Question

The key components of the conceptual framework include the objective of financial reporting, qualitative characteristics, the going concern assumption, and measurement of the elements of financial statements. the objective of financial reporting, qualitative characteristics, the going concern assumption, elements of financial statements and the measurement of those elements. the objective of financial reporting, qualitative characteristics and the going concern assumption. the objective of financial reporting, qualitative characteristics, the going concern assumption, and elements of financial statements.

Answer 1

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The IASB bases its financial reporting standards on the conceptual framework that it adopted in 2010. The conceptual framework was developed by IASB and it lays down the basic concepts and principles that act as the foundation for preparation and presentation of the financial statements. The framework is also used as guide to develop / improve standards and to resolve any accounting conflicts. Note that the conceptual framework is not an accounting standard in itself and cannot be used as an alternative to the financial reporting standards applicable in your country.

In March 2018, the International Accounting Standards Board (the Board) finished its revision of The Framework for Financial Reporting (the Framework).

The primary purpose of financial information is to be useful to existing and potential investors, lenders and other creditors (users) when making decisions about the financing of the entity and exercising rights to vote on, or otherwise influence, management’s actions that affect the use of the entity’s economic resources. The Framework sets out the information needed to assess management’s stewardship, and separates this from the information that users need to assess the prospects of the entity’s future net cash flows.

PURPOSE AND STATUS OF THE CONCEPTUAL FRAMEWORK

The Conceptual Framework consists of eight chapters and an extensive Basis for Conclusions. The introduction explains that its purpose is to:

Assist the IASB to develop and revise its standards;

Assist entities 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

Assist all stakeholders to understand and interpret the standards.

The status of the Conceptual Framework in relation to the IFRSs remains unchanged. The standards continue to take precedence over the Conceptual Framework. However, should new provisions depart from the Conceptual Framework, the IASB has undertaken to explain the reasons in the Basis for Conclusions on that standard.

EIGHT CHAPTERS FOCUSED ON FINANCIAL STATEMENTS

Although the document is entitled Conceptual Framework for Financial Reporting, most of the eight chapters (chapters 3 to 8) summarized below focus on the financial statements produced under IFRSs rather than on the much broader concept of financial reporting:

1. The objective of general purpose financial reporting

2. Qualitative characteristics of useful financial information; These two chapters had already been re-written in 2010. Nevertheless, some further changes have been made in response to the requests of constituents.

3. Financial statements and the reporting entity;

4. The elements of the financial statements;

5. Recognition and derecognition;

6. Measurement;

7. Presentation and disclosure;

8. Concepts of capital and capital maintenance. This chapter has been re-issued unchanged and without discussion by the IASB, so we will not return to it in this study.

1) The objective of financial reporting: In very simple words, the objective of Financial Statements is:

Let’s look at this statement more closely. There are three keywords here:

· Useful: The useful here refers to the need for financial statements to be able to provide high quality information to the users. The usefulness is described in the form of the qualitative characteristics of the financial statements.

· Information: This refers to what information should the financial statements provide. This includes financial position, financial performance, and changes in financial position. These three tips of information are provided in the three financial statements, namely, balance sheet, income statement, and statement of cash flow.

· Users: This refers to the end users of financial statements such as investors, lenders, employees, government, customers, vendors, etc.

Users base their expectations of returns on their assessment of:

· The amount, timing and uncertainty of future net cash inflows to the entity and

· Management’s stewardship of the entity’s resources.

The reintroduction of the concept of stewardship was requested by a large number of stakeholders. Although the IASB believed that it was always implicitly present in the 2010 Conceptual framework, this unambiguous reference marks it out as an objective of financial information in the same way as the assessment of future net cash flows.

Key points

Management’s stewardship is reintroduced as a part of the objective of financial information.

2) Qualitative characteristics of useful financial information

When this chapter was drafted in 2010, it defined the qualitative characteristics of useful financial information in two categories:

· The fundamental qualitative characteristics of relevance and faithful representation

· The characteristics that enhance the usefulness of financial information: comparability, verifiability, timeliness and understandability.

However, these characteristics are subject to cost constraints, and it is therefore important to determine whether the benefits to users of the information justify the cost incurred by the entity providing it.

We can summarise it into the following four qualitative characteristics of financial statements:

· Understandable: The users should be able to understand and appreciate the information.

· Relevant: The information should be relevant to the users so that they can make their decisions effectively.

· Reliable: The information should be factually accurate.

· Comparable: The users should be able to compare the information with the peers or with previous years’ information.

So, to be useful, the information on financial position, financial performance, and changes in financial position should be understandable, relevant, reliable, and comparable.

Prudence is introduced in support of the principle of neutrality for the purposes of faithful representation. Prudence is understood here as the exercise of caution when making judgements under conditions of uncertainty. Users find this concept important as they feel that it should help counteract the natural optimistic bias of management.

MEASUREMENT UNCERTAINTY AND FAITHFUL REPRESENTATION

The text provides clarification concerning measurement uncertainties. These are now conceived in terms of faithful representation, rather than in terms of the relevance of the information (as in the exposure draft).

This is because the faithful representation of information does not mean that that information must be accurate in all respects. The Conceptual Framework observes that the use of estimates, which imply a certain degree of uncertainty, is an essential part of the preparation of financial information and this does not necessarily weaken the usefulness of the information, if the estimates are clearly and accurately described and explained.

Note that these clarifications come in response to stakeholders’ requests for the reintroduction of the concept of measurement reliability, which was among the recognition criteria for assets and liabilities in the previous Conceptual Framework and in some existing IFRSs.

When this chapter in 2010 was drafted in 2010, the IASB considered that the concept of reliability was understood differently by stakeholders (in particular, as a synonym for verifiability or free of material error). These two aspects are considered as too simplistic by comparison with the IASB’s interpretation.

The concept of faithful representation adopted by the IASB is broader and, the Board says, covers the aspects of reliability.

SUBSTANCE OVER FORM AND FAITHFUL REPRESENTATION

The IASB states that a faithful representation provides information about the substance of an economic phenomenon instead of merely providing information about its legal form.

When the IASB drafted this chapter in 2010, this clarification was regarded as redundant in the light of the concept of faithful representation. It has been included in the new version following stakeholders’ requests for the reintroduction of this concept in an explicit fashion in the Conceptual Framework.

How substance is analyzed is set out in the chapter on the elements of financial statements (Chapter 4). Obviously, the contract terms must be analyzed in order to determine whether a term can be exercised in practice, or to identify terms that bind neither of the parties.

But the analysis does not stop there. Contract terms should generally be read in the light of the law on which the contract is based, but should also be considered in the context of other contracts or events and circumstances which could impact the analysis of its terms.

Some IFRSs, including IFRS 15 on contracts with customers, provide criteria for bundling different contracts.

3) The going concern assumption : Accrual accounting and ‘going concern’ are two key assumptions that underlie the preparation of financial statements and determine how financial statement elements are recognized and measured. ‘Going concern’ means that a company is assumed to continue in business for the foreseeable future.

The general purpose financial statements are prepared on the assumption that the reporting entity is a going concern. If this assumption is not appropriate, they are prepared in accordance with a basis other than IFRS.

The Conceptual Framework explains that this assumption means that the entity has neither the intention nor the need to enter liquidation or cease trading in the foreseeable future.

The Conceptual Framework also states that the financial statements are prepared from the perspective of the reporting entity as a whole, not from the perspective of some or all of the entity’s users.

This is a useful clarification, because in practice the perspective taken in drafting the various standards is not always clear. It is nevertheless not explained further by the Conceptual Framework.

4) Measurement of the elements of financial statements :

The framework lists five elements of financial statements:

· Assets: An asset is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity.

· Liabilities: A liability is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits.

· Equity: Equity is the residual interest in the assets of the entity after deducting all its liabilities.

· Income: Income is increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants.

· Expense: Expenses are decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants.

Along with the five elements, the framework also provides guidelines about when these elements are recognized in the financial reports.

To be recognized, an item must meet the definition of an element, and satisfy the following criteria:

· It is probable that any future economic benefit associated with the item will flow to or from the entity; and

· The item’s cost or value can be measured with reliability.

The founding concept underlying all the others, an economic resource is a right that has the potential to produce economic benefits. This definition is now separate from the definition of the elements of the financial statements, in order to avoid a certain confusion encountered by the IASB between assets and liabilities and flows of economic benefits. It also makes it easier to establish parallels between assets and liabilities.

In this definition, for the economic resource to have the “potential to produce” economic benefits, it does not need to be certain, or even likely, that the right will produce economic benefits. It is only necessary that the economic resource already exists and that there is at least one circumstance in which it would produce economic benefits.

It also clarifies that it is the economic resource that constitutes the right, not the future economic benefits.

Further, a right that does not create rights for the entity beyond those that exist for other parties will generate no economic benefits.

For example, this applies to the right of use of roads.

The final part of the framework describes how we should measure an item once it has been recognized. It suggests the following conceptual models:

· Historical Cost

· Current Cost

· Realizable (Settlement) Value

· Present Value

HISTORICAL COST

The historical cost of an asset is the value of the costs incurred in acquiring or creating the asset, i.e. the consideration paid to acquire or create the asset plus transaction costs. Conversely, the historical cost of a liability is the value of the consideration received minus transaction costs.

This historical cost is then updated to depict, where applicable:

· For an asset: the consumption of part or all of the economic resource that constitutes the asset (depreciation or amortization); payments received that extinguish part or all of the asset; the effect of events that cause part or all of the historical cost of the asset to be no longer recoverable (impairment); and the accrual of interest to reflect any financing component of the asset.

· For a liability: fulfilment of part or all of the liability (e.g. by making payments or by delivering goods); the effect of events that increase the value of the obligation to such an extent that the liability becomes onerous; and the accrual of interest to reflect any financing component of the liability.

CURRENT VALUE

The Conceptual Framework details three types of current value: fair value, value in use or fulfilment value, and current cost (a little used concept corresponding to the replacement value at the measurement date; unlike fair value and value in use or fulfilment value, this is an entry value).

FAIR VALUE

The definition of fair value is that given in IFRS 13. Fair value is the price that would be received to sell an asset, or paid to transfer a liability, in an orderly transaction between market participants at the measurement date.

This price includes:

· Estimates of future cash flows,

· Possible variations in the estimated amount or timing of future cash flows,

· The time value of money,

· The price for bearing the uncertainty inherent in the cash flows (a risk premium or risk discount),

· Other factors, for example, liquidity risk, if market participants would take those factors into account in the circumstances,

· For a liability, the possibility that the entity may fail to fulfil its liability (own credit risk).

· Transaction costs are not included in fair value, either or acquisition or disposal.

This does not prevent the IASB from requiring measurement at fair value less costs to sell: for example in IFRS 5 on assets held for sale, IAS 36 on the impairment of assets, or IAS 41 on biological assets and agricultural products.

VALUE IN USE (ASSETS) AND FULFILMENT VALUE (LIABILITIES)

For an asset, value in use is the present value of the cash flows that an entity expects to derive from the use of an asset and from its ultimate disposal, including transaction costs on disposal.

For a liability, fulfilment value is the present value of the cash flows that an entity expects to be obliged to transfer as it fulfils an obligation.

These current values are entity-specific (unlike fair value, which is a market value). As they cannot be observed directly, they are determined using cash-flow-based measurement techniques.

Because value in use and fulfilment value are based on future cash flows, they do not include transaction costs incurred on acquiring an asset or taking on a liability. However, any transaction costs an entity expects to incur on the ultimate disposal of the asset or on fulfilling the liability are taken into account.

Present value: In relation to assets, this refers to the present discounted value of the future net cash inflows that an asset is expected to generate during the normal course of business. In relation to liabilities, PV refers to the present discounted value of the future net cash outflows that are expected to be required to settle the liabilities of the normal course of business.

Relevance is a key issue. The Framework says that historical cost may not provide relevant information about assets held for a long period of time, and are certainly unlikely to provide relevant information about derivatives. In both cases, it is likely that some variation of current value will be used to provide more predictive information to users.

Conversely, the Framework suggests that fair value may not be relevant if items are held solely for use or to collect contractual cash flows. Alongside this, the Framework specifically mentions items used in a combination to generate cash flows by producing goods or services to customers. As these items are unlikely to be able to be sold separately without penalising the activities, a cost-based measure is likely to provide more relevant information, as the cost is compared to the margin made on sales.