Chapter 2-Conceptual Framework For Financial Reporting

CHAPTER 2
CONCEPTUAL FRAMEWORK FOR FINANCIAL

REPORTING
Department of Accounting
Faculty of Management Studies and Commerce
University of Sri Jayewardenepura
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ACC1370: Financial Accounting and Reporting Department of Accounting
Learning Outcomes
At the end of this chapter, you should be able to:
1. Explain what a conceptual framework is;
2. Explain what the conceptual framework for financial reporting is;
3. Explain the purpose of the conceptual framework for financial reporting;
4. Describe the evolution of the conceptual framework for financial reporting;
5. Outline the structure and components of the conceptual framework for financial
reporting;
6. Explain the components of the conceptual framework for financial reporting;
7. Explain the benefits and limitations of the conceptual framework for financial reporting;
and
8. Discuss other guidelines and directives on financial reporting.
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Glossary
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Glossary (Contd.)
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What is a Conceptual Framework?
• A conceptual framework is usually considered as a set of guiding
principles that influence and direct decisions in a particular area.
• Such frameworks are used in many areas to establish specific

guidelines to make decisions or solve problems.
Examples:
Conceptual Framework for Modern Economics
Conceptual Framework for Public Health
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Common Questions on Conceptual Framework (CF)
for Financial Reporting (FR)
What is a CF for FR?
What is the purpose of a CF for FR?
How did CF for FR evolve?
What are the elements of a CF for FR?

What are the benefits / limitations of a CF for
FR?
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What is the CF for FR?
“A coherent system of inter-related objectives and
fundamentals that can lead to consistent standards and that
prescribes the nature, function, limits of financial accounting
and financial statements”.
(FASB, 1989)
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Relationship Between CF for FR and Accounting Standards
Financial
Accounting
Conceptua
l General purpose
Framewor Accounting
Standards Financial
k Statements
(CF)
Provides the conceptual foundation to address Both External

new issues in the absence of accounting standards and Internal
Stakeholders
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What is the Purpose of a CF for FR?
The purpose of the CF for FR is to:
a) assist the standard setters to develop accounting standards that are
based on consistent concepts;
b) assist preparers 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; and
c) assist all parties to understand and interpret the standards.
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What is the Purpose of a CF for FR? (Contd.)
• Without agreement on the below issues, accounting standards will be
developed in an ad hoc manner.
– what is financial reporting and what should be its scope?
– What is a reporting entity?
– what is the objective of financial reporting?
– what qualitative characteristics that financial information should possess?
– what are the elements of financial reporting?
– what recognition and measurement rule should be employed?
• CF for FR assists to maintain consistency among accounting standards.
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Evolution of CF
Year Description
1978 Financial Accounting Standards Board (FASB) CF Framework
1978 to 2002 Release of 7 Statements of Financial Accounting Concepts (SFACs) by FASB
1989 International Accounting Standards Board (IASB) CF
2005 to 2010 FASB and IASB Convergence Project-jointly worked towards a CF
2010 IASB CF Revised Framework in 2010 (Objectives and Qualitative
Characteristics)
2013 Discussion Paper on other components of CF
2015 Exposure Draft on CF
2018 May Revised CF (Revisions in all components)
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Evolution of IASB CF
Conceptual Framework for

Financial Reporting 2018
Conceptual Framework for Financial
Reporting 2010
Framework for the Preparation

and Presentation of Financial Effective for annual
Statements 1989 reporting periods
beginning on or after
1 January 2020
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The Structure and Components of the CF for FR
1st Level – The purpose of financial

reporting
2nd Level – The bridge

between levels 1 and 3
3rd Level – The

implementation of
objective of financial
reporting
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Objectives of General Purpose Financial Reporting
The objective of general purpose • Decisions involve in the provision of
financial reporting is: resources:
– buying, selling, or holding equity and
“to provide financial information debt instruments;
about the reporting entity that is – providing or settling loans and other
useful to existing and potential forms of credit; or
investors, lenders, and other – exercising rights to vote on, or
creditors in making decisions about otherwise influence, management’s
providing resources to the entity”. actions that affect the use of the
entity’s economic resources.
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General Purpose Financial Statements
Statement of
Financial Position
Economic
resources and
claims Statement of Profit or
Loss and Other
Financial (Financial
Comprehensive Income
information Position)
about reporting
entity to users in Due to
making decisions Changes in financial
about providing economic performance
resources to the resources and Cash Flow
entity claims From other Statement
(Changes in events or
Financial transactions
Position)
Statement of
Changes in Equity 15
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Activity 2.1
State whether the following statements about the CF are true or false.
a) The objective of financial reporting provides the foundation to develop
other components of the framework logically.
b) General purpose financial reports are most useful to company insiders
when making business strategic decisions.
c) Capital providers are the only users that benefit from general purpose
financial reporting.
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Financial Statements and the Reporting Entity
• A reporting entity is defined as:
– A reporting entity is an entity that chooses or is required, to prepare general
purpose financial statements.
– A reporting entity is not necessarily a legal entity. It can comprise a portion of an
entity or two or more entities.
– Financial statements provide information about the assets, liabilities, equity, income
and expenses generated by the set of economic activities that lie within the
boundary of the reporting entity.
• Underlying Assumption – Going Concern

The financial statements are prepared with the assumption that the entity will continue
its operations for a foreseeable future.
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Qualitative Characteristics of Useful Financial
Information
Fundamental
• Relevance
• Faithful Representation
Enhancing
• Comparability
• Verifiability
• Timeliness
• Understandability
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Fundamental Qualitative Characteristics
1. Relevance (page 7)
The information is considered ‘relevant’ if it is capable of making a difference in the decisions made
by users of information.
1.1. Predictive Value
Financial information has ‘predictive value’ if it can be used as an input to the processes employed by users to predict future outcomes.
Example - The investors interested in purchasing company shares may analyze its assets, liabilities, and current performance to predict the
amount, timing and uncertainty of its future cash flows.
1.2. Confirmatory Value

Financial information has ‘confirmatory value’ if it provides feedback about (confirms or changes) previous evaluations.
Example - When the financial statements of a company are used at the year-end, it confirms or changes the past expectations based on
previous evaluations.
1.3. Materiality (entity-specific)

Information is material if its omission or misstatement could influence the economic decisions of users taken based on the financial
statements.
Example - A company encounters an accounting error that will require a retrospective application, but the amount is so small that altering
prior financial statements will have no impact on the users of those statements. 19
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Fundamental Qualitative Characteristics (Contd.)
2. Faithful Representation (page 8)

It suggests that the information presented in the financial statements must be represent
information faithfully to reflect the economic reality of transactions and events.
2.1. Completeness
It means that all the information that is necessary for faithful representation is provided.
Example - If a company fails to provide information as to how it has valued the inventory, the information is not complete.
2.2. Neutrality
It means that a company cannot select information to favour one set of interested parties over other.
Example - A company shouldn’t avoid disclosing information on lawsuits filed against it though such disclosure is damaging.
2.3. Free from Errors

Information that is free from error provides a more accurate representation of transactions and events that had occurred.
Example - If a company misstates its estimates on depreciation, the information is not free from error.
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Enhancing Qualitative Characteristics
1. Comparability (page 8)
It means information can be compared with similar information about other entities and
with similar information about the same entity for another period.
Example - The financial results of a motor vehicle trading company should be comparable
with another entity in the same industry. Similar, the year-to-year information of this
company should be comparable.
2. Verifiability (page 8)
It occurs when independent measures, using the same methods obtain similar results.
Example - The auditors of a company can compute the inventory value presented in the
financial statements based on the FIFO method.
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Enhancing Qualitative Characteristics (Contd.)
3. Timeliness (page 8)
It means the availability of information to users before it loses its capacity to influence
decisions.
Example - If the first quarter financial results of a company are presented after six months
from the quarter-end, their usefulness in decision-making is questionable.
4. Understandability (page 9)
It means classifying, characterizing and presenting information clearly and concisely make
the information presented in financial statements understandable.
Example - Investors of a company fail to understand why it has declared a low dividend
despite recording a significant amount of earnings and decide to sell their investments.
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Activity 2.2
Discuss how qualitative characteristics of financial information are applicable in the
following situations.
a) Assets are revalued at their fair values and recognized in the financial statements.
b) Assets purchased under a lease are recognized in the lessee’s financial statements.
c) The valuation basis of year-end inventory is changed to the weighted average from
FIFO, which has been used in prior periods.
d) Assessment of the carrying amount of year-end inventory presented in financial
statements based on its cost.
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Elements of Financial Statements
Element Definition
Assets A present economic resource controlled by the entity as
a result of past events.
Liabilities 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.
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What is an Economic Resource?
Right may arise in
Rights that Rights that do
A right that different forms:
correspond to an not correspond
has the • established by a
obligation of to an obligation
contract, legislation, or
another party potential to of another party similar means
produce • arise
Right over a from a
Rights to receive
cash
economic physical object constructive obligation
Right to receive benefits. Rights to use of another party
goods or services intellectual
property • arise from legal
Rights to exchange
economic resources ownership of a physical
with another party object
on favorable terms
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Elements of Financial Statements
Element Definition
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.
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Activity 2.3
Identify the element or elements associated with the following items.
Transaction Element
a) Obligation to transfer resources arising due to obtaining a bank loan
b) Increase in ownership interest by issuance of shares
c) Declaration and payment of dividend to owners
d) Interest paid on a bank loan
e) Item with a service potential or future economic benefits
f) Interest received on a bank deposit
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Recognition
It is the process of incorporating in the Statement of Financial Position or in the Statement
of Profit or Loss and Other Comprehensive Income, an item that meets the definition of an
element of the financial statements and satisfies the criteria for recognition. Below are the
recognition criteria.
i. Meets the definitions of elements.

ii. Provides relevant information about the asset or the liability and about any income,
expenses, or changes in equity.
iii. Provides faithful representation of the asset or the liability and of any income,
expenses, or changes in equity.
• In recognition, the cost of providing information in the financial statements must not
outweigh the benefit of that information to the users. 28
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Measurement
• It is the process of determining the monetary amounts at which the
elements of the financial statements are to be recognized and carried in
the financial statements.
• It involves the selection of the particular basis of measurement.
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Measurement (Contd.)
Measurement
Bases
Historical Cost Current Value
Value in Use
Fair Value and Fulfilment Current Cost
Value
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Measurement (Contd.)
Measurement Base Meaning
1. Historical Cost • Assets are recognized at 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.
• Liabilities are recorded at the value of the consideration received to incur or take on the liability
minus transaction costs.
2. Current Value • Provides monetary information about assets, liabilities and related income and expenses using
information updated to reflect conditions at the measurement date.
2.1. Fair Value • 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.
2.2. Value in Use • Value in use is the present value of the cash flows or other economic benefits, that an entity
and Fulfilment expects to derive from the use of an asset and from its ultimate disposal.
Value • Fulfilment 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.
2.3. Current Cost • The current cost of an asset is the cost of an equivalent asset at the measurement date, comprising
the consideration that would be paid at the measurement date plus the transaction costs that
would be incurred at that date.
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Concept of Capital
How an entity
defines the capital
that it expects to Invested capital
maintain.
Financial capital (Net
Assets/Equity)
Invested purchasing
power
Capital
Physical capital Productive capacity

of an entity
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Capital Maintenance
Capital of an entity is
maintained if it has as much Financial capital
of the capital at the end of maintenance
the period as it had at the (financial amount of NA)
beginning of the period.
Capital Maintenance
Physical capital
maintenance
Profit = NA at the end of the
year > NA at the beginning (Productive capacity/
year after excluding the operating capability of net
contributions from and assets)
distributions to owners
during the period
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Benefits of CF for FR
• Development of consistent and logical accounting standards from an
orderly set of concepts.
• Increased international compatibility of accounting standards.
• Enhanced communication between standard-setters and their
constituents.
• Development of accounting standards is more economical.
• Emphasis on the ‘decision usefulness’ role of financial reports.
• Reduction of the need for additional standards when CF cover a
particular issue.
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Limitations of CF for FR
• Smaller organisations may feel overburdened by reporting requirements.
• Typically economic in focus, ignore transactions that have not involved
market transactions or exchange of property rights.
• Represent a codification of existing practice.
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Other Guidelines and Directives on Financial
Reporting
Other than the conceptual framework for financial reporting and accounting
standards, there are other guidelines and directives on financial reporting issued
by the International Accounting Standards Board (IASB).
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Reporting |IFRIC Interpretations
• The IFRS Interpretations Committee is the interpretative body of the IASB.
• The Interpretations Committee responds to questions about the application of
the Accounting Standards and does other work at the request of the IASB.
• IFRIC Interpretations are developed by the IFRS Interpretations Committee and
are issued after approval by the IASB.
Examples
IFRIC 22 - Foreign Currency Transactions and Advance Consideration
IFRIC 23 - Uncertainty over Income Tax Treatments
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Reporting |IFRS Practice Statement 1: Management Commentary
• It provides a broad, non-binding framework for the presentation of
management commentary that relates to financial statements that have
been prepared in accordance with IFRS Standards.
• Management commentary must provide users of financial statements with
integrated information providing a context for the related financial
statements.
• It also provides management with an opportunity to explain its objectives
and its strategies for achieving those objectives.
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Reporting |IFRS Practice Statement 2: Making Materiality Judgements
• It provides companies with guidance on how to make materiality
judgements when preparing their general purpose financial statements
in accordance with IFRS standards.
• The need for materiality judgements is pervasive in the preparation of
financial statements.
• IFRS standards require companies to make materiality judgements in
decisions about recognition, measurement, presentation and disclosure.
• It is a non-mandatory document.
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Summary
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THANK
YOU!

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CHAPTER 2

CONCEPTUAL FRAMEWORK FOR FINANCIAL

• Such frameworks are used in many areas to establish specific

What is a CF for FR?

What is the purpose of a CF for FR?

How did CF for FR evolve?

What are the elements of a CF for FR?

Provides the conceptual foundation to address Both External

b) assist preparers to develop consistent accounting policies when no

c) assist all parties to understand and interpret the standards.

Conceptual Framework for

Framework for the Preparation

1st Level – The purpose of financial

2nd Level – The bridge

3rd Level – The

• Underlying Assumption – Going Concern

ACC1370: Financial Accounting and Reporting Department of Accounting

1.2. Confirmatory Value

1.3. Materiality (entity-specific)

2. Faithful Representation (page 8)

2.3. Free from Errors

Liabilities A present obligation of the entity to transfer an

Equity The residual interest in the assets of the entity after

Expenses Decreases in assets or increases in liabilities that result in

i. Meets the definitions of elements.

• It involves the selection of the particular basis of measurement.

Historical Cost Current Value

Physical capital Productive capacity

ACC1370: Financial Accounting and Reporting Department of Accounting

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