Conceptual Framework

Roshayani Arshad/Accounting Theory

Chapter 5 - Conceptual Framework

Learning Objectives

i. Understand the need for a conceptual framework of accounting standards ii. Understand and explain the development of a conceptual framework in relation to

financial reporting process

iii. Understand and explain the scope of the IASB Framework

iv. Understand the current joint project by IASB and FASB to update and converge

conceptual frameworks

1.0 Introduction

The need for reporting accounting information begins with the purpose of providing

information to capital providers of an entity in evaluating the performance of the managers

and the entity. Information about past events and transactions will provide the relevant

information for the capital providers to assess past performance. However, the current

reporting environment acknowledges that there are other parties that are interested in the

accounting information of an entity. As these users have different information needs, the

information reported need to be able to meet their various decision-making needs. In meeting

these needs, the accounting information must be prepared and communicated to the various

users in a manner that can facilitate their decision-making. This highlights the importance of

standard-setting approach that will be able to develop standards that meet the decision-making

needs of various parties. This chapter discusses the use of a conceptual framework in the

development of accounting standards.

2.0 The Need for a Conceptual Framework

A conceptual framework refers to a statement of generally accepted theoretical principles

which forms the basis of reference for financial reporting. The financial reporting process

involves application of certain rules and procedures to events and transactions engaged by an

entity and communicating the information to the various users. As such, the conceptual

framework should formulate a set of general accounting theory that covers the scope and

objective of financial reporting, the qualitative characteristics of the information reported in

order to achieve the objective, the basis for determining the events or transactions that should

be accounted for, the measurement for such events or transactions and the presentation of the

information to the users.

In the past, where a formally constructed conceptual framework did not exist, the accounting

standard setters have developed standards which allow entities to select their accounting

methods within the boundaries of generally accepted accounting principles. Generally

accepted accounting principles can be referred to as the rules that govern the accounting and

reporting process. These rules are derived from various sources applicable to a particular

country. The sources can include national company law, national accounting standards,

international accounting standards and local stock exchange. As a result, many accounting

standards developed in the past have resulted in many alternative accounting practices

applicable to similar transactions. From one perspective, the wide accounting choices allowed

entities to choose the most appropriate method applicable for certain event or transaction.

Alternatively, it can lead to wide variation in the accounting practices of similar transactions,

reduce comparability of the information reported and potential confusion among the users. In


resolving these effects, some accounting regulators have increased the issuance of accounting

standards in an attempt to establish the appropriate accounting practice for a particular

circumstance.

Where a conceptual framework does not exist, the accounting standards developed need to

specify detailed requirements in order to ensure that all potential situations are taken into

considerations. As new accounting issues arise in the existing standards or where there are no

specific standards, there will be increase pressure from preparers, auditors and also users for

accounting standard setters to develop more detailed standards. In contrast, development of

accounting standards based on agreed basic principles contained in a conceptual framework

provide standard setters with a conceptual defence in reducing these pressures.

In the absence of a conceptual framework, accounting standards will also be developed

whenever accounting issues arise. The new accounting requirements developed provide

random solution to the current pressing issues. Such approach can result in inconsistencies

and contradictions in basic concepts among the accounting standards. Consequently, it can

lead to ambiguity, reduces the usefulness of the information to the users and ultimately

reduces the credibility of the information reported to users.

The advantages and disadvantages of a conceptual framework are summarized as follows;

Advantages

i. Development of accounting standards based on a conceptual framework reduces the

probability of accounting standard setters focusing on the most important issue arising

at a particular time. Instead, accounting standard setters can channeled their efforts

and resources in developing new and existing standards in a more organized manner.

ii. Accounting standard setters are exposed to pressures from various parties in

developing the accounting standards, particularly where there are conflicts between

the various parties. In this situation, the accounting standard setters work will be

subject to less criticism if the accounting standards are derived from a conceptual

framework.

iii. Accounting standards derived from a conceptual framework reduces the need for

detailed requirements as issues not addressed specifically in the standards can be

referred to the conceptual framework.

Disadvantages

i. A single conceptual framework may not be able to provide a reference in preparing

and presenting information that can meet the needs of a variety of users.

ii. A single conceptual framework is used as a basis to develop accounting standards for a

particular purpose. For example, the current conceptual framework focuses on

concepts relevant in preparing and presenting information for general purpose. As

there are diverse group of users, a variety of accounting standards may need to be

developed for preparing and presenting information for other purposes.

3.0 The Development of Conceptual Framework

The development of conceptual framework started between the periods 1987 to 2000 where

the Financial Accounting Standard Board (FASB) in the United States issued seven concept

statements covering the following topics:

- Objective of financial reporting by business enterprises and non-profit organizations


- Qualitative characteristics of useful accounting information

- Elements of financial statements

- Criteria for recognizing and measuring the elements

- Use of cash flow and present value information in accounting measurements.

In the United Kingdom, following the lead from FASB, the International Accounting

Standards Committee (IASC) issued the Framework for the Preparation and Presentation of

Financial Statements n July 1989. Subsequently, the International Accounting Standards

Board (IASB) adopted the Framework in 2001. This framework will be explained in more

detail in the section 4.0 of this chapter.

In Australia, the development of conceptual framework started with the issuance of several

exposure drafts (ED) and statement of accounting concepts. The exposure drafts are as

follows:

Exposure Drafts Date of release

ED 42A – Objective of financial reporting December 1987

ED 42B – Qualitative characteristics of financial information December 1987

ED 42C – Definition and recognition of assets December 1987

ED42D – Definition and recognition of expenses December 1987

ED 46A – Definition of the reporting entity December 1987

ED 46B – Definition and recognition of revenues December 1987

ED 51A – Definition of equity April 1988

ED 51B – Definition of recognition of revenues April 1988

In 1990, the following statements of accounting concepts were released by Australian

Accounting Standards Board (AASB):

i. SAC 1 Definition of the Reporting Entity

ii. SAC 2 Objectives of General Purpose Financial Reporting

iii. SAC 3 Qualitative Characteristics of Financial Information

SAC 4 Definition and recognition of the elements of financial statements was first issued by

the AASB in March 1992. However, the release of SAC 4 was very controversial and after

intense lobbying by the business community, it was revised and reissued in May 1995. These

statements of accounting concepts were reviewed following the adoption of IASB accounting

standards in Australia to determine if the Australian conceptual framework is in line with the

AASB standards based on IFRSs. Following the review process, the AASB decided to retain

SAC 1 Definition of the Reporting Entity and SAC 2 Objectives of General Purpose Financial

Reporting in 2005. The AASB states that these two statements of accounting concepts are to

ensure clear interpretations of the application paragraphs of AASB equivalents to IASB

standard. In addition, the IASB has no equivalent to these two SACs. The AASB also adopts

the IASB conceptual framework, which superseded SAC 3 and SAC 4.

The IASB conceptual framework has also been adopted by many jurisdictions around the

world that adopt IFRSs as their national standards. Similarly in Malaysia, the Malaysian


Accounting Standards Board (MASB) has also issued the Framework for the Preparation and

Presentation of Financial Statements in 2007. This statement is similar to the conceptual

framework issued by the IASB.

3.1 Key Issues in Developing Conceptual Framework

The issues that have been considered in the development of accounting standards include:

i. Principles-based versus rules-based approaches to standard setting

ii. Information for decision-making

iii. Users of accounting information

Principles-based versus rules-based approaches to standard setting

Conceptual framework provides a point of reference in the standard-setting process in order to

develop a body of coherent standards based on consistent principles. The current IASB

standards are developed based on the guidelines provided in the conceptual framework. The

standards developed are also known as principle-based standards. Accordingly, these

standards are expected to be based on appropriate principles without too many detailed rules.

However, some parties argue that some of the IASB standards also include detailed technical

rules. For example, accounting standards for lease transactions, government grants and

employee benefits. These parties argue that the resulting detail rules could have been due to

lack or inappropriate principles being applied.

Standards with detailed requirements in relation to various accounting treatments to be

complied are also known as rules-based standards. The accounting standards in the United

States have often been described as rules-based due to this characteristic. The rules-based

standard setting approach in the United States has been influenced to a certain extent by the

SEC requirements. The SEC required detailed rules in the standards in order to determine if

companies are complying with the financial reporting requirements.

The advantage of rules-based standards is that it reduces subjective judgement in the

application of accounting treatments and consequently enhances comparability. It also

facilitates auditors and regulatory authorities in verifying the reported information. However,

it should not preclude the use of skills and judgement in interpreting the accounting standards.

Where application of rules-based standards precludes professional judgements, it can

potentially lead to fraudulent financial reporting. Some commentators argue that the rules-

based standard-setting in the United States is partly blamed for several corporate collapses.

Following a series of corporate collapses in the United States, the Sarbane-Oxley Act

introduced many changes to improve the quality of financial reporting and auditing. In line

with this, the standard-setting approach has also been changed to principle-based approach.

The FASB has also started working with the IASB on a joint project to develop a single,

complete and consistent conceptual framework that can be used by both boards.

Information for decision-making

Reporting of accounting information begins with the stewardship function. Stewardship

function refers to an environment where those who supply capital to the business want to

know how the stewards, or managers, have used the economic resources entrusted to them.

Based on the information, the capital providers will be able to evaluate the performance of the

managers and the entity.


The current reporting environment has moved beyond providing information for stewardship

purposes. Standard setters acknowledge that there are various parties interested in the

accounting information of an entity. These users have different information needs and the

information reported need to be able to meet their various decision-making needs.

Accordingly, the purpose of reporting accounting information shifts from merely focusing on

the stewardship purpose to decision-making purpose. While accounting information reports

on past events, it should also incorporate information that can facilitate information that

relates to the future for decision-making purposes. For example, information on current values

of resources owned by an entity provide relevant input to the users as this information is

closer to the future period relative to historical values. However, information based on

historical values is equally useful to users as this information is objective and can serve as a

reliable source for decision-making. The current emphasis on decision-making purpose of

accounting information highlights the necessity to have general concepts or principles in a

conceptual framework that can give guidance for standard setters in developing standards that

meet this purpose.

Users of accounting information

In line with the decision-making purpose of accounting information, a conceptual framework

needs to identify the users of accounting information. However, it is not possible to identify

every potential type of users of accounting information. In general, standard setters identify

three categories of users: resource providers, recipients of goods and services and parties

involved in the review or oversight function. Resource providers include investors and

lenders, recipient of goods and services include customers and suppliers while parties

involved in the review and oversight function include regulatory authorities and board of

directors. Once the users are identified, a conceptual framework needs to identify the

principles that can guide standard setters in developing standards that meet the information

needs of all these users.

4.0 The IASB’s Framework

The Framework for the Preparation and Presentation of Financial Statements (Framework)

was issued by the adopted International Accounting Standards Committee (IASC) in July

1989. Subsequently, the International Accounting Standards Board (IASB) adopted the

Framework in 2001. However, it is not an International Financial Reporting Standard for any

particular measurement or disclosure issues. Instead, the Framework describes the basic

concepts that underlie the preparation and presentation of Financial Statements in conformity

with IFRSs. It serves as a guide to the IASB in developing accounting standards.

Where a particular accounting issue is not addressed directly by a particular accounting

standard or Interpretation, the principles in the Framework will be used. In this situation, IAS

8 (revised, 2003) requires management to use its judgement in developing and applying an

accounting policy that results in information that is relevant and reliable. In making the

judgement, IAS 8 requires management to consider the following:

i. requirements and guidance of Standards and Interpretations dealing with similar

and related issues, and

ii. definitions, recognition criteria, and measurement concepts for assets, liabilities,

income, and expenses in the Framework.

The above requirement by IAS 8 strengthened the importance of the Framework in the

preparation and presentation of financial statements even though it is not mandatory.


However, where there are contradictions between the Framework and individual Standard or

Interpretation, the Standard or Interpretation takes precedence. In such situation, the

principles in the Framework cannot be used to justify a particular accounting treatment that

contradicts the particular Standard or Interpretation.

4.1 Purpose of the Framework

The introduction to the Framework provides a list of the purpose of the Framework as

follows:

i. The Framework guides the IASB in the development of future IFRSs and in the review

of existing accounting standards. For example, in developing an accounting standard

that deals with liability with uncertain amount or timing, the IASB will refer to the

definitions of the elements of financial statements in discussing the issues relating to

whether the liability meets the definition of a provision or contingent liability. With

the presence of the definitions in the Framework, the discussions are centered around

the definition of a liability while reducing the divergence of opinions. At the same

time, such approach towards standard setting enhances consistency among the body of

standards.

ii. The Framework assists the IASB in promoting harmonization of accounting standards,

accounting procedures and regulations in relation to the presentation of financial

statements as it reduces the number of alternative accounting treatments allowed in the

IFRSs.

iii. The Framework also assists national standard setters in developing national standards.

iv. The Framework provides guidance to preparers and auditors in resolving accounting

issues particularly where there are no specific standards or interpretations.

v. The Framework promotes development of accounting standards from the “principle-

based” perspective instead of as opposed to developing accounting standards with

detailed ruled that can cover various potential situations.

vi. The Framework reduces the volume of each standard as accounting issues not

addressed specifically by the standards can be resolved by referring to the Framework.

As it facilitates the exercise of judgement, it reduces the need for interpretations and

other detailed implementation guidance.

vii. Assists users of financial statements in interpreting the information presented in

financial statements which have been prepared in conformance with IFRSs. The

knowledge that the standards have been developed based on the guidance of the

Framework and the rigorous process enhances the credibility of the information

reported.

4.2 Scope of the Framework

The scope of the Framework deals with general purpose financial statements that an entity

prepares and presents at least annually in order to provide the needs of a wide range of users

external to the entity. Hence, the Framework may not apply to financial reports prepared for

special purpose, such as reports to tax authorities, prospectuses in relation to issue of new

shares and regulatory authorities. In addition, the Framework focuses on the financial

statements prepared by business entity. This entity can be privately owned or state-owned. It

does not focus on the financial statements of other entities such as not-for-profit organizations

and public sector entities. A complete set of financial statements includes:

- statement of financial position

- statement of comprehensive income


- statement of changes in financial position

- notes and other statements.

In relation to users of general purpose financial statements, the Framework identifies the

following categories of users:

- investors,

- employees,

- lenders,

- suppliers and other trade creditors,

- customers,

- government and their agencies, and

- public.

The Framework acknowledges that the above users rely on information in the financial

statements in making various economic decisions. However, such information cannot meet

the information needs of all users. For instance, the financial statements provide information

regarding past transactions and events while most users need to make decisions related to

future transactions and events. In addressing this issue, the Framework concludes that there

are information needs that are common to all these users. In addition, the Framework focuses

on meeting the need of the investors as providers of risk capital. It is expected that meeting

the needs of the investors will be able to satisfy the information needs of the other users. The

common information need is related to the ability of an entity to generate cash and cash

equivalents and also the timing and certainty of those future cash flows. By focusing on the

information needs of the investors, the Framework regards the investors as the most important

user group relative to the other categories of users.

The primary responsibility for the preparation and presentation of financial statements lies

with the management of an entity. This is noted in the financial statements.

The scope of the Framework includes:

i. the objective of financial statements;

ii. the qualitative characteristics that determine the usefulness of information in financial

statements;

iii. the definition, recognition and measurement of the elements from which financial

statements are constructed; and

iv. concepts of capital and capital maintenance.

4.3 The Objective of Financial Statements

The Framework states that the objective of financial statement 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 user in making economic decisions. Examples of economic decision-

making include:

- decision to invest, hold or sell equity investment

- assess entity’s ability to pay employees

- assessment of entity’s ability to settle amount lent to the entity

- determination of tax policies

- regulations of entity’s activities


Economic decision-making relates to the future. In contrast, certain decisions are related to

the past. For example, management performance in the last three years, prior year liquidity

position and operating costs for the last five years. These decisions are also referred to as

fulfilling the stewardship objective of financial statements. The Framework argues that the

economic decision-making objective overrides the stewardship objective because the past

information provided in financial statements allows users to make future-oriented decision-

making.

Financial Position

The financial position of an entity is reported in the statement of financial position, also

known as the balance sheet. The statement of financial position provides users with the

following information:

- assets owned by an entity,

- liabilities owed by and entity, and

- residual equity’s interests in an entity’s net assets.

Performance

Information on performance of an entity is reported in the income statement and/or statement

of comprehensive income. Information on performance reveals an entity’s ability to earn

profit from the resources invested into the entity. In assessing the performance of an entity, it

is also important to refer to information reported in the statement of changes in equity as some

items of income and expenses are reported directly in equity and not through the income

statement. For instance, when an entity adopts a fair value model in subsequent measurement

of its property, plant and equipment, it is possible that in certain situation, the surplus on

revaluation is reported directly in equity.

Changes in Financial Position

Changes in financial position of an entity are reported in the statement of cash flows. This

statement provides users with information about the sources and use of an entity’s cash and

cash equivalents during a particular reporting period. Sources of an entity’s cash and cash

equivalents are reported under three broad categories: operating activities, investing activities

and financing activities. These information provide users with the insights into an entity’s

cash and cash equivalents during a reporting period. For example, an investor will be able to

assess an entity ability in paying dividend and a creditor will be able to assess an entity’s

ability to settle the amount lend to the entity.

4.4 Qualitative Characteristics of Financial Statements

In order to report information that is useful to users, the financial statements must have certain

qualitative characteristics. The four main qualitative characteristics identified by the

Framework are summarized in the following diagram.


Diagram 1: Qualitative Characteristics of Financial Statements

Understandability

The financial statements should present information in such a way that it is readily

understandable to users who have a reasonable knowledge of business and economic activities

as well as accounting knowledge.

Relevance

Information reported in financial statements is relevant when it influences the economic

decisions of users. This is possible as the information allows users to evaluate past, present

and future performance and financial position of an entity. Accordingly, it can confirm or

correct past evaluations made by the users.

The Framework identifies the following two components that make information reported

relevant:

- materiality

- timeliness

Information is material if its omission or misstatement could influence the economic decisions

of users. Alternatively, information that does not influence the economic decisions of users is

information that is immaterial and lacks relevance. However, the Framework and various

IFRSs do not provide the specific measure in determining the level of materiality for a

particular event or transaction.

In addition to materiality, information can only influence the economic decisions of users if

the information is reported within the time period that is most likely to have some influence

on the decisions of the users. In contrast, information reported beyond this time period will

not influence the decisions of users as it is no longer relevant.

Qualitative Characteristics of Financial Statements

Understandability

Relevance

- Materiality

- Timeliness

Reliability

- Representational

faithfulness

- Substance over form

- Neutrality

- Prudence

- Completeness

-

Comparability


Reliability

The Framework states that information in financial statements is reliable if it is free from

material error and bias and can be depended upon by users to represent events and

transactions faithfully. In making the information reliable, the Framework identifies the

following attributes that information should have:

- representational faithfulness

- substance over form

- neutrality

- prudence

- completeness

Representational faithfulness

Reliable information must represent accurately the events and transactions reported in

financial statements. For instance, an entity reported its plant in the statement of position at

cost less accumulated depreciation. During the current reporting period, the recoverable

amount for the plant has fallen below the amount of its carrying value. It is important that the

value of the plant be reduced to its recoverable amount if it is to reflect accurately the effect

of certain events on the value of the plant if it is to represent accurate information to the users.

Substance over form

Information reported in financial statements should reflect the economic substance of the

transaction even though in some situations, it differs from the legal form. For instance, when

an entity leases a machine under a non-cancellable lease agreement for the entire life of the

machine and the total amount of the lease payments approximates the purchase consideration

of the machine if it was purchased by the entity, the machine must be accounted for similar to

accounting treatment for purchase asset. Even though the machine is not legally owned by the

entity, the economic nature of the transaction is equivalent to purchase of asset where the

entity is the legal owner of the asset. Hence, it is treated similar to purchase of asset.

Neutrality

Information is neutral if the information is not presented in a way that it will influence certain

economic decisions. This means that the information must not be presented in a way that it

will influence the users to make economic decisions that the preparers want the users to make.

Instead, it should provide users with information that can facilitate their economic decisions if

the information is neutral. For example, an entity is being sued by regulatory authority for not

fixing smoke filters to its factories and the entity is expected to incur some penalty costs. In

this case, the entity should assess the likelihood of the potential liability and discloses the

information to users in the financial statements. Disclosure decisions must be based on

appropriate assessments of the potential liability and should not be influenced by the entity’s

decision to influence the users. Disclosure of neutral information enhances the reliability of

the information reported to the users.

Prudence

The Framework states that an entity must exercise some degree of caution in making

judgement regarding estimates required under conditions of uncertainty. For example, an

assets and income should not be overstated while liabilities and expenses should not be


understated. In exercising caution, the Framework highlights that it should be considered in

the context of other qualitative characteristics of the financial statement, particularly

relevance and faithful representation.

Completeness

Financial statement can only provide useful information to users if all information is reported

completely. However, preparation and presentation of complete information by an entity is

usually subject to costs implication and materiality level of the information. Nevertheless, an

entity must report a reasonably complete information as incomplete information lacks

reliability and reduces relevance to the users.

The principle in relation to the costs and benefits of information is that the benefits to the

users should exceed the costs of obtaining the information and presenting it. However, the

evaluation of benefits and costs is a subjective area. The benefits can also accrue to parties

other than the intended users. For example, the potential benefit to the reporting entity is that

it can reduce its costs of capital. Similarly, the costs of preparing and presenting the

information can also include other indirect costs. For example, indirect costs to an entity

resulting from benefits gained by competitors based on the information reported in the

financial statements. Hence, while it is difficult to apply the costs and benefits analysis,

preparers and users of information should be aware of such constraint.

Comparability

Information presented in financial statements of an entity must be able to be compared over

several reporting periods in facilitating users to evaluate the performance and financial

position of an entity. At the same time, the information must also be able to be compared with

information presented in financial statements of another entity. In facilitating comparison of

these information, it is paramount that an entity discloses the accounting policies adopted for

events and transactions reported in the financial statements. Such disclosure will provide

information regarding the various accounting policies adopted by an entity during a particular

reporting period as there are several accounting policies allowed by IFRSs and statutes.

4.5 Trade-off between Relevance and Reliability

In some situations, a trade-off between relevance and reliability is necessary in reporting

information that meets the objective of financial statements.

Examples of situations where there is a trade-off between relevance and reliability are as

follows:

i. Reporting an entity’s assets based on fair value provides more relevant information to

users. However, it may not be possible to get a reliable measure of fair value measure

for certain asset. In this case, the relevant accounting standard usually allows an entity

to report on an alternative measurement basis. This highlights that a judgement is

required to provide an appropriate balance between these two qualitative

characteristics in reporting some information.

ii. An entity has entered into a transaction but not all aspects relating to the transaction

are known. If the entity delays the reporting of the transaction until all aspects of the

transaction are known, it may be too late and the information has become irrelevant.

On the other hand, reporting the information with lesser detail may compromise the

reliability of the information. In making judgement as to the timing and amount of


detail relating to the transaction, management must make the decisions that is best to

satisfy the economic decision-making of the users.

4.6 Elements of Financial Statements

The information presented in the financial statements are grouped into broad classes

according to their economic characteristics in order to potray their financial effects. The broad

classes are the elements of the financial statements. The elements and the respective financial

statement are shown in the following diagram.

Diagram 2: Elements of Financial Statements

Under each of the above elements, further sub-classification is made in presenting the

information to users. For example, assets are classified into non-current assets and current

assets in order to show the nature and function of each category of assets in the business. It

should be noted that the statement of cash flow does not present additional elements of

financial statements as it reflects both elements in the income statement and statement of

financial position.

Definitions of the Elements in the Statement of Financial Position

The Elements in the Statement of Financial Position are defined as follows:

Assets – A resource controlled by an entity as a result of past events and from which

future economic benefits are expected to flow to the entity.

Liabilities – 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 term economic benefits in the above definitions refer to future flows of cash or other

assets. In addition, the definitions also refer to past events. This criteria has been used in many

Elements of Financial Statements

Statement of Financial

Position:

- Assets

- Liabilities

- Equity

Measurement of

Performance in the

Income Statement:

- Income

- Expenses


accounting standards to prohibit an entity from recognizing an asset and liability if a

particular past event has not occurred. For example, an intention by an entity to purchase an

asset does not meet the definition of an asset as past event related to the purchase has not

occurred.

Definitions of the Elements Relating to Performance

The elements relating to performance are defined as follows:

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.

Expenses – Decreases in economic benefits during the accounting period in the form of

outflows or depletions of assets or incurrence of liabilities that result in decreases in

equity, other than those relating to distributions to equity participants.

The definition of income includes revenue and gains. Revenue arises in the course of ordinary

activities of an entity, such as from the sales of goods and rendering of services. Examples of

revenue are sales, rental income and fees. Income generated by other activities is usually

referred to as gains. For example, an entity sells its no-current asset at a selling price that is

higher than the carrying value of the non-current asset. The net profit made on the sale of the

non-current asset is a gain.

The definition of expenses includes expenses arising in the course of ordinary activities of the

entity as well as losses arising from other activities. Examples of expenses include salaries,

administrative expenses and interests expense. Examples of losses are those arising from sale

of non-current assets and fall in the value of an entity’s investments.

4.7 Recognition of the Elements of Financial Statements

Information on certain transaction or event can only be reported in the financial statements if

it meets the definition of an element and also satisfies the following recognition criteria:

- it is probable that any future economic benefits associated with the item will flow

to or from the entity.

- the item has a cost or value that can be measured with reliability.

Based on the above criteria, the recognition criteria for assets, liabilities, income and expenses

are summarized as follows:

Item Financial statement Recognition

Asset Statement of financial position 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.

Liability Statement of financial position 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.


Income Statement of comprehensive income An increase in future economic

benefits related to an increase in as

asset or a decrease of a liability has

arisen that can be measured reliably.

Expenses Statement of comprehensive income A decrease in future economic

benefits related to an increase in as

asset or a decrease of a liability has

arisen that can be measured reliably.

Most IFRSs specify the principles for recognizing specific types of assets, liabilities, income

and expenses. The recognition criteria for equity is not specified because it represents a

difference between assets and liabilities.

4.8 Measurement of the Elements of Financial Statements

Measurement refers to the process of determining the monetary amounts at which the

elements of the financial statements are to be recognized and reported in the financial

statements. It usually involves the selection of a particular basis of measurement from a

variety of measurement bases. These bases are used to different degrees and in varying

combinations for reporting purposes. The measurement bases include:

- historical cost

- current cost

- net realizable value

- present value

Historical cost

Historical cost is the most common basis used by entities. Under this basis, assets are

recorded at the amount of cash or cash equivalents paid or the fair value of the consideration

given at the acquisition date. Liabilities are recorded at the amount of proceeds received in

exchange for the obligation, or at the amounts of cash or cash equivalents expected to be paid

to satisfy the liability in the normal course of business.

Current cost

At current cost, assets are recorded at the amount of cash or cash equivalents that would have

been paid if the similar asset was acquired currently.

Net realizable value

Net realizable value is the amount of cash or cash equivalents that could be obtained by

selling an asset in an orderly manner. In relation to liability, it is the amount of cash or cash

equivalents expected to be paid to settle the liability in the normal course of business.

Present value

Present value is based on current estimate of the present discounted value of the future net

cash flows in the normal course of business.

To date, the Framework does not prescribe a particular concept in applying the measurement

bases to the various elements in the financial statements. Consequently, this could lead to an

ad hoc approach in measurement requirements in the standards developed by the IASB. The

IASB has recognized this issue and is working on a conceptual measurement project.


4.9 Concepts of Capital and Capital Maintenance

The concept of capital maintenance refers to a term that means an enterprise has maintained

as much capital at the end of the period as it had at the beginning of the period. Hence, where

the amount at the end of the period exceeds the amount at the beginning, the net amount is

profit for the period.

Concepts of capital maintenance can be divided into:

- financial capital maintenance; and

- physical capital maintenance.

Under financial capital maintenance concept, profit is the difference between the opening and

closing financial or money amount of the net assets, after excluding any distributions to or

contributions from the owners during the period. For example, the net assets at the beginning

of the year was RM1,000,000 and at the end of the year the net assets was RM1,200,000. If

there were no capital contribution or withdrawal during the year, profit earned during the year

is RM200,000. The maximum profit that can be withdrawn is RM200,000 in order to

maintain the opening capital at RM1,000,000.

Under physical capital maintenance, profit is earned only if the physical productive capacity

(also called operating capability) of the enterprise at the end of the period exceeds the

physical productive capacity at the beginning of the period. Price changes in the value of the

net assets are viewed as changes in the measurement of the physical productive capacity of

the entity. Adjustments for these are treated as part of equity and not as profit. Using the

above example, if the price level increases by 5% for the net assets at the end of the year, the

opening net assets need to be adjusted to RM1,050,000. The profit earned for the year is

RM150,000. Hence, the maximum amount of withdrawals is limited to RM150,000 in order

to maintain the opening capital at RM1,000,000.

5.0 IASB’s Current Conceptual Framework Project

The IASB and FASB are currently working on a joint project aims to update and refine the

existing conceptual framework. The overall objective of this project is to create a sound

foundation for future accounting standards that are principles-based, internally consistent and

internationally converged. The project is being conducted in 8 phases:

A. objectives and qualitative characteristics

B. definitions of elements, recognition and derecognition

C. measurement

D. reporting and concepts

E. boundaries of financial reporting, presentation and disclosure

F. purpose and status of the framework

G. application of the framework to not-for-profit entities

H. remaining issues if any

Exposure draft for the Objectives and Qualitative Characteristics (Phase A) was issued on 29

May 2008. On 28 September 2010, the IASB and FASB announced the completion of this

phase. The proposals in the exposure drafts include:

i. The objective of general purpose financial reporting is to provide financial information

about the reporting entity that is useful to existing and potential investors, lenders and

other creditors in making decisions about providing resources to the entity. General

purpose financial reporting is directed at users who provide resources to an entity but

http://www.ifrs.org/Current+Projects/IASB+Projects/Conceptual+Framework/EDMay08/EDMay08.htm

http://www.fasb.org/project/cf_phase-a.shtml


lack the ability to compel the entity to provide them with the information they need to

be able to make decisions.

ii. Primary users of accounting information comprise of existing and potential investors,

lenders and other creditors. These parties are providing, or are considering providing,

resources to the entity; and (b) do not have the power to compel the entity to provide

information directly to them and must rely on general purpose financial reports. Other

potential users, such as regulators, were not identified as primary users because they

often have the power to demand the information needed.

iii. Qualitative characteristics deal with the attributes that make financial information

useful. They are relevance and faithful representation, identified as the fundamental

qualitative characteristics. Comparability, timeliness, verifiability and

understandability identified as enhancing the qualitative characteristics that distinguish

more useful information from less useful information.

In addition to the above exposure draft, the boards have also issued a discussion paper for The

Reporting Entity (Phase D) on 29 May 2008. Subsequently an exposure draft was issued on

11 March 2010.

6.0 Summary

Financial reporting process involves application of certain rules and procedures to events and

transactions engaged by an entity and communicating the information to the various users.

The main objective of reporting this information is to provide useful information to a wide

range of users in making their economic decisions. In meeting this objective, it is paramount

that the information is prepared and presented in accordance with certain requirements. Under

the current reporting environment, these requirements are developed based on generally

accepted concepts or principles developed in a conceptual framework. Hence, a conceptual

framework forms the basis of reference for financial reporting. This is also referred to as

principle-based approach in standard-setting. In many jurisdictions around the world, national

standard setters are adopting the IASB Framework as the basis of their accounting standards.

The IASB convergence efforts to harmonise accounting standards around the world has

contributed to the increase in the principle-based approach relative to rules-based approach in

the standard-setting process. Currently, the IASB and FASB are jointly working on a project

to revise and conform their conceptual frameworks.

Questions

1. What is a conceptual framework?

2. Why is a conceptual framework needed in the development of accounting standards?

3. Discuss the key issues influencing the development of a conceptual framework?

4. Discuss the advantages and disadvantages of having a conceptual framework?

5. Explain the advantages and disadvantages of principles-based and rules-based

standards.

6. Relevance and reliability are two of the qualities of the information in financial

statements. Explain these two qualitative characteristics.

http://www.ifrs.org/Current+Projects/IASB+Projects/Conceptual+Framework/EDMay08/EDMay08.htm

http://www.fasb.org/project/cf_phase-d.shtml

http://www.fasb.org/project/cf_phase-d.shtml

http://www.ifrs.org/Current+Projects/IASB+Projects/Conceptual+Framework/EDMar10/Exposure+draft+and+comment+letters.htm


7. Explain what is meant by the “trade-off of relevance and reliability” in accounting

information. Give examples in your explanation.

8. What is the difference between consistency and comparability of accounting

information?

9. Explain why does the IASB and FASB need a common conceptual framework?

10. The following statement was made by a senior financial executive of a public listed

company:

“I always ensure that all events and transactions reported in the company’ financial

statements are in compliance with the accounting standards issued by MASB.

However, I am not so concerned if the accounting information is in compliance with

the Framework issued by the MASB as it is not an accounting standard”.

Required: Comment on the above statement.

References

1. MASBs, Framework for the Preparation and Presentation of Financial Statements,

Malaysian Financial Reporting Standards, 2007, www.masb.org.my.

2. International Accounting Standards Board, Framework for the Preparation and

Presentation of Financial Statements, International Financial Reporting Standards,

London: IAC Foundation, www.iasb.org.

http://www.masb.org.my/

Conceptual Framework

Documents

Transcript of Conceptual Framework