Conceptual Framework of Accounting

Need for Accounting Standards

In preparing financial statements, accountants are confronted with the potential
dangers of bias, misinterpretation, inexactness, and ambiguity. In order, to minimize
these dangers, the accounting profession has attempted to develop a set of standards
that is generally accepted and universally practiced. Without these standards each
enterprise would have to develop its own standards and readers of financial statements
would have to familiarize themselves with every company’s peculiar accounting and
reporting practices.
As a result, it would be almost impossible to prepare statements that could be
compared. The accounting profession has adopted a common set of standards and
procedures called generally accepted accounting principles (GAAP). The term
‘generally accepted’ can mean either that an authoritative accounting rule-making body
has established a principle of reporting in a given area or that over time a given practice
has been accepted as appropriate because of its universal application.
Since the early 1970s the business and governmental communities have given
the Financial Accounting Standards Board (FASB) the responsibility for developing
accounting principles in the country. This job is an ongoing process in which accounting
principles change to reflect changes in the business environment and in the needs of
users of accounting information.
The Financial Accounting Standards Board (FASB) views its conceptual
framework as “…a constitution, a coherent system of interrelated objectives and
fundamentals.”
The International Accounting Standards Committee (IASC) was formed in
1973 to encourage international cooperation and harmonization in developing
consistent worldwide accounting principles. Today, the organization has 155 members
representing 113 countries.
Standard Setting Process
What is a standard? Back in medieval times a personal flag or emblem on a pole
was known as a standard. It was used as a guide to identify where the troops hid.
Accounting standards are guidelines. They gave us the minimum level below which
quality is not expected to fall. Standards are a yardstick against which activities are
measured. They are intended to lend uniformity and comparability with some amount of
authority. But standards are not a comprehensive code of rigid rules (or cookbook, as
referred to locally).
In today’s global economy, there is increased demand by external users for
comparability in accounting reports. This often arises when companies which have to
raise money from lenders and investors in different countries. To that end, the
International Accounting Standards Board (IASB) issues International Financial
Reporting Standards (IFRS) that identify preferred accounting practices. The

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International Accounting Standards Board (IASB) hopes to create more harmony among
accounting practices of different countries.
The ultimate goal of harmonization is to have all companies around the world
follow one set of international accounting standards. If standards are harmonized, one
company can use a single set of financial statements in the financial markets.
The standards help to increase uniformity in the presentation of company accounts and
to reduce the subjective element in the disclosure of information.
Why standards are important
1. To determine the minimum information to be included in the financial statements.
2. To establish what must be disclosed by different forms of business organizations.
3. To ensure consistency in application of accounting methods.
4. To foster easy comparison.
5. To set a benchmark for understand ability.
6. To enable verification by external auditors.
7. To reduce or eliminate variations in accounting practice and so introduce a
degree of uniformity into financial reporting.

Arguments for harmonization or using one set of standards (IFRSs)

1. For many countries there are still no adequate codified standards of
accounting and auditing. Internationally accepted standards not only would
eliminate the
set- up costs for those countries but would allow them to immediately become
part of the mainstream of accepted international accounting standards.
2. The growing internationalization of the world’s economies and the
increasing interdependency of nations in terms of international trade and
investment flows is a major argument for some form of internationally accepted
standards of accounting and auditing.
3. It is argued that comparability of financial statements worldwide is necessary
for the globalization of capital markets. Financial statements comparability would
make it easier for investors to evaluate potential investments in foreign securities
and thereby take advantage of the risk reduction possible through international
diversification. It also would simplify the evaluation by multinational companies
of possible foreign takeover targets.
4. Companies could gain access to all capital markets in the world with one set of
financial statements. This would allow companies to lower their cost of capital
and would make it easier for foreign investors to acquire the company’s stock.

Arguments against harmonization or not using one set of standards (IFRSs)

1. The legal systems of some countries set out detailed accounting rules; other
countries have legal systems which provide only a broad framework of
accounting principles.

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2. The different environmental influences, differences in accounting across
countries might be appropriate and necessary. For example, countries at
different stages of economic development or that rely on different sources of
financing perhaps should have differently oriented accounting systems.
3. In some countries, business entities are largely financed by shareholders in other
countries, banks and other lenders are the main providers of business finance.
The quality and types of accounting information that these groups need from
financial reports may differ and this has an effect on the accounting systems of
the countries needed.
4. The lack of strong accountancy profession can make it difficult to exert influence
in some countries. Japanese accounting standards are set by a government
agency. Any attempt to introduce new standards through the professional body
would be hampered by its relative lack of influence. Similarly, standards are often
set by professional bodies, thus making it difficult to achieve harmonization at a
governmental level.

Objectives of the International Accounting Standards Committee

1. To develop, in the public interest, a single set of high quality, understandable and
enforceable global accounting standards to be observed in the preparation of
financial statements.
2. To promote a worldwide acceptance and observance.
3. Poor countries, which cannot afford to have standard setting bodies of their own,
can adopt the international standards instead of setting their own.
4. To work generally for the improvement and harmonization of regulations,
accounting standards and procedures relating to the presentation of financial
statements.
5. The growth in multinational firms. These firms have to produce accounts
covering a large number of countries. Standardization between countries makes
accounting work that much easier, and reduces costs.
6. To bring about the convergence of national standards and international
standards.

IFRS Foundation

IFRS Advisory International Accounting IFRS Interpretation

Council Standards Board Committee

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 The Development of an International Accounting Standard
Accounting standards are developed using ‘due process’. Due process is an
accounting procedure which gives the users a chance to comment on the proposed
content of accounting standard. In summary, this is what happens.
An International Accounting Standard is developed as follows:
1. The International Accounting Standards Board (IASB) identifies a financial
reporting issues based on requests/recommendations from stakeholders or
through other means
and appoints an Advisory Committee to advice on the issues.
2. Prepare a discussion paper for public comment and to obtain feedback.
3. Decide whether a standard is needed or modification to an existing standard; if
yes prepare an exposure draft.
4. The International Accounting Standards Board (IASB) publishes an Exposure
Draft for public comment, being a draft version of the intended standard or
revised standard.
5. Modify the exposure draft. If approved by the committee it becomes an
International Accounting Standard (IAS).
6. The Board issues an Accounting Standards Update describing amendments to
the Accounting Standards Codification or the New Standard.

The International Accounting Standards Board (IASB) publishes the final text of the
standard.
* The publication of a standard requires the voting approval of the International
Accounting Standards Board (IASB) members.

The Accounting Profession in the Caribbean

The Institute of Chartered Accountants of Jamaica (ICAJ) established in
1965 was an amalgamation of the Association of Accountants of Jamaica Incorporated
(founded 1946), the Jamaican Branch of the Association of Certified and Corporate
Accountants (founded 1962) and the society of Chartered Accountants of Jamaica
(founded 1972). It was incorporated by the Jamaican Public Accountancy Act of 1968.
The founder members were mainly members of the recognized British professional
bodies ICAEW, ICAS and ACCA who had qualified abroad. Full membership is
restricted to Jamaican citizens who pass the Institute’s examinations or other
recognized examinations and obtain the required practical experience. Non-Jamaicans
who are ordinarily resident in the island prior to the Institute’s incorporation and who
were members of certain recognized bodies were admitted into full membership on the
incorporation of the ICAJ. There are two categories of membership of the Jamaican
Institute: the associate member (CA) and the fellow (FCA). Five years approved
practical experience is required for admittance as an associate. A practicing certificate
is granted after two and half years in a practicing office. Fellowship is automatic after
ten years associate membership of five years if in practice.

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 The ICAJ is organized along the same lines as the professional bodies in the UK.
The official journal of ICAJ “Charter” is produced four times per year and there is a
Members’ newsletter. They have interesting articles which are good resource material.
The ICAJ has adopted some of the IAS, but in addition, the Institute has issued some
recommendations. These recommendations are intended as guide to members and
compliance is strongly urged, but they do not carry the same weight as the IAS.

The Institute of Chartered Accountants of Trinidad and Tobago (ICATT)

were formed in 1970. Members and or graduates of certain Accountancy bodies are
eligible for admission to membership the Council of ICATT has a President, Vice
President, Treasurer and 9 elected members. The Standing Committees of ICATT are
Accounting and Auditing Standards, Accounting and Auditing Standards for Oil & Gas,
Disciplinary, Education and Professional Development, Investigation, Legislation,
Membership, Public Relations and Taxation. There is a quarterly magazine called
“Institute of Chartered Accountants Newsletter” (ICAN). It has many informative
articles.
ICATT became a member of IFAC in 1977. ICATT was the driving force behind the
Company Law Reform in Trinidad and Tobago.

The Institute of Chartered Accountants of the Caribbean (ICAC) was

incorporated in October 1988. The regional institutes are its members and it currently
shares the offices and administrative staff of ICSJ. The founding members were the
Institutes of Chartered Accountants of the Bahamas, Barbados, Belize, Guyana,
Jamaica, St. Lucia and Trinidad and Tobago. There is a board made up of one Director
from each territory from whom are chosen a President, Vice President, a Secretary and
Treasurer. One of their projects has been to launch a regional professional
accountancy qualification.

Question:
What do you think are the roles of the regional institutes of Chartered Accountants?
- to establish standards of financial reporting
- to develop or adopt accounting standards
- to give guidance to the public, preparers, auditors and users of financial reporting
- to help in the education of accountants and auditors
- to provide oversight on the conduct of accountants in the profession.
- aid in better provision of skills for companies preparing their financial statements.

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Conceptual Framework
Accounting principles are not like physical laws; they are made by persons. All
accounting procedures have a reason for being done in a particular way that is
theoretically supported. This is described as the conceptual framework of accounting.
It is a statement of generally accepted accounting principles which form the reference
framework for financial reporting.
A conceptual framework is like a constitution: It is “a coherent system of
interrelated objectives and fundamentals that can lead to consistent standards
and that prescribes the nature, function, and limits of financial accounting and
financial statements.”
In 1978, the US body the Financial Accounting Standards Board (FASB)
completed a project describing a conceptual framework. It is a system of related
objectives. The main purpose of which is to have consistent standard in the
preparation of financial statements. The framework provides a basis for resolving
disputes, setting standards and outlining fundamental accounting principles.

The main purposes of the IASB conceptual framework are:-

1. To assist in the development and the review of international standards
1. To help IASB in promoting harmonisation of accounting standards and
procedures relating to the presentation of financial statements by providing a
basis for reducing the number of alternative accounting treatments permitted by
international standards (IAS).
2. To assist national accounting standard setting bodies in developing accounting
standards.
3. To assist practitioners to prepare financial statements in accordance with
international standards (IAS).
4. To help auditors in forming an opinion as to whether financial statements comply
with international standards (IAS).
5. To help users to interpret the information contained in financial statements and
increases their understanding of and confidence in financial reporting (which are
prepared in conformity with IAS).

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 These conceptual building blocks form a bridge between the why of accounting
(the objectives) and the how of accounting (recognition and measurement).

Recognition and measurement concepts

Third level:
Assumptions Principles Constraints The ‘how’

Implementation

Qualitative Elements
Characteristics of Second
level: Bridge
of accounting financial between
levels 1 and 3
information statements

First level:
The ‘why’
Goals and purposes
of reporting
of financial
accounting Objectives

The FASB’s conceptual framework consists of the following four items:

1. Objectives of Financial Reporting
2. Qualitative characteristics of accounting information
3. Elements of financial statements
4. Operating guidelines – (concepts, principles and constraints)

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Each of these items will be discussed in details below.

Chapter One / Level 1:- Objectives of Financial Reporting

The 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.
Also, provide information about the entity’s economic resources and the claims against
the reporting entity as well as information about the effects of transactions and other
events that change a reporting entity’s economic resources and claims.
The primary users need information about the resources of the entity not only to assess
an entity's prospects for future net cash inflows but also how effectively and efficiently
management has discharged their responsibilities to use the entity's existing resources
(i.e., stewardship). [1.3-1.4].

In summary, the objectives of financial reporting are to (1) information that is useful in
investment and credit decisions, (2) information that is useful in assessing cash flow
prospects, and (3) information about enterprise resources (assets), claims to those
resources (liabilities), and changes in them.
The objective of financial reporting is to assist the users of financial information in
making reasonable decisions.
Chapter Two / Level 2:- Qualitative characteristics of useful financial information
The qualitative characteristics of useful financial reporting identify the types of
information are likely to be most useful to users in making decisions about the reporting
entity on the basis
of information in its financial report. The qualitative characteristics apply equally to
financial information in general purpose financial reports as well as to financial
information provided in other ways. [2.1, 2.3]
Financial information is useful when it is relevant and represents faithfully what it
purports to represent. The usefulness of financial information is enhanced if it is
comparable, verifiable, timely and understandable. [2.4]
The accounting practice selected or the policy adopted should be the one that
generates the most useful financial information for making a decision. To be useful,
information should possess the following qualitative characteristics: relevance,
reliability, comparability and consistency.

1. RELEVANCE
Relevant financial information is capable of making a difference in the decisions
made by users. Financial information is capable of making a difference in
decisions if it has predictive value, confirmatory value, or both. The predictive
value and confirmatory value of financial information are interrelated. [2.6-2.10].
Predictive value helps users to look at the past, present and future events. For
example, when Exxon issues financial statements, the information in the

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 statements is considered relevant because it provides a basis for forecasting
(predicting) future earnings. Feedback value confirms or corrects prior
expectations. When Exxon issues financial statements, in addition to helping
predict future events, it confirms or corrects prior expectations about the financial
health of the company.
In addition, for accounting information to be relevant it must be timely. That
is, it must be available to decision makers before it loses its capacity to influence
decisions.
If information is not available when it is needed, or becomes available long after
the reported events, it loses its value for future action, as it lacks relevance and is
of little or no use to decision makers. Timeliness alone cannot make information
relevant, but a lack of timeliness can rob information of its relevance.
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.
If Exxon reported its financial information only every 5 years, the information
would have limited usefulness for decision-making purposes.

In summary, this information must be relevant in that it influences of users.

This influence occurs when information helps the reader to:
(a) predict future income and cash flows
(b) confirm or correct previous predictions by feeding back actual
results.
Problem: - in preparing financial statements, we must be able to identify the
needs of the users, given the variety of users.

2. RELIABILITY
Reliability of information means that the information is free of error and bias; it
can be depended on. To be reliable, accounting information must be verifiable –
we must be able to prove that it is free of error and bias that is information must
be capable of being tested (i.e. falsified, or provable by observation). The
information must be a faithful representation of what it purports to be – it must be
factual.
Representational faithfulness means that the numbers and descriptions
represent what really existed or happened. The accounting numbers and
descriptions agree with the resources or events that these numbers and
descriptions purport to represent. If General Motors income statement report
sales of $150 billion when it had sales of $138.2 billion, then the statement is not
a faithful representation. Finally, accounting information must be neutral - it
cannot be selected, prepared, or presented to favor one set of interested users
over another. To ensure reliability, certified public accountants audit financial

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 statements, just as the Internal Revenue Service audits tax returns for the same
purpose which should remove this bias.
In summary, reliable accounting information provides is free of error and
bias, is faithful representation (factual), verifiable and neutral. The
information should be of
a standard that can be relied on by external users.
Problem is the complex nature of modern business makes reliability difficult to
achieve in all cases.

3. COMPARABILITY
Comparability facilitates the comparison of financial reporting between
accounting periods of one company or the financial reporting of one company
with that of another company.
Information in an entity’s financial statements gains greatly in usefulness if it can
be compared with similar information about the entity for some other period in
order to identify trends in financial performance and financial position. It
adds to conservatism so that the same rules are used to prepare the financial
statements.
Users are provided with the opportunity to identify similarities and differences of
financial information and not to be misled by unexplained changes in accounting
rules.
The characteristic of comparability of financial statements is important
because it allows us to compare a set of financial statements with those of prior
periods and those of other companies. For example, Sears and J.C. Penney all
use the cost principle in reporting plant assets on the balance sheet. Moreover
each company uses the revenue recognition and matching principles in
determining its net income.
Each company must disclose the accounting methods used. From the
disclosures, the external user can determine whether the financial information is
comparable.

4. CONSISTENCY
Consistency means that a company uses the same accounting principles
and methods from year to year in the preparation of its financial
statements. It implies that a business must refrain from changing its accounting
policy unless on reasonable grounds. If for any valid reasons the accounting
policy is changed, a business must disclose the nature of change, the reasons
for the change and its effects on the items of financial statements.
For example: - Company B is a retailer dealing in shoes. It used first-in-first-out
method of inventory valuation in respect of shoes at Branch X and weighted
average inventory valuation method in respect of similar shoes at Branch Y.
Here, the auditors must investigate whether there are any valid reasons for the

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 different treatment of similar inventory located at different locations. If not, they
must direct the company to use any one of the valuation method uniformly for the
whole class of inventory.
Consistency concept prevents misleading profits arising from different methods
applied so that more meaningful comparisons of financial performance can be
made from year to year.

5. UNDERSTANDABILITY
Understandability implies that financial statement users who have a reasonable
knowledge of business and economic activities and who review and analyse the
information with diligence. [2.34-2.36]

It requires the information presented in financial reports to be concise, complete

and clear in presentation. The information should be presented so as to facilitate
the user of the information.
For example: - understandability would require the financial statements to be
identified by presenting the name of the financial statement, the name of the
entity and the period covered by the statement.

For information to be useful there must be a connection (linkage) between the

users and the decisions they make. This link, understandability is the quality of
information that permits informed users to perceive its significance.

The qualitative characteristics of accounting information are summarized in the

table below:

Qualitative Characteristics of Accounting Information

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 Useful
Financial
Information has:

Relevance Reliability

. predictive value . verifiable

. feedback value . faithful
Comparability representation
. timely and . neutral
Consistency

Relevance and Reliability are the two primary qualitative characteristics of

accounting information. The secondary qualitative characteristics of accounting
information are comparability and consistency.

Recognition and Measurement Concepts

Accounting principles are basic rules that are applied in recording transactions and
preparing financial statements. They are also known as concepts. These rules are
necessary to ensure that accounting records provide reliable information. All
businesses should apply the rules in their financial statements.

Assumptions/Concepts
Assumptions provide a foundation for the accounting process. There four basic
assumptions underlie the financial accounting structure:
1. Economic Entity Assumption or Separate Entity Assumption or Business Entity
In accounting we treat a business and its owners as two separately identifiable
parties. This concept is called business entity concept. It means that personal
transactions of owners are treated separately from those of the business. In other
words, the activity of a business enterprise can be kept separate and distinct
from its owners and any other business unit. For example, if the activities
and elements of General Motors could not be distinguished from those of Ford or
Chrysler, then it would be impossible to know which company financially
outperformed the other two in recent years. If there were no meaningful way to
separate all of the economic events that occur, no basis for accounting would
exist.
The entity concept does not apply solely to the segregation of activities among
given business enterprises. An individual, a department or division, or an entire
industry could be considered a separate entity if we choose to define the unit in
such a manner. Thus, the entity concept does not necessarily refer to a

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 legal entity. A parent and its subsidiaries are separate legal entities, but
merging their activities for accounting and reporting purposes does not violate
the economic entity assumption.
2. Going Concern Assumption
It has been defined as follows: ‘the enterprise will continue in operational
existence for the foreseeable future.’ It is assumed that the business entity
has an indefinite life and continues into the unforeseeable future.
An entity shall prepare financial statements on a going concern basis unless
management either intends to liquidate the entity or has no realistic alternative
but to do so.
For example the non-current (fixed) assets will normally be shown in the
statement of financial position at cost less aggregate depreciation to date that is
the net book value. Stock should be shown in the balance sheet at cost or net
realizable value.
If the business is not a going concern, the assets should be valued in the
statement of financial position at the amounts they could be expected to fetch in
an enforced sale, which could be much less than their real worth.
Depreciation and amortization policies are justifiable and appropriate only
if we assume some permanence to the enterprise.
3. Monetary Unit Assumption
The monetary unit assumption means that we can express business transactions
and events in monetary, or money or units. Money is the common denominator
in business.
The monetary unit is relevant, simple, universally available,
understandable, and useful. It implies that the monetary unit is a stable
measure without a change value.
Examples of monetary units are the dollars in the United States, Canada,
Jamaica, the pound sterling in the United Kingdom.
The monetary unit a company uses in its accounting reports usually depends on
the country where it operates, but many companies today are expressing reports
in more than one monetary unit.
4. Periodicity / Time Period Assumption
Businesses intend to continue in their operation in the long term. Therefore, it is
always helpful to account for their performance and position based on certain
time periods because it provides timely feedback and helps in making timely
decisions.
Under the time period assumption, we prepare financial statements
quarterly, half-yearly or annually.
One implication of the time period assumption is that we have to make estimates
and judgments at the end of the time period to correctly decide which events
need to be reported in the current time period and which ones in the next.

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 Revenue recognition and matching principles are relevant to time period
assumption. Revenue recognition principle provides guidance on when to record
revenue while matching concept tells us how to reach an accurate net income
figure by creating 1-1 correspondence between revenues and expenses
The shorter the time period, the more difficult it becomes to determine the proper
net income for the period. A month’s results are usually less reliable than a
quarter’s results, and a quarter’s results are likely to be less reliable than a year’s
results. Investors desire and demand that information be quickly processed and
disseminated; yet the quicker the information is released, the more it is subject to
error. This phenomenon provides an interesting example of the trade-off
between relevance and reliability in preparing financial data.

PRINCIPLES
There are four basic principles of accounting are used to record transactions:
(1) historical or cost, (2) revenue recognition, (3) matching and (4) full disclosure.
1. Historical / Cost Principle
Assets such as land, buildings, merchandise, and equipment are typical of the
many economic resources that will be used in producing revenue for the
business. The prevailing accounting view is that such assets should be recorded
at their cost. When we say that an asset is shown in the balance sheet at its
historical cost, we mean the original cost of the asset to the business
entity; this amount may be very different from the asset’s current market
value.
For example, let us assume that a business buys a piece of land for use as a
building site, paying $100 000 in cash. The amount to be entered in the
accounting records for the asset will be the cost of $100 000. If we assume a
booming real estate market, a fair estimate of the market value of land 10 years
later might be $250 000. although the market price or economic value of the land
has risen greatly, the accounting amount as shown in the accounting records and
on the balance sheet would continue unchanged at the cost of $100 000. This
policy of accounting for assets at their cost is often referred to as the cost
principle of accounting.
2. Revenue Recognition 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 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 principle.
It is concerned with the point in time at which income should be included in the
income statement.
There are two general principles of recognizing revenue:
a. the revenue must be earned when services have been undertaken

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 or goods provided.
b. the revenue must be realized when cash has been received or when
the likelihood of a cash receipt is a probable expectation.
In some cases a customer may pay in advance of the goods or services being
provided and thus the income should not be recognized until the revenue has
been earned. This principle is important as it prevents revenue from being
credited in the accounts before it has been earned.
Goods on sale or return – when a trader sends goods on sale or return to a
customer, no sale takes place until the customer informs the seller that he has
decided to buy them. The customer has the right to return the goods to the
trader. The goods remain the property of the seller until the sale actually takes
place. Goods on sale or return when final accounts are being prepared must be
treated as stock. If they have been wrongly treated as sold the accounting
treatment must be reversed. Sales and debtors must be reduced by the selling
price, and closing stock must be increased by the cost price of the goods.
However, one common exception to this rule is for companies that have long-
term contracts, which often recognize revenue using percentage of completion
method where costs and expenses are recognized based on work accomplished.
3. Matching Principle / Expense Recognition/ Accruals Principle.
Expenses recognition is traditionally tied to revenue recognition: ‘Let the expense
follow the revenue.’ This practice is referred to as the matching principle: it
dictates that expenses be matched with revenues in the period in which
efforts are expended to generate revenues. Expenses are not recognized
when cash is paid, or when the work is performed, or when the product is
produced; they are recognized when the labour (service) or the product actually
makes its contribution to revenue.
4. Substance over Form also referred to as Faithful Representation
To be useful, financial information must not only be relevant, it must also
represent faithfully the phenomena it purports to represent. Faithful
representation means representation of the substance of an economic
phenomenon instead of representation of its legal form only. [2.12]
Substance over form /( faithful representation) is an accounting concept, which
means that the economic substance of transactions and events must be
recorded in the financial statements rather than just their legal form in order to
present a true and fair view of the affairs of the entity. For example a machine
bought on hire purchase remains the property of the seller until the final
instalment has been paid. If the purchaser fails to pay the instalments as they
become due, the seller may reclaim the machine. That is the legal position, or the
‘form’.
However, the machine is being used in the purchaser’s business in the same
way as the other machines that have not been bought on hire purchase. From

15
 an accounting point of view and for all practical purposes, the machine is no
different from the other machines; that is ‘substance’ of the matter.
The practical view (the substance) is preferred to the legal view (form) in
accounting treatment. This is known as ‘substance over form’.
Substance over form is critical for reliable financial reporting. It is particularly
relevant in case of revenue recognition.

5. Full Disclosure Principle

Full disclosure principle is relevant to the materiality concept. It requires that all
material information has to be disclosed in the financial statements either on the
face of the financial statements or in the notes to the financial statements.
This principle recognizes that the nature and amount of information
included in financial statements reflects a series of judgmental trade-offs.
These trade-offs strive for (1) sufficient detail to disclose matters that make a
difference to users, yet (2) sufficient consideration to make the information
understandable, keeping in mind costs of preparing and using it. Information
about financial position, income, cash flows, and investments can be found in
one of three places: (1) within the main body of financial statements, (2) in the
notes to those statements, or (3) as supplementary information.
The financial statements are a formalized, structured means of communicating
financial information. To be recognized in the main body of financial statements,
an item should meet the definition of a basic element, be measurable with
sufficient certainty, and be relevant and reliable.
The notes to the financial statements generally explain the items presented
in the main body of the statements. If the information in the main body of the
financial statements gives an incomplete picture of the performance and position
of the enterprise, additional information that is needed to complete the
picture should be included in the notes. Information in the notes does not
have to be quantifiable, nor does it need to qualify as an element. Notes
can be partially or totally narrative.
Examples of notes to the financial statements are as follows:-
(a) Accounting policies need to be disclosed because they help understand the
basis of
accounting.
(b) A summary of accounting policies related to revenue recognition,
inventories,
property, plant and equipment, and financial instruments.
(c) Details of contingent liabilities, contingent assets, legal proceedings, etc.
are also
relevant to the decision making of users and hence need to be disclosed.
(d) Significant events occurring after the date of the financial statements but
before the

16
 issue of financial statements (i.e. events after the balance sheet date) need
to be
disclosed.
(d) Details of property, plant and equipment cannot be presented on the face of
the
balance sheet, but a detailed schedule outlining movement in cost and
accumulated
depreciation should be presented in the notes.
(e) Tax rate is expected to change in near future. This information needs to be
disclosed.
(f) The company sold one of its subsidiaries to the spouse of one of its
directors.
The information is material and needs disclosure.
(g) A detail of contingencies that may affect the business in future, for example
legal
proceedings against the business.

The notes are not only helpful but also essential to understanding the
enterprise’s performance and position.

Supplementary information may include details or amounts that present a

difference perspective from that adopted in the financial statements. It may
be quantifiable information that is high in relevance by low reliability, or
information that is helpful but not essential. One example of supplementary
information is the data schedules provided by oil and gas companies: Typically
they provide information on proven reserves as well as related discounted cash
flows.

CONSTRAINTS
Constraints permit a company to modify generally accepted accounting principles
(GAAP) without reducing the usefulness of the reported information. The constraints are
cost-benefit relationship, materiality, industry peculiarities and conservatism.
1. Cost-benefit relationship
It must be considered – the costs of providing the information must be weighed
against the benefits that can be derived from using the information. Obviously
the benefits should exceed the costs. Practicing accountants have traditionally
applied this constraint through the notions of ‘expediency’ (it is or is not
expedient) or ‘practically’ (it is or is not practical), but only recently have
standard-setting bodies and governmental agencies resorted to cost-benefit
analysis before making their information requirements final. In order to justify

17
 requiring a particular measurement or disclosure, the benefits perceived to be
derived from it must exceed the costs perceived to be associated with it.
The difficulty in cost-benefit analysis is that the costs and especially the benefits
are not always evident or measurable.

2. Materiality
Materiality relates to an item’s impact on a firm’s overall financial operations. An
item is material if its inclusion or omission would influence or change the
judgment of a reasonable person. It is immaterial and, therefore, irrelevant if it
would have no impact on a decision maker. In short, it must make a difference or
it need not be disclosed.
The point involved here is one of relative size (amount involved) or due to the
importance.
Examples:-
(i) The government of the country in which the company operates in working on a
new
legislation which would seriously impair the company's operations in future.
Although there are no figures involved but the impact is so large that
disclosure is
imminent.
(ii) The remuneration paid to the executives and the directors is material.
(iii) Assume that Rogers co. purchases a number of low cost plant assets, such
as wastepaper baskets. Although the proper accounting would appear to be
depreciable these wastepaper baskets over their useful life, they are usually
expensed immediately. This practice is justified because these costs are
considered immaterial.
3. Industry Peculiarities
this constraint comes about when certain accounting policies are peculiar to
particular industry. For example some accounting information for the oil industry
would not be pertinent to the banking industry.
4. Conservatism / Prudence
Prudence is defined as the exercise of caution when making judgements under
conditions of uncertainty. [2.16]. for example the estimated life span of a machine
and the probability of recovering provision for doubtful debts. They need to
exercise prudence to disclose such uncertainties in the financial statements.
Hence, prudence is the inclusion of a degree of caution when judgements are
needed to make estimates required under conditions of uncertainty, so that
income or assets are not overcast, and liabilities and expenses are not under
cast. Profits are not recognized until sales have been completed.. The principle
is sometimes known as the concept of conservatism. It is safer for profit to be
under stated rather than overstated.
The rule is:

18
 (a) profits should not be overstated
(b) losses should be provided for as soon as they are recognized.

Financial Statements
A financial statement is simply a declaration of what is believed to be true
communicated in terms of a monetary unit, such as dollars. When accountants
prepare financial statements, they are describing in financial terms certain attributes of
the enterprise that they believe fairly represent its financial activities.
Time is an important factor in preparing and understanding an enterprise’s financial
statements.
Financial statements might cover period as short as a week or as long as a year.
Interim Financial Statements – (quarterly or semi-annually)
Quarterly and semi-annual financial statements are called interim financial statements
and are normally prepared in a condensed form. It means that the disclosures required
in them are far less than those required in annual financial statements. Quarterly
financial statements are normally unaudited but semi-annual reports need to be at least
reviewed by an auditor who is a qualified professional accountant authorized to attest
the authenticity of financial statements.
IAS34.1 – Interim Reporting Period encourages publicly traded entities to provide
interim financial reports that conform to the recognition, measurement, and disclosure
principles set out in the standard, at least as of the end of the first half of their financial
year, such reports to be made available not later than 60 days after the end of the
interim period.
Annual Financial Statements
Financial statements prepared for a period of one year are called annual financial
statements and are required to be audited by an auditor (a chartered accountant or a
certified public accountant). Annual financial statements are normally published in an
annual report which also includes a directors' report (also called management
discussion and analysis) and an overview of the company, its operations and past
performance.

IAS1: Presentation of Financial Statements

Objective and scope of financial statements
This standard requires a complete set of financial statements to comprise a statement
of financial position, a statement of profit or loss and other comprehensive income, a
statement of changes in equity and a statement of cash flows.
The objective of financial statements is to provide information about an entity's assets,
liabilities, equity, income and expenses that is useful to financial statements users in
assessing the prospects for future net cash inflows to the entity and in assessing
management's stewardship of the entity's resources. [3.2]

19
This information is provided in the statement of financial position and the statement(s) of
financial performance as well as in other statements and notes. [3.3] to assist users of
financial statements in predicting the entity's future cash flows and, in particular, their
timing and certainty.
Reporting period
Financial statements are prepared for a specified period and provide comparative
information and under certain circumstances forward-looking information. [3.4-3.6]

Components of Financial Statements

A complete set of financial statements should include:

(a) a statement of financial position (balance sheet) at the end of the period

It is a financial statement showing the financial position of an enterprise by

summarizing its assets, liabilities, and owner’s equity at a point in time. It
sometimes described as a snapshot of the business in financial or dollar terms.
(b) a single statement of comprehensive income or two statements: an income

statement and a statement of comprehensive income for the period (or an

income statement and a statement of comprehensive income) describes a
company’s revenues and expenses along with the resulting net income or net
loss, over a period of time due to earnings activities.
(c) a statement of changes in equity for the period explains changes in equity from

net income (or loss) and from the owner investments and withdrawals over a
period of time.
(d) a statement of cash flows for the period is an activity statement that explains

the enterprise’s change in cash terms of its operating, investing, and financing
activities.
(e) notes, comprising a summary of accounting policies and other explanatory notes

Fair presentation and compliance with International Financial Reporting

Standards (IFRSs)
The financial statements must "present fairly" the financial position, financial
performance and cash flows of an entity. Fair presentation requires the faithful
representation of the effects of transactions, other events, and conditions in accordance
with the definitions and recognition criteria for assets, liabilities, income and expenses
set out in the Framework. The application of IFRSs, with additional disclosure when
necessary, is presumed to result in financial statements that achieve a fair presentation.
[IAS 1.15]
Accrual basis of accounting
IAS 1 requires that an entity prepare its financial statements, except for cash flow
information, using the accrual basis of accounting. [IAS 1.27]
Consistency of presentation

20
The presentation and classification of items in the financial statements shall be retained
from one period to the next unless a change is justified either by a change in
circumstances or a requirement of a new IFRS. [IAS 1.45]
Structure and content of financial statements in general
Clearly identify: [IAS 1.50]
(1) the financial statements; which must be distinguished from other information in a
published document
(2) the reporting enterprise
(3) whether the statements are for an individual entity or a group of entities
(4) information about the reporting period covered
(5) the presentation currency
(6) the level of rounding used (example: - thousands, millions)

Elements of the Statement of Financial Position (Balance Sheet)

Financial statements portray the financial effects of transactions and other events by
grouping them into broad classes according to their economic characteristics. These
broad classes are termed the elements of financial statements.

The elements directly related to financial position (balance sheet) are: [F 4.4]
Assets
Liabilities
Equity

The elements directly related to performance (income statement) are: [F 4.25]

Income
Expenses

The cash flow statement reflects both income statement elements and some changes in
balance sheet elements.

An entity must normally present a classified statement of financial position, separating

current and non-current assets and liabilities. [IAS 1.60]

IAS 1 establishes a set of criteria, which should be used to distinguish between current
and non-current assets and another set of criteria, which should be used to distinguish
between current and non-current liabilities.

An asset is 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. [F 4.4(a)]
Current and Non-current Assets
An asset is classified as a current asset if it satisfies any of the following criteria:-
(a) held for collection, sale or consumption within the entity's normal operating cycle

21
(b) held primarily for the purpose of trading

(c) expected to be realised within 12 months after the reporting period

(d) cash and cash equivalents

An asset that satisfies none of these criteria is a non-current asset. [IAS 1.66]

.
A liability is 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.
[F 4.4(b)]
Current and Non-current Liabilities
A liability is classified as a current liability if it satisfies any of the following criteria:

(a) expected to be settled within the entity's normal operating cycle

(b) held for purpose of trading
(c) due to be settled within 12 months
(d) for which the entity does not have an unconditional right to defer settlement
beyond 12 months.

A liability that satisfies none of these criteria is a non-current liability. [IAS 1.69].

When a long-term debt is expected to be refinanced under an existing loan facility and
the entity has the discretion the debt is classified as non-current, even if due within 12
months. [IAS 1.73].

quit
Equity is the residual interest in the assets of the entity after deducting all its liabilities.
[F 4.4(c)]

Format of Financial Statements

(a) Statement of Financial Position
IAS 1 does not prescribe the format of the statement of financial position. Assets can be
presented current then non-current, or vice versa, and liabilities and equity can be
presented current then non-current then equity, or vice versa. A net asset
presentation (assets minus liabilities) is allowed. The long-term financing approach
used in UK and elsewhere – fixed assets + current assets - short term payables =
long-term debt plus equity – is also acceptable.

An example of a Statement of Financial Position prepared under the format prescribed

by IAS 1 Presentation of Financial Statements.
XYZ
22
 Statement of Financial Position as at 31 December 2018
Notes 2018 2017
USD USD
ASSETS
Non-current assets
Property, plant & equipment 9 130,000
120,000
Goodwill 10 30,000 30,000
Intangible assets 11 60,000 50,000
Total non-current assets 220,000 200,000

Current assets
Inventories 12 12,000 10,000
Trade receivables 13 25,000 30,000
Cash and cash equivalents 14 8,000 10,000
45,000 50,000
TOTAL ASSETS 265,000 250,000

EQUITY AND LIABILITIES

Equity
Share capital 4 100,000 100,000
Retained earnings 50,000 40,000
Revaluation reserve 5 15,000 10,000
Total equity 165,000 150,000

Non-current liabilities
Long term borrowings 6 35,000 50,000

Current liabilities
Trade and other payables 7 35,000 25,000
Short-term borrowings 8 10,000 8,000
Current portion of long-term borrowings 6 15,000 15,000
Current tax payable 9 5,000 2,000

Total current liabilities 65,000 50,000

Total liabilities 100,000 100,000
TOTAL EQUITY AND LIABILITIES 265,000 250,000

NB Property, plant and equipment and capital reserves require disclosure note to show
details and movement in the period.

Statement of Changes in Equity

23
 Element of the Shareholders’ or (Owners’)Equity
IAS 1 requires an entity to present a separate statement of changes in equity.
A statement of changes in equity summarizes the movement in the equity accounts
during the year namely share capital, share premium, retained earnings, revaluation
surplus, unrealized gains on investments, etc.
A statement of changes in equity is an important component of financial statements
since it explains the composition of equity and how has it changed over the year.
Typical information we can get from a statement of changes in equity include:
1. The amount of new share capital issued
2. The amount of dividend paid during the year to shareholders
3. The amount by which PPE is valued up or valued down
4. The amount of net income earned during the year
5. The amount of net income retained during the year.
6. Any movement in the unrealized loss or gain reserve and reserve for changes in
foreign
exchange gain or loss, etc.
An example: - Statement of Changes in Equity prepared according to the format
prescribed by IAS 1 Presentation of Financial Statements.

ABC Plc
Statement of changes in equity for the year ended 31st December 2018
Share Capital Retained Earnings Revaluation Surplus
Total Equity
USD USD USD
USD
Balance at 1 January 2017 100,000 30,000 -
130,000
Changes in accounting policy - - -
-
Correction of prior period error - - -
-
Restated balance 100,000 30,000 -
130,000

Changes in equity for the year 2017

Issue of share capital - - -
-
Income for the year - 25,000 -
25,000
Revaluation gain - - 10,000
10,000

24
Dividends - (15,000) -
(15,000)
Balance at 31 December 2017 100,000 40,000 10,000
150,000

Changes in equity for the year 2018

Issue of share capital - - -
-
Income for the year - 30,000 -
30,000
Revaluation gain - - 5,000
5,000
Dividends - (20,000) -
(20,000)
Balance at 31 December 2018 100,000 50,000 15,000
165,000

Statement of Comprehensive Income

Comprehensive income for a period includes profit or loss for that period plus other
comprehensive income recognised in that period. As a result of the 2003 revision to IAS
1, the Standard is now using 'profit or loss' rather than 'net profit or loss' as the
descriptive term for the bottom line of the income statement.
An entity has a choice of presenting:
(a) a single statement of comprehensive income or
(b) two statements:
(i) an income statement displaying components of profit or loss and
(ii) a statement of comprehensive income that begins with profit or loss
(bottom line of the income statement) and displays components of other
comprehensive income [IAS 1.81]

Income Statement by Function of Expense

An income statement by function is the one in which expenses are disclosed according
to their functions such are cost of goods sold, selling expenses, administrative
expenses, other expenses/losses etc. This method allows us to calculate gross profit
and operating profit within the income statement and therefore it is usually used in the
multi-step format of income statement. Most large and medium sized businesses use
the function method of expense disclosure.
The use of function method to disclose expenses still requires us to disclose the
individual expenses by nature method under each function either on the face of the
income statement or in the notes to the income statement.
Multi-step Income Statement

25
Multi-step income statement involves more than one subtraction to arrive at net income
and it provides more information than a single-step income statement. The most
important of which are the gross profit and the operating profit figures.
Multi-step income statement is divided into two main sections: the operating section and
the non-operating sections.
The operating section contains information about revenues and expenses of the
principle business activities. The gross profit and the operating profit figures are
calculated in the operating section of a multi-step income statement. All operating
revenues are grouped at the top of the income statement. The operating expenses are
sub-classified into cost of goods sold, selling expenses and administrative expenses.
Selling expenses are those which are incurred directly on making sales. Examples are:
sales commissions, sales salaries, advertising expense, delivery expense and
depreciation expense of sales equipment. The administrative expenses are those
relating to general administrative activities. Examples are: depreciation expense on
office building, office salaries, office supplies expense and office utilities expense.
The non-operating section of a multi-step income statement, usually labeled as 'other
incomes and expenses' contains those revenues and expenses which are not earned
directly through principle business activities but are incidental to them. For example
gains/losses on sales of investments or fixed assets, interest revenue/expense etc. It
also includes extraordinary items of revenues and expenses which are infrequent and
unusual such as loss due to natural calamity.
Format and Example

Company A
Income Statement
For the Year Ended December 31, 2018

Sales Revenue:
Total Sales $137,460
− Sales Returns (2,060)
− Sales Discounts (5,190)
Net Sales Revenue $130,210
Less: Cost of Goods Sold:
Beginning Stock $12,300
+ Purchases 67,310
+ Freight-In 4,450
− Purchase Discounts (3,900)
− Purchase Returns (1,000)
− Ending Stock (16,170)
Cost of Goods Sold (62,990)
Gross Profit $67,220

26
Operating Expenses
Selling Expenses:
Freight-Out $6,150
Advertising Expense 5,790
Sales Commissions Expense 3,470
Administrative Expenses:
Office Salaries Expense 18,510
Office Rent Expense 14,000
Office Supplies Expense 5,330
Total Operating Expenses (53,250)
Operating Income $13,970
Other Incomes and Expenses:
Gains on Sale Equipment $2,430
− Loss on Sales of Investments (1,640)
− Interest Expense (930)
Net Other Incomes and Expenses (140)
Net Income $13,830

For example: the following is an extract of balances in the accounts of High Melton
Feeds and Fertilizers Limited Company as at 31 December 2018.
$m
Cost of sales 3.6
Sales 9.1
Distribution costs 1.3
Loan note interest 1.4
Administration expenses 2.1
Income tax expense 0.2

Find the net profit for the period for the example
Solution:
Milton Feeds and Fertilizers
Income Statement for the year ended 31 December 2018
$m $m
Revenue
Cost of sales
Gross profit
Distribution costs
Administration expenses
Profit from operations
Interest payable

27
 Profit before tax
Income tax expense
Net Income for period

Statement of Cash Flows (IAS7)

IAS 7 Statement of Cash Flows requires an entity to present a statement of cash flows
as an integral part of its primary financial statements. Cash flows are classified and
presented into operating activities (either using the 'direct' or 'indirect' method), investing
activities or financing activities, with the latter two categories generally presented on a
gross basis.
Presentation of the Statement of Cash Flows
Cash flows must be analysed between operating, investing and financing activities. [IAS
7.10]
The key principles specified by the standard for preparation are as follows:
(a) Operating activities are the main revenue-producing activities of the entity that are
not
investing or financing activities, so operating cash flows include cash received from
customers and cash paid to suppliers and employees [IAS 7.14]
(b) Investing activities are the acquisition and disposal of long-term assets and other
investments that are not considered to be cash equivalents [IAS 7.6]
(c) Financing activities are activities that alter the equity capital and borrowing
structure of
the entity [IAS 7.6]
Interest and dividends received and paid may be classified as operating, investing, or
financing cash flows, provided that they are classified consistently from period to period
[IAS 7.31]
Notes to the Financial Statements
Notes to the financial statement present all such information which cannot be presented
on the face of income statement, balance sheet, statement of cash flows and statement
of changes in equity.
The notes must:
(a) present information about the basis of preparation of the financial statements and
the
specific accounting policies used.
(b) present additional detail about an item on the financial statements.
(b) disclose any information required by IFRSs that is not presented elsewhere in the
financial statements and
(c) provide additional information that is not presented elsewhere in the financial
statements
but is relevant to an understanding of any of them.

28
Notes should be cross-referenced from the face of the financial statements to the
relevant note. [IAS 1.113]

IAS 1.114 suggests that the notes should normally be presented in the following order:

o a statement of compliance with IFRSs

o a summary of significant accounting policies applied, including: [IAS 1.117]
(i) the measurement basis (or bases) used in preparing the financial
statements
(ii) the other accounting policies used that are relevant to an understanding of
the
financial statements
o supporting information for items presented on the face of the statement of
financial position (balance sheet), statement of comprehensive income (and
income statement, if presented), statement of changes in equity and statement of
cash flows, in the order in which each statement and each line item is presented.
o other disclosures, including:
(i) contingent liabilities (see IAS 37) and unrecognised contractual

commitments
(ii) non-financial disclosures, such as the entity's financial risk management

objectives and policies (see IFRS 7)

Summary of Conceptual Framework

As we have seen, the conceptual framework for developing sound reporting practices
starts with a set of objectives for financial reporting and follows with the development of
qualities that make information useful. In addition, elements of financial statements are
defined. Operating guidelines in the form of assumptions and principles are then
provided. The conceptual framework also recognizes that important constraints exist on
the reporting environment. These points are illustrated graphically in diagram below:

Conceptual Framework of Accounting

CONSTRAINTS

29
 OBJECTIVES OF FINANCIAL REPORTING

Qualitative Elements of
Characteristics of Financial Statements
Accounting Information

Operating Guidelines

Assumptions Principles

CONSTRAINTS

A conceptual framework is ‘a constitution, a coherent system of interrelated

objectives and fundamentals that can lead to consistent standards and that prescribes
the nature, function and limits of financial accounting and financial statements.
Generally Accepted Accounting Principles (GAAP) refers to the whole
corpus of financial accounting methods in use in a particular regime. It compasses the
conventions, rules and procedures necessary to define accepted accounting practice at
a particular time. The standard of ‘generally accepted accounting’ includes not only
board guidelines of general application but also detailed rules and procedures.
Generally Accepted Accounting Principles (GAAP) is conventional- that is,
they become generally accepted by agreement rather than formal derivation from a set
of basic concepts. The principles have developed on the basis of experience, reason,
custom, usage and to a significant extent, practical necessity. Generally Accepted
Accounting Principles (GAAP) is accounting practice, which has a substantial
authoritative support amongst users.

Qualitative Characteristics
Qualitative Characteristics are the attributes that make the information provided in
financial statements useful to users.
The primary qualitative characteristics relating to content are relevance and reliability.
Information has the quality of relevance when it influences the economic
decisions of users by helping them evaluate past, present or future events or by
confirming, or correcting, their past evaluations.
Information has the quality of reliability when it is free from material error and
bias and can be depended upon by users to represent faithfully – in terms of valid

30
description – that which it either purports to represent or could reasonably be expected
to represent.
Verifiability helps to assure users that information represents faithfully the
economic phenomena it purports to represent. Verifiability means that different
knowledgeable and independent observers could reach consensus; although no
necessarily complete agreement, that a particular depiction is a faithful representation
[2.30]

The primary qualitative characteristics relating to presentation are comparability

and understandability.
Comparability, verifiability, timeliness and understandability are qualitative
characteristics that enhance the usefulness of information that is relevant and faithfully
represented. [2.23]

Users must be able to compare the financial statements of an enterprise over time,
and also financial statements of different enterprises. Consistency is therefore
required.
Users should present the information provided in financial statements in such a way that
it is readily understandable.

Threshold for recognition – immaterial amounts –not large enough to influence

important decisions.
The five elements of financial statements:
 Assets
 Liabilities
 Equity interest / Capital
 Income / Revenue
 Expenses

Income is increases in economic benefits during the accounting period in the form of
inflows or enhancements of assets or decreases in liabilities that result in increases in
equity, other than those relating to contributions from equity participants.
Expenses are decreases in economic benefits during the accounting period in the form
of outflows or depletions of assets or incurrence of liabilities that result in decreases in
equity, other than those relating to distributions to equity participants.

A Hierarchy of Accounting Qualities

Decision Makers Their Characteristics

Users of
(for example understanding or prior
Accounting Information knowledge)

31
Pervasive Benefits > Costs
Constraint

Understandability

User Specific Qualities

Decision Usefulness

Primary Decision Relevance Reliability

Specific Qualities

Timeliness Verifiability Representational

Faithfulness

Predictive Feedback Neutrality

Ingredients value value
Of Primary

Qualities Secondary and

Comparability and Consistency
Interactive Qualities

Threshold for Materiality

Recognition

32