b. Revenue Recognition Principle: When a company agrees to perform a service or
sell a product it has a performance obligation. Therefore, revenue is recognized in
the period in which the performance obligation is satisfied.
c. Expense Recognition Principle: Recognition of expenses is related to the
consumption of assets or incurring of liabilities. The expense recognition principle is
the main body of the financial statements, (2) in the notes to those statements, or (3)
as supplementary information.
11. (L.O. 8) In providing information with the qualitative characteristics that make it useful,
companies, must consider an overriding factor that limits the reporting. This is referred to
as the cost constraint.
a. Cost-Benefit Relationship: Rule-making bodies and governmental agencies use
cost-benefit analysis before making final their informational requirements. The
LECTURE OUTLINE
The material in this chapter can usually be covered in two class sessions. The first class
session can be used for lecture and discussion of the concepts presented in the chapter. The
second class session can be used to develop student’s understanding of these concepts by
applying them to specific accounting situations. Students frequently believe that they understand
the concepts but have difficulty correctly identifying improper accounting procedures in
practical situations. Apparently, students are not alone in this difficulty.
A. (L.O. 1) Need for a Conceptual Framework.
1. Build on and relate to an established body of concepts.
1. Financial information that is useful to present and potential equity investors, lenders
D. (L.O. 4) Second Level: Fundamental Concepts.
1. Qualitative characteristics. The overriding criterion for evaluating accounting information
is that it must be useful for decision making.
a. Fundamental qualities of useful accounting information.
(1) Relevance. Accounting information is relevant if it is capable of making
a difference in a decision. Relevant information includes:
(2) Faithful Representation. For accounting information to be useful, the
numbers and descriptions contained in the financial statements must faithfully
represent what really existed or happened. To be a faithful representation,
information must be:
b. Enhancing qualities of useful information distinguish more useful information from
less useful information.
(1) Comparability. Information that is measured and reported in a similar
manner for different companies is considered comparable. Consistency,
2. (L.O. 5) Elements. (See text page 37 for definitions.) Items a-c are elements at
a moment in time. Items d and e are elements during a period of time.
a. Asset.
E. (L.O. 6) Third Level: Recognition, Measurement, and Disclosure Concepts.
1. Basic Assumptions.
a. Economic entity assumption—economic activity can be identified with a particular
unit of accountability.
2. (L.O. 7) Basic Principles of Accounting.
a. Measurement principles
(1) Historical Cost Principle. Objective and verifiable.
Practical rules for expense recognition: Analyze costs to determine whether a
relationship exists with revenue.
(a) When a direct relationship exists, then expense costs against revenues
in the period when the revenue is recognized.
3. (L.O. 8) Cost Constraint: Financial information benefits must outweigh the costs of
producing the information.