Chapter 2 – The Conceptual Framework for Financial Reporting

Question 1

What is the objective of financial reporting?

Answer 1

To provide useful financial information to the users of financial statements who use the information to make financial decisions.

Question 2

What is the scope/purpose of a conceptual framework?

Answer 2

• A statement of generally accepted theoretical principle that provide the underlying basis of framework for preparation/presentation of financial statements
• This in turn provides reliable and relevant information about the business.
• The theoretical principles also provide the basis for the development and evaluation of new and existing accounting standards
• Theoretical basis (from principles) of what events should be accounted for and how measures and communicated to users

Question 3

What are the key benefits of conceptual frameworks?

Answer 3

• Basis for development and evaluation of new and existing accounting standards
• Standards tend to be haphazardly produced in absence of such a framework
• Standards developed from a framework are less open to criticism than national standards
  (subject to political interference from interested parties)

Question 4

What are the main limitations of conceptual frameworks?

Answer 4

• FS devised on a single conceptual framework basis may not suit all users given diversity of requirement
• May be a need for variety of financial reporting / accounting standards with different concepts as a basis – each one being produced for a different purpose
• Not clear that a conceptual framework makes standard-setting processes any easier than without

Question 5

What does the IASB’s Conceptual Framework deal with?

Answer 5

 Objective of financial reporting
 Underlying assumptions
 Qualitative characteristics
 The elements of financial statements – definition
 The elements of financial statements – measuring
 The elements of financial statements – recognition and de-recognition
 Concepts and guidance related to regulation and disclosure
 Concepts of capital and capital maintenance

Question 6

What are the main aims of the IASB’s conceptual framework?

Answer 6

 Assist IASB in development of future/review of current IFRS (+ IAS)
 Basis for reducing number of accounting treatments permitted by IFRS (assists harmonization/standards and procedures)
 Assist national standard-setting bodies to develop their national standards
 Assist those preparing FS in applying IFRS / dealing with topics not covered by a standard or where a choice of accounting policy
 Assist auditors form an opinion on whether FS comply with IFRS
 Assist users of FS in interpreting the financial statements prepared in compliance with IFRS
 Provide those interested in IASB’s work with info about its approach in formulating IFRS

Question 7

How does the IASB define the objective of general financial reporting?

Answer 7

..to provide financial information about the reporting entity that is useful to present and potential equity investors, lenders and other users in making decisions about providing resources to the entity

Question 8

What are the other benefits/objectives of general purpose financial reporting?

Answer 8

 Help stakeholders assess stewardship
 Provides information about
o Economic resources
o Claims against resources
 Financial performance (changes in resources/claims) – how efficiently/effectively resources used by management
 Info about an entity can help predict future returns
 FS highlight strengths/weaknesses of the entity
 Help users assess liquidity/solvency
 Help users determine future prospects of net cash flow/needs for additional financing
 IASB C.F – general purpose financial results cannot provide all info users need to make economic decisions
 Should consider pertinent information from other sources as well, ex.:
o Bench-marking
o Competitor analysis
o Industry analysis

Question 9

Who are the 7 main (groups of users) of general purpose financial reporting?

Answer 9

• Investors
• Employees/managers
• Lenders
• Customers
• Suppliers
• Public
• Governments/tax authorities

Question 10

What are the two fundemental and four enhancing qualiative characteristics of IASB conceptual framework?

Answer 10

Fundemental
* Relevance
Financial information is regarded as relevant if it is capable of influencing the decisions of users. In determining what is relevant to users, preparers of financial statements should consider whether information is material and the extent to which reliable information may be omitted. Information may be material or relevant simply
because of its magnitude or because its omission from the financial statements could affect decision making.
* Faithful representation
Faithful representation means that financial information must meet three criteria: completeness, neutrality and be free from error.Financial information is regarded as relevant if it is capable of influencing the decisions of users. In determining what is relevant to users, preparers of financial statements should consider whether information is material and the extent to which reliable information may be omitted. Information may be material or relevant simply because of its magnitude or because its omission from the financial statements could affect decision making.

Enhancing
* Comparability
The accounting methods, including the presentation and classification of items in the financial statements, must be applied consistently for similar situations. This facilitates comparison with similar information about other entities and with similar information about the same entity for another period. The consistency concept is important because of the need for comparability of financial statements.
* Verifiability
Verifiability means that the accounting information presented in financial statements must be checked or demonstrated to be true, accurate or justified. If information can be verified (such as by an independent accountant) this provides assurance to the users that it is both credible and reliable. If something is not verifiable, it is unlikely to be auditable; hence, its reliability and usefulness is diminished.
* Timeliness
Timeliness of accounting information is important due to its usefulness and relevance to the decision-making needs of the users of financial statements. Local legislation and market regulations impose specific deadlines on certain entities. Timeliness is important to protect the users of the financial statements, such as potential investors, from outdated information or from delayed financial reporting.
* Understandability
Information should be understandable through appropriate classification, characterisation and presentation of information. Some financial transactions are inherently complex and difficult to understand, but to omit such information
would not give a fair representation of the financial statements. It is therefore important that the format and layout of the financial statements, the accounting policies applied, the terminology used and other statements made within the financial statements are clear and concise.

Question 11

What are the 3 main criteria of ‘faithful representation’

Answer 11

Faithful representation means that financial information must meet three criteria: completeness, neutrality and be free from error.
* Completeness: all information that users need to understand the item is given.
* Neutral or unbiased: there is no bias in the selection or presentation of information.
* Free from error: there are no omissions, errors or inaccuracies in the process to produce the information. This is something that cannot be completely eradicated, due to human error. Inaccuracies can arise, particularly in cases of making estimates and judgements. The financial reporting and accounting standards expect that the estimates are made on a realistic basis, not arbitrarily and the information contained within the financial statements presents a fair view of the organisation.

Question 12

Re-introduction by IASB of ‘prudence’ as a concept

Answer 12

The IASB’s revised Conceptual Framework has reintroduced the concept of prudence. It clarifies that measurement uncertainty might have an influence on the faithful representation of an item.

• Prudence is the exercise of caution when making judgements under conditions of uncertainty. It supports neutrality of information by ensuring that assets and income are not overstated and liabilities and expenses are not understated.
• Measurement uncertainty is a factor that can affect faithful representation. For example, relevant information with a high level of measurement uncertainty may provide less useful information than less relevant information with a lower measurement uncertainty. It may be necessary to override the legal form of a transaction to portray the true economic position.

Question 13

What is the objective and scope of financial statements?

Answer 13

• The IASB Conceptual Framework addresses the scope and objectives of financial statements. The objective of financial statements is to provide information about the assets, liabilities, equity, income and expenses of the reporting entity.
• Financial statements are a particular form of financial report that provides useful information about the financial position, financial performance and cash flows of a reporting entity to a wide range of users.
• This enables those users to make rational investment decisions such as buying, selling or holding equity and debt instruments and credit decisions such as providing or settling loans and other forms of credit.
• This information is provided in the statement of financial position and the statement(s) of financial performance, as well as in other statements and notes.

Question 14

2 Main sets of elements making up financial statements per IASB

Answer 14

• Elements relating to the statement of financial position: assets, liabilities and equity.
• Elements relating to the statement of financial performance: income and expense.

Question 15

Define asset

Answer 15

An asset is a present economic resource controlled by the entity as a result of past events. An economic resource is a right that has the potential to produce future economic benefits. For example, a property that is owned and controlled by an entity that is used to house operations and generate revenues would be classed as an asset.

Question 16

liab

Define liability

Answer 16

A liability is a present obligation or duty of responsibility of the entity to transfer an economic resource as a result of past transactions or events that the entity has no practical ability to avoid. For example, a trade payable is a liability.

Question 17

Define equity

Answer 17

This is the ‘residual interest’ in the assets of the entity after deducting all its liabilities. It represents what is left when the business is wound up, all the assets are sold and all the outstanding liabilities are paid. It is effectively what is paid back to the owners (shareholders) when the business ceases to trade.
The amount ‘assigned’ to equity will be the excess of assets over liabilities.

Question 18

Define income

Answer 18

• Income is increases in assets or decreases in liabilities that result in an increase in equity, other than those relating to contributions from holders of equity claims.
• Sales revenue is a good example of income.
• Recognition of income occurs simultaneously with increase in assets or decrease in liabilities.

Question 19

Define expenses

Answer 19

• Both day-to-day expenses and loss of future economic benefits.
• Expenses are decreases in assets or increases in liabilities that result in a decrease in equity, other than those relating to distributions to holders of equity claims. The cost of goods or services is an example of an expense.
• Recognition of expenses occur simultaneously with decrease in assets or increase in liabilities - ex. depreciation of an asset is recognised as an expense, it results in a reduction in the cost of assets

Question 20

Per the Conceptual Framework
a) What is recognition?
b) When should items be recognised?

Answer 20

• Must meet definition of asset, liability or equity (statement of financial position)
• Must meet definition of income or expense (statement of profit or loss & OCI)
• Only recognised when recongition provides users with information that is both relevant and faithful representation of the element (judged on entity’s environment and any evidence available)

Question 21

Overview of de-recognition

Answer 21

Derecognition is the removal of all or part of a recognised asset or liability from an entity’s statement of financial position.
* Asset: derecognition of an asset occurs when the entity loses control of all or part of the recognised asset.
* Liability: derecognition of a liability occurs when the entity no longer has a present obligation for all or part of the recognised liability.

The derecognition guidance reflects the view that both the control approach and the risk-and-rewards approach to derecognition are valid, though it does not specify the use of one or the other.

The IASB has adopted an approach that aims to faithfully represent both:
* the change in the entity’s assets (resources) and liabilities (obligations) as a result of the derecognition transaction; and
* the assets and liabilities (if any) that are retained.

An entity should derecognise an asset or liability with appropriate presentation and disclosure.
In limited cases, it may be necessary to continue to recognise a transferred component of an asset or liability together with a liability or asset for the proceeds received or paid, with appropriate presentation and disclosure.

Question 22

What are the two categories of measurement bases the IASB Conceptual Framework identifies

Answer 22

Historical Cost
* Historical price of transaction/event gave rise to item being considered.
* Price paid/cost incurred to acquire/create asset
* Liability - consideration received persuant to incurring a liability
* Prices at date rather than at date of the FS -
* Historic cost = at date of event. A&L presented on this basis reflect prices at multiple dates so may make comparability difficult - not as at the date of the FS
* Historic costs of both assets and liabilities will be updated over time - depicting present condition - ex. asset historic cost reduced to depict any consumption (depreciation) or if asset has become impared.
* Historic cost of liabilities is increased if they become onerous.

Current value
* Based on current monetary value
* Updated to reflect conditions ast measurement date
* Applied where historical cost amount not available (ex. if the A or L did not arise from an exchange transaction)

Measurement bases for CV may include

• FV - price reflecting market current expectations (orderly transaction at measurement date per IFRS 13)
• Value in use for assets/fufilment value for liabilities - Value in use for assets and fulfilment value for liabilities: the value that reflects entity-specific current expectations about the amount, timing and uncertainty of future cash flows. The descriptions of value in use and fulfilment value are derived from IAS 36 (Impairment of Assets). For example, an asset must not be carried in the financial statements at more than the highest amount to be recovered through its use or sale. If the carrying amount exceeds the recoverable amount, the asset is described as impaired. The entity must reduce the carrying amount of the asset to its recoverable amount and recognise an impairment loss.
• Current Cost - reflects the current amount required to be paid to acquire an equivalent asset or received to settle an equivalent obligation or liability.

Question 23

What is meant by the concept of capital management?

Answer 23

Under the concept of capital maintenance, profit may be recognised only if the total value of all assets (net of all liabilities) at the end of the accounting period exceeds the value at the beginning of the accounting period (after excluding any distributions to and contributions from owners during the period). In other words, an organisation is said to be making a profit only if the net value of its assets increases.

Question 24

What are the two concepts of capital management identified by the Conceptual Framework?

Answer 24

• financial capital maintenance
• physical capital maintenance

Question 25

WHAT IS THE FINANCIAL CONCEPT OF CAPITAL MANAGEMENT

Answer 25

• According to this concept, the capital of the entity is linked to the net assets, which is the equity of the entity. Profit is earned only if the financial or monetary value of the net assets at the end of the accounting period exceeds the monetary value of net assets at the beginning of the accounting period.
• This is adjusted for any distributions (such as dividends) to or contributions (such as equity capital raised) from the owners.

The financial statements can be viewed by users as:
Opening equity (net assets) + profit – distributions = closing equity (net assets)
Where: assets – liabilities = equity

The financial concept of capital maintenance can be further categorised as
* money financial capital maintenance
* real financial capital maintenance

• The only difference between these two categories is that money financial capital maintenance considers the time value of money or the impact of inflation, whereas these are ignored in real financial capital maintenance.
• A financial concept of capital is usually followed by an entity where the financial statements are referred to by its users in the context of purchasing power of the amount invested as capital or the maintenance of their invested capital.

Question 26

WHAT IS THE PHYSICAL CONCEPT OF CAPITAL MANAGEMENT

Answer 26

• This concept works for an entity where the capital is regarded as its production capacity.
• Profit under this concept is earned **only **if the production capacity at the end of the year exceeds the production capacity of an entity at the beginning of the year, after excluding any distributions to or contributions from the owners.
• This production capacity may be based on units of output.
• The main concern of users of these financial statements is with the maintenance of the operating capability of the entity.
• This method is usually followed if the users of the financial statements are mostly concerned with the operating capacity of the entity, as well as enhancing such operating capacity.
• Most organisations use the financial concept of capital maintenance as it is easier to apply