CONCEPTUAL FRAMEWORK

LECTURE 4,5

Maliha Rabeta
Lecturer
Department of Business Administration in
Finance and Banking
BUP

31 July & 2 August 2022

BASES OF ACCOUNTING

 There are four bases of accounting which you need to be familiar with:
 Accrual basis: Under this basis of accounting, transactions are recognised when they
occur, not when the related cash flows into or out of the entity.
 Going concern basis: The accrual basis of accounting assumes that an entity is a going
concern. Under this basis, financial statements are prepared on the assumption that the
entity will continue in operation for the foreseeable future, in that management has neither
the intention nor the need to liquidate the entity by selling all its assets, paying off all its
liabilities and distributing any surplus to the owners.
BASES OF ACCOUNTING

 Cash basis: The cash basis of accounting is not used in the preparation of a company
balance sheet and income statement as it is not allowed by BFRS, although the cash effect of
transactions is presented in the form of a cash flow statement.
 Break-up basis: Followed when a business is undergoing financial difficulties and needs to
pay cash to its creditors. In these circumstances the financial statements will be prepared on
a break-up basis.
CONCEPTUAL FRAMEWORK

 The conceptual framework establishes the concepts that underlie financial reporting.
 Overview of the conceptual framework:
 Can be divided into Three levels:
 First Level: Basic Objective
 Second Level: Qualitative Characteristics and Elements of Financial Statements
 Third Level: Recognition, Measurement and Disclosure Concepts.
FIRST LEVEL: BASIC OBJECTIVE

 The basic objective of Financial Reporting is to provide financial information about the
reporting entity that is useful to present and potential equity investors, lenders and other
creditors in making decisions in their capacity as capital providers.
 This objective is served by issuing general purpose financial statements.
 It is assumed that the users have reasonable knowledge about business and financial
accounting matters to interpret the information from the financial reports.
SECOND LEVEL: QUALITATIVE CHARACTERISTICS

 Qualitative characteristics of accounting information:

 IASB identified the Qualitative Characteristics of accounting information that distinguish
better i.e. more useful information from inferior (less useful) information for decision making
purposes.
 Can be further distinguished into Fundamental and Enhancing Qualities.
FUNDAMENTAL QUALITY: RELEVANCE

 Relevance makes accounting information useful for decision making.

 Information has the quality of relevance when it influences the economic decisions of users
by helping them evaluate past, present or future events or confirming, or correcting, their
past evaluations.
 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. The
manner of presentation will enhance the ability to make predictions, e.g. by highlighting
unusual items.
 The two components of this fundamental quality are:
 Predictive Value and
 Confirmatory Value.
FUNDAMENTAL QUALITY: FAITHFUL REPRESENTATION
 Faithful representation means that the numbers and descriptions match with what really existed or
happened.
 Information has the quality of reliability when it is free from material error and bias and can be
depended upon by users to represent faithfully that which it either purports to represent or could
reasonably be expected to represent.
 Information must represent faithfully the transactions it purports to represent in order to be reliable.
There is a risk that this may not be the case, not due to bias, but due to inherent difficulties in
identifying the transactions or finding an appropriate method of measurement or presentation.
 The three components of this fundamental quality are:
 Completeness
 Neutrality
 Free from error
ENHANCING QUALITIES

 These qualities help in distinguishing more useful information from less useful information.
 These qualities are:
 Comparability
 Verifiability
 Timeliness
 Understandability
ELEMENTS OF FINANCIAL STATEMENTS

 Assets: A resource controlled by an entity as a result of past events and from which future economic
benefits are expected to flow to the entity.
 Liabilities: A present obligation of the entity arising from past events. The settlement of these
obligations are expected to result in an outflow from the entity of resources embodying economic
benefits.
 Equities:The residual interest in the assets of the entity after deducting all its liabilities.
 Income: Increase 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.
 Expenses: Decrease in economic benefit 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.
TYPES OF FINANCIAL STATEMENTS

 Companies prepare four financial statements from the summarized accounting data:
1. An income statement presents the revenues and expenses and resulting net income or net
loss for a specific period of time.
2. An owner’s equity statement summarizes the changes in owner’s equity for a specific period
of time.
3. A balance sheet reports the assets, liabilities, and owner’s equity at a specific date.
4. A statement of cash flows summarizes information about the cash inflows (receipts) and
outflows (payments) for a specific period of time.
THIRD LEVEL: RECOGNITION, MEASUREMENT AND DISCLOSURE
CONCEPTS
 These concepts explain how companies should recognise, measure and report financial elements and
events.
 The following diagram may help us get an initial idea:
INTRODUCTION TO ACCOUNTING PRINCIPLES

 Accounting principles are the rules and guidelines that must be followed by companies while
preparing financial reports.
 These standards are generally accepted and universally practiced. This common set of
standards is called generally accepted accounting principles (GAAP). These standards indicate
how to report economic events.
 The Financial Accounting Standards Board (FASB) issues a standardized set of accounting
principles in the U.S. referred to as generally accepted accounting principles (GAAP).
PURPOSE OF ACCOUNTING PRINCIPLES

 The primary purpose of these principles is to make the information in financial reports
relevant, reliable and comparable.
 Relevant information has the capacity to affect the decision making process of Financial
Statement users.
 Reliable information is necessary if the decision makers are to depend on it.
 In addition the information should allow statement users to compare companies. Notable
that, these comparisons are more likely to be useful if the companies are from similar
practices.
 The accounting principles impose limits on the variety of accounting practices that
companies can use, thereby making the financial statements more useful.
UNDERLYING ACCOUNTING PRINCIPLES & ASSUMPTIONS
1. Business Entity Principle:
The business entity principle requires every business to be accounted for separately from its
owner/owners.This principle applies to all three forms of business.
This principle also requires us to account separately for other entities that might be controlled
by the same owners. The reason behind this principle is that separate information for each
business is relevant to decisions that its users make.

2. Objectivity Principle:
Also called reliability principle. The objectivity principle requires financial statement information
to be supported by evidence other than someone's imagination or opinion. Information would
not be reliable if it were based on only what the statement preparer thinks might be true.
UNDERLYING ACCOUNTING PRINCIPLES & ASSUMPTIONS

3. Cost Principle:
The cost principle requires financial statement information to be based on costs incurred in
business transactions. This is the concept that a business should only record its assets, liabilities,
and equity investments at their original purchase costs.

4. Going Concern Principle:

This principle requires financial statements to reflect the assumption that the business will
continue operating instead of being closed or sold. Thus , the company’s balance sheet doesn’t
report the liquidation values of operating assets that are being held for long term use.
UNDERLYING ACCOUNTING PRINCIPLES & ASSUMPTIONS
5.Accrual principle:
This requires that accounting transactions should be recorded in the accounting periods when
they actually occur, rather than in the periods when there are cash flows associated with them.
This is the foundation of the accrual basis of accounting. It is important for the construction of
financial statements to show what actually happened in an accounting period, rather than being
artificially delayed or accelerated by the associated cash flows.
6. Revenue recognition principle:
This principle requires to only recognize revenue when the business has substantially
completed the earnings process. That means revenue should be recognised at a time it is earned
and the inflow of assets associated with revenue doesn’t have to be in the form of cash. The
amount of recognised revenue should be measured as the cash received plus cash equivalent
(fair market value) of any other asset or assets received.
UNDERLYING ACCOUNTING PRINCIPLES & ASSUMPTIONS
7. Conservatism principle:
This principle requires that that we should record expenses and liabilities as soon as possible,
but should record revenues and assets only when we are sure that they will occur. This
introduces a conservative angle to the financial statements that may yield lower reported
profits, since revenue and asset recognition may be delayed for some time. On the other hand,
this principle tends to encourage the recording of losses earlier than later.
8. Consistency Principle:
This principle requires us to continue to follow an accounting principle or method consistently
in future once we adopt it. Only change in an accounting principle or method is acceptable, if
the new version efficiently improves reported financial results. If such change is made, its effects
should be documented in the notes to the financial statements. Auditors are particularly
anxious that their clients follow the consistency principle, so that the results reported over
time are comparable.
UNDERLYING ACCOUNTING PRINCIPLES & ASSUMPTIONS
9. Full disclosure principle:
This principle requires a company to deliver sufficient information to facilitate an intelligent
user for making an informed decision. Owing to this principle, a company's financial statements
will include many disclosures and schedules in the notes to the financial statements.

10. Matching principle:

This is also called the expense recognition principle. This principle states that, when you record
revenue, you should record all related expenses at the same time. The ideal way to recognize
(report) expenses on the income statement is based on a cause-and-effect relationship.
Expenses are reported in the accounting period that the expenses occur.
UNDERLYING ACCOUNTING PRINCIPLES & ASSUMPTIONS
11. Monetary unit principle:
This principle requires us to only record business transactions that can be expressed in terms of a
currency/ monetary unit.Thus, a company cannot record such non-quantifiable items.
12. Time period principle
This principle states that, companies should report the results of its operations over a standard period of
time. It is intended to create a standard set of comparable periods. Accountants assume that a company's
ongoing multifaceted business operations and financial results can be divided into separate time periods
i.e. months/ quarters/ years.
13. Materiality Principle:
This principle states that a transaction should be recorded in the accounting records if not doing so
might have altered the decision making process of someone using the company's financial statements. This
is quite a vague concept. The concept of materiality means an accounting principle can be ignored if the
amount is insignificant.