ABFA3064 FINANCIAL ACCCOUNTING IV

Lecture 1: Conceptual Framework for Financial Reporting (the Conceptual Framework)

Summary of the lecture:
1. Objective of Conceptual Framework
2. Qualitative characteristic
3.Financial statement and Reporting Entity
4. Element of Financial Statement
5. Recognition and derecognition definition
6. Measurement basis
7.Presentation and Disclosure
8.Concepts of capital and Capital Maintenance
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What is the Conceptual Framework for Financial Reporting (Conceptual Framework”?
The Conceptual Framework is a basic document that sets objectives and the concepts for general
purpose financial reporting.
It is to provide the foundation for standards that contribute to transparency by enhancing the
international comparability and quality of financial information, enabling investors and other
market participants to make informed economic decisions.
The purposes of Conceptual Framework are:
(a) assist the MASB to develop MFRS Standards (Standards) that are based on consistent
concepts;
(b) assist preparers to develop consistent accounting policies when no Standard applies to a
particular transaction or other event, or when a Standard allows a choice of accounting
policy; and
(c) assist all parties to understand and interpret the Standards

It was issued by the International Accounting Standards Board (IASB) in September 2010. It
was revised in March 2018.
There eight (8) chapters in the framework:
CHAPTER 1: THE OBJECTIVE OF GENERAL PURPOSE FINANCIAL REPORTING
CHAPTER 2: QUALITATIVE CHARACTERISTICS OF USEFUL FINANCIAL I
NFORMATION
CHAPTER 3: FINANCIAL STATEMENTS AND THE REPORTING ENTITY
CHAPTER 4: THE ELEMENTS OF FINANCIAL STATEMENT
CHAPTER 5: RECOGNITION AND DERECOGNITION
CHAPTER 6: MEASUREMENT

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CHAPTER 7: PRESENTATION AND DISCLOSURE

CHAPTER 8: CONCEPTS OF CAPITAL AND CAPITAL MAINTENANCE

CHAPTER 1: THE OBJECTIVE OF GENERAL PURPOSE FINANCIAL REPORTING

The main objective of general purpose financial reports is to provide the financial information
about the reporting entity that is useful to existing and potential:
 Investors,
 Lenders, and
 Other creditors
to help them make various decisions (e.g. about trading with debt or equity instruments of a
reporting entity).
Chapter 1 is NOT about the financial statements itself – these are described in Chapter 3.
Instead, Chapter 1 describes more general purpose reports that should contain the following
information about the reporting entity:
 Economic resources and claims (this refers to the financial position);
 The changes in economic resources and claims resulting from entity’s financial
performance and from other events.
Chapter 1 puts an emphasis on accrual accounting to reflect the financial performance of an
entity. It means that the events should be reflected in the reports in the periods when the effects
of transactions occur, regardless the related cash flows.
However, the information about past cash flows is very important to assess management’s
ability to generate future cash flows.

CHAPTER 2: QUALITATIVE CHARACTERISTICS OF USEFUL FINANCIAL

INFORMATION
In this Chapter, the Framework describes 2 types of characteristics for financial information to
be useful:
 Fundamental, and
 Enhancing.
Fundamental qualitative characteristics:
 Relevance: capable of making a difference in the users’ decisions. The financial
information is relevant when it has predictive value, confirmatory value, or both.

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 Materiality is closely related to relevance.

Information is material if omitting, misstating or obscuring it could reasonably be
expected to influence decisions that the primary users made.
Board cannot specify a uniform quantitative threshold for materiality or predetermine
what could be material in a particular situation, because it is very much depends on the
nature or magnitude of the item.

 Faithful representation: The information is faithfully represented when it is complete,

neutral and free from error.
Enhancing qualitative characteristics:
Comparability: Information should be comparable between different entities or time
periods;
Verifiability: Independent and knowledgeable observers are able to verify the information;
Timeliness: Information is available in time to influence the decisions of users;
Understandability: Information shall be classified, presented clearly and concisely.

CHAPTER 3: FINANCIAL STATEMENTS AND THE REPORTING ENTITY

Financial Statements
The financial statements should provide the useful information about the reporting entity:
In the statement of financial position, by recognizing

 Assets
 Liabilities
 Equity
In the statements of financial performance, by recognizing
 Income is increases 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 are decreases in economic benefits 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.

In other statements, by presenting and disclosing information about

 recognized and unrecognized assets, liabilities, equity, income and expenses, their nature
and associated risks;

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 Cash flows;
 Contributions from and distributions to equity holders, and
 Methods, assumptions, judgements used, and their changes.
Financial statements are always prepared for a specified period of time, or the reporting
period.
Normally, the financial statements are prepared on the going concern assumption.
It means that an entity will continue to operate for the foreseeable future (usually 12 months after
the reporting date).

Reporting Entity
This is a new concept introduced in 2018.
Although the term “reporting entity” has been used throughout IFRS for some time, the
Framework introduced it and “made it official” only in 2018.
Reporting entity is an entity who must or chooses to prepare the financial statements. It can be:
 A single entity – for example, one company;
 A portion of an entity – for example, a division of one company;
 More than one entities – for example, a parent and its subsidiaries reporting as a group.
As a result, we have a few types of financial statements:
 Consolidated: a parent and subsidiaries report as a single reporting entity;
 Unconsolidated: e.g. a parent alone provides reports, or
 Combined: e.g. reporting entity comprises two or more entities not linked by parent-
subsidiary relationship

CHAPTER 4: THE ELEMENTS OF FINANCIAL STATEMENT

This chapter extensively deals with the definitions of individual elements of the financial
statements.
There are five basic elements:
 Asset = a present economic resource controlled by the entity as a result of past events;
(* economic resource is a right that has the potential to produce economic benefit)
economic benefits
 Liability = a present obligation of the entity to transfer an economic resource as a result
of past events;
 Equity = the residual interest in the assets of the entity after deducting all its liabilities;

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 Income = increases in assets or decreases in liabilities resulting in increases in equity,

other than contributions from equity holders;
 Expenses = decreases in assets or increases in liabilities resulting in decreases in equity,
other than distributions to equity holders;
The Framework then discusses each aspect of these definitions and provides wide guidance on
how to decide what element you are dealing with.

CHAPTER 5: RECOGNITION AND DERECOGNITION

Recognition
Simply speaking, recognition means including an element of financial statements in the
financial statements.
In other words, if you decide on recognition, you decide on WHETHER to show this item in the
financial statements.
Recognition process links the elements in the financial statements according to the following
formula:

Please let me stress here that not all items that meet the definition of one of the elements listed
above are recognized in the financial statements.
The Framework requires recognizing the elements only when the recognition provides useful
information – relevant with faithful representation.
Then, the Framework discusses the relevance, faithful representation, cost constraints and
other aspects in a detail.
Derecognition
Derecognition means removal of an asset or liability from the statement of financial position and
normally it happens when the item no longer meets the definition of an asset or a liability.

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Again, the Framework discusses the derecognition in a greater detail.

CHAPTER 6: MEASUREMENT
Measurement means IN WHAT AMOUNT to recognize asset, liability, piece of equity, income
or expense in your financial statements.
Thus, you need to select the measurement basis, or the method of quantifying monetary
amount for elements in the financial statements.
The Framework discusses two basic measurement basis:
 Historical cost – this measurement is based on the transaction price at the time of
recognition of the element;
 Current value – it measures the element updated to reflect the conditions at the
measurement date. Here, several methods are included:
 Fair value;
 Value in use;
 Current cost.
Each of these measurement base is discussed in a greater detail.
The Framework then gives guidance on how to select the appropriate measurement basis and
what factors to consider (especially relevance and faithful representation).
What I personally find really useful is the guidance on measurement of equity.
The issue here is that the equity is defined as “residual after deducting liabilities from assets” and
therefore total carrying amount of equity is not measured directly.
Instead, it is measured exactly by the formula:
 Total carrying amount of all assets, less
 Total carrying amount of all liabilities.
The Framework points out that it can be appropriate to measure some components of equity
directly (e.g. share capital), but it is not possible to measure total equity directly.

CHAPTER 7: PRESENTATION AND DISCLOSURE

The main aim of presentation and disclosures is to provide an effective communication tool in
the financial statements.
Effective communication of information in the financial statements requires:
 Focus on objectives and principles of presentation and disclosure, not on the rules;
 Group similar items and separate dissimilar items;

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 Aggregate information, but do not provide unnecessary detail or the opposite – excessive
aggregation to obscure the information.
The Framework discusses classification of assets, liabilities, equity, income and expenses in a
greater detail with describing offsetting, aggregation, distinguishing between profit or loss and
other comprehensive income and other related areas.

CHAPTER 8: CONCEPTS OF CAPITAL AND CAPITAL MAINTENANCE

The Framework explains two concepts of capital:
Financial capital – this is synonymous with the net assets or equity of the entity.
Under the financial maintenance concept, the profit is earned only when the amount of net
assets at the end of the period is greater than the amount of net assets in the beginning, after
excluding contributions from and distributions to equity holders.
The financial capital maintenance can be measured either in
 Nominal monetary units, or
 Units of constant purchasing power.
Physical capital – this is the productive capacity of the entity based on, for example, units of
output per day.
Here the profit is earned if physical productive capacity increases during the period, after
excluding the movements with equity holders.
The main difference between these concepts is how the entity treats the effects of changes in
prices in assets and liabilities.

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Quiz:
MCQ1. The purpose of the Conceptual Framework for Financial Reporting is: ( C)

1. to assist the IASB in setting IFRSs?

2. to assist preparers of financial statements in applying IFRSs?
3. to assist auditors in forming an opinion on whether financial statements comply with IFRSs?
4. to assist users of financial statements in interpreting IFRS financial statements?

a) 1 only
b) 1 and 4 only
c) All of the above
d) None of the above

MCQ2. The objective of general purpose financial reporting is: (A)

a) 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.
b) to inform government statistics.
c) to support the entity’s tax return.
d) to meet all the information needs of all the users of an entity’s financial statements.
e) to inform economic decision-making by a broad range of users (including managers, investors,
creditors and prudential regulators).

MCQ3. The fundamental qualitative characteristics are: (D)

a) comparability and relevance?

b) relevance and reliability?
c) relevance, reliability and comparability?
d) relevance, materiality and faithful representation?
e) comparability, relevance and faithful representation?

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Practical Question 1:
Consider the following situations. In each case, do we have an asset or liability within the definitions given
by the Framework? Give reasons for your answer.
(a) A screwdriver bought during the year.
(b) A machine hired / leased by the business.
(c) The good reputation of the business with its customers.
(d) Pelangi Sdn. Bhd. has purchased a patent for RM90,000. The patent gives the company sole use of a
particular manufacturing process which will save RM21,000 a year for the next five years.

Answer:
(To answers this question you must know what it the definition on ASSETS!!!!)
An asset is a present economic resource controlled (P19-25) by the entity as a
result of past events.
An economic resource is a right (P6-13) that has the potential to produce economic benefits
(P14-18)

a) The screwdriver is, strictly speaking, a non-current asset in the sense that it is likely that it will
be used for more than one year. However, because accounting for non-current assets and
depreciation is time consuming it is usual for a business may apply materiality concept to set a
minimum amount below which any item is regarded as having a life of less than one year.
Expenditure on such items is treated as revenue expenditure and is charge to the income
statement of the period in which it is incurred.
(b) A machine hired by a business is not a current asset nor a non-current asset because it is not
owned by the business. The payment for its hire is another example of revenue expenditure, unless
it is a finance lease.
(c) Good reputation or goodwill is a valuable asset: a business depends upon a good reputation to
work. This is an example of an intangible non-current asset, which normally appear in the
partnership business: an asset which does not have a physical existence and cannot be touched.
For limited companies, internally generated goodwill should not be recognised, only purchased

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goodwill to be recognised as an asset in the financial statements for publication purpose. Thus, it
cannot recognized as intangible asset in the financial statement
(d) This is an intangible asset. There is a past event (purchased a patent for RM90,000), control
(sole use of a particular manufacturing process) and future economic benefit (through cost savings
RM21,000 x 5 years) …

Practical Question 2: Application of accrual and matching concept

You are in a small town, whose main source of economic prosperity is the tourist trade. On 20
April 2023 the town celebrated the 100th anniversary of its existence. The town held a number of
festivals to mark this occasion and to bring in more tourists. Your business has had the good fortune
to be involved in the event. You have made 1,000 commemorative mugs. These were all made by
31 December 2022 to be ready at the beginning of the following year. They cost 40 cents each to
make and during the anniversary year they were for sale at 75 cents each. At the end of the
anniversary year, they are 200 still unsold. You estimate that you are unlikely to sell any more at
75 cents, but you might be able to sell them at 30 cents each.
Required:
(a) Which fundamental accounting assumptions and other matters will you consider when
assessing a value for the mugs in your statement of financial position:
(i) at 31 December 2022 (ii) at 31 December 2023
(b) On the basis of your considerations, note down the value of the mugs you would include in
the statement of financial position as at 31 December 2022 and 31 December 2023.

Suggested solution:
The accounting assumption mainly involved is accruals / matching. Prudence is also important
when determining the accounting policy. The accruals concept states that RM400 (i.e. 1000 mugs
x RM0.40) incurred during the year ended 31 December 2022 to be recognised as purchased (cost
of sales). All the mugs were not sold (closing inventories) at the year end to be deducted from
purchased (cost of sale), as no revenue to be matched in 2022.
The matching assumption states that income and expenditure should be matched in the same period
if reasonably possible, whereas prudence dictates that revenue should not be anticipated.
However, you are reasonably certain of selling the mugs, so you would value them in the statement
of financial position at the beginning of the year 2023 at cost, as an asset, rather than treating them
as an expense in the income statement for that earlier year. At 31 December 2023, you have 200
mugs, whose selling price (RM0.30) is less than the cost of making them RM0.40). Prudence
dictates therefore that they are valued in the statement of financial position at the lower of these
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two amounts, i.e. sales value if it is lower than cost. [Prudence: any possible loss to be accounted
immediately] You could argue that valuing them at a lower amount means a conflict with the
accruals assumption, because the loss is accounted for before the sale. This is true. Normally, when
accruals and prudence conflict, prudence should prevail.
As a consequence, at 31 December 2022, the mugs would be valued at 40 cents each. At 31
December 2023, the remaining mugs would be valued at 30 cents each.

Practical Question 2: Application of materiality concept in different situation

You work for a multinational company and you are preparing two accounting documents.
(a) A statement of account for a customer, listing invoices and receipts, and detailing the amounts
owed.
(b) A report sent to the senior management of a division, who want a brief comparative summary
of how well the firm is doing in Thailand and in Malaysia.
Required:
How would considerations of materiality influence your preparation of each document?

Suggested solution
Materiality as a fundamental concept does have strict limitations. It refers primarily to financial
reporting, but has no bearing at all on detailed procedural matters such as bank reconciliation or
statements of account sent to customers.
Consequently, the statement sent to the customer, described in option (a), must be accurate to the
last cent. After all, if you receive a bill from a company for RM147.50, you do not round it up to
RM150 when you pay. Nor will the company billing you be prepared to ‘round it down’ to RM145.
A customer pays an agreed price for an agreed product or service. Paying more by customers
effectively giving money away, and if your customer is going to do that, there might be worthier
beneficiaries of customer’s generosity. Paying less by customer exposes you to an unfair loss.
On the other hand, if you are preparing a performance report comparing how well the company is
doing in Thailand and Malaysia, entirely different considerations apply.
There is little point in being accurate to the last cent (and inconsistencies might occur from the
choice of currency rate used). This is because senior management is interested in the broad picture,
and they are looking to identify comparisons between the overall performance of each division.
Assume that Malaysia profits were RM1,234,567.89 and profit in Thailand were RM1,023,456.78.
You may report as RM1.2 million and RM1.0 million. The rounded figures are much easier to
understand, and so the relative performance is easier to compare. Considerations of materiality

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would allow you to ignore the rounding differences, because they are so small and the information
is used for comparative purpose only.

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