The Conceptual Framework for Financial Reporting

Conceptual Framework
Financial Reporting is concerned with providing information that is useful to users for economic
decision making. Conceptual framework for financial reporting is a set of theoretical principles that
is applied in the development of financial reporting standards.

The purpose of a conceptual framework is to provide a basic structure for answering some of the
fundamental questions of financial reporting such as:
- What is the purpose of preparing financial statements?
- For whom are the statements prepared?
- What are their information requirements?
- What statements should be produced?

The conceptual framework provides a basis on how transactions and events that have taken place to
be recognise how they should be measured and how the information should be presented to the
users of the financial statements. Having an agreed conceptual framework would mean that
financial reporting standard setting will be on a consistent bases to formulate financial reporting
standards.

Both the ASB of UK and the IASB of the IASCF based their accounting standards and financial
reporting standards on a conceptual framework. Whereas in the USA, the FASB’s accounting
standards are based on specific rules rather than general principles.

The arguments in favour for having a conceptual framework are:

(i) It enables accounting standards to be developed on agreed principles.
This should avoid accounting professions and national standards setter from establishing
conflicting accounting rules and practices.
(ii) The standard-setting process would be more difficult to be influenced by ‘vested
interest’ (eg large plc, business sectors).
(iii) As transactions become more complex and sophisticated it helps preparers and auditors
to deal with transactions which are yet to be covered by of an accounting standard.
(iv) Its fundamental principles do not have to be repeated within each of the accounting
standards, such as the term ‘fair value’.
(v) Lack of a conceptual framework may mean that certain critical issues are not addressed,
eg until recently there was no definition of basic terms such as ‘asset’, ‘liability’, ‘equity’,
‘income’ and ‘expense’.

The most important conceptual framework is that of the IASB’s Framework for the Preparation and
Presentation of Financial Statements.
The IASB’s Framework consists of the following sections:
The objective of financial statements
Underlying assumptions
Qualitative characteristics of financial statements
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

Recent examination questions set on IASB’s Framework are as below:

2008 Dec Q4 (a)
Define a liability and explain how definition of liabilities enhances the reliability of financial
statements. (5 marks)

2008 June Q4
(a) Briefly explain the meaning of each of the following concepts / assumptions.
Matching / accruals
Substance over form
Prudence
Comparability
Materiality (5 marks)

(b) Illustrate with examples how each of the above concept / assumptions may be applied to
accounting for inventory. (10 marks)

Pilot paper Q4 (a)

Explain what is meant by relevance, reliability and comparability and how they make financial
information useful. (9 marks)

2006 June Q3
(a) Explain the purpose and authoritative status of the Framework. (5 marks)
(b) State the definitions and recognition criteria for assets and liabilities and explain the
important aspects of their definitions. Explain why these definitions are of particular
importance to the preparation of an entity’s statement of financial position and statement
of comprehensive income. (8 marks)
IASB’S Framework for the Preparation and Presentation of
Financial Statements
Purpose and Status
Framework sets out the concepts that underlie the preparation and presentation of financial
statements for external users.
Why is a framework needed?
- To provide direction and structure to the financial accounting and reporting.
- Provides a sound and unified conceptual underpinning that provides direction and the
means for deciding whether one solution to a financial reporting issue is better than the
others.
- Provides unity and consistency as without a set of unified concepts, standard setters are like
a ship in a storm without an anchor.
- Without the guidance by the framework, standard setting becomes based on the (unstated)
concepts held by individual board members.
The purpose of the Framework is to:
(i) Assist the Board of IASC in development of future IFRSs and in its review of existing
IFRSs.
(ii) Assist the Board of IASC 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 IAS.
(iii) Assist national standard-setting bodies in developing national standards.
(iv) Assist preparers of financial statement in applying IFRSs and in dealing with topics that
have yet to form the subject of an International Accounting Standard.
(v) Assist auditors in forming an opinion as to whether financial statements conform with
IFRSs.
(vi) Assist users of financial statements in interpreting the information contained in financial
statements prepared in conformity with the IFRSs.
The framework is not an International Accounting Standard and hence does not define standards for
any particular measurement or disclosure. Nothing in this Framework overrides any specific IAS.

Advantages of a conceptual framework

There are a variety of arguments for having a conceptual framework. It enables accounting
standards and generally accepted accounting practice (GAAP) to be developed in accordance with
agreed principles.
(i) It avoids ‘fire-fighting’, whereby accounting standards are developed in a piecemeal way
in response to specific problems or abuses.
(ii) ‘Fire-fighting’ can lead to inconsistencies between different accounting standards and
between accounting standards and legislation.
(iii) Lack of a conceptual framework may mean that certain critical issues are not addressed,
e.g. until recently there was no definition of basic terms such as ‘asset’ or ‘liability’ in any
accounting standard.
 (iv) As transactions become more complex and businesses become more sophisticated it
helps preparers and auditors of accounts to deal with transactions which not the subject
of an accounting standard.
(v) Accounting standards based on principles are thought to be harder to circumvent.
(vi) A conceptual framework strengthens the credibility of financial reporting and the
accounting profession.
(vii) It makes it less likely that the standard-setting process can be influenced by ‘vested
interests’ (eg large companies /business sectors).

Scope
The framework deals with:
(a) The objective of financial statements
(b) The qualitative characteristics that determine the usefulness of information in financial
statements
(c) The definition, recognition and measurement of the elements from which financial
statements are constructed
(d) Concepts of capital and capital maintenance

The framework is concern with financial statements, including consolidated financial statements.
These are presented at least annually, and are directed toward the needs of a wide range of users.

Financial statements form part of the process of financial reporting. A complete set of financial
statements normally includes:
(i) A statement of financial position
(ii) A statement of comprehensive income
(iii) A statement of changes in equity
(iv) Notes, and other statements and explanatory material, that are an integral part of the
financial statements.

Users and their information needs

The users of financial statements include present and potential investors, employees, lenders,
suppliers and other trade creditors, customers, governments and the public. They use financial
statements in order to satisfy some of their different needs for information. These needs include the
following:
(a) Investors
The providers of risk capital and their advisers. They need information to help them determine
whether they should buy, hold or sell. Shareholders are also interested in information which
enables them to assess the ability of the entity to pay dividends.
(b) Employees
Employees and their representative groups are interested in information about the stability and
profitability of their employers. The ability of the entity to provide remuneration, retirement
benefits and employment opportunities.
(c) Lenders
Lenders are interested in information that enables them to determine whether their loans, and
the interest attaching to them, will be paid when due.
 (d) Suppliers and other trade creditors
They are interested in information that enables them to determine whether amounts owing to
them will be paid when due.
(e) Customers
Customers have an interest in information about the continuance of an entity, especially when
they have a long-term involvement with, or are dependent on, the entity.
(f) Governments and their agencies
They require information in order to regulate the activities of entities, determine taxation and as
the basis for national income and similar statistics.
(g) Public
Entities affect members of the public in a variety of ways.

The Objective of Financial Statements

The objective of financial statements is to provide information about the financial position,
performance and changes in financial position of an entity that is useful to a wide range of users in
making economic decisions.
Financial statements show the results of the stewardship of management.

Financial position, performance and changes in financial position

The economic decisions that are taken by users of financial statement s require an evaluation of the
ability of an entity to generate cash and cash equivalents and of the timing and certainty of their
generation.
The financial position of an entity is affected its financial structure, its liquidity and solvency, and its
capacity to adapt to changes in the environment in which it operates.
Information about liquidity and solvency is useful in predicting the ability of the entity to meet its
financial commitments as they fall due. Liquidity refers to the availability of cash in near future after
taking account of financial commitments over this period. Solvency refers to the availability of cash
over the longer term to meet financial commitments as they fall due.
Information about the performance of an entity, in particular its profitability, is required in order to
assess potential changes in the economic resources that it is likely to control in the future.
Information concerning changes in the financial position of an entity is useful in order to assess its
investing, financing and operating activities during the reporting period. This information is useful in
providing the user with a basis to assess the ability of the entity to generate cash and cash
equivalents and the needs of the entity to utilise those cash flows.

Notes and supplementary schedules

The financial statements also contain notes and supplementary schedules and other information.
They may include disclosures about the risks and uncertainties affecting the entity and any resources
and obligations not recognised in the statement of financial position.
Underlying Assumptions
Preparation of financial statements
There are two important assumptions that the users of financial statements have:
(1) Accrual basis
 Accrual accounting has been used when recording transactions.
 Under the accrual basis, the effects of transactions and other events are recognised when
they occur (and not as cash or its equivalent is received or paid) and they are recorded in the
accounting records and reported in the financial statements of the periods to which they
relate.
 Example: In November, you sell some goods on credit. You receive cash from your client in
January. You record the sale in November, not when you receive the cash.

(2) Going concern

 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. It is assumed that the
entity has 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.
 Example: Banks provide loans under specific conditions, including the financial performance
of clients. A breach of these conditions may enables the bank to liquidate the client. In
these circumstances, unless the client can secure an alternative source of finance, financial
statements should not be prepared on a going concern basis.

Qualitative Characteristics of Financial Statements

The four principal qualitative characteristics of financial statements are understandability,
relevance, reliability and comparability.

(1) Understandability
The users are assumed to have a reasonable knowledge of business and economic activities
and accounting and a willingness to study the information with reasonable diligence.

(2) Relevance
Information has the quality of relevance when it influence the economic decisions of users
by helping them evaluate past, present or future events or confirming, or correcting, their
past evaluations.
Relevant information has predictive value, confirmatory value or both.
Confirmatory value - confirming the validity of prior predictions or correcting them.
Predictive value – users forming their own expectations about the future.
That is not to say the financial statements should be predictive in the sense of forecasts, but
that (past) information should be presented in a manner that assists users to assess an
entity’s ability to take advantage of opportunities and react to adverse situations.

(3) Materiality
 The relevance of information is affected by its nature and materiality. In some cases, the
nature of information alone is sufficient to determine its relevance. For example, the
reporting of a new segment may affect the assessment of the risks and opportunities facing
the entity irrespective of the materiality of the results achieved by the new segment in the
reporting period.
Information is material if its omission or misstatement could influence the economic
decisions of users taken on the basis of the financial statements.
Materiality depends on the size of the item (or error) judged in the circumstances of its
omission (or misstatement).

(4) Reliability
Information has the quality of reliability when it is free from material error and bias and can
be depended upon by users to represent faithfully that which it either purports to represent.

Faithful representation
To be reliable, information must represent faithfully the transactions and other events it
either purports to represent or could reasonably be expected to represent.
For example, a statement of financial position should represent faithfully the transactions
and other events that result in assets, liabilities and equity of the entity at the reporting date
which meet the recognition criteria.

Substance over form

If information is to represent faithfully the transactions, it is necessary that they are
presented in accordance with their substance, and economic reality, and not merely their
legal form. There can be occasion where the legal form of a transaction can be engineered
to disguise the economic reality of the transaction.

Neutrality
To be reliable, the information contained in financial statements must be neutral, that is,
free from bias.
Financial statements are not neutral if, by the presentation of information, they influence
the making of a decision to achieve a predetermined result, or outcome.

Prudence
Uncertainties that inevitably surround many events and circumstances, such as collectability
of doubtful receivables, the probable useful life of plant and the number of warranty claims
that may occur.
Prudence is the inclusion of a degree of caution in the exercise of the judgements needed in
making the estimates required under condition of uncertainty.
However, the exercise of prudence does not allow, for example, the creation of hidden
reserve or excessive provisions.

Completeness
To be reliable, the information in financial statements must be complete within the bounds
of materiality and cost. An omission can cause information to be false or misleading and
thus unreliable and deficient in terms of its relevance.
Comparability
Users must be able to compare the financial statements of an entity through time in order to
identify trends in its financial position and performance. This is the principal reason why
financial statements contain corresponding amounts for previous period.
Users must also be able to compare the financial positions of different entities in order to
evaluate their relative financial position, performance and changes in financial position.
Hence the measurement and display of the financial effect of like transactions and other
events must be carried out in a consistent way throughout an entity and over time for that
entity and in a consistent way for different entities.
An important implication of comparability is that users be informed of the policies employed
in the financial statements, any changes in those policies, and the impacts of such changes.

What are financial Statements

There are three financial statements:
1. Measurement of financial position
2. The measurement of performance
3. The measurements of the changes in financial position

1. Financial Position – Statement of Financial Position

The elements directly related to the measurement of financial position are assets, liabilities
and equity.
(a) 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 into the entity.
(b) 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
benefit.
(c) Equity is the residual interest in the assets of the entity after deducting all its liabilities.

Assets
The future economic benefit embodied in an asset is its potential contribution (directly, or indirectly)
to the flow of cash to the entity.
The potential contribution may be a productive one that is part of the operating activities of the
entity such as producing inventories. It may also take the form of convertibility into cash (or a
capability to reduce the costs of production).
Assets are employed to produce goods (or services) capable of satisfying the wants (or needs) of
customers; customers are prepared to pay for them, and contribute to the cash flow of the entity.
Many assets, for example, property, plant and equipment, have a physical form. Physical form is not
essential to the existence of an asset; hence patents and copyrights are assets, if benefit will flow
from them, and if they are controlled by the entity.
Many assets for example receivables are associated with legal right including the right of ownership.
In determining the existence of an asset, the right of ownership is not essential.
Example: Property held on a lease is an asset, if the entity controls the benefits that will flow from
the property.
An entity may satisfy the definition of an asset, even when there is no legal control.
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 flow from it.
The assets of an entity result from past transactions. Entities normally obtain assets by purchasing
or producing them, but other transactions may generate assets for example property received by an
entity from government, as part of a program to encourage growth in an area.
Example: To generate employment in a depressed area, government may provide a range of grants.
One option is to provide disused property to investors either free or at a low price.
Transactions expected to occur in the future do not in themselves give rise to assets; 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 expenditures, this may provide evidence that
benefits were sought, but is not conclusive proof that an item satisfying the definition of an asset has
been obtained.

Liabilities
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 enforceable as a
consequence of a binding contract, or statutory requirement. This is normally the case with
amounts payable for goods and services received.
Obligation also arise from normal business practice, custom and a desire to maintain good business
relations, or act in an equitable manner.
Example: If an entity decides as a matter of policy to rectify faults in its products, even 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 a present obligation and a future commitment. A decision by the
management of an entity to acquire assets in 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. The irrevocable nature of an agreement means that the
entity has no choice but pay.
Settlement of a present obligation may occur in a number of ways, for example, by:
(a) Payment of cash
(b) Transfer of other assets
(c) Provision of services
(d) Replacement of that obligation with another obligation
(e) Conversion of the obligation to equity
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, as the concept of a liability is defined narrowly so as to exclude estimates. IFRS definition
of a liability follows a broader approach.
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.
Example: You have been sued. You have lost the case. Your total costs are not finalised. When the
accounts are approved, you have estimated your provision for the costs of the liability.
Examples include provisions for payments to be made under existing warranties and provisions to
cover pension obligations.

Equity
Although equity is defined as a residual, it may be sub-classified in the statement of financial
position. In a corporate entity,
- Funds contributed by shareholders
- Retained earnings
- Reserves representing appropriations of retained earnings
- Reserves representing capital maintenance adjustments may be shown separately.
The creation of reserves is sometimes required by statute, to give the entity, and its creditors, more
protection from the impacts of losses.
The amount at which equity is shown in the statement of financial position is dependent on the
measurement of assets and liabilities.

2. Performance – Income Statement

Profit
Profit is 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 concept of capital and capital maintenance used by the entity in preparing its
financial statements.

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 decrease of liabilities that result in increase in equity, other
than those relating to contributions from equity participants.
(b) Expenses are decreases in benefits during the accounting period in the form of outflows or
depletions of assets or incurrence of liabilities that result in decrease in equity, other than
those relating to distributions to equity participants.

Income and expenses may be presented in the income statement in different ways, to provide
information for decision making. It is common practice to distinguish between those items of
income and expenses that arise in the course of the ordinary activities, and those that do not.

This distinction is made for evaluating the ability to generate cash in the future. Incidental activities,
such as the disposal of long-term investment, do not recur on a regular

Income
Income encompasses both revenue and gains. Revenue arises from the ordinary activities of an
entity, and includes:
- Sales
- Fees
- Interest
 - Dividends
- Royalties
- Rent
Gains represent other items of income, and may (or may not) arise in the course of the ordinary
activities of an entity. Gains represent increases in benefits, and are no different in nature from
revenue.
Gains include those arising on the disposal of non-current assets. The definition of income also
includes unrealised gains: those arising on revaluations of marketable securities, and from increases
in the carrying amount of long term assets.
When gains are recorded in the income statements, they are displayed separately, because
knowledge of them is useful for decisions. Gains are often reported net of related expenses.
Various kinds of assets may be received (or enhanced) by income: cash, receivables, and goods (and
services) received in exchange for goods (and services) supplied.
Income may also result from the settlement of liabilities. An entity may provide goods (and services)
to a lender, in settlement of an outstanding loan.

Expenses
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 include 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.
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.
Losses include those resulting from disaster 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 increases in the rate of exchange for exchange for a foreign currency, in
respect of the borrowings of an entity in that currency.
When losses are recorded in the income statement, they are usually displayed separately, as
knowledge of them is useful for decisions. Losses are often reported net of related income.

Recognition of the Elements of Financial Statements

Recognition is the process of incorporating in the statement of financial position or income
statement and item that meets the definition of an element and satisfies the criteria for recognition.
An item that meets the definition of an element should be recognised if:
(a) It is probable that any future economic benefit associated with the item will flow to or from
the entity
 The concept of probability refers to the degree of uncertainty that the benefits associated
with the item will flow to (or from) the entity. Assessment of the uncertainty of the flow of
benefits are made on the evidence available, when the financial statements are prepared.
  When it is probable that a receivable will be paid, it is justifiable to record the receivable as
an asset. For a large population of receivables, some degree of non-payment is normally
considered probable; hence an expense representing the expected reduction in benefits is
recorded.

(b) The item has a cost or value that can be measured with reliability.
 Cost or value may be estimated, the use of reasonable estimate is part of the preparation of
financial statements and does not undermine their reliability.
 When a reasonable estimate cannot be made, the item is not recorded in the financial
statement position or income statement. The expected proceeds from a lawsuit may meet
the definitions of both an asset, and income, as well as the probability criterion for
recognition.
 If the claim cannot be measured reliably, it should not be recorded as an asset, or as income;
the existence of the claim should be disclosed in the notes, explanatory material or
supplementary schedules.

Recognition of Assets
An asset is recorded when it is probable that the benefits will flow to the entity, and the asset has a
cost (or value) that can be measured reliably.
An asset is not recorded in SOFP when costs have been incurred, but for which it is improbable that
benefits of this expenditure will flow beyond the current accounting period. Such a transaction
results in the recognition of an expense in the income statement.

Recognition of Liabilities
A liability is recognised in the statement of financial position 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.

Recognition of Income
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, if effect, that recognition of income occurs simultaneously with the recognition of increases
in assets or decreases in liabilities.

Recognition of Expenses
Expenses are recognised in the income statement when a decrease in future economic benefits
related to a decrease in an asset or an increase of a liability has arisen that can be measured reliably.
This means, in effect, that recognition of expenses occurs simultaneously with the recognition of an
increase in liabilities or a decrease in assets.
An expense is also recognised in the income statement in those cases when a liability is incurred
without the recognition of an asset, as when a liability under a product warranty arises.
Measurement of the Elements of Financial Statements
Measurement is the process of determining the monetary amounts at which the elements of the
elements of the financial statements are to be recognised and carried in the statement of financial
position and income statement.

A number of different measurement bases are employed in financial statements. They include the
following:
(a) Historical Cost (OLD)
Assets are recorded at the amount of cash paid or the fair value of the consideration given
to acquire them at the time of their acquisition. Liability are recorded at the amount of
proceeds received in exchange for the obligation, or at the amounts of cash expected to be
paid to satisfy the liability in the normal course of business.
Historical cost less accumulated depreciation = Net book value

(b) Current cost (BUY)

Assets are carried at the amount of cash that would have to be paid if the same asset was
acquired currently. Liabilities are carried at the undiscounted amount of cash or cash
equivalents that would be required to settle the obligation currently.
Gross replacement cost less accumulated depreciation = Net replacement cost

(c) Realisable (settlement) value (SELL)

Assets are carried at the amount that could currently be obtained by selling the asset (in the
normal course of business). It is the expected price less any cost still to be incurred in
getting the item ready for sale and then selling it. Liabilities are carried at their settlement
values: the undiscounted amounts to be paid to satisfy the liabilities, in the normal course of
business.
Expected selling price less expected cost of disposal.

(d) Present value / Economic value (KEEP and USE)

Assets are carried at the present discounted value of the net cash inflows that the item will
generate, in the normal course of business. Liabilities are carried at the present discounted
value of the net cash outflows, which will be required to settle the liabilities, in the normal
course of business.

The measurement basis most commonly used is historical cost. This is usually combined with
other bases. Inventories are usually carried at the lower of cost and net realisable value,
marketable securities may be carried at market value and pension liabilities are carried at their
present value.

Some entities use the current cost basis, due to the inability of the historical cost accounting to
deal with the impact of inflation of non-monetary assets.

Example
Asset values
A company owns a machine which it purchased four years ago for $100,000. The accumulated
depreciation on the machine to date is $40,000. The machine could be sold to another manufacturer for
$50,000 but there would be dismantling costs of $5,000. To replace the machine with a new version
 would cost $110,000. The cash flows from the existing machine are estimated to be $25,000 for the next
two years followed by $20,000 per year for the remaining four years of the machine’s life.
The relevant discount rate for this company is 10% and the DFs are:
Year 1 0.909
Year 2 0.826
Year 3-6 inclusive 2.619 (annuity rate)
Calculate the following values for the machine:
(a) Historical cost
(b) NRV
(c) Replacement cost
(d) Economic value

Concepts of Capital Maintenance and the Determination of Profit

Concepts of Capital
A financial concept of capital is adopted by most entities in preparing their financial statements.
Under a financial concept of capital, such as invested money, or invested purchasing power, capital
is synonymous with the net assets (or equity) of the entity.
Example : financial concept of capital
Your national inflation = 10% per year. If an investment in your company yields less than 10%,
investors’ purchasing power will have fallen.
If you provide a return of more than 10%, investors will deduct their loss of purchasing power from
the return that you have generated.
In summary, only returns above the national rate of inflation will be considered to be profits.

Under a physical concept of capital, such as operating capability, capital is regarded as the
productive capacity of the entity, based on units of output.
Example: physical concept of capital
Your national inflation = 10% per year. However, oil is your basic raw material, and your costs have
increased by 25%.
If an investment in your company yields less than 25%, the company’s operating capability will have
fallen.
In summary, only returns above the company’s rate of inflation will be considered to be profits.

The selection of the appropriate concept of capital by an entity should be based on the needs of
users. A financial concept of capital should be adopted if the users are primarily concerned with the
maintenance of nominal invested capital, or the purchasing power of invested capital.
If the main concern of users is with the operating capability of the entity, a physical concept of
capital should be used.
The concept chosen indicates the goal to be attained in determining profit, even though there may
be some measurement difficulties in making the concept operational.