Accounting 3

Topic 2:
The Conceptual Framework
for Financial Reporting
Learning outcomes
▪ Gain an understanding of the role of the Conceptual
Framework in IFRS

▪ An understanding of financial reports and financial

statements as defined by Conceptual Framework

▪ Understanding of qualitative characteristics and the

distinction between fundamental and enhancing Q.C.

▪ Ability to apply the definitions of the elements and

recognition criteria in the Conceptual Framework to an
accounting transaction

▪ Apply the different measurement bases to amounts in the

financial statements

▪ Section 10: Capital and capital maintenance – awareness only

Graphic illustration of IFRS

• The foundation on which

new standards are
Conceptual
developed
Framework

• Principles to be applied
IFRS Standards by accountants

• Explanations of
Interpretations complex standards
The Conceptual Framework
Where does it fit in?
• The Conceptual Framework (CF) for Financial Reporting is
technically not a standard nor an interpretation

• Serves as the foundation for all standards & interpretations.

Why do we need it?

• The CF serves three purposes:
1. To help the IASB in developing new standards
2. To help preparers of financial statements where there is no
standard or principle which deals with an issue and they must
develop their own, and
3. To help all parties understand and interpret IFRS’s.
The Conceptual Framework
The “new” CF and conflicts it creates
• A new CF was issued by IASB in 2018

• Changes to this CF means that in certain instances the CF

now conflicts with statements Know specifically which
already in issue ones that we deal
with…

➢ The CF does not override any of the IFRS’s but is used as the
basic logic when interpreting and applying a difficult IFRS.

➢ Where conflicts arise, follow the IFRS and not the CF. The CF can
not override a standard.
[NOTE: All tests and exams prior to 2019 are based on the previous version of
the CF. Take note of this when reviewing those solutions.]
The Conceptual Framework Refer to the Conceptual
Framework included in
‘The Annotated IFRS
Contents of the CF – Accounting 3 focus Standards’ (SAICA
Student Handbook).

1. the objective of general purpose financial reporting;

2. the qualitative characteristics of useful financial statements;
3. financial statements and the reporting entity
4. the elements in the financial statements (assets, liabilities, equity,
income and expenses);
5. the recognition and derecognition of elements
6. the measurement bases that may be used when measuring the
elements.
7. Presentation and disclosure
8. Capital and capital maintenance
1. Objective of general purpose financial reporting
• To provide financial information about a reporting entity
that is useful to users(*) in making decisions about
providing resources to the entity.

• These decisions involve:

• buying, selling or holding equity and debt instruments;
• providing or settling loans and other forms of credit; or
• exercising their rights to vote on management’s actions

(*) The CF states that although many users may find general purpose
financial reports useful, it is primarily designed for 3 users:
1. Existing and potential investors
2. Lenders
3. Other creditors/providers of capital
1. Objective of financial reports (continued)

FINANCIAL REPORTS SHOULD PROVIDE INFORMATION ABOUT

1. The economic resources 2. Management’s efficiency

of the entity, & effectiveness in
claims against the resources, managing the entity’
and changes in those claims resources.
and resources.
To help users assess
To help users predict future net management’s stewardship
cash inflows of the entity. over resources
3. Financial reports vs financial statements
• Financial reports is a BROAD term which includes a
number of different types of reports.

• Financial statements is one such type of report (one we

focus on in this course)

• Financial statements focus only on providing information

relating to the entity’s elements, i.e. assets, liabilities,
income, expenses and equity.

• Refer to the table on page 43 of Gripping GAAP for further

information on this distinction.
A complete set of financial statements includes:

1. Statement of financial position;

2. Statement of comprehensive income;
3. Statement of changes in equity;
4. Statement of cash flows; and
5. Notes to the financial statements (contains policies and
explanatory information)

Understand the specific purpose

of each one, and how they differ.
A complete set of financial statements includes:

Information about Information about changes

resources and in those resources and
claims (AT a point claims (DURING a period
in time) of time)

Statement of comprehensive
Statement of income/ profit and loss
financial position
Statement of cash flows

Statement of changes in
equity

Notes to the FS
Underlying assumption of FS

▪ Going concern
• entity that will continue operating for the foreseeable
future.
• i.e. the entity does not intend or need to liquidate or
materially downsize its operations.
2. Qualitative characteristics

• For information to be useful to users (refer objective), it

must meet certain characteristics set out by the CF.
• These characteristics are called qualitative characteristics
and are divided into two types:

1. Fundamental characteristics
o These are essential for useful information

2. Enhancing characteristics
o These improve usefulness of information

• Be aware of the cost constraint (section 6.4).

2. Qualitative characteristics

Relevance
Qualitative characteristics

Fundamental
Faithful representation

Comparability

Verifiability
Enhancing
Timeliness

Understandability
2.1 Relevance
▪ When deciding what is relevant, we must consider:
• Whether it will make a difference in users’ decision-making.

▪ Information is capable of making a difference if it has either

of the following or both:
• Predictive value:
Refer to 6.2.1 in Chapter 2 for explanation
• Confirmatory value:
Refer to 6.2.1 in Chapter 2 for explanation
Test for materiality:
▪ Relevance is affected by materiality - Would obscuring, omitting
(use materiality to determine what is relevant for or misstating this info
the entity in question – i.e. it is entity-specific) influence the decision of
users?
2.2 Faithful representation
This deals with substance over form. You will achieve faithful
representation if the information is:

• Complete
Giving all information necessary for the user to understand the
transaction (numerical and descriptive)
• Neutral
Free from bias – achieved with prudence
• Free from error
No errors in the description of the transaction as well as the
selection and application of the processes used to produce the
information. This does not mean accuracy in absolutely all aspects.
Applying the fundamental Q.C.
1. Identify the economic phenomenon (what we are trying to depict?).
2. Identify what information would be most relevant.
3. Determine whether the information is available and can be faithfully
represented.

In other words, first identify the most relevant information, and then see if
it can be faithfully represented. If not, move to the next most relevant
information.

Refer to Worked example 2 and 3 on page 48 to see how this works.

2.3 Comparability Enhances
relevance

▪ Comparability allows users to identify similarities

and differences among items in order to assist them in
making decisions.

▪ Financial statements should thus be comparable:

• from one year to the next: therefore, accounting
policies must be consistently applied,
• from one entity to the next: therefore entities must all
comply with the same standards.
2.4 Verifiability Enhances
faithful rep.

▪ Verifiability helps assure users that the information

is faithfully represented.

▪ Verifiability means that:

• different knowledgeable and independent observers
• could reach consensus, although not necessarily
complete agreement,
• that a particular depiction (e.g. description/ amount) is a
faithful representation.
2.5 Timeliness & 2.6 Understandability
Enhances
▪ Timeliness relevance

• Most information needs to be available soon after year-

end to be useful.
Enhances
relevance and
▪ Understandability faithful rep.

• The financial statements must be understandable to the

users.
• The Conceptual framework allows us to assume the
user:
- has a reasonable knowledge of business and economic activities; and
- will diligently (carefully) review and analyse the financial information
provided, obtaining assistance from an advisor for complex issues where
necessary.
 4. Elements of financial statements
• Every set of financial statements includes only 5 elements with
which it communicates financial information to users:

• Information about financial position is communicated using:

1. Assets
2. Liabilities
3. Equity

• Information about financial performance is communicated

using:
4. Income
5. Expense
ASSETS
A present economic resource
• Economic resource = “right that has potential to produce economic
benefit”
• RIGHT and not the physical asset is the resource
• Economic benefit includes cash inflows, avoiding cash outflows etc.
• Potential to produce economic benefit can be remote or unlikely and would
still meet the definition

Controlled by the entity

• Control is evidenced by ability to direct use of resource AND obtain benefit
from such use. Also evidenced if able to prevent others from doing so.
• Ability to enforce legal rights is best way of proving control.

As a result of past events

• Event which gave rise to resource must have occurred before year-end
ASSETS

Refer to example 1 on page 54:

“Alfa rents office space from a landlord, at R10 000 per month.
It uses this space to run a business selling advice.
At 31 December 20x4, it had paid for the rent for January 20x5.

Required: From Alfa’s perspective, prove that this payment is an

asset at 31 December 20x4.”
ASSETS - applied

A present economic resource

• There is a right to occupy the offices in Jan 20x5
• This right has the potential to produce economic benefit. (Explain how.)
Enables Alfa to offer services which they will be paid for.

Controlled by the entity

• We have legal rights – presumably through a contract, which arose due

to us having made a payment for the right to occupy the office.

As a result of past events

• Payment took place prior to year end.
• There is already a contract/agreement in place prior to year end.
ASSETS

• Refer to example 2 on page 55-56 for further examples of

commonly occurring assets

• Try to answer it yourself before looking at the solution.

LIABILITIES
A present obligation of the entity
• A duty or responsibility that it has no practical ability to avoid
• Obligation may be legal, constructive or conditional (refer to def on p. 57)
• Not necessary that you are able to identify the party you are obligated to

To transfer an economic resource

• There is a duty to transfer an asset (economic resource) – such as cash,
goods or rights
• The probability of the transfer taking place is not considered when deciding
if definition is met. Even a remote possibility would qualify.

As a result of past events

• The entity must have already either:
• - obtained an economic benefit, or
• - taken an action, and
• As a result, entity will or may have to transfer an economic resources that it
would not otherwise have had to do.
LIABILITIES

Refer to example 3 on page 59:

“Beta rents office space from a landlord, at R10 000 per month.
It uses this space to run a business selling advice.
At 31 December 20x4, it still owes the rent for Dec x4.

Required: From Beta’s perspective, prove that this payable is a

liability at 31 December 20x4.”
LIABILITIES - applied

A present obligation
• There is a duty to pay rent
• This duty is unavoidable as it is a legal obligation (based on contract)

To transfer economic resources

• The entity will have to transfer cash, an economic resource

As a result of past events

• The entity has already obtained the benefit of occupying the premises
for Dec X4.
• As a result of this benefit obtained, cash will have to be transferred by
Beta.
LIABILITIES

• Refer to example 4 on page 59-60 for further examples.

• Try to answer it yourself before looking at the solution.

Notice that for the definition of both asset and liability, probability of
transfer of the economic benefit is not relevant.
EQUITY

• Equity is defined as the residual interest in the assets of the

entity after deducting all of its liabilities
• The definition is based on the accounting equation “E = A – L”

• Consider this approach to the equation:

o Where do the assets of an entity come from?
1. Funded through liabilities (loans, trade creditors)
2. Funded through equity (profits made, shareholder
contributions).
INCOME
Increases in assets, or

• For example cash from sales or interest earned on an investment which

increases the investment (an asset)

Decreases in liabilities

• For example consider rent received in advance – it only qualifies as income

when the entity’s obligation (liability) to deliver the premises which the rent
relates to has been met – therefore a decrease in liabilities

Other than those relating to contributions from holders

of equity
• This is an important part of the definition as it results in proceeds from a
share issue being excluded from income
EXPENSES
Decreases in assets, or

• For example cash payments, depreciation of assets etc.

Increases in liabilities

• For example accrued expenses which have resulted in a obligation to pay

(liability) increasing

Other than those relating to distributions to equity

holders
• This is an important part of the definition as it results in dividends to
ORDINARY shareholders being excluded from expenses
INCOME & EXPENSES

Worked Example 4 & 5 on page 62-63: Self-study

EXPENSES

Refer to example 5 on page 63:

Continuation of the same example of Beta renting office space,

with Dec x4 unpaid at 31 Dec 20x4.

Required: Prove that Beta’s payable results in an expense at

31 December 20x4.
EXPENSES - applied

Increase in liabilities
• The payable increases Beta’s liabilities (demonstrated in Ex. 3)

Resulting in a decrease in equity

• The transaction increased liabilities but did not change the assets, and
thus equity does decrease.

…Is not a distribution to a holder of an equity claim

• The payable involves a landlord and not a holder of an equity claim
(e.g. ordinary shareholder), therefore not a distribution (i.e. not a
dividend).
FS approach is based on the definitions…

• Notice that income and expenses are defined in terms of

asset and liability movements.

• Financial reporting is determined from a SoFP perspective.

5. Recognition criteria

• Applying definitions to an accounting transaction is STEP 1

• Once we have identified the elements involved we need to

consider whether it is appropriate to RECOGNISE them –
STEP 2

• Recognition refers to the act of recording or journalising a

transaction so that it is reflected in the financial statements
(either individually or in aggregate with similar transactions)
5. Recognition criteria

A transaction will only be recognised if it meets the following

recognition criteria (applied to all 5 elements):

• Assets, liabilities, income, expenses or equity must only be

recognised if the user would find this information useful.

o Useful information is: Where have we

1. Relevant seen this before?

2. Faithfully represented

This is a SIGNIFICANT change from the previous CF!!

5. Recognition criteria

When considering the definitions (of A & L specifically)

uncertainties are not taken into account, but in recognition
criteria this is where we focus.

Three types of uncertainties can exist with respect to an

element:

1. Existence uncertainty RELEVANCE

2. Outcome uncertainty
3. Measurement uncertainty FAITHFUL REP.
5. Recognition criteria
RELEVANCE
• Existence uncertainty
o If it is uncertain whether the A or L exists
o Example: we are in a court case which will confirm whether or not
the entity will have an obligation to pay

• Outcome uncertainty
o Although an asset may have the potential to produce economic
benefit, the probability of it doing so may be very low.

• If these two uncertainties are significant, then including the

element it relates to in the financial statements might not
result in relevant information for users
• Examples: lotto ticket, law suit
5. Recognition criteria
FAITHFUL REPRESENTATION
• Measurement uncertainty
o Relates to the amount of the element
o If it cannot be measured it might have to be estimated, which
creates some uncertainty
o An estimate does not necessarily mean the amount is not faithfully
represented (many amounts are estimated – think about
depreciation, allowances, provisions…). The degree of uncertainty
in the estimation will be deciding factor.

• Examples: fair value of land (where it may not be possible to get a

reliable estimate based on a very limited market or having very variable prices,
for example)
5. Recognition criteria
• What happens if an element fails to meet the recognition
criteria?

• The transaction or event is not recognised

• Entity can still provide information about the transaction
but this disclosure is done in the notes to the financial
statement and not in the primary statements themselves.
6. Measurement
• Once a transaction has been classified into appropriate
elements, and recognition criteria have been met, we need to
record it.
• But a journal entry has two components:

Dr Element 1 Rxxx
Cr Element 2  Rxxx 

• And in measurement, we are looking at component two: the

amount.

• The CF describes different measurement bases available and

provides factors to consider in selecting the appropriate basis
6. Measurement
Different measurement bases available:
1. Historical cost – based on the price that A/L were acquired at
2. Current value – based on conditions at measurement date
a. Current cost (e.g. replacement cost)
b. Fair value (e.g. Inv Prop, FV model)
c. Value in use (e.g. impairment)

How do you decide which to use?

→ Judgement
• Is the measurement base providing RELEVANT information?
• Is the measurement base providing information that is
FAITHFULLY REPRESENTING the phenomenon?
→ Specific standards also specify.
7. Presentation & disclosure
Principle based.
Main principle of providing information that is RELEVANT and a
FAITHFUL REPRESENTATION of the transactions & events.

• Focus on objectives and principles rather than rules

• Group similar items, separate dissimilar items
• Aggregate information to achieve a balance of excessive
detail and excessive summarisation.

• Entity-specific information is more useful than standardised

descriptions
• Duplication of info in different parts of the AFS is unnecessary
and can reduce understandability (rather cross-reference).
TECHNIQUE
Work on your technique when answering CF-based questions.
1. Gather details from the required: what verbs are used (discuss, etc.), mark
allocation, definition vs recognition, disclosure?, timeframe, etc.
2. State the issue(s) at hand. Show insight into the question.
3. Start with the asset or liability definition first.
4. Provide each component of the definition, and next to each, apply the information
in the question and conclude. This is where the marks are. There is usually one
aspect of the definition that is more of a focus than others.
5. Conclude on the definition.
6. Discuss the recognition criteria. Apply the information in the question to each
aspect of the criteria (3 in total, for the 2 criteria).
7. Conclude on the recognition criteria.
8. Conclude overall and state how it should be treated with reference to a date/time
period.
9. Do you need to consider another element? Or disclosure?
10. Consider if there is anything else to address in the question.
11. Don’t be too wordy / long-winded or repeat points. Keep succinct. Neat layout to
better organise your thoughts.
THE MOST IMPORTANT THINGS TO REMEMBER
Ask yourself, where do you go wrong with CF questions?

Make sure you:

1. Correctly identify the issue. Do a quick Debit & Credit to make sure you are
picking up the right side of the transaction. Don’t talk about liability if its an
asset…

2. Structure your answer FULLY. Don’t miss anything out. Discipline. Provide
something from the question as application for EACH step of the process.

3. Does the Required say in accordance with the Conceptual Framework?

Sometimes students use the wrong definitions or recognition criteria, because
they are answering a framework question as if it were a provisions/contingencies
question (see next section). Or vice versa. Answer in the correct topic context.