Conceptual Framework for Financial Accounting
IASB Conceptual Framework
The IASB conceptual framework is not an accounting standard but a
framework that is intended to, among other things, assist in the:
preparation and presentation of financial statements,
development of future International Financial Reporting Standards
(IFRS)
reviewing existing ones and,
interpretation of the information contained in the financial
statements by the information users.
In essence, the framework covers very prominent issues relating to financial
reporting such as:
1. the objective of general purpose financial reporting,
2. qualitative characteristics of financial information,
3. elements of the financial statements, and
4. the concepts of capital and capital maintenance.
1. General Purpose Financial Reporting
The financial statements of an entity are primarily the statement of
comprehensive income, statement of financial position and cash flow
statement. According to the Framework, the objective of the general
purpose financial reporting [shortened as financial reporting] is to “provide
financial information about the reporting entity that is useful to existing
and potential investors, lenders and other creditors in making decisions
about providing resources to the entity.” It gives information to users who
have interests in the business to decide whether or not to invest in the
business. As you have already learned about the users of financial
statements in Introduction to Financial Accounting I, you are aware that
the needs of the users are diverse. However, the focus of financial
statements is to meet the needs of investors who are generally regarded as
the primary users.
2. Qualitative Characteristics of Useful Financial Statements
The conceptual framework highlights the qualitative characteristics that
give rise to decision useful information and these are broadly categorised
as fundamental and enhancing qualitative characteristics.
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a. Fundamental Qualitative Characteristics
According to the framework, financial information is considered useful if it
is relevant and faithfully represents what it purports to represent. The two
fundamental characteristics are relevance and faithful representation.
Financial information is relevant if it can make a difference in a decision-
making process in terms of predicting the future or providing feedback to
previous evaluation, or both. Faithful representation of a financial
information means that the information is complete, neutral and free from
error.
b. Enhancing Qualitative Characteristics
These qualitative characteristics are deemed to enhance the usefulness of
the fundamental qualitative characteristics. This means that in addition to
information being relevant and faithfully represents an economic event, it
must have the following qualities namely, comparability, verifiability,
timeliness and understandability.
Comparability, the information must be capable of being compared from
period to period within the same entity or in a single period across entities.
Comparability underpins the accounting convention of consistency.
Verifiability means that the information will permit different independent
and knowledgeable people to reach consensus to a large extent that a
particular estimate or value faithfully represents economic reality. Where
reported information about a phenomenon is complex, the usual practice
is to make a disclosure of the underlying assumptions, methods of
compiling the information as well as relevant factors in support of the
information.
Timeliness means that information should be made available early to the
users of the information for the purpose of decision-making. This is because
even though information is relevant and faithfully represents what it
purports to represent, it loses its value if not released on time.
Understandability, according to the framework, financial information
should be made understandable to users of the information in terms of
classification, characterisation and presentation in a clearly manner.
However, the framework expects the users to have some reasonable
knowledge of economic activities and business; in other words, the users
are not expected to be laymen in relation to financial accounting
information.
3. The Elements of Financial Statements
The elements of financial statements as defined by the conceptual
framework are assets, liabilities, income, expenses and equity.
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Assets: An asset is “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”. According to the conceptual framework, certain assets may have
physical form while other may not. For example, copyrights, patents,
trademarks, etc., are assets that could attract future economic benefits to
an entity but they do not have physical form. Assets that have physical form
include land and building, equipment, motor vehicles, cash and so on. What
is important is that the asset is owned and controlled by the entity and it
can attract future economic benefits.
Two factors that qualify an asset to be recognised in the statement of
financial position are:
first, it is probable that the asset will accrue future economic benefits;
second, the cost/value of the asset can be reliably measured.
Liabilities: A liability, according to the Framework, is “a present obligation
of the entity arising from past events, the settlement of which is expected
to result in an outflow form the entity of resources embodying economic
benefits”. This means that a liability will create the obligation for the entity
to give up resources that can produce economic benefits and such
payments could be in the form of cash, transfer of other assets, or the
replacement of one obligation with another obligation.
Like an asset, a liability is recognised in the statement of financial position
if two factors are satisfied, that is,
if it is probable the liability will result in the outflow of resources that
have the capacity to yield future economic benefits and
the liability payable can be reliably measured.
Examples of liabilities are accounts payable, debentures, loans, non-trade
payables, etc
.
Income: It is defined by the Framework as increases in economic benefits
during the accounting period in the form of inflows or enhancements of
assets, or decreases of liabilities, that result in increases in equity, other
than those relating to contributions from equity participants.
The Framework divides income into revenues and gains.
Revenues are regarded as income that arises from an entity’s ordinary
business activities which could be in the form of sales, fees, royalties and
rent, dividend and interest.
Gains are income but do not arise from the course of the ordinary activities
of an entity. For example, the gains that comes from the disposal of non-
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current assets, revaluation surplus of noncurrent assets or financial
instruments.
Expenses: They are defined as decreases in economic benefits during the
accounting period in the form of outflows or depletions of assets, or
incurrences of liabilities, that result in decreases in equity, other than those
relating to distributions to equity participants.
Equity: According the Framework, equity is “the residual interest in the
assets of an entity after deducting all of its liabilities. Equity can be
classified differently in the statement of financial position depending on the
nature of the entity. For a sole proprietorship form of business, the equity
will include such things as capital and profit for the period less drawings.
For a company, equity may include such things as share capital, retained
earnings and other forms of capital and revenue reserves.
Accounting Policies IASB’s definition of accounting policies is contained
in International Accounting Standard (IAS) 8. The standard defines
accounting policies as “the specific principles, bases, conventions, rules
and practices applied by an entity in preparing financial statements.” An
entity’s management reserves the judgement on the choice of accounting
policies to adopt in an entity. Accounting policies are to be consistently
applied from period to period for similar transactions.
The IAS 8 provides that an accounting policy can be changed only if the
change:
(i) Is required by an International Financial Reporting Standard; or
(ii) Results in financial statements providing reliable and more
relevant information about the effects of transactions, other events
or conditions on the entity’s financial position, financial
performance or cash flows.
But where an entity changes its accounting policies for a justifiable
reason, it needs to state the effects of those changes on the financial
statements of earlier periods except where this is impracticable.
Examples of an entity’s accounting policies include: methods of
depreciation of non-current assets, methods of valuing inventories;
valuation of investment property or securities.
Accounting Estimates According to Section 32 of IAS 8, “accounting
estimates arise from inherent uncertainties in business activities which
mean that many items in financial statements cannot be measured with
precision but can only be estimated. Estimates are formed using
judgements based on the latest available, reliable information.”
Examples of accounting estimates are:
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Allowances for bad debts;
Allowances for inventory obsolescence;
Fair value of financial assets or financial liabilities;
The useful lives of, or the expected pattern of consumption of future
economic benefits embodied in, depreciable assets; and
Warranty obligations.
IAS 8 also defines changes in accounting estimates as: “An adjustment
of the carrying amount of an asset or a liability, or the amount of the
periodic consumption of an asset, that results from the assessment of
the present status of, and expected future benefits and obligation
associated with, assets and liabilities. Changes in accounting estimates
results from new information or new developments and, accordingly, are
not correction of errors.” Where a change in accounting estimates
occurs, the change is adjusted in the profit or loss account of the year
and, unlike changes in accounting policy, no retrospective adjustment
would be required. For example, if allowance for bad debts increases on
the basis of new and more reliable information available to management,
the difference arising from change in estimate is recognised in the profit
or loss of the year. If inventory is written off on the basis of estimated
obsolescence, this is also written off to income statement as an
accounting estimate. But if the value of inventory estimates changes as
a result of a change in the inventory valuation method, the resulting
estimates would pass for a change in accounting policy rather than a
change in accounting estimate.
