Conceptual Framework for Financial Reporting PDF

Conceptual framework for financial reporting DR. INI E. UDOFIA  At the end of the lesson, students should be able to explain: A Explain the meaning and purpose of conceptual framework. LEARNING B Explain the objectives, qualitative ch...

Conceptual framework for financial reporting DR. INI E. UDOFIA  At the end of the lesson, students should be able to explain: A Explain the meaning and purpose of conceptual framework. LEARNING B Explain the objectives, qualitative characteristics OUTCOMES and limitations of financial statements. C Discuss the underlying assumptions in preparing financial statements. D Identify users of financial statements and their information needs. E Identify and discuss the components of financial statements. F Explain the concept of capital maintenance G Differentiate between principle-based and rule- based financial reporting frameworks. H Discuss financial statements in relation to reporting entities under the conceptual framework.  Most preparers and users of financial The statements recognise that there is a purpose of need for a formal conceptual framework that is useful for accounting, a accounting practice and accounting conceptual standards development. Lack of a formal framework often means that framework standards are developed randomly or only to deal with particular problems. The result is that standards are inconsistent with each other or with legislation or fail to address important issues. For example, until the IASB developed its Framework, there was no proper definition of terms such as ‘asset’, ‘liability’, ‘income’ and ‘expenses’. 3  The business environment is becoming increasingly complex. It is The unlikely that accounting standards purpose of can cover all possible transactions. a Where an entity enters into an conceptual unusual transaction and there is no framework relevant accounting standard, it can refer to the framework and apply the principles in it. It can therefore be argued that a conceptual framework strengthens the credibility of financial reporting and the accounting profession in general. 4  The alternative to a system based on a conceptual framework is a system based on The detailed rules. Accounting standards based on alternative detailed rules are open to abuse. ‘Creative accounting’ is the name given to techniques to a which enable management to give a biased conceptual impression (usually favourable) of the company’s performance while still complying with framework accounting standards and other regulations. During the 1980s there were a number of scandals in which investors were misled by the financial statements of apparently healthy companies which then collapsed. This was one of the original reasons why the IASB and other standard setters developed their conceptual frameworks. Principles are normally much harder to evade than rules. 5  Another disadvantage of a rule-based system is that standard setters are more likely to be The influenced by ‘vested interests’ such as large alternative companies or a particular business sector. The existence of a conceptual framework is an to a important safeguard against this kind of political pressure. conceptual Despite these problems, some preparers and framework regulators still appear to favour rule based standards. Standards based on principles may require management to use its judgement (and to risk making a mistake), while rules simply need to be followed. This can be important where management can face legal action if an investor makes a poor decision based on the financial statements. The use of a conceptual framework can lead to standards that are theoretical and complex. They may give the ‘right answer’ but be very difficult for the ordinary preparer to understand and apply. However, a system of extremely detailed rules can also be very difficult to apply. 6  Describes: Objectives the qualitative characteristics of useful financial information; of the IASB the definition, recognition and measurement conceptual of the elements from which financial statements are constructed; and concepts of framework capital and capital maintenance. assist the IASB to develop IFRS Standards (Standards) that are based on consistent concepts; assist preparers to develop consistent accounting policies when no standard applies to a particular transaction or other event, or when IFRS allows a choice of accounting policy; and assist all parties to understand and interpret IFRS. 7  The Conceptual Framework sets out the concepts that underlie the preparation and presentation of financial statements for external users. Its purpose is to: Purpose of assist the IASB to develop IFRS Standards IASB (Standards) that are based on consistent concepts; framework assist preparers to develop consistent accounting policies when no standard applies to a particular transaction or other event, or when IFRS allows a choice of accounting policy; and assist all parties to understand and interpret IFRS. The Conceptual Framework is not an IFRS and nothing in the Conceptual Framework overrides any specific IFRS. On very rare occasions there may be a conflict between the Conceptual Framework and an IFRS. In those cases, the requirements of the IFRS prevail over those of the Conceptual Framework. 8  Many existing and potential investors, lenders and other creditors cannot require Users and reporting entities to provide information their directly to them and must rely on general purpose financial reports for much of the information financial information they need. These are needs the primary users to whom general purpose financial reports are directed General purpose financial reports cannot provide all the information needed and users also need to consider pertinent information from other sources. General purpose financial reports do not show the value of a reporting entity; but they provide information to help users estimate a value. 9  Individual primary users have different Users and information needs. The aim of IFRSs is to provide information that will meet their the needs of the maximum number of information primary users. needs Regulators and members of the public other than investors, lenders and other creditors, may also find general purpose financial reports useful but these reports are not primarily directed to these groups. A company’s management is often interested in financial information but the management do not need to rely on general purpose financial reports 10  The objective of general purpose financial Chapter1: reporting forms the foundation of the Conceptual Framework. Other aspects of the Objective Conceptual Framework flow logically from the of general objective. purpose The objective The objective of general purpose financial financial reporting is to provide financial information statements 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. Those decisions involve buying, selling or holding equity and debt instruments, and providing or settling loans and other forms of credit. In order to make these decisions the users need information to help them assess the prospects for future net cash inflows to an entity. 11  In order to assess an entity’s prospects for future net cash inflows, users need information about: x the resources of the entity; x claims against the entity; and x how efficiently and effectively the entity’s management have discharged their responsibilities to use the entity’s resources. (This information is also useful for decisions by those who have the right to vote on or otherwise influence management performance). Information provided General purpose financial statements provide information about: the financial position of the entity – information about economic resources and the claims against them; and changes in its financial position which could be due to: x financial performance; and/or x other events or transactions (e.g share issues) 12  Information about the nature and amounts of economic resources and claims can help users to: ‰ identify the financial strengths and weaknesses of Economic a reporting entity; ‰ to assess a reporting entity’s liquidity and solvency resources and its needs for additional financing; and claims Information about priorities and payment requirements of existing claims helps users to predict how future cash flows will be distributed among those with a claim against the reporting entity. Changes in economic resources and claims – Financial performance Accrual accounting depicts the effects of transactions and other events and circumstances on a reporting entity’s economic resources and claims in the periods in which those effects occur, even if the resulting cash receipts and payments occur in a different period. This is important because such information provides a better basis for assessing the entity’s past and future performance than information solely about cash receipts and payments during that period.. 13  It helps users to understand the return generated Importance of from its economic resources. This in turn provides information an indication of how well management has about a discharged its responsibilities to make efficient and effective use of these resources. reporting It shows the capacity of a reporting entity to entity’s generate net cash inflows through its operations financial rather than by obtaining additional resources performance: directly from investors and creditors. It gives an indication of the extent to which events such as changes in market prices or interest rates affect its ability to generate net cash inflows. Information about the variability and components of return is also important, especially in assessing the uncertainty of future cash flows Information about past financial performance is helpful in predicting the entity’s future returns on its economic resources. 14  Another aspect of performance is management of cash flow. Information about a reporting entity’s cash flows during a period helps users to assess the entity’s ability to generate future net cash inflows. Management It indicates how the reporting entity obtains and spends cash, including information about of cash flow its borrowing and repayment of debt, cash dividends or other cash distributions to investors, and other factors that may affect the entity’s liquidity or solvency. Information about cash flows helps users understand a reporting entity’s operations, evaluate its financing and investing activities, assess its liquidity or solvency and interpret other information about financial performance. 15  Changes in Information about this type of economic change is necessary to give users resources and claims – a complete understanding of why Other events the reporting entity’s economic and resources and claims changed transactions and the implications of those changes for its future financial performance. 16  The objectives of financial Objectives statements are met by: of financial the main financial statements statements: (statement of financial position, summary statement of profit or loss and other comprehensive income (or statement of profit or loss and statement of other comprehensive income), statement of cash flows, and statement of changes in equity), and supporting notes to the accounts, which provide additional details. 17  The objective of financial Chapter3: statements is to provide financial Objective and scope information about the reporting of financial entity’s assets, liabilities, equity, statements income and expenses that is useful to users of financial statements in assessing the prospects for future net cash inflows to the reporting entity and in assessing management’s stewardship of the entity’s economic resources. 18  That information is provided: in the statement of financial position, by Purpose of recognising assets, liabilities and equity; general in the statement(s) of financial performance, by recognising income and expenses; and purpose in other statements and notes, by presenting and disclosing information about: financial X recognised and unrecognised assets and liabilities, statements equity, income and expenses; x cashflows; x contributions from holders of equity claims and distributions to them; and x the methods, assumptions and judgements used in estimating the amounts presented or disclosed, and changes in those methods, assumptions and judgements. 19  Reporting period Financial statements are prepared for a specified period of time (reporting period) Key and provide information about: concepts ‰ assets and liabilities (including unrecognised assets and 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. Perspective Financial statements provide information viewed from the perspective of the reporting entity as a whole. 20  Going concern assumption Financial statements are normally prepared on the assumption that Key the reporting entity is a going concepts concern and will continue in operation for the foreseeable future. It is assumed that the entity does not intend or need to enter liquidation or to cease trading. If that is not the case, the financial statements may have to be prepared on a different basis and the basis used must be described. 21  A reporting entity is one that prepares financial statements. The A reporting entity can be a single reporting entity or a portion of an entity or entity can comprise more than one entity (e.g., a group). A reporting entity is not necessarily a legal entity. It can be difficult to determine the boundary of a reporting entity that is not a legal entity. In this case the boundary is determined by taking into account the information needs of the primary users. 22  Information must have certain characteristics in order for it to be useful Chapter 2 for decision making. The IASB Conceptual QUALITATIVE Framework describes: CHARACTERISTICS fundamental qualitative characteristics; OF USEFUL and FINANCIAL enhancing qualitative characteristics INFORMATION The qualitative characteristics that enhance the usefulness of information are: ‰ relevance; and ‰ faithful representation ‰ comparability; ‰ verifiability ‰ timeliness; and ‰ understandability 23  Information must be both relevant and faithfully represented if it is to be useful. The enhancing qualitative characteristics cannot make Fundamental information useful, if that information is irrelevant or not faithfully represented. characteristic Relevance Information must be relevant to the decision-making - Relevance needs of users. Information is relevant if it can be used for predictive and/or confirmatory purposes. predictive value if it helps users to predict what might happen in the future. confirmatory value if it helps users to confirm the assessments and predictions they have made in the past. The relevance of information is affected by its materiality. Information is material if omitting it or misstating it could influence decisions that users make on the basis of financial information about a specific reporting entity. 24  Materiality is an entity-specific Qualitativ aspect of relevance based on the e nature or magnitude (or both) of characteri the items to which the information stics relates in the context of an individual entity’s financial report. Therefore, it is not possible for the IASB to specify a uniform quantitative threshold for materiality or predetermine what could be material in a particular situation 25  Financial reports represent Fundamental economic phenomena (economic characteristic- resources, claims against the Faithful reporting entity and the effects of representation transactions and other events and conditions that change those resources and claims) by depicting them in words and numbers. To be useful, financial information must not only represent relevant phenomena, but it must also faithfully represent the phenomena that it purports to represent. 26  A perfectly faithful representation would have three characteristics. It Fundamental would be: complete – the depiction includes all characteristic- information necessary for a user to Faithful understand the phenomenon being representation depicted, including all necessary descriptions and explanations. neutral – the depiction is without bias in the selection or presentation of financial information; free from error – where there are no errors or omissions in the description of the phenomenon, and the process used to produce the reported information has been selected and applied with no errors in the process. 27  Comparability Comparability is the qualitative Enhancing characteristic that enables users to identify qualitative and understand similarities in, and differences among, items characteristi Information about a reporting entity is cs more useful if it can be compared with similar information about other entities and with similar information about the same entity for another period or another date. Consistency is related to comparability but is not the same. Consistency refers to the use of the same methods for the same items, either from period to period within a reporting entity or in a single period across entities. Consistency helps to achieve the goal of comparability. 28  Verifiability This quality helps assure users that information faithfully Enhancing represents the economic phenomena it purports to represent. Verifiability means that different qualitative knowledgeable and independent observers could reach consensus that a particular depiction is a faithful characteri representation. Quantified information need not be a single point estimate to be verifiable. A range of possible stics amounts and the related probabilities can also be verified. Timeliness This means having information available to decision- makers in time to be capable of influencing their decisions. Understandability Information is made understandable by classifying, characterizing and presenting it in a clear and concise manner. Financial reports are prepared for users who have a reasonable knowledge of business and economic activities and who review and analyse the information diligently 29  ANY QUESTIONS? 30  THE END 31