The Conceptual Framework for Financial Reporting
Conceptual Framework The Conceptual Framework for Financial Reporting The Conceptual Framework was issued by the IASB in September 2010. It superseded the Framework for the Preparation and Presentation of Financial Statements. © IFRS Foundation A21 Conceptual Framework CONTENTS paragraphs FOREWORD THE CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING
INTRODUCTION Purpose and status Scope CHAPTERS 1 2 3 4 The objective of general purpose financial reporting The reporting entity to be added Qualitative characteristics of useful financial information The Framework (1989): the remaining text Underlying assumption The elements of financial statements Recognition of the elements of financial statements Measurement of the elements of financial statements Concepts of capital and capital maintenance FOR THE ACCOMPANYING DOCUMENTS BELOW, SEE PART B OF THIS EDITION APPROVAL BY THE BOARD OF THE CONCEPTUAL FRAMEWORK 2010 BASIS FOR CONCLUSIONS ON CHAPTERS 1 AND 3 TABLE OF CONCORDANCE 4. 4. 2–4. 36 4. 37–4. 53 4. 54–4. 56 4. 57–4. 65 QC1–QC39 OB1–OB21 A22 © IFRS Foundation Conceptual Framework Foreword The International Accounting Standards Board is currently in the process of updating its conceptual framework. This conceptual framework project is conducted in phases. As a chapter is finalised, the relevant paragraphs in the Framework for the Preparation and Presentation of Financial Statements that was published in 1989 will be replaced.
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When the conceptual framework project is completed, the Board will have a complete, comprehensive and single document called the Conceptual Framework for Financial Reporting. This version of the Conceptual Framework includes the first two chapters the Board published as a result of its first phase of the conceptual framework project—Chapter 1 The objective of general purpose financial reporting and Chapter 3 Qualitative characteristics of useful financial information. Chapter 2 will deal with the reporting entity concept.
The Board published an exposure draft on this topic in March 2010 with a comment period that ended on 16 July 2010. Chapter 4 contains the remaining text of the Framework (1989). The table of concordance, at the end of this publication, shows how the contents of the Framework (1989) and the Conceptual Framework (2010) correspond. © IFRS Foundation A23 Conceptual Framework The Introduction has been carried forward from the Framework (1989). This will be updated when the IASB considers the purpose of the Conceptual Framework.
Until then, the purpose and the status of the Conceptual Framework are the same as before. Introduction Financial statements are prepared and presented for external users by many entities around the world. Although such financial statements may appear similar from country to country, there are differences which have probably been caused by a variety of social, economic and legal circumstances and by different countries having in mind the needs of different users of financial statements when setting national requirements.
These different circumstances have led to the use of a variety of definitions of the elements of financial statements: for example, assets, liabilities, equity, income and expenses. They have also resulted in the use of different criteria for the recognition of items in the financial statements and in a preference for different bases of measurement. The scope of the financial statements and the disclosures made in them have also been affected.
The International Accounting Standards Board is committed to narrowing these differences by seeking to harmonise regulations, accounting standards and procedures relating to the preparation and presentation of financial statements. It believes that further harmonisation can best be pursued by focusing on financial statements that are prepared for the purpose of providing information that is useful in making economic decisions. The Board believes that financial statements prepared for this purpose meet the common needs of most users.
This is because nearly all users are making economic decisions, for example: (a) (b) (c) (d) (e) (f) (g) (h) to decide when to buy, hold or sell an equity investment. to assess the stewardship or accountability of management. to assess the ability of the entity to pay and provide other benefits to its employees. to assess the security for amounts lent to the entity. to determine taxation policies. to determine distributable profits and dividends. to prepare and use national income statistics. o regulate the activities of entities. The Board recognises, however, that governments, in particular, may specify different or additional requirements for their own purposes. These requirements should not, however, affect financial statements published for the benefit of other users unless they also meet the needs of those other users. Financial statements are most commonly prepared in accordance with an accounting model based on recoverable historical cost and the nominal financial capital maintenance concept.
Other models and concepts may be more appropriate in order to meet the objective of providing information that is useful for making economic decisions although there is at present no consensus for change. This Conceptual Framework has been developed so that it is applicable to a range of accounting models and concepts of capital and capital maintenance. A24 © IFRS Foundation Conceptual Framework Purpose and status This Conceptual Framework sets out the concepts that underlie the preparation and presentation of financial statements for external users.
The purpose of the Conceptual Framework is: (a) (b) to assist the Board in the development of future IFRSs and in its review of existing IFRSs; to assist the Board in promoting harmonisation of regulations, accounting standards and procedures relating to the presentation of financial statements by providing a basis for reducing the number of alternative accounting treatments permitted by IFRSs; to assist national standard-setting bodies in developing national standards; to assist preparers of financial statements in applying IFRSs and in dealing with topics that have yet to form the subject of an IFRS; to assist auditors in forming an opinion on whether financial statements comply with IFRSs; to assist users of financial statements in interpreting the information contained in financial statements prepared in compliance with IFRSs; and to provide those who are interested in the work of the IASB with information about its approach to the formulation of IFRSs. (c) (d) (e) (f) (g) This Conceptual Framework is not an IFRS and hence does not define standards for any particular measurement or disclosure issue. Nothing in this Conceptual Framework overrides any specific IFRS. The Board recognises that in a limited number of cases there may be a conflict between the Conceptual Framework and an IFRS. In those cases where there is a conflict, the requirements of the IFRS prevail over those of the Conceptual Framework.
As, however, the Board will be guided by the Conceptual Framework in the development of future IFRSs and in its review of existing IFRSs, the number of cases of conflict between the Conceptual Framework and IFRSs will diminish through time. The Conceptual Framework will be revised from time to time on the basis of the Board’s experience of working with it. Scope The Conceptual Framework deals with: (a) (b) (c) (d) the objective of financial reporting; the qualitative characteristics of useful financial information; the definition, recognition and measurement of the elements from which financial statements are constructed; and concepts of capital and capital maintenance. © IFRS Foundation A25 Conceptual Framework
CHAPTER 1: THE OBJECTIVE OF GENERAL PURPOSE FINANCIAL REPORTING paragraphs INTRODUCTION OBJECTIVE, USEFULNESS AND LIMITATIONS OF GENERAL PURPOSE FINANCIAL REPORTING INFORMATION ABOUT A REPORTING ENTITY’S ECONOMIC RESOURCES, CLAIMS, AND CHANGES IN RESOURCES AND CLAIMS Economic resources and claims Changes in economic resources and claims Financial performance reflected by accrual accounting Financial performance reflected by past cash flows Changes in economic resources and claims not resulting from financial performance OB1 OB2–OB11 OB12–OB21 OB13–OB14 OB15–OB21 OB17–OB19 OB20 OB21 A26 © IFRS Foundation Conceptual Framework Chapter 1: The objective of general purpose financial reporting Introduction OB1 The objective of general purpose financial reporting forms the foundation of the Conceptual Framework. Other aspects of the Conceptual Framework—a reporting entity concept, the qualitative characteristics of, and the constraint on, useful financial information, elements of financial statements, recognition, measurement, presentation and disclosure—flow logically from the objective.
Objective, usefulness and limitations of general purpose financial reporting OB2 The objective of general purpose financial reporting* is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity. Those decisions involve buying, selling or holding equity and debt instruments, and providing or settling loans and other forms of credit. Decisions by existing and potential investors about buying, selling or holding equity and debt instruments depend on the returns that they expect from an investment in those instruments, for example dividends, principal and interest payments or market price increases. Similarly, decisions by existing and potential lenders and other creditors about providing or settling loans and other forms of credit depend on the principal and interest payments or other returns that they expect.
Investors’, lenders’ and other creditors’ expectations about returns depend on their assessment of the amount, timing and uncertainty of (the prospects for) future net cash inflows to the entity. Consequently, existing and potential investors, lenders and other creditors need information to help them assess the prospects for future net cash inflows to an entity. To assess an entity’s prospects for future net cash inflows, existing and potential investors, lenders and other creditors need information about the resources of the entity, claims against the entity, and how efficiently and effectively the entity’s management and governing board† have discharged their responsibilities to use the entity’s resources.
Examples of such responsibilities include protecting the entity’s resources from unfavourable effects of economic factors such as price and technological changes and ensuring that the entity complies with applicable laws, regulations and contractual provisions. Information about management’s discharge of its responsibilities is also useful for decisions by existing investors, lenders and other creditors who have the right to vote on or otherwise influence management’s actions. OB3 OB4 * Throughout this Conceptual Framework, the terms financial reports and financial reporting refer to general purpose financial reports and general purpose financial reporting unless specifically indicated otherwise.
Throughout this Conceptual Framework, the term management refers to management and the governing board of an entity unless specifically indicated otherwise. † © IFRS Foundation A27 Conceptual Framework OB5 Many existing and potential investors, lenders and other creditors cannot require reporting entities to provide information directly to them and must rely on general purpose financial reports for much of the financial information they need. Consequently, they are the primary users to whom general purpose financial reports are directed. However, general purpose financial reports do not and cannot provide all of the information that existing and potential investors, lenders and other creditors need.
Those users need to consider pertinent information from other sources, for example, general economic conditions and expectations, political events and political climate, and industry and company outlooks. General purpose financial reports are not designed to show the value of a reporting entity; but they provide information to help existing and potential investors, lenders and other creditors to estimate the value of the reporting entity. Individual primary users have different, and possibly conflicting, information needs and desires. The Board, in developing financial reporting standards, will seek to provide the information set that will meet the needs of the maximum number of primary users.
However, focusing on common information needs does not prevent the reporting entity from including additional information that is most useful to a particular subset of primary users. The management of a reporting entity is also interested in financial information about the entity. However, management need not rely on general purpose financial reports because it is able to obtain the financial information it needs internally. Other parties, such as regulators and members of the public other than investors, lenders and other creditors, may also find general purpose financial reports useful. However, those reports are not primarily directed to these other groups.
To a large extent, financial reports are based on estimates, judgements and models rather than exact depictions. The Conceptual Framework establishes the concepts that underlie those estimates, judgements and models. The concepts are the goal towards which the Board and preparers of financial reports strive. As with most goals, the Conceptual Framework’s vision of ideal financial reporting is unlikely to be achieved in full, at least not in the short term, because it takes time to understand, accept and implement new ways of analysing transactions and other events. Nevertheless, establishing a goal towards which to strive is essential if financial reporting is to evolve so as to improve its usefulness. OB6 OB7 OB8 OB9 OB10
OB11 Information about a reporting entity’s economic resources, claims, and changes in resources and claims OB12 General purpose financial reports provide information about the financial position of a reporting entity, which is information about the entity’s economic resources and the claims against the reporting entity. Financial reports also provide information about the effects of transactions and other events that change a reporting entity’s economic resources and claims. Both types of information provide useful input for decisions about providing resources to an entity. A28 © IFRS Foundation Conceptual Framework Economic resources and claims
OB13 Information about the nature and amounts of a reporting entity’s economic resources and claims can help users to identify the reporting entity’s financial strengths and weaknesses. That information can help users to assess the reporting entity’s liquidity and solvency, its needs for additional financing and how successful it is likely to be in obtaining that financing. Information about priorities and payment requirements of existing claims helps users to predict how future cash flows will be distributed among those with a claim against the reporting entity. Different types of economic resources affect a user’s assessment of the reporting entity’s prospects for future cash flows differently.
Some future cash flows result directly from existing economic resources, such as accounts receivable. Other cash flows result from using several resources in combination to produce and market goods or services to customers. Although those cash flows cannot be identified with individual economic resources (or claims), users of financial reports need to know the nature and amount of the resources available for use in a reporting entity’s operations. OB14 Changes in economic resources and claims OB15 Changes in a reporting entity’s economic resources and claims result from that entity’s financial performance (see paragraphs OB17–OB20) and from other events or transactions such as issuing debt or equity instruments (see paragraph OB21).
To properly assess the prospects for future cash flows from the reporting entity, users need to be able to distinguish between both of these changes. Information about a reporting entity’s financial performance helps users to understand the return that the entity has produced on its economic resources. Information about the return the entity has produced provides an indication of how well management has discharged its responsibilities to make efficient and effective use of the reporting entity’s resources. Information about the variability and components of that return is also important, especially in assessing the uncertainty of future cash flows. Information about a reporting entity’s past financial performance and how its management discharged its responsibilities is sually helpful in predicting the entity’s future returns on its economic resources. OB16 Financial performance reflected by accrual accounting OB17 Accrual accounting depicts the effects of transactions and other events and circumstances on a reporting entity’s economic resources and claims in the periods in which those effects occur, even if the resulting cash receipts and payments occur in a different period. This is important because information about a reporting entity’s economic resources and claims and changes in its economic resources and claims during a period provides a better basis for assessing the entity’s past and future performance than information solely about cash receipts and payments during that period. ©
IFRS Foundation A29 Conceptual Framework OB18 Information about a reporting entity’s financial performance during a period, reflected by changes in its economic resources and claims other than by obtaining additional resources directly from investors and creditors (see paragraph OB21), is useful in assessing the entity’s past and future ability to generate net cash inflows. That information indicates the extent to which the reporting entity has increased its available economic resources, and thus its capacity for generating net cash inflows through its operations rather than by obtaining additional resources directly from investors and creditors.
Information about a reporting entity’s financial performance during a period may also indicate the extent to which events such as changes in market prices or interest rates have increased or decreased the entity’s economic resources and claims, thereby affecting the entity’s ability to generate net cash inflows. OB19 Financial performance reflected by past cash flows OB20 Information about a reporting entity’s cash flows during a period also helps users to assess the entity’s ability to generate future net cash inflows. It indicates how the reporting entity obtains and spends cash, including information about its borrowing and repayment of debt, cash dividends or other cash distributions to investors, and other factors that may affect the entity’s liquidity or solvency.
Information about cash flows helps users understand a reporting entity’s operations, evaluate its financing and investing activities, assess its liquidity or solvency and interpret other information about financial performance. Changes in economic resources and claims not resulting from financial performance OB21 A reporting entity’s economic resources and claims may also change for reasons other than financial performance, such as issuing additional ownership shares. Information about this type of change is necessary to give users a complete understanding of why the reporting entity’s economic resources and claims changed and the implications of those changes for its future financial performance. A30 © IFRS Foundation Conceptual Framework CHAPTER 2: THE REPORTING ENTITY [to be added] © IFRS Foundation A31 Conceptual Framework
CHAPTER 3: QUALITATIVE CHARACTERISTICS OF USEFUL FINANCIAL INFORMATION paragraphs INTRODUCTION QUALITATIVE CHARACTERISTICS OF USEFUL FINANCIAL INFORMATION Fundamental qualitative characteristics Relevance Materiality Faithful representation Applying the fundamental qualitative characteristics Enhancing qualitative characteristics Comparability Verifiability Timeliness Understandability Applying the enhancing characteristics THE COST CONSTRAINT ON USEFUL FINANCIAL REPORTING QC1–QC3 QC4–QC34 QC5–QC18 QC6–QC11 QC11 QC12–QC16 QC17–QC18 QC19–QC34 QC20–QC25 QC26–QC28 QC29 QC30–QC32 QC33–QC34 QC35–QC39 A32 © IFRS Foundation Conceptual Framework Chapter 3: Qualitative characteristics of useful financial information Introduction
QC1 The qualitative characteristics of useful financial information discussed in this chapter identify the types of information that are likely to be most useful to the existing and potential investors, lenders and other creditors for making decisions about the reporting entity on the basis of information in its financial report (financial information). Financial reports provide information about the reporting entity’s economic resources, claims against the reporting entity and the effects of transactions and other events and conditions that change those resources and claims. (This information is referred to in the Conceptual Framework as information about the economic phenomena. Some financial reports also include explanatory material about management’s expectations and strategies for the reporting entity, and other types of forward-looking information. The qualitative characteristics of useful financial information* apply to financial information provided in financial statements, as well as to financial information provided in other ways. Cost, which is a pervasive constraint on the reporting entity’s ability to provide useful financial information, applies similarly. However, the considerations in applying the qualitative characteristics and the cost constraint may be different for different types of information.
For example, applying them to forward-looking information may be different from applying them to information about existing economic resources and claims and to changes in those resources and claims. QC2 QC3 Qualitative characteristics of useful financial information QC4 If financial information is to be useful, it must be relevant and faithfully represent what it purports to represent. The usefulness of financial information is enhanced if it is comparable, verifiable, timely and understandable. Fundamental qualitative characteristics QC5 The fundamental qualitative characteristics are relevance and faithful representation. Relevance QC6 Relevant financial information is capable of making a difference in the decisions made by users.
Information may be capable of making a difference in a decision even if some users choose not to take advantage of it or are already aware of it from other sources. Financial information is capable of making a difference in decisions if it has predictive value, confirmatory value or both. QC7 * Throughout this Conceptual Framework, the terms qualitative characteristics and constraint refer to the qualitative characteristics of, and the constraint on, useful financial information. © IFRS Foundation A33 Conceptual Framework QC8 Financial information has predictive value if it can be used as an input to processes employed by users to predict future outcomes.
Financial information need not be a prediction or forecast to have predictive value. Financial information with predictive value is employed by users in making their own predictions. Financial information has confirmatory value if it provides feedback about (confirms or changes) previous evaluations. The predictive value and confirmatory value of financial information are interrelated. Information that has predictive value often also has confirmatory value. For example, revenue information for the current year, which can be used as the basis for predicting revenues in future years, can also be compared with revenue predictions for the current year that were made in past years.
The results of those comparisons can help a user to correct and improve the processes that were used to make those previous predictions. QC9 QC10 Materiality QC11 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, of the items to which the information relates in the context of an individual entity’s financial report. Consequently, the Board cannot specify a uniform quantitative threshold for materiality or predetermine what could be material in a particular situation. Faithful representation
QC12 Financial reports represent economic phenomena in words and numbers. To be useful, financial information must not only represent relevant phenomena, but it must also faithfully represent the phenomena that it purports to represent. To be a perfectly faithful representation, a depiction would have three characteristics. It would be complete, neutral and free from error. Of course, perfection is seldom, if ever, achievable. The Board’s objective is to maximise those qualities to the extent possible. A complete depiction includes all information necessary for a user to understand the phenomenon being depicted, including all necessary descriptions and explanations.
For example, a complete depiction of a group of assets would include, at a minimum, a description of the nature of the assets in the group, a numerical depiction of all of the assets in the group, and a description of what the numerical depiction represents (for example, original cost, adjusted cost or fair value). For some items, a complete depiction may also entail explanations of significant facts about the quality and nature of the items, factors and circumstances that might affect their quality and nature, and the process used to determine the numerical depiction. QC13 A34 © IFRS Foundation Conceptual Framework QC14 A neutral depiction is without bias in the selection or presentation of financial information. A neutral depiction is not slanted, weighted, emphasised, de-emphasised or otherwise manipulated to increase the probability that financial information will be received favourably or unfavourably by users.
Neutral information does not mean information with no purpose or no influence on behaviour. On the contrary, relevant financial information is, by definition, capable of making a difference in users’ decisions. Faithful representation does not mean accurate in all respects. Free from error means there are no errors or omissions in the description of the phenomenon, and the process used to produce the reported information has been selected and applied with no errors in the process. In this context, free from error does not mean perfectly accurate in all respects. For example, an estimate of an unobservable price or value cannot be determined to be accurate or inaccurate.
However, a representation of that estimate can be faithful if the amount is described clearly and accurately as being an estimate, the nature and limitations of the estimating process are explained, and no errors have been made in selecting and applying an appropriate process for developing the estimate. A faithful representation, by itself, does not necessarily result in useful information. For example, a reporting entity may receive property, plant and equipment through a government grant. Obviously, reporting that an entity acquired an asset at no cost would faithfully represent its cost, but that information would probably not be very useful.
A slightly more subtle example is an estimate of the amount by which an asset’s carrying amount should be adjusted to reflect an impairment in the asset’s value. That estimate can be a faithful representation if the reporting entity has properly applied an appropriate process, properly described the estimate and explained any uncertainties that significantly affect the estimate. However, if the level of uncertainty in such an estimate is sufficiently large, that estimate will not be particularly useful. In other words, the relevance of the asset being faithfully represented is questionable. If there is no alternative representation that is more faithful, that estimate may provide the best available information. QC15 QC16
Applying the fundamental qualitative characteristics QC17 Information must be both relevant and faithfully represented if it is to be useful. Neither a faithful representation of an irrelevant phenomenon nor an unfaithful representation of a relevant phenomenon helps users make good decisions. The most efficient and effective process for applying the fundamental qualitative characteristics would usually be as follows (subject to the effects of enhancing characteristics and the cost constraint, which are not considered in this example). First, identify an economic phenomenon that has the potential to be useful to users of the reporting entity’s financial information.
Second, identify the type of information about that phenomenon that would be most relevant if it is available and can be faithfully represented. Third, determine whether that information is available and can be faithfully represented. If so, the process of satisfying the fundamental qualitative characteristics ends at that point. If not, the process is repeated with the next most relevant type of information. QC18 © IFRS Foundation A35 Conceptual Framework Enhancing qualitative characteristics QC19 Comparability, verifiability, timeliness and understandability are qualitative characteristics that enhance the usefulness of information that is relevant and faithfully represented.
The enhancing qualitative characteristics may also help determine which of two ways should be used to depict a phenomenon if both are considered equally relevant and faithfully represented. Comparability QC20 Users’ decisions involve choosing between alternatives, for example, selling or holding an investment, or investing in one reporting entity or another. Consequently, information about a reporting entity is more useful if it can be compared with similar information about other entities and with similar information about the same entity for another period or another date. Comparability is the qualitative characteristic that enables users to identify and understand similarities in, and differences among, items.
Unlike the other qualitative characteristics, comparability does not relate to a single item. A comparison requires at least two items. Consistency, although related to comparability, is not the same. Consistency refers to the use of the same methods for the same items, either from period to period within a reporting entity or in a single period across entities. Comparability is the goal; consistency helps to achieve that goal. Comparability is not uniformity. For information to be comparable, like things must look alike and different things must look different. Comparability of financial information is not enhanced by making unlike things look alike any more than it is enhanced by making like things look different.
Some degree of comparability is likely to be attained by satisfying the fundamental qualitative characteristics. A faithful representation of a relevant economic phenomenon should naturally possess some degree of comparability with a faithful representation of a similar relevant economic phenomenon by another reporting entity. Although a single economic phenomenon can be faithfully represented in multiple ways, permitting alternative accounting methods for the same economic phenomenon diminishes comparability. QC21 QC22 QC23 QC24 QC25 Verifiability QC26 Verifiability helps assure users that information faithfully represents the economic phenomena it purports to represent.
Verifiability means that different knowledgeable and independent observers could reach consensus, although not necessarily complete agreement, that a particular depiction is a faithful representation. Quantified information need not be a single point estimate to be verifiable. A range of possible amounts and the related probabilities can also be verified. A36 © IFRS Foundation Conceptual Framework QC27 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 example, using the first-in, first-out method). It may not be possible to verify some explanations and forward-looking financial information until a future period, if at all. To help users decide whether they want to use that information, it would normally be necessary to disclose the underlying assumptions, the methods of compiling the information and other factors and circumstances that support the information. QC28 Timeliness QC29 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.
However, some information may continue to be timely long after the end of a reporting period because, for example, some users may need to identify and assess trends. Understandability QC30 QC31 Classifying, characterising and presenting information clearly and concisely makes it understandable. Some phenomena are inherently complex and cannot be made easy to understand. Excluding information about those phenomena from financial reports might make the information in those financial reports easier to understand. However, those reports would be incomplete and therefore potentially misleading. Financial reports are prepared for users who have a reasonable knowledge of business and economic activities and who review and analyse the information diligently.
At times, even well-informed and diligent users may need to seek the aid of an adviser to understand information about complex economic phenomena. QC32 Applying the enhancing qualitative characteristics QC33 Enhancing qualitative characteristics should be maximised to the extent possible. However, the enhancing qualitative characteristics, either individually or as a group, cannot make information useful if that information is irrelevant or not faithfully represented. Applying the enhancing qualitative characteristics is an iterative process that does not follow a prescribed order. Sometimes, one enhancing qualitative characteristic may have to be diminished to maximise another qualitative characteristic.
For example, a temporary reduction in comparability as a result of prospectively applying a new financial reporting standard may be worthwhile to improve relevance or faithful representation in the longer term. Appropriate disclosures may partially compensate for non-comparability. QC34 © IFRS Foundation A37 Conceptual Framework The cost constraint on useful financial reporting QC35 Cost is a pervasive constraint on the information that can be provided by financial reporting. Reporting financial information imposes costs, and it is important that those costs are justified by the benefits of reporting that information. There are several types of costs and benefits to consider.
Providers of financial information expend most of the effort involved in collecting, processing, verifying and disseminating financial information, but users ultimately bear those costs in the form of reduced returns. Users of financial information also incur costs of analysing and interpreting the information provided. If needed information is not provided, users incur additional costs to obtain that information elsewhere or to estimate it. Reporting financial information that is relevant and faithfully represents what it purports to represent helps users to make decisions with more confidence. This results in more efficient functioning of capital markets and a lower cost of capital for the economy as a whole. An individual investor, lender or other creditor also receives benefits by making more informed decisions.
However, it is not possible for general purpose financial reports to provide all the information that every user finds relevant. In applying the cost constraint, the Board assesses whether the benefits of reporting particular information are likely to justify the costs incurred to provide and use that information. When applying the cost constraint in developing a proposed financial reporting standard, the Board seeks information from providers of financial information, users, auditors, academics and others about the expected nature and quantity of the benefits and costs of that standard. In most situations, assessments are based on a combination of quantitative and qualitative information.
Because of the inherent subjectivity, different individuals’ assessments of the costs and benefits of reporting particular items of financial information will vary. Therefore, the Board seeks to consider costs and benefits in relation to financial reporting generally, and not just in relation to individual reporting entities. That does not mean that assessments of costs and benefits always justify the same reporting requirements for all entities. Differences may be appropriate because of different sizes of entities, different ways of raising capital (publicly or privately), different users’ needs or other factors. QC36 QC37 QC38 QC39 A38 © IFRS Foundation Conceptual Framework CHAPTER 4: THE 1989 FRAMEWORK: THE REMAINING TEXT aragraphs UNDERLYING ASSUMPTION Going concern THE ELEMENTS OF FINANCIAL STATEMENTS Financial position Assets Liabilities Equity Performance Income Expenses Capital maintenance adjustments RECOGNITION OF THE ELEMENTS OF FINANCIAL STATEMENTS The probability of future economic benefit Reliability of measurement Recognition of assets Recognition of liabilities Recognition of income Recognition of expenses MEASUREMENT OF THE ELEMENTS OF FINANCIAL STATEMENTS CONCEPTS OF CAPITAL AND CAPITAL MAINTENANCE Concepts of capital Concepts of capital maintenance and the determination of profit 4. 1 4. 1 4. 2–4. 36 4. 4–4. 7 4. 8–4. 14 4. 15–4. 19 4. 20–4. 23 4. 24–4. 28 4. 29–4. 32 4. 33–4. 35 4. 36 4. 37–4. 53 4. 40 4. 41–4. 43 4. 44–4. 45 4. 46 4. 47–4. 48 4. 49–4. 53 4. 54–4. 56 4. 57–4. 65 4. 57–4. 58 4. 59–4. 65 © IFRS Foundation A39 Conceptual Framework Chapter 4: The Framework (1989): the remaining text The remaining text of the Framework for the Preparation and Presentation of Financial Statements (1989) has not been amended to reflect changes made by IAS 1 Presentation of Financial Statements (as revised in 2007).
The remaining text will also be updated when the Board has considered the elements of financial statements and their measurement bases. Underlying assumption Going concern 4. 1 The financial statements are normally prepared on the assumption that an entity is a going concern and will continue in operation for the foreseeable future. Hence, it is assumed that the entity has neither the intention nor the need to liquidate or curtail materially the scale of its operations; if such an intention or need exists, the financial statements may have to be prepared on a different basis and, if so, the basis used is disclosed. The elements of financial statements 4. Financial statements portray the financial effects of transactions and other events by grouping them into broad classes according to their economic characteristics. These broad classes are termed the elements of financial statements. The elements directly related to the measurement of financial position in the balance sheet are assets, liabilities and equity. The elements directly related to the measurement of performance in the income statement are income and expenses. The statement of changes in financial position usually reflects income statement elements and changes in balance sheet elements; accordingly, this Conceptual Framework identifies no elements that are unique to this statement.
The presentation of these elements in the balance sheet and the income statement involves a process of sub-classification. For example, assets and liabilities may be classified by their nature or function in the business of the entity in order to display information in the manner most useful to users for purposes of making economic decisions. 4. 3 Financial position 4. 4 The elements directly related to the measurement of financial position are assets, liabilities and equity. These are defined as follows: (a) (b) An asset is 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.
A liability is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits. A40 © IFRS Foundation Conceptual Framework (c) 4. 5 Equity is the residual interest in the assets of the entity after deducting all its liabilities. The definitions of an asset and a liability identify their essential features but do not attempt to specify the criteria that need to be met before they are recognised in the balance sheet. Thus, the definitions embrace items that are not recognised as assets or liabilities in the balance sheet because they do not satisfy the criteria for recognition discussed in paragraphs 4. 37–4. 53.
In particular, the expectation that future economic benefits will flow to or from an entity must be sufficiently certain to meet the probability criterion in paragraph 4. 38 before an asset or liability is recognised. In assessing whether an item meets the definition of an asset, liability or equity, attention needs to be given to its underlying substance and economic reality and not merely its legal form. Thus, for example, in the case of finance leases, the substance and economic reality are that the lessee acquires the economic benefits of the use of the leased asset for the major part of its useful life in return for entering into an obligation to pay for that right an amount approximating to the fair value of the asset and the related finance charge.
Hence, the finance lease gives rise to items that satisfy the definition of an asset and a liability and are recognised as such in the lessee’s balance sheet. Balance sheets drawn up in accordance with current IFRSs may include items that do not satisfy the definitions of an asset or liability and are not shown as part of equity. The definitions set out in paragraph 4. 4 will, however, underlie future reviews of existing IFRSs and the formulation of further IFRSs. 4. 6 4. 7 Assets 4. 8 The future economic benefit embodied in an asset is the potential to contribute, directly or indirectly, to the flow of cash and cash equivalents to the entity. The potential may be a productive one that is part of the operating activities of the entity.
It may also take the form of convertibility into cash or cash equivalents or a capability to reduce cash outflows, such as when an alternative manufacturing process lowers the costs of production. An entity usually employs its assets to produce goods or services capable of satisfying the wants or needs of customers; because these goods or services can satisfy these wants or needs, customers are prepared to pay for them and hence contribute to the cash flow of the entity. Cash itself renders a service to the entity because of its command over other resources. The future economic benefits embodied in an asset may flow to the entity in a number of ways.
For example, an asset may be: (a) (b) (c) (d) used singly or in combination with other assets in the production of goods or services to be sold by the entity; exchanged for other assets; used to settle a liability; or distributed to the owners of the entity. 4. 9 4. 10 © IFRS Foundation A41 Conceptual Framework 4. 11 Many assets, for example, property, plant and equipment, have a physical form. However, physical form is not essential to the existence of an asset; hence patents and copyrights, for example, are assets if future economic benefits are expected to flow from them to the entity and if they are controlled by the entity. Many assets, for example, receivables and property, are associated with legal rights, including the right of ownership.
In determining the existence of an asset, the right of ownership is not essential; thus, for example, property held on a lease is an asset if the entity controls the benefits which are expected to flow from the property. Although the capacity of an entity to control benefits is usually the result of legal rights, an item may nonetheless satisfy the definition of an asset even when there is no legal control. For example, know-how obtained from a development activity may meet the definition of an asset when, by keeping that know-how secret, an entity controls the benefits that are expected to flow from it. The assets of an entity result from past transactions or other past events.
Entities normally obtain assets by purchasing or producing them, but other transactions or events may generate assets; examples include property received by an entity from government as part of a programme to encourage economic growth in an area and the discovery of mineral deposits. Transactions or events expected to occur in the future do not in themselves give rise to assets; hence, for example, an intention to purchase inventory does not, of itself, meet the definition of an asset. There is a close association between incurring expenditure and generating assets but the two do not necessarily coincide. Hence, when an entity incurs expenditure, this may provide evidence that future economic benefits were sought but is not conclusive proof that an item satisfying the definition of an asset has been obtained.
Similarly the absence of a related expenditure does not preclude an item from satisfying the definition of an asset and thus becoming a candidate for recognition in the balance sheet; for example, items that have been donated to the entity may satisfy the definition of an asset. 4. 12 4. 13 4. 14 Liabilities 4. 15 An essential characteristic of a liability is that the entity has a present obligation. An obligation is a duty or responsibility to act or perform in a certain way. Obligations may be legally enforceable as a consequence of a binding contract or statutory requirement. This is normally the case, for example, with amounts payable for goods and services received. Obligations also arise, however, from normal business practice, custom and a desire to maintain good business relations or act in an equitable manner.
If, for example, an entity decides as a matter of policy to rectify faults in its products even when these become apparent after the warranty period has expired, the amounts that are expected to be expended in respect of goods already sold are liabilities. A distinction needs to be drawn between a present obligation and a future commitment. A decision by the management of an entity to acquire assets in the future does not, of itself, give rise to a present obligation. An obligation normally arises only when the asset is delivered or the entity enters into an irrevocable agreement to acquire the asset. In the latter case, the irrevocable nature of the 4. 16 A42 © IFRS Foundation Conceptual Framework agreement means that the economic consequences of failing to honour the obligation, for example, because of the existence of a substantial penalty, eave the entity with little, if any, discretion to avoid the outflow of resources to another party. 4. 17 The settlement of a present obligation usually involves the entity giving up resources embodying economic benefits in order to satisfy the claim of the other party. Settlement of a present obligation may occur in a number of ways, for example, by: (a) (b) (c) (d) (e) payment of cash; transfer of other assets; provision of services; replacement of that obligation with another obligation; or conversion of the obligation to equity. An obligation may also be extinguished by other means, such as a creditor waiving or forfeiting its rights. 4. 18 Liabilities result from past transactions or other past events.
Thus, for example, the acquisition of goods and the use of services give rise to trade payables (unless paid for in advance or on delivery) and the receipt of a bank loan results in an obligation to repay the loan. An entity may also recognise future rebates based on annual purchases by customers as liabilities; in this case, the sale of the goods in the past is the transaction that gives rise to the liability. Some liabilities can be measured only by using a substantial degree of estimation. Some entities describe these liabilities as provisions. In some countries, such provisions are not regarded as liabilities because the concept of a liability is defined narrowly so as to include only amounts that can be established without the need to make estimates.
The definition of a liability in paragraph 4. 4 follows a broader approach. Thus, when a provision involves a present obligation and satisfies the rest of the definition, it is a liability even if the amount has to be estimated. Examples include provisions for payments to be made under existing warranties and provisions to cover pension obligations. 4. 19 Equity 4. 20 Although equity is defined in paragraph 4. 4 as a residual, it may be sub-classified in the balance sheet. For example, in a corporate entity, funds contributed by shareholders, retained earnings, reserves representing appropriations of retained earnings and reserves representing capital aintenance adjustments may be shown separately. Such classifications can be relevant to the decision-making needs of the users of financial statements when they indicate legal or other restrictions on the ability of the entity to distribute or otherwise apply its equity. They may also reflect the fact that parties with ownership interests in an entity have differing rights in relation to the receipt of dividends or the repayment of contributed equity. © IFRS Foundation A43 Conceptual Framework 4. 21 The creation of reserves is sometimes required by statute or other law in order to give the entity and its creditors an added measure of protection from the effects of losses.
Other reserves may be established if national tax law grants exemptions from, or reductions in, taxation liabilities when transfers to such reserves are made. The existence and size of these legal, statutory and tax reserves is information that can be relevant to the decision-making needs of users. Transfers to such reserves are appropriations of retained earnings rather than expenses. The amount at which equity is shown in the balance sheet is dependent on the measurement of assets and liabilities. Normally, the aggregate amount of equity only by coincidence corresponds with the aggregate market value of the shares of the entity or the sum that could be raised by disposing of either the net assets on a piecemeal basis or the entity as a whole on a going concern basis.
Commercial, industrial and business activities are often undertaken by means of entities such as sole proprietorships, partnerships and trusts and various types of government business undertakings. The legal and regulatory framework for such entities is often different from that applying to corporate entities. For example, there may be few, if any, restrictions on the distribution to owners or other beneficiaries of amounts included in equity. Nevertheless, the definition of equity and the other aspects of this Conceptual Framework that deal with equity are appropriate for such entities. 4. 22 4. 23 Performance 4. 24 Profit is frequently used as a measure of performance or as the basis for other measures, such as return on investment or earnings per share.
The elements directly related to the measurement of profit are income and expenses. The recognition and measurement of income and expenses, and hence profit, depends in part on the concepts of capital and capital maintenance used by the entity in preparing its financial statements. These concepts are discussed in paragraphs 4. 57–4. 65. The elements of income and expenses are defined as follows: (a) 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 equity participants.
Expenses are decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants. 4. 25 (b) 4. 26 The definitions of income and expenses identify their essential features but do not attempt to specify the criteria that would need to be met before they are recognised in the income statement. Criteria for the recognition of income and expenses are discussed in paragraphs 4. 37–4. 53. Income and expenses may be presented in the income statement in different ways so as to provide information that is relevant for economic decision-making.
For example, it is common practice to distinguish between those items of income and expenses that arise in the course of the ordinary activities of the entity and 4. 27 A44 © IFRS Foundation Conceptual Framework those that do not. This distinction is made on the basis that the source of an item is relevant in evaluating the ability of the entity to generate cash and cash equivalents in the future; for example, incidental activities such as the disposal of a long-term investment are unlikely to recur on a regular basis. When distinguishing between items in this way consideration needs to be given to the nature of the entity and its operations. Items that arise from the ordinary activities of one entity may be unusual in respect of another. 4. 8 Distinguishing between items of income and expense and combining them in different ways also permits several measures of entity performance to be displayed. These have differing degrees of inclusiveness. For example, the income statement could display gross margin, profit or loss from ordinary activities before taxation, profit or loss from ordinary activities after taxation, and profit or loss. Income 4. 29 The definition of income encompasses both revenue and gains. Revenue arises in the course of the ordinary activities of an entity and is referred to by a variety of different names including sales, fees, interest, dividends, royalties and rent. Gains represent other items that meet the definition of income and may, or may not, arise in the course of the ordinary activities of an entity.
Gains represent increases in economic benefits and as such are no different in nature from revenue. Hence, they are not regarded as constituting a separate element in this Conceptual Framework. Gains include, for example, those arising on the disposal of non-current assets. The definition of income also includes unrealised gains; for example, those arising on the revaluation of marketable securities and those resulting from increases in the carrying amount of long-term assets. When gains are recognised in the income statement, they are usually displayed separately because knowledge of them is useful for the purpose of making economic decisions. Gains are often reported net of related expenses.
Various kinds of assets may be received or enhanced by income; examples include cash, receivables and goods and services received in exchange for goods and services supplied. Income may also result from the settlement of liabilities. For example, an entity may provide goods and services to a lender in settlement of an obligation to repay an outstanding loan. 4. 30 4. 31 4. 32 Expenses 4. 33 The definition of expenses encompasses losses as well as those expenses that arise in the course of the ordinary activities of the entity. Expenses that arise in the course of the ordinary activities of the entity include, for example, cost of sales, wages and depreciation.
They usually take the form of an outflow or depletion of assets such as cash and cash equivalents, inventory, property, plant and equipment. © IFRS Foundation A45 Conceptual Framework 4. 34 Losses represent other items that meet the definition of expenses and may, or may not, arise in the course of the ordinary activities of the entity. Losses represent decreases in economic benefits and as such they are no different in nature from other expenses. Hence, they are not regarded as a separate element in this Conceptual Framework. Losses include, for example, those resulting from disasters such as fire and flood, as well as those arising on the disposal of non-current assets.
The definition of expenses also includes unrealised losses, for example, those arising from the effects of increases in the rate of exchange for a foreign currency in respect of the borrowings of an entity in that currency. When losses are recognised in the income statement, they are usually displayed separately because knowledge of them is useful for the purpose of making economic decisions. Losses are often reported net of related income. 4. 35 Capital maintenance adjustments 4. 36 The revaluation or restatement of assets and liabilities gives rise to increases or decreases in equity. While these increases or decreases meet the definition of income and expenses, they are not included in the income statement under certain concepts of capital maintenance.
Instead these items are included in equity as capital maintenance adjustments or revaluation reserves. These concepts of capital maintenance are discussed in paragraphs 4. 57–4. 65 of this Conceptual Framework. Recognition of the elements of financial statements 4. 37 Recognition is the process of incorporating in the balance sheet or income statement an item that meets the definition of an element and satisfies the criteria for recognition set out in paragraph 4. 38. It involves the depiction of the item in words and by a monetary amount and the inclusion of that amount in the balance sheet or income statement totals. Items that satisfy the recognition criteria should be recognised in the balance sheet or income statement.
The failure to recognise such items is not rectified by disclosure of the accounting policies used nor by notes or explanatory material. An item that meets the definition of an element should be recognised if: (a) (b) 4. 39 it is probable that any future economic benefit associated with the item will flow to or from the entity; and the item has a cost or value that can be measured with reliability. * 4. 38 In assessing whether an item meets these criteria and therefore qualifies for recognition in the financial statements, regard needs to be given to the materiality considerations discussed in Chapter 3 Qualitative characteristics of useful financial information.
The interrelationship between the elements means that an item that meets the definition and recognition criteria for a particular element, for example, an asset, automatically requires the recognition of another element, for example, income or a liability. * Information is reliable when it is complete, neutral and free from error. A46 © IFRS Foundation Conceptual Framework The probability of future economic benefit 4. 40 The concept of probability is used in the recognition criteria to refer to the degree of uncertainty that the future economic benefits associated with the item will flow to or from the entity. The concept is in keeping with the uncertainty that characterises the environment in which an entity operates.
Assessments of the degree of uncertainty attaching to the flow of future economic benefits are made on the basis of the evidence available when the financial statements are prepared. For example, when it is probable that a receivable owed to an entity will be paid, it is then justifiable, in the absence of any evidence to the contrary, to recognise the receivable as an asset. For a large population of receivables, however, some degree of non-payment is normally considered probable; hence an expense representing the expected reduction in economic benefits is recognised. Reliability of measurement 4. 41 The second criterion for the recognition of an item is that it possesses a cost or value that can be measured with reliability.
In many cases, cost or value must be estimated; the use of reasonable estimates is an essential part of the preparation of financial statements and does not undermine their reliability. When, however, a reasonable estimate cannot be made the item is not recognised in the balance sheet or income statement. For example, the expected proceeds from a lawsuit may meet the definitions of both an asset and income as well as the probability criterion for recognition; however, if it is not possible for the claim to be measured reliably, it should not be recognised as an asset or as income; the existence of the claim, however, would be disclosed in the notes, explanatory material or supplementary schedules.
An item that, at a particular point in time, fails to meet the recognition criteria in paragraph 4. 38 may qualify for recognition at a later date as a result of subsequent circumstances or events. An item that possesses the essential characteristics of an element but fails to meet the criteria for recognition may nonetheless warrant disclosure in the notes, explanatory material or in supplementary schedules. This is appropriate when knowledge of the item is considered to be relevant to the evaluation of the financial position, performance and changes in financial position of an entity by the users of financial statements. 4. 42 4. 43 Recognition of assets 4. 4 An asset is recognised in the balance sheet when it is probable that the future economic benefits will flow to the entity and the asset has a cost or value that can be measured reliably. An asset is not recognised in the balance sheet when expenditure has been incurred for which it is considered improbable that economic benefits will flow to the entity beyond the current accounting period. Instead such a transaction results in the recognition of an expense in the income statement. This treatment does not imply either that the intention of management in incurring expenditure was other than to generate future economic benefits for the entity or that management was misguided.
The only implication is that the degree of certainty that economic benefits will flow to the entity beyond the current accounting period is insufficient to warrant the recognition of an asset. 4. 45 © IFRS Foundation A47 Conceptual Framework Recognition of liabilities 4. 46 A liability is recognised in the balance sheet when it is probable that an outflow of resources embodying economic benefits will result from the settlement of a present obligation and the amount at which the settlement will take place can be measured reliably. In practice, obligations under contracts that are equally proportionately unperformed (for example, liabilities for inventory ordered but not yet received) are generally not recognised as liabilities in the financial statements. However, such bligations may meet the definition of liabilities and, provided the recognition criteria are met in the particular circumstances, may qualify for recognition. In such circumstances, recognition of liabilities entails recognition of related assets or expenses. Recognition of income 4. 47 Income is recognised in the income statement when an increase in future economic benefits related to an increase in an asset or a decrease of a liability has arisen that can be measured reliably. This means, in effect, that recognition of income occurs simultaneously with the recognition of increases in assets or decreases in liabilities (for example, the net increase in assets arising on a sale of goods or services or the decrease in liabilities arising from the waiver of a debt payable).
The procedures normally adopted in practice for recognising income, for example, the requirement that revenue should be earned, are applications of the recognition criteria in this Conceptu