Conceptual Framework for Financial Reporting PDF

CONCEPTUAL FRAMEWORK & ACCOUNTING STANDARDS 1 Conceptual Framework for Financial Reporting Learning Objectives State the purpose, status, and scope of the Conceptual Framework. State the objective of financial reporting. Identify the primary users of f...

CONCEPTUAL FRAMEWORK & ACCOUNTING STANDARDS 1 Conceptual Framework for Financial Reporting Learning Objectives State the purpose, status, and scope of the Conceptual Framework. State the objective of financial reporting. Identify the primary users of financial statements. Explain briefly the qualitative characteristics of useful information and how they are applied in financial reporting. Define the elements of financial statements and state their recognition criteria and their derecognition. State the measurement bases used in financial reporting. ) 2 Purpose of the Conceptual Framework The Conceptual Framework prescribes the concepts for general purpose financial reporting. Its purpose is to: a. assist the International Accounting Standards Board (IASB) in developing Standards that are based on consistent concepts; b. assist preparers in developing consistent accounting policies when no Standard applies to a particular transaction or when a Standard allows a choice of accounting policy; and c. assist all parties in understanding and interpreting the Standards. 3 Status of the Conceptual Framework The Conceptual Framework is not a PFRS. When there is a conflict between the Conceptual Framework and a PFRS, the PFRS will prevail. In the absence of a standard, management shall consider the Conceptual Framework in making its judgment in developing and applying an accounting policy that results in useful information. 4 Scope of the Conceptual Framework The Conceptual Framework is concerned with general-purpose financial reporting. General-purpose financial reporting involves the preparation of general-purpose financial statements. The Conceptual Framework provides the concepts regarding the following: 1. The objective of financial reporting 2. Qualitative characteristics of useful financial information 3. Financial statements and the reporting entity 4. The elements of financial statements 5. Recognition and derecognition 6. Measurement 7. Presentation and disclosure 8. Concepts of capital and capital maintenance 5 Objective of general purpose financial reporting The objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to primary users in making decisions about providing resources to the entity. The objective of general purpose financial reporting forms the foundation of the Conceptual Framework. 6 Primary Users Primary users – are those who cannot demand information directly from reporting entities. The primary users are: (a) Existing and potential investors (b) Lenders and other creditors. Only the common needs of primary users are met by the financial statements. Other Users – regulators and members of the public who are not investors, lenders or creditors. Ex. Regulatory bodies – compliance with accounting standards ensuring transparency & integrity; government agencies – taxation/policy formulation; customers – stability of employer and employee benefits 7 Qualitative Characteristics I. Fundamental qualitative characteristics - (1) Relevance (a) Predictive value (b) Feedback value Materiality – entity-specific aspect of relevance (2) Faithful representation (a) Completeness – with full disclosure of information needed (b) Neutrality – without bias in the selection or presentation of financial info (c) Free from error – no errors or omissions in the description of phenomena and in the applied process. II. Enhancing qualitative characteristics (1) Comparability – recognize and comprehend similarities & differences among items. Consistency aids comparability (use of the same methods of same items) (2) Verifiability – knowledgeable and independent observers could generally agree (3) Timeliness – availability of information to decision-makers on time (4) Understandability – classify, characterize and present info clearly and concisely 8 Fundamental vs. Enhancing The fundamental qualitative characteristics are the characteristics that make information useful to users. The enhancing qualitative characteristics are the characteristics that enhance the usefulness of information 9 Relevance Information is relevant if it can affect the decisions of users. Relevant information has the following: a. Predictive value – the information can be used in making predictions b. Confirmatory value – the information can be used in confirming past predictions Materiality – is an ‘entity-specific’ aspect of relevance. 10 Faithful Representation Faithful representation means the information provides a true, correct and complete depiction of what it purports to represent. Faithfully represented information has the following: a. Completeness – all information necessary for users to understand the phenomenon being depicted is provided. b. Neutrality – information is selected or presented without bias. c. Free from error – there are no errors in the description and in the process by which the information is selected and applied. 11 Enhancing Qualitative Characteristics 1. Comparability – the information helps users in identifying similarities and differences between different sets of information. 2. Verifiability – different users could reach consensus as to what the information purports to represent. 3. Timeliness – the information is available to users in time to be able to influence their decisions. 4. Understandability – users are expected to have: a. reasonable knowledge of business activities; and b. willingness to analyze the information diligently. 12 Financial statements and the Reporting entity Objective and scope of financial statements The objective of general purpose financial statements is to provide financial information about the reporting entity’s assets, liabilities, equity, income and expenses that is useful in assessing: a. the entity’s ability to generate future net cash inflows; and b. management’s stewardship over economic resources. 13 Financial statements and the Reporting entity Reporting period Financial statements are prepared for a specific period of time (i.e., the reporting period) and include comparative information for at least one preceding reporting period. Going concern Financial statements are normally prepared on the assumption that the reporting entity is a going concern, meaning the entity has neither the intention nor the need to end its operations in the foreseeable future. 14 Financial statements and the Reporting entity Reporting entity A reporting entity is one that is required, or chooses, to prepare financial statements, and is not necessarily a legal entity. It can be a single entity or a group or combination of two or more entities. 15 Elements of Financial Statements 16 Asset Asset is “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.” (Conceptual Framework 4.3 & 4.4) 17 Three aspects in the definition of an asset 1. Right – asset refers to a right, and not necessarily to a physical object, e.g., the right to use, sell, lease, or transfer a building. 2. Potential to produce economic benefits – the right has the potential to produce economic benefits for the entity that is beyond the benefits available to all others. Such potential need not be certain or even likely – what is important is that the right already exists and that, in at least one circumstance, it would produce economic benefits for the entity. 18 3. Control – means the entity has the exclusive right over the benefits of an asset and the ability to prevent others from accessing those benefits. Liability Liability is “a present obligation of the entity to transfer an economic resource as a result of past events.” (Conceptual Framework 4.26) 19 Three aspects in the definition of a liability 1. Obligation – An obligation is “a duty or responsibility that an entity has no practical ability to avoid.” (CF 4.29) An obligation can be either legal obligation or constructive obligation. 2. Transfer of an economic resource – the obligation has the potential to require the transfer of an economic resource to another party. Such potential need not be certain or even likely – what is important is that the obligation already exists and that, in at least one circumstance, it would require the transfer of an economic resource. 20 Three aspects …… liability (continuation) 3. Present obligation as a result of past events – A present obligation exists as a result of past events if: a. the entity has already obtained economic benefits or taken an action; and b. as a consequence, the entity will or may have to transfer an economic resource that it would not otherwise have had to transfer. (Conceptual Framework 4.43) 21 Executory contracts An executory contract “is a contract that is equally unperformed – neither party has fulfilled any of its obligations, or both parties have partially fulfilled their obligations to an equal extent.” (CF 4.56) An executory contract establishes a combined right and obligation to exchange economic resources. The contract ceases to be executory when one party performs its obligation. If the entity performs first, the entity’s combined right and obligation changes to an asset. If the other party performs first, the entity’s combined right and obligation changes to a liability. 22 Equity “Equity is the residual interest in the assets of the entity after deducting all its liabilities.” (Conceptual Framework 4.63) Equity equals Assets minus Liabilities 23 Income and Expenses Income Income is “increases in assets, or decreases in liabilities, that result in increases in equity, other than those relating to contributions from holders of equity claims.” (Conceptual Framework 4.68) Expenses Expenses are “decreases in assets, or increases in liabilities, that result in decreases in equity, other than those relating to distributions to holders of equity claims.” (Conceptual Framework 4.69) 24 Recognition & Derecognition The recognition process Recognition is the process of including in the statement of financial position or the statement(s) of financial performance an item that meets the definition of one of the financial statement elements (i.e., asset, liability, equity, income or expense). This involves recording the item in words and in monetary amount and including that amount in the totals of either of those statements. 25 Recognition & Derecognition Recognition criteria An item is recognized if: a. it meets the definition of an asset, liability, equity, income or expense; and b. recognizing it would provide useful information, i.e., relevant and faithfully represented information. 26 Recognition & Derecognition Relevance The recognition of an item may not provide relevant information if, for example: a. it is uncertain whether an asset or liability exists; or b. an asset or liability exists, but the probability of an inflow or outflow of economic benefits is low. (Conceptual Framework 5.12) However, the presence of one or both of the foregoing does not automatically lead to the non-recognition of an item. Other factors should also be considered. 27 Recognition & Derecognition Faithful representation The level of measurement uncertainty and other factors can affect an item’s faithful representation, but not necessarily its relevance. Measurement uncertainty Measurement uncertainty exists if the asset or liability needs to be estimated. A high level of measurement uncertainty does not necessarily lead to the non-recognition of an asset or liability if the estimate provides relevant information and is clearly and accurately described and explained. However, measurement uncertainty can lead to the non-recognition of an asset or a liability if making an estimate is exceptionally difficult or exceptionally subjective. 28 Recognition & Derecognition Derecognition Derecognition is the removal of a previously recognized asset or liability from the entity’s statement of financial position. Derecognition occurs when the item ceases to meet the definition of an asset or liability. 29 Unit of account Unit of account is “the right or the group of rights, the obligation or the group of obligations, or the group of rights and obligations, to which recognition criteria and measurement concepts are applied.” (Conceptual Framework 4.48) 30 Measurement bases 1. Historical cost 2. Current value a. Fair value b. Value in use and fulfilment value c. Current cost 31 Historical cost The historical cost of: a. an asset is the consideration paid to acquire the asset plus transaction costs. b. a liability is the consideration received to incur the liability minus transaction costs. Historical cost is updated over time to depict the following: ✓ Depreciation, amortization, or impairment of assets ✓ Collections or payments that extinguish part or all of the asset or liability ✓ Unwinding of discount or premium when the asset or liability is measured at amortized cost 32 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.” (Conceptual Framework 6.12) 33 Value in use and fulfilment value Value in use is “the present value of the cash flows, or other economic benefits, that an entity expects to derive from the use of an asset and from its ultimate disposal.” (Conceptual Framework 6.17) 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.” (Conceptual Framework 6.17) Current cost The current cost of: a. 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.” b. a liability is “the consideration that would be received for an equivalent liability at the measurement date minus the transaction costs that would be incurred at that date.” (Conceptual Framework 6.21) 35 Entry values vs. Exit values Current cost and historical cost are entry values (i.e., they reflect prices in acquiring an asset or incurring a liability), whereas fair value, value in use and fulfilment value are exit values (i.e., they reflect prices in selling or using an asset or transferring or fulfilling a liability). 36 Considerations when selecting a measurement basis When selecting a measurement basis, it is important to consider the following: a. The nature of information provided by a particular measurement basis (e.g., measuring an asset at historical cost may lead to the subsequent recognition of depreciation or impairment, while measuring that asset at fair value would lead to the subsequent recognition of gain or loss from changes in fair value). b. The qualitative characteristics, the cost-constraint, and other factors (e.g., a particular measurement basis may be more verifiable or more costly to apply than the other measurement bases). 37 Measurement of Equity Total equity is not measured directly. It is simply equal to difference between the total assets and total liabilities. Because different measurement bases are used for different assets and liabilities, total equity cannot be expected to be equal to the entity’s market value nor the amount that can be raised from either selling or liquidating the entity. Equity is generally positive, although some of its components can be negative. In some cases, even total equity can be negative such as when total liabilities exceed total assets. 38 Presentation and Disclosure Information is communicated through presentation and disclosure in the financial statements. Effective communication makes information more useful. Effective communication requires: a. focusing on presentation and disclosure objectives and principles rather than on rules. b. classifying information by grouping similar items and separating dissimilar items. c. aggregating information in a manner that it is not obscured either by excessive detail or by excessive summarization. 39 Presentation and disclosure objectives and principles The objectives are specified in the Standards. The principles include: a. the use of entity-specific information is more useful that standardized descriptions, and b. duplication of information is usually unnecessary. 40 Classification Classifying means combining similar items and separating dissimilar items. Offsetting of assets and liabilities is generally not appropriate. Classification of income and expenses Income and expenses are classified as recognized either in: a. profit or loss; or b. other comprehensive income. 41 Aggregation Aggregation is “the adding together of assets, liabilities, equity, income or expenses that have shared characteristics and are included in the same classification.” (Conceptual Framework 7.20) 42 Concepts of Capital and Capital Maintenance Financial concept of capital – capital is regarded as the invested money or invested purchasing power. Capital is synonymous with equity, net assets, and net worth. Physical concept of capital – capital is regarded as the entity’s productive capacity, e.g., units of output per day. 43  APPLICATION OF CONCEPTS PROBLEM 6: FOR CLASSROOM DISCUSSION 44  QUESTIONS????  REACTIONS!!!!! 45 END 46