Conceptual Framework for the Financial Reporting 2018
The Conceptual Framework for the Financial Reporting (let’s title it just “Framework”) is a basic document that sets objectives and the concepts for general purpose financial reporting.
Its predecessor, Framework for the preparation and presentation of the financial statements was issued back in 1998.
Then in 2010, IASB published the new document, Conceptual Framework for the Financial Reporting, however it was a bit unfinished as a few concepts and chapters were missing.
The newest and completed Framework published in 2018 comprises 8 chapters and in this article, I would like to sum it up.
Is the Framework equivalent to the Standard?
Let me please make one point clear:
Framework is NOT a Standard itself.
Thus if you wish to decide on the financial reporting of certain transaction, you need to look into the appropriate standard – IFRS or IAS.
Sometimes, it may even happen that the rules in that IFRS or IAS standard will be contrary to what the Framework says.
In this case, you need to apply the standard, not the Framework.
When should you apply the Framework?
In most cases, when there are no specific rules for your transaction and you need to develop your accounting policy, then you would look to the Framework as you cannot depart from its basic principles and definitions.
Chapter 1: The objective of general purpose financial reporting
The main objective of general purpose financial reports is to provide the financial information about the reporting entity that is useful to existing and potential:
- Lenders, and
- Other creditors
to help them make various decisions (e.g. about trading with debt or equity instruments of a reporting entity).
Chapter 1 is NOT about the financial statements itself – these are described in Chapter 3.
Instead, Chapter 1 describes more general purpose reports that should contain the following information about the reporting entity:
- Economic resources and claims (this refers to the financial position);
- The changes in economic resources and claims resulting from entity’s financial performance and from other events.
Chapter 1 puts an emphasis on accrual accounting to reflect the financial performance of an entity. It means that the events should be reflected in the reports in the periods when the effects of transactions occur, regardless the related cash flows.
However, the information about past cash flows is very important to assess management’s ability to generate future cash flows.
Chapter 2: Qualitative characteristics of useful financial information
In this Chapter, the Framework describes 2 types of characteristics for financial information to be useful:
- Fundamental, and
Fundamental qualitative characteristics
- Relevance: capable of making a difference in the users’ decisions. The financial information is relevant when it has predictive value, confirmatory value, or both.
Materiality is closely related to relevance.
- Faithful representation: The information is faithfully represented when it is complete, neutral and free from error.
Enhancing qualitative characteristics
- Comparability: Information should be comparable between different entities or time periods;
- Verifiability: Independent and knowledgeable observers are able to verify the information;
- Timeliness: Information is available in time to influence the decisions of users;
- Understandability: Information shall be classified, presented clearly and consisely.
Chapter 3: Financial Statements and the Reporting Entity
The financial statements should provide the useful information about the reporting entity:
- In the statement of financial position, by recognizing
- In the statements of financial performance, by recognizing
- Income, and
- In other statements, by presenting and disclosing information about
- recognized and unrecognized assets, liabilities, equity, income and expenses, their nature and associated risks;
- Cash flows;
- Contributions from and distributions to equity holders, and
- Methods, assumptions, judgements used, and their changes.
Financial statements are always prepared for a specified period of time, or the reporting period.
Normally, the financial statements are prepared on the going concern assumption.
It means that an entity will continue to operate for the foreseeable future (usually 12 months after the reporting date).
By the way – what if an entity cannot present as going concern? For example, when the liquidation is assumed within 12 months? Learn what to do here.
This is a new concept introduced in 2018.
Although the term “reporting entity” has been used throughout IFRS for some time, the Framework introduced it and “made it official” only in 2018.
Reporting entity is an entity who must or chooses to prepare the financial statements. It can be:
- A single entity – for example, one company;
- A portion of an entity – for example, a division of one company;
- More than one entities – for example, a parent and its subsidiaries reporting as a group.
As a result, we have a few types of financial statements:
- Consolidated: a parent and subsidiaries report as a single reporting entity;
- Unconsolidated: e.g. a parent alone provides reports, or
- Combined: e.g. reporting entity comprises two or more entities not linked by parent-subsidiary relationship.
Chapter 4: Elements of the financial statements
This chapter extensively deals with the definitions of individual elements of the financial statements.
There are five basic elements:
- Asset = a present economic resource controlled by the entity as a result of past events;
- Liability = a present obligation of the entity to transfer an economic resource as a result of past events;
- Equity = the residual interest in the assets of the entity after deducting all its liabilities;
- Income = increases in assets or decreases in liabilities resulting in increases in equity, other than contributions from equity holders;
- Expenses = decreases in assets or increases in liabilities resulting in decreases in equity, other than distributions to equity holders;
The Framework then discusses each aspect of these definitions and provides wide guidance on how to decide what element you are dealing with.
Chapter 5: Recognition and derecognition
This chapter discusses the recognition and derecognition process.
Simply speaking, recognition means including an element of financial statements in the financial statements.
In other words, if you decide on recognition, you decide on WHETHER to show this item in the financial statements.
Recognition process links the elements in the financial statements according to the following formula:
Please let me stress here that not all items that meet the definition of one of the elements listed above are recognized in the financial statements.
The Framework requires recognizing the elements only when the recognition provides useful information – relevant with faithful representation.
Then, the Framework discusses the relevance, faithful representation, cost constraints and other aspects in a detail.
Derecognition means removal of an asset or liability from the statement of financial position and normally it happens when the item no longer meets the definition of an asset or a liability.
Again, the Framework discusses the derecognition in a greater detail.
Chapter 6: Measurement
Measurement means IN WHAT AMOUNT to recognize asset, liability, piece of equity, income or expense in your financial statements.
Thus, you need to select the measurement basis, or the method of quantifying monetary amount for elements in the financial statements.
The Framework discusses two basic measurement basis:
- Historical cost – this measurement is based on the transaction price at the time of recognition of the element;
- Current value – it measures the element updated to reflect the conditions at the measurement date. Here, several methods are included:
- Fair value;
- Value in use;
- Current cost.
Each of these measurement base is discussed in a greater detail.
The Framework then gives guidance on how to select the appropriate measurement basis and what factors to consider (especially relevance and faithful representation).
What I personally find really useful is the guidance on measurement of equity.
The issue here is that the equity is defined as “residual after deducting liabilities from assets” and therefore total carrying amount of equity is not measured directly.
Instead, it is measured exactly by the formula:
- Total carrying amount of all assets, less
- Total carrying amount of all liabilities.
The Framework points out that it can be appropriate to measure some components of equity directly (e.g. share capital), but it is not possible to measure total equity directly.
Chapter 7: Presentation and disclosure
The main aim of presentation and disclosures is to provide an effective communication tool in the financial statements.
Effective communication of information in the financial statements requires:
- Focus on objectives and principles of presentation and disclosure, not on the rules;
- Group similar items and separate dissimilar items;
- Aggregate information, but do not provide unnecessary detail or the opposite – excessive aggregation to obscure the information.
The Framework discusses classification of assets, liabilities, equity, income and expenses in a greater detail with describing offsetting, aggregation, distinguishing between profit or loss and other comprehensive income and other related areas.
Chapter 8: Concepts of capital and capital maintenance
This chapter is carried forward from previous versions of Framework, so there’s nothing new here.
Let me recap shortly.
The Framework explains two concepts of capital:
- Financial capital – this is synonymous with the net assets or equity of the entity.
Under the financial maintenance concept, the profit is earned only when the amount of net assets at the end of the period is greater than the amount of net assets in the beginning, after excluding contributions from and distributions to equity holders.
The financial capital maintenance can be measured either in
- Nominal monetary units, or
- Units of constant purchasing power.
- Physical capital – this is the productive capacity of the entity based on, for example, units of output per day.
Here the profit is earned if physical productive capacity increases during the period, after excluding the movements with equity holders.
The main difference between these concepts is how the entity treats the effects of changes in prices in assets and liabilities.
You can watch a video with the summary of the Conceptual Framework here:
Any comments or questions? Please leave me a message below. Thank you!
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