The current report intends to describe the scope of the new conceptual framework for financial reporting. For doing so, the objectives of financial reporting and underlying assumptions of the conceptual framework are discussed briefly. Secondly, this report explains the qualitative characteristics of the stated framework like fundamental and enhancing characteristics. In addition, various elements of the financial statements of an organisation have been discussed along with the concepts of capital and capital maintenance. Finally, the report sheds light on the use of fair values in preparing and presenting the financial statements from the perspective of business organisations.
In the words of Baker and Burlaud (2015), conceptual framework could be described as a group of objectives and ideas, which result in the formation of a developed set of standards and rules. Particularly in accounting, the standards set the purpose, characteristics and confines of financial accounting as well as financial statements. There are certain reasons for which the conceptual framework needs to be developed and they are described as follows:
In case, there is absence of any framework related to the preparation of financial statements, the standards of accounting would be created in a jumbled and random manner for dealing with the issues when they take place. This would lead to standards that would not be consistent with one another or legislation (Brouwer, Faramarzi and Hoogendoorn 2014). With the help of only one conceptual framework, it would be possible for the users and preparers of the financial statements to understand that one common ideology develops the accounting standards and accounting practices. In addition, unusual transactions could be identified with the help of the conceptual framework, which could be interpreted and the credibility of the accounting profession is enhanced.
The conceptual framework enables in formulating the concepts underlying financial reporting. There are three objectives of financial reporting, as laid out in the conceptual framework and they are discussed as follows:
Useful in making credit and investment decisions:
The main objective of financial reporting in the conceptual framework is to deliver information, which is beneficial to the present and potential investors, creditors and other stakeholders in undertaking credit, investment and equivalent decisions related to allocation of resources.
Useful in evaluating the cash flow projects:
For accomplishing its objective, financial reporting is required to deliver information for enabling the present and potential investors, creditors and other stakeholders to evaluate the timing, amounts and uncertainty of the future cash inflows and outflows of the organisation. Such information is crucial in order to analyse the ability of the organisation in generating cash inflows. Hence, this would enable in providing returns to the creditors and the investors (Biondi et al. 2014).
Information about organisational resources, resource claims and changes in claims and resources:
Financial reporting intends to help the potential and current investors, creditors and other stakeholders to evaluate the capability of an organisation in generating net cash inflows by providing information regarding the economic resources (assets) of the organisation and claims to such resources like equity and liabilities. It is vital as well to provide the information related to the impact of transactions, other events and circumstances, which alter the change claims and resources to them.
Underlying assumptions:
Two underlying assumptions of the conceptual framework of IFRS are inherent for preparing financial statements, which are discussed briefly as follows:
Accrual basis:
Under this basis, the impact of transactions and other events are realised at the time of their occurrence and not as the receipt or payment of cash (Chaudhry et al. 2015). The financial statements developed on this basis provide information to the users about past transaction at the time of payment or receipt of cash along with obligations to make future cash payments and receipts.
Going concern basis:
This basis assumes that in developing the financial statements, an organisation would carry out its operations in future and it does not have any plan to liquidation or it would not be compelled to liquidate or curtail its operations. This is significant for asset valuation, since they might need valuation on break-up basis, if the organisation would stop trading.
The qualitative characteristics:
In conceptual framework, there are two qualitative characteristics, one is fundamental and another is enhancing. These two characteristics are described briefly as follows:
Fundamental qualitative characteristics:
The fundamental qualitative characteristics of conceptual framework include relevance and faithful representation for providing valuable financial information. Relevance could be described as the relevant financial information, which is able to make a difference in the process of decision-making of the users (Cheng et al. 2014). In case, financial information contains predictive value or confirmatory value or both, it is capable to make change in decisions. Thus, the confirmatory value and predictive value of financial information are related to each other. In addition, relevance is used as a base in order to undertake future decisions.
As commented by Gebhardt, Mora and Wagenhofer (2014), the general purpose financial reports signify economic phenomena in numbers and words. For increasing the usefulness of financial information, faithful representation needs to be present for depicting the phenomena faithfully. For specific information to be faithful, it needs to be neutral, complete and free from errors. For instance, it might constitute of information regarding the represented cost and fair value of an asset along with description of the related facts and circumstances like nature and location of the asset.
Enhancing qualitative characteristics:
The enhancing qualitative characteristics constitute of comparability, verifiability, timeliness and understandability for enhancing the value of information, which contains relevance and faithful representation. Information related to an organisation is of greater value, if it could be contrasted with identical information about other organisations and with identical information about the same firm for another date or period (Gordon et al. 2015). Comparability helps the users to detect and gain an insight of the similarities and variations among items.
Verifiability, on the other hand, enables to ensure the users about the faithful representation of the information related to economic phenomena depicted. This would help the independent and knowledgeable observers in arriving at a consensus, even though they might not agree entirely that a specific depiction is faithful representation (Henderson et al. 2015). Verification implies verifying an amount or other depiction with the help of direct observation, which could be in the form of counting cash. Indirect verification implies input checking to model formula or other technique along with recomputing the output with the help of the identical methodology. Timeliness is another enhancing qualitative characteristic, which implies that the decision-makers could avail information within time for affecting their decisions. Generally, the information that has become outdated and old is less useful for the decision-makers.
Understandability is the final component of enhancing qualitative characteristics, which signifies that categorising, characterising and depicting information evidently and concisely makes the same understandable (Lin 2015). According to FASB, if information regarding complex phenomena is not included in the financial reports, it enables in making those reports easier to understand. However, certain events and transactions are complicated inherently and it might be difficult to enhance their understandability. Although their exclusion might help in easy understanding of the financial reports, the information provided could be incomplete as well as potentially misleading. Hence, the preparation of financial statements is made for those users having sound knowledge of economic activities and business operations and they have the ability to evaluate and review the provided information in a diligent manner.
The main elements of the financial statements, as laid out in the conceptual framework for financial reporting, are discussed briefly as follows:
Assets:
Assets represent those items having the potential of providing future economic benefits to the organisation. This is the first element of the financial statements, which is reported only in the balance sheet statement (Linsmeier 2016). Assets could be of two types, which are current assets and non-current assets. The current assets have lives of less than a year; however, the non-current assets have lives of more than a year. For instance, assets include inventory, marketable securities, cash, accounts receivable, land, building, machinery and others.
Liabilities:
Liabilities are the obligations of an organisation of transferring economic resources to other organisation in future. Alike assets, liabilities could be categorised into current liabilities and non-current liabilities. The current liabilities could be defined as those obligations to be settled less than a year and non-current liabilities are defined as those obligations to be settled above a year (Mala and Chand 2015). For example, liabilities include bank overdraft, loan, accounts payable, tax payable and others.
Equity:
Equity signifies the residual interests in an organisation, which is obtained by deducting liabilities from assets (Miller and Oldroyd 2017). In other words, the overall amount of net assets obtained by deducting overall liabilities from overall assets, equity amount could be obtained. This amount is in the hands of the owners of the organisation. For a corporation, in which the owners are classified as shareholders, the owners’ equity is termed as shareholders’ equity. For instance, the shareholders’ equity comprise of retained earnings and paid-in-capital.
Income:
Income denotes the items, which increase the equity of an organisation; however, it does not take into account the items categorised in the form of other comprehensive income and equity distributions to shareholders (Pelger 2016). For instance, income includes sales revenue and service revenue.
Expense:
Expense denotes the items decreasing the overall equity of an organisation; however, it does not take into account the equity distributions to the shareholders and the items categorised in the form of other comprehensive income. Each expense is recorded in the form of operational cost in the income statement in the period of occurrence. However, expense is not the same as capital expenditure incurred for buying fixed assets (Ryan et al. 2014). For example, expense might be in the form of cost of sales, salary expense, insurance expense, income tax expense, advertising expense and many others.
The conceptual framework of IASB has identified two concepts of capital and capital maintenance, which are discussed as follows:
Financial capital maintenance:
In this concept, the capital of an organisation is associated with the net assets, which is its overall equity. At the time of using this concept, profit is made only if the overall amount associated with net assets at the beginning of the year is lower compared to the net assets at the end of the year. In addition, it adjusts any contributions incurred to the owners during the year or raising equity capital (Simnett and Huggins 2015). This is further segregated into money and real financial capital maintenance. Under money financial capital maintenance, the net assets are measured at historical cost and it fails to consider time value of money or inflation rate. Under real financial capital maintenance, the net assets are gauged at current prices and for doing this, the inflation rate increases the beginning figure of net assets.
Physical capital maintenance:
In this concept, the capacity of production is another term associated with the capital of an organisation which could be developed on the overall output units. When this concept is used, profit is made only if the operating capability of the organisation at the beginning of the year is lower compared to its operating capability at the end of the year with necessary adjustments. However, the significant issue is related to maintaining the operating capability of the organisation (Sutton, Cordery and Zijl 2015).
Use of fair value:
IFRS 13 states that fair value is the amount obtained through sale of an asset or amount incurred for shifting a liability in a transaction, which is in order between the market participants at the measurement date. In addition, this standard states that the following needs to be considered at the time of gauging fair value:
Use of historical cost:
In the words of Watts and Zuo (2016), historical cost is a measure of value utilised in accounting where an asset price on the balance sheet statement is based on original or nominal cost at the time of acquisition. For instance, the headquarter of an organisation comprising of land and building was purchased for £200,000 in 1930 and the expected market value of the asset stands at £25 million at the current date. Under historical cost approach, the asset would be recorded on the balance sheet statement still at £200,000.
Difference between fair value and historical cost:
|
Points of dissimilarities |
Fair value |
Historical cost |
|
Concept |
Fair value is the price, which would be obtained for selling an asset or paid in transferring a liability in an orderly transaction between the market participants at the date of measurement. |
Historical cost is a measure of value utilised in accounting where an asset price on the balance sheet statement is based on original or nominal cost at the time of acquisition. |
|
Approach |
This method records the current market price of an asset or liability on the financial statements of an organisation and hence, it is not conservative. |
This method is reliant on the past transactions of an organisation and hence, it is conservative (Whittington 2014). |
|
Relevancy |
The fair value method is more accurate and relevant; however, the fluctuations in market price might pose problems for the organisation. |
The historical cost method lacks relevance, since it values an asset based on its acquisition price and not the current market price. |
|
Example |
An organisation has purchased machinery worth £500,000 in 2005. The current value of the machine stands at £95,000 after depreciation. In this case, the asset would be recorded at £95,000 under the fair value approach. |
Considering the same example as in case of fair value, the asset would be recorded at £500,000, which would inflate the balance sheet statement of the organisation. Hence, historical cost method might provide misleading information to the users of the financial statements (Zhang and Andrew 2014). |
Conclusion:
From the above evaluation, it has been found out that conceptual framework is necessary for preparing the financial statements to avoid providing misleading information to the users. Two underlying assumptions of this framework include accrual basis and going concern basis. The qualitative characteristics of this framework identified include relevance, faithful representation, comparability, timeliness, understandability and verifiability. The capital concepts of this framework are physical and financial capital maintenance, which are useful for realising the profits earned. Finally, the historical cost and fair value concepts have been discussed to ascertain the price of an asset from the organisational context.
References:
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Biondi, Y., Tsujiyama, E., Glover, J., Jenkins, N.T., Jorgensen, B., Lacey, J. and Macve, R., 2014. ‘Old hens make the best soup’: accounting for the earning process and the IASB/FASB attempts to reform revenue recognition accounting standards. Accounting in Europe, 11(1), pp.13-33.
Brouwer, A., Faramarzi, A. and Hoogendoorn, M., 2014. Does the new conceptual framework provide adequate concepts for reporting relevant information about performance?. Accounting in Europe, 11(2), pp.235-257.
Chaudhry, A., Coetsee, D., Bakker, E., Varughese, S., McIlwaine, S., Fuller, C., Rands, E., De Vos, N., Longmore, S. and Balasubramanian, T.V., 2015. Conceptual Framework. 2015 Interpretation and Application of International Financial Reporting Standards, pp.29-37.
Cheng, M., Green, W., Conradie, P., Konishi, N. and Romi, A., 2014. The international integrated reporting framework: key issues and future research opportunities. Journal of International Financial Management & Accounting, 25(1), pp.90-119.
Gebhardt, G., Mora, A. and Wagenhofer, A., 2014. Revisiting the fundamental concepts of IFRS. Abacus, 50(1), pp.107-116.
Gordon, E.A., Bischof, J., Daske, H., Munter, P., Saka, C., Smith, K.J. and Venter, E.R., 2015. The IASB’s discussion paper on the Conceptual framework for financial reporting: a commentary and research review. Journal of International Financial Management & Accounting, 26(1), pp.72-110.
Henderson, S., Peirson, G., Herbohn, K. and Howieson, B., 2015. Issues in financial accounting. Pearson Higher Education AU.
Lin, H., 2015. Discussion about conceptual framework. International Business Research, 8(6), p.191.
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Walton, P., 2018. Discussion of Barker and Teixeira ([2018]. Gaps in the IFRS Conceptual Framework. Accounting in Europe, 15) and Van Mourik and Katsuo ([2018]. Profit or loss in the IASB Conceptual Framework. Accounting in Europe, 15). Accounting in Europe, pp.1-7.
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