Chapter 7 - Financial Accounting and Measurement Flashcards
What is the Conceptual Framework of Financial Reporting?
The Conceptual Framework for Financial Reporting is a coherent system of concepts that flow from an objective. The objective of financial reporting is the foundation for the framework.
What is the objective of the Conceptual Framework of Financial Reporting?
The objective of general purpose financial reporting provided in the current IASB Conceptual Framework is deemed to be:
“To provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions relating to providing resources to the entity.” Those decisions involve decisions about:
(i) Buying, selling or holding equity and debt instruments (decision-usefulness)
(ii) Providing or settling loans and other forms of credits; or (decision usefulness)
(iii) Exercising rights to vote on, or otherwise influence, managements actions that affect the use of the entities economic resources. (stewardship)
The framework provides general guidance about such issues as the objective of financial reports, which entities should produce general purpose financial reports, the qualitative characteristics that useful financial information will possess, how the elements of financial accounting (assets, liabilities, income, expenses and equity) should be defined, and when they should be recognised
Reporting entity
Reporting entity: When users are said to exist who do not have access to information relevant to decision making and who are judged to be dependent on general purpose financial statements, the entity is deemed to be a reporting entity. (considers separation of management and control, economic and political influence and the financial characteristics).
Users of Financial Reporting
Users of financial statements are identified as primarily being investors, lenders and other creditors with reasonable knowledge.
Other users are regulators and members of the public.
Stewardship
Stewardship involves monitoring the past actions of management (which relates to such factors as the integrity of management), as well as providing information to enable predictions about future cash flows.
Qualitative Characteristics of Conceptual Framework
Relevance is a fundamental qualitative characteristic of financial reporting. This qualitative characteristic requires that financial statements should only include financial information that could be expected to make a difference to user resource allocation decisions. For information to be relevant it should have both predictive- and confirmatory value. Another trait is materiality.
**Faithful representation
**
To be a perfectly faithful representation, a depiction would have three characteristics. It would be complete, neutral and free from error.
Completeness: A complete depiction includes all information necessary for a user to understand the phenomenon being depicted, including all necessary descriptions and explanations.
Neutrality: A neutral depiction is without bias in the selection or presentation of financial information. Should not be manipulated to increase the probability that financial information will be received favourably or unfavourably by users.
Freedom from error: An estimate must be based on appropriate inputs and each inputs should reflect the best available information.
Enhancing Qualitative Characteristics
Enhancing qualitative characteristics
Characteristics or attributes that enhance the usefulness of information that otherwise satisfies the fundamental qualitative characteristics.
Comparability: Various researchers have argued that a key role of a conceptual framework should be to produce consistent accounting standards that lead to comparable accounting information between different entities, as without such comparability it would be difficult for users to evaluate accounting information.
Verifiability: Refers to the ability, through consensus among measurers, to ensure (verify) that information represents what it purports to represent, or that the chosen method of measurement has been used without error or bias.
Timeliness: The timelier (or more up to date) that financial information is, the more useful it will be. Having information available to decision-makers in time to be capable of influencing their decisions.
Understandability: For information to be useful it needs to be understandable to the users. In the IASB Conceptual Framework, information is considered to be understandable if its likely to be understood by users with some business and accounting knowledge.
Elements of Financial Reporting
The IASB Conceptual Framework identifies five elements, split into two broad groups.The first group compromises elements relating to financial position, the elements of assets, liabilities and equity. The second group includes elements relating to performance and compromises income and expenses
IASB definition of asset
Asset: A present economic resource controlled by the entity as a result of past events.
(1) an asset is an economic resource (right) controlled by the entity.
(2) an asset exists as a result of past events.
(3) the right has the potential to produce economic benefits.
Recognising asset also requires that it is relevant and provide representationally faithful information. Uncertainties regarding potential economic benefits might lead to not recognizing the asset.
Two factors to consider in determining whether the disclosure of information about an asset would be relevant to financial users are:
Existence uncertainty
Probability associated with the expected inflow of economic benefits.
IASB definition of liability
Liability: A present obligation of the entity to transfer an economic resource as a result of past events.
(i) A liability represent a present obligation of the entity
(ii) It arises from past events
(iii) It creates an obligation to transfer economic resources away from the entity.
Two factors to consider in determining whether the disclosure of information about a liability would be relevant to financial users are:
(i) Existence uncertainty
(ii) Assessments about the probabilities of an outflow of economic benefits
IASB definition of expenses
Expenses: expenses are decreases in asset, or increases in liabilities, that result in decreases in equity, other than those relating to distributions to holders of equity claims.
(i) A decrease in assets, or an increase in liabilities.
(ii) A resulting decrease in equity, other than as a result of distributions to owners.
Implies that unless we understand what assets and liabilities represent, we will not be able to understand what an expense is.
IASB definition of expenses
IASB definition of income
Incomes: increases in assets, or decreases in liabilities, that results in increases in equity, other than those relating to contributions from holders of equity claims
Mixed Measurement Principles
IASB states that the selection of a measurement:
i) For a particular asset should depend on how that asset contributes to future cash flows; and
ii) For a particular liability should depend on how the entity will settle or fulfil that liability.
Measurement bases can be broadly divided into either historical cost or current value. Current value measurement basis can be further classified into:
1) fair value
2) value-in use (for assets), or fulfilment value (for liabilities)
Current cost.
Accounting is a practice that impacts many people throughout society, thereby making accounting a social practice.
Pros and cons with Conceptual Framework
- Pros
- Consistent and logical reporting standards
- Increased international compatibility of reporting standards
- Accountability of standard-setters with an explicit ‘standard’
- Enhanced communication between standard-setters and their constituents using a common base
- The development of accounting standards more economical
- Reduced need for additional standards if an issue is covered
- Cons
- A very restricted view of accountability
- Stifles future reporting innovation
- A potentially distorted view of an organisation’s ‘performance’
- Reflects existing accounting practice
- Used for legitimising financial reporting standard setters and the accounting profession, e.g. position of
accounting, self-regulation
