Chapter 2 - The Conceptual Framework of Financial Reporting

Question 1

What is the purpose of the Conceptual Framework?

Answer 1

a) to assist the IASB in the development of future IFRS and in its review of existing IFRS;
b) to provide a basis for reducing the number of alternative accounting treatments permitted by IFRS and thus assist the harmonisation of regulations, accounting standards and procedures relating to financial reporting;
c) to assist national standard setting bodies in developing national standards;
d) to assist preparers of financial statements in applying IFRS and in dealing with topics that are not covered by a standard or where there is choice of accounting policy;
e) to assist auditors in forming an opinion as to whether financial statements comply with IFRS;
f) to assist users of financial statements in interpreting the financial statements prepared in compliance with IFRS;
g) to provide those who are interested in the work of the IASB with information about its approach to the formulation of IFRS.

Question 2

Why is there a need for businesses to prepare financial statements for their users?

Answer 2

The key benefits of preparing financial statements for their users are listed below.
-Investors: financial statements help investors to decide about buying or selling shares by providing information about the level of dividend and any changes in share price. It also helps investors to see the company’s prospects, present liquidity position and how the company’s shares compare with those of its competitors.
-Employees and management: company performance is related to the security of employment and future prospects for jobs in the company. The financial position and performance help management in managing the
business.
-Lenders: the information in the financial statements help lenders decide whether to lend to a company. This information is checked for adequacy of the value of security, ability to make interest and capital repayments and to ensure financial covenants have not been
breached.
-Suppliers: are interested in information to assess whether the company will be a good customer and pay its debts.
-Customers: the company should be in a good financial position to be able to continue producing and supplying goods or services.
-Government: is specifically concerned with compliance with tax and company law, ability to pay tax and its general contribution to the economy.
-The public: All of the reasons stated above could be useful to the general public.

Question 3

Briefly explain the meaning of faithful representation.

Answer 3

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.
Interpreting Financial and Accounting Information.
-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.

The idea of ‘substance over form’ is key for the faithful representation of financial information. It may be necessary to override the legal form of a transaction to portray a true economic position.

Question 4

Management commits to purchase assets in the future. Does this give rise to a liability?

Answer 4

An essential characteristic of a liability is that the entity has a present obligation. A liability is present obligation of the entity to transfer economic benefit as a result of past transactions or events. For example, a trade payable is a liability.

It is important to distinguish between a present obligation and a future commitment. A management decision to purchase assets in the future does not,
in itself, give rise to a present obligation. It is rather a future commitment.

Question 5

Explain how you would report a transaction that fails to satisfy the recognition criteria.

Answer 5

Where an essential element is not recorded as an asset, liability, income or expense because it is unable to meet the criteria for recognition, it can be disclosed in the form of explanatory notes if the knowledge would be relevant to the users of the financial report in making and evaluating their decisions. The revised recognition criteria refer explicitly to the qualitative characteristics of
useful information.

For example, an entity may be engaged in litigation in defence of a claim for a certain amount of damages. Although the claim may not meet the recognition criteria of a liability, such information may be considered to be relevant to the users of the financial report in making and evaluating their decisions. Accordingly, it may warrant disclosure in the notes in the financial report.

Question 6

Explain the most commonly used measurement in financial statements.

Answer 6

Historical cost is the measurement basis most commonly used today. It is usually combined with other measurement bases. Examples of this include:

• assets on finance leases are to be carried at the lower of:
  a) Fair value at the date of its acquisition; or
  b) Discounted value of the minimum lease payments at that date;
• construction contracts shall be carried at historical cost plus a proportion of the expected profit;
• inventories are also measured as per IAS 2 at the lower of cost and net realisable value.

Consideration of different factors is likely to result in different measurement bases for different assets, liabilities, income and expenses. The factors to be
considered when selecting a measurement basis are relevance and faithful representation, because the aim is to provide information that is useful to investors, lenders and other creditors.

Question 7

Limitations of a conceptual framework

Answer 7

1) FS are devised based on a single CF may not suit all users given the diversity of user’s requirements
2) There may be a need for variety on accounting standards with different concepts as a basis, each produced for a different purpose
3) It is not clear that a CF makes the standard setting process any easier than without a CF.

Question 8

What are the fundamental qualitative characteristics?

Answer 8

1. Relevance

2. Faithful representation

Question 9

What are the enhancing qualitative characteristics?

Answer 9

(CUT-V)

1. Comparability
2. Verifiability
3. Timeliness
4. Understandability

Question 10

What are the elements of FS?

Answer 10

1. Asset - present economic resource controlled by the entity as a result of past events.
2. Liability - present obligation of the entity to transfer an economic resource as a result of past events that the entity has no practical ability to avoid.
3. Equity - residual interest in the assets of the entity after deducting all its liabilities.
4. 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.
5. Expense - 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 11

What are the 2 categories of measurement basis?

Answer 11

1. Historical Cost - Historical price of the transaction/event that gave rise to the item being considered for
   measurement. Price paid to acquire the asset. For a liability, this is the value of consideration
   received in connection with the incurrence of a liability.
2. Current Value Basis - Current monetary value updated to reflect conditions at the measurement date.

Question 12

What are the 2 concepts of capital and capital maintenance?

Answer 12

1. Financial Capital Maintenance - Capital of the entity is linked to the net assets which is the equity of the entity. Only profit where net value of assets increases.
2. Physical Capital Maintenance - Used for an entity where the capital is regarded as its production capacity. Only profit where the net value of production capacity increases.