Lecture: The Conceptual Framework PDF

TOPIC 2: THE CONCEPTUAL FRAMEWORK FINANCIAL REPORTING AND ASSUMPTIONS Conceptual Framework for Financial Reporting describes the objective of, and the concepts for, general purpose financial reporting. Purpose of the Conceptual Framework is to: a. assist the International Accounting Standards Bo...

TOPIC 2: THE CONCEPTUAL FRAMEWORK FINANCIAL REPORTING AND ASSUMPTIONS Conceptual Framework for Financial Reporting describes the objective of, and the concepts for, general purpose financial reporting. Purpose of the Conceptual Framework is to: a. assist the International Accounting Standards Board to develop IFRS Standards that are based on consistent concepts; b. assist preparers to develop consistent accounting policies when no Standard applies to a particular transaction or other event, or when a Standard allows a choice of accounting policy; and c. assist all parties to understand and interpret the Standards. The Conceptual Framework is not a Standard. Nothing in the Conceptual Framework overrides any Standard or any requirement in a Standard. Objective of General-Purpose Financial Reporting It is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions relating to providing resources to the entity. Those decisions involve decisions about:  buying, selling or holding equity and debt instruments;  providing or settling loans and other forms of credit; or  exercising rights to vote on, or otherwise influence, management's actions that a ect the use of the entity's economic resources. To make assessments, existing and potential investors, lenders and other creditors need information about:  the economic resources of the entity, claims against the entity and changes in those resources and claims; and  how e iciently and e ectively the entity's management and governing board have discharged their responsibilities to use the entity's economic resources. General purpose financial reports are not designed to show the value of a reporting entity; but they provide information to help existing and potential investors, lenders and other creditors to estimate the value of the reporting entity. To a large extent, financial reports are based on estimates, judgements and models rather than exact depictions. The Conceptual Framework establishes the concepts that underlie those estimates, judgements and models. General purpose financial reports provide information about the financial position of a reporting entity, which is information about the entity's economic resources and the claims against the reporting entity. Financial reports also provide information about the e ects of transactions and other events that change a reporting entity's economic resources and claims. Both types of information provide useful input for decisions relating to providing resources to an entity. Economic resources and claims Information about the nature and amounts of a reporting entity's economic resources and claims can help users to identify the reporting entity's financial strengths and weaknesses. That information can help users to assess the reporting entity's liquidity and solvency, its needs for additional financing and how successful it is likely to be in obtaining that financing. That information can also help users to assess management's stewardship of the entity's economic resources. Changes in a reporting entity's economic resources and claims result from that entity's financial performance and from other events or transactions such as issuing debt or equity instruments. Information about a reporting entity's financial performance helps users to understand the return that the entity has produced on its economic resources. Information about the return the entity has produced can help users to assess management's stewardship of the entity's economic resources. Accrual basis accounting It depicts the e ects of transactions and other events and circumstances on a reporting entity's economic resources and claims in the periods in which those e ects occur, even if the resulting cash receipts and payments occur in a di erent period. Simply stated, accrual accounting means that income is recognized when earned regardless of when received and expense is recognized when incurred regardless of when paid. Cash basis accounting Information about a reporting entity's cash flows during a period also helps users to assess the entity's ability to generate future net cash inflows and to assess management's stewardship of the entity's economic resources. That information indicates how the reporting entity obtains and spends cash, including information about its borrowing and repayment of debt, cash dividends or other cash distributions to investors, and other factors that may a ect the entity's liquidity or solvency. Management Stewardship Information about how e iciently and e ectively the reporting entity's management has discharged its responsibilities to use the entity's economic resources helps users to assess management's stewardship of those resources. Such information is also useful for predicting how e iciently and e ectively management will use the entity's economic resources in future periods. Examples of management's responsibilities to use the entity's economic resources include protecting those resources from unfavorable e ects of economic factors, such as price and technological changes, and ensuring that the entity complies with applicable laws, regulations and contractual provisions. QUALITATIVE CHARACTERISTICS FUNDAMENTAL QUALITATIVE CHARACTERISTICS are relevance and faithful representation. 1.) Relevance Financial information is capable of making a di erence in the decisions made by users. Information may be capable of making a di erence in a decision even if some users choose not to take advantage of it or are already aware of it from other sources. Financial information is capable of making a di erence in decisions if it has predictive value, confirmatory value or both. Financial information has predictive value if it can be used as an input to processes employed by users to predict future outcomes. Financial information need not be a prediction or forecast to have predictive value. Financial information with predictive value is employed by users in making their own predictions. Financial information has confirmatory value if it provides feedback about (confirms or changes) previous evaluations. Materiality - information is material if omitting, misstating or obscuring it could reasonably be expected to influence decisions that the primary users of general-purpose financial reports make on the basis of those reports, which provide financial information about a specific reporting entity. 2.) Faithful Representation To be useful, financial information must not only represent relevant phenomena, but it must also faithfully represent the substance of the phenomena that it purports to represent. In many circumstances, the substance of an economic phenomenon and its legal form are the same. If they are not the same, providing information only about the legal form would not faithfully represent the economic phenomenon. To be a perfectly faithful representation, a depiction would have three characteristics. It would be complete, neutral and free from error. Complete depiction includes all information necessary for a user to understand the phenomenon being depicted, including all necessary descriptions and explanations. For example, a complete depiction of a group of assets would include, at a minimum, a description of the nature of the assets in the group, a numerical depiction of all of the assets in the group, and a description of what the numerical depiction represents (for example, historical cost or fair value). Neutral depiction is without bias in the selection or presentation of financial information. A neutral depiction is not slanted, weighted, emphasized, de-emphasized or otherwise manipulated to increase the probability that financial information will be received favorably or unfavorably by users. Neutrality is supported by the exercise of prudence. Prudence is the exercise of caution when making judgements under conditions of uncertainty. The exercise of prudence means that assets and income are not overstated, and liabilities and expenses are not understated. Free from error means 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. In this context, free from error does not mean perfectly accurate in all respects. ENHANCING QUALITATIVE CHARACTERISTICS Comparability, verifiability, timeliness and understandability are qualitative characteristics that enhance the usefulness of information that both is relevant and provides a faithful representation of what it purports to represent. 1.) Comparability Information about a reporting entity is 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. Comparability is the qualitative characteristic that enables users to identify and understand similarities in, and di erences among, items. Unlike the other qualitative characteristics, comparability does not relate to a single item. A comparison requires at least two items. Consistency, although related to comparability, 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. Comparability is the goal; consistency helps to achieve that goal. 2.) Verifiability It means that di erent knowledgeable and independent observers could reach consensus, although not necessarily complete agreement, that a particular depiction is a faithful representation. Verification can be direct or indirect. Direct verification means verifying an amount or other representation through direct observation, for example, by counting cash. Indirect verification means checking the inputs to a model, formula or other technique and recalculating the outputs using the same methodology. An example is verifying the carrying amount of inventory by checking the inputs (quantities and costs) and recalculating the ending inventory using the same cost flow assumption (for example, using the first-in, first-out method). 3.) Timeliness It means having information available to decision-makers in time to be capable of influencing their decisions. Generally, the older the information is the less useful it is. However, some information may continue to be timely long after the end of a reporting period because, for example, some users may need to identify and assess trends. 4.) Understandability Classifying, characterizing and presenting information clearly and concisely makes it understandable. Some phenomena are inherently complex and cannot be made easy to understand. Excluding information about those phenomena from financial reports might make the information in those financial reports easier to understand. However, those reports would be incomplete and therefore possibly misleading. Financial reports are prepared for users who have a reasonable knowledge of business and economic activities and who review and analyze the information diligently. At times, even well-informed and diligent users may need to seek the aid of an adviser to understand information about complex economic phenomena. Cost is a pervasive constraint on the information that can be provided by financial reporting. Reporting financial information imposes costs, and it is important that those costs are justified by the benefits of reporting that information. There are several types of costs and benefits to consider.