Chapter 4

The conceptual framework

 Learning objectives
• Understand what is meant by generally accepted accounting practice
• Understand the purpose of the conceptual framework
• Understand the objective of financial reporting
• Know who the primary users of financial reports are
• Understand the going concern concept, which is the basic assumption
that underlies the preparation of all financial reports
• Realise that information in financial reports should have certain
qualitative characteristics that assist financial reports in achieving their
objective
• Understand how qualitative characteristics enhance the usefulness of
financial reports
• Know how to apply the definition of elements (i.e. asset, liability,
equity, income, expense)
• Recognise assets and liabilities, income and expenses
• Understand the accrual concept.
 Link with Chapter 3
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 HP
3. Hired vehicle from AVIS
? account
is DR?
 Link with Chapter 3
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
 GAAP
• What is GAAP?
– Generally accepted accounting practice
– Set of principles
• Helps all financial statements to be drawn up in a similar
manner.
• Includes a “conceptual framework”
– General explanation of financial statement preparation
– Basis from which all statements/standards are
prepared
• Includes Standards
– Principles for specific topics i.e. IAS2 for “Inventories”.
 The conceptual framework
• Describes the objective of general purpose
financial reporting and the concepts that underlie
the preparation and presentation of financial
reports.
 The conceptual framework
• Objectives of financial reporting

• Qualitative characteristics of useful financial

information

• Definition and recognition of elements

• Measurement of elements
 Objectives of financial
reporting
• Provide financial information about the entity that is
useful to existing and potential investors, lenders
and other creditors in making decisions about
providing resources to the entity.
 Objectives of financial
reporting
• Users will also be interested in management's
stewardship of the economic resources in the
business.

• So, what does ‘‘stewardship’’ mean?

Stewardship is ‘‘the job of supervising or taking care

of something’’.
 Objectives of financial
reporting
• Decisions depend on returns
– Equity (dividends, market price)
– Debt (interest, principal repayment).

• Expectation of returns depend on:

– Amount
– Timing
– Uncertainty of future net cash inflows.
 Objectives of financial
reporting
• To assess future net cash inflows
– Resources of entity
– Claims against the entity
– How efficiently resources are used.
 Primary users of financial
statements
• Existing and potential investors

• Existing and potential lenders and other creditors

 Going concern
• Financial statements prepared under assumption
that entity is a going concern (underlying
assumption).
• Expectation than business will continue to operate
in foreseeable future at same or larger scale of
operations.
• Relevant – impacts on how elements measured.
• If going concern – can use cost/fair value as
measurement basis.
 Going concern
• If not considered a going concern need to state this
in financials.

• What other assumption/basis would then be used?

• How does this differ from the going concern

assumption?
 Going concern

• Financial statement are normally prepared on the

assumption that the reporting entity is a going
concern and will continue in operation for the
foreseeable future. Hence, it is assumed that the
entity has neither the intention not the need to
enter liquidation or to cease trading. If such an
intention or need exists, the financial statements
may have to be prepared on a different basis. If
so, the financial statements describe the 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
usefulness of info Timeliness usefulness. It is impossible
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
 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.
 Elements
• Elements directly related to measurement of financial
position
– Assets, Liabilities, Equity

• Elements directly related to measurement of

performance (profit/loss)
– Income, expenses
 Assets: Definition

• An asset is a present economic resource

controlled by the business as a result of past
events.
• So what is meant by ‘‘an economic resource’’?
An economic resource is a right that has the
potential to produce economic benefits.
 Assets: Definition
• Rights include:
– Rights that relate to an obligation of another
party:
o the right to receive cash
o the right to receive goods or services.
– Rights not related to an obligation of another
party:
o the rights over physical items such
as vehicles, land or inventory

• If the right does not create an exclusive right for the

business, it is not considered a right that has the
potential to produce economic benefit.
 Assets: Definition
The potential to produce economic benefit
• An economic resource has the potential to
produce economic benefit if it enables the
business produce cash inflows, avoid cash
outflows, or receive contractual cash flows or
another economic resource.

Control
• Control is the present ability to direct the use of an
economic resource and obtain the economic
benefits that may flow from it.
 Learn Accounting video

www.learnaccounting.uct.ac.za
Go and watch Control. This video explains the term
“control”: a term that is often used in accounting.
 Liabilities: Definition
• A liability is a present obligation of the business to
transfer an economic resource as a result of past
events.

• An obligation is a duty or responsibility that the

business has no practical ability to avoid.
 Liabilities: Definition
• The ‘‘present’’ obligation means the business
must have received economic benefit.

• What does ‘‘no practical ability to avoid’’ mean?

If any action it took to avoid the transfer of

resources would have negative economic
consequences significantly worse than the
transfer itself.
 Equity
• Equity is what would be left once the liabilities have
been settled i.e. assets – liabilities.
• Equity is referred to as the residual claim as well as
net asset value.

Equity = Assets – Liabilities

 Equity
• Transactions that lead to a change in equity
(net asset value) can come about due to:
– transactions with the owner, and
– transactions not with the owner.
 Income
• Income: occurs when transactions (not with the
owner) result in an increase or decrease in
either assets or liabilities of the business.
• The increase/decrease in the assets or liabilities
increases the equity of the business.
 Expenses
• Expenses: Occur when transactions (not with
the owner) result in an increase or decrease in
either assets or liabilities of the business.
• The increase/decrease in the assets or liabilities
decreases the equity of the business.
 Recognition criteria
• Recognising an asset, liability, income or expense
means the item appears in the financial reports of a
business.
• An asset, liability, income or expense is recognised
on the financial statements if it meets the definition
and recognition criteria of the element.
• Assets, liabilities, income, expenses or changes in
equity will be recognised if such recognition
provides users of the financial statements with
relevant information and a faithful representation of
the underlying transaction.
 Recognition criteria
• Relevance is influenced by uncertainties, i.e. it may
be uncertain whether an asset or liability actually
exists.

• Uncertainty also exists where there is a low

probability of inflows or outflows of economic benefit
occurring.

• Faithful representation can be affected by the level of

measurement uncertainty.
 An example
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?

 An example
• 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.
 Learn Accounting video

www.learnaccounting.uct.ac.za
Go and watch What are Liabilities. This video explains
when a business can recognise a liability.
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
 Learn Accounting video

www.learnaccounting.uct.ac.za
Go and watch The Asset Life Cycle. This video
explains the financial reporting process from initial
recognition until de-recognition, with a focus on assets.
 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 (see next slide)
o Value in use: measurement is based on the
expected EBs
o Current cost: measurement is based on the
cost of an equivalent item.
 Fair value
“The price that would be received to sell an asset in
an orderly transaction between market participants
at the measurement date”
• Note two aspects of the conceptual framework
inherent in this definition:
– Going concern assumption
– Neutrality
• Where an active market exists, the FV is the
market price.
• Where no active market exists, an independent
expert can be used to determine FV.
 Which measurement base
to use at initial recognition
of an asset
• The decision should be based on which
measure would provide useful information. In
other words, which measurement would provide
the most relevant information that is a faithful
representation of the transaction.
 Time value of money
• Fair value of consideration or payment given for the
asset
• Cash:
• Paid on purchase date – cash given
• Paid after purchase date?

Is R1.00 received today worth the same as R1.00

received in one year’s time?
 Time value of money
• Assume an interest rate of 10% per annum
• Over a year, you will earn interest.

PV + interest
PV 100 x 110/100
FV

R100 One year R110

110 x 100/110
FV - interest
 Time value of money
• So the fair value of consideration or payment given
for the asset when you pay cash after the purchase
date is...
– The present value of the amount paid in the
future.
 Learn Accounting video

www.learnaccounting.uct.ac.za
Go and watch Using a financial calculator – Part 1:
This video explains the concept of time value of money,
Part 2: This video explains how to use a financial
calculator and present workings in the exam
 An example
Let's look at an example of initial measurement: historical
cost.
The following transactions occurred on 1 January X1:
1. Took delivery of a vehicle and paid R100 000 by
cheque.
2. Took delivery of inventory. The business will pay
R40 000 on 31 March X1. The payment period is less
than one year.
3. Took delivery of equipment. The business will pay R1
000 000 on 1 January X2. The payment period is more
than one year. Assume a fair interest rate of 12%.
 An example
DR Vehicle (A) 100 000
CR Bank (A) 100 000
If cash is paid at acquisition, the historical cost is the
amount of cash paid.
DR Inventory (A) 40 000
CR Trade payables (L) 40 000
If payment is made within a year, historical cost is the
amount of cash paid.
DR Trade payables (L) 40 000
CR Bank 40 000
If payment is made within a year, historical cost is the
amount of cash paid.
 An example
DR Equipment (A) 892 857
CR Trade payables (L) 892 857
Payment period more than one year, the consideration will
be the present value of the amount to be paid.

R1 000 000 = 112% (cost of asset = 100% plus

interest @ 12% for one year)
How much is 100%?

R1 000 000 × 100/112

= R892 857, which is the portion of the payment
relating to the assets acquisition.
 An example

DR Trade payables (L) 892 857

CR Bank 892 857
Payment period more than one year, the consideration will
be the present value of the amount to be paid.
DR Interest expense 107 143
CR Bank 107 143

Interest amount payable 1 000 000 − 892 857 = 107 143

 Subsequent measurement
• When financial statements are prepared, the
assets and liabilities must be accurately presented.

• The framework recommends using the same

measurement basis for initial recognition and
subsequent measurement – change in the value of
the asset/liability is not due to a change in the
measurement basis.
 Subsequent measurement
• Asset initially recognised at historical cost – the
carrying amount at subsequent measurement date
= unconsumed or uncollected historical cost
considered to be recoverable.

• Asset initially recognised at fair value, carrying

amount at subsequent measurement date – price
that would be received to sell the asset at that
point in time. If a portion of the asset has been sold
or consumed, this will decrease the carrying
amount shown at that date.
 Measurement of PPE:
subsequent recognition
Two accounting policy choices

Cost model Revaluation model

• Uses historical cost basis • Uses fair value (FV) basis
• Carrying amount is based on • Carrying amount is based
cost, though reduced when: on the fair value though
– Benefits are consumed reduced when:
(depreciation) – Benefits are consumed
(depreciation)
 PPE example
1 Jan X0 : Business purchased land for R400 000 cash

Journal entry on 1 X0
DR PPE: Land (A) 400 000
CR Bank (A) 400 000
Purchase of land – both cost and revaluation model.

FV movements:
31 Dec X2 FV = R450 000
31 December X2: Cost Model
No Journal entry
31 December X2: Revaluation Model
DR Land(A) 50 000
CR Revaluation gain (OCI) 50 000
Increasing the value of the asset to fair value

DR Revaluation gain (OCI) 50 000

CR Revaluation Surplus (E) 50 000
Revaluation gain closed off to Equity
 Asset damaged?
• Inventory will be written down to its net realisable
value (selling price less disposal costs) if the net
realisable value is below cost.

• PPE stated at lower of cost and recoverable amount.

 PPE damaged
• Impairment test
• What is economic benefit expected from item of
PPE?
– recoverable amount.
• If recoverable amount lower than carrying amount
– write down the asset (impairment expense).
• Carrying amount – amount item currently stated at in
the books.
 Recoverable amount

Higher of:

• VALUE IN USE: Benefit of using the asset is the

present value of the net cash to be received, i.e.
cash from selling goods produced by asset.

• NET SELLING PRICE: Benefit from selling an asset

i.e. the amount you receive from the sale less the
costs of selling the asset.
 Journal entries
DR Impairment expense
CR Accumulated impairment
Asset written down to recoverable amount

• Do NOT credit asset account.

• Credit an account called Accumulated Impairment.
• Purpose of Accumulated Impairment account –
reduce the carrying value (amount on SoFP) of the
asset, i.e. vehicle.
 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.