BA 114.

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Topic: Conceptual Framework
Subtopic: Classification, Initial Recognition and Measurement
References:
IFRS Conceptual Framework

1. Nature of the Conceptual Framework [Purpose and Status]

The Conceptual Framework sets out the concepts that underlie the preparation and
presentation of financial statements for external users. The Conceptual Framework is not an
IFRS and hence does not define standards for any particular measurement or disclosure
issue. It does not override any specific IFRS. In cases where there is a conflict, the
requirements of the IFRS prevail over those of the Conceptual Framework.

2. Enumerate the objective of IFRS Conceptual Framework [OB2]

a. to assist the Board in the development of future IFRSs and in its review of existing
IFRSs;
b. to assist the Board in promoting harmonization 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
IFRSs;
c. to assist national standard-setting bodies in developing national standards;
d. to assist preparers of financial statements in applying IFRSs and in dealing with
topics that have yet to form the subject of an IFRS;
e. to assist auditors in forming an opinion on whether financial statements comply with
IFRSs;
f. to assist users of financial statements in interpreting the information contained in
financial statements prepared in compliance with IFRSs; and
g. to provide those who are interested in the work of the IASB with information about its
approach to the formulation of IFRSs.

3. Understand the components of IFRS [Scope]

a. the objective of financial reporting;
b. the qualitative characteristics of useful financial information;
c. the definition, recognition and measurement of the elements from which financial
statements are constructed; and
d. concepts of capital and capital maintenance.

4. Enumerate the objectives of financial statements

▪ To provide financial information about the reporting entity that is useful to existing
and potential investors, lenders and other creditors in making decisions about
providing resources to the entity. [OB2]
▪ General purpose financial reports provide information about the financial position of a
reporting entity, which is information about the entity’s economic resources and the
claims against the reporting entity. Financial reports also provide information about
the effects of transactions and other events that change a reporting entity’s economic
resources and claims. Both types of information provide useful input for decisions
about providing resources to an entity. [OB12]
▪ Economic resources and the claims [OB13, OB14]

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 ✓ Information about the nature and amounts of a reporting entity’s economic
resources and claims can help users to identify the reporting entity’s financial
strengths and weaknesses.
➢ To assess the reporting entity’s liquidity and solvency
• its needs for additional financing and how successful it is likely to be in
obtaining that financing.
• Information about priorities and payment requirements of existing claims
helps users to predict how future cash flows will be distributed among
those with a claim against the reporting entity.
➢ Although cash flows cannot be identified with individual economic resources
(or claims), users of financial reports need to know the nature and amount of
the resources available for use in a reporting entity’s operations.

▪ Changes in economic resources and claims [OB15, OB16]

✓ Result from that entity’s financial performance (statement of comprehensive
income) and from other events or transactions such as issuing debt or equity
instruments (statement of changes in equity, statement of cash flows).
✓ Helps users to understand the return that the entity has produced on its economic
resources.
➢ provides an indication of how well management has discharged its
responsibilities to make efficient and effective use of the reporting entity’s
resources.
➢ Information about the variability and components of that return is also
important, especially in assessing the uncertainty of future cash flows.

▪ Financial performance reflected by accrual accounting [OB17, OB18, OB19]

✓ Accrual accounting depicts the effects of transactions and other events and
circumstances on a reporting entity’s economic resources and claims in the
periods in which those effects occur, even if the resulting cash receipts and
payments occur in a different period.
➢ provides a better basis for assessing the entity’s past and future performance
than information solely about cash receipts and payments during that period.
▪ Financial performance reflected by past cash flows [OB20]
✓ Information about cash flows helps users understand a reporting entity’s
operations, evaluate its financing and investing activities, assess its liquidity or
solvency and interpret other information about financial performance.
▪ Changes in economic resources and claims not resulting from financial performance
[OB21]
✓ A reporting entity’s economic resources and claims may also change for reasons
other than financial performance, such as issuing additional ownership shares.
Necessary to give users a complete understanding of why the reporting entity’s
economic resources and claims changed and the implications of those changes
for its future financial performance.

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5. Identify the users of financial statements
▪ existing and potential investors, lenders and other creditors who cannot require
reporting entities to provide information directly to them and must rely on general
purpose financial reports for much of the financial information they need. [OB6]
▪ Users will decide on the following → buying, selling or holding equity and debt
instruments, and providing or settling loans and other forms of credit. [OB2]
▪ Need information on returns that they expect from an investment in those
instruments, for example dividends, principal and interest payments or market price
increases. [OB3]
▪ Need information to assess an entity’s prospects for future net cash inflows. [OB4]

6. Nature of general-purpose financial statements.

▪ General purpose financial reports are directed for users (existing and potential
investors, lenders and other creditors) who cannot require reporting entities to
provide information directly to them and must rely on these financial reports for much
of the financial information they need. [OB6]
✓ The management of a reporting entity need not rely on general purpose financial
reports because it is able to obtain the financial information it needs internally.
[OB9]
✓ Note: Regulators are not primary users of general-purpose reports because
regulators can require reporting entities to submit specific reports geared towards
providing their information needs. [OB10]
▪ General purpose financial reports do not and cannot provide all of the information
that existing and potential investors, lenders and other creditors need. Users need to
consider pertinent information from other sources. [OB6]
▪ While general purpose financial reports are not designed to show the value of a
reporting entity; these reports provide information to help existing and potential
investors, lenders and other creditors to estimate the value of the reporting entity.
[OB7]
▪ Due to varying information needs of primary users, general purpose financial reports
seek to provide the information set that will meet the needs of the maximum number
of primary users. [OB8]

7. List the qualitative characteristics of accounting information [QC4 to QC34]

▪ The fundamental qualitative characteristics are relevance and faithful representation
[QC5]. Information must be both relevant and faithfully represented if it is to be
useful [QC17]..
✓ Relevant financial information is capable of making a difference in the decisions
made by users [QC6].
➢ Financial information is capable of making a difference in decisions if it has
predictive value, confirmatory value or both.
o Financial information has predictive value if it can be used as an input to
processes employed by users to predict future outcomes. [QC8]
o Financial information has confirmatory value if it provides feedback about
(confirms or changes) previous evaluations. [QC9]

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 ➢ Information is material if omitting it or misstating it could influence decisions
that users make on the basis of financial information about a specific
reporting entity [QC11]. Materiality is an entity-specific aspect of relevance
based on the nature or magnitude, or both, of the items to which the
information relates in the context of an individual entity’s financial report.
✓ To be a perfectly faithful representation, a depiction would be complete, neutral
and free from error. [QC12]
➢ A complete depiction includes all information necessary for a user to
understand the phenomenon being depicted, including all necessary
descriptions and explanations. [QC13]
➢ A neutral depiction is without bias in the selection or presentation of financial
information. A neutral depiction is not slanted, weighted, emphasized, de-
emphasized or otherwise manipulated to increase the probability that financial
information will be received favorably or unfavorably by users.
➢ Free from error means there are no errors or omissions in the description of
the phenomenon, and the process used to produce the reported information
has been selected and applied with no errors in the process.
▪ The enhancing qualitative characteristics of financial information are comparability,
verifiability, timeliness and understandability. [QC19]
✓ Comparability is the qualitative characteristic that enables users to identify and
understand similarities in, and differences among, items [QC21]. Comparability is
the goal; consistency helps to achieve that goal.
➢ Information about a reporting entity is more useful if it can be compared with
similar information about other entities and with similar information about the
same entity for another period or another date.
➢ Consistency refers to the use of the same methods for the same items, either
from period to period within a reporting entity or in a single period across
entities.
✓ Verifiability means that different knowledgeable and independent observers could
reach consensus, although not necessarily complete agreement, that a particular
depiction is a faithful representation.
➢ Direct verification means verifying an amount or other representation through
direct observation, for example, by counting cash. Indirect verification means
checking the inputs to a model, formula or other technique and recalculating
the outputs using the same methodology.
➢ It would normally be necessary to disclose the underlying assumptions, the
methods of compiling the information and other factors and circumstances
that support the information.
✓ Timeliness means having information available to decision-makers in time to be
capable of influencing their decisions.
✓ Classifying, characterising and presenting information clearly and concisely
makes it understandable.

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8. Pervasive constraint on the information
Cost is a pervasive constraint on the information that can be provided by financial
reporting. Reporting financial information imposes costs, and it is important that those
costs are justified by the benefits of reporting that information.

9. Specify the underlying assumptions of accounting [4.1, 4.37 to 4.56]

The financial statements are normally prepared on the assumption that an entity is a going
concern and will continue in operation for the foreseeable future. Hence, it is assumed that
the entity has neither the intention nor the need to liquidate or curtail materially the scale
of its operations.

10. Define the elements of financial statements: assets, liabilities, equity, revenue and
expenses [4.2 to 4.36] → Financial statements portray the financial effects of
transactions and other events by grouping them into broad classes according to their
economic characteristics termed as elements of financial statements.
▪ The elements directly related to the measurement of financial position are assets,
liabilities and equity. [4.4]
✓ An asset is 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.
➢ The future economic benefit embodied in an asset is the potential to
contribute, directly or indirectly, to the flow of cash and cash equivalents to
the entity.
o The potential may be a productive one that is part of the operating
activities of the entity.
o It may also take the form of convertibility into cash or cash equivalents or
a capability to reduce cash outflows, such as when an alternative
manufacturing process lowers the costs of production.
➢ Incurrence of expenditure may provide evidence of existence of future
economic benefits but is not conclusive proof that an item satisfying the
definition of an asset has been obtained. Similarly, the absence of a related
expenditure does not preclude an item from satisfying the definition of an
asset and thus becoming a candidate for recognition in the balance sheet.
(Note: expenditure means the reporting entity expends cash).
✓ A liability is a present obligation of the entity arising from past events, the
settlement of which is expected to result in an outflow from the entity of resources
embodying economic benefits.
➢ An obligation is a duty or responsibility to act or perform in a certain way.
[4.15]
➢ The settlement of a present obligation usually involves the entity giving up
resources embodying economic benefits in order to satisfy the claim of the
other party. [4.17]
o payment of cash;
o transfer of other assets;
o provision of services;
o replacement of that obligation with another obligation; or
o conversion of the obligation to equity.
➢ Provisions are liabilities that can be measured only by using a substantial
degree of estimation. [4.19]

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 ✓ Equity is the residual interest in the assets of the entity after deducting all its
liabilities.
▪ Profit is frequently used as a measure of performance or as the basis for other
measures, such as return on investment or earnings per share. The elements directly
related to the measurement of profit are income and expenses. [4.24]
✓ 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.
➢ 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. [4.29]
➢ 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. [4.30]
✓ 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.
➢ Expenses that arise in the course of the ordinary activities of the entity. [4.33]
➢ 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. [4.34]

11. Recognition of the elements of financial statements [4.37]

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 criteria for recognition set
out in paragraph 4.38.

▪ An item that meets the definition of an element should be recognized if: [4.38]
a. it is probable that any future economic benefit associated with the item will flow to
or from the entity; and
b. the item has a cost or value that can be measured with reliability.

▪ An asset is recognized in the balance sheet when [4.44]

a. it is probable that the future economic benefits will flow to the entity, and
b. the cost or value that can be measured reliably.

▪ A liability is recognized in the balance sheet when [4.46]

a. it is probable that an outflow of resources embodying economic benefits will
result from the settlement of a present obligation, and
b. the amount at which the settlement will take place can be measured reliably.

▪ Income is recognized 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. [4.47]

▪ Expenses are recognized in the income statement 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.

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 a. Expenses are recognized in the income statement on the basis of a direct
association between the costs incurred and the earning of specific items of
income → matching of costs with revenues. [4.50]
b. Expenses are recognized in the income statement on the basis of systematic and
rational allocation procedures when economic benefits are expected to arise over
several accounting periods and the association with income can only be broadly
or indirectly determined. [4.51]
c. An expense is recognized immediately in the income statement when an
expenditure produces no future economic benefits or when, and to the extent
that, future economic benefits do not qualify, or cease to qualify, for recognition in
the balance sheet as an asset. [4.52]

12. Measurement of the elements of financial statements [4.54]

Measurement is the process of determining the monetary amounts at which the elements
of the financial statements are to be recognized and carried in the balance sheet and
income statement.

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.

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13. Understand the concepts of capital and capital maintenance [4.57 to 4.65]
▪ Under a financial concept of capital, such as invested money or invested purchasing
power, capital is synonymous with the net assets or equity of the entity.
▪ Under a physical concept of capital, such as operating capability, capital is regarded
as the productive capacity of the entity based on, for example, units of output per
day.

Additional Exercise
I. True or False. For statements that are false, explain why.
1. The conceptual framework focuses on both the needs of internal and external users of
financial information.
2. Capital providers are the only users who benefit from general purpose financial reports.
3. Information that is a faithful representation is characterized as having predictive or
confirmatory value.
4. Neutrality is an ingredient of both reliability and relevance.
5. Comprehensive income includes changes in equity resulting from distributions to owners.
6. Financial statements are most commonly prepared using the historical cost basis and the
nominal financial capital maintenance concept.
7. Issuance of interim financial reports is an example of timeliness, which is an enhancing
qualitative characteristic.
8. Materiality is a company-specific aspect of reliability based on the nature or magnitude, or
both, of the items to which the information relates in the context of an individual’s entity’s
financial report. Thus, no quantitative threshold is set by IASB.
9. Faithful representation requires that all financial information should be free from error and
accurate.
10. A faithful representation, by itself, does not necessarily result in useful financial
information.
11. An estimate can be faithfully represented if the reporting entity has properly applied an
appropriate process, properly described the estimate and explained any uncertainties that
significantly affect the estimate.
12. Once an accounting method is adopted, it should never be changed.
13. It may not be possible to verify some explanations and forward-looking financial
information until a future period. To aid users decide whether they want to use such
information, it would normally be necessary to disclose the underlying assumptions, the
methods of compiling the information and other factors and circumstances that support the
information.
14. Financial reports are prepared for users who have a reasonable knowledge of business
and economic activities and who review and analyze the information diligently.
15. Appropriate disclosures can fully compensate for non-comparability.
16. Items that have been donated to an entity can, in some cases, satisfy the definition of an
asset.
17. A finance lease gives rise to items that satisfy the definition of an asset and a liability and
are recognized as such in the lessor’s balance sheet.
18. Distinguishing between items of income and expenses that arise from the ordinary course
of operations and those that do not provides useful evaluation on the entity’s ability to
generate future cash flows.
19. Current cost basis of measurement is a response to the inability of historical cost
accounting model to deal with the effects of changing prices of financial assets.
20. International accounting standard-setters prescribe that the financial concept of capital be
adopted by all reporting entities.
21. Prospectively applying a new accounting standard decreases comparability but may
increase relevance and reliability.

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22. Classifying, characterizing and presenting information clearly and concisely make it
understandable.
23. Failure to recognize an item in the balance sheet or income statement can be corrected
by disclosure in the explanatory note.
24. Historical cost can be combined with other measurement bases.
25. Comparability pertains only to the reporting of information in a similar manner for different
companies.

Solutions to True or False Exercises:

1. False – external users (Introduction) 14. True (QC32)
2. False – others users such as 15. False – partially compensate only
regulators and the public (OB10) (QC34)
3. False – information that is relevant 16. True (4.14)
(QC7)
4. False – only reliability (QC12) 17. False – lessee’s balance sheet (4.6)
5. False – excludes (4.24 and 4.25) 18. True (4.27)
6. True (Introduction) 19. False – non-monetary assets (4.56)
7. True (QC29) 20. False – IASB does not prescribe any
particular concept (4.65)
8. False – relevance (QC11) 21. True
9. False – accuracy is not required 22. True (QC30)
(QC15)
10. True – faithful representation + 23. False – disclosure does not correct
relevance (QC16) failure to recognize item
11. True (QC16) 24. True (4.56)
12. False – it can be changed 25. False (QC22)
13. True (QC28)

II. Asset Definition

Using the definition of an asset, indicate whether each of the following should be listed as an
asset by Ingalls Company.
a. Ingalls has legal title to a coal mine in a remote location. Historically, the mine has yielded
more than $25 million in coal. Engineering estimates suggest that no additional coal is
economically extractable from the mine. [Not asset]
b. Ingalls employs a team of five geologists who are widely recognized as worldwide leaders
in their field. [Not asset]
c. Several years ago, Ingalls purchased a large meteor crater on the advice of a geologist
who had developed a theory claiming that vast deposits of iron ore lay underneath the
crater. The crater has no other economic use. No ore has been found, and the geologist’s
theory is not generally accepted. [Not asset]
d. Ingalls claims ownership of a large piece of real estate in a foreign country. The real estate
has a current market value of over $225 million. The country expropriated the land 35
years ago, and no representative of Ingalls has been allowed on the property since. [Not
asset]
e. Ingalls is currently negotiating the purchase of an oil field with proven oil reserves totaling
5 billion barrels. [Not asset]

III. Liability Definition

Using the definition of a liability, indicate whether each of the following should be listed as a
liability by Pauli Company.
a. Pauli was involved in a highly publicized lawsuit last year. Pauli lost and was ordered to
pay damages of $125 million. The payment has been made. [Not liability]

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b. In exchange for television advertising services that Pauli received last month, Pauli is
obligated to provide the television station with building maintenance service for the next
four months. [liability]
c. Pauli contractually guarantees to replace any of its stain-resistant carpets if they are
stained and can’t be cleaned. [liability]
d. Pauli estimates that its total payroll for the coming year will exceed $35 million. [Not
liability]
e. In the past, Pauli has suffered frequent vandalism at its storage warehouses. Pauli
estimates that losses due to vandalism during the coming year will total $3 million. [Not
liability]

IV. Revenue Recognition

Indicate which of the following transactions or events gives rise to the recognition of income
in 2011 under the accrual basis of accounting. If revenue is not recognized, what account, if
any, is credited?
a. On December 15, 2011, Howe Company received $20,000 as rent revenue for the 6-
month period beginning January 1, 2012. [Unearned revenue]
b. Monroe Tractor Co., on July 1, 2011, sold one of its tractors and received $10,000 in cash
and a note for $50,000 at 12% interest, payable in one year. The fair market value of the
tractor is $60,000. [Gain from sale of PPE]
c. Oswald, Inc., issued additional shares of common stock on December 10, 2011, for
$30,000 above par value. [APIC]
d. Balance Company received a purchase order in 2011 from an established customer for
$10,200 of merchandise. The merchandise was shipped on December 20, 2011. The
company’s credit policy allows the customer to return the merchandise within 30 days and
a 3% discount if paid within 20 days from shipment. [Revenue]
e. Gloria, Inc., sold merchandise costing $2,000 for $2,500 in August 2011. The terms of the
sale are 15% down on a 12-month conditional sales contract, with title to the goods being
retained by the seller until the contract price is paid in full. [Unearned revenue]
f. On November 1, 2011, Jones & Whitlock entered into an agreement to audit the 2011
financial statements of Lehi Mills for a fee of $35,000. The audit work began on December
15, 2011 and will be completed around February 15, 2012. [15 days revenue]

V. Expense Recognition
For each of the following items, indicate whether the expense should be recognized using (1)
direct matching, (2) systematic and rational allocation, or (3) immediate recognition. Provide
support for your answer.
a. Johnson & Smith, Inc., conducts cancer research. The company’s hope is to develop a
cure for the deadly disease. To date, its efforts have proven unsuccessful. It is testing a
new drug, Ebzinene, which has cost $400,000 to develop. immediate recognition
b. Sears offers warranties on many of the products it sells. Although the warranty periods
range from days to years, Sears can reasonably estimate warranty costs. direct matching
c. Stocks Co. recently signed a 2-year lease agreement on a warehouse. The entire cost of
$15,000 was paid in advance. systematic and rational allocation (advance payment to
be systematically allocated over 2 years)
d. John Clark assembles chairs for the Stone Furniture Company. The company pays Clark
on an hourly basis. direct matching
e. Hardy Co. recently purchased a fleet of new delivery trucks. The trucks are each expected
to last for 100,000 miles. systematic and rational allocation
f. Taylor Manufacturing Inc. regularly advertises in national trade journals. The objective is
to acquire name recognition, not to promote a specific product. immediate recognition

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