Chapter 1 The Conceptual Framework

Answer 1 (a) The purpose of the Framework is to assist the various bodies and users that may be interested in the financial statements of an entity. It is there to assist the IASB itself other standard setters preparers auditors and users of financial statements and any other party interested in the work of the IASB. !ore specifically" to assist the Board in the development of new and the review of e#istin$ standards. It is also believed that the Framework will assist in promotin$ harmonisation of the preparation of financial statements and also reduce the number of alternative accountin$ treatments permitted by IF%Ss national standard setters that have e#pressed a desire for local standards to be compliant with IF%S will be assisted by the Framework the Framework will help preparers to apply IF%S more effectively if they understand the concepts underlyin$ the Standards additionally the Framework should help in dealin$ with new or emer$in$ issues which are as yet not covered by an IF%S the above is also true of the work of the auditor in particular the Framework can assist the auditor in determinin$ whether the financial statements conform to IF%S users should be assisted by the Framework in interpretin$ the performance of entities that have complied with IF%S. It is important to realise that the Framework is not itself an accountin$ standard and thus cannot override a re&uirement of a specific standard. Indeed the Board reco$nises that there may be (rare) occasions where a particular IF%S is in conflict with the Framework. In these cases the re&uirements of the standard should prevail. The Board believes that such conflicts will diminish over time as the development of new and (revised) e#istin$ standards will be $uided by the Framework and the Framework itself may be revised based on the e#perience of workin$ with it. (b) Definitions assets: The IASB's Framework defines assets as (a resource controlled by an entity as a result of past events and from which future economic benefits are e#pected to flow to the entity'. The first part of the definition puts the emphasis on control rather than ownership. This is done so that the statement of financial position reflects the substance of transactions rather than their le$al form. This means that assets that are
A1-1

not le$ally owned by an entity but over which the entity has the ri$hts that are normally conveyed by ownership are reco$nised as assets of the entity. )ommon e#amples of this would be finance leased assets and other contractual ri$hts such as aircraft landin$ ri$hts. An important aspect of control of assets is that it allows the entity to restrict the access of others to them. The reference to past events prevents assets that may arise in future from bein$ reco$nised early. Definition liabilities: The IASB's Framework defines liabilities as (a present obli$ation of the entity arisin$ from past events the settlement of which is e#pected to result in an outflow from the entity of resources embodyin$ economic benefits'. !any aspects of this definition are complementary (as a mirror ima$e) to the definition of assets however the IASB stresses that the essential characteristic of a liability is that the entity has a present obli$ation. Such obli$ations are usually le$ally enforceable (by a bindin$ contract or by statute) but obli$ations also arise where there is an e#pectation (by a third party) of an entity assumin$ responsibility for costs where there is no le$al re&uirement to do so. Such obli$ations are referred to as constructive (by IAS *+ ,rovisions contin$ent liabilities and contin$ent assets). An e#ample of this would be repairin$ or replacin$ faulty $oods (beyond any warranty period) or incurrin$ environmental costs (e.$. landscapin$ the site of a previous &uarry) where there is no le$al obli$ation to do so. -here entities do incur constructive obli$ations it is usually to maintain the $oodwill and reputation of the entity. .ne area of difficulty is where entities cannot be sure whether an obli$ation e#ists or not it may depend upon a future uncertain event. These are more $enerally known as contin$ent liabilities. Importance of the definitions of assets and liabilities: The definitions of assets and liabilities are fundamental to the Framework. Apart from formin$ the obvious basis for the preparation of a statement of financial position they are also the two elements of financial statements that are used to derive the e&uity interest (ownership) which is the residue of assets less liabilities. Assets and liabilities also have a part to play in determinin$ when income (which includes $ains) and e#penses (which include losses) should be reco$nised. Income is reco$nised (in the income statement) when there is an increase in future economic benefits relatin$ to increases in assets or decreases in liabilities provided they can be measured reliably. /#penses are the opposite of this. )han$es in assets and liabilities arisin$ from contributions from and distributions to the owners are e#cluded from the definitions of income and e#penses.
A1-2

)urrently there is a $reat deal of concern over (off balance sheet finance'. This is an aspect of what is commonly referred to as creative accountin$. !any recent company failure scandals have been in part due to companies havin$ often massive liabilities that have not been included on the statement of financial position. %obust definitions based on substance of assets and liabilities in particular should ensure that only real assets are included on the statement of financial position and all liabilities are also included. In contradiction to the above point there have also been occasions where companies have included liabilities on their statement of financial positions where they do not meet the definition of liabilities in the Framework. )ommon e#amples of this are $eneral provisions and accountin$ for future costs and losses (usually as part of the ac&uisition of a subsidiary). )ompanies have used these $eneral provisions to smooth profits i.e. creatin$ a provision when the company has a $ood year (in terms of profit) and releasin$ them to boost profits in a bad year. ,rovidin$ for future costs and losses durin$ an ac&uisition may effectively allow them to bypass the income statement as they would become part of the $oodwill fi$ure. Answer 2 (a) Rele ance Information has the &uality of relevance when it can influence on a timely basis users' economic decisions. It helps to evaluate past present and future events by confirmin$ or perhaps correctin$ past evaluations of economic events. There are many ways of interpretin$ and applyin$ the concept of relevance for e#ample only material information is considered relevant as by definition information is material only if its omission or misstatement could influence users. Another common debate re$ardin$ relevance is whether current value information is more relevant than that based on historical cost. An interestin$ emphasis placed on relevance within the Framework is that relevant information assists in the predictive ability of financial statements. That is not to say the financial statements should be predictive in the sense of forecasts but that (past) information should be presented in a manner that assists users to assess an entity's ability to take advanta$e of opportunities and react to adverse situations. A $ood e#ample of this is the separate presentation of discontinued operations in the income statement. From this users will be better able to assess the parts of the entity that will produce future profits (continuin$ operations) and users can 0ud$e the merits of the discontinuation ie has the entity sold a profitable part of the business (which would lead users to &uestion why) or has the entity acted to curtail the adverse affect of a loss makin$ operation.
A1-3

Reliabilit! The Framework states that for information to be useful it must be reliable. The &uality of reliability is described as bein$ free from material error (accurate) and a faithful representation of that which it purports to portray (i.e. the financial statements are a faithful representation of the entity's underlyin$ transactions). There can be occasions where the le$al form of a transaction can be en$ineered to dis$uise the economic reality of the transaction. A cornerstone of faithful representation is that transactions must be accounted for accordin$ to their substance (i.e. commercial intent or economic reality) rather than their le$al or contrived form. To be reliable information must be neutral (free from bias). Biased information attempts to influence users (perhaps to come to a predetermined decision) by the manner in which it is presented. It is reco$nised that financial statements cannot be absolutely accurate due to inevitable uncertainties surroundin$ their preparation. A typical e#ample would be estimatin$ the useful economic lives of non1current assets. This is addressed by the use of prudence which is the e#ercise of a de$ree of caution in matters of uncertainty. 2owever prudence cannot be used to deliberately understate profit or create e#cessive provisions (this would break the neutrality principle). %eliable information must also be complete omitted information (that should be reported) will obviously mislead users. Comparabilit! )omparability is fundamental to assessin$ an entity's performance. 3sers will compare an entity's results over time and also with other similar entities. This is the principal reason why financial statements contain correspondin$ amounts for previous period(s). )omparability is enhanced by the use (and disclosure) of consistent accountin$ policies such that users can confirm that comparative information (for calculatin$ trends) is comparable and the disclosure of accountin$ policies at least informs users if different entities use different policies. That said comparability should not stand in the way of improved accountin$ practices (usually throu$h new Standards)4 it is reco$nised that there are occasions where it is necessary to adopt new accountin$ policies if they would enhance relevance and reliability. (b)(i) This item involves the characteristic of reliability and specifically reportin$ the substance of transactions. As the lease a$reement is for substantially the whole of the asset's useful economic life ,orto will e#perience the same risks and rewards as if it owned the asset. Althou$h the le$al form of this transaction is a rental its substance is the e&uivalent to ac&uirin$ the asset and raisin$ a loan. Thus in order for the financial
A1-4

statements to be reliable (and comparable to those where an asset is bou$ht from the proceeds of a loan) the transaction should be shown as an asset on ,orto's balance sheet with a correspondin$ liability for the future lease rental payments. The income statement should be char$ed with depreciation on the asset and a finance char$e on the (loan'. (b)(ii) This item involves the characteristic of comparability. )han$es in accountin$ policies should $enerally be avoided in order to preserve comparability. ,resumably the directors have $ood reason to be believe the new policy presents a more reliable and relevant view. In order to minimise the adverse effect a chan$e in accountin$ policy has on comparability the financial statements (includin$ the correspondin$ amounts) should be prepared on the basis that the new policy had always been in place (retrospective application). Thus the assets (retail outlets) should include the previously e#pensed finance costs and income statements will no lon$er show a finance cost (in relation to these assets whilst under construction). Any finance costs relatin$ to periods prior to the policy chan$e (i.e. for two or more years a$o) should be ad0usted for by increasin$ retained earnin$s brou$ht forward in the statement of chan$es in e&uity. (b)(iii) This item involves the characteristic of relevance. This situation &uestions whether historical cost accountin$ is more relevant to users than current value information. ,orto's current method of reportin$ these events usin$ purely historical cost based information (i.e. showin$ an operatin$ loss but not reportin$ the increases in property values) is perfectly acceptable. 2owever the company could choose to revalue its hotel properties (which would sub0ect it to other re&uirements). This option would still report an operatin$ loss (probably an even lar$er loss than under historical cost if there are increased depreciation char$es on the hotels) but the increases in value would also be reported (in e&uity) ar$uably $ivin$ a more complete picture of performance. Answer " Faithful representation The Framework states that in order to be useful information must be reliable and the two main components of reliability are freedom from material error and faithful representation. The Framework describes faithful representation as where the financial statements (or other information) have the characteristic that they faithfully
A1-5

represent the transactions and other events that have occurred. Thus a balance sheet should faithfully represent transactions that result in assets liabilities and e&uity of an entity. Some would refer to this as showin$ a true and fair view. An essential element of faithful representation is the application of the concept of substance over form. There are many e#amples where recordin$ the le$al form of a transaction does not convey its real substance or commercial reality. For e#ample an entity may sell some inventory to a finance house and later buy it back at a price based on the ori$inal sellin$ price plus a finance cost. Such a transaction is really a secured loan attractin$ interest costs. To portray it as a sale and subse&uent repurchase of inventory would not be a faithful representation of the transaction. The (sale' would probably create a (profit' there would be no finance cost in the income statement and the balance sheet would not show the asset of inventory or the liability to the finance house 5 all of which would not be representative of the economic reality. A further e#ample is that an entity may issue loan notes that are (optionally) convertible to e&uity. In the past sometimes mana$ement has ar$ued that as they e#pect the loan note holders to take the e&uity option the loan notes should be treated as e&uity (which of course would flatter the entity's $earin$). In some cases transactions similar to the above particularly off balance sheet finance schemes have been deliberately entered into to manipulate the balance sheet and income statement (so called creative accountin$). %atios such as return on capital employed (%.)/) asset turnover interest cover and $earin$ are often used to assess the performance of an entity. If these ratios were calculated from financial statements that have been manipulated they would be distorted (usually favourably) from the underlyin$ substance. )learly users cannot rely on such financial statements or any ratios calculated from them. Answer # The Framework defines an asset as a resource controlled by an entity as a result of past transactions or events from which future economic benefits (normally net cash inflows) are e#pected to flow to the entity. 2owever assets can only be reco$ni6ed (on the balance sheet) when those e#pected benefits are probable and can be measured reliably. The Framework reco$ni6es that there is a close relationship between incurrin$ e#penditure and $eneratin$ assets but they do not necessarily coincide. 7evelopment e#penditure perhaps more than any other form of e#penditure is a classic e#ample of the relationship between e#penditure and creatin$ an asset. )learly entities commit to e#penditure on both research and development in the hope that it will lead to a profitable product process or service but at the time that the e#penditure is bein$ incurred entities cannot be certain (or it may not even be probable) that the pro0ect will be successful. %elatin$ this to accountin$ concepts
A1-6

would mean that if there is doubt that a pro0ect will be successful the application of prudence would dictate that the e#penditure is char$ed (e#pensed) to the income statement. At the sta$e where mana$ement becomes confident that the pro0ect will be successful it meets the definition of an asset and the accruals8matchin$ concept would mean that it should be capitali6ed (treated as an asset) and amortised over the period of the e#pected benefits. Accountin$ Standards (IAS *9 Intan$ible Assets) interpret this as writin$ off all research e#penditure and only capitalisin$ development costs from the point in time where they meet strict conditions which effectively mean the e#penditure meets the definition of an asset. Answer $ (a) The accruals basis re&uires transactions (or events) to be reco$nised when they occur (rather than on a cash flow basis). %evenue is reco$nised when it is earned (rather than when it is received) and e#penses are reco$nised when they are incurred (i.e. when the entity has received the benefit from them) rather than when they are paid. %ecordin$ the substance of transactions (and other events) re&uires them to be treated in accordance with economic reality or their commercial intent rather than in accordance with the way they may be le$ally constructed. This is an important element of faithful representation. ,rudence is used where there are elements of uncertainty surroundin$ transactions or events. ,rudence re&uires the e#ercise of a de$ree of caution when makin$ 0ud$ements or estimates under conditions of uncertainty. Thus when estimatin$ the e#pected life of a newly ac&uired asset if we have past e#perience of the use of similar assets and they had had lives of (say) between five and ei$ht years it would be prudent to use an estimated life of five years for the new asset. )omparability is fundamental to assessin$ the performance of an entity by usin$ its financial statements. Assessin$ the performance of an entity over time (trend analysis) re&uires that the financial statements used have been prepared on a comparable (consistent) basis. :enerally this can be interpreted as usin$ consistent accountin$ policies (unless a chan$e is re&uired to show a fairer presentation). A similar principle is relevant to comparin$ one entity with another4 however it is more difficult to achieve consistent accountin$ policies across entities. Information is material if its omission or misstatement could influence (economic)
A1-7

decisions of users based on the reported financial statements. )learly an important aspect of materiality is the (monetary) si6e of a transaction but in addition the nature of the item can also determine that it is material. For e#ample the monetary results of a new activity may be small but reportin$ them could be material to any assessment of what it may achieve in the future. !ateriality is considered to be a threshold &uality meanin$ that information should only be reported if it is considered material. Too much detailed (and implicitly immaterial) reportin$ of (small) items may confuse or distract users. (b) Accountin$ for inventory by ad0ustin$ purchases for openin$ and closin$ inventories is a classic e#ample of the application of the accruals principle whereby revenues earned are matched with costs incurred. )losin$ inventory is by definition an e#ample of $oods that have been purchased but not yet consumed. In other words the entity has not yet had the (benefit' (i.e. the sales revenue they will $enerate) from the closin$ inventory4 therefore the cost of the closin$ inventory should not be char$ed to the current year's income statement. )onsi$nment inventory is where $oods are supplied (usually by a manufacturer) to a retailer under terms which mean the le$al title to the $oods remains with the supplier until a specified event (say payment in three months time). .nce the $oods have been transferred to the retailer normally the risks and rewards relatin$ to those $oods then lie with the retailer. -here this is the case then (in substance) the consi$nment inventory meets the definition of an asset and the $oods should appear as such (inventory) on the retailer's balance sheet (alon$ with the associated liability to pay for them) rather than on the balance sheet of the manufacturer. At the year end the value of an entity's closin$ inventory is by its nature uncertain. In the ne#t accountin$ period it may be sold at a profit or a loss. Accountin$ standards re&uire inventory to be valued at the lower of cost and net realisable value. This is the application of prudence. If the inventory is e#pected to sell at a profit the profit is deferred (by valuin$ inventory at cost) until it is actually sold. 2owever if the $oods are e#pected to sell for a (net) loss then that loss must be reco$ni6ed immediately by valuin$ the inventory at its net realisable value. There are many acceptable ways of valuin$ inventory (e.$. avera$e cost or FIF.). In order to meet the re&uirement of comparability an entity should decide on the most appropriate valuation method for its inventory and then be consistent in the use of that
A1-8

method. Any chan$e in the method of valuin$ (or accountin$ for) inventory would break the principle of comparability. For most businesses inventories are a material item. An error (omission or misstatement) in the value or treatment of inventory has the potential to affect decisions users may make in relation to financial statements. Therefore (correctly) accountin$ for inventory is a material event. )onversely there are occasions where on the $rounds of immateriality certain (inventories' are not (strictly) accounted for correctly. For e#ample at the year end a company may have an unused supply of stationery. Technically this is inventory but in most cases companies would char$e this (inventory' of stationery to the income statement of the year in which it was purchased rather than show it as an asset. (;ote" other suitable e#amples would be acceptable.) Answer % There are four elements to the assistant's definition of a non1current asset and he is incorrect in respect of all of them. The term non1current assets will normally include intan$ible assets and certain investments4 the use of the term (physical asset' would be specific to tan$ible assets only. -hilst it is usually the case that non1current assets are of relatively hi$h value this is not a definin$ aspect. A waste paper bin may e#hibit the characteristics of a non1 current asset but on the $rounds of materiality it is unlikely to be treated as such. Furthermore the past cost of an asset may be irrelevant4 no matter how much an asset has cost it is the e#pectation of future economic benefits flowin$ from a resource (normally in the form of future cash inflows) that defines an asset accordin$ to the 2<I),A's Framework for the preparation and presentation of financial statements. The concept of ownership is no lon$er a critical aspect of the definition of an asset. It is probably the case that most noncurrent assets in an entity's statement of financial position are owned by the entity4 however it is the ability to (control' assets (includin$ preventin$ others from havin$ access to them) that is now a definin$ feature. For e#ample" this is an important characteristic in treatin$ a finance lease as an asset of the lessee rather than the lessor.
A1-9

It is also true that most non1current assets will be used by an entity for more than one year and a part of the definition of property plant and e&uipment in 2<AS => ,roperty plant and e&uipment refers to an e#pectation of use in more than one period but this is not necessarily always the case. It may be that a non1current asset is ac&uired which proves unsuitable for the entity's intended use or is dama$ed in an accident. In these circumstances assets may not have been used for lon$er than a year but nevertheless they were reported as non1currents durin$ the time they were in use. A non1current asset may be within a year of the end of its useful life but (unless a sale a$reement has been reached under 2<F%S ? ;on1current assets held for sale and discontinued operations) would still be reported as a non1current asset if it was still $ivin$ economic benefits. Another definin$ aspect of non1current assets is their intended use i.e. held for continuin$ use in the production supply of $oods or services for rental to others or for administrative purposes. Answer & 'a( The $oin$ concern assumption is that an entity will continue in operational e#istence for the foreseeable future. This means that the financial statements of an entity are prepared on the assumption that the entity will continue tradin$. If this were not the case various ad0ustments would have to be made to the accounts" provisions for losses4 revaluation of assets to their possible market value4 all non1current assets and liabilities would be reclassified as current4 and so forth. 3nless it can be assumed that the business is a $oin$ concern other accountin$ assumptions cannot apply. For e#ample it is meanin$less to speak of consistency from one accountin$ period to the ne#t when this is the final accountin$ period. The accruals basis of accountin$ states that items are reco$nised as assets liabilities e&uity income and e#penses when they satisfy the definitions and reco$nition criteria in the Framework. The effect of this is that revenue and e#penses which are related to each other are matched so as to be dealt with in the same accountin$ period without re$ard to when the cash is actually paid or received. This is particularly relevant to the purchase of non1current assets. The cost of a noncurrent asset is spread over the accountin$ periods e#pected to benefit from it thus matchin$ costs and revenues. In the absence of the $oin$ concern convention this cannot happen as an e#ample will illustrate.
A1-10

Suppose a company has a machine which cost @=A AAA two years a$o and now has a net book value of @> AAA. The machine can be used for another three years but as it is hi$hly specialised there is no possibility of sellin$ it and so it has no market value. If the $oin$ concern assumption applies the machine will be shown at cost less depreciation in the accounts (ie @> AAA) as it still has a part to play in the continued life of the entity. 2owever if the assumption cannot be applied the machine will be $iven a nil value and other assets and liabilities will be similarly revalued on the basis of windin$ down the companyBs operations. 'b( .ne of the ideas behind the Framework is to a oid the fire)fi*htin* approach which has characterised the development of accountin$ standards in the past and instead develop an underlyin$ philosophy as a basis for consistent accountin$ principles so that each standard fits into the whole framework. %esearch be$an from an analysis of the fundamental ob0ectives of accountin$ and their relationship to the information needs of accounts users. The Framework has $one behind the re&uirements of e#istin$ accountin$ standards which define accountin$ treatments for particular assets liabilities income and e#penditure to define the nature of assets liabilities income and e#penditure.

A1-11