CHAPTER 3 CONCEPTUAL FRAMEWORK Qualitative characteristics Definition Qualitative characteristics ave the qual ties or attributes that make financial accounting inform: ation useful to the users. In deciding which informatio: n to include in financial Statements, the objective is to ensure ‘e that the information is useful to the users in making economic decisions, Under the Conceptual Framework for Fin qualitative characteristics are classified qualitative characteristi characteristics, nancial Reporting, into fundamental s and enhancing qualitative Fundamental qualitative characteristics The fundamental qualitative characteristics relate to the content or substance of finan cial information The fundamental qualitative characteristics arte: a. Relevance b. Faithful representation Information must be bi oth relevant and faithfully represented if it is to be useful. Neither a faithful represent. phenomenon nor an unfaithful ro phenomenon helps users make ation of an irrelevant Presentation of a relevant good decisions. 62 So‘a Relevance In the simplest terms, relevance is the capacity of the information to influence a decision. ‘To be relevant, the financial information must be capable of making a difference in the decisions made by users. In other words, relevance requires that the financial information should be related or pertinent to the economic decision. Information that does not bear on an economic decision is useless. To be useful, information must be relevant to the decision making needs of users. For example, broadly, the statement of financial position is relevant in determining nancial position, and the income statement is relevant in determining performance. More specifically, the earnings per share information is more relevant than book value per share in determining the attractiveness of an investment. Ingredients of relevance Financial information is capable of making a difference in a decision if it has predictive value and confirmatory value. Financial information has predictive value if it can be used as an input to processes employed by users to predict future outcome. In other words, financial information has predictive value when it can help users increase the likelihood of correctly or accurately predicting or forecasting outcome of events. For example, information about financial position and past performance is frequently used in predicting dividend and wage payments and the ability of the entity to meet maturing commitments. i ‘The net cash provided by operating activities is valuable in predicting loan payment or default. 63ene ce ee i | Financial information has confirmatory value if it provides leedback about previous evaluations. In other words, financial information has confirmatory value when it enables users confirm or correct earlier expectations. For example, a net income measure has confirmatory value if it can help shareholders confirm or revise their expectation about an entity's ability to generate earnings. Often, information has both predictive and confirmatory value. The predictive and confirmatory roles of information are interrelated, An example is an interim income statement which provides feedback about income to date and serves as a basis for Rredicting the annual income. The interim income Statement for the first quarter shows net income of P2,000,000 (confirmatory value), If this trend continues for the entire year, it is logical to assume that the net income after four quarters or one year would be P8,000,000 (predictive value). Materiality Materiality is a practical rule in accounting which dictates that strict adherence to GAAP ig not required when the items- are not significant enough to affect the evaluation, decision and fairness of the financial statements The materiality concept is also known as the doctrine of convenience. Materiality is really a quantitative "threshold" linked very closely to the qualitative characteristic of relevance. The relevance of information is affected by its nature and materiality, In other words, materiality is a "subquality" of relevance based on the nature or magnitude or both of the items to which the information relates, The Conceptual Framework does not specify a uniform quantitative threshold for materiality or predetermine what could be material in g particular situation. 64Materiality is a relativity Materiality of an item depends on relative size rather than absolute size. What is material for one entity may be immaterial for another. An error of P100,000 in the financial statements of a multinational entity may not be important but may be so critical for a small entity. When is an item material? There is no strict or uniform rule for determining whether an item is material or not. Very often, this is dependent on good judgment, professional expertise and common sense. However, a general guide may be given, to wit: “An item is material if knowledge of it would affect or influence the decision of the informed users of the financial statements”. Information is material if its omission or misstatement could influence the economic decision that the users make on the basis of the financial information about an entity. For example, small expenditures for tools are often expensed immediately rather than depreciated over their useful lives to save on clerical costs of recording depreciation because the effect on the financial statements is not large enough to affect economic decision. Another example of the application of materiality is the common practice of large entities of rounding amounts to the nearest thousand pesos in their financial statements. Small entities may round off to the nearest peso. 65Factors of materiality In the exercise of judgment in determining materiality, the relative size and nature of an item are considered. The size of the item in relation to the total of the group to which the item belongs is taken into account. For example, the amount of advertising in relation to total selling expenses, the amount of office salaries to total administrative expenses, the amount of prepaid expenses to total current assets and the amount of leasehold improvements to total property, plant and equipment. The nature of the item may be inherently material because by its very nature it affects economic decision. For example, the discovery of a P20,000 bribe is a material event even for a very large entity. Faithful representation Faithful representation means that financial reports represent economic phenomena or transactions in words and numbers. : Stated differently, the descriptions and figures must match what really existed or happened. Simply worded, faithful representation means that the actual effects of the transactions shall be properly accounted for and reported in the financial statements. : For example, if the entity reports purchases of P5,000,000 when the actual amount is P8,000,000, the information would not be faithfully represented. To record a sale of merchandise as miscellaneous income would not also be a faithful representation of the sale transaction. 66Ingredients of faithful representation To be a perfectly have three chan aithful representation, a depiction should acteristics, namely a. Completeness b. Neutrality ¢. Free from error Completeness Completeness requires that relevant information should be ented in a way that facilitates understanding and avoids erroneous implication. Completeness is the result of the adequate disclosure standard or the principle of full disclosure A complete depiction includes all information necessary for a user to understand the phenomenon being depicted, including all necessary descriptions and explanations. For example, a complete depiction of a group of assets would include description of the assets, numerical depiction and description of the numerical depiction, such as cost, current cost or fair value. Standard of adequate disclosure ate disclosure means that all t information leading to the ts shall be clearly reported The standard of adequ significant and relevan preparation of financial statemen Adequate disclosure however does not mean disclosure of just any data. The accountant shall disclose a material fact known to him which is not disclosed in the financial statements but disclosure of which is necessary in order that the financial statements would not be misleading. In other words, the standard of adequate disclosure 18 best described by disclosure of any financial facts significant enough to influence the judgment of informed users. 67Notes to financial statements Actually, to be complete, the financial statements shall be accompanied by "notes to financial statements". The purpose of the notes is to provide the necessary disclosures required by Philippine Financial Reporting Standards. Notes to financial statements provide narrative description or disaggregation of the items presented in the financial statements and information about items that do not qualify for recognition. Neutrality A neutral depiction is "without bias" in the preparation or presentation of financial information. A neutral depiction is not slanted, weighted, emphasized, de-emphasized or otherwise manipulated to increase the probability that financial information will be received favorably or unfavorably by users. In other words, to be neutral, the information contained in the financial statements must be free from bias. The financial information should not favor one party to the detriment of another party. The information is directed to the common needs of many users, and not to the particular needs of specific users. Neutrality is synonymous with the al l-encompassing "principle of fairness". To be neutral is to be fair, 68eae Free from error Free fromierrorinbana there are no errors or omissions in proc sci : i) ithe phenomenon or transaction, and the vlccted tal ‘0 produce the reported information has been ted and applied with no errors in the process. In this context, free from error does not mean perfectly accurate in all respects. For example, an estimate of an unobservable price oF value cannot be determined to be accurate or inaccurate However, a representation of that © stimate can be faithful if the amount is described clearly and accurately as an estimate. Moreover, the nature and limitations of the estimating process are explained, and no errors have been made in Selecting and applying an appropriate process for developing the estimate. Substance over form If information is to represent faithfully the transactions and other events it purports to represent, it 18 necessary that the transactions and events are ‘accounted in accordance with their substance and reality and not merely their legal form. The economic substance of transactions and events are usually emphasized when economic substance differs from legal form. Substance over form is not considered a separate component se eslchfal representation because it would be redundant Faithful representation inherently represents the substance of an economic phenomenon or transaction rather than merely yepresenting the legal form. Representing & legal form that differs from the economic substance of the underlying economic phenomenon or transaction could not result in a faithful representation. An example is when the lessee leased property from the lessor. The terms of the lease provide that the lease transfers ownership of the asset to the lessee by the end of the lease term. 69In form, the contract is a lease as popularly understood. But in substance, in reality, if the "transfer of ownership Provision" is to be considered, the real intent of the parties is an installment purchase of property by the lessee from the lessor. Accordingly, the lessee shall record an acquisition of an asset and set up a liability to the lessor. The periodic rental is conceived as an installment payment representing interest and principal. Another example is the computation of earnings per share. Normally, earnings per share would simply involve dividing the net income for a period by the average number of ordinary shares outstanding. However, certain securit: convertible into ordinary s| ordinary shares.” ies such as bonds that are hares are treated as "potential Accordingly, the ordinary shares into which the bonds are ‘convertible are included in the computation of diluted earnings per share in recognition of the concept of economic substance over legal form. What about conservatism? There is no discussion of conservatism or prudence in the Conceptual Framework for Financial Reporting, The Conceptual Framework did not include conservatism or prudence as an aspect of faithful representation because to dy so would be inconsistent with neutrality, Most often, a conservative or prudent approach is subjective and may contain an element of bias. However, discussion of the qualities of financial information would not be complete without discussion of conservatism or prudence. 70Conservatism Dae one tism, when alternatives exist, the alternative which has the least effect on equity should be chosen. Stated differently, managers, investor and accountants have generally preferred that possible errors in meastirement be in the direction of understatement rather than overstatement of net income and net assets. In the simplest words, conservatism means “in case of doubt, record any loss and do not record any gain." For example, if there is a choice between two acceptable asset values, the lower figure is selected. Accordingly, inventories are measured at the lower of cost and net realizable value. Contingent loss is recognized as a "provision" if the loss is probable and the amount can be reliably measured. Contingent gain is not recognized but disclosed only. It is to be emphasized that “conservatism is not,a license to deliberately understate net income and net assets”. For example, if an entity has a cash of P500,000 and reports only P100,000, this is not conservatism but fraud or inaccurate reporting. Conservatism is synonymous with prudence. Prudence is the desire to exercise care and caution when vtaling with the uncertainties in the measurement process such that assets or income are not overstated and liabilities or expenses are not understated. Expressions of conservatism or prudence “Anticipate no profit and provide for probable and measurable loss.” “In the matter of income recognition, the accountant takes the position that no matter how sure the businessman might be in capturing the bird in the bush, he, the accountant, must see it in the hand.” “Don't count your chicks until the eggs hatch”. vetEnhancing qualitative characteristics The enhancing qualitative characteristics relate to the presentation or form of the financial information. The enhancing qualitative characteristics are intended to increase the usefulness of the financial information that is relevant and faithfully represented The enhancing qualitative characteristics are a. Comparability b. Understandability c. Verifiability d. Timelines: Relevant and faithfully represented financial information is useful but the information would be most useful if it is comparable, understandable, verifiable and timely. Comparability Comparability means the ability to bring together for the purpose of noting points of likeness and difference Comparability is the enhancing qualitative characteristic that enables users to identify and understand similarities and dissimilarities among items. Comparability may be made within an entity or between and across entities. Comparability within an entity is the quality of information that allows comparisons within a single entity through time or from one accounting period to the next. Comparability within an entity is also known as horizontal comparability or intracomparability. Comparability between and across entities is the quality of information that allows comparisons between two or more entities engaged in the same industry. Comparability across entities is also known as intercomparability or dimensional comparability. 72Users’ decisions involve choosing between alternatives Consequently, relevant and faithfully represented information is most useful if it ean be compared with similar information about the same entity for the previous period and with similar information reported by other entities. For information to be comparable, like things must look alike and different things must look different Comparability is not enhanced by making unlike things look alike or making like things look different. Consistenc Implicit in the qualitative characteristic of comparability 15 the principle of consistency The principle of consistency requires that “the accounting methods and practices on principh e% “ex see are recognized when yneurved” Teas ee But th ion i ¢ question is when are expenses incurred? vocal pb provides that “expenses are nized when it is probable that a decrease in future economic benefits related to decrease in an asset or 4 increase in liability has occurred and that the decrease 17 economic benefits can be measured reliably”. The Conceptual Framewor Thus, two conditions must be present for the recognition of expenses: Je that a decrease 1) future economic penefits a decrease in an asset or an a. It is probab! esult of has occurred as a" pb. The decrease 17 economic benefits can be measured reliably, Matching principle Actually, the expense recognition principle is the application of the matching principle. The generation of revenue is not without any cost There has st in earning @ revenue. got to be some CO! “There is NO gain y principle requ ‘d in earning @ if there is no pain”. jres that “those costs and The matching revenue shall be reported in expenses incurre| the same perio! es ing principle has three applications, namely: and effect association atic and rational allocation recognition a, Cause pb. System: c. Immediate amg TS eg or |Cause and effect association Under this principle, the expense is recognized when the revenue is already recognized. The reason is the presumed direct association of the expense with specific items of income This is actually the “strict matching concept”. This process, commonly referred to as the matching of cost with, revenue, involves the simultaneous or combined recognition of revenue and expenses that result directly and jointly from the same transactions or events. The best example is the cost of merchandise inventory. Such cost is considered as an asset in the meantime that the merchandise is on hand. When the merchandise is sold, the cost thereof is expensed in the form of “cost of goods sold” because at such time revenue may be recognized. Other examples include doubtful accounts, warranty expense and sales commissions. Systematic and rational allocation Under this principle, some costs are expensed by simply allocating them over the periods benefited. The reason for this principle.is that the cost 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 broadly or indirectly determined, expenses are recognized on the basis of systematic and allocation procedures. Concrete examples include depreciation of property, plant and equipment, amortization of intangibles, and allocation of prepaid rent, insurance and other prepayments. 100Immediate recognition is expensed outright ic benefits or ts with future Under this principle, the cost incurred because of uncertainty of future econom difficulty of reliably associating certain cos 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 include officers’ salaries and most administrative expenses, advertising and most selling expenses, amount to settle lawsuit and worthless intangibles. Many losses, such as loss from disposal of building, loss from gale of investments, and casualty loss, ave immediately mecognized because they are not directly related to specific revenue. Measurement of elements Measurement is the process of determining the monetary amounts at which the elements of the financial statements are to be recognized and carried in the statement of financial position and income statement. There are four measurement bases or financial attributes namely: a. Historical cost b. Current cost c. Realizable value d. Present value 101Definition of terms a. sh equivalent Historical cost is the amount of cash or Paid or t&e fair value of the consideration given to acquire an asset at the time of acquisition. This is also known as "past purchase exchange price". Historical cost is the measurement basis most commonly adopted in preparing the financial statements. Current cost is the amount of cash or cash equivalent that would have to be paid if the same or equivalent asset was acquired currently. This is also known as "current purchase exchange price" Realizable value is the amount of cash or cash equivalent that could currently be obtained by selling the asset in an orderly disposal. This is also known as "current sale exchange price". Present value is the discounted value of the future net cash inflows that the assct is expected to generate in the normal course of business. This is also known as "future exchange price", 102