Conceptual Framework for Financial Reporting PDF

# Conceptual Framework for Financial Reporting ## Learning Objectives 1. State the purpose, status, and scope of the Conceptual Framework. 2. State the objective of financial reporting. 3. Identify the primary users of financial statements. 4. Explain briefly the qualitative characteristics of use...

# Conceptual Framework for Financial Reporting ## Learning Objectives 1. State the purpose, status, and scope of the Conceptual Framework. 2. State the objective of financial reporting. 3. Identify the primary users of financial statements. 4. Explain briefly the qualitative characteristics of useful information and how they are applied in financial reporting. 5. Define the elements of financial statements and state their recognition criteria and their derecognition. 6. State the measurement bases used in financial reporting. ## Purpose of the Conceptual Framework The Conceptual Framework prescribes the concepts for general purpose financial reporting. Its purpose is to: * assist the International Accounting Standards Board (IASB) in developing Standards* that are based on consistent concepts; * 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 * assist all parties in understanding and interpreting the Standards. * In our succeeding discussions, we will use the term Standard(s) to refer to both the International Financial Reporting Standards (IFRS) and the Philippine Financial Reporting Standards (PFRS). The Conceptual Framework provides the foundation for the development of Standards that: * promote transparency by enhancing the international comparability and quality of financial information. * strengthen accountability by reducing the information gap between providers of capital and the entity's management. * contribute to economic efficiency by helping investors to identify opportunities and risks around the world, thus improving capital allocation. The use of a single, trusted accounting language lowers the cost of capital and reduces international reporting costs. (Conceptual Framework SP1.5) ## Status of The Conceptual Framework The Conceptual Framework is not a Standard. If there is a conflict between a Standard and the Conceptual Framework, the requirement of the Standard will prevail. ### Hierarchy of Reporting Standards The authoritative status of the Conceptual Framework is depicted in the hierarchy of guidance shown below: 1. PFRSS 2. Judgment *When making the judgment, management shall consider the following:* * Requirements in other PFRSs dealing with similar transactions * Conceptual Framework *Management may consider the following:* * Pronouncements issued by other standard-setting bodies * Other accounting literature and industry practices The hierarchy guidance above means that in the absence of a PFRS that specifically applies to a transaction, management shall consider the applicability of the Conceptual Framework in developing and applying an accounting policy that results in useful information. To meet the objectives of general purpose financial reporting, a Standard sometimes contains requirements that depart from the Conceptual Framework. In such cases, the departure is explained in the 'Basis for Conclusions' on that Standard. The Conceptual Framework may be revised from time to time based on the IASB's experience of working with it. However, revisions do not automatically result to changes in the Standards - not until after the IASB goes through its due process of amending a Standard. ## 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 that underlie general purpose financial reporting with regard to 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 ## The Objective of Financial Reporting "The objective of general purpose 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." (Conceptual Framework.1.2) This objective is the foundation of the Conceptual Framework. All the other aspects of the Conceptual Framework revolve around this objective. ## Primary Users The objective of financial reporting refers to the following, so called the primary users: 1. Existing and potential investors; and 2. Lenders and other creditors These users cannot demand information directly from reporting entities and must rely on general purpose financial reports for much of their financial information needs. Accordingly, they are the primary users to whom general purpose financial reports are directed to. Lenders refer to those who extend loans (e.g., banks), while other creditors refer to those who extend other forms of credit (e.g., supplier). The Conceptual Framework is concerned with general purpose financial reporting. General purpose financial reporting (or simply 'financial reporting') deals with providing information that caters to the common needs of the primary users. Therefore, general purpose financial reports do not and cannot provide all the information needs of primary users. These users will need to consider other sources for their other information needs (for example, general economic conditions and expectations, political events and political climate, and industry and company outlooks). The information needs of individual primary users may differ and possibly conflict. Accordingly, financial reporting aims to provide information that meets the needs of the maximum number of primary users. Focusing on common needs, however, does not prohibit the provision of additional information that is most useful to a particular subset of primary users. Other users, such as the entity's management, regulators, and the public, may find general purpose financial reports useful. However, such reports are not primarily directed to these users. General purpose financial reports do not directly show the value of a reporting entity. However, they provide information that helps users in estimating the value of an entity. Providing useful information requires making estimates and judgments. The Conceptual Framework establishes the concepts that underlie those estimates and judgments. ## Decisions about Providing Resources to the Entity The primary users' decisions about providing resources to the entity involve decisions on: * buying, selling or holding investments; * providing or settling loans and other forms of credit; or * exercising voting or similar rights that could influence management's actions relating to the use of the entity's economic resources. These decisions depend on the investor/lender/other creditor's expected returns (e.g., investment income or repayment of loan). Expectations about returns, in turn, depend on assessments of the entity's (i) prospects for future net cash inflows and (ii) management stewardship. To make these assessments, investors, lenders and other creditors need information on: * the economic resources of the entity, claims against the entity and changes in those resources and claims; and * how efficiently and effectively the entity's management has utilized the entity's economic resources. ## Information on Economic Resources, Claims, and Changes General purpose financial reports provide information on a reporting entity's: * **Financial position** - information on economic resources (assets) and claims against the reporting entity (liabilities and equity); and * **Changes in economic resources and claims** - information on financial performance (income and expenses) and other transactions and events that lead to changes in financial position. Collectively, these are referred to under the Conceptual Framework as the economic phenomena. ## Economic Resources and Claims Information about the nature and amounts of an entity's economic resources (assets) and claims (liabilities and equity) can help users to identify the entity's financial strengths and weaknesses. That information can help users in assessing the entity's: * Liquidity and solvency; * Needs for additional financing and how successful it is likely to be in obtaining that financing; and * Management's stewardship on the use of economic resources. **Liquidity** refers to an entity's ability to pay short-term obligations, while **solvency** refers to an entity's ability to meet its long-term obligations. All of these contribute to the assessment of the entity's ability to generate future cash flows. For example: * Information on currently maturing receivables and obligations can help users assess the timing of future cash flows. * Information about the nature of economic resources can help users assess whether a resource can produce future cash flows independently or only in combination with other resources. * Information on liquidity and solvency can help users assess the entity's ability to obtain additional financing. * Overleverage (use of too much debt) may cause difficulty in obtaining additional financing. * Information about priorities and payment requirements of claims can help users predict how future cash flows will likely to be distributed among the claims. ## Changes in Economic Resources and Claims Changes in economic resources and claims result from: * financial performance (income and expenses); and * other events and transactions. Information on financial performance helps users assess the entity's ability to produce return from its economic resources. Return provides an indication on how well management has efficiently and effectively used the entity's resources. Information on the variability of the return helps users in assessing the uncertainty of future cash flows. For example, significant fluctuations in reported profits may indicate financial instability and uncertainty on the entity's ability to generate cash flows from its operations. Information based on accrual accounting provides a better basis for assessing an entity's financial performance than information based solely on cash receipts and payments during the period. Information on past cash flows helps users assess the entity's ability to generate future cash flows by providing users a basis in understanding the entity's operating, investing and financing activities, assessing its liquidity or solvency, and interpreting other information about its financial performance. Economic resources and claims may also change for reasons aside from financial performance, such as issuing debt or equity instruments. Information on these types of changes is necessary for a complete understanding of the entity's changes in economic resources and claims and the possible impact of those changes on the entity's future financial performance. ## Information about Use of the Entity's Economic Resources Information on how efficiently and effectively the entity's management has discharged its responsibilities to use the entity's economic resources helps users assess the entity's management's stewardship. This information also helps in predicting how efficiently and effectively the entity's resources will be used in future periods; thus, helping in the assessment of the entity's prospects for future net cash inflows. Examples of management's responsibilities to use the entity's economic resources include safeguarding those resources and ensuring the entity's compliance with laws, regulations and contractual provisions. **Summary:** The decisions of primary users are based on assessments of an entity's prospects for future net cash inflows and management stewardship. To make these assessments, users need information on the entity's financial position, financial performance and other changes in financial position, and utilization of economic resources. ## Qualitative Characteristics The qualitative characteristics of useful financial information identify the types of information that are likely to be most useful to the primary users in making decisions using an entity's financial report. Qualitative characteristics apply to information in the financial statements as well as to financial information provided in other ways. The Conceptual Framework classifies the qualitative characteristics into the following: ### Fundamental Qualitative Characteristics These are the characteristics that make information useful to users. They consist of the following: * **Relevance:** Information is relevant if it can make a difference in the decisions of users. Relevant information has the following: * **Predictive value** - the information can help users in making predictions about future outcomes. * **Confirmatory value (feedback value)** - the information can help users in confirming their previous predictions. Predictive value and confirmatory value are interrelated. Information that has predictive value is likely to also have confirmatory value. For example, revenue in the current period can be used to predict revenue in a future period and at the same time can also be used in confirming a past prediction. * **Faithful Representation:** Faithful representation means the information provides a true, correct and complete depiction of the economic phenomena that it purports to represent. When an economic phenomenon's substance differs from its legal form, faithful representation requires the depiction of the substance (i.e., substance over form). Depicting only the legal form would not faithfully represent the economic phenomenon. Faithfully represented information has the following characteristics: * **Completeness:** All information (in words and numbers) necessary for users to understand the phenomenon being depicted is provided. These include description of the nature of the item, numerical depiction (e.g., monetary amount), description of the numerical depiction (e.g., historical cost or fair value) and explanations of significant facts surrounding the item. * **Neutrality:** Information is selected or presented without bias. Information is not manipulated to increase the probability that users will receive it favorably or unfavorably. Neutrality is supported by prudence, which is the use of caution when making judgments under conditions of uncertainty, such that assets or income are not overstated and liabilities or expenses are not understated. Equally, the exercise of prudence does not allow the understatement of assets or overstatement of liabilities because the financial statements would not be faithfully represented. * **Free from error:** This does not mean that the information is perfectly accurate in all respects. Free from error means there are no errors in the description and in the process by which the information is selected and applied. If the information is an estimate, that fact should be described clearly, including an explanation of the process used in making that estimate. ### Enhancing Qualitative Characteristics These are the characteristics that enhance the usefulness of information. They consist of the following: * **Comparability:** Information is comparable if it helps users identify similarities and differences between different sets of information that are provided by: * a single entity but in different periods (intra-comparability); or * different entities in a single period (inter-comparability). Unlike the other qualitative characteristics, comparability does not relate to only one item because a comparison requires at least two items. Comparison is not uniformity, meaning like things must look alike and different things must look differently. It would be inappropriate to make different things look alike, or vice versa. Although related, consistency and comparability are not the same. Consistency refers to the use of the same methods for the same items. Comparability is the goal while consistency is the means of achieving that goal. * **Verifiability:** Information is verifiable if different users could reach a general agreement as to what the information purports to represent. Verification can be direct or indirect. Direct verification involves direct observation (e.g., counting of cash). Indirect verification involves checking the inputs to a model or formula and recalculating the outputs using the same methodology (e.g., checking the debits and credits in the cash ledger and recalculating the ending balance). * **Timeliness:** Information is timely if it is available to users in time to be able to influence their decisions. * **Understandability:** Information is understandable if it is presented in a clear and concise manner. Understandability does not mean that complex matters should be excluded to make information understandable to users because this would make information incomplete and potentially misleading. Accordingly, financial reports are intended for users: * who have reasonable knowledge of business activities; and * who are willing to analyze the information diligently. **Summary:** * **Fundamental qualitative characteristics:** * **Relevance** (predictive value & confirmatory value) * **Materiality** (entity-specific aspect of relevance) * **Faithful representation** (completeness, neutrality, & free from error) * **Enhancing qualitative characteristics:** * **Comparability** * **Verifiability** * **Timeliness** * **Understandability** ## Applying the Qualitative Characteristics The fundamental qualitative characteristics are essential to the usefulness of information; meaning, information must be both relevant and faithfully represented for it to be useful. For example, neither a relevant information that is erroneous nor a correct information that is irrelevant helps users make good decisions. The enhancing qualitative characteristics only enhance the usefulness of information that is both relevant and faithfully represented but cannot make information that is irrelevant or erroneous to be useful. Accordingly, the enhancing qualitative characteristics should be maximized to the extent possible. There is no prescribed order in applying the enhancing qualitative characteristics. Sometimes one enhancing qualitative characteristic may have to be sacrificed to maximize another. ## The Cost Constraint Cost is a pervasive constraint on the entity's ability to provide useful financial information. Providing information entails cost and this can only be justified by the benefits expected to be derived from using the information. Accordingly, an optimum balance between costs and benefits is desirable such that costs do not outweigh the benefits. ## 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: * the entity's prospects for future net cash inflows; and * management's stewardship over economic resources. That information is provided in the: * **Statement of financial position** (for recognized assets, liabilities and equity; * **Statement(s) of financial performance** (for income and expenses); * **Other statements and notes** (for additional information on recognized assets and liabilities, information on unrecognized assets and liabilities, information on cash flows, information on contributions from/distributions to owners, and other relevant information). ### Reporting Period Financial statements are prepared for a specified period of time and provide information on assets, liabilities and equity that existed at the end of the reporting period, or during the reporting period, and income and expenses for the reporting period. (Conceptual Framework 3.4) ### Comparative Information To help users of financial statements in evaluating changes and trends, financial statements also provide comparative information for at least one preceding reporting period. For example, an entity's 2019 current-year financial statements include the 2018 preceding year-financial statements as comparative information. This allows users to assess the information's intra-comparability. ### Forward-Looking Information Financial statements are designed to provide information about past events (i.e., historical data). Information about possible future transactions and other events is included in the financial statements only if it relates to the past information presented in the financial statements and is deemed useful to users of financial statements. Financial statements, however, do not typically provide forward-looking information about management's expectations and strategies for the reporting entity. Financial statements include information about events after the end of the reporting period if it is necessary to meet the objective of financial statements. ### Perspective Adopted in Financial Statements Information in financial statements is prepared from the perspective of the reporting entity, not from the perspective of any particular group of financial statement user. ### Going Concern Assumption 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. If this is not the case, the entity's financial statements are prepared on another basis (e.g., measurement at realizable values rather than mixture of costs and values). *Going concern is referred to as the 'underlying assumption' in the previous version of the Conceptual Framework. ### The 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. Sometimes an entity controls another entity. The controlling entity is called the parent, while the controlled entity is called the subsidiary. "If a reporting entity comprises both the parent and its subsidiaries, the reporting entity's financial statements are referred to as 'consolidated financial statements'. If a reporting entity is the parent alone, the reporting entity's financial statements are referred to as 'unconsolidated financial statements'." (Conceptual Framework 3.11) "If a reporting entity comprises two or more entities that are not all linked by a parent-subsidiary relationship, the reporting entity's financial statements are referred to as 'combined financial statements." (Conceptual Framework 3.12) For example, Jollibee Foods Corporation controls Chowking, Greenwich, Mang Inasal, Dunkin' Donuts and many other companies. Jollibee is the parent, while the controlled companies are the subsidiaries. The financial statements of Jollibee, including its subsidiaries, are called consolidated financial statements. The financial statements of Jollibee alone, excluding its subsidiaries, are called unconsolidated financial statements. (The financial statements of each subsidiary alone are referred to as 'individual financial statements.') If financial statements are prepared to include only Chowking and Greenwich (two subsidiaries only without the parent), the financial statements would be referred to as combined financial statements. ### Consolidated and Unconsolidated Financial Statements * **Consolidated financial statements** provide information on a parent and its subsidiaries viewed as a single reporting entity. Consolidated financial statements are not designed to provide information on any particular subsidiary; that information is provided in the subsidiary's own financial statements. Consolidated information enables users to better assess the parent's prospects for future cash flows because the parent's cash flows are affected by the cash flows of its subsidiaries. Accordingly, when consolidation is required, unconsolidated financial statements cannot be used as substitute for consolidated financial statements. However, a parent may nonetheless be required or choose to prepare unconsolidated financial statements in addition to consolidated financial statements. * **Unconsolidated financial statements** provide information on a single entity, without taking its subsidiaries into account. Unconsolidated financial statements are useful for understanding the financial position and performance of the single entity, without considering the impact of its subsidiaries. ## The Elements of Financial Statements The elements of financial statements are: * **Assets:** These relate to the entity's financial position. * **Liability:** These relate to the entity's financial performance. ### 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) The definition of asset has the following three aspects: * **Right:** Asset is an economic resource and an economic resource is a right that has the potential to produce economic benefits. * **Potential to produce economic benefits:** Rights that have the potential to produce economic benefits include: * **Rights that correspond to an obligation of another party:** * right to receive cash, goods or services. * right to exchange economic resources with another party on favorable terms. * right to benefit from an obligation of another party to transfer an economic resource if a specified uncertain future event occurs. * **Rights that do not correspond to an obligation of another party:** * right over physical objects (e.g., right to use a property or right to sell an inventory). * right to use intellectual property. (Conceptual Framework 4.6) Rights normally arise from law, contract or similar means. For example, the right to use a property may arise from owning it or leasing it. However, rights could also arise from other means, for example, by creating a know-how (e.g., trade secret) that is not in the public domain or through a constructive obligation created by another party. For goods or services that are received and immediately consumed (e.g., supplies and employee services), the entity's right to obtain the related economic benefits exists momentarily until the entity consumes the goods or services. **Not all rights are assets.** To be an asset, the right must have the potential to produce for the entity economic benefits that are beyond the benefits available to all other parties and those economic benefits must be controlled by the entity. For example, a public road which anybody can access without significant cost and a know-how that is in the public domain are not assets of the entity. An entity cannot have a right to obtain economic benefits from itself. Thus, treasury shares are not an entity's assets. Similarly, debt and equity instruments issued by a parent and held by its subsidiary (or vice versa) are not assets (or liabilities) in the consolidated financial statements. **Theoretically, each right** is a separate asset. However, for accounting purposes, related rights are often treated as a single asset. For example, ownership of a physical object typically gives rise to several rights, such as the right to use the object, the right to sell it, the right to pledge it, and other similar rights. **The asset is the set of rights and not the physical object.** For example, a lessee (someone who rents a property) may recognize an asset for its right to use the property (i.e., 'right-of-use asset' or, in layman's terms, leasehold rights) but not for the property itself (because the lessee does not legally own the leased property - the lessor does). Nonetheless, describing the set of rights as the physical object will often provide a faithful representation of those rights. There can be instances where the existence of a right is uncertain, for example, when the entity's right is disputed by another party. Until that uncertainty is resolved (for example, by a court ruling), it is uncertain whether an asset exists. * **Control:** Control means the entity has the exclusive right over the benefits of an asset and the ability to prevent others from accessing those benefits. Accordingly, if one party controls an asset, no other party controls that asset. Control does not mean that the entity can ensure that the resource will produce economic benefits in all circumstances. It only means that if the resource produces benefits, it is the entity who will obtain those benefits and not another party. Control links an economic resource to an entity and indicates the extent to which an entity should account for that economic resource. For example, an economic resource that an entity does not control is not an asset of the entity. If an entity controls only a portion of an economic resource, the entity accounts only that portion and not the entire resource. Control normally stems from legally enforceable rights (e.g., ownership or legal title). However, ownership is not always necessary for control to exist because control can arise from other rights. For example, Entity A acquires a car through bank financing. Although the bank retains legal title over the car until full payment, the car is nonetheless an asset of Entity A because Entity A has the exclusive right to use the car and therefore controls the benefits from it. **Physical possession is also not always necessary for control to exist.** For example, goods transferred by a principal to an agent on consignment remain as assets of the principal until the goods are sold to third parties. This is because the principal retains control over the goods despite the fact that physical possession is transferred to the agent. Similarly, the agent does not recognize the goods as his assets because he does not control the economic benefits from the goods - the principal does. * **Potential to produce economic benefits:** The asset is the present right that has the potential to produce economic benefits and not the future economic benefits that the right may produce. Thus, the right's potential to produce economic benefits 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. Consequently, an asset can exist even if the probability that it will produce benefits is low, although that low probability affects decisions on whether the asset is to be recognized, how it is measured, what information is to be provided about the asset, and how that information is provided. (Conceptual Framework 4.14, 4.15 & 4.17) An economic resource can produce economic benefits for an entity in many ways. For example, the asset may be: * Sold, leased, transferred or exchanged for other assets; * Used singly or in combination with other assets to produce goods or provide services; * Used to enhance the value of other assets; * Used to promote efficiency and cost savings; or * Used to settle a liability. The presence or absence of expenditure is not necessary in determining the existence of an asset. For example, expenditure on penalty for violation of law does not result to an asset. On the other hand, an asset can be obtained for free from donation. Moreover, acquiring an asset and incurring expenditure do not necessarily need to coincide. For example, inventory purchased on account is recognized as asset before the purchase price is paid. ### Liability Liability is "a present obligation of the entity to transfer an economic resource as a result of past events." (Conceptual Framework 4.26) The definition of liability has the following three aspects: * **Obligation:** An obligation is "a duty or responsibility that an entity has no practical ability to avoid." (Conceptual Framework 4.29) * **Transfer of an economic resource:** * **Present obligation as a result of past events:** **An obligation is either:** * **Legal obligation:** An obligation that results from a contract, legislation, or other operation of law; or * **Constructive obligation:** An obligation that results from an entity's actions (e.g., past practice or published policies) that create a valid expectation on others that the entity will accept and discharge certain responsibilities. An obligation is always owed to another party. However, it is not necessary that the identity of that party is known, for example, an obligation for environmental damages may be owed to the society at large. **One party's obligation** normally corresponds to another party's right. For example, a buyer's obligation to pay an accounts payable of $100 normally corresponds to the seller's right to collect an accounts receivable of $100. However, this accounting symmetry is not maintained at all times because the Standards sometimes contain different recognition and measurement requirements for the liability of one party and the corresponding asset of the other party. For example, direct origination costs result to different measurements of the lender's loan receivable and the borrower's loan payable. Similarly, a seller may be required to recognize a warranty obligation but the buyer would not recognize a corresponding asset for that warranty. There can be instances where the existence of an obligation is uncertain. Until that uncertainty is resolved (for example, by a court ruling), it is uncertain whether a liability exists. * **Transfer of an Economic Resource:** The liability is the obligation that has the potential to require the transfer of an economic resource to another party and not the future economic benefits that the obligation may cause to be transferred. Thus, the obligation's potential to cause a transfer of economic benefits need not be certain, or even likely, for example, the transfer may be required only if a specified uncertain future event occurs. What is important is that the obligation already exists and that, in at least one circumstance, it would require the entity to transfer an economic resource. Consequently, a liability can exist even if the probability of a transfer of an economic resource is low, although that low probability affects decisions on whether the liability is to be recognized, how it is measured, what information is to be provided about the liability, and how that information is provided. (Conceptual Framework 4.37 & 4.38) An obligation to transfer an economic resource may be an obligation to: * pay cash, deliver goods, or render services; * exchange assets with another party on unfavorable terms; * transfer assets if a specified uncertain future event occurs; or * issue a financial instrument that obliges the entity to transfer an economic resource. * **Present Obligation as a Result of Past Events:** The obligation must be a present obligation that exists as a result of past events. A present obligation exists as a result of past events if: * the entity has already obtained economic benefits or taken an action; and * 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) **Examples** * **Entity A intends to acquire goods in the future.** Analysis: Entity A has no present obligation. A present obligation arises only when Entity A: * has already purchased and received the goods; and * as a consequence, Entity A will have to pay the purchase price. * **Entity B operates a nuclear power plant. In the current year, a new law was enacted penalizing the improper disposal of toxic waste. No similar law existed in prior years.** Analysis: The enactment of legislation is not in itself sufficient to result in an entity's present obligation, except when the entity: * has already taken an action contrary to the provisions of that law; and * as a consequence, the entity will have to pay a penalty. Accordingly: * Entity B has no present obligation if its existing method of waste disposal does not violate the new law. Similarly, Entity B has no present obligation if it can avoid penalty by changing its future method of waste disposal. * On the other hand, Entity B has a present obligation if its previous waste disposal has already caused damages, and as a consequence, Entity B has to pay for those damages. * **Entity C enters into an irrevocable commitment with another party to acquire goods in the future, on credit.** Analysis: A non-cancellable future commitment gives rise to a present obligation only when it becomes onerous (i.e., burdensome), for example, if the goods become obsolete before the delivery but Entity C cannot cancel the contract without paying a substantial penalty. Unless it becomes burdensome, no present obligation normally arises from a future commitment. * **Although not stated in the sales contract, Entity D has a publicly-known policy of providing free repair services for the goods it sells. Entity D has consistently honored this implied policy in the past.** Analysis: Entity D has a present constructive obligation to provide free repair services for the goods it has already sold because: * Entity D has already taken an action by creating valid expectations on the customers that it will provide free repair services; and * as a consequence, Entity D will have to provide those free services. * **Entity E obtained a loan from a bank. Repayment of the loan is due in 10-years' time.** Analysis: Entity E has a present obligation because it has already received the loan proceeds, and as a consequence, has to make the repayment, even though the bank cannot enforce the repayment until a future date. * **Entity F employed Mr. Juan.** Analysis: Entity F has no present obligation until after Mr. Juan has rendered services. Before then, the contract is executory - Entity F has a combined right and obligation to exchange future salary for Mr. Juan's future services. ### 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." (Conceptual Framework 4.56) An executory contract establishes a combined right and obligation to exchange economic resources, which are interdependent and inseparable. Thus, the two constitute a single asset or liability. The entity has an asset if the terms of the contract are favorable; a liability if the terms are unfavourable. However, whether such an asset or liability is included in the financial statements depends on the recognition criteria and the selected measurement basis, including any assessment of whether the contract is onerous. 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. *Continuing the previous example:* * Entity F neither recognizes an asset nor a liability upon entering the employment contract with Mr. Juan because, at that point, the contract is executory. * If Mr. Juan renders services, the contract ceases to be executory, and Entity F's combined right and obligation changes to a liability - an obligation to pay Mr. Juan's salary (e.g., salaries payable). * If Entity F pays Mr. Juan's salary in advance, Entity F's combined right and obligation changes to an asset - a right to receive the services or a right to be reimbursed if the services are not received (e.g., advances to employees). ## Equity "Equity is the residual interest in the assets of the entity after deducting all its liabilities." (Conceptual Framework 4.63) The definition of equity applies to all entities regardless of form (i.e., sole proprietorship, partnership, cooperative, corporation, non-profit entity, or government entity). Although, equity is defined as a residual, it may be sub-classified in the statement of financial position. For example, the equity of a corporation may be sub-classified into share capital, retained earnings, reserves and other components of equity. Reserves may refer to amounts set aside for the protection of the entity's creditors or stakeholders from losses. For some entities (e.g., cooperatives), the creation of reserves is required by law. Transfers to such reserves are appropriations of retained earnings rather than 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) **The definitions of income and expenses are opposites.** | Income | Expenses | |---|---| | Increases in assets or Decreases in liabilities | Decreases in assets or Increases in liabilities | | Results in increase in equity | Results in decrease in equity | | Excludes contributions from the entity's owners | Excludes distributions to the entity's owners | **Contributions from, and distributions to, the entity's owners are not income and expenses, but rather direct adjustments to equity.** Although income and expenses are defined in terms of changes in assets and liabilities, information on income and expenses is just as important as information on assets and liabilities because financial statement users need information on both the financial position and financial performance of an entity. ## Recognition and 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. "The amount at which an asset, a liability or equity is recognized in the statement of financial position is referred to as its 'carrying amount'." (Conceptual Framework 5.1) Recognition links the elements, the statement of financial position and the statement(s) of financial performance as follows: <start_of_image> Schematic of the recognition process: Statement of financial position at beginning of reporting period ``` Assets minus liabilities equal equity + Statement(s) of financial performance Income