Study Unit 2

CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING

Accounting an Introduction – JE Myburgh – Chapter 2

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LEARNING OUTCOMES

YOU ARE REQUIRED TO UNDERSTAND AND DISCUSS THE

FOLLOWING PRINCIPLES:
• SPECIFIC PURPOSE OF FINANCIAL STATEMENTS
• UNDERLYING ASSUMPTIONS
• FUNDAMENTAL QUALITATIVE CHARACTERISTICS
• ENHANCING QUALITATIVE CHARACTERISTICS
• DEFINITION OF THE ELEMENTS OF FINANCIAL STATEMENTS
• RECOGNITION AND DE-RECOGNITION CRITERIA
• MEASUREMENT BASES AVAILABLE FOR THE ELEMENTS OF FINANCIAL STATEMENTS
• CONCEPTS OF CAPITAL AND CAPITAL MAINTENANCE
Homework

Refer to the work program

Homework questions are uploaded on moodle in the learning materials folder under each study unit.
These questions will be covered during the tutorial class. You can attempt other questions on moodle.
The Conceptual Framework:
• Is aimed at the preparation of general purpose financial reports
• Has a specific objective in rendering support to standard setters,
auditors, preparers and users of financial statements.
Conceptual framework

• Objective • Financial
1 3 statements

• Qualitative

2
Characteristics
4 • Elements
Conceptual framework

• Recognition • Presentation
and and

5 derecognition 7 disclosure

• Capital

6
• Measurement
8
Conceptual framework

Objective
General purpose financial statements that are useful

Existing/potential shareholders, lenders, other creditors

Financial position, performance, cash flows

Accrual accounting Depicts transaction when occurs,

not when cash flows.
Conceptual framework

Qualitative characteristics
Fundamental characteristics

Enhancing characteristics
Fundamental qualitative characteristics:

o Relevance
 Information that has the capability make a difference in the
decisions made by users
 Assist users of financial statements to make decisions
 Predictive value or confirmatory value
 Materiality (Nature=Qualitative & Amount=Quantitative)

o Faithful representation (substance over legal form)

 Completeness
 Neutrality: free from bias
 Free from error
CLASS EXAMPLE 1
CLASS EXAMPLE 1 - Solution

According to the Conceptual Framework financial information should be relevant and a faithful
representation of the phenomenon or the situation.
1)Relevance
o Information is relevant when it can make a difference in the decisions made by users.
 Unfair dismissal and the possible claim against the company can influence the decisions of users.
o It is material due to the nature thereof
 as it may cause reputational damage .

2)Faithful representation (CNF)

o The situation has to be completely described and disclosed, and has to be neutral and free from error.
 Not including the information about the legal claim will result in incomplete disclosure
o To be neutral means that information should be disclosed without bias and that all information should be
disclosed and not just some information.
 Excluding information merely because it will upset the users results in not neutral/biased info
o Free from error means that there should be no omissions.
 Omitting the info on claims against the business leads to financials are not free from error

Conclusion:
o The info about the claim is relevant, and as such the directors should therefore disclose the claim and
Enhancing qualitative characteristics of uselfulness (VCUT):
Comparability: Verifiability:
Users decision choosing between alternatives: • Verifiable by auditors
• Invest in CO.A or CO.B • Assures the users that the information reflect a
• Hold or Sell current investment faithful representation
• Different knowledgeable and independent can
Users Compare reach a consensus that the information is faithfully
• Current year and the prior year represented
• Co. A and CO.B (Uniformity/IFRS)
The entity has to apply IFRS consistently (the same) Direct or Indirect

Timeliness: Understandability:
• For information to be useful it must be timely • If information is classified, characterized &
• The longer it takes the less useful the information presented clearly and concisely it will be
becomes. understandable.
• If users do not understand, then the information
serves no purpose.
• Average person with a reasonable knowledge of
Accounting and Business.
• Info should not be excluded because management
thinks it will not be understood.
CLASS EXAMPLE 2
COMPLETENESS VS TIMELINESS

COMPARABILITY VS RELEVANCE
Conceptual framework
Financial statements
SFP, SPLOCI, Notes, SCF, SCE

A & L AT a date, I & E for a period comparative year

Going concern

Consolidated fin statements

 This the only financial
statement with “AS AT”
COMPONENTS OF FINANCIAL
STATEMENTS
1. Statement of financial position
(balance sheet)
• Portrays the economic resources
of an entity as at a point in time
• The claims against the resources,
as at a point in time
• The impact of transactions and
events on the resources, and
• The liquidity and solvency of the
entity.
• Information is useful in predicting
future cash flows and the ability of
the entity to raise finance and
meet commitments.
Statement of profit or loss and 8.
COMPARATIVES
other comprehensive income 4. DATE OF LAST DAY
OF PERIOD COVERED
(Income statement): 1. NAME OF
COMPANY
2. NAME OF FS
o Provides information on
3. PERIOD COVERED
the financial
performance during a
5. YEAR
specified period
o Historic information is 6. CURRENCY

7. ROUNDING (IF
used to predict future APPLICABLE)

performance and the

ability to generate cash
flow
Statement of cash flow :
o Provides information on the changes in financial position in order to
assess the entity’s investing, financing and operating activities, during
a period and
o The way the entity acquires and distributes cash and cash equivalents
Statement of changes in equity:
o Information on the changes in the structure of the entity’s equity during a period,
o Capital transactions,
o Dividends paid and
o Other distributions made to the owners
Notes and supplementary schedules:
oNecessary for a better understanding of the financial
statements
oAccounting policies applied
oRisks and uncertainties affecting the entity
oResources and obligations not recognised in the
financial statements
The underlying assumptions in the
preparation of financial statements is
the:
oGoing concern principle, and the
oAccrual basis
 GOING CONCERN
 The assumption that the entity will continue to operate in the
foreseeable future
 Should this assumption not be valid, elements of the financial
statements should be measured at liquidation values and
 Provision for liquidation costs should be made
CLASS EXAMPLE 3

1) Assess whether the entity is a going concern?

2) At what value should the factory be disclosed at?
CLASS EXAMPLE 3 - SOLUTION
 ACCRUAL CONCEPT
 All transactions are recorded when they occur and not when cash is
received or paid.
 The expected future movement of cash is therefore shown in the
financial statements.

CLASS EXAMPLE 4

1) USING THE ACCRUAL BASIS OF ACCOUNTING WHEN SHOULD WE RECORD THE ADVERT?
2) IN WHICH PERIOD DO WE INCLUDE THE ADVERT IN STATEMENT OF CASHFLOWS?
CLASS EXAMPLE 4 - SOLUTION
Conceptual framework

Elements

Assets, liabilities, equity

Income and expenses

Definitions of the elements of financial statements
ASSETS
 Definition:
o Is a Present economic resource
o Controlled by the entity
o As a result of past events.

• Economic resource:
o An economic resource is a right that has the potential to produce economic benefits
 A Right is:
o Rights to receive cash
o Rights to receive goods or services
o Rights to benefit from an obligation of another party to transfer economic resources if an uncertain
specified future event occurs
o Rights over physical objects, such as property, plant, equipment, inventory, etc
o Rights to use intellectual property

• What is “potential to produce economic benefits”

o Does NOT mean it is certain, or likely, that the right will produce economic benefits
o The right must just exist and in one circumstance produce the entity economic benefits beyond those
available to any other party.
 Conceptual framework

• Some goods or services are received and

immediately consumed. EXPENSED

• Right to obtain economic benefits exists only

momentarily until consumed!

RIGHT
Conceptual framework
• Does not need to be certain or likely
• Right must already exist AND in at
least one circumstance it will give
economic benefits beyond those
available to all other parties.
• Even if probability is low

POTENTIAL TO PRODUCE ECONOMIC BENEFITS

 • What does “CONTROL” mean?
o Control links an economic resource to an entity
o The entity has the ability to direct the use of the economic resource and obtain economic
benefits that flow from it
o The entity has the ability to enforce legal rights over the resource
o The entity will either directly or indirectly receive the economic benefits arising from the use
of the resource (risk and rewards)

Substance over form

Substance of contracts

To represent contractual rights and obligations faithfully, financial statements must

report their substance. In some cases, the substance of such rights and obligations is
clear from a contract’s legal form. But, in other cases, the terms of the contract, or of a
group or series of contracts, may require analysis to identify the substance of the rights
and obligations
 Application of the definition of asset
Theory Application
Asset:
i. Present economic resource
economic resource: Right What right do we have from the question/scenario?
That has a potential to produce Based on the question/scenario, How can the asset produce economic benefit
economic benefits only that one instance?
(Not need for certainty/ one instance is
enough)
i. Controlled by the entity
1.Risk and rewards (legally enforceable) <Link to below>
2.Ability to direct the use and How do they have the ability to direct based on question/scenario?
3. obtain economic benefits from the asset (either How can they obtain economic benefits based on question/scenario?
directly or indirectly)
Controls links an economic resource to the entity.
If one party controls an economic resource, no
other party controls that resource.
i. As a result of a past event What happened in the past based on the question/scenario to create the
asset? i.e. What led to the transfer of risk and rewards?

Conclusion Conclude on whether the asset (specify name based on question/scenario)

meets the definition or not. If it meets the definition, refer to the
consideration of the recognition criteria (only if required by question). The
question will tell students if they don’t have to consider the recognition
criteria, otherwise they should consider it.
 LIABILITIES
 Definition:
• Is a present obligation of the entity
• To transfer an economic resource
• As a result of past events
Always to another party
• What is meant by “obligation” Legal and constructive (don’t need to identify)
• Is a duty or responsibility that the entity has no practical ability to avoid
• Many obligations are being established by contract or legislation and is legally enforceable by the
parties to whom they are owed
• In order to transfer the obligation, there must only be a probability that the economic resource will
be transferred

• Obligations to transfer an economic resource may include:

o Obligations to pay cash
o Obligations to provide goods or services
o Obligations to transfer an economic resource if a specified uncertain future event occurs
o if a duty or responsibility arises from the entity’s customary practices, published policies or
specific statements—the entity has an obligation if it has no practical ability to act in a manner
inconsistent with those practices, policies or statements.
Conceptual framework
Entity ALREADY obtained
economic benefit or taken
action
AND
As consequence entity
will/may have to transfer
economic resources that it
would not otherwise have
had to transfer.

Present obligation past event

 EQUITY
 Definition:
oThe residual interest in the assets of an entity after
deducting all its liabilities; i.e.
oE = A - L
 Equity is thus dependant on the amount of assets and
liabilities and not on the market value of the entity’s shares
 Subdivided in:
oContributions by owners (share capital)
oRetained earnings and reserves
 INCOME

 Definition:
• Increases in assets, or decreases in liabilities
• That result in increases in equity,
• Other than those relating to contributions from holders of equity
claims.

• Divided into:
• revenue (arising from normal business activities) and
• gains (meet the requirements of the definition of income and may, or
may not, arise in the course of ordinary activities of an entity.
EXPENSES
 Definition:
• Decreases in assets, or increases in liabilities;
• That result in decreases in equity,
• Other than those relating to distributions to holders of equity claims.

 Include losses, as well as those expenses arising in the course of

the ordinary activities of the entity.

THUS: Income and expenses represent

 Changes in economic resources and claims,
 Reflecting financial performance.
Conceptual framework
Recognition and derecognition

Can only recognise if provides users with useful

information

Relevant

Faithful representation
Recognition criteria
The process of capturing for inclusion in the statement of financial
Recognition position or the statement of profit or loss and other
comprehensive income (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, creditors and other
users of the financial statements.
 Recognition links the elements, the statement of financial position and statement of
financial performance as follows:
o In the statement of financial position total assets less total liabilities equal equity
o Recognised changes in equity comprise of:
 Income less expenses in the statement of financial performance, and
 Contributions from holders of equity claims less distributions to holders of
equity claims
o The recognition of income occurs at the same time as:
 the original recognition of an asset, or
 the de-recognition of a liability.
o The recognition of expenses occurs at the same time as:
 the initial recognition of a liability, or
 the de-recognition of an asset.
o Relevance
 Information on assets, liabilities , income and expenditure items
must ALWAYS be relevant to the user of the financial information Uncertainty:
 It is doubtful if • Existence
It is uncertain whether the asset or liability exists; or • Flow of
resources
The assets or liability exists , but the probability of future
economic inflows or outflows are low
 Even if uncertainty and probability of economic inflow are low, full
disclosure should be given in the notes to the financial statements.

o Faithful representation
 Faithful representation might be affected by the level of
measurement uncertainty Uncertainty:
However, reasonable estimates, which are clearly and accurately • Measurement

described, are an essential part of the preparation of financial

information
 The removal of all or part of a recognised asset or
Derecognition liability from an entity’s statement of financial
position
Derecognition normally occurs
For an asset For a liability

when the entity loses control of all or part of the when the entity no longer has a present
recognised asset obligation for all or part of the recognised liability

Derecognition aims to faithfully represent both

 any assets and liabilities retained after the transaction that led to the derecognition;
 the change in the entity’s assets and liabilities as a result of that transaction
 Recognition criteria
Relevance Faithful representation
• whether recognition of an • whether recognition of an
item results in relevant item results in a faithful
information may be representation may be
affected by, for example: affected by, for example:
* low probability of a * measurement
flow of economic uncertainty
benefits * recognition
* existence uncertainty inconsistency
(accounting mismatch)
* presentation and
disclosure
Conceptual framework
Measurement

Historical cost

Current value

Fair value

Value in use

Current cost
Conceptual framework
Historical cost

ASSET Price of transaction plus transaction costs

LIABILITY Value of consideration received minus transaction

costs

If not available or relevant use

current value as starting point.
Conceptual framework
Historical cost updated for:

Depicting consumption (depreciation)

ASSET
Payment received for extinguishing (sale)

Impairment

Financing component
Conceptual framework

Historical cost updated for:

Fullfilment (payments)

LIABILITY
Increases in obligation

Interest
Conceptual framework

WHY Historical cost ?

Conceptual framework

WHY Historical cost?

Price of transaction

Amount at least expected to be recovered

Value to fullfil obligation

Conceptual framework
Current value

Ignores price of transaction

Reflects conditions at measurement date

Bases include
- Fair value
- Value in use /Fulfilment value
- Current cost
Conceptual framework
Fair value

Price that would be received to sell an asset or paid

to transfer a liability in an orderly transaction
between market participants at measurement date
Conceptual framework
Fair value

Observing prices in active market

Indirectly by estimating future cash flows, time

value of money etc

Does not reflect transaction costs

Conceptual framework

WHY Fair value?

Conceptual framework

WHY Fair value??

Shows market participants current expectations

Conceptual framework
Value in use / Fulfilment value

Present value of cash flows expected to be

derived from use of asset and from disposal

Present value of cash/other resources the entity

expects to be obliged to transfer to fulfil.
Conceptual framework

Value in use / Fulfilment value

Does not include transaction costs

Entity-specific assumption
Conceptual framework

WHY Value in use?

Conceptual framework

WHY Value in use?

Shows present value of future cash flows

Conceptual framework

Current cost

Cost of equivalent asset at measurement date (what

would have paid now plus transaction costs
THE MEASUREMENT OF ELEMENTS

The following measurement bases are

generally acceptable in terms of the
Conceptual Framework:
 Historical cost
 Current value
 Fair value
 Value in use and Fulfilment value
 Current cost
Conceptual framework

Presentation and disclosure

Effective communication

Entity-specific info

Duplication
Conceptual framework

Capital maintenance
 CONCEPTS OF CAPITAL AND CAPITAL MAINTENANCE

 Financial concept of capital:

o Capital is equal to the net assets or equity of an entity

 Physical concept of capital

o Capital is equal to the production capacity of an entity

TABALDI YOUTUBE VIDEO – CAPITAL MAINTENANCE:

https://www.youtube.com/watch?v=r-4sDagNvP0
Conceptual framework

CLASS EXAMPLE
Example of answering a theory question

On 28 December 20x11 a company accounted for an

invoice received from the municipality relating to
electricity usage amounting of R1 500. The company’s
year-end is 31 December. Bank statements indicate that
the electronic payment of the account occurred on 10
January 20x12. Discuss whether the company may
recognise the transaction in 20x11 in terms of the
Conceptual Framework.
 Definition of an element of Application
financial statements:
Liabilities
Is a present obligation of The entity has used the electricity and is legally obliged to
the entity (unavoidable & pay for it. The entity has no practical ability to avoid paying
legally enforceable for the electricity.
To transfer an economic An economic resource is a right that has the potential to
resource produce economic benefits. The economic resource that will
be transferred is the amount that will be paid for electricity,
which will reduce the cash resources of the entity. Does not
need highly probable, we look at that one instance of entity
having to pay.
As a result of past events The electricity was already consumed in December, which
Entity must have ALREADY obtained constitutes a past event and as a result the entity owes
economic benefit AND As
consequence entity will/may have municipality money
to transfer economic resources that
it would not otherwise have had to
transfer.
Conclusion:

Based on the above the definition of liability is met as at

31 December 20x11. A liability will only be recognised in the
recognition criteria is met. Please see below where the recognition
criteria was considered.
Recognition criteria: Application:
Relevance:
Financial information is relevant for The cost was incurred in the current financial
the user and have an impact on the year and must be recorded in the financial
results of the current financial year. records in the accounting period under review.
There must be no uncertainty There is no uncertainty that the liability
that the expense and the liability exists as the electricity was consumed
exists, nor must there be no and not paid for and it is highly probable
uncertainty that a flow of that there will be an outflow of economic
economic resources will take resources when payment is made to the
place in the future. municipality
Faithful representation: The amount of the obligation is known (i.e.
The amount of the obligation R1,500) and there is no uncertainty of what the
must be reflected with as little amount payable is, when the liability is going to
uncertainty as possible be settled. There is also no estimation.
Conclusion:

Based on the above the both the definition and recognition criteria
of a liability are met as at 31 December 20x11. As a result the
liability to the municipality should be recognised in our financial
statements, i.e. a journal has to passed.
Definition of an element of Application
financial statements: Expenses
Decreases in assets, or increases in Although the service was rendered in December,
liabilities payment hasn’t taken place yet, therefore there is a
present obligation to pay for it. Liabilities will
increase as a result of the obligation. (see above)

That result in decreases in equity When payment is made the net asset value will
decrease (cash resources will be reduced), therefore
equity will also decrease. Also an expense has a
negative impact on equity, electricity expense will
reduce equity.

Other than those relating to Payment will not be made to equity holders, but to
distributions to holders of equity the service provider (i.e. the municipality)
claims
CONCLUSION:

o The transaction meets the definition and recognition criteria of an

expense and a liability as at 31 December 20x11.
o In accordance with the concept of accrual accounting, the Conceptual
Framework requires that the expense and the liability be recognised in
the 20x11 financial year.
o An expense (statement of profit or loss) and a liablility (Statement of
financial position) are recognised.
LEARNING OUTCOMES ACHIEVED?

YOU ARE REQUIRED TO UNDERSTAND AND DISCUSS THE FOLLOWING

PRINCIPLES:

• SPECIFIC PURPOSE OF FINANCIAL STATEMENTS

• UNDERLYING ASSUMPTIONS
• FUNDAMENTAL QUALITATIVE CHARACTERISTICS
• ENHANCING QUALITATIVE CHARACTERISTICS
• DEFINITION OF THE ELEMENTS OF FINANCIAL STATEMENTS
• RECOGNITION AND DE-RECOGNITION CRITERIA
• MEASUREMENT BASES AVAILABLE FOR THE ELEMENTS OF FINANCIAL
STATEMENTS