CONCEPTUAL FRAMEWORK (PREPERATION DOCUMENT)

IASB HAS 2 PROJECTS:

1. CONCEPTUAL FRAMEWORK
2. IAS/IFRS (DEVELOPMENT/UPGRADATION)

Importance

A conceptual framework is a set of theoretical principles and concepts that underlie the preparation
and presentation of financial statements.

If no conceptual framework existed, then accounting standards would be produced on a haphazard

basis as particular issues and circumstances arose. These accounting standards might be inconsistent
with one another, or perhaps even contradictory.

A strong conceptual framework means that there are principles in place from which all future
accounting standards draw. It also acts as a reference point for the preparers of financial statements if
no accounting standard governs a particular transaction (although this will be extremely rare).

Background

The Framework for the Presentation and Preparation of Financial Statements was issued in 1989. In
2004 the Board and the US Financial Accounting Standards Board (FASB) started a joint project to revise
their respective frameworks. As a result of this project the Board issued the Conceptual Framework for
Financial Reporting in 2010. Most of the text from the 1989 Framework was simply rolled over but two
chapters were revised. These covered:

 The objective of financial reporting

 The qualitative characteristics of useful financial information.

The Board and the FASB subsequently suspended work on this joint project.

Several criticisms emerged of the 2010 Conceptual Framework

 It did not cover certain areas, such as derecognition, and presentation and disclosure
 Guidance in some areas was unclear, such as with regards to measurement uncertainty
 Some aspects were out of date, such as recognition criteria for assets and liabilities.

As a result of criticism, the Conceptual Framework was identified as a priority project so, in 2012, the
Board restarted this project without the FASB. A Discussion Paper outlining the Board’s thinking was
published in 2013 and an Exposure Draft of the proposed amendments was published in 2015. Feedback
from these documents informed the revised Conceptual Framework, which was published in 2018.

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Purpose

The purpose of the Conceptual Framework is to assist:

(a) the Board when developing new IFRS Standards, helping to ensure that these are based on
consistent concepts
(b) preparers of financial statements when no IFRS Standard applies to a particular transaction, or
when an IFRS Standard offers a choice of accounting policy
(c) all parties when understanding and interpreting IFRS Standards.

The Conceptual Framework is not an accounting standard. It does not override the requirements in
a particular IFRS Standard.

Chapter 1: The objective of financial reporting

 Objective of general purpose financial reporting
 What information is needed to achieve that objective and
 Who the primary users of financial reports are = INVESTOR & POTENTIAL INVESTOR

PURPOSE OF FR

The Conceptual Framework states that the purpose of financial reporting is to provide information to
current and potential investors, lenders and other creditors that will enable them to make decisions
about providing economic resources to an entity.

INFORMATION NEEDED

If investors, lenders and creditors are going to make these decisions then they require information that
will help them to assess:

 an entity’s potential future cash flows, and

 management’s stewardship of 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.

To assess an entity’s future cash flows, users need information about:

 economic resources of the entity e.g. assets

 economic claims against the entity e.g. liabilities and equity
 changes in economic resources and claims e.g. income and expenses.

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Chapter 2—Qualitative characteristics of useful financial
information
 What makes financial information useful

Fundamental characteristics

The Conceptual Framework states that financial information is only useful if it is:

 Relevant
 A faithful representation of an entity’s transactions.

Relevance and faithful representation are the fundamental characteristics of useful financial
information.

1. Relevant information will make an impact on the decisions made by users of the financial
statements. Relevance requires management to consider materiality.
An item is material if omitting, misstating or obscuring it would influence the economic
decisions of users.
2. A faithful representation of a transaction would represent its economic substance rather
than its legal form.

A perfectly faithful representation would be:

 complete
 neutral
 free from error.

The Board note that this is not fully achievable, but that these qualities should be maximised.

Neutrality is supported by the exercise of prudence.

When preparing financial reports, preparers should exercise prudence.

Prudence is the exercise of caution when making judgements under conditions of uncertainty. Prudence
means that assets and income are not overstated and liabilities and expenses are not understated and it
does not allow for overstatement or understatement of assets, liabilities, income or expenses.

However, this does not mean that assets and income should be purposefully understated, or liabilities
and expenses purposefully overstated, such intentional misstatements are not neutral.

Measurement uncertainty

Measurement uncertainty does not prevent information from being useful. However, in some cases the
most relevant information may have such a high level of measurement uncertainty that the most useful
information is information that is slightly less relevant but is subject to lower measurement
uncertainty.

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Enhancing characteristics

In addition to the two fundamental qualitative characteristics, there are four enhancing qualitative
characteristics of useful financial information:

 Comparability – investors should be able to compare an entity’s financial information year-on-

year, and one entity’s financial information with another.
 Timeliness – older information is less useful.
 Verifiability – knowledgeable users should be able to agree that a particular depiction of a
transaction offers a faithful representation.
 Understandability – information should be presented as clearly and concisely as possible.

Chapter 3—Financial statements and the reporting

entity
 Objective and scope of financial statements and
 Description of the reporting entity.

The reporting entity

A reporting entity is one that prepares financial statements (either through choice, or as a result of
legal requirements).

Financial statements are particular form of financial reports.

The purpose of financial statements is to provide information to users about an entity’s:

 Assets  Liabilities  Equity  Income  Expenses.

This information is provided in:

 a statement of financial position  statements of financial performance  other statements, such as

statements of cash flows and notes.

Financial statements are prepared on the assumption that the entity is a going concern. This means that
it will continue to operate for the foreseeable future. If this assumption is not accurate, then the financial
statements should be prepared on a different basis.

Consolidated financial statements

Provide information about assets, liabilities, equity, income and expenses of both the parent and its
subsidiaries as a single reporting entity

This information is important for investors in the parent because their economic returns are dependent
on distributions from the subsidiary to the parent.

Unconsolidated financial statements

Provide information about assets, liabilities, equity, income and expenses of the parent only

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Also provide useful information to investors in a parent company (for example, about the level of
distributable reserves) but they are not a substitute for information provided in consolidated financial
statements.

Combined financial statements

Financial statements produced for two or more entities that are not parent/subsidiaries are called
‘combined financial statements’.

Provide information about assets, liabilities, equity, income and expenses of two or more entities that
are not all linked by a parent-subsidiary relationship

Boundary of a reporting entity

Determining the appropriate boundary of a reporting entity can be difficult if, for example, the entity is
not a legal entity.

Note that the Conceptual Framework does not stipulate how or when to prepare combined financial
statements, although the Board may develop a standard on this issue in the future.

In such cases, the boundary is determined by considering the information needs of the users of the
entity’s financial statements. Those users need information that is relevant and that faithfully represents
what it purports to represent. A reporting entity does not comprise an arbitrary or incomplete collection
of assets, liabilities, equity, income and expenses.

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Chapter 4—The elements of financial statements

Defines the five elements of financial statements—an asset, a liability, equity, income and expenses

The elements are the building blocks of financial statements:

Statements of financial position report assets, liabilities and equity

Statements of financial performance report income and expenses.

STATEMENTS OF FINANCIAL POSITION

ASSET

Previous definition.

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.

Revised definition (Asset as Economic resource)

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:

 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 decisions and the
measurement of the asset

LIABILITY

Previous definition.

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.

Revised definition (Liability as Economic claim)

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

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Main changes:

 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 implications as set out above for an asset
 Introduction of the ‘no practical ability to avoid’ criterion to the definition of obligation.

EQUITY

The definition of equity as the residual interest in the assets of the entity after deducting all its liabilities
is unchanged.

The Board’s research project on Financial Instruments with Characteristics of Equity is exploring the
distinction between liabilities and equity.

STATEMENTS OF FINANCIAL PERFORMANCE

Changes in economic resources and claims as a result of financial performance

INCOME

Increases in assets or decreases in liabilities 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 distributions to
equity holders).

OTHER CHANGES

Contributions from, and distributions to, equity holders.

Exchanges of assets and liabilities that do not increase or decrease equity.

Although income and expenses are defined in terms of changes in assets and liabilities, information
about income and expenses is just as important as information about assets and liabilities.

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Chapter 5—Recognition and derecognition
 Criteria for including assets and liabilities in financial statements (recognition) and
 Guidance on when to remove them (derecognition).

RECOGNITION

The process of capturing for inclusion in the statement of financial position or the statement(s) of
financial performance an item that meets the definition of an asset, a liability, equity, income or
expenses.

Recognition is appropriate if it results in both relevant information about assets, liabilities, equity,
income and expenses and a faithful representation of those items, because the aim is to provide
information that is useful to investors, lenders and other creditors.

However, Items are recognised in the financial statements if they meet the definition of one of the
elements.

CRITERIA

Relevance =

Whether recognition of an item results in relevant information may be affected by, for example:

 low probability of a flow of economic benefits

 existence uncertainty = DOUBT ABOUT THE OCCURRENCE OF THE EVENT

Example

Recognition might not provide relevant information if there is uncertainty over the existence of the
element or if there is a low probability of an inflow or outflow of economic resources.

IAS 37 Provisions, Contingent Liabilities and Contingent Assets prohibits recognition of contingent
liabilities and assets because it is not probable that resources will flow from or to the reporting entity.

Faithful Representation = ECONOMIC REALITY (C+N+E)

Whether recognition of an item results in a faithful representation may be affected by, for example:

 measurement uncertainty
 recognition inconsistency (accounting mismatch)
 presentation and disclosure

Recognition of an element might not provide a faithful representation if there is a very high degree of
measurement uncertainty.

Judgement is required in deciding if recognition of an element is appropriate. This is why specific

recognition criteria vary from one IFRS Standard to another.

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Example

Bottle operates in the publishing industry. The Bottle brand is highly respected and, as a result, the
books published by Bottle receive extensive coverage both online and in national and international
press. The brand is internally generated and, in accordance with IAS 38 Intangible Assets, is not
recognised in Bottle’s financial statements.

Required:

Discuss the extent to which the accounting treatment of the Bottle brand is consistent with the
Conceptual Framework.

Answer

The brand is an economic resource controlled by Bottle. It has the potential to bring economic benefits
because of the exposure that Bottle-branded books receive.

Despite meeting the definition of an element, the brand is not recognised in the financial statements.

However, the Conceptual Framework states that elements should only be recognised if this provides
relevant information, or a faithful representation of the asset or liability.

If there is a high degree of measurement uncertainty (RELIABILITY) then recognition may not provide a
faithful representation.

The cost of an internally generated brand cannot be reliably measured. This is because the costs of
setting up and developing the brand cannot be separated from the operating costs of the business. The
fair value of a brand is also very difficult to determine because brands are unique.

Thus, it would seem that the accounting treatment of the brand, per IAS 38 Intangible Assets, is
consistent with the Conceptual Framework.

WHAT’S THE CHANGE

The previous recognition criteria were that an entity should recognise an item that met the definition of
an element if it was probable that economic benefits would flow to the entity and if the item had a cost
or value that could be determined reliably.

The revised recognition criteria refer explicitly to the qualitative characteristics of useful information.
The Board’s aim was to develop a more coherent set of concepts, not to increase or decrease the range
of assets and liabilities recognised.

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Another Important Point: Cost constraint

Cost constrains recognition decisions, just as it constrains other financial reporting decisions

Producing financial reports takes time and costs money. When developing IFRS Standards, the Board
assesses whether the benefits of reporting particular information outweigh the costs involved in
providing it.

Example

IFRS 16 Leases, which replaced IAS 17 Leases, radically changed lessee accounting by requiring all lessees
to recognise an asset and liability at the inception of a lease (unless the lease is short-term or of minimal
value). However, IFRS 16 did not change the accounting treatment of leases by lessors. This was because
most stakeholders did not believe that the requirements relating to lessors in IAS 17 were ‘broken’. The
perceived time and costs involved in implementing substantial changes to lessor accounting was
therefore believed to outweigh any benefits.

DERECOGNITION

The removal of all or part of a recognised asset or liability from an entity’s statement of financial
position.

CRITERIA

Derecognition normally occurs:

ASSET: When the entity loses control of all or part of the recognised asset.

LIABILITY: When the entity no longer has a present obligation for all or part of the recognised liability

Accounting for derecognition should faithfully represent the changes in an entity’s net assets, as well as
any assets or liabilities retained.

This is achieved by:

 Derecognising any transferred, expired or consumed component

 Recognising a gain or loss on the above, and
 Recognising any retained component.

Sometimes an entity might appear to have transferred an asset or liability. However, derecognition
would not be appropriate if exposure to variations in the element’s economic benefits is retained.

Example

An entity sells a building for $2 million and retains the right to buy it back for $3 million in five years’
time. At the date of sale, the building had a fair value of $7 million. Property prices are expected to rise.
The entity does not derecognise the building from its statement of financial position. The entity has not
lost control over the building because its ability to buy the building back for substantially less than fair
value enables it to benefit from future price rises. The cash received would be recognised as a loan
liability.

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Chapter 6—Measurement
 Describes various measurement bases and
 Discusses factors to be considered when selecting a measurement basis

MEASURMENT BASES

When recognised in the financial statements, elements must be quantified in monetary terms.

The Conceptual Framework outlines two broad measurement bases:

Historical cost

 Information derived from the price of the transaction or other event that gave rise to the item
being measured
 HC of assets is reduced if they become impaired and HC of liabilities is increased if they become
onerous
 One way to apply a historical cost measurement basis to financial assets and financial liabilities
is to measure them at amortised cost

Current value (this includes fair value, value-in-use, and current cost)

Provides information updated to reflect conditions at the measurement date

Measurement bases include:

Fair value (IFRS 13)

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

Reflects market participants’ current expectations about the amount, timing and uncertainty of future
cash flows.

Value in use (for assets)/ fulfilment value (for liabilities):

Reflects entity-specific current expectations about the amount, timing and uncertainty of future cash
flows.

Current Cost

Reflects the current amount that would be:

 paid to acquire an equivalent asset

 received to take on an equivalent liability

Changes

The previous version of the Conceptual Framework included little guidance on measurement.

The revised Conceptual Framework describes what information measurement bases provide and
explains the factors to consider when selecting a measurement basis.

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FACTORS TO CONSIDER IN SELECTING A MEASUREMENT BASIS

The factors to be considered when selecting a measurement basis are relevance and faithful
representation, because the aim is to provide information that is useful to investors, lenders and other
creditors

RELEVANCE

Relevance of information provided by a measurement basis is affected by:

Characteristics of the asset or liability

 the variability of cash flows

 sensitivity of the value to market factors or other risks
 for example, amortised cost cannot provide relevant information about a deriviative

Contribution to future cash flows

 Whether cash flows are produced directly or indirectly in combination with other economic
resources
 The nature of the entity’s business activities
 For example, if assets are used in combination to produce goods or services, historical cost can
provide relevant information about margins achieved in a period

This applies to the Board when developing or revising an IFRS Standard. It also applies to preparers of
financial statements when applying an IFRS Standard that permits a choice of measurement bases.

FAITHFUL REPRESENTATION

Whether a measurement basis can provide a faithful representation is affected by:

Measurement Inconsistency

 If financial statements contain measurement inconsistencies (accounting mismatch), those

financial statements may not faithfully represent some aspects of the entity’s financial position
and financial performance.

Measurement Uncertainty

 does not necessarily prevent the use of a measurement basis that provides relevant information
 but if too high might make it necessary to consider selecting a different measurement basis

Selecting a measurement basis –

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Example

Mist purchases an investment property in a prime location. Property prices are increasing in this area.
As such, the value of the property is susceptible to market factors, and could substantially differ from
the initial purchase price paid by Mist.

IAS 40 Investment Property offers a choice of accounting policy. Mist might choose:

The fair value model if they intend to sell the asset because this most faithfully represents the future
cash flows they will receive from its eventual disposal

The cost model if they have no intention of selling the property because this best matches the rental
income generated with the cost of the asset.

Note that Mist might have no intention of selling the asset but still conclude that the fair value model
provides the most relevant information about the building to financial statement users. This might be
because increases in property prices will enable Mist to charge higher rents to its tenants, thus
contributing to greater net cash inflows.

Chapter 7—Presentation and disclosure

 Guidance on including income and expenses in the statement of profit or loss and other
comprehensive income.
 Concepts on presentation and disclosure and

The statement of profit or loss:

 Primary source of information about an entity’s financial performance for the reporting period
 In principle, all income and expenses are classified and included in the statement of profit or loss
 The statement(s) of financial performance include(s) a total (subtotal) for profit or loss

Other comprehensive income

When developing or revising standards, the Board notes that it might require an income or expense to
be presented in other comprehensive income if it results from remeasuring an item to current value and
if this means that:

 Profit or loss provides more relevant information, or

 More faithful representation is provided of an entity’s performance.

Recycling

 In principle, income and expenses included in other comprehensive income in one period are
recycled to the statement of profit or loss in a future period when doing so results providing
more relevant information or a more faithful representation.
 When recycling does not result in the statement of profit or loss providing more relevant
information or a more faithful representation, the Board may decide income and expenses
included in other comprehensive income are not to be subsequently recycled.

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Example

Entity A owns land and buildings that are accounted for using the revaluation model in IAS 16 Property,
Plant and Equipment.At the reporting date, Entity A revalued these assets from $250 million to $300
million. IAS 16 stipulates that the $50 million gain must be recognised in other comprehensive income.

Property, plant and equipment is not held for trading, but is instead used over more than one period to
produce, supply, store and distribute goods. Including this $50 million gain in profit or loss would not
offer a faithful representation of Entity A’s financial performance during the period.

Presentation and disclosure

Effective presentation and disclosure

Effective presentation and disclosure is a balance between

 Allowing entities to flexibly report relevant information about their financial performance and
position, and
 Requiring information that enables comparisons to be drawn year on-year and with other
entities.

The Board believes that:

 Entity specific information is more useful than standardised descriptions

 Duplication makes financial information less understandable.

Classification

Classification of an asset or liability into separate components may provide relevant information if the
components have different characteristics.

Example

At the reporting date, Bottled owed $10 million to a bank. $1 million of this loan is due for repayment
within 12 months and is presented as a current liability. The remaining $9 million is presented as a non-
current liability.

Classifying the liability in this way provides additional information to users, which helps them to assess
Bottled’s future cash flows, as well as its solvency.

Offsetting

Offsetting classifies dissimilar items together and is therefore generally not appropriate.

Example

Ellipsis has $3 million in an account held with Animal Bank. This money earns 1% interest per year. The
balance is presented in Ellipsis’ statement of financial position as a current asset.

Ellipsis also has a $1 million overdraft in an account held with Sotoro Bank. This incurs an interest charge
of 10% a year. This overdraft is presented in Ellipsis’ statement of financial position as a current liability.

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Ellipsis must not offset its $3 million cash balance with its $1 million overdraft e.g. it cannot show a net
$2 million current asset. The cash balance and the overdraft have different characteristics and risks, and
offsetting would obscure these differences. Separate classification provides relevant information to the
users of the financial statements.

Aggregation

Aggregation refers to the adding together of items that have shared characteristics. Aggregation is
useful because it summarises information that would otherwise be too detailed. However, too much
aggregation obscures relevant information. Different levels of aggregation will be required throughout
the financial statements. For example, the statement of profit or loss may be heavily aggregated, but
accompanying disclosure notes will disaggregate the information.

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