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Principles and concepts

1 A conceptual framework
1.1 Meaning and purpose
An accounting conceptual framework is a theory that explains the reasoning which underlies the
preparation of financial statements.
A framework sets out generally accepted accounting principles, which form the basis of financial
accounting and reporting standards. It provides answers to fundamental questions such as:
 What are financial statements?
 What are they for?
 Who are they for?
 What makes them useful?
The IFRS Conceptual Framework helps:

 the IASB to develop Standards that are based on consistent concepts;

 preparers of financial statements to develop consistent accounting policies in the absence of a
standard or where a standard allows a choice; and
 all parties to understand and interpret the Standards
The Conceptual Framework is not a standard and does not override any requirement in a Standard.

1.2 Principles-based vs rules-based frameworks

A rules-based system is generally prescriptive and relies on a series of detailed rules that prescribe
how financial statements should be prepared.
Such a system is considered less flexible, but often more comparable and consistent than a principles-
based system.
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Some would argue that rules-based systems can lead to looking for ‘loopholes’.
Also, it is not possible for rules to cover all possible accounting transactions.
By contrast, a principles-based system relies on generally accepted accounting principles that are
conceptually based and are normally underpinned by a set of key objectives.
They are more flexible than a rules-based system, but they do require judgement and interpretation
which could lead to inconsistencies between reporting entities and can sometimes lead to the
manipulation of financial statements.
Standards that are based on a conceptual framework are described as principles-based. Of course IFRS
Standards contain many requirements (often lengthy and complex), but their critical feature is that
‘rules’ are based on underlying concepts.
In reality most accounting systems have an element of both rules and principles and their designation
as rules-based or principles-based depends on the relative importance and robustness of the principles
compared to the volume and manner in which the rules are derived.

2 General purpose financial reports

2.1 Objective
A general purpose financial report provides financial information that is useful to the primary users so
that they can make decisions about providing resources to the entity. Primary users are:
 Existing and potential investors
 Lenders
 Other creditors
Many of these users cannot require reporting entities to provide information directly to them and
must rely on general purpose financial statements for much of the financial information they need.
Users of the financial statements need information about:
 an entity’s economic resources (assets); claims against it (liabilities); and changes in these
resources and claims; and
 how efficiently and effectively management have used the entity’s economic resources
(stewardship)
General purpose financial reports cannot provide all of the information that primary and other users
need. They need to consider other relevant information, e.g. general economic conditions, political
events, conditions in the industry sector in which the entity operates etc.

3 Financial information
3.1 Qualitative characteristics
Useful information is characterised by qualities that may be categorised as:
 Fundamental (i.e. essential)
 Enhancing (i.e. a further improvement).
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Fundamental qualitative characteristics

These are the characteristics needed to ensure that the financial statements are “true and fair”.
 Relevance - Information is relevant when it can make a difference to the economic decisions of
users. Relevant information helps users to assess past, present or future events (predictive
value) and helps users to confirm past assessments (confirmatory value).
Materiality is an entity-specific aspect of relevance. Information is material if omitting,
misstating or obscuring it could influence the decisions of primary users based on the financial
statements.
 Faithful representation has three qualities. It is:
 Complete
 Neutral
 Free from error
Neutrality is supported by prudence: exercising caution when making judgements under
conditions of uncertainty.
Faithful representation reflects the substance of an entity’s transactions, even where this is
different from their legal form.

EXAM SMART
For example, when an entity leases an asset it can control and use that asset to generate
profit for the business, even though it does not legally own it. Faithful representation implies
that an asset is recognised in the statement of financial position.
Leasing is covered in Chapter 12.

Enhancing qualitative characteristics

 Comparability – Comparability should enable users to identify similarities and differences
between items, both between different periods for the same entity and between different
entities. Comparability is facilitated by the existence and disclosure of accounting policies.
 Verifiability – Verifiable information which enables users to determine whether a particular
accounting treatment is a faithful representation. Some figures in a set of financial statements
can be directly verified e.g. by counting cash.
 Timeliness – To be useful, information must be provided to users within a reasonable time.
 Understandability – Information should be presented in such a way that it is understandable by
users with reasonable business knowledge. This can present management with a problem
because clearly not all users have the same (financial) abilities and knowledge. However, useful
information should not be omitted from the financial statements simply because it may be too
complex for some users to understand.

3.2 Financial statements and the reporting entity

A reporting entity is an entity that is required, or chooses, to prepare financial statements.
A reporting entity does not have to be a legal entity and can comprise only a portion of an entity or
two or more entities.
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For example, if one entity (a parent) controls another entity (a subsidiary) the parent and the
subsidiary together form a single economic entity.
 Consolidated (group) financial statements are prepared to provide information about the group
as a single reporting entity.
 These normally provide more useful information to users than the two individual sets of
financial statements for the parent and the subsidiary.
Financial statements provide information about transactions and other events from the perspective of
the reporting entity as a whole, not from the perspective of any particular group of users.

Going concern assumption

It is assumed that the company preparing the financial statements is a going concern i.e. the financial
statements are being prepared on the assumption that an entity will continue in operation for the
foreseeable future. This is sometimes referred to as the underlying assumption.

3.3 The elements of financial statements

Financial statements show the reporting entity’s:
 Economic resources: assets
 The claims against it: liabilities and equity
 Changes in economic resources and claims: income and expenses, contributions from owners
(e.g. capital) and distributions to owners (e.g. dividends)
Element Definition
Asset 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
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
i.e: EQUITY = NET ASSETS = SHARE CAPITAL + RESERVES
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

3.4 Recognition and derecognition

Recognition means including an item in the financial statements.
An item is recognised in the financial statements if:
 it meets the definition of an element; and
 it provides useful information (i.e. is relevant and faithfully represents the item).
Derecognition (removing all or part of an item from the financial statements) normally occurs when
the entity:
 loses control of an asset; or
 no longer has a present obligation for a liability.
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3.5 Measurement
In order to recognise an element in the financial statements, we need to select a measurement basis.
This may be either:
 Historical cost – elements in the statement of financial position are measured at their historical
cost i.e. the amount of cash that was paid to acquire or create them (asset), or the cash that will
be paid to settle them (liability); or
 Current value: historical cost amounts are updated to reflect conditions at the measurement
date (normally the year end).

CURRENT VALUE

FAIR VALUE VALUE IN USE

CURRENT COST
The price that would be Present value of the cash flows, or
The cost of an equivalent asset at the
received to sell an asset, other economic benefits that an
measurement date (or consideration
or paid to transfer a entity expects to derive from the use
that would be received for a
liability, in an orderly of an asset and its ultimate disposal.
liability).
transaction between
market participants at (Fulfilment value is the present value
the measurement date of cash/economic resources that an
(see below) entity expects to transfer to meet a
liability.)

Historical cost accounting v current value accounting

In practice, most assets and liabilities in the statement of financial position are measured at historical
cost.
Advantages:
 Easy to calculate and prove
 Concept is familiar to users
Disadvantages:
 Out of date assets lead to information which isn’t “relevant” (assets will be understated in times
of rising prices)
 These “out-of-date” assets lead to “out-of-date” costs being recorded (e.g. depreciation)
Items such as property are often measured at current value (normally fair value) as this provides more
relevant information than historic cost. For example, if an asset is held for its investment potential, its
fair value shows users the amount that the asset is actually worth and might realise if it were sold.
Disadvantages of current value/fair value accounting:
 It may not be possible to measure current values reliably, for example where there is no active
market for an asset. Current values may have to be based on judgement and estimates.
72 7: Principles and concepts ACCA FR

 Fair value measurement may mean that an entity recognises a profit it may never actually
realise (for example, if an asset is unlikely to be sold)
 It can cause volatility in the financial statements (for example, where prices change rapidly).
This means that users may not be able to assess an entity’s financial performance.

Fair value
Fair value is a market-based measurement based on current market conditions rather than the
intentions of an entity. It assumes that an asset will be sold in its principal or most advantageous
market. The condition and location of the asset should be taken into account, together with any
restrictions on sale or use. The fair value of a non-financial asset should take into account its highest
and best use.
An entity should use the valuation technique that is appropriate for it given its circumstances. A fair
value hierarchy describes the types of inputs which help determine the fair value of an item:
 Level 1 – a quoted price from an active market for an identical asset e.g. the share price of a
publicly traded equity investment.
 Level 2 – observable directly or indirectly for the asset. E.g. the quoted price of a similar asset in
an active market.
 Level 3 – unobservable, but based on the best information available e.g. the estimated present
value of the future cash flows relating to an item.

Selecting a measurement basis

The information provided must be useful to users (relevant and faithfully represented). An entity
should consider:
 Characteristics of the asset or liability being measured (e.g. does it change value rapidly?)
 How the asset or liability contributes to future cash flows (e.g. will it continue to be used in the
business or will it be sold?)
 Whether there is measurement uncertainty (e.g. can current value be determined by using
market prices or must it be estimated in some other way?)

3.6 Presentation and disclosure

A reporting entity communicates by presenting and disclosing information in its financial statements.
Effective communication in financial statements requires:
 Focusing on objectives and principles rather than on rules (entity specific disclosure is more
useful than standardised descriptions; duplication of information in different parts of the
financial statements can make them harder to understand).
 Classifying information in a manner that groups similar items and separates dissimilar items
(e.g. assets and liabilities should not normally be offset).
 Aggregating (adding together) information in such a way that it is not obscured either by
unnecessary detail or excessive summarisation.
In principle all income and expenses are presented in the statement of profit or loss. However in
exceptional circumstances, certain items of income and expenditure are presented within other
comprehensive income instead. This is to ensure that the statement of profit or loss provides relevant
information and a faithful representation.
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4 Regulatory framework
4.1 Regulatory structure

IFRS Foundation

IFRS IASB IFRS Interpretations

Advisory Council Committee

IFRS Foundation
The Foundation is responsible for:
 Appointing members to the Board, the IFRS Interpretations Committee and the IFRS Advisory
Council
 Reviewing the general strategy of the Board and monitoring its effectiveness
 Approving the annual budget and determining the funding of the Board

International Accounting Standards Board (IASB)

The Board is responsible for the development and publication of International Financial Reporting
Standards (IFRSs and previously IASs) and the Conceptual Framework.

IFRS Interpretations Committee

IFRS Interpretations Committee provides timely guidance on the application and interpretation of
IFRSs and, in the context of the Conceptual Framework, guidance on new financial reporting issues not
specifically addressed by IFRSs. Interpretations are approved for issue by the Board.

The IFRS Advisory Council

This formal advisory body takes recommendations from individuals, corporations and national
standard-setters and provides advice to the Board on priority areas of accounting.
The International Sustainability Standards Board (ISSB)
The objective of the International Sustainability Standards Board (ISSB) is to deliver a comprehensive
global baseline of sustainability-related disclosure standards (IFRS Sustainability Disclosure Standards).
International investors called for corporate reporting on climate and other environmental, social and
governance matters that is high quality, transparent, reliable and comparable. The aim is to provide
users with reliable, comparable, sustainability-related information to help them make informed
decisions concerning sustainability-related risks and opportunities relevant to individual entities.

4.2 Advantages of IFRS over a national framework

 Since IFRSs have been produced in co-operation with other internationally renowned standard
setters, a company using IFRS may enhance its status and reputation (for example, an improved
credit rating).
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 Its own financial statements would be comparable with other companies that use IFRS. This
would help the company to better assess and rank prospective investments.
 The use of IFRSs may make the audit fee less expensive.
 If a company needs to raise finance in the future, it will find it easier to get a listing on any
security exchange.

4.3 The standard setting process

There are four basic steps in the process leading to the publication or revision of an International
Financial Reporting Standard (IFRS):

STEPS
Step 1: Identify a subject and e stablish an advisory committee
Step 2: Issue a discussion paper setting out the possible options for a new standard, with public
comment invited.
Step 3: Issue of Exposure Draft (again with public comment invited), being a draft of the final
standard. Any feedback on this draft or the discussion paper would be analysed.
Step 4: Issue of final IFRS

5 Accounting policies, estimates and errors

5.1 Accounting policies
Accounting policies are the significant principles, bases, conventions, rules and practices applied by an
entity in preparing and presenting the financial statements.

Changes in accounting policy

Generally, an entity should use the same accounting policies from one period to the next
(consistency). However, an entity should only change an accounting policy if:
 There is a new statutory requirement or accounting standard
 The new policy presents more relevant information about the financial statements
A change in accounting policy occurs if there is a change in:
 recognition e.g. recognising an item as an asset rather than an expense,
 presentation e.g. Co A is an accountancy training college which has previously presented
tutor salaries as “administrative” expenses. It has now decided that “cost of sales” is a more
suitable category of expense, or
 measurement basis of an item e.g. using replacement cost instead of historical cost
Examples of change in accounting policy include:
 Changing from FIFO to weighted average on inventory valuation.
 Measuring assets at fair value having previously measured them at historic cost.
ACCA FR 7: Principles and concepts 75

Accounting treatment
When an accounting policy is changed, the entity should not only adjust this year’s figures, but should
also, as far as practicable, adjust the comparative amounts for the prior period. This has the effect of
preparing the financial statements as if the new policy had always been in place (“retrospective
application”).
In the exam this may mean adjusting the current year figures and adjusting the retained earnings
brought forward in the statement of changes in equity (see Chapter 8).
Note that although the change from the cost model to the revaluation model for property, plant and
equipment (see Chapter 9) is a change in accounting policy, it is not applied retrospectively, but
“prospectively” (i.e. to current and future periods).
Key disclosures
 The nature of the change in accounting policy,
 The reasons why the change provides more relevant and reliable information,
 The amount of the adjustment for the current and each prior period presented,
 The amount of the adjustment to periods before those presented.

5.2 Accounting estimates

Many figures in the financial statements have to be estimated in the absence of a precise means of
measurement. Management has to make assumptions and to exercise judgement based on the
available information.
Accounting estimates are monetary amounts in financial statements that are subject to measurement
uncertainty.
Changes in accounting estimates result from new information or new developments. Examples of
estimates that may change include:
 Warranty provisions changing from 5% of sales to 10%
 Inventory obsolescence
 Depreciation method changing from straight-line to reducing-balance
 A change in the residual value of an item of PPE
 Changing the useful lives of depreciable assets
Changes in accounting estimates are simply adjusted in the financial statements of the period in which
they arise.

5.3 Prior period errors

Prior period errors are omissions from, and misstatements in, the entity's financial statements for one
or more prior periods arising from a failure to use, or misuse of, reliable information that:
(a) Was available when the financial statements for those periods were authorised for issue; and
(b) Could reasonably be expected to have been obtained and taken into account in the preparation
and presentation of those financial statements.
Prior period errors are treated in the same way as changes in accounting policies i.e. the entity should
not only adjust this year’s figures, but should also, as far as practicable, adjust the comparative
amounts for the prior period.
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Knowledge diagnostic
Before you move on to the next chapter, complete the following knowledge diagnostic and check you
are able to confirm you possess the following essential learning from this chapter. If not, you are
advised to revisit the relevant learning from this chapter.
Confirm your learning Yes/No

Do you understand the difference between a rules-based and a principles-based

framework?

Can you explain the objective of general purpose financial reports?

Do you understand the two fundamental qualitative characteristics and the four
enhancing characteristics of useful financial information?

Do you know what is meant by the term ‘reporting entity’?

Can you define the following: assets; liabilities; equity; income; and expenses?

Can you explain the conditions that must be met before an asset or a liability is
recognised in the financial statements?

Can you explain what is meant by historic cost and the three measurement bases of
current value: fair value; value in use; and current cost?

Do you understand the roles and responsibilities of the following regulatory bodies:
IFRS Foundation; IFRS Advisory Council: IASB; IFRS Interpretations Committee?

Can you explain the steps in the standard-setting process?

Do you understand the difference between an accounting policy and an accounting

estimate and the way in which each of these is treated in the financial statements?

Do you understand how to account for and present a prior period error in the financial
statements?

Question Practice
Question practice is the key to passing the financial accounting exam. Once you have worked through
this chapter, you must work through the questions that can be found both online, and in your printed
question bank. You are only ready to move to the next chapter when you have worked these questions
and are confident you would get them right should they appear in your exam.