MODULE 2 CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING

LEARNING OBJECTIVES:
1. Describe the usefulness of a conceptual framework.
2. Describe efforts to construct a conceptual framework.
3. Understand the objective of financial reporting.
4. Identify the qualitative characteristics of accounting information.
5. Define the basic elements of financial statements.
6. Describe the basic assumptions of accounting.
7. Explain the application of the basic principles of accounting.
8. Describe the impact that constraints have on reporting accounting information.

OVERVIEW
The Conceptual Framework (or “Concepts Statements”) is a body of interrelated objectives and
fundamentals. The objectives identify the goals and purposes of financial reporting and the
fundamentals are the underlying concepts that help achieve those objectives. Those concepts
provide guidance in selecting transactions, events and circumstances to be accounted for, how
they should be recognized and measured, and how they should be summarized and reported.

Acquiring new knowledge

Asynchronous - links to more information: www.farhatlectures.com; http://www.ifrsbox.com
A synchronous discussion for this lesson will be scheduled on AUGUST 11, 2020 (Tuesday
9:00 – 10:00 AM)

The Conceptual framework are the basic concepts and principles that serves as the
foundation for preparation and presentation of the financial statements.

Purpose of the Conceptual Framework

 Assist the International Accounting Standards Board(IASB) in developing standards.
 Assist in developing accounting policies when no Standard applies to a particular
transactions or when Standard allows a choice of accounting policy.
 Assist in understanding and interpreting the Standards.

The 2018 revised Conceptual Framework sets out:

 the objective of general purpose financial reporting;
 the qualitative characteristics of useful financial information;
 a description of the reporting entity and its boundary;
 definitions of an asset, a liability, equity, income and expenses and guidance supporting
these definitions;
 criteria for including assets and liabilities in financial statements (recognition) and
guidance on when to remove them (derecognition);
 measurement bases and guidance on when to use them;
 concepts and guidance on presentation and disclosure; and concepts relating to capital
and capital maintenance
1 – The objective of general-purpose financial reporting
“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.”

When considering the objective of general-purpose financial reporting, the Board reintroduced
the concept of ‘stewardship’.

Stewardship - the job of supervising or taking care of something, such as an organization or

property.

Users base their expectations of returns on their assessment of:

 the amount, timing and uncertainty of future net cash inflows to the entity, and
• management’s stewardship of the entity’s resources.

2 – Qualitative characteristics of useful financial information

The Framework clarifies what makes financial information useful, that is, information must be
relevant and must faithfully represent the substance of financial information.

Board decided to reinstate explicit references to prudence and substance over form.

Prudence is the exercise of caution when making judgements under conditions of uncertainty.

The Board concluded that substance over form was not a separate component of faithful
representation. Faithful representation provides information about the substance of an economic
phenomenon rather than its legal form.

Relevance
Relevance refers to how helpful the information is for financial decision-making processes.
Accounting information is relevant if it can provide helpful information about past events and
help in predicting future events or in taking action to deal with possible future events.

For accounting information to be relevant, it must possess:

Confirmatory value – Provides information about past events
Predictive value – Provides predictive power regarding possible future events

Representational Faithfulness
Representational faithfulness, also known as reliability, is the extent to which information
accurately reflects a company’s resources, obligatory claims, transactions, etc.

For accounting information to possess representational faithfulness, it must be:

Complete – Financial statements should not exclude any transaction.
Neutral – The degree to which information is free from bias.
Free from error – The degree to which information is free from errors.

(secondary)The enhancing qualitative characteristics of financial information:

 Comparability is the quality of information that enables users to identify similarities in and
differences between two sets of economic phenomena. Making decisions about one
entity may be enhanced if comparable information is available about similar entities; for
example, if profit per share is calculated using the same accounting policies.
  Verifiability is a quality of information that helps assure users that information faithfully
represents the economic phenomena that it purports to represent. Verifiability is
achieved if different independent observers could reach the same general conclusions
that the information represents the economic phenomena or that a particular recognition
or measurement model has been appropriately applied.

 Timeliness means having information available to decision makers before it loses its
capacity to influence decisions. If such capacity is lost, then the information loses its
relevance. Information may continue to be timely after it has been initially provided, for
example, in trend analysis.

 Understandability is the quality of information that enables users to comprehend its

meaning. Information may be more understandable if it is classified, characterized and
presented clearly and concisely. Users of financial statements are assumed to have a
reasonable knowledge of business and economic activities and to be able to read a
financial report.

3 – Financial statements and the reporting entity

The Board has proposed the description of a reporting entity as: “an entity that chooses or is
required to prepare general purpose financial statements”.

It is useful to users to understand that the general purpose financial statements are prepared on
the assumption that the reporting entity is a going concern.

The Framework explains that this assumption means that the entity has neither the
intention nor the need to enter liquidation or cease trading in the foreseeable future.

4 – The elements of Financial Statements - The main focus of this chapter is on the
definition of assets, liabilities, equities, income and expenses.

• Asset – A present economic resource controlled by the entity as a result of past events. An
economic resource is right that has the potential to produce 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.

• Income – Increases in assets or decreases in liabilities that result in increases in equity,

other than those relating to contributions from holders of equity claims

• Expenses – Decreases in assets or increases in liabilities that result in decreases in equity,

other than those relating to distributions to holders of equity claims.

The definition of assets and liabilities also no longer refer to ‘expected’ inflows or outflows.
Instead, the definition of an economic resource refers to the potential of an asset/liability to
produce/to require a transfer of economic benefits.
 5 – Recognition and derecognition

An entity should recognize an asset or a liability (and any related income, expense or
changes in equity) if such recognition provides users of financial statements with:

• relevant information about the asset or the liability and about any income, expense or
changes in equity

• a faithful representation of the asset or liability and of any income, expenses or changes
in equity, and

• information that results in benefits exceeding the cost of providing that information.

The key point here relates to relevance. If the probability of the event is low, this may not be
the most relevant information. The most relevant information may be about the potential
magnitude of the item, the possible timing and the factors affecting the probability.

Derecognition refers to the removal of an asset or liability (or a portion thereof) from an
entity's balance sheet.

Framework states that derecognition should aim to represent faithfully both:

(a) the assets and liabilities retained after the transaction or other event that led to the
derecognition (including any asset or liability acquired, incurred or created as part of the
transaction or other event), and

(b) the change in the entity’s assets and liabilities as a result of that transaction or other
event.

6 – Measurement
The selection of a measurement basis must take into account the key characteristics of useful
financial information (relevance and faithful representation) and more particularly the
characteristics of the element, the contribution to cash flows due to economic activities, and
measurement uncertainty and the cost constraint.

The Framework also describes three measurements of current value: fair value, value in use (or
fulfilment value for liabilities) and current cost.

 Fair value continues to be defined as the price in an orderly transaction between market
participants.

 Value in use (or fulfilment value) is defined as an entity-specific value, and remains as
the present value of the cash flows that an entity expects to derive from the continuing
use of an asset and its ultimate disposal.

 Current cost is different from fair value and value in use, as current cost is an entry
value. This looks at the value in which the entity would acquire the asset (or incur the
 liability) at current market prices, whereas fair value and value in use are exit values,
focusing on the values which will be gained from the item.

7 – Presentation and disclosure

This is a new section, containing the principles relating to how items should be presented
and disclosed.

 The first of these principles is that income and expenses should be included in the
statement of profit or loss unless relevance or faithful representation would be enhanced
by including a change in the current value of an asset or a liability in OCI.

 The second of these relates to the recycling of items in OCI into profit or loss.

The Framework contains a statement that income and expenses included in OCI are recycled
when doing so would enhance the relevance or faithful representation of the information.
OCI may not be recycled if there is no clear basis for identifying the period in which recycling
should occur.

Full Disclosure – providing information that is of sufficient importance to influence the judgment
and decisions of an informed user.

Provided through:
 Financial Statements
 Notes to the Financial Statements
 Supplementary information

Constraints
Cost – the cost of providing the information must be weighed against the benefits that can be
derived from using it.
MODULE 2 Post-test
Conceptual Framework for Financial Reporting

Multiple Choice
Identify the choice that best completes the statement or answers the question.
All answers shall be submitted on or before AUGUST 14, 2020 (Friday)

1. Which of the following is not one of the fundamental criteria for recognition?
a. Timeliness
b. Measurability
c. Relevance
d. Reliability

2. When a large number of individuals, using the same measurement method, demonstrate that a high
degree of consensus can be secured among independent measurers, then the result exhibits the
characteristic of
a. Verifiability
b. Neutrality
c. Relevance
d. Reliability

3. The assumed continuation of a business entity in the absence of evidence to the contrary is an
example of the accounting concept of
a. Accrual
b. Consistency
c. Comparability
d. Going concern

4. Accounting for inventories by applying the lower-of-cost-or- market is an example of the application
of
a. Conservatism
b. Comparability
c. Consistency
d. Materiality

5. Important constraints underlying the qualitative characteristics of accounting information are

a. historical cost and going concern
b. materiality, conservatism, and cost-effectiveness
c. consistency, comparability, and conservatism
d. verifiability, neutrality, and representational faithfulness

6. The secondary qualitative characteristics of accounting information are

a. relevance and reliability
b. comparability and consistency
c. understandability and decision usefulness
d. materiality and conservatism
7. The branch of accounting that is concerned primarily with providing information for internal users is
called
a. Auditing
b. managerial accounting
c. financial accounting
d. income tax accounting

8. Financial information exhibits the characteristic of consistency when

a. accounting procedures are adopted which smooth net income and make results
consistent between years
b. extraordinary gains and losses are shown separately on the income statement
c. accounting entities give similar events the same accounting treatment each period
d. expenditures are reported as expenses and netted against revenue in the period in which
they are paid

9. The primary current source of generally accepted accounting principles for nongovernmental
operations is the
a. American Institute of Certified Public Accountants
b. Securities and Exchange Commission
c. Financial Accounting Standards Board
d. Governmental Accounting Standards Board

10. Accountants prepare financial statements at arbitrary points in time during a company's lifetime in
accordance with the accounting concept of
a. Matching
b. Comparability
c. Accounting periods
d. Materiality

11. When financial reports from two different companies have been prepared and presented in a
similar manner, the information exhibits the characteristic of
a. Relevance
b. Reliability
c. Comparability
d. Consistency

12. A conceptual framework of accounting should

a. lead to uniformity of financial statements among companies within the same industry
b. eliminate alternative accounting principles and methods
c. guide the AICPA in developing generally accepted auditing standards
d. define the basic objectives, terms, and concepts of accounting

13. Historical cost has been the valuation basis most commonly used in accounting because of its
a. Timelessness
b. Conservatism
c. Reliability
d. Accuracy
14. The financial statements that are prepared for the business are separate and distinct from the
owners according to the
a. going-concern principle
b. matching principle
c. economic entity assumption
d. full disclosure principle

15. Which of the following statements concerning the objectives of financial reporting is correct?
a. The objectives are intended to be specific in nature.
b. The objectives are directed primarily toward the needs of internal users of accounting
information.
c. The objectives were the end result of the FASB's conceptual framework project.
d. The objectives encompass not only financial statement disclosures, but other information
as well.

16. According to the FASB's conceptual framework, the process of reporting an item in the financial
statements of an entity is
a. Realization
b. Recognition
c. Matching
d. Allocation

17. The overriding qualitative characteristic of accounting information is

a. Relevance
b. Understandability
c. Reliability
d. Decision usefulness

18. Recording the purchase price of a chalkboard eraser (with an estimated useful life of 10 years) as an
expense of the current period is justified by the
a. going-concern assumption
b. materiality constraint
c. matching principle
d. comparability principle

19. What accounting concept justifies the use of accruals and deferrals?
a. Going concern assumption
b. Corporate form of organization
c. Consistency characteristic
d. Arm's-length transactions

20. The process of establishing financial accounting standards

a. is a democratic process in that a majority of practicing accountants must agree with a
standard before it becomes implemented.
b. is a legislative process based on rules promulgated by government agencies.
c. is based solely on economic analysis of the effects each standard will have if it is
implemented.
d. is a social process which incorporates political actions of various interested user groups
as well as professional research and logic.