TOPIC 3:

THE CONCEPTUAL
FRAMEWORK
Textbook: Ch 4
 LEARNING
OBJECTIVES
1. Understand what is meant by generally accepted accounting practice.
2. Understand the purpose of the conceptual framework.
3. Understand the objective of financial reporting.
4. Know who the primary users of financial reports are.
5. Understand the going concern concept, which is the basic assumption that
underlies the preparation of all financial reports.
6. Realise that information in financial reports should have certain
qualitative characteristics that enable financial reporting to achieve its
objective.
7. Understand how qualitative characteristics enhance the usefulness of
financial reports.
8. Know how to apply the definition of elements.
9. Recognise assets, liabilities, income and expenses.
10. Understand the accrual concept.
 Link with Topic 2
INPUTS PROCESS OUTPUTS
Transaction Dr & Cr SOFP
SOCI
SCF

Why do businesses prepare

financial statements?

For each transaction

Identified which element increased/decreased

BUT:
Which
1. Bought vehicle and paid cash
2. Bought vehicle on Hire Purchase
3. Hired vehicle from AVIS
? account
is DR?
 Link with Topic 2
Is it an asset/liability/equity? Definition
Can it appear on the F/S? Recognition criteria
At what amount is it Measurement
recognised?

IFRS/GAAP Initially At each

recognised subsequent
recognition
Principles that allow similar reporting

Conceptual framework
Standards – how to report on particular items i.e.
Inventory; PPE
 Sole trader

Same
legal
Owner
Business person
 Income
Entity Concept
earned Sole trader

Expenses Contributes capital

incurred

Statement
of
Separate Changes
In
business equity
and private Owner
Business transactions
Statement of profit or loss => Profit/loss belongs to owner
profit or loss for the period

Withdraws assets = Drawings

 Entity Concept
ASSETS
Sole trader

LIABILITIES

Statement
of
Separate Changes
In
business equity
and private Owner
Business transactions

STATEMENT OF EQUITY
FINANCIAL POSITION

Assets less Liabilities = Equity

 Company

Different
legal
Owner
Business entities
 Income
Entity Concept
earned Company

Expenses
incurred Buys Share Capital

Statement
of
Separate Changes
In
business equity
Business and shareholder Shareholder
transactions
Statement of profit or loss => Profit/loss increases equity
profit or loss for the period

Withdraws dividends
 Entity Concept
ASSETS
Company

LIABILITIES

Statement
of
Separate Changes
In
business equity
Business and shareholder Shareholder
transactions

STATEMENT OF EQUITY
FINANCIAL POSITION

Assets less Liabilities = Equity

 What is GAAP?
- Generally Accepted Accounting Practice
- Set of principles applied when preparing financial statements.

Includes the Conceptual framework which describes the:

- objective of general purpose financial reporting and the
- concepts that underlie the preparation and presentation of financial statements
The Conceptual framework is the basis from which all accounting
statements/standards are prepared.

Includes accounting Standards which provide:

- Principles for specific topics, e.g. IAS2 for Inventories, IFRS 15 for Revenue.
International Accounting Standards = IAS
International Financial Reporting Standards = IFRS
 THE CONCEPTUAL
FRAMEWORK
Issued by the International Accounting Standards Board (IASB)
Assists the IASB to develop standards that are based on
consistent principles e.g. IAS2 for Inventories, IFRS 15 for
Revenue.
Also used to decide how to treat transactions when no specific
accounting standard applies
 The conceptual framework:
 is not a standard.
 does not override a Standard => if a Standard differs from
the info in the Conceptual Framework, then the Standard
prevails.
 THE CONCEPTUAL
FRAMEWORK
- Objectives of financial reporting
- Qualitative characteristics of useful financial
information
- Definition and recognition of elements
- Measurement of elements
 OBJECTIVE OF
FINANCIAL REPORTING
- Provide financial information about the business that is
useful
- To the users of the financial statements
- In order for them to make decisions about providing
economic resources to the entity.
 GOING CONCERN
ASSUMPTION
- Financial statements (AFS) are prepared on assumption
that the business is a going concern.
- Expectation is that the business will continue to trade in
the foreseeable future at similar or larger scale
Relevant: Impacts on how elements are measured
 If going concern can use cost/fair value as measurement
× If not a going concern then use more approiate values for
measurement, e.g. liquidation basis
× If AFS are not prepared on going concern basis => must
be disclosed in AFS with explanation of basis used
 Going concern Example
A business’s financial statements for the year ended 30 June 2020 have
been prepared using the same IFRS accounting principles and practices
that it has used for years. Because of Covid-19, the business is likely to
enter liquidation within two months.
Required:
Discuss whether it is appropriate for the business to continue using the
same basis for preparing its financial statements as in the past.
Solution:
It is not appropriate to continue with the same basis for preparing the
financial statements => in the past the going concern assumption was
appropriate. However, the going concern assumption is only appropriate
when the business has no need or intention to cease trading.
As the business is likely to enter liquidation within two months, it can no
longer be assumed to be a going concern as it would not be able to
continue trading in the foreseeable future. The financial statements should
therefore be prepared on the liquidation basis.
 Qualitative characteristics of
useful financial information
Fundamental Predictive value
Relevance
characteristics Confirmatory value
Without these, Faithful Complete
info is not useful representation
Neutral
Free from error
Enhancing Comparability Cost constraint!
characteristics Costs of reporting info
Verifiability must be justified by its
These enhance the
Timeliness usefulness. It is impossible
usefulness of info
to provide all info that a
Understandability user finds relevant.
 Fundamental characteristics
• Information that is NOT relevant and faithfully
represented is NOT useful.
– Cannot be made useful if more comparable,
verifiable, timely or understandable.

• Information that IS relevant and faithfully

represented IS useful
– Even if it does not have enhancing characteristics.
 Relevance
Capable of Can be used to
making a predict future
difference to outcomes
users’ decisions

Predictive value
Relevance
Confirmatory value

Materiality: info is material Provides

if omitting or misstating it feedback about
could influence a user’s previous
decisions. Threshold is evaluations
entity-specific.
 Faithful representation
Includes all info
Reveals the substance, necessary for
rather than merely the legal understanding
form, of the economic
phenomenon
Without bias; not
Complete slanted, weighted,
Faithful Neutral emphasised, de-emphasised,
representation Free from error manipulated, etc.
Prudence: assets &
income not overstated; Description &
liabilities and expenses not process are without error;
understated. Supports not necessarily perfectly
neutrality. accurate
 Faithful representation
Example
A business purchases a machine for R500 000. The accountant does not
include the accounting policy on machinery i.e. how machinery is
measured, in the notes to the financial statements.
How would this affect the usefulness of the financial statements?
Solution:
The financial statements are not complete without the accounting policy,
therefore the financial statements are not faithfully represented.
Information is complete if everything necessary to understand the
transaction or element is provided
Not all essential information is provided if the accounting policy is omitted.
 Enhancing characteristics
Across time for one entity; and
Comparability across different entities. Not uniformity.
Consistency helps.
Different knowledgeable,
Verifiability independent observers would reach
consensus. Can be direct or indirect.

Info provided in time to influence

Timeliness decisions.
Present info clearly
& concisely. Assumes a reasonable
Understandability knowledge of business, and diligent
review. May not omit complex info.
 Enhancing characteristics
Example 1
A business’s financial statements for the year ended 30 June 2020 have
been prepared using different accounting principles and practices to those
it has used in prior years. Although the new principles and practices are
permitted by IFRS, the business has provided no information to explain
how the changes have affected the financial statements.
REQUIRED:
Identify the enhancing characteristic of useful information that the
accountant is failing to comply with.
Solution:
Comparability
Comparability requires that an entity’s financial statements can be
compared across time.
 Enhancing characteristics
Example 2
A business has developed a brand that has significant value. Three
independent brand valuation experts have valued the brand at R1 million,
R4 million and R10 million respectively. The business has measured the
brand at R10 million on its statement of financial position.
REQUIRED:
Identify the enhancing characteristic of useful information that the
accountant is failing to comply with.
Solution:
Verifiability
Verifiability requires that different, knowledgeable, independent observers
would reach a consensus about the business’s financial information. In this
case, there is clearly no consensus about the value of the brand.
 Enhancing characteristics
Example 3
A business has a year-end of 30 November 2018. The accountant started
maternity leave in December 2018 and requested that the financial
statements be completed upon her return. The board agreed to this and
the financial statements were released to the public in August 2019.
REQUIRED:
Identify the enhancing characteristic of useful information that the
accountant is failing to comply with.
Solution:
Timeliness
The main concern with the financial statements being released to the
public 8 months after year-end is that it is too old to influence the users’
decision-making.
 Enhancing characteristics
Example 4
During the current financial year, a business has entered into an extremely
complex funding arrangement involving six different financial institutions
based in three different countries. The directors are concerned that the
arrangement is so complex that it would be better to leave it out of the
financial statements for the current year.
REQUIRED:
Identify the enhancing characteristic of useful information that the
accountant is failing to comply with.
Solution:
Understandability
The Conceptual Framework specifically mentions that to achieve
understandability, a business may not omit complex information.
 COMPONENTS OF
FINANCIAL STATEMENTS
Statement of Financial position
• Assets
• Liabilities
• Owners Equity
Statement of Profit or Loss
• Income
• Expenses
Statement of Changes in Equity

Lets look at the elements of the AFS in more detail

 ASSET
An asset is a
- present economic resource,
- controlled by the entity,
- due to a past event.
What is an economic resource?
A right that has the potential to produce economic benefits.
What is a right?
There are two types:
(1) Rights relating to an obligation of another party, for example,
 The right to receive cash
 The right to receive goods/services
(2) Rights not related to an obligation of another party, for example,
 The rights over physical items such as vehicles, land or inventory
 ASSET
What is an economic resource?
A right that has the potential to produce economic benefits.
An economic resource has the potential to produce economic benefits if it
enables the business to:
- Produce cash inflows e.g. inventory
- Avoid cash outflows e.g. a printer purchased to avoid having to send
printing to a printing service provider.
- Receive contractual cash flows e.g. trade receivables
- Receive another economic resource e.g. a machine used to produce
inventory
 ASSET
An asset is a
- present economic resource,
- controlled by the entity,
- due to a past event.
Control: present ability to direct use of an economic resource and obtain the
economic benefits that may flow from it.
Past event: transaction that happened/occurred

What is an asset?
Asset definition: Example 1
A business purchases a delivery vehicle for R510 000.
The vehicle will be used to deliver goods to customers.

Would the business recognise the vehicle as an asset?

 Asset definition: Example 1
• The vehicle is a present economic resource – the
business has the right to use or sell the delivery
vehicle.
• The delivery vehicle has the potential to generate
cash (future economic benefit) indirectly, as it is
used in the business, or directly, if it is sold.
• The delivery vehicle is controlled by the business
that will obtain the economic benefits. No one else
has any rights to the vehicle.
• The past event was the delivery of the vehicle.
 Asset Definition Example 2
A business owns a vehicle that it uses to make deliveries of the goods it
sells. Which of the following is NOT true, i.e. FALSE?
a. The business’ asset is the right to use the vehicle, not the vehicle
itself.
b. The economic benefits of the vehicle include the avoidance of the
cash outflows that would be required to pay a courier if the business
did not have a vehicle.
c. The business controls the vehicle even if it still owes money for the
purchase of the vehicle.
d. If the business stopped making deliveries, the vehicle would no
longer be an asset of the business.
False
The vehicle still has the potential
to produce economic benefits
 LIABILITIES
A liability is:
- A present obligation of the business,
- to transfer an economic resource,
- as a result of past events.
What is an obligation?
An obligation is a duty/ responsibility that the business has no
practical ability to avoid.
 LIABILITIES
A liability is:
- A present obligation of the business,
- to transfer an economic resource,
- as a result of past events.
Present => business must have received economic benefit
 LIABILITIES
A liability is:
- A present obligation of the business,
- to transfer an economic resource,
- as a result of past events.
Transfer of economic resource: “economic resource?” sounds
familiar? (Used in asset definition as well!)
e.g. Accounts payable = transfer cash
Income received in advance = deliver goods/service
 LIABILITIES
A liability is:
- A present obligation of the business,
- to transfer an economic resource,
- as a result of past events.

Past event: Transaction happened or occurred

Need to determine if the entity has already:
- Obtained a benefit, or
- Taken an action
What is a liability?
 Liability Example 1
A landlord rents a building to a tenant for six months, starting
on 1 July. The rental agreement is signed on 1 June. The first
month’s rent is due on 30 June. The tenant begins using the
building on 1 July, despite not paying the rent due on 30 June.
Which is the first day on which the tenant has a liability in
respect of the rental agreement?
Answer:
1 July
The obligating event is the landlord’s performance in terms
of the contract, that is, making the property available to the
tenant from 1 July. From this day onward, the tenant’s liability
begins to increase, until it is settled.
 Liability Example 2
A business orders a machine and signs a purchase
agreement on 1 June. The business pays a 20% deposit on 3
June. The machine is delivered on 20 June. The business
pays the remaining 80% of the purchase price on 30 June.
Which is the first day on which the business has a liability in
respect of this purchase agreement?
Answer:
20 June
The obligating event is the supplier’s performance in terms
of the contract, that is, delivering the machine which took
place on 20 June. From 20 June, the business has a liability,
until it is settled.
 EQUITY
Accounting equation:

A = OE + L OR OE = A – L

Thus OE is known as the residual interest in the assets after

deducting all of its liabilities.
OR

Net asset value

 EQUITY
Changes in equity (net asset value) arise because of:
- Transactions with the owner (capital contributed,
drawings/dividends)
- Transactions not with the owner (income and expenses)
 INCOME AND
EXPENSES
• Income: occurs when transactions (not with the owner) result
in an
• increase in assets or a decrease in liabilities of the business
=> increases the equity of the business.

• Expenses: Occur when transactions (not with the owner)

result in a
• decrease in assets or an increase in liabilities of the
business.
=> decreases the equity of the business.
 RECOGNITION
CRITERIA
Recognising an asset, liability, income or expense means that the item
appears in AFS. (Journal processed in acc records)
1st => element must meet definition criteria
2nd => recognition criteria must be met
Recognition criteria:
Assets and liabilities, and any resulting income and expenses or changes
in equity, must only be recognised if the user would find this information
useful, i.e. we only recognise elements if it means that we are providing
information that is relevant and a faithful representation.

Fundamental
qualitative
characteristics
 RECOGNITION
CRITERIA (cont.)
So what is meant by useful information?
 Relevant information about the asset or liability, and any resulting
income or expense or changes in equity, and
 Consider existence uncertainty: Does the element actually exist?
 Consider outcome uncertainty: Is there a low probability of inflows or outflows
of economic benefits?
 Faithful representation of the asset or liability, and any resulting
income or expense or changes in equity.
 Consider measurement uncertainty: If all estimates available are highly
uncertain? No estimates available?
 Asset definition
Business A purchases a lottery ticket for R250, giving rise to a 4% chance
of winning R10 000.
Does the lottery ticket meet the asset definition requirements?
- Present economic resource
- Right that has the potential to produce economic benefits
- The economic resource is the right to claim the winnings should your ticket be the
winning ticket and not the amount that you could potentially win.
- Controlled by the business
- Ability to direct the use of the economic resource and obtain the economic benefits that
may flow from it.
- Business A has the right to decide what to do with the lottery ticket and is able to prevent
others from obtaining the benefit that would arise if the ticket is the winning ticket.
- As a result of past events
- Purchase of the lottery ticket
 Asset recognition criteria
Business A purchases a lottery ticket for R250, giving rise to a 4% chance
of winning R10 000. The lottery ticket meets the asset definition.
Should the lottery ticket be recognized as an asset in the financial
statements?
 Relevant information
 There is no existence uncertainty regarding the lottery ticket. It does exist.
 Outcome uncertainty is an issue: as there is a low probability of inflow of
economic benefits
 Faithful representation
 There is no measurement uncertainty as the price of the lottery ticket is
known.
Recognition and measurement
• Recognition
– Process of incorporating in the SoFP/SoCI an
item that meets the definition and recognition
criteria
• Measurement
– Process of determining the monetary amount at
which the elements in the financial statements
are recognised and carried at (CARRYING
AMOUNT)
Timeline of elements
Element definition

Initial recognition
Recognition criteria

Initial measurement

Subsequent measurement

De-recognition
 Derecognition
• Derecognition is defined as the removal of all or
part of a previously recognised asset or liability
from a business statement of financial position.

• Derecognition of an asset normally happens when

the business loses control of all or part of the
recognised asset.

• Derecognition of a liability happens when the

business no longer has a present obligation for all
or part of the recognised liability.
 Measurement
• The conceptual framework allows several different
measurement bases:
– Historical cost: measurement is based on the cost
– Current value: measurement is updated for current
conditions
o Fair value: measurement is based on the fair
value
o Value in use: measurement is based on the
expected EBs
o Current cost: measurement is based on the
cost of an equivalent item.
 Accrual basis
• Effects of transactions reported in financial period
in which they occur, i.e. when assets/liabilities
change, not necessarily when cash is received or
paid.
• Reporting information on business’s resources and
claims (statement of financial position), and
changes in its resources and claims (statement of
profit or loss and other comprehensive income and
statement of changes in equity) on accrual basis is
a better basis for assessing a business’s past and
future performance.
• Statement of cash flow NOT on accrual basis.
 THE ACCRUAL CONCEPT
TRANSACTION 1 TRANSACTION 2
INCOME 1. CASH CASH ↑ INCOME
SALES RECEIVED EARNED
2. CREDIT CUSTOMER INCOME CASH ↑ CUSTOMER
SALES OWES EARNED RECEIVED SETTLED
(DEBTOR ↑) (DEBTOR↓)

3. CASH ↑ UNEARNED UNEARNED INCOME

UPFRONT RECEIVED INCOME INCOME EARNED
RECEIPT (LIABILITY↑) (LIABILITY↓)

 Income is recognized when it is earned, and not when the money is received.
 Income is recognized when we provide a service or sell goods to customers.
 THE ACCRUAL CONCEPT
TRANSACTION 1 TRANSACTION 2
INCOME 1. CASH CASH
DR Asset INCOME
CR
SALES RECEIVED EARNED
Income
2. CREDIT CUSTOMER
DR Asset INCOME
CR CASH
DR Asset CUSTOMER
CR Asset
SALES OWES EARNED RECEIVED SETTLED
Income
(DEBTOR↑) (DEBTOR↓)

3. CASH UNEARNED UNEARNED INCOME

UPFRONT DR Asset
RECEIVED CR
INCOME DR
INCOME CR
EARNED
RECEIPT Liability (LIABILITY↓)
(LIABILITY↑) Liability Income

 Income is recognized when it is earned, and not when the money is received.
 Income is recognized when we provide a service or sell goods to customers.
 THE ACCRUAL CONCEPT
TRANSACTION 1 TRANSACTION 2
EXPENSE 1. CASH EXPENSE CASH PAID ↓
PURCHASE INCURRED
2. CREDIT EXPENSE OWE SUPPLIER CASH PAID↓
PURCHASE INCURRED SUPPLIER SETTLED
(CREDITOR↑) (CREDITOR↓)

3. UPFRONT PREPAID CASH PAID↓ EXPENSE PREPAID

PAYMENT EXPENSE INCURRED EXPENSE
(ASSET↑) (ASSET↓)

 Expenses are recognized when they are incurred and not when they
are paid.
 Expenses are recognized when we use a service or consume
goods/assets.
 THE ACCRUAL CONCEPT
TRANSACTION 1 TRANSACTION 2
EXPENSE 1. CASH EXPENSE
DR CASH PAID
CR Asset
PURCHASE INCURRED
Expense
2. CREDIT EXPENSE OWE SUPPLIER CASH PAID
PURCHASE DR
INCURRED CR Liability
SUPPLIER DR
SETTLED CR Asset
Expense (CREDITOR↑) Liability
(CREDITOR↓)

3. UPFRONT PREPAID
DR Asset CASH PAID
CR Asset EXPENSE
DR PREPAID
PAYMENT EXPENSE INCURRED
CR Asset
EXPENSE
(ASSET↑) Expense (ASSET↓)

 Expenses are recognized when they are incurred and not when they
are paid.
 Expenses are recognized when we use a service or consume
goods/assets.
 CASH BASIS
COMPARED
TO ACCRUAL BASIS
• Accrual basis: statement of profit or loss measures results of
operations or performance
– Income recognised as a measure of accomplishment when
earned
• goods sold or services provided
• not dependant on cash received
– Expenses included as measure of effort when incurred
• relates expenses to income
• not dependant on cash paid

• Cash basis factual but may misrepresent the long run cash
generating ability of the business