1. Financial Statements 2 Lecture 3
Conceptual Framework

2. Learning objectives To understand the need for a conceptual framework
To understand the contents of the IASB framework
To be familiar with key concepts and definitions which will be applied in the study of specific accounting standards

3. What is a conceptual framework
“A set of agreed fundamental principles which underpin financial accounting and so provide a sound theoretical basis for the development of accounting standards”
Melville

4. Accounting theory Empirical inductive approach
Starts from what accountants do and derives principles from this.
Practical approach – accounting is about being useful
Principles derive from a consensus of opinion amongst preparers and auditors of accounts (mainly the large firms) about the best treatment of particular items.
May lack consistency between different areas of the accounts.
Examples include use of historic cost, treatment of depreciation, revaluation of property

5. Accounting Theory Deductive approach
Starts from a theoretical approach to basic principles and derives the treatment of specific items in the accounts from these principles
More consistent but may be unrealistic in a practical situation
Examples include current cost accounting, accounting for finance leases

6. Purpose of the IASB Framework
To assist in the development of international standards
To provide a basis for reducing the number of alternative treatments
To assist national standard setters
To assist preparers of financial statements in applying standards and dealing with topics where no standard exists
To assist auditors in forming an opinion on whether financial statements comply with international standards
To assist users in interpreting financial statements

7. Content of the IASB Framework
The objective of financial statements
Underlying assumptions
Qualitative characteristics
Elements of financial statements
Recognition of elements
Measurement of elements
Concepts of capital and capital maintenance

8. Objective of financial statements
“To provide information about the financial position, performance and changes in financial position of an entity that is useful to a wide range of users in making economic decisions” IASB Framework
Balance sheet, income statement and cash flow statement, plus notes to the accounts
Users of accounts – focus on investors

9. Underlying assumptions
Accruals basis - transactions are recognised in the period in which they occur, not necessarily when cash is received or paid
Going concern – financial statements are prepared on the basis that the business will continue to operate for the foreseeable future without the need to close down or significantly reduce the scale of its operations

10. Qualitative characteristics
Understandability – assumes a reasonable knowledge of business and accounting
Relevance – helps users evaluate past, present or future events
Reliability – free from material error – an error is material if it could influence the decisions made by users
Faithful representation and substance over form
Neutrality
Prudence
Completeness
Comparability

11. Elements of financial statements
Financial position
Assets
Liabilities
Equity
Financial performance
Income
Expenses

12. Elements – key definitions
Asset
A resource controlled by the enterprise as a result of past events and from which future economic benefits are expected to flow to the enterprise
Liability
A present obligation of the enterprise arising from past events, the settlement of which is expected to result in an outflow from the enterprise of resources

13. Recognition
“The process of incorporating in the balance sheet or income statement an item that meets the definition of an element and satisfies the criteria for recognition”
Provided it is probable the future economic benefit will flow to or from the company and the cost or value can be measured reliably.
Where necessary to show a true & fair view additional information may need to be disclosed in the notes to the accounts

14. Measurement Four possible measurement bases are identified:
Historic cost – amount paid to acquire assets or amount received in exchange for a liability
Current cost – amount required to acquire an equivalent asset at the present time, or to settle a liability
Realisable value – the amount which could be obtained by selling an asset at the present time, or the amount required to settle a liability
Present value – discounted present value of expected future cash inflows

15. Measurement Most commonly used is historic cost
Current cost is used when valuing property
Realisable value is used when valuing inventory at the lower of cost and net realisable value
Present value is not often used but can be used in valuing certain long term assets or liabilities such as pensions
This is an area of current debate over the extent to which market values (fair values) should be used

16. Capital and capital maintenance
It is considered important that a company's capital should be maintained.
This depends on how capital (and thus assets and liabilities) are measured.
Physical capital refers to the operating capacity of the business
Financial capital considers the monetary value of capital

17. Current developments
IASB and FASB have been collaborating on a new conceptual framework. Some progress on qualitative characteristics but difference of approach - IASB is principles-based and FASB is rules-based
Debate on the use of fair values for financial assets and liabilities in the current financial crisis