Chapter 1 The Conceptual Framework

1. 1.1 1.2 1.3 1.4 1.5 1.! 1.$ Objectives Describe what is meant by a conceptual framework. Discuss whether a conceptual framework is necessary. Describe the qualitative characteristics of relevance, reliability, comparability and understandability. Define the five elements of financial statements. Define what is meant by reco nition in financial statements and discuss the reco nition criteria. "#plain the measurement of the elements of financial statements. Describe the concept of financial and physical capital maintenance
' o n c e p tu al + ra m e w o rk

* u rp o se and s ta tu s

( h e o b ) e c ti v e s o f fi n a n c i a l s t a t e m e n ts

% n d erly in a ss u m p tio n s

& u a l it a ti v e c h arac teristics

" le m e n ts o f fi n a n c i a l s t a t e m e n ts

' a p i ta l a n d c a p i ta l m a i n t a n a n c e

N1-1

2. A! 2.1

Conceptual Framework and GAAP "hat is conceptual #ramework$ , conceptual framework is.a/ a coherent ! s%stem of interrelated ob)ectives and fundamental principles0 .b/ a framework which prescribes the nature& #unction and limits of financial accountin and financial statements. The ()*CPA+s Framework 123'*, produced a document, 4+ramework for the *reparation and *resentation of +inancial 5tatements6 .+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. (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/ 7eco nition of the elements of financial statements .f/ 8easurement of the elements of financial statements .h/ 'oncepts of capital and capital maintenance Preface (he preface to the +ramework points out the fundamental reason why financial statements are produced worldwide, i.e. to satis#% the re.uirements o# e/ternal users. (he preface emphasi9es the way #inancial statements are used to make economic decisions and 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 .

'! 2.2

2.3

(a) 2.4

2.5

N1-2

0sers 1. 3nvestors 2. "mployees 3. ;enders 4. 5uppliers 5. 'ustomers !. <overnment $. *ublic

*n#ormation needs 1elp to make a decision about buyin or sellin shares ,bout the level of dividend :hether the mana ement has been runnin the company efficiently 2now about the financial position of the company 5ecurity of employment and future prospects 1elp them decide whether to lend to a company 2now whether the company will be a ood customer and pay its debts 2now whether the company will be able to continue producin and supplyin oods 'omply with ta# and company law :ish to have information for all the reasons mentioned above

(b) 2.!

Introduction Purpose and status (he introduction ives a list of the purposes of the +ramework. .a/ ,ssist the =oard of the 123'*, in the development o# #uture ()F,-s and in its review o# e/istin1 ()A-s. .b/ ,ssist preparers o# #inancial statements in appl%in1 ()F,-s and in dealin with topics that have yet to form the sub)ect of an 12+75. .c/ ,ssist auditors in #ormin1 an opinion as to whether financial statements conform with 12+75s. .d/ ,ssist users o# #inancial statements in interpretin1 in#ormation contained in financial statements prepared in conformity with 12+75s and ,ccountin <uidelines. .e/ *rovide those who are interested in the work o# the Council with information about its approach to the formulation of 12+75s and ,ccountin <uidelines.. Introduction Scope (he +ramework deals with.a/ (he objective of financial statements .b/ (he .ualitative characteristics that determine the usefulness of
N1-3

(c) 2.$

2.>

information in financial statements .c/ (he de#inition& reco1nition and measurement of the elements from which financial statements are constructed .d/ 'oncepts of capital and capital maintenance (he +ramework is concerned with 1eneral 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 chan es in equity .e/ ?otes, other statements and e#planatory material The Objective o# Financial -tatements The Objective o# Financial -tatements (he objective of eneral purpose financial statements is to provide in#ormation about the #inancial position& per#ormance and chan1es in #inancial position of an entity that is useful to a wide ran e of users in makin1 economic decisions. <eneral purpose financial statements are defined in 12,5 1 as those intended to meet the needs o# users who are not in a position to re.uire an entit% to prepare reports tailored to their particular in#ormation needs. +inancial statements also show the results o# the mana1ement+s stewardship of the resources entrusted to it.

2. 3.1

3.2

3nformation that enables users to evaluate.a/ ability of entity to enerate cash and cash equivalents0 .b/ timin and certainty of their eneration.

N1-4

3. 4.1

0nderl%in1 Assumptions Accruals and 1oin1 concern are the two underlyin assumptions in preparin financial statements. 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 reco1ni4ed 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.

4.2

4.3

Goin1 Concern (he entity is normally viewed as a oin concern, that is, as continuin1 in operation #or the #oreseeable #uture. 3t 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

:hen an entity does not prepare financial statements on a oin concern basis. 3t should disclose that #act, to ether with the basis on which it prepared the #inancial statements and the reason why it is not re arded as a oin concern. 5. 5.1 6ualitative Characteristics o# Financial -tatements +or financial reportin information to be useful, it must possess the four principal .or primary/ qualitative characteristics.a/ relevance, .b/ reliability, .c/ comparability, and .d/ understandability. ,elevance ,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 value A helps users to evaluate past, present or future events of the entity0 .b/ con#irmator% value A helps users to confirm or chan e their past .or present/ e#pectations based on previous evaluations. 5.3 ,elevance depends lar1el% on materialit%. 8ateriality should be considered when decidin whether information has sufficient predictive or confirmatory value to be relevant to users. 7aterialit% 3nformation is considered material if its omission or misstatement can in#luence the economic decisions o# users taken on the basis of an entityBs financial information. 5.5 8ateriality depends on the nature .e. . remuneration of mana ement,
N1-6

A! 5.2

5.4

provisions, etc./ and amount of the item )ud ed in the particular circumstances of its omission or misstatement. '! 5.! ,eliabilit% ,eliabilit% 3nformation 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#%in1 the transactions or #indin1 an appropriate method o# measurement or presentation . :here measurement of the financial effects of an item is so uncertain, entities should not reco1ni4e such an item, e. . internally enerated oodwill. -ubstance over Form +aithful representation of a transaction is only possible if it is accounted for accordin to its substance and economic realit%, not with its le al form. 5.C 8/ample 1 Dne party may sell an asset to another party and the sales documentation may record that le al ownership has been transferred. 1owever, if a reements 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, )ud ement 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.>

5.11

Completeness
N1-7

(he information must be complete sub)ect to materiality and cost. ,n omission ma% cause to be #alse and misleadin1 and thus unreliable to the users of financial statements. C! 5.12 Comparabilit% Comparabilit% 3nformation 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 1ence, 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 reportin1 standards, includin the disclosure of accountin policies, is particularl% important, in order to achieve comparability. 0nderstandabilit% 0nderstandabilit% 3nformation should be readil% comprehended by users with a reasonable knowled e of business and economic activities and accountin , and a willin ness to study the information with reasonable dili ence. 5.15 3nformation that is relevant should not be e/cluded from financial statements only because it ma% be too comple/ or di##icult for some users to understand without help. Constraints on ,elevant and ,eliable *n#ormation Timeliness 3nformation 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! 5.14

:. A! !.1

!.2

8/ample 2 'ompanies listed on the 8ain =oard must issue their hal#;%earl% interim #inancial reports not later than three months after 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 earnin s@ eneratin capacity and cash@flow@ eneratin capacity, as well as its financial condition and liquidity. 1owever, the interim fi ures may be less reliable as they use more estimates than annual financial reports.

'! !.3 !.4

Cost considerations 'alance between bene#its and cost A when information is provided, its bene#its must e/ceed the costs of obtainin and presentin it. 'alance between .ualitative characteristics A 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. 3t is a matter for professional )ud ement as to the relative importance of these characteristics in each case. One usual trade;o## is between relevance and reliabilit%. 8/ample 2 (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/

!.5

<. $.1

8lements o# Financial -tatements (he +ramework identifies five elements of financial statements.i/ assets .ii/ liabilities .iii/ equity interest .iv/ income
N1-9

.v/ A! $.2 Asset Asset

e#penses

,n asset is a resource controlled b% an entit% as a result of past events and from which #uture economic bene#its are e#pected to #low to the entit%. $.3 $.4 'ontrolled by enterprise A 'ontrol is the abilit% to obtain the economic bene#its and to restrict the access o# others. *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 ri ht to demand delivery or access to the assetBs potential. +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 5uppose a business owns a buildin in an abandoned radioactive area. 3t is of no use to the enterprise and cannot be sold. 5ince it canBt provide future economic benefits, it is not an asset. '! $.$ ?iabilit% ?iabilit% , liability is a present obli ation 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. $.> Dbli ation A ,n obli ation is a dut% or responsibilit% to act or perform in a certain way. Dbli ation may be le1all% en#orceable as a consequence of bindin1 contract or statutor% re.uirement. ,lmost all liabilities stem from le ally enforceable obli ations, for e#ample, with amounts payable for oods and services received. Dutflow of economic benefits A (his could be a trans#er o# cash, or other
N1-10

$.5

$.!

$.C

propert%, the provision o# a service, or the refrainin from activities which would otherwise be profitable. C! $.1E 8.uit% 8.uit% "quity is the residual interest in the assets of an entity after deductin all its liabilities. $.11 "quity is sub@classified into.a/ +unds contributed by shareholders0 .b/ 7etained earnin s0 .c/ 7eserves. *ncome *ncome 3ncome is increases in economic bene#its durin the accountin period in the #orm of in#lows or enhancements o# assets or decreases in liabilities that result in increases in e.uit% , other than those relatin to contributions from equity participants. 8! $.13 8/penses 8/penses "#penses are decreases in economic bene#its durin the accountin period in the #orm of out#lows or depletions o# assets or incurrences o# liabilities ! that result in decreases in e.uit%, other than those relatin to distributions to equity participants. @. >.1 ,eco1nition o# the 8lements o# Financial -tatements 3tems which meet the definition of assets or liabilities may still not be reco ni9ed in financial statements because they must also meet certain reco nition criteria.
N1-11

9! $.12

>.2

,eco1nition 3t is the process o# incorporatin1 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 reco nition.a/ it is probable that any #uture economic bene#it associated with the item will #low to or #rom the entit%0 and .b/ the item has a cost or value that can be measured with reliabilit%.

>.3

The sta1es o# reco1nition A (he reco nition of assets and liabilities falls into three sta es.a/ 3nitial reco nition .e. ., of a non@current asset by purchase transaction/ .b/ 5ubsequent remeasurement .e. ., revaluation of the above asset/ .c/ Dereco nition .e. ., sale or destruction of the asset/. 7easurement o# the 8lements o# Financial -tatements (he +ramework identifies four possible measurement bases.i/ historical cost .ii/ current cost .iii/ reali9able value .iv/ present value (istorical Cost ,ssets are recorded at the amount of cash or cash e.uivalents paid or the #air value o# the consideration 1iven to ac.uire them at the time of acquisition. ;iabilities are recorded at the amount o# proceeds received in e/chan1e #or the obli1ation.

A. C.1

C.2

C.3

Current Cost ,ssets are carried at the amount of cash or cash equivalents required to ac.uire them currentl%.

N1-12

;iabilities are carried at the undiscounted amount currentl% re.uired to settle them.

C.4

,ealisable -ettlement! Balue ,ssets are carried at the amount of cash or cash equivalents that could currently be obtained by sellin1 an asset in 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#lows that 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.!

,lthou h historical cost is the commonest basis, the others are often used to modify 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. Concepts o# Capital and Capital 7aintenance (he concepts of capital maintenance provide linka e 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. 3n fact there are two main concepts of capital maintenance.a/ financial capital maintenance .b/ physical capital maintenance Financial Capital 7aintenance %nder this concept a profit is earned only if the financial .or money/ amount
N1-13

1C. 1E.1

1E.2

of the net assets at the end of a period e#ceeds the financial .or money/ amount of net assets at the be innin of the period.

1E.3

Ph%sical Capital 7aintenance %nder this concept a profit is earned only if the physical productive capacity of the business at the end of the period e#ceeds the physical productive capacity at the be innin of the period. (he physical capital maintenance concept requires the adoption of the current cost basis of measurement. +or e#ample, instead of lookin at 5imonBs openin capital as F4EE, we should look upon it as bein the ability to buy 1E bo# files, i.e. F5EE.

N1-14

8/amination -t%le 6uestions

6uestion 1 .a/ (he 3,5=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. ,e.uiredD "#plain the purpose and authoritative status of the +ramework. .b/ .5 marks/

Df particular importance within the +ramework are the definitions and reco nition criteria for assets and liabilities. ,e.uiredD 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/ .,'', 2.5.3?(/ +inancial 7eportin Gune 2EE! &3.a/ H .b//

6uestion 2 .a/ (he qualitative characteristics of relevance, reliability and comparability identified in the 3,5=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. ,e.uiredD "#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

.ii/

a decision was made by the =oard to chan e 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 outwei hed the operatin loss. ,e.uiredD "#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/ .,'', +$ .3?(/ +inancial 7eportin *ilot *aper &4/ 6uestion 2 ,n important requirement of the 123'*,Bs +ramework for the *reparation and *resentation of +inancial 5tatements .+ramework/ is that in order to be reliable, an entityBs financial statements should represent faithfully the transactions and events that it has undertaken. ,e.uiredD "#plain what is meant by faithful representation and how it enhances reliability. .5 marks/ .,'', +$ .12</ +inancial 7eportin December 2EE$ &4.a// 6uestion 3 *roduct development costs are a material cost for many companies. (hey are either written off as an e#pense or capitalised as an asset. ,e.uiredD Discuss the conceptual issues involved and the definition of an asset that may be applied in determinin whether development e#penditure should be treated as an e#pense or an asset. .4 marks/ .,'', +$ .12</ +inancial 7eportin December 2EE$ &5.a//
N1-16

6uestion 5 .a/ (he 123'*,Bs +ramework for the *reparation and *resentation of +inancial 5tatements requires financial statements to be prepared on the basis that they comply with certain accountin concepts, underlyin assumptions and .qualitative/ characteristics. +ive of these are8atchin Iaccruals 5ubstance over form *rudence 'omparability 8ateriality ,e.uiredD =riefly e#plain the meanin of each of the above conceptsIassumptions. .5 marks/ +or most entities, applyin the appropriate conceptsIassumptions in accountin for inventories is an important element in preparin their financial statements. ,e.uiredD 3llustrate with e#amples how each of the conceptsIassumptions in .a/ may be applied to accountin for inventory. .1E marks/ .15 marks/ .,'', +$ .12</ +inancial 7eportin Gune 2EE> &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 Ja physical asset of substantial cost, owned by the company, which will last lon er than one yearB. ,e.uiredD *rovide an e#planation to your assistant of the weaknesses in his definition of non@ current assets when compared to the 1on 2on 3nstitute of 'ertified *ublic ,ccountantsB view of assets. .4 marks/ .,'', +$ .12</ +inancial 7eportin December 2EEC &4.a//
N1-17

.b/

6uestion < .a/ "#plain and ive an e#ample of the effect on a set of published financial statements if the oin concern convention is held not to apply. .b/ "#plain in eneral terms what the 3,5= +ramework is tryin to achieve. .1E marks/

N1-18