[46]

Conceptual Framework of Accounting (Shortly)

1.2 Conceptual Framework of Financial

Reporting
Objective of Financial Reporting

The main purpose of financial reporting is to provide useful financial information to investors,
lenders, and creditors, helping them make informed decisions about providing resources to a
business.

Example:
If you are thinking of investing in Tesla, you will check its financial statements to see if the
company is profitable before making a decision.

Key Components of the Conceptual Framework

A conceptual framework serves as a foundation for financial reporting. It helps in:

1. Defining the boundaries of financial reporting.

2. Selecting which transactions and events should be reported.
3. Determining how transactions should be measured and recorded.
4. Ensuring consistency in financial statements.

Example:
When Apple sells an iPhone, it must decide:

• What information to report (sales revenue, production costs, profit).

• How to measure it (in dollars, using historical cost or fair value).
• How to present it (in income statement, balance sheet, or cash flow statement).

Kazi Sifuzzaman Mim (20AIS033) @GSTU

 [47]

🔹 Qualitative Characteristics of Useful Accounting Information

For financial information to be decision-useful, it must have two fundamental qualities and
four enhancing qualities.

1. Fundamental Qualities

✔ Relevance – Information must influence decisions.

• Predictive Value: Helps users forecast future performance.

Example: If Amazon’s sales have increased every year, investors might expect this trend
to continue.
• Confirmatory Value: Helps validate past decisions.
Example: If a bank gave a loan to a company and it later reports strong profits, the
decision was justified.
• Materiality: If omitting or misstating information changes a decision, it is material.
Example: A $10,000 error in Apple’s financials may be immaterial, but for a small
business, it could be significant.

✔ Faithful Representation – Information should reflect reality.

• Completeness: No important details are omitted.

Example: If Tesla reports revenue but hides its debt, the financial report is incomplete.
• Neutrality: Reports should be unbiased.
Example: A company should not overstate profits to attract investors.
• Free from Error: No material misstatements.
Example: If Coca-Cola mistakenly reports its total sales as $10 billion instead of $9
billion, it misleads investors.

Kazi Sifuzzaman Mim (20AIS033) @GSTU

 [48]

2. Enhancing Qualities

✔ Comparability – Information should be reported consistently across companies and time

periods.
Example: If one company records inventory using the FIFO method, another should not use
LIFO for comparison purposes.
✔ Verifiability – Independent auditors should be able to confirm reported figures.
Example: If two auditors check Tesla’s cash balance and get the same number, the information
is verifiable.
✔ Timeliness – Information should be available before it loses relevance.
Example: If Apple releases last year’s sales data six months late, it is less useful to investors.
✔ Understandability – Clear presentation so users can interpret it easily.
Example: A financial report should not use overly technical language that only accountants
understand.

🔹 Elements of Financial Statements

Financial statements consist of ten key elements, divided into two groups:

✔ At a Moment in Time (Balance Sheet Elements)

• Assets – Resources owned by a company (cash, buildings, equipment).

Example: A company’s office building is an asset.
• Liabilities – Obligations to pay (loans, salaries payable).
Example: A company’s bank loan is a liability.
• Equity – Owner’s residual interest after liabilities are deducted.
Example: If a company has $10M in assets and $6M in liabilities, its equity is $4M.

✔ Over a Period of Time (Income Statement Elements)

• Revenues – Money earned from sales/services.

Example: If McDonald's sells a burger for $5, that’s revenue.
• Expenses – Costs incurred to generate revenue.
Example: The cost of ingredients for that burger is an expense.
• Gains & Losses – Profits or losses from non-core activities (e.g., selling old equipment).
Example: If Apple sells an old office building at a profit, it’s a gain.
• Comprehensive Income – Includes all changes in equity except owner transactions.
Example: If a company earns extra income from foreign exchange rates, it is part of
comprehensive income.

Kazi Sifuzzaman Mim (20AIS033) @GSTU

 [49]

1.3 Assumptions and Principles of

Accounting
🔹 Basic Accounting Assumptions
Accounting is based on four key assumptions:

✔ Economic Entity – A business is separate from its owner.

Example: Jeff Bezos’ personal bank account is not included in Amazon’s financial statements.

✔ Going Concern – The company will continue operating in the foreseeable future.
Example: A company in financial trouble may state in its report if it expects to shut down soon.

✔ Monetary Unit – Transactions are recorded in a stable currency.

Example: A company in the U.S. records transactions in dollars without adjusting for inflation.

✔ Periodicity – Companies report financial results at regular intervals (monthly, quarterly,

annually).
Example: Apple releases quarterly financial reports for investors.

🔹 Key Accounting Principles

To ensure financial statements are accurate and consistent, accountants follow four key
principles:

✔ 1. Measurement Principle

• Historical Cost: Assets & liabilities are recorded at their original purchase price.
• Fair Value: Some assets (like stocks) are reported at their current market value.

Example:
If a company bought land in 2010 for $100,000, it is recorded at that price even if its value rises
to $500,000. However, investments like stocks are reported at fair value.

Kazi Sifuzzaman Mim (20AIS033) @GSTU

 [50]

✔ 2. Revenue Recognition Principle

• Revenue is recorded when earned, not when cash is received.

Example:
If a company sells a car in December but receives payment in January, the revenue is recorded in
December when the sale occurred.

✔ 3. Expense Recognition (Matching) Principle

• Expenses are recorded in the same period as the revenue they help generate.

Example:
A bakery buys flour in June and sells cakes in July. The cost of flour is recorded as an expense
in July, when the revenue from cake sales is recognized.

Kazi Sifuzzaman Mim (20AIS033) @GSTU

 [51]

✔ 4️. Full Disclosure Principle

• Companies must fully disclose all relevant financial information.

• This can be done through financial statements, footnotes, and supplementary reports.

Example:
If a company is facing a major lawsuit, it must disclose this risk in its financial reports.

🔹 Cost Constraint

✔ The cost of providing financial information should not exceed its benefits.
✔ Companies must balance detailed reporting with practical limitations.

Example:
A small business does not need to follow the same complex reporting standards as a
multinational corporation.

Kazi Sifuzzaman Mim (20AIS033) @GSTU

 [52]

Put It into Practice: LO 1.3 – Identify Assumptions and

Principles (Short math)

SOLUTION WITH DETAILED EXPLANATION

1. The belief that the company will continue for the foreseeable future.

✔ Matching Assumption: (b) Going Concern Assumption

Explanation:
The going concern assumption assumes that a business will continue operating without
liquidation in the near future. This assumption allows companies to use normal accounting
methods, such as depreciation and amortization, instead of reporting assets at liquidation value.

Example:
A company purchases equipment with a useful life of 10 years. Under the going concern
assumption, the company spreads the cost over the 10-year period instead of expensing it all at
once.

Kazi Sifuzzaman Mim (20AIS033) @GSTU

 [53]

2. The reporting of all information that would make a difference to financial

statement users.

✔ Matching Principle: (h) Full Disclosure Principle

Explanation:
The full disclosure principle requires that all relevant and material financial information be
presented in financial statements or notes to provide users with a complete understanding of the
company’s financial health.

Example:
If a company is involved in a pending lawsuit, it must disclose this information in the notes to
the financial statements, even if no financial liability has yet been recorded.

3. The practice of preparing financial statements at regular intervals.

✔ Matching Assumption: (d) Periodicity Assumption

Explanation:
The periodicity assumption states that a company should divide its financial activities into
specific time periods (monthly, quarterly, yearly) to ensure that financial statements provide
timely and useful information to users.

Example:
A publicly traded company like Apple Inc. releases quarterly financial statements so that
investors and analysts can track performance regularly.

4️. The belief that items should be reported on the balance sheet at the price that
was paid to acquire the item.

✔ Matching Principle: (e) Historical Cost Principle

Explanation:
The historical cost principle states that assets should be recorded at their original purchase
price, rather than their market value, to provide verifiable and reliable financial information.

Example:
If a company buys a building for $1 million in 2010 and its market value increases to $3 million
in 2025, the company still reports the asset at $1 million in its books.

Kazi Sifuzzaman Mim (20AIS033) @GSTU

 [54]

5️. Tracing accounting events to companies.

✔ Matching Assumption: (a) Economic Entity Assumption

Explanation:
The economic entity assumption ensures that a business is treated as a separate entity from its
owners and other businesses. This prevents mixing personal and business transactions in
financial reporting.

Example:
If a business owner pays personal bills from the company’s bank account, the accountant must
separate these transactions and ensure they are not recorded as business expenses.

6️. Reporting only those things that can be measured in dollars.

✔ Matching Assumption: (c) Monetary Unit Assumption

Explanation:
The monetary unit assumption states that only transactions that can be measured in a stable
currency (such as USD) should be recorded in the financial statements. It ignores factors like
inflation and qualitative factors.

Example:
A company’s brand reputation is valuable but not recorded in financial statements unless it is
acquired and assigned a dollar value (e.g., goodwill in an acquisition).

7️. Recognize wages when the work contributes to revenue.

✔ Matching Principle: (g) Expense Recognition (Matching) Principle

Explanation:
The expense recognition principle states that expenses should be recorded in the same period as
the related revenue to match costs with earnings. This ensures accurate measurement of
profitability.

Example:
A company pays employee wages in January for work done in December. Under the expense
recognition principle, the expense is recorded in December, when the work contributed to
revenue.

Kazi Sifuzzaman Mim (20AIS033) @GSTU

 [55]

8️. Recognize sale of goods when performance obligation is satisfied.

✔ Matching Principle: (f) Revenue Recognition Principle

Explanation:
The revenue recognition principle states that revenue is recorded when the company completes
its performance obligation (delivers goods or services), not when cash is received.

Example:
A company sells furniture on credit in June but receives payment in August. The revenue is
recognized in June, when the furniture was delivered.

Kazi Sifuzzaman Mim (20AIS033) @GSTU