MBA (Weekend) Program; 23rd Batch
MKT-503; Principles of Accounting
Principles of Accounting: Lecture 2
Conceptual Framework for Financial Accounting
• What is it? Think of the conceptual framework as a foundation for a house. You can't
see it, but it holds everything up and ensures the house is strong and stable. In the
same way, the conceptual framework is a coherent system of objectives and
fundamentals that leads to consistent standards and prescribes the nature, function,
and limits of financial accounting and reporting. It's the "theory" behind the
accounting "practice."
1. Basic Objectives of Financial Reporting
The primary goal of financial reporting is straightforward:
• Objective: To provide financial information about the reporting entity that is useful to
present and potential investors, lenders, and other creditors in making decisions
about providing resources to the entity.
o In simple terms: We create financial reports to help people who are putting
money into a business (like buying its shares or giving it a loan) decide if it's a
good idea. They need to know if the company can generate cash and if their
investment will be safe and profitable.
o Example: Before you lend your friend some money, you'd want to know if they
have a job (income) and if they can pay you back. Similarly, before a bank lends
a company millions of dollars, it wants to see the company's financial reports
to assess its ability to repay the loan.
2. Qualitative Characteristics of Accounting Information
For accounting information to be useful, it must have certain qualities. We can divide these
into two main types: Fundamental characteristics and Enhancing characteristics.
A. Fundamental Characteristics
These are the most critical qualities. Information must have this to be useful.
I. Relevance
Information is relevant if it can make a difference in a user's decision. It helps users make
predictions about the future or confirm their past expectations.
• Predictive Value: The information helps users predict future outcomes.
o Example: If a company's sales have been consistently increasing over the
past three years (as shown in its income statements), an investor might use
this information to predict that sales will continue to grow next year.
• Confirmatory Value (or Feedback Value): The information helps users confirm or
correct their prior expectations.
o Example: Suppose you predicted that the company's sales would grow. The
new income statement is released, and it shows that sales did indeed grow.
This information confirms your prediction. If sales went down, it would correct
your expectation.
II. Faithful Representation (Often called Reliability)
Faithful Representation means the numbers and descriptions in the financial reports
actually match what happened in the real world. The information must be a true and fair
picture of the business's economic activities. (Note: The term "Faithful Representation" has
largely replaced "Reliability" in official standards, but they mean very similar things. Think of
it as providing a trustworthy picture.)
To be a faithful representation, information must be:
• Complete: All the information necessary for a user to understand the economic
event is provided. Leaving something important out makes the information
misleading.
o Example: A company reports that it bought a new building, but it fails to
mention that it took out a very large loan to do so. This information is
incomplete and misleading.
• Neutral: The information is not slanted, biased, or manipulated to make the company
look better or worse. It should not be presented in a way that tries to influence a user's
decision in a particular direction.
o Example: A company is facing a lawsuit that it will probably lose. It would be
neutral to disclose this potential loss. It would be biased to ignore it or to
downplay its significance in the financial reports.
• Free from Error: This doesn't mean perfect accuracy down to the last penny, as many
accounting numbers involve estimates. It means the process used to develop the
number was applied correctly and the description of the event is accurate.
o Example: An accountant calculates the depreciation expense for a
company's delivery truck. If they use the correct formula and the correct cost
for the truck, the resulting number is free from error, even if the "useful life" of
the truck was just an estimate.
B. Enhancing Characteristics
These characteristics enhance the usefulness of relevant and faithfully represented
information.
• Comparability: This quality allows users to identify and understand similarities and
differences among items. We can compare a company's performance from one year
to the next, or we can compare two different companies in the same industry.
o Consistency: This is a key part of comparability. Consistency means a
company applies the same accounting methods and principles from one
period to the next. If a company changes its methods, it must disclose the
change and its effect.
o Example: If Company A and Company B are both in the shoe business, an
investor can use their financial statements to compare which one was more
profitable last year. This is Comparability. If Company A uses the same
method to value its inventory this year as it did last year, it is applying
Consistency.
• Verifiability: This means that different, independent observers could reach a
consensus that the information is a faithful representation. It's about being able to
prove that the numbers are not just made up.
o Example: If a company reports it has $1 million in cash, this is verifiable. An
auditor can count the cash or confirm the bank balances.
• Timeliness: Information must be available to decision-makers before it loses its
ability to influence their decisions. Old information is less useful.
o Example: A company's report on its 2024 performance is much more useful if
it's released in early 2025 rather than in 2027.
• Understandability: The information should be presented clearly and concisely so
that a user with a reasonable knowledge of business and accounting can understand
it.
o Example: Complicated financial data should be organized into well-labeled
tables and charts with clear headings in the financial statements, rather than
being buried in long, confusing paragraphs.
3. Basic Elements of Financial Statements
The conceptual framework identifies ten key elements that make up the financial
statements:
1. Assets: Resources the company owns that will provide a future economic benefit
(e.g., cash, inventory, equipment).
2. Liabilities: Obligations the company owes to others; debts that must be paid in the
future (e.g., loans, amounts owed to suppliers).
3. Equity: The owners' stake in the company. It's what's left over after you subtract
liabilities from assets (Assets−Liabilities=Equity).
4. Revenues: Increases in assets (or decreases in liabilities) from a company's main
business activities, like selling goods or services.
5. Expenses: Costs incurred to generate revenues (e.g., salaries, rent, cost of goods
sold).
6. Gains: Increases in equity from transactions that are not part of the main business
operations (e.g., selling an old piece of land for more than it originally cost).
7. Losses: Decreases in equity from transactions that are not part of the main business
operations (e.g., a factory being destroyed by a flood).
8. Investment by Owners: When owners put their own money or other assets into the
business.
9. Distribution to Owners: When the company gives cash or other assets to its owners
(e.g., paying dividends).
10. Comprehensive Income: The total change in equity during a period from all non-
owner sources. It includes net income plus other items like certain gains and losses
on investments.
4. Operational Guide: GAAP
• What is GAAP? GAAP stands for Generally Accepted Accounting Principles. These
are the common set of standards, rules, and procedures that public companies must
follow when they compile their financial statements. Think of GAAP as the specific
"laws" of accounting that stem from the "constitution" (the conceptual framework).
• Why do we need it? GAAP ensures that financial reporting is transparent and
consistent, which makes it easier for users to compare different companies.
GAAP is built upon a foundation of basic assumptions, principles, and constraints.
Basic Assumptions
1. Economic Entity Assumption: The business is treated as a separate entity, distinct
from its owners. Its financial records should not be mixed with the personal records
of the owners.
o Example: The owner of a bakery should not pay for their personal family
vacation using the bakery's bank account and record it as a business expense.
2. Going Concern Assumption: We assume the business will continue to operate for
the foreseeable future. This allows us to record assets at their cost, assuming they
will be used over time, rather than at their liquidation value (what they would sell for
today).
o Example: A company buys a machine for $50,000 that will last 10 years. It
records the machine at $50,000 and spreads that cost over 10 years. It doesn't
record the machine at the $30,000 it might get if it had to sell it immediately.
3. Monetary Unit Assumption: We record business transactions in a single, stable
currency (like the Bangladeshi Taka, U.S. Dollar, or Euro). We assume the value of this
currency is stable over time, ignoring the effects of inflation.
o Example: A company bought a piece of land in 1990 for ৳500,000. Today, that
land is still recorded on the books at ৳500,000, even though its actual market
value might be much higher due to inflation and development.
4. Periodicity Assumption (or Time Period Assumption): The long life of a business
can be divided into smaller, artificial time periods (like a month, a quarter, or a year)
so we can prepare and analyze financial reports for these periods.
o Example: Companies prepare an Income Statement for the "Year Ended
December 31, 2024," to show their performance for that specific year, rather
than waiting until the business shuts down to see if it was profitable.
Basic Principles
1. Measurement Principle: This tells us how to value assets and liabilities. The two
most common principles are:
o Historical Cost: We record assets at their original cost when they were
purchased.
o Fair Value: We record assets and liabilities at the price they could be sold for
in the market today.
o Example: Historical cost is used for the land example above. Fair value is
often used for financial investments like stocks, which are reported at their
current market price.
2. Revenue Recognition Principle: We recognize (record) revenue when the
performance obligation is satisfied—that is, when the goods or services have been
provided to the customer, not necessarily when the cash is received.
o Example: A construction company builds a house for a client in December
and gives them the keys. The client agrees to pay in February. The company
should record the revenue in December when it "earned" it, not in February
when it gets the cash.
3. Expense Recognition Principle (or "Matching Principle"): We match expenses with
the revenues they helped to generate in the same accounting period.
o Example: A company sells t-shirts. The revenue from selling the shirts is
recorded in the month they are sold. The cost of those specific t-shirts and the
salary of the salesperson for that month should be recorded as expenses in
the same month, to accurately calculate the profit for that period.
4. Full Disclosure Principle: Companies must disclose all information that is
important enough to influence a user's decision. This information can be in the
financial statements themselves or in the notes that accompany them.
o Example: If a company is the defendant in a major lawsuit that could cost it
millions, it must disclose this information in the notes to the financial
statements, even if the outcome is uncertain.
Constraints
These are practical limits or exceptions to the basic principles.
1. Materiality: An item is material if its size or nature is likely to influence the decision
of a reasonable person. If an item is immaterial (not important), a company can be
less strict about following GAAP.
o Example: A large company like Grameenphone might have a rule to expense
any purchase under ৳10,000 immediately, like a wastebasket, even though it's
technically an asset that will last for years. The cost is so small (immaterial) to
a huge company that it's not worth the effort to track it as an asset. However,
a ৳10,000 purchase would be very material to a small local tea stall.
2. Cost Constraint (or Cost-Benefit Relationship): The benefit of providing certain
information should outweigh the cost of gathering and presenting it.
o Example: A company could theoretically calculate the exact amount of
electricity used by each individual lightbulb in its factory to allocate costs.
However, the cost of installing meters on every bulb and tracking this data
would be enormous, and the benefit of having such precise information would
be tiny. Therefore, the company doesn't do it.
