1.2 The Conceptual Framework for Financial Reporting

The Conceptual Framework for Financial Reporting

The Conceptual Framework for Financial Reporting (revised by the IASB in March 2018 and adopted in the Philippines) is the reference point for FAR theory questions and for policy choices when no standard applies. This section works through the objective of general purpose financial reporting, the qualitative characteristics, the elements, recognition and derecognition, measurement bases, and the capital maintenance concepts that decide how profit is measured.

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1. Status and Objective of the Conceptual Framework

Status and Authority of the Conceptual Framework

The Conceptual Framework for Financial Reporting (issued by the IASB in March 2018 and adopted by the FRSC) sets out the fundamental concepts for financial reporting. Candidates must remember three vital legal and technical principles:

1. The Conceptual Framework is not a PFRS or PAS. It is not an accounting standard.
2. Nothing in the Conceptual Framework overrides any specific PFRS or PAS.
3. In the rare circumstance where a specific PFRS conflicts with the Conceptual Framework, the requirements of the specific PFRS take precedence.

The framework assists the FRSC in developing standards that are based on consistent concepts, helps preparers develop consistent accounting policies when no PFRS applies to a particular transaction, and assists all parties in understanding and interpreting standards.

Objective of General Purpose Financial Reporting

The primary objective of general purpose financial reporting is:

To provide financial information about the reporting entity that is useful to existing and potential investors, lenders, and other creditors in making decisions relating to providing resources to the entity.

Those resource allocation decisions involve:

• Buying, selling, or holding equity and debt instruments.
• Providing or settling loans and other forms of credit.
• Exercising rights to vote on, or otherwise influence, management's actions that affect the use of the entity's economic resources.

Primary Users vs Other Users

General purpose financial reports are not designed to show the value of a reporting entity; rather, they provide information to help primary users estimate the entity's value.

Information about Economic Resources, Claims, and Changes

To support user decisions, general purpose financial reports provide information regarding:

1. Economic resources and claims (Financial Position): Depicts the entity's liquidity, solvency, financial structure, and operational capability.
2. Financial performance reflected by accrual accounting: Depicts effects of transactions and other events on economic resources and claims in the periods in which those effects occur, even if the resulting cash receipts and payments occur in a different period.
3. Financial performance reflected by past cash flows: Assesses the entity's ability to generate future net cash inflows and evaluate management's cash management.
4. Changes in economic resources and claims not resulting from financial performance: E.g., issuing share capital or distributing dividends.

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2. Qualitative Characteristics of Useful Financial Information

The Conceptual Framework identifies qualitative characteristics that distinguish useful financial information from information that is not useful. These are categorized into Fundamental Qualitative Characteristics and Enhancing Qualitative Characteristics.

Fundamental Qualitative Characteristics

For financial information to be useful, it must be both relevant and faithfully represented. Neither a faithful representation of an irrelevant phenomenon nor an unfaithful representation of a relevant phenomenon helps users make good decisions.

1. Relevance

Financial information is relevant if it is capable of making a difference in the decisions made by users. Information may be capable of making a difference in a decision even if some users choose not to take advantage of it or are already aware of it from other sources.

• Predictive Value: Financial information has predictive value if it can be used as an input to processes employed by users to predict future outcomes. It does not need to be a forecast itself.
• Confirmatory Value: Financial information has confirmatory value (feedback value) if it provides feedback about (confirms or changes) previous evaluations.
• Interrelation: Predictive and confirmatory values are interrelated. For example, revenue information for the current year can be used as the basis for predicting revenues in future years (predictive value) while simultaneously confirming or disproving revenue predictions made in previous years (confirmatory value).

Materiality (Entity-Specific Aspect of Relevance)

Information is material if omitting, misstating, or obscuring it could reasonably be expected to influence decisions that the primary users of general purpose financial reports make on the basis of those reports. Materiality is an entity-specific aspect of relevance based on the nature, magnitude, or both, of the items to which the information relates in the context of an individual entity's financial report. The FRSC and IASB do not specify a uniform quantitative threshold for materiality.

2. Faithful Representation

Financial reports represent economic phenomena in words and numbers. To be useful, financial information must not only represent relevant phenomena, but it must also faithfully represent the substance of the phenomena that it purports to represent (substance over form).

A perfectly faithful representation possesses three characteristics:

1. Complete: Includes all information necessary for a user to understand the phenomenon being depicted, including all necessary descriptions and explanations.
2. Neutral: Unsupported by bias in the selection or presentation of financial information. A neutral depiction is not slanted, weighted, emphasized, de-emphasized, or otherwise manipulated to increase the probability that financial information will be received favorably or unfavorably by users.
   • Prudence: Neutrality is supported by the exercise of prudence. Prudence is the exercise of caution when making judgments under conditions of uncertainty. The exercise of prudence means that assets and income are not overstated and liabilities and expenses are not understated. Equally, prudence does not allow the intentional understatement of assets or income, or the intentional overstatement of liabilities or expenses (asymmetric prudence), because such misstatements introduce bias and violate neutrality.
3. Free from Error: Means there are no errors or omissions in the description of the phenomenon, and the process used to produce the reported information has been selected and applied with no errors. Free from error does not mean perfectly accurate in all respects. For example, an estimate of an unobservable price can be faithfully represented if the amount is clearly described as an estimate, the nature and limitations of the estimating process are explained, and no errors were made in selecting and applying an appropriate process for developing the estimate.

Enhancing Qualitative Characteristics

Enhancing qualitative characteristics improve the usefulness of information that is already relevant and faithfully represented. They cannot make information useful if that information is irrelevant or not faithfully represented.

The Cost Constraint on Useful Financial Reporting

Cost is a pervasive constraint on the information that can be provided by financial reporting. Reporting financial information imposes costs on preparers (collecting, processing, verifying, disseminating) and users (analyzing, interpreting). The FRSC and IASB evaluate whether the benefits of reporting particular information are likely to justify the costs incurred to provide and use that information.

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3. Elements of Financial Statements

The 2018 Revised Conceptual Framework established refined, modern definitions of the five elements directly related to the measurement of financial position and performance:

                               Elements of Financial Statements
                                               │
                     ┌─────────────────────────┴─────────────────────────┐
                     ▼                                                   ▼
            Financial Position                                  Financial Performance
       ┌─────────────┼─────────────┐                             ┌───────┴───────┐
       ▼             ▼             ▼                             ▼               ▼
     Asset       Liability       Equity                        Income         Expense

Detailed Element Definitions

1. Asset

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. The right does not need to be certain or even likely to produce economic benefits; it is only necessary that the right already exists and that, in at least one circumstance, it would produce economic benefits.
• Control links an economic resource to an entity. An entity controls an economic resource if it has the present ability to direct the use of the economic resource and obtain the economic benefits that may flow from it, while preventing other parties from directing that use.
• Physical form is not essential for an asset (e.g., patents, receivables, and software rights meet the asset definition).

2. Liability

A present obligation of the entity to transfer an economic resource as a result of past events.

• An obligation is a duty or responsibility that the entity has no practical ability to avoid.
• A liability always involves an obligation to transfer an economic resource to another party; the identity of the party does not need to be known prior to settlement.
• The obligation must be a present obligation arising from past events (the entity has already obtained economic benefits or taken an action that establishes the duty).

3. Equity

The residual interest in the assets of the entity after deducting all its liabilities.

• Equity represents net assets: $\text{Equity} = \text{Assets} - \text{Liabilities}$.
• Equity claims are claims on the residual interest that do not meet the definition of a liability.

4. Income

Increases in assets, or decreases in liabilities, that result in increases in equity, other than those relating to contributions from holders of equity claims.

• Encompasses both revenue (arising in the course of ordinary activities) and gains (other items that meet the definition of income and may or may not arise in the course of ordinary activities).

5. Expense

Decreases in assets, or increases in liabilities, that result in decreases in equity, other than those relating to distributions to holders of equity claims.

• Encompasses both expenses arising in the course of ordinary activities (e.g., cost of sales, wages, depreciation) and losses (e.g., losses on asset disposals, disaster damages).

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4. Recognition and Derecognition Criteria

Modern Recognition Criteria under the 2018 Framework

Recognition is the process of capturing for inclusion in the statement of financial position or the statement(s) of financial performance an item that meets the definition of an element.

Under the 2018 Conceptual Framework, an item is recognized only if:

1. It meets the definition of an asset, a liability, equity, income, or an expense; and
2. Recognition provides users of financial statements with useful information, namely:
   • Relevant information about the asset or liability and about any resulting income, expense, or changes in equity; and
   • A faithful representation of the asset or liability and of any resulting income, expense, or changes in equity.

Historical Shift in Recognition Criteria

Candidates must recognize an important evolution from the older 1989/2010 framework:

• Old Criteria: Mandated two universal tests: (a) it was probable that any future economic benefit would flow to or from the entity; and (b) the item had a cost or value that could be measured with reliability.
• 2018 Revision: Eliminated the strict probability and reliability thresholds as separate criteria. Under the current framework, an asset or liability can exist even if the probability of an inflow or outflow of economic benefits is low. If probability is low or measurement uncertainty is exceptionally high, recognition may not provide relevant information; in such cases, disclosing explanatory information in the notes provides superior utility to recognizing an asset or liability on the face of the balance sheet.

Derecognition

Derecognition is the removal of all or part of a recognized asset or liability from an entity's statement of financial position:

• For an Asset: Derecognition normally occurs when the entity loses control of all or part of the recognized asset (e.g., when the asset is sold or rights expire).
• For a Liability: Derecognition normally occurs when the entity no longer has a present obligation for all or part of the liability (e.g., when the debt is settled, cancelled, or expires).

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5. Measurement Bases

Elements recognized in financial statements are quantified in monetary terms. The 2018 Conceptual Framework classifies measurement bases into two fundamental categories:

                                     Measurement Bases
                                             │
                    ┌────────────────────────┴────────────────────────┐
                    ▼                                                 ▼
             Historical Cost                                    Current Value
                                             ┌────────────────────────┼────────────────────────┐
                                             ▼                        ▼                        ▼
                                        Fair Value               Value in Use /           Current Cost
                                         (PFRS 13)             Fulfillment Value

1. Historical Cost

Historical cost measurement provides monetary information about assets, liabilities, and related income and expenses using information derived, at least in part, from the transaction or event that created them:

• Historical Cost of Assets: The consideration paid to acquire or construct the asset, plus transaction costs incurred.
• Historical Cost of Liabilities: The consideration received to incur or take on the liability, minus transaction costs incurred.
• Historical cost is updated over time to depict consumption, depreciation, amortization, impairment, or accrual of interest. It does not reflect changes in value due to subsequent market price fluctuations.

2. Current Value

Current value measurement provides monetary information about assets, liabilities, and related income and expenses using information updated to reflect conditions at the measurement date. Current value bases include:

A. Fair Value (PFRS 13 Fair Value Measurement)

• Defined as the price that would be received to sell an asset, or paid to transfer a liability, in an orderly transaction between market participants at the measurement date.
• It is an exit price from the perspective of market participants who have access to the primary (or most advantageous) market.
• Fair value is not entity-specific; it reflects market participant assumptions, including risks and market conditions, rather than entity-specific intentions.

B. Value in Use and Fulfillment Value

• Value in Use (Assets): The present value of the cash flows, or other economic benefits, that an entity expects to derive from the continuing use of an asset and from its ultimate disposal. It is an entity-specific value that reflects the entity's own expectations and operational efficiencies, rather than market participant consensus.
• Fulfillment Value (Liabilities): The present value of the cash, or other economic resources, that an entity expects to be obliged to transfer as it fulfills a liability. Like value in use, fulfillment value is entity-specific.

C. Current Cost

• The cost of an equivalent asset at the measurement date, comprising the consideration that would be paid at the measurement date plus the transaction costs that would be incurred at that date.
• Current cost is an entry value (reflecting replacement purchase costs), whereas fair value and value in use are exit values.

6. Concepts of Capital and Capital Maintenance

The Conceptual Framework (Chapter 8) explains that the concept of capital an entity adopts determines how profit is measured.

Worked illustration. An entity starts the year with net assets of PHP 1,000,000 and ends with PHP 1,150,000; the owners invested an additional PHP 50,000 and no dividends were paid. Under nominal financial capital maintenance, profit is $1{,}150{,}000 - 1{,}000{,}000 - 50{,}000 = \text{PHP }100{,}000$. If general prices rose 6% during the year (constant purchasing power), capital to be maintained is $1{,}000{,}000 \times 1.06 = \text{PHP }1{,}060{,}000$, and profit falls to $1{,}150{,}000 - 1{,}060{,}000 - 50{,}000 = \text{PHP }40{,}000$; the PHP 60,000 is a capital maintenance adjustment in equity.

Under physical capital maintenance, price changes affecting the entity's assets and liabilities are also capital maintenance adjustments rather than profit. The choice of concept is what separates historical cost accounting from current cost accounting models.