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CHAPTER 1: THE CONCEPTUAL FRAMEWORK

A conceptual framework for financial reporting is a statement of generally accepted

theoretical principles, which form the frame of reference for financial reporting. Its
theoretical principles provide the basis for:

 The development of accounting standards; and

 The understanding and interpretation of accounting standards.

Therefore, a conceptual framework will form the theoretical basis for determining

 which events should be accounted for,

 how they should be measured and
 how they should be communicated to users of financial statements.

IASB Conceptual Framework

The IASB Framework provides the underlying rules, conventions and definitions that
underpin the preparation of all financial statements prepared under International Financial
Reporting Standards (IFRS).

 Ensures standards developed within a conceptual framework

 Provide guidance on areas where no standard exists
 Aids process to improve existing standards
 Ensures financial statements contain information that is useful to users
 Helps prevent creative accounting

The revised IASB Conceptual Framework was issued in March 2018 and the new areas
included are as follows:

 Measurement basis
 Presentation and disclosure
 Derecognition

Whilst updates have been made to the following:

 Definitions of assets/liabilities
 Recognition of assets/liabilities

And clarification on:

 Measurement uncertainty

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 Prudence
 Stewardship
 Substance over form

The objective of general purpose financial reporting

The objective of general purpose financial reporting is ‘[t]o 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’ (Conceptual
Framework: para. 1.2)

The decisions made by users will involve:

 Investment decisions
 Financing decisions
 Voting, or influencing management actions

The users will be assessing the management’s stewardship of the entity alongside its
prospects for the future, which will require the following information:

 Economic resources of the entity

 Claims against the entity
 Changes in the entity’s economic resources and claims.
 Efficiency and effectiveness of management

Accrual Accounting
The Conceptual Framework requires financial statements to be prepared using accrual
accounting. That is, the effects of transactions and events are reported in the periods in
which those effects occur, even if the resulting cash receipts and payments occur in a
different period. This is also referred to as the ‘matching’ concept.

Underlying assumption: Going concern

Financial statements are normally prepared on the assumption that an entity is a going
concern and will continue in operation for the foreseeable future.

This means that it is assumed that the entity has neither the intention nor the need to
liquidate or curtail materially the scale of its operations.

However, if such an intention or need exists, the financial statements may have to be
prepared on a different basis such as the ‘break-up bases’.

Qualitative characteristics – make information useful

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Fundamental qualitative characteristics

 Relevance – information that makes a difference to decisions made by users (nature and
materiality)
 Faithful information – must faithfully represent the substance of what it represents, and
is therefore complete (helps understand and includes descriptions and explanations),
neutral (no bias, and therefore supported by the exercise of prudence) and free from
error. Measurement uncertainty will impact the level of faithful representation.

Enhancing qualitative characteristics

 Comparability – identify similarities/differences between entities and year-on-year
 Verifiability – assures the information represents the economic phenomena it represents
 Timeliness – information is less useful the longer it takes to report it
 Understandability – user have a reasonable knowledge of business and activities

A cost constraint applies in ensuing that the information is useful, in that the benefit of
obtaining the information should outweigh the cost of obtaining it.

Financial statements and the reporting entity

Reporting entity

Is the entity that is required to prepare financial statements and does not necessarily have
to be a legal entity.

Financial statements

Report the entities assets, liabilities, income, and expenses for:

 Consolidated financial statements

 Un-consolidated financial statements
 Combined financial statements
 Prepared for the entity as a whole
 Entity is a going concern and will continue to do so

The elements of financial statements

 Assets: A present economic resource controlled by the entity as a result of past events
(Conceptual Framework: para. 4.2).
 Liabilities: A present obligation of the entity to transfer an economic resource as a result
of past events (Conceptual Framework: para. 4.2)

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 Equity: The residual interest in the assets of an entity after deducting all its liabilities
(Conceptual Framework: para. 4.2).
 Income: Increases in assets, or decreases in liabilities, that result in increases in equity,
other than those relating to contributions from equity participants (Conceptual
Framework: para. 4.2).
 Expense: Decreases in assets, or increases in liabilities, that result in decreases in equity,
other than those relating to distributions to equity participants (Conceptual Framework:
para. 4.2).

The changes to the definitions of assets and liabilities can be seen below.

2010 definition 2018 definition Supporting concept

Asset (of A resource controlled by the A present economic

an entity) entity as a result of past events resource controlled by
and from which future the entity as a result
economic benefits
are expected to flow to the
of past events.
entity

Economic A right that has

resource the potential to
produce economic
benefits.

Liability (of A present obligation of the A present obligation of An entity’s obligation to

an entity) entity arising from past events,
the settlement of which
is expected to result in an
outflow from the entity of
resources embodying economic
benefits.
the entity to transfer an
economic resource as a
result of past events.
transfer an economic
resource must have
the potential to require the
entity to transfer an
economic resource to
another party.

Obligation A duty or responsibility

that an entity has no
practical ability to avoid.

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Recognition and derecognition

Recognition process

The Conceptual Framework defines recognition as ‘the process of capturing for inclusion in
the statement of financial position or the statement(s) of financial performance an item that
meets the definition of one of the elements of financial statements (para. 5.1).

Recognising one element requires the recognition or derecognition of one or more other
elements
Eg:

Recognise an At the same time Derecognise an or Recognise a

expense asset liability

Debit expense credit asset or credit liability

Recognizing an element

Items are only recognized in the financial statements if they meet the definition of one of
the elements. However, not all items meeting these definitions are recognized.
Elements are recognized if recognition provides users with the useful financial information.
In other words, recognition must provide:

 Relevant information
 A faithful representation of the asset and liability and resulting income, expense, or
equity movements.

Derecognition

Derecognition normally occurs when the item no longer meets the definition of an element:

 For an asset – when control is lost (derecognize part of a recognised asset if control of
that part is lost)
 For a liability – when there is no longer a present obligation (Conceptual Framework:
para. 5.26)

Measurement

The Conceptual Framework specifically looks at the two measurement bases:

 Historical cost

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 Current value

Historical cost

Historical cost for an asset is the cost that was incurred when the asset was acquired or
created and, for a liability, is the value of the consideration received when the liability
was incurred

Advantages of historical cost basis for measurement

 Amounts used are objective.
 Amounts are reliable and can be always verified
 Amounts are consistent
 Less possibility of manipulation
 Cost is a measure that is readily understood

Limitations of the historical cost basis for measurement

 Overstatement of profit
 Out-of-date asset values – based on their historical values.
 Return on assets/capital employed is distorted by both (a) and (b).
 Holding gains/losses (ie the fact that something is worth more or costs more over time
simply due to price rises) are not measured separately from operating results.
 HCA does not measure any gain/loss on monetary items arising from the impact of
inflation
 HCA gives a misleading trend of results since comparative figures are not restated for
the effects of inflation.

Current value

Current value accounting attempts to address some of the problems of HCA by using
information updated to reflect conditions at the measurement date. Current value
measurement bases include:
 Fair value
 Value in use for assets
 Current cost

Fair value

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
(Conceptual
ACCA Framework: para.
FR Conceptual 6.12 and IFRS 13: Appendix A).
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Fair value is measured in accordance with IFRS 13 Fair Value Measurement
Fair value is most commonly calculated by taking the open market value. Where there is
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Value in use

Value in use: 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 (Conceptual Framework: para. 6.17).

Value in use looks at the likely future value to the entity of using the asset.

Value in use considers entity-specific factors, whereas fair value is market specific

Current cost
Current cost of an asset: The current cost of an asset is 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
(Conceptual Framework: para. 6.21).
Current cost of a liability: 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 (Conceptual Framework: para. 6.21).
Current cost differs from historical cost as current cost assesses the price to purchase at the
reporting date, rather than the date the asset was acquired or liability assumed. Where the
current cost cannot be obtained from information in the market, then the entity can adjust
for condition and age to buy a similar model

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Advantages of using current value

 Assets are valued after management has considered the expected benefits from their
future use. Value in use is therefore a useful guide for management in deciding whether
to hold or sell assets.
 It is relevant to the needs of information users in:

 Assessing the stability of the business entity

 Assessing the vulnerability of the business (eg to a takeover), or the liquidity of the
business
 Evaluating the performance of management in maintaining and increasing the
business substance
 Judging prospects

Limitations of using the current value

 The discount factor used to calculate the present value of future cash flows requires
subjective judgements by management. Also, the expected benefits from cash flows
from the asset will be upon management’s best estimates and judgements.
 There may be problems in deciding how to provide an estimate of current costs for
noncurrent assets which can only be purchased new, such as a bespoke or specialist
piece of machinery.
 As the Conceptual Framework allows different groups of assets and liabilities to be
valued on different bases (which are the most useful to users of the financial
statements), this can mean that some assets will be valued at current cost, but others
will be valued at value in use or fair value

Presentation and disclosure

Statement of profit or loss is the primary source of information for a company’s
performance, which includes all income and expense. If the income and expense arises from
changes in current value then it can be recognised though other comprehensive income.
Reclassification of other comprehensive to profit or loss is allowable if it gives more relevant
information.

PRACTICE QUESTIONS AND ANSWERS

Example 1
The IASB’s Conceptual Framework for Financial Reporting identifies characteristics which make
financial information faithfully represent what it purports to represent.
Which of the following are examples of those characteristics?
1. Accruals
2. Completeness

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3. Going concern
4. Neutrality

A (1) and (2)

B (2) and (4)
C (2) and (3)
D (1) and (4

Example 2
Which of the following statements describes comparability?
 The non-cash effects of transactions should be reflected in the financial statements for the
accounting period in which they occur and not in the period where any cash involved is
received or paid.
 Information should be provided to a decision maker in time to be capable of influencing
decisions.
 Information must have a predictive and/or confirmatory value.
 Similar items within a single set of financial statements should be given similar accounting
treatment

Example 3
In a country where the economy is growing and prices are subject to regular increases, which
of the following are false when using historical cost accounting compared to current value
accounting?
1. Historical cost profits are understated in comparison to current value profits
2. Capital employed which is calculated using historical cost is understated compared to current
value capital employed
3. Historical cost profits are overstated in comparison to current value profits
4. Capital employed which is calculated using historical costs is overstated compared to current
value capital employed
A (1) and (2)
B (1) and (4)
C (2) and (3)
D (2) and (4

Example 4

Ergo Co acquired an item of plant on 1 July 20X5 at a cost of $250,000. Ergo Co depreciates its
plant at a rate of 20% on a reducing balance basis. As at 30 June 20X6, the manufacturer of
the plant still makes the same item of plant and its current price is $300,000.
Required What is the correct carrying amount to be shown in the statement of financial
position of Drexler as at 30 June 20X6 under historical cost and current cost?
 Historical cost: $200,000; Current cost: $300,000
 Historical cost: $200,000; Current cost: $240,000
 Historical cost: $250,000; Current cost: $300,000

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 Historical cost: $250,000; Current cost $240,000

Example 5
Which of the following would correctly describe the net realisable value of a two year old
asset?
 The original cost of the asset less two years' depreciation
 The amount that could be obtained from selling the asset, less any costs of disposal
 The cost of an equivalent new asset less two years' depreciation
 The present value of the future cash flows obtainable from continuing to use the asset

Example 6
Which TWO of the following are purposes of the IASB's Conceptual Framework?
To assist preparers to develop consistent accounting policies when no Standard applies to a
particular event
To issue rules regarding the accounting treatment of elements in the financial statements
To assist in determining the treatment of items not covered by an existing IFRS
To be authoritative where a specific IFRS conflicts with the Conceptual Framework
SOLUTIONS

EXAMPLE 1
Answer B – For information to faithfully represent the transaction it needs to be complete, free
from bias and neutral.
EXAMPLE 2
Answer D- Similar items within a single set of financial statements should be given similar
accounting treatment.
Using accrual accounting, the effects of transactions should be reflected in the financial
statements for the accounting period in which they occur and not in the period where any cash
involved is received or paid. Information is relevant if it has a predictive and/or confirmatory
value. The second option describes the qualitative characteristics of timeliness.

EXAMPLE 3

Answer B -Historical cost profits are understated in comparison to current value profits.
Capital employed which is calculated using historical costs is overstated compared to the
current value of capital employed

EXAMPLE 4
The correct answer is: Historical cost: $200,000; Current cost: $240,000
Historical cost: $250,000 × 80% = $200,000 carrying amount
Current cost: $300,000 × 80% = $240,000 carrying amount

EXAMPLE 5

ANSWER B- The amount that could be obtained from selling the asset, less any costs of

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disposal.

EXAMPLE 6
To assist preparers to develop consistent accounting policies when no Standard applies to a
particular event.
To assist in determining the treatment of items not covered by an existing IFRS.

It is not to be authoritative where a specific IFRS conflicts with the Conceptual Framework as
the Conceptual Framework will be overridden if there is a specific IFRS. Whenever there is a
conflict between an IFRS and the Conceptual Framework, the IFRS takes precedence. Nor is it
to issue rules regarding the accounting treatment of elements in the financial statements, as
the Conceptual Framework is a principles-based format, not a prescriptive, rules-based
approach.

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