5 September 2016

The Conceptual Framework

(Week 1)
PowerPoint Slides
by Sharmela

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Learning Outcome (s)

On successful completion of this topic students should be
able to:
Evaluate the consistency and clarity of corporate reports
Discuss the usefulness of corporate reports in making
investment decisions
Discuss the use of the conceptual framework for
financial reporting in the production of accounting
standards.
Identify the relationship between accounting theory and
practice

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Introduction
Corporate reporting is to provide useful information
about performance and resources of an entity to its
users, to assist the users in making economic
decisions.
The conceptual framework set out the concepts which
underlie the preparation and presentation of financial
information for users.

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Conceptual Framework
A statement of generally accepted theoretical principles
Forms the frame of reference for financial reporting
Provide the basis for the 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.

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Meaning of Conceptual Framework

Conceptual framework is a system of concepts and
principles including document or statement that sets out
and explains the concepts and principles, that underpin
the preparation of financial statements.

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Purpose of Conceptual Framework

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.
Lack of a conceptual framework may also means that accounting
standards fail to address important issues. Eg until the IASB
developed its Framework, there was no proper definition of terms
such as asset, liability, income and expenses.
Where an entity enters into an unusual transaction and there is no
relevant accounting standard, it can refer to the Framework and
apply the principles in it.

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Principle-based verses Rule-based Accounting

System
The alternative to a system based on a conceptual framework (principle
based) is a system based on detailed rules. Disadvantages of rules
based:
Accounting standards based on detailed rules are open to abuse
Standard setters are more likely to be influenced by vested interests such as
large companies or a particular business sector.

Standards based on principles may require management to use its

judgment (and to risk making a mistake), while rules simply need to be
followed. This can be important where management can face legal action if
an investor makes a poor decision based on the financial statement.
The use of a conceptual framework can lead to standards that are
theoretical and complex. This may give the right answer but be very
difficult for the ordinary preparer to understand and apply. However, a
system of extremely detailed rule can also be difficult to apply.

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Dangers of not having a Conceptual Framework

Standards tend to be produced in a haphazard and firefighting approach. Where an agreed framework exists, the
standard-setting body act as an architect or designer, rather
than a fire-fighter, building accounting rules on the
foundation of sound, agreed basic principles.
Fundamental principles are tackled more than once in
different standards, thereby producing contradictions and
inconsistencies in basic concepts, such as those of prudence
and matching. This leads to ambiguity and it affects the
true and fair concept of financial reporting.

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Dangers of not having a Conceptual Framework

Another problem with the lack of a conceptual framework
has become apparent in the USA. The large number of
highly detailed standards produced by the Financial
Accounting Standards Board (FASB) has created a
financial reporting environment governed by specific
rules rather than general principles.
This would be avoided if a cohesive set of principles
were in place.
A conceptual framework can also bolster standard
setters against political pressure and interested parties.
Such pressure would only prevail if it was acceptable
under the conceptual framework.

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Advantages
The situation is avoided whereby standards are developed on
a patchwork basis, where a particular accounting problem is
recognised as having emerged, and resources were then
channelled into standardising accounting practice in that area,
without regard to whether that particular issue was
necessarily the most important issue remaining at that time
without standardisation.
As stated above, the development of certain standards
(particularly national standards) have been subject to
considerable political interference from interested parties.
Where there is a conflict of interest between user groups on
which policies to choose, policies deriving from a conceptual
framework will be less open to criticism that the standardsetter buckled to external pressure.

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Advantages
Some standards may concentrate on the income
statement whereas some may concentrate on the
valuation of net assets (statement of financial position).

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Diadvantages
Financial statements are intended for a variety of users,
and it is not certain that a single conceptual framework
can be devised which will suit all users.
Given the diversity of user requirements, there may be a
need for a variety of accounting standards, each
produced for a different purpose (and with different
concepts as a basis).
It is not clear that a conceptual framework makes the
task of preparing and then implementing standards any
easier than without a framework.

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Conceptual Framework
IASB produced a document, Framework for the
Preparation & Presentation of F/S (Framework) which
was replaced, in September 2010, by the Conceptual
Framework for Financial Reporting.

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IASB Framework

The objective of financial statement (f/s)

Underlying assumptions of F/S
Qualitative characteristics of f/s
The elements of f/s
Recognition of the elements of f/s
Measurement of the elements of f/s
Concepts of capital & capital maintenance.

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The Purpose Of The IASB Framework For The

Preparation & Presentation Of F/S
Assist with the development of new international
accounting standards.
Assist national standard-setting bodies to develop
accounting standards for their own country.
Provide guidance for the preparation of f/s
Assist users in understanding f/s that have been
prepared in accordance with international accounting
standard.

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The Purpose Of The IASB Framework For The

Preparation & Presentation Of F/S
Assist the Board of the IASB 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 IASs.
Assist preparers of financial statements in applying IASs
and in dealing with topics that have yet to form the
subject of an IAS.
Assist auditors in forming an opinion as to whether
financial statements conform with IASs.

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Warning
The Framework is not an IAS and so does not overrule
any individual IAS. In the (rare) cases of conflict between
an IAS and the Framework, the IAS will prevail. These
cases will diminish over time as the Framework will be
used as a guide in the production of future IASs. The
Framework itself will be revised occasionally depending
on the experience of the IASB in using it.

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Users of financial statements.

Present & future investors

Employees
Lenders
Suppliers
Customers
Government & government agencies
General public.

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Question
Consider the information needs of the users of financial
information listed above.

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Users of financial statements.

Financial statements cannot meet all these users' needs,
but financial statements which meet the needs of
investors (providers of risk capital) will meet most of the
needs of other users.
The Framework emphasises that the preparation and
presentation of financial statements is primarily the
responsibility of an entity's management. Management
also has an interest in the information appearing in
financial statements.

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Objectives Of Financial Statement.

To provide users with information about:
The financial position of the entity
The financial performance of the entity
Changes in its financial position.
Users need this information to evaluate the ability of the
entity to generate cash, and the timing and certainty of this
cash generation. This ability to generate cash determines
whether the entity will be able to pay its employees,
suppliers, interest and repayment of loans, and dividend to
its shareholders.
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Objectives Of Financial Statement

Financial reporting is a means by which the directors are
made accountable to the shareholders for:
The way they have managed the company, &
The financial results they have achieved.

Financial position of an entity is affected by:

The economic resources that it owns or controls
Its financial structure
Its liquidity and solvency.

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Objectives Of Financial Statement

Financial performance in particular profitability is useful
for:
Assessing future profitability
Assessing potential changes in the resources that an entity might
have (control) in the future
Making a judgment about how effectively an entity would make
use of any additional resources that it obtains.

Changes in financial position provide information that is

useful for assessing:
The investing, financing and operating activities of an entity
during the reporting period.
Its ability to generate cash &
Its need for cash

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Underlying Assumptions In The Framework:

Accruals basis
Going concern basis.

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Accruals Basis
Does NOT use cash basis
Transactions/ events recognised if relates to the period
of the financial statement prepared
Revenue recognise when earned
Expense incurred
Income is matched with expense for the year

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Going Concern
Financial statements prepared on the
assumption that entity will continue
to be in operation for the
foreseeable future
Implication:
Assets shown at historical cost

If not going concern assets shown

at break up value

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Qualitative Characteristics
The qualitative characteristics of useful financial
reporting identify the types of information are likely to be
most useful to users in making decisions about the
reporting entity on the basis of information in its financial
report.
Financial information is useful when it is relevant and
represents faithfully what it purports to represent. The
usefulness of financial information is enhanced if it is
comparable, verifiable, timely and understandable.

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Fundamental qualitative characteristics

Relevance
Information is relevant if it is capable of making a difference in
the decision made by users.

Financial information is capable of making a difference in

decisions if it has predictive value, confirmatory value, or both.
The predictive value and confirmatory value of financial
information are interrelated.
The relevance of information is affected by:
Its nature and
Its materiality

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Fundamental qualitative characteristics

Faithful representation
Financial reporting information must faithfully represent the
economic phenomena that it purports to represent. A perfectly
faithful representation is complete, neutral and free from error.
Fnancial information must account for transactions and other
events in a way that reflects their substance and economic
reality (ie true commercial impact) rather than their legal form

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Enhancing qualitative characteristics

Enhancing qualitative characteristics
maximised to the extent necessary.

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Enhancing qualitative characteristics

Understandability
Information in f/s must be readily understandable to users.
Users are assumed to have a reasonable knowledge of
business activities & accounting. It is also assumed that they are
willing to study information with reasonable diligence.
Relevant information should not be excluded from the f/s
simply because it is too complex or may be too difficult for some
users to understand.

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Enhancing qualitative characteristics

Comparability
Financial information must be comparable over time and for one
business entity over other business entities.
Comparability over time can identify trends in an entity financial
position or performance.
Comparability with different business entities, can assess the
relative financial position and performance.
To be comparable, f/s should be prepared in a consistent way
from one year to the next and disclosing comparative figures.

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Enhancing qualitative characteristics

Timeliness if there is undue delay in reporting
financial information, it might lose its usefulness.

Verifiability - It means that different knowledgeable and

independent observers could reach consensus, although
not necessarily complete agreement, that a particular
depiction is a faithful representation.

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Constraints on useful information.

Cost & benefits the benefits obtained from financial
information should exceed the cost of obtaining &
providing it. Information should not be provided if the
cost is not worth the benefit.
Since it is difficult to measure the benefits of financial
information, the setters of accounting standards must
use their judgement in deciding whether certain items of
information should be provided in the fianancial
statements (and if so, in how much detail).

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Elements of Financial Statements

Assets
Liabilities
Equity
Income
Expense

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Elements of Financial Statements

Assets defined as:
A resource controlled by the entity
As a result of past events, and
From which future economic benefits are expected to flow to the
entity.

Assets result from past transactions and not created by

any transaction that is expected to occur in the future but
has not yet happened. Eg an intention to buy inventory
does not create an asset.

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Elements of Financial Statements

Liabilities defined as:
A present obligation of an entity
Arising from past events
The settlement of which is expected to result in an outflow of
resources that embody economic benefits.

A liability is an obligation that already exists. An obligation

may be legally enforceable as a result of a binding contract or
a statutory requirement or arise from normal business
practice.
A liability arises out of past transaction eg trade payable
arises out of past purchases.

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Elements of Financial Statements

Equity is the residual interest in an entity after the
value of all its liabilities has been deducted from the
value of all its assets.
Equity may be sub-classified in the balance sheet eg into share
capital, retained profits & other reserve.

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Elements of Financial Statements

Income. Income is 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.
Expense. Expenses are 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.
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Elements of Financial Statements

Income encompasses both revenue and gains.
Revenue arises in the course of the ordinary activities of an
entity and is referred to by a variety of different names including
sales, fees, interest, dividends, royalties and rent.
Gains represent other items that meet the definition of income
and may, or may not, arise in the course of the ordinary
activities of an entity. Gains represent increases in economic
benefits and as such are no different in nature from revenue.
Hence, they are not regarded as constituting a separate element
in the IFRS Framework.

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Elements of Financial Statements

The definition of expenses encompasses losses as well
as those expenses that arise in the course of the
ordinary activities of the entity.
Expenses that arise in the course of the ordinary activities of
the entity include, for example, cost of sales, wages and
depreciation. They usually take the form of an outflow or
depletion of assets such as cash and cash equivalents, inventory,
property, plant and equipment.
Losses represent other items that meet the definition of expenses
and may, or may not, arise in the course of the ordinary activities
of the entity. Losses represent decreases in economic benefits
and as such they are no different in nature from other expenses.
Hence, they are not regarded as a separate element in this
Framework.

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Recognition In The Financial Statement.

Recognition is the process of incorporating in the balance
sheet or income statement an item that meets the definition of
an element and satisfies the following criteria for recognition:
It is probable that any future economic benefit associated with the
item will flow to or from the entity; and
The item's cost or value can be measured with reliability.

Based on these general criteria:

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Recognition In The Financial Statement.

An asset is recognised in the balance sheet when it is
probable that the future economic benefits will flow to
the entity and the asset has a cost or value that can be
measured reliably
A liability is recognised in the balance sheet when it is
probable that an outflow of resources embodying
economic benefits will result from the settlement of a
present obligation and the amount at which the
settlement will take place can be measured reliably

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Recognition In The Financial Statement.

Income is recognised in the income statement when an
increase in future economic benefits related to an
increase in an asset or a decrease of a liability has
arisen that can be measured reliably. This means, in
effect, that recognition of income occurs simultaneously
with the recognition of increases in assets or decreases
in liabilities (for example, the net increase in assets
arising on a sale of goods or services or the decrease in
liabilities arising from the waiver of a debt payable).

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Recognition In The Financial Statement.

Expenses are recognised when a decrease in future
economic benefits related to a decrease in an asset
or an increase of a liability has arisen that can be
measured reliably. This means, in effect, that
recognition of expenses occurs simultaneously with the
recognition of an increase in liabilities or a decrease in
assets (for example, the accrual of employee
entitlements or the depreciation of equipment). [F 4.49]

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Measurement
The IFRS Framework acknowledges that a variety of measurement bases are
used today to different degrees and in varying combinations in financial
statements, including:

Historical cost
Current cost
Net realisable (settlement) value
Present value (discounted)

Historical cost is the measurement basis most commonly used today, but it is
usually combined with other measurement bases.

The IFRS Framework does not include concepts or principles for selecting
which measurement basis should be used for particular elements of financial
statements or in particular circumstances. Individual standards and
interpretations do provide this guidance, however.

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