Fundamentals of Accounting I Conceptual Framework and Elements of Financial Statements

PURPOSE AND STATUS

 This Conceptual Framework sets out the concepts that underlie the preparation and presentation of financial
statements for external users. The purpose of the Conceptual Framework is:

a. to assist Financial Reporting Standards Council (FRSC) in the development of future Philippine
Financial Reporting Standards (PFRSs) and in its review of existing PFRSs
b. to assist FRSC in promoting harmonization of regulations, accounting standards and procedures
relating to the presentation of financial statements by providing a basis for reducing the number of
alternative accounting treatments permitted by PFRSs
c. to assist national standard-setting bodies in developing national standards
d. to assist preparers of financial statements in applying PFRSs and in dealing with topics that have yet
to form the subject of an PFRS
e. to assist auditors in forming an opinion on whether financial statements comply with PFRSs;
f. to assist users of financial statements in interpreting the information contained in financial
statements prepared in compliance with PFRSs; and

 This Conceptual Framework is not a PFRS and hence does not define standards for any particular
measurement or disclosure issue. Nothing in this Conceptual Framework overrides any specific PFRS. In case
of conflict, the provisions of specific PFRS prevail.

SCOPE
 The Conceptual Framework deals with:
1. the objective of financial reporting
2. the qualitative characteristics of useful financial information
3. the definition, recognition and measurement of the elements from which financial statements are
constructed; and
4. concepts of capital and capital maintenance

GENERAL PURPOSE FINANCIAL REPORTING: OBJECTIVE, USEFULNESS AND LIMITATIONS

 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 about providing resources to the entity.
 USERS of financial statements and their information needs:
PRIMARY USERS:
1. INVESTORS. To decide when to buy, hold or sell an equity investment.
2. CREDITORS. To assess the security for amounts lent to the entity.
Other Users:
1. Employees. To assess the ability of the entity to pay and provide other benefits.
2. Customers. To assess the continuance of an entity especially if they have long-term involvement with
or are dependent on the entity
3. Government. To determine taxation policies, to regulate the activities of entities and to prepare and
use national income statistics.
4. General Public. To determine the trend and range of activities of the entity.

 PRIMARY users of financial statements are INVESTORS and CREDITORS. Primary users are to whom the
reports are primary directed.
Why should there be primary users? Different users use financial statements for a variety of reasons.
Satisfying all of these information needs would not be feasible, and without a defined group of primary users,
the Conceptual Framework would risk becoming unduly abstract or vague. It was concluded therefore that
the investors and the creditors are the primary users if financial statements. These parties assume the most
risks in the activities of the entity because they either provide the risk capital (in case of investors) or lend
substantial amount of resources to the entity (in case of lenders). Thus, these users have the most critical
and immediate need for the information in financial reports and many cannot require the entity to provide the
information to them directly. They turn to general financial reports to meet much of their information need.
Information that meets the needs of these specified primary users is likely to also meet the needs of other
users.

 However, general purpose financial reports do not and cannot provide all of the information that existing and
potential investors, lenders and other creditors need. Those users need to consider pertinent information
from other sources, for example, general economic conditions and expectations, political events and political
climate, and industry and company outlooks.

 General purpose financial reports are not designed to show the value of a reporting entity; but they provide
information to help existing and potential investors, lenders and other creditors to estimate the value of the
reporting entity.

 General purpose financial reports satisfy common information needs and cannot address every specific
information that a certain user may seek to request.

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Fundamentals of Accounting I Conceptual Framework and Elements of Financial Statements
 To a large extent, financial reports are based on estimates, judgments and models rather than exact
depictions.

UNDERLYING ASSUMPTION
 Going concern. The financial statements are normally prepared on the assumption that an 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 liquidate or curtail materially the scale of its operations; if such an
intention or need exists, the financial statements may have to be prepared on a different basis and, if so, the
basis used is disclosed. Implicit in the going concern assumption are:
1. Entity concept
2. Periodicity concept
3. Stable Monetary Unit concept

ECONOMIC RESOURCES, CLAIMS AGAINST

Concepts related to the Objective of financial Reporting:
THE ENTITY AND CHANGES IN RESOURCES
1. Entity Theory.
AND CLAIMS
 Geared toward proper income determination
 General purpose financial reports
 Matching Principle
provide information about:
1. Financial position of a reporting  Emphasis on Income Statement
entity. Information about the  [ Assets = Liability + Capital]
entity’s economic resources [assets] 2. Proprietary Theory.
and the claims against the reporting  Geared toward proper valuation of asset
entity [liabilities], the [equity] being  Emphasis on Balance Sheet
the residual amount after deducting  [ Assets – Liabilities = Capital/Net Asset ]
the liabilities from the assets. 3. Residual Equity Theory
2. Performance of a reporting  Geared toward proper asset valuation when there are 2
entity. Effects of transactions and classes of owner [shareholders]
other events that change a reporting  [ Assets – Liabilities – Preference Equity = Ordinary
entity’s economic resources and Equity ]
claims. 4. Fund Theory
 Custody and administration of funds
 Information about Economic resources  [ Cash inflow – Cash outflow = Fund ]
and claims help users to identify the  Used by Government and Not for profit orgs
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. 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.
1. Liquidity. The ability of cash and cash equivalents to meet currently maturing obligations.
2. Solvency. The ability of cash and cash equivalents over the long run to meet financial obligations
when they fall due.

 Information about changes in economic resources and claims help users to:
1. Properly assess the prospects for future cash flows from the reporting entity. Cash flow can result
from:
 Entity’s financial performance (Result of operations)
 Events or transactions such as issuing debt or equity instruments (Debt or Equity Financing)
Users need to be able to distinguish between both of these changes.
2. Assess stewardship of Management. Information about the return the entity has produced provides
an indication of how well management has discharged its responsibilities to make efficient and
effective use of the reporting entity’s resources.
3. Assess future returns on the economic resources of the entity.

 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

 Information about financial performance reflected by cash flows helps users to assess the entity’s
ability to generate future net cash inflows. It helps users understand a reporting entity’s operations, evaluate
its financing and investing activities, assess its liquidity or solvency and interpret other information about
financial performance

HOW DO FINANCIAL STATEMENTS BECOME USEFUL TO USERS?

 The Qualitative Characteristics are the qualities that make financial accounting information useful to
users.
 If financial information is to be useful, it must be [both]:
1. Relevant; and
2. Faithfully represent what it purports to represent
 The usefulness of financial information is enhanced if it is:
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Fundamentals of Accounting I Conceptual Framework and Elements of Financial Statements
1. Comparable
2. Verifiable
3. Timely; and
4. Understandable.
 Relevance. Relevant financial information is capable of making a difference in the decisions made by users.
The ingredients of relevance are:
1. Predictive value. If it can be used as an input to processes employed by users to predict future
outcomes.
2. Confirmatory value. If it provides feedback about (confirms or changes) previous evaluations.
The predictive value and confirmatory value of financial information are interrelated. Information that has
predictive value often also has confirmatory value.

 Materiality – a concept related to relevance.

Information is material if omitting it or misstating it could influence decisions that users make on the basis of
financial information about a specific reporting entity. In other words, materiality is an entity-specific aspect
of relevance based on the nature or magnitude, or both, of the items to which the information relates in the
context of an individual entity’s financial report. Consequently, FRSC does not specify a uniform quantitative
threshold for materiality or predetermine what could be material in a particular situation.

 Faithful representation. To be useful, financial information must not only represent relevant transactions,
events and balances, but it must also faithfully represent the items that it purports to represent. The
ingredients of faithful representation are:
1. Completeness
2. Neutrality and
3. Freedom from error

 A complete depiction includes all information necessary for a user to understand the phenomenon being
depicted, including all necessary descriptions and explanations. Implication: Adequate Disclosure.
A neutral depiction is without bias in the selection or presentation of financial information.
Faithful representation does not mean accurate in all respects. Free from error means there are no errors
or omissions in the description of the phenomenon, and the process used to produce the reported
information has been selected and applied
with no errors in the process.
Concepts Not Anymore Discussed in the New Framework:
1. Substance Over Form
THE ENHANCING CHARACTERISTICS  Already implicit in the concept of faithful representation in which
 Comparability. Comparability is the the items should represent what they purport to represent
qualitative characteristic that enables users  Accordingly, the economic substance of the transaction prevails
to identify an understand similarities in, and regardless of the legal form that the parties may have designed
differences among, items. Unlike the other to a specific transaction
qualitative characteristics, comparability  For example, a sale with a buyback agreement where the seller
does not relate to a single item. A of the asset will be required to “repurchase” the asset at a fixed
comparison requires at least two items. price plus margin is actually a borrowing with the asset given as
 Consistency, although related to collateral and the margin as interest. Thus, the seller should
comparability, is not the same. Consistency recognize the liability and retain to record the asset given even
if the contract entered into by the parties is a sales contract.
refers to the use of the same methods for
2. Conservatism
the same items, either from period to period  When alternatives exist, choose the item which has the least
within a reporting entity or in a single period effect on equity.
across entities. Comparability is the goal;  Sample applications: Recording the inventory at lower of cost or
consistency helps to achieve that goal. net realizable value.
 Verifiability. Verifiability means that  Note however that conservatism is not a license to deliberately
different knowledgeable and independent understate net income and net assets
observers could reach consensus, although 3. Prudence
not necessarily complete agreement, that a The desire to exercise care and caution when dealing with
particular depiction is a faithful uncertainties in the measurement process such that assets and
representation. Quantified information need income are not understated or liabilities and expenses are not
understated.
not be a single point estimate to be
verifiable. A range of possible amounts and
the related probabilities can also be verified.
 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.
 Understandability. 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.

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.

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Fundamentals of Accounting I Conceptual Framework and Elements of Financial Statements
ELEMENTS OF FINANCIAL STATEMENTS
 Financial statements portray the financial effects of transactions and other events by grouping them into
broad classes according to their economic characteristics. These broad classes are termed the elements of
financial statements.
 The elements directly related to the measurement of financial position in the statement of financial position
are assets, liabilities and equity.
 The elements directly related to the measurement of performance in the statement of comprehensive income
are income and expenses.

STATEMENT OF FINANCIAL POSITION ELEMENTS

 Asset. An asset is a resource controlled by the entity as a result of past events and from which future
economic benefits are expected to flow to the entity.
 Physical Form. Many assets, for example, property, plant and equipment, have a physical form. However,
physical form is not essential to the existence of an asset; hence patents and copyrights, for example, are
assets if future economic benefits are expected to flow from them to the entity and if they are controlled by
the entity
 Legal rights. Many assets, for example, receivables and property, are associated with legal rights, including
the right of ownership. In determining the existence of an asset, the right of ownership is not essential;
thus, for example, property held on a lease is an asset if the entity controls the benefits which are expected
to flow from the property. Although the capacity of an entity to control benefits is usually the result of legal
rights, an item may nonetheless satisfy the definition of an asset even when there is no legal control. For
example, know-how obtained from a development activity may meet the definition of an asset when, by
keeping that know-how secret, an entity controls the benefits that are expected to flow from it.
 Should be a result of past transaction or event. Transactions or events expected to occur in the future do not
in themselves give rise to assets; hence, for example, an intention to purchase inventory does not, of itself,
meet the definition of an asset.
 Expenditure and asset recognition. There is a close association between incurring expenditure and generating
assets but the two do not necessarily coincide. Hence, when an entity incurs expenditure, this may provide
evidence that future economic benefits were sought but is not conclusive proof that an item satisfying the
definition of an asset has been obtained. Similarly the absence of a related expenditure does not preclude an
item from satisfying the definition of an asset and thus becoming a candidate for recognition in the balance
sheet; for example, items that have been donated to the entity may satisfy the definition of an asset.

 Liability. A liability is a present obligation of the entity arising from past events, the settlement of which is
expected to result in an outflow from the entity of resources embodying economic benefits.
 Present obligation. An obligation is a duty or responsibility to act or perform in a certain way. Obligations
may:
1. Be legally enforceable
2. Arise from normal business practice, custom and a desire to maintain good business relations or act
in an equitable manner
A decision by the management of an entity to acquire assets in the future does not, of itself, give rise to a
present obligation. An obligation normally arises only when the asset is delivered or the entity enters into an
irrevocable agreement to acquire the asset.
 Estimated liabilities. Some liabilities can be measured only by using a substantial degree of estimation. These
are known as provisions. When a provision involves a present obligation and satisfies the rest of the
definition, it is a liability even if the amount has to be estimated. Examples include provisions for payments
to be made under existing warranties and provisions to cover pension obligations.
 Equity. Equity is the residual interest in the assets of the entity after deducting all its liabilities.
 Sub-classification. Although equity is defined as a residual, it may be sub-classified in the balance sheet. For
example, in a corporate entity, the following may shown separately:
1. funds contributed by shareholders,
2. retained earnings,
3. reserves representing appropriations of retained earnings; and
4. reserves representing capital maintenance adjustments (i.e. Accumulated OCI)
 Such classifications can be relevant to the decision-making needs of the users of financial statements when
they indicate legal or other restrictions on the ability of the entity to distribute or otherwise apply its equity.
They may also reflect the fact that parties with ownership interests in an entity have differing rights in
relation to the receipt of dividends or the repayment of contributed equity.

RECOGNITION
 Recognition is the process of incorporating in the statement of financial position or statement of
comprehensive income an item that meets the definition of an element and satisfies the criteria
for recognition.

 An item that meets the definition of an element should be recognized if:

1. it is probable that any future economic benefit associated with the item will flow to or from the
entity; and
2. the item has a cost or value that can be measured with reliability.

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Fundamentals of Accounting I Conceptual Framework and Elements of Financial Statements
 An asset is recognized in the statement of financial position when it is probable that the future economic
benefits will flow to the entity and the asset has a cost or value that can be measured reliably.

 A liability is recognized in the statement of financial position when it is probable that an outflow of resources
embodying economic benefits will result from the settlement of a present obligation and the amount at which
the settlement will take place can be measured reliably.
 An item that, at a particular point in time, fails to meet the recognition criteria may qualify for recognition at
a later date as a result of subsequent circumstances or events.
 An item that possesses the essential characteristics of an element but fails to meet the criteria for recognition
may nonetheless warrant disclosure in the notes, explanatory material or in supplementary schedules.

CLASSIFICATION
 For recognition and measurement purposes:
Financial/Non-financial assets
 A financial asset is any asset that is:
1. cash;
2. an equity instrument of another entity; or
3. a contractual right:
i. to receive cash or another financial asset from another entity; or
ii. to exchange financial assets or financial liabilities with another entity under conditions that are
potentially favorable to the entity.

All other assets are non-financial.

Financial/Non-financial liabilities

 A financial liability is any liability that is a contractual obligation:

(i) to deliver cash or another financial asset to another entity; or
(ii) to exchange financial assets or financial liabilities with another entity under conditions that are
potentially unfavorable to the entity.

All other liabilities are non-financial.

 For presentation purposes:

Current/Noncurrent assets
 An asset shall be classified as current when it satisfies any of the following criteria:
1. it is expected to be realized in, or is intended for sale or consumption, in the entity’s normal
operating cycle;
2. it is held primarily for the purpose of being traded;
3. it is expected to be realized within 12 months after the reporting period; or
4. it is cash or a cash equivalent (as defined in PAS 7) unless restricted from being exchanged or used
to settle a liability for at least 12 months after the reporting period.

All other assets shall be classified as noncurrent.

Current/Noncurrent liabilities

 A liability shall be classified as current when it satisfies any of the following criteria:
• it is expected to be settled in the entity’s normal operating cycle;
• it is held primarily for the purpose of being traded;
• it is due to be settled within 12 months after the reporting period; or
• the entity does not have an unconditional right to defer settlement of the liability for at least 12
months after the reporting period.

All other liabilities shall be classified as noncurrent.

STATEMENT OF COMPREHENSIVE INCOME ELEMENTS

 Profit is frequently used as a measure of performance or as the basis for other measures, such as return on
investment or earnings per share. Profit or loss is the total of income less expenses, excluding the
components of other comprehensive income.

 Other comprehensive income comprises items of income and expenses (including reclassification
adjustments) that are not recognized in profit or loss as required or permitted by other PFRSs. The
components of other comprehensive income include:
1. Gains and losses on remeasuring financial asset at fair value through other comprehensive
income
2. Changes in revaluation surplus
3. Gains and losses arising from translating the financial statements of a foreign operation
4. The effective portion of gains and losses on hedging instruments in a cash flow hedge
5. Actuarial gains and losses on defined benefit plans
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Fundamentals of Accounting I Conceptual Framework and Elements of Financial Statements

 Reclassification adjustments are amounts reclassified to profit or loss in the current period that were
recognized in other comprehensive income in the current or previous periods.

 Total comprehensive income is the change in equity during a period resulting from transactions and other
events, other than those changes resulting from transactions with owners in their capacity as owners. Total
comprehensive income comprises all components of ‘profit or loss’ and of ‘other comprehensive income’.

 Income is increases in economic benefits during the accounting period in the form of inflows or
enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating
to contributions from equity participants.

 Income encompasses both revenue and gains

1. Revenue arises in the course of the ordinary activities of an entity.
2. Gains represent other items that meet the definition of income and may, or may not, arise in the
course of the ordinary activities of an entity. Gains are often reported net of related expenses.

 Expenses are decreases in economic benefits during the accounting period in the form of outflows or
depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to
distributions to equity participants.

 Expenses encompass losses as well as those expenses that arise in the course of the ordinary activities of the
entity.

REVENUE RECOGNITION PRINCIPLE

 Income is recognized in the income statement when increase in future economic benefits related to an
increase in an asset or a decrease in liability has arisen that can be measured reliably.

 This means, in effect, that recognition of income occurs simultaneously with the recognition of increases in
assets or decreases in liabilities (for example, the net increase in assets arising on a sale of goods or services
or the decrease in liabilities arising from the waiver of a debt payable).

 Income is generally recognized at the point of sale (i.e. when goods are delivered or when services are
rendered).

EXPENSES RECOGNITION PRINCIPLES

 Expenses are recognized in the income statement when a decrease in future economic benefits related to a
decrease in an asset or an increase of a liability has arisen that can be measured reliably.

 This means, in effect, that recognition of expenses occurs simultaneously with the recognition of an increase
in liabilities or a decrease in assets (for example, the accrual of employee entitlements or the depreciation of
equipment).

 Applications of matching principle:

1. Cause and effect association – involves the simultaneous or combined recognition of revenues and
expenses that result directly and jointly from the same transactions or other events.
2. Systematic and rational allocation – used when economic benefits are expected to arise over several
accounting periods and the association with income can only be broadly or indirectly determined.
3. Immediate recognition - an expense is recognized immediately in the income statement when an
expenditure produces no future economic benefits or when, and to the extent that, future economic
benefits do not qualify, or cease to qualify, for recognition in the balance sheet as an asset.

CAPITAL AND CAPITAL MAINTENANCE

1. Financial concept (such as invested money or invested purchasing power)
1. capital is synonymous with net assets or equity of the enterprise.
2. 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 the net assets at the beginning of the period, after
excluding any distributions to, and contributions from, owners during the period.

2. Physical concept (such as operating capability)

1. capital is regarded as the productive capacity of the entity based on, for example, units of output per
day.
2. 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.

References:
International Financial Reporting Standards®, PART A © IFRS Foundation

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Fundamentals of Accounting I Conceptual Framework and Elements of Financial Statements
International Financial Reporting Standards®, PART B, Basis for Conclusions, © IFRS Foundation
Principles of Accounting by Kieso, Weygandt © John Wiley & Sons Publication (The Prescribed Text)
International Financial Reporting Standards, Certificate Learning Materials, © The Institute of Chartered Accountants,
In England and Wales

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