CHAPΤER 2

CONCEPTUAL FRAMEWORK

Financial reporting and assumptions

TECHNICAL KNOWLEDGE

To know the nature of a conceptual framework.

To describe the purpose and usefulness of a conceptual framework.

To understand the authoritative status of a conceptual framework.

To understand the objective of financial reporting.

To know the limitations of financial reporting.

To understand the underlying assumptions of accounting.

Definition

The Conceptual Framework for Financial Reporting is a complete, comprehensive and single document
promulgated by the International Accounting Standards Board.

The Conceptual Framework is a summary of the terms and concepts that underlie the preparation and
presentation of financial statements for external users.

The Conceptual Framework is an attempt to provide an overall theoretical foundation for accounting.

The Conceptual Framework is intended to guide standard-setters, preparers and users of financial
information in the preparation and presentation of statements.

It is the underlying theory for the development of accounting standards and revision of previously issued
accounting standards.

The Conceptual Framework is concerned with general purpose financial statements, including
consolidated financial statements. The financial statements are prepared at least annually and are
directed toward the common needs of a wide range of users.

However, special purpose financial reports, for example, prospectuses and computations prepared for
taxation purposes, are outside the scope of the Conceptual Framework.

Purposes of Conceptual Framework

a. To assist the FRSC in developing accounting standards and reviewing existing standards.

b. To assist preparers of financial statements in applying accounting standards and in dealing with issues
not yet covered by GAAP.

c. To assist the FRSC in the review and adoption of International Financial Reporting Standards.

d. To assist users of financial statements in interpreting the information contained in the financial
statements.

e. To assist auditors in forming an opinion as to whether financial statements conform with Philippine
GAAP.

f. To provide information to those interested in the work of the FRSC in the formulation of PFRS.
Authoritative status of Conceptual Framework

If there is a standard or an interpretation that specifically applies to a transaction, the standard or

interpretation overrides the Conceptual Framework.

In the absence of a standard or an interpretation that specifically applies to a transaction, management

shall consider the applicability of the Conceptual Framework in developing and applying an accounting
policy that results in information that is relevant and reliable.

However, it is to be stated that the Conceptual Framework is not a Philippine Financial Reporting
Standard.

The Conceptual Framework does not define standard for any particular measurement or disclosure issue.

Nothing in this Conceptual Framework overrides any specific Philippine Financial Reporting Standard.

In case where there is a conflict, the requirements of the Philippine Financial Reporting Standards shall
prevail over the Conceptual Framework.

Users of financial information

Under the Conceptual Framework for Financial Reporting, the users of financial information may be
classified into two namely:

a. Primary users
b. Other users

The primary users include the existing and potential investors, lenders and other creditors.

The other users include the employees, customers, governments and their agencies, and the public.

Primary users

The primary users of financial information are the parties to whom general purpose financial reports are
primarily directed.

Such users cannot require reporting entities to provide information directly to them and therefore must
rely on general purpose financial reports for much of the financial information they need.

Existing and potential investors

Existing and potential investors are concerned with the risk inherent in and return provided by their
investments.

The investors need information to help them determine whether they should buy, hold or sell.

Shareholders are also interested in information which enables them to assess the ability of the entity to
pay dividends.

Lenders and other creditors

Existing and potential lenders and other creditors are interested in information which enables them to
determine whether their loans, interest thereon and other amounts owing to them will be paid when
due.
Other users

By residual definition, "other users" are users of financial information other than the existing and
potential investors, lenders and other creditors.

Other users are so called because they are parties that may find the general purpose financial reports
useful but the reports are not directed to them primarily.

Employees

Employees are interested in information about the stability and profitability of the entity.

The employees are interested in information which enables them to assess the ability of the entity to
provide remuneration, retirement benefits and employment opportunities.

Customers

Customers have an interest in information about the continuance of an entity especially when they have
a long-term involvement with or are dependent on the entity.

Governments and their agencies

Governments and their agencies are interested in the allocation of resources and therefore the activities
of the entity.

These users require information to regulate the activities of the entity, determine taxation policies and
as a basis for national income and similar statistics.

Public

Entities affect members of the public in a variety of ways.

For example, entities make substantial contribution to the local economy in many ways including the
number of people they employ and their patronage of local suppliers.

Financial statements may assist the public by providing information about the trend and the range of its
activities.

Scope of Conceptual Framework

a. Objective of financial reporting

b. Qualitative characteristics of useful financial information

c. Definition, recognition and measurement of the elements from which financial statements are
constructed

d. Concepts of capital and capital maintenance

Financial reporting

Financial reporting is the provision of financial information about an entity to external users that is useful
to them in making economic decisions and for assessing the effectiveness of the entity's management.

The principal way of providing financial information to external users is through the annual financial
statements.

However, financial reporting encompasses not only financial statements but also other means of
communicating information that relates directly or indirectly to the financial accounting process.
Financial reports include not only financial statements but also other information such as financial
highlights, summary of important financial figures, analysis of financial statements and significant ratios.

Financial reports also include nonfinancial information such as description of major products and a listing
of corporate officers and directors.

OBJECTIVE OF FINANCIAL REPORTING

The objective of financial reporting forms the foundation of the Conceptual Framework.

The overall objective of 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.

The objective of financial reporting is the "why", purpose or goal of accounting.

Target users

Financial reporting is directed primarily to the existing and potential investors, lenders and other
creditors which compose the primary user group.

The reason is that existing and potential investors, lenders and other creditors have the most critical
and immediate need for information in financial reports.

As a matter of fact, the primary users of financial information are the parties that provide resources to
the entity.

Moreover, information that meets the needs of the specified primary users is likely to meet the needs
of other users such as employees, customers, governments and their agencies.

The management of a reporting entity is also interested in financial information about the entity.

However, management need not rely on general purpose financial reports because it is able to obtain
or access additional financial information internally.

Specific objectives of financial reporting

The overall objective of financial reporting is to provide information that is useful for decision making.

Specifically, the Conceptual Framework for Financial Reporting states the following objectives of financial

reporting:

a. To provide information useful in making decisions about providing resources to the entity.

b. To provide information useful in assessing the cash flow prospects of the entity.

c. To provide information about entity resources, claims and changes in resources and claims.

Economic decisions

Existing and potential investors need general purpose financial reports in order to enable them in making
decisions whether to buy, sell or hold equity investments.
Existing and potential lenders and other creditors need general purpose financial reports in order to
enable them in making decisions whether to provide or settle loans and other forms of credit.

Assessing cash flow prospects

Decisions by existing and potential investors about buying, selling or holding equity instruments depend
on the returns that they expect from an investment, for example, dividends.

Similarly, decisions by existing and potential lenders and other creditors about providing or settling
loans and other forms, of credit depend on the principal and interest payments or other returns that
they expect.

Consequently, financial reporting should provide information that is useful in assessing the amount,
timing and uncertainty of prospects for future net cash inflows to the entity.

Economic resources and claims

General purpose financial reports provide information about the financial position of a reporting entity.

Financial position is information about the entity's economic resources and the claims against the
reporting entity.

The economic resources are the assets and the claims are the liabilities and equity of the entity.

In other words, the financial position comprises the assets, liabilities and equity of an entity at a
particular moment in time.

Information about the nature and amounts of an entity's economic resources and claims can help users
identify the entity's financial strength and weakness.

Otherwise stated, information about financial position can help users to assess the entity's liquidity,
solvency and the need for additional financing.

Liquidity is the availability of cash in the near future to cover currently maturing obligations.

Solvency is the availability of cash over a long term to meet financial commitments when they fall due.

Information about priorities and payment requirements of existing claims can help users to predict how
future cash flows will be distributed among those with a claim against the reporting entity.

Changes in economic resources and claims

General purpose financial reports also provide information about the effects of transactions and other
events that change the economic resources and claims.

Changes in economic resources and claims result from financial performance and from other events or
transactions, such as issuing debt or equity instruments.

The financial performance of an entity comprises revenue, expenses and net income or loss for a period
of time.

In other words, financial performance is the level of income earned by the entity through the efficient
and effective use of its resources.

The financial performance of an entity is also known as results of operations and is portrayed in the
income statement and statement of comprehensive income.

Usefulness of financial performance

Information about financial performance helps users to understand the return that the entity has
produced on the economic resources.
Information about the return the entity has produced provides an indication of how well management
has discharged its responsibilities to make efficient and effective use of the entity's economic resources.

Information about past financial performance is usually helpful in predicting the future returns on the
entity's economic resources.

Information about financial performance during a period is useful is assessing the entity's ability to
generate future cash inflows from operations.

Accrual accounting

Accrual accounting depicts the effects of transactions and other events and circumstances on an entity's
economic resources and claims in the periods in which those effects occur even if the resulting cash
receipts and payments occur in a different period.

In other words, under the accrual basis, the effects of transactions and other events are recognized
when they occur and not as cash is received or paid.

Simply stated, accrual accounting means that income is recognized when earned regardless of when
received and expense is recognized when incurred regardless of when paid.

Information about financial performance measured in accordance with accrual accounting provides a
better basis for assessing past and future performance than information solely about cash receipts and
payments during a period.

Limitations of financial reporting

a. General purpose financial reports do not and cannot provide all of the information that existing and
potential investors, lenders and other creditors need.

These users need to consider pertinent information from other sources, for example, general economic
conditions, political events and industry outlook.

b. General purpose financial reports are not designed to show the value of an entity but the reports
provide information to help the primary users estimate the value of the entity.

c. General purpose financial reports are intended to provide common information to users and cannot
accommodate every request for information.

d. To a large extent, general purpose financial reports are based on estimate and judgment rather than
exact depiction.

UNDERLYING ASSUMPTIONS

Accounting assumptions are the basic notions or fundamental premises on which the accounting process
is based. Accounting assumptions are also known as postulates.

Like a building structure that requires a solid foundation to avoid or prevent future collapse and provide
room for expansion, and so with accounting.

Accounting assumptions serve as the foundation or bedrock of accounting in order to avoid

misunderstanding but rather enhance the understanding and usefulness of the financial statements.

The Conceptual Framework for Financial Reporting mentions only one assumption, namely going
concern.
However, implicit in accounting are the basic assumptions of accounting entity, time period and
monetary unit.

Going concern

The going concern or continuity assumption means that in the absence of evidence to the contrary, the
accounting entity is viewed as continuing in operation indefinitely.

In other words, the financial statements are normally prepared on the assumption that the entity will
continue in operations for the foreseeable future.

The going concern postulate is the very foundation of the cost principle.

Thus, assets are normally recorded at cost. As a rule, market values are ignored.

However, some new standards require measurement of certain assets at fair value.

If there is evidence that the entity would experience large and persistent losses or that the entity's
operations are to be terminated, the going concern assumption is abandoned.

In this case, the users of the statements will have a great interest in the amount of cash that will be
generated from the entity's assets in the short term.

Accounting entity

In financial accounting, the accounting entity is the specific business organization, which may be a
proprietorship, partnership or corporation.

Under this assumption, the entity is separate from the owners, managers, and employees who constitute
the entity.

Accordingly, the transactions of the entity shall not be merged with the transactions of the owners.

The reason for the entity assumption is to have a fair presentation of financial statements.

The personal transactions of the owners shall not be allowed to distort the financial statements of the
entity.

For example, the cash invested by the proprietor is treated as an asset of the proprietorship.

If an enterprising entrepreneur owns department store, restaurant and bookstore, separate statements
shall be prepared for each business in order to determine which business is profitable.

Each business is an independent accounting entity.

When a major shareholder of a corporation borrows money from a bank on his own personal account,
the loan is a liability of the shareholder alone and not of the corporation.

The shareholder is not the corporation and the corporation is not the shareholder.

However, where parent and subsidiary relationship exists, consolidated statements for the affiliates are
usually made because for practical and economic purposes, the parent and the subsidiary are a "single
economic entity".

The consolidation, however, does not eliminate the legal boundary segregating the affiliated entities.

Accounting will continue to be done separately for each entity.

Time period

A completely accurate report on the financial position and performance of an entity cannot be obtained
until the entity is finally dissolved and liquidated.

Only then can the final net income and networth of the entity be determined precisely.

However, users of financial information need timely information for making an economic decision.

It becomes necessary therefore to prepare periodic reports on financial position, performance and cash
flows of an entity.

The time period assumption requires that the indefinite life of an entity is subdivided into accounting
periods which are usually of equal length for the purpose of preparing financial reports on financial
position, performance and cash flows.

By convention, the accounting period or fiscal period is one year or a period of twelve months.

The "one-year period" is traditionally the accounting period because usually it is after one year that
government reports are required.

The accounting period may be a calendar year or a natural business year.

A calendar year is a twelve-month period that ends on December 31.f

A natural business year is a twelve-month period that ends on any month when the business is at the
lowest or experiencing slack season.

Monetary unit

The monetary unit assumption has two aspects, namely quantifiability and stability of the peso.

The quantifiability aspect means that the assets, liabilities, equity, income and expenses should be
stated in terms of a unit of measure which is the peso in the Philippines.

How awkward to see financial statements without any common unit of measure. Such statements would
be largely unintelligible and incomprehensible.

The stability of the peso assumption means that the purchasing power of the peso is stable or constant
and that its instability is insignificant and therefore may be ignored.

The stable peso postulate is actually an amplification of the going concern assumption so much so that
adjustments are unnecessary to reflect any changes in purchasing power.

The accounting function is to account for nominal pesos only and not for constant pesos or changes in
purchasing power.

In today's world, the assumption that the peso is a stable measure over time is not necessarily valid.

Consider an equipment that was imported 10 years ago from the United States for $100,000 when the
exchange rate was P35 to $1 or an equivalent of P3,500,000.

If the same equipment is purchased now and assuming there is no change in the $100,000 purchase
price, the replacement cost in terms of pesos would be in the vicinity of P5,000,000, considering a
current exchange rate of P50 to $1.

Obviously, there is a significant gap between historical cost and current replacement cost.

In this regard, an entity may choose the revaluation model as an accounting policy.