The Conceptual Framework for Financial Reporting 2010 provides important information on the concepts which underlie the preparation and presentation of financial statements for the benefit of all financial statement users. It has several components which are outlined in figure 1 below.
Outline of the IASB Conceptual Framework
Figure 1 – IFRS Framework for the Preparation and Presentation of Financial Reports
The Conceptual Framework (2010) has a core objective from which all other aspects of the framework flow. This central objective is: to provide financial information which is useful to both current and potential providers of resources (investors, lenders, other creditors) in the making of decisions. The financial information to be provided will include (i) information on a company’s financial position i.e. its resources and financial obligations; (ii) information on its financial performance i.e. information which explains why the company’s financial position changed in the past; and (iii) information on the company’s cash.
The Conceptual Framework (2010) identifies relevance and faithful representation as the two fundamental qualitative characteristics which make financial information useful. Financial information is relevant if it would potentially affect or make a difference in a user’s decision. Faithful representation relates to the fact that information which faithfully represents an economic phenomenon that it allegedly represents is ideally complete, neutral, and free from error.
The Conceptual Framework (2010) also identifies comparability, verifiability, timeliness, and understandability as the four enhancing qualitative characteristics:
- Comparability permits the identification and understanding of similarities and differences between items of information.
- Verifiability means that different observers would independently agree that the information that is presented faithfully represents the economic phenomena that it alleges to represent.
- Timeliness means that information is available to decision-makers on a timely basis prior to the need for a decision to be made.
- Understandability means that the information should be understandable by users who have a reasonable knowledge of business and economic activities, and who are willing to diligently study the information.
Constraints on Financial Reports
The cost of providing and using financial information is a constraint which must be balanced with the benefits that are to be derived from this information.
Elements of Financial Statements
The financial effects of transactions and other events are represented in financial statements by grouping them into broad classes or elements according to their economic characteristics.
The elements of financial statements that are directly related to financial positions are assets, liabilities, and equity, while the elements directly related to financial performance are income and expenses.
Accrual accounting and ‘going concern’ are two key assumptions which underlie the preparation of financial statements and determine how financial statement elements are recognized and measured. Accrual accounting means that financial statements reflect transactions in the period in which they occur and not necessarily when cash movement occurs. ‘Going concern’ means that a company is assumed to continue in business for the foreseeable future.
Recognition refers to the inclusion of an item on the balance sheet or income statement. An item should be recognized if it is probable that future economic benefits that are associated with it will flow to or from the reporting entity, and it has a cost or value that can be reliably measured.
In measuring financial statement elements, the following bases of measurement may be used:
- Historical cost: This refers to the amount of cash or cash equivalents paid or the fair value of what was given to purchase an asset. In relation to liabilities, it refers to the amount of proceeds received in exchange for an obligation.
- Amortized cost: This refers to the historical cost after adjustments are made for amortization, depreciation, depletion and/or impairment.
- Current cost: In relation to assets, this refers to the amount of cash or cash equivalents that would have to be paid to purchase the same or an equivalent asset today. In relation to liabilities, the current cost refers to the undiscounted amount of cash or cash equivalents that is required to settle the obligation today.
- Realizable (settlement) value: Realizable value refers to the amount of cash or cash equivalents that could currently be obtained by selling an asset in an orderly disposal. In relation to liabilities, settlement value refers to the undiscounted amount of cash or cash equivalents that are expected to be paid to satisfy the liabilities in the normal course of business.
- Present value: In relation to assets, this refers to the present discounted value of the future net cash inflows that an asset is expected to generate during the normal course of business. In relation to liabilities, PV refers to the present discounted value of the future net cash outflows that are expected to be required to settle the liabilities of the normal course of business.
- Fair value: This refers to the amount at which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction.
Which of the following are the two fundamental qualitative characteristics which the Conceptual Framework (2010) has identified as making financial information useful?
A. Timeliness and understandability
B. Accrual accounting and going concern
C. Relevance and faithful representation
The correct answer is C.
The Conceptual Framework (2010) identifies relevance and faithful representation as the two fundamental qualitative characteristics which make financial information useful. ‘Timeliness’ and ‘understandability’ are two of the enhancing qualitative characteristics, while ‘accrual accounting’ and ‘going concern’ are the underlying assumptions identified by the Conceptual Framework (2010).
Reading 22 LOS 22d:
Describe the International Accounting Standards Board’s conceptual framework, including the objective and qualitative characteristics of financial statements, required reporting elements, and constraints and assumptions in preparing financial statements