Financial Statements 2Lecture 3

Conceptual Framework

Learning objectives

• To understand the purpose of a conceptual framework

• To know the outline of the contents of the IASB framework

• To be familiar with the joint project to revise the conceptual framework

• To be familiar with key concepts and definitions which will be applied in the study of specific accounting standards

What is a conceptual framework

• “A set of agreed fundamental principles which underpin financial accounting and so provide a sound theoretical basis for the development of accounting standards”

Melville

Purpose of the IASB Framework

• To assist in the development of international standards• To provide a basis for reducing the number of alternative

treatments• To assist national standard setters• To assist preparers of financial statements in applying

standards and dealing with topics where no standard exists• To assist auditors in forming an opinion on whether financial

statements comply with international standards• To assist users in interpreting financial statements

Content of the IASB Framework

• The objective of financial statements• Underlying assumptions• Qualitative characteristics• Elements of financial statements• Recognition of elements• Measurement of elements• Concepts of capital and capital maintenance

Joint project

• Ongoing project between IASB and FASB (US standards setting body) to harmonise accounting standards with a view to international standards being acceptable for use in the US

• Working on individual standards• Working on revising the conceptual

framework, chapter by chapter

Progress in 2010

• Revised chapters on “objective of financial statements” and “qualitative characteristics” published

• Copies of the original framework and revised chapters are in teaching resources on studynet.

• A very good essay will consider both; a middling essay could stick to the original, which is covered in the textbook.

Objective of financial statements

• “To provide information about the financial position, performance and changes in financial position of an entity that is useful to a wide range of users in making economic decisions”

IASB Framework

• Statement of Financial Position, Statement of Comprehensive Income and cash flow statement, plus notes to the accounts

Users of accounts

• Original framework covered a wide range of users. In practice needs of investors and lenders took priority

• Revised framework is focussed on investors and other providers of finance

• Result will be accounting standards will be more explicitly focussed on providers of finance

Underlying assumptions

• Accruals basis - transactions are recognised in the period in which they occur, not necessarily when cash is received or paid

• Going concern – financial statements are prepared on the basis that the business will continue to operate for the foreseeable future without the need to close down or significantly reduce the scale of its operations

Qualitative characteristics – original framework

• Understandability – financial statements should be presented clearly – assumes a reasonable knowledge of business and

accounting• Relevance– Influences the economic decisions of users– helps users evaluate past, present or future

events• Comparability – Over time and with other entities

Qualitative characteristics – original framework

• Reliability – free from material error – an error is material if it

could influence the decisions made by users– Faithful representation and substance over form – the

accounts show the true economic reality of the activities of the company

– Neutrality – free from bias– Prudence – judgment is exercised with caution so as

not to overstate net assets or profits. – Completeness – subject to constraints of materiality

and cost, relevant information should not be omitted

Qualitative characteristics – revised framework

• Relevance– Capable of influencing the economic decisions of users– Materiality – information is material if omitting it or

misstating it could influence decisions of users

• Faithful representation– Must give a true picture of the economic reality of the

business– Includes completeness, neutrality and freedom from

material error

Elements of financial statements

• Financial position– Assets– Liabilities– Equity

• Financial performance– Income– Expenses

Elements – key definitions

• AssetA resource controlled by the enterprise as a result of

past events and from which future economic benefits are expected to flow to the enterprise

• LiabilityA present obligation of the enterprise arising from

past events, the settlement of which is expected to result in an outflow from the enterprise of resources

Recognition

• “The process of incorporating in the balance sheet or income statement an item that meets the definition of an element and satisfies the criteria for recognition”

• Provided it is probable the future economic benefit will flow to or from the company and the cost or value can be measured reliably.

• Where necessary to show a true & fair view additional information may need to be disclosed in the notes to the accounts

Measurement• Four possible measurement bases are identified:– Historic cost – amount paid to acquire assets or amount

received in exchange for a liability– Current cost – amount required to acquire an equivalent

asset at the present time, or to settle a liability– Realisable value – the amount which could be obtained by

selling an asset at the present time, or the amount required to settle a liability

– Present value – discounted present value of expected future cash inflows

Measurement• Most commonly used is historic cost• Current cost is used when valuing property• Realisable value is used when valuing inventory at

the lower of cost and net realisable value• Present value is not often used but can be used in

valuing certain long term assets or liabilities such as pensions

• This is an area of current debate over the extent to which market values (fair values) should be used

Capital and capital maintenance

• It is considered important that a company's capital should be maintained.

• This depends on how capital (and thus assets and liabilities) are measured.

• Physical capital refers to the operating capacity of the business

• Financial capital considers the monetary value of capital

Current developments

• IASB and FASB continue to collaborate on a new conceptual framework.

• There is some difference of approach - IASB is principles-based and FASB is rules-based

• Debate on the use of fair values for financial assets and liabilities in the current financial crisis