Conceptual Framework for Financial Reporting

Purpose of the Conceptual Framework

• The Conceptual Framework prescribes the concepts for general purpose financial reporting. Its purpose is
to:
a. assist the International Accounting Standards Board (IASB) in developing Standards that are based on
consistent concepts;
b. assist preparers in developing consistent accounting policies when no Standard applies to a particular
transaction or when a Standard allows a choice of accounting policy; and
c. assist all parties in understanding and interpreting the Standards.
Status of the Conceptual Framework

• The Conceptual Framework is not a PFRS. When there is a conflict between the Conceptual Framework
and a PFRS, the PFRS will prevail.
• In the absence of a standard, management shall consider the Conceptual Framework in making its
judgment in developing and applying an accounting policy that results in useful information.
Scope of the Conceptual Framework
The Conceptual Framework is concerned with general purpose financial reporting. General purpose
financial reporting involves the preparation of general-purpose financial statements. The Conceptual
Framework provides the concepts regarding the following:
1. The objective of financial reporting
2. Qualitative characteristics of useful financial information
3. Financial statements and the reporting entity
4. The elements of financial statements
5. Recognition and derecognition
6. Measurement
7. Presentation and disclosure
8. Concepts of capital and capital maintenance
Objective of general-purpose financial reporting

• The objective of general-purpose financial reporting is to provide financial information about the reporting
entity that is useful primary users in to making decisions about providing resources to the entity.
• The objective of general-purpose financial reporting forms the foundation of the Conceptual Framework.

Primary Users

• Primary users – are those who cannot demand information directly from reporting entities. The primary
users are:
a) Existing and potential investors
b) Lenders and other creditors.
• Only the common needs of primary users are met by the financial statements.

QUALITATIVE CHARACTERISTICS
I. Fundamental qualitative characteristics
(1) Relevance
(a) Predictive value
(b) Feedback value

➢ Materiality – entity-specific aspect of relevance

 (2) Faithful representation
(a) Completeness
(b) Neutrality
(c) Free from error

II. Enhancing qualitative characteristics

(a) Comparability
(b) Verifiability
(c) Timeliness
(d) Understandability
Fundamental vs. Enhancing

• The fundamental qualitative characteristics are the characteristics that make information useful to users.
• The enhancing qualitative characteristics are the characteristics that enhance the usefulness of
information.
Relevance

• Information is relevant if it can affect the decisions of users.

• Relevant information has the following:
a. Predictive value – the information can be used in making predictions
b. Confirmatory value – the information can be used in confirming past predictions
 Materiality – is an ‘entity-specific’ aspect of relevance.
Faithful Representation

• Faithful representation means the information provides a true, correct and complete depiction of what it
purports to represent.
• Faithfully represented information has the following:
a. Completeness – all information necessary for users to understand the phenomenon being depicted is
provided.
b. Neutrality – information is selected or presented without bias.
c. Free from error– there are no errors in the description and in the process by which the information is
selected and applied.
Enhancing Qualitative Characteristics
1. Comparability – the information helps users in identifying similarities and differences between different
sets of information.
2. Verifiability – different users could reach consensus as to what the information purports to represent.
3. Timeliness – the information is available to users in time to be able to influence their decisions.
4. Understandability – users are expected to have:
a. reasonable knowledge of business activities; and
b. willingness to analyze the information diligently.
FINANCIAL STATEMENTS AND THE REPORTING ENTITY
Objective and scope of financial statements

• The objective of general-purpose financial statements is to provide financial information about the
reporting entity’s assets, liabilities, equity, income and expenses that is useful in assessing:
a. the entity’s ability to generate future net cash inflows; and
b. management’s stewardship over economic resources.
Reporting period
• Financial statements are prepared for a specific period of time (i.e., the reporting period) and include
comparative information for at least one preceding reporting period.

Going concern

• Financial statements are normally prepared on the assumption that the reporting entity is a going concern,
meaning the entity has neither the intention nor the need to end its operations in the foreseeable future.
Reporting entity

• A reporting entity is one that is required, or chooses, to prepare financial statements, and is not
necessarily a legal entity. It can be a single entity or a group or combination of two or more entities.
ELEMENTS OF FINANCIAL STATEMENTS
Asset

• Asset is “a present economic resource controlled by the entity as a result of past events. An economic
resource is a right that has the potential to produce economic benefits.” (Conceptual Framework 4.3 & 4.4)
Three aspects in the definition of an asset
1. Right – asset refers to a right, and not necessarily to a physical object, e.g., the right to use, sell, lease or
transfer a building.
2. Potential to produce economic benefits – the right has a potential to produce economic benefits for the
entity that are beyond the benefits available to all others. Such potential need not be certain or even likely–
what is important is that the right already exists and that, in at least one circumstance, it would produce
economic benefits for the entity.
3. Control – means the entity has the exclusive right over the benefits of an asset and the ability to prevent
others from accessing those benefits.
Liability

• Liability is “a present obligation of the entity to transfer an economic resource as a result of past events.”
(Conceptual Framework 4.26)
Three aspects in the definition of a liability
1. Obligation – An obligation is “a duty or responsibility that an entity has no practical ability to avoid.” (CF
4.29) An obligation can be either legal obligation or constructive obligation.
2. Transfer of an economic resource – the obligation has the potential to require the transfer of an economic
resource to another party. Such potential need not be certain or even likely– what is important is that the
obligation already exists and that, in at least one circumstance, it would require the transfer of an
economic resource.
3. Present obligation as a result of past events – A present obligation exists as a result of past events if:
a. the entity has already obtained economic benefits or taken an action; and
b. as a consequence, the entity will or may have to transfer an economic resource that it would not
otherwise have had to transfer. (Conceptual Framework 4.43)
Executory contracts

• An executory contract “is a contract that is equally unperformed – neither party has fulfilled any of its
obligations, or both parties have partially fulfilled their obligations to an equal extent.” (CF 4.56)
• An executory contract establishes a combined right and obligation to exchange economic resources.
• The contract ceases to be executory when one party performs its obligation.
 If the entity performs first, the entity’s combined right and obligation changes to an asset.
  If the other party performs first, the entity’s combined right and obligation changes to a liability.
Equity

• “Equity is the residual interest in the assets of the entity after deducting all its liabilities.” (Conceptual
Framework 4.63)
• Equity equals Assets minus Liabilities

Income and Expenses

• Income is “increases in assets, or decreases in liabilities, that result in increases in equity, other than those
relating to contributions from holders of equity claims.” (Conceptual Framework 4.68)
• Expenses are “decreases in assets, or increases in liabilities, that result in decreases in equity, other than
those relating to distributions to holders of equity claims.” (Conceptual Framework 4.69)
Recognition & Derecognition
The recognition process

• Recognition is the process of including in the statement of financial position or the statement(s) of financial
performance an item that meets the definition of one of the financial statement elements (i.e., asset,
liability, equity, income or expense). This involves recording the item in words and in monetary amount and
including that amount in the totals of either of those statements.
Recognition criteria

• An item is recognized if:

a. it meets the definition expense; and of an asset, liability, equity, income or
b. recognizing it would provide useful information faithfully represented information. , i.e., relevant and
Relevance

• The recognition of an item may not provide relevant information if, for example:
a. it is uncertain whether an asset or liability exists; or
b. an asset or liability exists, but the probability of an inflow or outflow of economic benefits is low.
(Conceptual Framework 5.12)
However, the presence of one or both of the foregoing does not automatically lead to the non-
recognition of an item. Other factors should also be considered.
Faithful representation

• The level of measurement uncertainty and other factors can affect an item’s faithful representation, but not
necessarily its relevance.
Measurement uncertainty

• Measurement uncertainty exists if the asset or liability needs to be estimated. A high level of measurement
uncertainty does not necessarily lead to the non-recognition of an asset or liability if the estimate provides
relevant information and is clearly and accurately described and explained.
• However, measurement uncertainty can lead to the non-recognition of an asset or a liability if making an
estimate is exceptionally difficult or exceptionally subjective.
Derecognition

• Derecognition is the removal of a previously recognized asset or liability from the entity’s statement of
financial position.
• Derecognition occurs when the item ceases to meet the definition of an asset or 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.” (Conceptual
Framework 4.48)

Measurement bases
1. Historical cost
2. Current value
a. Fair value
b. Value in use and fulfilment value
c. Current cost
Historical cost

• The historical cost of:

a. an asset is the consideration paid to acquire the asset plus transaction costs.
b. a liability is the consideration received to incur the liability minus transaction costs.
• Historical cost is updated over time to depict the following:
 Depreciation, amortization, or impairment of assets
 Collections or payments that extinguish part or all of the asset or liability
 Unwinding of discount or premium when the asset or liability is measured at amortized cost
Fair value

• 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.” (ConceptualFramework6.12)
Value in use and fulfilment value

• Value in use is “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 6.17)
• Fulfilment value is “the present value of the cash, or other economic resources, that an entity expects to be
obliged to transfer as it fulfils a liability.” (Conceptual Framework 6.17)
Current cost

• The current cost of:

a. 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.”
b. 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 6.21)
Entry values vs. Exit values

• Current cost and historical cost are entry values (i.e., they reflect prices in acquiring an asset or incurring a
liability), whereas fair value, value in use and fulfilment value are exit values (i.e., they reflect prices in
selling or using an asset or transferring or fulfilling a liability).
Considerations when selecting a measurement basis

• When selecting a measurement basis, it is important to consider the following:

a. The nature of information provided by a particular measurement basis (e.g., measuring an asset at
historical cost may lead to the subsequent recognition of depreciation or impairment, while measuring
 that asset at fair value would lead to the subsequent recognition of gain or loss from changes in fair
value).
b. The qualitative characteristics, the cost-constraint, and other factors (e.g., a particular measurement
basis may be more verifiable or more costly to apply than the other measurement bases).
Measurement of Equity

• Total equity is not measured directly. It is simply equal to difference between the total assets and total
liabilities.
• Because different measurement bases are used for different assets and liabilities, total equity cannot be
expected to be equal to the entity’s market value nor the amount that can be raised from either selling or
liquidating the entity.
• Equity is generally positive, although some of its components can be negative. In some cases, even total
equity can be negative such as when total liabilities exceed total assets.
Presentation and Disclosure

• Information is communicated through presentation and disclosure in the financial statements.

• Effective communication makes information more useful. Effective communication requires:
a. focusing on presentation and disclosure objectives and principles rather than on rules.
b. classifying information by grouping similar items and separating dissimilar items.
c. aggregating information in a manner that it is not obscured either by excessive detail or by excessive
summarization.
Presentation and disclosure objectives and principles

• The objectives are specified in the Standards.

• The principles include:
a. the use of entity-specific information is more useful that standardized descriptions, and
b. duplication of information is usually unnecessary.
Classification

• Classifying means combining similar items and separating dissimilar items.

• Offsetting of assets and liabilities is generally not appropriate.

Classification of income and expenses

• Income and expenses are classified as recognized either in:

a. profit or loss; or
b. other comprehensive income.
Aggregation

• Aggregation is “the adding together of assets, liabilities, equity, income or expenses that have shared
characteristics and are included in the same classification.” (Conceptual Framework 7.20)
Concepts of Capital and Capital Maintenance

• Financial concept of capital – capital is regarded as the invested money or invested purchasing power.
Capital is synonymous with equity, net assets, and net worth.
• Physical concept of capital – capital is regarded as the entity’s productive capacity, e.g., units of output per
day.
RESEARCH AND STANDARD SETTING
Standard-setting process

Research Programme
• A broad research and development programme
o lower threshold to get onto the programme
o higher threshold to progress further

• Emphasis on defining the problem

o identify whether there is a financial reporting matter that justifies an effort by the IASB
o evidence-based

• The programme is designed to shorten the time needed to develop improvements to financial reporting,
by:
o clarifying the problem up front, before a solution is developed
o feeding manageable projects into the Exposure Draft phase on a timely basis

Outcomes
• A recommendation to:
o propose a change to IFRS Standards
o put a project on hold, for the time being
 resourcing
 other factors
o stop working on the issue
 o develop education or support material

EVIDENCE-INFORMED DECISION MAKING

• Identifying financial reporting problems
o Financial reporting differences
o Scale
o Evidence of estimation error
• Assessing solutions
o Surveys
o Decision experiments
o Evidence of how information is incorporated by markets
o Fieldwork
 Systems testing
 Testing draft words
 Financial statement simulations
• Implementation
o Evidence of diversity

Opportunities
• IASB
o Get a broader range of (different) perspectives
o Better decision making
 Better informed decisions
 Ability to defend decisions

• Academics
o Potential for research to have an observable effect

• Both
o Get a better understanding of each others needs
o Reduce the expectation gaps

Problem areas in using academic research

• Timeliness
• Vast literature
o Only tangentially relevant
o Or very narrow, marginal contribution
o Need synthesis / literature review
• Not accessible to standard setters
• Needs interpretation
• Need to understand limitations
• Overclaiming results
Pitfalls for us to avoid
• Selectivity bias
o We might cite tiny number of papers, only favourable.
• How to summarise what we have read
• Biased population
o Non-English
o Non Anglo-Saxon
 o Not just empirical capital markets

Bridging the gap between the academic community and the IASB
• Research centre on IASB website
• Annual research forum
• External research funding
o IAAER-KPMG funding
o ICAS calls for research
• ‘Ad-hoc’ events like today