CH 1. Financial Reporting Framework Flashcards
What is the Conceptual Framework?
And
What is the importance of it?
The Conceptual Framework is a set of theoretical principles and concepts that underlie the preparation and presentation of financial statements.
Importance:
- Avoid the accounting standards being produced on a haphazard basis when particular issues and circumstances arise.
- Provide Key Principles from which all future accounting standards draw.
- Acts as a reference point for the preparers of financial statements, if standards are inconsistent or contradictory, also provide guidance if no accounting standard governs a particular transaction (although this will be extremely rare).
- In order to achieve fair presentation, on entity must comply with (IAS 1: para. 15):
- International Financial Reporting Standards (IFRSs, IASs and IFRIC Interpretations)
- The Conceptual Framework for Financial Reporting.
What is the purpose of the Conceptual Framework?
The Purpose of the Conceptual Framework is to assist:
- (a) the Board to develop new IFRS Standards, based on consistent concepts
- (b) Provides guidance to Preparers of financial statements, when no IFRS Standard applies, or when an IFRS Standard offers a choice of accounting policy
- (c) Supporting Users and all other parties in understanding and interpreting IFRS Standards.
The Conceptual Framework is not an accounting standard. It does not override the requirements in a particular IFRS Standard.
What are the chapters of the Conceptual Framework?
Chapter 1 - The objective of general purpose financial reporting
Chapter 2 - Qualitative characteristics of useful financial information
Chapter 3 - Financial statements and the reporting entity
Chapter 4 - The elements of financial statements
Chapter 5 - Recognition and derecognition
Chapter 6 - Measurement
Chapter 7 - Presentation and disclosure
Chapter 8 - Concepts of capital and capital maintenance
Ch.1 - What is the objective of the Conceptual Framework?
The Framework states that the purpose of financial reporting is to:
- Provide information to current and potential investors and providers of credit
- Enabling them to make decisions about providing economic resources to an entity.
They require information that will help them to assess:
- Potential future cash flows, and
- Management’s stewardship of the entity’s economic resources.
To assess an entity’s future cash flows, users need information about:
- Resources of the entity e.g. assets
- Claims/Obligations against the entity e.g. liabilities and equity
- Changes in economic resources and claims e.g. income and expenses.
Chapter 2 - What are the Fundamental Qualitative characteristics of useful financial information?
2 Fundamental Characteristics:-
- Information is RELEVANT so:
- It makes a difference to decisions made by users. It has predictive and/or confirmatory value.
- INFO is Material if omitting or misstating it could influence a decision.
-
Faithful representation of information is:
- Substance rather than the legal form
- Complete
- Neutral
- Prudent
- Free from error
Chapter 2 - What are the Enhancing Qualitative characteristics of useful financial information?
- Comparability - of different account items, accounting policies and disclosures (not the same as uniformity)
- Verifiability - means that different knowledgeable and independent observers could reach the same consensus that the accounts are of a faithful representation
- Timeliness - information is made available in time to be capable of influencing decisions
-
Understandability - Information should be presented as clearly and
concisely as possible. - Cost Constraints - assesses whether the benefits of reporting particular information outweigh the costs involved in providing it.
Chapter 3 - What are Financial statements and the reporting entity?
The objective of Financial Statements:
To provide information about the reporting entity’s assets, liabilities, equity, income and expenses that is useful in assessing the prospects for future net cash inflows and in assessing management’s stewardship.
Type of Statements and information presented as:
- Statement of Financial Position (SOFP)
- Statement of profit or loss and other comprehensive income (SPLOCI)
- Other Statements and Notes
- Cash Flow statement
- The nature of recognised items and associated risks
- The nature of unrecognised assets and liabilities and associated risks
- Transactions with equity holders
- Methods, assumptions and judgements used to estimate amounts presented or disclosed
The Reporting Entity
A reporting entity is one that prepares financial statements (either through choice or as a result of legal requirements).
Note. financial statements of 2 or more entities (combined statements/Consolidated statements) can be difficult to determine the boundaries, the framework currently doesn’t currently provide guidance on this but may do so in the future.
Chapter 4 - What are the elements of financial statements?
Asset
Liability
Equity
Income
Expenses
Definition of Economic Resource
The elements of financial statements
Asset - A present economic resource controlled by an entity as a result of a past event’
Liability - A present obligation to transfer an economic resource as a result of a past event’
Equity - The residual interest in the net assets of an entity.
Income - Increases in assets or decreases in liabilities that result in an increase in equity
Expenses - Decreases in assets or increases in liabilities that result in decreases in equity
Economic resource: is a ‘right that has the potential to produce economic benefits’
Chapter 5 - Explain the Recognition and derecognition process?
Recognition
Items are only recognised in the financial statements if they meet the definition of one of the elements.
Elements are recognised if it provides users with useful information. if it provides:
- relevant information
-
faithful representation
- Probable inflow or outflow of economic resources
Note. However, not all items meeting these definitions are recognised, if there is uncertainty over the existence of the element or if there is a low probability of an inflow or outflow of economic resources.
Judgement is required when recognising elements, this is why their specific criteria vary from one element to another.
Derecognition
Derecognition is the removal of some or all of an asset or liability from the statement of financial position. This normally occurs when the entity:
- loses control of the asset, or
- has no present obligation for the liability.
Accounting for derecognition should faithfully represent the changes in an entity’s net assets, as well as any assets or liabilities, retained. This is achieved by:
- derecognising any transferred expired or consumed component
- recognising a gain or loss on the above, and
- recognising any retained component.
Sometimes an entity might appear to have transferred an asset or liability. However, derecognition would not be appropriate if exposure to variations in the element’s economic benefits is retained. (ie if the risk and rewards stay with the entity)
Chapter 6 - What is the Measurement basis of an element?
and
What are the factors of selecting a measurement basis?
IFRSs use a mixed measurement approach, which means that different measurement bases are used for different classes of elements.
2 main Measurements bases:
- - Historical Cost - Cost to acquire the asset, depreciated/amortised over its life, possibly impaired.
-
Current Value
- Fair Value (IFRS 13) Price expected to receive in an orderly transaction in an active market.
- Value in Use - P.V of cash flows (including disposal)
- Fulfilment value: P.V of the amount expected to be obligated to transfer to settle the liability.
-
Not referred to that often:
- <strong>Current cost of an asset: - </strong>Cost of equivalent asset on measurement date + transaction costs
- <strong>Current cost of a liability:</strong> is the consideration received for an equivalent liability at the measurement date -(less) transaction costs.
-
Current Value
Selecting a measurement base.
When selecting a measurement basis, the Conceptual Framework states that faithful representation and relevance is maximised if the following are considered:
- The characteristics of the asset and/or liability
- The ways in which the asset and/or liability contribute to future cash flows.
Chapter 7 - Why is effective Presentation and disclosure Important?
And
What is required for effective presentation and disclosure?
Effective communication of information makes information more relevant, it contributes:
- - to a faithful representation of financial position and performance
- - enhances the understandability and comparability of information.
Effective presentation and disclosure require:
- Focusing on presentation and disclosure objectives and principles rather than on rules
- Classifying information by grouping similar items and separating dissimilar items
- Aggregating information appropriately so that it is not obscured by unnecessary detail or excessive aggregation
Why is the classification of income and expenditure in the P/L or OCI important?
From a stakeholder perspective, how is the presentation and disclosure of information Important?
The statement of profit or loss is the primary source of information about an entity’s performance. So in principal all income and expenditure should be accounted for in this statement.
Except the IASB may decide that income or expenses arising from a change in the current value of an asset or liability should be classified as other comprehensive income (OCI). as it provides more useful and faithful representation, and income and expenditure may be transferred to the P/L in the future.
Stakeholder perspective
Investors tend to focus their analysis, which means they focus on profit and loss rather than OCI, and many accounting ratios are calculated using profit or loss for the year, rather than total comprehensive income.
As such, the wrong classification of income and expenses can potentially have a significant effect on how an investor perceives the performance of the entity.
A common misconception is that profit or loss is for realised gains and losses, and OCI for
unrealised.
However, this distinction is itself controversial and therefore of limited use in determining
the profit or loss versus OCI classification.
It could be argued that:
- OCI is defined in opposition to profit or loss -Meaning, items that are not profit or loss
- Or even that it has been used as a ‘dumping ground’ for items that entities do not wish to report in profit or loss.
- Reclassification from OCI has been said to compromise the reliability of both profit or loss and OCI.
In 2015, as a result of a joint outreach investor event, the IASB was asked to define what financial performance is, clarify the meaning and importance of OCI and how the distinction between profit or loss and OCI should be made in practice.
The revised Conceptual Framework does go some way to address these issues, however, it does not define the concepts of profit or loss so some of these questions remain unanswered.
Chapter 8 - Concepts of capital and capital maintenance
Chapter 8 - Concepts of capital and capital maintenance
Discuss how might a Crypto Currency be accounted for using the conceptual framework as there currently is no IAS or IFRS it fits directly into?
1st does the item meet a definition of an element
- Definition of Asset - A economic resource that is under the control of the company occurring from a past event.
- - Crypto Currencies meets the definition of an asset.
2nd Recognition
Elements are recognised only if it meets a definition of an element and it provides users with useful information. if it provides:
- Relevant information (it is relevant as it provides investors info of an investment)
- Faithful representation (can be reliably measured as it is traded)
- Probable inflow or outflow of economic resources (Yes it is probable)
3 what measurement basis?
Measurements are allowed based on Historical cost and Current Value.
But the choice should be based on the:
- *- Characteristics of the asset and liabilities
- The way in which the asset or liability contributes to future casflows.**
The asset is Crypto’s are held and sold for fair value gain, (similar to stocks and highly volatile)
Historical cost - Uses cost of an asset and does not account for highly volatile price valuations.
Current Value(fair value) - accounts for the price fluctuations which is a more fair representation. (—- Fair value is the choice.
4. Presentation
Fair value through P/L or OCI
- P/L value is more likely as assets are likely to be sold quickly.
- asset are held at cost and depreciated,
Explain the roles of the Prudence Concept and Substance over form in financial reporting?
For Financial Reports to be faithfully presented preparers should exercise Prudence, and transactions should be recorded on the substance rather then the legal form.
The Prudence Concept.
Prudence – caution should be exercised when making judgements. This Means:
- assets and income are not overstated
- liabilities and expenses are not understated.
Substance over form
Substance over form – transactions should be accounted for in accordance with their economic substance rather than their legal form.
