Conceptual Framework USN (CPA Gold Medalist, Dip in IFR Gold Medalist)

Conceptual Framework for Financial Reporting

Why do we need a Framework?

Sometimes it is not always obvious what to put in financial statement.

• What is an asset or a liability?

• Who uses financial statements and why?
• Should my expenses go into Profit or Loss or OCI?

The Framework was produced to answer these questions and more.

What is the Framework?

• Issued by the IASB

• Last updated in 2018
• NOT an accounting standard
• Underpins financial reporting by setting out the underlying concepts and definitions
➢ Help accounts to decide how to account for difficult or judgmental issues
➢ Helps standard setters to develop accounting standards that are consistent with each other
➢ Ensures financial statements are produced with the end user in mind

What is in the Framework?

I. The purpose of Financial Reporting: Who uses the FS and why do they use it?

II. Qualitative Characteristics: What underlying characteristics does financial information need to make it
useful to uses?

III. The Elements: Definitions of assets, liabilities, equity, income and expenses

IV. Recognition: When to recognize the elements in the FS

V. Derecognition: When to take elements out of the FS

VI. Measurement: How to measure an item in the FS (Amount)

VII. Presentation and Disclosure: How to decide between PL or OCI

VIII. Concept of capital and capital maintenance: What is capital and capital maintenance?

I. The purpose of the Financial Reporting

To provide information to current and potential investors, lenders and other creditors that will enable
them to make decisions about providing economic resources to the entity.

Financial information includes information about the financial position, financial performance, cash flow
and changes in equity of an entity this is useful to a wide range of users in making economic decisions.

Primary users = Investors and creditors

Help them make informed decisions about investing in or lending to the entity.

Users need information to assess:

• An entity’s future cash flows; and

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Conceptual Framework USN (CPA Gold Medalist, Dip in IFR Gold Medalist)

• Management’s stewardship of the entity’s economic resources

E.g. Show discontinued operations separately on the face of the SPL so the users know they will not be
there in the future.

II. Qualitative Characteristics: What underlying characteristics does financial information need to make
it useful to uses?

There are two characteristics.

1. Fundamental Characteristics

• Relevance (Predictive, Confirmatory, Materiality) (PCM)

• Faithful Representation (CFSN)

2. Enhancing Characteristics (TVCU)

• Verifiability
• Timeliness
• Understandability
• Comparability

What is relevance?

• Predictive value
• Confirmatory value
• Materiality

The financial information must be relevant to the need of users. Relevant information is capable of
making different decision of users.

Financial information is capable of making a difference in decisions if it has predictive value, confirmatory
value or both.

Financial information has predictive value if it can be used as an input to processes employed by users to
predict future outcomes.

Financial information has confirmatory value if it provides feedback about (confirms or changes) previous
evaluations.

What is materiality?

Information is material if omitting it or misstating it could influence decisions that users make on the basis
of the reported financial information.

E.g. Only do a prior year adjustment for a material PY error, not for an immaterial one.

What is Faithful Representation?

• Completeness
• Free from error
• Substance over form
• Neutral but prudent if uncertain

Faithful representation means that the numbers and descriptions match what really existed or happened.

Completeness means that all the information must be completed in the financial statements.
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Conceptual Framework USN (CPA Gold Medalist, Dip in IFR Gold Medalist)

An information item that is free from error will be a more accurate (faithful) representation of a financial
item.

Neutrality means that a company cannot select information to favor one set of interested parties over
another (free from bias)

Substance over form is the principle that transactions and other events are accounted for and presented
in accordance with their substance and economic reality and not merely their legal from.

E.g. Show most redeemable preference shares as a liability

Only include variable consideration in revenue if it is highly likely (IRFS 15 Sales with return basis)

Enhancing Characteristics

Verifiability: Information is credible and reliable

Timeliness: In time to affect users’ decisions

Understandability: Information is clear and concise

Comparability: The same entity over time. Between different entities.

Verifiability occurs when independent measures, using the same method, obtain similar results.

Timeliness means having information available to decision-makers before it loses its capacity to influence
decisions.

Understandability means classifying, characterizing and presenting information clearly and concisely
makes it understandable.

Comparability means users must be able to compare an entity’s financial statements with similar
information about other entities and with similar information about the same entity for another period.

E.g. Do PYA for a change in accounting policy so FS are comparable year on year.

III. Elements

There are FIVE basic elements in the Financial Statements.

Asset: A present economic resource controlled by an entity as a result of a past event

E.g. Staff training does not create an asset it is not under the company’s control, so do not capitalize it.

Lability: A present obligation of the entity to transfer an economic resource as a result of a past event

An obligation can be constructive or legal.

Equity: The residual interest in the net assets of an entity

Income: Increases in assets or decreases in liability that result in an increase to equity (excluding
contributions from equity holders)

Expenses: Decreases in assets or increases in liabilities that result in decreases to equity (excluding
distribution to equity holders)

An economic resource is a “right that has the potential to produce economic benefits”

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Conceptual Framework USN (CPA Gold Medalist, Dip in IFR Gold Medalist)

IV. Recognition: When to recognize the elements in the FS

Items which meet the definition of assets or liabilities may still not be recognized in the financial
statements because they must also meet certain recognition criteria.

Recognition

The process of incorporating in the statement of financial position or statement of profit or loss and other
comprehensive income if an item meets the definition of element and satisfied the following criteria for
recognition;

(a) It is probable that any future economic benefit associated with the item will flow to or from the entity:
and

(b) The item has a cost or value that can be measured with reliability.

Items are recognized in the financial statements if:

• They meet the definition of an element; and

• Recognition provides relevant information; and (PCM)
• Recognition faithfully represents the entity’s financial performance and position (CFSN)

E.g. Do not recognize internally generated goodwill as its value cannot be determined so it cannot be
faithfully represented.

Don’t recognize if:

• Uncertainty over existence; or

• Low probability; or
• Can’t reliably measure

If you don’t recognize as asset or liability, you may need to disclose it.

E.g. Contingent liability: Don’t recognize in the SOFP, but disclose in a note to the FS.

V. Derecognition: When to take elements out of the FS

Derecognition is the removal of all or part of a recognized asset or liability from an entity’s statement of
financial position. Derecognition normally occurs when that item no longer meets the definition of an
asset or of a liability.

Derecognize when the entity:

• Loses control of the assets; or

• Has not present obligation for the liability

E.g. Sell an asset: Remove the CV of the asset from the SFP as the company no longer has control of it.
Convert a liability to shares: Remove the liability from the SFP as the company no longer owes any money.

To account for derecognition: Faithfully represent the changes in the entity’s net assets, as well as any
assets or liabilities retained. This involves:

• Derecognizing any transferred, expired or consumed component; and

• Recognizing any gain or loss on the above: and
• Recognizing any retained component

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Conceptual Framework USN (CPA Gold Medalist, Dip in IFR Gold Medalist)

E.g. Sell an asset

• Derecognizing any transferred, expired or consumed component: DERECOGNIZE ASSET

• Recognizing any gain or loss on the above: PROFIT ON DISPOSAL
• Recognizing any retained component: CASH PROCEEDS

VI. Measurement: How to measure an item in the FS

The process of determining the money amounts at which the elements of the financial statements are to
be recognized and carried in the statements.

If recognized in the financial statements, an element must be quantified. The two main bases of
measurement identified by the Framework are:

• Historical cost: Often obtained from the original transaction price

• Current value:
➢ Current cost
➢ Fair value
➢ Realizable (settlement)
➢ Value in use (present value of future cash flow)

Measurement bases

Assets Liability
Historical Costs The amount paid (or the fair of the The amount received in exchange for
consideration given) to acquire them at the obligation
the time of their acquisition.
Land is the best example of an asset
measured at historical cost, and would
be valued at the invoice price of the
purchase.
Current Cost The amount which would have to be The undiscounted amount which
paid if the same or an equivalent asset would be required to settle the
were acquired currently. obligation currently.
A financial asset is a good example of an
asset measured at current cost; its value
would be based on the market price of
the instrument.
Realizable The amount which could currently be At settlement value (i.e. the
(Settlement) Value obtained by selling the asset in an undiscounted amounts expected to be
orderly disposal. paid to satisfy the liabilities in the
Inventory may be value at net realizable normal course of business)
value.
Present value Present discounted value of the future Present discounted value of the future
net cash inflows which the item is net cash outflows which are expected
expected to generate in the normal to be required to settle the liabilities in
course of business. the normal course of business.
The liability element of a compound
instrument is a good example of a
liability measured at the present value
of future cash flows.

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Conceptual Framework USN (CPA Gold Medalist, Dip in IFR Gold Medalist)

Historical Cost Accounting

Historically, accounting is based on what an item had cost (i.e. historical cost). As economies have
advanced, however, there has been concern that historical cost accounting does not reflect the modern
economics of today’s transactions.

Advantages of Historical Cost

✓ Easy to understand and follow.

✓ Objective evidence of transactions.
✓ Used throughout the world.

Disadvantages of Historical Cost

✓ Current revenues are matched with historical costs

✓ Value of the assets in the statement of financial position do not equate to the economic benefits
to be earned from their use.
✓ Holding gains are not separated from operating gains. Holding gains are gains made merely by
holding onto an asset.
✓ Historical cost accounting does not reflect the general rise in prices (inflation) which affects an
economy

When selecting measurement basis, relevance is maximized if the following are considered:

• The characteristics of the asset or liability

• How the asset or liability contributes to future cash flows

E.g. Buy a factory to use in the business: historic cost

Buy an investment property to sell at a profit: fair value

Initial measurement: Measurement at the time of inception

Subsequent measurement: Measurement at the financial year end.

VII. Presentation and Disclosure: How to decide between PL or OCI

Disclosure:

Additional information and explanation attached to an entity’s financial statements. Usually it is

explanation for the financial information per primary statements.

The statement of profit or loss is the primary source of information about an entity’s financial
performance. So, income and expenses should usually go to Profit or Loss.

An item of income or expense may be required to be presented in OCI if it results from measuring an item
to its current value and if it means that:

• Profit or loss provides more relevant information; or

• A more faithful representation is provided of an entity’s performance

E.g. Revaluation gains on PPE go to OCI.

Foreign exchange gains and losses on an oversea subsidiary go to OCI.

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Conceptual Framework USN (CPA Gold Medalist, Dip in IFR Gold Medalist)

Income and expenditure included in other comprehensive income should be reclassified to profit or loss
when doing so results in profit or loss providing more relevant information

E.g. When an overseas subsidiary is sold, the cumulative foreign exchange gains on the subsidiary are
reclassified to profit or loss.

VIII. Concept of capital and capital maintenance

The framework identifies main two concepts of capital

1. The financial concept

2. The physical concept

Under the financial concept, capital is the net assets or equity of the entity.

Capital can be measured in two ways:

1. As per invested money

2. As per invested purchasing power.

Under a physical concept of capital, such as operating capability, capital is regarded as the productive
capacity of the entity based on, for example, units of out-put per day.

The selection of the appropriate concept of capital by an entity should be based on the needs of the users
of its financial statements.

Concepts of capital maintenance and the determination of profit

The concept of capital maintenance is concerned with how an entity defines the capital that it seeks to
maintain.

Capital maintenance, also known as capital recovery, is an accounting concept based on the principle that

1. a company’s income should by recognized after it has fully recovered its costs or

2. its capital has been maintained. Any excess amount above this represents the company’s profit.

There are two main concepts under capital maintenance.

i. Financial Capital Maintenance

ii. Physical Capital Maintenance

i. Financial Capital Maintenance

Under this concept;

Profit is earned only if the financial (or money) amount of net assets at the end of the period exceeds the
financial (or money) amounts of net assets at the beginning of the period (after excluding any
distributions to and contributions from owners during the period). There are two theories based on
financial capital maintenance:

1. “Money” concept, which is historical cost accounting;

2. “Real term” concept, which considers the effect of a general level of inflation. This method is called
Current Purchasing Power (CPP) accounting and in its simplest form would uplift asset, liability, revenue
and cost figures to reflect levels of inflation in the economy.

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Conceptual Framework USN (CPA Gold Medalist, Dip in IFR Gold Medalist)

ii. Physical Capital Maintenance

Under this concept,

Profit is earned only if the physical productive capacity (operating capability) of the entity at the end of
the period exceeds the physical productive capacity at the beginning of the period (after excluding any
distributions to and contributions from owners during the period). Current Cost Accounting (CCA) is an
accounting model used in the past to reflect changes in the operating capabilities of an entity. This
method applies specific changes in value to each component of the operations of an entity.

The effect of both real term and physical capital maintenance concepts would be to reduce the level of
distributable profits of an entity, taking account of either inflation or specific price level changes.

Is Current Value Accounting the Answer?

Over the past 30 Years, the accounting profession has attempted to introduce some form of current
accounting value model. Until 2005 the IASB had in issue IAS 15 Information Reflecting the Effects of
Changing Prices, an optional standard which allowed the use of a form of CPP accounting.

In the 1970s and 1980s, UK GAAP had a compulsory standard requiring accounts to incorporate a current
cost accounting model into their financial statements, as well as their historical cost accounts.

Implementing current value accounting models has invariably caused problems and has never achieved
the backing of the preparers and analyst who prefer the more conservative approach of historical cost
accounting. Although some current values are easily obtained (e.g. replacement cost of inventory), the
calculation of “value in use” (see section 15) can be very subjective (and therefore less reliable).
Valuations may be almost impossible to verify and comparisons between companies made even more
difficult. The majority of users may not understand what the figures represent.

Under IFRS today, there is no formal model of current cost accounting, however, a number of standards
do require some assets and liabilities to be measured at fair value, such as financial instruments. Some
accountants believe that fair value accounting is current cost accounting by another name.

Although current value accounting seeks to provide more relevant financial information than historical
cost accounting. It opens up new problems and issues which are probably greater than those under
historical cost accounting.

Fair Value

Background

When the framework document was first issued, the concept of fair value was not widely used in
accounting and so was not incorporated into the Framework as a measurement basis.

Over the past 10 to 15 years the use of fair value in accounting has become far more widespread, with
many IFRSs now requiring or allowing the use of fair value. When the IASB issued new standards which
required or allowed the use of fair value, there was no consistency between each standard as to how fair
value should be measured.

In May 2011, the IASB issued IFRS 13 Fair Value Measurement, which prescribes that when a particular
standard requires an item to be measured at fair value then IFRS 13 specified how fair value should be
measured.

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Conceptual Framework USN (CPA Gold Medalist, Dip in IFR Gold Medalist)

Terminology

Fair Value: the price which would be received to sell an asset or paid to transfer a liability in an orderly
transaction between market participants at the measurement date.

When measuring fair value all characteristics of the asset (or liability) which market participants would
take into account should be reflected in the valuation. This could include the condition or location of the
asset and any restriction on its use.

The definition is market based and is not entity specific. It reflects factors which market participants
would apply to the asset (or liability), not the factors which a specific entity would necessarily apply.

Active market: a market in which the transaction for the asset or liability takes place with sufficient
frequency and volume to provide pricing information on an ongoing basis.

Highest and best use: the use of a non-financial asset by market participants which would maximize the
value of the asset or the group of assets and liabilities within which the asset would be used.

Non-Financial Assets

Fair value measurement of a non-financial asset (e.g an investment property) reflects its highest and best
use. Highest and best use takes into account:

1. the use which is physically possible

2. what is legally allowed; and

3. the financial feasibility of using the asset

Taking account of the highest and best use may need to assume that the asset will be combined with or
complement, other assets (or liabilities) available to market participants.

IFRS 13 does not specify when an entity should use fair value but how it is used.

“if an entity holds investment property, it is IAS 40 which allows the use of fair value but IFRS 13 which
specifies how fair value is measured.

The definition of fair value is based on an “exit price” (i.e. taking the asset or liability out of the entity)
rather than “entry price” (i.e. bringing the asset or liability into the entity)

“Highest and best use does not reflect illegal activities in the use of an asset but does reflect what is
economically viable (considering any financial constraints)

“if an entity uses a stand-alone asset but its best use would be in combination with other assets, fair
value is based on this best use (i.e. irrespective of the entity’s current use it reflects any synergy or using
the asset in a group of assets).

Valuation techniques

IFRS 13 assumes that the transaction will occur in the principal market for the asset (or liability), if one
exists. If there is no principal market then the standard requires the valuation to be based on the most
advantageous market. Unless proved otherwise, the market place will be presumed to be the one in
which the entity transactions on a regular basis.

The objective of the standard is to estimate the price at which the asset (or liability) could exit the entity
in an orderly transaction. Three common techniques which would give an accurate estimate are
considered.
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Conceptual Framework USN (CPA Gold Medalist, Dip in IFR Gold Medalist)

Market Approach

This approach uses prices, and other information, generated in a market place which involves identical or
comparable assets or liabilities.

Cost Approach

This approach reflects the amount which would be required to replace the service capacity of the asset
(current replacement cost)

Income Approach

This approach considers future cash flows and discounts those cash flows to a current value. Models
which follow an income approach include:

1. present value; and

2. option pricing models (e.g. Black-Scholes-Merton)

Hierarchy of inputs

The techniques used to estimate fair values should maximize observable inputs wherever possible. The
standard lays down a hierarchy (order) with the intention of increasing consistency of usage and
comparability in the measurement of fair values and their related disclosures.

Level 1 inputs

These are quoted prices in active markets for identical assets or liabilities which the entity can access at
the measurement date.

Level 2 inputs

These are inputs other than quoted prices which are observable for the asset or liability, either directly
or indirectly. These would include prices for similar, but not identical assets or liabilities which were then
adjusted to reflect the factors specific to the measured asset or liability.

Level 3 inputs

These are unobservable inputs for the asset or liability.

For example:

a valuation of a decommissioning liability assumed in a business combination;

use of internal data as part of the calculation of cash flow relating to a cash-generating unit.

Level 1 inputs should be used wherever possible. The use of level 3 inputs should be kept to a minimum.

Disclosure

The disclosure requirements of IFRS 13 are very extensive and depend on whether level 1, 2 or 3 inputs
are being used in the measurement techniques. The disclosures required are of a quantitative and
qualitative nature. The standard also distinguishes between measurement of a recurring nature and
those of a non-recurring nature. Disclosures include the following.

* the reason for using fair value;

* the level of hierarchy used;

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Conceptual Framework USN (CPA Gold Medalist, Dip in IFR Gold Medalist)

* description of techniques used for level 2 or 3 inputs

For non-financial assets, disclosure is required if the highest and best use differs from what the entity is
using; and for level 3 inputs, a reconciliation of the opening and closing balances and any amounts
included in profit or loss for the period.

Basic Assumption / Main Concepts

Accrual (or) Matching Concept

Accrual concept is the most fundamental principle of accounting which requires recording revenue when
they are earned and not when they are received in cash, and recording expenses when they are incurred
and not when they are paid.

Match expenses with income that directly related with the expenses.

Prudence Concept

We have to make estimates requiring judgment to counter the uncertainty. While making judgment we
need to be cautious and prudent. Prudent is a key accounting principle which makes sure that assets and
income are not overstated and liabilities and expenses are not understated.

Revenue & Assets must not be overstated

Expenses & Liability must not be understated

Going Concern Concept

Generally, a business is seen as going concern up to foreseeable future (next 12 months)

If the company is not expected to continue operations i.e. it is required (or reasonably expected) to wind
up, its financial statements are prepared using break-up basis.

Substance over form

Substance over form is an accounting concept which means that the economics substance of transactions
and events must be recorded in the financial statements rather than just their legal form in order to
present a true and fair view of the affairs of the entity.

Consistency Concept

The concept of consistency means that accounting methods once adopted must be applied consistently
in future. Also, same methods and techniques must be used for similar situations.

Materiality Concept

Information is material if omitting it or misstating it could influence decisions that users make on the basis
of the reported financial information.

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