Conceptual Framework

Elements of Financial Statements

1. Elements of financial statements

a) Financial statements portray the financial effects of transactions and other events by grouping them into
broad classes according to their economic characteristics. These broad classes are termed the elements of
financial statements.
b) The elements of financial statements are the “building blocks” from which financial statements are constructed.
c) The elements directly related to the measurement of financial position are
i. asset
ii. liability
iii. equity
d) The elements directly related to the measurement of financial performance are:
i. income
ii. expense

2. Recognition of elements
a) Recognition is a term which means the reporting of an asset, liability, income or expense on the face of the
financial statements of an entity.
b) Main recognition principles
i. asset recognition principle
ii. liability recognition principle
iii. income recognition principle
iv. expense recognition principle

3. Asset recognition principle

a) An asset is defined as
i. a resource
ii. controlled by the entity
iii. as a result of past events
iv. and from which future economic benefits are expected to flow to the entity.
b) An asset is recognized when
i. it is probable that future economic benefits will flow to the entity
ii. and the asset has a cost or value that can be measured reliably.

4. Future economic benefit

a) The future economic benefit embodied in an asset is the potential to contribute directly or indirectly to the flow
of cash to the entity.
b) The future economic benefit embodied in an asset may flow to the entity in a number of ways, for example, by
being
i. Used singly or in combination with other assets in the production of goods or services to be sold by the
entity.
ii. Exchanged for other assets.
iii. Used to settle a liability.
iv. Distributed to the owners of the entity.

5. The probability of future economic benefit

a) The concept of probability is used in the recognition criteria to refer to the degree of uncertainty that the future
economic benefits associated with the item will flow to or from the entity. The concept is in keeping with the
uncertainty that characterises the environment in which an entity operates. Assessments of the degree
of uncertainty attaching to the flow of future economic benefits are made on the basis of the evidence available
when the financial statements are prepared. For example, when it is probable that a receivable owed to an entity
will be paid, it is then justifiable, in the absence of any evidence to the contrary, to recognise the receivable
as an asset. For a large population of receivables, however, some degree of non-payment is normally
considered probable; hence an expense representing the expected reduction in economic benefits is
recognised.

6. Reliability of measurement
a) The second criterion for the recognition of an item is that it possesses a cost or value that can be measured with
reliability. In many cases, cost or value must be estimated; the use of reasonable estimates is an essential part of
the preparation of financial statements and does not undermine their reliability. When, however, a reasonable
estimate cannot be made the item is not recognised in the balance sheet or income statement. For example, the
expected proceeds from a lawsuit may meet the definitions of both an asset and income as well as the probability
criterion for recognition; however, IF it is not possible for the claim to be measured reliably, it should not
be recognised as an asset or as income; the existence of the claim, however, would be disclosed in the
notes, explanatory material or supplementary schedules.
b) An item that, at a particular point in time, fails to meet the recognition criteria may qualify for recognition at a
later date as a result of subsequent circumstances or events.
 c) An item that possesses the essential characteristics of an element but fails to meet the criteria for recognition
may nonetheless warrant disclosure in the notes, explanatory material or in supplementary schedules. This is
appropriate when knowledge of the item is considered to be relevant to the evaluation of the financial position,
performance and changes in financial position of an entity by the users of financial statements.

7. Liability recognition principle

a) A liability is defined as
i. a present obligation
ii. arising from past events
iii. the settlement of which is expected to result in an outflow from the entity of resources embodying economic
benefits.
b) A liability is recognized when
i. it is probable that an outflow of resources embodying economic benefits will be required for the settlement
of a present obligation
ii. and the amount of the obligation can be measured reliably.

8. Definition of income
a) Income is
i. increase in economic benefit
ii. during the accounting period
iii. in the form of inflow or increase in asset or decrease in liability that results in increase in equity,
iv. other than contribution from equity participants.
b) The definition of income encompasses both revenue and gains.
c) Revenue arises in the course of the ordinary regular activities and is referred to by a variety of different names
including sales, fees, interest, dividends, royalties and rent. The essence of revenue is regularity.
d) Gains represent other items that meet the definition of income and DO NOT arise in the course of the ordinary
regular activities. For example, gains include gain from disposal of noncurrent assets.

9. Income recognition principle

a) The basic principle is that income shall be recognized when earned.
b) The Conceptual Framework provides that income is recognized when
i. it is probable that an increase in future economic benefits related to an increase in an asset or a decrease in
a liability has arisen
ii. and that the increase in economic benefits can be measured reliably.
c) e.g., admission fees which must be recognized when the event takes place

10. Point of sale

a) Undoubtedly, the two conditions for income recognition are present at the point of sale.
b) At the point of sale, the entity has transferred to the buyer the significant risks and rewards of ownership of the
goods. Legal title to the goods passes to the buyer at the point of sale. Incidentally, the point of sale is usually the
point of delivery. Legally, it is delivery that transfers ownership from the seller to the buyer.

11. Definition of expense

a) Expense is
i. decrease in economic benefit
ii. during the accounting period
iii. in the form of an outflow or decrease in asset or increase in liability that results in decrease in equity,
iv. other than distribution to equity participants.
b) Expenses encompass losses as well as those expenses that arise in the course of the ordinary regular activities.
c) Expenses that arise in the course of the ordinary regular activities include, for example, cost of sales, wages and
depreciation
d) Losses do not arise in the course of the ordinary regular activities and include losses resulting from disasters.
i. Examples include losses from fire, flood, storm surge, tsunami and hurricane, as well as those arising from
disposal of noncurrent assets.

12. Expense recognition principle

a) The basic expense recognition principle means that “expenses are recognized when incurred”.
b) The Conceptual Framework provides that expenses are recognized when
i. it is probable that a decrease in future economic benefits related to decrease in an asset or an increase in
liability has occurred
ii. and that the decrease in economic benefits can be measured reliably.

13. Matching principle

a) Actually, the expense recognition principle is the application of the matching principle.
b) The generation of revenue is not without any cost. There has got to be some cost in earning a revenue.
c) The matching principle requires that those costs and expenses incurred in earning a revenue shall be reported
in the same period.
 d) Applications
i. Cause and effect association
1. the expense is recognized when the revenue is already recognized.
2. used when there is direct association of the expense with specific items of income.
3. e.g., cost of merchandise inventory, doubtful accounts, warranty expense and sales commissions.
ii. Systematic and rational allocation
1. some costs are expensed by simply allocating them over the periods benefited.
2. used when the cost incurred will benefit future periods and there is an abosence of a direct or clear
association of the expense with specific revenue.
3. e.g., depreciation, amortizatiion of intangible assets, and allocation of prepaid rent, insurance and other
prepayments.
iii. Immediate recognition
1. the cost incurred is expensed outright.
2. used when there is uncertainty of future economic benefits or there is difficulty of reliably associating
certain costs with future revenue.
3. also used when an expenditure produces no future economic benefit or when cost incurred does not
qualify or ceases to qualify for recognition as an asset.
4. e.g., amount to settle lawsuit, worthless intangible assets, loss from disposal of building.

14. Measurement of the elements of financial statements

a) Measurement is the process of determining the monetary amounts at which the elements of the financial
statements are to be recognised and carried in the balance sheet and income statement. This involves the
selection of the particular basis of measurement.

15. Measurement bases

a) Historical cost. Assets are recorded at the amount of cash or cash equivalents paid or the fair value of the
consideration given to acquire them at the time of their acquisition. Liabilities are recorded at the amount of
proceeds received in exchange for the obligation, or in some circumstances (for example, income taxes), at the
amounts of cash or cash equivalents expected to be paid to satisfy the liability in the normal course of business.
b) Current cost. Assets are carried at the amount of cash or cash equivalents that would have to be paid if the
same or an equivalent asset was acquired currently. Liabilities are carried at the undiscounted amount of cash or
cash equivalents that would be required to settle the obligation currently.
c) Realizable (settlement) value. Assets are carried at the amount of cash or cash equivalents that could
currently be obtained by selling the asset in an orderly disposal. Liabilities are carried at their settlement values;
that is, the undiscounted amounts of cash or cash equivalents expected to be paid to satisfy the liabilities in the
normal course of business.
d) Present value. Assets are carried at the present discounted value of the future net cash inflows that the item is
expected to generate in the normal course of business. Liabilities are carried at the present discounted value of
the future net cash outflows that are expected to be required to settle the liabilities in the normal course of
business.

Note: The measurement basis most commonly adopted by entities in preparing their financial statements is
historical cost. This is usually combined with other measurement bases. For example, inventories are usually
carried at the lower of cost and net realizable value, marketable securities may be carried at market value and
pension liabilities are carried at their present value. Furthermore, some entities use the current cost basis as a
response to the inability of the historical cost accounting model to deal with the effects of changing prices of non-
monetary assets.