CONFRAS-HANDOUT PDF - Financial Reporting Concepts

UNIT 2: CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING Introduction Unit Learning Objective The Conceptual Framework for By the end of this unit, you should be Financial Reporting is a single able to discuss the Revised document promulgated by the...

UNIT 2: CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING Introduction Unit Learning Objective The Conceptual Framework for By the end of this unit, you should be Financial Reporting is a single able to discuss the Revised document promulgated by the Conceptual Framework for Financial IASB. Reporting. It is a summary of terms and concepts that underlie the preparation and presentation of “general-purpose financial statements” for external users. It is the underlying theory for the development of accounting standards and revisions of the previously issued accounting standards. General-purpose financial statements are financial reports directed to the general information needs of a wide range of users who are not in a position to demand reports tailored to their specific information needs. Revised Conceptual Framework -It is a comprehensive set of concepts for financial reporting. Read: IFRS Conceptual Framework Project Summary (Check our GC.) https://www.ifrs.org/content/dam/ifrs/project/conceptual- framework/fact-sheet-project-summary-and-feedback- statement/conceptual-framework-project-summary.pdf Timing This unit is expected to consume six (6) study hours – four (4) hours for reading and comprehension, and two (2) hours for answering the assessments. Getting Started! 2.1 PURPOSES OF THE CONCEPTUAL FRAMEWORK The following are among the purposes of the Conceptual Framework for Financial Reporting: a. To assist the Board to develop IFRS Standards (Standards) based on consistent concepts, resulting in financial 1  information that is useful to investors, lenders and other creditors; b. To assist preparers of financial reports to develop consistent accounting policies for transactions or other events when no Standard applies or a Standard allows a choice of accounting policies; c. To assist all parties to understand and interpret Standards. The Conceptual Framework is not a standard. If there is a standard or an interpretation that specifically applies to a transaction, the standard or interpretation overrides the Conceptual Framework. Nothing in this Conceptual Framework overrides any specific PFRS. In the case of conflict between the two, the latter (PFRS) prevails. The Conceptual Framework attempts to provide an overall theoretical foundation for accounting that will guide standard-setters, preparers, and users of financial information in preparing and presenting statements. Nothing in this document is designed to provide a specific treatment for a particular accounting transaction or event, and such is the accounting standard’s job. In the absence of a Standard or an Interpretation that specifically applies to a transaction, management must use its judgment in developing and applying an accounting policy that results in relevant and reliable information. In making that judgment, IAS 8.11 requires management to consider the definitions, recognition criteria, and measurement concepts for assets, liabilities, income, and expenses in the Framework. 2.2 SCOPE OF CONCEPTUAL FRAMEWORK Chapter 1 - Objective of financial reporting; Chapter 2 - Qualitative characteristics of useful financial information; Chapter 3 - Description of the reporting entity and its boundary; Chapter 4 - Definitions of an asset, a liability, equity, income and expenses; Chapter 5 - Criteria for including assets and liabilities in financial statements (recognition) and guidance on when to remove them (derecognition); Chapter 6 - Measurement bases and guidance on when to use them; Chapter 7 - Concepts and guidance on presentation and disclosure. Chapter 8 – Concepts of Capital and Capital Maintenance 2 CHAPTER 1: OBJECTIVE OF FINANCIAL REPORTING Summary of changes: This chapter was issued in 2010 and went through extensive due process at that time. Therefore, in revising the Conceptual Framework, the Board did not fundamentally reconsider this chapter. However, it clarified why information used in assessing stewardship is needed to achieve the objective of financial reporting. Stewardship - Users of financial reports need information to help them assess management’s stewardship. The Conceptual Framework explicitly discusses this need as well as the need for information that helps users assess the prospects for future net cash I nflows to the entity. The objective of financial reporting is to provide financial information that is useful to users in making decisions relating to providing resources to the entity. Users of financial reports are an entity’s existing and potential investors, lenders and other creditors. Those users must rely on financial reports for much of the financial information they need. Financial reporting is directed primarily to the existing and potential investors, lenders, and other creditors, which compose the primary user group. Information that meets the needs of the specified primary users is likely to meet the needs of other users such as employees, customers, governments, and their agencies. Users’ decisions involve decisions about buying, selling or holding equity or debt instruments, providing or settling loans and other forms of credit, and voting, or otherwise influencing management’s actions. To make these decisions, users assess prospects for future net cash inflows to the entity and management’s stewardship of the entity’s economic resources. To make both these assessments, users need information about both the entity’s economic resources, claims against the entity and changes in those resources and claims how efficiently and effectively management has discharged its responsibilities to use the entity’s economic resources. General-purpose financial reports do not and cannot provide all the information that the users need. These users need to consider pertinent information from other sources, such as general economic conditions, political events, and industry outlook. General-purpose financial reports are not designed to show the value of an entity. They provide, however, the information to help the primary users estimate the value of the entity. 3 CHAPTER 2: QUALITATIVE CHARACTERISTICS (Fundamental & Enhancing) Summary of changes: This chapter was issued in 2010 and went through extensive due process at that time. Therefore, in revising the Conceptual Framework the Board did not fundamentally reconsider this chapter. However, the Board clarified the roles of prudence, measurement uncertainty and substance over form in assessing whether information is useful. Prudence - Neutrality is supported by the exercise of prudence. Prudence is the exercise of caution when making judgements under conditions of uncertainty. Prudence does not allow for overstatement or understatement of assets, liabilities, income or expenses. Measurement uncertainty - Measurement uncertainty does not prevent information from being useful. However, in some cases the most relevant information may have such a high level of measurement uncertainty that the most useful information is information that is slightly less relevant but is subject to lower measurement uncertainty. For information to be useful it must both be relevant and provide a faithful representation of what it purports to represent. Relevance and faithful representation are the fundamental qualitative characteristics of useful financial information, and the guiding concepts that apply throughout the revised Conceptual Framework. FUNDAMENTAL QUALITATIVE CHARACTERISTICS (Relevance & Faithful Representation) RELEVANCE Relevance is the capacity of the information to influence a decision. Information that does not bear an influence on any economic decision is useless. Financial information is capable of making a difference in a decision if it has predictive value and confirmatory value. Financial information has predictive value if it can be used as an input to processes employed by users to predict future outcome. Financial information has confirmatory value when it enables users to confirm or correct earlier expectations. Illustration 1 If the interim income statement for the first quarter is ₱2,000,000 (confirmatory value), and this trend continues for the entire year, it is logical to assume that the net income after four quarters or one year would be ₱8,000,000 (predictive value). 4  Inherent in the concept of relevance is the practical rule of MATERIALITY. This rule dictates that strict adherence to GAAP is not required when the items are not significant enough to affect evaluation, decision and fairness of the financial statements. This concept is also known as the doctrine of convenience. The materiality of an item depends on its relative size rather than absolute size. What may be material for one entity may be immaterial for another. Materiality is an entity-specific aspect of relevance based on the nature or magnitude (or both) of the items to which the information relates in the context of an individual entity's financial report. Illustration 2 An omission of ₱1,000,000 in the financial statements of a multi- billion-dollar entity like Apple or Alphabet may not be important to it but maybe so critical for small start-up entities. When is an item material then? There is no hard and fast rule in determining whether an item is material or not. Very often, this is dependent on sound judgment, professional expertise, and common sense honed by years of experience. Information is material, usually if its omission or misstatement could influence the economic decision that the users make based on the financial information about an entity. FAITHFUL REPRESENTATION (Completeness, Neutrality & Free from Error) General-purpose financial reports represent economic phenomena in words and numbers. To be useful, financial information must not only be relevant, but it must also represent faithfully the phenomena it purports to represent. Faithful representation means representing the substance of an economic phenomenon instead of representing its legal form only. A financial report is faithfully represented when it represents the actual effects of the transactions during the accounting period. To perfectly have faithful representation, a depiction should possess three characteristics: Completeness Completeness requires that all relevant information be presented to facilitate understanding and avoid erroneous implications. Completeness is the result of the adequate disclosure standard or the principle of full disclosure. However, keep in mind the previously discussed concept of materiality. Completeness and materiality must be harmonized for a 5 faithfully represented financial report. Completeness, in this context, does not mean the disclosure of all possible data but merely the substantial disclosure of all RELEVANT data, setting aside the immaterial items. Too much data often leads to complicated and incomprehensible reports. Neutrality A neutral depiction is without bias in the preparation or presentation of financial information. The financial information should not enrich one party at the expense of another. Information contained in the financial statements must be free from bias. It is well to remember that general purpose financial statements are directed to the common needs of many users and not to the particular desires of specific users. The exercise of prudence supports a neutral depiction. Prudence is the exercise of caution when making judgments under conditions of uncertainty. In accounting, the convention of conservatism, also known as the doctrine of prudence, is a policy of anticipating possible future losses but not future gains. This policy tends to understate rather than overstate net assets and net income, and therefore lead companies to "play safe." When given a choice between several outcomes where the probabilities of occurrence are equally likely, you should recognize that transaction resulting in a lower amount of profit, or at least the deferral of a profit. It states that when choosing between two solutions, the one that will be least likely to overstate assets and income should be selected. Essentially, "expected losses are losses but expected gains are not gains." The conservatism principle is the foundation for the lower of cost or market rule, which states that you should record inventory at the lower of either its acquisition cost or its current market value. Another concept of prudence or conservatism is illustrated in IAS 37 – Provisions, Contingent Liabilities, and Contingent Assets, where a contingent liability is recognized in the financial statements despite its chances of outflow being probable only. In contrast, a contingent asset is recognized only when its existence is virtually certain. Freedom from Error A report that is free from error does not connote a perfectly infallible report. This principle substantially complies with the clear, reasonable, and good faith disclosure of items in the financial reports. Implicit to this is the principle of “substance over form.” A faithfully represented report inherently represents the substance of an economic phenomenon or transaction rather than merely representing its legal form. 6 Illustration 3 A lease contract that bears a provision of a transfer of ownership at the termination of the lease period may hint that, in substance, the contract is an installment sale rather than a contract of lease. Thus, in disclosing this fact in a financial report, it is wise to present it as a sale contract rather than a lease contract. ENHANCING QUALITATIVE CHARACTERISTICS (VCUT) Enhancing qualitative characteristics, as contrasted with the fundamental qualitative characteristics, relate to the form rather than the substance of the financial reports. These four qualitative characteristics enhance the usefulness of information, but they cannot make non-useful information useful. COMPARABILITY Comparability is the enhancing qualitative characteristic that enables users to identify and understand similarities and dissimilarities among items in the financial reports. Comparability may be made horizontally or dimensionally. Horizontal comparability is the quality of information that allows comparisons within a single entity through time or from one accounting period to the next. Dimensional comparability is the quality of information that allows comparisons between two or more entities engaged in the same industry. For information to be comparable, things must look alike, and different things must look different. Comparability is not enhanced by making, unlike things look-alike or making like things look different. Implicit in the concept of comparability is the principle of consistency. This principle prescribes that accounting methods and practices should be applied uniformly from period to period. Comparability is the goal, and consistency is the means to achieve that goal. 7 Illustration 4 An entity that has adopted the straight-line method of depreciation in 2020 is advised to use the same method of depreciation in the subsequent year for more comparable reports. The usage of another depreciation method, such as the declining balance method, for the subsequent years, may result in the distortion of data leading to erroneous comparisons and ultimately erroneous decisions. Consider the following simple financial reports: Rickrolled, Inc. 2021 Revenue ₱1,000,000 Expenses, including ₱700,000 depreciation expense of P200,000, computed under the double-declining method for 10 years Income ₱300,000 Rickrolled, Inc. 2020 Revenue ₱1,000,000 Expenses, including ₱P700,000 depreciation expense of P100,000, computed under the straight-line method for 10 years Income ₱300,000 In this scenario, suppose that the change was not apparent and was not disclosed in any other accompanying reports, the users may be led to believe that the expenses incurred by Rickrolled, Inc. remained unchanged for the periods presented, where in fact, there was actually savings of ₱100,000 as the additional ₱100,000 expense is only brought about by the change in depreciation method employed by the company. However, consistency does not mean that no change in accounting methods can be made. If the change results in more useful and meaningful information, then such change may be allowed. In doing so, the entity may be required to disclose the effects of the change and the reasons, therefore. UNDERSTANDABILITY Understandability requires that financial information must be comprehensible or intelligible if it is to be most useful. Accordingly, the information should be presented in a form and expressed in a language that a user understands. However, complex economic activities make it impossible to reduce the financial information to the simplest terms. Financial statements cannot realistically be comprehensible to everyone. Medical personnel or even those in the legal field without much background on accounting and management may not easily understand a report which appears to be simple if seen through the lenses of accountants. 8  Understandability simply means that users who have reasonable knowledge of business, economic activities, and accounting in general, who review and analyze the financial reports, should understand such reports. VERIFIABILITY Verifiability means that different knowledgeable and independent observers could reach a consensus, although not necessarily complete agreement, that a particular depiction is a faithful representation. Verifiable financial information provides results that would be substantially duplicated by measurers using the same measurement method. TIMELINESS Timeliness requires that financial information must be available or communicated early enough when a decision is to be made. Information no matter how relevant or faithfully represented furnished after a decision has already been made is useless and of no value. Generally, the older the information, the less useful it is. The famous proverb, “What good is the grass if the horse is already dead” is clearly at play in this qualitative characteristic of a good financial report. However, some information may continue to be relevant despite the end of the reporting period, as some users may need to identify and assess future trends. Enhancing qualitative characteristics should be maximized to the extent necessary. However, enhancing qualitative characteristics (individually or collectively) cannot render information useful if that information is irrelevant or not represented faithfully. COST CONSTRAINT The benefit of providing the information needs to justify the cost of providing and using the information Distinct and separate from the fundamental and enhancing qualitative characteristics of financial information is the concept of COST. Cost is a pervasive content on the information that can be provided by financial reporting. Reporting financial information imposes cost and it is important that such cost is justified by the benefit derived from the financial information. 9 CHAPTER 3: FINANCIAL STATEMENTS AND THE REPORTING ENTITY This chapter is new. It describes the objective and scope of financial statements and provides a description of the reporting entity Boundary of a reporting entity: Determining the appropriate boundary of a reporting entity can be difficult if, for example, the entity is not a legal entity. In such cases, the boundary is determined by considering the information needs of the users of the entity’s financial statements. Those users need information that is relevant and that faithfully represents what it purports to represent. A reporting entity does not comprise an arbitrary or incomplete collection of assets, liabilities, equity, income and expenses. Reporting entity Reporting entity is defined as an entity that is required, or chooses, to prepare financial statements. It is not necessarily a legal entity—it could be a portion of an entity or comprise more than one entity. Financial statements It is a particular form of financial reports that provide information about the reporting entity’s assets, liabilities, equity, income and expenses. Consolidated financial statements - provides information about assets, liabilities, equity, income and expenses of both the parent and its subsidiaries as a single reporting entity Unconsolidated financial statements - provides information about assets, liabilities, equity, income and expenses of the parent only Combined financial statements - provides information about assets, liabilities, equity, income and expenses of two or more entities that are not all linked by a parent-subsidiary relationship 10 CHAPTER 4: THE ELEMENTS OF FINANCIAL STATEMENTS Summary of changes: The definitions of an asset and a liability have been refined and the definitions of income and expenses have been updated only to reflect that refinement. The definition of equity as the residual interest in the assets of the entity after deducting all its liabilities is unchanged. The Board’s research project on Financial Instruments with Characteristics of Equity is exploring the distinction between liabilities and equity. No practical ability to avoid - The revised Conceptual Framework discusses how the ‘no practical ability to avoid’ criterion is applied in the following circumstances: (a) 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. (b) if a duty or responsibility is conditional on a particular future action that the entity itself may take—the entity has an obligation if it has no practical ability to avoid taking that action. Executory contract - An executory contract is a contract that is equally unperformed. It establishes a single asset or liability for the inseparable combined right and obligation to exchange economic resources. 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. 11  Previous definition of an ASSET Revised definition of an ASSET A resource controlled by the entity as A present economic resource a result of past events and from controlled by the entity as a result of which future economic benefits are past events expected to flow to the entity An economic resource is a right that has the potential to produce economic benefits. Main Changes: separate definition of an economic resource—to clarify that an asset is the economic resource, not the ultimate inflow of economic benefits deletion of ‘expected flow’—it does not need to be certain, or even likely, that economic benefits will arise a low probability of economic benefits might affect recognition decisions and the measurement of the asset Previous definition of an Revised definition of an LIABILITY LIABILITY A present obligation of the entity A present obligation of the entity to arising from past events, the transfer an economic resource as a settlement of which is expected to result of past events An obligation is result in an outflow from the entity of a duty or responsibility that the resources embodying economic entity has no practical ability to avoid benefits Main Changes: separate definition of an economic resource—to clarify that a liability is the obligation to transfer the economic resource, not the ultimate outflow of economic benefits deletion of ‘expected flow’—with the same implications as set out above for an asset introduction of the ‘no practical ability to avoid’ criterion to the definition of obligation Revised definition of INCOME Previous definition of a EXPENSES Increases in assets, or decreases in Decreases in assets, or increases in liabilities, that result in increases in liabilities, that result in decreases in equity, other than those relating to equity, other than those relating to contributions from holders of equity distributions to holders of equity claims claims Unit of account - the right(s) or obligation(s), or group of rights and obligations, to which recognition criteria and measurement concepts are applied Selecting the unit of account: 1. Relevance - A unit of account is selected to provide relevant information about the asset or liability and any related income and expenses. 2. Faithful Representation - A unit of account is selected to provide a faithful represention of the substance of the transaction or other event from which the asset, liability and any related income or expenses have arisen. 12  THE ELEMENTS OF FINANCIAL STATEMENTS EXPLAINED The objective of financial statements is to provide information about an entity's assets, liabilities, equity, income, and expenses that is useful to financial statements users in assessing the prospects for future net cash inflows to the entity and in assessing management's stewardship of the entity's resources. This information is provided in the statement of financial position, statement(s) of financial performance, and other statements and notes. Financial statements portray the financial effects of transactions and other events by grouping them into broad classes according to their economic characteristics. These broad classes are termed the elements of financial statements. The elements of financial statements refer to the quantitative pieces of information that make up the statement of financial position and the statement of comprehensive income. These elements are the so-called building blocks from which financial statements are constructed. The Statement of Financial Position is composed of: ASSETS An 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. An asset is recognized when it is probable (The term probable means that the chance of the future economic benefit arising is more likely rather than less likely, in other words, the chance of occurrence is more than 50%) that future economic benefits will flow to the entity and the asset has a cost or value that can be measured reliably. It is worth noting that ownership is not important in the process of recognizing an asset. What is essential is the CONTROL exercised by the entity over the resource. Control may be briefly described as the ability of the entity to enjoy and reap the benefits derived from an asset while excluding others from enjoying the same benefits. The best example would be the right-of-use assets introduced by PFRS 16. The lease asset is the right to use the underlying asset and is presented in the statement of financial position either as part of property, plant, and equipment or as its own line item. LIABILITIES A liability is a present obligation of the entity to transfer an economic resource as a result of past events. An obligation is a duty or responsibility that an entity has no practical ability to avoid. Obligations may be legally enforceable due to a legally enforceable contract or law (legal) and practice (constructive). 13  A liability is recognized when it is probable that an outflow of resources embodying economic benefits will be required for the settlement of a present obligation, and the amount of the obligation can be measured reliably. EQUITY Equity is the residual interest in the assets of the entity after deducting all of its liabilities. The Statement of Comprehensive Income is composed of: INCOME Income is an increase in asset or decrease in liability that results in an increase in equity, other than contribution from equity participants. Income is recognized when it is probable that an increase in future economic benefits related to an increase in an asset or a decrease in liability has arisen and that the increase in economic benefits can be measured reliably. In other words, income is recognized when it is earned, regardless of the flow of cash. The definition of income encompasses both revenue and gains. Revenue arises in the course of the ordinary activities of an entity and is referred to by a variety of different names including sales, fees, interest, dividends, royalties and rent. Gains represent other items that meet the definition of income and may, or may not, arise in the course of the ordinary activities of an entity. Gains represent increases in economic benefits and as such are no different in nature from revenue. Hence, they are not regarded as constituting a separate element in the IFRS Framework. EXPENSE Expense is the decrease in economic benefit during the accounting period in the form of an outflow or decrease in asset or increase in liability that results in decrease in equity, other than distribution to equity participants. Expenses are recognized when it is probable that a decrease in future economic benefits related to a decrease in an asset or an increase in liability has occurred and that the decrease in economic benefits can be measured reliably. In other words, expense is recognized when incurred, regardless of the flow of cash. 14  The definition of expenses encompasses losses as well as those expenses that arise in the course of the ordinary activities of the entity. Expenses that arise in the course of the entity's ordinary activities include, for example, the cost of sales, wages, and depreciation. They usually take the form of an outflow or depletion of assets such as cash and cash equivalents, inventory, property, plant, and equipment. Losses represent other items that meet the definition of expenses and may, or may not, arise in the course of the entity's ordinary activities. Losses represent decreases in economic benefits, and as such, they are no different in nature from other expenses. Hence, they are not regarded as a separate element in this Framework. The EXPENSE RECOGNITION PRINCIPLE is the application of the matching principle. Under the matching principle, the costs and expenses incurred in earning a revenue shall be reported in the same period the latter is earned. APPLICATION OF THE MATCHING PRINCIPLE Cause and effect association; Expense is recognized when the related revenue is recognized. The reason is the presumed direct association of the expense with the specific items of income. This is an application of the strict matching concept. Illustration 5 Rickrolled, Inc. sold merchandise for ₱400,000 on account. Said merchandise cost the company ₱95,000 to manufacture. Journal Entry: Accounts receivable ₱ 400,000 Sales P 400,000 Cost of Sales ₱ 95,000 Merchandise Inventory ₱ 95,000 When a merchandise inventory is sold, the cost of sale is simultaneously recognized with the revenue (sales). Systematic and rational allocation; Costs are expensed by allocating them over the periods benefited by such costs. The reason is that the cost incurred will directly benefit future periods and that there is an absence of a direct or clear association of the expense with specific revenue. 15 Illustration 6 Rickrolled, Inc. erected a new building with a total cost of ₱10,000,000. The company estimates that the total economic life of the building is 10 years. Under the straight-line method of depreciation, the company must recognize ₱100,000 annually as depreciation expense. Journal Entry: Depreciation Expense ₱ 100,000 Accumulated Depreciation ₱ 100,000 The depreciation expense represents the allocated expense, from the total cost of ₱10,000,000, to each year the building is expected to be used. Immediate recognition The cost incurred is expensed outright because of the uncertainty of future economic benefits or the difficulty of reliably associating certain costs with future revenue. The expenditure is expensed outright when no future economic benefits are expected from the expenditure. Illustration 7 Rickrolled Inc. paid its minimum-wage employees ₱8,125 each for the month of February. The company employs ten employees. Journal Entry: Salaries Expense ₱ 81,250 Cash ₱ 81,250 The entire salaries paid to the employees are immediately recognized as an expense as there are no expected future benefits that will arise from the said transaction. It may be said that the benefits were already reaped from the time the employees worked for the company, and the payment of salaries they already earned is the result of such an event. 16 CHAPTER 5: RECOGNITION AND DERECOGNITION This chapter discusses criteria for including assets and liabilities in financial statements (recognition) and guidance on when to remove them (derecognition). RECOGNITION Summary of changes: The previous recognition criteria were that an entity should recognise an item that met the definition of an element if it was probable that economic benefits would flow to the entity and if the item had a cost or value that could be determined reliably. The revised recognition criteria refer explicitly to the qualitative characteristics of useful information. The Board’s aim was to develop a more coherent set of concepts, not to increase or decrease the range of assets and liabilities recognised. Why recognition is important- Recognising assets, liabilities, equity, income and expenses depicts an entity’s financial position and financial performance in structured summaries (the statements of financial position and financial performance). The amounts recognised in a statement are included in the totals and, if applicable, subtotals, in the statement. The statements are linked because income and expenses are linked to changes in assets and liabilities. RECOGNITION This is the process of capturing for inclusion in the statement of financial position or the statement(s) of 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 and other creditors. Recognition criteria: 1. Relevance - whether recognition of an item results in relevant information may be affected by, for example: a. low probability of a flow of economic benefits; and b. existence uncertainty 2. Faithful Representation - whether recognition of an item results in a faithful representation may be affected by, for example: a. measurement uncertainty; and b. recognition inconsistency (accounting mismatch) c. presentation and disclosure Cost constraint Cost constrains recognition decisions, just as it constrains other financial reporting decisions. 17  DERECOGNITION Summary of changes: The guidance on derecognition is new. Derecognition resulting from a transfer- Normally, a faithful representation of a transfer of an asset or liability is achieved by derecognition of the asset or liability with appropriate presentation and disclosure. However, in limited cases, it may be necessary to continue to recognise a transferred component of an asset or liability together with a liability or asset for the proceeds received or paid, with appropriate presentation and disclosure. DERECOGNITION The removal of all or part of a recognised asset or liability from an entity’s statement of financial position. 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 Derecognition normally occurs: 1. For an asset- when the entity loses control of all or part of the recognised asset 2. For a liability - when the entity no longer has a present obligation for all or part of the recognised liability 18 CHAPTER 6: MEASUREMENT This chapter describes various measurement bases and discusses factors to be considered when selecting a measurement basis. Summary of changes: The previous version of the Conceptual Framework included little guidance on measurement. The revised Conceptual Framework describes what information measurement bases provide and explain the factors to consider when selecting a measurement basis. Selecting a measurement basis: In selecting a measurement basis, it is necessary to consider the nature of the information in both the statement of financial position and the statement(s) of financial performance. The relative importance of each factor to be considered depends upon the facts and circumstances of individual cases. Consideration of the factors and the cost constraint is likely to result in the selection of different measurement bases for different assets, liabilities, income, and expenses. 1. Historical Cost  Historical cost provides information derived, at least in part, from the price of the transaction or other event that gave rise to the item being measured.  Historical cost of assets is reduced if they become impaired and historical cost of liabilities is increased if they become onerous.  One way to apply a historical cost measurement basis to financial assets and financial liabilities is to measure them at amortised cost. 2. Current Value Current value provides information updated to reflect conditions at the measurement date. It includes: a. Fair Value  This 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.  This reflects market participants’ current expectations about the amount, timing and uncertainty of future cash flows. b. Value in Use (for assets) Fulfilment Value (for liabilities)  This reflects entity-specific current expectations about the amount, timing and uncertainty of future cash flows. c. Current Cost  This reflects the current amount that would be:  paid to acquire an equivalent asset  received to take on an equivalent liability 19  The factors to be considered when selecting a measurement basis are relevance and faithful representation, because the aim is to provide information that is useful to investors, lenders and other creditors. Relevance of information provided by a measurement basis is affected by: a. characteristics of the asset or liability  the variability of cash flows  sensitivity of the value to market factors or other risks  for example, amortised cost cannot provide relevant information about a deriviative b. contribution to future cash flows  whether cash flows are produced directly or indirectly in combination with other economic resources  the nature of the entity’s business activities  for example, if assets are used in combination to produce goods or services, historical cost can provide relevant information about margins achieved in a period Faithful representation - Whether a measurement basis can provide a faithful representation is affected by: a. measurement inconsistency  If financial statements contain measurement inconsistencies (accounting mismatch), those financial statements may not faithfully represent some aspects of the entity’s financial position and financial performance. b. measurement uncertainty  does not necessarily prevent the use of a measurement basis that provides relevant information  but if too high might make it necessary to consider selecting a different measurement basis Cost constraint Cost constrains the selection of a measurement basis, just as it constrains other financial reporting decisions. 20 CHAPTER 7: PRESENTATION AND DISCLOSURE This chapter includes concepts on presentation and disclosure and guidance on including income and expenses in the statement of profit or loss and other comprehensive income. Summary of changes: This chapter is new. Better Communication: Information about assets, liabilities, equity, income and expenses is communicated through presentation and disclosure in the financial statements. Effective communication of information in financial statements makes that information more relevant and contributes to a faithful representation of an entity’s assets, liabilities, equity, income and expenses. The revised Conceptual Framework includes concepts that describe how information should be presented and disclosed in financial statements. The Board is also working on several projects on the theme of Better Communication to make financial information more useful to investors, lenders and other creditors and to improve the communication of that information. The Statement of Profit or Loss  the primary source of information about an entity’s financial performance for the reporting period  could be a section of a single statement of financial performance or a separate statement  The statement(s) of financial performance include(s) a total (subtotal) for profit or loss  In principle, all income and expenses are classified and included in the statement of profit or loss. Other comprehensive income  In exceptional circumstances, the Board may decide to exclude from the statement of profit or loss income or expenses arising from a change in current value of an asset or liability and include those income and expenses in other comprehensive income  The Board may make such a decision when doing so would result in the statement of profit or loss providing more relevant information or a more faithful representation. 21 CHAPTER 8: CONCEPTS OF CAPITAL AND CAPITAL MAINTENANCE The Board decided that updating the discussion of capital and capital maintenance was not feasible when it developed the 2018 Conceptual Framework and could have delayed the completion of the 2018 Conceptual Framework significantly. The Board decided that it would be inappropriate for the 2018 Conceptual Framework to exclude a discussion of capital and capital maintenance altogether. Those concepts are important to financial reporting and influence the definitions of income and expenses, the selection of measurement bases, and presentation and disclosure decisions. Therefore, the material in Chapter 8—Concepts of capital and capital maintenance of the 2018 Conceptual Framework has been carried forward unchanged from the 2010 Conceptual Framework. That material originally appeared in the 1989 Framework. The Board may decide to revisit the concepts of capital and capital maintenance in the future if it considers such a revision necessary. The financial performance of an entity is determined using two approaches: The transaction approach The transaction approach is the traditional preparation of an income statement wherein an entity recognizes each accountable transaction as they occur and summarizes the ultimate result thereof by comparing the total accumulated revenue and total accumulated expense during a specific accounting period. The capital maintenance approach The capital maintenance approach is the process of determining the income of an entity by simply comparing the capital at the beginning of the accounting period and the end of the same period. If the latter exceeds the former, then there is income. If otherwise, there is a loss. Two concepts of capital maintenance approach: Financial capital - the absolute monetary amount of the net assets contributed by the shareholders and the amount of the increase in net assets resulting from earning retained by the entity. This is based on historical cost. Physical capital - the quantitative measure of the physical productive capacity to produce goods and services. This concept requires that productive assets shall be measured at current costs rather than historical costs. 22  Unit Summary  The Conceptual Framework for Financial Reporting sets out the basic concepts and postulates in financial reporting that will aid in the creation of accounting standards, preparation, presentation, audit, and general use of financial statements.  It does not seek to replace or override any accounting standard as its operation is merely suppletory to such accounting standards. Its scope includes: the objective of a financial reporting; qualitative characteristics of useful financial information; definition, recognition, and measurement of the elements from which financial statements are constructed; concepts of capital and capital maintenance; and the reporting entity. 23