Chapter 2

The Conceptual Framework for

financial reporting( Released in
2019)

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Objectives of this lecture

• Understand the objective of general purpose financial reporting

(Chapter 1)
• Understand what qualitative characteristics of financial
information if such information is useful (Chapter 2)
• Understand the concept of materiality
• Be able to define the elements of financial accounting and be
able to explain the recognition criteria (Chapter 4)

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What are general purpose financial
statements and reporting entities? Chapter
1

GPFSs to be produced by entities who have users who cannot

command the preparation of specific information
 Such entities are deemed to be ‘reporting entities’
 If an entity is not deemed to be a ‘reporting entity’ it will
not be required to produce GPFRs—and not necessarily
be required to comply with all accounting standards

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Main users of general purpose
financial statements

Existing Potential Lenders

investors investors

Other
creditors General
purpose
FS

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 Qualitative characteristics of financial
information Chapter 2
• The Conceptual Framework identifies the characteristics of
financial information necessary to allow users to make and
evaluate decisions about the allocation of scarce resources
• Two fundamental qualitative characteristics of financial
reporting are identified in the Conceptual Framework:
– Relevance
– Faithful representation
• Information must be both relevant and faithfully represented
if it is to be useful. Neither a faithful representation of an
irrelevant phenomenon nor an unfaithful representation of a
relevant phenomenon helps users make good decisions

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Relevance
For information to be relevant it should have both predictive value
and confirmatory value (or feedback value), the latter referring to
information’s utility in confirming or correcting earlier expectations

• Closely tied to the notion of relevance is the notion of materiality

– General purpose financial statements are to include all
financial information that satisfies the concepts of ‘relevance’
and ‘faithfully represent’ to the extent that such information is
material

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Faithful representation

• The other primary qualitative characteristic is ‘faithful

representation’
• To be a perfectly faithful representation, a depiction would have
three characteristics. It would be complete, neutral and free
from error. Of course, perfection is seldom, if ever, achievable.
The IASB’s objective is to maximise those qualities to the
extent possible.

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Balancing relevance and
representational faithfulness
• Ideally, financial information should be both relevant and
representationally faithful. However, it is possible for information to
be representationally faithful, but not very relevant, or the other
way around. Such information would, in this case, not be deemed
to be useful.
• There can, in practice, be a need to balance one against the other.
However, if the data or information severely lacks one of the
characteristics of relevance or faithful representation, then that
information should not be provided to financial statement readers.
• Another consideration that needs to be addressed when deciding
whether to disclose particular information is the potential costs of
producing relevant and representationally faithful information,
relative to the associated benefits.

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Elements of financial accounting
• Five elements of financial accounting are defined in the AASB
Framework
– assets
– liabilities
– equity
– expenses
– income
• In relation to the different elements, we will need guidance in
terms of:
– how they are to be defined
– when they are to be recognised for financial statement
purposes
– how they shall be measured, and
– how they should be presented and disclosed

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Elements (cont.)
Definition and recognition of assets
• Assets are defined as
– a resource controlled by the entity as a result of past
events and from which future economic benefits are
expected to flow to the entity
• Three key characteristics of the definition:
1. There must be future economic benefits
2. The reporting entity must control the future economic
benefits
3. The transaction or other event giving rise to the control
must have occurred

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Elements (cont.)
Definition and recognition of assets (cont.)
• An asset is to be recognised in the financial statements if
(AASB Framework par. 83):
– it is probable that any future economic benefit associated
with the asset will flow to or from the entity, and
– the item has a cost or value that can be measured with
reliability

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Elements (cont.)

Definition and recognition of assets (cont.)

• ‘Probable’ is generally considered to mean ‘more likely rather
than less likely’
• If an asset or other element fails to meet the recognition criteria
in one period but satisfies them in another period, the asset can
be reinstated (subject to requirements, in particular accounting
standards)

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Liabilities do not necessarily need to be
‘legally enforceable’
• An essential characteristic of a liability is that the entity has a
present obligation. Obligations can be legally enforceable
• However, obligations also arise from normal business practice,
custom and a desire to maintain good business relations or act
in an equitable manner
• Hence the liabilities that appear within an entity’s statement of
financial position might include obligations that are legally
enforceable as well as obligations that are deemed to be
equitable or constructive
• An equitable obligation is governed by social or moral sanctions
or custom rather than legal sanctions. A constructive obligation
is created, inferred or construed from the facts in a particular
situation rather than contracted by agreement with another
entity or imposed by government
• So … don’t assume that all liabilities shown in a statement of
financial position (balance sheet) are legally enforceable

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Contingent liabilities
• What is a contingent liability and how is it different from a
liability?
• How would we disclose contingent liabilities?

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Elements of accounting (cont.)
Definition and recognition of expenses
• The definition is dependent upon the definitions of ‘assets’ and
‘liabilities’
• Expenses are defined as:
– decreases in economic benefits during the accounting
period in the form of outflows or depletions of assets or
incurrences of liabilities that result in decreases in equity,
other than those relating to equity participants
• Usual tests of probability and measurability apply

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Elements (cont.)
Definition and recognition of expenses (cont.)
• Expenses are recognised in the statement of comprehensive
income when:
– a decrease in future economic benefits related to a
decrease in an asset or an increase in a liability has arisen
that can be measured reliably
• If a resource is used up or damaged by an entity but that entity
does not control the resource (not an asset of the entity), to the
extent that no liabilities or fines are imposed, no expenses will
be recorded by the entity

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Elements (cont.)
Definition and recognition of income
• Again, the definition is dependent on those of ‘assets’ and
‘liabilities’
• Income is defined as:
– increases in economic benefits during the accounting period
in the form of inflows or enhancements of assets or
decreases of liabilities that result in increases in equity,
other than those relating to contributions from equity
participants

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Elements (cont.)
Definition and recognition of income (cont.)
• Income can be recognised in the financial statements when:
– it is probable that the inflow or other enhancement or saving
in outflows has occurred, and
– the inflow or other enhancement or saving in outflows of
economic benefits can be measured reliably

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Elements
Definition and recognition of income (cont.)
• ‘Revenues’ and ‘gains’ distinguished between in the
Conceptual Framework
– Revenue arises in the course of the ordinary activities of an
entity and includes: sales, fees, interest, dividends, royalties
and rent
– Gains represent other items that meet the definition of
income and might or might not arise in the ordinary activities
of an entity, e.g. disposal of non-current assets
– Some professional judgement is required to determine
whether a component of income should be classified as
revenue or a gain

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Elements (cont.)
Definition of equity:
– residual interest in the assets of the entity after deducting
all of its liabilities
• Directly a function of the definitions given to assets and
liabilities
• No need for separate recognition criteria for equity

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Measurement principles

• Conceptual frameworks have provided little guidance in relation

to measurement issues
• We currently have a multitude of measurement bases for
assets and liabilities
• The IASB favours an approach whereby different measurement
bases can be applied to different classes of assets and
liabilities
• Do we think it is conceptually valid to have different
measurement bases for different classes of assets and
liabilities?

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Critical review of conceptual
frameworks
• Objective of GPFRs implies that reports should be primarily
economic in focus
– Should social issues be ignored in the annual report?
• An individual’s view of business responsibilities directly impacts
on perceptions of accountability
• In determining whether or not an entity is a reporting entity,
should the need for information to enable informed ‘resource
allocation decisions’ be the only or dominant consideration?
• Economic focus of GPFSs ignores transactions or events not
resulting from market transactions or an exchange of property
rights
• Ignores environmental externalities caused by business

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Critical review of conceptual
frameworks (cont.)
• Financial statements included within reports reflect only
financial performance and do not provide a means of assessing
social or environmental performance
• Financial press also generally use financial indicators as a
guide to a firm’s success

It has also been argued that:

• Conceptual frameworks simply codify existing practice and
therefore provide little hope for improving financial reporting
• Conceptual frameworks have been used as devices to
legitimise the existence of the accounting profession

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