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GUIDELINES IN THE PREPARATION OF FINANCIAL STATEMENTS

A. COMPONENTS OF THE FRAMEWORK

Conceptual Framework

1. A conceptual framework is important as a coherent system of concepts that flow from an objective and the
objective identifies the purpose of financial reporting. By building upon an established body of concepts, a soundly
developed conceptual framework leads to more useful and consistent pronouncements over time and allows the
accounting profession to solve new and emerging practical problems more quickly.

2. Although the IASB issued the Conceptual Framework for Financial Reporting in 2010, it remains a work in process. The
framework consists of three levels. The first level identifies the objective of financial reporting. The second level
provides the qualitative characteristics that make accounting information useful and the elements of financial
statements. The third level identifies the assumptions, principles and constraints that describe the reporting
environment. Working together the IASB and the FASB developed the converged concept statements on the
objective of financial reporting and qualitative characteristics of accounting information. Both Boards are now
working on their own individual schedules to address the remaining elements of the framework.

First Level: Basic Objective


3. The objective of financial reporting is the foundation of the Conceptual Framework. The objective of general-
purpose financial reporting is to provide financial information about the reporting entity that is useful to present
and potential equity investors, lenders, and other creditors in making decisions about providing resources to
the entity.
4. An implicit assumption is that users need reasonable knowledge of business and financial accounting matters to
understand the information contained in financial statements. This means that financial statement preparers
assume a level of competence on the part of users, which impacts the way and the extent to which companies
report information.

Second Level: Fundamental Concepts


5. The second level bridges the “why” or objective of accounting with the “how of accounting that addresses
recognition, measurement and financial presentation. The fundamental qualities that make accounting
information useful for decision making are relevance and faithful representation.
a. Relevance: Accounting information is relevant if it is capable of making a difference in a decision. Financial
information is capable of making a difference when it has predictive value, confirmatory value, or both. If the
monetary size of an item could influence a user’s discussion, then the item is material and must be disclosed.
(1) Predictive Value: Financial information has value as an input to predictive processes used by potential
investors in forming their expectations of a company’s future.
(2) Confirmatory Value: Financial information that helps users confirm or correct prior expectations.
(3) Materiality: Materiality is a company-specific aspect of relevance. Information is material if omitting or
misstating would make a difference in users’ decisions. It requires evaluating both the relative size and
importance of an item. While companies and auditors adopt a general rule of thumb is that anything
under 5 percent of net income is considered immaterial, this depends upon specific rules; companies
must consider both quantitative and qualitative factors when determining materiality thresholds.
b. Faithful Representation: Means that the numbers and descriptions contained in the financial statements
match what really existed or happened. To be a faithful representation, information must be complete,
neutral, and free from error.
(1) Completeness: The financial statements include all the information that is necessary for faithful
representation of the economic phenomena that it purports to represent.
(2) Neutrality: Information is neutral if it is unbiased, i.e., it is not presented in a manner that favors one set
of interested parties over another.
(3) Free from error: Does not mean total freedom from error. It means that the information presented is as
accurate as possible, given that any estimates are based on the best information available at the time.

6. The enhancing qualities are complementary to the fundamental qualitative characteristics. They include
comparability, verifiability, timeliness, and understandability.
a. Comparability: Information that is measured and reported in a similar manner for different companies is
considered comparable. It enables users to identify the real similarities and differences in economic events
between companies. Another type of comparability is consistency, which is present when a company applies
the same accounting treatment to similar events, from period to period.
b. Verifiability: Occurs when independent measurers, using the same methods, obtain similar results.
c. Timeliness: Means having information available to decision-makers before it loses its capacity to influence
decisions.

d. Understandability: Is the quality of information that lets reasonably informed users see the connection
between their decisions and the information contained in the financial statements. Understandability is
enhanced when information is classified, characterized, and presented clearly and concisely.

7. The IASB classifies the elements of the financial statements into two groups. The first group describes amounts of
resources and claims to resources at a moment in time. The second group describes transactions, events and
circumstances that affect a company during a period time.

a. Resources and claims to resources at a moment in time.


(1) Asset: A resource controlled by the entity as a result of past events and from which future economic
benefits are expected to flow to the entity.
(2) Liability: A present obligation of the entity arising from past events, the settlement of which is expected to
result in an outflow from the entity of resources embodying economic benefits.
(3) Equity: The residual interest in the assets of the entity after deducting all its liabilities.

b. Transactions, events, and circumstances that affect a company during a period of time.
(1) Income: Increases in economic benefits during the accounting period in the form of inflows or
enhancements of assets or decreases of liabilities that result in increases in equity, other than those
relating to contributions from equity participants.
(2) Expenses: Decreases in economic benefits during the accounting period in the form of outflows or
depletions of assets or incurrences of liabilities that result in decreases in equity, other than those
relating to distributions to equity participants.

Third Level: Recognition, Measurement, and Disclosure Concepts


8. In the practice of financial accounting, certain basic assumptions are important to an understanding of the manner
in which information is presented. The following five basic assumptions underlie the financial accounting
structure.
a. Economic Entity Assumption: Means that economic activity can be identified with a particular unit of
accountability. In other words, a company keeps its activity separate and distinct from its owners and any
other business unit.
b. Going Concern Assumption: In the absence of information to the contrary, a company is assumed to have a
long life. The legitimacy of the cost principle is dependent upon the going concern assumption, whereby
depreciation and amortization policies are justified and appropriate only if there is some permanence to the
company’s continuance.
c. Monetary Unit Assumption: Money is the common denominator of economic activity and provides an
appropriate basis for accounting measurement and analysis. The monetary unit is assumed to remain
relatively stable over the years in terms of purchasing power. Therefore, this assumption disregards any
inflation or deflation in the economy in which the company operates.
d. Periodicity Assumption: The life of a company can be divided into artificial time periods for the purpose of
providing periodic reports on the economic activities of the company.
e. Accrual Basis of Accounting: Transactions that change a company’s financial statements are recorded in the
periods in which the events occur. The cash basis of accounting is prohibited under IFRS because it violates
both the revenue recognition principle and the expense recognition principle.

10. The basic principles of accounting are used to record and report transaction. The four basic principles of
accounting are:
a. Measurement Principles: We currently have two acceptable measurement principles: historical cost and fair
value. Choosing which principle to follow generally reflects the trade off between relevance and faithful
representation.
(1) Historical Cost: IFRS requires many assets and liabilities be reported at their acquisition price, or cost,
sometimes referred to as historical cost. Using cost has an important advantage: It is thought to be a
faithful representation of the amount paid for a given item. Many users favor historical cost because it
provides a verifiable benchmark for measuring historical trends.
(2) Fair Value: Is a market-based measure. At acquisition, historical cost and fair value are identical. In
subsequent periods, as market and economic conditions change, the two values may diverge. It is felt
that where fair value information is available, it provides more relevant information about the expected
future cash flows related to an asset or liability. The IASB allows companies the option to use fair value,
known as the fair value option, for the measurement basis of financial assets and financial liabilities.

b. Revenue Recognition Principle: When a company agrees to perform a service or sell a product it has a
performance obligation. Therefore, revenue is recognized in the period in which the performance
obligation is satisfied.

c. Expense Recognition Principle: Recognition of expenses is related to the consumption of assets or incurring
of liabilities. The expense recognition principle is implemented in accordance with the definition of expense
by matching efforts (expenses) with accomplishments (revenues). Some costs are difficult to associate with
revenues and must be allocated to expense based on a “rational and systematic” allocation policy. Product
costs, like materials, labor, and overhead, are expensed when the units they are attached to are sold. Period
costs, like officers’ salaries or other administrative expenses, are expensed as incurred.

d. Full Disclosure Principle: Financial statements should include sufficient information to permit a
knowledgeable user to make an informed decision about the financial condition of the company in question.
Users can find financial information (1) within the main body of the financial statements, (2) in the notes to
those statements, or (3) as supplementary information.

11. In providing information with the qualitative characteristics that make it useful, companies, must consider an
overriding factor that limits the reporting. This is referred to as the cost constraint.
a. Cost-Benefit Relationship: Rule-making bodies and governmental agencies use cost-benefit analysis before
making final their informational requirements. The difficulty in cost-benefit analysis is that the costs and
especially the benefits are not always evident or measurable.

(1) Costs: The costs are of several kinds: costs of collecting and processing, of
disseminating, of auditing, of potential litigation, of disclosure to competitors, and
of analysis and interpretation.

(2) Benefits: Benefits to preparers may include greater management control and
access to capital at a lower cost. User benefits may include receiving better
information for allocation of resources, tax assessment, and rate regulation.

b. The IASB seeks input on costs and benefits of new standards during the due process procedure and attempts to
determine that the costs imposed by each proposed pronouncement is justified by the overall benefits of the
financial information gained.

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