Conceptual Framework for the Financial Reporting 2018

Conceptual Framework for the Financial Reporting 2018

The Financial Reporting Conceptual Framework is a basic document that establishes the aims and principles for general purpose financial reporting.

Framework for the preparation and presentation of financial reports, which preceded it, was published in 1989. Then, in 2010, the IASB released a new document, Conceptual Framework for Financial Reporting, which was incomplete due to the absence of a few concepts and chapters. The most recent and finished Framework was published in 2018, and I'd like to summarize it in this blog.

The chapters in the 2018 Conceptual Framework for financial reporting are:

Chapter 1: The objective of general purpose financial reporting

Chapter 2: Qualitative characteristics of useful financial information

Chapter 3: Financial Statements and the Reporting Entity

Chapter 4: Elements of the financial statements

Chapter 5: Recognition and derecognition

Chapter 6: Measurement

Chapter 7: Presentation and disclosure

Chapter 8: Concepts of capital and capital maintenance

Chapter 1: The objective of general purpose financial reporting

The primary goal of general purpose financial reports is to offer financial information about the reporting business that is valuable to current and potential investors, lenders, and other creditors in order to assist them in making 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.

The emphasis in Chapter 1 is on accrual accounting to reflect an entity's financial performance. It indicates that occurrences should be recorded in reports in the periods when transaction effects occur, regardless of the cash flows involved.

However, past cash flow information is critical for evaluating management's ability to generate future cash flows.

Chapter 2: Qualitative characteristics of useful financial information

The Framework defines two types of characteristics for financial information to be valuable in this chapter: Fundamental and Enhancing.

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

Financial Statements

The financial statements should provide the useful information about the reporting entity:

1. In the statement of financial position, by recognizing assets, liabilities and equity.

2. In the statements of financial performance, by recognizing income, and expenses.

3. In other statements, by presenting and disclosing information about elements (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.

Reporting Entity

The term "reporting entity" refers to the firm that is required to prepare financial statements or chooses to do so. 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

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;

Chapter 5: Recognition and derecognition

Recognition

The term "recognition" refers to the inclusion of a financial statement element in the financial statements.

Recognition of assets

An asset will only be recognised if:

• a present economic resource controlled by the entity as a result of past events

• it can be measured with sufficient reliability

• there is sufficient evidence of its existence.

Recognition of liabilities

A liability will only be recognised if:

• a present obligation of the entity to transfer an economic resource as a result of past events

• it can be measured with sufficient reliability

• there is sufficient evidence of its existence.

Recognition of income

Income is recognised in profit or loss when:

• increases in assets or decreases in liabilities resulting in increases in equity, other than contributions from equity holders; and

• the increase can be measured reliably.

Recognition of expenses

Expenses are recognised in profit or loss when:

• a decrease in future economic benefits arises from a decrease in an asset or an increase in a liability, and

• it can be measured reliably.

Derecognition

Derecognition means removal of an element from the financial statement

Chapter 6: Measurement

Measurement means how to value asset, liability, piece of equity, income or expense in your financial statements.

As a result, you must choose the measurement basis, or method for quantifying monetary amounts for financial statement elements.

Two basic measurement bases are discussed in the Framework:

1. Historical cost

The historical cost measurement is based on the transaction price at the time of recognition of the element.

2. Current value

It measures the element updated to reflect the conditions at the measurement date. Here, three (3) methods are included:

a. Fair value;

b. Value in use;

c. Current cost.

Chapter 7: Presentation and disclosure

The primary goal of presentation and disclosures in financial statements is to create an effective communication tool.

In order for financial statements to communicate information effectively, they must:

Instead of focusing on the rules, concentrate on the goals and principles of presentation and disclosure.
Similar items should be grouped together, while different items should be separated.
Aggregate data, but avoid providing unneeded detail or, conversely, excessive aggregation that obscures data.

Chapter 8: Concepts of capital and capital maintenance

The Framework explains two concepts of capital:

1. Financial capital

The term "financial capital" refers to the entity's net assets or equity. Profit is earned only when the amount of net assets at the end of the period is greater than the amount of net assets at the beginning, after removing contributions from and distributions to equity holders, according to the financial maintenance concept.

The financial capital maintenance can be measured either in nominal monetary units, or units of constant purchasing power.

2. 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.