B.C.S.

Villaluz
COLEGIO DE SAN JUAN DE LETRAN
A.Y. 2020 – 2021, First Semester
ACC103: Conceptual Framework and Accounting Standards
HANDOUT NO. 1 – Conceptual Framework for Financial Reporting

NATURE OF THE CONCEPTUAL FRAMEWORK

The Conceptual Framework:
❖ Is an attempt to provide an overall theoretical foundation for accounting.
❖ Is a summary of the terms and concepts that underlie the preparation and presentation of financial statements.
❖ Describes the concepts for general purpose financial reporting.
❖ Is the underlying theory for the development of accounting standards and revision of previously issued accounting
standards.
❖ Provides the foundation for standards that:
(a) Contribute to transparency by enhancing international comparability and quality of financial information.
(b) Strengthen accountability by reducing information gap between providers of capital and the people to whom
they have entrusted their money.
(c) Contribute to economic efficiency by helping investors to identify opportunities and risks across the world.
❖ Contains the following chapters:

Figure 1:
Contents of the Conceptual Framework for Financial Reporting

➢ The contents of these chapters will be discussed in detail in this module. This lesson covers the introductory
paragraphs and the first chapter of the conceptual framework.

PURPOSES OF THE CONCEPTUAL FRAMEWORK

The purpose of the Conceptual Framework is to:
a. Assist the International Accounting Standards Board (IASB) to develop International Financial Reporting Standards
(IFRS) that are based on consistent concepts;
b. Assist preparers of financial statements to develop consistent accounting policies when no Standard applies to a
particular transaction or other event, or when a Standard allows a choice of accounting policy; and
c. Assist all parties to understand and interpret the Standards.

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AUTHORITATIVE STATUS OF THE CONCEPTUAL FRAMEWORK
If there is a standard or an interpretation that specifically applies to a transaction, the standard or interpretation overrides
the Conceptual Framework.

In the absence of a standard or an interpretation that specifically applies to a transaction, management shall consider the
applicability of the Conceptual Framework in developing and applying an accounting policy that results in information that
is relevant and reliable.

It is to be stated that the Conceptual Framework is not an accounting standard. Nothing in the Conceptual Framework
overrides any specific IFRS. In case where there is a conflict, the requirements of the IFRS shall prevail.

USERS OF FINANCIAL INFORMATION

The users of financial information are classified into:
1. Primary users, and
2. Other users

Primary users
➢ The parties to whom general purpose financial reports are primarily directed.

Primary user Information need

Investors Information on risk inherent in and return provided by their investments.

Lenders and other creditors Information which enables them to determine whether their loans, interest thereon and
other amounts owing to them will be paid when due.

Other users
➢ By residual definition, these are the users of financial information other than the primary users.
➢ These users may find the general purpose financial reports useful but these are not directed to them primarily.

Other user Information need

Employees Information about the stability and profitability of the company where they are working
in.

Information which enables them to assess the ability of the company to provide
remuneration, retirement benefits and employment opportunities.

Customers Information about the continuance of an entity especially when they have a long-term
involvement with or are dependent on the entity.

Government and its agencies Information of the company to regulate its activities, determine taxation policies and as
a basis for national income and similar statistics.

OBJECTIVE OF FINANCIAL REPORTING

➢ This forms the foundation of the Conceptual Framework.
➢ It is the “why” of accounting.
➢ The overall objective is to provide financial information for decision-making.
➢ Specifically, the objectives of financial reporting is to provide information:
(a) Useful in making decisions about providing resources to the entity.
(b) Useful in assessing the cash flow prospects of the company.
(c) About the company resources, claims and the changes in those.
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LIMITATIONS OF FINANCIAL REPORTING
(a) General purpose financial reports do not and cannot provide all of the information that existing and potential
investors, lenders and other creditors need.
(b) General purpose financial reports are not designed to show the value of an entity but these reports provide
information to help the primary users estimate the value of the entity.
(c) General purpose financial reports are intended to provide common information to users and cannot
accommodate every request for information.
(d) To a large extent, general purpose financial reports are based on estimate and judgment rather than exact
depiction.

QUALITATIVE CHARACTERISTICS OF FINANCIAL STATEMENTS

❖ These are the qualities or attributes that make financial information useful to the users in making economic
decisions.
Qualitative
Characteristics of
Financial
Statements

Fundamental Enhancing
Qualitative Qualitative
Characteristics Characteristics

Faithful
Relevance Verifiability Comparability Understandability Timeliness
representation

Confirmatory
Predictive value Completeness Neutrality Free from error
value

Figure 2:
Qualitative Characteristics of Financial Statements

FUNDAMENTAL QUALITATIVE CHARACTERISTICS

❖ These relates to the content or substance of financial information.
❖ Financial information must be both relevant and faithfully represented if it is to be useful.

Relevance
• Refers to the capacity of the information to influence a decision.
• Information has predictive value when it can help users increase the likelihood of predicting or forecasting
outcome of events.
• Information has confirmatory value if it provides feedback about previous evaluations.
• The relevance of information is affected by its nature and materiality.
▪ Materiality is defined by the International Accounting Standards Board (IASB) in the following manner:

Information is material if omitting, misstating or obscuring it could reasonably be expected to influence the
economic decisions that primary users of general-purpose financial statements make on the basis of those
statements which provide financial information about a specific reporting entity.

▪ Simply stated, an information is material if its omission, misstatement and obscuring of the information could
reasonably affect the economic decision of primary users.
➢ Materiality dictates that strict adherence to Generally Accepted Accounting Principles (GAAP) is not
required when the items are not significant enough to affect the evaluation, decision and fairness of the
financial statements. In simple terms, materiality is just a “quantitative threshold”.
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➢ The materiality of an item depends on relative size rather than absolute size. What is material for one
may not be material to another.
➢ There is no uniform quantitative threshold for materiality as it depends on the professional judgment of
an accountant.
✓ An item is material if knowledge of it would affect or influence the decision of the primary users of
the financial statements.

Faithful Representation
• This means that the actual effects of the transactions shall be properly accounted for and reported in the financial
statements.
• The descriptions and figures presented in the financial statements should match what really existed or happened.
• Three ingredients:
(a) Completeness – this requires that relevant information should be presented in a way that facilitates
understanding and avoids erroneous implication.
➢ The standard of adequate disclosure (or the full disclosure principle) means that all significant and
relevant information leading to the preparation of financial statements shall be clearly reported. This is
best described as disclosure of any financial facts significant enough to influence the judgment of informed
users.
(b) Neutrality – the financial statements should not be prepared so as to favor one party to the detriment of
another party.
➢ To be neutral or fair, the information contained in the financial statements must be free from bias.
➢ Neutrality is supported by the exercise of prudence (or conservatism).
✓ Prudence (or conservatism) the exercise of care and caution when dealing with the uncertainties in
the measurement process such that assets or income are not overstated and liabilities or expenses
are not understated.
- When alternatives exist, the alternative which has the least effect on equity shall be chosen.
(c) Free from error – this means there are no errors or missions in the description of the phenomenon or
transactions.
• If information is to represent faithfully the transactions it purports to represent, it is necessary that the
transactions are accounted for in accordance with their economic substance and reality and not merely their legal
form. This is called the concept of substance over form.
➢ If there is a conflict between substance and form, the economic substance of the transaction shall prevail over
the legal form.

ENHANCING QUALITATIVE CHARACTERISTICS

❖ These are intended to increase the usefulness of the financial information that is relevant and faithfully
represented.
❖ These relates to the presentation or form of financial information.

Verifiability
• This means that different knowledgeable and independent observers could reach consensus that a particular
depiction is a faithful representation.
• The information is verifiable if it is supported by evidence that an accountant would look into and arrive at the
same conclusion.

Comparability
• It enables users to identify and understand similarities and dissimilarities among items.
• This may be made within an entity or between and across entities.
➢ Comparability within an entity is the quality information that allows comparisons within a single entity from
one accounting period to the next. This is known as intracomparability.
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➢ Comparability between or across entities is the quality of information that allows comparisons between two
or more entities engaged in the same industry. This is known as intercomparability.
• Consistency refers to the use of the same method for the same item, either from period to period within an entity
or in a single period across entities.
➢ This is not synonymous to comparability.
➢ Comparability is the goal and consistency helps to achieve that goal.

Understandability
• Information should be presented in a form and expressed in terminology that a user understands.
• An essential quality of the information provided in financial statements is that it is readily understandable by
users.
• Understandability is very essential because a relevant and faithfully represented information may prove useless
if it is not understood by users.

Timeliness
• This means having the information available to decision makers in time to influence their decisions.
• Relevant information may lose relevance if there is undue delay in the reporting.

COST CONSTRAINT
• Cost is a pervasive constraint on the information that can be provided by financial reporting.
• Reporting financial information imposes cost and it is important that such cost is justified by the benefit derived
from the financial information.
➢ The benefit derived from the information should exceed the cost incurred in obtaining the information. This
is known as the cost-benefit consideration.
➢ Assessing whether the cost of reporting outweighs or falls short of the benefit to be derived is a matter of
professional judgment.

GENERAL OBJECTIVE OF FINANCIAL STATEMENTS

• Financial statements provide information about economic resources of the reporting entity, claims against the
entity and changes in the economic resources and claims.
✓ In simple terms, financial statements provide information about an entity’s assets, liabilities, equity, income
and expenses.

TYPES OF FINANCIAL STATEMENTS

1. Consolidated financial statements
➢ These are the financial statements prepared when the reporting entity comprises both the parent and its
subsidiaries.
➢ It provides information about the assets, liabilities, equity, income and expenses of both the parent and its
subsidiaries as a single reporting entity.
✓ The parent is the entity that exercises control over the subsidiaries.
✓ The parent obtains control over a subsidiary by acquiring a majority ownership interest (e.g., more than
50%) in the voting common stocks of the subsidiary.

2. Unconsolidated financial statements

➢ These are the financial statements prepared when the reporting entity is the parent only.
➢ Designed to provide information about the parent’s assets, liabilities, income and expenses and not about
those of the subsidiaries.

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3. Combined financial statements
➢ These are the financial statements when the reporting entity comprises two or more entities that are not
linked by a parent and subsidiary relationship.

NATURE OF A REPORTING ENTITY

• It is an entity that is required or chooses to prepare financial statements.
• It can be a single entity or a portion of an entity, or can comprise more than one entity.
• The following can be considered a reporting entity:
(a) Sole proprietorship, partnership, or corporation;
(b) Parent company;
(c) The parent and its subsidiaries as single reporting entity;
(d) Two or more entities without parent and subsidiary relationship as a single reporting entity

REPORTING PERIOD
• The period when financial statements are prepared for general purpose financial reporting.
• Financial statements are prepared at least annually. Optionally, it may be prepared on an interim basis (i.e., three
months, six months, nine months).

UNDERLYING ACCOUNTING ASSUMPTIONS

• Serves as the foundation of accounting in order to avoid misunderstanding but rather enhance the understanding
and usefulness of the financial statements.
• The Conceptual Framework mentions only one assumption, which is going concern.
➢ The entity is viewed as continuing in operation indefinitely in the absence of evidence to the contrary.
➢ Financial statements are prepared normally on the assumption that the entity shall continue in operation for
the forseeable future.
• Implicit in accounting are the following basic assumptions:
➢ Accounting entity assumption – this assumption requires that the transactions of the entity should not be
combined with the personal transactions of the owners.
➢ Time period assumption – this assumption requires that the life of an entity is subdivided into accounting
periods which are usually of equal length for the purpose of preparing financial statements.
✓ By convention, the accounting period is one year or twelve months. It may be either a:
(a) Calendar year – the accounting period that begins on January 1 and ends on December 31.
(b) Fiscal year – the accounting period that begins on the first day of any month other than January.
➢ Monetary unit assumption – this assumption has two aspects:
(a) Quantifiability aspect – this means that the assets, liabilities, equity, income and expenses should be
stated in terms of a unit of measure which is the Philippine peso.
(b) Stability aspect – this means that the purchasing power of the peso is stable or constant and that its
instability is insignificant and therefore may be ignored.

ELEMENTS OF FINANCIAL STATEMENTS

• These refers to the quantitative information reported in the financial statements.
• They are regarded as the building blocks from which financial statements are constructed.

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Elements of
financial
statements

Elements of Elements of
Financial Financial
Position Performance

Asset Liability Equity Income Expense

Figure 3:
Classification of Elements of Financial Statements

Asset
• Under the Conceptual Framework, an asset is defined as a present economic resource controlled by the entity as
a result of past events.
➢ An economic resource is a right that has the potential to produce economic benefits. Rights that have the
potential to produce economic benefits may take the following forms:
1. Rights that correspond to an obligation of another entity
(a) Right to receive cash;
(b) Right to receive goods or services;
(c) Right to exchange economic resources with another party on favorable terms; and
(d) Right to benefit from an obligation of another party if a specified uncertain future event occurs.

2. Rights that do not correspond to an obligation of another entity

(a) Right over physical objects, such as property, plant and equipment or inventories
(b) Right to intellectual property

3. Rights established by contract or legislation

➢ An entity controls an asset if it has the present ability to direct the use of the asset and obtain the economic
benefits that flow from it.
✓ Control also includes the ability to prevent others from using such asset and therefore preventing others
from obtaining the economic benefits from the asset.
✓ Control may arise if an entity enforces legal rights.

Liability
• Under the Conceptual Framework, a liability is defined as present obligation of an entity to transfer an economic
resource as a result of past events.
• Essential characteristics:
(a) The entity has an obligation
(b) The obligation is to transfer an economic resource.
(c) The obligation is a present obligation that exists as a result of past event.
➢ An obligation is a duty or responsibility that an entity has no practical ability to avoid.
✓ Can either be legal or constructive.
❖ Obligation may be legally enforceable as a consequence of a binding contract or statutory
requirement.

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❖ Constructive obligation arises for normal business practice, custom and a desire to maintain good
business relations or act in an equitable manner.
• Obligations to transfer an economic resource as a result of past event include:
✓ Obligation to pay cash;
✓ Obligation to deliver goods;
✓ Obligation to provide services at some future time;
✓ Obligation to exchange economic resources with another party on unfavorable terms; and
✓ Obligation to transfer an economic resource if specified uncertain future event occurs.

Equity
• The residual interest in the assets of an entity after deducting all of the liabilities.

Income
• Defined as increases in assets or decreases in liabilities that result in increases in equity, other than those relating
to contributions from equity holders.
• Income encompasses both revenue and gains.
➢ Revenue arises in the course of the ordinary regular activities.
➢ Gains represent other items that meet the definition of income and do not arise in the course of the ordinary
regular activities.

Expense
• Defined as decreases in assets or increases in liabilities that result in decreases in equity, other than those relating
to distributions to equity holders.
• Expense encompasses losses as well as those expenses that arise in the course of the ordinary regular activities.
➢ Losses do not arise in the course of the ordinary regular activities.

CONCEPT OF RECOGNITION
• According to the Conceptual Framework, recognition is the process of capturing for inclusion in the financial
statements an item that meets the definition of an asset, liability, equity, income or expense.
• Only items that meet the definition of an asset, liability, income, or expense are recognized in the financial
statements.

Income recognition principle

• Income shall be recognized when earned regardless of when cash is received.

Expense recognition principle

• Expenses shall be recognized when incurred regardless of when cash is paid.
• This principle is an application of matching principle.
➢ This requires that those costs and expenses incurred in earning a revenue shall be reported in the same period.
➢ Three applications:
(1) Cause and effect association – This principle means that the expense is recognized when the revenue is
already recognized on the basis of a presumed direct association of the expense with specific revenue.
➢ Examples:
(a) Cost of goods sold
(b) Doubtful accounts
(c) Warranty expenses
(d) Sales commissions

(2) Systematic and rational allocation – Under this principle, some costs are expensed by simply allocating
them over the periods benefited.
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➢ Costs incurred will benefit future periods and that there is an absence of a direct or clear association
of the expense with specific revenue.
➢ When economic benefits are expected to arise over several accounting periods and the association
with income can only be indirectly determined, expenses are recognized on the basis of systematic
and allocation procedures.
➢ Examples:
(a) Depreciation
(b) Amortization
(c) Allocation of prepaid expenses

(3) Immediate recognition – Under this principle, the cost incurred is expensed outright because of
uncertainty of future economic benefits or difficulty of reliably associating certain costs with future
revenue.
➢ An expense is recognized immediately:
(a) When an expenditure produces no future economic benefit.
(b) When cost incurred does not qualify or ceases to qualify for recognition as an asset.
➢ Examples:
(a) Officers’ salaries
(b) Administrative expenses
(c) Advertising expenses

DERECOGNITION
• Defined as the removal of all or part of a recognized asset or liability from the statement of financial position.
• Normally occurs when an item no longer meets the definition of an asset or a liability.

MEASUREMENT
• Quantifying in monetary terms the elements in the financial statements.
• Categories:
(a) Historical cost
- The entry price or value to acquire an asset or incur a liability.
- This measure provides monetary information about assets, liabilities and related income and expenses,
using information derived, at least in part, from the price of the transaction or other event that gave rise
to them.
- The historical cost of an asset is updated over time to depict, if applicable:
(a) The consumption of part or all of the economic resource that constitutes the asset (depreciation or
amortization);
(b) Payments received that extinguish part or all of the asset;
(c) The effect of events that cause part or all of the historical cost of the asset to be no longer recoverable
(impairment); and
(d) Accrual of interest to reflect any financing component of the asset.
- The historical cost of a liability is updated over time to depict, if applicable:
(a) Fulfilment of part or all of the liability, for example, by making payments that extinguish part or all of
the liability or by satisfying an obligation to deliver goods;
(b) The effect of events that increase the value of the obligation to transfer the economic resources
needed to fulfil the liability to such an extent that the liability becomes onerous. A liability is onerous
if the historical cost is no longer sufficient to depict the obligation to fulfil the liability; and
(c) Accrual of interest to reflect any financing component of the liability.

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(b) Current value
- This measure provides monetary information about assets, liabilities and related income and expenses,
using information updated to reflect conditions at the measurement date.
- This includes the following:
(a) Fair value – the price that would be received to sell an asset, or paid to transfer a liability, in an orderly
transaction between market participants at the measurement date.
- This can be observed directly using market price of the asset or liability in an active market.
- In cases where fair value cannot be directly measured, an entity can use present value of cash
flows.
(b) Value in use for asset – The present value of the cash flows, or other economic benefits, that an entity
expects to derive from the use of an asset and from its ultimate disposal.
(c) Fulfillment value for liability – The present value of the cash, or other economic resources, that an
entity expects to be obliged to transfer as it fulfils a liability.

NOTE: Because value in use and fulfilment value are based on future cash flows, they do not include transaction costs
incurred on acquiring an asset or taking on a liability. However, value in use and fulfilment value include the present value
of any transaction costs an entity expects to incur on the ultimate disposal of the asset or on fulfilling the liability.

(d) Current cost – The cost of an equivalent asset at the measurement date, comprising the consideration
that would be paid at the measurement date plus the transaction costs that would be incurred at that
date. The current cost of a liability is the consideration that would be received for an equivalent
liability at the measurement date minus the transaction costs that would be incurred at that date.

Selecting a measurement basis

• The IASB did not mandate a single measurement basis because the different measurement bases could produce
useful information under different circumstances.
• Historical cost is the measurement basis most commonly adopted in preparing financial statements.

PRESENTATION AND DISCLOSURE

• Presentation and disclosure are an effective communication tool about the information in financial statements.
• A reporting entity communicates information about its assets, liabilities, equity, income and expenses by
presenting and disclosing information in the financial statements.
• This can be achieved by classification and aggregation of assets, liabilities, equity, income and expenses.
➢ Classification is the sorting of assets, liabilities, equity, income and expenses on the basis of shared or similar
characteristics.
✓ Offsetting is generally not appropriate.
✓ Income and expenses are classified either:
(a) In the statement of profit or loss; or
(b) In other comprehensive income
➢ Aggregation is the adding together of assets, liabilities, equity, income and expenses that have similar or
shared characteristics and are included in the same classification.
✓ This makes information more useful by summarizing a large volume of detail. However, aggregation
conceals some of that detail. Hence, a balance needs to be found so that relevant information is not
obscured either by a large amount of insignificant detail or by excessive aggregation.

CONCEPTS OF CAPITAL
• A financial concept of capital is adopted by most entities in preparing their financial statements. 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.

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• 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.

CONCEPTS OF CAPITAL MAINTENANCE

(a) Financial capital maintenance. Under this concept a profit is earned only if the financial (or money) amount of
the net assets at the end of the period exceeds the financial (or money) amount of net assets at the beginning of
the period, after excluding any distributions to, and contributions from, owners during the period. Financial
capital maintenance can be measured in either nominal monetary units or units of constant purchasing power.
(b) Physical capital maintenance. Under this concept a profit is earned only if the physical productive capacity (or
operating capability) of the entity (or the resources or funds needed to achieve that capacity) at the end of the
period exceeds the physical productive capacity at the beginning of the period, after excluding any distributions
to, and contributions from, owners during the period.
➢ The physical capital maintenance concept requires the adoption of the current cost basis of measurement.
The financial capital maintenance concept, however, does not require the use of a particular basis of
measurement.

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