Conceptual Framework Notes

Week 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.

Introduction to Financial Accounting/Reporting

• Accounting involves:

  • Recording financial information (bookkeeping).
  • Reporting financial information.

• Types of accounting:

  • Management accounting: Generates reports for internal management use.
  • Financial accounting (financial reporting): Prepares financial statements for external users.

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 South African companies?
  • International Accounting Standards Board (IASB).
• What are these standards called?
  • International Financial Reporting Standards (IFRS).

Examples of IFRS and IAS Standards

• 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 Standards:
  • 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 IFRS standards are based on the Conceptual Framework for Financial Reporting (85 pages).
• 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.

Objectives of Financial Reporting

• 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 & expense that is useful in assessing the prospects of future net cash inflows and management’s stewardship of the entity’s resources.

Qualitative Characteristics of Useful Financial Information

• Fundamental characteristics (Without these, information is not useful):
  • Relevance:
    • Predictive value.
    • Confirmatory value.
    • Materiality: Information is material if omitting or misstating it could influence a user’s decisions. The threshold is entity-specific.
  • Faithful representation:
    • Complete: Includes all information necessary for understanding.
    • Neutral: Without bias; not slanted, weighted, emphasized, de-emphasized, or manipulated.
    • Free from error: Description & process are without error; not necessarily perfectly accurate.
• Enhancing characteristics (These enhance the usefulness of information):
  • Comparability: Across time for one entity and across different entities. Consistency helps.
  • Verifiability: Different, knowledgeable, independent observers would reach consensus. Can be direct or indirect.
  • Timeliness: Information is 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.
• Cost constraint: Costs of reporting information must be justified by its usefulness. It is impossible to provide all information that a user finds relevant.

Underlying Assumptions of Financial Statements

• Going concern assumption:
  • Financial statements are normally prepared on the assumption that the reporting entity is a going concern and will continue in operation for the foreseeable future. Hence, it is assumed that the entity has neither the intention nor the need to enter liquidation or to cease trading.
  • If such an intention or need exists, the financial statements may have to be prepared on a different basis. If so, the financial statements describe the basis used.
• Accrual Basis
  • Depicts effect of transaction in the period in which assets or liabilities change, even if the cash receipts and payments occur in a different period.
  • Revenue is recognized when earned and expenses when incurred. It matches revenue and expenses to the period in which they occur, rather than when cash is received or paid.

The Elements of the Financial Statements

• Asset: A present economic resource controlled by the entity as a result of past events.
  • An economic resource is a right that has the potential to produce economic benefits.
• Liability: A present obligation of the entity to transfer an economic resource as a result of past events.
• Equity: The residual interest in the assets of the entity after deducting all its liabilities. $A – L = E$
• Income: Increases in assets, or decreases in liabilities, that result in increases in equity, other than those relating to contributions from holders of equity claims (owners).
• Expense: Decreases in assets, or increases in liabilities, that result in decreases in equity, other than those relating to distributions to holders of equity claims (owners).

Asset Definition and Recognition Criteria

• Definition:
  • A present economic resource
  • Controlled by the entity
  • As a result of past events
• Recognition criteria:
  • Recognition provides relevant info about the item.
    • There is no existence uncertainty about the item
    • The probability of a flow of economic benefits is not low
  • Recognition provides a faithful representation: the level of measurement uncertainty is not high

An Economic Resource (Assets)

• A right that has the potential to produce economic benefit (e.g., right to use a physical object, right to use intellectual property, receive cash, goods, services, or other economic resources).
• Economic benefits (EBs) include cash, other economic resources, avoidance of cash outflows.
• “Potential” EBs do not have to be certain or even likely: benefits must merely arise “in at least one circumstance”.
• Controlled by the entity: Ability to direct the use of the resource and obtain the EBs. Usually true when the entity owns the resource, except where the ability has been transferred to another party.
• Present as a result of past events: The key event giving rise to control is in the past.

Control: FOB (Free on board)

• FOB Shipping Point:
  • At supplier: Supplier's asset
  • Loaded at shipping point: Supplier's asset
  • Unloaded at destination: Customer’s asset
  • At customer: Customer’s asset
• FOB Destination:
  • The legal term indicating who is responsible for an asset during transit.
• When do we obtain control?
  • If FOB Shipping Point: Supplier loads.
  • If FOB Destination: Arrives at destination.
  • If the business obtains the ability to direct its use on delivery (assume this if the question doesn’t specify).
    • Delivery to premises.
    • Installation.
    • Safety checks.
  • If, per contract, the supplier retains the ability to direct its use until installation is complete: Again, see the contract.

Journal entries for a typical asset purchase

• Order asset: No JE
• Pay deposit: DR Receivables (A), CR Bank (A)
• Obtain control: DR Inventory, PPE, etc. (A), CR Receivables (A) or CR Payables (L) or CR Bank (A)
• Pay balance: DR Payables (L), CR Bank (A)
• Ready for use: No JE
• Actual use: No JE

Liability Definition and Recognition Criteria

• Definition:
  • A present obligation of the entity
  • To transfer an economic resource
  • As a result of past events
• Recognition criteria:
  • Recognition provides relevant info about the item.
    • There is no existence uncertainty about the item
    • The probability of a flow of economic benefits is not low
  • Recognition provides a faithful representation: the level of measurement uncertainty is not high

Liabilities

• An obligation of the entity:
  • Duty or responsibility that entity has no practical ability to avoid (Remember going concern assumption)
• To transfer an economic resource:
  • Include obligations to pay cash, deliver goods, provide services, etc.
  • “Potential” means transfer of EBs does not have to be certain or even likely: obligation must have the potential to require the entity to transfer benefits “in at least one circumstance”.
• Present as a result of past events:
  • The event that leads to the obligation being present – known as the obligating event – is in the past
  • Obligating event is usually obtaining economic benefits

What is the (obligating) past event?

• When does a tenant have a liability for April’s rent?
  • Contract signed 1 March
  • Rent is due 31 March
  • What if the tenant pays on 31 March? – No obligation arises, so the tenant never has a liability
  • What if the tenant does not pay?
    • The tenant’s liability increases every day from 1 April.
    • The tenant’s full liability has arisen by 30 April.

The life of an asset or liability

• Initial recognition:
  • When the item is first included in the SOFP
  • Happens when the item meets the definition and satisfies the recognition criteria
• Subsequent recognition:
  • When the item is included in later SOFPs
  • Happens as long as the asset still meets the definition and satisfies the recognition criteria
• Derecognition:
  • When the item is removed from the SOFP
  • Happens as soon as the asset no longer meets the definition and/or satisfies the recognition criteria

Measurement

• What do the definitions tell us?
  • Whether asset or liability exists
• The do the recognition criteria tell us?
  • Whether to include the item in the SOFP
• What does measurement tell us?
  • The monetary amount to use when reporting it in the SOFP
• Different measurement bases:
  • Historical cost: measurement is based on the cost
  • Current value: measurement is updated for current conditions
    • Fair value: measurement is based on the fair value
    • Value in use: measurement is based on the expected economic benefits
    • Current cost: measurement is based on the cost of an equivalent item

Fair Value

• “The price that would be received to sell an asset in an orderly transaction between market participants at the measurement date”
• Note two aspects of the Conceptual Framework inherent in this definition:
  • Going concern assumption
  • Neutrality
• Where an active market exists, the FV is the market price
• Where no active market exists, an independent expert can be used to determine FV

Measurement of Property Plant and Equipment (PPE)

• What is the accounting standard on PPE?
  • “IAS16: Property, Plant & Equipment”
• How does IAS16 require PPE to be measured?
  • Initial recognition: “the amount of cash or cash equivalents paid or the fair value of the other consideration given to acquire an asset”
  • Subsequent recognition: businesses have a choice between the cost model and the revaluation model

Measurement of PPE: initial recognition

• “the amount of cash or cash equivalents paid or the fair value of the other consideration given to acquire an asset”
  • Amount of cash paid: Cash paid on the date of purchase.
  • Present value of cash paid: Cash paid within normal credit terms.
  • Fair value of asset exchanged: A non-cash asset is exchanged for the PPE.
• Time Value of Money: the value of money in the future is equal to a lower amount of money in the present.

Payment deferred beyond normal credit terms

• Purchase PPE, Pay $R120 000$, Market-related interest: 20%
• DR PPE (A) $R100 000$, CR Payable (L) $R100 000$
• DR Payable (L) $R20 000$, DR Interest exp (P/L) $R20 000$, CR Bank (A) $R120 000$
• The cost of the PPE is $R120 000 * 100/120 = R100 000$
• The extra $R20 000$ payment is a cost of financing (interest expense).

When a non-cash asset is exchanged

• Suppose that in order to acquire a new bakkie, the business exchanges it for a 3-year old BMW
  • The bakkie was advertised for $R400 000$
  • On the date of sale, the BMW had a carrying amount in the business’s books of $R350 000$
  • New similar BMWs cost $R700 000$
  • Other similar 3-year old BMWs are selling for $R370 000$
• What is the cost used to measure the new bakkie?
  • The fair value of the consideration given = $R370 000$

Measurement of PPE: subsequent recognition

• Two accounting policy choices:
  • Cost model
  • Revaluation model

Cost model

• Uses historical cost basis
• Carrying amount is based on cost, though reduced when:
  • Benefits are consumed (depreciation)
  • Probable economic benefits fall below carrying amount (impairment)

Revaluation model

• Uses fair value (FV) basis
• Carrying amount is based on the fair value

Journal entry to impair PPE

• To decrease the carrying amount, do NOT credit the PPE account
  • Why? The notes to the financial statements must disclose the “gross carrying amount” which (on the cost model) is the cost, so this is kept in the PPE account
• Instead, credit “PPE: Accumulated Impairment”
  • This is a negative asset account , whose balance will be subtracted from the PPE account to determine the carrying amount on the SOFP
• The debit is to an expense called “impairment loss”. DR Impairment loss (P/L), CR PPE: Accumulated impairment (-A)

Negative asset accounts

• Do they appear in the GL? YES
• Do they appear in the TB? YES
• Do they appear on the SOFP? No
• Why not? They are netted off against the related asset account before preparing SOFP
• What’s the purpose? To avoid reducing the balance in the asset account (the reasons differ depending on the asset)

Measurement: Cost model

• FV:
  • No entry
• Cost:
  • No entry
• DR Impairment loss (P/L), CR Acc impairment (-A)
• Closing entries:
  • Close off Impairment losses to Profit & Loss

Measurement: Revaluation model

• FV:
  • DR PPE: Land (A), CR Reval gain (OCI)
• Cost:
  • DR Reval loss (OCI), CR Acc impairment (-A)
• DR Impairment loss (P/L), CR Acc impairment (-A)
• Closing entries:
  • Close off Reval Gains & Losses to Revaluation Surplus
  • Close off Impairment losses to Profit & Loss
  • On the revaluation model, the gross carrying amount disclosed in the notes is the higher of the cost and the highest revalued

Measurement of land example

• Purchase of land 1 Jan of Year 1: business purchased land for $R2 000 000$ cash
• Journal entry on 1 January of Year 1: DR PPE: Land (A) $2 000 000$, CR Bank (A) $2 000 000$
• FV movements:
  • 31 Dec of Year 1: FV of land is $R3 000 000$
  • 31 Dec of Year 2: FV of land is $R2 400 000$
  • 31 Dec of Year 3: FV of land is $R1 900 000$

Cost Model: End of Year 1

• 31 December of Year 1: No entry as cost model does not record increases of FV
• Statement of financial position: Land $2 000 000$

Cost Model: End of Year 2

• 31 December of Year 2: No entry on cost model as FV has not decreased below cost
• Statement of financial position: Land $2 000 000$

Cost Model: End of Year 3

• 31 December of Year 3: DR Impairment expense (P/L) $100 000$, CR Accumulated impairment: Land (-A) $100 000$
• Decrease in FV below cost ($2 000 000 – 1 900 000$)
• DR Profit or loss (E) $100 000$, CR Impairment expense (P/L) $100 000$
• Closing entry – impairment expense closed off to P/L
• Statement of financial performance: Impairment expense $100 000$
• Statement of financial position: Land $1 900 000$

Revaluation Model: End of Year 1

• 31 December of Year 1: DR PPE: Land (A) $1 000 000$, CR Revaluation gain (OCI) $1 000 000$
• Increase in FV recognised ($R3m -R2m$)
• DR Revaluation gain (OCI) $1 000 000$, CR Revaluation surplus (E) $1 000 000$
• Closing entry - gain closed off to SOFP equity account
• Statement of financial performance: Presenting OCI Revaluation Gain $1 000 000$
• Statement of financial position: Land $3 000 000$, Equity: Revaluation Surplus $1 000 000$

Revaluation Model: End of Year 2

• 31 December of Year 2: DR Revaluation loss (OCI) $600 000$, CR Accumulated impairment: Land (-A) $600 000$
• Decrease in FV recognised ($R3m – R2,4m$)
• DR Revaluation surplus (E) $600 000$, CR Revaluation loss (OCI) 6000 000
• Closing entry - loss closed off to SOFP equity account
• Statement of financial performance: Presenting OCI Revaluation loss ($600 000$)
• Statement of financial position: Land $2 400 000$, Equity: Revaluation Surplus $400 000$

Revaluation Model: End of Year 3

• 31 December of Year 3: DR Revaluation loss (OCI) $400 000$, DR Impairment expense (P/L) $100 000$, CR Accumulated impairment: Land (-A) $500 000$
• Decrease in FV recognised ($R3m –R1,9m$)
• DR Revaluation surplus (E) $400 000$, CR Revaluation loss (OCI) $400 000$
• Closing entry - loss closed off to SOFP equity account
• DR Profit or loss (E) $100 000$, CR Impairment expense (P/L) $100 000$
• Closing entry – impairment expense closed off to P/L

Revaluation Model: End of Year 3

• Statement of financial performance
  • Profit or loss section: Impairment expense $100 000$
  • Section presenting OCI: Revaluation loss ($400 000$)
• Statement of financial position: Land $1 900 000$

Statement of Financial Performance

• Sales income: XXX
• Cost of sales expense: (XX)
• Gross profit: XXX
• Rent expense: (XX)
• Salaries & wages expense: (XX)
• Operating profit: XXX
• Profit before financing: XXX
• Interest expense: (X)
• Profit for year: XX
• Other comprehensive income:
  • Revaluation gain on land: XX
• Total comprehensive income: XXX

Example of Statement of Changes in Equity

Example Statement of Financial Position

• Non-current assets:
  • Land: xxx
• Current assets:
  • Inventory: xxx
  • Bank: xxx
• Total assets:
• Equity:
  • Capital: xxx
  • Retained earnings: xxx
  • Revaluation surplus: xxx
• Non-current liabilities:
  • Loan: xxx
• Current liabilities:
  • Trade payables: xxx
• Total equity & liabilities:

By considering PPE, what have you learned about measurement?

• IFRS often prescribes, and sometimes gives a choice about:
  • How to measure most classes of assets and liabilities.
  • At both initial and subsequent recognition.
  • And how changes in carrying amount are reported in the statement of financial performance.
• Sometimes the measurement is based on cost.
• Sometimes it is based on current value (which may be FV).
• Changes in carrying amount (gains or losses) may be reported in the P/L section or the OCI section of the statement of financial performance.
• If they are reported in OCI, they are closed off to their own equity account in the SOFP.
• In the case of an asset, at no point may the measurement be above the amount of EBs that are expected to be produced. In such cases, the asset must be impaired.