TOPIC 2: THE CONCEPTUAL FRAMEWORK

Chapter 4: Financial Statements and Reporting Entity - Underlying Assumptions

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
 in assessing management's stewardship of the entity's economic resources.

The financial information is provided in the following:

1. Statement of financial position, by recognizing assets, liabilities and equity.
2. Income statement, by recognizing income and expenses.
3. Statement of cash flows, by recognizing cash flows from operating, investing and financing activities.
4. Statement of changes in equity, by recognizing contributions from equity holders and distributions to equity
holders.
5. Notes to financial statements, by recognizing disclosures required by accounting standards.

TYPES OF FINANCIAL STATEMENTS (Parent-Subsidiary Relationship)

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.

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.

Combined Financial Statements

are financial statement on which the reporting entity comprises two or more entities that are not all linked by a
parent-subsidiary relationship.

REPORTING ENTITY
 A reporting entity is an entity that is required, or chooses, to prepare financial statements.
 A reporting entity can be a single entity or a portion of an entity or can comprise more than one entity.
 A reporting entity is not necessarily a legal entity.

REPORTING PERIOD
It is the period when FS are prepared for general purpose. Either:
1. Annual Basis (Calendar or Fiscal period)
2. Interim Basis (Every 3 months, 6 months or anything that is less a year). Not required but optional (in general).

Financial statements may include information about transactions and other events that occurred after the end of
reporting period if the information is necessary to meet the general objective of financial statements.

GOING CONCERN ASSUMPTION

 It is assumed that the entity will continue in operation for the foreseeable future and 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 di erent basis.
Chap. 5: Elements of Financial Statements
 ASSETS - economic resources
 LIABILITIES - claims or obligations
 EQUITY - residual interest
 INCOME - revenue and gains
 EXPENSE - Normal Operating Expense (Selling, Admin., Finance cost) and losses

ASSET
 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.

Right
Rights that have the potential to produce economic benefits take many forms, including:

Rights that correspond to an obligation of another party

 rights to receive cash.
 rights to receive goods or services.
 rights to exchange economic resources with another party on favourable terms.
 rights to benefit from an obligation of another party to transfer an economic resource if a specified uncertain
future event occurs

Rights that do not correspond to an obligation of another party

 rights over physical objects, such as property, plant and equipment or inventories. Examples of such rights
are a right to use a physical object or a right to benefit from the residual value of a leased object.
 rights to use intellectual property.

Potential to produce economic benefits

 An economic resource is a right that has the potential to produce economic benefits.
 A right can meet the definition of an economic resource, and hence can be an asset, even if the probability
that it will produce economic benefits is low.
 An economic resource could produce economic benefits for an entity by entitling or enabling it to do, for
example, one or more of the following:
o receive contractual cash flows or another economic resource
o exchange economic resources with another party on favorable terms
o produce cash inflows or avoid cash outflows
o receive cash or other economic resources by selling the economic resource
o extinguish liabilities by transferring the economic resource

Control
An entity controls an economic resource if it has the present ability to direct the use of the economic resource and
obtain the economic benefits that may flow from it.

Control of an economic resource usually arises from an ability to enforce legal rights.

If there are no legal rights, control can still exist if an entity has other means of ensuring that no other party can
benefit from an asset. For example, an entity has access to technical know-how and has the ability to keep this
know-how secret.

LIABILITIES
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:
 the entity has an obligation.
 the obligation is to transfer an economic resource.
 the obligation is a present obligation that exists as a result of past events.
Obligation
An obligation is a duty or responsibility that an entity has no practical ability to avoid. Obligations can either be legal
or constructive.

Types of Obligations
1. Legal Obligations - many obligations are established by contract, legislation or similar means and are
legally enforceable by the party (or parties) to whom they are owed.
2. Constructive Obligations - Obligations from an entity's customary practices, published policies or specific
statements if the entity has no practical ability to act in a manner inconsistent with those practices, policies
or statements.

Transfer of an Economic Resource

 To satisfy this criterion, the obligation must have the potential to require the entity to transfer an economic
resource to another party (or parties).
 An obligation can meet the definition of a liability even if the probability of a transfer of an economic
resource is low.
 Obligations to transfer an economic resource include:
o obligations to pay cash
o obligations to deliver goods or provide services.
o obligations to exchange economic resources with another party on unfavorable terms.
o obligations to transfer an economic resource if a specified uncertain future event occurs.
o obligations to issue a financial instrument if that financial instrument will oblige the entity to transfer
an economic resource.

Past event
An obligation exists as a result of past event if both of the following conditions are satisfied:
a. An entity has already obtained economic benefits.
b. An entity must transfer an economic resource.

EQUITY
Equity is the residual interest in the assets of the entity after deducting all its liabilities.

INCOME AND EXPENSES

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. Income encompasses both:
 Revenue
 Gains

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.
 Expenses
 Losses

Chap. 6: Recognition and Measurement

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.

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'.

Recognition links the elements, the statement of financial position and the statement(s) of financial performance as
follows:
 in the statement of financial position at the beginning and end of the reporting period, total assets minus total
liabilities equal total equity; and
 recognized changes in equity during the reporting period comprise:
 income minus expenses recognized in the statement(s) of financial performance; plus
 contributions from holders of equity claims, minus distributions to holders of equity claims.
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.

DERECOGNITION PROCESS
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:
 for an asset, derecognition normally occurs when the entity loses control of all or part of the recognized asset;
and
 for a liability, derecognition normally occurs when the entity no longer has a present obligation for all or part of
the recognized liability.

MEASUREMENT
Measurement is defined as quantifying in monetary terms the elements in the financial statements.

The Revised Conceptual Framework mentions two categories:

a. Historical cost
b. Current value

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.

The historical cost of an asset when it is acquired or created is the value of the costs incurred in acquiring or creating
the asset, comprising the consideration paid to acquire or create the asset plus transaction costs. The historical cost
of a liability when it is incurred or taken on is the value of the consideration received to incur or take on the liability
minus transaction costs.

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:
 fair value
 value in use for assets and fulfilment value for liabilities
 current cost

a. Fair Value
 Fair value is the price that would be received to sell an asset, or paid to transfer a liability, in an orderly
transaction between market participants at the measurement date.
 Fair value reflects the perspective of market participants-participants in a market to which the entity has
access. The asset or liability is measured using the same assumptions that market participants would use
when pricing the asset or liability if those market participants act in their economic best interest.

b. Value in Use and Fulfillment Value

 Value in use is the present value of the cash flows, or other economic benefits, that an entity expects to
derive from the use of an asset and from its ultimate disposal.
 Fulfillment value is the present value of the cash, or other economic resources, that an entity expects to be
obliged to transfer as it fulfils a liability. Those amounts of cash or other economic resources include not only
the amounts to be transferred to the liability counterparty, but also the amounts that the entity expects to be
obliged to transfer to other parties to enable it to fulfil the liability.
 Because value in use and fulfilment value are based on future cash flows, they do not include transaction
costs incurred on acquiring an asset or taking on a liability. However, value in use and fulfilment value include
the present value of any transaction costs an entity expects to incur on the ultimate disposal of the asset or
on fulfilling the liability.

c. Current Cost
 The current cost of an asset is the cost of an equivalent asset at the measurement date, comprising the
consideration that would be paid at the measurement date plus the transaction costs that would be incurred
at that date.
 The current cost of a liability is the consideration that would be received for an equivalent liability at the
measurement date minus the transaction costs that would be incurred at that date.
 Current cost, like historical cost, is an entry value: it reflects prices in the market in which the entity would
acquire the asset or would incur the liability. Hence, it is di erent from fair value, value in use and fulfilment
value, which are exit values. However, unlike historical cost, current cost reflects conditions at the
measurement date.

Chap. 7: Presentation and Disclosure | Concepts of Capital and Capital Maintenance

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.

Presentation and disclosure objectives and principle

To facilitate e ective communication of information in financial statements, when developing presentation and
disclosure requirements in standards a balance is needed between:
 giving entities the flexibility to provide relevant information that faithfully represents the entity's assets,
liabilities, equity, income and expenses; and
 requiring information that is comparable, both from period to period for a reporting entity and in a single
reporting period across entities.

Classification
Classification is the sorting of assets, liabilities, equity, income or expenses on the basis of 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.

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 di erent 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.
O setting
 O setting 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.
 O setting classifies dissimilar items together and therefore is generally not appropriate.

Classification of income and expenses

Profit or loss and other comprehensive income:
 Income and expenses are classified and included either:
o in the statement of profit or loss; or
o 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.

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 large amount of insignificant detail or by excessive aggregation.
 Di erent levels of aggregation may be needed in di erent parts of the financial statements. For example,
typically, the statement of financial position and the statement(s) of financial performance provide
summarize information and more detailed information is provided in the notes.

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.
 The selection of the appropriate concept of capital by an entity should be based on the needs of the users of
its financial statements.
 Thus, a financial concept of capital should be adopted if the users of financial statements are primarily
concerned with the maintenance of nominal invested capital or the purchasing power of invested capital.
 If, however, the main concern of users is with the operating capability of the entity, a physical concept of
capital should be used. The concept chosen indicates the goal to be attained in determining profit, even
though there may be some measurement di iculties in making the concept operational.

Concepts of capital maintenance and the determination of profit

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.

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.

Capital maintenance adjustments

The revaluation or restatement of assets and liabilities gives rise to increases or decreases in equity. While
these increases or decreases meet the definition of income and expenses, they are not included in the income
statement under certain concepts of capital maintenance. Instead, these items are included in equity as capital
maintenance adjustments or revaluation reserves.