Conceptual Framework of Accounting

 CONCEPTUAL FRAMEWORK

It’s the framework for the preparation and presentation of Financial Statements. It sets out the concepts that underlie financial statements for external users.

Purpose of Conceptual framework

1.      Assists IASB in the development of new standards and reviewing of the existing standards

2.      Assists IASB in harmonizing accounting standards and procedures

3.      Assists National Standard setting bodies in developing national accounting standards

4.      Assists preparers of financial statements in applying standards to deal with topics which aren’t discussed in the standards framework

5.      Assists auditors in forming an opinion as to whether financial statements conform with IASs or IFRSs

Scope of the Conceptual Framework

1.      The objectives of the Financial Statements

2.      The qualitative characteristics of financial statements

3.      Definition, Recognition and Measurement of the Elements from which Financial Statements are constructed

4.      Concept of Capital and Capital Maintenance

1.      Objectives of Financial Statements

Provide information on the financial position, financial performance and changes in financial position to a wide range of users of the financial statements to enable them make informed decisions.

Assumptions of the Financial Statements (Underlying)

There are two fundamental accounting assumptions

1)      Accrual Basis Assumption

Simply means the matching concept. That is, match income with expenses

This means transactions and events will be recorded in the financial statements when they occur but not when money is paid in or received in the accounting records and in the correct period

2)      Going Concern Assumption

It’s the assumption that the business will be in operation for the foreseeable future. That is, the business entity has no intention or necessity to liquidate or curtail the major operations of the business

If the business entity has that intention or necessity to liquidate, the FS should be prepared on realization method and the method should be disclosed in the notes to the financial statements.

NB. Accruals basis could be meaningless if the going concern is not there.

2.      Qualitative Characteristics of Financial Statements

1)      Relevance

2)      Reliability

3)      Understandability

4)      Comparability

1)      Relevance

Information is relevant if it has the ability to influence economic decisions of users and provided in time to influence those decisions.

To give information of great value, accountants must review the materiality of all transactions and events which will be used to construct the financial statements.

Materiality

Information is material if its omission or misstatement would influence the economic decisions of the users of financial statements. Materiality is judged on the size or amount of error under that circumstance.

2)      Reliability

For information to be reliable, it should be free from biasness, errors and must be complete.

Information is said to be reliable if the following are evident:

a)      Faithful Representation

b)      Substance over form

c)      Prudence

d)     Completeness

e)      Neutrality

a)      Faithful Representation

Business entities are going to disclose all the information that could influence the economic decisions of the users of financial statements. That is, they will not understate their expenses and liabilities while also not overstate income and assets of Financial Statement.

b)     Substance over Form

While preparing financial statements, accountants will record all transactional events and their commercial reality but not on their legal form. Example, in the hire purchase.

c)      Prudence

Prudence involves exercising a degree of caution when preparing the Financial Statements. That is, we should not anticipate assets or incomes but we should provide for possible expenses and liabilities. That is why depreciation is normally charged on idle assets since even if we are not using them, there is a loss in value thru tear and wear.

d)     Completeness

When preparing the financial statements, we should not be biased, but we should provide all the necessary information which the users of the financial statements may deem necessary while making economic decisions.

e)      Neutrality

The financial statements should be free from biasness. That is, they should not favour any party. Not favour business entity or the users of the financial statements.

3)      Understandability

Financial statements prepared by the business entity must be readily understandable by the users. The users are assumed to have a reasonable knowledge on the nature of the business practice.

4)      Comparability

The financial statements should be compared through time and should be compared with different business entities within the same industry.

To enhance comparability, the business entity must adopt the same accounting policies in each year they are reporting. This is in accordance with IAS 8 Accounting Policies, which are the principles, conventions, bases, rules and practices business entities use in the preparation and presentation of financial statements.

3.      Definition, Recognition and Measurement of the Elements from which Financial Statements are constructed

Definition of the Elements of Financial Statements

1.      Assets

An asset is a resource controlled by the business entity as a result of a past event, from which future economic benefits are expected to flow to the entity. Control is the ability to generate economic benefits from the asset and also to restrict others from using the asset.

2.      Liabilities

A Liability is a present obligation as a result of a past event, the settlement of which will result into an outflow from the entity of resources embodying economic benefits.

3.      Capital

Capital is the amount invested in a business by the owner. Equity is the residual interest of the assets of the entity after deducting all its liabilities.

4.      Income

Income is the increase in economic benefits during the accounting period in the form of inflows, enhancement of assets or reduction in liabilities resulting to increase in equity other than those relating to the contribution by the members.

Income can be classified into two:

a)      Revenue

Increase in economic benefits from the ordinary activities of the business which qualify to be an income. E.g sales, fees, dividends, interests, royalties etc.

b)     Gains

Other items that meet the definition of an income but do not relate to the ordinary activities of the business. E.g sales of NCA. Gains

5.      Expenses

Expenses are decrease in economic benefits during the accounting period in form of outflows, depletion of assets or incurrence of liabilities resulting to decrease in equity other than distribution made to the owners of the entity.

Recognition of the Elements of the Financial Statements

Recognition means incorporating in the SOFP and IS an item that meets the definition and satisfies the criteria for recognition.

·         It’s probable that future economic benefits is going to flow to or from the entity

·         The cost or value can be measured reliably

Measurement of the Elements of Financial Statements

When preparing the financial statements, the following methods of measurement should be used.

a.      Historical Cost: original monetary value of an economic item

b.      Current Cost: the market value (new asset)

c.       Realizable Cost: the disposal value, if you assume you are liquidating

d.      Present Cost: the discounted cost. Discounted value of the assets and liabilities

4.      Concept of Capital and Capital Maintenance

Capital is the amount invested in the business by the owners.

Capital maintenance is the accounting equation:

Capital = Assets

New Capital = Old Capital + Profits – Losses

Capital Maintenance is viewed in two dimensions

a.      Financial Capital Maintenance

The value of the firm is seen in monetary terms. That is, the value at the beginning of the year against the value at the end of the accounting period. Financial capital maintenance must be in money terms.

b.      Physical Capital Maintenance

Looking at the value of the firm by comparing the assets held by the entity at the beginning and assets held at the end of the accounting period