CHAPTER 2 - CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING

General Definition
● General accepted theoretical framework for a field of study

Specific Definition
● Basis for the development of new accounting standard and evaluation of existing ones
● Sets out agreed concepts that underlie financial reporting
➢ The framework is not an IFRS (PFRS)
➢ When there is a conflict between IFRS (PFRS) and the frameworks, the IFRS (PFRS) prevails
➢ Although theoretical in nature, the frameworks has a clear practical value

Purpose of Conceptual Framework

Stakeholder Purpose

IASB ● Development of IFRS

● Review of existing IFRS
● Harmonization of standards
➢ Enhances consistency across standards and board

FRSC ● Developing national standards

FS Preparers ● Application of IFRS

● topics not dealt by IFRS

Auditors ● Expressing audit opinion

Users ● Interpret the financial information

General Public ● Work of IASB

● Standards formulation process

Conceptual Framework Overview

Objective of Financial Provide useful information (other aspects of the conceptual framework flow
Reporting logically from the objective)

Qualitative Fundamental:
Characteristics Relevance and faithful representation
Enhancing:
Verifiability, comparability, understandability, and timeliness

Elements of FS Financial Position:

Asset, Liabilities and equity
Financial Performance:
Income and Expense

Other Concepts Capital and capital maintenance

Objectives of financial reporting

● General purpose versus specific purpose of financial statement
● Objective of general purpose financial reporting:
Users of financial information
Users Decisions Information

Existing and potential investors Buy, sell, hold investments Returns such as dividends, market
price increases and principal and
interest payments

Existing and potential lenders and Providing or settling the loan and Principal and interest repayments
creditors extending credit lines

Users’ return expectation depends on the entity’s future net cash inflows based on resources and claims of
the entity and how they are effectively and efficiently managed

Liquidity and solvency

● Liquidity - refers to the ease with which an asset, or security, can be converted into ready cash without
affecting its market price.
● Solvency - the ability of a company to meet its long-term debts and financial obligations.
● If assets exceeds the liability it means its liquid and solvent
● If asset is not cash but exceeds the liability the entity is still solvent but not liquid
● If the liability exceeds the assets then the entity is already in a state of insolvency

Profitability and operating and financial flexibility

● Profitability - The ability of the entity to effectively utilize resources to gain profit
● Operating and financial flexibility - Pertains to the ability of the entity to adapt on an unexpected
downturns

Financial information - Caveats

● The general purpose of financial statements are:
➢ Not meant to cater to all the needs of users, focus is in the need of maximum no. of users
➢ Not designed to show the value of a reporting entity, users must estimate it themselves
➢ Not based on exact depictions but on estimates, judgments and models
➢ Not primarily directed to regulators, but may find them useful still

Qualitative Characteristics
● Financial information is useful if
a. It is relevant and
b. It faithfully represents what it purports to represent (fundamental qualities)
● Usefulness of financial information is enhanced by its verifiability, comparability, understandability, and
timeliness
● Financial information cannot be useful if it is not relevant and not faithfully represented, even though it
is verifiable, complete, understandable and timely
● Fundamental qualities = sine qua non;
● Enhancing qualities = less critical but highly desirable; must be maximized as necessary

Fundamental Characteristics
● Relevance
➢ Making a difference in users’ decision
- Predictive value - help user to make predictions about the future outcome
- Confirmatory value - if it can help users confirm their past prediction. It confirms your
expectations
- Materiality (entity specific) - profession judgment is a tool to determine if an item is a
material or not
● Faithful representation
➢ Present what it purports to present. If the written data is an actual effect of events that have
taken place
- Completeness (words and numbers) - all information necessary for users have a
complete understanding of the financial statement
- Neutrality (not biased) -
 - Free from error (ideally)

Is compliance to the standard an absolute or a general rule?

● It is a general rule because there are characteristics such as materiality that are not specifically stated
in the standard and is actually dependent of the professional judgment

Enhancing Characteristics
● Comparability
➢ Like things look alike; different things look different
➢ Inter Comparability - comparing of 2 different company
➢ Intra Comparability - comparing 2 information from the same company but different accounting
period
● Verifiability
➢ Knowledgeable and independent observers could reach consensus, but not necessarily
complete agreement, that a depiction is a faithful representation
● Timeliness
➢ Having information available to decision makers in time to be capable of influencing their
decisions
● Understandability
➢ Classifying, characterizing and presenting information clearly and concisely makes it
understandable
➢ Complex phenomenon might not be understandable but omission will make the information
incomplete
➢ users = reasonable knowledge of business and economic activities; review and analyze the
information with diligence

Pervasive Constraint
● Financial reporting has costs that must be justified by benefits
● Benefits: more efficient functioning of capital markets and lower cost of capital for the economy
● Costs: collecting, processing, verifying and disseminating financial information and the costs of
analyzing and interpreting the information provided
● Assessing cost-benefit constraints involves both qualitative and quantitative assessments
● The board assesses cost-benefit constraints in relation to financial reporting in general, and not entity
specific.

Elements of Financial Statements

● Definitions of the elements identify their essential features, but do not attempt to specify recognition
criteria
● Substance and economic reality over legal form
● Financial position
➢ Assets
- Resources controlled, from past events with future economic benefit
- Sources of future economic benefits:
1. Used in production
2. Exchanged for other assets
3. Used to settle a liability
4. Distributed to owners
- Physical form is not essential
- Legal ownership is not essential
- Close association between expenditures and generating assets, but not absolute
➢ Liabilities
- Present obligation, from past events with outflow of resources
- Legally enforceable or normal business practice
- Present obligation versus future commitment
- Settlement may be in the form of:
1. Payment of cash
2. Transfer of other assets
3. Provision of services
4. Replacement with another obligation
5. Conversion to equity
- Some can only be measured with a substantial degree of estimation
➢ Equity
- Residual definition; assets minus liabilities
- May have sub-classifications
 a. Contributions
b. Retained earnings
c. Reserves
d. Appropriations
- Amount of equity shown in the balance sheet is dependent on the measurement of
assets and liabilities
● Financial performance
➢ Income
Increase in economic benefits from:
- Inflow / enhancement of assets
- Decrease in liabilities
- Increase in equity, other than capital contribution
- Includes both revenue and income
- Revenue: sales, fees, interest, dividends, royalties and rent. Arises in ordinary course of
business
- Gains: May or may not arise in ordinary course of business. Often presented net of any
related expense.
➢ Expenses
Decrease in economic benefits from:
- Outflow / depletion of assets
- Incurrence of liabilities
- Decrease in equity, other than distributions
- Includes both expenses and losses
- Expense – Normal Course; Losses may or may not arise from the ordinary course of
business
- Losses are often presented net of any related income
➢ Capital Maintenance adjustments
- Meets definition of expenses and income, but not presented in income statement
● Recognition: process of incorporating the elements to the financial statements
➢ Recognition criteria (accrual basis):
- Meets the definition of Asset, Liability, Equity, Income or Expense
- Provides useful information that is relevant and faithfully represented
- Measurable
- Benefits justify the cost
➢ Recognition of income and expenses occurs simultaneously with the increase or decrease in
asset or liability
● Measurement: process of determining monetary amounts of elements

Measurement Bases
● Historical cost
➢ Assets:
- Cash or cash equivalent paid or FV of consideration given
➢ Liabilities:
- Proceeds received or amount to be paid
● Current cost
➢ Assets:
- Cash or cash equivalent that would have been paid if similar asset is acquired currently
➢ Liabilities:
- Cash or cash equivalent required to settle the obligation (undiscounted) currently
● Realizable (settlement) value
➢ Assets:
- Cash or cash equivalent to be received if sold in an orderly disposal
➢ Liabilities:
- Cash or cash equivalent expected to be paid to satisfy obligations (undiscounted)
● Present value
 ➢ Assets:
- Discounted net cash inflow expected from the asset
➢ Liabilities:
- Discounted net cash outflow expected from the asset
● Most common basis is historical cost
● Historical cost is usually combined with other bases

Concept of capital, capital maintenance, and profit

Financial concept Physical concept

Definition Net assets Productive capacity

Examples Total shareholders’ equity of a Generation capacity of a power

retail company plant

Maintenance Profit is: Profit is:

NA End PC End
less. NA Beg less. PC Beg
less. Contributions less. Contributions
Add. back distributions Add. back distributions

Price changes Nominal: Part of equity, not profit or loss

Considered in profit or loss, after
taking away effect of changes in
general price indices

Selection of measurement bases and concepts of capital depends on the accounting model used in the
preparation of the financial statements