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CONCEPTUAL FRAMEWORK

FOR FINANCIAL
ACCOUNTING
Learning Objectives
1. Understand the significance of the conceptual
frame work in outlining the qualities of good
accounting information.

2. Identify the key items of the conceptual framework

3. Learn the underlying concepts, assumptions and


principles of accounting.

4. Defining terms such as assets and revenue, and


providing guidance about appropriate recognition,
measurement and reporting
WHAT IS
CONCEPTUAL FRAMEWORK?
‘The Framework sets out the concepts that
underlie the preparation and presentation of
financial statements for external users. ‘
-MASB

‘The Conceptual Framework is like a constitution


for financial reporting, providing the foundation
for standards. The Conceptual Framework
provides structure to the process of creating
financial reporting standards and ensures that
standards are based on fundamental principles. ‘
-CPA Journal
.
The Purpose
of the Conceptual Framework

 to assist the standard setters in the development of future accounting


standards and in reviewing the standards;
 to assist preparers of financial statements in applying the accounting
standards and in dealing with topics that have yet to be addressed by
the accounting standards;
 to assist auditors in forming an opinion on whether financial
statements comply with the accounting standards;
 to assist users of financial statement in interpreting the information
contained in financial statements prepared in compliance with the
accounting standards; and
 to provide those who are interested in the work of MASB and IASB
with information about its approach to the formulation of accounting
standards
Differences between the Conceptual Framework
and Financial Reporting Standards

Conceptual Framework for


Financial Reporting Standards
Financial Reporting
• Provides a general guide on how • Provide guidance on a very
financial statements should be
prepared specific issue related to financial
• Sets up principals which are general reporting, e.g. how to account
concepts for inventories, how financial
• Applicable to a wide range of issues statements should be presented
• Not an accounting standard - when
there is conflict between the and how to apply fair value
Conceptual Framework and an measurement
accounting standardrequirement of
standard prevails • Apply concepts set out in the
Conceptual Framework
Three Levels of Developing a
Conceptual Framework

Level 1 Objectives
of Financial
Reporting

Level 2 Qualitative
Elements
Characteristics
of Financial
of Accounting
Statements
Information

Level 3 Recognition and Measurement Concepts

Assumptions Principles Constraints


1st Level : Objectives of Financial Reporting

Certain basic questions need to be answer in the form of


 Who uses financial statements? Why?
 What information do they need?
How knowledgeable about business and accounting are
financial statement users?
 How should financial information be reported so that it is
best understood?

The framework spells out the objectives of financial


statement as “ to provide information about financial
position, performance and changes in financial position of an
enterprise that is useful to a wide range of users in making
economic decisions.”
Objectives of Financial Reporting

The key financial reporting objectives outlined in the


conceptual framework are:

Usefulness.
Understandability.
Targetaudience: investors and creditors.
Assessing future cash flows.
Evaluating economic resources.
Primary focus on earnings.
Objectives of Financial Reporting
Usefulness
Financial reporting should provide
information that is useful to present and
potential investors and creditors and
other users in making rational
investment, credit, and similar
decisions.
Objectives of Financial Reporting
Understandability

Financial reporting should provide


information that is understandable to
one who has a reasonable knowledge
of accounting and business and who is
willing to study and analyze the
information presented.
Objectives of Financial Reporting
Target Audience

While there are many potential users


of financial reports, the objectives are
directed primarily toward investors
and creditors.
Objectives of Financial Reporting
Assessing Future Cash Flows

Financial reporting should provide


information that is useful in assessing
amounts, timing, and uncertainty (risk) of
prospective cash flows.
 Creditors expect interest and loans principal to be
paid in cash
 Investors desire cash dividend and sufficient cash
flow to allow the business to grow
Objectives of Financial Reporting

Evaluating Economic Resources

Financial reporting should also provide


information about an enterprise’s assets,
liabilities, and owners’ equity to help
investors, creditors, and others evaluate the
financial strengths and weaknesses of the
enterprise and its liquidity and solvency.
Objectives of Financial Reporting
Primary Focus on Earnings

Information about enterprise earnings,


measured by accrual accounting,
generally provides a better basis for
forecasting future performance than
does information about current cash
receipts and disbursements.
2nd Level : Qualitative Characteristics of
Accounting Information
As the framework spelt out the objective of financial statements is primarily to provide
information useful for decision making by a wide range of users.
The Conceptual framework identifies the qualitative characteristics of a useful
accounting information are:

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Fundamental Qualitative
Characteristics (Relevance)

Predictive value
Can be used to predict
future outcomes

Relevance Confirmatory value


Information that is Provides feedback about
previous evaluation
relevant is capable of
changing the decision
Material
made by users
In terms of amount and
nature
Omission or isstatement of
information affect users
decision
Fundamental Qualitative Characteristics
(Faithful Representation)

Complete
Includes all information necessary for
users to understand the business
Faithful standing
representation Neutral
Information should Information is not slanted,
represent the actual weighted, emphasized,
situation of a business deemphasized or manipulated
or entity
Free from error
No errors in the information or
omission of information
No error in the process used to
produce the information
Enhancing Qualitative
Characteristics
• Enables users to understand the similarities and
differences
Comparability
• Comparable between periods, companies, industries
and countries

• Different knowledgeable and independent observers


Verifiability could reach consensus, although not a complete
agreement.

• Information should be made available in time to


Timeliness influence decision-making.
• The older the information, the less useful it is.

• Classifying, characterizing and presenting information


clearly and concisely to make it understandable.
Understandability • The users of financial information are assumed to be
knowledgeable users.
Elements of Financial Statements

• Assets An important
part of
• Liabilities accounting
• Equity conceptual
• Investment framework is a
• Distribution set of
definitions that
• Comprehensive Income describe the
• Revenues basic terms
• Expenses used in
• Gains accounting.
• Losses
Elements of Financial Statements
Asset Income
An asset is Income includes both revenue and gains.
• a resource controlled by the entity Revenue arises in the course of ordinary activities of an
•as a result of past events and entity.
•from which future economic Gains may not arise from the ordinary activities of an
benefits are expected to flow to the entity such as those arising from the disposal of non-
entity.
current assets. Some gains may be unrealised such as the
surplus on the revaluation of non-current assets.
Liability
A liability is the
• present obligation of the entity
• arising from past events,
• the settlement of which is Expenses
expected to result in an outflow Expenses include both losses as well as expenses that arise
from the entity of resources in the ordinary course of the business. Expenses decrease
embodying economic benefits. the economic benefits during the accounting period in the
form of outflows or depletions of assets or the incurrence
Equity of liabilities that result in decreases in equity, other than
Equity is the residual interest in those relating to contributions/payments from/to equity
the assets of the entity after participants.
deducting all its liabilities.
Recognition of Assets, Liabilities, Income and
Expense

 When an item is recognized, it is included in the


statement of financial position or statement of profit or
loss and other comprehensive income.
 For an item to be recognized, it must meet the definition
of the element (assets, liabilities, equity, income or
expenses) and fulfil the recognition criteria.
 Recognition criteria
1. It is probable that the future economic benefit
associated with an item will flow to or from the
entity; and
2. The item has a cost or value that can be measured
reliably.
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Recognition of Assets

Example: To recognize a building as an asset

Does the building meet the definition of an asset?


YES
It is probable that the future economic benefit
associated with the building will flow to the entity?
YES
The building has a cost or value that can be
measured reliably?
YES
Recognize the building as an asset
Dr Building
Cr Cash
3rd Level : Measurement of Elements of Financial
Statements
 Measurement is the process of determining the monetary amounts for
specific items to be recognized, and carried, on the statement of financial
position and the statement of profit or loss and other comprehensive
income.
 A number of different bases of measurement are used to different
degrees, and in varying combination, in the financial statements.

The following are the measurement bases discussed in the Framework:


• Historical Cost
• Current Cost
• Net Realisable Value
• Present Value
• Fair Value
Measurement: Historical Cost

 Historical cost is the amount of cash or cash equivalents


paid, or the fair value of the consideration given, to acquire
an asset at the date of acquisition.

Example : Syarikat Wawasan paid cash amounting to


RM60,000 to acquire a van.
Explanation: The historical cost of the van is determined based
on the amount of cash paid to acquire the asset. Therefore,
the historical cost of the van is RM60,000.
Measurement: Current Cost

 The current cost for an asset is the amount of cash or cash


equivalents that would have to be paid if the same or
equivalent asset was acquired currently.
 The current cost of a liability is the undiscounted amount of
cash or cash equivalents that would be required to settle the
current obligation.
Example: On 1 June 20x4, Syarikat Wawasan bought a piece of
land and paid RM70,000 in cash. On 1 June 20x5, the market value
of the land is RM80,000. The current cost of the land is RM80,000.
Measurement: Realizable Value

 Realizable value of an asset is the amount of cash or cash


equivalents that could currently be obtained by selling the asset
in an orderly disposal.
 Orderly disposal means that the sale is not a forced sale.

Example: On 1 June 20x4, Syarikat Wawasan bought a van and paid


RM60,000 in cash.
On 1 June 20x5, the market value of the van is RM58,000.
To sell the van, a cost equivalent to 2% of the market price is
expected to be incurred.
The net realizable value of the van is RM56,840 [RM58,000 –
(58,000 × 0.02)].
Measurement: Present Value
 The present value of an asset is the present discounted value of the future
net cash inflows that the asset is expected to generate in the normal course
of business.
 The present value of a liability is the present discounted value of the future
net cash outflows that is expected to be required to settle the liability in the
normal course of business.
Example: On 1 June 20x4, Syarikat Wawasan bought a piece of land for
RM70,000. Syarikat Wawasan will pay RM10,000 in cash in equal instalments
over a period of seven years.
Since the payment for the asset will be over several years, the cost of the van
should be stated at its present value.
To determine the present value of the asset, RM10,000 is multiplied by the
present value factor.
Assuming the interest rate is 10%, the present value factor of 10% for seven
years is 4.8684. Therefore, the present value of the land is RM48,684 (RM10,000
× 4.8684).
Fair Value Measurement
Fair value is defined as “the price that would be received to
sell an asset or paid to transfer a liability in an orderly
transaction between market participants at the measurement
date (an exit price).”
Fair value of an asset(liability) is the amount at which that
asset(liability) could be bought(incurred) or sold(settled) in
a current transaction between willing parties, other than
liquidation.
If available, a quoted market price in an active market is the
best evidence of fair value. If quoted market price is not
available, preparers should make an estimate of fair value
using the best information available in the circumstances.
Recognition and
Measurement Concepts

Established in its conceptual framework to


assist in solving practical problems –
recognition and measurement concept
Assumptions Principles Constraints
• Economic • Historical Cost • Cost-Benefit
Entity • Revenue • Materiality
• Going Concern Recognition • Industry Practice
• Arm’s-Length • Matching • Conservatism
Transactions • Full Disclosure
• Monetary Unit
• Periodicity
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Traditional Assumptions of the Accounting
Model
Provide a foundation for the accounting
process
• Economic entity.
• Going concern.
• Arm’s-length transactions.
• Monetary unit.
• Time period.
ECONOMIC ENTITY
ASSUMPTION
• The activities of the entity are to be
kept separate and distinct from the
activities of the owner and all other
economic entities.

• Economic events can be identified with


a particular unit of accountability.
GOING CONCERN ASSUMPTION

The enterprise will continue in


operation long enough to carry out its
existing objectives.

 If the entity is no more a going


concern, then the assets will be
shown at the liquidation value or
realisable value and not at cost.
ARM’s LENGTH TRANSACTIONS

• Occur between independent


parties, each of whom is capable
of protecting its own interest.
• Related party transactions
MONETARY UNIT ASSUMPTION
• Only transaction data that can be
expressed in terms of money be
included in the accounting records.

 E.g. The process of hiring an employee is not


recorded because it cannot be expressed in terms of
monetary units.
 E.g When paying an employee, the salary expense
can be denoted in terms of monetary unit - record
this transaction
TIME PERIOD ASSUMPTION

 The economic life of a business can be


divided into artificial time periods.

 Normal period of reporting – Yearly

 Supplemented by interim reports –


quarterly or monthly reporting
Basic Accounting Principles
Specific rules that indicate how economic events
should be reported in accounting process

1. HISTORICAL COST
2. REVENUE RECOGNITION
3. MATCHING
4. FULL DISCLOSURE
Historical Cost principle

Requires assets to be recorded at cost – the amount of


cash or cash equivalent paid or the fair value of the
consideration given at the date of acquisition.

COST COST
is relevant because it
is reliable because it is:
represents:
OBJECTIVELY MEASURED
PRICE PAID
or
or
FACTUAL
ASSETS SACRIFICED
or
or
VERIFIABLE
COMMITMENT MADE
Revenue Recognition Principle

Revenue should be recognized in the


accounting period in which it is earned.
(ACCRUAL basis)

When a sale is involved, revenue is


recognized at the point of sale.
This sales basis involves an exchange
transaction between seller & buyer.
Matching Principle

Expenses are matched with revenues in the period


in which efforts are made to generate revenues.

Examples:
Sales for the period is offset with the cost of the
inventory sold

Charging of depreciation over the economic life


of the asset.
Full Disclosure Principle

Disclose circumstances and events that make a difference to


the financial statement users in one of two places.

Body/Data in Notes to accounts


Financial statement

SUMMARY OF SIGNIFICANT
ACCOUNTING POLICIES USUALLY
THE FIRST FOOTNOTE
Materiality
Material Information:
 All items that are material will be reported.
 It depends on the size of the item
 If the inclusion or omission of the item may influence the
judgment of the users of financial information, it is
material.
 However, there is no definitive numerical materiality
threshold – based on judgment
What About Conservatism?

The concept of conservatism can be


summarized as follows: When in doubt,
recognize all losses but don’t recognize
any gains.
The approach of choosing an accounting
method when in doubt that will least likely
overstate assets and income.
Other Characteristics

Substance over form


Transactions and events are to be reported as
to the commercial or economic reality and not
strictly according to legal form.

Substance

Factored Sale & Consignment


Receivables Sale & Leaseback Inventory
Repurchase
Arrangements
Agreement
Substance over form
MFRS101 requires that financial statements :
• Must represent faithfully the transactions that have been carried out.
• Must reflect the economic substance of events and transactions and
not merely their legal form.

Examples of accounts reflecting economic or commercial substance which


we have already met are:
• The production of consolidated accounts
• Recognising redeemable preference shares as liabilities
• The capitalisation of a finance lease.

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Substance over form

Common features of transactions whose substance is not readily


apparent are :
• The legal title to an asset may be separated from the principal
benefits and risks associated with the asset.
• A transaction may be linked with other transactions which means
that the commercial effect of the individual transaction cannot
be understood without an understanding of all of the
transactions.
• Options may be included in a transaction where the terms of the
option make it highly likely that the option will be exercised.

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Substance over form
Factored Receivables
 A company transfers its receivables balances to another organization (a
Factor) and receives an advance on the value of those receivables in
return.
 The receivables are legally “sold” to the factor.
 The factor advances the company cash, eg. 90% of receivables.
 The factor collects receivables balance from the customer and may
advance further sums to the company.

Accounting issue

Have the receivables Has the company


been sold? received a short-term
46 loan from the factor?
Substance over form
The following relates to AB for the year ended 31 October 2015.
AB supplies all its customers on credit terms. On 1 November 2014
it entered into a factoring agreement with CD:
• It would receive 90% of its receivables total on the day of the
sale.
• At the year end receivables stood at RM15m.
• CD has no limit on the amount of recourse.
Required:
Explain the accounting treatment.

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Substance over form
If the factor has full recourse then AB will not have transferred
the risks and rewards since it still faces the risk of non payment
entirely. Therefore, the receivables will not be derecognised and
the sum advanced represents a loan secured on the receivables.
Dr. Bank (90% x RM15m) 13,500,000
Cr. Loan 13,500,000
The loan and receivables balance would then be derecognised
when the customer pays the factor, with any difference being
expensed as a finance cost.

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Substance over form
Sale and repurchase transactions
 An asset is sold by one party to another.
 The terms of the sale provide for the seller to repurchase the asset in
certain circumstances at some point in the future.
 The asset has been “legally” sold, but there is either a commitment or
an option to repurchase the asset at a later date.

Accounting issue

Have the asset been Has the company received a loan


sold? secured on the asset which is
repaid when the asset is
49 repurchased?
Substance over form
Sale and repurchase transactions
Treatment

Asset has been sold:. Company received a loan:

Dr. Bank Dr. Bank


Cr. Asset Cr. Loan
Dr/Cr IS – Loss/gain
Then,
Dr. Finance costs
Cr. Loan
To increase loan to repurchase
price
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Tutorial Questions
Jane Lazar & Huang (4th Ed.)
Chapter 1
Q4, Q5, Q7, Q8