Chapter 1 Framework

chapter 1
Conceptual and regulatory

framework
Contents
Introduction
Examination context
Topic List
1 Financial statements
2 Purpose and use of financial statements
3 Bases of accounting
4 BFRS Framework
5 International Accounting Standards Committee
Foundation (IASCF)
6 Bangladesh Financial Reporting Standards (BFRS)
7 Inherent limitations of financial statements
8 Not-for-profit entities
Summary and Self-test
Technical reference
Answers to Self-test
Answers to Interactive questions
© The Institute of Chartered Accountants in England and Wales, March 2009 1

Financial accounting
Introduction
Learning objectives Tick off

 Explain the nature of financial reporting
 Explain the objectives of financial statements

 Discuss the conceptual and regulatory framework affecting the preparation of financial
statements
 Discuss the importance of BFRS Framework
 Apply the principles of BFRS Framework, including the qualitative characteristics of financial
information, the elements of financial statements, recognition and measurement of the
elements
 Explain and demonstrate the differences between financial statements produced using:
– The accrual basis
– Cash accounting
– The break-up basis
 Explain and illustrate the different definitions of capital and capital maintenance
 Explain the regulatory framework affecting not-for-profit entities

Specific syllabus references for this chapter are: 1a, b, c, d, e, f, 2e.
Practical significance
The way that items and transactions are treated and presented in the financial statements may affect an
investor's perception of the position and performance of an entity. Whilst individual accounting standards
can be developed to deal with specific issues it is also important that there is a framework that sets out the
wider purposes that accounting standards are intended to achieve. This helps to ensure that standards are
consistent and not overly affected by political influence or self-interest groups. The International Accounting
Standards Board's Framework for the Preparation and Presentation of Financial Statements (IASB Framework),
which has been adopted by ICAB without any changes is known as BFRS Framework. The framework
attempts to provide this framework in the context of International Accounting Standards and International
Financial Reporting Standards (jointly referred to from this point as 'IFRS'/ BFRS in Bangladesh). It does so
by setting out consistent principles which form the basis for the development of detailed requirements in
IFRS.
Stop and think

What do you think are the advantages of a principles based approach to the setting of accounting standards?
Working context
In the working environment you are unlikely to be consciously aware of the effect of the issues covered by
this chapter. They are important nevertheless as these principles underpin all the financial statements which
you will prepare or audit.
2 © The Institute of Chartered Accountants in England and Wales, March 2009

CONCEPTUAL AND REGULATORY FRAMEWORK 1
Syllabus links
The issues covered by this chapter and particularly the principles introduced by BFRS Framework are a
fundamental part of the Financial Accounting syllabus.
Throughout the rest of the text we will make reference to the way that the Framework affects the way that
specific transactions are accounted for and presented. These principles will be further developed in Financial
Reporting and at the Advanced Stage.

Examination context
Exam requirements
Accounting and reporting concepts constitute 10% of the syllabus. This area of the syllabus is likely to be
examined in the written test section of the paper in conjunction with another topic, rather than in its own
right. For example, in a question on tangible non-current assets you could be asked to consider how the
definition of an asset affects the recognition of certain expenses as capital or revenue items. Part (a) of
question 4 in the sample paper required an explanation and discussion of the concept of substance over
form in the context of the topic of leasing.
You could also be asked to discuss the objectives of financial information and the qualitative characteristics
which make information useful. Again this would typically be part (b) or (c) of a longer question rather than
the main focus of the question.
Alternatively, or in addition, this topic could be examined in the short-form questions in the paper.
In the examination, candidates may be required to:
 Discuss the purpose of accounting regulations and standards for both profit-making and not-for-profit
entities
 Explain, with examples, the objectives of financial statements
 Explain the qualitative characteristics of financial information and the constraints on such information
 Describe the financial effects of the application of the definitions of BFRS Framework
 Perform simple calculations to demonstrate the difference between the accrual basis, cash accounting
and the break-up basis
 Explain the different concepts of capital maintenance

1 Financial statements
Section overview
 In Bangladesh financial statements must:
– Be prepared in accordance with Companies Act and BFRS
– Give a true and fair view
1.1 What is financial accounting?

Financial accounting is the process of identifying, measuring and communicating economic information to
others so that they may make decisions on the basis of that information and assess the stewardship of the
entity's management.
Financial accounting involves:
 Recording transactions undertaken by a business entity
 Grouping similar transactions together which are appropriate to the business
 Presenting periodic results.
The Financial Accounting syllabus focuses on the preparation of published financial information. Typically,
this information is made available annually or half-yearly (sometimes quarterly) and is presented in formats
laid down or approved by governments in each national jurisdiction. (The Financial Reporting syllabus deals
with more complex reporting issues and analysis and interpretation.)
By contrast, management accounting or reporting is internal reporting for the use of the
management of a business itself. Internal management information can be tailored to management's own
needs and provided in whatever detail and at whatever frequency (e.g. continuous real-time information)
management decides.
General principles relating to financial accounting are set out in BFRS Framework for the Preparation and
Presentation of Financial Statements (Framework), which is explained further below.
1.2 Entity
Most accounting requirements are written with a view to use by any type of accounting entity, including
companies and other forms of organisation, such as partnership. In this text, the term 'company' is often
used, because the main focus of the Financial Accounting syllabus is on the accounts of companies and
groups of companies.
1.3 Financial statements

The principal means of providing financial information to external users is the annual financial statements.
Financial statements are the accountant's summary of the performance of an entity over a particular period
and of its position at the end of that period.
A complete set of financial statements comprises:
 The balance sheet (a statement of financial position)
 The income statement (a statement of financial performance)
 The statement of changes in equity (another statement of financial performance)
 The statement of changes in financial position (usually in the form of a cash flow statement)
 Notes to the financial statements
The notes to the financial statements include:
 Accounting policies, i.e. the specific principles, conventions, rules and practices applied in order to
reflect the effects of transactions and other events in the financial statements.

 Detailed financial and narrative information supporting the information in the primary financial
statements.
 Other information not reflected in the financial statements, but which is important to users in making
their assessments.
The individual elements that are included in the financial statements are covered in detail later in this chapter.
1.4 Requirement to produce financial statements

Limited liability companies are required by law to prepare and publish financial statements annually. The
form and content may be regulated primarily by national legislation, and in most cases must also comply
with Financial Reporting Standards.
In Bangladesh, all companies must comply with the provisions of the Companies Act 1994 (CA 1994).
The provisions of the Act are relevant for the purpose of the Financial Accounting exam and therefore this
Study Manual refers to the Companies Act 1994 throughout. The key impact of this is as follows:
 Every registered company is required to prepare a balance sheet and profit and loss account for
each financial year which gives a true and fair view.
 The financial statements must comply with Schedule XI to CA 1994 as regards format and
additional information provided by way of notes. Therefore the only disclosures covered by this
text in Chapter 2 are those currently contained in schedule XI.
 Specialised entities, such as financial institutions, insurance companies, co-operatives, NGOs and public
sector entities must comply with the rules, requirements of the relevant regulatory bodies.
1.5 Financial reporting standards

In most cases company financial statements must also comply with relevant Financial Reporting Standards
and other professional guidance. In Bangladesh these are as follows.
 Accounting Standards
These include Bangladesh Financial Reporting Standards (BFRSs which are issued by the
International Accounting Standards Board (IASB) as IASs and IFRSs and adopted by ICAB as
BASs and BFRSs.
These learning materials assume the preparation of financial statements in accordance with
BFRS.
1.6 True and fair view

In Bangladesh there is a Companies Act requirement that financial statements should present 'a true
and fair view.' This term is not defined in the Companies Act or Accounting Standards.
Truth is usually seen as an objective concept reflecting factual accuracy within the bounds of materiality.
Fairness is usually seen as meaning that the view given is objective and unbiased.
True and fair is usually defined in terms of accounting concepts. This means:
 Compliance with Accounting Standards (which can be overridden on true and fair grounds only
very rarely)
 Adherence to the requirements of the Companies Act 1994, including its true and fair
override (see below)
 In the absence of more specific requirements, application of general accounting principles and
fundamental concepts and, where appropriate, adherence to accepted industry practices.

Points to note
 CA 1994 uses the term 'a true and fair view' rather than 'the true and fair view' because it is possible
for there to be more than one true and fair view. For example, financial statements based on historical
cost can be true and fair, as can financial statements which incorporate revaluations.
 What constitutes a true and fair view can then be restricted by stating that where a choice of
treatments or methods is permitted, the one selected should be the most appropriate to the
company’s circumstances. This restriction is likely to ensure compliance with the spirit and underlying
intentions of requirements, not just with the letter of them.
 A further restriction is that financial statements should reflect the economic position of the company,
thereby reflecting the substance of transactions (i.e. commercial reality), not merely their legal
form. In most cases this will be achieved by adhering to Accounting Standards. (We will look at
substance in more detail in section 4 below).
 The equivalent international term to a true and fair view is 'fair presentation.' We will look at this in
detail in Chapter 2.
Section overview
 Financial statements are used to make economic decisions by a wide range of users.
 All users require information regarding:
– Financial position
– Financial performance, and
– Changes in financial position.
2.1 Users and their information needs

The form and content of financial statements must be influenced by the use to which they are put. Nearly
everybody using them does so when making economic decisions such as those to:
 Decide when to buy, hold or sell shares.
 Assess the stewardship or accountability of management.
 Assess an entity's ability to provide benefits to employees.
 Assess security for amounts lent to the entity.
Much of the information needed for these different decisions is in fact common to them all. Financial
statements aimed at meeting these common needs of a wide range of users are known as 'general
purpose' financial statements.
BFRS Framework identifies the following users of financial statements and their specific information
needs. (We will look at BFRS Framework in more detail in Section 4 of this chapter).
Users Need information to
Present and potential  Make investment decisions, therefore need information on:
investors
– Risk and return on investment
– Ability of entity to pay dividends
Employees  Assess their employer's stability and profitability
 Assess their employer's ability to provide remuneration,
employment opportunities and retirement and other benefits

Lenders  Assess whether loans will be repaid, and related interest will be
paid, when due
Suppliers and other trade  Assess the likelihood of being paid when due
payables
Customers  Assess whether entity will continue in existence – important
where customers have a long-term involvement with, or are
dependent on, the entity, e.g. where there are product warranties
or where specialist parts may be needed
Governments and their  Assess allocation of resources and, therefore, activities of entities
agencies
 Assist in regulating activities
 Assess taxation
 Provide a basis for national statistics
The public  Assess trends and recent developments in the entity's prosperity
and its activities – important where the entity makes a substantial
contribution to a local economy, e.g. by providing employment
and using local suppliers
In most cases the users will need to analyse the financial statements in order to obtain the information they
need. This might include the calculation of accounting ratios. (The calculation of accounting ratios and the
analysis of those ratios is covered in the Financial Reporting syllabus.)
2.2 Objective of financial statements

The objective of financial statements is to provide information about the reporting entity's financial
position and financial performance that is useful to a wide range of users in making economic
decisions.
This objective can usually be met by focusing exclusively on the information needs of present and potential
investors. This is because much of the financial information that is relevant to investors will also be relevant
to other users.
2.3 Accountability of management

Management also has a stewardship role, in that it is accountable for the safe-keeping of the entity’s
resources and for their proper, efficient and profitable use. Providers of risk capital are interested in
information that helps them to assess how effectively management has fulfilled this role, but again this
assessment is made only as the basis for economic decisions, such as those about investments and the
reappointment/ replacement of management.
Financial reporting helps management to meet its need to be accountable to shareholders, and also to other
stakeholders (e.g. employees or lenders), by providing information that is useful to the users in making
economic decisions.
However, financial statements cannot provide the complete set of information required for assessing the
stewardship of management (see section 7 ‘Inherent Limitations of Financial Statements’ later in this
chapter).
2.4 Financial position, performance and changes in financial position

All economic decisions are based on an evaluation of an entity’s ability to generate cash and of the timing
and certainty of its generation. Information about the entity’s financial position, performance and changes in
financial position provides the foundation on which to base such decisions.

2.4.1 Financial position

An entity's financial position covers:
 The economic resources it controls
 Its financial structure (i.e. debt and share finance)
 Its liquidity and solvency and
 Its capacity to adapt to changes in the environment in which it operates
Investors require information on financial position because it helps in assessing:
 The entity's ability to generate cash in the future
 How future cash flows will be distributed among those with an interest in, or claims on, the
entity
 Requirements for future finance and ability to raise that finance
 The ability to meet financial commitments as they fall due
Information about financial position is primarily provided in a balance sheet.
2.4.2 Financial performance

The profit earned in a period is used as the measure of financial performance, where profit is calculated as
income less expenses. Information about performance and variability of performance is useful in:
 Assessing potential changes in the entity's economic resources in the future
 Predicting the entity's capacity to generate cash from its existing resource base, and
 Forming judgements about the effectiveness with which additional resources might be employed.
Information on financial performance is provided by:
 The income statement, and
 The statement of changes in equity.
2.4.3 Changes in financial position

Changes in financial position can be analysed under the headings of investing, financing and operating
activities and are usually shown in a cash flow statement.
Cash flow information is largely free from the more judgemental allocation and measurement issues
(i.e. in which period to include things and at what amount) that arise when items are included in the balance
sheet or performance statements. For example, depreciation of non-current assets involves judgement and
estimation as to the period over which to charge depreciation. Cash flow information excludes non-cash
items such as depreciation.
Cash flow information is therefore seen as being factual in nature, and hence more reliable than other
sources of information.
Information on the generation and use of cash is useful in evaluating the entity’s ability to generate cash and
its needs to use what is generated.
2.4.4 Notes and supplementary schedules

Notes and schedules attached to financial statements can provide additional information relevant to
users, for example the non-current assets note (see Chapter 2).

3 Bases of accounting
Section overview
 There are four bases of accounting which you need to be familiar with:
– Accrual basis
– Going concern basis
– Cash basis
– Break-up basis
 The accrual basis of accounting and going concern are referred to by BFRS Framework as 'underlying
assumptions'.
3.1 Accrual basis

Under this basis of accounting, transactions are recognised when they occur, not when the related
cash flows into or out of the entity. You will be familiar with this basis from your Accounting studies.
Examples of the importance of this basis are as follows:
 Sales are recorded in the period in which the risks and rewards of ownership pass from seller
to buyer, not when the seller receives full payment. While this basis has no effect on the timing of the
recognition of cash sales, it does mean that credit sales are recorded earlier than if the cash basis of
accounting was used. When credit sales are recognised, a receivable is set up in the entity's books.
 Expenses are recognised in the period when the goods or services are consumed, not when
they are paid for. An amount payable will be set up in the entity's books for credit purchases, again
leading to earlier recognition than if the cash basis was used.
 The consumption of non-current assets, such as plant and machinery, is recognised over the period
during which they are used by the entity (i.e. the asset is depreciated), not in the year of
purchase as they would be under the cash basis of accounting.
Financial statements prepared on this basis provide information both about past transactions involving cash
and about future resources flowing into the entity (when customers pay up) and flowing out of it (when
suppliers are paid). They are therefore more useful for the making of economic decisions than those
produced on the cash basis.
3.2 Going concern basis

The accrual basis of accounting assumes that an entity is a going concern. Under this basis, financial
statements are prepared on the assumption that the entity will continue in operation for the
foreseeable future, in that management has neither the intention nor the need to liquidate the entity by
selling all its assets, paying off all its liabilities and distributing any surplus to the owners. Examples of the
importance of this basis are as follows:
 The measurement of receivables from trade customers is made on the basis that there is no time
limit over which management will chase slow payers. If the entity were to cease operation in,
say, three months, a number of balances might have to be regarded as bad debts
 The measurement of non-current assets is made on the basis that they can be utilised throughout
their planned life. Otherwise, they would have to be valued at what they could immediately be sold
for, which might not be very much, in the case of assets used in markets where there is excess
capacity.
The accrual basis and going concern are referred to by BFRS Framework as 'underlying assumptions'.
3.3 Cash basis

The cash basis of accounting is not used in the preparation of a company balance sheet and income
statement as it is not allowed by BFRS, although the cash effect of transactions is presented in the form of a

cash flow statement. (We will look at the cash flow statement in Chapter 3.) The cash basis may be used
however, for small unincorporated entities, for example clubs and societies.
In many ways the cash basis of accounting is very simple. Only the cash impact of a transaction is
recorded. Examples of the impact of this are as follows:
 Sales are recorded in the period in which the seller receives full payment. For credit sales this will
delay the recognition of the transaction.
 Purchases are recorded in the period in which goods are paid for rather than the period in which the
goods are purchased. For credit purchases this will delay the recognition of the purchase.
 The purchase of a capital asset is treated as a cash outflow at the point that the cash consideration is
paid. No subsequent adjustment is made for depreciation as this has no impact on the cash balance of
the business.
Worked example: Comparison of accrual basis and cash basis

Joe Co buys 100 T-shirts in January at CU3.50 each. The purchase is made for cash. During January 30
T-shirts are sold for cash at CU7.00 each.
Using accrual based accounting the results for January would be as follows:
CU CU
Revenue (30 × CU7) 210
Cost of sales
Purchases (100 × CU3.50) 350
Closing inventory (70 × CU3.50) (245)
(105)
Profit 105
Using cash accounting the results for January would be as follows:

CU
Revenue (30 × CU7) 210
Cost of sales (100 × CU3.50) (350)
Loss (140)
Notice that there is an overall loss of CU140 using cash accounting even though there is a profit for the
month of CU105 using the accrual basis. The difference of CU245 is the value of the closing inventories
which is carried forward as an asset under accrual based accounting.
3.4 Break-up basis

As we saw in section 3.2 one of the key assumptions made in accrual based accounting is that the business
will continue as a going concern. However, this will not necessarily always be the case. There may be an
intention or need to sell off the assets of the business. Such a sale typically arises where the business is in
financial difficulties and needs the cash to pay its creditors. Where this is the case an alternative method
of accounting must be used (in accordance with BAS 1 Presentation of Financial Statements). In these
circumstances the financial statements will be prepared on a break-up basis. The effect of this is seen
primarily in the balance sheet as follows:
 Classification of assets
All assets and liabilities would be classified as current rather than non-current.
 Valuation of assets
Assets would be valued on the basis of the recoverable amount on sale. This is likely to be
substantially lower than the carrying amount of assets held under historical cost accounting.

4 BFRS Framework
Section overview
 BFRS Framework for the Preparation and Presentation of Financial Statements (Framework) is the
conceptual framework upon which all BASs and BFRSs are based. It determines:
– How financial statements are prepared, and
– The information they contain.
4.1 Conceptual Framework

The Framework consists of a Preface and an Introduction followed by a number of chapters:
 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
In this chapter we have already introduced some of the concepts dealt with by the Framework.
We will now look specifically at each section in turn.
4.2 Preface
The Preface to the Framework points out the fundamental reason why financial statements are produced
worldwide, i.e. to satisfy the requirements of external users, but that practice varies due to the
individual pressures in each country. These pressures may be social, political, economic or legal, but they
result in variations in practice from country to country including:
 The form of the statements
 The definition of their component parts (assets, liabilities, etc)
 The criteria for recognition of items
 Scope and disclosure of financial statements.
It is these differences which the IASB wishes to narrow by harmonising all aspects of financial statements,
including the regulations governing accounting standards and their preparation and presentation.
The Preface also emphasises the way the financial statements are used to make economic decisions. We
looked at these decisions previously in Section 2.1.
4.3 Introduction
The Introduction provides a list of the purposes of the Framework:
 Provide those who are interested in the work of the IASB with information about its approach to
the formulation of IASs (now IFRSs).
 Assist the Board of the IASB in the development of future IASs and in its review of existing IASs.
 Assist the Board of the IASB 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 IASs.
 Assist national standard-setting bodies in developing national standards.
 Assist preparers of financial statements in applying IASs and in dealing with topics that have yet to
form the subject of an IAS.
 Assist auditors in forming an opinion as to whether financial statements conform with IASs.

 Assist users of financial statements in interpreting the information contained in financial

statements prepared in conformity with IASs.
The Framework is not an IFRS and so does not overrule any individual IFRS. In the (rare) case of conflict
between an IFRS and the Framework, the IFRS will prevail. These cases will diminish over time as the
Framework will be used as a guide in the production of future IFRSs. The Framework itself will be revised
occasionally depending on the experience of the IASB in using it.
The Introduction also considers users and their information needs. We have already looked at this in
section 2.1 of this chapter.
4.4 Qualitative characteristics of financial statements

4.4.1 Overview
The Framework states that qualitative characteristics are the attributes that make the information provided
in financial statements useful to users.
The four principal qualitative characteristics are understandability, relevance, reliability and
comparability.
The key issues can be summarised as follows:
Qualitative characteristics
Understandability Relevance Reliability Comparability
Nature Materiality Consistency Disclosure

Faithful Substance over Prudence Completeness
representation form
Constraints
Timeliness Cost v benefit Balance between

characteristics
Results in fair
presentation
4.4.2 Understandability
Users must be able to understand financial statements. They are assumed to have some business, economic
and accounting knowledge and to be able to apply themselves to study the information properly. Complex

matters should not be left out of financial statements simply due to its difficulty if it is relevant
information.
4.4.3 Relevance
Relevant information is both predictive and confirmatory. These roles are interrelated.
Definition
Relevance: Information has the quality of relevance when it influences the economic decisions of users by
helping them evaluate past, present or future events or confirming, or correcting, their past evaluations.
Information on financial position and performance is often used to predict future position and performance
and other things of interest to the user, e.g. likely dividend, wage rises. The manner of presentation will
enhance the ability to make predictions, e.g. by highlighting unusual items.
Materiality
The relevance of information is affected by its nature and its materiality.
Definition
Materiality: Information is material if its omission or misstatement could influence the economic decisions
of users taken on the basis of the financial statements.
Information may be judged relevant simply because of its nature (e.g. remuneration of management). In
other cases, both the nature and materiality of the information are important. Materiality is not a primary
qualitative characteristic itself (like reliability or relevance), because it is merely a threshold or cut-off point.
4.4.4 Reliability
Information must also be reliable to be useful. The user must be able to depend on it being a faithful
representation.
Definition
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 or could
reasonably be expected to represent.
Even if information is relevant, if it is very unreliable it may be misleading to recognise it, e.g. a disputed
claim for damages in a legal action.
Faithful representation
Information must represent faithfully the transactions it purports to represent in order to be reliable. There
is a risk that this may not be the case, not due to bias, but due to inherent difficulties in identifying the
transactions or finding an appropriate method of measurement or presentation. Where
measurement of the financial effects of an item is so uncertain, entities should not recognise such an item.
For example, although there is usually no doubt as to the existence of internally generated goodwill, there is
considerable doubt as to its true value, i.e. it cannot be measured reliably. Therefore BAS 38 Intangible
Assets prohibits the recognition of such goodwill (see Chapter 6).

Substance over form

Faithful representation of a transaction is only possible if it is accounted for according to its substance and
economic reality, not with its legal form.
Definition
Substance over form: The principle that transactions and other events are accounted for and presented
in accordance with their substance and economic reality and not merely their legal form.
Most transactions are reasonably straightforward and their substance, i.e. commercial effect, is the same as
their strict legal form. However, in some instances this is not the case as can be seen in the following
worked example.
Worked example: Sale and repurchase agreement

A Ltd sells goods to B Ltd for CU10,000, but undertakes to repurchase the goods from B Ltd in 12 months’
time for CU11,000.
The legal form of the transaction is that A has sold goods to B as it has transferred legal title. To reflect the
legal form, A Ltd would record a sale and show the resulting profit, if any, in its income statement. In 12
months’ time when legal title is regained, A Ltd would record a purchase. There would be no liability to B
Ltd in A Ltd’s balance sheet until the goods are repurchased.
The above treatment does not provide a faithful representation because it does not reflect the economic
substance of the transaction. After all, A Ltd is under an obligation from the outset to repurchase the goods
and A Ltd bears the risk that those goods will be obsolete and unsaleable in a year’s time.
The substance is that B Ltd has made a secured loan to A Ltd of CU10,000 plus interest of CU1,000. To
reflect substance, A Ltd should continue to show the goods as an asset in inventories (at cost or net
realisable value, if lower) and should include a liability to B Ltd of CU10,000 in payables. A Ltd should
accrue for the interest over the duration of the loan.
When A Ltd pays CU11,000 to regain legal title, this should be treated as a repayment of the loan plus
accrued interest.
Other examples of accounting for substance:

 Leases
Accounting for finance leases under BAS 17 Leases (which is covered in Chapter 8) is an example of
the application of substance as the lessee includes the asset on its balance sheet even though the legal
form of a lease is that of renting the asset, not buying it.
 Group financial statements
Group financial statements are covered in detail in Chapters 10 to 16. The central principle underlying
group accounts is that a group of companies is treated as though it were a single entity, even though
each company within the group is itself a separate legal entity.
Neutrality
Information must be free from bias to be reliable. Neutrality is lost if the financial statements are
prepared so as to influence the user to make a judgement or decision in order to achieve a predetermined
outcome.

Prudence
Uncertainties exist in the preparation of financial information, e.g. the collectability of doubtful
receivables. These uncertainties are recognised through disclosure and through the application of prudence.
Prudence involves exercising a degree of caution when making judgements in conditions of uncertainty.
Prudence does not, however, allow the creation of hidden reserves or excessive provisions,
understatement of assets or income or overstatement of liabilities or expenses.
Completeness
Financial information must be complete, within the restrictions of materiality and cost, to be reliable.
Omission may cause information to be misleading.
4.4.5 Comparability
Users must be able to compare an entity's financial statements:
(a) Through time to identify trends.
(b) With other entities’ statements, to evaluate their relative financial position, performance and
changes in financial position.
The consistency of treatment is therefore important across like items over time, within the entity and
across all entities.
The disclosure of accounting policies is particularly important here. Users must be able to distinguish
between different accounting policies in order to be able to make a valid comparison of similar items in the
accounts of different entities.
Comparability is not the same as uniformity. Entities should change accounting policies if those policies
become inappropriate.
Corresponding information for preceding periods should be shown to enable comparison over time.
4.4.6 Constraints on useful information

(a) Timeliness
Information may become irrelevant if there is a delay in reporting it. There is a balance between
timeliness and the provision of reliable information. Information may be reported on a timely
basis when not all aspects of the transaction are known, thus compromising reliability.
If every detail of a transaction is known, it may be too late to publish the information because it has become
irrelevant. The overriding consideration is how best to satisfy the economic decision-making needs of the
users.
(b) Balance between benefits and cost
This is a pervasive constraint, not a qualitative characteristic. When information is provided, its
benefits must exceed the costs of obtaining and presenting it. This is a subjective area and there are
other difficulties: others, not the intended users, may gain a benefit; also the cost may be paid by
someone other than the users. It is therefore difficult to apply a cost-benefit analysis, but preparers
and users should be aware of the constraint.
(c) Balance between qualitative characteristics
A trade-off between qualitative characteristics is often necessary, the aim being to achieve an
appropriate balance to meet the objective of financial statements. It is a matter for professional
judgement as to the relative importance of these characteristics in each individual case.
Relevance v reliability
The most relevant information may not always be the most reliable. For example, an entity may be
facing a potential liability as a result of a legal claim. The outcome of the claim may not be sufficiently
reliable to recognise a provision in the financial statements. However, information about the claim
would be relevant to the users of the financial statements as it would provide information about future

liabilities. The conflict between relevance and reliability here is normally resolved through disclosure of
the facts involved.
Understandability v relevance
Relevant information may not always be the most understandable. This is particularly true where the
information involves complex issues. In this situation relevance would take priority. It would not be
appropriate to omit information simply because it was difficult to understand.
Faithful recognition v completeness
In some cases faithful recognition may override the characteristic of completeness. For example, as
discussed in section 4.4.4, internally generated goodwill is not recognised as its measurement is
uncertain.
4.4.7 True and fair view/fair presentation

The Framework does not attempt to define these concepts directly. It does state, however, that the
application of the principal 'qualitative' characteristics and of appropriate accounting standards
will usually result in financial statements which show a true and fair view, or are presented fairly. (We will
look at these terms in more detail in Chapter 2).
4.5 The elements of financial statements

4.5.1 Overview
Transactions and other events are grouped together in broad classes and in this way their financial effects
are shown in the financial statements. These broad classes are the elements of financial statements.
The Framework lays out these elements as follows.
Elements of financial
statements
Financial position in the Performance in the

balance sheet income statement
 Assets  Income
 Liabilities  Expenses
 Equity
Contributions from equity participants and distributions to them are also shown in the statement of
changes in equity.
4.5.2 Definitions of elements

Element Definition Comment
Asset A resource controlled by an entity as a result of Technically, the asset is the access to
past events and from which future economic future economic benefits (e.g. cash
benefits are expected to flow to the entity. generation) not the underlying item of
property itself (e.g. a machine).
Liability A present obligation of the entity arising from An obligation implies that the entity is
past events, the settlement of which is expected not free to avoid the outflow of
to lead to the outflow from the entity of resources.
resources embodying economic benefits.

Element Definition Comment
Equity The residual amount found by deducting all of the Equity = ownership interest = net
entity’s liabilities from all of the entity’s assets. assets. For a company, this usually
comprises shareholders’ funds (i.e.
capital and reserves).
Income Increases in economic benefits in the form of Income comprises revenue and gains,
asset increases/liability decreases not resulting including all recognised gains on non-
from contributions from equity participants. revenue items (e.g. revaluations of
non-current assets).
Expenses Decreases in economic benefits in the form of Expenses includes losses, including all
asset decreases/liability increases not resulting recognised losses on non-revenue
from distributions to equity participants. items (such as write-downs of non-
current assets).
Note the way that the changes in economic benefits resulting from asset and liability increases and
decreases are used to define:
 Income, and
 Expenses.
This arises from the ‘balance sheet approach’ adopted by BFRS Framework which treats performance
statements, such as the income statement, as a means of reconciling changes in the financial position
amounts shown in the balance sheet.
These key definitions of ‘asset’ and ‘liability’ will be referred to again and again in these learning materials,
because they form the foundation on which so many accounting standards are based. It is very important
that you can reproduce these definitions accurately and quickly.
4.5.3 Assets
We can look in more detail at the components of the definitions given above.
Assets must give rise to future economic benefits, either alone or in conjunction with other items.
Definition
Future economic benefit: The potential to contribute, directly or indirectly, to the flow of cash and cash
equivalents to the entity. The potential may be a productive one that is part of the operating activities of
the entity. It may also take the form of convertibility into cash or cash equivalents or a capability to reduce
cash outflows, such as when an alternative manufacturing process lowers the cost of production.
In simple terms, an item is an asset if:

 It is cash or the right to cash in future, e.g. a receivable, or a right to services that may be used to
generate cash, e.g. a prepayment.
or
 It can be used to generate cash or meet liabilities, e.g. a tangible or intangible non-current asset.
The existence of an asset, particularly in terms of control, is not reliant on:
 Physical form (hence intangible assets such as patents and copyrights may meet the definition of an
asset and appear on the balance sheet – even though they have no physical substance).
 Legal ownership (hence some leased assets, even though not legally owned by the company, may be
included as assets on the balance sheet. (See Chapter 8)).
Transactions or events in the past give rise to assets. Those expected to occur in future do not in
themselves give rise to assets.

4.5.4 Liabilities
Again we look more closely at some aspects of the definition.
An essential feature of a liability is that the entity has a present obligation.
Definition
Obligation: A duty or responsibility to act or perform in a certain way. Obligations may be legally
enforceable as a consequence of a binding contract or statutory requirement. Obligations also arise,
however, from normal business practice, custom and a desire to maintain good business relations or act in
an equitable manner.
As seen above, obligations may be:

 Legally enforceable as a consequence of a binding contract or statutory requirement. This is
normally the case with amounts payable for goods and services received
 The result of business practice. For example, even though a company has no legal obligation to do
so, it may have a policy of rectifying faults in its products even after the warranty period has expired.
A management decision (to acquire an asset, for example) does not in itself create an obligation,
because it can be reversed. But a management decision implemented in a way which creates expectations in
the minds of customers, suppliers or employees, such as the warranty example above, becomes an
obligation. This is sometimes described as a constructive obligation. This issue is covered more fully in
Chapter 9 in the context of the recognition of provisions.
Liabilities must arise from past transactions or events. For example, the sale of goods is the past
transaction which allows the recognition of repair warranty provisions.
Settlement of a present obligation will involve the entity giving up resources embodying economic
benefits in order to satisfy the claim of the other party. In practice, most liabilities will be met in cash but
this is not essential.
Interactive question 1: Asset or liability? [Difficulty level: Easy]
Question Fill in your answer
(a) Oak Ltd has purchased a patent for CU40,000. The

patent gives the company sole use of a particular
manufacturing process which will save CU6,000 a
year for the next five years.
(b) Elm Ltd paid John Brown CU20,000 to set up a car
repair shop, on condition that priority treatment is
given to cars from the company's fleet.
(c) Sycamore Ltd provides a warranty with every
washing machine sold.
See Answer at the end of this chapter.

4.5.5 Equity
Equity is the residual of assets less liabilities, so the amount at which it is shown is dependent on the
measurement of assets and liabilities. It has nothing to do with the market value of the entity's shares.
Equity may be sub-classified in the balance sheet providing information which is relevant to the decision-
making needs of the users. This will indicate legal or other restrictions on the ability of the entity to
distribute or otherwise apply its equity.
In practical terms, the important distinction between liabilities and equity is that creditors have the right to
insist that the transfer of economic resources is made to them regardless of the entity's financial position,
but owners do not. All decisions about payments to owners (such as dividends or share capital buy-back)
are at the discretion of management.
4.5.6 Performance
Profit is used as a measure of performance, or as a basis for other measures (e.g. EPS). It depends
directly on the measurement of income and expenses, which in turn depend (in part) on the concepts of
capital and capital maintenance adopted.
Income and expenses can be presented in different ways in the income statement, to provide
information relevant for economic decision-making. For example, an income statement could distinguish
between income and expenses which relate to continuing operations and those which do not.
Items of income and expense can be distinguished from each other or combined with each other.
Income
Both revenue and gains are included in the definition of income. Revenue arises in the course of
ordinary activities of an entity. (We will look at revenue in more detail in Chapter 7.)
Definition
Gains: Increases in economic benefits. As such they 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, e.g. on revaluation of non-current assets.
A revaluation gives rise to an increase or decrease in equity.
Although these increases and decreases meet the definitions of income and expenses they are not
included in the income statement under certain concepts of capital maintenance, however, but are
included in equity.
(In your Accounting studies you will have seen that a gain on revaluation is recognised in a revaluation
reserve.)
Expenses
As with income, the definition of expenses includes losses as well as those expenses that arise in the
course of ordinary activities of an entity.
Definition
Losses: Decreases in economic benefits. As such they are no different in nature from other expenses.
Losses will include those arising on the disposal of non-current assets. The definition of expenses will also
include unrealised losses. You will come across examples of these in your Financial Reporting and
Advanced Stage studies.

4.6 Recognition of elements in financial statements

4.6.1 Meaning of recognised
An item is recognised when it is included in the balance sheet or income statement.
Definition
Recognition: The process of incorporating in the balance sheet or income statement an item that meets
the definition of an element and satisfies the following criteria for recognition:
 It is probable that any future economic benefit associated with the item will flow to or from the
entity, and
 The item has a cost or value that can be measured with reliability.
Points to note:
(1) Regard must be given to materiality (see section 4.4.3 above).
(2) An item which fails to meet these criteria at one time may meet it subsequently.
(3) An item which fails to meet the criteria may merit disclosure in the notes to the financial statements.
(This is dealt with in more detail by BAS 37 Provisions, Contingent Liabilities and Contingent Assets which is
covered in Chapter 9).
4.6.2 Probability of future economic benefits

Probability here refers to the degree of uncertainty that the future economic benefits associated with an
item will flow to or from the entity. This must be judged on the basis of the characteristics of the
entity's environment and the evidence available when the financial statements are prepared.
The Framework does not give a definition of 'probable'. A working definition is 'more likely than not'.
4.6.3 Reliability of measurement

The cost or value of an item in many cases must be estimated. The use of reasonable estimates is an
essential part of the preparation of financial statements and does not undermine their reliability.
Where no reasonable estimate can be made, the item should not be recognised (although its existence
should be disclosed in the notes.)
4.6.4 Recognition of items

We can summarise the recognition criteria for assets, liabilities, income and expenses, based on the
definition of recognition given above.
Item Recognised in When

Asset The balance sheet It is probable that the future economic benefits will flow to the entity
and the asset has a cost or value that can be measured reliably.
Liability The balance sheet 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.
Income The income statement 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.
Expenses The income statement 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.

Points to note:
(1) There is a direct association between expenses being recognised in the income statement and the
generation of income. This is commonly referred to as the accrual or matching concept. However, the
application of the accrual concept does not permit recognition of assets or liabilities in the
balance sheet which do not meet the appropriate definition.
(2) Expenses should be recognised immediately in the income statement when expenditure is not
expected to result in the generation of future economic benefits.
(3) An expense should also be recognised immediately when a liability is incurred without the
corresponding recognition of an asset.
4.7 Measurement in financial statements

For an item or transaction to be recognised in an entity's financial statements it needs to be measured as
a monetary amount. BFRS uses several different measurement bases but the Framework refers to
just four.
The four measurement bases referred to in BFRS Framework are:
 Historical cost. Assets are recorded at the amount of cash or cash equivalents paid or the fair value
of the consideration given to acquire them at the time of their acquisition. Liabilities are recorded at
the amount of proceeds received in exchange for the obligation, or in some circumstances (for
example, income taxes), at the amounts of cash or cash equivalents expected to be paid to satisfy the
liability in the normal course of business.
 Current cost. Assets are carried at the amount of cash or cash equivalents that would have to be
paid if the same or an equivalent 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.
 Realisable (settlement) value.
– Realisable value. The amount of cash or cash equivalents that could currently be obtained by
selling an asset in an orderly disposal.
– Settlement value. The undiscounted amounts of cash or cash equivalents expected to be paid
to satisfy the liabilities in the normal course of business.
 Present value. A current estimate of the present discounted value of the future net cash flows in the
normal course of business.
Historical cost is the most commonly adopted measurement basis, but this is usually combined with other
bases, e.g. an historical cost basis may be modified by the revaluation of land and buildings.
4.8 Capital and capital maintenance

The final section of BFRS Framework is devoted to a brief discussion of the different concepts of capital and
capital maintenance, pointing out that:
 The choice between them should be made on the basis of the needs of users of financial statements.
 The IASB has no present intention of prescribing a particular model.
4.8.1 Financial capital and capital maintenance
Definition
Financial capital maintenance: 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.

The financial concept of capital is adopted by most entities.

This concept measures capital as the equity in the balance sheet. Profit is only earned in an accounting
period if the equity at the end of the period is greater than it was at the start, having excluded
the effects of distributions to or contributions from the owners during the period.
Monetary measure of capital
Financial capital is usually measured in monetary terms, i.e. the CU sterling or the euro. This is the
concept applied in historical cost accounting. This measure can be quite stable over short periods of years,
but is debased by even quite low rates of general inflation over longer periods, such as 20 years. So
comparisons between capital now and capital 20 years ago are invalid, because the measurement instrument
is not constant.
Constant purchasing power
A variant on the monetary measure of financial capital is the constant purchasing power measure. On this
basis, the opening capital (i.e. equity) is uprated by the change in a broadly based price index,
often a retail prices index, over the year. Also, the transactions during the year are uprated by the change in
the same index. A profit is only earned if the capital at the end of the year exceeds these uprated
values. (The value of the uprating is taken to equity, but is not regarded as a profit, merely a ‘capital
maintenance’ adjustment.) So this capital maintenance adjustment can be thought of as an additional
expense in the income statement. Comparisons over a 20-year period will be more valid if the capital 20
years ago is uprated for general inflation over that 20-year period.
But there is no reason why inflation measured by a retail prices index should be at all close to the inflation
experienced by an individual company.
4.8.2 Physical capital and capital maintenance
Definition
Physical capital maintenance: Under a physical concept of capital, such as operating capability, capital is
regarded as the productive capacity of the entity based on, for example, units of output per day.
This concept looks behind monetary values, to the underlying physical productive capacity of the
entity. It is based on the approach that an entity is nothing other than a means of producing saleable
outputs, so a profit is earned only after that productive capacity has been maintained by a ‘capital
maintenance’ adjustment. (Again, the capital maintenance adjustment is taken to equity and is treated as an
additional expense in the income statement.) Comparisons over 20 years should be more valid than under a
monetary approach to capital.
The difficulties in this approach lie in making the capital maintenance adjustment. It is basically a current cost
approach, normal practice being to use industry-specific indices of movements in non-current assets, rather
than go to the expense of annual revaluations by professional valuers. The difficulties lie in finding indices
appropriate to the productive capacity of a particular entity.

Worked example: Capital maintenance concepts

Meercat Ltd purchased 20,000 electrical components on 1 January 20X7 for CU10 each. They were all sold
on 31 December 20X7 for CU250,000. On that date the replacement cost of an electrical component was
CU11.50. The general rate of inflation as measured by the general price index was 12% during the year.
Profit could be calculated as follows:
Financial capital Financial capital Physical capital
maintenance maintenance maintenance
(monetary terms) (constant purchasing
power)
CU CU CU
Revenue 250,000 250,000 250,000
Cost of sales
20,000 × 10 (200,000)
20,000 × 11.2 (224,000)
20,000 × 11.5 (230,000)
Profit 50,000 26,000 20,000
5 International Accounting Standards Committee

Foundation (IASCF)
Section overview
 The IASCF is the parent entity of the IASB.
 The IASB is responsible for setting accounting standards.
5.1 The IASCF

IASCF was formed in March 2001 as a not-for-profit corporation and is the parent entity of the IASB.
The IASCF is an independent organisation and its trustees exercise oversight and raise necessary
funding for the IASB to carry out its role as standard setter. It also oversees the work of the
International Financial Reporting, Interpretations Committee (IFRIC) and the Standards
Advisory Council (SAC). These are organised as follows:

IASCF is responsible for:

 Funding
 Appointment of members of IASB, SAC
and IFRIC
IASB is responsible for: SAC is responsible for:

 All technical matters in general  Input on IASB's agenda
 In particular, the preparation and issue of  Input on IASB's project timetable and
international accounting standards priorities
 Advice on standard-setting projects
 Supporting IASB in promotion/adoption of
IFRS throughout the world
IFRIC is responsible for:
 Interpretation and application of
international accounting standards
5.2 Membership
Membership of the IASCF has been designed so that it represents an international group of preparers and
users, who become IASCF trustees. The selection process of the 19 trustees takes into account
geographical factors and professional background. IASCF trustees appoint the IASB members.
5.3 The IASB

The IASB is responsible for setting accounting standards. It is made up of 14 members (12 full-time and two
part-time members) coming from nine countries. They have a variety of backgrounds and include:
 Auditors
 Preparers of financial statements
 Users of financial statements, and
 Academics
5.4 Objectives of the IASB

The Preface to International Financial Reporting Standards states that the objectives of the IASB are as follows:
 To develop in the public interest, a single set of high-quality, understandable and enforceable
global accounting standards that require high quality, transparent and comparable information in
financial statements and other financial reporting to help participants in the various capital markets of
the world and other users of the information to make economic decisions.
 To promote the use and rigorous application of those standards, and
 To work actively with national standard-setters to bring about convergence of national accounting
standards and IFRS to high quality solutions.
The issue of convergence is very topical. A number of exercises are being undertaken at the moment aiming
to bring national and international accounting standards into line.

6 International Financial Reporting Standards (IFRS)
Section overview
 The influence of IFRS is growing.
 They aim to ensure that like transactions and events are treated consistently.
 In Bangladesh ICAB has adopted all IASs and IFRSs issued by IASB with the exception of IAS 29 as at
30/6/2009.
6.1 The purpose of accounting standards

The overall purpose of accounting standards is to identify proper accounting practices for the
preparation of financial statements.
Accounting standards create a common understanding between users and preparers on how particular
items, for example the valuation of property, are treated. Financial statements should therefore comply
with all applicable accounting standards.
6.2 Application of IFRS

Within each individual country local regulations govern, to a greater or lesser degree, the issue of
financial statements. These local regulations include accounting standards issued by the national regulatory
bodies or professional accountancy bodies in the country concerned.
Over the last 25 years however, the influence of IFRS on national accounting requirements and
practices has been growing. For example:
 For accounting periods commencing on or after 1 January 2005, all EU companies whose securities are
traded on a regulated public market such as the London Stock Exchange, must prepare their
consolidated accounts in accordance with IFRS. (Note that although group financial statements
must follow IFRS the individual financial statements do not need to.)
 In the UK unquoted companies are permitted (but not required) to adopt IFRS (see section 1.5).
 In Bangladesh ICAB has adopted all IASs and IFRSs issued by the IASB as BASs and BFRSs, with no
changes, with the exception of IAS 29, Financial Reporting in Hyperinflationary Economies, which has
not been adopted as at 30/06/2009.
6.3 Setting of IFRS

The overall agenda of the IASB will initially be set by discussion with the SAC. The process for developing
an individual standard would involve the following steps.
Step 1
During the early stages of a project, IASB may establish an Advisory Committee to give advice on issues
arising in the project. Consultation with the Advisory Committee and the SAC occurs throughout the
project.
Step 2
IASB may develop and publish a Discussion Document for public comment.
Step 3
Following the receipt and review of comments, IASB would develop and publish an Exposure Draft for
public comment.

Step 4
Following the receipt and review of comments, the IASB would issue a final International Financial
Reporting Standard.
The period of exposure for public comment is normally 90 days. However, in exceptional circumstances,
proposals may be issued with a comment period of 60 days. Draft IFRIC Interpretations are exposed for a
60-day comment period.
6.4 Scope and authority of IFRS

The Preface to IFRS makes the following points:
 IFRS apply to all general purpose financial statements i.e. those directed towards the common
information needs of a wide range of users.
 The IASB's objective is to require like transactions and events to be accounted for in a like
way.
 It recognises that the IASC (the predecessor to the IASB) permitted different treatments
(benchmark treatment and allowed alternative treatment) for like transactions and events. Where
these still exist either treatment would constitute compliance with IFRS.
 Standards include paragraphs in bold and plain type. Bold type paragraphs indicate the main
principles, but both types have equal authority.
 Any limitation of the applicability of a specific IFRS is made clear in that standard. IFRSs are not
intended to be applied to immaterial items, nor are they retrospective. Each individual IFRS lays
out its scope at the beginning of the standard.
7 Inherent limitations of financial statements
Section overview
 There are limitations inherent in financial statements, including the fact that they are:
– A conventionalised representation, involving classification, aggregation and the allocation of
items to particular accounting periods
– Historical (backward-looking), and
– Based almost exclusively on financial data.
7.1 Conventionalised representation

Financial statements are highly standardised in terms of their overall format and presentation although
businesses are very diverse in their nature. This may limit the usefulness of the information.
Financial statements are highly aggregated in that information on a great many transactions and balances
is combined into a few figures in the accounts, which can often make it difficult for the reader to evaluate
the components of the business.
Allocation issues include, for example, the application of the accrual concept and depreciation of non-
current assets, where management’s judgements and estimates affect the period in which expenses or
income are recognised.
7.2 Backward-looking
Financial statements are backward-looking whereas most users of financial information base their
decisions on expectations about the future. Financial statements contribute towards this by helping to

identify trends and by confirming the accuracy of previous expectations, but cannot realistically provide the
complete information set required for all economic decisions by all users.
7.3 Omission of non-financial information

By their nature, financial statements contain financial information. They do not generally include non-
financial data such as:
 Narrative description of the major operations.
 Discussion of business risks and opportunities.
 Narrative analysis of the entity’s performance and prospects.
 Management policies and how the business is governed and controlled.
Financial statements include the elements as defined in BFRS Framework. This means that items which do
not meet those definitions are not included. For example, the value of the entity’s internally generated
goodwill i.e. through its reputation, loyalty and expertise of its management and employees, or its client
portfolio. While some companies do experiment with different types of disclosure for such items, these
disclosures are considered unsuitable for inclusion in the financial statements (precisely because such items
do not fall within its definition of assets).
7.4 Other sources of information

Some of the limitations of financial statements are addressed in the other information which is often
provided along with the financial statements, especially by large companies, such as operating and financial
reviews and the Chairman’s statement. Note that other information provided with financial statements is
outside the scope of the Financial Accounting syllabus.
There are also many other sources of information available to at least some users of financial statements,
for example:
 In owner-managed businesses, the owners have access to internal management information because
they are the management. This information is, potentially, available on a continuous real-time basis and
may include:
– Future plans for the business
– Budgets or forecasts
– Management accounts, including, for example, divisional analysis
 Banks will often obtain additional access to entity information under the terms of loan agreements.
 Potential investors (e.g. if they are planning to take a major stake or even a controlling interest) will
often negotiate additional access to corporate information.
 Publicly available information, such as entity brochures and publicity material (e.g. press releases)
 Brokers’ reports on major companies, and
 Press reports and other media coverage (e.g. television or internet).

8 Not-for-profit entities
Section overview
 Not-for-profit entities include NGOs, clubs, and public sector organisations.
 Reporting requirements will vary depending on the nature of the entity.
8.1 Not-for-profit entities

The objective of most company directors is to manage the shareholders' investment. In a majority of cases
this will mean creating a profit. However, this is not always the case. For some entities their primary
purpose is to provide a service rather than to make a profit.
Interactive question 2: Not-for-profit entities [Difficulty level: Easy]

List as many types of not-for-profit organisations as you can.
See Answer at the end of this chapter.
As this exercise has demonstrated not-for-profit entities include a broad range of organisations involved in
very different activities. Not-for-profit entities also vary considerably in size from the local rugby club to an
internationally renowned charity.
8.2 Reporting requirements

Many of the organisations mentioned above may be companies. In this case they will need to prepare
financial statements and have them audited in accordance with local legislation and accounting
regulation. In Bangladesh this would include compliance with the Companies Act and BFRSs.
For unincorporated entities the reporting requirements are normally less onerous, although best practice
would be to follow BFRSs.
In addition, many not-for-profit organisations will need to comply with regulations specific to their sector.
For example in Bangladesh, NGOs are required to comply with the Foreign Donations Rules (FDRs),
1978.
8.3 International public sector accounting standards

International Public Sector Accounting Standards (IPSAS) are issued by the International Public Sector
Accounting Standards Board (IPSASB). The objective of IPSASB is to:
 Develop high quality public sector financial reporting standards.
 Facilitate convergence of international and national standards.
 Enhance the quality and uniformity of financial reporting.
Currently there is no requirement for IPSAS to be adopted and in jurisdictions where national standards
already exist since it is the local regulation which will be applied. The IPSASB however, envisage an
increasing role for IPSAS in future, particularly in the following areas:
 Assisting national standard-setters in the development of new standards and the revision of
existing standards.
 Being applied in jurisdictions where there is no national legislation.

Summary and Self-test
Summary
Regulated by:
Local legislation
FDRs
IPSAS
Self-test
Answer the following questions
1 Which of the following is the best description of why BFRS Framework requires financial statements to
be prepared on the basis of accrual accounting?
A As a result of the 'substance over form' requirement
B So as to be prudent
C Because it is the most objective basis
D Because it presents both past transactions and future obligations

2 The following relate to the going concern assumption.

(1) The entity has no need to liquidate
(2) The entity has no intention to liquidate
(3) The entity has no need to curtail materially its scale of operations
(4) The entity has no intention to curtail materially its scale of operations
Which of the above are the best description of the conditions which BFRS Framework identifies as
necessary if the going concern basis is to be used for the preparation of financial statements?
A (1), (2) and (3) only
B (1), (2) and (4) only
C (1), (3) and (4) only
D (1), (2), (3) and (4)
3 According to BFRS Framework which of the following is one of the qualitative characteristics which
make information in financial statements useful?
A True and fair view
B Comparability
C Timeliness
D Historical cost
4 Which of the following is the closest approximation to BFRS Framework’s definition of an asset?
A A resource controlled by the entity from which future economic benefits are expected which can
be measured reliably
B A resource controlled by the entity as a result of past events from which future economic
benefits are expected which can be measured reliably
C A resource controlled by the entity from which future economic benefits are expected
D A resource controlled by the entity as a result of past events from which future economic
benefits are expected
5 Which of the following is the closest approximation to BFRS Framework’s definition of a liability?
A A legal obligation arising from past events, the settlement of which is expected to result in an
outflow of resources embodying economic benefits
B An obligation arising from past events, the settlement of which is expected to result in an outflow
of resources embodying economic benefits which can be measured reliably
C An obligation arising from past events, the settlement of which is expected to result in an outflow
of resources embodying economic benefits
D A legal obligation arising from past events, the settlement of which is expected to result in an
outflow of resources embodying economic benefits which can be measured reliably
6 Future settlement is an essential part of BFRS Framework’s definition of a liability. Which of the
following best describes the way that settlement may occur?
A Payment of cash
B Payment of cash or transfer of other assets
C Payment of cash or transfer of other assets or replacement of the obligation with another
obligation
D Payment of cash or transfer of other assets or replacement of the obligation with another
obligation or conversion of the obligation to equity

7 Which of the following is the closest approximation to BFRS Framework’s definition of income?
A Increase in assets
B Increase in assets or decrease in liabilities
C Increase in assets or decrease in liabilities, other than those relating to transactions with equity
participants
D Increase in assets, other than those relating to transactions with equity participants
8 Which of the following is the closest approximation to BFRS Framework’s requirement as to when an
asset or liability should be recognised?
A It is probable that future economic benefits will flow to or from the entity and the item’s cost or
value can be estimated
B It is probable that future economic benefits will flow to or from the entity and the item’s cost or
value can be measured reliably
C The item’s cost or value can be measured reliably
D The item’s cost or value can be estimated
9 Which of the following statements is true in respect of International Public Sector Accounting
Standards (IPSAS)?
A Currently there is no requirement for IPSAS to be adopted by public sector entities
B IPSAS must be adopted by public sector entities where there are no national standards
C Both IPSAS and national standards must be adopted by public sector entities
D None of the above statements is correct
10 TRADITIONAL FRUITS LTD
Traditional Fruits Ltd, a Herefordshire based fruit bottling and canning company, is looking to expand
its operations. The directors are hoping to increase the range of preserved fruit products and in doing
so will need to invest in new equipment. They are also hoping to open a new facility in the South East
near to the fruit farms of Kent and Surrey.
The finance director has been asked to prepare a résumé of the financial performance of the company
in order that possible providers of finance can assess the future potential of the company.
The finance director wants to address all issues in her résumé and has asked for your assistance.
Requirements
Prepare brief notes for the finance director, addressing each of the following and using BFRS
Framework as a source of reference.
(a) Identify potential providers of finance for Traditional Fruits Ltd and their information
requirements in respect of financial statements.
(b) Explain the terms 'performance' and 'position' and identify which of the financial statements will
assist the user in evaluating performance and position.
(c) Indicate why, for decision-making purposes, the financial statements alone are insufficient.

11 DAVIES AND SAYERS LTD

Davies and Sayers Ltd (D&S Ltd) is a well-known publisher of children’s educational books. The
finance director, Carol Roberts, is known for her commercial acumen rather than her technical ability.
She is therefore seeking your advice on two particular accounting issues.
(1) Value of head of publishing
D&S Ltd have recently appointed a new head of publishing, Jane Lindsay. Jane recently worked for
a key competitor, Surridge and Hughes Ltd (S&H Ltd). Jane is extremely popular amongst the
leading authors in the market and is sure to attract the services of certain authors currently
working for S&H Ltd. Carol believes that Jane is therefore of great value to D&S Ltd and that
such value should therefore be recognised in the balance sheet in the form of an asset.
(2) Provision for alleged breach of copyright
Carol is aware that Poppy Anderson, one of D&S Ltd’s authors, is being accused of 'including
ideas in her texts that have previously been published'. Carol is certain a legal case will ensue and
therefore, being prudent, wishes to recognise a liability in the accounts now for any damages that
are likely to arise.
Requirements
Using BFRS Framework
(a) Define the terms 'asset', 'liability' and 'recognised'.
(b) Prepare brief notes for Carol Roberts, discussing whether the above result in an asset or liability
and whether or not they should be recognised in the financial statements.
Note: You are not required to refer to specific BFRSs that may be relevant.
Now, go back to the Learning Objectives in the Introduction. If you are satisfied you have achieved these
objectives, please tick them off.

Technical reference
Point to note: The whole of BFRS Framework (Frame) and Preface to International Financial Reporting
Standards (Preface) is examinable. The paragraphs listed below are the key references you should be familiar
with.

 Users’ core need is for information for making economic decisions Frame (Preface)
 Objective is to provide information on financial position, financial performance and Frame (12)
changes in financial position
 Financial position: Frame (16)
– Resources controlled
– Financial structure
– Liquidity and solvency
– Capacity to adapt to changes
 Financial performance, measured as profit = income less expenses: Frame (17)
– Potential changes to resources in the future
– Capacity to generate cash from existing resource base
– Effectiveness with which additional resources might be employed
 Changes in financial position: Frame (18)
– Ability to generate cash
– Needs to use what is generated
 Notes and schedules: Frame (21)
– Risks and uncertainties
– Resources and obligations not recognised in financial statements
2 Underlying assumptions
 Accrual basis Frame (22)
 Going concern Frame (23)
3 Qualitative characteristics of financial statements

 To be useful, information needs to have the attributes of:
– Understandability Frame (25)
– Relevance, to include: Frame (26)
 Materiality Frame (29)
– Reliability, to include: Frame (31)
 Faithful representation Frame (33)
 Substance over form Frame (35)
 Neutrality Frame (36)
 Prudence Frame (37)
 Realised/unrealised
– Comparability Frame (39)
 Application of these should result in a true and fair view/fair presentation Frame (46)

4 Elements of financial statements

 Asset: a resource controlled by the entity as a result of past events and from Frame (49)
which future economic benefits are expected to flow to the entity
 Liability: a present obligation of the entity arising from past events, the Frame (49)
settlement of which is expected to lead to the outflow from the entity of
resources embodying economic benefits
 Equity: the residual interest in assets less liabilities, i.e. net assets Frame (49)
 Income (comprising revenue and gains): increases in economic benefits in the Frame (70, 74-
form of asset increases/liability decreases, other than contributions from equity 75)
 Expenses (including losses): decreases in economic benefits in the form of asset Frame (70, 78-
decreases/liability increases, other than distributions to equity 79)
5 Recognition
 Assets and liabilities are recognised in financial statements if: Frame (83)
– It is probable that any future economic benefit associated with the item will
flow to or from the entity, and
– Its cost or value can be measured with reliability
6 Measurement
 Historical cost Frame (100)
 Current cost
 Realisable value
 Present value
7 Capital maintenance
 Financial capital: Frame (104)
– Monetary
– Constant purchasing power
 Physical capital
8 IASB
 Objectives Preface (6)
 Scope and authority Preface (7-17)
 Process Preface (18)

Answers to Self-test
1 D
2 D
3 B
4 D
5 C
6 D
7 C
8 B
9 A
10 TRADITIONAL FRUITS LTD
(a) Potential providers of finance Information requirements
 The existing shareholders of the  The profit before interest of Traditional Fruits
company and potential new Ltd (TF Ltd), to determine risk.
shareholders – through a new issue
of share capital.
 The trend of profitability of TF Ltd together
with a history of dividend payments. This will
enable them to assess return and risk of their
investment.
 The financial structure of TF Ltd, to determine
the level of debt finance as a measure of risk.
 TF Ltd's liquidity or ability to pay out dividends
and redeem share capital.
 TF Ltd's ability to generate cash and the timing
and certainty of its generation.
 Existing and future lenders and  The liquidity of TF Ltd and its ability to repay
creditors to the company. interest and capital instalments.
 The existing level of debt and any security over
that debt.
(b) Performance and position and the financial statements which assist in evaluation
Performance
The financial performance of a company comprises the return it obtains on the resources it
controls. Performance can be measured in terms of the profits of the company and its ability to
generate cash flows.
Management will be assessed on their skill in achieving the highest level of performance, given the
resources available to them.
Information on performance can be found in
 The income statement.
 The statement of changes in equity.
 The cash flow statement.

Position
The financial position of the company is evaluated by reference to
 The economic resources (assets and liabilities) it controls.
 Its capital structure, i.e. its level of debt finance and shareholders’ funds.
 Its liquidity and solvency.
The user of the financial statements can then make assessments on the level of risk, ability to
generate cash, the likely distribution of this cash and the ability of the company to adapt to
changing circumstances.
The balance sheet is the prime source of information on a company’s position but the cash flow
statement will also indicate a company’s cash position over a period of time.
(c) Financial statements – inherent limitations as a tool of decision-making
Financial statements are prepared by reference to a relatively rigid set of accounting standards
applicable to all companies, regardless of the sectors of the economy they operate in. As a result,
information for individual and specialised companies may not be forthcoming. Further, the
preparation of financial statements is based on estimates and judgements by the management and
therefore are not a source of totally reliable information.
Financial statements primarily use the historical cost convention. They can identify trends from
the past which may be relevant to the future, but they are not forecasts and are therefore less
helpful when making predictions.
In deciding whether or not to invest in a company, a decision-maker will also want access to non-
financial data not contained in the financial statements such as
 A discussion of business risks and opportunities
 An evaluation of the quality of management
 A narrative analysis of position and performance
11 DAVIES AND SAYERS LTD
(a) Terms
Asset
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.
Legal ownership is not an essential part of the definition of an asset, even though such ownership
is indicative that the control criterion has been met. But the key is whether the entity controls a
resource, so having the continued use of an item will often be sufficient evidence of control.
Liability
A liability is
 A present obligation of the entity
 Arising from past events
 The settlement of which is expected to result in an outflow from the entity of resources
embodying economic benefits.
An obligation arises from a legally-enforceable contract, but it may also result from an entity’s
normal business practices.

Recognised
Recognition means that an item is recorded in the financial statements. An asset or liability is
recognised if
 It is probable that any future economic benefit associated with the item will flow to or from
the entity, and
 The cost or value can be measured with reliability.
(b) Notes for Carol Roberts
(1) Value of head of publishing
Existence of an asset
If you apply the definition of an asset from BFRS Framework to the head of publishing, Jane
Lindsay, it is possible to argue that she has the characteristics of an asset.
As a full-time employee, Jane is likely to have a contract which was signed prior to the
balance sheet date. The legal contract will prevent Jane working for any other company,
giving D&S Ltd unrestricted access to any benefits she may provide.
If Jane is able to persuade new authors to join the D&S team, she is creating a flow of future
economic benefits – on the assumption that the authors’ new work will prove salesworthy.
However, there is uncertainty over
 The enforceability of Jane’s contract: she may recruit new authors to D&S Ltd, but
within a short period of time might leave and join a new company; her authors are
then likely to follow her.
 The revenue stream to result from the new authors: they have not as yet been
recruited and it is only possible that they will be; there are also no guarantees as to the
quality of their future work and therefore the level of revenue they are likely to
generate.
Therefore, at this stage we cannot conclude that an asset exists.
Recognition of the asset
An item is recognised when it is included in the financial statements at a monetary value.
Carol Roberts is proposing to include Jane Lindsay as an asset in the balance sheet.
However, certain criteria should be applied prior to recognition.
 Is there sufficient evidence of the existence of the asset?
 Can the asset be measured at a monetary amount with sufficient reliability?
(2) Provision for breach of copyright
Existence of a liability
At this stage Poppy Anderson has been accused of breach of copyright. From the
information given, there is no opinion from lawyers as to the strength of the case or
estimate of the possible value of any claim. Therefore, whilst a past transaction has allegedly
occurred, there is insufficient evidence of, and uncertainty over, whether an obligation
exists.
Recognition of the liability
To recognise the liability in the financial statements there must be sufficient evidence of the
existence of the liability and it should be probable that economic benefit will flow from the
entity. In this case, there is insufficient evidence of a liability and we are unable to reliably
measure any potential liability.
The case is at far too early a stage to estimate the possible loss. It would therefore be over-
prudent and inappropriate to recognise the liability in the financial statements.

Answers to Interactive questions
Answer to Interactive question 1

Question Answer
(a) Oak Ltd has purchased a patent for CU40,000. This is an asset, albeit an intangible one. There
The patent gives the company sole use of a is a past event, control and future economic
particular manufacturing process which will save benefit (through cost saving).
CU6,000 a year for the next five years.
(b) Elm Ltd paid John Brown CU20,000 to set up a This cannot be classed as an asset. Elm Ltd has
car repair shop, on condition that priority no control over the car repair shop and it is
treatment is given to cars from the company's difficult to argue that there are future
fleet. economic benefits.
(c) Sycamore Ltd provides a warranty with every This is a liability. The business has an obligation
washing machine sold. to fulfil the terms of the warranty. The liability
would be recognised when the warranty is
issued rather than when a claim is made.
Answer to Interactive question 2

 NGOs
 Friendly societies
 Public sector hospitals
 Public sector schools
 Clubs
 Associations
 Local councils
 Public services
 Trade unions
 Societies
 Housing associations


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chapter 1

Conceptual and regulatory

© The Institute of Chartered Accountants in England and Wales, March 2009 1

Learning objectives Tick off

 Explain the objectives of financial statements

– The break-up basis

 Explain the regulatory framework affecting not-for-profit entities

Stop and think

2 © The Institute of Chartered Accountants in England and Wales, March 2009

© The Institute of Chartered Accountants in England and Wales, March 2009 3

4 © The Institute of Chartered Accountants in England and Wales, March 2009

1.1 What is financial accounting?

1.3 Financial statements

© The Institute of Chartered Accountants in England and Wales, March 2009 5

1.4 Requirement to produce financial statements

1.5 Financial reporting standards

1.6 True and fair view

6 © The Institute of Chartered Accountants in England and Wales, March 2009

2 Purpose and use of financial statements

2.1 Users and their information needs

Users Need information to

© The Institute of Chartered Accountants in England and Wales, March 2009 7

2.2 Objective of financial statements

2.3 Accountability of management

2.4 Financial position, performance and changes in financial position

8 © The Institute of Chartered Accountants in England and Wales, March 2009

2.4.1 Financial position

2.4.2 Financial performance

2.4.3 Changes in financial position

2.4.4 Notes and supplementary schedules

© The Institute of Chartered Accountants in England and Wales, March 2009 9

3.1 Accrual basis

3.2 Going concern basis

3.3 Cash basis

10 © The Institute of Chartered Accountants in England and Wales, March 2009

Worked example: Comparison of accrual basis and cash basis

Using cash accounting the results for January would be as follows:

3.4 Break-up basis

© The Institute of Chartered Accountants in England and Wales, March 2009 11

4.1 Conceptual Framework

12 © The Institute of Chartered Accountants in England and Wales, March 2009

 Assist users of financial statements in interpreting the information contained in financial

4.4 Qualitative characteristics of financial statements

Understandability Relevance Reliability Comparability

Nature Materiality Consistency Disclosure

Timeliness Cost v benefit Balance between

© The Institute of Chartered Accountants in England and Wales, March 2009 13

14 © The Institute of Chartered Accountants in England and Wales, March 2009

Substance over form

Worked example: Sale and repurchase agreement

Other examples of accounting for substance:

© The Institute of Chartered Accountants in England and Wales, March 2009 15

4.4.6 Constraints on useful information

16 © The Institute of Chartered Accountants in England and Wales, March 2009

4.4.7 True and fair view/fair presentation

4.5 The elements of financial statements

Financial position in the Performance in the

4.5.2 Definitions of elements

© The Institute of Chartered Accountants in England and Wales, March 2009 17

Element Definition Comment