Module 1: The Role and Importance of Financial Reporting (10%) 

Understand WHY do we do Financial Reporting?

Assets, Liabilities, Equity, Income, Expenses:

• Wages - Expenses
• Stationery - Expenses
• Accounts Payable - Liabilities
• Debtors - Assets
• Sales - Income

1.1 THE ROLE AND IMPORTANCE OF FINANCIAL REPORTING

Financial Reporting:  
• Process of documenting an entity’s financial status in the form of financial reports/statements
(communication tool).  
• Critical for financial statements to be prepared in accordance with a financial reporting framework
that recognises and endeavours to satisfy the needs of these users --> Conceptual Framework 
• Financial Statements provide users with financial info about the entity – its financial position,
financial performance and cash flows. 

Role of Financial Reporting

o Provides different users (shareholders, banks, creditors, competitors, employees and financial
analysts) with relevant and timely information to achieve effective decision making. 
o Also provides a stewardship/accountability role bya requiring managers to give an account of
how they have used the resources provided by those users (shareholders, creditors, etc) 
o Objective of General Purpose Financial Reporting (GPFR): To provide financial info about the
reporting entity that is useful to its primary uses for making decisions about providing resources
to the entity: 
▪ Buying, selling or holding equity and debt instruments 
▪ Providing or settling loans and other forms of credit, or 
▪ Exercising rights to vote on, or otherwise influence, management’s actions that affect the use
of the entity’s resources (Conceptual Framework, para 1.2) 
• Identification of the primary users of financial reports is crucial in determining the information that
should be disseminated through the financial reports to effectively satisfy their decision-making
needs.
• IASB (International Accounting Standards Board) identifies primary users as those that provide equity
or debt finance to the entity – existing and potential investors, lenders and other creditors that must
rely on GPFR for much of the information they need as they may be unable to command information
from an entity directly.

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 Importance of Financial Reporting

• Significant level of resources under the responsibility of managers 

• Financial impact of the decisions that users make from relying on information provided in FRs 
• Company regulators & stock exchanges require FS to be prepared by entities as part of reporting
obligations 

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1.2 The Conceptual Framework for Financial Reporting - Pg 12
• Based on 2 Assumptions:
• Accrual Basis - income/expense recognised when incurred
• Going concern - entity will continue to operate for the foreseeable future

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1.3 Qualitative Characteristics of useful Financial Information - Pg 16

 
Qualitative Characteristics  
Fundamental Characteristics: 
1. Relevance: Ability of users to make decisions based on information presented 
• Relevance = Predictive Value + Confirmatory Value

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 • Predictive Value: The ability of users to use the current info to develop trends and forecast what
future performance might be 
• Confirmatory Value: The ability of users to confirm their own understanding and estimates with
actual results (feedback and variance analysis)
• Materiality underpins relevance --> Material if it has the ability to influence users’ decisions. 
 
2. Faithful Representation:  
• Information that is presented in the financial statements needs to reflect what it is in reality
• Financial information is complete, neutral and error-free

Application of Fundamental Qualitative Characteristics

For information to be useful, it must be both relevant and faithfully represented. This may involve
professional judgement in making a trade-off between relevance and faithful representation. For
example, information about future cash flows expected to be derived from an asset may be highly
relevant, but it may be difficult to faithfully represent this aspect of the asset because of the inherent
uncertainty of future events. Paragraph 2.21 of the Conceptual Framework suggests a process for making
such judgements as follows.
1. Identify an economic phenomenon, information about which may be useful to decision makers
(historical value, revaluation)
2. Identify the information that would be most relevant about this phenomenon. (Eg. discounted cash
flows, future earning potential)
3. Determine if the information is available and can provide a faithful representation of the economic
phenomenon.
 
Enhancing Characteristics: 
1. Comparability:  
• Ability to compare with other entities for different years. (Apple to apple, like to like) 
• All about consistency: Using the same methods for the same items 
 
2. Verifiability 
• Third person test: can be verified directly or indirectly by supporting documents (inputs, etc) 

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 • If knowledgeable and informed third parties can observe and agree that financials are faithful,
then it has satisfied the verifiable characteristic 
• Validity, accuracy and completeness 
3. Timeliness 
• Refers to making info available at the appropriate time for useful decision making. 
• Estimates of future financial items and events are often required to comply with timeliness. 
• Eg. Debt will be incurred but not yet, to include a reliable estimate in the current year. 
 
4. Understandability 
• Information to be concisely classified, characterised and presented.  
• Includes an assumption that users are knowledgeable and competent in comprehending financial
information
 
 

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 1.4 The Elements of Financial Statements

Defining the elements of Financial Statements

5. Assets:
• a present economic resource controlled by the entity as a result of past events. An economic resource
is a right that has the potential to produce economic benefits (CF, paras 4.3–4.4)
• 3 Key Components:
1. it is a right (resource)
2. it has the potential to produce future economic benefits (inflow of economic benefits)
3. asset is controlled by the entity
• For an entity to have control, it does not necessarily follow that the entity has ownership of the
asset. For example, IFRS 16 Leases requires a right-of-use asset to be recognised for a leased asset,
even though the
• entity does not own the underlying asset (e.g. a building). This is because the entity controls the
benefits arising from using the asset during the lease term

• Example of Asset: Prepaid Expense ("Prepaid Insurance")

• Recognising the payment of gym membership fees in advance (3 months payment of $180):
• DR Prepaid Membership Expense $180
• CR Cash in Bank $180
• Recognising gyn fees when obligation is met:
• DR Gym Fees $60
• CR Prepaid Membership Expense $60

6. Liabilities
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 • a present obligation of the entity to transfer an economic resource as a result of past events
(Conceptual Framework, para. 4.26).
• The key components of the liability definition are:
1. the requirement for the entity to have a present obligation
2. the obligation is to transfer an economic resource: outflow of economic benefit
3. that the present obligation exists as a result of past events

• Example of Liability: Income received in advance ($75 for 3 months)

• Record receival of $225 cash:
• DR Cash in Bank $225
• CR Income received in advance $225
• When obligation has been met:
• DR Income received in advance $75
• CR [Actual] Income $75

7. Equity = Assets - Liabilities

• Equity changes during the reporting period because of an entity’s financial performance

8. Income
• increases in assets, or decreases of liabilities, that result in increases in equity, other than those
relating to contributions from holders of equity claims (Conceptual Framework, para. 4.68).
• The two essential characteristics of income are:
1. an increase in assets or a reduction in liabilities
2. an increase in equity, other than as a result of a contribution from owners.
• Income can be either Revenue (from ordinary activities) or Gains (may or may not arise due to
ordinary course of activities eg. sale of non-current asset, revaluation)
9. Expenses
• decreases in assets, or increases of liabilities, that result in decreases in equity, other than those
relating to distributions to holders of equity claims (Conceptual Framework, para. 4.69).
• The two essential characteristics of an expense are:
1. a decrease in assets or an increase in liabilities
2. a decrease in equity, other than those arising from distributions to holders of equity claims.

Criteria for Recognising Elements of FS

• Recognising elements of financial statements involves capturing, in words and with a monetary amount,
the items that meet the definition of an asset, a liability, equity, income or expenses, either alone or in
combination with other items that meet the same definition.
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• The monetary amount at which an asset, liability or equity is recognised in the statement of financial
position is referred to as its carrying amount (Conceptual Framework, para. 5.1).
• However, not all items that meet the definition of elements of financial statements are recognised.
• An asset or liability is recognised only if recognition of that asset or liability and of any resulting income,
expenses or changes in equity provides users of financial statements with information that is useful
(Conceptual Framework, para. 5.7).
• Need not be recognised if it’s not relevant or faithfully represent what it’s supposed to be represent;
uncertain/low probability of inflow/outflow of economic benefits is low; measurement uncertainty with
regards to amount to be recognised.
• Cost constraint: ‘An asset or liability is recognised in the financial statements if the benefits of the
information provided to users of financial statements by recognition are likely to justify the costs of
providing and using that information’ (Conceptual Framework, para. 5.8)
• The recognition of income and expenses is based on the recognition of assets and liabilities to which
they relate. According to the Conceptual Framework, paragraph 5.4:
(a)  the recognition of income occurs at the same time as:
(i) the initial recognition of an asset, or an increase in the carrying amount of an asset; or
(ii) the derecognition of a liability, or a decrease in the carrying amount of a liability.
(b)  the recognition of expenses occurs at the same time as:
(i) the initial recognition of a liability, or an increase in the carrying amount of a liability; or
(ii) the derecognition of an asset, or a decrease in the carrying amount of an asset.

Derecognition of Assets and Liabilities

• Derecognition is a concept that applies only to recognised assets and liabilities. According to the
Conceptual Framework, an item is normally derecognised when it no longer meets the definition of an
asset or a liability (para. 5.26):
• (a)  for an asset, derecognition normally occurs when the entity loses control of all or part of the
recognised asset; and
• (b)  for a liability, derecognition normally occurs when the entity no longer has a present
obligation for all or part of the recognised liability.

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1.5 Measurement of Elements of Financial Statements

• An item meets definition of an element of FS (recognition criteria satisfied) -> how to measure the item
• 2 stages of measurement decision:
1. how to measure the asset/liability at initial recognition
2. how to measure the asset/liability subsequent to initial recognition

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1.6 Application of Measurement Principles in the IFRS (International Financial Reporting Standards)
Recognition Criteria for the Lessee
• At the commencement date of a lease, the lessee recognises a right-of-use asset at cost and a lease
liability (IFRS 16, paras 22–23).
• A right-of-use asset is the asset specified in the lease contract that the lessee has the right to use
during the lease term. The recognition and measurement criteria for a lessee are summarised in table
1.8:

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