The Conceptual Framework for Financial Reporting 2020

Introduction

The framework has been revised for 2020 onwards.

The Conceptual Framework for the Financial Reporting (let’s title it just “Framework”) is a basic document that sets objectives and the concepts for general purpose financial reporting.

Its predecessor, Framework for the preparation and presentation of the financial statements was issued back in 1998.

Then in 2010, IASB published the new document, Conceptual Framework for the Financial Reporting, however it was a bit unfinished as a few concepts and chapters were missing.

The newest and completed Framework published in 2018 comprises 8 chapters

Is the Framework equivalent to the Standard?

Framework is NOT a Standard itself.

Thus if you wish to decide on the financial reporting of certain transaction, you need to look into the appropriate standard – IFRS or IAS.

Sometimes, it may even happen that the rules in that IFRS or IAS standard will be contrary to what the Framework says. In this case, you need to apply the standard, not the Framework.

When should you apply the Framework?

In most cases, when there are no specific rules for your transaction and you need to develop your accounting policy, then you would look to the Framework as you cannot depart from its basic principles and definitions.

The Conceptual Framework for Financial Reporting

The International Accounting Standards Board (IASB) was formed to develop and have agreed standards of good practice that can be applied thoughout the world.

Financial statements are presented to users, by many undertakings around the world. Although such financial statements may appear similar from country to country, there are differences that have been caused by a variety of social, economic and legal circumstances, and by different countries serving the needs of different users when setting national requirements.

IASB is committed to narrowing these differences, by seeking to harmonise regulations, accounting standards and procedures, relating to the preparation and presentation of financial statements.

An undertaking preparing financial statements under IFRS is required to consider the IASB Framework when there is no standard, or interpretation, that specifically applies to a transaction, other event or condition or that deals with a similar and related issue.

The Framework is the foundation of IFRS and is frequently referred to by writers of standards. The Framework does not have a number and is sometimes omitted when standards are translated.

Whilst many of the elements are common to other systems, the concept of materiality is new to many readers and is detailed only in the Framework. Other elements may be defined differently, or accounted for differently in various jurisdictions.

Scope

This framework document deals with:

(i) the objective of financial statements;

(ii) the qualitative characteristics that determine the usefulness of information in financial statements;

(iii) the definition, recognition and measurement of the elements from which financial statements are constructed; and

(iv) concepts of capital and capital maintenance.

The framework is concerned with financial statements, including consolidated financial statements. These are presented at least annually, and are directed toward the needs of a wide range of users.

Some users can obtain information in addition to the financial statements. Many users, however, have to rely on the financial statements as their major source of financial information.

Financial statements form part of the process of financial reporting. A complete set of financial statements normally includes

• a balance sheet (statement of financial position),
• an income statement,
• a statement of changes in financial position and
• notes, and other statements and explanatory material, that are an integral part of the financial statements.

This list does not include an auditor’s report, but most annual financial statements include one.

The framework applies to the financial statements of all commercial, industrial and business reporting undertakings, in the public or the private sectors.

Users and Their Needs for Information.

The main users of financial statements are

• Investors. The providers of risk capital, and their advisers, are concerned with the risk in, and return provided by, their investments. They need to know whether they should buy, hold or sell (and the ability of the undertaking to pay dividends).
• Employees. Employees, and their representatives, are interested in the stability, and profitability, of their employers. They are also interested to assess the ability of the undertaking to provide remuneration, retirement benefits and employment opportunities.
• Lenders. Lenders wish to know whether their loans, and interest, will be paid, when due.
• Government though various ministries.

Customers, suppliers and other trade creditors are taking an increasing interest in financial statements.

For banks, correspondent banks, depositors and bank regulators analyse the financial statements to determine a bank’s risks and its management. From that analysis, they can determine the amount and price of funds that they are willing to lend to the bank.

There are needs that are common to all users. As investors are providers of risk capital to the undertaking, financial statements that meet their needs will also meet most of the needs of other users.

The management of an undertaking has the primary responsibility for the presentation of the financial statements.

The Objective of Financial Statements

The objective of financial statements is to provide information about the financial position, performance and changes in financial position of an undertaking, useful to a wide range of users in making decisions.

Financial statements show the results of the stewardship of management.

Those users who wish to assess the management do so to make decisions: whether to hold, or sell, to increase their investment, and whether to reappoint (or replace) the management.

Preparation of Financial Statements.

There are two important assumptions that the users of financial statements have.

The first assumption is that accrual accounting has been used when recording transactions.

Financial statements are prepared on the accrual basis of accounting. The impacts of transactions, and other events are recorded when they occur (and not when cash is received, or paid).

EXAMPLE - the accrual basis of accounting

In December, you sell some goods on credit. You receive cash from your client in February. You record the sale in December, not when you receive the cash.

In December you pay office rent for January to March. The rent cost is spread over these three months, not just expensed in full in the month that it was paid.

This is the accrual basis of accounting.

EXAMPLE - the accrual basis of accounting

In November, you buy some goods on credit. You pay cash in February. Your December accounts will show the trade payable, alerting users to the obligation to pay cash in the future.

The second assumption is that of Going Concern.

The financial statements are normally prepared on the assumption that an undertaking is a going concern, and will continue in operation for the foreseeable future. It is assumed that the undertaking has neither the intention, nor the need to liquidate, or curtail materially the scale of its operations.

Assets are valued on the basis that the undertaking will continue, and no forced sale will take place that would reduce their resale values.

If such an intention (or need) exists, the financial statements may have to be prepared on a different basis and, if so, the basis used is disclosed.

EXAMPLE-going concern

Banks provide loans under specific conditions, including the financial performance of clients. A breach of these conditions may enable the bank to liquidate the client. In these circumstances, unless the client can secure an alternative source of finance, financial statements should not be prepared on a going concern basis.

Objective, usefulness and limitations of general purpose financial reporting

The objective of general purpose financial reporting is to provide financial information about the reporting undertaking that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the undertaking.

Those decisions involve buying, selling or holding equity and debt instruments, and providing or settling loans and other forms of credit.

Decisions by existing and potential investors about buying, selling or holding equity and debt instruments depend on the returns that they expect from an investment in those instruments, for example dividends, principal and interest payments, or market price increases.

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

Users' expectations about returns depend on their assessment of the amount, timing and uncertainty of future net cash inflows to the undertaking.

Consequently, users need information to help them assess the prospects for future net cash inflows to an undertaking.

To assess an undertaking's prospects for future net cash inflows, existing and potential investors, lenders and other creditors need information about the resources of the undertaking, claims against the undertaking, and how efficiently and effectively the undertaking's management has discharged its responsibilities to use the undertaking's resources.

Examples of such responsibilities include protecting the undertaking's resources from unfavourable effects of economic factors such as price and technological changes and ensuring that the undertaking complies with applicable laws, regulations and contractual provisions.

Information about management's discharge of its responsibilities is also useful for decisions of existing investors, lenders and other creditors who have the right to vote on, or otherwise influence, management's actions.

Many investors, lenders and other creditors must rely on general purpose financial reports for much of the financial information they need. They are the primary users to whom general purpose financial reports are directed.

However, financial reports do not and cannot provide all of the information that existing and potential investors, lenders and other creditors need. Those users need to consider pertinent information from other sources, for example, general economic conditions and expectations, political events and political climate, and industry and company outlooks.

Financial reports are not designed to show the value of a reporting undertaking; but they provide information to help existing and potential investors, lenders and other creditors to estimate the value of the reporting undertaking.

Individual primary users have different, and possibly conflicting, information needs and desires. IASB, in developing financial reporting standards, will seek to provide the information set that will meet the needs of the maximum number of primary users.

However, focusing on common information needs does not prevent the reporting undertaking from including additional information that is most useful to a particular subset of primary users.

The management is also interested in financial information about the undertaking. However, management need not rely on general purpose financial reports as it is able to obtain the financial information it needs internally.

Other parties, such as regulators and members of the public other than investors, lenders and other creditors, may also find general purpose financial reports useful. However, those reports are not primarily directed to these other groups.

To a large extent, financial reports are based on estimates, judgements and models rather than exact depictions. The Conceptual Framework establishes the concepts that underlie those estimates, judgements and models. The concepts are the goal towards which the Board and preparers of financial reports strive.

The Conceptual Framework's vision of ideal financial reporting is unlikely to be achieved in full, at least not in the short term, because it takes time to understand, accept and implement new ways of analysing transactions and other events. Nevertheless, establishing a goal towards which to strive is essential if financial reporting is to evolve so as to improve its usefulness.

Information about a reporting undertaking's economic resources, claims, and changes in resources and claims

Financial reports provide information about the financial position of a reporting undertaking, which is information about the undertaking's economic resources and the claims against the reporting undertaking.

Financial reports also provide information about the effects of transactions and other events that change a reporting undertaking's economic resources and claims. Both types of information provide useful input for decisions about providing resources to an undertaking.

Economic resources and claims

Information about the nature and amounts of a reporting undertaking's economic resources and claims can help users to identify the reporting undertaking's financial strengths and weaknesses.

That information can help users to assess the reporting undertaking's liquidity and solvency, its needs for additional financing and how successful it is likely to be in obtaining that financing. Information about priorities and payment requirements of existing claims helps users to predict how future cash flows will be distributed among those with a claim against the reporting undertaking.

Different types of economic resources affect a user's assessment of the reporting undertaking's prospects for future cash flows differently. Some future cash flows result directly from existing economic resources, such as accounts receivable.

Other cash flows result from using several resources in combination to produce and market goods or services to customers. Although those cash flows cannot be identified with individual economic resources (or claims), users of financial reports need to know the nature and amount of the resources available for use in a reporting undertaking's operations.

Changes in economic resources and claims

Changes in a reporting undertaking's economic resources and claims result from that undertaking's financial performance and from other events, or transactions, such as issuing debt or equity instruments. To properly assess the prospects for future cash flows from the reporting undertaking, users need to be able to distinguish between both of these changes.

Information about a reporting undertaking's financial performance helps users to understand the return that the undertaking has produced on its economic resources.

Information about the return the undertaking has produced provides an indication of how well management has discharged its responsibilities to make efficient and effective use of the reporting undertaking's resources.

Information about the variability and components of that return is also important, especially in assessing the uncertainty of future cash flows. Information about a reporting undertaking's past financial performance and how its management discharged its responsibilities is usually helpful in predicting the undertaking's future returns on its economic resources.

Financial performance reflected by accrual accounting

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

This is important as information about a reporting undertaking's economic resources and claims and changes in its economic resources and claims during a period provides a better basis for assessing the undertaking's past and future performance than information solely about cash receipts and payments during that period.

Information about financial performance during a period, reflected by changes in its economic resources and claims, other than by obtaining additional resources directly from investors and creditors, is useful in assessing the undertaking's past and future ability to generate net cash inflows.

That information indicates the extent to which the reporting undertaking has increased its available economic resources, and thus its capacity for generating net cash inflows through its operations rather than by obtaining additional resources directly from investors and creditors.

Information about financial performance during a period may also indicate the extent to which events such as changes in market prices or interest rates have increased, or decreased, the undertaking's economic resources and claims, thereby affecting the undertaking's ability to generate net cash inflows.

Financial performance reflected by past cash flows

Information about cash flows during a period also helps users to assess the undertaking's ability to generate future net cash inflows. It indicates how the reporting undertaking obtains and spends cash, including information about its borrowing and repayment of debt, cash dividends or other cash distributions to investors, and other factors that may affect the undertaking's liquidity or solvency.

Information about cash flows helps users understand a reporting undertaking's operations, evaluate its financing and investing activities, assess its liquidity or solvency and interpret other information about financial performance.

Changes in economic resources and claims not resulting from financial performance

A reporting undertaking's economic resources and claims may also change for reasons other than financial performance, such as issuing additional ownership shares.

Information about this type of change is necessary to give users a complete understanding of why the reporting undertaking's economic resources and claims changed and the implications of those changes for its future financial performance.

Qualitative Characteristics of Financial Statements

It is important that financial information should be

• understandable
• relevant,
• important – material to the user
• reliable and
• comparable.

1 Understandable

An essential quality of the information is that it is readily understandable by users. Users are assumed to have a reasonable knowledge of business and accounting, and a willingness to study the information with reasonable diligence. Information about complex matters should not be excluded, merely on the grounds that it may be too difficult for certain users to understand.

EXAMPLE-understandability

You are in property development. Publishing architects’ and surveyors’ reports should be done, if this confirms specific aspects of your work. Not all of your users will understand these reports, but they will be able to take expert advice, if they so wish.

The same would apply to pension actuaries’ reports on pension schemes.

2 Relevance

Information has the quality of relevance when it helps users evaluate past, present or future events, or confirms (or corrects), their past evaluations.

The same information plays a confirmatory role in respect of past predictions about the way in which the undertaking would be structured, or the outcome of planned operations.

EXAMPLE -relevance

Reporting on segments of business activities may help users if your firm has diverse activities.

The relevance of information is affected by its nature and materiality. In some cases, the nature of information alone is sufficient to determine its relevance.

The predictive value and confirmatory value of financial information are interrelated. Information that has predictive value often also has confirmatory value.

For example, revenue information for the current year, which can be used as the basis for predicting revenues in future years, can also be compared with revenue predictions for the current year that were made in past years.

The results of those comparisons can help a user to correct and improve the processes that were used to make those previous predictions.

3 Important – Materiality

Information is material if its omission, or misstatement, could influence the decisions of users. Materiality depends on the size of the item (or error) judged in the circumstances of its omission (or misstatement).

EXAMPLE-materiality

Your business has previously been limited to your country. You have expanded into another country, in another continent, with a view to further foreign expansion. Though this may not be material to your business today, reporting of your results and commitments in this new market will help users understand your business.

In other cases, both the nature and materiality are important, for example, the amounts of inventories held in each of the main categories of the business.

EXAMPLE-materiality

A competitor has filed a lawsuit against you for a large amount of money. Your lawyers are concerned, but you believe the lawsuit to be frivolous. You should disclose this information as a contingent liability, with expression of your views, and those of the lawyers.

Materiality provides a threshold (or cut-off point) rather than being a primary qualitative characteristic, which information must have, if it is to be useful.

4 Reliability

Information has reliability when it is free from material error, and bias, and can be depended upon to represent that which it either purports to represent, or could reasonably be expected to represent.

EXAMPLE - reliabilty

If the validity, and amount of a claim, for damages under a legal action are disputed, it may be inappropriate to record the full amount of the claim in the balance sheet (although it may be appropriate to disclose the amount in the notes, and circumstances of the claim).

If information is to represent faithfully the transactions, it is necessary that they are presented in accordance with their substance, and economic reality, and not merely their legal form.

EXAMPLE-substance over form

An undertaking may dispose of an asset to another party so that the documentation purports to pass legal ownership to that party. Nevertheless, agreements may exist that ensure that the undertaking continues to enjoy the benefits from the asset. This may be done to raise finance, using the asset as collateral.

In such circumstances, the reporting of a sale would not represent faithfully the transaction.

Neutrality

The information contained in financial statements must be free from bias. Financial statements are not neutral if, by the presentation of information, they influence the making of a decision to achieve a predetermined result, or outcome.

EXAMPLE-neutrality

Accounts should not reflect an over-optimistic nor an over-pessimistic view. Provisions should reflect the current view of events and not be increased just because “surplus” profits are available. Accounts should not be distorted to achieve management targets, if these targets had not actually been met.

To be reliable, the information in financial statements must be complete taking account of materiality, and cost. An omission can cause information to be false, or misleading, and thus unreliable and deficient in terms of its relevance.

EXAMPLE-completeness

Major commitments and contingent liabilities can easily omitted from financial statements. Their omission may mislead users.

5 Comparability

Users must be able to compare the financial statements of an undertaking through time, to identify trends in its financial position, and performance.

Users must also be able to compare the financial statements of different undertakings in order to evaluate their relative financial position, performance and changes in financial position.

The measurement, and display, of the financial impact of similar transactions must be carried out in a consistent way by an undertaking, and over time, and in a consistent way for different undertakings.

An important implication of comparability is that users be informed of the policies employed in the financial statements, any changes in those policies, and the impacts of such changes.

EXAMPLE-consistent policies

Using different measurement systems of inventory (FIFO and weighted-average cost are permitted by IFRS) generates different results. Consistent use of one method is essential to allow users to compare one period with another. There should be no change of method, unless a Standard decrees it, or it would help users.

If other undertakings, in the same industry, use particular accounting policies, users will benefit if yours are consistent with theirs, to enable comparison.

Users need to be able to identify differences between the policies for like transactions, used by the same undertaking from period to period, and by different undertakings. Compliance with Standards, including the disclosure of policies, helps to achieve comparability.

Consistency refers to the use of the same methods for the same items, either from period to period within a reporting undertaking, or in a single period across undertakings. Comparability is the goal; consistency helps to achieve that goal.

Verifiability

Verifiability helps assure users that information faithfully represents the economic phenomena it purports to represent. Verifiability means that different knowledgeable and independent observers could reach consensus, although not necessarily complete agreement, that a particular depiction is a faithful representation. Quantified information need not be a single point estimate to be verifiable. A range of possible amounts and the related probabilities can also be verified.

Verification can be direct or indirect. Direct verification means verifying an amount or other representation through direct observation, for example, by counting cash. Indirect verification means checking the inputs to a model, formula or other technique and recalculating the outputs using the same methodology.

An example is verifying the carrying amount of inventory by checking the inputs (quantities and costs) and recalculating the ending inventory using the same cost flow assumption (for example, using the first-in, first-out method).

It may not be possible to verify some explanations and forward-looking financial information until a future period, if at all. To help users decide whether they want to use that information, it would normally be necessary to disclose the underlying assumptions, the methods of compiling the information and other factors and circumstances that support the information.

As users wish to compare the financial position, performance and changes in financial position over time, it is important that the financial statements show corresponding information for the preceding periods.

Constraints on Provision of Information

Certain limits have to be places on the quality of information. They include

Timeliness

Management may need to balance the relative merits of timely reporting, and the provision of reliable information. To provide information on a timely basis, it may often be necessary to report before all aspects of a transaction are known, thus impairing reliability.

Conversely, if reporting is delayed until all aspects are known, the information may be reliable, but of little use to those who have had to make decisions in the interim. In achieving a balance between relevance and reliability, the overriding consideration is how best to satisfy the needs of users.

Some information may continue to be timely long after the end of a reporting period because, for example, some users may need to identify and assess trends.

Balance Between Benefit and Cost

The benefits derived from information should not exceed the cost of providing it. The evaluation of benefits and costs is a judgmental process. The costs do not necessarily fall on those users who enjoy the benefits.

True and Fair View/Fair Presentation

Financial statements are frequently described as showing a ‘true and fair view’ of the financial position, performance, and changes in financial position of an undertaking.

The application of the principal qualitative characteristics, and of appropriate standards, normally results in financial statements that convey a ‘true and fair view’ of such information.

What are Financial Statements

There are three financial statements:

1. measurement of financial position;
2. the measurement of performance;
3. the measurements of the changes in financial position.

1 Financial Position - Balance Sheet (SFP)

The elements directly related to the measurement of financial position are assets, liabilities and equity. These are defined as follows:

(i) An asset is a resource, controlled by the undertaking, as a result of past events, and from which benefits will flow to the undertaking.

(ii) A liability is a present obligation, arising from past events, the settlement of which will be payment.

(iii) Equity is the residual interest in the assets, after deducting all liabilities.

EXAMPLE-equity – residual interest

You have $100 million of assets and $85 million of liabilities.

Your equity = $15 million.

Assets

The benefit embodied in an asset is its contribution (directly, or indirectly) to the flow of cash to the undertaking.

The benefit may be realised when goods are produced. It may also take the form of convertibility into cash (or a capability to reduce the costs of production).

Assets produce goods (or services) capable of satisfying the wants (or needs) of clients; clients are prepared to pay for them, and contribute to the cash flow of the undertaking.

Many assets, for example, property, plant and equipment, have a physical form. Physical form is not essential to the existence of an asset; hence patents and copyrights are assets, if benefits will flow from them, and if they are controlled by the undertaking

In determining the existence of an asset, the right of ownership is not essential.

EXAMPLE – property held on a lease

Property held on a lease is an asset, if the undertaking controls the benefits that will flow from the property.

An item may satisfy the definition of an asset, even when there is no legal control.

EXAMPLE-asset with no legal control.

Know-how obtained from a development activity may meet the definition of an asset when, by keeping that know-how secret, an undertaking controls the benefits that will flow from it.

The assets of an undertaking result from past transactions. Undertakings normally obtain assets by purchasing or producing them, but other transactions may generate assets; property received by an undertaking from government, as part of a program to encourage growth in an area, and the discovery of mineral deposits.

EXAMPLE-government grant

To generate employment in a depressed area, government may provide a range of grants. One option is to provide disused property to investors, either free, or at a low price.

Transactions expected to occur in the future do not in themselves give rise to assets; an intention to purchase inventory does not, of itself, meet the definition of an asset.

EXAMPLE-inventory on order

You have placed an order for inventory, which has yet to be delivered. This is not (yet) an asset, as you do not (yet) control it.

There is a close association between incurring expenditure and generating assets, but the two do not necessarily coincide. Hence, when an undertaking incurs expenditure, this may provide evidence that benefits were sought, but is not conclusive proof that an item satisfying the definition of an asset has been obtained.

Similarly the absence of a related expenditure does not preclude an item from satisfying the definition of an asset, and thus becoming a candidate for recognition in the balance sheet; items that have been donated to the undertaking may satisfy the definition of an asset.

EXAMPLE- absence of a related expenditure

To generate employment in a depressed area, government may provide a disused property to investors without payment. This donation provides the undertaking with an asset, even if related payments (to develop a business on the site) have yet to be made.

Liabilities

An essential characteristic of a liability is that the undertaking has a present obligation (to pay money). Obligations may be enforceable as a consequence of a binding contract, or statutory requirement. This is normally the case with amounts payable for goods (and services) received.

Obligations also arise from normal business practice, custom and a desire to maintain good business relations, or act in an equitable manner.

EXAMPLE – Voluntary obligation

If an undertaking decides (as a matter of policy) to rectify faults in its products, even after the warranty period has expired, the amounts expended, in respect of goods already sold, are liabilities.

A distinction needs to be drawn between a present obligation and a future commitment. A decision to acquire assets in the future does not, of itself, give rise to a present obligation.

An obligation normally arises only when the asset is delivered, or the undertaking enters into an irrevocable agreement to acquire the asset. The irrevocable nature of an agreement means that the undertaking must pay.

The settlement of a present obligation usually involves paying the other party. Settlement of a present obligation may occur in a number of ways, for example, by:

(i) payment of cash;

(ii) transfer of other assets (including barter);

(iii) provision of services;

(iv) replacement of that obligation with another obligation; or

(v) conversion of the obligation to equity.

An obligation may also be extinguished by other means, such as a creditor waiving, or forfeiting its rights.

Liabilities result from past transactions.

EXAMPLES - liabilities

The acquisition of goods (and the use of services) gives rise to trade payables (unless paid for in advance, or on delivery) and the receipt of a bank loan results in an obligation to repay the loan.

An undertaking may also record future rebates, based on annual purchases by clients, as liabilities; the sale of the goods in the past gives rise to the liability.

Some liabilities can be measured only by using estimation. Some undertakings describe these liabilities as provisions. In some countries, such provisions are not regarded as liabilities, as the concept of a liability is defined narrowly so as to exclude estimates. IFRS definition of a liability follows a broader approach.

When a provision involves a present obligation, and satisfies the rest of the definition, it is a liability, even if the amount has to be estimated.

EXAMPLE- estimated provision

You have been sued. You have lost the case. Your total costs are not finalised when the accounts are approved. You have estimated your provision for the costs of the liability.

Examples include provisions for payments to be made under existing warranties, and provisions to cover pension obligations.

Equity

Although equity is defined as a residual, it may be sub-classified in the balance sheet. In a corporate undertaking,

• funds contributed by shareholders,
• retained earnings,
• reserves representing appropriations of retained earnings, and
• reserves representing capital maintenance adjustments may be shown separately.

Such classifications can be relevant to the users of financial statements, when they indicate legal, or other restrictions, on the ability to distribute its equity. Parties with ownership interests have differing rights to the receipt of dividends, or the repayment of capital.

The creation of reserves is sometimes required by statute, to give the undertaking, and its creditors, more protection from the impacts of losses. An example for banks is the capital required to be maintained as a result of the Central Bank regulations.

Other reserves may be established, if national tax law grants exemptions from (or reductions in) taxation liabilities, when transfers to such reserves are made.

The existence and size of these legal and tax reserves is information that is relevant to users. Transfers to such reserves are appropriations of retained earnings, rather than expenses.

EXAMPLE- ‘legal’ reserves

Some jurisdictions require firms to donate 10% of annual profit to a reserve that cannot be distributed to shareholders (except in liquidation). Such regulations may be of concern to investors, as this will limit dividends.

The amount of equity, shown in the balance sheet, depends on the measurement of assets and liabilities. Normally, the aggregate amount of equity only by coincidence corresponds with the aggregate market value of the shares of the undertaking, or the sum that could be raised by disposing of the net assets on a piecemeal basis, or the undertaking as a whole on a going concern basis.

EXAMPLE- market valuations

The market valuation of your firm is much higher than the value of net assets.

This is due to investors valuing your firm for its anticipated future dividends, rather than its past performance.

Commercial, industrial and business activities are often undertaken by means of sole proprietorships, partnerships, trusts and various types of government business undertakings. The legal and regulatory framework for such undertakings is often different from that applying to corporate undertakings.

There may be few restrictions on the distribution to owners (or other beneficiaries) of amounts included in equity. Nevertheless, the definition of equity, and the other aspects of this framework that deal with equity, are appropriate for such undertakings.

Performance – Income Statement

Profit is used as a measure of performance, or as the basis for other measures (such as return on investment, or earnings per share). The elements directly related to profit are income and expenses. The recording and measurement of income and expenses (and hence profit) depends on the concepts of capital and capital maintenance used (see below).

The elements of income and expenses are defined as follows:

(i) Income creates increases in benefits, in the form of inflows (or enhancements) of assets, (or decreases of liabilities) that result in increases in equity, other than contributions from equity participants.

(ii) Expenses are decreases in benefits, in the form of outflows (or depletions) of assets, (or increases in liabilities) that result in decreases in equity, other than distributions to equity participants.

Income and expenses may be presented in the income statement in different ways, to provide information for decision-making. It is common practice to distinguish between those items of income (and expenses) that arise in the course of the ordinary activities, and those that do not.

This distinction is made for evaluating the ability to generate cash in the future. Incidental activities, such as the disposal of a long-term investment, do not recur on a regular basis.

Consideration needs to be given to the nature of the undertaking, and its operations. Items that arise from the ordinary activities of one undertaking may be unusual in another.

EXAMPLE – ordinary activities

For many firms, buying and selling property is a rare event.

To house builders and property developers, it is an ordinary activity.

Distinguishing between items of income and expense, and combining them in different ways, also allows several measures of undertaking performance to be displayed.

For example, the income statement could display:

• gross margin,
• profit from ordinary activities before taxation,
• profit from ordinary activities after taxation, and
• net profit.

Income

Income encompasses both revenue and gains. Revenue arises from the ordinary activities of an undertaking, and includes:

• sales,
• fees,
• interest,
• dividends,
• royalties and
• rent.

Gains represent other items of income, and may (or may not) arise in the course of the ordinary activities of an undertaking. Gains represent increases in benefits, and are no different in nature from revenue.

Gains include those arising on the disposal of non-current assets. The definition of income also includes unrealised gains: those arising on revaluations of marketable securities, and from increases in the carrying amount of long term assets.

EXAMPLE-unrealised gain

You have revalued your head office (but have not sold it). The revaluation gain is unrealised, and will remain so, until you sell it.

The revaluation gain is shown in the revaluation reserve.

When gains are recorded in the income statements, they are displayed separately, because knowledge of them is useful for decisions. Gains are often reported net of related expenses.

EXAMPLE- gains on foreign currencies

You are an importer. You make currency gains (and losses) as a result of foreign trading transactions. These are shown as a separate line in your income statement. These are shown net of bank (currency) transaction charges.

Various kinds of assets may be received (or enhanced) by income: cash, receivables, and goods (and services) received in exchange for goods (and services) supplied.

Income may also result from the settlement of liabilities. An undertaking may provide goods (and services) to a lender, in settlement of an outstanding loan.

Expenses

The definition of expenses encompasses losses, as well as those expenses that arise in ordinary activities of the undertaking.

Expenses that arise in the course of the ordinary activities include cost of sales, wages and depreciation. They usually take the form of an outflow (or depletion) of assets, such as cash and cash equivalents, inventory, property, plant and equipment.

Losses represent other items that meet the definition of expenses, and may (or may not) arise in the course of ordinary activities. Losses represent decreases in benefits, and they are no different in nature from other expenses.

Losses include those resulting from disasters such as fire and flood, as well as those arising on the disposal of non-current assets.

The definition of expenses also includes unrealised losses, for example, those arising from increases in the rate of exchange for a foreign currency, in respect of the borrowings of an undertaking in that currency.

EXAMPLE- losses on foreign currencies

You are an importer. You make currency losses (and gains) as a result of foreign trading transactions. These are shown as a separate line in your income statement. These are shown net of bank (currency) transaction charges.

When losses are recorded in the income statement, they are usually displayed separately, as knowledge of them is useful for decisions. Losses are often reported net of related income.

Recognition of the Elements of Financial Statements

Recognition is the process of recording (in the balance sheet or income statement) an item that meets the definition of an element, and satisfies the criteria for recognition.

It involves the depiction of the item in words, and by a monetary amount, and the inclusion of that amount in the balance sheet (or income statement) totals. Items that satisfy the recognition criteria should be recorded in the balance sheet, or income statement.

The failure to record such items is not rectified by disclosure of the policies used, nor by notes or explanatory material.

EXAMPLE- warranties unbooked

You know that you will have to pay warranty claims for goods that you have sold. You have not included a warranty provision in your accounts. It is not sufficient to mention in the notes that this has not been done. The warranty provision should be made in the accounts themselves.

An item that meets the definition of an element should be recorded if:

(i) it is probable that any benefit of the item will flow to (or from) the undertaking; and

(ii) the item has a cost, or value, that can be measured with reliability.

In assessing whether an item meets these criteria, regard needs to be given to the materiality considerations above.

The Probability of Future Benefit

The concept of probability refers to the degree of uncertainty that the benefits associated with the item will flow to (or from) the undertaking. Assessments of the uncertainty of the flow of benefits are made on the evidence available, when the financial statements are prepared.

When it is probable that a receivable will be paid, it is justifiable to record the receivable as an asset. For a large population of receivables, some degree of non-payment is normally considered probable; hence an expense representing the expected reduction in benefits is recorded.

EXAMPLE- probability of future benefit

You know that some of your inventory is obsolete. Any benefit will be limited to its scrap value. You make an obsolescence provision to reduce this inventory’s carrying value.

Reliability of Measurement

The second criterion (for the recognition of an item) is that it has a cost (or value) that can be measured with reliability. Cost (or value) may be estimated, and does not undermine their reliability.

When an estimate cannot be made, the item is not recorded in the balance sheet (or income statement). The expected proceeds from a lawsuit may meet the definitions of both asset and income, as well as the probability criterion for recognition.

If the claim cannot be measured reliably, it should not be recorded as an asset, or as income; the existence of the claim should be disclosed in the notes, explanatory material or supplementary schedules. (see IAS 37)

An item that, at first, fails to meet the recognition criteria may qualify for recognition at a later date, as a result of subsequent events.

EXAMPLE- later recognition

At the start of a lawsuit, the result may be difficult to estimate, and only a contingent liability can be noted.

As a lawsuit nears conclusion, the result may be estimable, and a provision or asset may be recorded.

An item that possesses the characteristics of an element, but fails to meet the criteria for recognition, may nonetheless warrant disclosure in the notes.

This is appropriate when knowledge of the item is relevant to the evaluation of the financial position, performance and changes in financial position of an undertaking.

Recognition of Assets

An asset is recorded when it is probable that the benefits will flow to the undertaking, and the asset has a cost (or value) that can be measured reliably.

An asset is not recorded when costs have been incurred, but it is improbable that benefits of this expenditure will flow beyond the current accounting period. Such a transaction results in the recognition of an expense in the income statement.

EXAMPLE- asset recognition

General administration salaries are expensed when incurred, and not treated as an asset. There is a presumption that no benefits, related to them, will flow beyond the current accounting period.

Recognition of Liabilities

A liability is recorded when it is probable that an outflow of resources will result from the settlement of an obligation, and the amount can be measured reliably.

EXAMPLE-No obligation, no liability

Amounts that will be paid for inventory ordered (but not yet received) are not recorded as liabilities.

Recognition of Income

Income is recorded when an increase in benefits, related to an increase in an asset (or a decrease of a liability) has arisen that can be measured reliably.

Recognition of income occurs simultaneously with the recognition of increases in assets (or decreases in liabilities). Examples are: the net increase in assets arising on a sale of goods (or services), or the decrease in liabilities from the waiver of a debt payable.

EXAMPLE- debt waiver (see IAS 20)

Some government grants are given in the form of loans. As the firm meets the terms of the grant (such as the number of jobs that are to be created), the government may cancel part of the loan. This cancellation is shown as income,(and should be matched with the related expenditure).

Procedures restrict the recognition (as income) to items that can be measured reliably, and have a sufficient degree of certainty.

Recognition of Expenses

Expenses are recorded when a decrease in benefits (related to a decrease in an asset, or an increase of a liability) has arisen, that can be measured reliably.

Recognition of expenses occurs with the recognition of an increase in liabilities, or a decrease in assets (for example, the accrual of employee entitlements, or the depreciation of equipment).

Expenses are recorded on the basis of a direct association between the costs incurred, and the earning of specific items of income. This is called the matching of costs with revenues. It involves the recognition of revenues and expenses that result directly, and jointly, from the same transactions.

EXAMPLE-matching

When goods are sold, the cost of those sales, and all costs of delivery and commission should be booked to provide the full transaction.

Various components of expense, comprising the cost of goods sold, are recorded at the same time as the income, derived from the sale of the goods. The application of the matching concept does not allow the recognition of items in the balance sheet which do not meet the definition of assets, or liabilities.

When benefits arise over several periods, and the link to income can only be broadly determined, expenses are recorded in the income statement, on the basis of systematic (and rational) allocation procedures.

EXAMPLE-construction contracts (see IAS 11)

Construction contracts involve a number of accounting periods, involving a spreading of both revenue and costs on a systematic basis.

This is necessary in recording the expenses associated with the using up of assets such as property, plant, equipment, goodwill, patents and trademarks.

Such expense is referred to as depreciation, or amortisation. These allocations are intended to record expenses in the periods in which the benefits are consumed, or expire.

An expense is recorded immediately in the income statement when an expenditure produces no benefits.

An expense is also recorded when a liability is incurred without the recognition of an asset, as when a liability under a product warranty arises.

Accounting Measurement

Measurement is the process of determining the amounts at which transactions are recorded, and carried in the balance sheet and income statement. This involves the selection of the particular basis of measurement.

A number of different measurement bases are employed in financial statements. They include the following:

(i) Historical cost. Assets are recorded at the amount of cash paid (or the fair value of the consideration given). Liabilities are recorded at the amount received in exchange for the obligation, or for items such as income taxes, at the amounts to be paid to satisfy the liability, in the normal course of business.

1. . Assets are carried at the amount that would have to be paid if the same (or an equivalent) asset was acquired today. Liabilities are carried at the undiscounted amount that would be required to settle the obligation today.

EXAMPLE- current cost

You hold assets and liabilities in foreign currency. At the balance sheet date, you revalue them to reflect the current exchange rates (‘marking to market’).

(iii) Realisable (settlement) value. Assets are carried at the amount that could currently be obtained by selling the asset (in the normal course of business). Liabilities are carried at their settlement values: the undiscounted amounts to be paid to satisfy the liabilities, in the normal course of business.

EXAMPLE- realisable value

For certain assets, you chose to use ‘fair values’ in the balance sheet. You find the market prices, and apply them to the assets.

(iv) Present value. Assets are carried at the present discounted value of the net cash inflows that the item will generate, in the normal course of business. Liabilities are carried at the present discounted value of the net cash outflows, which will be required to settle the liabilities, in the normal course of business.

EXAMPLE-present value

You have a provision for decommissioning costs for a mine. The work will not be carried out for 20 years, and the amount is material. You discount the cost to present value (see IAS 37).

The measurement basis most commonly is historical cost. This is usually combined with other bases. Inventories are usually carried at the lower of cost and net realisable value, marketable securities may be carried at market value and pension liabilities are carried at their present value.

Some undertakings use the current cost basis, due to the inability of the historical cost accounting to deal with the impact of inflation of non-monetary assets.

Concepts of Capital and Capital Maintenance

Concepts of Capital

A financial concept of capital is adopted by most undertakings in preparing their financial statements. Under a financial concept of capital, such as invested money, or invested purchasing power, capital is synonymous with the net assets (or equity) of the undertaking.

EXAMPLE- financial concept of capital

Your national inflation =10% per year. If an investment in your company yields less than 10%, investors’ purchasing power will have fallen.

If you provide a return of more than 10%, investors will deduct their loss of purchasing power from the return that you have generated.

In summary, only returns above the national rate of inflation will be considered to be profits.

Under a physical concept of capital, such as operating capability, capital is regarded as the productive capacity of the undertaking, based on units of output.

EXAMPLE- physical concept of capital

Your national inflation =10% per year. However, oil is your basic raw material, and your costs have increased by 25%.

If an investment in your company yields less than 25%, the company’s operating capability will have fallen.

In summary, only returns above the company’s rate of inflation will be considered to be profits.

The selection of the appropriate concept of capital by an undertaking should be based on the needs of users. A financial concept of capital should be adopted if the users are primarily concerned with the maintenance of nominal invested capital, or the purchasing power of invested capital.

If the main concern of users is with the operating capability of the undertaking, a physical concept of capital should be used.

The concept chosen indicates the goal to be attained in determining profit, even though there may be some measurement difficulties in making the concept operational.

Concepts of Capital Maintenance and the Determination of Profit

Financial capital maintenance. Under this concept, a profit is earned if the financial amount of the net assets at the end of the period exceeds those at the beginning of the period. (This excludes any distributions to, and 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. Under this concept, a profit is earned only if the physical productive capacity (or operating capability) of the undertaking at the end of the period exceeds the capacity at the beginning of the period, (after excluding any distributions to, and contributions from, owners during the period).

Only inflows of assets, in excess of amounts needed to maintain capital, may be regarded as profit, and as a return on capital.

EXAMPLE- working capital in times of inflation

During times of high inflation (either for the individual firm, or for the nation)

extra working capital (inventory and accounts receivable minus accounts payable) will be needed just to continue operating at the same level. Each replacement item of inventory will be more expensive, as will each account receivable, though mitigated by higher accounts payable.

The firm needs more cash to finance operations. At the same time, investors want higher returns, due to the loss in purchasing power.

Profit is the residual amount that remains after expenses (including capital maintenance adjustments) have been deducted from income. If expenses exceed income, the shortfall is a net loss.

The physical capital maintenance concept requires the adoption of the current cost basis of measurement.

EXAMPLE- physical capital maintenance concept –inventory

Inventory needs to be valued at current cost, rather than historic cost, to record the cost of the inventory replacement at its replacement cost.

If inflation is high, there may be a substantial difference between historic and current cost.

The financial capital maintenance concept does not require the use of a particular basis of measurement. The basis under this concept is dependent on the type of financial capital that the undertaking is seeking to maintain.

The principal difference between the two concepts of capital maintenance is the impacts of changes in the prices of assets, and liabilities, of the undertaking.

An undertaking 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 amount above that is profit.

Under the concept of financial capital maintenance, where capital is defined in terms of nominal monetary units, profit represents the increase in nominal money capital over the period. Increases in the prices of assets held over the period, (‘holding gains’), are conceptually, profits. They may not be recorded as such, until the assets are disposed of.

EXAMPLE-holding gain

You hold a property. That property has appreciated, at the balance sheet date. You choose not to revalue the property. At the balance sheet date, you have an (unrealised) ‘holding gain’.

When the concept of financial capital maintenance is defined in terms of constant purchasing power units, profit represents the increase in invested purchasing power over the period. Only the increase in the prices of assets that exceeds inflation is regarded as profit. The rest of the increase is treated as a capital maintenance adjustment, and as part of equity.

Under the concept of physical capital maintenance, when capital is defined in terms of capacity, profit represents the increase in that capital over the period.

All price changes affecting the assets (and liabilities) are viewed as changes in the measurement of the physical productive capacity of the undertaking: they are treated as capital maintenance adjustments, that are part of equity, and not as profit.

The selection of the measurement bases, and concept of capital maintenance, will determine the accounting model used in the preparation of the financial statements.

Different accounting models exhibit different degrees of relevance and reliability, and management must seek a balance between relevance and reliability.

This framework is applicable to a range of accounting models and provides guidance on preparing and presenting the financial statements constructed under the chosen model.