1. Financial Statements 2 Lecture 3 Conceptual Framework

2. Learning objectives To understand the purpose of a conceptual framework To know the outline of the contents of the IASB framework To be familiar with the joint project to revise the conceptual 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. 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

5. 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

6. Joint project Ongoing project between IASB and FASB (US standards setting body) to harmonise accounting standards with a view to international standards being acceptable for use in the US Working on individual standards Working on revising the conceptual framework, chapter by chapter

7. Progress in 2010 Revised chapters on “objective of financial statements” and “qualitative characteristics” published Copies of the original framework and revised chapters are in teaching resources on studynet. A very good essay will consider both; a middling essay could stick to the original, which is covered in the textbook.

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 Statement of Financial Position, Statement of Comprehensive Income and cash flow statement, plus notes to the accounts

9. Users of accounts Original framework covered a wide range of users. In practice needs of investors and lenders took priority Revised framework is focussed on investors and other providers of finance Result will be accounting standards will be more explicitly focussed on providers of finance

10. 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

11. Qualitative characteristics – original framework Understandability – financial statements should be presented clearly – assumes a reasonable knowledge of business and accounting Relevance – Influences the economic decisions of users – helps users evaluate past, present or future events Comparability – Over time and with other entities

12. Qualitative characteristics – original framework Reliability – free from material error – an error is material if it could influence the decisions made by users – Faithful representation and substance over form – the accounts show the true economic reality of the activities of the company – Neutrality – free from bias – Prudence – judgment is exercised with caution so as not to overstate net assets or profits. – Completeness – subject to constraints of materiality and cost, relevant information should not be omitted

13. Qualitative characteristics – revised framework Relevance – Capable of influencing the economic decisions of users – Materiality – information is material if omitting it or misstating it could influence decisions of users Faithful representation – Must give a true picture of the economic reality of the business – Includes completeness, neutrality and freedom from material error

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

15. 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

16. 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

17. 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

18. 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

19. 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

20. Current developments IASB and FASB continue to collaborate on a new conceptual framework. There is some 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