Conceptual
Framework for Financial Reporting
Purpose of the
Conceptual framework
i.
To assist the
Board in the development of future IFRSs and in its review of existing IFRSs
ii.
To assist the
Board in promoting harmonisation of regulations, accounting standards and procedures relating to the
presentation of financial statements by providing a basis for reducing the
number of alternative accounting treatments permitted by IFRSs
iii.
To assist national standard-setting bodies in developing national standards
iv.
To assist preparers of financial statements in applying IFRSs and in dealing with topics that have yet to form
the subject of an IFRS
v.
To assist auditors in forming an opinion as to whether financial statements comply with
IFRSs
vi.
To assist users of financial statements in interpreting the information contained in financial statements
prepared in compliance with IFRSs
vii.
To provide
those who are interested in the work of the IASB with information about its approach to the formulation of IFRSs
Note: The Conceptual Framework is not an IFRS
and so does not overrule any individual IFRS. In the (rare) case of conflict
between an IFRS and the Conceptual
Framework, the IFRS will prevail.
Scope of Conceptual Framework.
a) The objective of financial statements
b) The qualitative characteristics that determine the usefulness of information in financial statements
c) The definition, recognition and
measurement of the elements from which financial statements are constructed
d) Concepts of capital and capital maintenance
Users of financial information and their information need.
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USERS
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NEED INFORMATION TO:
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Present and potential investors
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Make investment decisions, therefore need information on:
– Risk and return on investment
– Ability of entity to pay dividends
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Employees
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-Assess their employer's stability and profitability
-Assess their employer's ability to provide remuneration,
employment opportunities and retirement and other benefits
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Lenders
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-Assess whether loans will be repaid, and related interest will
be paid, when due
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Suppliers and other trade payables
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-Assess the likelihood of being paid when due
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Customers
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-Assess whether entity will continue in existence – important
where customers have a long-term involvement with, or are
dependent on, the entity, eg where there are product warranties or where
specialist parts may be needed
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Governments and their agencies
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-Assess allocation of resources and, therefore, activities of
entities
-Assist in regulating activities
-Assess taxation
-Provide a basis for national statistics
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The public
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-Assess trends and recent developments in the entity's prosperity
and its activities – important where the entity makes a substantial
contribution to a local economy, eg by providing employment and using local
suppliers
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The objective of general purpose financial reporting
The objective of general purpose financial reporting is to provide information about the
reporting entity that is useful to existing and potential investors, lenders
and other creditors in making decisions about providing resources to the
entity.
Underlying assumptions
Going
concern is the underlying assumption in preparing financial statements. Going
concern.The entity is normally viewed as a going concern, that is, as
continuing in operation for the foreseeable future. It is assumed that the
entity has neither the intention nor the necessity of liquidation or of curtailing materially the scale of its operations.
Qualitative
characteristics of useful financial information
The Conceptual Framework distinguishes between fundamental and enhancing qualitative characteristics, for analysis purposes. Fundamental
qualitative characteristics distinguish useful financial reporting information
from information that is not useful or misleading. Enhancing qualitative
characteristics distinguish more useful information from less useful
information.
Fundamental qualitative characteristics
a) Relevance
Relevant financial information is capable of
making a difference in the decisions made by users. Information may be capable
of making a difference in a decision even if some users choose not to take
advantage of it or are already aware of it from other sources. It is capable
of making a difference in decisions if it has predictive value, confirmatory
value or both.
i.
Predictive
value
Financial
information has predictive value if it can be used as an input for processes
employed by users to predict future outcomes.
ii.
Confirmatory
value
Financial
information has confirmatory value if it provides feedback (confirms or
changes) about previous evaluations.
b) Faithfull representation (True and Fair view)
Faithful representation. Financial
reports represent economic phenomena in words and
numbers. To be useful, financial information must not only represent relevant
phenomena but must faithfully represent the phenomena
that it purports to represent. To be a faithful representation information must
be complete,
neutral and free from error.
i.
A complete depiction includes all information necessary for a user to
understand the phenomenon being depicted, including all necessary descriptions
and explanations.
ii.
A neutral depiction is without bias in the selection or presentation of financial
information. This means that information must not be manipulated in any way in
order to influence the decisions of users.
iii.
Free from error means there are no errors or omissions in the description of the
phenomenon and no errors made in the process by which the financial information
was produced. It does not mean that no inaccuracies can arise, particularly
where estimates have to be made.
Enhancing qualitative characteristics
i.
Comparability
Comparability is the qualitative
characteristic that enables users to identify and understand similarities in,
and differences among, items. Information about a reporting entity is more
useful if it can be compared with similar information about other entities and
with similar information about the same entity for another period or date.
ii.
Understandability
Classifying, characterising and
presenting information clearly and concisely makes it understandable. These users are likely to use the information
to make economic decisions and must therefore be able to understand the
contents of the statements.
iii.
Verifiability
Information has the quality of verifiability
when different knowledgeable and independent observers could reach consensus,
although not necessarily complete agreement, that a particular depiction is a
faithful representation. If users are to take decisions based on the
financial statements, the information in the statements has to be verifiable;
otherwise it would not be of any help even if it is relevant.
iv.
Timeliness
Timeliness means having information available
to decision-makers in time to be capable of influencing their decisions.
Generally, the older the information is, the less useful it is. For the users
of general purpose financial statements, the information is useful for decision
making only if it is timely.
The
elements of financial statements
Statement of financial position
i.
Assets
ii.
Liabilities
iii.
Equity
Statement of profit or loss
iv.
Revenues
v.
Expenses
i.
Asset. 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.
Breaking down this
definition;
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A
resource controlled by an entity:
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If the resource is not controlled by the
entity, it cannot be considered an asset in financial accounting terms. For
example, a building is a resource which is ‘controlled’, as the entity has
the option of using the building in whichever way it wants to.
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As
a result of past events:
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Something must have happened in the past,
to ensure that the asset has the right to be controlled by the entity.
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From
which future economic benefits are expected to flow:
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An asset
contribute, directly or indirectly, to the flow of cash and cash equivalents
to the entity.
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An
asset may be classified as current or non-current asset. Examples of assets are
machinery, land, bank, receivables, inventory etc.
An entity shall classify an
asset as current when:
(a) It
expects to realise the asset, or intends to sell or consume it, in its normal
operating cycle;
(b)
It holds the asset primarily for the purpose of trading;
(c)
It expects to realise the asset within twelve months after
the reporting period; or
(d) The
asset is cash or a cash equivalent (as defined in IAS 7) unless the asset is
restricted from being exchanged or used to settle a liability for at least
twelve months after the reporting period.
An entity shall classify all other assets as non-current. A
similar logic applies to classification of liabilities into current and
non-current.
ii.
Liability. 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
resources embodying economic benefits.
An essential feature of a liability is that the entity has a present
obligation.
Obligation: A duty or responsibility to act or perform in a certain way.
Obligations may be legally enforceable as a consequence of a binding contract
or statutory requirement. Obligations also arise, however, from normal business
practice, custom and a desire to maintain good business relations or act in an
equitable manner.
As seen above, obligations may be:
·
Legally enforceable as a consequence of a binding
contract or statutory requirement.
·
The result of business practice. For example, even though a company has no legal obligation to do
so, it may have a policy of rectifying faults in its products even after the
warranty period has expired.
A management decision (to acquire
an asset, for example) does not in itself create an
obligation, because it can be reversed. But a management decision implemented
in a way which creates expectations in the minds of customers, suppliers or
employees, such as the warranty example above, becomes an obligation. This is
sometimes described as a constructive obligation.
Liabilities must arise from past transactions or events. For
example, the sale of goods is the past transaction which allows the recognition
of repair warranty provisions.
Settlement of a present obligation will involve
the entity giving up resources embodying
economic benefits in order to satisfy the claim of the other party. In
practice, most liabilities will be met in cash but this is
not essential.
iii.
Equity. The residual interest in the assets of the entity after deducting
all its liabilities.
Equity may be sub-classified
in the balance sheet providing information which is relevant to the
decision making needs of the users. This will indicate legal or other restrictions
on the ability of the entity to distribute or otherwise apply its equity.
iv.
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 increases in equity, other than those relating to contributions from
equity participants.
Breaking down
this definition
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Increase in economic benefits:
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The entity should see an
increase in economic benefits e.g. cash
through
sales etc.
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Inflows or enhancements of
assets or decreases of liabilities:
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This shows a SOFP approach. All
inflows are measured in terms of increasing assets or decreasing liabilities.
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Result in increases in equity, other than those relating to
contributions from equity:
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The resultant effect should be
to see that equity increases. So if a dividend is received, it means cash
(asset) increases and correspondingly profit for the period increases
(dividend income), thereby increasing equity.
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Both revenue and gains are included in the definition of income. Revenue arises in the course of ordinary activities of an entity. Examples of income include sales revenue, dividends
received, consultancy receipts, revaluation of non-current assets etc.
v.
Expenses.
Decreases in economic benefits during the accounting period in the
form of outflows or depletions of assets or incurrences of liabilities that
result in decreases in equity, other than those relating to distributions to
equity participants.
The
same logic shown above in income can be used here for expenses. Examples of
expenses include operating expenses, administrative expenses, selling expenses
etc.
Recognition
of the elements of financial statements
Recognition
is the
process of incorporating in the statement of financial position or statement of
profit or loss and other comprehensive income an item that meets the definition
of an element and satisfies the following criteria for recognition:
(a) It is probable
that any future economic benefit associated with the item will flow to or from
the entity.
(b) The item has a
cost or value that can be measured with reliability (the cost or value of an item in many cases must be estimated)
Measurement
of the elements of financial statements
For an item or transaction to be recognised in an entity's
financial statements it needs to be measured as a monetary amount. IFRS uses several different measurement bases but the Framework
refers to just four.
The four measurement bases referred to in the IASB Framework are:
Historical
cost. Assets are recorded at the amount of cash or cash equivalents
paid or the fair value of the consideration given to acquire them at the time
of their acquisition. Liabilities are recorded at the amount of proceeds
received in exchange for the obligation, or in some circumstances (for example,
income taxes), at the amounts of cash or cash equivalents expected to be paid
to satisfy the liability in the normal course of business.
Current cost. Assets are
carried at the amount of cash or cash equivalents that would have to be paid if
the same or an equivalent asset was acquired currently. Liabilities are carried
at the undiscounted amount of cash or cash equivalents that would be required
to settle the obligation currently.
Realisable (settlement) value.
–
Realisable
value. The amount of cash or cash equivalents that could currently be
obtained by selling an asset in an orderly disposal.
–
Settlement
value. The undiscounted amounts of cash or cash equivalents expected to
be paid to satisfy the liabilities in the normal course of business.
Present
value. A current estimate of the present discounted value of the future
net cash flows in the normal course of business.
Historical cost is the most commonly adopted measurement basis, but this is usually
combined with other bases, eg an historical cost basis may be modified by the
revaluation of land and buildings.
REVIEW QUESTIONS.
NBAA November 2015 Qn. 2
a) There
has be some mechanisms to ensure the accounting work is performed according to
set principles and standards. Furthermore, an assurance is needed that the
assumed professional expertise does actually exist and is applied to the work
in hand. This is achieved by means of a regulatory framework. Regulatory
framework is a structure which helps an entity decides how to treat item that
need to be included in the financial statements.
REQUIRED
i.
Evaluate the reasons why do we need regulatory
framework. (6 marks)
ii.
What does the IASBs Conceptual Framework of
Financial Reporting deals with?
b) The
word faithful ‘representation’, indicates truthfulness and fairness in the
financial statements presentations. In the financial statements each element
therein (assets, liability, equity, income and expense) represents something to
us. If all representations regarding these elements are true and fair, we call
them faithful representations. Financial information that faithfully represents
economic phenomena has three characteristics.
REQUIRED:
i.
Explain the three characteristics that make
financial statement presentation being faithfully represented.
ii.
What are the things needed to be observed to
ensure above characteristics are achieved?
CPA IRELAND August 2012 Qn. 4
The
International Accounting Standards Board is currently in the process of updating
its conceptual framework for financial reporting. The updated project is being
conducted in phases. To date, two chapters of the updated framework have been
issued: Chapter 1: The Objective of General Purpose Financial Reporting, and
Chapter 3: Qualitative Characteristics of Useful Financial Information. Chapter
4 of the conceptual framework contains the remaining text of the approved 1989
conceptual framework. Within this chapter, it describes the elements of financial
statements and discusses definitions of each.
REQUIREMENT:
(a) (i) Explain
the objective of “General Purpose Financial Reporting” as described in Chapter
1 of the revised conceptual framework; and (5
Marks)
(ii) Discuss
the usefulness of Chapter 1 in helping accountants determine appropriate
accounting policies and practices.
(5 marks)
(b) Prepare a
short memo for your Finance Director in which you briefly discuss the
recognition and measurement of one element of financial statements relating to
financial performance and another element relating to financial position. (10
marks)
[Total: 20 MARKS]
CPA IRELAND August 2015 Qn. 4
The IASB’s Conceptual
Framework for Financial Reporting attempts to set out the concepts that underlie the preparation and
presentation of financial statements for external users. The most recent
version was issued in September 2010.
REQUIREMENT:
(a) Discuss the
purpose and status of the Conceptual Framework. In particular, you should cover
the aims of the framework and its status in the event of a conflict between it
and a particular standard. (10 marks)
(b) Outline the
advantages and disadvantages of having a statement such as the Conceptual
Framework.
(10 marks)
[Total: 20 MARKS]
Nette, a public limited company, manufacturer mining
equipment and extracts natural gas. The directors are uncertain about the role
of the IASB’s Conceptual Framework for
Financial Reporting (the “Framework”) in corporate reporting. Their view is
that accounting is based on the transactions carried out by the company and
these transactions are allocated to company’s accounting period by using the
matching and prudence concepts. The argument put forward by the directors is
that the Framework does not take into account business and legal constraints
within which companies operate.
Required:
Explain the importance of the “Framework” to the
reporting of the reporting of corporate performance and whether it takes into
account the business and legal constraints placed upon companies.
Financial statements identify positions, performance
and changes in position over a period of time. The main statements include
Statement of Financial Position, Statement of Comprehensive Income and
Statement of Cash Flows. These statements are intended to show well a company
has performed and give an indication of the value of the business. However,
many accountants feel that the financial statements are limited in their value
to the users of financial statements.
Required:
Identify and discuss the limitations of financial
statements.
(a)
State the main purpose of the Conceptual Framework Reporting (“The
Framework”) adopted by the International Accounting Standard Board (IASB)
(b)
Explain the status of (“The
Framework”)
(c)
State the underlying assumption of
financial statements identified by (“The Framework”)
Briefly explain what a regulatory framework is and
discuss the reasons why there is a need for a regulatory framework in financial
reporting.
Define the following accounting concepts and explain
for each their implications for the preparation of financial statements:
The entity concept
Going concern
Materiality
Fair presentation (true and fair view)
Comparability is an enhancing qualitative
characteristics which add to the usefulness of financial statements.
Required:
(a)
Explain what is meant by the term
“comparability” in financial statements, referring to TWO types of comparison
that users of financial statements may make.
(b)
Explain TWO ways in which the IASB’s Conceptual Framework of Financial Reporting and
the requirements of accounting standards aid the comparability of financial
information.
“The accounting treatment and disclosure of the vast
majority of transactions will remain the same whether they are accounted for on
the basis of ‘substance’ or ‘form’. However, some transactions will have a
commercial effect not fully indicated by their legal form, and where this is
the case, it will not be sufficient to account for them merely by recording
that form”
Required:
Discuss the proposal that accounts should always
reflect the commercial substance of transactions.
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