CONCEPTUAL FRAMEWORK AND ACCOUNTING STANDARDS

Topic 2: Conceptual Framework

Purpose of the Conceptual Framework

 The conceptual framework prescribes the concepts of general purpose financial reporting. Its purpose if to:
a. Assist the International Accounting Standards Board (IASB) in developing Standards that are based on
consistent concepts;
b. Assist preparers in developing consistent accounting policies when no Standard applies to a particular
transaction or when a Standard allows a choice of accounting policy; and
c. Assist all parties in understanding and interpreting the Standards.

 The conceptual framework provides the foundation for the development of Standards that:
a. Promote transparency by enhancing the international comparability and quality of financial information.
b. Strengthen accountability by reducing the information gap between providers of capital and the entity’s
management.
c. Contribute to economic efficiency by helping investors to identify opportunities and risks around the world,
thus improving capital allocation. The use of a single, trusted accounting language lowers the cost of capital
and reduces international reporting costs.

Status of the Conceptual Framework

 The conceptual framework is not a Standard. If there is a conflict between a Standard and the Conceptual
Framework, the requirements of the Standard will prevail.
 The authoritative status of the conceptual framework is depicted in the hierarchy of guidance shown below:
1. Philippine Financial Reporting Standards (PFRSs)
2. Judgment
When making judgment:
 Management shall consider the following:
a. Requirements in other PFRSs dealing with similar transactions
b. Conceptual framework
 Management may consider the following:
a. Pronouncements issued by other standard-setting bodies
b. Other accounting literature and industry practices
 To meet the objectives of general purpose financial reporting, a Standard sometimes contains requirements that
depart from the Conceptual Framework. In such cases, the departure is explained in the “Basis of Conclusions”
on that Standard.
 The conceptual framework may be revised from time to time based on the IASB’s experience of working with it.
However, revisions do not automatically result to changes in the Standards – not until after the IASB goes through
its due process of amending a Standard.

Scope of the Conceptual Framework

 The conceptual framework is concerned with general purpose financial reporting. General purpose financial
reporting involves the preparation of general purpose financial statements. The conceptual framework provides
the concepts that underlie general purpose financial reporting with regard to the following:
1. The objective of financial reporting
2. Qualitative characteristics of useful financial information
3. Financial statements and the reporting entity
4. The elements of financial statements
5. Recognition and derecognition
6. Measurement
7. Presentation and disclosure
8. Concepts of capital and capital maintenance

The objective of Financial Reporting

 The objective of general purpose financial reporting is to provide financial information about the reporting entity
that is useful to existing and potential investors, lenders and other creditors in making decisions about providing
resources to the entity.
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Topic 2: Conceptual Framework

 This objective is the foundation of the conceptual framework. All the other aspects of the conceptual framework
revolve around this objective.

Primary users
 The objective of financial reporting refers to the following, so called the primary users:
a. Existing and potential investors; and
b. Lenders and other creditors
 The conceptual framework is concerned with general purpose financial reporting. General purpose financial
reporting deals with providing information that caters to the common needs of primary users. Therefore, general
purpose financial reports do not and cannot provide all the information needs of primary users.

Decisions about providing resources to the entity

 The primary users’ decisions about providing resources to the entity involve decisions on:
a. Buying, selling or holding investments;
b. Providing or settling loans and other forms of credit; or
c. Exercising voting or similar rights that could influence management’s actions relating to the use of the entity’s
economic resources.
 These decisions depend on the investor/lender/other creditor’s expected returns. Expectations about returns
depend on assessments of the entity’s prospects for future net cash inflows and (ii) management stewardship.

Information on economic resources, claims and changes

 General purpose financial reports provide information on a reporting entity’s:
a. Financial position – information on economic resources (assets) and claims against the reporting entity
(liabilities and equity); and
b. Changes in economic resources and claims – information on financial performance (income and expenses)
and other transactions and events that lead to changes in financial position.

Economic resources and claims

 Information about the nature and amounts of an entity’s economic resources (assets) and claims (liabilities and
equity) can help users to identify the entity’s financial strengths and weaknesses. That information can help users
in assessing the entity’s:
a. Liquidity and solvency
b. Needs for additional financing and how successful it is likely to be in obtaining that financing; and
c. Management’s stewardship on the use of economic resources.

Changes in economic resources and claims

 Changes in economic resources and claims result from:
a. Financial performance (income and expenses); and
b. Other events and transactions
 Information on financial performance help users assess the entity’s ability to produce return from its economic
resources.
 Information on the variability of the return help users in assessing the uncertainty of future cash flows.
 Information based on accrual accounting provides a better basis for assessing the entity’s financial performance
than information based solely on cash receipts and disbursements during the period.
 Information on past cash flows help users assess the entity’s ability to generate future cash flows by providing
uses a basis in understanding the entity’s operating, investing, and financing activities, assessing its liquidity or
solvency, and interpreting other information about its financial performance.
 Economic resources and claims may also change for reasons aside from financial performance, such as issuing
debt or equity instruments. Information of these types of changes is necessary for complete understanding of the
entity’s changes in economic resources and claims and the possible impact of those changes on the entity’s future
financial performance.

Information about use of the entity’s economic resources

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Topic 2: Conceptual Framework

 Information on how efficiently and effectively the entity’s management has discharged its responsibilities to use
the entity’s economic resources help users assess the entity’s management’s stewardship. Examples of
management’s responsibilities to use the economic resources include safeguarding those resources and ensuring
the entity’s compliance with laws, regulations, and contractual provisions.

Qualitative Characteristics
 The qualitative characteristics of useful financial information identify types of information that are likely to be
most useful to the primary users in making decisions using an entity’s financial report. Qualitative characteristics
apply to information in the financial statements as well as to financial information provided in other ways.
 The conceptual framework classifies the qualitative characteristics into the following:
1. Fundamental qualitative characteristics – these are the characteristics that make information useful to users.
They consist of the following:
a. Relevance
b. Faithful representation
2. Enhancing qualitative characteristics – these are the characteristics that enhance the usefulness of
information, they consist of the following:
a. Comparability
b. Verifiability
c. Timeliness
d. Understandability

Relevance
 Information is relevant if it can make a difference in the decisions of users. Relevant information has the following:
a. Predictive value – the information can help users in making predictions about future outcomes.
b. Confirmatory value (feedback value) – the information can help users in confirming their previous predictions.
 Materiality. Information is material if omitting, misstating or obscuring it could reasonably be expected to influence
decisions that the primary users of a specific reporting entity’s general purpose financial statements make on the
basis of those financial statements.
 The conceptual framework states that materiality is an entity-specific aspect of relevance, meaning materiality
depends on the facts and circumstances surrounding a specific entity. Accordingly, the conceptual framework and
the standards do not specify a uniform quantitative threshold for materiality. Materiality is a matter of judgment.
 Four-step process in making materiality judgment (IFRS Practice Statement 2)
1. Identify information that has the potential to be material.
2. Assess whether the information identified in Step 1 is, in fact, material.
3. Organize the information within the draft financial statements in a way that communicates the information
clearly and concisely to primary users.
4. Review the draft financial statements to determine whether all material information has been identified and
materiality considered from a wide perspective and in aggregate, on the basis of the complete set of financial
statements.

Faithful representation
 Faithful representation means the information provides a true, correct, and complete depiction of the economic
phenomena that it purports to represent.
 When an economic phenomenon’s substance differs from its legal form, faithful representation requires the
depiction of the substance.
 Faithfully represented information has the following characteristics:
a. Completeness – all information necessary for users to understand the phenomenon being depicted is
provided.
b. Neutrality – information is selected or presented without bias. Information is not manipulated to increase the
probability that users will receive it favorably or unfavorably.
c. Free from error – this does not mean that the information is perfectly accurate in all respect. Free from error
means there are no errors in the description and in the process by which the information is selected and
applied. If the information is an estimate, the fact should be described clearly, including an explanation of the
process used in making that estimate.
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Topic 2: Conceptual Framework

Comparability
 Information is comparable if its help users identify similarities and differences between different sets of
information that are provided by:
a. A single entity but in different periods (inter-comparability); or
b. Different entities in a single period (inter-comparability)

Verifiability
 Information is verifiable if different users could reach a general agreement as to what the information purports
to represent.
 Verification can be direct or indirect. Direct verification involves direct observation. Indirect verification involves
checking the inputs to a model or formula and recalculating the outputs using the same methodology.

Timeliness
 Information is timely if it is available to users in time to be able to influence their decisions.

Understandability
 Information is understandable if it is presented in a clear and concise manner.
 Understandability does not mean that complex matters should be excluded to make information understandable
to users because this would make information incomplete and potentially misleading.
 Accordingly, financial reports are intended for users who:
a. Have reasonable knowledge of business activities; and
b. Are willing to analyze the information diligently.

The Cost Constraint

 Providing information entails cost and this can only be justified by the benefits expected to be derived from using
the information.
 An optimum balance between costs and benefits is desirable such that costs do not outweigh the benefits.

Reporting period
 Financial statements are prepared for a specified period of time and provide information on assets, liabilities and
equity that existed at the end of the reporting period, or during the reporting period, and income and expenses for
the reporting period.
 To help users of financial statements in evaluating changes and trends, financial statements also provide
comparative information for at least one preceding reporting period.
 Financial statements are designed to provide information about past events. Information about possible future
transactions and other events is included in the financial statements only if its relates to the past information
presented in the financial statements and is deemed useful to users.
 Information in financial statements is prepared from the perspective of the reporting entity, not from the
perspective of any particular group of financial statement user.

Going concern assumption

 Financial statements are normally prepared on the assumption that the reporting entity is a going concern,
meaning the entity has neither the intention nor the need to end its operations in the foreseeable future.

The reporting entity

 The reporting entity is one that is required, or chooses, to prepare financial statements, and is not necessarily a
legal entity. It can be a single entity or a group or combination of two or more entities.

The elements of financial statements

1. Assets’
2. Liabilities
3. Equity
4. Income
5. Expenses
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Topic 2: Conceptual Framework

Asset
 Asset is a present economic resource controlled by the entity as a result of past events. An economic resource is
a right that has the potential to produce economic benefits.
 Right. Asset is an economic resource and an economic resource is a right that has the potential to produce
economic benefits. Rights that have the potential to produce economic benefits include:
a. Rights that correspond to an obligation of another party:
i. Right to receive cash, goods or services
ii. Right to exchange economic resources with another party on favorable terms
iii. Right to benefit from an obligation of another party to transfer an economic resource if a specified
uncertain future event occurs.
b. Rights that do not correspond to an obligation of another party:
i. Right over physical objects
ii. Right to use intellectual property
 Potential to produce economic benefits. The asset is the present right that has the potential to produce economic
benefits and not the future economic benefits that the right may produce. Thus, the right’s potential to produce
economic benefits need not be certain, or even likely – what is important is that the right already exists and that,
in at least one circumstance, it would produce economic benefits for the entity.
 Control means the entity has the exclusive right over the benefits of an asset and the ability to prevent others
from accessing those benefits. Accordingly, if one party controls an asset, no other party controls that asset.
Control does not mean that the entity can ensure that the resource will produce economic benefits. It only means
that if the resource produces benefits, it is the entity who will obtain those benefits. Control normally stems from
legally enforceable rights, however, ownership is not always necessary for control to exist because control can
arise from other right. Physical possession is also not always necessary for control to exist.

Liabilities
 Liability is a present obligation of the entity to transfer an economic resource as a result of past events.
 Obligation is a duty or responsibility that an entity has no practical ability to avoid. An obligation is either:
a. Legal obligation – an obligation that results from a contract, legislation, or other operation of law; or
b. Constructive obligation – an obligation that results from an entity’s actions that create a valid expectation on
others that the entity will accept and discharge certain responsibilities.
 Transfer of an economic resource. The liability is the obligation that has the potential to require the transfer of an
economic resource to another party and not the future economic benefits that the obligation may cause to be
transferred. Thus, the obligation’s potential to cause a transfer of economic benefits need not be certain, what is
important is that the obligation already exists and that, in at least one circumstance, it would require the entity to
transfer an economic resource.
 Present obligation as a result of past events. The obligation that exists as a result of past events. A present
obligation exists as a result of past events if:
a. The entity has already obtained economic benefits or taken an action; and
b. As a consequence, the entity will or may have to transfer an economic resource that it would otherwise have
had to transfer.

Equity
 Equity is a residual interest in the assets of the entity after deducting all its liabilities.

Income
 Income is increases in assets, or decreases in liabilities, that result in increases in equity, other than those relating
to contributions from holders of equity claims.

Expenses
 Expenses are decreases in assets, or increases in liabilities, that result in decreases in equity, other than those
relating to distributions to holders of equity claims.

Recognition and derecognition

CONCEPTUAL FRAMEWORK AND ACCOUNTING STANDARDS
Topic 2: Conceptual Framework

 Recognition is the process of including in the statement of financial position or the statement(s) of financial
performance an item that meets the definition of one of the elements of financial statements. This involves
recording the item in words and in monetary amount and including the amount in the totals of either of those
statements.
 An item is recognized if (both criteria should be met):
a. It meets the definition of an asset, liability, equity, income or expense; and
b. Recognizing it would provide useful information
 Even if an item that meets the definition of an asset or liability is not recognized, information about the item may
still need to be disclosed in the notes.

 Derecognition is the opposite of recognition. It is the removal of a previously recognized asset or liability from the
entity’s statement of financial position.
 Derecognition occurs when the item no longer meet the definition of an asset or liability.
 Derecognition is not appropriate if the entity retains substantial control of a transferred asset.

Measurement
 Recognition requires quantifying an item in monetary terms, thus necessitating the selection of an appropriate
measurement basis.
 The standards prescribe specific measurement bases for different types of assets, liabilities, income and
expenses.

Measurement bases
 The conceptual framework describes the following measurement bases:
1. Historical cost
2. Current value
a. Fair value
b. Value in use and fulfillment
c. Current cost

Historical cost
 The historical cost of an asset is the consideration paid to acquire the asset plus transaction costs. The historical
cost of a liability is the consideration received to incur the liability minus transaction costs.
 In cases where it is not possible to identify the cost the resulting asset or liability is initially recognized at current
value. That value becomes the asset’s (liability’s) deemed cost for subsequent measurement at historical cost.

Fair value
 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.
 Fair value reflects the perspective of market participants. Accordingly, it is not an entity-specific measurement.

Value in use and fulfillment value

 Value in use is the present value of the cash flows, or other economic benefits, that an entity expects to derive
from the use of an asset and from its ultimate disposal.
 Fulfillment value is the present value of the cash, or other economic resources, that an entity expects to be obliged
to transfer as it fulfills a liability.
 Value in use and fulfillment value are measured indirectly using cash-flow-based measurement techniques.
 Value in use and fulfillment value do not include transaction costs in acquiring an asset or incurring a liability but
include transaction costs expected to be incurred on the ultimate disposal of the asset or fulfillment of the liability.

Current cost
 Current cost of an asset is the cost of an equivalent asset as the measurement date, comprising the consideration
that would be paid at the measurement date plus the transaction costs that would be incurred at that date.
 Current cost of a liability is the consideration that would be received for an equivalent liability at the measurement
date minus the transactions costs that would be incurred at that date.
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Topic 2: Conceptual Framework

Considerations when selecting a measurement basis

 When selecting a measurement basis, it is important to consider the following:
a. The nature of information provided by a particular measurement basis; and
b. The qualitative characteristics, the cost constraint, and other factors.

Presentation and disclosure

 Information about assets, liabilities, equity, income, and expenses is communicated through presentation and
disclosure in the financial statements.
 Effective communication makes information more useful, Effective communication requires:
a. Focusing on presentation and disclosure objectives and principles rather than on rules
b. Classifying information by grouping similar items and separating dissimilar items
c. Aggregating information in a manner that it is not obscured either by excessive detail or by excessive
summarization
 Presentation and disclosure objectives are specified in the standards. Those requirements strive for a balance
between:
a. Giving entities the flexibility to provide relevant and faithfully represented information; and
b. Requiring information that has both intra-comparability and inter-comparability.

Classification
 Classification refers to the sorting of assets, liabilities, equity, income or expenses with similar nature, function
and measurement basis for presentation and disclosure purposes.
 Classification is applied to an asset’s or liability’s selected unit of account. However, it is sometimes necessary to
apply classification to a higher level of aggregation and then sub-classify the components separately.

Offsetting
 Offsetting occurs when an asset and a liability with separate units of account are combined and only the net
amount is presented in the statement of financial position. Offsetting is generally not appropriate because it
combines dissimilar items.

Classification of income and expenses

 Income and expenses are classified as recognized either in:
a. Profit or loss; or
b. Other comprehensive income
 The standards specify whether an income or expense is to be recognized in profit or loss or in other
comprehensive income. Generally, income and expenses associated with assets and liabilities that are measured
at historical cost are recognized in profit or loss.

Aggregation
 Aggregation is the adding together of assets, liabilities, equity, income or expenses that have shared
characteristics and are included in the same classification.
 Aggregation summarizes a large volume of detail, thus making information more useful. However, balance should
be strived for because excessive aggregation can conceal important detail.
 Typically, summarized information is presented in the statement of financial position and the statement of financial
performance while detailed information is provided in the notes.

Concepts of capital and capital maintenance

 The conceptual framework mentions two concepts of capital namely:
a. Financial concept of capital – capital is regarded as the invested money or invested purchasing power. Capital
is synonymous with equity, net assets, or net worth.
b. Physical concept of capital – capital is regarded as the entity’s productive capacity.
 The concept chosen affects the determination of profit. In this regard, the concepts of capital give rise to the
following concepts of capital maintenance:
a. Financial capital maintenance. Under this concept, profit is earned if the net assets at the end of the period
exceeds the net assets at the beginning of the period, after excluding any distributions to, and contributions
CONCEPTUAL FRAMEWORK AND ACCOUNTING STANDARDS
Topic 2: Conceptual Framework

from, owners during the period. Financial capital maintenance can be measured in either nominal monetary
units or units of constant purchasing power.
b. Physical capital maintenance. Under this concept, profit is earned only if the entity’s productive capacity at the
end of the period exceeds the productive capacity at the beginning of the period, after excluding any
distributions to, and contributions from, owners during the period. Only inflows of assets in excess of the
amount needed to maintain capital is regarded as return on capital or profit. The physical capital maintenance
concept requires the use of current cost.
 The conceptual framework does not prescribe a particular model, except for financial reporting under
hyperinflationary economy.