Conceptual Framework

Weeks 4 & 5: Conceptual Framework

Learning Objectives

• Become familiar with the terms “GAAP” & “IFRS.”
• Recognize the value of accounting standards and international harmonization.
• Understand the role of the Conceptual Framework.
• Know the purpose of financial reporting and of financial statements.
• Identify the primary users of financial statements.
• Know and be able to apply the qualitative characteristics of useful financial information.
• Understand the going concern assumption.
• Know and be able to apply the asset and liability definitions.
• Know and be able to apply the recognition criteria.
• Be familiar with the different measurement bases.

Accounting

• Accounting is the recording of financial information and reporting it.
• Management accounting provides reports for management.
• Financial accounting (Financial Reporting) produces financial statements for external users.

Objectives

• Who are the primary users of financial reporting? Existing & potential investors, lenders, and other creditors.
• What is the objective of financial reporting? To provide financial information that is useful to users in making decisions relating to providing resources to the entity.
• What is the objective of financial statements? To provide financial information about the assets, liabilities, equity, income, and expenses that is useful in assessing the prospects of future net cash inflows.

The Need for International Standards: Daimler-Benz Example

• In 1993, Daimler-Benz, already listed on the German Stock Exchange, wanted to list on the NYSE as well.
• Two sets of financial statements were prepared for 1993 using GAAP from the two different countries.
  • Under German rules (German GAAP), Daimler-Benz reported a profit of DM$615$m.
  • Under American rules (US GAAP), Daimler-Benz reported a loss of DM$1.8$b.
• This highlighted the desperate need to make accounting standards globally applicable.

Financial Accounting Standards

• Why is the preparation of financial statements regulated?
  • So external users can rely on them.
• What do we call regulation that applies to the preparation of financial statements?
  • Generally Accepted Accounting Practice (GAAP).
• Who sets the accounting standards used by SA’s companies?
  • International Accounting Standards Board (IASB).
• What are these standards called?
  • International Financial Reporting Standards (IFRS).

IFRS Standards

• IFRS 2 Share-based Payment
• IFRS 9 Financial Instruments
• IFRS 10 Consolidated Financial Statements
• IFRS 15 Revenue from Contracts with Customers
• IFRS 16 Leases
• IFRS 17 Insurance Contracts
• IFRS 18 Presentation of Financial Statements
• IAS 2 Inventories
• IAS 7 Statement of Cash Flows
• IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors
• IAS 10 Events after the Reporting Period
• IAS 16 Property, Plant and Equipment
• IAS 17 Leases
• IAS 18 Revenue
• IAS 19 Employee Benefits
• IAS 36 Impairment of Assets
• IAS 37 Provisions, Contingent Liabilities and Contingent Assets
• IAS 38 Intangible Assets
• IAS 39 Financial Instruments: Recognition and Measurement
• IAS 40 Investment Property

The Conceptual Framework

• All of the standards are based on the 85-page Conceptual Framework for Financial Reporting.
• Chapters:
  • Chp 1: The objective of financial reporting
  • Chp 2: Qualitative characteristics of useful financial information
  • Chp 3: Financial statements and the reporting entity
  • Chp 4: The elements of financial statements
  • Chp 5: Recognition and derecognition
  • Chp 6: Measurement
  • Chp 7: Presentation and disclosure
  • Chp 8: Concepts of capital and capital maintenance

Qualitative Characteristics of Useful Financial Information

• Fundamental Characteristics: Without these, information is not useful.
  • Relevance
    • Predictive value
    • Confirmatory value
  • Faithful representation
    • Complete
    • Neutral
    • Free from error
• Enhancing Characteristics: These enhance the usefulness of information.
  • Comparability
  • Verifiability
  • Timeliness
  • Understandability

Relevance

• Capable of making a difference to users’ decisions.
• Can be used to predict future outcomes.
• Provides feedback about previous evaluations.
• Materiality: Information is material if omitting or misstating it could influence a user’s decisions. Threshold is entity-specific.
• Cost constraint: Costs of reporting information must be justified by its usefulness. It is impossible to provide all information that a user finds relevant.

Relevance Examples

• Example 1: Financial statements for the financial year ended 30 June 2024 (most recent available).
  • Relevant because it is capable of making a difference to a user's decisions.
  • The information has predictive value.
  • Alternatively, if outdated, information reduces the predictive value.
• Example 2: Two machines at the back that appear not to have been used for years. The owner explains that they broke down in 2021 and are now virtually worthless. However, they are still on the statement of 2024 financial position, measured at their original cost.
  • Reporting a value for an asset that is not being used and worthless, reduces the predictive value of the financial statements.

Faithful Representation

• Includes all information necessary for understanding.
• Assets & income not overstated; liabilities and expenses not understated.
• Supports neutrality (prudence).
• Complete
• Neutral
• Free from error
• Without bias; not slanted, weighted, emphasized, de-emphasized, manipulated, etc.
• Description & process are without error; does not necessarily mean perfectly accurate.
• Reveals the substance, rather than merely the legal form, of the economic phenomenon.

Faithful Representation Examples

• Example 1: The financial statements include a statement of financial position and a statement of changes in equity, and one statement of financial performance: the statement of cash flows. The owner explains to you that this is sufficient because the users of the business' financial statements care only about how much cash it generates. "Cash is king!", she says.
  • To faithfully represent the financial performance of the business, the financial statements must be complete. A Statement of Comprehensive Income contains necessary information.
• Example 2: When you contrast the 2024 financial statements to the 2023 financial statements, you notice that they have been prepared according to different accounting policies. No. information is available to understand what the 2023 results would have been had they been prepared using 2024 accounting policies.
  • To faithfully represent the financial affairs of the business, the financial statements must be complete. Policy information is necessary for the financial statements to be useful.
• Example 3: The financial statements were prepared using many estimates. One estimate is an amount of R$15$ million for the value of the business's brand. When you ask the owner of Engafani how thisvalue was established, she explains that she engaged two brand valuation firms to value thebrand. One valued the business' brand at R$6$ million; the other came up with the R$15$ millionfigure. She used the higher figure because she says she has a very strong feeling that the brandis worth at least that much.
  • To faithfully represent the financial affairs of the business, the financial statements must be neutral. The owner's opinion about the brand's value may be subject to bias. It is not prudent to risk overvaluing an asset.
• Example 4: In conversation with the owner, you discover that in the 2024 financial year the businessentered into a sale-and-leaseback arrangement for its main business premises, and yet there isno information about this in the financial statements. When you ask her about this, sheexplains that she prefers to leave out any information that may be too complex tounderstand for her investors, many of whom are not experienced businesspeople.
  • To faithfully represent the financial affairs of the business, the financial statements must be complete. Information about the sale-and-leaseback is necessary for the financial statements to be useful.
• Example 5: Two machines at the back that appear not to have been used for years. The owner explains that they broke down in 2021 and are now virtually worthless. However, you notice that they are still on the statement of 2024 financial position, measured at their original cost.
  • By reporting an asset at an amount greater than expected economic benefits, the asset is being overstated and this is not prudent.

Enhancing Characteristics

• Comparability: Across time for one entity; and across different entities. Not uniformity. Consistency helps.
• Verifiability: Different, knowledgeable, independent observers would reach consensus. Can be direct or indirect.
• Timeliness: Information provided in time to influence decisions.
• Understandability: Present information clearly & concisely. Assumes a reasonable knowledge of business, and diligent review. May not omit complex information.

Enhancing Characteristics Examples

• Example 1: The financial statements are for the financial year ended 30 June 2024. This is the most recent set of financial statements available.
  • These financial statements are timely as in March 2025, a user would be able to use financial statements for the year ended 30 June 2024.
  • These financial statements are not timely as in March 2025, a user would not be able to use financial statements for the year ended 30 June 2024.
• Example 2: When you contrast the 2024 financial statements to the 2023 financial statements, you notice that they have been prepared according to different accounting policies. No information is available to understand what the 2023 results would have been had they been prepared using 2024 accounting policies.
  • An entity's financial statements are not comparable if they cannot be compared across time. Changing accounting policies requires additional information to achieve comparability.
• Example 3: The financial statements were prepared using many estimates. One estimate is an amount of R$15$ million for the value of the business's brand. When you ask the owner of Engafani how this value was established, she explains that she engaged two brand valuation firms to value the brand. One valued the business' brand at R$6$ million; the other came up with the R$15$ million figure. She used the higher figure because she says she has a very strong feeling that the brand is worth at least that much.
  • Verifiability requires that different, knowledgeable, independent observers would reach consensus. Given the process followed (accepting one estimate even though the 2 estimates were so far apart), it is unknown whether different, knowledgeable, independent observers would reach an amount similar to the amount on the SOFP.
• Example 4: In conversation with the owner, you discover that in the 2024 financial year the business entered into a sale-and-leaseback arrangement for its main business premises, and yet there is no information about this in the financial statements. When you ask her about this, she explains that she prefers to leave out any information that may be too complex to understand for her investors, many of whom are not experienced businesspeople.
  • Understandability specifically requires that businesses do not omit complex information; and asks businesses to assume that users have a reasonable knowledge of business.
• Example 5: Inventory is reported on the statement of financial position, but there is no further information about inventory in the notes to the financial statements. Instead, the entire inventory general ledger account has been attached to the financial statements.
  • Understandability requires that businesses present information clearly and concisely. Appending the entire inventory account is not a concise way of presenting information about inventory.