The | Conceptual Ke] Framework INTRODUCTION ‘The Accounting Standards Board (ASB) of the Institute of Chartered Accountants of India (ICAD, issued the Framework for the Preparation and Presentation of Financial State- ments in July 2000. The Framework is primarily based on the ‘Framework for the Preparation and Presentation of Financial Statements’ issued by the International Accounting Standards Committee (IASC) in April 1989. The newly constituted International Accounting Standards Board (IASB) adopted the Framework in April 2001. The Financial Accounting Standards Board (FASB) of USA has so far issued seven Statements of Financial Accounting Concepts. FASB Concepts No. 1 (CON 1) was issued in 1978. CON 2 was issued in May 1980. CON 3 (superseded by CON 6) and CON 4 were issued in December 1980. CON 5 was issued in December 1984, CON 6 in December 1985, and CON 7 in February 2002. Financial accounting concepts and conventions discussed in the Framework issued by ASB and IASB are similar to concepts discussed in the first six Concept Statements issued by FASB. The new Concept Statement No. 7 discusses the use of cash flow information and present value (PV) in accounting measurements. According to CON 7, PV should be used only as a proxy for ‘fair value’ (FV) in situations where assets and liabilities should be measured at FV, and where FV cannot be determined reliably.1.2_ Indian Accoun red by ASB is to: counting Standards, and in dealing with topics ying Ac a ting Standards, The purpose of the Framework on (a) Assist reporting entities in app! that are not covered in existing Accoun ‘Accounting Standards, (b) Assist the ASB in developing future counting, treatments permitted (©) Provide a basis for reducing a number of alternative a by Accounting Standards, (a) Assist auditors in forming an opinion as to whether financial statements conform to Accounting Standards, (©) Assist in interpreting the information contained in financi (© Provide information about the approach to the formulation of Accounting Standards Nothing in the Framework overrides any specific Accounting Standard. It is expected that the conflict between the Framework and Accounting Standards will diminish in future with the review and consequent revision of present Accounting Standards. The purpose, scope and authority of IASB Framework and Concept Statements issued by FASB are similar to the purpose, scope, and authority of the ASB Framework. ial statements, and OBJECTIVES OF FINANCIAL REPORTING The objective of financial reporting is to provide information useful in: (a) Evaluating management in their stewardship function, and (>) Making business and economic decisions by investors and potential investors. There is no conflict between these two objectives. Management of an entity is le to its shareholders and other providers of fund for optimal utilisation of retpurces avaiable with the entity, the management should use resources for the benefit of shareholders while enforcing rights of other investors and stakeholders. The present focus of corporate management is on creating shareholder value within the legal framework and social norms. Management is accountable to shareholders and others of its decisions and their impact on the economic performance and financial position of the entity. Shareholders evaluate management in terms of its ability to create shareholder value, . Contemporary theories suggest that investors and potential investors use ‘cash flow models’ eae an enterprise in the capital market. Valuation depends on the estimated amount «= fming Projects a orien tncertainies surrounding the same. Therefore, the ‘onomic decis po investors ii cst geet douche ne tas ey depends on the past performance of the entity and the estimated cae in theThe Conceptual Framework _1.3 environment in which it operates. Therefore, the same set of information may be useful for evaluating the management in their stewardship function, and for making business and economic decisions by investors and potential investors. The information provided by financial statements relates to the entity and not fo the management Therefore, it does not help to isolate the performance of the management from the performance of the entity. The performance of the entity depends on many variables, which are not within the control of the management. Therefore, an entity's performance does not depend solely on the performance of the management. However, the information in financial statements helps to evaluate the performance of the entity and to an extent, the performance of the management. The current focus is on ‘decision usefulness’ of the information contained in financial statements. The objective does not include determination of what the business and economic decisions to be taken by investors and potential investors should be. Corporate financial reports help to create a favourable environment for capital formation decisions. High quality financial reports form the cornerstone of a well performing financial system. The role of financial reporting requires it to provide even handed, neutral, unbiased, and complete information. Regulators, including bodies authorised to issue accounting standards, endeavor to ensure transparency in corporate financial reporting. Financial reporting provides information that helps present and potential investors, creditors, and other users in assessing the amount, timing, and uncertainty of prospective net cash inflows to the reporting entity. CHARACTERISTICS AND LIMITATIONS OF A FINANCIAL REPORT Financial statements are at the centre of a financial report. Although objectives of both financial statements and a financial report are the same, the scope of a financial report is much wider than the scope of financial statements. In addition to financial statements, a financial report includes various statements such as the board of directors’ report, the corporate governance report, management discussion and analysis, and voluntary disclosures of financial and non-financial information. The information provided by a financial report is historical and is primarily financial in nature. It is generally quantified and expressed in units of money. The numbers are usually exchange prices or amounts derived from exchange prices. Financial information is often limited by the need to measure it in units of money. Although prudence and verifiability enhance the reliability or objectivity of the information, they also create constraints in the financial accounting procedure. For example, bias towards prudence does not allow recognition of internally generated goodwill and brand equity because their cost or value cannot be determined reliably.14 _Indian Accounting Standards Financial statements and most other financial reporting are historical. Financial reporting. does not intend to project future performance. Although financial statements do not contain any futuristic information, the entity provides such information in other parts of the report to facilitate the forecasting of future performance. Financial reporting is only one source of, information needed by those who make economic decisions on business entities. Therefore, a financial report does not endeavour to provide all the information needed by investors and potential investors. The balance between benefit and cost is a pervasive constraint. The benefits derived from information should exceed the cost of providing it. However, the benefits from financial information are usually difficult or impossible to measure objectively. Similarly, it is difficult to measure the costs of providing information (for example, it is difficult to measure the cost of issuing segment information). This includes the cost of collecting and analysing information and the implicit cost of sharing sensitive information with competitors. Different persons might honestly disagree about whether the benefits of information justify its cost. In the regulatory regime of Accounting Standards, the evaluation of costs and benefits of a particular accounting method or a particular disclosure is not left to individual entities. Standard setters assess the benefits and costs of an accounting policy while formulating Accounting Standards. Timeliness is also a constraint on relevant and reliable information. A delay in the reporting impairs the relevance, while to report before all aspects of a transaction or other event are known impairs reliability. Management needs to balance the relative merits of timely reporting and the provision of reliable information. Ina sense, a financial report is an incomplete economic model that endeavours to capture the economic impact of transactions and events that have occurred in the period covered by the report. For example, financial reports fail to recognise holding gains arising from holding inventories. Similarly, in India, holding gain for long term investments is not recognised. Thus, financial reports fail to recognise the economic impact of events that influenced the performance and financial position of the entity. The reason being, financial reporting models are primarily transaction based rather than event based. UNDERLYING ASSUMPTIONS The following are the underlying assumptions in the preparation and presentation of financial statements: (a) Accrual basis (b) Going concern (©) Consistency.The Conceptual Framework _15 Accrual Basis Unless otherwise stated, readers of financial statements assume that those statements are prepared on the basis of the principles of accrual accounting. Under accrual accounting, the economic effect of transactions and events that have cash consequences for the entity are recognised in the period in which they occur, rather than in the periods in which cash is received or paid by the entity. Accrual accounting provides information about an entity's assets and liabilities and changes in them, which cannot be obtained in cash basis accounting. For example, if revenue is recognised on cash basis, the balance sheet does not recognise receivables. Similarly, in pure cash basis of accounting, purchase of long-lived assets (e.g fixed assets) finds place in the profit and loss account, and the balance sheet does not present a stock of those assets, ‘Accrual accounting captures the economic impact of the operating process rather than the end points of the ‘cash-to-cash’ cycle. Accrual accounting involves accruals and deferrals, including allocation and amortisation. ‘Accrual recognises assets or liabilities and the related liabilities, assets, revenues, expenses, gains, or losses for amounts expected to be received or paid. For example, interest from investments in bonds is recognised before it is due for payment, provided the entity reasonably expects to collect the same when due. Let us take an example. A Ltd. invested Rs 2,00,000 (face value) in 6% debentures of B Ltd. on January1, 2003. The interest is payable on June 30 and December 31. A Ltd. closes its year on March 31. A Ltd. should recognise interest for three months (January to March 2003), that is, Rs 3,000 in the profit and loss account for the year ended March 31, 2003. Similarly, interest payable on loans is recognised even before the payment is due. It is presented in the balance sheet as amount ‘accrued but not due’. Deferral is concerned with past cash receipts and payments. For example, cash received in advance from a customer is recognised as a liability. Similarly, prepayments are recognised 1s assets. Let us take an example. § Ltd. paid insurance premium of Rs 12,000 on January 1, 2003 to cover the one-year peciod ending on December 31, 2003. The company should recognise (Rs 12,000/12) x 9, that is, Rs 9000 as pre-paid insurance premium in its balance sheet as on March 31, 2003. Pre-paid insurance is a current asset. Recognition of revenues, expenses, gains or losses is deferred until the obligation underlying the liability is partly or wholly satisfied, or until the future economic benefit underlying the asset is partly or wholly used or lost. Allocation is the accounting process of assigning or distributing an amount according to a plan or a formula. For example, accrual accounting requires allocation of manufacturing overhead to the stock of finished goods and work-in-progress at the balance sheet date. Allocation includes amortisation. Amortisation is the process of reducing an amount by periodic payments or write-downs. Common examples of amortisation are depreciation, depletion, and recognition of earned subscription revenues. mi 731 657.021854 BHACIND)CI SkCCL16 _Indian Accounting Standards Going Concern Unless otherwise stated, readers of financial statements assume that those statements are Prepared on the assumption that the enterprise is a going concern. Financial statements are normally prepared with the assumption that the enterprise has neither the intention nor the need to liquidate or curtail materially the scale of its operations in the foreseeable future. In the preparation of financial statements, an entty’s continuance as a going concern for the foreseeable future, generally a period not exceeding one-year after the balance sheet date, is assumed [Ref. SAP-16, issued by ICAI] The measurement conventions, such as carrying fixed assets at historical cost, are appropriate only if the entity is a going concem. If it is inappropriate to assume continuance of the entity as a going concem in the foreseeable future, the financial statement may have to be prepared on a different basis and, if so, the basis used should be disclosed. Consistency Unless otherwise stated, readers of financial statements assume that those statements are Prepared using accounting policies and procedures followed in earlier years. Consistency in following accounting policies and procedures over a span of time enhances comparability of financial statements, particularly when comparison involves time series data, A change in policy should be disclosed. Qua.irative CHARACTERISTICS (a) Understandability (b) Relevance (©) Reliability (4) Comparability CON-2 issued by FASB provides the following hier (@) Primary qualities # Relevance (Predictive value, farchy of accounting qualities: feedback value and timeliness) * Reliability (verifiability, and representational faithfulness)‘The Conceptual Framework _1.7 (b) Secondary and interactive qualities ¢ Comparability (including consistency) ¢ Neutrality (0) User specific qualities ¢ Understandability (@) Pervasive constraint # Benefits and costs (e) Threshold for recognition * Materiality Relative weight should be given to different qualities according to circumstances. To be useful, financial information must have each of the qualities to a minimum degree. However, the rate at which one quality can be sacrificed in return for a gain of another quality without reducing the overall usefulness of the information differs in different situations. For example, in segment reporting, comparability is compromised for the sake of relevance. ‘Almost everyone agrees that criteria for formally recognising elements in financial statements call for a minimum level or threshold of reliability of measurement that should be higher than what is usually considered necessary for disclosing information outside financial statements. For example, the threshold of reliability of FV used for carrying investments in the balance sheet should be higher than the threshold of reliability for disclosing the FV of investments in explanatory notes. Therefore, for long, regulators all over the globe required disclosure of FV, rather than use of FV for measuring investments, Relevance Information is relevant if it has the potential to influence the economic decision of users by helping them evaluate past, present or future events, or confirming or correcting their past evaluation. Usually, the same information has both predictive and confirmatory values. For example, information about the capital structure of an entity at the balance sheet date helps to predict the ability of the entity to respond to the changes in the environment. The same information helps confirm past prediction about the structure of the entity. It is not necessary that in order to have predictive value, information should be in the form of an explicit forecast. Predictive value of information refers to the potential of that information to improve the prediction about the future performancelfinancial position of the firm. Financial predictions are the joint product of the financial model being used and the data that goes into it. Therefore, the predictive value of information cannot be assessed in abstract. Contemporary economic models use the amount, timing and risk of cash flows in valuing18 _Indian Accounting Standards to improve the prediction of amount ore, information that has the potential i . pusness ae a a (aeenia ae entity will generate in future, is considered to have iming, and risk of cash flows predictive value and relevance ‘The appropriate presentation of information on past transactions and Sree enhances the Predictive value. For example, presentation of unusual, abnormal and infrequent items ‘separately in the profit and loss account, enhances the Predictive value of the profit and loss account, Similarly, the predictive value of the balance sheet increases when assets and liabilities are classified into ‘current’ and ‘non-current’ categories. The relevance of information 1s affected by its materiality. Materiality Information is material if it is probable that its omission or misstatement would change or influence the judgment of a reasonable person relying on the information. Materiality depends on the size and nature of the item, Usually, to test the materiality of an item, accountants Sment of the circumstances and the nature of the em. For example, AS-17, Segment Reporting, considers 10 percent Or segment result as the threshold to determin fom materi , what it purports to represent ‘terial error or bias and should faithfully representee ‘The Conceptual Framework _1.9 becomes increasingly difficult. For example, the reliability ofthe acquisition cost of an asset in an exchange transaction is less reliable than the acquisition cost in a cash transaction, Similarly, in absence of a price in an active market, it is difficult to assess the representational faithfulness of the amount that purports to represent fair value of an asset or a liability. Reliability does not imply certainty or precision Reliable information should be neutral in the sense that it does not have bias intended to attain a predetermined result or to induce a particular mode of behaviour. For example, financial reporting should not selectively disclose information to induce potential investors to buy shares of the entity. Usually information is reliable if itis verifiable. Verifiability by itself does not add to the degree of reliability, but it helps to test the presence of material error or bias in the information. Information is verifiable if it can be replicated by different experts. Verifiability implies that although experts may not arrive at the same result, the results should vary in a narrow range. For example, at present, the value of ‘brand equity’ is not verifiable. Different experts arrive at different values due to absence of a widely accepted model and difficulties in measuring inputs to available models. Substance Over Form If information is to represent transactions and other events faithfully, it is necessary that they are accounted for and presented in accordance with their substance and economic reality ‘The substance of transactions or other events is not always consistent with that which is apparent from the legal or contrived form. For example, a sale transaction where a seller concurrently agrees to repurchase the same goods later, is in substance a financing transaction. Similarly, the finance lease is in substance a financing transaction rather than a leasing transaction. A redeemable preference share, which is redeemable for a fixed or determinable amount at a fixed or determinable future date, is in substance a liability and should be Glassified as such [Ref. IAS-32]. However, Schedule VI of the Companies Act requires presentation of redeemable preference shares as a part of equity. Therefore, in India, preference shares are presented as a part of equity. CON-2 issued by FASB states that representational faithfulness leaves no room for accounting representation that subordinates substance to form. According to the Statement, ‘substance over form’ is a rather vague idea that defies precise definition. Prudence Prudence or conservatism is an accountant’s approach towards uncertainties surrounding events and circumstances, such as uncertainty about collectibility of receivables. Prudence is the inclusion of a degree of caution in exercising judgment over the making of estimates1.10 Indian Accounting Standards ,, accountants prefer that possible errors in rue ude contons of wet, nl net of! oe oo assets This preference introduces bias in financial reporting. Prudence ena allow deliberate overstatement of liabilities or understatement of assets to create hidden reserves. An example of the application of the principle of prudence is to value inventories a ae or net realisable value. Similarly, the accounting principle of not recognising a esearch expenditure presents an application of the principle of prudence. Comparability Comparability is an important quality of financial statements. Users should be able to compare financial statements to detect similarities and differences. They should be able to compare financial position, performance and cash flows of different entities, or financial position, performance and cash flows of the same entity over time. Financial statements substantially lose their usefulness if they are not comparable. Investors and potential investors are therefore interested in evaluating financial position and performance of an entity relative of others. They evaluate financial positions and performances of different entities, to decide allocation of funds available for investment. Lack of comparability might result in sub-optimal allocation of funds by investors to different entities. Understandability An essential quality of the information provided in financial statements is that it must be readily understandable by users. Understandability is achieved if users, who have a reasonable knowledge of business and economic activities, and accounting, understand the information. It is assumed that they will study the information with reasonable diligence, Therefore, an entity should not enhance understandability through simplistic presentation of complex transactions. An entity cannot defend choice of an inappropriate accounting policy on the argument that it enhances understandability. ACCOUNTING APPROACH Accounting Standard setters across the balance sheet, rather than on the profit the asset-liability measurement approach. i consequently on the matching principle. 7‘The Conceptual Framework _1.11 riod. For example, costs of purchase or production of finished goods are debited to the profit and loss account for the period in which finished goods are sold, and the resultant revenue is recognised. Under the balance sheet approach, even in the absence of a cause and effect relationship between revenues recognised in the profit and loss account, certain items of expenditure are charged as an expense in the account. These items of expenditure are recognised as an expense independent of the recognition of particular revenues. They are deducted from particular revenues by being recognised in the same period. They arise from systematic and rational allocation of expenditure, such as depreciation. They also arise from the immediate recognition of expenditure as an expense, which occurs if no asset can be recognised from the same. Asset cannot be recognised because either it is not probable that the expenditure will result in future economic benefits, or because the cost or value of the asset cannot be measured reliably. Similarly, recognition of a liability, such as obligations for sales warranty, without recognition of a corresponding asset also results in the recognition of an expense. Paragraph 94 of the Framework issued by ASB of ICAI stipulates that the application of the matching concept does not allow recognition of items in the balance sheet, which do not meet the definition of assets or liabilities. Paragraph 96 stipulates that an expense is recognised immediately in the profit and loss account when expenditure produces no future economic benefits, It further stipulates that an expense is recognised to the extent that future economic benefits from expenditure do not qualify or cease to qualify for recognition in the balance sheet as an asset. Paragraph 56 of AS-26, Intangible Assets, provides examples of expenditure that are recognised as an expense when they are incurred. Examples include expenditure on: (@) Start-up activities, unless this expenditure is included in the cost of an item of fixed asset under AS-10 (b) Training activities () Advertising and promotional activities (d) Relocating or reorganising part or all of an enterprise Immediate recognition of the expenditures listed above as expenses for the period in which they are incurred, distorts the presentation of financial performance. Let us take an example. Management incurs expenditure on advertising and promotion, with the expectation that the expenditure will benefit the entity over future years. Since it is probable that future periods will benefit, in terms of revenue, from the expenditure, strict application of the matching principle requires allocation of the expenditure to periods that are expected to benefit from the expenditure. The balance sheet approach however, does not permit recognition of an asset from that expenditure for two reasons. First, it is difficult to resolve the uncertainty surrounding future benefits. Second, it is difficult to measure the value of1.12 Indian, Accounting Standards a 1.42 _Indian Accounting Standards ___ itio total expenditure as a the benefit reliably. Immediate recognition of the total Pe Peau Fe ePERS forthe period in which it is incurred, distorts the reported operating result. However, distortion of the presentation of assets and liabilities in the balance sheet. + it avoig, The Framework and new Indian Accounting Standards have adopted the ‘asset-labily measurement’ approach, which is a shift from the conventional approach, which focyee the profit and loss account. Accordingly, certain items of expenditure that used 14 be accounted for as ‘deferred revenue expenditure’ will be charged to the profit and jae account for the period in which the expenditure is incurred. The use of deferred reves. expenditure is likely to be eliminated in future. ELEMENTS OF FINANCIAL STATEMENTS The elements directly related to the measurement of financial position are assets, liabilities and equity. Those are defined as follows. (a) An asset is a resource controlled by the entity because of past events from which future economic benefits are expected to flow to the entity (b) A liability is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of economic benefits (©) Equity is the residual interest in the assets of the entity after deducting all its liabilities Thus, equity = assets ~ liabilities. This relationship is known as accounting equation, The definitions of assets and liabilities are very important, because they are used as the first screen in the process of recognising assets or liabilities Profit is frequently used to measure the performance of the entity. It is also used as the basis for other measures, such as, retum on investment or earnings per share. The following are the elements in the profit and loss account: (a) Income is increase in economic benefits during the accounting period, in the form of inflows or enhancement of assets or reduction of liabilities that result in increase in equity, other than those relating to contributions from equity participants. (©) Expenses are a decrease in economic benefit during the accounting period, in the form of outflows or depletion of assets or incurrence of liabilities that result in decrease in equity, other than those relating to distribution to equity participants Income encompasses both revenue and gains, Revenue represents income from core activities of the entity. Income from the sale of products or service and commission earned by a commission agent are examples of revenue. Revenue is recognised on the completion of the process of earning profit. Other income arises from peripheral activities of the enti Examples of other income are interest or dividend earned on favestmente eeeThe Conceptual Framework _1.13 Gains represent other items that meet the definition of income. They may ot may not arise in the ordinary course of activities of an entity. While revenue is presented as gross, gains including other income are presented net of expenses, For example, profit from sale of fixed assets is reported as net of related expenses Expenses encompass those expenses that arise in the course of the ordinary activities of the entity, as well as losses. Assets An asset has the following three essential characteristics: (a) Ithas service potential, that is, it has the potential to provide economic benefits to the entity in future, (b) The entity has control over it, and (©) The transaction or other event giving rise to the entity's right to the economic benefit or its control on the same has already occurred. ‘An asset provides future economic benefit primarily in the form of cash inflows or savings in cash outflows. Assets are also used to settle liabilities or to acquire another asset or service. Services provided by other entities, including personal services cannot be stored. They are received and used simultaneously. They are not recognised as an asset in the balance sheet. However, their use may create another asset or they may enhance the service potential of an existing asset. For example, salaries and wages paid to employees to produce an asset are not recognised as assets, because services provided by them cannot be stored. However, the asset produced by them is recognised as an item of assets in the balance sheet. Thus, salaries and wages attributable to the production or construction of an asset form part of the cost of that asset. An entity controls an asset, if it: (a) Enjoys the benefits embedded in the asset to the exclusion of others, and (b) Has the right to control others’ access to the benefits of the asset. For example, an entity has control over railway sidings in its factory premises, because it enjoys the benefit of the asset to the exclusion of others. An entity enjoys the benefit of a Public road, but it cannot exclude others from the use of the road or control their access. Therefore, the entity has no control over the road. Usually control comes with ownership. In some situations however, control can be obtained without ownership. For example, although an entity does not obtain ownership of an asset under a non-cancelable lease for a period covering substantially the economic life of the asset, it has control over the asset. Similarly, although control usually comes with legally _—1.14 _Indian Accounting Standards enforceable rights, it is not essential that the right to control should be protected through a legal right. For example, an entity may control knowledge created through its research activity by imposing a duty on employees to maintain confidentiality. An asset should result from past trarsactions or events. Usually, an entity acquires or Produces assets. Other events, such as government grants may also generate assets. The criterion of past events is important because a balance sheet presents the stock of assets and liabilities at the balance sheet date. A commitment to purchase an asset neither creates an obligation nor transfers control over the asset. Therefore, a commitment to purchase does not result in the recognition of an asset or a liability. Similarly, a promise by an agency to donate an asset does not result in transfer of control over the asset, and therefore, no asset is created. The criterion reinforces the condition that an item is an asset only if the entity has control over the same. Once acquired, an asset continues to be the asset of the entity until the services embedded in it are used up. For example, a receivable continues to be an asset until the entity collects it. Similarly, equipment continues to be an asset until its service potential is exhausted. Some event or circumstance may destroy the service potential of the asset or removes the entity's ability to obtain it. For example, a fire in the factory may damage equipment and thus destroy its service potential. Similarly, acquisition of land by the government removes the entity’s ability to enjoy the benefits embedded in the asset. Those events result in removal of the asset from the balance sheet. Liabilities A liability has the following three essential characteristic (a) It embodies present obligation, (b) The entity has no or little discretion to avoid the outflow of economic benefits that will be required to settle it, and (©) The transaction or other obligating event has already occurred. A future obligation or a possible obligation is not a liability. The obligation should be Present at the balance sheet date. It is quite possible that the timing, amount and the party to whom the entity is obligated are uncertain at the balance sheet date. For example, an entity has an obligation to repair defects in products sold, if detected during the product warranty period. The obligation exists at the balance sheet date and settlement of the same will result in outflow of economic benefits. Therefore, it is a liability, although the timing, amount and party are uncertain. A disputed claim on the entity, which is under arbitration, might result in an obligation at a future date depending on the judgment of the arbitrator. Therefore, there is no present obligation, although there is a possible obligation that might arise at a future date. However, if experience of the entity (and others) shows that it is probable thatThe Conceptual Framework 1.15 the arbitrator's judgment will be unfavourable to the entity, the obligation is a present obligation and not a possible obligation. In some situations, it is difficult to form a judgment about whether the obligation is a present or a possible one, because there is only a thin line between the two. [A present obligation is a liability, if itis probable that settlement of the obligation will result in outflow of economic benefits. The test is whether the entity has the discretion to avotd the outflow of economic benefits. In case it has the discretion, the obligation is not a liability. For example, a party has made a request to refund a non-refundable advance paid by it to the entity for purchase of its product on compassionate ground. There is no contractual obligation to repay the advance. The claim of the party is not a liability, because the entity has the discretion to avoid the outflow of economic benefits. Obligation usually arises from a legally enforceable contract or from statutory requirements However, an obligation may also arise from normal business practice, custom and a desire to maintain good business relation or to act in an equitable manner. Such obligations are termed as ‘constructive obligations’. Constructive obligation arises when an entity, by its behavior or current statement, undertakes certain responsibilities and creates a valid expectation among others that the entity will fulfill those responsibilities. In the above example, if it is the normal business practice to refund the advance on cancellation of the order, the entity has no discretion to avoid the outflow of economic benefits. Therefore, although there is no legal obligation to refund, there is a constructive obligation. Constructive obligation may arise in another situation. Let us continue with the example. Although the normal business practice is to forfeit the amount, the entity has decided to refund the advance on compassionate grounds. Accordingly, it has informed the party that it will refund the advance. The entity has created a constructive obligation by informing the party about its decision to refund the advance. ‘An entity must be careful in identifying constructive obligations. If the entity interprets the term in a narrow sense, it is likely to exclude some unavoidable present obligations. On the other hand, if the entity interprets the term in a wider sense, it is likely to include some avoidable obligations. An entity should take a balance view and form its judgment based on reasonable and supportable evidence. An example of constructive obligation is an obligation to rectify damages in products detected after the expiry of the contractual warranty period. Similarly, an obligation to clean the environment after disposal of an asset might arise not from an environmental law, but from the custom of the industry in which the entity operates, or from a public statement issued by the entity. The concept of constructive obligation leads to the recognition of an obligation much before it gets converted into a contractual or legal obligation. For example, application of the concept of ‘constructive obligation’ requires recognition of a liability immediately on communication of a ‘voluntary retirement scheme’ (VRS) to concerned employees. On the other hand, if a firm does not apply the concept of constructive obligation, it recognises the liability only on acceptance of employees’ applicationscounting Standards — yunting Standards — for VRS by the management of the firm. The present Indian practice generally does nop recognise the concept of constructive obligation. However, AS-15 (Revised) recognises thy concept of constructive obligation in measuring liabilities for ‘post retirement benefit’, employees. An obligation should arise from a past transaction or event, usually termed as ‘obligating coent’. For example, credit purchase of goods or use of service results in assumption of , liability. Similarly, receipt of a loan from a bank or advance from a customer result in liability. An entity may also recognise a liability for future rebates based on past purchases by customers. Equity Equity is the owner's claim on the assets of the entity. The claim of owners is residual in the sense that it is subordinate to all other claims on the assets of the entity. In bankruptcy or liquidation of an entity, the owners’ claim comes last in order of seniority. Owners get back assets, which are left after meeting claims of others. The concept is simple, but its application becomes difficult for entities, which issue compound instruments that have elements of both equity and debt. Equity consists of funds or other resources contributed by owners and profit retained in the business. In case of a limited liability company, equity is classified as share capital, share premium, and reserves and surplus. In case of accumulated loss, equity is the total of share capital and share premium, reduced by the accumulated loss appearing in the balance sheet. Equity is often termed as net worth or net assets. The amount of equity presented in the balance sheet depends on the recognition and measurement of assets and liabilities. Therefore, correct application of the principles of recognition and measurement of assets and liabilities is essential to measure the equity correctly. ConcePT OF CaPITAL AND CapITaL MAINTENANCE Under a financial concept of capital, capital is synonymous with equity of the entity. Under physical concept of capital, capital represents the productive capacity of the entity. The models use the financial concept of capital. The above two concepts of capital give rise to the following two concepts of capital maintenance: (a) Financial capital maintenance (b) Physical capital maintenance.The Conceptual Framework 1.17 Under the concept of financial capital maintenance, a profit is earned only if the equity at the end of the period exceeds the equity at the commencement of the period. Profit for a period is the difference between the equity at the end and at the beginning of the period, adjusted for any distribution to, and contribution from, owners during the period. Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power. Most accounting models measure capital in nominal monetary units Under physical capital maintenance, a profit is earned only if the physical productive capacity of the enterprise at the end of the period exceeds the physical productive capacity at the beginning of the period. Profit for the period is the difference between the equity at the end and at the beginning of the period, adjusted for any distribution to, and contribution from, owners during the period. The physical maintenance of capital concepts requires the current cost basis of measurement of assets and liabilities. An entity holds a portfolio of variety of assets and liabilities. Therefore, it is almost impossible to measure physical productive capacity in non-monetary terms. Usually, physical productive capacity is measured in terms of current costs of assets and liabilities. The principal difference between the two concepts of capital maintenance is the treatment of the effects of change in prices on assets and liabilities of the entity. RECOGNITION OF ELEMENTS OF FINANCIAL STATEMENTS Recognition is the process of incorporating items of assets, liabilities, incomes, and expenses in financial statements. The amount of equity in the balance sheet is the difference between the carrying amount of assets and the carrying amount of liabilities. Therefore, recognition of an item of asset or liability should be perceived as recognising the same for measuring capital. For example, when an entity recognises ‘brand equity’ in the balance sheet, it counts brand equity as an asset in measuring capital. Therefore, Standards stipulate recognition criteria that should be used as the second screen in deciding whether an item of asset or liability should be recognised in the balance sheet. An item that passes through the first screen, the definition of an asset (liability) , should be recognised if: (a) It is probable that any future economic benefit associated with the item will flow to (from) the entity (b) The item has a cost or value, which can be measured reliably The concept of probability is used in the recognition criteria to recognise that the business is surrounded by uncertainty and consequently, cash flows to or from the entity are also surrounded by uncertainty. The uncertainty should be resolved at an acceptable level based on the evidence available when the financial statements are prepared. For example, the probability that the1.18 Indian Accounting Standards _ be assessed with reference to am a customer will be realised should 8 ev he tne of approval of financial statements. If it is probable that the rece ceivable in the balance sheus id amount due lence available at the time of approval o will not be collected, the entity should not recognise the rec In most situations, probability should be interpreted as ‘more likely than nol’. For example when we say that it is probable that a customer will pay the amount due from him, we mear that it is ‘more likely than not’ that the customer will pay the amount. The second criterion focuses on the reliability of measurement. Estimation is at the centre of measurement. However, if the cost or value of an item cannot be estimated reliably, the item should not be recognised in financial statements. For example, there might be a situation when itis probable that an entity will have to pay damages to one of its customers, who has filed a law suit but it is unable to reliably estimate the amount payable. The firm should not recognise the liability. It should disclose the obligation. An entity should trade off between ‘relevance’ and ‘reliability’. Recognition of an item may be relevant, but estimate of its cost or value might be so unreliable that the information would mislead users of the financial statements. In that situation, the item is not recognised An entity should not defer recognition of an item until it achieves ‘absolute reliability’ in measuring the cost or value of an item. An acceptable degree of reliability is sufficient to recognise an item. The acceptable degree of reliability is a matter of judgment and depends on the situation or circumstance. For example, under US GAAP, ‘Asset Retirement Obligation’, (ARO) should be measured at fair value (FV). However, in absence of an observable price in the active market, PV determined with third party market approach is used as a fait measure of FV. US GAAP states that market assumptions should be incorporated in the PV model only if the information is available at ‘reasonable cost and effor’. Thus, US GAAP permits recognition of ARO, even when the degree of reliability of the estimate of the present value is lower than the ‘absolute reliability’. An entity should disclose, by way of notes, items that posses the essential characteristics of an element, if it is unable to recognise those items because they fail to meet the recognition criteria. For example, if an entity is unable to determine the FV of a derivative instrument reliably, it should not recognise the item, but should disclose the same by way of a note. Standard Setters take into consideration the economic conditions, developments in economics and finance, availability of data, and other such factors to assess whether a measurement attribute for an item can be determined reliably. They use the result of such assessments in formulating Accounting Standards. Accounting Standards stipulate the attributes to be used to measure different items in financial statements They also stipulate what information should be disclosed in financial statements at the minimum. MEASUREMENT OF ELEMENTS OF FINANCIAL STATEMENTS A number of different measurement bases are em, ployed, in different di din varying combinations in financial statements. They include, ifferent degrees an ide the following:The Conceptual Framework 1.19 (a) Historical cost (b) Current cost (©) Realizable (settlement) value (a) Present value Historical cost is most commonly used in measuring assets and liabilities in accounting models. In contemporary accounting models, a combination of the historical cost and various other measurement bases is used to measure assets and liabilities in the balance sheet. For example, inventory is carried at lower of cost or net realisable value. Common accounting models are ‘transaction-driven’. Therefore, assets and liabilities are initially measured at the exchange value. Subsequently, the historical cost (exchange value) is adjusted for accumulated depreciation and accumulated impairment loss. In addition, the carrying amount of monetary items is adjusted for change in foreign exchange rates. The recent trend shows a shift from transactions-based accounting to transactions and events based accounting. For example, financial instruments and investments are carried at fair value at the balance sheet date, which has no relationship with the amount at which those items were carried in the previous balance sheet. This measurement principle is known as ‘fresh start measurement’. In India, ‘fresh start measurement’ principle is seldom used to measure assets and liabilities. Historical Cost Under historical cost basis, an asset is initially recorded at the amount of cash paid or the fair value of any other consideration given to acquire it. Subsequently, the asset is carried at acquisition cost adjusted for accumulated depreciation and accumulated impairment loss. The carrying amount of the asset is adjusted for impairment loss, because, as a general principle, no asset should be carried at an amount higher than its recoverable amount or fair value. Recoverable amount is the present value (PV) of cash flows that the asset is expected to generate over its estimated useful life. However, under US GAAP, an asset is tested for impairment by comparing its carrying, amount and undiscounted cash flow that the asset is expected to generate over its useful life. Indian Accounting Standards (AS) and Intemational Accounting Standards (IAS) measure impairment loss at the excess of carrying amount over the PV of cash flow that the asset will generate, over its useful life. For example, if the PV of the estimated cash flow is Rs 1,00,000 and the carrying amount is Rs 1,20,000, the impairment loss is measured at Rs 20,000. The asset is written down to Rs 1,00,000. The US GAAP measures impairment loss at the excess of carrying amount of an asset over its fair value. Liabilities are recorded at the amount of proceeds received in exchange for the obligation. For example, loan received from a financial institution is recorded at the amount of proceeds>» 1.20 Indian Accounting Standards received. In some circumstances, liabilities are recorded at the amounts of cash or cay, equivalents expected to be paid to setle the obligation in the normal course of business. pe example, excise duty payable is recorded at the cash payable to satisfy the obligation Monetary items are assets and liabilities to be received or paid in fixed or determinable amount of money. Examples are receivables from customers, deposits with revenyg authorities, sundry creditors, and loans. Historical cost of monetary items denominated in foreign currency is adjusted for changes in the exchange rate during the period between acquisition of the asset or assumption ofthe liability and the balance sheet date. For example, an entity has a receivable of US$1,000 against export. The exchange rate on the date of the transaction was US$1 = Rs 45. Thus, the receivable was recorded at Rs 45,000. The exchange rate at the balance sheet date was US$1 = Rs 50. The receivable should be adjusted for the change in the exchange rate. It should be reported at Rs 50,000. Current Cost Under current cost basis, an asset is carried at the amount of cash that would have to be Paid if the same or an equivalent asset were acquired currently. Liabilities are carried at the undiscounted amount of cash that would be required to settle the obligation currently. Thus, current cost is the replacement cost of assets and liabilities at the balance sheet date. Current cost represents the entry value. For example, under this method, fixed assets are reported at replacement cost. However, in practice it is difficult to ascertain the replacement cost of used by the entity. In such situations, even thi that held by the entity may not be available, Realisable (Settlement) Value normal course of business. Thus, realisable value such as financial instruments, the current cost This is not true for long lived assets. For exar are not same for special purpose equipment Tepresents the exit value. For some assets, and the realisable value are almost the same. mple, the current cost and the realisable valueThe Conceptual Framework _1.21 Present Value Under present value (PV) basis, an asset is carried at the PV of the future net cash inflows that the item is expected to generate in the normal course of business. Liabilities are carried at the PV of the net cash outflows that are required to settle the liabilities in the normal course of business. Until recently, standard setters did not accept present value (PV) as a basis for measuring assets and liabilities in financial statements. However, the Statement of Financial Accounting Concepts No. 7 (CON-7), issued by FASB in February 2002, stipulates use of PV in measurement of fair value (FV). PV should be used when FV cannot be determined due to the absence of observable price of the asset (liability) or of similar assets (liabilities) in an active market, but Standards require measurement of the item at FV. Farr VALUE MEASUREMENT The conventional and most commonly used definition of fair value (FV) is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable and willing parties in an arm’s length transaction. ‘CON-7 issued by FASB defines FV as the amount at which the asset (or liability) could be bought (or incurred) or sold (or settled) in a current transaction between willing parties, that is, other than in a forced or liquidation sale. There is no substantive difference between the two definitions. Assets and liabilities are initially measured at FV, irrespective of the measurement basis used by the entity. In absence of any evidence to the contrary, it is assumed that the price paid in an exchange transaction represents FV. Therefore, even under historical cost basis of accounting, assets and liabilities are initially measured at FV. FVis also used in ‘fresh-start measurement’. Fresh start measurement refers to measurement of assets and liabilities after initial measurement at an amount that is unrelated to the earlier carrying amount. For example, IAS-39 requires measurement of most financial instruments at FV. The FV at each balance sheet date is unlikely to have any direct linkage with the earlier carrying amount. FV is appropriate for measuring certain types of assets and liabilities, such as financial instruments. Historical cost basis of measurement fails to recognise the timing and, risk of the cash inflow that the asset will generate, or the cash outflow that will be required to settle the liability. Thus, under historical cost basis of measurement, dissimilar assets or liabilities are carried at the same amount. This is particularly true for financial instruments including monetary items and investments. For example, an enterprise expects that it will realise Rs 10,00,000 receivables from customer A immediately, while the same amount receivable from customer B will be realised after two years. Under historical cost basis of measurement,os 1.22 _Indian Accounting Standards both the debtors will be carried in the balance sheet at Rs 10,00,000. Similarly, historical cost basis of measurement does not differentiate between the loan repayable after ten years and loan repayable immediately. Historical cost measurement also fails to take into consideration the difference in probabilities that the actual cash flows might differ from expected cash flows arising from different monetary assets and liabilities of the same maturity. In other words, historical cost basis of measurement fails to capture the uncertainty surrounding the cash flow to or from the entity. Let us take an example, although the amount receivable from customer A ig almost certain, the probability of recovering the amount receivable from customer B is estimated at 50 percent. Historical cost basis of measurement will carry both the receivables in the balance sheet at the same amount. The entity even under historical cost basis of measurement should provide for loss expected to be incurred due to non-recovery of the full amount due from B. However, provision for doubtful debt is measured with entity-specific assumptions. The FV captures market assumptions about the amount that is likely to be realised from B. Therefore, historical cost basis of measurement is not appropriate for measuring financial instruments, which includes receivables and payables. In the above situation, FV is the appropriate measurement basis. Similarly, FV is used in situations where cost cannot be measured reliably. An example of assets for which FV can be measured more reliably than cost is the ‘biologically regenerative assets’. For example, it is difficult to determine the cost of production of tea leafs, but the FV can be determined with reference to observable prices in tea auctions. Observable market price of the asset (liability) in an active market is the best estimate of the FV. An active market is the market where items traded are homogeneous, willing buyers and sellers are found at any time, and prices are available to the public. Capital markets and commodity markets are examples of active market. In the absence of observable market prices on the measurement date, most recent transactions form the basis for measuring FV at the measurement date. In the absence of observable market price of the asset (liability), observable market prices of similar assets (liabilities) are used as bench mark for estimating the FV of the asset Giability). CON-7 issued by FASB stipulates that a PV that incorporates the time value of money and uncertainty in estimated future cash flows, always provides more relevant information than a measurement based on undiscounted cash flows or a discounted measurement that ignores uncertainties. The only objective of PV, when used in accounting measurements at initial recognition and fresh-start measurement is to estimate FV. In other words PV should attempt to capture the elements that taken together would, comprise a market price if one existed, tha! is, FV. The use of an entity’s own assumption about future cash flows is compatible in an estimate of a fair value, as long as there is no contradictory data indicating that market place Participants use different assumptions. If such data exists, the entity must adjust its assumption to incorporate that market information, provided the information can be gathered with reasonable cost and effort.The Conceptual Framework 1.23 CON-7 stipulates use of the expected cash flow approach. Expected cash flow is the expected value (as defined in Statistics) of estimated cash flows. Thus, the expected cash flows should be discounted by the risk-free rate of interest, adjusted for the credit risk of the entity. The expected cash flows incorporate risk associated with those cash flows. In developing a measurement of expected cash flow, the entity uses all expectations about possible cash flows instead of the single most likely cash flow. The expected cash flow approach differs from the traditional approach by focusing on direct analysis of the cash flows in question. In this approach, the entity makes explicit statements of the assumptions used in the measurement of PV. CONCLUSIONS The ‘frame work for the preparation and presentation of financial statements’ provides the reference point for setting accounting standards and for interpreting standards. It provides guidance for formulating accounting policy for events and transactions not covered by extant accounting standards. Moreover, if an enterprise’s accounting policy deviates from an accounting standard, the enterprise should defend its accounting policy with reference to the Framework. However, nothing in the framework overrides any specific Accounting Standard. Substantive accounting principles and concepts adopted by the Indian Accounting Standards Board, the International Accounting Standards Board, and Financial Accounting Standards Board (FASB) of USA, are the same. This facilitates revision of accounting standards/GAAP to achieve convergence between accounting principles and methods stipulated in AS, IFRS (IAS), and US GAAP.