Ch1-ConceptualFramework

8/13/2019 Ch1-ConceptualFramework

1/18

Chapter 1 The Conceptual Framework

1. Objectives

1.1 Describe what is meant by a conceptual framework.

1.2 Discuss whether a conceptual framework is necessary.

1.3 Describe the qualitative characteristics of relevance, reliability, comparability

and understandability.

1.4 Define the five elements of financial statements.

1.5 Define what is meant by reconition in financial statements and discuss the

reconition criteria.

1.! "#plain the measurement of the elements of financial statements.

1.$ Describe the concept of financial and physical capital maintenance

% n d e r l y i n

a s s u m p t i o n s

& u a l i t a t i v e

c h a r a c t e r i s t i c s

" l e m e n t s o f

f i n a n c i a l s t a t e m e n t s

' a p i t a l a n d

c a p i t a l m a i n t a n a n c e

( h e o b ) e c t i v e s o f

f i n a n c i a l s t a t e m e n t s

* u r p o s e a n d

s t a t u s

' o n c e p t u a l

+ r a m e w o r k

N1-1


2/18

2. Conceptual Framework and GAAP

A! "hat is conceptual #ramework$

2.1 conceptual framework is-

a/ a coherent ! s%stem of interrelated ob)ectives andfundamental principles0

b/ a framework which prescribes the nature& #unction and limits of

financial accountin and financial statements.

'! The ()*CPA+s Framework

2.2 '* produced a document, +ramework for the *reparation and

*resentation of +inancial tatements6 +ramework/. (he +ramework is, in

effect, the conceptual #ramework upon which all ()F,-s are based and

hence which determines how #inancial statements are prepared and the

in#ormation the% contain.

2.3 (he +ramework consists of several sections or chapters, followin on after a

preface and introduction. (hese chapters are as follows.

a/ (he ob)ective of financial statements

b/ %nderlyin assumptions

c/ &ualitative characteristics of financial statements

d/ (he elements of financial statements

e/ 7econition of the elements of financial statements

f/ 8easurement of the elements of financial statements

h/ 'oncepts of capital and capital maintenance

(a) Preface

2.4 (he preface to the +ramework points out the fundamental reason why financial

statements are produced worldwide, i.e. to satis#% the reuirements o#

e/ternal users.

2.5 (he preface emphasi9es the way #inancial statements are used to make

economic decisionsand thus financial statements should be prepared to this

end. (he types of economic decisions for which financial statements are likely

to be used include the followin.

N1-2


3/18

0sers *n#ormation needs

1. nvestors elp to make a decision about buyin or sellin shares

bout the level of dividend

:hether the manaement has been runnin thecompany efficiently

now about the financial position of the company

2. "mployees ecurity of employment and future prospects

3. ;enders elp them decide whether to lend to a company

4. uppliers now whether the company will be a ood customer

and pay its debts

5. 'ustomers now whether the company will be able to continue

producin and supplyin oods

!.


4/18

information in financial statements

c/ (he de#inition& reconition and measurementof the elements from

which financial statements are constructed

d/ 'oncepts of capital and capital maintenance

2.> (he +ramework is concerned with eneral purpose #inancial statements, but

it can be applied to other types of accounts. complete set of financial

statements includes-

a/ statement of financial position

b/ statement of comprehensive income

c/ statement of cash flows

d/ statement of chanes in equity

e/ ?otes, other statements and e#planatory material

. The Objective o# Financial -tatements

3.1 The Objective o# Financial -tatements

(he objective of eneral purpose financial statements is to provide

in#ormation about the #inancial position& per#ormance and chanes in

#inancial position of an entity that is useful to a wide rane of users in

makin economic decisions.


5/18

3. 0nderl%in Assumptions

4.1 Accrualsand oin concernare the two underlyin assumptions in preparin

financial statements.

4.2 Accruals 'asis

n entity should prepare its financial statements, e#cept for cash flow

information, usin the accrual basis of accountin. %nder this basis, the

e##ects o# transactions and other events are reconi4ed when the% occur

and not as cash or its equivalent is received or paid/. (ransactions and other

events are recorded in the accountin records and reported in the financial

statements of the periods to which they relate.

4.3 Goin Concern

(he entity is normally viewed as a oin concern, that is, as continuin in

operation #or the #oreseeable #uture. t is assumed that the entity has neither

the intention nor the necessity of liquidation or of curtailin / materially

the scale of its operations.

N1-5


6/18

:hen an entity does not prepare financial statements on a oin concern

basis. t should disclose that #act, toether with the basis on which it

prepared the #inancial statementsand the reasonwhy it is not rearded as

a oin concern.

5. 6ualitative Characteristics o# Financial -tatements

5.1 +or financial reportin information to be useful, it must possess the four

principal or primary/ qualitative characteristics-

a/ relevance,

b/ reliability,

c/ comparability, andd/ understandability.

A! ,elevance

5.2 ,elevance

(o be useful, information must be relevant to the decision@makin needs of

users. 7elevant information is capable of makin a difference in decision@

makin by virtue of its-

a/ predictive valueA helps users to evaluate past, present or future events

of the entity0

b/ con#irmator% valueA helps users to confirm or chane their past or

present/ e#pectations based on previous evaluations.

5.3 ,elevance depends larel% on materialit%. 8ateriality should be considered

when decidin whether information has sufficient predictive or confirmatory

value to be relevant to users.

5.4 7aterialit%

nformation is considered material if its omission or misstatement can

in#luence the economic decisions o# userstaken on the basis of an entityBs

financial information.

5.5 8ateriality depends on the nature e.. remuneration of manaement,

N1-6


7/18

provisions, etc./ and amount of the item )uded in the particular

circumstances of its omission or misstatement.

'! ,eliabilit%

5.! ,eliabilit%

nformation has the quality of reliability when it is #ree #rom material error

and bias or neutralit%!and can be depended upon by users to represent

#aith#ull%that which it either purports / to represent / or

could reasonably be e#pected to represent.

5.$ (here is a risk that the information may not be represented faithfully, not due

to bias, but due to inherent di##iculties in identi#%in the transactions or

#indin an appropriate method o# measurement or presentation. :here

measurement of the financial effects of an item is so uncertain, entities should

not reconi4esuch an item, e.. internally enerated oodwill.

5.> -ubstance over Form

+aithful representation of a transaction is only possible if it is accounted foraccordin to its substance and economic realit%, not with its leal form.

5.C 8/ample 1

ne party may sell an asset to another party and the sales documentation

may record that leal ownership has been transferred. owever, if

areements e#ist whereby the party sellin the asset continues to en)oy the

future economic benefits arisin from the asset, then in substance no sale has

taken place.

5.1E Prudence or Conservatism!

%nder conditions of uncertainty, )udement must be e#ercised cautiously of

hidden in makin the estimates required, such that assets or income are not

overstated and liabilities or e#penses are not understated.

5.11 Completeness

N1-7


8/18

(he information must be complete sub)ect to materiality and cost. n

omission ma% cause to be #alse and misleadin and thus unreliable to the

users of financial statements.

C! Comparabilit%

5.12 Comparabilit%

nformation about an entity is more useful if users are able to compare its

financial statements-

a/ across time periods

b/ with other entities

5.13 ence, accountin treatments and presentation of similar transactions must be

carried out in a consistent wa% over time for the entity and in a consistent

wa% #or di##erent entities. Compliance with #inancial reportin standards,

includin the disclosure of accountin policies, is particularl% important, in

order to achieve comparability.

9! 0nderstandabilit%

5.14 0nderstandabilit%

nformation should be readil% comprehended by users with a reasonable

knowlede of business and economic activities and accountin, and a

willinness to study the information with reasonable dilience.

5.15 nformation that is relevant should not be e/cludedfrom financial statements

only because it ma% be too comple/ or di##icultfor some users to understand

without help.

:. Constraints on ,elevant and ,eliable *n#ormation

A! Timeliness

!.1 nformation may become irrelevant if there is a delay in reportin it. (here is a

balance between timeliness and the provision of reliable information.

N1-8


9/18

!.2 8/ample 2

'ompanies listed on the 8ain =oard must issue their hal#;%earl% interim

#inancial reportsnot later than three monthsafter the end of the first half@yearly period in the financial year.

(he release of interim financial reportin information will provide timely

and relevant information to improve the usersB ability to understand an

entityBs up@to@date earnins@eneratin capacity and cash@flow@eneratin

capacity, as well as its financial condition and liquidity. owever, the interim

fiures may be less reliable as they use more estimates than annual financial

reports.

'! Cost considerations

!.3 'alance between bene#its and cost A when information is provided, its

bene#its must e/ceed the costsof obtainin and presentin it.

!.4 'alance between ualitative characteristicsA a trade@off between qualitative

characteristics is often necessary, the aim bein to achieve an appropriate

balance to meet the ob)ective of financial statements. t is a matter for

professional )udement as to the relative importance of these characteristics in

each case. One usual trade;o## is between relevance and reliabilit%.

!.5 8/ample

(he followin shows two situations where there is a trade@off between

relevance and reliability-

a/ historical cost for valuation of property, plant and equipment

reliability/ versus market value relevance/

b/ depreciation reliability/ versus impairment loss relevance/


10/18

v/ e#penses

A! Asset

$.2 Asset

n asset is a resource controlled b% an entit%as a result of past eventsand

from which #uture economic bene#itsare e#pected to #low to the entit%.

$.3 'ontrolled by enterprise A 'ontrol is the abilit% to obtain the economic

bene#itsand to restrict the access o# others.

$.4 *ast events A (he event must be =past>before an asset can arise. +or e#ample

equipment will only become an asset when there is the riht to demand

delivery or access to the assetBs potential.

$.5 +uture economic benefits A (hese are evidenced by the prospective receipt o#

cash. (his could be cash itself, a debt receivable or any item which may be

sold.

$.! 8/ample 3

uppose a business owns a buildin in an abandoned radioactive area. t is of

no use to the enterprise and cannot be sold. ince it canBt provide future

economic benefits, it is not an asset.

'! ?iabilit%

$.$ ?iabilit%

liability is a present obliation of an entity arisin from past events, the

settlement of which is e#pected to result in an outflow of resources from the

entity embodyin economic benefits.

$.> bliation A n obliation is a dut% or responsibilit%to act or perform in a

certain way. bliation may be leall% en#orceable as a consequence of

bindin contract or statutor% reuirement. lmost all liabilities stem from

leally enforceable obliations, for e#ample, with amounts payable for oods

and services received.

$.C utflow of economic benefits A (his could be a trans#er o# cash, or other

N1-10


11/18

propert%, the provision o# a service, or the refrainin from activities which

would otherwise be profitable.

C! 8uit%

$.1E 8uit%

"quity is the residual interestin the assets of an entity after deductin all its

liabilities.

$.11 "quity is sub@classified into-

a/ +unds contributed by shareholders0

b/ 7etained earnins0

c/ 7eserves.

9! *ncome

$.12 *ncome

ncome is increases in economic bene#itsdurin the accountin period in the

#ormof in#lows or enhancements o# assetsor decreases in liabilitiesthatresult in increases in euit%, other than those relatin to contributions from

equity participants.

8! 8/penses

$.13 8/penses

"#penses are decreases in economic bene#itsdurin the accountin period

in the #ormof out#lows or depletions o# assets or incurrences o# liabilities

!that result in decreases in euit%, other than those relatin todistributions to equity participants.

@. ,econition o# the 8lements o# Financial -tatements

>.1 tems which meet the definition of assets or liabilities may still not be

reconi9ed in financial statements because they must also meet certain

reconition criteria.

N1-11


12/18

>.2 ,econition

t is the process o# incorporatin in the statement of financial position or

statement of comprehensive income an item that meets the definition of an

element and satisfies the followin criteria for reconition-

a/ it is probable that any #uture economic bene#itassociated with the

item will #low to or #rom the entit%0 and

b/ the item has a cost or valuethat can be measured with reliabilit%.

>.3 The staes o# reconitionA (he reconition of assets and liabilities falls into

three staes-

a/ nitial reconition e.., of a non@current asset by purchase transaction/

b/ ubsequent remeasurement e.., revaluation of the above asset/

c/ Dereconition e.., sale or destruction of the asset/.

. 7easurement o# the 8lements o# Financial -tatements

C.1 (he +ramework identifies four possible measurement bases-

i/ historical cost

ii/ current cost

iii/ reali9able value

iv/ present value

C.2 (istorical Cost

ssets are recorded at the amount of cash or cash euivalents paid or the

#air value o# the consideration iven to acuire them at the time of

acquisition.

;iabilities are recorded at the amount o# proceeds received in e/chane #or

the obliation.

C.3 Current Cost

ssets are carried at the amount of cash or cash equivalents required to

acuire them currentl%.

N1-12


13/18

;iabilities are carried at the undiscounted amount currentl% reuired to

settlethem.

C.4 ,ealisable -ettlement! Balue

ssets are carried at the amount of cash or cash equivalents that could

currently be obtained by sellin an assetin orderly disposal.

;iabilities are carried at their settlement values A the amount to be paid to

satisfy them in the normal course of business.

C.5 Present Balue

ssets are carried at the present discounted value o# the #uture net cash

in#lowsthat the item is e#pected to enerate in the normal course of business.

;iabilities at the present discounted value o# the e/pected out#lows

necessary to settle them.

C.! lthouh historical cost is the commonest basis, the others are often used tomodify historical cost. +or e#ample, inventories are usually carried at the

lower of cost and net reali9able value, investments may be carried at market

value and pension liabilities are carried at their present value.

1. Concepts o# Capital and Capital 7aintenance

1E.1 (he concepts of capital maintenance provide linkae between the concepts of

capital and the concepts of profit because they provide the point of reference

with which profit is measured. Definitions of profit may refer to the need to

maintain the capital of the enterprise. n fact there are two main concepts of

capital maintenance-

a/ financial capital maintenance

b/ physical capital maintenance

1E.2 Financial Capital 7aintenance

%nder this concept a profit is earned only if the financial or money/ amount

N1-13


14/18


15/18

8/amination -t%le 6uestions

6uestion 1

a/ (he =Bs +ramework for the preparation and presentation of financial

statements +ramework/ sets out the concepts that underlie the preparation and

presentation of financial statements that e#ternal users are likely to rely on when

makin economic decisions about an enterprise.

,euiredD

"#plain the purpose and authoritative status of the +ramework. 5 marks/

b/ f particular importance within the +ramework are the definitions and

reconition criteria for assets and liabilities.

,euiredD

Define assets and liabilities and e#plain the important aspects of their

definitions. "#plain why these definitions are of particular importance to the

preparation of an entityBs statement of financial position and statement of

comprehensive income. > marks/

'' 2.5?(/ +inancial 7eportin Gune 2EE! &3a/ H b//

6uestion 2

a/ (he qualitative characteristics of relevance, reliability and comparability

identified in the =Bs +ramework for the preparation and presentation of

financial statements +ramework/ are some of the attributes that make financial

information useful to the various users of financial statements.

,euiredD

"#plain what is meant by relevance, reliability and comparability and how they

make financial information useful. C marks/

b/ Durin the year ended 31 8arch 2EE!, *orto e#perienced the followin

transactions or events-

i/ entered into a finance lease to rent an asset for substantially the whole of

its useful economic life.

N1-15


16/18

ii/ a decision was made by the =oard to chane the companyBs accountin

policy from one of e#pensin the finance costs on buildin new retail

outlets to one of capitalisin such costs.

iii/ the companyBs income statement prepared usin historical costs showed a

loss from operatin its hotels, but the company is aware that the increase

in the value of its properties durin the period far outweihed the

operatin loss.

,euiredD

"#plain how you would treat the items in i/ to iii/ above in *ortoBs financial

statements and indicate on which of the +rameworkBs qualitative characteristics

your treatment is based. ! marks/

(otal 15 marks/

'' +$ ?(/ +inancial 7eportin *ilot *aper &4/

6uestion

n important requirement of the '*Bs +ramework for the *reparation and

*resentation of +inancial tatements +ramework/ is that in order to be reliable, an

entityBs financial statements should represent faithfully the transactions and events

that it has undertaken.

,euiredD

"#plain what is meant by faithful representation and how it enhances reliability.

5 marks/

'' +$


17/18

6uestion 5

a/ (he '*Bs +ramework for the *reparation and *resentation of +inancial

tatements requires financial statements to be prepared on the basis that they

comply with certain accountin concepts, underlyin assumptions and

qualitative/ characteristics. +ive of these are-

8atchinIaccruals

ubstance over form

*rudence

'omparability

8ateriality

,euiredD

=riefly e#plain the meanin of each of the above conceptsIassumptions.

5 marks/

b/ +or most entities, applyin the appropriate conceptsIassumptions in accountin

for inventories is an important element in preparin their financial statements.

,euiredD

llustrate with e#amples how each of the conceptsIassumptions in a/ may be

applied to accountin for inventory. 1E marks/

15 marks/

'' +$ &4/

6uestion :

n assistant of yours has been criticised over a piece of assessed work that he

produced for his study course for ivin the definition of a non@current asset as Japhysical asset of substantial cost, owned by the company, which will last loner than

one yearB.

,euiredD

*rovide an e#planation to your assistant of the weaknesses in his definition of non@

current assets when compared to the on on nstitute of 'ertified *ublic

ccountantsB view of assets. 4 marks/

'' +$


18/18

6uestion

Documents

Ch1-ConceptualFramework