MODULE 1

DEVELOPMENT OF FINANCIAL REPORTING FRAMEWORK

AND STANDARD SETTING BODY

Overview:
This module describes the environment that has influenced both the development and use
of the financial accounting process. The chapter traces the development of financial accounting
standards, focusing on the groups that have had or currently have the responsibility for developing
such standards. Certain groups other than those with direct responsibility for developing financial
accounting standards have significantly influenced the standard-setting process.
World markets are becoming increasingly intertwined. And, due to technological advances
and less onerous regulatory requirements, investors can engage in financial transactions across
national borders, and to make investment, capital allocation, and financing decisions involving
many foreign companies. As a result, an increasing number of investors are holding securities of
foreign companies, and a significant number of foreign companies are found on national exchanges.
The move toward adoption of international financial reporting standards has and will continue to
facilitate this movement.
Accounting is important for markets, free enterprise, and competition because it assists in
providing information that leads to capital allocation. Reliable information leads to a better, more
effective process of capital allocation, which in turn is critical to a healthier economy.
Financial accounting is the process that culminates in the preparation of financial reports
on the enterprise for use by both internal and external parties.
Financial statements are the principal means through which a company communicates
its financial information to those outside it. The financial statements most frequently provided are
(1) the statement of financial position, (2) the income statement or statement of comprehensive
income, (3) the statement of cash flows, and (4) the statement of changes in equity. Note
disclosures are an integral part of each financial statement. Other means of financial reporting
include the president’s letter or supplementary schedules in the corporate annual report,
prospectuses, and reports filed with government agencies.
The major standard-setters of the world, coupled with regulatory authorities, now
recognize that capital formation and investor understanding is enhanced if a single set of high-
quality accounting standards is developed.

Module Objectives:
❖ describe the purpose of accounting and financial reporting;
❖ identify the need for information of the users of accounting information;
❖ describe the branches of accounting;
❖ discuss the development of accounting standards and financial reporting standards;
❖ identify the organizations involved in the promulgation of the accounting standards;
❖ describe the due process of developing the international financial reporting standards; and
❖ describe the due process of developing and promulgating Philippine Financial Reporting
Standards.

ACCO 20063: CONCEPTUAL FRAMEWORK AND ACCOUNTING STANDARDS 1

OBJECTIVE OF FINANCIAL REPORTING
The objective of general-purpose financial reporting is to provide financial information
about the reporting entity that is useful to present and potential equity investors, lenders, and
other creditors in making decisions about providing resources to the entity.
I. General-purpose financial are those statements intended to meet the needs of the
users to provide the most useful information to a wide variety of users.

Objective, usefulness and limitations of general-purpose financial reporting

The objective of general-purpose financial reporting forms the foundation of the
Conceptual Framework. Other aspects of the Conceptual Framework—the qualitative
characteristics of, and the cost constraint on, useful financial information, a reporting entity
concept, elements of financial statements, recognition and derecognition, measurement,
presentation and disclosure—flow logically from the objective.
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 relating to providing resources to the entity. Those decisions involve decisions
about:
a) buying, selling or holding equity and debt instruments;
b) providing or settling loans and other forms of credit; or
c) exercising rights to vote on, or otherwise influence, management’s actions that affect the
use of the entity’s economic resources.

II. Equity investors and creditors are the primary user groups and have the most critical
and immediate needs for information in the financial statements. Investors and creditors
need this information to assess a company’s ability to generate net cash inflows and to
understand management’s ability to protect and enhance the assets of a company.
III. The entity perspective means that the company is viewed as being separate and distinct
from its investors (both shareholders and creditors). Therefore, the assets of the company
belong to the company, not a specific creditor or shareholder. Financial reporting focused only
on the needs of the shareholder—the proprietary perspective—is not considered
appropriate.
IV. Decision-usefulness means that information contained in the financial statements should
help investors assess the amounts, timing, and uncertainty of prospective cash inflows
from dividends or interest, and the proceeds from the sale, redemption, or maturity of
securities or loans. For investors to make these assessments, the financial statements and
related explanations must provide information about the company’s economic resources,
the claims to those resources, and the changes in them.

To facilitate efficient capital allocation, investors need relevant information and a faithful
representation of that information to enable them to make comparisons across borders. A
single, widely accepted set of high-quality accounting standards is a necessity to ensure
adequate comparability. In order to achieve this goal the following element must be present:
a. A single set of high-quality accounting standards established by a single standard-
setting body.
b. Consistency in application and interpretation.
c. Common disclosures.
d. Common high-quality auditing standards and practices.
e. A common approach to regulatory review and enforcement.
f. Education and training of market participants.
ACCO 20063: CONCEPTUAL FRAMEWORK AND ACCOUNTING STANDARDS 2
 g. Common delivery systems (e.g., extensible Business Reporting Language—XBRL).
h. A common approach to corporate governance and legal frameworks around the world.

BRANCHES OF ACCOUNTING
❖ Financial Accounting is focused on the recording of business transactions and the
periodic preparation of reports on financial position and results of operations. Financial
accountants accord importance to existing accounting standards.
❖ Management Accounting, as defined by Institute of Management Accountants (IMA) is
a profession that involves partnering in management decision making, devising planning
and performance management systems, and providing expertise in financial reporting and
control to assist management in the formulation and implementation of organization’s
strategy.
❖ Cost Accounting deals with the collection, allocation and control of the cost of producing
specific goods and services.
❖ Auditing is an independent examination that ensures the fairness and reliability of the
reports that management submits to users outside the business entity.
❖ Government Accounting is concerned with the identification of the sources and uses of
government funds.
❖ Tax Accounting includes preparation of tax returns and the consideration of tax
consequences of proposed business transactions.
❖ Accounting Education employs accountants either as researchers, professors or
reviewers. They guarantee the continued development of the profession.

STANDARD-SETTING ORGANIZATIONS
The main international standard setting organization is the International Accounting
Standards Board (IASB), based in London, United Kingdom. The IASB issues International
Financial Reporting Standards (IFRS) which are used by most foreign exchanges.

The two organizations that have a role in international standard-setting are the
International Organization of Securities Commissions (IOSCO) and the IASB.
a. The IOSCO does not set accounting standards; it is dedicated to ensuring that the global
markets can operate in an efficient and effective basis.
b. The member agencies have agreed to:
1. Cooperate to promote high standards of regulation in order to maintain just,
efficient, and sound markets.
2. Exchange information on their respective experiences in order to promote the
development of domestic markets.
3. Unite their efforts to establish standards and an effective surveillance of
international securities transactions.
4. Provide mutual assistance to promote the integrity of the markets by a rigorous
application of the standards and by effective enforcement against offenses.

IOSCO recommends that its members allow multinational issuers to use IFRS in cross-
folder offerings and listings, as supplemented by reconciliation, disclosure, and interpretation
where necessary, to address outstanding substantive issues at a national or regional level.

The international standard-setting structure is composed of the following four organizations:

a. The IFRS foundation (22 trustees) provides oversight to the IASB, IFRS Advisory

ACCO 20063: CONCEPTUAL FRAMEWORK AND ACCOUNTING STANDARDS 3

 Council, and IFRS Interpretations Committee. It appoints members, reviews
effectiveness, and helps in fundraising efforts for these organizations.
b. The International Accounting Standards Board (IASB) consisting of 16 members,
develops in the public interest, a single set of high-quality, enforceable, and global
international financial reporting standards for general-purpose financial statements.
c. The IFRS Advisory Council (30 or more members) provides advice and council to the
IASB on major policies and technical issues.

d. The IFRS Interpretations Committee (22 members) assists the IASB through the
timely identification, discussion, and resolution of financial reporting issues within the
framework of IFRS.

In addition, as part of the governance structure, a Monitoring Board was created. It

establishes a link between accounting standard-setters and those public authorities that
generally oversee them (e.g. IOSCO). It also provides political legitimacy to the overall
organization.
The IASB has a thorough, open and transparent due process in establishing financial
accounting standards. It consists of the following elements:
a. An independent standard-setting board overseen by geographically and professionally
diverse body of trustees.
b. A thorough and systematic process for developing standards.
c. Engagement with investors, regulators, business leaders, and the global accountancy
profession at every stage of the process.
d. Collaborative efforts with the worldwide standard-setting community.

To implement its due process, the IASB follows specific steps to develop a typical IFRS.
a. Topics are identified and placed on the Board’s agenda.
b. Research and analysis are conducted, and preliminary views of pros and cons are
issued.
c. Public hearings are held on the proposed standard.
d. The Board evaluates research and public responses and issues an exposure draft.
e. The Board evaluates the responses and changes the exposure draft, if necessary. Then
the final standard is issued.

The following characteristics of the IASB are meant to reinforce the importance of an open,
transparent, and independent due process.
a. Membership: The Board consists of 16 well-paid members, from different countries,
serving 5-year renewable terms.
b. Autonomy: The IASB is not part of any professional organization. It is appointed by and
answerable only to the IFRS Foundation.
c. Independence: Full-time IASB members must sever all ties with their former employer.
Members are selected for their expertise in standard-setting rather than to represent a
given country.
d. Voting: Nine of 16 votes are needed to issue a new IFRS.

The IASB issues three major types of pronouncements:

a. International Financial Reporting Standards: To date the IASB has issued 13
standards. In addition, the previous international standard-setting body, the International
Accounting Standards Committee (IASC) issued 41 International Accounting Standards
ACCO 20063: CONCEPTUAL FRAMEWORK AND ACCOUNTING STANDARDS 4
 (IAS). Those that have not been amended or superseded are considered under the
umbrella of IFRS.
b. Conceptual Framework for Financial Reporting: The IASB issued the Framework for
the Preparation and Presentation of Financial Statements (referred to as the
Framework) with the intent to create a conceptual framework that would serve as a tool
for solving existing and emerging problems in a consistent manner. However, the
Framework is not an IFRS and does not define standards for any measurement or
disclosure issue. Nothing in the Framework overrides any specific IFRS.

c. International Financial Reporting Interpretations: Interpretations are issued by the

IFRS Interpretations Committee and are considered authoritative and must be followed.
Twenty have been issued to date. These interpretations cover (1) newly identified
financial reporting issues not specifically dealt with in IFRS, and (2) issues where
unsatisfactory or conflicting interpretations have developed, or seem likely to develop,
in the absence of authoritative guidance.

The IASB has no regulatory mandate and no enforcement mechanism. It relies on other
regulators to enforce the use of its standards. For example, the European Union requires publicly
traded member country companies to use IFRS. Any company indicating that it prepares its
financial statements in conformity with IFRS must use all of the standards and interpretations. The
hierarchy of authoritative pronouncements is: IFRS, IAS, Interpretations issued by either the IFRS
Interpretation Committee or its predecessor the IAS Interpretations Committee, the Conceptual
Framework for Financial Reporting, and pronouncements of other standard-setting bodies that
use a similar conceptual framework to develop accounting standards (e.g., U.S. GAAP).

ACCOUNTING STANDARDS IN THE PHILIPPINES

On November 18, 1981, the Philippine Institute of Certified Public Accountants (PICPA)
created the Accounting Standards Council (ASC) to establish and improve accounting standards
that will be generally accepted in the Philippines.
The creation of the Council received the support of the following: the Securities and
Exchange Commission (SEC) and the Central Bank of the Philippines (CB)-regulatory agencies
where the financial statements are filed; the Professional Regulation Commission (PRC) through
the Board of Accountancy—which supervises CPAs and auditors, and the Financial Executives
Institute of the Philippines (FINEX)—which is the largest organization of financial executives who
are responsible for the preparation of the financial statements. The ASC was composed of eight
(8) members-four from PICPA including the designated Chairman; and one each from SEC, CB,
PRC and FINEX.
The standards would generally be based on the following: existing practices in the
Philippines, research or studies by the Council; locally or internationally available literature on the
topic or subject; and statements, recommendations, studies or standards issued by other
standard-setting bodies such as the International Accounting Standards Board (LASB) and the
Financial Accounting Standards Board (FASB).
The statements and interpretations issued by the Council represented represent generally
accepted accounting principles in the Philippines. Accounting principles become generally
accepted if they have substantial authoritative support from the relevant parties interested in the
financial statements-the preparers and users, auditors and regulatory agencies.

ACCO 20063: CONCEPTUAL FRAMEWORK AND ACCOUNTING STANDARDS 5

Financial Reporting Standards Council
When created per Section 9(A) of the Rules and Regulations Implementing Republic Act
No. 9298 otherwise known as the Philippine Accountancy Act of 2004, the Financial Reporting
Standards Council (FRSC) shall be the new accounting standard setting body.
The FRSC shall be composed of fifteen (15) members with a Chairman, who had been or
presently a senior accounting practitioner in any of the scope of accounting practice and fourteen
representatives from the following: one each from the BOA, SEC, BSP, BIR, COA and a major
organization composed of preparers and users of financial statements, and two representatives each from
the accredited national professional organization of CPAs in public practice, commerce and industry,
education/academe and government

ACCO 20063: CONCEPTUAL FRAMEWORK AND ACCOUNTING STANDARDS 6

 Module 2
CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING

Overview
A conceptual framework can be defined as a system of ideas and objectives that lead to
the creation of a consistent set of rules and standards. Specifically, in accounting, the rule and
standards set the nature, function and limits of financial accounting and financial statements.
Different companies and countries follow different methods of financial accounting and
reporting. This might not always be due to choose but also a requirement of the business model
itself. For example, a company working with the distributorship model records its sale when the
goods leave the factory against a purchase order from the distributor. On the other hand, a
company working under the consignment sale model can record a sale only when goods are sold
to customer (and not the sale channel intermediaries). As such, there arise differences in financial
accounting and reporting, which magnify upon reaching the analysis and reporting stage.
The main reasons for developing an agreed conceptual framework are that it provides:
• a framework for setting accounting standards;
• a basis for resolving accounting disputes; and
• fundamental principles which then do not have to be repeated in accounting standards.
Having a fixed set of definitions of each line item, hence, becomes useful and rather
indispensable to ensure conceptual consistency amongst the audience of the report. It also helps
the potential investor better gauge and compare the performances of target companies,
regardless of their physical location and differences in business models.
The International Accounting Standards Board (Board) issued the revised Conceptual
Framework for Financial Reporting (Conceptual Framework), a comprehensive set of concepts
for financial reporting, in March 2018. It sets out, the objective of financial reporting; the qualitative
characteristics of useful financial information; a description of the reporting entity and its boundary;
definitions of an asset, a liability, equity, income and expenses; criteria for including assets and
liabilities in financial statements (recognition) and guidance on when to remove them
(derecognition); measurement bases and guidance on when to use them; and concepts and
guidance on presentation and disclosure.

Module Objectives:
After successful completion of this module, you should be able to:
❖ Understand the objective of financial reporting;
❖ Identify the qualitative characteristics of financial information;
❖ Describe the objective of financial statement;
❖ Identify the elements of financial statements;
❖ Understand the criteria for recognition and derecognition of the elements of financial
statement;
❖ Understand the measurement principles of financial reporting;
❖ Understand the presentation and disclosure principles of financial reporting; and
❖ Understand the concepts of capital and capital maintenance

ACCO 20063: CONCEPTUAL FRAMEWORK AND ACCOUNTING STANDARDS 7

Course Materials

STATUS AND PURPOSE OF THE CONCEPTUAL FRAMEWORK

The Conceptual Framework for Financial Reporting (Conceptual Framework) describes
the objective of, and the concepts for, general purpose financial reporting. The purpose of the
Conceptual Framework is to:
a) assist the International Accounting Standards Board (Board) to develop IFRS Standards
(Standards) that are based on consistent concepts;
b) assist preparers to develop consistent accounting policies when no Standard applies to
a particular transaction or other event, or when a Standard allows a choice of accounting
policy; and
c) assist all parties to understand and interpret the Standards.

The Conceptual Framework is not a Standard. Nothing in the Conceptual Framework

overrides any Standard or any requirement in a Standard. To meet the objective of general-
purpose financial reporting, the Board may sometimes specify requirements that depart from
aspects of the Conceptual Framework. If the Board does so, it will explain the departure in the
Basis for Conclusions on that Standard.

Objective, usefulness and limitations of general-purpose financial reporting

The objective of general-purpose financial reporting forms the foundation of the
Conceptual Framework. Other aspects of the Conceptual Framework—the qualitative
characteristics of, and the cost constraint on, useful financial information, a reporting entity
concept, elements of financial statements, recognition and derecognition, measurement,
presentation and disclosure—flow logically from the objective.
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 relating to providing resources to the entity. Those decisions involve decisions
about:
a) buying, selling or holding equity and debt instruments;
b) providing or settling loans and other forms of credit; or
c) exercising rights to vote on, or otherwise influence, management’s actions that affect the
use of the entity’s economic resources.

The decisions described depend on the returns that existing and potential investors,
lenders and other creditors expect, for example, dividends, principal and interest payments or
market price increases. Investors’, lenders’ and other creditors’ expectations about returns
depend on their assessment of the amount, timing and uncertainty of (the prospects for) future
net cash inflows to the entity and on their assessment of management’s stewardship of the entity’s
economic resources. Existing and potential investors, lenders and other creditors need
information to help them make those assessments. To make the assessments described in
paragraph 1.3, existing and potential investors, lenders and other creditors need information
about:
a) the economic resources of the entity, claims against the entity and changes in those
resources and claims; and
b) how efficiently and effectively the entity’s management and governing board have
discharged their responsibilities to use the entity’s economic resources.

Many existing and potential investors, lenders and other creditors cannot require reporting
entities to provide information directly to them and must rely on general purpose financial reports
for much of the financial information they need. Consequently, they are the primary users to whom

ACCO 20063: CONCEPTUAL FRAMEWORK AND ACCOUNTING STANDARDS 8

general purpose financial reports are directed. To a large extent, financial reports are based on
estimates, judgements and models rather than exact depictions. The Conceptual Framework
establishes the concepts that underlie those estimates, judgements and models. The concepts
are the goal towards which the Board and preparers of financial reports strive. As with most goals,
the Conceptual Framework’s vision of ideal financial reporting is unlikely to be achieved in full, at
least not in the short term, because it takes time to understand, accept and implement new ways
of analyzing transactions and other events. Nevertheless, establishing a goal towards which to
strive is essential if financial reporting is to evolve to improve its usefulness.

Economic resources and claims

Information about the nature and amounts of a reporting entity’s economic resources and
claims can help users to identify the reporting entity’s financial strengths and weaknesses. That
information can help users to assess the reporting entity’s liquidity and solvency, its needs for
additional financing and how successful it is likely to be in obtaining that financing. That
information can also help users to assess management’s stewardship of the entity’s economic
resources. Information about priorities and payment requirements of existing claims helps users
to predict how future cash flows will be distributed among those with a claim against the reporting
entity.

Changes in economic resources and claims

Changes in a reporting entity’s economic resources and claims result from that entity’s
financial performance and from other events or transactions such as issuing debt or equity
instruments. To properly assess both the prospects for future net cash inflows to the reporting
entity and management’s stewardship of the entity’s economic resources, users need to be able
to identify those two types of changes.

Financial performance reflected by accrual accounting

Accrual accounting depicts the effects of transactions and other events and circumstances
on a reporting entity’s economic resources and claims in the periods in which those effects occur,
even if the resulting cash receipts and payments occur in a different period. This is important
because information about a reporting entity’s economic resources and claims and changes in its
economic resources and claims during a period provides a better basis for assessing the entity’s
past and future performance than information solely about cash receipts and payments during
that period.

QUALITATIVE CHARACTERISTICS OF USEFUL FINANCIAL INFORMATION

The qualitative characteristics of useful financial information discussed in this chapter
identify the types of information that are likely to be most useful to the existing and potential
investors, lenders and other creditors for making decisions about the reporting entity on the basis
of information in its financial report (financial information). Financial reports provide information
about the reporting entity’s economic resources, claims against the reporting entity and the effects
of transactions and other events and conditions that change those resources and claims. (This
information is referred to in the Conceptual Framework as information about the economic
phenomena.) Some financial reports also include explanatory material about management’s
expectations and strategies for the reporting entity, and other types of forward-looking information.
If financial information is to be useful, it must be relevant and faithfully represent what it purports
to represent. The usefulness of financial information is enhanced if it is comparable, verifiable,
timely and understandable.

ACCO 20063: CONCEPTUAL FRAMEWORK AND ACCOUNTING STANDARDS 9

Fundamental qualitative characteristics

Relevance
Relevant financial information can make a difference in the decisions made by users.
Information may be capable of making a difference in a decision even if some users choose not
to take advantage of it or are already aware of it from other sources. Financial information can
make a difference in decisions if it has predictive value, confirmatory value or both.

Faithful representation
Financial reports represent economic phenomena in words and numbers. To be useful,
financial information must not only represent relevant phenomena, but it must also faithfully
represent the substance of the phenomena that it purports to represent. In many circumstances,
the substance of an economic phenomenon and its legal form are the same. If they are not the
same, providing information only about the legal form would not faithfully represent the economic
phenomenon. To be a perfectly faithful representation, a depiction would have three
characteristics. It would be complete, neutral and free from error. Of course, perfection is seldom,
if ever, achievable. The Board’s objective is to maximize those qualities to the extent possible.

Enhancing qualitative characteristics

Comparability, verifiability, timeliness and understandability are qualitative characteristics
that enhance the usefulness of information that both is relevant and provides a faithful
representation of what it purports to represent. The enhancing qualitative characteristics may also
help determine which of two ways should be used to depict a phenomenon if both are considered
to provide equally relevant information and an equally faithful representation of that phenomenon.

Comparability
Users’ decisions involve choosing between alternatives, for example, selling or holding an
investment, or investing in one reporting entity or another. Consequently, information about a
reporting entity is more useful if it can be compared with similar information about other entities
and with similar information about the same entity for another period or another date.
Comparability is the qualitative characteristic that enables users to identify and understand
similarities in, and differences among, items. Unlike the other qualitative characteristics,
comparability does not relate to a single item. A comparison requires at least two items.

Verifiability
Verifiability helps assure users that information faithfully represents the economic
phenomena it purports to represent. Verifiability means that different knowledgeable and
independent observers could reach consensus, although not necessarily complete agreement,
that a depiction is a faithful representation. Quantified information need not be a single point
estimate to be verifiable. A range of possible amounts and the related probabilities can also be
verified.

Timeliness
Timeliness means having information available to decision-makers in time to be capable
of influencing their decisions. Generally, the older the information is the less useful it is. However,
some information may continue to be timely long after the end of a reporting period because, for
example, some users may need to identify and assess trends.

ACCO 20063: CONCEPTUAL FRAMEWORK AND ACCOUNTING STANDARDS 10

Understandability
Classifying, characterizing and presenting information clearly and concisely makes it
understandable. Financial reports are prepared for users who have a reasonable knowledge of
business and economic activities and who review and analyze the information diligently. At times,
even well-informed and diligent users may need to seek the aid of an adviser to understand
information about complex economic phenomena.

The cost constraint on useful financial reporting

Cost is a pervasive constraint on the information that can be provided by financial
reporting. Reporting financial information imposes costs, and it is important that those costs are
justified by the benefits of reporting that information. There are several types of costs and benefits
to consider.

Financial statements
Financial statements provide information about economic resources of the reporting entity,
claims against the entity, and changes in those resources and claims, that meet the definitions of
the elements of financial statements. The objective of financial statements is to provide financial
information about the reporting entity’s assets, liabilities, equity, income and expenses that is
useful to users of financial statements in assessing the prospects for future net cash inflows to
the reporting entity and in assessing management’s stewardship of the entity’s economic
resource. That information is provided:
a) in the statement of financial position, by recognizing assets, liabilities and equity;
b) in the statement(s) of financial performance, by recognizing income and
expenses; and
c) in other statements and notes, by presenting and disclosing information about:
i. recognized assets, liabilities, equity, income and expenses, including information
about their nature and about the risks arising from those recognized assets and
liabilities;
ii. assets and liabilities that have not been recognized, including information about
their nature and about the risks arising from them;
iii. cash flows;
iv. contributions from holders of equity claims and distributions to them; and
v. the methods, assumptions and judgements used in estimating the amounts
presented or disclosed, and changes in those methods, assumptions and
judgements.

Reporting period
Financial statements are prepared for a specified period of time (reporting period) and
provide information about:
a) assets and liabilities—including unrecognized assets and liabilities—and equity that
existed at the end of the reporting period, or during the reporting period; and
b) income and expenses for the reporting period.
To help users of financial statements to identify and assess changes and trends, financial
statements also provide comparative information for at least one preceding reporting period.

Going concern assumption

Financial statements are normally prepared on the assumption that the reporting entity is
a going concern and will continue in operation for the foreseeable future. Hence, it is assumed
that the entity has neither the intention nor the need to enter liquidation or to cease trading. If such
an intention or need exists, the financial statements may have to be prepared on a different basis.
If so, the financial statements describe the basis used.

ACCO 20063: CONCEPTUAL FRAMEWORK AND ACCOUNTING STANDARDS 11

THE ELEMENTS OF FINANCIAL STATEMENTS

An asset is a present economic resource controlled by the entity as a result of past events.
An economic resource is a right that has the potential to produce economic benefits. This section
discusses three aspects of those definitions:
a) right;
b) potential to produce economic benefits; and
c) control.

A liability is a present obligation of the entity to transfer an economic resource as a result

of past events. For a liability to exist, three criteria must all be satisfied:
a) the entity has an obligation;
b) the obligation is to transfer an economic resource; and
c) the obligation is a present obligation that exists as a result of past events.

Equity is the residual interest in the assets of the entity after deducting all its liabilities.
Equity claims are claims on the residual interest in the assets of the entity after deducting all its
liabilities. In other words, they are claims against the entity that do not meet the definition of a
liability. Such claims may be established by contract, legislation or similar means, and include, to
the extent that they do not meet the definition of a liability:
a) shares of various types, issued by the entity; and
b) some obligations of the entity to issue another equity claim.

ACCO 20063: CONCEPTUAL FRAMEWORK AND ACCOUNTING STANDARDS 12

 Income is increases in assets, or decreases in liabilities, that result in increases in equity,
other than those relating to contributions from holders of equity claims.

Expenses are decreases in assets, or increases in liabilities, that result in decreases in

equity, other than those relating to distributions to holders of equity claims.

Income and expenses are the elements of financial statements that relate to an entity’s
financial performance. Users of financial statements need information about both an entity’s
financial position and its financial performance. Hence, although income and expenses are
defined in terms of changes in assets and liabilities, information about income and expenses is
just as important as information about assets and liabilities.

THE RECOGNITION PROCESS

Recognition is the process of capturing for inclusion in the statement of financial position
or the statement(s) of financial performance an item that meets the definition of one of the
elements of financial statements—an asset, a liability, equity, income or expenses. Recognition
involves depicting the item in one of those statements—either alone or in aggregation with other
items—in words and by a monetary amount and including that amount in one or more totals in
that statement. The amount at which an asset, a liability or equity is recognized in the statement
of financial position is referred to as its ‘carrying amount’.
The statement of financial position and statement(s) of financial performance depict an
entity’s recognized assets, liabilities, equity, income and expenses in structured summaries that
are designed to make financial information comparable and understandable. An important feature
of the structures of those summaries is that the amounts recognized in a statement are included
in the totals and, if applicable, subtotals that link the items recognized in the statement.
Recognition links the elements; the statement of financial position and the statement(s) of
financial performance as follows (see Diagram 5.1):
a) in the statement of financial position at the beginning and end of the reporting period,
total assets minus total liabilities equal total equity; and
b) recognized changes in equity during the reporting period comprise:
i. income minus expenses recognized in the statement(s) of financial
performance; plus
ii. contributions from holders of equity claims, minus distributions to holders of
equity claims.

The statements are linked because the recognition of one item (or a change in its carrying
amount) requires the recognition or derecognition of one or more other items (or changes in the
carrying amount of one or more other items). For example:
a) the recognition of income occurs at the same time as:
i. the initial recognition of an asset, or an increase in the carrying amount of an
asset; or
ii. the derecognition of a liability, or a decrease in the carrying amount of a liability.

b) the recognition of expenses occurs at the same time as:

i. the initial recognition of a liability, or an increase in the carrying amount of a
liability; or
ii. the derecognition of an asset, or a decrease in the carrying amount of an asset.

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How recognition links the elements of financial statements

Recognition criteria
Only items that meet the definition of an asset, a liability or equity are recognized in the
statement of financial position. Similarly, only items that meet the definition of income or expenses
are recognized in the statement(s) of financial performance. However, not all items that meet the
definition of one of those elements are recognized. Not recognizing an item that meets the
definition of one of the elements makes the statement of financial position and the statement(s)
of financial performance less complete and can exclude useful information from financial
statements. On the other hand, in some circumstances, recognizing some items that meet the
definition of one of the elements would not provide useful information. An asset or liability is
recognized only if recognition of that asset or liability and of any resulting income, expenses or
changes in equity provides users of financial statements with information that is useful.

Derecognition
Derecognition is the removal of all or part of a recognized asset or liability from an entity’s
statement of financial position. Derecognition normally occurs when that item no longer meets the
definition of an asset or of a liability:
a) for an asset, derecognition normally occurs when the entity loses control of all or part
of the recognized asset; and
b) for a liability, derecognition normally occurs when the entity no longer has a present
obligation for all or part of the recognized liability.

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MEASUREMENT BASES
Elements recognized in financial statements are quantified in monetary terms. This
requires the selection of a measurement basis. A measurement basis is an identified feature—for
example, historical cost, fair value or fulfilment value—of an item being measured. Applying a
measurement basis to an asset or liability creates a measure for that asset or liability and for
related income and expenses.

Historical cost
Historical cost measures provide monetary information about assets, liabilities and related
income and expenses, using information derived, at least in part, from the price of the transaction
or other event that gave rise to them. Unlike current value, historical cost does not reflect changes
in values, except to the extent that those changes relate to impairment of an asset or a liability
becoming onerous.

Current value
Current value measures provide monetary information about assets, liabilities and related
income and expenses, using information updated to reflect conditions at the measurement date.
Because of the updating, current values of assets and liabilities reflect changes, since the
previous measurement date, in estimates of cash flows and other factors reflected in those current
values. Unlike historical cost, the current value of an asset or liability is not derived, even in part,
from the price of the transaction or other event that gave rise to the asset or liability. Current value
measurement bases include:
a) fair value;
b) value in use and fulfilment value for liabilities; and
c) current cost

Measurement of equity
The total carrying amount of equity (total equity) is not measured directly. It equals the
total of the carrying amounts of all recognized assets less the total of the carrying amounts of all
recognized liabilities.

Presentation and disclosure as communication tools

A reporting entity communicates information about its assets, liabilities, equity, income
and expenses by presenting and disclosing information in its financial statements. Effective
communication of information in financial statements makes that information more relevant and
contributes to a faithful representation of an entity’s assets, liabilities, equity, income and
expenses. It also enhances the understandability and comparability of information in financial
statements. Just as cost constrains other financial reporting decisions, it also constrains decisions
about presentation and disclosure. Hence, in making decisions about presentation and disclosure,
it is important to consider whether the benefits provided to users of financial statements by
presenting or disclosing particular information are likely to justify the costs of providing and using
that information.

Classification
Classification is the sorting of assets, liabilities, equity, income or expenses based on
shared characteristics for presentation and disclosure purposes. Such characteristics include—
but are not limited to—the nature of the item, its role (or function) within the business activities
conducted by the entity, and how it is measured.

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Classification of assets and liabilities
Classification is applied to the unit of account selected for an asset or liability. However, it
may sometimes be appropriate to separate an asset or liability into components that have different
characteristics and to classify those components separately. That would be appropriate when
classifying those components separately would enhance the usefulness of the resulting financial
information. For example, it could be appropriate to separate an asset or liability into current and
non-current components and to classify those components separately.

Offsetting
Offsetting occurs when an entity recognizes and measures both an asset and liability as
separate units of account, but groups them into a single net amount in the statement of financial
position. Offsetting classifies dissimilar items together and therefore is generally not appropriate.

Classification of equity
To provide useful information, it may be necessary to classify equity claims separately if
those equity claims have different characteristics

Classification of income and expenses

Classification is applied to:
a) income and expenses resulting from the unit of account selected for an asset or liability;
or
b) components of such income and expenses if those components have different
characteristics and are identified separately. For example, a change in the current value
of an asset can include the effects of value changes and the accrual of interest. It would
be appropriate to classify those components separately if doing so would enhance the
usefulness of the resulting financial information.

Profit or loss and other comprehensive income

Income and expenses are classified and included either:
a) in the statement of profit or loss; or
b) outside the statement of profit or loss, in other comprehensive income.

The statement of profit or loss is the primary source of information about an entity’s
financial performance for the reporting period. That statement contains a total for profit or loss
that provides a highly summarized depiction of the entity’s financial performance for the period.
Many users of financial statements incorporate that total in their analysis either as a starting point
for that analysis or as the main indicator of the entity’s financial performance for the period.
Nevertheless, understanding an entity’s financial performance for the period requires an analysis
of all recognized income and expenses—including income and expenses included in other
comprehensive income—as well as an analysis of other information included in the financial
statements.

Aggregation
Aggregation is the adding together of assets, liabilities, equity, income or expenses that
have shared characteristics and are included in the same classification. Aggregation makes
information more useful by summarizing a large volume of detail. However, aggregation conceals
some of that detail. Hence, a balance needs to be found so that relevant information is not
obscured either by a large amount of insignificant detail or by excessive aggregation

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 CONCEPTS OF CAPITAL
A financial concept of capital is adopted by most entities in preparing their
financial statements. Under a financial concept of capital, such as invested money or
invested purchasing power, capital is synonymous with the net assets or equity of the
entity. Under a physical concept of capital, such as operating capability, capital is
regarded as the productive capacity of the entity based on, for example, units of output
per day.

Concepts of capital maintenance and the determination of profit

The concepts of capital in paragraph 8.1 give rise to the following concepts of
capital maintenance:
a) Financial capital maintenance. Under this concept a profit is earned only if the
financial (or money) amount of the net assets at the end of the period exceeds
the financial (or money) amount of net assets at the beginning of the period,
after excluding any distributions to, and contributions from, owners during the
period. Financial capital maintenance can be measured in either nominal
monetary units or units of constant purchasing power.
b) Physical capital maintenance. Under this concept a profit is earned only if the
physical productive capacity (or operating capability) of the entity (or the
resources or funds needed to achieve that capacity) at the end of the period
exceeds the physical productive capacity at the beginning of the period, after
excluding any distributions to, and contributions from, owners during the
period.
The concept of capital maintenance is concerned with how an entity defines the
capital that it seeks to maintain. It provides the linkage between the concepts of capital
and the concepts of profit because it provides the point of reference by which profit is
measured; it is a prerequisite for distinguishing between an entity’s return on capital and
its return of capital; only inflows of assets in excess of amounts needed to maintain
capital may be regarded as profit and therefore as a return on capital. Hence, profit is
the residual amount that remains after expenses (including capital maintenance
adjustments, where appropriate) have been deducted from income. If expenses exceed
income the residual amount is a loss.
The physical capital maintenance concept requires the adoption of the current
cost basis of measurement. The financial capital maintenance concept, however, does
not require the use of a basis of measurement. Selection of the basis under this concept
is dependent on the type of financial capital that the entity is seeking to maintain.
Under the concept of financial capital maintenance where capital is defined in
terms of nominal monetary units, profit represents the increase in nominal money capital
over the period. Thus, increases in the prices of assets held over the period,
conventionally referred to as holding gains, are, conceptually, profits. They may not be
recognized as such, however, until the assets are disposed of in an exchange
transaction. When the concept of financial capital maintenance is defined in terms of
constant purchasing power units, profit represents the increase in invested purchasing
power over the period. Thus, only that part of the increase in the prices of assets that
exceeds the increase in the general level of prices is regarded as profit. The rest of the
increase is treated as a capital maintenance adjustment and, hence, as part of equity.
Under the concept of physical capital maintenance when capital is defined in
terms of the physical productive capacity, profit represents the increase in that capital
over the period. All price changes affecting the assets and liabilities of the entity are
viewed as changes in the measurement of the physical productive capacity of the entity;

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 hence, they are treated as capital maintenance adjustments that are part of equity and
not as profit.

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