B. THE FINANCIAL REPORTING FRAMEWORK

Question 1

In order to achieve fair presentation, an entity must comply with:

Answer 1

 International Financial Reporting Standards

 The Conceptual Framework for Financial Reporting

Question 2

Conceptual Framework

Answer 2

A conceptual framework is a statement of generally accepted theoretical principles which form the frame of reference for financial reporting. These theoretical principles provide the basis for the IASB’s development of new accounting standards and the evaluation of those already in existence. The financial reporting process is concerned with providing information that is useful in the business and economic decision-making process. Therefore, a conceptual framework will form the theoretical basis for determining which events should be accounted for, how they should be measured and how they should be communicated to the user. Although it is theoretical in nature, a conceptual framework for financial reporting has highly practical final aims.

Question 3

The purpose of the Conceptual Framework is to:

Answer 3

 Assist the IASB to develop IFRSs that are based on consistent concepts
 Assist the preparers of accounts to develop accounting policies in cases where there is no IFRS applicable to a particular transaction, or where a choice of accounting policy exists;
 Assist all parties to understand and interpret IFRSs.

Question 4

Importance of Conceptual Framework

Answer 4

 Where there is a formal conceptual framework for accounting, accounting practice and accounting standards are based on this framework. Lack of a formal framework often means that standards are developed randomly or only to deal with particular problems. The result is that standards are inconsistent with each other or with legislation.
 Lack of a conceptual framework may also mean that accounting standards fail to address important issues.
 The business environment is becoming increasingly complex. It is unlikely that accounting standards can cover all possible transactions.
 It can also be argued that a conceptual framework strengthens the credibility of financial reporting and the accounting profession in general.

Question 5

The objective of general purpose financial reporting

Answer 5

The objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors (primary users) in making decisions about providing resources to the entity. Those decisions involve buying, selling or holding equity and debt instruments and providing or settling loans and other forms of credit.

Question 6

Information need of primary users

Answer 6

To make decisions, primary users need information about the economic resources of the entity, claims against the entity and changes in those resources and claims. Information about a reporting entity’s economic resources and claims assists users to assess that entity’s financial strengths and weaknesses; to assess liquidity and solvency, and its need and ability to obtain financing. Information about the claims and payment requirements assists users to predict how future cash flows will be distributed among those with a claim on the reporting entity.
Information about a reporting entity’s financial performance (the changes in its economic resources and claims) helps users to understand the return that the entity has produced on its economic resources. This is an indicator of how efficiently and effectively management and governing board have discharged their responsibilities to use the entity’s economic resources (management’s stewardship) and is helpful in predicting future returns.

Question 7

Three aspects are relevant to users of financial statements (FR):

Answer 7

 Financial performance reflected by accrual accounting;
 Financial performance reflected by past cash flows;
 Changes in economic resources and claims not resulting from financial performance (share issue).

Question 8

Limitations of FS.

Answer 8

The Framework notes that general purpose financial reports cannot provide all the information that users may need to make economic decisions. They will need to consider pertinent information from other sources as well. Users of financial reports should be aware of the limitations of the information included in such reports – specifically, estimates and the use of judgement. Additionally, financial reports are but one source of information needed by those who make investment decisions. Information about general economic conditions, political events and industry outlooks should also be considered. Financial reporting should also include management’s explanations, since management knows more about the entity than external users.

Question 9

Fundamental qualitative characteristics.

Answer 9

Financial information is useful if it is relevant and faithfully represents what it purports to represent.
Relevance: Relevant information is capable of making a difference in the decisions made by users. Financial information is capable of making a difference in decisions if it has predictive value, confirmatory value, or both.
Materiality: information is material if omitting or misstating it could influence decisions of primary users.
Faithful representation: Faithful representation reflects economic substance rather than legal form, and is:
 Complete includes all information necessary for understanding;
 Neutral without bias, supported by exercise of prudence;
 Free from error – processes and descriptions without error, does not mean perfect.

Question 10

Applying the fundamental qualitative characteristics.

Answer 10

 Identify the economic phenomenon
 Identify the type of information about it that would be most relevant
 Determine if that information is available and if it would give a faithful representation. If so, use that information. If not, then identify the next most relevant information and apply step 3 again.

Question 11

Enhancing qualitative characteristics

Answer 11

The usefulness of financial information is enhanced if it is comparable, verifiable, timely and understandable.
 Comparability is the qualitative characteristic that enables users to identify and understand similarities in, and differences among, items.
o The disclosure of accounting policies is particularly important here. Users must be able to distinguish between different accounting policies in order to be able to make a valid comparison of similar items in the accounts of different entities.
o When an entity changes an accounting policy, the change is applied retrospectively so that the results from one period to the next can still be usefully compared.
 Verifiability helps assure users that information faithfully represents the economic phenomena it purports to represent. It means that different knowledgeable and independent observers could reach consensus, although not necessarily complete agreement, that a particular depiction is a faithful representation (verified to a model or valuation by specialist).
 Timeliness means that information is available to decision-makers in time to be capable of influencing their decisions. There is a balance between timeliness and the provision of reliable information.
 Understandability. Classifying, characterising and presenting information clearly and concisely makes it understandable. Financial reports are prepared for users who have a reasonable knowledge of business and economic activities and who review and analyse information diligently.

Question 12

The cost constraint on useful financial reporting.

Answer 12

Cost is a pervasive constraint on the information that can be provided by general purpose financial reporting. Reporting such information imposes costs and those costs should be justified by the benefits of reporting that information.

Question 13

Prudence

Answer 13

Prudence is the inclusion of a degree of caution in the exercise of the judgements needed in making the estimates required under conditions of uncertainty, such that assets or income are not overstated and liabilities or expenses are not understated. The concept of prudence was removed when the Conceptual Framework was redrafted. However, this concept remains the foundation of many rules in existing standards.

Question 14

Substance over form.

Answer 14

Substance over form is an accounting concept which means that the economic substance of transactions and events must be recorded in the financial statements rather than just their legal form in order to present a true and fair view of the affairs of the entity.

Question 15

Measurement uncertainty

Answer 15

Measurement uncertainty is one factor that can make information less relevant. It arises when estimates are used to measure assets and liabilities. However, the use of estimates is an essential part of financial reporting and does not necessarily undermine its relevance. Furthermore, an estimate can provide relevant information, even if the estimate is subject to a high level of measurement uncertainty. Nevertheless, if measurement uncertainty is high, an estimate is less relevant than it would be if it were subject to low measurement uncertainty. This means that there is a trade-off between the level of measurement uncertainty and other factors that make information relevant.

Question 16

Recognition.

Answer 16

Recognition: is the process of capturing for inclusion in the statement of financial position or the statement of financial performance an item that meets the definition of one of the elements of financial statements – an asset, liability, equity, income or expenses.
Recognition is subject to cost constraints: the benefits of the information provided by recognizing an element should justify the costs of recognizing that element.

Question 17

An item is recognized in the financial statements if:

Answer 17

 The item meets the definition of an element (asset, liability, equity, income or expenses)
 Recognition of that element provides users of the financial statements with information that is useful, ie with:
o Relevant information about the element
o A faithful representation of the element.

Question 18

Derecognition.

Answer 18

Derecognition normally occurs:
 For an asset – when control is lost
 For a liability – when there is no longer a present obligation.
The requirements for derecognition aim to faithfully represent both:
 Any assets and liabilities retained after derecognition; and
 The changes in the entity’s assets and liabilities as a result of derecognition
To give a faithful representation, it may also be necessary to provide explanatory information and/ or to present separately related income/expenses and retained components in financial statements

Question 19

Measurement

Answer 19

Measurement involves assigning monetary amounts at which the elements of the financial statements are to be recognised and reported. IFRSs use a mixed measurement approach, which means that different measurement bases are used for different classes of elements.

Question 20

There are 2 main measurement bases:

Answer 20

Historical cost for an asset is the cost that was incurred when the asset was acquired or created and, for liability is the value of the consideration received when the liability was incurred. Historical cost is updated as the asset is consumed or as the liability is settled.
Current value uses information available at the reporting date to update the carrying amounts of assets and liabilities.

Question 21

Current value (4)

Answer 21

 Fair value – is the price that would be received to sell an asset, or paid to transfer a liability, in an orderly transaction between market participants at the measurement date.
 Value in use – is the present value of the cash flows, or other economic benefit, that an entity expects to derive from the use of an asset and from its ultimate disposal.
 Fulfilment value – is the present value of the cash, or other economic resources, that an entity expects to be obliged to transfer as it fulfils a liability.
 Current cost of an asset – is the cost of an equivalent asset at the measurement date, comprising the consideration that would be paid at the measurement date plus the transaction costs that would be incurred at that date.
 Current cost of a liability – is the consideration that would be received for an equivalent liability at the measurement minus the transaction costs that would be incurred at that date.

Question 22

Entry and exit values

Answer 22

Current cost and historical cost are both entry values, they ‘reflect prices in the market in which the entity would acquire the asset or would incur the liability’. Fair value, value in use and fulfilment value are exit values. Fair value reflects the perspective of market participants, whereas value in use and fulfilment value reflect entity-specific assumptions.

Question 23

Factors to consider in selecting a measurement basis.

Answer 23

Nature of information provided. Different information is produced by applying a different measurement basis to the same asset (or other element). Therefore, it is important to consider what information is produced by a measurement basis in both the statement of financial position and the statement of profit or loss. Which one is more important will depend on the particular circumstances.
Usefulness of information provided. To be useful, the information provided by a measurement basis must be relevant and a faithful representation.
 Relevance is affected by
o How the asset/liability contributes to future cash flows; and
o The characteristics of the asset or liability.
 Faithful representation is affected by
o Measurement inconsistency using different measurement basis for related assets and liabilities can result in accounting mismatch.
o Measurement uncertainty arises when a measure must be estimated and cannot be determined by observing prices in an active market.
Other factors
 Cost constraint: do the benefits of the information provided by the selected measurement basis justify the costs?
 Enhancing qualitative characteristics.

Question 24

Objective of financial statements

Answer 24

Objective of financial statements is to provide financial information about the reporting entity’s assets, liabilities, equity, income and expenses that is useful to users of financial statements in assessing the prospects for future net cash inflows to the reporting entity and in assessing management’s stewardship of the entity’s economic resources.

Question 25

Useful financial information is presented in:

Answer 25

 The statement of financial position (SOFP) by recognizing assets, liabilities and equity
 The statement of profit and loss and other comprehensive income (SPLOCI) by recognizing income and expenses
 Other statements and notes by presenting and disclosing information about:
o The nature of recognized items and associated risks
o The nature of unrecognized assets and liabilities and associated risks
o Cash flows
o Transactions with equity holders
o Methods, assumptions and judgements used to estimate amounts presented or disclosed

Question 26

Financial statements are:

Answer 26

 Prepared for a period of time, with comparative information and include information about transactions after the reporting date if necessary
 Presented from the perspective of the reporting entity as a whole and not from a particular group of users
 Normally prepared on the assumption that an entity is a going concern and will continue in operation for the foreseeable future.

Question 27

Reporting entity:

Answer 27

Reporting entity: A reporting entity is an entity that is required, or chooses, to prepare financial statements. A reporting entity can be a single entity or a portion of an entity or can comprise more than one entity. A reporting entity is not necessarily a legal entity. Where a reporting entity is not a legal entity or a group linked by parent-subsidiary relationships, then the boundary of a reporting entity is driven by the information needs of the users of the reporting entity’s financial statements.

Question 28

The elements directly related to financial position (balance sheet) are:

Answer 28

 Asset is a present economic resource controlled by the entity as a result of past events.
 Liability is a present obligation of the entity to transfer an economic resource as a result of past events.
 Equity is the residual interest in the assets of the entity after deducting all its liabilities.
An economic resource is a right that has the potential to produce economic benefits.

Question 29

Economic benefits include:

Answer 29

 Cash flows, such as returns on investment sources
 Exchange of goods, such as by trading, selling goods, provision of services
 Reduction or avoidance of liabilities, such as paying loans.

Question 30

Obligation

Answer 30

Obligation. A duty or responsibility that the entity has no practical ability to avoid. A present obligation exists as a result of past events if the entity has already obtained economic benefits or taken an action, and as a consequence, the entity will or may have to transfer an economic resource that it would not otherwise have had to transfer.

Question 31

The elements directly related to performance (income statement) are:

Answer 31

 Income increases in assets, or decreases in liabilities, that result in increases in equity, other than those relating to contributions from holders of equity claims.
 Expenses decreases in assets, or increases in liabilities, that result in decreases in equity, other than those relating to distributions to holders of equity claims.

Question 32

The cash flow statement reflects

Answer 32

both income statement elements and some changes in balance sheet elements.

Question 33

Effective presentation and disclosure requires:

Answer 33

 Focusing on presentation and disclosure objectives and principles rather than on rules
 Classifying information by grouping similar items and separating dissimilar items
 Aggregating information appropriately so that it is not obscured by unnecessary detail or excessive aggregation

Question 34

Capital maintenance

Answer 34

The concept of capital maintenance links the concepts of capital and the concepts of profit:
 The measurement of profit depends on the method used to value capital
 Profit is only generated if the capital at the end of the reporting period is greater than that at the start, ie only inflows of assets in excess of amounts needed to maintain capital are profits.

Question 35

Two concepts of capital maintenance:

Answer 35

Two concepts:
 Financial capital maintenance. Capital refers to the net assets or equity of the entity. Profit is made if the financial amount of net assets at the end of reporting period is greater than the financial amount at the start, after excluding contributions from and distributions to owners.
 Physical capital maintenance. Capital refers to the productive capacity of the entity. Requires the use of current cost basis of measurement. Profit is made if the operating capability at the end of reporting period is greater than that at the start, ie over and above increases due to changes in prices.
If primary users are concerned mainly with the maintenance of nominal invested capital, then the financial concept of capital should be used (most entities use this one). If primary users are concerned mainly with the operating capability of the entity, a physical concept of capital should be used