Conceptual Framework for Financial Reporting

Imagine a situation wherein your teacher returned your test papers, and you saw your score at twelve over
twenty. How will you react? Normally, you would ask your friend if they got the same score. What if your
friend got twenty-five over thirty, can you compare your score with that of your friend’s? Is there anything
wrong with the scoring of your teacher?
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The above situation made you question, because of the basic problem of incomparable reports. Having
comparable information is crucial in decision making. Accountants are required to produce financial reports
that can be compared with other similar reports to make a meaningful decision. To have comparable financial
information, accountants follow the guidance of the Conceptual Framework for Financial Reporting, or
Conceptual Framework, in short.

The Conceptual Framework provides the foundation for the development of Accounting Standards, to
promote comparability of financial information, and reduce the information gap between the management
and owners of the business.

The Conceptual Framework prescribes the concepts for general purpose financial reporting. It is to assist the
IFRS Foundation in developing Accounting Standards, assist preparers of financial statements to be consistent
on its accounting policies when no Accounting Standards is applicable, and assist all users of financial
information in understanding, and interpreting the Accounting Standards.
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The Conceptual Framework is not an Accounting Standard. When identifying business transactions, measuring
its monetary terms, and presenting for communication, the following hierarchy of rules should be followed.
 follow the applicable Accounting Standard on the said transaction.
 use judgement based on other similar transactions that has an existing Accounting Standards and the
Conceptual Framework.
The Conceptual Framework is applicable with the general-purpose financial statements. It contains the
following sections:
The objective of financial reporting
 Qualitative characteristics of useful financial information
 Financial statements and the reporting entity
 The elements of financial statements
 Recognition and derecognition
 Measurement
 Presentation and disclosure
 Concepts of capital and capital maintenance
Objectives of Financial Reporting
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.

Users of General-Purpose Financial Statements

 1. Existing and Potential Investors
2. Lenders and Other Creditors
These primary users, however, cannot demand whatever information from the business, and must rely on
general purpose financial statements. The Conceptual Framework is concerned with the preparation general-
purpose financial reporting. General-purpose financial reporting provides information that caters to the
common needs of the primary users.

The primary users of general-purpose financial information depend on their decision on business’s expected
return.
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Expectation about the return depends on the assessment of the entity’s prospective net cash inflows, and
management stewardship.

To make these assessments, the primary users need the financial information:
 on the economic resources of the entity, the claims, and the change in those resources and claims, and
 how efficiently the business management utilized these economic resources.

Qualitative characteristics of useful financial information

Financial information needs qualitative characteristics, not just a group of words and numbers. These
qualitative characteristics make financial information more useful for primary users. The

Conceptual Framework classified these qualitative characteristics as:

 Fundamental qualitative characteristics
 Enhancing qualitative characteristics.

Fundamental qualitative characteristics make financial information useful to users. These are the
characteristics of
 Relevance and
 Faithful representation.

A financial information is Relevant when it can make a difference in the decision making of users. Information
is relevant when it has a predictive value, it helps users in making predictions about the future, and when it
has a confirmatory value, it can help users in confirming their previous predictions. Information is relevant
when material information is presented properly. Information is material if omitting or misstating it could
reasonably be expected to influence decisions that the primary users make, based on those financial
statements.

Faithful representation means the information provides a true, correct, and complete depiction of the
economic situation that it represents. Faithfully represented information has the following characteristics:
Completeness, Neutrality, and Free from error.
 Completeness means that the information presents all (in words and numbers) necessary information for the
user to understand the situation of the business. These include description of the nature of the transactions,
the explanations, and the monetary effect to the financial statements.
Neutrality means that the information is presented without bias. Information is not manipulated to increase
the probability that users will receive it, favorably or unfavorably. Neutrality is supported by the principle of
conservatism, to use caution when making judgement or estimates.
Free from error means that there are no errors in the description and in the process by which the information
is selected and applied. It does not mean that the information is perfect in all aspect.

When any fundamental qualitative characteristic is lacking, then the financial information is not that useful to
the users, to arrive a good economic decision.

Enhancing qualitative characteristics make a financial information more useful to decision makers. Lacking on
these areas, however, still makes the financial information useful for having a good economic decision.
Enhancing qualitative characteristics are Comparability, Verifiability, Timeliness, and Understandability.
Financial information is comparable when it helps users identify similarities and differences between sets of
information from other time periods or other business reports. Comparability can be achieved when observing
the concept of consistency.
Financial information is verifiable when different users can reach a general agreement as to what the
information purports to represent. Direct verification involves physical observation, and indirect verification is
when using calculations, formula, or models to verify an information.
Timeliness means making the information timely enough to be able to influence the users on their decisions.
Financial information is understandable if it is presented in a clear and concise manner. Understandability
means making the information simple enough for primary users, the people who have reasonable knowledge
about the business, and who are willing to analyze the information diligently.
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The accountants should strive to achieve these qualitative characteristics on their financial statements or
financial reports. In reality, there are situations, and circumstances that hinders the accountant to achieve
these characteristics (like the cost and time needed to generate the reports). The accountant should make
judgement to balance the need to have financial information that is useful for the users.

Financial Statements and the Reporting Entity

The Financial Statements
The financial statements are reports on the business’s, or entity’s, economic resources, claims, and how
efficiently the business’s management utilized these economic resources. The parts of a complete financial
statement are.
 Statement of financial position, or balance sheet
 Statement of comprehensive income, or income statement
 Statement of changes in equity
 Statement of cash flows
 Notes to financial statements
 Additional statement of financial position, when necessary.
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These economic resources of the entity, the claims, and the change in those resources and claims are
primarily found in the statement of financial position.
The information on how the management utilized these economic resources are primarily shown in the
statement of comprehensive income.
The statement of changes in equity shows the items or transactions that affect the equity accounts, or
the owner’s accounts, during the period.
The statement of cash flows shows the information as to where the cash of the business, or entity, is
coming from, or where the cash is spent on, during the period.
The note to financial statements explains in detail the items found in the previous statements.
And the additional statement of financial position is required when there are changes in the
accounting policy from one period to the other.

In the rest of the course, we are going to prepare these parts of the financial statements in accordance with
the requirements of the Accounting Standards, and the Conceptual Framework.

As discussed previously, 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.
To make these decisions, the primary users need to assess the financial information on the economic
resources of the entity, the claims, and the change in those resources and claims, and how efficiently the
business management utilized these economic resources.

The Reporting Entity

The reporting entity is the organization, or component of an organization, or a group of organizations, that
the financial statements are prepared for. Sometimes an organization, the parent company, controls other
organization, the subsidiaries. If the financial statements include both the parent and the subsidiary, then it is
called a consolidated financial statement. If the report is for the parent or subsidiary alone, then it is called as
unconsolidated financial statements. If two subsidiaries are combined in a report, then it is called a combined
financial statement.
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Financial statements are prepared on the perspective of the organization. It shows the organization’s
economic resources, its claims, the movements of these resources and claims. It also shows how the
management efficiently uses these economic resources.

The financial statements are prepared under the following assumptions:

 Fair presentation in compliance with the Accounting Standards
 Going concern assumption
 Accrual Accounting
 Materiality and Aggregation
 Offsetting principle
 Reporting frequency
  Comparative information
 Consistency of presentation.

The Elements of Financial Statements

The financial statements provide information on the entity's (a) economic resources; (b) claims of these
resources; and (c) the change in those resources and claims.
The financial statements therefor should contain the following elements:
 Assets - the present economic resources controlled by the entity as a result to past events. An
economic resource is a right that has the potential to produce economic benefits. Learn more about
assets here: https://www.investopedia.com/terms/a/asset.asp
 Liabilities - present obligations of the entity to transfer an economic resource as a result of past
events. An obligation is a duty or responsibility that the entity has no practical ability to avoid. Learn
more about liabilities here: https://www.investopedia.com/terms/l/liability.asp
 Equity - the residual interest in the assets of the entity after deducting all its liabilities.
 Income - the increase in the assets of the entity, or decrease in liabilities, that results in the increase in
equity, other than those relating to contributions from holders of equity claims (owner's investments).
 Expenses - is the decrease in assets, or increase in liabilities, that result in decrease in equity, other
than those relating to distribution to holders of equity claims (owner's withdrawals).
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An accountant should master the analysis of business transactions to the effects in the elements of the
financial statements.
Recognition and Derecognition
Recognition
Recognition is the process of including in the statement of financial position or in the statement of
comprehensive income, an item that meets the definition of one of the elements of a financial statement. This
involves recording the item in words and in monetary terms within the financial report.
An item is recognized in the financial statements, if:
 It meets the definition of an asset, liability, equity, income, or expense; and
 Recognizing it would provide useful information. It should be relevant and faithfully represented
information
Recognition is actually what is being determined in the accounting process of analyzing business transactions.
When a business transaction has an effect on assets, liabilities, or equity, then that transaction shall be
recognized as part of the financial statements.
Derecognition
Derecognition is the opposite of recognition. It is the removal of a previously recognized asset or liability from
the entity’s financial statements. Derecognition occurs when the item no longer meets the definition of an
asset or liability, such as when the entity loses control of all or part of an asset, or no longer has the present
obligation for all or part of the liability.

Unit of Account
Unit of account
is the right or the group of rights, the obligation or the group of obligations, or the group of rights and
obligations, to which recognition criteria and measurement concepts are applied. Assets are different from
each other, depending on the nature and purpose, hence these are recognized and measured separately.

For example, cash is an asset, and it has its own recognition and measurement rules from the accounting
standards, while office equipment is another kind of asset that has its own accounting standard for recognition
and measurement.
Although both are the same assets, each has its own separate unit of account. This concept also applies to
liabilities, equity, income, and expense.
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To recap, recognition is the process of including an item of a transaction into the financial statements while
derecognition is the process of removing a previously recognized asset, liability, or equity.

Measurement
Recognition requires quantifying an item in monetary terms, thus necessitating the selection of an appropriate
measurement basis. The Conceptual Framework describes the following measurement bases:
 Historical cost
 Current value
The historical cost of an asset is the consideration paid to acquire the asset, plus transaction costs, while
historical cost of a liability is the consideration received to incur the liability, minus transaction costs.
Illustration: A business purchased a blending machine paying ten thousand pesos for the item, and five
hundred pesos for delivery cost. The historical cost of the blending machine therefore is ten thousand five
hundred pesos, the consideration paid (the ten thousand pesos) plus transaction cost (the five hundred
pesos).
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Current value measurement is subclassified as:
 Fair value
 Value in use or Fulfilment value
 Current cost
Fair value is 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.
Value in use is the present value of cash flows or other economic benefits that an entity expects to derive from
the use of an asset. Fulfilment value is the present value of the cash, or other economic resources, that the
entity expects to be obliged to transfer as it fulfils a liability.
Current cost of an asset is the cost of an equivalent asset at the measurement date, comprising that would be
paid, plus transaction costs. Current cost of a liability is the consideration that would be received for an
equivalent liability at the measurement date, minus the transaction costs.

In the higher accounting subjects, Accounting Standards give a specific measurement basis for a specific unit of
account. When the Accounting Standard mentions historical cost or fair value, then it means the following
definitions above.
When a transaction has no Accounting Standards yet, the accountant can choose between historical cost or
current value, taking into consideration the effort needed for measuring the transaction, the qualitative
characteristics of relevance and faithful representation, against the benefits that the information will provide
to the decision makers.

Presentation and Disclosure

Information about the assets, liabilities, equity, income and expenses is communicated through presentation
and disclosure in the financial statements. Effective communication makes information more useful. It
requires:
 focusing on presentation and disclosure objectives and principles, rather than rules
 classifying information by grouping similar items and separating dissimilar items.
 aggregating information in a manner that it is not obscured by excessive detail or by excessive
summarization.
The cost constraint affects the decision about presentation and disclosure. The accountant should judge when
the item requires more cost than benefit when presented or when disclosed.

Effective communication through presentation and disclosure requires:

 entity-specific information, not a standardized descriptions;
 aggregation for large volume of detail, thus making information more useful;
 the minimization of providing duplication of information;
 the avoidance of combining dissimilar items since it reduces the usefulness of information;
 the avoidance of offsetting since it combines dissimilar items;
Typically, aggregation is presented at the statement of financial position and comprehensive income, while the
detailed information is disclosed at the notes to financial statements.
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Concepts of capital and capital maintenance
Equity is the residual of assets less liabilities while capital is the amount of investment by the owners into the
business. These terms are mostly used interchangeably but it is important to know the difference. To learn
more about the concept of capital and capital maintenance, please read this link:

Concept of Capital and Capital Maintenance:

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