CHAPTER
R EVI EW O F THE
C O NC EP T U AL FR AM E WO R K
2
IFRS references
This chapter focuses on the Conceptual Framework
for Financial Reporting (IASB, 2018).
IFRS for SMEs references
Section 2: Concepts and Pervasive Principles
1 Introduction......................................................20
1.1 Development of the Conceptual Framework.... 20
2 The purpose of the Conceptual Framework.......21
3 General purpose financial reporting..................23
3.1 What is the objective of general purpose
financial reporting?........................................ 23
3.2 Who are the users of the financial statements?.25
3.3 Who is responsible for the preparation and
presentation of financial statements?............ 26
4 Characteristics of useful financial information..26
4.1 Relevance........................................................ 27
4.1.1 What makes financial information useful?.27
4.2 Faithful representation.................................... 28
4.3 Enhancing qualitative characteristics.............. 29
4.3.1 Comparability...................................... 29
4.3.2 Verifiability.......................................... 29
4.3.3 Understandability................................ 30
4.3.4 Timeliness........................................... 30
4.3.5 Choosing which enhancing qualitative
characteristic to focus on.................... 30
4.4 Balancing the cost of information with
its benefits..................................................... 32
4.4.1 The cost constraint on useful
financial reporting............................... 32
5 Financial statements and the reporting entity..... 32
5.1 The entity as a going concern.........................33
5.2 The reporting entity.........................................33
6 The elements of financial statements................34
6.1 Definition of an asset...................................... 35
6.1.1 What are the rights associated with
the asset?........................................... 35
6.1.2 Does the asset have the potential to
produce economic benefits?............... 35
6.1.3 Does the entity have control of the asset?.35
6.2 Definition of a liability..................................... 36
6.2.1 Does the entity have an obligation?..... 36
6.2.2 Is the obligation a duty of responsibility
to transfer the economic resource?..... 36
6.2.3 Does the obligation exist as a result
of past events?................................... 36
6.3 Assets and liabilities – Unit of account........... 37
6.4 Definitions of equity........................................ 37
6.5 Income and expenses..................................... 37
7 Recognition and derecognition..........................38
7.1 The recognition process..................................38
7.2 Recognition and the qualitative characteristics
of financial reporting...................................... 39
7.2.1 Relevance........................................... 39
7.2.2 Faithful representation......................... 39
7.3 Derecognition..................................................40
7.4 Contract modifications....................................40
8 Measurement....................................................41
9 Presentation and disclosure..............................42
9.1 Presentation and disclosure objectives
and principles................................................. 42
9.2 Classification..................................................43
9.2.1 Assets and liabilities........................... 43
9.2.2 Equity................................................. 43
9.2.3 Income and expenses......................... 43
9.3 Aggregation.....................................................44
10 Concepts of capital...........................................44
Questions...............................................................45
References.............................................................45
20 Financial Accounting: IF R S PR INC IPL ES

Learning objectives

By the end of this chapter, you should be able to:
✓✓ Describe the purpose and importance of the Conceptual
Framework
✓✓ Explain the objective of financial reporting
✓✓ Identify and explain the qualities of useful financial
information
✓✓ Explain the objective and scope of financial statements
and describe the reporting entity
✓✓ Explain ‘elements’ of financial statements – an asset, a
liability, equity, income and expenses
✓✓ Explain and apply the general principles for including
elements in the financial statements (recognition) and
removing elements from the financial statements
(derecognition)
✓✓ Explain the various measurement bases and discuss the
factors to be considered when selecting a
measurement basis
✓✓ Apply the general concepts relating to presentation and
disclosure and the guidance on including income and
expenses in the statement of profit or loss and other
comprehensive income
✓✓ Explain the concept of capital maintenance.
✓✓ Chapter summary

Purpose and status of

Conceptual Framework
Objective of
financial reporting
Capital maintenance

Qualitative characteristics of
useful financial information
• Fundamental
– Relevance
Presentation and Conceptual – Faithful representation
disclosure principles Framework • Enhancing

Reporting entity

Measurement basis
• Initial and subsequent Elements
• Historical cost • Assets
• Current value Recognition and • Liabilities
derecognition • Equity
• Income and expenses

1 Introduction
At this stage of your journey into accounting, you
should have a good understanding of some of the
basic accounting concepts used to prepare finan-
cial statements. The purpose of this chapter is to
enhance your current understanding of funda-
mental accounting principles and practices
(collectively referred to as the Conceptual Frame-
work), as well as to introduce you to some new
accounting concepts that form part of this
framework.
1.1 Development of the Conceptual
Framework
Let’s start by looking at the development of the
Conceptual Framework over time.
In 1989, the IASB’s predecessor body, the
International Accounting Standards Committee,
issued the Framework for the Preparation and
Presentation of Financial Statements (1989
Framework). Then in 2004, the IASB and the US
national standard-setter, the Financial Accounting
 C HAP TER 2
Standards Board (FASB), started a joint project to
revise their conceptual frameworks.
The first phase of the joint project was to
develop chapters that describe the objective of
general purpose financial reporting and the quali-
tative characteristics of useful financial informa-
tion. This was completed in 2010 when the IASB
and the FASB issued two chapters of a revised
Conceptual Framework for Financial Reporting
(2010 Conceptual Framework). The remaining text
of the 1989 Framework was carried forward to the
2010 Conceptual Framework unchanged. The
IASB proceeded on its own and the focus was to
develop and revise the Conceptual Framework as
a whole rather than in parts, and to enable the
IASB and stakeholders to see more clearly the
links between different aspects of the Conceptual
Framework. After considering feedback on the
various documents that the IASB published and
information gained from consultations with
interested parties between 2013 and 2018, the
IASB completed its Conceptual Framework project
when it issued the revised Conceptual Framework
for Financial Reporting in March 2018 (2018
Conceptual Framework).
In developing the 2018 Conceptual Framework,
the IASB built on the 2010 Conceptual Frame-
work. This was done:
By filling in gaps where important areas were
●●
not covered or existing guidance was unclear;
and
●● By clarifying and updating aspects that were
out of date and no longer reflected the IASB’s
most developed thinking on these matters.
The 2018 Conceptual Framework comprises eight
chapters:
●● Chapter 1 – The objective of general purpose
financial reporting
●● Chapter 2 – Qualitative characteristics of useful
information
●● Chapter 3 – Financial statements and the
reporting entity
●● Chapter 4 – The elements of financial
statements
●● Chapter 5 – Recognition and derecognition
●● Chapter 6 – Measurement
●● Chapter 7 – Presentation and disclosure
●● Chapter 8 – Concepts of capital and capital
maintenance
R E VI E W O F T H E C O N C E P T U A L FR A M E W O R K 21
The chapters on the objective of financial reporting
and qualitative characteristics of useful financial
information remained largely the same.
The objective of this textbook is not to discuss
the content of the Conceptual Framework in its
entirety or in detail, but to focus on complexities
not yet encountered in your studies and to help
you in your application of these basic accounting
concepts. You are therefore encouraged to refer to
the 2018 Conceptual Framework to revise any of
the details and concepts not discussed in
this chapter.
Something to do
Revise your prior knowledge of the Conceptual
Framework, and prepare a mind-map after reading the
complete 2018 Conceptual Framework.
IFRS for SMEs, Section 2, Concepts and Pervasive
Principles, describes the objectives of financial
statements of small and medium-sized entities and
the qualities that make the information in the financial
statements of SMEs useful. It also sets out the
concepts and basic principles underlying the financial
statements of SMEs.
2 The purpose of the Conceptual
Framework
The purpose of the Conceptual Framework is
threefold:
●● To assist the IASB in the development of future
IFRS standards and in its review of existing
IFRS standards.
●● To assist preparers to develop consistent
accounting policies when no IFRS applies to
a particular transaction or event or when a
particular IFRS allows a choice of accounting
policy.
●● To assist all parties to understand and interpret
IFRSs.
The Conceptual Framework describes the objec-
tive of and the concepts for general purpose
f inancia l reporting. The IASB uses the
Conceptual Framework in the development of
future IFRS standards and in its review of an
existing IFRS standard. Preparers use the
Conceptual Framework when preparing financial
statements by applying IFRS as well as when
22 Financial Accounting: IF R S PR INC IPL ES
dealing with topics that have yet to form the
subject of an IFRS standard, and auditors are
assisted in forming an opinion of whether finan-
cia l statements comply w it h IFRS. The
Conceptual Framework also helps management
to prepare financial statements where a business
transaction or other event needs to be recognised
and reported, and there is no appropriate IFRS
standard. Using the principles set out in the
Conceptual Framework, management can formu-
late a basis to use in order to recognise the
transaction or other event. In most cases, the
accounting treatment of a transaction or circum-
stance is set out in an IFRS standard. Where
management is preparing financial statements
and has difficulty in applying an IFRS standard
to a transaction or other event, the Conceptual
Framework helps to guide the interpretation of
IFRS and therefore aids its implementation.
The Conceptual Framework is not only useful
to preparers of financial statements. Users of
financial statements should also have a thorough
understanding of the Conceptual Framework.
Users’ knowledge of the general principles under-
lying the financial statements enhances their
understanding of the financial information
reported in these statements, thereby improving
the quality of their decision-making. For users of
financial statements, the Conceptual Framework
assists in interpreting the information contained
in financial statements when they are prepared in
compliance with IFRS, and those who are inter-
ested in the work of the IASB are provided with
information about its approach to the formulation
of IFRS standards.
When preparing financial statements, you
should consider the definitions, recognition crite-
ria and measurement concepts for developing
accounting policies for transactions, events or
conditions that are set out in the Conceptual
Framework. This is particularly relevant in the
absence of an IFRS standard that specifically
applies or that applies to similar circumstances.
IAS8, Accounting Policies, Changes in Accounting
Estimates and Errors, provides guidance for
dealing with accounting issues that are not
addressed by any IFRS standard. See Chapter 18
for a detailed discussion of IAS8.
The 2018 Conceptual Framework does not pre-
scribe standards of measurement or disclosure.
The Conceptual Framework is consequently not
considered an IFRS standard, but merely a set
of guiding principles. Where preparers find incon-
sistencies between an existing IFRS standard and
the Conceptual Framework, the specific IFRS
standard applies as the Conceptual Framework
does not override any IFRS or requirement in an
IFRS standard.
IFRS UPDATE:
Transitioning to 2018 Conceptual Framework
and its impact on the existing IFRSs
We currently have the 1989 Conceptual
Framework, updated by the 2010 amendments
(the 2010 Conceptual Framework) and the 2018
Conceptual Framework. The IFRS standards
that are currently effective would have been
developed prior to the IASB issuing the 2018
Conceptual Framework.
The IASB has clarified that the IASB
and the IFRS Interpretations Committee will
start using the 2018 Conceptual Framework
immediately once it is issued. These revised
concepts will guide the IASB when it develops
or revises IFRS standards. However, it is not
automatic or assumed that changes to the
Conceptual Framework will lead to changes in
existing IFRS standards, as changes to IFRS
standards are generally made to fix a problem in
financial reporting.
Therefore, changes to the Conceptual
Framework will have no immediate effect on
the financial statements of most reporting
entities. Preparers of financial statements could
be directly affected by the changes only if they
need to use the Conceptual Framework to
develop an accounting policy when no Standard
applies to a particular transaction or other
event or when a Standard allows a choice of
accounting policy. To achieve transition to the
2018 Conceptual Framework for such entities,
the IASB issued Amendments to References to
the Conceptual Framework in IFRS Standards in
2018. Where appropriate, that document replaces
references in IFRS standards to the previous
Conceptual Framework with references to the
2018 Conceptual Framework and is effective for
annual reporting periods beginning on or after
1 January 2020.
 C HAP TER 2
3 General purpose financial
reporting
General purpose financial reporting provides the
owners of the business (for example, the share-
holders of a company) with some means of assess-
ing the proficiency with which their business is
being run. In comparison to sole proprietors, the
owners of large companies are often not the people
who are responsible for running the day-to-day
operations of the business. This management role
is performed by employees of the company, called
executive directors. The financial statements are
therefore one way in which the shareholders can
assess or evaluate the directors’ performance in
running the company, for example, how effective
management has been in protecting the entity’s
economic resources from unfavourable economic
factors and changes in technology, and that the
entity has complied with relevant laws and regula-
tions. This is because the financial statements
report the impact that management decisions have
had on the company’s economic resources and
claims against the company (as well as changes in
these resources and claims), and cash flows for the
year. This reporting function therefore enables
management to be held accountable to investors
and lenders. Where management is not managing
the entity’s economic resources responsibly, the
investors and lenders can take action.
General purpose financial statements are not
tailored to the needs of any one group of users.
Many existing and potential investors, lenders and
other creditors cannot require an entity to provide
information directly to them and must rely on
general purpose financial reports for much of the
financial information that they need. The prepara-
tion of general purpose financial reports is there-
fore considered the most efficient and effective way
to meet the information needs of a variety of users.
General purpose financial statements are an
appropriate means of meeting the information
needs of both external and internal users.
The financial information included in the
financial statements should be relevant to the
primary users’ decisions. Although the various
users make different types of financial decisions,
all of these decisions require information about
the entity’s ability to produce cash in the future,
an indication of when these cash flows will occur
and an assessment of the uncertainty surrounding
the production of these future cash flows. This
R E VI E W O F T H E C O N C E P T U A L FR A M E W O R K 23
common need has resulted in financial statements
containing financial information to assist users in
being able to make reliable and informed predic-
tions about the extent, nature, timing and uncer-
tainties of future cash flows produced by the entity.
The financial statements that help users to make
these forecasts are those that communicate the
reporting entity’s economic resources and claims
against the reporting entity as well as the changes
in the entity’s economic resources and claims
during a period.
Something to think about
Who are the primary users of general purpose
financial statements?
The primary users of general purpose financial
reporting are present and potential investors, lenders
and other creditors who use that financial information
to make decisions about buying, selling or holding
equity or debt instruments and providing or settling
loans or other forms of credit.
What are the information needs of these
primary users?
The primary users need financial information about the
resources of the entity in order to assess an entity’s
prospects for future net cash inflows as well as to
evaluate how effectively and efficiently management
has discharged its responsibilities to use the entity’s
existing resources (in other words, stewardship).
Do general purpose financial statements provide
all of the information that users may need?
General purpose financial reports cannot provide all of
the financial information that users may need to make
economic decisions. Users also need to consider
pertinent information from other sources.
3.1 What is the objective of general
purpose financial reporting?
The objective of general purpose financial reporting is to provide
existing and potential investors, lenders and other creditors with
relevant and decision-useful information about the financial
status of the entity at the end of each reporting period.
The information provided in financial statements
informs users who must make decisions about
whether to buy, sell or hold an investment or inter-
est in the entity (in the case of investors), or
whether to provide or settle loans and other forms
24 Financial Accounting: IF R S PR INC IPL ES

of credit to the entity (in the case of lenders and investors, lenders and other creditors need infor-
creditors). In order to assess an entity’s prospects mation, as shown in Table 2.1 below:
for future net cash inflows, existing and potential
Table 2.1 Information needs of users

ASSETS LIABILITIES EQUITY

What are the economic resources of
the entity?
How are these economic resources
used by the entity?
Examples:
What is the accounts receivable and
estimated uncollectible portion?
How are the resources used to
produce and market goods or
services to customers?
What are the claims against the entity?
What are the unavoidable obligations of
the entity?
Examples:
What are the accounts payable and other
short term liabilities?
What provisions and other non-current
obligations of the entity would result in an
outflow of economic resources?
What are the changes in the economic
resources and claims?
Has management discharged its responsibilities
in using the entity’s economic resources
efficiency and effectively?
Examples:
What is the profitability of the entity?
What portion of the profit (or loss) comprise of
unrealised gains and losses that are included in
the carrying amounts of assets?

Information about the nature and amounts of the

economic resources and claims of an entity can
help users to identify its financial strengths and
weaknesses. Such information is useful in
assessing the liquidity and solvency situation of
the entity, its needs for additional financing and
how successful it is in obtaining financing.
Information about priorities and payment require-
ments of existing claims helps users to predict the
distribution of future cash flows among those with
a claim against the entity, for example, its credi-
tors. The statement of financial position contains
most of the information about the entity’s
resources and claims (assets, liabilities and equity)
on a particular day, thereby helping the user to
assess the financial status of that entity. The state-
ment of financial position enables a user to
evaluate financial indicators such as financial risk,
liquidity and solvency.
Changes in the economic resources and claims
result from the entity’s performance and from
other events or transactions, such as issuing debt
or equity instruments. The entity’s financial per-
formance information helps users to understand
the return that the entity has produced on its eco-
nomic resources. The performance of an entity can
change its financial position. For example, an
entity may be in a difficult financial position at the
beginning of the year, but it may increase its sales
significantly during the year, thereby improving
its position. The extent to which an entity’s finan-
cial performance has changed its financial position
over a period of time is reflected in profit or loss or
other comprehensive income.
Something to think about
The financial statements differentiate between the
various changes in the entity’s financial position. The
changes caused by increases or decreases in assets
and liabilities are reported separately from the changes
caused by other factors (such as transactions with the
owners and specific events defined by IFRS that should
be reflected as other comprehensive income for the
reporting period). The presentation of items of income
and expenses in profit or loss or other comprehensive
income makes this distinction to help the user to
forecast an entity’s future cash flows.
Before making their financial decisions, users need
to identify and understand all of the factors
responsible for the return that the entity produces
on its economic resources, which is also referred
to as the financial performance of the entity. The
statement of changes in equity reports the changes
in the equity of the entity from one reporting year
to the next. This statement includes the changes in
an entity’s economic resources and claims against
the entity resulting from its financial performance
as well as transactions with owners. The statement
provides sufficient detail to enable users to under-
stand the reason for the change and adjust their
forecast accordingly.
The financial information needs of the primary
users place an increased focus on the entity’s
ability to generate and predict its future cash flows.
The accrual basis of accounting requires the effects
of transactions as well as other events and
 C HAP TER 2
circumstances to be recorded and reported when
they occur, even if the resulting cash receipts and
payments occur in a different period. This implies
that information about the entity’s economic
resources and claims as well as changes in these eco-
nomic resources and claims must be reported during
the period when they were incurred, resulting in a
better basis for assessing the entity’s past and future
performance than information that relates solely to
cash receipts and payments during that period, as
reported in the statement of cash flows.
The way in which an entity obtains and spends
cash, details about its borrowing and repayment
of debt, cash dividends or other cash distributions
to investors, all represent information reported in
the statement of cash flows, and provide useful
information about the entity’s liquidity and sol-
vency. Information about cash flows helps users to
understand the operations of the entity, and to
evaluate its financing and investing activities,
assess its liquidity or solvency and interpret other
information relating to financial performance.
Any additional information that will inform
users’ financial decisions should be provided by
the entity in the notes to its financial statements.
It is important not to consider each of the
financial statements independently, as all of these
statements are inter-related and contribute
towards the entity’s financial profile and risk
profile. The structure and contents of financial
statements are the subject of IAS1, Preparation of
Financial Statements, and are discussed further in
Chapter 3, Presentation of financial statements.
3.2 Who are the users of the financial
statements?
Primary users of financial statements:
Investors
Lenders and other creditors
Not every information need of each stakeholder
can be met, owing to time and cost constraints.
Existing and potential investors, lenders and cred-
itors have been identified as the primary users of
financial information provided by an entity.
Information provided in general purpose financial
statements is useful to these primary users in
making decisions about providing resources to the
entity, which involves buying or selling, or holding
equity and debt instruments, and providing
or  settling loans and other forms of credit.
R E VI E W O F T H E C O N C E P T U A L FR A M E W O R K 25
The identification of these primary users does not
imply that these are the only users of financial
information. This is done mainly because these
users have the most critical and immediate need
for the information in financial reports they bear
the most risk. Also, many of these users cannot
require the entity to provide the information
directly to them. Furthermore, the information
needs of these primary users are likely to meet the
needs of most of the other types of stakeholders.
Other users and stakeholders include manage-
ment, regulators, employees and the public.
The investor invests resources in an entity
(usually money) in exchange for an interest in the
net assets of the entity or by buying an interest
from existing investors, which enables the seller to
liquidate his or her investment. Investors are inter-
ested in seeing growth in their capital investments
through an increasing share price and receiving
payment for the use of their capital in the form of
dividends. Consequently, investors are concerned
about the entity’s ability to produce the cash flow
required to facilitate these returns on their invest-
ments (in other words, capital growth or payment
of dividends). They are also interested in the level
of uncertainty that exists around the entity’s
ability to generate these cash flows (referred to as
‘entity risk’). In order to be able to decide if they
should buy, sell or continue to hold their interest
in the entity, investors need information to esti-
mate the future cash flows of the entity as well as
to assess the uncertainties surrounding those cash
flows (the ‘entity risk profile’).
Lenders are also primary users of financial
information. They are interested in the future cash
flows of the entity in order to assess when the loan
that they have made to the reporting entity will be
repaid (the capital balance and the interest
amount). They are also interested in assessing the
risk profile of the entity to see if there is any uncer-
tainty about the entity’s ability to repay the loan,
both in terms of the timing of the repayment and
the probability of the repayment.
There are a number of other stakeholders, not
all of whom are all individually identified here.
Each one has a unique relationship with the entity,
and each stakeholder has a different decision-mak-
ing process that requires certain types of informa-
tion to inform the decision. Employees are one
interested party. Employees are interested in infor-
mation such as the salaries expense in relation to
the entity’s profit, descriptions of HIV/Aids
26 Financial Accounting: IF R S PR INC IPL ES
policies, and amounts spent on training and devel-
oping staff. Employees are also concerned about
job security and the ability of the entity to exist for
a long time. The public may be interested in finan-
cial and non-financial information about the
social and environmental responsibility pro-
grammes implemented by the entity.
Something to think about
With the increased scepticism regarding the reliability
of the financial reporting environment, users are requiring
more information about an entity’s risk profile, its position
in respect of financial, social and environmental factors,
and its status in respect of corporate governance.
Consequently, a lot more information is now provided
in the notes to the financial statements, as well as
in supplementary schedules (for example, in an
employees’ report, where the financial information
is simplified). This need for holistic and integrated
information has resulted in the identification of integrated
reporting, where an entity reports its performance in
terms of both its finance and its sustainability. Entities
are required to fulfil the information needs of those
who provide them with economic resources, resulting
in entities accepting wider accountability in current
times towards stakeholders on whose interests they
have an impact (for example, labour, space, air or
natural resources) and stakeholders who enter into
transactions with the entity (for example, customers).
Identify the information needs of the primary users
of financial information that you would include in an
integrated report. Think about how you would gather
and report that information to ensure that it is useful,
relevant, understandable and timely.
3.3 Who is responsible for the preparation
and presentation of financial
statements?
Preparation of financial statements:
Responsibility of directors
In several jurisdictions, it is a legal requirement
for entities to present financial statements in
compliance with IFRS.
Something to do
Refer to Chapter 1, Section 5, for a discussion of the
South African financial reporting system.
If financial information is published that does not
represent the actual state of the company’s affairs,
the directors of the company are held responsible
for any misrepresentation. This is because, in terms
of the Companies Act, No. 71 of 2008, and the
Conceptual Frame­work, management has the
responsibility for the preparation and presentation
of the financial statements. IFRS requires the financial
information contained in the financial statements
to be a faithful representation of the results; it must
report the actual transactions and other events as
they occurred. Where the financial statements of a
company do not represent the company’s state of
affairs faithfully, the directors (or management of
the company) are in contravention of IFRS and the
Companies Act, No. 71 of 2008.
Such a misrepresentation could be because of
negligence on the part of management, or it could
be a result of fraud. In both cases, the stakeholders
have legal recourse against the directors; the direc-
tors can face large fines and/or be sent to jail (as
with certain of the Enron directors). The misrep-
resentation of financial information is an activity
that is classified as white-collar crime, which is
receiving increased attention in the courts and is
subject to increasingly severe penalties.
However, while management bears the respon-
sibility of preparing relevant financial statements
that faithfully represent the transactions and
events of the entity, the various pieces of legisla-
tion and IFRS do provide a significant amount of
guidance. The Conceptual Framework provides
preparers (that is, management) with some funda-
mental accounting principles to assist in the prep-
aration of financial statements.
4 Characteristics of useful
financial information
The Conceptual Framework refers to certain quali-
ties that financial information should embody in
order to be useful to existing and potential inves-
tors, lenders and creditors (that is, the primary
users of financial information). You will have come
across these qualitative characteristics of financial
information in your first year of accounting, but
we will revise these attributes by looking at some
scenarios demonstrating their application.
The qualitative characteristics of useful financial
reporting identify the types of information that are
likely to be most useful to users in making decisions
 C HAP TER 2 R E VI E W O F T H E C O N C E P T U A L FR A M E W O R K 27

about the reporting entity. The qualitative charac-
teristics apply equally to financial information in
general purpose financial reports as well as to
financial information provided in other ways.
For financial information to be useful, it must
be relevant and it must faithfully represent what it
purports to represent. The usefulness of financial
information is enhanced if it is comparable,
verifiable, timely and understandable.
The qualitative characteristics of useful finan-
cial information apply to financial information
that is provided in financial statements, as well as
other information that is included in other reports,
such as the annual report or in an integrated
report. The financial statements include informa-
tion about the entity’s economic resources, claims
against the entity, and the effects of transactions
and other events and conditions that change those
resources and claims. Some financial reports may
also include explanatory information about man-
agement’s expectations and strategies for the
reporting entity as well as other types of forward-
looking information. You should consider the cost
(which is a pervasive constraint) of providing such
information, keeping in mind that the information
should be useful (see Figure 2.1).

Fundamental qualitative characteristics

Financial information is useful when it is relevant and faithfully represents what it purports to represent.

Relevance Faithful representation

Predictive value Complete depiction

Confirmatory value Neutral depiction
Materiality (entity specific) Free from error

Enhancing qualitative characteristics

The usefulness of financial information is enhanced if it is comparable, verifiable, timely and understandable.

Comparability Verifiability Timeliness Understandability

Pervasive constraint: Cost to provide information

Figure 2.1 Qualitative characteristics of financial information

4.1 Relevance
Users are only interested in information that
informs their financial decisions. In order to know
what information is relevant to a primary user, you
need to understand his or her interest in the entity
and the type of decisions that he or she makes in
regard to the entity. However, all users are similar
in that they use the information in the financial
statements to assess past events and estimate future
events. Relevant financial information is capable of
making a difference in the decisions made by users.
4.1.1 What makes financial information useful?
Relevant financial information is information that
is capable of making a difference in the decisions
made by users. Financial information is capable of
making a difference in decisions if it has predictive
value, confirmative value or both. The predictive
value and confirmative value of financial
information are inter-related.
Consider an investor’s interest in an entity. The
shareholder’s financial decision is based on estimating
the future cash flows of the company and assessing the
uncertainties attached to these cash flows. This infor-
mation need means that certain types of information
are relevant for the shareholder, such as separate dis-
closure of the financial implications of unusual trans-
actions. Revenue that is disclosed separately in finan-
cial statements is an example of information that has
both predictive and confirmative value. The revenue
28 Financial Accounting: IF R S PR INC IPL ES
reported in the current year can be used as the basis
for predicting revenues in future years. The same
revenue can also be compared with revenue predic-
tions for the current year that were made in past years.
The results of these comparisons help users to make
predictions about future outcomes of the entity,
and to correct and improve the processes that were
used when previous predictions were made.
Where the omission (failure to record or report
information) or misstatement of information could
affect the decisions made by a user, this information
is referred to as being material. If a user would have
made a different decision had he or she known
about certain unreported information, this infor-
mation is also regarded as being material. All infor-
mation that is material is by definition relevant, as
it influences users’ decisions. Materiality is an
entity-specific consideration based on the nature or
magnitude (or both) of the items to which the infor-
mation relates in the context of an individual enti-
ty’s financial report. This means that you cannot
specify a uniform or general quantitative threshold
for materiality or pre-determine what could be
material in a particular situation. Materiality is
determined separately for each entity and in each
situation by using your professional judgement.
Something to think about
Imagine that you invested in a company five years
ago on the basis of the good financial performance
reported in its financial statements at that time. Now
imagine that you find out that there was an error in
these financial statements, an error that resulted in the
reported profit being stated incorrectly. For one specific
transaction, instead of a loss of R1, the company had
reported a profit of R1 in error. Would this error have
changed your decision to invest in the company? In
other words, was this a material error? It is highly
unlikely that this error would have changed your
decision to invest in the company because the amounts
involved are so small. If this is the case, this error was
immaterial.
All of the practices and principles that are set out
in the IFRS standards are required to be applied only
to transactions that are material, either individually
or in aggregate. This means that technically, if you
bought postage stamps for R10 that were unused at
the year end, in terms of IFRS, this should be reported
as an asset. However, because this transaction is not
material, the stamps could be shown as an expense. In
other words, IFRS need not be applied in this situation.
4.2 Faithful representation
Financial information should faithfully represent the
transaction or other event (‘the economic phenom-
enon’) that it purports to represent. In achieving this,
it is important to consider the substance of the trans-
action or event. The legal form of transactions or
events is in many instances the same as the sub-
stance, but there may be instances where they are
different. If an entity only provides financial infor-
mation based on the legal form, it would not
faithfully represent the transaction or event. Faithful
representation is described as a fundamental quality,
and should be maximised to the greatest extent pos-
sible. In order to be useful, the information must
therefore be complete, neutral and free from error.
For information to be complete, it should
include all descriptions and explanations. For
example, it should include a complete summary of
all of the assets controlled by the entity as well as
a description of the nature of the different assets
and the different amounts, including a description
of what those amounts represent (for example,
cost, accumulated depreciation or fair value). In
some cases, for information to be complete, it must
also include other relevant information, for
example, explanations of significant factors about
the quality and nature of the items, factors and cir-
cumstances that may affect its quality and nature,
and the process of determining its amount.
Neutral information is prepared and presented
without any bias in the selection or presentation
thereof. This means that the information is not
emphasised, de-emphasised or manipulated in any
way so as to increase the probability that it will be
received favourably or unfavourably by users. The
information is still relevant and capable of making
a difference to users’ decisions, and it is reported in
a neutral way. Neutrality is supported by prudence,
which is the exercise of caution when making
judgements, particularly when conditions are
uncertain. Exercising prudence means that assets
and income are not overstated and liabilities and
expenses are not understated. Similarly, exercising
prudence does not allow for understating assets or
income and overstating liabilities and expenses.
Accountants should, at all times, aim to avoid
any errors or omissions when financial informa-
tion is prepared and reported. Faithful representa-
tion does not mean correct in all respects, but that
the information faithfully represents the underly-
ing facts of the transaction or event, and that you
 C HAP TER 2
have taken due care when preparing and present-
ing it. For example, using estimates does not make
financial information incorrect, but when an
amount is estimated, it can only be faithful if:
●● The amount is described clearly and accurately
as being an estimate
●● The nature and limitations of the estimating
process are clearly explained
●● No errors were made in selecting and applying
an appropriate process for developing the
estimate.
Something to think about
You may have read some years ago in the financial press
about how the financial statements of corporations such
as WorldCom and Enron, and more recently Steinhoff,
reported incorrect financial information to stakeholders.
These misrepresentations resulted in many stakeholders
suffering financial loss owing to poor investment
decisions as a result of misleading information. How do
you think governments, regulators and investors should
respond in such instances?
How does the above differ to when to an entity revises
the estimated useful life of its machinery annually?
Reporting financial information that is relevant and
faithfully represents what it purports to represent
helps users to make decisions with more confidence.
This results in more efficient functioning of capital
markets, and a lower cost of capital for the economy
as a whole. However, the two fundamental qualita-
tive characteristics may give rise to conflicting
guidance on how to account for a specific transac-
tion or other event. For example, the measurement
base that provides the most relevant information
about an asset does not always provide the most
faithful representation. Once the criterion of rele-
vance is applied to information to determine which
economic information should be contained in the
financial statements, the criterion of faithful repre-
sentation is applied to determine how to depict
those transactions and events in the financial state-
ments. Thus, the two characteristics work together.
4.3 Enhancing qualitative characteristics
You have seen that there are a number of qualities
that information should possess in order to inform
the decision-making process of stakeholders effec-
tively. In the section above, we focused on the
R E VI E W O F T H E C O N C E P T U A L FR A M E W O R K 29
fundamental qualitative characteristics of financial
information, that is, that information should be rel-
evant and represented faithfully. Comparability,
verifiability, timeliness and under­standability are
qualitative characteristics that enhance the useful-
ness of financial information that is relevant and
faithfully represents the transactions and other
events.
How do you think you would react if you were
provided with financial information as soon as you
requested it, but the information was not correct? In
such a case, the information could be considered rel-
evant but not faithful. Alternatively, if you needed to
make an investment decision immediately and were
provided with the company’s financial statements
nine months later, the fact that this information was
correct would be irrelevant, because it would be too
late to be used to inform your decision. In such a
case, the information could be considered faithful
but not relevant. It is obvious that some balance
between these characteristics needs to be reached in
order for the information to be useful to users.
4.3.1 Comparability
Information about the entity is more useful if it can
be compared with similar information about other
entities and with similar information about the
same entity for another period or another date. This
enables users to identify and understand similari-
ties in items as well as differences among items. For
information to be comparable, the same methods
for recording and reporting should be used for the
same items from period to period within the report-
ing entity or in a single period across entities. This
means that you should apply the same accounting
policies and methods consistently for the same
items and from one reporting period to the next.
4.3.2 Verifiability
Information is directly verifiable through direct
observation, for example, observing the book-
keeper counting the cash. Indirect verification
means checking the inputs, formula or other tech-
niques, recalculating the outputs using the same
methodology and reaching a similar answer, for
example, reperforming an inventory count by
checking the inputs (quantities and costs) and
recalculating the closing inventory using the same
costing formula (for example, first-in-first-out).
When information that is based on assumptions
and estimates is recorded and reported, you need
to disclose the underlying assumptions and the
30 Financial Accounting: IF R S PR INC IPL ES
methods of compiling the information as well as
other factors and circumstances that support the
information in order to assist the users in their
decision whether to use the information or not.
Verifiability helps to assure users that informa-
tion faithfully represents the economic phe­nomena
that it purports to represent. Verifiability means
that different knowledgeable and independent
observers could reach consensus, although not nec-
essarily complete agreement, that a particular
depiction is a faithful representation.
When users with a different knowledge base (in
their capacity as independent observers) reach
similar conclusions about financial information
although they may not necessarily be in complete
agreement, it can be said that the information has
been represented faithfully.
4.3.3 Understandability
Certain users have difficulty understanding the
accounting language used to prepare financial state-
ments. This occurs when highly technical financial
matters are presented in a complex manner, using
technical terms and jargon. Users who do not
understand the information contained in the finan-
cial statements are not able to use this information
to inform their decision-making processes. Infor-
mation that is supplied to primary users is normally
prepared and presented on the assumption that
those users have a reasonable knowledge of business
and economic activities, and that they are able to
review and analyse the information diligently. They
may, at times, need to seek the aid of an advisor to
understand information about complex economic
transactions and events.
Understandability involves classifying, charac-
terising and presenting information clearly and
concisely in order to make it understandable.
Some phenomena are inherently complex and
cannot be made easy to understand. However,
excluding this information would make financial
reports incomplete and potentially misleading.
Something to think about
Imagine that you purchased 1 000 shares in
Eshowe Ltd last year. It is now one year later and you
want to see how this investment has done to decide
if you should sell the shares, buy more or hold your
current investment position. Your main source of
Something to think about
information about the company is the annual financial
statements for Eshowe Ltd, the most recent of which
has just been published. These financial statements
are written in Zulu, a language with which you are not
familiar. Unless you understand Zulu, the language in
which these financial statements are written, you are
unlikely to understand the financial statements.
4.3.4 Timeliness
Information should be made available to decision-
makers before it loses its capacity to influence
decisions. For example, publishing financial
results and information that is old would not be
relevant or decision-useful. If information is pub-
lished too late, it loses its relevance. However,
information may continue to be useful after its ini-
tial provision, for example, in trend analysis.
Timeliness means that information is available
to decision-makers in time to be useful and
capable of influencing their decisions.
4.3.5 Choosing which enhancing qualitative
characteristics to focus on
These enhancing qualitative characteristics do
not follow a prescribed order. In some cases, one
enhancing qualitative characteristic may have to
be diminished in order to maximise another qual-
itative characteristic. If you were relying on
financial information to make a decision, think
about the qualities you would want this informa-
tion to embody. The over-arching guiding
principle is that the enhancing qualitative charac-
teristics do not make information useful if the
information is irrelevant or does not provide a
faithful representation of what it purports to
represent.
The following questions should prompt you to
think about the desirable qualities of financial
information:
●● Would you want to use information that
contained errors? (Quality: Free from mate-
rial error)
●● Would you want the statement of financial
position to show property that does not actually
exist? Or would you prefer only real property
to be shown on the statement of financial posi-
tion? (Quality: Faithful representation)
●● Would you want to know the directors’
birthdays? The birthdays of the directors are
 C HAP TER 2
unlikely to influence your decisions and there-
fore should not be disclosed. However, the years
in which they were born might influence your
decision, as that information would give you
some idea of how much longer the company
would be able to benefit from their experience.
(Quality: Relevance)
●● Would you want information recorded
according to the legal status of the transaction
or according to the economic reality? If your
company had to buy a property, would you be
happy not to record this as an asset while the
bank holds the title deeds to the property? The
bank is legally the owner of the property until
you have repaid the purchase price. (Quality:
Faithful representation)
●● How would you feel if the directors’ goal was to
report the profits to make them seem as high
as possible, and therefore in every situation
where judgement was required, they recog-
nised the minimum amount of expenses and
the maximum amount of profits? (Although
the Conceptual Framework provides a firm
foundation, there is still an element of subjec-
tivity in how the principles should be applied,
such as when deciding on the size of an allow-
ance for doubtful debts or what depreciation
rate to use.) Would you be able to rely on the
information if you knew that the directors were
selecting and filtering the information to influ-
ence your decision? (Quality: neutrality)
●● How do you think the shareholders of Enron
felt when they found out that the directors had
omitted certain liabilities from the financial
statements? (Quality: Faithful representation)
●● If you were trying to choose a listed company
to invest in, how would you decide between the
different investment opportunities? You would
need to compare the financial results of each
company to see what the best investment would
be. Do you think you could do this if each
company used different methods of recording
and measuring transactions? It would be
difficult to compare these companies as the
financial position and performance would
be determined on different bases. (Quality:
Comparability between entities)
●● If you owned shares in a company, how would
you know whether to buy more shares or sell
your shares? You would need to look at how
the company’s financial position had changed
over the year. This would mean looking at the
R E VI E W O F T H E C O N C E P T U A L FR A M E W O R K 31
company’s financial results for the current year
and comparing them to the previous year’s
results in order to establish how the position
had changed. It is to facilitate this kind of eval-
uation that IFRS requires the corresponding
information for the previous period to be
disclosed. (Quality: Comparability between a
company’s figures from year to year)
●● How do you think you would compare two
different companies that used different
accounting practices and policies? IFRS
allows for alternative accounting policies in
the treatment of many items, for example,
inventory and cost of sales, non-current assets
and depreciation, and leasing transactions.
A company is required by IFRS to explain all
of the accounting policies used to prepare its
financial statements. This is achieved by docu-
menting the accounting policies in a note to
the financial statements. The accounting
policy that is applied to a specific transaction
or event should be applied consistently (refer
to IAS8, which is discussed in more depth in
Chapter  18, Accounting policies, changes in
accounting estimates and errors) from one
period to another and for similar transactions.
Users can then read about the bases of prepa-
ration and make appropriate adjustments to
their understanding of the respective financial
positions where policies between companies
differ. (Quality: Consistency of information
and understanding of companies’ accounting
policies)
●● Should a company avoid changing how it
represents its financial affairs? For example, a
company decides that its investments in shares
should be measured at market value, with
the increases or decreases in market value
being shown in the statement of profit or loss
and other comprehensive income. This new
accounting policy is expected to result in fairer
presentation of the company’s financial affairs.
One of the directors does not want to change
the accounting policy in the current year
because he thinks that users will not be able to
compare the company’s performance between
years if different policies are used. Do you think
that this director is correct? You would prob-
ably prefer the company to use appropriate
accounting policies rather than for them to
ensure that the policies remain the same. The
information can still be comparable despite the
32 Financial Accounting: IF R S PR INC IPL ES
change in policies underlying the preparation
of the information, so long as these policies and
changes are adequately disclosed in the finan-
cial statements. IAS8, which is discussed in
more depth in Chapter 18, Accounting policies,
changes in accounting estimates and errors,
sets out how changes in accounting policy
should be disclosed to ensure comparability.
(Quality: Comparability between a company’s
accounting policies from year to year)
●● Let us assume that you invested in a company
based on its financial position at 31 December
20x9. The statement of financial position at
that time showed a liability of R500  000 for
damages that the company would have to pay
in the future as it was being sued by a customer.
How would you feel if two years later, the court
case was concluded and the company had to
pay R10m in damages to the customer, which
resulted in the company going insolvent and
you losing the capital that you had invested?
This situation arose because the company
underestimated its obligation for damages at
the time that this obligation was recognised in
the financial statements. You probably would
have preferred the directors to be neutral in
applying their judgement to quantify an obli-
gation. (Quality: Faithful representation)
4.4 Balancing the cost of information with
its benefits
The cost of reporting financial information to the
primary users and the benefits that they receive
from it must be viewed against the profitability of
the entity and the cost of providing this informa-
tion. Providers of financial information incur
costs when collecting, processing, verifying and
disseminating financial information. Users may
also incur costs when analysing and interpreting
the information provided.
Evidence suggests that good-quality financial
reporting reduces the risks associated with the
entity as investors have the useful information to
balance the returns that they require relative to the
risks that they are taking on.
4.4.1 The cost constraint on useful financial
reporting
Cost is a pervasive constraint on the information
that can be provided by general purpose financial
reporting. The cost of providing information
should be justified by the benefits of reporting the
information.
In all reporting, it is important to evaluate con-
stantly the benefits that users receive from the
information against what it costs to provide that
information. However, the calculation is not
always a simple one, as less direct benefits should
also be accounted for (for example, the reduced
cost of finance that results from good reporting
because the entity’s risk assessment is reduced sig-
nificantly for both investors and lenders).
Something to think about
Imagine that you are a shareholder in a company
called Wool System Ltd, which has an annual turnover
of R2m. You attend the annual general meeting, during
which the director says, ‘I am sure that all of the
shareholders will be very pleased with our reporting
process. The financial statements are perfect. We
spent a significant amount of time on them, and the
cost of preparing and presenting this information was
R900 000.’ Do you think you would be pleased by
this? The cost of providing you and other stakeholders
with financial information about the company cost
the company 45% of its sales. This means that the
growth in the company’s net asset value is significantly
reduced by the cost of preparing financial statements.
Is the shareholders’ improved decision-making a
benefit that is greater than the cost of preparing the
financial statements?
5 Financial statements and the
reporting entity
Having considered the objective of financial
reporting, let’s focus a bit more on financial state-
ments, the end product of the financial reporting
process. The objective of financial statements is to
provide financial information about the reporting
entity’s assets, liabilities, income and expenses that
is useful to users of financial statements in assess-
ing the ability of the entity to generate future net
cash inflows to the reporting entity and in assess-
ing management’s stewardship of the entity’s eco-
nomic resources. Financial statements are pre-
pared for a specified period of time, the reporting
period, and provide information about assets and
liabilities and equity at the end of the reporting
period or during the reporting period and income
and expenses for the reporting period.
 C HAP TER 2 R E VI E W O F T H E C O N C E P T U A L FR A M E W O R K 33

As discussed in section 3.1, Table 2.2 shows which information is provided:

Table 2.2 Information generally included in financial statements (refer to Conceptual Framework, paragraph 3.3(c))

Statement of financial position Assets, liabilities and equity

Statement(s) of financial performance
Other statements and notes:
Statement of changes in equity
Statement of cash flows
Notes to the financial statements
Income and expenses, gains and losses
• Contributions from holders of equity claims and distributions to them;
• Recognised assets, liabilities, equity, income and expenses, including information about
their nature and about the risks arising from those recognised assets and liabilities
• Cash inflows and outflows
• Assets and liabilities that have not been recognised, including information about their
nature and about the risks arising from them; and
• The methods, assumptions and judgements used in estimating the amounts presented or
disclosed, and changes in those methods, assumptions and judgements.

Financial statements include comparative infor-
mation for at least one preceding reporting period.
Financial information about possible future trans-
actions and other events or transactions and other
events that have occurred after the end of the
reporting period is also included if providing that
information achieves the objective of financial
reporting. Presentation of financial statements is
discussed in more detail in Chapter 3, Presentation
of financial statements.
5.1 The entity as a going concern
One of the underlying assumptions for the prepa-
ration and presentation of financial statements is
the principle of a going concern. This simply
means that an entity’s financial statements are pre-
pared assuming that it will continue to trade in the
foreseeable future. Consequently, there is no need
or intention on the part of the entity to wind up its
operations, liquidate or reduce the size of its oper-
ations significantly. This assumption has an
impact on the basis used to measure the entity’s
assets and liabilities.
Adopting the going concern assumption has
important implications in financial reporting. For
example, this assumption justifies the use of his-
torical cost in accounting for non-current assets
and for the systematic allocation of the cost of
using the assets (for example, depreciation), which
is recognised as an expense over the useful lives of
the assets. Because of the assumption that the
entity will continue to use the assets as opposed to
selling them in the near future, the current market
values of the assets are not relevant and fluctua-
tions in their market values cause no gains or loss.
They also do not increase or decrease the useful-
ness of the assets.
On the other hand, if management intends to
liquidate the entity’s operations, the going concern
assumption is set aside and the financial state-
ments are prepared on a different basis, such as the
expected liquidation values. When the entity is
aware of its intention to liquidate in the future (in
other words, it is not a going concern), the state-
ment of financial position has to be prepared with
reference to liquidation or forced sales values for
the assets. This is in line with the principle that all
assets have to be valued at what their estimated
sale price will be when they are sold over the fol-
lowing few months. The liabilities have to be
valued at their estimated settlement value when
they are paid in the following few months.
However, assuming that the entity is a going
concern, there are a number of alternative mea-
surement bases with which to measure its assets
and liabilities on reporting date, which is dis-
cussed further in section 8.
5.2 The reporting entity
In your studies so far, you have learnt that the
records of the business should be separate from
the records of the owners. This is referred to as the
entity concept. When we record the financial per-
formance and position of a business, we keep the
records of the business and the owners separate.
Sometimes, the way in which the business operates
may make it difficult to establish a boundary for
reporting purposes. In this case, the reporting
entity is determined based on faithfully represent-
ing information that meets the needs of the
34 Financial Accounting: IF R S PR INC IPL ES

primary users of the financial statements. When
the business operates as a company or a close cor-
poration, this is normally not a problem, as these
business forms are separate legal entities. The sep-
aration of the activities of the owners from the
business activities of a sole proprietor or a partner-
ship is usually more complex.
Also, as we have seen, general purpose financial
reporting does not serve a particular need. Finan-
cial statements should therefore reflect the perspec-
tive of the entity rather than the perspective of the
entity’s equity investors. Thus, the focus is on the
entity’s resources and the changes in them, rather
than on the shareholders as owners of the entity.
Thus, it makes sense, that for the purposes of
financial reporting, the Conceptual Framework
provides guidance on the identification of the
entity that should be reported on. This entity
known as the reporting entity. The Conceptual
Framework defines the reporting entity as an
entity that is required to, or chooses to, prepare
financial statements. In more basic terms, this
means that each company is a separate reporting
entity and that the business of a sole trader is a
separate reporting entity. If we break this down
further, we see that an independent division or
branch within a company may also constitute a
reporting entity. This means that a reporting
entity is not limited by legal boundaries (for
example, the legal form of a company).
Furthermore, a group that comprises an entity
(subsidiary) that is controlled by another company
(the parent) also constitutes a reporting entity. In
this case, the reporting entity that comprises a
parent and subsidiary prepares consolidated finan-
cial statements and if the reporting entity is solely
the parent, it prepares unconsolidated financial
statements. If a reporting entity comprises two or
more entities that are not linked by a parent-sub-
sidiary relationship, the reporting entity’s financial
statements are referred to as combined financial
statements. You will cover groups in more detail
in Part 4 of this textbook.
6 The elements of financial
statements
The elements of financial statements defined in the
Conceptual Framework are assets, liabilities and
equity, which relate to a reporting entity’s financial
position; and income and expenses, which relate
to a reporting entity’s financial performance.

Table 2.3 Summary of existing definitions and changes

Existing definitions – 2010 Conceptual Revised definition – 2018 Conceptual

Framework Framework

Asset (of an entity) A resource controlled by the entity as a result of past A present economic resource controlled by the entity
events and from which future economic benefits are as a result of past events
expected to flow to the entity

Liability (of an entity) A present obligation of the entity arising from past A present obligation of the entity to transfer an
events, the settlement of which is expected to result economic resource as a result of past events
in an outflow from the entity of resources embodying
economic benefits

Economic resource No existing definition A right that has the potential to produce economic
benefits

As mentioned earlier, the 2018 Conceptual
Framework includes revised definitions of an
asset, a liability and an economic resource.
Table 2.3 summarises the definitions and recog-
nition criteria in the 2010 Conceptual Framework
as well as the new definitions in the 2018
Conceptual Framework. The revised definitions
are discussed further in this section (see below),
but you should be aware that there are some
subtle differences between the revised definitions
and how these elements are defined in the rest of
the textbook.
 C HAP TER 2
6.1 Definition of an asset
Definition of an asset
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
Assessing whether an asset exists is dependent on
the understanding of the following items:
● Right
● Potential to produce economic benefits; and
● Control
6.1.1 What are the rights associated with the asset?
Rights that have the potential to produce eco-
nomic benefits can take many forms, but an entity
cannot have a right to obtain economic benefits
from itself. Rights include:
●● Rights that relate to an obligation of another
party such as the rights to receive cash, rights
to receive goods or services, rights to exchange
economic resources with another party on
terms that are favourable to the entity and
rights to benefit from an obligation of another
party to transfer an economic resource if a
specified uncertain future event occurs.
●● Rights that do not relate to an obligation of
another party, such as rights to use or sell
physical objects, such as property, plant and
equipment or inventories.
●● Rights that are established by contract or
legislation. For example when an entity lends
money to a third party and enters into a loan
agreement with that party, the entity’s right to
receive cash in the future through the capital
repayments and the interest is established
through the loan agreement. However, an
entity might also obtain rights in other ways,
for example by acquiring or creating know-how
that is not publically available.
6.1.2 Does the asset have the potential to produce
economic benefits?
An economic resource has the potential to pro-
duce economic benefits for an entity because it
enables or entitles the entity to do, for example one
or more of the following: receive contractual cash
flows or another economic resource; exchange
R E VI E W O F T H E C O N C E P T U A L FR A M E W O R K 35
economic resources with another party on favour-
able terms; produce cash inflows or avoid cash out-
flows, receive cash or other economic resources by
selling the economic resource; or can be used to
settle liabilities.
Although an economic resource derives its
value from its present potential to produce future
economic benefits, the economic resource is the
present right that contains that potential, not the
future economic benefits that the right may
produce. So for example, if you purchase lottery
tickets, the economic resource is the right to
potentially win and not the amount that you could
potentially win.
The potential to produce economic benefits
only needs to already exist and the entity can show
at least one instance that the economic benefits are
being produced for the entity beyond those avail-
able to all other parties.
Something to think about
Rights of access to public goods, such as public rights
of way over land, or know-how that is in the public
domain are typically not assets for the entities that
hold them. Why is this the case?
When an entity incurs expenditure, this may
provide evidence that the entity has sought future
economic benefits, but does not provide conclusive
proof that the entity has obtained an asset. Similarly,
the absence of related expenditure does not preclude
an item from meeting the definition of an asset for
example, assets that have been donated to the entity.
The definition focuses on potential, thus making
it clear that it does not need to be certain, or even
likely, that the right will produce economic benefits.
Therefore, a right can meet the definition of an
economic resource, and hence can be an asset, even
if the probability that it will produce economic benefits
is low.
6.1.3 Does the entity have control of the asset?
Control links the specific economic resource to an
entity. Therefore, assessing whether control exists
helps to identify the economic resource that the
entity can account for. For example, an entity may
control a proportionate share in a property with-
out controlling the rights arising from ownership
of the entire property. In such cases, the entity’s
asset is the share in the property, which it controls,
not the rights arising from ownership of the entire
property, which it does not control.
36 Financial Accounting: IF R S PR INC IPL ES
An entity controls an economic resource if it
has the present ability to direct the use of the eco-
nomic resource and obtain the economic benefits
that may flow from it. The present ability may arise
from contractual and legal rights, but this does not
always need to be the case.
The present ability to direct the use of an eco-
nomic resource exists if an entity has the right to use
that economic resource in its activities, or the entity
is able to prevent other parties from directing the use
of the economic resource and from obtaining the
economic benefits that may flow from it. Therefore,
if one party controls an economic resource, no other
party controls that same economic resource.
For an entity to control an economic resource,
the future economic benefits from that resource
must flow to the entity either directly or indirectly
rather than to another party. Sometimes one party
(a principal) engages another party (an agent) to
act on behalf of, and for the benefit of, the princi-
pal. For example, a principal may engage an agent
to arrange sales of goods controlled by the princi-
pal. If an agent has custody of an economic
resource controlled by the principal, that eco-
nomic resource is not an asset of the agent.
Something to do
Watch the Learn Accounting video on “Control” at
www.learnaccounting.uct.ac.za/
6.2 Definition of a liability
Definition of a liability
A present obligation of the entity to transfer an
economic resource as a result of past events.
An obligation is a duty or responsibility that the
entity has no practical ability to avoid.
When assessing whether a liability exists, you need
to identify whether:
● The entity has an obligation;
● The obligation is to transfer an economic
resource; and
● The obligation is a present obligation that exists
as a result of past events.
6.2.1 Does the entity have an obligation?
An obligation is a duty or responsibility that an
entity has no practical ability to avoid. An obliga-
tion is always owed to another party but it is not
necessary to know the identity of the party to
whom the obligation is owed. Obligations to trans-
fer an economic resource include obligations to
pay cash, obligations to deliver goods or provide
services, obligations to exchange economic
resources with another party on unfavourable
terms, obligations to transfer an economic
resource if a specified uncertain future event
occurs.
Many obligations are established by contract,
legislation and as such are legally enforceable by
the party to whom they are owed. Obligations can
also arise, however, from an entity’s customary
practices, published policies or specific statements
if the entity has no practical ability to act in a
manner inconsistent with those practices, policies
or statements. The obligation that arises in such
situations is sometimes referred to as a ‘construc-
tive obligation’.
6.2.2 Is the obligation a duty of responsibility to
transfer an economic resource?
It is important that the obligation must already
exist and that the obligation must have the poten-
tial to require the entity to transfer an economic
resource to another party. This means that the
obligation does not need to be certain, and also
that an obligation can meet the definition of a lia-
bility even if the probability of a transfer of an eco-
nomic resource is low. However, the entity should
have no practical ability to avoid this obligation.
6.2.3 Does the obligation exist as a result of
past events?
A present obligation exists as a result of past events
only if the entity has already obtained economic
benefits or taken an action; and as a consequence,
the entity will or may have to transfer an economic
resource that it would not otherwise have had to
transfer. For example, if an entity has entered into
a contract to pay an employee a salary in exchange
for receiving the employee’s services, the entity has
a present obligation to pay the salary when it has
received the employee’s services.
Similarly, if new legislation comes into effect, a
present obligation arises only when, as a conse-
quence of obtaining economic benefits or taking
an action to which that legislation applies, an
 C HAP TER 2
entity will or may have to transfer an economic
resource that it would not otherwise have had to
transfer. The enactment of legislation is not in itself
sufficient to give an entity a present obligation.
6.3 Assets and liabilities – Unit of account
Having identified the assets and liabilities, the unit
of account is the right or the group of rights, the
obligation or the group of obligations, or the group
of rights and obligations, to which recognition cri-
teria and measurement concepts are applied. A
unit of account is selected for an asset or liability
when considering how recognition criteria and
measurement concepts will apply to that asset or
liability and to the related income and expenses.
For example, think about a machine that the entity
owns and uses in its operations. The entity has the
potential to benefit from the right to use the ben-
efits and the right to sell the machine. In this
instance, treating the machine as a single unit of
account is appropriate.
6.4 Definition of equity
The Conceptual Framework defines equity as the
‘residual (remaining) interest in the assets of the
entity after deducting all its liabilities’. Put another
way, equity claims are claims against the entity that
do not meet the definition of a liability. Equity
includes funds contributed by shareholders as well as
reserves retained in the entity. These reserves include
retained earnings, revaluation surpluses and other
reserves. Retained earnings (and other reserves) are
distributed to the owners in the form of dividends.
The amount shown as equity in the statement
of financial position is dependent on the measure-
ment of assets and liabilities. You have learnt in
the accounting equation that owners’ equity is
equal to assets less liabilities. Alternatively stated,
owners’ equity is equal to the net assets of the
entity. However, it is a common misconception
that the total of owners’ equity represents a value
for the entity. The value (or net worth) of an entity
is normally higher than its owners’ equity, as some
assets are measured at historic cost, which is below
their fair value.
Equity increases as a result of profitable opera-
tions (that is, the excesses of income over
expenses) and by contributions by owners. Simi-
larly, equity is diminished by unprofitable opera-
tions and by distributions to owners (in the form
R E VI E W O F T H E C O N C E P T U A L FR A M E W O R K 37
of drawings and dividends). Before making their
financial decisions, users need to identify and
understand all of the factors responsible for the
change in the entity’s assets and liabilities over the
financial year. These changes are reported in the
statement of changes in equity.
The owners’ equity of an entity can change
because of factors other than its performance.
These changes in equity are not referred to as
income or expenses, but have different terms to
give some indication of the nature of the underly-
ing activities. Where the owners contribute assets
to the business, the resulting increase in equity is
referred to as share capital (in the case of a
company), as opposed to income. Conversely, if a
company distributes assets to its shareholders, this
reduction in equity is referred to as a dividend and
not an expense. This is to differentiate between the
transaction with the owner and the entity’s perfor-
mance. Dividends are disclosed as a distribution
of equity on the statement of changes in equity and
not on the statement of profit or loss and other
comprehensive income.
The different forms of entities (for example, sole
proprietors, partnerships, trusts, universities and
government business undertakings) may have dif-
ferent sub-classifications within equity, for
example, capital accounts of each partner in a
partnership. The definition of equity applies to all
entities, despite the different legal and regulatory
form of the entity. (Owners’ equity is discussed in
detail in Chapter 16, Owners’ equity.)
Equity cannot be defined independently of the
other elements in the statement of financial posi-
tion. Remember that equity is a residual.
Accounting equation:
Equity = Assets – Liabilities
6.5 Income and expenses
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 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.
Contributions from holders of equity claims are
not income, and distributions to holders of equity
claims are not expenses.
38 Financial Accounting: IF R S PR INC IPL ES
Income and expenses are the elements of finan-
cial statements that relate to an entity’s financial
performance. Users of financial statements need
information about both an entity’s financial posi-
tion and its financial performance. Hence,
although income and expenses are defined in
terms of changes in assets and liabilities, informa-
tion about income and expenses is just as impor-
tant as information about assets and liabilities.
Income and expenses are netted off to deter-
mine profit or loss for the reporting period, which
is transferred to equity at the end of each report-
ing period.
Following from sections 6.4 and 6.5, the flow is
demonstrated in the extension of the accounting
equation, as follows:
Equity = Assets – Liabilities
Equity = Opening equity + transactions with owners
(contributions by equity holders – distributions to equity
holders) ± profit or loss for the reporting period
THUS:
Assets – Liabilities = Opening equity + transactions with
owners (contributions by equity holders – distributions to
equity holders) ± profit or loss for the reporting period
7 Recognition and derecognition
7.1 The recognition process
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 state-
ments – an asset, a liability, equity, income or
expenses. It is useful to think of recognition in a
scaffolded approach:
●● Only items that meet the definition of an asset,
a liability or equity are recognised in the state-
ment of financial position and only items that
meet the definition of income or expenses
are recognised in the statement(s) of finan-
cial performance. However, not all items that
meet the definition of one of those elements
are recognised. Not recognising an item that
meets the definition of one of the elements
makes the statement of financial position
and the statement(s) of financial performance
less complete and can exclude useful infor-
mation from financial statements. However,
in some circumstances, recognising some
items that meet the definition of one of the
elements would not provide useful informa-
tion. Remember that information is useful if
the information is relevant and faithfully repre-
sents the element. Just as cost constrains other
financial reporting decisions, it also constrains
recognition decisions. Preparers of financial
statements incur costs in obtaining a relevant
measure of an asset or liability. Users of finan-
cial statements also incur costs in analysing
and interpreting the information provided. An
asset or liability is recognised if the benefits of
the information provided to users of financial
statements by recognition are likely to justify
the costs of providing and using that informa-
tion. In some cases, the costs of recognition
may outweigh its benefits.
●● Having identified the element that is to be
recognised, that element is depicted as an
item in one of the statement of financial posi-
tion or statement(s) of financial performance,
either alone or in aggregation with other items.
This depiction is in words and by a monetary
amount.
●● The monetary amount is referred to as the
carrying amount of the item, which is then
included in one or more totals in the relevant
statement. The statements are structured
summaries that make financial information
comparable and understandable. An important
feature of the structures of those summaries
is that the amounts recognised in a statement
are included in the totals and, if applicable,
subtotals that link the items recognised in the
statement.
Recognition links the elements, the statement of
financial position and the statement(s) of financial
performance as follows in Figure 2.2 as extracted
from the Conceptual Framework:
 C HAP TER 2
Statement of financial position at beginning of period
Assets minus liabilities equal equity
Statement(s) of financial performance
Income minus expenses
+ Changes in equity
Contributions from holders of equity claims minus distributions to holders of equity claims
Statement of financial position at the end of reporting period
Assets minus liabilities equal equity
Figure 2.2 How recognition links the elements of financial statements (refer to Conceptual Framework,
Chapter 5, Diagram 5.1)
Something to do
Watch the Learn Accounting video on “Financial
Statements – the Big Picture” at www.learnaccounting.
uct.ac.za/
7.2 Recognition and the qualitative
characteristics of financial reporting
It is important when making decisions about rec-
ognition to consider the information that would
be given if an asset or liability were not recognised.
For example, if no asset is recognised when expen-
diture is incurred, an expense is recognised. Over
time, recognising the expense may, in some cases,
provide useful information, for example, informa-
tion that enables users of financial statements to
identify trends.
7.2.1 Relevance
Information about assets, liabilities, equity,
income and expenses is relevant to users of finan-
cial statements. However, recognition of a particu-
lar asset or liability and any resulting income,
expenses or changes in equity may not always pro-
vide relevant information. That may be the case if,
for example, it is uncertain whether an asset or
liability exists; or an asset or liability exists, but the
probability of an inflow or outflow of economic
benefits is low. In some cases, uncertainty, possibly
combined with a low probability of inflows or out-
flows of economic benefits and an exceptionally
R E VI E W O F T H E C O N C E P T U A L FR A M E W O R K 39
wide range of possible outcomes, may mean that
the recognition of an asset or liability, necessarily
measured at a single amount, would not provide
relevant information.
An asset or liability can exist even if the prob-
ability of an inflow or outflow of economic benefits
is low. If the probability of an inflow or outflow of
economic benefits is low, the most relevant infor-
mation about the asset or liability may be informa-
tion about the size of the possible inflows or out-
flows, their possible timing and the factors affect-
ing the probability of their occurrence. Typically,
such information is provided in the notes. Alter-
natively, even if the probability of the inflow or
outflow of economic benefits is low, recognition of
the asset or liability may provide more relevant
information than only provide note disclosure.
7.2.2 Faithful representation
Whether a faithful representation can be provided
may be affected by the level of measurement
uncertainty associated with the asset or liability or
by other factors. For an asset or liability to be rec-
ognised, it must be measured. In many cases, such
measures must be estimated and are therefore sub-
ject to measurement uncertainty. Using reasonable
estimates is an essential part of the preparation of
financial information and does not undermine the
usefulness of the information if the estimates are
clearly and accurately described and explained.
Even if there is significant measurement uncer-
tainty, this does not necessarily prevent such an
40 Financial Accounting: IF R S PR INC IPL ES
estimate from providing useful information. In
limited circumstances, all relevant measures of an
asset or liability that are available (or can be
obtained) may be subject to such high measure-
ment uncertainty that none would provide useful
information about the asset or liability (and any
resulting income, expenses or changes in equity),
even if the measure were accompanied by a
description of the estimates made in producing it
and an explanation of the uncertainties that affect
those estimates. In those limited circumstances,
the asset or liability would not be recognised.
7.3 Derecognition
Derecognition is the removal of all or part of a rec-
ognised asset or liability from an entity’s statement
of financial position. Derecognition normally
occurs when that item no longer meets the defini-
tion of an asset or of a liability. Therefore, for an
asset, derecognition normally occurs when the
entity loses control of all or part of the recognised
asset. For a liability, derecognition normally occurs
when the entity no longer has a present obligation
for all or part of the recognised liability. Events that
lead to derecognition include the consumption of
economic resources, collection of receivables, obli-
gations that have been fulfilled or transferred.
The assets and liabilities (or parts thereof) that
are derecognised are referred to as the transferred
component. In some cases, only a part of the asset
or liability has been derecognised and thus a part
is retained. The parts that are retained are referred
to as the retained component. For example, an
entity owns an investment that comprises
100 shares and sells 40 shares (transferred compo-
nent), but retains 60 shares (retained component).
Generally the transferred component results in
recognising any resulting income and expenses
and no income or expenses are recognised on the
retained component, unless there is a change in
the measurement requirements applicable to the
retained component.
It is important to consider the substance of the
transactions or events. In some cases, an entity
might appear to transfer an asset or liability, but
that asset or liability might still remain an asset or
liability of the entity. Derecognition of that asset
or liability is not appropriate in this instance. For
example, if an entity has transferred an asset to
another party that holds the asset as an agent for
the entity, the entity still controls the asset.
Something to think about
What would happen if an entity has transferred an asset
and, at the same time, entered into another transaction
that results in a present right or present obligation to
reacquire the asset or if an entity has retained exposure
to significant positive or negative variations in the
amount of economic benefits that may be produced by
a transferred component of the entity?
Something to do
Watch the Learn Accounting video on “The Asset life
cycle” at www.learnaccounting.uct.ac.za/
7.4 Contract modifications
As you would have seen earlier in section 6, rights
and obligations often arise from contracts. The
terms of a contract may be changed or modified
and this could result in derecognition. In deciding
how to account for contract modifications, it is
necessary to consider which unit of account pro-
vides users of financial statements with the most
useful information about the assets and liabilities
retained after the modification, and how the modi-
fication changed the entity’s assets and liabilities:
●● A contract modification may only eliminate
existing rights or obligations in which case the
entity considers the derecognition principles in
deciding to derecognise those rights or obligations;
●● A contract modification may add new rights
or obligations. Then, it is necessary to decide
whether these new rights and obligations are
treated as separate assets or liabilities, or as
part of the same unit of account as the existing
rights and obligations; and
●● A contract modification may both eliminate
existing rights or obligations and add new rights
or obligations. Then, it is necessary to consider
both the separate and the combined effect of
those modifications. In some such cases, the
contract has been modified to such an extent
that, in substance, the modification replaces the
old asset or liability with a new asset or liability.
In cases of such extensive modification, the
entity may need to derecognise the original
asset or liability, and recognise the new asset
or liability. We cover contract modifications
further in the chapters on revenue and leasing.
 C HAP TER 2
8 Measurement
Measurement is the process of determining the
monetary amounts at which elements of the finan-
cial statements are to be recognised. Measurement
is dependent on selecting an appropriate measure-
ment basis.
The Conceptual Framework does not include
specific concepts or principles for selecting which
measurement basis should be used for particular
elements of financial statements or in particular
circumstances. Specific IFRS standards may need
to describe how to implement the measurement
basis selected in that standard by specifying tech-
niques that may or must be used to estimate a par-
ticular measurement basis. The information pro-
vided by a measurement basis must be useful to
the users of financial statements and as such dif-
ferent measurement bases may exist for different
elements so as to achieve the qualitative character-
istics of financial reporting and considering the
cost constraint of useful information:
●● The relevance of information provided by a
measurement basis for an asset or liability and
related income and expenses is affected by the
characteristics of the asset or liability and how
that asset or liability contributes to future cash
flows as this would affect users’ judgement
about the future cash flows and the associated
risks.
●● Applying different measurement bases to assets
and liabilities that are related in some way, can
create measurement inconsistencies which may
result in financial statements that do not faith-
fully represent aspects of the financial position
and financial performance of the entity.
●● Consistently using the same measurement basis
for the same items, either from period to period
within a single reporting entity, or in a single
period across entities, makes financial state-
ments more comparable.
●● Changes in measurement basis may make
information less understandable, but could
still provide more relevant information. There-
fore, measurement bases that are selected for
particular assets and liabilities can change from
period to period, provided doing so results in
more relevant information.
●● Using different measurement bases for different
assets and liabilities may make information
more complex and less understandable, but is
appropriate, if this provides useful information.
R E VI E W O F T H E C O N C E P T U A L FR A M E W O R K 41
●● The verifiability of a measurement basis is
enhanced using measures that can be inde-
pendently corroborated directly or indirectly.
The Conceptual Framework identifies measure-
ment bases with reference to historical cost and
current value:
Historical cost measurement Current value measurement
bases bases
• Fair value
• Value in use
• Fulfilment value
• Current cost
1 Under the historical cost measurement basis,
monetary information is largely based on the
price of the transaction or event that resulted
in the asset, liability, income or expense. This
means that an asset is recorded at the value
of the costs incurred in acquiring or creating
the asset, comprising the consideration paid
plus transaction costs given to acquire it at its
acquisition date. Liabilities are recorded at the
amount of the consideration received when
the liability is incurred, minus transaction
costs. Historical cost is updated over time
to reflect transactions or events such as
depreciation, amortisation, payments received
that extinguish parts or all of the asset, accrual
of interest to reflect financing and impairment.
The historical cost of a liability is updated to
reflect payments that settle part or all of the
liability and accrual of interest.
2 By contrast, current value measures provide
monetary information about assets, liabilities
and the related income and expenses using
information updated to reflect conditions
at the measurement date and is not derived
from the price of the transaction or event that
gave rise to the asset or liability. Current value
measurement bases include: fair value, value in
use for assets or fulfilment value for liabilities
and current cost:
●● Fair value, which is an exit price, as it 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 participants in a market
to which the entity has access, using the
same assumptions that the entity would use
when pricing the asset or liability assuming
42 Financial Accounting: IF R S PR INC IPL ES
that those market participants act in their
economic best interest. The fair value can
either be observed directly in the market or
determined indirectly using measurement
techniques, such as present valuing estimated
cash flows. Fair value is not derived from
the transaction or event that resulted in the
asset or liability, and thus is not increased or
decreased by transaction costs incurred to
acquire an asset or when a liability is incurred.
●● Value in use, which is the present value of
estimated cash flows, or other economic
resources, that an entity expects to derive
from using an asset and from its ultimate
disposal. Fulfilment value is the present
value of cash, or other economic resources,
that an entity expects to be obliged to
transfer as it fulfils (or settles) a liability.
Value-in-use and fulfilment value are
entity-specific assumptions rather than
assumptions used by market participants
and cannot be directly observed. Value-in-
use and fulfilment value are based on future
cash flows and thus do not include the trans-
action costs incurred to acquire an asset
or when a liability is incurred. However,
value in use and fulfilment value include
the present value of any transaction costs
an entity expects to incur on the ultimate
disposal of an asset or fulfilling of a liability.
●● Current cost, which is an entry value. For
an asset, current cost represents the amount
of cash or cash equivalents that would
be paid if the same or an equivalent asset
was acquired at the measurement date plus
transaction costs that would be incurred
at that date. A liability is measured at the
amount of cash or cash equivalents needed
to settle the obligation at the measurement
date less the transaction costs that would be
incurred at that date.
Something to think about
• Which measurement basis do you think most
entities apply to items of machinery that they use in
their operations, and why would this be the case?
• If an entity invests in shares of other entities, which
measurement basis do you think would provide
the most useful information relating to the entity’s
investments?
Something to think about
• If an entity has a loan receivable, which
measurement basis do you think would provide the
most useful information relating to the entity’s loan
receivable? Would it matter if the entity intends
to collect the cash flows from the debtor or if the
entity intends to sell the loan receivable?
• If a mining entity has an obligation to rehabilitate
the environment as a result of damage done when it
started its operations, what measurement basis do
you think the entity should apply to the obligation?
9 Presentation and disclosure
A reporting entity communicates information
about its assets, liabilities, equity, income and
expenses by presenting and disclosing information
in its financial statements. Therefore, it is impor-
tant how that information is communicated if the
information is to be useful to users and meet the
qualitative characteristics of financial reporting.
Table 2.4 Principles for effective communication
Effective communication of information in financial
statements requires preparers to
Focus on Classify Aggregate
presentation information information in
and disclosure in a manner such a way that it
objectives and that groups is not obscured or
principles rather similar items hidden either by
than focusing on and separates unnecessary detail
rules dissimilar items or by excessive
aggregation.
Cost constraint
The benefits of reporting financial information should justify
and be greater than the costs incurred of supplying it.
9.1 Presentation and disclosure objectives
and principles
Presentation and disclosure objectives help report-
ing entities to identify useful information and to
decide how to communicate that information in
the most effective manner. This gives entities the
flexibility to provide relevant information that
faithfully represents the entity’s assets, liabilities,
equity, income and expenses; and ensures compa-
rability, both from period to period for a reporting
entity and in a single reporting period across
entities.
 C HAP TER 2
Reporting entities communicate effectively in
their financial statements when focusing on entity-
specific information rather than standardised
descriptions, which are sometimes referred to as
‘boilerplate’ and are not useful in understanding
that entity’s financial position and financial per-
formance. Also, preparers should avoid unneces-
sary duplication of information in different parts
of the financial statements that can make financial
statements less understandable.
9.2 Classification
Classification is the sorting of the elements on the
basis of shared characteristics for presentation and
disclosure purposes, considering the nature of the
item, its role (or function) within the business
activities conducted by the entity, and how it is
measured. Classifying dissimilar assets, liabilities,
equity, income or expenses together can hide rel-
evant information, reduce understandability and
comparability and may not provide a faithful rep-
resentation of what it purports to represent. There-
fore, the Conceptual Framework provides guid-
ance on classification.
9.2.1 Assets and liabilities
Classification of assets and liabilities is applied to the
unit of account selected for an asset or liability.
Sometimes it may be appropriate to separate an asset
or liability into components that have different char-
acteristics and to classify those components sepa-
rately. A common example is to separate an asset or
liability into current and non-current components
and to classify those components separately.
Offsetting occurs when an entity recognises
and measures both an asset and liability as sepa-
rate units of account, but groups them into a single
net amount in the statement of financial position.
Offsetting classifies dissimilar items together and
therefore is generally not appropriate. Therefore,
IFRS standards give specific guidance of when off-
setting is allowed.
9.2.2 Equity
To provide useful information, it may be necessary
to classify equity claims separately if those equity
claims have different characteristics or if some of
those components are subject to particular legal,
regulatory or other requirements. In these
instances, separate presentation or disclosure of
those reserves may provide useful information.
R E VI E W O F T H E C O N C E P T U A L FR A M E W O R K 43
9.2.3 Income and expenses
Income and expenses reflect the financial perfor-
mance of the reporting entity. The issue is how
best to communicate that information and the link
between income and expenses and assets and lia-
bilities, and also, where to present that
information.
Thus, classification of income and expenses is
applied to: (a) income and expenses resulting from
the unit of account selected for an asset or liability;
or (b) components of such income and expenses if
those components have different characteristics
and are identified separately. For example, a
change in the current value of an asset can include
the effects of value changes and the accrual of
interest. It would be appropriate to classify those
components separately if doing so would enhance
the usefulness of the resulting financial
information.
In addition, income and expenses are classified
and included either: (a) in the statement of profit
or loss; or (b) outside the statement of profit or
loss, in other comprehensive income. The state-
ment of profit or loss is the primary measure of
financial performance. Therefore, in principle all
items of income and expenses should be included
in the statement of profit or loss. However, the
IASB may decide that in exceptional circum-
stances including income and expenses in the
statement of profit or loss would result in the state-
ment of profit or loss providing less relevant infor-
mation or would not provide more faithful repre-
sentation of the entity’s financial performance. In
these circumstances, for that period, the IASB
would require the income or expenses to be
included in other comprehensive income. This
would relate to income or expenses arising from a
change in the current value of an asset or liability,
where a specific IFRS standard includes the
income and expense in other comprehensive
income. For example, IFRS9 allows an entity that
invests in shares to present the changes in the fair
value of its investments in other comprehensive
income if the entity does not trade in the shares.
In principle, income and expenses included in
other comprehensive income in one period are
reclassified or ‘recycled’ from other comprehensive
income into the statement of profit or loss in a
future period when doing so results in the state-
ment of profit or loss providing more relevant
information, or providing a more faithful repre-
sentation of the entity’s financial performance for
44 Financial Accounting: IF R S PR INC IPL ES
that future period. However, if, for example, there
is no clear basis for identifying the period in which
reclassification would have that result, or the
amount that should be reclassified, the IASB may,
in developing IFRS standards, decide that income
and expenses included in other comprehensive
income are not to be subsequently reclassified.
9.3 Aggregation
Aggregation is defined as “the adding together of
assets, liabilities, equity, income or expenses that
have shared characteristics and are included in the
same classification.” This enhances the usefulness
of information summarising a large volume of
detail, but too much aggregation can also hide
some of the detail. Preparers need to strike a bal-
ance and different levels of aggregation may be
needed in different parts of the financial state-
ments. A typical example is where the statement
of financial position and the statement(s) of finan-
cial performance provide summarised informa-
tion and more detailed information is provided in
the notes.
10 Concepts of capital
If you look at the business cycle of an entity, you
will see that owners contribute money (capital) to
the business. This is invested in assets, which, if
managed effectively, increase in value. This
increase in assets is retained in the business, used
to repay debt or distributed to the owners (for
example, as dividends). An entity has maintained
its capital if it has as much capital at the end of the
period as it had at the beginning of the period; any
excess amount is profit.
Concepts of capital maintenance are important
because only income earned in excess of amounts
needed to maintain capital can be regarded as
profit. The following concepts of capital mainte-
nance are included in t he Conceptua l
Framework:
●● Financial capital maintenance: According
to this concept, a profit is only earned if the
financial (or money) amount of the net asset at
the end of the period exceeds the financial (or
money) amount of net assets at the beginning
of the period, after excluding any distributions
to and/or contributions from owners during
the period. Financial capital maintenance can
be measured in either nominal monetary units
or units of constant purchasing power.
●● Physical capital maintenance: According to this
concept, a profit is only earned if the physical
productive capacity (or operating capacity) of
the entity (or the resources or funds needed to
achieve that capacity) at the end of the period
exceeds the physical productive capacity at the
beginning of the period, after excluding any
distributions to and/or contributions from
owners during the period.
It is argued that before an entity can determine its
income for any period, it must adopt a measure-
ment basis for assets and liabilities as well as a
concept of capital.
Key points from this chapter
The 2018 Conceptual Framework was developed
with the purpose to clarify and update the previous
versions of the Conceptual Framework, and to
provide guidance regarding the preparation of
general purpose financial statements that meets the
information needs of users.
The Conceptual Framework does not prescribe
standards of measurement or disclosure, instead, it
is a set of guiding principles that the IASB uses in
the development of future IFRSs.
Financial information presented in financial
statements are underpinned by important principles
and concepts that supports the relevance and
decision-usefulness of the information.
Financial information should meet certain
qualities in order to faithfully represent what it
purports to represent – these include qualities such
as that the information should be complete, neutral
and free from error.
 C HAP TER 2
QUESTIONS
2
1 DISCUSSION QUESTIONS
1 Explain the objective of general purpose
financial reporting and financial statements.
2 Define the accrual basis of accounting.
Illustrate your definition by using an example.
3 What is meant when we say that accounting
information should be ‘decision-useful’?
Discuss how this requirement is met in terms
of the qualitative characteristics of financial
statements.
4 List the types of users of financial statements
and their respective information needs.
5 Discuss the fundamental and enhancing
qualities of useful financial statements and
how they differ.
6 Discuss the cost constraint on useful financial
reporting.
7 Describe what is meant by the term
‘elements’ of financial statements and where
are they presented in the financial statements.
8 How do recognition and derecognition differ?
9 Describe what is meant by a measurement
basis and give examples.
10 Where are elements presented and what
guidance does the Conceptual framework
provide relating to presentation and disclosure?
11 How does the Conceptual Framework aid
professional ethics?
2
1 EXERCISE QUESTIONS
Question 1
ABC (Pty) Ltd has installed a specific plant, costing
CU250 000, which is used for the manufacturing of
certain sports equipment (for example, netballs and
rugby balls). The plant was delivered on 10 January
20x7 and after installation, the machine was ready
for use on 1 March 20x7.
The directors of ABC (Pty) Ltd wanted
to recognise the plant at its selling price at
31 December 20x7 and argued that they did not
understand why an asset needs to be depreciated.
R E VI E W O F T H E C O N C E P T U A L FR A M E W O R K 45
You are required to do the following:
Write a memorandum to the directors of
the company, explaining to them using the
Conceptual Framework how and at what value the
asset should be recognised at 31 December 20x7.
Question 2
Westville (Pty) Ltd (‘Westville’) recently completed
work on a refurbishment of the company’s front
offices.
During the early part of 20x5, the company’s
customers started complaining about the state
of its front offices. The customer experience
officer suggested placing comment cards at the
reception desk in an effort to understand the
problem better. The comments received indicated
that the company’s customers were so upset
about the conditions that they would take their
business to Westville’s main competitor unless
Westville improved its customer experience.
The management of Westville therefore
began the refurbishment in August 20x5. It was
completed in November 20x5. The total cost of
the refurbishment amounted to CU570 000.
The management of Westville is unsure how
to account for the CU570 000 in the company’s
financial statements for the year ended
31 December 20x5.
You are required to do the following:
Advise the management of Westville (Pty) Ltd
on the appropriate accounting treatment of the
refurbishment costs in the reporting period ended
31 December 20x5 in terms of the Conceptual
Framework.
References
International Accounting Standards Board (IASB).
2018. Conceptual Framework for Financial
Reporting. [Online], Available: www.iasb.org.
International Accounting Standards Board (IASB).
2010. Conceptual Framework for Financial
Reporting. [Online], Available: www.iasb.org.
International Accounting Standards Board (IASB).
1989. Framework for the Preparation and Pre-
sentation of Financial Statements. (Included as
Chapter 4 in the Conceptual Framework for
Financial Reporting [2010].)