FINANCIAL ACCOUNTING & REPORTING 3

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Financial statements and conceptual framework for financial reporting

Module 003 Week001- FinAcct3 Financial

statements and conceptual framework for
financial reporting
In providing information with the qualitative characteristics that make it
useful, companies must consider an overriding factor that limits the
reporting. This is referred to as the cost constraint (the cost-benefit
relationship). That is, companies must weigh the costs of providing the
information against the benefits that can be derived from using it. In order to
justify requiring a particular measurement or disclosure, the benefits
perceived to be derived from it must exceed the costs perceived to be
associated with it.
Accounting assumptions are the basic notions or fundamental premises on
which the accounting process is based. Accounting assumptions are also
known as postulates. Like a building structure that requires a solid
foundation to avoid or prevent future collapse and provide room for
expansion and so with accounting. They serve as the foundation or bedrock
of accounting in order to avoid misunderstanding but rather to enhance the
understanding and usefulness of the financial statements.
Measurement, on the other hand, is the process of determining the
monetary amounts at which the elements of financial statements are
recognized and carried in the statement of financial position and income
statement. The most commonly used measurement is based on historical cost
which is adopted by entities in preparing their financial statements.
The concept of capital maintenance is concerned with how an entity
defines the capital that it seeks to maintain. It is a prerequisite for
distinguishing between an entity's return on capital (i.e. profit) and its return
of capital. In general terms, an entity has maintained its capital if it has as
much capital at the end of the period as it had at the beginning of the period.
Any amount over and above that required to maintain the capital at the
beginning of the period is profit.

At the end of this module, you will be able to:

1. Define the concept of cost constraint of useful financial reporting
2. Identify the four basic underlying assumptions of financial reporting
3. Identify the four measurement bases or financial attributes of elements

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Financial statements and conceptual framework for financial reporting

4. Define the concepts of capital and capital maintenance

Cost constraint on useful information

Cost is a pervasive constraint on the information that can be provided by financial

reporting. Reporting financial information imposes cost and it is important that such cost is
justified by the benefit derived from the financial information.
The rules is “the benefit derived from the information should exceed the cost incurred in
obtaining the information”.
However, the evaluation of the cost constraint is substantially a judgmental process.
Assessing whether the cost of reporting outweighs or falls short of the benefit is difficult to
measure and becomes a matter of professional judgment.

Underlying assumptions

Four basic assumptions underlie the financial accounting structure: (1) economic entity,
(2) going concern, (3) monetary unit, and (4) periodicity.
Economic entity assumption
The economic entity assumption means that economic activity can be identified with a
particular unit of accountability. In other words, a company keeps its activity separate and
distinct from its owners and any other business unit. Equally important, financial statement
users need to be able to distinguish the activities and elements of difference companies.
The entity concept does not apply solely to the segregation of activities among competing
companies. An individual, department, division, or an entire industry could be considered a
separate entity if we choose to define it in this manner. Thus, the entity concept does not
necessarily refer to a legal entity.
Going concern assumption
Going concern means that the accounting entity is viewed as continuing in operation
indefinitely in the absence of evidence to the contrary. It is also known as continuity
assumption.
The going concern assumption applies in most business situations. Only where liquidation
appears imminent is the assumption inapplicable. In these cases, a total revaluation of
assets and liabilities can provide information that closely approximates the company’s net
realizable value.

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Financial statements and conceptual framework for financial reporting

Monetary unit assumption

The monetary unit assumption means that money is the common denominator of
economic activity and provides an appropriate basis for accounting measurement and
analysis. That is, the monetary unit is the most effective means of expressing to interested
parties changes in capital and exchanges of goods and services. The monetary unit is
relevant, simple, universally available, understandable, and useful.
Periodicity assumption
To measure the results of a company’s activity accurately, we would need to wait until it
liquidates. Decision-makers, however, cannot wait that long for such information. Users need
to know a company’s performance and economic status on a timely basis so that they can
evaluate and compare firms, and take appropriate actions. Therefore, companies must
report information periodically.
The periodicity assumption implies that a company can divide its economic activities into
artificial time periods. These time periods vary, but the most common are monthly,
quarterly, and yearly.

Measurement bases

Measurement is the process of determining the monetary amounts at which the elements of
financial statements are recognized and carried in the statement of financial position and
income statement.
The measurement bases or financial attributes include:
a. Historical cost
b. Current cost
c. Realizable value
d. Present value
The most commonly used measurement is based on historical cost which is adopted by
entities in preparing their financial statements.
Historical cost
Historical cost is the amount of cash or cash equivalents paid or the fair value of the
consideration given to acquire an asset at the time of acquisition.
Historical cost has an important advantage over other valuations: It is generally thought to
be verifiable.
It is also known as “past purchase exchange price”.

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Financial statements and conceptual framework for financial reporting

Current cost
Current cost is the amount of cash or cash equivalent that would have to be paid if the same
or an equivalent assets was acquired currently.
Current cost is also known as “current purchase exchange price”
Realizable value
Realizable value is the amount of cash or cash equivalent that could currently be obtained by
selling the asset in an orderly disposal.
Realizable value is also known as “current sale exchange price” or “exit value”
Present value
Present value is the discounted value of the future net cash inflows that the item is expected
to generate in the normal course of business.
Present value is also known as “future exchange price”

Capital and capital maintenance concepts

Capital maintenance
The financial performance of an entity is determined using two approaches, namely capital
maintenance and transaction approach.
The transaction approach is the traditional preparation of an income statement.
The capital maintenance approach means that net income occurs only after the capital
used from the beginning of the period is maintained. In other words, net income is the
amount an entity can distribute to its owners and be as “well-off” at the end of the year as at
the beginning.
The Conceptual Framework considers two concepts of capital maintenance or well-offness,
namely financial capital and physical capital.
Financial capital
Financial capital is the absolute monetary amount of the net assets contributed by
shareholders and the amount of the increase in net assets resulting from earnings retained
by the entity.
Financial capital is based on historical cost. It is the concept that is adopted by most entities.
Under the financial capital concept, net income occurs:
“When the nominal amount of the net assets at the end of the period exceeds the nominal
amount of the net assets at the beginning of the period, after excluding distributions to and
contributions by owners during the period.”
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Financial statements and conceptual framework for financial reporting

Physical capital
Physical capital is the quantitative measure of the physical productive capacity to produce
goods and services.
This concept requires that productive assets shall be measured at current cost rather than
physical cost.
Productive assets include inventories and property, plant and equipment.
Under the physical capital concept, net income occurs:
“When the physical productive capital at the end of the period exceeds the physical
productive capital at the beginning of the period, after excluding distributions to and
contributions from owners during the period.”

Glossary

Economic entity: means that economic activity can be identified with a particular unit of
accountability
Going concern: means that the accounting entity is viewed as continuing in operation
indefinitely in the absence of evidence to the contrary. It is also known as continuity
assumption.
Monetary unit: means that money is the common denominator of economic activity and
provides an appropriate basis for accounting measurement and analysis.
Periodicity: requires that “the indefinite life of an entity is subdivided into time periods
or accounting periods which are usually of equal length for the purpose of preparing
financial reports on financial position, performance and cash flows.”
Historical cost: is the amount of cash or cash equivalents paid or the fair value of the
consideration given to acquire an asset at the time of acquisition
Current cost: is the amount of cash or cash equivalent that would have to be paid if the
same or an equivalent assets was acquired currently
Realizable value: is the amount of cash or cash equivalent that could currently be
obtained by selling the asset in an orderly disposal
Present value: is the discounted value of the future net cash inflows that the item is
expected to generate in the normal course of business
Financial capital: is the absolute monetary amount of the net assets contributed by
shareholders and the amount of the increase in net assets resulting from earnings
retained by the entity
Physical capital: is the quantitative measure of the physical productive capacity to
produce goods and services
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Financial statements and conceptual framework for financial reporting

References and Supplementary Materials

Books and Journals

Valix, C., Peralta, J. & Valix, C.A; 2016; Financial Accounting Volume 3; Metro Manila,
Philippines; GIC Enterprises & Co., Inc.

Valix, C., Peralta, J. & Valix, C.A; 2016; Financial Accounting Volume 1; Metro Manila,
Philippines; GIC Enterprises & Co., Inc.

Donald E. Kieso, Jerry J. Weygandt, Terry D. Warfield; 2013; Intermediate Accounting;

United States; John Wiley & Sons, Inc.

Barry Elliot, Jamie Elliot; 2011; Financial Accounting and Reporting; Essex CM20 2JE,
England; Pearson Education Limited

Online Supplementary Reading Materials

The Conceptual Framework;
http://www.fasb.org/jsp/FASB/Page/BridgePage&cid=1176168367774; October 29,
2017

The Conceptual Framework; http://www.ifrs.org/projects/work-plan/conceptual-

framework/; October 29, 2017

IASplus; https://www.iasplus.com/en/resources/ifrsf/iasb-ifrs-ic/iasb; October 29,

2017

IASplus; https://www.iasplus.com/en/standards/ias/ias; October 29, 2017

Online Instructional Videos

The Conceptual Framework Intermediate Accounting CPA Exam;
https://www.bing.com/videos/search?q=conceptual+framework&&view=detail&mid=222
050C98AACF518049E222050C98AACF518049E&FORM=VRDGARl; January 10, 2018

Financial Accounting Conceptual Framework (Financial Accounting Tutorial #12);

https://www.bing.com/videos/search?q=conceptual+framework&&view=detail&mid=8E
AF86DFB689D8DCF6278EAF86DFB689D8DCF627&FORM=VRDGAR; January 10, 2018

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