Postgraduate Diploma

in Professional Accounting

Basic Accounting

Lecture 1
Conceptual Framework for Financial Reporting
&
Regulatory Framework

By: Mr. Steve T. W. Lee, CPA

10 January 2020
1
Today’s Topic

• What is accounting?

• Conceptual Framework of Financial

Reporting

• Regulatory Framework

2
What is accounting?
•Accounting can be defined as ‘the process of identifying,
measuring and communicating economic information to
permit informed judgments and decisions by users of the
information’.

– Recording accounting data (i.e. record the transaction

of a company to provide day-to-day information to the
management)

– Classifying and summarizing the transaction of a

period to provide information of a company’s
performance (profit and loss) and financial position
(assets and liabilities) to the interested parties

3
What is accounting?

•Accounting has many objectives, including letting people

and organization know:
– If they are making a profit or a loss
– What their business is worth
– What a transaction was worth to them
– How much cash they have

•The primary objective of accounting is to provide

information for decision-making.

4
What is accounting?
Financial Reporting is achieved through the use of four
financial statements:

•Statement of Financial Position (the Balance Sheet);

•Statement of Profit or Loss and Other Comprehensive
Income (the Income Statement);
•Statement of Cash Flow;
•Statement of Changes in Equity.

5
What is accounting?
Business can be organized in several ways

•Sole Proprietorship – A business is owned and operated by one

person with or without employees. The assets & liabilities of the
business entity are distinctly separated from those of the owner.
Unlimited liability, i.e. the owner is personally liable for any obligation of
the business entity. Ownership and management usually rest on the
same person.

•Partnership – Several people jointly owning and running the

business. Two or more individuals as co-owners, and the assets &
liabilities of the business entity are treated the same way as Sole
Proprietorship. Partnerships also have unlimited liability, and
ownership and management are often combined. Some professional
partnerships have limited liability, LLP.

6
What is accounting?
•Corporations/Limited companies – a legal person/entity created by
law, and the owners have limited liability – up to the limit of the amount
of capital that they have invested. Ownership and management in
Corporations may be separate. The funds providers are called the
shareholders or members of the company. They own the company but
often do not participate in the management. The shareholders appoint
directors to run the business. However, set up and administrative costs
are high for corporation, such as incorporation expenses, legal fees,
audit fees, annual filing fees, etc. etc. (And in Hong Kong, profits tax
rate is 16.5% for limited companies as compared to 15% for
individuals.)

•Club - The non-profit organization provides facilities and activities for

the members.

7
What is accounting?
Scope of Accounting
Financial Accounting focuses on the specific needs of decision
makers external to the organization, such as stockholders, suppliers,
banks, and government agencies.
•For external users
•Required by Law
•General purpose
•Historical
Management Accounting serves internal decision makes, such as top
executives, managers, administrators within the organization.
•For internal users
•Not mandatory
•Specific purpose
•Future oriented
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Conceptual Framework Of
Financial Reporting

1. The need for a conceptual framework

2. Underlying assumptions
3. Qualitative characteristics of financial
statements
4. Elements of financial statements
5. Recognition and measurement of the elements
of the financial statements

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The need for a conceptual framework
What is conceptual framework of financial reporting?

•The framework provides the CONCEPTS, PRINCIPLES

AND RULES that address the nature, purpose and broad
content of financial reporting and underlie the preparation
and presentation of financial statements for external users.
All the concepts, principles, conventions, laws, rules and
regulations that are used to prepared and present the
financial statements are known as Generally Accepted
Accounting Principles or GAAP.

•Provide logical and sensible guide for preparing accounting

standards

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The need for a conceptual framework
What is the use of a conceptual framework?

•To give guidance to the standards-setting bodies (e.g.

IASB, HKICPA) in developing new financial reporting
standards and reviewing existing standards. Accounting
standards will be more consistent and logical if they are
developed from an orderly set of concepts;

•Assist preparers of financial statements in applying

accounting standards;

•Assist auditors in forming opinion on whether a set of

financial statements complies with IASs/ HKFRSs; and

•Assist users of financial statements in interpreting the

information
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Objective of Financial Statements
Usefulness for particular purposes
• Provide economic decisions
- buy or sell shares
- re-elect or replace board of directors

• Ability to generate cash, as well as to predict

the timing and certainty of the cash generated.

Users need historic information about:

- financial position
- performance
- cash flow of an entity
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Users of Financial Statements
What are the users of the financial statements and
their respective information needs?

•Present and potential shareholders – concerned with the

risk inherent in, and return provided by their investments;
•Employees – Stability and profitability of their employers;
•Lenders – to determine whether their loans and interest
will be paid when due;
•Suppliers and other creditors – to determine whether their
outstanding amount will be paid;
•Customers;
•Government and their agencies; and
•General public

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Accounting Principles

Generally Accepted Accounting Principles (GAAP) refers to

the overall body of financial reporting principles and
practices used in any given jurisdiction, for example, US
GAAP is adopted in the USA while HK GAAP is adopted
in Hong Kong.

GAAP includes the standards, conventions and rules that

accountants should follow in recognizing, measuring and
reporting transactions and in the preparation of financial
statements.

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Accounting Principles
• Accounting Principles are conventions, concepts, rules,
practices or assumptions which apply generally to
transactions. All the conventions have influence in
determining:
- which assets and liabilities are recorded on a balance sheet and
at what value
- what income and expenditure is recorded in the profit and loss
account and at what amount.
• It is important that the users of a company’s account are
aware of the principles upon which the accounts have
been prepared, particularly if they compare the accounts
from year to year or with other companies. The rule and
guidelines help to ensure consistency and comparability.

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Accounting Principles
Common accounting conventions

• Business entity concept – Implies that the affairs of a

business are to be treated as being separate from the
non-business activities of its owners

• Double entry (Duality) - Each transaction has two effects.

A debit and the corresponding credit.

• Historical cost - The values of the accounts are based on

the historical costs incurred. E.g. PP&E are stated at
their historical costs.

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Accounting Principles
Common accounting conventions

Materiality

• Immaterial items should not be given the same emphasis

as material items. Each material item should be
presented separately in the financial statements.
• An item is material if its non-disclosure could influence
the economic decisions of users taken on the basis of
the financial statements.
• The materiality is different from company to company. In
assessment the materiality is not only the amount but the
nature and context is also important.

17
Accounting Principles
Going concern
• This assumes that the company will continue in
operational existence for the foreseeable future. The
financial statements are drawn up on the assumption that
there is no intention or necessity to liquidate or curtail
significantly the scale of business.
• The directors and auditors of a company both have a
responsibility to ensure that the company is indeed a
going concern if the going concern basis is adopted.
• The going concern assumption should not be used:
– If the business is going to close down in the near future
– Where a shortage of cash makes it almost certain that
the business will have cease trading
– Where a large part of the business will almost certainly
have to be closed down because of a shortage of cash
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Accounting Principles
Accrual (matching) concept
• Transactions and events are recognized when they
occur (and not as cash or its equivalent is received or
paid) and they are recorded in the accounting records
and reported in the financial statements of the periods to
which they relate.
• Expenses are recognized in the income statement on the
basis of a direct association between the costs incurred
and the earning of specific items of income.
• Examples of applying accrual concept include the
depreciation of PP&E and recording the accruals and
prepayments of expenses.

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Accounting Principles
Prudence

• Under the conditions of uncertainty, judgment must be

exercised cautiously in making the estimates required,
such that assets or income are not overstated and
liabilities or expenses are not understated

• Only realized profits and revenue are recognized in the

income statement. Provisions are made for all known
liabilities, expenses and losses, whether the amounts are
known with certainty or are reasonably estimates. The
prudence concept overrides that of accrual.

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Accounting Principles
Consistency

• A company should be consistent in its accounting

treatment of similar items, both within a particular
accounting period and between one and future accounting
period.

• The main reason for this is to enable comparability as it

helps users make comparisons over time and pick out
useful trends.

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Conceptual Framework Of
Financial Reporting

1. The need for a conceptual framework

2. Underlying assumptions
3. Qualitative characteristics of financial
statements
4. Elements of financial statements
5. Recognition and measurement of the elements
of the financial statements

22
Underlying assumptions
In order to meet the objectives of accounting, financial
statements are prepared on 2 basic underlying
assumptions:

•Accrual basis – To recognize the effects of transactions

and events when they occur rather than when cash or its
equivalent is received or paid.

•Going concern basis – Assume the entity will continue

operate in the foreseeable future, and does not intend to go
into liquidation and will not be forced into liquidation.

To be elaborated in more details later in this lecture (under

the accounting concept section).

23
Conceptual Framework Of
Financial Reporting

1. The need for a conceptual framework

2. Underlying assumptions
3. Qualitative characteristics of financial
statements
4. Elements of financial statements
5. Recognition and measurement of the elements
of the financial statements

24
Qualitative Characteristics
•Attributes that make the financial information
useful to users

•If financial information is to be useful, it must be

relevant and faithfully represents what it purports
to represent.

•The usefulness of financial information is

enhanced if it is comparable, verifiable, timely and
understandable.

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Qualitative Characteristics
Fundamental Qualitative Characteristics
• Relevance
• Faithful Representation

Enhancing Qualitative Characteristics

• Comparability
• Verifiability
• Timeliness
• Understandability

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Qualitative Characteristics
- Fundamental Qualitative Characteristics
Relevance
• Relevant financial information is capable of making a
difference in the decisions made by users
• Provided in time to influence the decisions

• Financial information is capable of making a difference in

decisions if it has:
- predictive value
Enable users to evaluate the past, present or future
events
- confirmatory value
Helps users to confirm the past evaluations and
assessments
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Qualitative Characteristics
- Fundamental Qualitative Characteristics
Relevance
Materiality has a direct impact on the relevance of
information

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, .
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Qualitative Characteristics
- Fundamental Qualitative Characteristics
Faithful representation

•Faithful representation - Information must faithfully represent

the effects of transactions and other events.

•Must be accounted for and presented in accordance with

their substance and economic reality, and not merely their
legal form (Substance over form)

•Substance over form - Transaction may have a real nature

(substance) that differs from their legal form. Whenever it is
legally possible, the real substance prevails over the legal
form. E.g. Finance lease vs. Operating lease
29
Qualitative Characteristics
- Fundamental Qualitative Characteristics
Faithful representation

To be a perfectly faithful representation, a depiction

would have three characteristics. It would be:

•Completeness
•Neutrality
•Free from error

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Qualitative Characteristics
- Fundamental Qualitative Characteristics
Faithful representation

Completeness
• must contain all necessary descriptions and explanations

Neutrality
•Free from bias. Avoid to have predetermined outcome

Free from error

•Within the bounds of materiality
•free from error does not mean perfectly accurate in all
respects
•representation of that estimate can be faithful if the amount
is described clearly and accurately as being an estimate 31
Qualitative Characteristics
- Enhancing Qualitative Characteristics
Comparability

Information in financial statements must enable users to

compare the information through time for any company so
that the users can identify trends in a company’s financial
performance and position. Users must also be able to
compare the financial statements of different companies to
facilitate them in making investment decisions.

Consistency and disclosure are required

32
Qualitative Characteristics
- Enhancing Qualitative Characteristics
Verifiability
•means that different knowledgeable and independent
observers could reach consensus
• Verification can be direct or indirect.
•Direct verification means verifying an amount or other
representation through direct observation, for example, by
counting cash.
•Indirect verification means checking the inputs to a model,
formula or other technique and recalculating the outputs
using the same methodology. An example is verifying the
carrying amount of inventory by checking the inputs
(quantities and costs) and recalculating the ending inventory
using the same cost flow assumption (for using FIFO) 33
Qualitative Characteristics
- Enhancing Qualitative Characteristics
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.

34
Qualitative Characteristics
- Enhancing Qualitative Characteristics
Understandability

Information should be presented in a way that is readily

understood by users.

Users are assumed to have a reasonable knowledge of

business, economic activities and accounting. Relevant
information about complex matters should not be excluded
merely on the grounds that it may be too difficult for certain
users to understand.

35
Qualitative characteristics of financial
statements
Limits to relevant and reliable information

• Balance between qualitative characteristics

• Timeliness

• Benefit must outweigh cost

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The concept of true and fair view
IAS1/ HKAS1 states that financial statements shall give a true
and fair view of the financial position, financial performance
and cash flows of an entity. It goes on to define ‘true and fair’
as the faithful representation of the effects of transactions,
other events and conditions in accordance with the definitions
and recognition criteria for assets, liabilities, income and
expenses. The application of IASs/ HKFRSs is presumed to
result in financial statements that achieve a true and fair
presentation.

The Framework does not define these ideas, but compliance

with accounting standards and the Framework will help to
achieve them.
37
Conceptual Framework
of Financial Reporting

Let’s go to activity 1-3

38
Conceptual Framework Of
Financial Reporting

1. The need for a conceptual framework

2. Underlying assumptions
3. Qualitative characteristics of financial
statements
4. Elements of financial statements
5. Recognition and measurement of the elements
of the financial statements

39
Elements of financial statements
Assets:

•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

Liabilities:

•A present obligation of an entity

•Arising from past events, and
•The settlement of which is expected to result in an outflow
of resources that embody economic benefits
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Elements of financial statements

Equity:

Is the residual interest in an entity after the value of all

liabilities has been deducted from the value of all its assets.
It is a ‘balance sheet value’ of the entity’s net assets. It
does not represent in the market value of the equity.

The Accounting Equation

Assets = Liabilities + Owners’ Equity

41
Elements of financial statements
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
shareholders.

Income includes both revenue and gains.

Expenses:
Expense is decreases in economic benefits during the
accounting period in the form of outflows or depletion of
assets or incurrence of liabilities that result in decreases in
equity.

Expenses includes both expenses and losses. 42

Format of Income Statement

43
44
Format of Balance Sheet

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46
47
Distinction between types of Accounts
• The main reason for recording commercial transactions
in an accounting system is to enable a company to
determine its financial performance (profit or loss) over a
period of time and to determine its financial position
(assets and liabilities) at the end of that period.

• The financial position is measured by comparing what a

business owns (assets) to what a business owes (liability)
to outsider.

• The sales revenue and expenses accounts will form the

basis of the trading and profit and loss account. The
asset and liability accounts will form the basis of the
balance sheet.

48
Capital and Revenue Expenditure
• If item is purchased for use in the business over a long
period of time, then the expenditure is classified as a
capital expenditure and is a fixed asset. Fixed assets
are items purchased, not for resale but for use within the
business in their generation of profits over more than one
accounting period. Property, machinery, motor car and
furniture are examples of fixed assets.

• Expenditure which is not spent on increasing the value of

fixed assets, but on running the business on a day-to-day
basis, is known as revenue expenditure.

49
Capital and Revenue Expenditure

• Revenue expenditure is expenditure classified as

expense in the trading and profit and loss account
whereas capital expenditure is expenditure on fixed
assets and will be shown on balance sheet.

50
Conceptual Framework
of Financial Reporting

Let’s go to activity 4

51
Conceptual Framework Of
Financial Reporting

1. The need for a conceptual framework

2. Underlying assumptions
3. Qualitative characteristics of financial
statements
4. Elements of financial statements
5. Recognition and measurement of the
elements of the financial statements

52
Recognition and Measurement
Measurement bases for the elements of financial
statements:
•Historical cost – the amount of cash received/ paid in
exchange for the asset/ obligation

•Fair value – the amount for which an item could be

exchanged between knowledgeable, willing parties in an
arm’s length transaction

•Net realizable value - estimated selling price in the

ordinary course of business, less the estimated costs
necessary to make the sale.

•Present value of future cash flows – value of the future net

cash inflows/ outflows that the item is expected to
generate/ settle, discounted to a present value
53
Recognition and Measurement

Which accounting approach do we use to

prepare financial statements traditionally?

A: Historical cost accounting

54
Recognition and Measurement

Advantages of historical cost accounting

•Provide objective measurement of the elements of

financial statements
•Simple and cheap
•The profit concept is well understood
•Provide basis for comparison with the results of
other companies, with the results of the same
entity for previous periods and budgets

55
Recognition and Measurement
Disadvantages of historical cost accounting
When there is high rate of inflation and there is significant
rise over time in selling prices and costs:
•The carrying value of assets is often significantly lower
than their current fair value or market value (e.g. PP&E,
inventories).
•The income statement understates the ‘real’ value of the
cost of sales and so overstates the profit. It fails to show
the profit in real economic terms.
•If an entity used HCA to measure profit and then
distributed all the profits as dividends to shareholders, it
would be unable to replace all the assets it has consumed
in the cost of sales.
•There is no recognition of the effect of inflation on
monetary items, such as loans, A/P and A/R. This results
in a benefit for the borrower and the loss for the lender.
56
Recognition and Measurement
Alternative to HCA: (1) Current Cost Accounting

The current cost accounting involves taking account of

specific price changes as they affect a particular business
and will result in a separate set of financial statements,
distinct from the historical cost financial statement.

Alternative to HCA: (2) Constant Purchasing Power

Accounting

Under the constant purchasing power accounting, the

financial statements are adjusted so that all the items are
presented in terms of money with the same purchasing
power, using a general price index.

57
.
Regulatory Framework
Accounting standards and basic legal
requirements

•The regulatory framework of accounting consists of a set

of formal, but not necessary legislated, rules and
guidelines that accountants are expected to follow when
preparing financial statements.

•The sources of the rules include:

-Company Ordinance
-Accounting standards (local and international) and
-Stock exchange regulations.

58
Regulatory framework
In Hong Kong, financial statements are required to prepare
in accordance with:

•Companies Ordinance - The legal requirements for

preparing financial statements in Hong Kong are set out in
the Tenth Schedule to the Companies Ordinance.

•However, there are no prescribed formats for the

presentation of financial statements in the Companies
Ordinance and, therefore, a reasonable degree of flexibility
is allowed.

59
Regulatory framework
Hong Kong Financial Reporting Standards
(HKFRSs)

The financial statements are also required to comply with

the HKFRSs, which are the most authoritative sources of
accounting principles generally accepted in Hong Kong. The
application of the HKFRSs is presumed to result in financial
statements that give a true and fair view.

The HKFRS set out recognition, measurement, presentation

and disclosure requirements dealing with transactions and
events that are important in preparing general purpose
financial statements.
60
Regulatory framework
Hong Kong Financial Reporting Standards
(HKFRSs)

The term HKFRSs includes all HKFRSs, HKAS and

Interpretations currently in use.

HKFRSs are applicable to general purpose financial

statements of all profit-oriented entities.

HKFRSs are based on the Conceptual Framework, which

addresses the concepts underlying the information
presented in general purpose financial statements

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Regulatory framework
Hong Kong Financial Reporting Standards
(HKFRSs)
Included in the HKFRSs, there are some interpretations of
HKFRSs which give an authoritative guidance on newly
identified issues about financial reporting that are not
specifically or satisfactorily addressed in HKFRSs.

Entities shall apply interpretations if their financial

statements are described as being prepared in accordance
with HKFRSs.

Interpretations apply to current and future reporting periods

from the date of issue or other specified effective date.
Transitional provisions that apply on initial application of an
interpretation are specified in the interpretation. 62
The standard setting process
The role of the HKICPA

The HKICPA is the only statutory accounting body in

existence in Hong Kong responsible for the establishment
of accounting and auditing standards and guidelines, as
well as, for the administration and regulation of the
accounting profession in Hong Kong.

Pursuant to the Professional Accountants Ordinance

(Chapter 50), the Council of the HKICPA may, in relation to
the practice of accountancy, issue or specify any standards
of accounting practices required to be observed,
maintained or otherwise applied by members of the
HKICPA.
63
The standard setting process
The role of the HKICPA

The objectives of the Council are:

•To develop, in the public interest, a single set of high
quality, understandable and enforceable accounting
standards to help participants in the capital markets and
other users of the information to make economic decisions;
•To promote the use and rigorous application of those
standards;
•To promote, support and enforce compliance with those
standards by members of HKICPA whether as preparers or
auditors of financial information; and
•To bring about convergence of accounting standards with
IFRSs.

64
Regulatory framework

Standards setting procedures in Hong Kong

•The Hong Kong Institute of CPAs has mandated

the Financial Reporting Standards Committee
(FRSC) to develop accounting standards to
achieve convergence with the International
Financial Reporting Standards (IFRSs) issued by
the International Accounting Standards Board
(IASB) through a due process.

65
The standard setting process
Various committees are involved in the standard setting
process, which are briefly described as follows:

•The Council of the HKICPA is given statutory power under

the Professional Accountants’ Ordinance to issue or specify
any accountant standards, exposure drafts or discussion
documents.
•The Council has given its Financial Reporting Standards
Committee (“FRSC”) the responsibility to develop
standards and achieve convergence with IFRSs. The
FRSC may form advisory sub-committees or engage other
specialist advisors in preparing new or revised HKFRSs.

66
The standard setting process
• The Urgent Issues and Interpretation Sub-committee
(“UII”) is a sub-committee formed under the auspices of
the FRSC. The role of the UII is to address current issues
arising in financial reporting practice and prepare
interpretations of HKFRSs for consideration by the FRSC.
• The HKICPA also has a Standard-setting Steering Board
(“SSSB”) responsible for reviewing and advising on
HKICPA’s overall strategy, policies and processes for
setting accounting standards.
• The actual due process of developing standards and
interpretations is closely co-ordinated to the IASB’s due
process.

67
The standard setting process
The due process of setting HKFRSs is summarized as
follows:

• The staff of HKICPA are asked to identify and review all

the issues associated with the exposure draft or a draft
interpretation issued by the IASB for possible adoption in
Hong Kong or any other topics and to consider the
application of the Framework to the issues, if needed;

• Consulting the HKICPA’s Standard-Setting Steering

Board about the advisability of adding the topic to the
FRSC agenda;

68
The standard setting process
• Publishing for public comment a discussion document;

• Publishing for public comment an exposure draft or a

draft interpretation;

• Publishing within an exposure draft a basis for

conclusions;

• Approval of a standard by the HKICPA’s Council, and

publishing within a standard a basis for conclusions, if
appropriate, explaining how the conclusions were
reached and to give background information that may
help users of HKFRSs to apply them in practice.
69
The standard setting process
Advantages of accounting standards

•Accounting standards result in consistency of accounting

treatment this means that (in theory) it is possible to
compare the financial statements of different entities in a
meaningful way.
•Similar transactions are treated in the same way over time;
making it possible to evaluate an entity’s performance over
time.
•Make it more difficult (although not impossible) for entities
to adopt accounting treatments that deliberately mislead
users of the financial statements
•Improve the quality of the information provided

70
The standard setting process
Disadvantages of accounting standards

•It can be argued that the selection of accounting policies is

a matter of judgment and should be left to individual entities.
Different entities operate under different conditions; an
accounting policy that is appropriate for some entities may
not be appropriate for others and may actually reduce the
usefulness of the financial statements.
•Some accounting standards may change the commercial
decisions made by entities. An entity avoid actions that
would benefit in the long term if a standard required a
treatment that would reduce profits in the short term.
•Many recent accounting standards have been drawn up
primarily to meet the information needs of large institutional
investors in public companies. For many smaller
companies, the cost of complying may outweigh the
benefits to users and preparers. 71
The standard setting process

Disadvantages of accounting standards

•Where accounting standards require complex treatments

and extensive disclosures, it can be argued that these
make the financial statements harder to understand and
therefore less useful.

However, please note that most of the disadvantages apply

to particular situations, rather than to accounting standards
in themselves. Most preparers and users of the financial
statements consider that the advantages of accounting
standards far outweigh the disadvantages.
72