Chapter 1 – Financial Statements and Conceptual framework for Financial Reporting

Financial statements are the means by which the information accumulated and processed in
financial accounting is periodically communicated to the users. It is a structured
representation of the financial position and financial performance of an entity. The objective
of the financial statements is to provide information about the financial position, financial
performance and cash flows of an entity that is useful to a wide range of users in making
economic decisions. Financial statements that are intended to meet the needs of users who are
not in a position to require an entity to prepare reports tailored to their particular information
needs are called general purpose financial statements. A complete set of financial
statements comprises the following components: statement of financial position, income
statement, statement of comprehensive income, statement of changes in equity, statement of
cash flows and notes. The main standard that will be considered in this module is PAS 1
Presentation of Financial Statements. Per PAS 1, financial statements shall present fairly
the financial position, financial performance and cash flows of an entity. Fair presentation
requires the faithful representation of the effects of transactions, other events and conditions
in accordance with the definitions and recognition criteria for assets, liabilities, income and
expenses set out in the IASB’s Conceptual Framework for Financial Reporting (IASB
Framework). PAS 1 applies to general purpose financial statements.

At the end of this module, you will be able to:

1. Understand the nature, purpose and objective of financial statements
2. Identify and define each components of financial statements
3. Understand the responsibility and the accountability of management in the financial
statements
4. Enumerate and explain the general features of the financial statements
5. Define the elements of financial statements
6. Clearly identify financial statement and distinguish from other information

Definition of financial statements

The published accounts of an entity are intended to provide a report to enable shareholders to
assess current year stewardship and management performance and to predict future cash
flows. In order to assess stewardship and management performance, there have been
mandatory requirements for standardized presentation, using formats prescribed by Philippine
Financial Reporting Standards and this is called financial statements.

Financial statements are a structured representation of the financial position and financial
performance of an entity.

They are intended to be understandable by readers who have "a reasonable knowledge of
business and economic activities and accounting and who are willing to study the information
diligently."
Elements of financial statements - broad classes of events or transactions that are grouped
according to their economic characteristics. The elements of financial statements are the
"building blocks” from which financial statements are constructed.

The elements directly related to the measurement of financial position are asset, liability and
equity.

The elements directly related to the measurement of financial performance are income and
expense.

Asset is defined as "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"

Liability is defined as "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"
Equity is the "residual interest in the assets of the entity after deducting all of the liabilities”
Income is "increase in economic benefit during the accounting period in the form of inflow or
increase in asset or decrease in liability that results in increase in equity, other than contribution
from equity participants"
Expense is "decrease in economic benefit during the accounting period in the form of outflow
or decrease in asset or increase in liability that results in decrease in equity, other than
distribution to equity participants"

General purpose financial statements

PAS 1 prescribes the basis for presentation of general purpose financial statements to ensure
comparability both with the entity's financial statements of previous periods and with the
financial statements of other entities. It sets out overall requirements for the presentation of
financial statements, guidelines for their structure and minimum requirements for their
content.
General purpose financial statements are those statements intended to meet the needs of
users who are not in a position to require an entity to prepare reports tailored to their
particular information needs.
However, it may be difficult or impossible to satisfy the needs of all users. For example,
users may have different time-scales - shareholders may be interested in the long-term trend
of earnings over three years, whereas creditors may be interested in the likelihood of
receiving cash within the next three months.

The information needs of the shareholders are regarded as the primary concern. The
government perceives shareholders to be important because they provide companies with
 their economic resources. It is shareholders’ needs that take priority in deciding on the
nature and detailed content of the general-purpose reports.

Components of financial statements

A complete set of financial statements comprises:

a. a statement of financial position as at the end of the period;

b. a statement of profit or loss and other comprehensive income for the period;
c. statement of changes in equity for the period;
d. a statement of cash flows for the period;
e. notes, comprising significant accounting policies and other explanatory
information;
f. comparative information in respect of the preceding period; and
g. a statement of financial position as at the beginning of the preceding period when
an entity applies an accounting policy retrospectively or makes a retrospective
restatement of items in its financial statements, or when it reclassifies items in its
financial statements.
Many entities also present reports and statements such as environmental reports and value
added statements, particularly in industries in which environmental factors are significant and
when employees are regarded as an important user group.

However, such statements and reports are not components of financial statements and
therefore outside of the scope of PFRS.

Objectives of financial statements

The objective of financial statements is to provide information about the financial position,
financial performance and cash flows of an entity that is useful to a wide range of users in
making economic decisions. Financial statements also show the results of management's
stewardship of the resources entrusted to it.
To meet this objective, financial statements provide information about an entity's:
a. Assets
b. Liabilities
c. Equity
d. Income and expenses, including gains and losses
e. Contributions by and distributions to owners in their capacity as owners, who are
holders of instruments classified as equity.
f. Cash flows
This information, along with other information in the notes, assists users of financial
statements in predicting the entity's future cash flows and, in particular, their timing and
certainty.
However, financial statements do not provide all the information that users may need to
 make economic decisions since they largely portray the financial effects past events and
don not necessarily provide nonfinancial information.
The financial position comprises the assets, liabilities and equity of an entity at a
particular moment in time. Specifically, financial position pertains to the liquidity,
solvency, and the need of the entity for additional financing. This information is pictured
in the
statement of financial position.
The financial performance comprises the revenue, expenses and net income or loss of an
entity for a period of time. Performance is the level of income earned by the entity through
the efficient and effective use of its resources. The financial performance of an entity is
also known as results of operations and is portrayed in the income statement and
statement of comprehensive income.
Cash flows are the cash receipts and cash payments arising from the operating, investing
and financing activities of the entity. This information is presented in the statement of
cash flows.

Responsibility of financial statements

The management of the entity is primarily responsible for the preparation and presentation
of the financial statements.

The Board of Directors in discharging its responsibilities reviews and authorizes the
financial statements for issue before these are submitted to the shareholders.

Accountability of management

Management is also accountable for the safekeeping of the resources and their proper,
efficient and profitable use.

Shareholders are interested in information that helps them assess how effectively
management has fulfilled this role as this is relevant to the decision concerning their
investment and the reappointment or replacement of management.

General features of financial statements

Fair presentation and compliance with IFRS

Financial statements shall present fairly the financial position, financial performance and
cash flows of an entity. Fair presentation requires the faithful representation of the effects
of transactions, other events and conditions in accordance with the definitions and
recognition criteria for assets, liabilities, income and expenses.
 Virtually, in all circumstances, fair presentation is achieved if the financial statements are
prepared in accordance with the Philippine Financial Reporting Standards which represent
the GAAP in the Philippines. The application of PFRSs, with additional disclosure when
necessary, is presumed to result in financial statements that achieve a fair presentation.
An entity whose financial statements comply with PFRS shall make an explicit and
unreserved statement of such compliance in the notes.
Fair representation requires an entity:

a. To select and apply accounting policies in accordance with PFRS

b. To present information, including accounting policies, in a manner that provides
relevant, reliable, comparable and understandable information.
c. To provide additional disclosures when compliance with the specific requirements in
PFRSs is insufficient to enable users to understand the impact of particular transactions,
other events and conditions on the entity's financial position and financial performance.

In the extremely rare circumstances in which management concludes that compliance with a
requirement in an IFRS would be so misleading that it would conflict with the objective of
financial statements, the entity shall depart from that requirement if the relevant regulatory
framework requires, or otherwise does not prohibit, such a departure.
Going concern
Going concern means that the accounting entity is viewed as continuing in operation
indefinitely in the absence of evidence to the contrary. It is also known as continuity
assumption.
Thus, assets are normally recorded at original acquisition cost. As a rule, market values are
ignored.
This postulate is the very foundation of the cost principle.

When preparing financial statements, management shall make an assessment of an entity's

ability to continue as a going concern. An entity shall prepare financial statements on a going
concern basis unless management either intends to liquidate the entity or to cease trading, or
has no realistic alternative but to do so.
Accrual basis
An entity shall prepare its financial statements, except for cash flow information, using the
accrual basis of accounting.

When the accrual basis of accounting is used, an entity recognizes items as assets, liabilities,
equity, income and expenses (the elements of financial statements) when they satisfy the
definitions and recognition criteria for those elements.

This means that the effects of transactions and other events are recognized when they occur
and not as cash or cash equivalent is received or paid, and they are recorded and reported in
the financial statements of the periods to which they relate.
Materiality and aggregation
An entity shall present separately each material class of similar items. An entity shall
present separately items of a dissimilar nature or function unless they are immaterial.

Financial statements result from processing large numbers of transactions or other events that
are aggregated into classes according to their nature or function.

The final stage in the process of aggregation and classification is the presentation of
condensed and classified data, which form line items in the financial statements.

For example, cash on hand, petty cash fund, cash in bank and cash equivalent shall be
presented as one item "cash and cash equivalents".

If a line item is not individually material, it is aggregated with other items either in those
statements or in the notes. An item that is not sufficiently material to warrant separate
presentation in those statements may warrant separate presentation in the notes.
For example, an investor’s share in the net income of an associate is presented as a separate
line item in the income statement.

When is an item material?

There is no strict or uniform rule for determining whether an item is material or not.
Very often, this is dependent on good judgement, professional expertise and common
sense.

However, a general guide may be given, to wit:

An item is material if knowledge of it would affect the decision of the informed users of the
financial statements.
An example is the common practice of large entities of rounding amounts to the nearest
thousand pesos in their financial statements while small entities may round off to the
nearest peso.

Factors of materiality
a. Relative size of the item in relation to the total of the group to which the item belongs.
b. Nature of the item - An item may be inherently material because by its very nature it
affects economic decision.
This means that the effects of transactions and other events are recognized when they occur
and not as cash or cash equivalent is received or paid, and they are recorded and reported in
the financial statements of the period s to which they relate.
Offsetting
An entity shall not offset assets and liabilities or income and expenses, unless required or
permitted by the standards.

An entity reports separately both assets and liabilities, and income and expenses. Offsetting
in the statement(s) of profit or loss and other comprehensive income or financial position,
except when offsetting reflects the substance of the transaction or other event, detracts from
the ability of users both to understand the transactions, other events and conditions that have
occurred and to assess the entity's future cash flows. Measuring assets net of valuation
allowances—for example, obsolescence allowances on inventories and doubtful debts
allowances on receivables—is not offsetting.

Frequency of reporting
An entity shall present a complete set of financial statements (including comparative
information) at least annually.

When an entity changes the end of its reporting period and presents financial statements for a
period longer or shorter than one year, an entity shall disclose, in addition to the period
covered by the financial statements:
a. The reason for using a longer or shorter period, and
b. The fact that amounts presented in the financial statements are not entirely
comparable.
Normally, an entity consistently prepares financial statements for a one-year period.
However, for practical reasons, some entities prefer to report, for example, for a 52-week
period. This Standard does not preclude this practice.

Comparative information
Except when permitted or required otherwise by PFRS, an entity shall disclose comparative
information in respect of the previous period for all amounts reported in the current period’s
financial statements.
Comparative information shall be included for narrative and descriptive information when it
is relevant to an understanding of the current period’s financial statements.

An entity shall present, as a minimum, two statements of financial position, two statements of
profit or loss and other comprehensive income, two separate statements of profit or loss (if
presented), two statements of cash flows and two statements of changes in equity, and related
notes.
A third statement of financial position is required when an entity:

a. Applies an accounting policy retrospectively

b. Makes retrospective restatement of items in the financial statements
c. Reclassifies items in the financial statements
Under these circumstances, an entity shall present three statement of financial position as at:

a. The end of the current period

b. The end of the previous period
c. The beginning of the earliest comparative period
Consistency of presentation
Implicit in the presentation of comparable information is the principle of consistency.
The principle of consistency requires that "the accounting methods and practices shall be
applied on a uniform basis from period to period”.

The presentation and classification of financial statement items shall be uniform from one
accounting period to the next.

Consistency is desirable and essential to achieve comparability of financial statements.

However, consistency does not mean that no change in accounting method can be made.

If the change will result to information that is faithfully represented and more relevant to the
users of financial statements, then such change should be made but there should be full
disclosure of the change and the peso effect of the change.

It is inappropriate for an entity to leave accounting policies unchanged when better

and acceptable alternatives exist.

Identification of financial statements

An entity shall clearly identify the financial statements and distinguish them from other
information in the same published document.
In addition, an entity shall display the following information prominently, and repeat it
when necessary for the information presented to be understandable:

• the name of the reporting entity or other means of identification, and any change in
that information from the end of the preceding reporting period;
• whether the financial statements are of an individual entity or a group of entities;
• the date of the end of the reporting period or the period covered by the set of
financial statements or notes;
• the presentation currency; and
• the level of rounding used in presenting amounts in the financial statements.
Financial statements are often made more understandable by presenting information in
thousands or millions of units of the presentation currency.
 This is acceptable as long as the level of rounding in presentation is disclosed and relevant
and material transaction is not lost or omitted.

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. 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 harmonize regulations, accounting standards and procedures
relating to the preparation and presentation of financial statements. It believes that further
harmonization 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.

In general terms, a conceptual framework is a statement of generally accepted theoretical

principles which form the frame of reference for a particular field of enquiry. In terms of
financial reporting, these theoretical principles provide the basis for both the development of
new reporting practices and the evaluation of existing ones. Since the financial reporting
process is concerned with the provision of information that is useful in making business and
economic decisions, a conceptual framework will form the theoretical basis for determining
which events should be accounted for, how they should be measured and how they should be
communicated. Therefore, although it is theoretical in nature, a conceptual framework for
financial reporting has a highly practical end in view.

At the end of this module, you will be able to:

1. Describe the usefulness and scope of conceptual framework
2. Understand the objective of conceptual framework
3. Identify the qualitative characteristics of useful accounting information
4. Identify the fundamental and enhancing qualitative characteristics.

Conceptual framework for financial reporting and its purposes

In general terms, a conceptual framework is a statement of generally accepted theoretical
principles which form the frame of reference for a particular field of enquiry. In terms of
financial reporting, these theoretical principles provide the basis for both the development
of new reporting practices and the evaluation of existing ones. Since the financial reporting
process is concerned with the provision of information that is useful in making business and
economic decisions, a conceptual framework will form the theoretical basis for determining
which events should be accounted for, how they should be measured and how they should
 be communicated. Therefore, although it is theoretical in nature, a conceptual framework
for financial reporting has a highly practical end in view.
The purpose of the Conceptual Framework is:
• to assist the Board in the development of future PFRSs and in its review of existing
IFRSs;
• to assist the Board in promoting harmonization 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
PFRSs;
• to assist national standard-setting bodies in developing national standards;
• to assist preparers of financial statements in applying PFRSs and in dealing with
topics that have yet to form the subject of an PFRS;
• to assist auditors in forming an opinion on whether financial statements comply
with PFRSs; and
• to provide those who are interested in the work of the IASB with information about
its approach to the formulation of PFRSs.
This Conceptual Framework is not a standard and hence does not define standards for any
particular measurement or disclosure issue.
Nothing in this Conceptual Framework overrides any specific standard.
The Board recognizes that in a limited number of cases there may be a conflict between the
Conceptual Framework and a PFRS. In those cases where there is a conflict, the
requirements of the PFRS prevail over those of the Conceptual Framework. As, however,
the Board will be guided by the Conceptual Framework in the development of future PFRSs
and in its review of existing PFRSs, the number of cases of conflict between the Conceptual
Framework and PFRSs will diminish through time.

Scope of the framework

The Conceptual Framework deals with:

• 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.

Main objective of conceptual framework

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.
Target users
Financial reporting is directed primarily to the existing and potential investors, lenders and
other creditors which compose the primary user group.
The reason is that existing and potential investors, lenders and other creditors have the most
critical and immediate need for information in financial reports.
As a matter of fact, the primary users of financial information are the parties that provide
resources to the entity.
Specific objectives of financial reporting
Specifically, the Conceptual Framework for Financial Reporting states the following
objectives of financial reporting:
• To provide information useful in making decisions about providing resources to the
entity
• To provide information useful in assessing the prospects of future net cash flows to
the entity
• To provide information about entity resources, claims and changes in resources and
claims.
Economic decisions
Existing and potential investors need general purpose financial reports in order to enable
them in making decisions whether to buy, sell or hold equity instruments.

Existing and potential lenders and other creditors need general purpose financial reports in
order to enable them in making decisions whether to provide or settle loans and other forms
of credit.
Assessing future cash flows
Decisions by existing and potential investors about buying, selling or holding equity
instruments depend on the returns that they expect from an investment, for example,
dividends.

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 they expect.
Economic resources and claims
General purpose financial reports provide information about the financial position of a
reporting entity.

Information about the nature and amount of an entity's economic resources and claims can
help users identify the entity’s financial strength and weakness.

Otherwise stated, information about financial position can help users to assess the entity's
liquidity, solvency and the need for additional financing.
 Liquidity is the availability of cash in the near future to cover currently maturing
obligations.
Solvency is the availability of cash over a long term to meet financial commitments when
they fall due.
Changes in economic resources and claims
General purpose financial reports also provide information about the effects of transactions
and other events that change the entity's economic resources and claims.

Changes in economic resources and claims result from the entity's financial performance
and from other events or transactions.
Accrual accounting
The financial performance of an entity shall be measured in accordance with accrual
accounting.

Accrual accounting depicts the effects of transactions and other events and circumstances
on an 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.

Qualitative characteristics of useful financial information

The qualitative characteristics of useful financial information 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.
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.
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

The fundamental qualitative characteristics relate to the content or substance of financial
information.
The fundamental qualitative characteristics are:

a. Relevance
b. Faithful representation

Information must be both relevant and faithfully represented if it is to be useful.

 a. Relevance
In the simplest terms, relevance is the capacity of the information to influence a decision.
To be relevant, the financial information must be capable of making a difference in the
decisions made by users.
Information that does not bear on an economic decision is useless.
For example, the statement of financial position is relevant in determining financial position
and the income statement is relevant in determining performance.
Ingredients of relevance
Financial information is capable of making a difference in a decision if it has predictive
value and confirmatory value.
Financial information has predictive value if it can be used as an input to processes
employed by users to predict future outcome.
In other words, financial information has predictive value when it can help users increase
the likelihood of correctly or accurately predicting or forecasting outcome of events.

Financial information has confirmatory value if it provides feedback about previous

evaluations.

In other words, financial information has confirmatory value when it enables users confirm or
correct earlier expectations.
Materiality
Materiality is a practical rule in accounting which dictates that strictly adherence to GAAP is
not required when the items are not significant enough to affect the evaluation, decision and
fairness of the financial statements. This concept is also known as doctrine of convenience.

It is a company-specific aspect of relevance. Information is material if omitting it or

misstating it could influence decisions that users make on the basis of the reported financial
information. An individual company determines whether information is material because
both the nature and/or magnitude of the item(s) to which the information relates must be
considered in the context of an individual company's financial report.

b. Faithful representation

Under the New Conceptual Framework for Financial Reporting, the term ‘faithful
representation” is used instead of the term “reliability".

Faithful representation means that financial reports represent economic phenomena or

transactions in words and numbers.
Simply worded, faithful representation means that the actual effects of the transactions shall
be properly accounted for and reporting in the financial statements.
Ingredients of faithful representation
Completeness
Completeness requires that relevant information should be presented in a way that facilitates
understanding and avoids erroneous implication.

Completeness is the result of the adequate disclosure standard or the principle of full
disclosure.

The standard of adequate disclosure means that all significant and relevant information
leading to the preparation of financial statements shall be clearly reported.

The rule is that the accountant shall disclose a material fact known to him which is not disclosed
in the financial statements but disclosure of which is necessary in order that the statements
would not be misleading.

Neutrality

A neutral depiction is "without bias" in the preparation or presentation of financial

information.
A neutral depiction is not slanted, weighted, emphasized, de-emphasized or otherwise
manipulated to increase the probability that financial information will be received favorably
or unfavorably by users.
In other words, to be neutral, the information contained in the financial statements must be
free from bias.

To be neutral is to be fair.
Free from errors

Free from error means there are no errors or missions in the description of the phenomenon or
transaction, 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 an estimate.

Moreover, 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.
Substance over form
If information is to represent faithfully the transactions and other events it purports to
represent, it is necessary that they are accounting in accordance with their substance and
reality and not merely their legal form.

The economic substance of transactions and events are usually emphasized when economic
substance differs from legal form.

Substance over form is not considered a separate component of faithful representation

because it would be redundant.
Faithful representation inherently represents the substance of an economic phenomenon or
transaction rather than merely representing its legal form.

Enhancing qualitative characteristics

The enhancing qualitative characteristics relate to the presentation or form of the financial
information. These are intended to increase the usefulness of the financial information that
is relevant and faithfully represented.

The enhancing qualitative characteristics are:

a. Comparability
b. Understandability
c. Verifiability
d. Timeliness
Information must be both relevant and faithfully represented if it is to be useful but to be
most useful it must be comparable, understandable, verifiable and timely.

a. Comparability
Comparability means the ability to bring together for the purpose of noting points of
likeness and difference.

Comparability is the enhancing qualitative characteristic that enables users to identify and
understand similarities and dissimilarities among items.

The economic substance of transactions and events are usually emphasized when economic
substance differs from legal form.
Comparability may be made within an entity or between and across entities.
 Comparability within an entity is also known as horizontal comparability or
intracomparability.
Comparability across entities is also known as intercomparability or dimensional
comparability.
Consistency
Implicit in the qualitative characteristic of comparability is the principle of consistency.
The principle of consistency requires that "the accounting methods and practices should be
applied on a uniform basis from period to period”.

Consistency is not the same as comparability.

b. Understandability
Understandability requires that financial information must be comprehensible or
intelligible if it is to be most useful.

An essential quality of the information provided in financial statements is that it is readily

understandable by users.
Financial statements cannot realistically be understandable to everyone.
At times, even well-informed and diligent users may need to seek the aid of an adviser to
understand information about complex phenomena or transactions.

Understandability is very essential because a relevant and faithfully represented information

may prove useless if it is not understood by users.

c. Verifiability
Verifiability means that different knowledgeable and independent observers could reach
consensus, although not necessarily complete agreement, that a particular depiction is a
faithful representation. In other words, verifiability implies consensus.

The financial information is verifiable in the sense that it is supported by evidence so that an
accountant that would look into the same evidence would arrive at the same economic
decision or conclusion.
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 model, formula or other technique and
recalculating the inputs using the same methodology.

d. Timeliness
Timeliness means that financial information must be available or communicated early enough
when a decision is to be made.
Relevant information and faithfully represented financial information furnished after a
decision is made is useless or of no value.

Generally, the older the information, the less useful.

Timeliness enhances the truism that "without knowledge of the past, the basis for prediction
will usually be lacking and without interest in the future, knowledge of the past is sterile".

In providing information with the qualitative characteristics that make it useful, companies
must consider an overriding factor that limits the reporting. This is referred to as the cost
constraint (the cost-benefit relationship). That is, companies must weigh the costs of
providing the information against the benefits that can be derived from using it. In order to
justify requiring a particular measurement or disclosure, the benefits perceived to be derived
from it must exceed the costs perceived to be associated with it.

Accounting assumptions are the basic notions or fundamental premises on which the
accounting process is based. Accounting assumptions are also known as postulates. Like a
building structure that requires a solid foundation to avoid or prevent future collapse and
provide room for expansion and so with accounting. They serve as the foundation or bedrock
of accounting in order to avoid misunderstanding but rather to enhance the understanding and
usefulness of the financial statements.

Measurement, on the other hand, is the process of determining the monetary amounts at
which the elements of financial statements are recognized and carried in the statement of
financial position and income statement. The most commonly used measurement is based on
historical cost which is adopted by entities in preparing their financial statements.

The concept of capital maintenance is concerned with how an entity defines the capital that
it seeks to maintain. It is a prerequisite for distinguishing between an entity's return on capital
(i.e. profit) and its return of capital. In general terms, an entity has maintained its capital if it
has as much capital at the end of the period as it had at the beginning of the period. Any
amount over and above that required to maintain the capital at the beginning of the period is
profit.

At the end of this module, you will be able to:

1. Define the concept of cost constraint of useful financial reporting
2. Identify the four basic underlying assumptions of financial reporting
3. Identify the four measurement bases or financial attributes of elements
4. Define the concepts of capital and capital maintenance.

Cost constraint on useful information

Cost is a pervasive constraint on the information that can be provided by financial

 reporting. Reporting financial information imposes cost and it is important that such cost
is justified by the benefit derived from the financial information.
The rules is "the benefit derived from the information should exceed the cost incurred in
obtaining the information”.
However, the evaluation of the cost constraint is substantially a judgmental process.
Assessing whether the cost of reporting outweighs or falls short of the benefit is difficult
to measure and becomes a matter of professional judgment.

Underlying assumptions

Four basic assumptions underlie the financial accounting structure: (1) economic entity,
(2) going concern, (3) monetary unit, and (4) periodicity.
Economic entity assumption
The economic entity assumption means that economic activity can be identified with a
particular unit of accountability. In other words, a company keeps its activity separate and
distinct from its owners and any other business unit. Equally important, financial statement
users need to be able to distinguish the activities and elements of difference companies.
The entity concept does not apply solely to the segregation of activities among competing
companies. An individual, department, division, or an entire industry could be considered
a separate entity if we choose to define it in this manner. Thus, the entity concept does not
necessarily refer to a legal entity.
Going concern assumption
Going concern means that the accounting entity is viewed as continuing in operation
indefinitely in the absence of evidence to the contrary. It is also known as continuity
assumption.
The going concern assumption applies in most business situations. Only where liquidation
appears imminent is the assumption inapplicable. In these cases, a total revaluation of
assets and liabilities can provide information that closely approximates the company’s net
realizable value.

Monetary unit assumption

The monetary unit assumption means that money is the common denominator of
economic activity and provides an appropriate basis for accounting measurement and
analysis. That is, the monetary unit is the most effective means of expressing to interested
parties changes in capital and exchanges of goods and services. The monetary unit is
relevant, simple, universally available, understandable, and useful.

Periodicity assumption
To measure the results of a company’s activity accurately, we would need to wait until it
liquidates. Decision-makers, however, cannot wait that long for such information. Users
need to know a company’s performance and economic status on a timely basis so that they
 can evaluate and compare firms, and take appropriate actions. Therefore, companies must
report information periodically.
The periodicity assumption implies that a company can divide its economic activities into
artificial time periods. These time periods vary, but the most common are monthly,
quarterly, and yearly.

Measurement bases

Measurement is the process of determining the monetary amounts at which the elements of
financial statements are recognized and carried in the statement of financial position and
income statement.
The measurement bases or financial attributes include:
a. Historical cost
b. Current cost
c. Realizable value
d. Present value
The most commonly used measurement is based on historical cost which is adopted by
entities in preparing their financial statements.

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 time of acquisition.
Historical cost has an important advantage over other valuations: It is generally thought to
be verifiable.
It is also known as "past purchase exchange price”.

Current cost
Current cost is the amount of cash or cash equivalent that would have to be paid if the same
or an equivalent assets was acquired currently.
Current cost is also known as "current purchase exchange price”

Realizable value
Realizable value is the amount of cash or cash equivalent that could currently be obtained
by selling the asset in an orderly disposal.

Realizable value is also known as "current sale exchange price" or "exit value"
 Present value
Present value is the discounted value of the future net cash inflows that the item is expected
to generate in the normal course of business.
Present value is also known as "future exchange price"

Capital and capital maintenance concepts

Capital maintenance
The financial performance of an entity is determined using two approaches, namely capital
maintenance and transaction approach.
The transaction approach is the traditional preparation of an income statement.
The capital maintenance approach means that net income occurs only after the capital
used from the beginning of the period is maintained. In other words, net income is the
amount an entity can distribute to its owners and be as "well-off at the end of the year as at
the beginning.
The Conceptual Framework considers two concepts of capital maintenance or well-offness,
namely financial capital and physical capital.

Financial capital
Financial capital is the absolute monetary amount of the net assets contributed by
shareholders and the amount of the increase in net assets resulting from earnings retained by
the entity.

Financial capital is based on historical cost. It is the concept that is adopted by most entities.
Under the financial capital concept, net income occurs:

"When the nominal amount of the net assets at the end of the period exceeds the nominal
amount of the net assets at the beginning of the period, after excluding distributions to and
contributions by owners during the period.”

Physical capital
Physical capital is the quantitative measure of the physical productive capacity to produce
goods and services.

This concept requires that productive assets shall be measured at current cost rather than
physical cost.
Productive assets include inventories and property, plant and equipment.

Under the physical capital concept, net income occurs:

"When the physical productive capital at the end of the period exceeds the physical productive
capital at the beginning of the period, after excluding distributions to and contributions
from owners during the period.”

Glossary

Economic entity: means that economic activity can be identified with a particular unit of
accountability

Going concern: means that the accounting entity is viewed as continuing in operation
indefinitely in the absence of evidence to the contrary. It is also known as continuity
assumption.

Monetary unit: means that money is the common denominator of economic activity and
provides an appropriate basis for accounting measurement and analysis.

Periodicity: requires that "the indefinite life of an entity is subdivided into time periods or
accounting periods which are usually of equal length for the purpose of preparing financial
reports on financial position, performance and cash flows.”
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 time of acquisition

Current cost: is the amount of cash or cash equivalent that would have to be paid if the same
or an equivalent assets was acquired currently

Realizable value: is the amount of cash or cash equivalent that could currently be obtained
by selling the asset in an orderly disposal

Present value: is the discounted value of the future net cash inflows that the item is expected
to generate in the normal course of business

Financial capital: is the absolute monetary amount of the net assets contributed by
shareholders and the amount of the increase in net assets resulting from earnings retained by
the entity

Physical capital: is the quantitative measure of the physical productive capacity to produce
goods and services