3) IFRS Conceptual Framework

1Roberto Di Pietra 1

IFRS Conceptual Framework

Prof. Roberto Di PietraDepartment of Business and Social Studies

University of Siena

Roberto Di Pietra 2

Pre-requisites and learning objectives Pre-requisites

Basic financial accounting and reporting concepts Introductory accounting course

Learning objectives Understand the purpose of the IASB Framework Describe the primary group of users Identify the qualities that make Financial Statements

(FS) useful Define the basic elements of FS

f.gaushiya.01Typewritten texthttp://www.disas.unisi.it/mat_did/dipietra/732/3%29_IFRS_Conceptual_Framework.pdf


IASB Framework

Some historical notes The IASC (predecessor of IASB) has issued in

1989 the Framework for the preparation and presentation of Financial Statements (as part of the Comparability project)

This Framework in 2001 was re-adopted by the IASB

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Purpose and status of the IASB Framework The Framework

describes the basic concepts that underlie FS prepared under the IFRSs

Serves as a guide to the IASB in developing accounting standards resolving accounting issues that are not

addressed directly in a IFRS Is not itself an IASB standard


Purpose and status of the IASB Framework The Framework

Defines the objective of FS Identifies the qualitative characteristics that make

information in FS useful Defines the basic elements of FS and the concepts for

recognising and measuring them in FS IAS 8 (2003) on Accounting policies has introduced a

hierarchy of sources by which an entity would choose its accounting policies In the absence of a specific standard addressing an

issue, an entity is required to look to the IASB Framework

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Purpose and status of the IASB Framework The Framework has a variety of uses:

The Framework guides the IASB and IFRIC members in deliberating and establishing IFRS and interpretations of those standards

The Framework helps to ensure that the body of standards is internally consistent

Preparers and Auditors of FS use the Framework as a point of reference to resolve an accounting question in the absence of a standard or interpretation that specifically deals with the question

The Framework establishes precise terminology by which people can discuss accounting questions

The Framework reduces the volume of standards (without the F., each accounting question would have to be answered ad hoc)


Purpose and status of the IASB Framework The Framework has a variety of uses:

The Framework makes it more likely that the standards will be principles based rather than detailed rules that try to cover every conceivable potential situation

The Framework reduces the need for interpretations and other detailed implementation guidance

The Framework enhances public confidence in financial reports

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Purpose and status of the IASB Framework Authority of the Framework

IASB Preface to IFRS (2002) IFRSs are based on the Framework, which

addresses the concepts underlying the information presented in general purpose FS. The objective of the Framework is to facilitate the consistent and logical formulation of IFRSs. The Framework also provides a basis for the use of judgement in resolving accounting issues ( 8)


Purpose and status of the IASB Framework Authority of the Framework

The IASB Preface also describes a due process steps that have to be followed in developing IFRS

Step 1: the Staff are asked to identify and review all of the issues associated with the topic and to consider the application of the Framework to the issues

An identical Step 1 is set out in the due process followed by IFRIC in developing its interpretations

Step 2: see 10 and 11 of IAS 8 (2003). IAS 8 is an authoritative, binding standard, and it states that the Framework is the first place to which a preparer or auditor must look in the absence of a specific standard or interpretation

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General purpose of FSs Definition

The Framework addresses general purpose FS, which are the financial statements that an entity prepares and presents at least annually to meet the common information needs of a wide range of usersexternal to the entity

Therefore the Framework does not necessarily apply to special purpose FS such as reports to tax authorities, report to government regulatory authorities, prospectus prepared in connection with securities offerings, and reports prepared in connection with proposed business combinations, etc.


General purpose of FSs

The Framework focuses on the FS of business entities, which would include both privately owned and state-owned business entities The entities does not necessarily apply to the

FS of governments, government non-business units, or other not-for-profit entities, although most of the concepts in the Framework would seem to be equally relevant to those types of entities


General purpose of FSs The Framework acknowledges that some parties who

use the general purpose FSs of an entity may have the power to obtain information in addition to that contained in the FSs Many present and potential investors, creditors,

vendors, and other who seek financial information about the entity do not have the same power as the major lender to get special information

They must rely on the general purpose FSs to meet their information needs


Users and their information needs The Framework identifies the principal

classes of users of general purpose FSs as Present and potential investors (and their

advisers) Lenders Suppliers and other trade creditors Employees (and their representative groups) Customers Governments (and their agencies) The general public


Users and their information needs All of these 7 categories of users rely on FSs

to help them in making various kinds of economic and public policy decisions The Framework also concludes that

Because investors are providers of risk capital to the entity, FSs that meet their needs will also meet most of the general financial information needs of the other classes of FS users

Common to all of these user groups is their interest in the ability of an entity to generate cash and cash equivalents, and the timing and certainty of those future cash flows


Users and their information needs The Framework regards investors as the

primary, overriding user group The Framework notes that FSs cannot provide

all the information that users may need to make economic decisions

FSs show the financial effects of past events and transactions, whereas the decisions that most users of FSs have to make relate to future

The information in FSs helps users to make their own forecasts


Responsibility for FSs

The management of an entity has the primary responsibility for preparing and presenting the entitys FSs This responsibility is noted in the auditors

report in most countries Some countries require that company

management include, as part of the FSs, an explicit statement of managements responsibility for the FSs


Responsibility for FSs The auditors responsibility is to form and express an

opinion as to whether the FSs are prepared in accordance with IFRS or some other identified financial-reporting framework

The fact that FSs are audited does not relieve management of its fundamental responsibility

In a converse case this could show a sort of conflict of interest that could affect the expression of an independent opinion ISA 700 on the Auditors Report on FSs requires that

the auditors report include a statement that the FSsare the responsibility of the entitys management


The objective of FSs Objective of FSs is

To provide information about the financial position, performance and changes in financial position of an entity that is useful to a wide range of users in making economic decisions

Decision usefulness is an objective of FSs(this has been subject of heated debate)

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The objective of FSs From one hand the objective as set out in the IASB

Framework is to help people to make decision From the other hand large part of the decisions are

future-oriented Some disagree with this objective They argue that the FSs is strictly to be a scorecard of

the past (stewardship objective of FSs) The IASB Framework does not reject this objective, but

it says that people want to know about the past (stewardship) not merely out of curiosity, but because they want to use the information about the past to help them in making future-oriented economic decisions


The objective of FSs

Information from the past

Decision as a predictive processTime series

Actualized Values

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The objective of FSs Financial position

The financial position of an entity is affected by economic resources

its controls, its financial structure, its liquidity and solvency and Its capacity to adapt to changes in the

environment in which it operates The Balance sheet presents this kind of

information


The objective of FSs Performance

Performance is the ability of an entity to earn a profit on the resources that have been invested in it

Information about the amount and variability of profits helps in forecasting future cash flows from the entitys existing resources and in forecasting potential additional cash flows from additional resources that might be invested in the entity

Information about performance is primarily provided in an Income statement (or statement of profit and loss, or statement of financial performance)

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IAS 1 added a fourth basic financial statement: The statement showing the changes in equity

It is important to look to both the income statement and the equity statement in assessing performance because several IFRS provide that certain items if income and expense should be reported directly in equity (thereby by passing the income statement) permanently or temporarily



Some examples Changes in FV of available-for-sale financial assets are

reported directly in equity until financial asset is sold Major classes of property, plant and equipment are re-

measured to FV at each BS, with the change in FV reported in a revaluation reserve directly in equity

Foreign currency translation adjustment arising when the FSsof a foreign operation are translated from the foreign currency into the reporting companys currency are reported directly in equity

Companies have an option of reporting actuarial gains and losses on their pension funds directly in equity when they arise

This value changes are part of an entitys performance, but under existing IFRSs they are not reported in the IS; They show up in the Equity statement; In assessing performance, both of those FSs must be considered

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The objective of FSs Changes in financial position

Users of FSs seek information about the sources and users of an entitys cash and cash equivalents such as bank deposits during the reporting period

Cash comes into and goes out of an entity from 3 broad categories of activity

Its operations (producing and selling its goods and services)

Its investing activities (buying and selling long-lived assets and financial investments)

Its financing activities (raising and repaying debt and equity capital)


The objective of FSs Changes in financial position

The cash flow statement (CFS) provides this kind of information

All investors, creditors, and other capital providers to an entity want to get cash out of their investment

The cash flow statement helps them assess the prospects of receiving cash from the entity

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The objective of FSs Notes and Supplementary schedules The FSs also contain notes and supplementary

schedules and other information that Explain items in the balance sheet and IS Explain any resources and obligations not recognised

in the BS The notes also sometimes contain information that

meets disclosure requirements arising under national laws or regulations


Underlying assumptions

The Framework sets out the underlying assumptions of FSs There are:

Accrual basis of accounting Going concern assumption

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Underlying assumptions Accrual basis

Accounting recognises the effects of transactions and other events when they occur rather than only when cash (or its equivalent) is received or paid and accounting reports these effects in the FSs of the period to which they relate

The accrual basis recognises that a companys financial position and performance can change without any cash changing hands

Accrual accounting recognises these changes when they occur

The cash basis is not consistent with IASB Framework


Underlying assumptions Going concern

The FSs presume that an entity will continue in operation indefinitely or disclosure and a different basis of reporting are required

An entity that is not a going concern is likely to be liquidated in the near term

The users of the FSs of such an entity will have a great interest in the net amount of cash that can be generated from the entitys assets in the very short term

IFRS are not necessarily designed to provide this kind of information presume that entity will continue to operate for the foreseeable

future and therefore will generate its cash flows from operations rather than from liquidation sales

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Qualitative characteristics of FSs Attributes that make the information in FSs

useful to investors, creditors, and others Four principal qualitative characteristics

Understandability Relevance Reliability Comparability


Qualitative characteristics of FSs Understandability

Information should be presented in a way that is readily understandable by users

Who have a reasonable knowledge of business economic activities and accounting

Who are willing to study the information diligently

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Qualitative characteristics of FSs Relevance

Information in FSs is relevant when it influences the economic decisions of users

It can do that by Helping users to evaluate past, present or future

events relating the entity Conforming or correcting past evaluations users have

made There are sub-characteristics under the relevance:

Materiality Timeliness


Qualitative characteristics of FSs Relevance

Materiality: is a component of relevance Information is material if its omission or misstatement

could influence the economic decisions of users Conversely if information does not have a bearing on

the economic decisions of users, it is immaterial Neither the IASB Framework nor individual IFRS

provide quantified measures of materiality (some traces are in IAS 14 and IAS 19)

Timeliness: is another component of relevance To be useful, information must be provided to users

within the time period in which it is most likely to bear on their decisions

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Qualitative characteristics of FSs Reliability

Information in FSs is reliable if it is free from material error and bias and can be dependent on by users to represent events and transactions faithfully

5 attributes that make information reliable Representational faithfulness Substance over form Neutrality Prudence Completeness



Representational faithfulness To be reliable, information must represent

accurately the transaction or other circumstance that the information purports to present

Substance over form FSs should reflect the substance of transactions

and not-necessarily their legal form

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Neutrality The Framework is clear that accounting information

must be decision-neutral This means that information is not designed in a way

that intentionally leads the users of that information to make an economic decision that the preparer of the information would like them to make

Saying that accounting information should be decision-neutral is entirely consistent with saying that accounting information should be relevant

Relevance requires that the information bear on the economic decisions that users want to make



Prudence: is the inclusion of a degree of caution in the exercise of the judgements needed in making the estimates required under conditions of uncertainty, such that

assets or income are not overstated and liabilities or expenses are not understated

While there is noting wrong with healthy scepticism, prudence has sometimes been used to justify the deliberate overstatement of liabilities or expenses, or the deliberate understatement of assets or income

When this happens, the FSs measurements lose their reliability

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Completeness Reliability requires that the FSs must report what they

purport to report completely, subject to constraints of cost and materiality

Omissions make FSs just as wrong as unreliable or irrelevant information

Balance between benefit and cost The benefits that users of FSs derive from information

should exceed the cost of providing that information The evaluation of benefits and costs is a difficult

judgemental process (costs of providing information should include direct and indirect costs for its preparation)

Trade-off between relevance and reliability


Qualitative characteristics of FSs Comparability

User must be able to compare the FSs of an entity over time so that they can identify trends in its financial position and performance

Users must also be able to compare the FSsto different entities to make decisions about where to invest their capital and at what price

Disclosure of accounting policies is essential for comparability

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Qualitative characteristics of FSs


The elements of FSs FSs portray the financial effects of transactions and

other events by grouping them into broad classes according to their economic characteristics The elements directly related to financial position (BS)

are: Assets Liabilities Equity

The elements directly related to performance (IS) are: Income Expenses

The CFS reflects both IS elements and changes in BS elements

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The elements of FSs Definitions of the elements relating to financial

position Asset

A resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity

Liability A present obligation of the entity arising from past

events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits

Equity The residual interest in the assets of the entity after

deducting all its liabilities


The elements of FSs

Definitions of the elements relating to financial position Economic benefits means future flows of

cash or other assets An assets is expected to help generate cash

or other assets coming into the entity, and a liability is expected to result in cash or other assets flowing out of the entity

Both the Asset and Liability definitions refer to past events

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The elements of FSs Definitions of the elements relating to performance

Income Increases in economic benefits during the accounting

period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants

Expense Decreases in economic benefits during the accounting

period in the form of outflows or depletions of assets, or the incurrence of liabilities that result in decreases in equity other than those relating to distributions to equity participants


The elements of FSs Definitions of the elements relating to performance

The definition of income encompasses both revenue and gains

Revenue arises in the course of the normal operating activities of the entity

Gains represent other items that meet the definition of income but that do not reflect from the normal sales of goods and services produced by the entities

The definition of expenses encompasses expenses and losses

Expenses arise in the course of the ordinary activities of an entity (cost of sales, wages, marketing costs, administrative costs, depreciation)

Losses represent other items that meets the definition of expenses and may or may not arise in the course of the ordinary activities of the entity

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Recognition of the elements of FSs Recognition:

is the process of incorporating in the BS an item that meets the definition of an element and satisfies both the following criteria for recognition

Probable economic benefits It is probable that any future economic benefit

associated with the item will flow to or from the entity Measurement reliability

The items cost or value can be measured reliably All items that satisfy these recognition criteria

should be recognised in the BS or IS


Recognition of the elements of FSs The recognition criteria for the elements of FSs under

the Framework are as follows: An asset is recognised in the BS when it is probable

that the future economic benefits will flow to the entity and the asset has a cost or value that can be measured reliably

A liability is recognised in the BS when it is probable that an outflow of resources embodying economic benefits will result from the settlement of a present obligation and the amount at which the settlement will take place can be measured reliably

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Recognition of the elements of FSs The recognition criteria for the elements of FSs under

the Framework are as follows: Income is recognised in the IS when an increase in

future economic benefits related to an increase in an asset or a decrease in a liability has arisen that can be measured reliably

Expenses are recognised when a decrease in future economic benefits related to a decrease in an asset or an increase in a liability has arisen that can be measured reliably

Because equity is the arithmetic difference between assets and liabilities, a separate recognition criterion for equity is not needed


Recognition of the elements of FSs Recognition of revenue from the sale of goods

This revenue should be recognised when all of the following criteria have been satisfied

The seller has transferred to the buyer the significant risks and rewards of ownership

The seller retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold

The amount of revenue can be measured reliably It is probable that the economic benefits associated

with the transaction will flow to the seller The costs incurred or to be incurred in respect of the

transaction can be measured reliably

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Recognition of the elements of FSs Recognition of revenue from the tendering of

services This revenue should be recognised when all of

the following criteria have been satisfied The amount of revenue can be measured reliably It is probable that the economic benefits will flow

to the seller The stage of completion at the BS date can be

measured reliably The costs incurred, or to be incurred, in respect of

the transaction can be measured reliably


Recognition of the elements of FSs Recognition of revenue from interest,

royalties and dividends These revenues should be recognised when

all of the following criteria have been satisfied Interest should be recognised using the effective

interest method set out in IAS 39 ( 5) Royalties should be recognised on an accrual

basis in accordance with the substance of the relevant agreement

Dividends should be recognised when the shareholders right to receive payment is established

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Measurement of the elements of FSs

Measurement involves assigning monetary amounts at which the elements of the FSs are to be recognised and reported The Framework acknowledges that a variety of

measurement bases are used to different degreesand in varying combinations in FSs including:

Historical cost Current replacement cost Net realisable value Present value (discounted expected future cash flow)



Historical cost: Is the measurement basis most commonly

used today, but it is usually combined with other measurement bases

Net realisable value: Is an assets selling price or a liabilitys

settlement amount

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The Framework does not include concepts or principles for selecting which measurement basis should be used for particular elements of FSs or in particular circumstances After covering the objective of FSs, qualitative

characteristics, and elements definitions, the Framework addresses measurement in only three paragraphs

It is fair to say that this is a significant deficiency in the Framework


The IASBs current Conceptual Framework project Because the Framework does not include concepts

for choosing the proper measurement attribute for various elements, the IASB standards today result in what is called a mixed attribute accounting model, with different measurement bases for different types of assets, liabilities, income and expenses Some members of the IASB have a tendency to favour

fair value measurements if at all possible Other members lean towards cost-based measures

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The IASBs current Conceptual Framework project The IASB and US FASB have worked a joint project

designed to update and align the two boardsConceptual Framework Eight phases

Objectives and qualitative characteristics Elements: recognition and measurement attributes Initial and subsequent measurement Reporting entity Presentation and disclosure Status of Framework in GAAP hierarchy Applicability to not-for-profit entities Reconsideration of the entire Framework


The IASBs current Conceptual Framework project Objective

The boards have tentatively concluded that financial reports should aim to provide information to a wide range of users that focus on the information needs of existing common shareholders only

The objective is to provide information about the entity to the external users who lack the power to prescribe the information they require and therefore must rely on the information provided by an entitys management

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The IASBs current Conceptual Framework project Qualitative characteristics

The 2 boards have tentatively concluded to identify the following 5 primary qualitative characteristics of accounting information

Relevance: is an essential qualitative characteristics Faithful representation of real-world economic

phenomena Comparability: is an important characteristics of

financial reporting information and should be included in the converged conceptual framework

Understandability: is an essential characteristics of financial reporting information and should be included in the converged conceptual framework

Materiality: relates not only to relevance, but also to faithful representation


The IASBs current Conceptual Framework project Exposure Draft in May 2008

The objective of Financial reporting Is to provide information about the reporting entity that

is useful to present and potential equity investors, lenders and other creditors in making decisions in their capacity as capital providers

Information that is decision-useful to capital providers may also be useful to other users of financial reporting who are not capital providers

FSs should reflect the perspective of the entity rather than the perspective of the entitys investors

The key users of FSs are capital providers Capital providers require information that is decision-useful

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The IASBs current Conceptual Framework project Exposure Draft in May 2008

The objective of Financial reporting For financial information to be useful, it must possess 2

fundamental qualitative characteristics: Relevance Faithful representation (a depiction of an economic phenomenon

have to be complete, neutral and free from material error) The ED provides 4 enhancing qualitative characteristics

Comparability Verifiability Timeliness Understandability

This characteristics are complementary to the fundamental characteristics


The IASBs current Conceptual Framework project Next steps

The Convergence process between IASB and FASB on the Conceptual Framework was paused

This project was paused until the IASB concludes its ongoing deliberations about its future work plan (visit the Agenda consultation project page for more information)

3) IFRS Conceptual Framework

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