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Intermediate accounting note

Chapter 1: conceptual frame work

 What is the conceptual frame work?

 It is a set of generally accepted principles and concepts that underlie the preparation
of financial statements
 It assists standard setters, statement preparers and users.
 Provides guidance to statement prepares in
1. Identifying the boundaries/ scope of a financial report
2. Selection of transaction and events to be reported
3. How they should be recognized and measured
4. How it should all be summarized
 Why do we need a conceptual frame work?
 Guide the development of accounting standards.
 Help practicing accountants in Solving new and emerging problems
 The conceptual frame work is not IFRS. The Conceptual Framework sets out the
fundamental concepts for financial reporting that guide the Board in developing IFRS
Standards. The conceptual frame work has a broader scope.
 Development of the conceptual frame work :
 Is developed by IASB , it was first issued in 2010 and was last revised in march 2018
 It has 8 chapters / concepts :
1. The objective of general purpose financial reporting
2. Qualitative characteristic of a useful financial information
3. Financial statement and reporting entity
4. Elements of financial statements
5. Recognition and de-recognition
6. Measurement
7. Presentation and disclosure
8. Concepts of capital and capital maintenance

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 The 3 main levels of the conceptual frame work :

1. Objective of financial reporting
2. Qualitative characteristics and elements of a financial statement
3. Recognition Measurement and disclosure (assumptions , principles and constraints)
 Objectives of a financial report :
 Is the foundation of the conceptual frame work and other concepts of the conceptual
frame work follow from it.
 The objective of a general purpose objective is to present useful financial information
about the reporting entity to external users (investors and creditors) and minimize the
information asymmetry between management and investors.
 to assist users in making decisions;
1. Investment decision
2. Financing decision
3. Voting and influencing management
 To help users asses:
1. The company’s future prospects (profitability, cash flow, returns ) : buy using
information about changes in assets and claims against them.
2. Managerial stewardship (how well the management is using the resources): buy
using information about how management has discharged the resources.
 The general purpose financial statement is prepared for users who cannot demand all the
information they need from a company so they rely on the GPFS.
 The users are external parties so financial statement preparers assume the level of the
user’s competence in understanding the statement and report it as such.

 Qualitative characteristics of accounting information- qualities that affect the decision-

usefulness of a financial statement. Conceders the pervasive cost constraint of the financial
report (the cost must not exceed the benefit of the reporting practice).
 It has a hierarchy:
1. Fundamental quality –relevance: The information reported must be able to cause a
difference in decision. An information has influence on decision if it has:
 Predictive value : if the information helps investors in prediction

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 Confirmatory value : if the information helps to confirm investors past

predictions
 Materiality: is the company specific (it is relative) analysis of the nature
(qualitative) and magnitude (quantitative) of the information to be reported.
companies use the rule of thumb “anything less than 5% of the net income is
Immaterial”
2. Fundamental quality - faithful representation: The matching of numbers and
description with reality. It is concerned with the substance of what is reported.
For information to be faithful it must be :
 Complete : all relevant information must be included
 Neutral : the report without favoritism and bias (trying to make the company look
good) and Is supported by prudence ( caution when making judgment)
 Free from error: no mistakes. note that faithful representation does not
necessarily mean total freedom from errors ( we make estimation errors)

3. Enhancing qualities: complementary to the fundamental characteristics

 Comparability: is measuring and reporting information in the same manner
across different companies which enable us to identify differences and similarities
between items.
 Consistency: the use of the same measuring and reporting method for an event
consistently .The company can change methods but has to disclose it.
 Verifiability: two different observers of the information can evaluate and come to
the same conclusion about the information’s faithful representation.
 Timeliness: reporting the information with in its period of usefulness.
 Understandability: the information should be presented in a clear way; we just
can’t omit information because it is too complex.
4. Constraints: constraint on the qualitative characteristics of report
 Materiality : is the amount being reported of any significance
 Cost-benefit: the cost of providing detailed information must not exceed the
benefit of the information

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 Prudence / conservatism: The prudence or conservatism accounting

constraint dictates that all potential losses are taken into the financial statements,
but all potential profits are left out. We will prioritize
 Industrial practice: For some industries detailed financial report is hard to
develop due to the nature of activities
 Financial statements and the reporting entity :
 Financial statements are particular forms of a report which provide information about
assets, liabilities, equity, revenue and expenses.
 Financial statements have 3 forms :
1. Consolidated: Consolidated financial statements provide information about the
assets, liabilities, equity, income and expenses of both the parent and its subsidiaries
as a single reporting entity. ( reported as a single economic entity)
2. Unconsolidated: Unconsolidated financial statements are designed to provide
information about the parent's assets, liabilities, equity, income and expenses, and not
about those of its subsidiaries.
3. Combined: The combined financial statement reports the finances of the subsidiaries
and the parent company separately, but combined into one document.
 Financial statements are prepared for a period of time, with comparative information
and predictive information during uncertainty.
 Financial statements are based on the going-concern assumption and are from a reporting
entity POV.
 A reporting entity: is an economic unit which prepares its own financial reports. It can
be a parent or a subsidiary or a segment of a parent entity.
 A reporting entity is not necessarily a legal entity.
 Basic elements of a report and their definitions
 Elements of a financial statement: 5 of them
1. Asset is an economic resources controlled by an entity as a result of past events with
future income-generating ability. ( do some questions on identifying if items are
assets or not)
2. Liability is a current obligation to transfer economic resources as a result of past
events that a company has no ability to avoid. (do some questions)

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3. Equity is residual interest in the assets of a entity after deducting its liability
4. Expense a decrease in assets or an increase in liabilities that result in decrease in
equity other than dividends.
5. Income an increase in assets or a decrease in liabilities that result in an increase in
equity other than share contributions.

The 5 elements are grouped into two, the first three represent resources and claims against the
resources at a given time (related to financial position) but the last two represent the events or
circumstances that result in changes of the former group ( related to financial performance). This
interaction between the two groups is called articulation.

 Assumptions:
 The conceptual frame work only identifies one assumption – the going concern
assumption but others exist.
1. The economic entity assumption: the separation of a company’s activities from its
owner’s or other entity’s. This separation can be on department level or division etc…
2. Going concern assumption: the assumption that a company is going to have a long
life. It is an important in order to justify :
 Amortization and depreciation policies.
 Classifying assets and liabilities current and non- current (becomes pointless
without this assumption).
3. The monetary assumption: monetary unit is the basis of measurement of an
economic event. Note that accounting does not adjust its reporting to inflation or
deflation unless its dramatic.
4. The periodicity/ time period assumption: a company divides its economic events in
to artificial time periods. It results in a trade-off between relevance and faithful
representation.
5. Accrual basis of accounting assumption: an economic event is reported in the
period in which it occurred ( as opposed to cash basis)

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 Recognition: is the inclusion of items that meet the definition of one of the elements in
financial statement. The amount at which it is recognized at is called carrying amount.
 De-recognition; is the complete removal of recognized items. This can occur when 1) the
entity loses control over an asset or when it is no longer responsible for a liability.
1. Revenue recognition principle: when a company agrees to perform a task it has a
performance obligation, when it fulfills the performance obligation it recognizes
revenue. Revenue is to be recognized in the period in which the performance
obligation is fulfilled.
2. Expense recognition: expenses are out-flows or using up of assets and the incurrence
of liabilities as a result of operational activities. The expense recognition principle
matches expenses with revenues. Expenses are to be recognized in the period in
which they were incurred.

 Measurement principle : there are 2 measurement principles , the choice between the two
results in a trade-off between relevance and faithful representation :

1. Historical cost: on the basis of price at acquisition for assets and value of
consideration to be incurred for liabilities.
 This can be preferred when reporting liabilities or due to cost ineffectiveness of
reevaluating resources every end of period.
 When historical cost of assets is reduced overtime it is called impairment.
 Impairment is the sudden loss in value (while depreciation is an expected loss
in value)
 When the historical cost of liabilities increases it is called onerous.
 An onerous contract is an accounting term that refers to a contract that will
cost a company more to fulfill than what the company will receive in return.
 Current cost/ value: updated valuing that reflects the conditions at the reporting
date. This includes:
 Fair value
 Value in uses of assets and fulfillment of liabilities.
 Current cost

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 Fair value (IFRS 13): The price that would be received to sell an asset or paid to
transfer a liability in an orderly transaction (not forced) between market
participants (market based not entity based) at the measurement date (current
price). It is the value of an asset or liability in the market at reporting date. It is
based on “exit price” notion- The price is a bid price .IFRS gives the option to
use fair value.

Exit price: The price that would be received to sell an asset or paid to transfer a liability.
Exit price Entry price.

Entry price: The price paid to acquire an asset or received to assume a liability in an
exchange transaction.

Fair value measurement requires some level of establishes subjective judgment when the
market price is not readily available. So IFRS established the hierarchy of fair value (3 broad
levels- from least subjective to most subjective);

 Level 1 inputs - unadjusted quoted prices of identical items in the active

market unadjusted and is the most reliable. Level 1 input will rarely be
available for non-financial assets and non-financial liabilities. Level 1 inputs
should be used without adjustments. However, IFRS 13 provides a few very
restrictive exceptions where adjustments may be appropriate. These
adjustments rarely apply in practice. Any adjustment to the quoted price
results in a fair value measurement categorized within a lower level of the fair
value hierarchy
 Level 2 inputs - inputs not quoted but are observable for the item. And need
adjustments. Inputs include:
 Quoted price for similar items in an active market
 Quoted prices for identical or similar items in a non-active market
 Level 3 inputs - unobservable inputs used when observable inputs aren’t
available. So it’s highly dependent on subjective judgment.

Note: Observable means information is available in the market and unobservable means there is
no information so we use our judgment.

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An example for level 1 inputs: share prices quoted in an active market . (if it’s not quoted it’s
not level 1)

An example of a Level 2 input: is a valuation multiple for a business unit that is based on the
sale of comparable entities. Another example is the price per square foot for a building, based on
prices involving comparable facilities in similar locations (since we do have mkt information it
would not be 3rd level)

 Determining the fair value of a non-financial asset

1. Select appropriate market : selection between
 primary market ; the one with the highest volume and activity
 advantageous market : the one that maximizes the amount to be received when
asset is sold or minimizing the cost of transferring a liability after considering
transaction cost and transport cost

Note: if we can tell which market is the principal (with volume) we immediately take the price
and call it the fair value . If we don’t know which market is the principal (don’t know the volume
or volume is equal in all markets) we look for the most advantageous market buy deducting the
transaction cost from the price (we take the highest price –transaction cost)

 https://www.youtube.com/watch?v=2SPNlOLCp-U
 Do question on slide no55 and 56
2. Identify market participants : participants in the principal / advantageous market are
 Independent
 Knowledgeable
 Have the capacity to transact
 Willing to transact
3. Use market participant assumptions:
4. Determine highest and best use: fair value assumes that a company will put assets to
their best use. (is not prudent)
 Do question on slide no59 and 60
5. Apply.

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 The 3 approaches to fair valuation /valuation methods : describes three main

approaches to measuring the fair value of assets and liabilities:
1. the market approach,
2. the income approach, and
3. the cost approach

 The time value of money

 Presentation and disclosure

 Presentation of profit or loss and OIC:
 Full Disclosure principle : states that all decision- useful information must be disclosed
reported Users can find information in 3 parts of a report :

1. The main body of financial statement : contains the basic financial statements
2. The notes to the financial statement :
 Information in items not reported in the main body
 Explain the items in the main body ( the main body reports an incomplete
information)
 Does not have to quantifiable it can be narrative
 E.g. Description of accounting methods and policies
3. The supplementary information :
 Giving different perspective
 May include management discussion /explanation
 The concept of capital and capital maintenance: The concepts of capital give rise to the two
concepts of capital maintenance:
 Under a financial concept of capital, capital is synonymous with the net assets or equity
of the entity. 
 Under a physical concept of capital, it is regarded as the productive capacity of the entity
based on, for example, units of output per day.

 Summary

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