Chapter 1: Introduction to Financial

Reporting
Introduction
Financial Accounting and Reporting deals with preparation of financial statements. These
statements provide information about financial performance and financial position of the
business and information is of value to a wide range of user groups. The term “Financial
Reporting” relates to preparation of financial statements for a limited company. In this case the
main users of the financial statements are company’s shareholders. However information
contained in the financial statements may also be used by other user groups such as lenders,
employees, management and the tax authorities.

Learning Objectives
By the end of this chapter, learners must be able to:

a. List the main sources of accounting regulations and explain the need for regulation
b. Explain the term Generally Accepted Accounting Principles (GAAP)
c. Outline the structure and functions of International Accounting Standards Board (IASB)
and its associated bodies.
d. Outline the structure of international financial reporting standard (IFRS) or International
Accounting Standard (IAS)

What is a conceptual framework?

In a broad sense a conceptual have questioned whether a conceptual framework is necessary in
order to produce reliable financial statements. Past history of standard setting bodies throughout
the world tells us it is. In the absence of a conceptual framework, accounting standards were
often produced that had serious defects – that is:

• they were not consistent with each other particularly in the role of prudence versus
accruals/matching
• they were also internally inconsistent and often the effect of the transaction on the
statement of financial position was considered more important than its effect on income
the statement
• standards were produced on a ‘fire fighting’ approach, often reacting to a corporate
scandal or failure, rather than being proactive in determining best policy.
• Some standard setting bodies were biased in their composition (ie not fairly
representative of all user groups) and this influenced the quality and direction of
standards
 • the same theoretical issues were revisited many times in successive standards – for
example , does a transaction give rise to an asset (research and development expenditure )
or liability (environmental provisions)?

It could be argued that the lack of a conceptual framework led to a proliferation of ‘rules-based’
accounting systems whose main objective is that the treatment of all accounting transactions
framework can be seen as an attempt to define the nature and purpose of accounting. A
conceptual framework must consider the theoretical and conceptual issues surrounding financial
reporting and form a coherent and consistent foundation that will underpin the development of
accounting standards. It is not surprising that early writings on this subject were mainly from
academics.

Conceptual frameworks can apply to many disciplines, but when specifically related to financial
reporting, a conceptual framework can be seen as a statement of generally accepted accounting
principles (GAAP) that form a frame of reference for the evaluation of existing practices and the
development of new ones. As the purpose of financial reporting is to provide useful information
as a basis for economic decision making, a conceptual framework will form a theoretical basis
for determining how transactions should be measured (historical value or current value) and
reported – i.e. how they are presented or communicated to users.

Some accountants should be dealt with by detailed specific rules or requirements. Such a system
is very prescriptive and inflexible, but has the attraction of financial statements being more
comparable and consistent.

History of the Framework

Framework for the Preparation and Presentation of Financial Statements (the
April 1989
Framework) was approved by the IASC Board
July 1989 Framework was published
April 2001 Framework adopted by the IASB.
Conceptual Framework for Financial Reporting 2010 (the IFRS Framework)
September 2010
approved by the IASB

Introduction to the IFRS Framework

A conceptual framework for financial reporting consists of a set of agreed fundamental
principles which underpin financial accounting and reporting, and so provides a basis for the
development of accounting standards.

Conceptual framework is defined by the Financial Accounting Standards Board (FASB) as

“A coherent system of inter-related objectives and fundamentals that can lead to consistent
standards and that prescribes the nature, function and limits of financial accounting and
financial statements”

In the absence of conceptual framework standards are more difficult to develop since each
standard must begin from scratch. It is also most likely there will be inconsistencies and
contradictions between one standard and another.

Purposes of the conceptual framework

The IFRS Framework describes the basic concepts that underlie the preparation and presentation
of financial statements for external users. The IFRS Framework serves as a guide to the Board in
developing future IFRSs and as a guide to resolving accounting issues that are not addressed
directly in an International Accounting Standard or International Financial Reporting Standard or
Interpretation.

In the absence of a Standard or an Interpretation that specifically applies to a transaction, man-

agement must use its judgement in developing and applying an accounting policy that results in
information that is relevant and reliable. In making that judgement, IAS 8 requires management
to consider the definitions, recognition criteria, and measurement concepts for assets, liabilities,
income, and expenses in the IFRS Framework. This elevation of the importance of the [IFRS]
Framework was added in the 2003 revisions to IAS 8.

Scope of the conceptual framework

The IFRS Framework addresses:

1. the objective of financial reporting

2. the qualitative characteristics of useful financial information
3. the going concern assumption
4. the elements of financial statements
5. the reporting entity
6. the definition, recognition and measurement of the elements from which financial state-
ments are constructed
7. concepts of capital and capital maintenance

The Objective of general purpose financial reporting

The primary users of general purpose financial reporting are present and potential investors,
lenders and other creditors, who use that information to make decisions about buying, selling or
holding equity (e.g. shares) or debt instruments (e.g. loans) and providing or settling loans or
other forms of credit.
The primary users need information about the resources of the entity not only to assess an
entity's prospects for future net cash inflows but also how effectively and efficiently management
has discharged their responsibilities to use the entity's existing resources (i.e., stewardship).

The IFRS Framework notes that general purpose financial reports cannot provide all the informa-
tion that users may need to make economic decisions. They will need to consider pertinent infor-
mation from other sources as well.

The IFRS Framework notes that other parties, including prudential and market regulators, may
find general purpose financial reports useful. However, the Board considered that the objectives
of general purpose financial reporting and the objectives of financial regulation may not be con-
sistent. Hence, regulators are not considered a primary user and general purpose financial reports
are not primarily directed to regulators or other parties.

Information about a reporting entity's economic resources, claims, and changes in resources
and claims

Economic resources and claims

Information about the nature and amounts of a reporting entity's economic resources and claims
assists users to assess that entity's financial strengths and weaknesses; to assess liquidity and
solvency, and its need and ability to obtain financing. Information about the claims and payment
requirements assists users to predict how future cash flows will be distributed among those with
a claim on the reporting entity.

A reporting entity's economic resources and claims are reported in the statement of financial
position.

Changes in economic resources and claims

Changes in a reporting entity's economic resources and claims result from that entity's perfor-
mance and from other events or transactions such as issuing debt or equity instruments. Users
need to be able to distinguish between both of these changes.

Financial performance reflected by accrual accounting

Information about a reporting entity's financial performance during a period, representing

changes in economic resources and claims other than those obtained directly from investors and
creditors, is useful in assessing the entity's past and future ability to generate net cash inflows.
Such information may also indicate the extent to which general economic events have changed
the entity's ability to generate future cash inflows.

The changes in an entity's economic resources and claims are presented in the statement of com-
prehensive income.

Financial performance reflected by past cash flows

Information about a reporting entity's cash flows during the reporting period also assists users to
assess the entity's ability to generate future net cash inflows. This information indicates how the
entity obtains and spends cash, including information about its borrowing and repayment of debt,
cash dividends to shareholders, etc.

The changes in the entity's cash flows are presented in the statement of cash flows

Changes in economic resources and claims not resulting from financial performance

Information about changes in an entity's economic resources and claims resulting from events
and transactions other than financial performance, such as the issue of equity instruments or dis-
tributions of cash or other assets to shareholders is necessary to complete the picture of the total
change in the entity's economic resources and claims.

The changes in an entity's economic resources and claims not resulting from financial perfor-
mance is presented in the statement of changes in equity.

The Reporting entity

The chapter on the Reporting Entity will be reconsidered as part of the IASB's comprehensive
project on the framework.

Qualitative characteristics of useful financial information

The qualitative characteristics of useful financial reporting identify the types of information are
likely to be most useful to users in making decisions about the reporting entity on the basis of in-
formation in its financial report. The qualitative characteristics apply equally to financial infor-
mation in general purpose financial reports as well as to financial information provided in other
ways.

Financial information is useful when it is relevant and represents faithfully what it purports to
represent. The usefulness of financial information is enhanced if it is comparable, verifiable,
timely and understandable.

Fundamental qualitative characteristics

Relevance and faithful representation are the fundamental qualitative characteristics of useful
financial information.

Relevance

Relevant financial information is capable of making a difference in the decisions made by users.
Financial information is capable of making a difference in decisions if it has predictive value,
confirmatory value, or both. The predictive value and confirmatory value of financial informa-
tion are interrelated.
Materiality is an entity-specific aspect of relevance based on the nature or magnitude (or both)
of the items to which the information relates in the context of an individual entity's financial
report.

Faithful representation

General purpose financial reports represent economic phenomena in words and numbers, To be
useful, financial information must not only be relevant, it must also represent faithfully the
phenomena it purports to represent. This fundamental characteristic seeks to maximise the under-
lying characteristics of completeness, neutrality and freedom from error. Information must be
both relevant and faithfully represented if it is to be useful.

Enhancing qualitative characteristics

Comparability, verifiability, timeliness and understandability are qualitative characteristics that

enhance the usefulness of information that is relevant and faithfully represented.

Comparability

Information about a reporting entity is more useful if it can be compared with a similar informa-
tion about other entities and with similar information about the same entity for another period or
another date. Comparability enables users to identify and understand similarities in, and differ-
ences among, items.

Verifiability

Verifiability helps to assure users that information represents faithfully the economic phenomena
it purports to represent. Verifiability means that different knowledgeable and independent
observers could reach consensus, although not necessarily complete agreement, that a particular
depiction is a faithful representation.

Timeliness

Timeliness means that information is available to decision-makers in time to be capable of influ-

encing their decisions.

Understandability

Classifying, characterising and presenting information clearly and concisely makes it under-
standable. While some phenomena are inherently complex and cannot be made easy to under-
stand, to exclude such information would make financial reports incomplete and potentially mis-
leading. Financial reports are prepared for users who have a reasonable knowledge of business
and economic activities and who review and analyse the information with diligence.

Applying the enhancing qualitative characteristics

Enhancing qualitative characteristics should be maximised to the extent necessary. However,
enhancing qualitative characteristics (either individually or collectively) render information
useful if that information is irrelevant or not represented faithfully.

The cost constraint on useful financial reporting

Cost is a pervasive constraint on the information that can be provided by general purpose
financial reporting. Reporting such information imposes costs and those costs should be justified
by the benefits of reporting that information. The IASB assesses costs and benefits in relation to
financial reporting generally, and not solely in relation to individual reporting entities. The IASB
will consider whether different sizes of entities and other factors justify different reporting re-
quirements in certain situations.

Underlying assumption

The IFRS Framework states that the going concern assumption is an underlying assumption.
Thus, the financial statements presume that an entity will continue in operation indefinitely or, if
that presumption is not valid, disclosure and a different basis of reporting are required.

The elements of financial statements

Financial statements portray the financial effects of transactions and other events by grouping
them into broad classes according to their economic characteristics. These broad classes are
termed the elements of financial statements.

The elements directly related to financial position (balance sheet) are:

• Assets
• Liabilities
• Equity

The elements directly related to performance (income statement) are:

• Income
• Expenses

The cash flow statement reflects both income statement elements and some changes in balance
sheet elements.

Definitions of the elements relating to financial position

• 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 to the entity.
• Liability. A liability is a present obligation of the entity arising from past events, the set-
tlement of which is expected to result in an outflow from the entity of resources
embodying economic benefits.
 • Equity. Equity is the residual interest in the assets of the entity after deducting all its lia-
bilities.

Definitions of the elements relating to performance

• Income. Income is increases in economic benefits during the accounting period in the
form of inflows or enhancements of assets or decreases of liabilities that result in
increases in equity, other than those relating to contributions from equity participants.
• Expense. Expenses are decreases in economic benefits during the accounting period in
the form of outflows or depletions of assets or incurrences of liabilities that result in
decreases in equity, other than those relating to distributions to equity participants.

The definition of income encompasses both revenue and gains. Revenue arises in the course of
the ordinary activities of an entity and is referred to by a variety of different names including
sales, fees, interest, dividends, royalties and rent. Gains represent other items that meet the defin-
ition of income and may, or may not, arise in the course of the ordinary activities of an entity.
Gains represent increases in economic benefits and as such are no different in nature from
revenue. Hence, they are not regarded as constituting a separate element in the IFRS Framework.

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
of the entity include, for example, 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. Hence, they
are not regarded as a separate element in this Framework.

Recognition of the elements of financial statements

Recognition is 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's cost or value can be measured with reliability.

Based on these general criteria:

• An asset is recognised in the balance sheet when 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.
 • A liability is recognised in the balance sheet when it is probable that an outflow of
resources embodying economic benefits will result from the settlement of a present oblig-
ation and the amount at which the settlement will take place can be measured reliably.
• 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, in effect, that recognition of income occurs simultane-
ously with the recognition of increases in assets or decreases in liabilities (for example,
the net increase in assets arising on a sale of goods or services or the decrease in liabili-
ties arising from the waiver of a debt payable).
• Expenses are recognised 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 recog-
nition of an increase in liabilities or a decrease in assets (for example, the accrual of
employee entitlements or the depreciation of equipment).

Measurement of the elements of financial statements

Measurement involves assigning monetary amounts at which the elements of the financial state-
ments are to be recognised and reported.

The IFRS Framework acknowledges that a variety of measurement bases are used today to
different degrees and in varying combinations in financial statements, including:

• Historical cost
• Current cost
• Net realisable (settlement) value
• Present value (discounted)

Historical cost is the measurement basis most commonly used today, but it is usually combined
with other measurement bases. The IFRS Framework does not include concepts or principles for
selecting which measurement basis should be used for particular elements of financial statements
or in particular circumstances. Individual standards and interpretations do provide this guidance,
however