Conceptual Framework For Financial Reporting

Conceptual Framework Objective and Purpose

General Purpose Financial Reporting

Objective

 to provide financial information about the reporting entity that is useful to existing and potential
investors, lenders and other creditors in making decisions relating to providing resources to the
entity.

Purpose

a. Assist the IASB in developing the Standards that are based on consistent concepts;

b. Assist preparers of financial statements 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;

c. Assist all parties to understand and interpret the Standards

2018 Conceptual Framework Objective and Purpose

Objective of Financial Reporting

 To provide financial information that is useful to users in making decisions relating to providing
resources to the entity.

Users' decisions involve decisions about:

 Buying, selling or holding equity or debt instruments

 Providing or settling loans and other forms of credit
 Voting, or otherwise influencing management's action

To make these decisions, users assess:

 Prospects for future net cash inflows to the entity

 Management's stewardship of the entity's economic resources

To make both these assessments users need information about both:

 the entity's economic resources, claims against the entity, and changes in those resources and
claims
 How efficiently and effectively management has discharged its responsibilities to use the entity's
economic resources.

Stewardship

Users of financial reports need information to help them assess management's stewardship. The
Conceptual Framework explicitly discusses this need as well as the need for information that helps users
assess the prospects for future net cash inflows to the entity.

General Purpose Financial Reporting

The financial statements provide information about an entity's economic resources and claims, plus their
changes.
Changes and Previsions to the Conceptual Framework

• To meet the objective of general-purpose financial reporting, the IASB may sometimes specify
requirements that depart from aspects of the Conceptual Framework. If the IASB does so, it will explain
the departure in the Basis for Conclusions on that Standard.

• The Conceptual Framework may be revised from time to time on the basis of the IASB's experience of
working with it. Revisions of the Conceptual Framework will not automatically lead to changes to the
Standards. Any decision to amend a Standard would require the IASB to go through its due process for
adding a project to its agenda and developing an amendment to that Standard

Conceptual Framework Qualitative Characteristics

The Reporting Entity

 an entity that is required, or chooses, to prepare financial statements.

 A reporting entity can be a single entity or a portion of an entity or can comprise more than one
entity.
 A reporting entity is not necessarily a legal entity
 Sometimes one entity (parent) has control over another entity (subsidiary). If a reporting entity
comprises both the parent and its subsidiaries, the reporting entity's financial statements are
referred to as 'consolidated financial statements'
 If a reporting entity is a parent alone, the reporting entity's financial statements are referred to
as 'unconsolidated financial statements'
 If a reporting entity comprises two or more entities that are not all linked by a parent-subsidiary
relationship, the reporting entity's financial statements are referred to as 'combined financial
statements'

The Reporting Entity Legal Entity

• Determining the appropriate boundary of a reporting entity can be difficult if the reporting entity:

a) is not a legal entity; and

b) does not comprise only legal entities linked by a parent-subsidiary relationship.

• In such cases, determining the boundary of the reporting entity is driven by the information needs of
the primary users of the reporting entity's financial statements. Those users need relevant information
that faithfully represents what it purports to represent. Faithful representation requires that:

a) the boundary of the reporting entity does not contain an arbitrary or incomplete set of
economic activities;
 b) including that set of economic activities within the boundary of the reporting entity results in
neutral information; and
c) a description is provided of how the boundary of the reporting entity was determined and of
what constitutes the reporting entity

Going Concern Assumption

• The Conceptual Framework of Accounting, published by the International Accounting Standards

Board (IASB), mentions the underlying assumption of going concern.
• The going concern principle, also known as continuing concern concept or continuity
assumption, means that a business entity will continue to operate indefinitely, or at least for
another twelve months.
• Financial statements are prepared with the assumption that the entity will continue to exist in
the future unless otherwise stated.
• The going concern assumption is the reason assets are generally presented in the balance sheet
at cost rather than at fair market value. Long-term assets are included in the books until they are
fully utilized and retired.

Accrual Basis of Accounting

• means that "revenue or income is recognized when earned regardless of when received and
expenses are recognized when incurred regardless of when paid".
• Hence, income is not the same as cash collections and expense is different from cash payments.
• Under an accrual basis, revenues and expenses are recognized when they occur regardless of
when the amounts are received or paid.
a. For example, ABC Company rendered repair services to a client on December 9, 2021. The client
paid after 30 days - January 8, 2022.
b. Another example, suppose ABC Company received its electricity bill for the month of March on
April 5 and paid it on April 10. When should the electricity expense be recorded?

Accounting Entity Concept

• Recognizes a specific business enterprise as one accounting entity, separate and distinct from the
owners, managers, and employees of that business.
• In other words, it means that a company has its own identity set apart from its owners or
anyone else. Personal transactions of the owners, managers, and employees must not be mixed
with transactions of the company.
a. For example, if ABC Company buys a vehicle to be used as delivery equipment, then it is
considered a transaction of the business entity.
b. However, if Mr. A, owner of ABC Company, buys a car for personal use using his own money, that
transaction is not recorded in the company's accounting system because it clearly is not a
transaction of the company.

Conceptual Framework Elements of Financial Statements

Elements of Financial Statements

Asset

 2010

• A resource controlled by the entity as a result of past events and from which future economic benefits
are expected to flow to the entity.

 2018

• 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.

Main changes in the definition of an asset:

 Separate definition of an economic resource - to clarify that an asset is the economic

resource, not the ultimate inflow of economic benefits.
 Deletion of "expected flow" - it does not need to be certain, or even likely, that economic
benefits will arise.
 A low probability of economic benefits might affect recognition decision and the
measurement of the asset.

Liability

2010

 A present obligation of the entity arising from past events, the settlement of which is expected
to result in an outflow from the entity of resources embodying economic benefits.

2018

• A present obligation of the entity to transfer an economic resource as a result of past events. An
obligation is a duty or responsibility that the entity has no practical ability to avoid.

Main changes in the definition of a liability:

• Separate definition of an economic resource - to clarify that a liability is the obligation to transfer
the economic resource, not the ultimate outflow of economic benefits.
• Deletion of "expected flow" - with the same implication as asset.
• Introduction of the "no practical ability to avoid" criterion to the definition of obligation

2018

• A present obligation of the entity to transfer an economic resource as a result of past events. An
obligation is a duty or responsibility that the entity has no practical ability to avoid.

• Introduction of the "no practical ability to avoid" criterion to the definition of obligation
• "No practical ability to avoid" is applied to:
• If a duty or responsibility arises from the entity's customary practices, published policies or
specific statements - the entity has an obligation of it as no practical ability to act in a manner
inconsistent with those practices, polices or statements.
• If a duty or responsibility is conditional on a particular future action that the entity itself may
take - the entity has an obligation if it has no practical ability to avoid taking that action.

Elements of Financial Statements Definition

• Equity is defined as "any contract that evidences a residual interest in the assets of an entity
after deducting all of its liabilities. IAS 32.11
• Revenue is the gross inflow of economic benefits during the period arising from the course of
the ordinary activities of an entity, other than increases relating to contributions from equity
participants. IAS 18

• Revenue arising from the following transactions and events:

• Sale of goods
• Rendering of services; and
• Use by others of entity assets yielding interest, royalty and dividends.
• 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.

• 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.

Recognition Criteria

• Recognition represents the question WHEN.

• It is necessary to know WHEN to recognize or show certain items in the financial statements.

• This is the general criteria used in recognizing the elements:

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

b. The item's cost or value can be measured with reliability.

Why Recognition is Important?

• Recognizing assets, liabilities, equity, income and expenses depicts an entity's financial position and
financial performance in structured summaries (FS).

• The amounts recognized in a statement are included in the totals and, if applicable, subtotals, in the
statement.

• The statements are linked because income and expenses are linked to changes in assets and liabilities.

Recognition Criteria

Asset's recognition criteria:

a. It is probable that the future economic benefits will flow to the entity; and
b. The asset has a cost or value that can be measured reliably.

Liability's recognition criteria:

a. It is probable that an outflow of resources embodying economic benefits will result from the
settlement of a present obligation; and
b. The amount at which the settlement will take place can be measured reliably.

Income recognition criteria:

a. An increase in future economic benefits related to an increase in an asset; or

b. A decrease of liability has arisen that can be measured reliably.

Expenses' recognition criteria:

a. A decrease in future economic benefits related to a decrease in an asset;

or
b. An increase of a liability has arisen that can be measured reliably.

Derecognition Criteria

• 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:
 for an ASSET, derecognition normally occurs when the entity loses control of all or part of the
recognized asset; and
 for a LIABILITY, derecognition normally occurs when the entity no longer has a present obligation
for all or part of the recognized liability.

Measurement of the Elements

• Measurement represents the question HOW MUCH should we recognize the asset, liability, equity,
income or expense.
Measurement Impairment

• Measurement uncertainty arises when a measure for an asset or liability cannot be observed directly
and must be estimated.

• Impairment describes a permanent reduction in the value of a company's asset, typically a fixed asset
or an intangible asset.

NOTE: When testing an asset for impairment, the total profit, cash flow, or other benefit expected to be
generated by that specific asset is periodically compared with its current book value. If it is determined
that the book value of the asset exceeds the future cash flow or benefit of the asset, the difference
between the two is written off and the value of the asset declines on the company's balance sheet.

Key Takeaways on Impairment

 Impairment can occur as the result of an unusual or one-time event, such as a change in
legal or economic conditions, change in consumer demands, or damage that impacts an
asset.
 Assets should be tested for impairment regularly to prevent overstatement on the balance
sheet.
 Impairment exists when an asset's fair value is less than its carrying value on the balance
sheet.
 If impairment is confirmed as a result of testing, an impairment loss should be recorded.
 An impairment loss records an expense in the current period which appears on the income
statement and simultaneously reduces the value of the impaired asset on the balance sheet

Impairment Loss

 The technical definition of impairment loss is a decrease in net carrying value, the acquisition
cost minus depreciation, of an asset that is greater than the future undisclosed cash flow of the
same asset.
 An impairment occurs when assets are sold or abandoned because the company no longer
expects them to benefit long-run operations.
 This is different from a write-down, though impairment losses often result in a tax deferral for
the asset. Depending on the type of asset being impaired, stockholders of a publicly held
company may also lose equity in their shares, which results in a lower debt-to-equity ratio.

Measurement of the Elements

Historical cost -.This is the price of the element at the date of the transaction.

• The historical cost of an asset when it is acquired or created is the value of the costs incurred in
acquiring or creating the asset, comprising the consideration paid to acquire or create the asset
plus transaction costs.
• The historical cost of a liability when it is incurred or taken on is the value of the consideration
received to incur or take on the liability minus transaction costs.

Current value - This is the value of the element at every measurement date (or at balance sheet
reporting date). This value changes because of changing estimates in cash flows or other factors. Current
value measurement bases include:

 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.
  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.
 Fulfilment value (or the present 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.
 Current cost - Like historical cost, it is an entry value. It reflects prices in the market in which the
entity would acquire the asset or would incur the liability

Principles

Measurement:

• Cost is generally thought to be a faithful representation of the amount paid for a given item.
• Fair value is "the amount for which an asset could be exchanged, a liability settled, or an equity
instrument granted could be exchanged, between knowledgeable, willing parties in an arm's
length transaction."
• IASB has taken the step of giving companies the option to use fair value as the basis for the
measurement of financial assets and financial liabilities.
 Fair market value is the price at which a willing seller sells a good or service to a willing buyer. Or
a layman's definition, it is the selling price to which a seller and buyer can agree.

Principles

• Revenue Recognition - revenue is to be recognized when it is probable that future economic benefits
will flow to the company and reliable measurement of the amount of revenue is possible

• Expense Recognition - outflows or "using up" of assets or incurring of liabilities (or a combination of
both) during a period as a result of delivering or producing goods and/or rendering services.

• "Let the expense follow the revenues."

ASSUMPTIONS

1. Economic entity

2. Going concern

3. Monetary unit

4. Periodicity

5. Accrual

PRINCIPLES

1. Measurement

2. Revenue recognition

3. Expense recognition

4. Full disclosure

CONSTRAINTS

1. Cost

2. Materiality

Third Level: Principles Constraints

Third Level: Principles

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

Third Level: Constraints

Cost - the cost of providing the information must be weighed against the benefits that can be derived
from using it.

Materiality - an item is material if its inclusion or omission would influence or change the judgment of a
reasonable person.

Presentation and disclosure as communication tools

• A reporting entity communicates information about its assets, liabilities, equity, income and
expenses by presenting and disclosing information in its financial statements.
• Effective communication of information in financial statements makes that information more
relevant and contributes to a faithful representation of an entity's assets, liabilities, equity,
income and expenses.
• It also enhances the understandability and comparability of information in financial statements.
• Effective communication of information in financial statements requires:
a. focusing on presentation and disclosure objectives and principles rather than focusing on rules;
b. classifying information in a manner that groups similar items and separates dissimilar items; and
c. aggregating information in such a way that it is not obscured either by unnecessary detail or by
excessive aggregation.

Presentation and disclosure objectives and principles

• To facilitate effective communication of information in financial statements, when developing

presentation and disclosure requirements in Standards a balance is needed between:

a. giving entities the flexibility to provide relevant information that faithfully represents the entity's
assets, liabilities, equity, income and expenses; and
b. requiring information that is comparable, both from period to period for a reporting entity and
in a single reporting period across entities.

• Including presentation and disclosure objectives in Standards supports effective communication in

financial statements because such objectives help entities to identify useful information and to decide
how to communicate that information in the most effective manner.

• Effective communication in financial statements is also supported by considering the following

principles:

a. entity-specific information is more useful than standardized descriptions, sometimes referred to

as 'boilerplate'; and
b. duplication of information in different parts of the financial statements is usually unnecessary
and can make financial statements less understandable.

Concepts of Capital

1. Financial capital - This is adopted by most entities in preparing their financial statements. Capital
is linked to the net assets or equity of a company.

- Under the money financial capital maintenance, the profit is measured if the closing net assets is
greater than the opening net assets, and the net assets in both cases are measured at historical cost.
• Examples of these financial concepts are invested money or invested purchasing power.

2. Physical capital - One examples of a physical concept is operating capability. Physical capital is
regarded as the productive capacity of the entity based on units of output per day.

• A financial concept of capital should be used if the users of the financial statements are mostly
concerned with the maintenance of their invested capital, or the purchasing power of the
invested capital.
• A physical concept of capital should be used if the users of the financial statements are mostly
concerned with the operating capacity of the entity, and current value accounting.

Concepts of Capital Maintenance

1. Financial capital maintenance - This concept states that a profit is earned only if the amount of the
net assets at the end of the period exceeds the amount of net assets at the beginning of the period.
2. Physical capital maintenance - This concept states that a profit is earned only if the physical
productive capacity at the end of the period exceeds the physical productive capacity at the beginning of
the period.

Note:

Profits will usually be higher when the financial concept of capital is used compared to the physical
concept of capital. This is due to the inflation adjustment.

Concepts of Capital Example

Scenario:

• An entity is established on January 1, 20X1 with 200,000 ordinary shares af P1 each.

• It then buys P200,000 worth of stock, which it sells during the year for P250,000.

• There were no other transactions during the period.

• At the end of the year the purchase price of the stock increased to P230,000.

Answer:

• Using the physical maintenance concept, the profit for the reporting period is P20,000
(P250,000-230,000).
• If the financial capital maintenance concept is used, the profit for the year is P50,000, but if the
company paid out the P50,000 profit to shareholders, it would be unable to buy the same stock
again as the purchase price has risen.
• To keep the operating capability of the entity the same, profit is measured as sales less the
replacement cost of the goods sold.

Concepts of Capital Example

Explanation:

• Most entities use the financial capital maintenance concept, as it is the easiest to apply because
it uses actual prices paid for goods, rather than making adjustments.
• Both capital maintenance concepts provide useful information.
• Investors prefer to use the financial capital maintenance concepts as they are focused on
increasing and maximizing the returns they get on their investments.
• Staff and management may prefer to use the physical capital maintenance concept as it allows
them to assess the entity's ability to maintain its operating capacity.
• This is useful for manufacturing businesses in particular where management may need to ensure
the business can keep producing the same volume of goods.