THE CONCEPTUAL FRAMEWORK

CHAPTER 1
 LEARNING OBJECTIVES
On completion of this chapter you will be able to:
• Demonstrate the need for a conceptual framework and the characteristics of
useful information
• Understand recognition and measurement
• Distinguish between a principles-based and a rules-based framework
VISUAL OVERVIEW
 Conceptual Framework for financial
reporting
• Is a statement of generally accepted theoretical principles, which form the
frame of reference for financial reporting.
• It lays down the foundation for Standards
• Its theoretical principles is the basis for:
– Development of accounting standard, and
– Understanding and interpretation of these standards
 The IASB’s Conceptual Framework

• Purpose
– To assist the IASB to develop IFRS that are .
– +35094based on consistent concepts
– To assist preparers to develop consistent accounting policies when no
Standard applies or a Standard allows a choice;
– To assist all parties to understand and interpret the Standards
• Status
– Is not IFRS standards and therefore does not override any IFRS
standard
– Only forms the basis for development of standards
 Advantages and Disadvantages of a
conceptual framework
Advantages Disadvantages
• Accounting standards are • Not certain that a single framework
developed from the same can be devised to suit all users
theoretical principles • Diversity of user requirements may
• Development of accounting require a variety of accounting
standards is less subjective to standards to be produced for
political pressure different purposes and based on
• Accounting standards use a different basis.
consistent approach • It is not confirmed that conceptual
• Same underlying principles can be framework make the preparation
applied to any scenario (Principles- and implementation of standards
approach) easier.
 Financial Statements
• A set of financial statements includes:
– Statement of financial position;
– Statement of profit or loss and other comprehensive income;
– Statement of changes in equity;
– Statement of changes in financial position (e.g. a statement of cash
flows)
– Integral notes, other statements and explanatory material.
• It exclude:
– Reports by directors;
– Statements by chairman;
– Discussion and analysis by management and similar items included in a
financial or annual report.
 Users and their Information Needs
Users Information Needs
•Risk and return of investment:
Investors and their advisers • for decision-making (buy, hold or sell?)
• to assess ability to pay dividends.
•Stability and profitability of employers.
Employees and their representatives •Ability to provide remuneration, retirement benefits and
employment opportunities.
Lenders •Whether loans and interest will be paid when due.
Suppliers and other trade payables •Whether amounts owing will be paid when due.
•Continuance – important for long-term involvement with, or
Customers
dependence on, the entity.
•Allocation of resources and, therefore, activities of entities.
Governments and their agencies •Information to regulate activities, determine taxation policies
and as the basis for national income and similar statistics.
•Contribution to the local economy, including the number of
employees and the patronage of local suppliers.
Public
•Trends and recent developments in prosperity and range of
 General Purpose Financial Reporting

Is the set of financial reports that are intended to be used by a wide range of
users, including investors, creditors, regulators, and management
 Objective and Usefulness of general purpose
financial reporting

• They provide financial information that is useful to existing and potential

primary users in making decisions relating to providing resources to the
entity.
• Primary users - investors, lenders and other creditors
• Primary users mostly rely on published financial information, as they cannot
obtain it directly
• Decisions depend on primary users’ expectations about returns which
depend on their assessment of:
– the amount, timing and uncertainty of future net cash inflows; and
– management’s stewardship of economic resources.
 Objective and Usefulness of general purpose
financial reporting…..

• Primary users need information about:

– the entity’s economic resources (assets), claims against its liabilities and
changes in those resources and claims; and
– how efficiently and effectively the entity’s management and governing
board have discharged their responsibilities to use the entity’s economic
resources
Objective and Usefulness of general purpose
financial reporting…..
 Limitations of general purpose financial
reports
• They cannot meet all the information needs of the primary users. Those
users must therefore consider other sources of information (e.g. economic
conditions, political events and industry outlooks).
• IFRS Accounting Standards are developed to meet the information
requirements of primary users. Although other users may find them useful,
such financial reports do not specifically aim to meet their needs.
• General purpose financial reports do not purport to show the value of the
reporting entity.
• General purpose financial reports are based largely on estimates, judgments
and models.
 Accrual Accounting
• It is the ddefault method of accounting
• Accrual accounting provides a better basis for assessing performance than
cash receipts and payments.
• Effects of transactions and other events are:
– recognised when they occur, not as cash is received or paid;
– recorded in the accounting records and reported in the financial
statements of the periods to which they relate.
• Financial statements prepared on the accrual basis:
– inform users of obligations to pay cash in the future and of resources
that represent cash to be received in the future.
• The accrual basis gives rise to the "matching" concept:
– expenses are recognised based on a direct association between costs
incurred and earning of income
 Going Concern
• It is the only one assumption that underlies the preparation of financial
statements.
• It assumes that an entity will continue in operation for the foreseeable future.
• This basis is presumed to apply unless users of financial statements are
told otherwise (i.e. in the notes to the financial statements).
Qualitative characteristics of useful financial
information
• These are attributes which make information provided within financial
statements useful to primary users.
• Fundamental qualitative characteristics
1. Relevance
2. Faithful representation
• Enhancing qualitative characteristics
1. Comparability
2. Verifiability
3. Timeliness
4. Understandability
 Fundamental Qualitative Characteristics
1. Relevance:
– information is relevant if it is capable of making a difference in the decision-
making needs of users.
• Financial information can make a difference if it helps users:
– to evaluate past, present or future events (i.e. has a predictive value); and/or
– to confirm or correct their past evaluations (i.e. has a confirmatory value).
• Relevance of information is affected by materiality:
– materiality is entity specific and based on nature (e.g. disclosure of earnings
per share) and/or magnitude;
– a uniform quantitative threshold for materiality cannot be specified because it
depends on an entity and particular circumstances.
• Materiality – information is material if its omission or misstatement could influence
the decisions that primary users make based on the financial information about the
specific reporting entity.
 Fundamental Qualitative
Characteristics…
2. Faithful Representation:
– Means the financial statements accurately reflect financial transactions
and conditions within the business.
• A faithful representation of information must be:
– Neutral (i.e. free from bias); this is supported by the exercise of
prudence;
– Complete (within bounds of materiality and cost) – an omission can
cause information to be false or misleading and therefore unreliable; and
– Free from error (i.e. no errors or omissions). This does not (it cannot)
mean perfectly accurate (e.g. due to the nature of accounting estimates).
• Prudence – the exercise of caution when making estimates under
conditions of uncertainty, such that assets and income are not
overstated and liabilities and expenses are not understated.
 Enhancing Characteristics
1. Comparability:
• Users need to be able to compare financial statements of:
– an entity through time (“internal” comparability) – to identify trends in
financial position and performance; and
– different entities (“external” comparability) – to evaluate relative financial
position, performance and changes in financial position.
• It requires consistent measurement, classification and presentation of
the financial effect of like transactions and other events.
• Implication of comparability:
– Users must be informed of the accounting policies employed, any
changes in those policies and the effects of such changes.
– Financial statements must show corresponding information for preceding
periods.
 Enhancing Characteristics…..
2. Verifiability:
• It means that knowledgeable, independent observers could reach a
consensus that a particular representation has the fundamental quality of
faithfulness.
• Verification may be:
– direct (e.g. through physical inspection); or
– indirect (e.g. using a model, formula or technique).
• Verifiability relates both to single point estimates and to ranges of outcomes
and related probabilities.
 Enhancing Characteristics…..
3.Timeliness:
• Information needs to be available in time for users to make decisions.
• Older information is generally less useful (but may still be useful in
identifying and assessing trends).
4. Understandability:
• Information should be made understandable through clear and concise
classification and presentation.
• Users are assumed to have a reasonable knowledge of business and
economic activities and accounting and a willingness to study information
with reasonable diligence.
• Information about complex matters should not be excluded because it may
be too difficult for certain users to understand.
 Cost Constraint of providing information
• The cost of providing information should not exceed the benefit obtained
from it:
– This cost, though initially borne by the reporting entity, is ultimately borne
by the users (e.g. through lower returns on their investment).
– Users also incur costs (e.g. in analysing and interpreting information).
• Benefits are most difficult to quantify and assess:
– the better the quality of information, the better decision-making should
be;
– confidence in the efficiency of capital markets lowers the cost of capital.
 Elements of financial statements
1. Assets - a present economic resource controlled by the entity
as a result of past events
• Economic resource – a right that has the potential to
produce economic benefit.
2. Liabilities -a present obligation to transfer an economic
resource as a result of past events.
3. Equity - is the residual interest in the entity’s assets after
deducting all its liabilities.
4. Income -increases in assets or decreases of liabilities that
result in increases in equity other than those relating to
contributions from holders of equity claims.
5. 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.
 Recognition and derecognition of elements of
financial statements
• Recognition – Process of capturing elements for inclusion in the financial
statements.
• Items are recognised if:
– They meet the definition of an element, and
• Recognition Criteria:
• An asset or liability is recognised only if recognising it (and any resulting
income, expenses or changes in equity) provides information that is useful
(i.e. relevant and faithful representation).
 Recognition and derecognition of elements of
financial statements….
• Recognition may not always provide relevant information. For example:
– if it is uncertain whether an asset or liability exists (“existence
uncertainty”); or
– it exists, but there is a low probability of a flow of economic benefits.
• Derecognition – is the removal of all (or part) of a recognised asset or
liability from the statement of financial position.
• It normally occurs when an item no longer meets the definition of an asset or
liability when the entity:
– loses control of an asset;
– no longer has a present obligation for a liability.
 Measurement bases of elements of financial
statements
• Measurement bases
1. Historical cost
• Is the cost of an asset when acquired or the value of the consideration received
when the liability was incurred
• It is based on the transaction price when an asset was acquired/created or a
liability was incurred.
• It does not generally reflect changes in values
2. Current value - reflect changes in values
• Current value measurements:
i. Fair value - The price in an orderly transaction between market participants
ii. Value in use (for asset) or fulfilment value (for liability)
– Value in use is the present value of cash flows expected to be derived from using an asset and
its ultimate disposal
– Fulfilment value is the present value of resources transferred to fulfil a liability. These are entity-
specific values.
iii. Current cost- The cost of an equivalent asset/consideration that would be received
for an equivalent liability, at the measurement date
 Advantages and disadvantages of historical cost
basis
Advantages Disadvantages
1. Easy to understand and follow, because it 1. Overstatement of profit due to non-
does not change consideration of inflation
2. Objective amounts are more difficult to 2. “mis-match” in reporting profit as current
manipulate, reducing the possibility of revenues are matched with out-of- date
historical costs (e.g. cost of goods sold and
“creative accounting”.
depreciation on outdated assets values).
3. Amounts are reliable as they can be verified 3. Distortion of return on assets/capital
from the documents such as invoices. employed due to overstated profit and out
4. Conservative measures prevent dated assets values
overvaluation 4. Holding gains are not separated from
operating gains. Holding gains are gains
5. Widely used throughout the world made merely by holding onto an asset
6. Consistency between statement of financial 5. Values of assets in the statement of
position and statement of cash flow figures. financial position do not equate to the
7. Cost is a measure that is readily understood economic benefits to be earned from their
use
 Advantages and disadvantages of current
value
Advantages Disadvantages
1. There is no one “current value
1. It provides information that is more relevant to users of
the financial statements, especially for companies with 2. Although some current values are easily
an older asset base. obtained, the calculation of "value-in-use"
can be very subjective and therefore less
2. In times of inflation, current values of assets and
reliable.
liabilities are likely to be much higher than their
recorded amount 3. The discount factor used to calculate the
present value of future cash flows
3. Assets and liabilities are measured after consideration
requires subjective judgements by
of expected benefits from their future use or cash
management
flows incurred in their fulfilment.
4. The majority of users may not
4. It is relevant to the needs of users in:
understand what the figures represent.
– Assessing the stability of the businesses entity
– Assessing the vulnerability of the businesses
– Evaluating management performance in
maintaining and increasing the business
substance
– Judging future prospects
 IFRS 13 Fair Value Measurement
• Fair value – is 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.
• 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 maximise the value of the asset or the group of
assets and liabilities within which the asset would be used.
• Principal market – the market with the greatest volume and level of activity
for the asset/liability.
• Most advantageous market – the market that maximises fair value, after
taking transaction and transport costs into account
Fair value measurement of a non-financial asset

• Example of non-financial asset

– an investment property
• Fair value measurement of a non-financial asset reflects its highest and
best use.
• Highest and best use takes into account:
– the use which is physically possible;
– what is legally allowed; and
– the financial feasibility of using the asset.
• Highest and best use does not reflect illegal activities but reflect what
is economically viable.
 Price
• IFRS 13 assumes that the transaction will occur in the principal market for
the asset (or liability), provided such a market exists.
• If there is no principal market, the valuation must be based on the most
advantageous market.
• Unless proved otherwise, the market place will be presumed to be the one in
which the entity transacts on a regular basis.
• The price is not adjusted for transaction costs.
• The price is adjusted for transport costs; if location is a characteristic of the
asset, price is adjusted for any costs that would be incurred to transport the
asset from its current location to the principal (or most advantageous)
market.
 Price….
Three valuation techniques used to estimate fair value:
• Market approach: uses prices and other information generated in a market
place which involves identical or comparable assets or liabilities.
• Cost approach: reflects the amount which would be required to replace the
service capacity of the asset (current replacement cost).
• Income approach: considers future cash flows and discounts those cash
flows to a current value. Models which follow an income approach include:
– present value; and
– option pricing models (e.g. Black-Scholes-Merton).
NB: Option pricing is not examinable
 Hierarchy of Inputs
• Valuation techniques require the use of inputs (e.g. an income approach
requires the use of estimated cash flows and interest rates).
• Inputs are categorised as level 1, 2 or 3.
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.
 Hierarchy of Inputs…
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 flows relating to a
cash-generating unit.
• NB:
• The techniques used to estimate fair values should maximise observable
inputs wherever possible.
• The hierarchy of inputs aims to increase consistency of usage and
comparability in the measurement of fair values and their related disclosures.
 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 measurements 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;
– 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.
 Q&A
SESSION

Thank you