Professional Documents
Culture Documents
Topic list
1 A conceptual framework
2 The IASB's Conceptual Framework an introduction
3 The Conceptual Framework objective of general purpose financial reporting
4 The Conceptual Framework qualitative characteristics of financial statements
5 The Conceptual Framework the underlying assumption
6 The Conceptual Framework elements of financial statements
7 The Conceptual Framework recognition of the elements of financial statements
8 The Conceptual Framework measurement of the elements of financial statements
9 Fair presentation and compliance with IFRS
10 IAS 8 Accounting policies, changes in accounting estimates and errors
15
Introduction
The IASB's document Conceptual Framework for Financial Reporting sets out and explains the principles and
concepts that underpin IFRSs. IAS 8 Accounting policies, changes in accounting estimates and errors explains
how an entity should select and apply accounting policies.
The chapter content is summarised in the diagram below.
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If you have studied these topics before, you may wonder whether you need to study this chapter in full. If
this is the case, please attempt the questions below, which cover some of the key subjects in the area.
If you answer all these questions successfully, you probably have a reasonably detailed knowledge of the
subject matter, but you should still skim through the chapter to ensure that you are familiar with everything
covered.
There are references in brackets indicating where in the chapter you can find the information, and you will C
also find a commentary at the back of the Study Manual. H
A
1 What is a conceptual framework? (Section 1.1) P
T
2 What chapters make up the Conceptual Framework? (Section 2) E
R
3 Identify three purposes of the Conceptual Framework. (Section 2.2)
4 What are the two fundamental qualitative characteristics and the four enhancing qualitative
characteristics of financial statements identified by the Conceptual Framework? 2
(Section 4)
5 Which assumption is identified by the Conceptual Framework as the 'underlying assumption' of a set of
financial statements? (Section 5)
6 What are the elements of financial statements identified by the Conceptual Framework? (Section 6)
7 How is an asset defined within the Conceptual Framework? (Section 6.1)
8 When should an element of the financial statements be recognised? (Section 7)
9 Identify four measurement bases that may be used in the financial statements. (Section 8)
10 What are accounting policies? (Section 10.1)
11 How is a change in accounting policy accounted for? (Section 10.3)
12 How is a change in accounting estimate accounted for? (Section 10.4)
Section overview
A conceptual framework is a statement of principles which provides the frame of reference for
financial reporting.
Section overview
The Conceptual Framework provides the conceptual framework for the development of IFRSs and
IASs.
LO The Conceptual Framework is, in effect, the theoretical framework upon which all IFRSs are based. It
1.1 determines how financial statements are prepared and the information they contain.
The Conceptual Framework consists of several sections or chapters, following on after an introduction. These
chapters are as follows: C
H
The objective of general purpose financial reporting A
P
Qualitative characteristics of useful financial information T
Underlying assumption E
The elements of financial statements R
Recognition of the elements of financial statements
Measurement of the elements of financial statements
2
Concepts of capital and capital maintenance.
We will look briefly at the preface and introduction to the Conceptual Framework as these will place the
document in context, and in particular the context of the Conceptual Framework in the IASB's approach to
developing IFRSs.
2.1 Introduction
The introduction to the Conceptual Framework points out the fundamental reason why financial statements
are produced worldwide, i.e. to satisfy the requirements of external users, but that practice varies
due to the individual pressures in each country. These pressures may be social, political, economic or legal,
but they result in variations in practice from country to country, including the form of statements, the
definition of their component parts (assets, liabilities and so on), the criteria for recognition of items and
both the scope and disclosure of financial statements.
The IASB wishes to narrow these differences by harmonising all aspects of financial statements.
The preface emphasises the way financial statements are used to make economic decisions. The
types of economic decisions for which financial statements are likely to be used include the following:
Decisions to buy, hold or sell equity investments
Assessment of management stewardship and accountability
Assessment of the entity's ability to pay employees
Assessment of the security of amounts lent to the entity
Determination of taxation policies
Determination of distributable profits and dividends
Inclusion in national income statistics
Regulations of the activities of entities.
Any additional requirements imposed by national governments for their own purposes should not affect
financial statements produced for the benefit of other users.
The Conceptual Framework recognises that financial statements can be prepared using a variety of models.
Although the most common is based on historical cost and a nominal unit of currency (e.g. pound sterling,
Australian dollar and so on), the Conceptual Framework can be applied to financial statements prepared
under a range of models.
2.3 Scope
The Conceptual Framework deals with:
(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.
(d) Concepts of capital and capital maintenance.
The Conceptual Framework is concerned with general purpose financial reporting. The term is not
defined or discussed in the Conceptual Framework, but generally means a normal set of annual financial
statements or published annual report available to users outside the reporting entity.
Section overview
The Conceptual Framework states that:
'The objective of general purpose financial reporting is 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.'
LO These decisions involve buying, selling or holding equity shares and debt instruments (such as loan stock or
1.1 debentures) and providing or settling loans and other forms of credit.
Investors and lenders must normally rely on general purpose financial reports for most of the
financial information that they need. Therefore they are the primary users to which general purpose
financial reports are directed.
The Conceptual Framework explains that other users, such as regulators and members of the public may also
find general purpose financial reports useful. However, financial reports are not primarily prepared for
these groups of users.
Definitions
Liquidity. The availability of sufficient funds to meet short-term financial commitments as they fall due.
Solvency. The availability of cash over the longer term to meet financial commitments as they fall due.
Changes in an entity's economic resources and claims result from its financial performance and also
from other transactions and events such as the issue of shares or an increase in debt (borrowings).
Information about a reporting entity's financial performance helps users to understand the return that
the entity has produced on its economic resources. This is an indicator of how efficiently and
effectively management has used the resources of the entity and is helpful in predicting future
returns.
Information about an entity's financial performance helps users to assess the entity's past and future ability
to generate net cash inflows from its operations.
Financial information should be prepared using accrual accounting. Information about an entity's
economic resources and claims and changes in these during a period is more useful in assessing an entity's
past and future performance than information based solely on cash receipts and payments during that
period.
Definition
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. (Conceptual Framework)
Information about a reporting entity's cash flows during a period also helps users assess the entity's ability
to generate future net cash inflows and provides information about factors that may affect its liquidity or
solvency. It also gives users a better understanding of the entity's operations and of its financing and
investing activities.
Section overview
Qualitative characteristics are the attributes that make the information provided in financial
statements useful to users.
LO There are two fundamental qualitative characteristics: relevance and faithful representation.
1.3 Information must be possess these characteristics in order to be useful.
There are four enhancing qualitative characteristics: comparability, verifiability, timeliness and
understandability. These qualities enhance the usefulness of financial information.
4.1 Relevance
Relevant financial information has predictive value, confirmatory value, or both.
Definition
Relevance. Relevant financial information is capable of making a difference in the decisions made by users.
(Conceptual Framework)
Information on financial position and performance is often used to predict future position and performance
and other things of interest to the user, e.g. likely dividend, wage rises. Financial information is also used to
confirm (or change) users' past conclusions about an entity's financial performance or financial position.
Information can have both predictive value and confirmatory value. For example, revenue for the current
year can be used to predict revenue for next year. Actual revenue for the current year can also be
compared with expected revenue that was predicted using last year's financial statements.
4.1.1 Materiality
The relevance of information is affected by its materiality.
Definition
Materiality. 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.
(Conceptual Framework)
The Conceptual Framework explains that materiality is entity-specific. It depends on the nature or size (or
both) of items taken in the context of an individual entity's financial report.
Information may be judged relevant simply because of its nature (e.g. remuneration of management), even
though the amounts involved may be small in relation to the financial statements as a whole. In other cases,
both the nature and materiality of the information are important. Materiality is not a primary qualitative
characteristic itself because it is merely a threshold or cut-off point.
4.4 Verifiability
Verifiability helps assure users that information faithfully represents the economic phenomena it purports to
represent.
Verifiability means that different knowledgeable and independent observers could reach consensus (not
necessarily complete agreement) that a particular depiction is a faithful representation.
4.5 Timeliness
Timeliness means having information available to users in time to be capable of influencing their decisions.
Generally, the older the information is, the less useful it is. However, older financial information may still be
useful for identifying and assessing trends (for example, growth in profits over a number of years).
4.6 Understandability
Classifying, characterising and presenting information clearly and concisely makes it understandable.
Some information is inherently complex and difficult to understand. Excluding this information from the
financial statements would make them more understandable, but they would also be incomplete and
potentially misleading.
Financial reports are prepared for users who have a reasonable knowledge of business and economic
activities and who review and analyse the information diligently. Users may sometimes need to seek help
from an adviser in order to understand information about complex economic phenomena.
Section overview
Going concern is the underlying assumption in preparing financial statements.
Definition
Going concern. The entity is normally viewed as a going concern, that is, as continuing in operation for
the foreseeable future. It is assumed that the entity has neither the intention nor the need to liquidate or
curtail materially the scale of its operations. (Conceptual Framework)
If the entity did intend or need to liquidate or curtail its major operations, then the financial statements
might have to be prepared on a different basis and that basis disclosed.
Section overview
Transactions and other events are grouped together in broad classes and in this way their financial
effects are shown in the financial statements. These broad classes are the elements of financial
statements.
2
IFRSs use the titles statement of financial position and statement of profit or loss and other
comprehensive income for the two financial statements above. In practice, the statement of financial
position is sometimes called the balance sheet and the statement of profit and loss and other
comprehensive income may also be called the profit and loss account, the income statement, or the
statement of comprehensive income.
A process of sub-classification then takes place for presentation in the financial statements, e.g. assets are
classified by their nature or function in the business to show information in the best way for users to take
economic decisions.
These definitions are important, but they do not cover the criteria for recognition of any of these items,
which are discussed in the next section of this chapter. This means that the definitions may include items
which would not actually be recognised in the statement of financial position because they fail to satisfy
recognition criteria particularly, as we will see below, the probable flow of any economic benefit to or
from the business.
Whether an item satisfies any of the definitions above will depend on the substance and economic
reality of the transaction, not merely its legal form.
6.1.1 Assets
We can look in more detail at the components of the definitions given above.
Definition
Future economic benefit. The potential to contribute, directly or indirectly, to the flow of cash and cash
equivalents to the entity. The potential may be a productive one that is part of the operating activities of
Assets are usually employed to produce goods or services for customers; customers will then pay for these.
Cash itself renders a service to the entity due to its command over other resources.
The existence of an asset, particularly in terms of control, is not reliant on:
(a) Physical form (hence patents and copyrights); nor
(b) Legal rights (hence leases).
Transactions or events in the past give rise to assets; those expected to occur in the future do not in
themselves give rise to assets. For example, an intention to purchase a non-current asset does not, in itself,
meet the definition of an asset.
6.1.2 Liabilities
Again we can look more closely at some aspects of the definition. An essential characteristic of a liability is
that the entity has a present obligation.
Definition
Obligation. A duty or responsibility to act or perform in a certain way. Obligations may be legally
enforceable as a consequence of a binding contract or statutory requirement. Obligations also arise,
however, from normal business practice, custom and a desire to maintain good business relations or act in
an equitable manner. (Conceptual Framework)
Definition
Provision. A present obligation which satisfies the rest of the definition of a liability, even if the amount of
the obligation has to be estimated. (Conceptual Framework)
(b) Baldwin Co paid Don Brennan $10 000 to set up a car repair shop, on condition that priority
treatment is given to cars from the company's fleet.
6.2 Performance
Profit is used as a measure of performance, or as a basis for other measures. It depends directly on the
measurement of income and expenses, which in turn depend (in part) on the concepts of capital and capital C
maintenance adopted. H
A
The elements of income and expense are therefore defined. P
T
E
Definitions R
Income. 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. 2
Expenses. 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. (Conceptual Framework)
Income and expenses can be presented in different ways in the statement of profit or loss and other
comprehensive income, to provide information relevant for economic decision-making. This is considered in
more detail in the next chapter.
Items of income and expense can be distinguished from each other or combined with each other.
6.2.1 Income
Both revenue and gains are included in the definition of income. Revenue arises in the course of
ordinary activities of an entity.
Definition
Gains. Increases in economic benefits. As such they are no different in nature from revenue.
(Conceptual Framework)
Gains include those arising on the disposal of non-current assets. The definition of income also includes
unrealised gains, e.g. on revaluation of marketable securities.
6.2.2 Expenses
As with income, the definition of expenses includes losses as well as those expenses that arise in the course
of ordinary activities of an entity.
Definition
Losses. Decreases in economic benefits. As such they are no different in nature from other expenses.
(Conceptual Framework)
Losses will include those arising on the disposal of non-current assets. The definition of expenses will also
include unrealised losses, e.g. exchange rate effects on borrowings.
Definition
Revaluation. Restatement of assets and liabilities, giving rise to increases or decreases in equity.
(Conceptual Framework)
These increases and decreases meet the definitions of income and expenses. They are not included in
profit or loss under certain concepts of capital maintenance, however, but rather in equity. This is explained
in more detail in the next chapter.
Section overview
Items which meet the definition of assets or liabilities may still not be recognised in financial
statements because they must also meet certain recognition criteria.
Definition
Recognition. The process of incorporating in the statement of financial position or statement of profit or
loss and other comprehensive income an item that meets the definition of an element and satisfies the
following criteria for recognition:
(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. (Conceptual Framework)
Asset The statement of financial It is probable that the future economic benefits will flow to the
position entity and the asset has a cost or value that can be measured
reliably.
Liability The statement of financial It is probable that an outflow of resources embodying economic
position benefits will result from the settlement of a present obligation and
the amount at which the settlement will take place can be measured
reliably. C
H
Income The statement of profit or An increase in future economic benefits related to an increase in an A
loss and other asset or a decrease of a liability has arisen that can be measured P
comprehensive income reliably. T
E
Expenses The statement of profit or A decrease in future economic benefits related to a decrease in an R
loss and other asset or an increase of a liability has arisen that can be measured
comprehensive income reliably.
2
Section overview
A number of different measurement bases are used in financial statements. They include:
Historical cost
Current cost
Realisable (settlement) value
Present value of future cash flows.
Definition
Measurement. The process of determining the monetary amounts at which the elements of the financial
statements are to be recognised and carried in the statement of financial position and statement of profit or
loss and other comprehensive income. (Conceptual Framework)
This involves the selection of a particular basis of measurement. A number of these are used to different
degrees and in varying combinations in financial statements. They include the following:
Definitions
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.
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.
Historical cost is the most commonly adopted measurement basis, but this is usually combined with other
bases, e.g. inventory is carried at the lower of cost and net realisable value.
2
10.1 Definitions
The following definitions are given in the Standard:
Definitions
Accounting policies are the specific principles, bases, conventions, rules and practices adopted by an
entity in preparing and presenting financial statements.
A change in accounting estimate is an adjustment of the carrying amount of an asset or a liability or the
amount of the periodic consumption of an asset, that results from the assessment of the present status of,
and expected future benefits and obligations associated with, assets and liabilities. Changes in accounting
estimates result from new information or new developments and, accordingly, are not corrections of
errors.
Material: Omissions or misstatements of items are material if they could, individually or collectively,
influence the economic decisions that users make on the basis of the financial statements. (This is very
similar to the definition in the Conceptual Framework.)
Prior period errors are omissions from, and misstatements in, the entity's financial statements for one or
more prior periods arising from a failure to use, or misuse of, reliable information that:
Was available when financial statements for those periods were authorised for issue, and
Could reasonably be expected to have been obtained and taken into account in the preparation and
presentation of those financial statements.
Such errors include the effects of mathematical mistakes, mistakes in applying accounting policies, oversights
or misinterpretations of facts, and fraud.
Retrospective application is applying a new accounting policy to transactions, other events and
conditions as if that policy had always been applied.
Retrospective restatement is correcting the recognition, measurement and disclosure of amounts of
elements of financial statements as if a prior period error had never occurred.
Prospective application of a change in accounting policy and of recognising the effect of a change in an
accounting estimate, respectively, are:
Applying the new accounting policy to transactions, other events and conditions occurring after the
date as at which the policy is changed; and
Recognising the effect of the change in the accounting estimate in the current and future periods
affected by the change.
Section overview
Changes in accounting policy are normally applied retrospectively.
The same accounting policies are usually adopted from period to period, to allow users to analyse trends
over time in profit, cash flows and financial position. Changes in accounting policy will therefore be
unusual and should be made only if required by one of two things:
(a) By virtue of an IFRS.
(b) If the change will result in a more relevant and reliable presentation of events or transactions
in the financial statements of the entity.
This means that all comparative information must be restated as if the new policy had always been in
force, with amounts relating to earlier periods reflected in an adjustment to opening reserves of the
earliest period presented.
Certain disclosures are required when a change in accounting policy has a material effect on the current
period or any prior period presented, or when it may have a material effect in subsequent periods:
(a) Reasons for the change.
(b) Amount of the adjustment for the current period and for each period presented.
(c) Amount of the adjustment relating to periods prior to those included in the comparative
information.
(d) The fact that comparative information has been restated or that it is impracticable to do so.
An entity should also disclose information relevant to assessing the impact of new IFRS on the financial
statements where these have not yet come into force.
Section overview
Changes in accounting estimate are not applied retrospectively.
Estimates arise in relation to business activities because of the uncertainties inherent within them.
Judgments are made based on the most up to date information and the use of such estimates is a necessary
part of the preparation of financial statements. It does not undermine their reliability. Here are some
examples of accounting estimates:
(a) A necessary irrecoverable debt allowance.
(b) Useful lives of depreciable assets.
(c) Provision for obsolescence of inventory.
The rule here is that the effect of a change in an accounting estimate should accounted for
prospectively ie it should be included in the determination of net profit or loss in one of:
(a) The period of the change, if the change affects that period only.
(b) The period of the change and future periods, if the change affects both.
10.5 Errors
Section overview
Material prior period errors must be corrected retrospectively.
Errors discovered during a current period which relate to a prior period may arise through:
(a) Mathematical mistakes
(b) Mistakes in the application of accounting policies
(c) Misinterpretation of facts
(d) Oversights
(e) Fraud.
Most of the time these errors can be corrected through net profit or loss for the current period.
Where they are material prior period errors, however, this is not appropriate.
A conceptual framework is a statement of principles which provides the frame of reference for
financial reporting.
The IASB's Conceptual Framework provides the theoretical framework for the development of IFRSs.
The Conceptual Framework provides the basic principles on which new and improved international
accounting standards are based.
The Conceptual Framework states that 'The objective of general purpose financial reporting is 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'.
Qualitative characteristics are the attributes that make the information provided in financial
statements useful to users.
The fundamental qualitative characteristics are: relevance and faithful representation.
The enhancing qualitative characteristics are: comparability; verifiability; timeliness; and
understandability.
Going concern is the underlying assumption identified by the Conceptual Framework in preparing
financial statements.
The elements of financial statements shown in the statement of financial position are assets, liabilities
and equity.
The elements of financial statements shown in the statement of profit or loss and other
comprehensive income are income and expenses.
Elements of the financial statements are recognised when the recognition criteria of the Conceptual
Framework are met.
A number of different measurement bases are used in financial statements. They include:
Historical cost
Current cost
Realisable (settlement) value
Present value of future cash flows.
IAS 8 deals with the treatment of changes in accounting estimates, changes in accounting policies and
errors.
Accounting policies are the specific principles, bases, conventions, rules and practices adopted by an
entity in preparing and presenting financial statements.
A change in accounting policy is only allowed where it is required by legislation, by an accounting
standard or will result in more appropriate presentation.
A change in accounting policy is normally applied retrospectively.
A change in accounting estimate is applied prospectively.
A prior period error is corrected retrospectively.
1 According to the Conceptual Framework, which of the following, is the underlying assumption relating to
financial statements?
A The information is free from material error or bias.
B The accounts have been prepared on an accruals basis.
C The business is expected to continue in operation for the foreseeable future.
D Users are assumed to have sufficient knowledge to be able to understand the financial
statements.
C
2 Which two of the following are not elements of financial statements per the Conceptual Framework? H
A
I Profits IV Equity P
II Assets V Losses T
E
III Income VI Expenses R
A I and V only
B II and IV only
C III and IV only 2
D V and VI only
3 Listed below are some characteristics of financial information.
I Neutrality III Understandability
II Verifiability IV Timeliness
Which of these are enhancing qualitative characteristics, according to the IASB's Conceptual
Framework for Financial Reporting?
A I, II and III only
B I, II and IV only
C I, III and IV only
D II, III and IV only
4 Listed below are some comments on accounting concepts and useful financial information.
I Financial information prepared using accrual accounting provides a better basis for assessing
an entity's performance than information based only on cash flows.
II Materiality means that only items having a physical existence may be recognised as assets.
III A faithful representation of financial information can never include amounts based on
estimates.
Which, if any, of these comments is correct, according to the IASB's Conceptual Framework for
Financial Reporting?
A I only
B II only
C III only
D None of the above
7 A An asset is recognised when it is probable that economic benefits will flow to an entity and
the asset can be measured reliably. The timing and measurement of the future economic
benefits are irrelevant, and the measurement of the asset is generally by reference to cost,
rather than an open market value.
8 B Where there is conflict between the Conceptual Framework and a Standard, the Standard
prevails.
9 B Comparability, understandability and verifiability are all enhancing qualitative characteristics.
(The fourth enhancing qualitative characteristic is timeliness.)
10 B Historical cost is the most common measurement basis.
1 (a) This is an intangible asset. There is a past event, control and future economic benefit (through
cost savings).
(b) This cannot be classified as an asset. Baldwin Co has no control over the car repair shop and
it is difficult to argue that there are 'future economic benefits'.
(c) The warranty claims in total constitute a liability; the business has taken on an obligation. It
would be recognised when the warranty is issued rather than when a claim is made.
2 STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME
20X6 20X7
$'000 $'000
Sales 47 400 67 200
Cost of goods sold (W1) (38 770) (51 600)
Profit before tax 8 630 15 600
Income tax (W2) (2 620) (4 660)
Profit for the year 6 010 10 940
RETAINED EARNINGS
20X6 20X7
Opening retained earnings $'000 $'000
As previously reported 13 000 21 950
Correction of prior period
error (4 200 1 260) (2 940)
As restated 13 000 19 010
Profit for the year 6 010 10 940
Closing retained earnings 19 010 29 950
Workings
1 Cost of goods sold 20X6 20X7
$'000 $'000
As stated in question 34 570 55 800
Inventory adjustment 4 200 (4 200)
38 770 51 600
2 Income tax 20X6 20X7
$'000 $'000
As stated in question 3 880 3 400
Inventory adjustment (4 200 × 30%) (1 260) 1 260
2 620 4 660