Conceptual Framework for Financial Reporting: an overview

The objective of the Framework Document is to set out the concepts that underlie the preparation and presentation of financial statements for external users as set out in the Conceptual Framework for Financial Reporting.  It is important at the outset to understand that the Framework Document itself is not a standard – its primary purpose is to assist the IASB in developing new or revised accounting standards and to assist preparers of financial statements applying accounting standards and dealing with issues which are not covered by accounting standards.

It covers:

• the objectives;
• the underlying assumptions;
• the qualitative characteristics;
• the elements of financial statements;
• recognition and measurement of the elements of financial statements; and
• the concepts of capital and capital maintenance.

Amendments to the Framework Document will also include coverage of The Reporting Entity.

The objectives

The objective of financial statements is to provide information about:

• the financial position;
• the financial performance; and
• changes in financial position

of a reporting entity that is useful to a wide range of users in making economic decisions.

The financial position = the statement of financial position

The financial performance = the statement of profit or loss (the income statement)

The changes in financial position = the statement of cash flows

The IASB issued new chapters on the objectives and qualitative characteristics on 28 September 2010 which took immediate effect.

The financial position

The financial position of an entity is affected by:

(a)  the economic resources under  its control;

(b)  the way it is financially structured;

(c)   the entity’s liquidity and solvency; and

(d)  the entity’s capacity to adapt to change.

The financial performance

The financial performance (primarily profitability) can be assessed to:

(a)  predict the opportunity to generate cash flows from the resources the entity controls; and

(b)  to form judgements above how the resources employed by the entity are effective.

Changes in financial position

These can be used to assess the investing, financing and operating activities as well as evaluating the entity’s ability to generate cash and cash equivalents.  In addition to evaluating the entity’s ability to generate cash and cash equivalents, the changes in financial position can also be assessed to see how the entity uses those cash flows.  The statement of cash flows is useful because it can convey information to the user of the financial statements which might not otherwise be conveyed in the statement of comprehensive income or the statement of financial position.  A typical example is the amount of taxation paid during the year.

The underlying assumptions

There are two fundamental terms which are dealt with in the Framework:

(a)  the accruals basis of accounting; and

(b)  the going concern basis.

The accruals basis

The accruals basis of accounting stipulates that an entity should recognise the effects of transactions and other events when they occur and not when they are paid or when cash is received in settlement.

In addition, an entity should also recognise these transactions and events in the financial statements in the period to which they relate.

By complying with the accruals concept this ensures that the financial statements inform users of obligations to pay cash in the future and also inform users of the entity’s obligations to also receive cash in the future.

The going concern basis

If financial statements are prepared on a going concern basis, this assumes that the entity will continue in operation for the foreseeable future.  This informs the user that the entity neither intends to liquidate or materially curtail the scale of operations.

The ‘foreseeable future’ is not defined in the Framework Document but under IAS 1 Presentation of Financial Statements, this period is considered be for a period of at least 12 months after the reporting date.

The qualitative characteristics

Following the issuance of new chapters on the objectives and qualitative characteristics of financial statements on 28 September 2010, the fundamental qualitative characteristics contained in the Conceptual Framework are relevance and faithful representation.  There are then four additional enhancing qualitative characteristics, namely:

• comparability;
• verifiability;
• timeliness; and
• understandability.

Relevance

Relevant financial information is capable of influencing the decisions made by users of the financial statements.  The Conceptual Framework recognises that financial information is capable of making a difference in decisions if it has a ‘predictive value’, ‘confirmatory value’ or both.

Predictive value refers to financial information with predictive value as a tool employed by users of financial statements in making their own predictions.

Confirmatory value refers to feedback about previous evaluations.

Materiality is an entity-specific aspect of relevance based on the nature or magnitude (or both) of the items which the information relates in the context of an individual entity’s financial report.  An item is material if its omission or misstatement would influence decisions that users make on the basis of financial information about a specific reporting entity.

Faithful representation

Faithful representation encompasses both relevance and faithful representation.  Faithful representation contains three characteristics according to the Conceptual Framework:

• complete;
• neutral; and
• free from error.

Comparability

The Conceptual Framework refers to comparability being the qualitative characteristic that enables users to identify and understand similarities in, and differences among, items.  It identifies that a comparison needs two items, for example a current year’s financial information and a preceding year’s financial information.

Verifiability

The Conceptual Framework recognises that verifiability helps assure users that information faithfully represents the economic phenomena it purports to represent.  It suggests that different users (observers) could reach consensus, albeit not complete agreement, relating to whether a particular depiction is a faithful representation.  It recognises two methods of verification:

• direct; and
• indirect.

Direct verification can be achieved by direct confirmation, such as cash counts.  Indirect verification is achieved by verifying the inputs to a model or other technique and re-calculating the outputs using the same methodology.

Timeliness

The Conceptual Framework recognises that the older the information, the less useful that information, dependant on users’ needs (older information may be useful to users’ when assessing trends).  It acknowledges that decision-makers need information available in time to be capable of making informed decisions.

Understandability

This concept works on the basis of classifying, characterising and present information clearly and concisely.  If this is achieved, information becomes understandable.

The Conceptual Framework recognises that financial reports are prepared for users who have a reasonable knowledge of business and economic activities and who review and analyse the information diligently.  Despite this, however, the Framework also recognises that even such well-informed users may need advice to understand information about complex issues.

Application of enhancing qualitative characteristics

The Conceptual Framework requires the enhancing qualitative characteristics to be maximised to the extent possible.  Conversely it also recognises that the enhancing qualitative characteristics cannot make information useful if that same information is irrelevant or not faithfully represented.

The application of the enhancing qualitative characteristics is an iterative process and the Conceptual Framework recognises that it does not follow a prescribed order.  It also recognises that in some instances one enhancing qualitative characteristic may have to be diminished to maximise another qualitative characteristic, though appropriate disclosures may be required in such situations.

The Eeements of the financial statements

Financial statements are made up of the following elements:

(a)  assets;

(b)  liabilities;

(c)   equity;

(d)  income; and

(e)  expenses.

Assets

An asset is a resource controlled by the entity as a result of past events from which future economic benefits are expected to flow.

‘Control’ means the ability to restrict the use of the asset – for example inventory could be stored in a locked warehouse.  In contrast, if an entity has a highly skilled workforce, it cannot recognise these as an asset because the entity cannot ‘control’ its workforce – they could leave at any time.

Liabilities

A liability is a present obligation of the entity arising from past events, settlement of which is expected to result in an outflow of resources embodying economic benefits.

Equity

Equity is the residual interest in the assets of the entity after deducting all its liabilities.

Income

Income is increases in economic benefits during the reporting 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.

Income can include both revenue and gains even though they may be included in equity rather than the statement of comprehensive income (for example a revaluation surplus).

An example of a contribution from equity participants is the purchase of additional shares.

Expenses

Expenses are decreases in economic benefits during the reporting 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.

Capital and capital maintenance

There are two concepts of ‘capital’.  There is the ‘financial’ concept and there is the ‘physical’ concept.

Financial concept

The financial concept of capital is the same as net assets or equity of the entity.

It works on the basis that profit is earned only if the financial amount of the net assets at the end of the period is more than the financial amount of net assets at the beginning of the period after excluding any distributions to, or contributions from, the owners during the period.

Physical concept

The physical concept is regarded as the productive capacity of the entity based on operating capability.

It works on the basis that profit is earned only if the physical productive capacity of the entity at the end of the period is in excess of the physical productive capacity at the beginning of the period after excluding any distributions to, or contributions from, the owners during the period.

Category: Accounting and standards