What is the Conceptual Framework for financial reporting and what is its purpose?

The concept of materiality refers to the relative significance of an amount, activity, or item to informative disclosure, proper presentation of financial position, and the results of operations. Materiality has qualitative and quantitative aspects; both the nature of the item and its relative size enter into its evaluation.

An accounting misstatement is said to be material if knowledge of the misstatement will affect the decisions of the average informed reader of the financial statements. Financial statements are misleading if they omit a material fact or include so many immaterial matters as to be confusing. In the examination, the auditor concentrates efforts in proportion to degrees of materiality and relative risk and disregards immaterial items.

The relevant criteria for assessing materiality will depend upon the circumstances and the nature of the item and will vary greatly among companies. For example, an error in current assets or current liabilities will be more important for a company with a flow of funds problem than for one with adequate working capital.

The effect upon net income (or earnings per share) is the most commonly used measure of materiality. This reflects the prime importance attached to net income by investors and other users of the statements. The effects upon assets and equities are also important as are misstatements of individual accounts and subtotals included in the financial statements. The FASB is proposing a definition of materiality in the Conceptual Framework, which will be aligned with that in the securities laws and which can used in disclosure decisions.

There are no rigid standards or guidelines for assessing materiality. The lower bound of materiality has been variously estimated at 5% of net income, but the determination will vary based upon the individual case and might not fall within these limits. Certain items, such as a questionable loan to a company officer, may be considered material even when minor amounts are involved. In contrast a large misclassification among expense accounts may not be deemed material if there is no misstatement of net income.

In general, conservatism should not be the basis for determining the accounting for transactions, because it is in conflict with the conceptual framework quality of neutrality.

​(a)​ Acceptable if reasonably accurate estimation is possible. To the extent that warranty costs can be estimated accurately, they should be recorded when an obligation exists, usually in the period of the sale.

​(b)​ Not acceptable. Most accounts are collectible or the company will be out of business very soon. Hence sales can be recorded when made. Also, other companies record sales when made rather than when collected, so if accounts for Landowska Co. are to be compared with other companies, they must be kept on a comparable basis. However, estimates for uncollectible accounts should be recorded if there is a reasonably accurate basis for estimating bad debts.

​(c) ​Not acceptable. A provision for the po ssible loss can be made through an appropriation of retained earnings but until judgment has been rendered on the suit or it is otherwise settled, entry of the loss usually represents anticipation. Recording it earlier is probably an unwise legal strategy as well. For the loss to be recognized at this point, the loss would have to be probable and reasonably estimable. (See FASB ASC 450-10-05 for additional discussion if desired.) Note disclosure is required if the loss is not recorded; however, conservatism is not part of the conceptual framework.

The Conceptual Framework for Financial Reporting (2010) provides important information on the concepts which underlie the preparation and presentation of financial statements. This framework is of great benefit to all financial statement users. It has several components that are outlined in figure 1 below.

Outline of the IASB Conceptual Framework

Figure 1 – IFRS Framework for the Preparation and Presentation of Financial Reports

Main Objective of the Conceptual Framework

The Conceptual Framework (2010) has a core objective from which all its other aspects flow. This central objective is “to provide financial information which is useful to both current and potential providers of resources (investors, lenders, other creditors) in decision-making.“

The financial information to be provided will include: (i) information on a company’s financial position (its resources and financial obligations); (ii) information on a company’s financial performance (information which explains why the company’s financial position changed in the past); and (iii) information on the company’s cash and cash equivalents.

Qualitative Characteristics

The Conceptual Framework (2010) identifies relevance and faithful representation as the two fundamental qualitative characteristics which make financial information useful. Financial information is relevant if it would potentially affect or make a difference in its consumer’s decision. Faithful representation relates to the fact that information that represents an economic phenomenon should ideally be complete, neutral, and free from error.

The Conceptual Framework (2010) also identifies comparability, verifiability, timeliness, and understandability as the four enhancing qualitative characteristics of information:

• comparability permits the identification and understanding of similarities and differences between items of information;
• verifiability means that different observers would independently agree that the information that is presented faithfully represents the economic phenomena that it alleges to represent;
• timeliness refers to the availability of information to decision makers when it is needed i.e. before the need for decision-making arises; and
• understandability means that the information should be comprehensible to its users who have a reasonable knowledge of business and economic activities, and are willing to diligently study it.

Constraints on Financial Reports

The cost of providing and using financial information is a constraint that must be balanced with the benefits that are to be derived from the information.

Elements of Financial Statements

The financial effects of transactions and other events are represented in financial statements by grouping them into broad classes or elements. The grouping is done according to their economic characteristics.

The elements of financial statements that are directly related to financial positions are assets, liabilities, and equity. The elements directly related to financial performance, on the other hand, are income and expenses.

Accrual accounting and ‘going concern’ are two key assumptions that underlie the preparation of financial statements. These assumptions determine how financial statement elements are recognized and measured. Accrual accounting means that financial statements reflect transactions in the period in which they occur and not necessarily when cash movement occurs. ‘Going concern’ means that a company is assumed to continue in business for the foreseeable future.

Recognition refers to the inclusion of an item on the balance sheet or income statement. An item should be recognized if it is probable that future economic benefits that are associated with it will flow to or from the reporting entity, and it has a cost or value that can be reliably measured.

In measuring financial statement elements, the following bases of measurement may be used:

• historical cost: this refers to the amount of cash or cash equivalents paid or the fair value of what was given to purchase an asset. Concerning liabilities, it refers to the amount of proceeds received in exchange for an obligation;
• amortized cost: this refers to the historical cost after adjustments are made for amortization, depreciation, depletion, and/or impairment;
• current cost: concerning assets, this refers to the amount of cash or cash equivalents that would have to be paid to purchase the same or an equivalent asset today. Concerning liabilities, the current cost refers to the undiscounted amount of cash or cash equivalents that are required to settle the obligation today;
• realizable (settlement) value: realizable value refers to the amount of cash or cash equivalents that could currently be obtained by selling an asset in an orderly disposal. Concerning liabilities, settlement value refers to the undiscounted amount of cash or cash equivalents that are expected to be paid to satisfy the liabilities in the normal course of business;
• present value: concerning assets, this refers to the present discounted value of the future net cash inflows that an asset is expected to generate during the normal course of business. In regard to liabilities, PV refers to the present discounted value of the future net cash outflows that will likely be required to settle the liabilities of the normal course of business; and
• fair value: this refers to the amount at which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction.

Question

According to the Conceptual Framework (2010), which of the following are the two fundamental qualitative characteristics that make financial information useful?

1. Timeliness and understandability.
2. Relevance and faithful representation.
3. Accrual accounting and going concern.

Solution

The correct answer is B.

The Conceptual Framework (2010) identifies relevance and faithful representation as the two fundamental qualitative characteristics which make financial information useful.

‘Timeliness’ and ‘understandability’ are two of the enhancing qualitative characteristics of information, while ‘accrual accounting’ and ‘going concern’ are the underlying assumptions identified by the Conceptual Framework (2010).

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