What are the components of the Conceptual Framework for financial reporting?

Objective:

The Conceptual Framework is a body of interrelated objectives and fundamentals. The objectives identify the goals and purposes of financial reporting and the fundamentals are the underlying concepts that help achieve those objectives. Those concepts provide guidance in selecting transactions, events, and circumstances to be accounted for, how they should be recognized and measured, and how they should be summarized and reported. A Statement of Financial Accounting Concepts is nonauthoritative and does not establish or change generally accepted accounting standards.

On December 22, 2021, the Financial Accounting Standards Board (FASB) issued FASB Concepts Statement No. 8, Conceptual Framework for Financial Reporting—Chapter 4, Elements of Financial Statements.

Chapter 4 defines elements of financial statements to be applied in developing standards for both business and not-for-profit entities. These elements provide a foundation for information that is relevant to the objective of financial reporting—namely, 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. Chapter 4 supersedes Concepts Statement No. 6, Elements of Financial Statements.

Additional Information:

• Download Chapter 4
• Press Release
• Educational Video

The Conceptual Framework for Financial Reporting (2010) provides important information on the concepts which underlie the preparation and presentation of financial statements. This framework is of great benefit to all financial statement users. It has several components that are outlined in figure 1 below.

Outline of the IASB Conceptual Framework

Figure 1 – IFRS Framework for the Preparation and Presentation of Financial Reports

Main Objective of the Conceptual Framework

The Conceptual Framework (2010) has a core objective from which all its other aspects flow. This central objective is “to provide financial information which is useful to both current and potential providers of resources (investors, lenders, other creditors) in decision-making.“

The financial information to be provided will include: (i) information on a company’s financial position (its resources and financial obligations); (ii) information on a company’s financial performance (information which explains why the company’s financial position changed in the past); and (iii) information on the company’s cash and cash equivalents.

Qualitative Characteristics

The Conceptual Framework (2010) identifies relevance and faithful representation as the two fundamental qualitative characteristics which make financial information useful. Financial information is relevant if it would potentially affect or make a difference in its consumer’s decision. Faithful representation relates to the fact that information that represents an economic phenomenon should ideally be complete, neutral, and free from error.

The Conceptual Framework (2010) also identifies comparability, verifiability, timeliness, and understandability as the four enhancing qualitative characteristics of information:

• comparability permits the identification and understanding of similarities and differences between items of information;
• verifiability means that different observers would independently agree that the information that is presented faithfully represents the economic phenomena that it alleges to represent;
• timeliness refers to the availability of information to decision makers when it is needed i.e. before the need for decision-making arises; and
• understandability means that the information should be comprehensible to its users who have a reasonable knowledge of business and economic activities, and are willing to diligently study it.

Constraints on Financial Reports

The cost of providing and using financial information is a constraint that must be balanced with the benefits that are to be derived from the information.

Elements of Financial Statements

The financial effects of transactions and other events are represented in financial statements by grouping them into broad classes or elements. The grouping is done according to their economic characteristics.

The elements of financial statements that are directly related to financial positions are assets, liabilities, and equity. The elements directly related to financial performance, on the other hand, are income and expenses.

Accrual accounting and ‘going concern’ are two key assumptions that underlie the preparation of financial statements. These assumptions determine how financial statement elements are recognized and measured. Accrual accounting means that financial statements reflect transactions in the period in which they occur and not necessarily when cash movement occurs. ‘Going concern’ means that a company is assumed to continue in business for the foreseeable future.

Recognition refers to the inclusion of an item on the balance sheet or income statement. An item should be recognized if it is probable that future economic benefits that are associated with it will flow to or from the reporting entity, and it has a cost or value that can be reliably measured.

In measuring financial statement elements, the following bases of measurement may be used:

• historical cost: this refers to the amount of cash or cash equivalents paid or the fair value of what was given to purchase an asset. Concerning liabilities, it refers to the amount of proceeds received in exchange for an obligation;
• amortized cost: this refers to the historical cost after adjustments are made for amortization, depreciation, depletion, and/or impairment;
• current cost: concerning assets, this refers to the amount of cash or cash equivalents that would have to be paid to purchase the same or an equivalent asset today. Concerning liabilities, the current cost refers to the undiscounted amount of cash or cash equivalents that are required to settle the obligation today;
• realizable (settlement) value: realizable value refers to the amount of cash or cash equivalents that could currently be obtained by selling an asset in an orderly disposal. Concerning liabilities, settlement value refers to the undiscounted amount of cash or cash equivalents that are expected to be paid to satisfy the liabilities in the normal course of business;
• present value: concerning assets, this refers to the present discounted value of the future net cash inflows that an asset is expected to generate during the normal course of business. In regard to liabilities, PV refers to the present discounted value of the future net cash outflows that will likely be required to settle the liabilities of the normal course of business; and
• fair value: this refers to the amount at which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction.

Question

According to the Conceptual Framework (2010), which of the following are the two fundamental qualitative characteristics that make financial information useful?

1. Timeliness and understandability.
2. Relevance and faithful representation.
3. Accrual accounting and going concern.

Solution

The correct answer is B.

The Conceptual Framework (2010) identifies relevance and faithful representation as the two fundamental qualitative characteristics which make financial information useful.

‘Timeliness’ and ‘understandability’ are two of the enhancing qualitative characteristics of information, while ‘accrual accounting’ and ‘going concern’ are the underlying assumptions identified by the Conceptual Framework (2010).

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