CLASS NOTES

TOPIC 8: The Conceptual Framework and Accounting Standards

Introduction

When an organization prepares financial statements, it recognizes that several individuals will
use the information presented in several different ways. The analyses may differ among decision
makers, but they all rely on the same conceptual framework that guides the preparation of the
financial statements. Accounting standards are guidelines. They give us the minimum level
below which quality is expected to fall. They are intended to lend uniformity and comparability
with some amount of authority.

The Standard-Setting Process a and the Development of Standards

It is necessary to establish an accounting conceptual framework before proceeding to develop

accounting standards for the preparation of financial statements. Without the accounting
conceptual framework, it is like putting the cart before the horse. In order to pull the cart, it is
natural to position the horse in front of the cart. As such, the accounting conceptual framework
needs to be established as it serves as the foundation, before any other related work to accounting
can take place.

The accounting conceptual framework developed by the International Accounting Standards

Board (IASB) is used as the basis for discussion in this context as adopted by the members of the
Institute of Chartered Accountants of the Caribbean (ICAB). The IASB assumes the role of the
predecessor, International Accounting Standards Committee (IASC) which was set up in 1973,
based in the United Kingdom. The IASB is committed to develop, in the public interest, a single
set of high quality, understandable and enforceable global accounting standards that require
transparent and comparable global accounting standards that require transparent and comparable
information in general purpose financial statements. The IASB also produces accounting
standards for member countries to adopt and adapt. Different countries may have different set of
accounting standards, but international standardization and harmonization of accounting
standards have taken place over the past decades and more countries are adopting the accounting
standards prescribed by the IASB. Furthermore, the IASB strives to cooperate with national
accounting standard-setters to achieve convergence in accounting standards around the World.

The accounting conceptual framework developed by IASB sets outs concepts that underlie the
preparation of financial statements for external users. The main purpose of the IASB accounting
conceptual framework I to:

i. Assist IASB and national accounting standard-setting bodies in developing accounting

standards;
 ii. Assist IASB in promoting harmonization of accounting standards and procedures relating
to presentation of financial statements by providing a basis for reducing the number of
alternatives accounting treatments permitted by International Accounting Standards
(IAS);
iii. Assist practitioners’ to prepare financial statements in accordance with IAS;
iv. Assist auditors in forming an opinion as to whether the financial statements prepared
conform with IAS; and
v. Assist users of financial statements in interpreting the information presented in the
financial statements (which are prepared in conformity with IAS).

The Use of IAS in Preparation of Financial Statements

The objective of financial statements is to provide information about the financial position,
performance and changes in financial position of a business of a business entity that is useful to a
wide range of users in making economic decisions. International accounting standards (IAS) 1
aims to prescribe the basis for presentation of general purpose financial statements, to ensure
comparability both with the business entity’s financial statements to previous accounting periods
and with the financial statements of other business entities. This standard applies to all general
purpose financial statements prepared and presented in accordance with International Financial
Reporting Standards (IFRS).

For your CAPE studies, you are required to understand, how these relate to the income
statement:

 IAS 2 inventories

 IAS 4 Depreciation Accounting

 IAS 5 Information to be Disclosed in Financial Statements and

 IAS 18 Revenues

As well as to the balance sheet:

 IAS 5 Information to be Disclosed in Financial Statements

 IAS 13 Presentation of Current Assets and Current Liabilities

For further reading see CAPE Caribbean Accounting, pages 3 to 15, and CAPE Accounting
Study Guide pages 15 to 32
The Conceptual Framework

Level 1: Objectives of financial reporting

The objectives of financial reporting provide information about a business that:

1. Is useful to those making investment and credit decisions

2. Is helpful; in projecting the future cash flows of that business
3. Identifies the economic resources (assets), the claims to those resources (liabilities) and
the changes in those resources.

In summary, the objective of financial reporting is to assist the user of financial information in
making reasonable decisions.

Level 2: Qualitative Characteristics of Accounting Information

Level 2 is divided into two chapters: first we will consider the qualitative characteristics of
accounting information.

What makes financial information useful?

1. Relevance 3. Comparability
2. Reliability 4. Understandability.
Accounting information is relevant if it has the ability to influence decisions. It has predictive
and confirmatory value (feedback value)

Accounting information that is a complete and faithful representation of the situation is reliable.
It is verifiable, free from material error, free from bias and prudent.

Comparability in accounting information ensures that similarities and differences can be

discerned and evaluated. There should be full disclosure.

Consistency exists when an entity applies the same accounting treatment to similar events. This
is considered to be understandable if the information can be perceived or understood, but this
depends on the users’ abilities and the classification.

Accounting Information

With reference to Essential characteristics

1. Users Decision makers who need financial
information
2. Objective Decision usefulness - helps users make better
decisions
3. Threshold for recognition Immaterial amounts - not large enough to
influence important decisions
4. Cost-benefit Cost of developing and reporting should be
less than the value of the benefit to decision
makers
5. Qualitative characteristics Understandability to users
Relevance to decisions
Reliability – correct information
Timeliness
Verifiability
Neutrality
Comparability
Completeness
Consistency

The first characteristics deals with the users who are described as decision makers’ .To make
good decisions; users are expected to have a reasonable understanding of accounting concepts
and procedures. Knowledge of business and economics activities is also helpful to assist in
making decisions that get results.

The next two characteristics focus on the cost of preparing accounting information. The
threshold for recognition is often referred to as the materiality concept. Its means that accounting
for a transaction may not agree with specific accounting guidelines if the amount is too small
(i.e. it is not large enough to affect important decisions). The cost-benefit constraint suggests that
the accounting should not use up more resources to develop and report a transaction than is value
is its value to the decision makers, as this would be uneconomical. This measurement is
subjective. Qualitative characteristics provide a description of what makes information useful.
These characteristics are defined below, with a summary of the problems that arise in
determining what information is useful.

Understandability

Definition: Information must be understandable to users who are mature and willing to study the
information diligently

Problem: Users have different level of sophistication; with the complexity of modern business, it
is not easy to have full understanding of all the different types of business ventures.

Relevance

Definition: This information must be relevant in that it influences the decisions of users. This
influence occurs when information helps users to:

a. Predict future income and cash flows

b. 2. Confirm or correct previous predictions by deeding back actual results.
c. Problem: In preparing the financial statements, we must be able to identify the needs of
the users, given the variety of users

Reliability

Definition: Information must be reliable to be useful. The information should be of a standard

that can be relied on by external users.

Problem: The complex nature of modern business makes reliability difficult to achieve in all
cases

Timeliness

Definition Information must be timely if it is to be relevant. Financial statements should be

published as soon as possible after year-end.
Problem: There is a conflict between this characteristic and that of reliability because in
preparing financial statements quickly, it means using more estimates and this reduces reliability.

Verifiability

Definition: Verifiability means that information must be capable of being tested (i.e. falsified, or
provide provable by observation)

Problem: all financial data should be capable of being, tested , either internally or externally.
However, the reliability and relevance factors may be eliminated. The knowledge level of the
person testing the information may also limit the verification process.

Neutrality

Definition: Freedom from bias as as to ensure that there is no overstatement or understatement in

favor of any particular group of users or individual users.

Problem: Financial statements are prepared by one user group, management. The external audit
should remove this basis, but some question he effectiveness of the audit to do this.

Comparability

Definition: The ability to compare the same organization over time. It adds to conservatism so
that the same rules are used to prepare the financial statements. For example, the use the same
method of recording inventory from period to another (FIFO or LIFO). Users are provided with
the opportunity to identify similarities and differences of financial information and not to be
misled by unexplained changes in the accounting rules.

Problem: The use of different accounting policies by different enterprises. Accounting standards
have reduced but not eliminated this problem.
Level 2: Elements of financial statements

The main method of presenting financial information to persons outside a business is through a
document called financial statements. A complete set of financial statements contains:

1. A balance sheet, which gives the financial condition of a business on a specific date. It
shows the resources that a business owns (assets), the debts it owes (liabilities) and the
amount of capital invested by the owners (equity). This statement gives a snapshot view
of the business

2. An income statement (or profit and loss account), which shows the profitability of a
business over a period of time. The statement has two sides_ revenues and expenses.

3. A statement of cash flows, which shows where money has come from and what it has
been spent on during the accounting period. It may be a summary of cash receipts and
cash payments.

Other elements include the following:

4. Investment by owners_ these are increases in net assets resulting from transfers to an
entity from other entities. For example, new money put in as capital by owners after the
business has been in existence for a while.

5. Distributions to owners_-decreases net assets by transferring assets, rendering services

or incurring liabilities by the entity to owners. It ay be in the form of dividends.

6. Gains_ increases in equity or net assets form incidental transactions an other events that
affect the entity, except those that are not revenues or investments by owners.
 7. Losses_ decreases in equity (net assets) from incidental transactions and other events that
affect the entity, except those that are not expenses or distributions to owners.

The accounting equation

The characteristics of accounting are developed on the fundamental concepts, which are a
number of assumptions and principles. The assumptions are understood as given by all readers of
financial statements. The assumptions set boundaries or limits on the environment in which
accounting information is reported. The principles of accounting are the conceptual guidelines
for applying the basic accounting equation:

Assets = Liabilities +Owners’ Equity or Capital

Level 3 : Assumptions of accounting

Level 3 of the conceptual framework is made up of the assumptions, principles and constraints.
This level is referred to as the recognition and measurement concepts.

Separate entity

The separate entry assumption implies that the business is separate from its owners. It must be
treated as a legal person in its own right. Therefore, the transactions that are recorded in the
financial statements must relate only to the business entry and not include any that relate to the
owners’ private lines. This is also known as the economic entity assumption.

Going concern

For accounting purposes, a business is assumed to have an indefinite life. Therefore, I is assumed
that the activities of a business will continue into the foreseeable future.

Unit of measure

Each business entity will report its financial results in terms of a monetary unit. This assumption
implies that that the monetary unit is a stable measure without a change value. In the Caribbean
the financial statements of businesses are reported in the national currency (Jamaica, Bahamas,
Eastern Caribbean, Barbados, Trinidad and Tobago and Guyana dollars). A conversion into U.S.
dollars is often made since these currencies are linked in some way to the currency of the US.
This is also known as the monetary unit assumption.
Time period

The time period assumption is that decision makers need information about the financial
condition of the business periodically. The reporting dies not have to fall in line with the
calendar year, but the processing cycle usually covers one full year. The time period assumption
states that the economic life of an entity can be divided into artificial time periods. This is also
known as the periodicity assumption.

Level 3: Principles of accounting

Cost principle

This principle defines the basis for measuring assets, liabilities and capital (including revenues
and expenses) of a business. The cost principle is also known as the historical cost principle
since the latter name explains the method of arriving at the cost. This principle dictates that
assets are recorded at their cost. This cost is used because it is relevant since it represents the
price paid, and it is reliable in that it is objectively measurable and can be verified.

Revenue principle

This principle indicates when revenue should be recognized and how it should be measured.
Revenue should be recognized when there is an inflow of net assets from the sale of goods or
services, which is when there is reasonable certainty that the cash will be collected. Revenue is
measured as the cash or non-cash considerations received. The revenue principle includes the
accrual concept.

Under the accrual concept, revenue is recognized in the period in which it is earned, that is ,
when the goods or services are delivered to customers, which may not be the period in which the
cash is received.

Recognition is the test that determines whether revenue should be recorded in the financial
statements. To be recognized, revenue must be:

a. Earned-goods or a service performed

b. . realized- cash or a claim to cash ( credit) is received in exchange for the goods or
service
 Under the cash basis, revenues are recorded when a sale is made for cash at the time when
the cash changes hands. Expenses are recorded when a purchase is made for cash at the time
the cash changes hands. Doctors and some other professionals tend to use the cash basis for
recognition of their revenues. However, the accrual basis is the current standard for
measurement of income.

Matching principle

Similarly, expenses are recorded in the period in which they are incurred, even if the expense
is not paid. The matching principle dictates that expenses be matched with revenues in the
period in which efforts are expended to generate revenues.

Full disclosure principle

This principle requires that companies disclose circumstances and events that make a
difference to financial statement users. For example, investors who lost money in Enron,
WorldCom, and Global Crossing have complained that the lack of full disclosure regarding
some of the companies’ transactions caused the financial statements to be misleading.
Investors want to be made aware of events that can affect the financial health of a company.

Level 3: Constraints

These permit an entity to modify GAAP without reducing the usefulness of the reported
information

Conservatism

This is a condition of prudence in the face of uncertainty. It is not appropriate to deliberately

overstate assets or revenues or to understate liabilities and expenses. However, undue pessimism
is not acceptable either. When in doubt of an accounting treatment, the accountant will always
choose a method that is least likely to overstate assets and income

Materiality

Relates to an item’s impact on the entity’s overall financial condition and operations. An item is
considered material when it is likely to influence the decision of a reasonably prudent investor or
creditor. It is considered immaterial if it is not likely to impact on the decision if omitted or
included in the information presented. To determine whether an item is material or not the
accountant normally compares it with items such as total assets, total liabilities and net income.

The diagram below highlights all the different levels of the Conceptual Framework.