CONCEPTUAL FRAMEWORK

OF FINANCIAL REPORTING

Conceptual Framework of
Financial Reporting
Definition
 A conceptual framework is like a
constitution: It is “a coherent system of
interrelated objectives and fundamentals
that can lead to consistent standards and
that prescribes the nature, function, and
limits of financial accounting and financial
statements.”
 Many have considered the FASB’s real
contribution—and even its continued
existence—to depend on the quality and
utility of the conceptual framework.
Need for Conceptual
Framework
 First, to be useful, standard setting should
build on and relate to an established body
of concepts and objectives.
 A soundly developed conceptual framework
should enable the FASB to issue more useful
and consistent standards over time.
 A coherent set of standards and rules
should be the result, because they would be
built upon the same foundation.
Why is a conceptual framework necessary?

 CF serves the following critical objectives;

 It increases financial statement users’ understanding
of and confidence in financial reporting,
 It should enhance comparability among companies’
financial statements.
 It helps to solve new and emerging practical
problems more quickly by reference to an existing
framework of basic theory.
 For example, Sunshine Mining (a silver mining
company) sold two issues of bonds that it would
redeem either with $1,000 in cash or with 50 ounces
of silver, whichever was worth more at maturity.
Development of Conceptual Framework

 Over the years numerous organizations,

committees, and interested individuals
developed and published their own conceptual
frameworks.
 But no single framework was universally
accepted and relied on in practice.
 Recognizing the need for a generally accepted
framework, the FASB in 1976 began work to
develop a conceptual framework that would be
a basis for setting accounting standards and
for resolving financial reporting controversies.
Development of Conceptual
Framework (Contd…)

 The FASB has issued six Statements of Financial

Accounting Concepts that relate to financial
reporting for business enterprises. They are:
 SFAC No. 1, “Objectives of Financial Reporting by
Business Enterprises,” presents the goals and purposes
of accounting.
 SFAC No. 2, “Qualitative Characteristics of Accounting
Information,” examines the characteristics that make
accounting information useful.
 SFAC No. 3, “Elements of Financial Statements of
Business Enterprises,” provides definitions of items in
financial statements, such as assets, liabilities,
revenues, and expenses.
Development of Conceptual
Framework (Contd…)

 SFAC No. 5, “Recognition and Measurement in

Financial Statements of Business Enterprises,” sets
forth fundamental recognition and measurement
criteria and guidance on what information should be
formally incorporated into financial statements and
when.
 SFAC No. 6, “Elements of Financial Statements,”
replaces SFAC No. 3and expands its scope to include
not-for-profit organizations.
 SFAC No. 7, “Using Cash Flow Information and
Present Value in Accounting Measurements,” provides
a framework for using expected future cash flows and
present values as a basis for measurement.
Illustration of Conceptual Framework
for Financial Reporting
FIRST LEVEL: BASIC
OBJECTIVES
The objectives of financial reporting are to provide information that is:
 Useful to those making investment and credit decisions who have a
reasonable understanding of business and economic activities;
 Helpful to present and potential investors, creditors, and other users in
assessing the amounts, timing, and uncertainty of future cash flows; and
 about economic resources, the claims to those resources, and the
changes in them.
 This approach is referred to as decision usefulness
 It has been said that the golden rule is the central message in many religions and the
rest is elaboration. Similarly, decision usefulness is the message of the conceptual
framework and the rest is elaboration.
 In providing information to users of financial statements, general-purpose financial
statements are prepared.
 These statements provide the most useful information possible at minimal cost to
various user groups.
 However, underlying these objectives is the notion that users need reasonable
knowledge of business and financial accounting matters to understand the
information contained in financial statements.
SECOND LEVEL: FUNDAMENTAL
CONCEPTS

 Between the first and third levels it is

necessary to provide certain conceptual
building blocks that explain the qualitative
characteristics of accounting information
and define the elements of financial
statements.
 These conceptual building blocks form a
bridge between the why of accounting
(the objectives) and the how of accounting
(recognition and measurement).
Qualitative Characteristics of
Accounting Information

 The FASB has identified the qualitative

characteristics of accounting information
that distinguish better (more
useful)information from inferior (less
useful) information for decision making
purposes.
 Primary Qualities: Relevance and
Reliability
 Secondary Qualities: Comparability
and Consistency
Qualitative Characteristics (Contd…)

 Understandability: It implies the expression with clarity

and lucidity, of accounting information in such a way that it
will be understood and comprehended by the users. To
enhance understandability, users are assumed to have
knowledge of business and economic activities.

 Relevance: To be useful, accounting information must assist

a user to form, confirm or maybe revise a view - usually in
the context of making a decision (e.g. should I invest, should I
lend money to this business? Should I work for this business?)

 Consistency: This implies consistent and unswerving

treatment of similar items and application of accounting
policies.
Qualitative Characteristics (Contd…)

 Comparability: This implies the ability for users to be able

to compare similar companies in the same industry group
and to make comparisons of performance over time. Much of
the work that goes into setting accounting standards is
based around the need for comparability.

 Reliability: This implies that the accounting information that

is presented is truthful, accurate, complete (nothing
significant missed out) and capable of being verified (e.g. by
a potential investor).

 Objectivity: This implies that accounting information is

prepared and reported in a "neutral" way. In other words, it is
not biased towards a particular user group or vested interest
Basic Elements
 An important aspect of developing any
theoretical structure is the body of basic
elements or definitions to be included in
the structure.
 At present, accounting uses many terms
that have distinctive and specific
meanings. These terms constitute the
language of business or the jargon of
accounting.
elements of Financial Statements

 ASSETS- Probable future economic benefits

obtained or controlled by a particular entity as a
result of past transactions or events.
 LIABILITIES- Probable future sacrifices of
economic benefits arising from present
obligations of a particular entity to transfer
assets or provide services to other entities in the
future as a result of past transactions or events.
 EQUITY- Residual interest in the assets of an
entity that remains after deducting its liabilities.
In a business enterprise, the equity is the
ownership interest.
Elements FS ( Contd…)
 INVESTMENTS BY OWNERS: Increases in net assets of a
particular enterprise resulting from transfers to it from other entities
of something of value to obtain or increase ownership interests (or
equity) in it. Assets are most commonly received as investments by
owners, but that which is received mayalso include services or
satisfaction or conversion of liabilities of the enterprise.
 DISTRIBUTIONS TO OWNER: Decreases in net assets of a
particular enterprise resulting from transferring assets, rendering
services, or incurring liabilities by the enterprise to owners.
Distributions to owners decrease ownership interests (or equity) in
an enterprise.
 COMPREHENSIVE INCOME: Change in equity (net assets) of an
entity during a period from transactions and other events and
circumstances from non-owner sources. It includes all changes in
equity during a period except those resulting from investments by
owners and distributions to owners.
Elements FS ( Contd…)
 REVENUES: Inflows or other enhancements of assets of an entity or
settlement of its liabilities (or a combination of both) during a period
from delivering or producing goods, rendering services, or other
activities that constitute the entity’s ongoing major or central
operations.
 EXPENSES: Outflows or other using up of assets or incurrences of
liabilities (or a combination of both) during a period from delivering or
producing goods, rendering services, or carrying out other activities
that constitute the entity’s ongoing major or central operations.
 GAINS: Increases in equity (net assets) from peripheral or incidental
transactions of an entity and from all other transactions and other
events and circumstances affecting the entity during a period except
those that result from revenues or investments by owners.
 LOSSES: Decreases in equity (net assets) from peripheral or incidental
transactions of an entity and from all other transactions and other
events and circumstances affecting the entity during a period except
those that result from expenses or distributions to owners.
Third level: Recognition and
Measurement Concepts

 The third level of the framework consists of

concepts that implement the basic objectives
of level one. These concepts explain which,
when, and how financial elements and events
should be recognized, measured, and
reported by the accounting system.
 Most of them are set forth in FASB Statement
of Financial Accounting Concepts No. 5,
“Recognition and Measurement in Financial
Statements of Business Enterprises.”
Contd…
 According to Statement of Financial
Accounting Concepts (SFAC), SFAC No.
5, to be recognized, an item (event or
transaction) must meet the definition of
an “element of financial statements” as
defined in SFAC No. 6 and must be
measurable.
 Most aspects of current practice are
consistent with this recognition and
measurement concept
Contd…
 The accounting profession continues to use the concepts in
SFAC No. 5as operational guidelines. For discussion
purposes, I have chosen to identify the concepts as;
 Basic assumptions,
 Principles
 Constraints.
 Not everyone uses this classification system, so it is best to
focus your attention more on understanding the concepts
than on how they are classified and organized.
 These concepts serve as guidelines in developing rational
responses to controversial financial reporting issues.
Basic Assumptions
1. Economic Entity Assumption
 The economic entity assumption means

that economic activity can be identified

with a particular unit of accountability.
 In other words, the activity of a business

enterprise can be kept separate and

distinct from its owners and any other
business unit.
Basic Assumptions
(Contd…)
2. Going Concern
 It is assumed that a business unit has a

reasonable expectation of continuing

business at a profit for an indefinite period
of time. A business unit is deemed to be a
going concern and not a gone concern.
 It will continue to operate in the future.

 Transactions are recorded in the books

keeping in view the going concern aspect of
the business unit.
Basic Assumptions
(Contd…)
3. Money Measurement
 Money is the only practical unit of measurement
that can be employed to achieve the homogeneity
of financial data, accountants record only those
transactions which can be expressed in terms of
money though quantitative records are also kept.
 The advantages of expressing business
transactions in terms of money is that money
serves as a common denominator by means of
which heterogeneous facts about a business can be
expressed in terms of numbers (i.e. money) which
are capable of additions and subtractions.
Basic Assumptions
(Contd…)
4. Periodicity Assumption
 Under the going concern concept it is assumed that a

business entity has a reasonable expectation of continuing

business for an indefinite period of time.
 This assumption provides much of the justification that the

business will not be terminated, so it is reasonable to

divide the life of the business into accounting periods so as
to be able to know the profit or loss of each such period
and the financial position at the end of such a period.
 Normally accounting period adopted is one year as it helps

to take any corrective action, to pay income tax, to absorb

the seasonal fluctuations and for reporting to the outsiders.
A period of more than one year reduces the utility of
accounting data.
Basic Principles of
Accounting
 Four basic principles of accounting are used to record
transactions:
1. Historical Cost Principle
 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.
Basic Principles of Accounting
(Contd)

2. Revenue (Accruals) Recognition Principle

 Revenue is generally recognized (1) when realized or

realizable and (2) when earned.

 Revenues are realized when products (goods or

services), merchandise, or other assets are

exchanged for cash or claims to cash.
 Revenues are realizable when assets received or held

are readily convertible into cash or claims to cash.

 Assets are readily convertible when they are salable

or interchangeable in an active market at readily

determinable prices without significant additional
cost.
Basic Principles of Accounting
(Contd)

3. Matching Principle
 It dictates that efforts (expenses) be matched with

accomplishment (revenues) whenever it is

reasonable and practicable to do so.
 In recognizing expenses, the approach followed is,

“Let the expense follow the revenues.”

 Expenses are recognized not when wages are paid,

or when the work is performed, or when a product

is produced, but when the work (service) or the
product actually makes its contribution to revenue.
 Thus, expense recognition is tied to revenue
Basic Principles of Accounting
(Contd)

4. Full Disclosure (Objectivity) Principle

 Objectivity connotes reliability, trustworthiness and
verifiability, which means that there is some evidence in
ascertaining the correctness of the information reported.
 Entries in accounting records and data reported in financial

statements must be based on objectively determined

evidence, without close adherence to this principle; the
confidence of many users of the financial statements could
not be maintained.
 Invoices and vouchers for purchases and sales, bank
statements for amount of cash at bank, physical checking of
stock in hand etc. are examples, of objective evidence, which
are capable of verification. As far as possible, some objective
evidence should support every entry in accounting records.
Constraints
 In providing information with the qualitative
characteristics that make it useful, two
overriding constraints must be considered:
 Cost-benefit relationship
 Materiality
 Two other less dominant yet important
constraints that are part of the reporting
environment are;
 Industry practices
 Conservatism.
Constraints (Contd…)
1. Cost-benefit relationship
 The costs of providing the information must be

weighed against the benefits that can be

derived from using the information.
 Standards-setting bodies and governmental
agencies use cost-benefit analysis before
making their informational requirements final.
 In order to justify requiring a particular
measurement or disclosure, the benefits
perceived to be derived from it must exceed
the costs perceived to be associated with it.
Constraints (Contd…)
2. Materiality
 The constraint of materiality relates to an item’s

impact on a firm’s overall financial operations. An

item is material if its inclusion or omission would
influence or change the judgment of a reasonable
person.
 It is immaterial and, therefore, irrelevant if it

would have no impact on a decision maker. In

short, it must make a difference or it need not be
disclosed.
 The point involved here is one of relative size and

importance.
Constraints (Contd…)
3. Industry practices
 The peculiar nature of some industries and business

concerns sometimes require departure from basic theory.

 In the public utility industry, noncurrent assets are reported

first on the balance sheet to highlight the industry’s capital-

intensive nature.
 Agricultural crops are often reported at market value

because it is costly to develop accurate cost figures on

individual crops. Such variations from basic theory are not
many, yet they do exist.
 Whenever we find what appears to be a violation of basic

accounting theory, we should determine whether it is

explained by some peculiar feature of the type of business
involved before we criticize the procedures followed.
Constraints (Contd…)
4. Conservatism (Prudence)
 Conservatism means when in doubt choose the solution

that will be least likely to overstate assets and income.

 Conservatism if properly applied provide a very reasonable

guide in difficult situations: refrain from overstatement of

net income and net assets.
 Examples of conservatism in accounting are the use of the

lower of cost or market approach in valuing inventories and

the rule that accrued net losses should be recognized on
firm purchase commitments for goods for inventory.
 If the issue is in doubt, it is better to understate than
overstate net income and net assets.
NB: if there is no doubt, there is no need to apply the
constraint.
THE BASIC ACCOUNTING EQUATION

 The accounting equation is reflected in

the statement of financial position.
 The equation, normally called the book
keeping equation is:
 Assets = Liabilities + Capital
Or
Capital = Assets - Liabilities
Double entry system of book
keeping
 Transactions are recorded using the double entry
system of book keeping showing the two-fold effect
that is done to maintain equality of the equation. The
double entry system requires the use of an account.
 An Account is the most basic accounting record. It
summarizes the increases and decreases in a
particular asset, liability, revenue, expense or a capital
item.
 An account is divided into two sides; the left being the
debit and the other the credit side.
 The double entry concept states that “for every
debit entry, there is a corresponding credit
entry”.
Accounting Cycle
 Accounting cycle is a step-by-step
process of recording, classification and
summarization of economic transactions
of a business.
 It generates useful financial information
in the form of financial statements
including income statement, balance
sheet, cash flow statement and
statement of changes in equity.
Accounting Cycle
Contd…
 The time period principle requires that a
business should prepare its financial
statements on periodic basis.
 Therefore accounting cycle is followed
once during each accounting period.
 Accounting Cycle starts from the
recording of individual transactions and
ends on the preparation of financial
statements and closing entries.
Major Steps in Accounting Cycle

 Analyzing and classification of source

documents
 Analyzing and recording transactions via
journal entries
 Posting journal entries to ledger
accounts
 Preparing a trial balance
 Preparing financial statements
SOURCE DOCUMENTS
 Source documents are documents, such
as cash slips, invoices, etc. that form
the source of (and serve as proof for) a
transaction. In other words, they are the
first documents that exist relating to a
transaction.
 Invoices, cash slips, receipts, check
counterfoils, bank deposit slips and even
internet payment confirmations are
all source documents.
JOURNALS
 These are chronological (date-order)
records of transactions entered into by a
business.
 They include; purchases journal, sales
journal, (Sales return Journal) return
inwards journal, (Purchases return
Journal) return outwards journal and
General journal and cash journal
 E.g. Purchases journal- Is used to record
Date
all purchasesDetails
made onFolio Amount (Sh)
credit only.
1/12/201
7 J. Chege PL 009 4,200
LEDGER (T-ACCOUNTS)
 The ledger is a book in which various accounts are
kept. There are three main types of ledgers:
 i. Sales ledger- Individual accounts of the debtors
 ii. Purchases ledger- Individual creditors’ account.
 iii. General ledger- All other accounts that do not fall
under either the sales or purchases ledger
 The accounts are in the shape of a ‘T’ and thus are
often referred to as ‘T-accounts’.
 In this step we take all the debits and credits
(journals) relating to one account – let’s say ‘bank’ –
and draw up an account for bank that shows all the
transactions relating to it.
TRIAL BALANCE
 A sheet displaying all the accounts of a
business, drawn up as a trial (test) of
whether the total of all the debit
balances equal the total of all the credit
balances (A balance is the amount of an
item at a point in time.
 The trial balance is prepared as a final
check just before the financial
statements are drawn up.
FINANCIAL STATEMENTS
 These statements are prepared from the
information in the trial balance.
 The purpose of these statements is to show the
reader the financial position, financial performance
and cash flows of a business, as well as other useful
information concerning the business.
 Financial statements are usually prepared
periodically.
 Financial statements consist of; income statement,
statement of changes in the owner’s equity,
balance sheet, cash flow statement and (where
needed) an auditor’s report.
 ILLUSTRATION
 Given the following details; enter them in the sales
journal, purchases journal, general journal, and
then post them to the relevant ledger accounts and
extract trial balance.
 Year 2018
 January 2 Credit sales to E. Kamau Sh 12,800
 “2 Credit purchases to H Opati Sh 9,600
 “4 Credit sales to J Omondi Sh 11,700
 “7 Credit sales to N.Kimanzi Sh 20,700
 “8 Credit sales to P.Amino Sh. 4,900
 “12 Credit purchases from M. Kibaki Sh 7,200
ILLUSTRATION CONTD….
 “13 Credit sales to E. Kamau Sh 42,000
 “13 Credit purchases from G.Njenga Sh. 9,700
 “15 Return inwards from J Hadija Sh. 200
 “16 Return outwards to K Nyongesa Sh.1, 200
 “20 Credit purchases from H. Opati Sh.
11,200
 “21 Credit purchases from E. Joe Sh 4,900
 “23 Credit purchases from O. Mbiyu Sh. 4,500
 “27 Bought motor vehicle cash Sh 20,000
 “30 Sales to E Williams Sh. 10,600
 END

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