Conceptual Framework

Purpose of Financial Statements

• Main Financial Statements:

  • Statement of Financial Position: Shows the financial position of an entity at a specific point in time.

  • Statement of Profit or Loss and Other Comprehensive Income: Captures the performance of a business over a period through income and expenses.

  • Statement of Changes in Equity: Shows changes in equity from transactions with owners, comprehensive income, and other adjustments.

  • Statement of Cash Flows: Provides information about cash inflow and outflow over a period.

Definitions of Key Financial Terms

• Assets: What a company owns that has value (e.g., cash, inventory).

• Liabilities: What a company owes to others (e.g., loans, payables).

• Equity: The owner's residual interest in the assets after liabilities have been deducted.

• Income: Earnings from primary business activities or other sources (e.g., revenue from sales).

• Expenses: Costs incurred in earning income (e.g., cost of goods sold, operating expenses).

Importance of Definitions

• These terms frequently appear in multiple-choice questions on accounting exams.

• Learning definitions verbatim is crucial for selecting the right answers.

Key Accounting Concepts

• Going Concern: The assumption that a business will continue to operate for the foreseeable future (usually the next twelve months).

• Accruals: Recognizing transactions when they occur, regardless of cash flow.

• Prudence: Recognizing expenses and liabilities as soon as possible, but revenues only when they are assured.

• Duality: The accounting equation, where every transaction affects two accounts.

• Historic Cost: Recording assets at their original purchase cost.

Qualitative Characteristics of Financial Information

• Fundamental Characteristics:

  • Relevance: Information must be relevant to the decision-making needs of users.

  • Faithful Representation: Information must accurately reflect what it represents.

• Enhancing Characteristics:

  • Comparability: Users should be able to compare the financial statements across time and entities.

  • Verifiability: Information should be supported by evidence, enabling different knowledgeable users to reach consensus.

  • Timeliness: Information should be available when needed for decision-making.

  • Understandability: Information must be presented clearly to users.

Conceptual Framework Overview

• The framework has eight chapters, of which the following four are relevant for exams:

  1. Objective of Financial Reporting

  2. Qualitative Characteristics

  3. Financial Statements and Reporting Entity

  4. Elements of Financial Statements (Assets, Liabilities, Equity, Income, and Expenses)

• The framework guides the recognition and measurement in financial statements.

Going Concern Illustration

• Example: A retailer buys 20 washing machines for $100 each and sells 17 for $150 each.

  • Forced Sale Value: If the business closes, remaining machines valued at $60 each (not at cost or expected selling price).

  • Continuing Business Value: If intending to continue, machines valued at cost ($100 each) or lower realistic selling price ($150 each).

Accruals Basis Concept

• Transactions should be accounted for when they occur, regardless of cash flow. This aligns revenues and expenses correctly, depicting the true financial performance.

• Matching Principle: Revenues and expenses should be matched in the same accounting period.

Prudence Concept

• Always record expected losses but do not anticipate profits, ensuring a conservative approach in preparing financial statements.

Key Takeaways

• Understand the main financial statements and their purposes.

• Memorize key definitions, as they are frequently tested.

• Focus on understanding the qualitative characteristics to answer narrative questions correctly.

• Recognize the importance of the going concern assumption in asset valuation.