Financial Accounting

Financial Accounting

The Conceptual Framework 2010 is a revised framework that was introduced in September 2010 for the general purpose of financial statements. This framework is based on fundamental economic concepts, and it will replace the existing IASB and FASB frameworks resulting in a common basis for standard setters and eliminate discrepancies that result from conclusions about similar issues in accounting. The 2010 Conceptual Framework has introduced new concepts, and it has also maintained some old concepts from previous Conceptual frameworks. This essay discusses the purpose of an entity’s financial position and performance based on the Conceptual Framework 2010. 

The purpose of the conceptual framework

The Conceptual Framework is mainly based on the general purpose of financial reporting, which is to provide financial information of an entity for use by investors, lenders, creditors, and other external users. These external users use the information to make appropriate decisions regarding investing or providing resources to the entity. Financial information is also important to users who are not able to compel an entity to provide the needed financial information (IAS Plus, 2014). 

The Conceptual Framework for Financial Reporting 2010 is a framework that describes the basic concepts and steps to be used while preparing financial statements to be used by people external to an entity. The framework acts as a guide to the board while developing future Conceptual Framework for Financial Reporting and it also provides guidance when addressing accounting issues that cannot be solved using International Accounting Standard, International Financial Reporting Standard or interpretation. When there are no standards or interpretation that applies to a financial transaction, it is the duty of an entity’s management to apply its judgement in solving the issue in a way that the information is relevant and reliable. When making such decisions, the management is required to consider various concepts, including the definition, recognition and measurement of assets, liabilities, expenses, and income as specified in the framework (IAS Plus, 2014). 

The scope of the framework

The Conceptual Framework 2010 addresses various concepts, including the objective of the general purpose financial reporting, the features of useful financial information, the reporting entity, the definition, recognition, and measurements of elements that are used to construct financial information, and the concepts of capital and capital maintenance. 

General-purpose of financial reporting

The primary users of general purpose financial reporting are current and potential investors, lenders, and other creditors, and they use the financial information to make decisions about buying, selling or holding equity, and providing or settling loans. These users also use the financial information to assess anan entity’s future cash flow as well as assess how an entity has effectively and efficiently managed its resources. According to the framework, the financial reports cannot contain all the information that external parties need to make economic decisions these external users should therefore seek other important information from other sources apart from the financial reports. 

There are different types of information that an entity is required to include in its financial reports. These include information about economic resources and claims and changes in economic resources and claims. Information about economic resources and claims is important as it enables users to assess the financial strengths and weaknesses of an entity, its liquidity and solvency, as well as its ability to obtain financing. Information about an entity’s resources and claims also enables users how future cash flows of an entity would be distributed. Information about changes in economic resources and claims will enable users to differentiate changes that result from an entity’s performance from changes that result from other events and transactions (IAS Plus, 2014). 

An entity is also required to provide accrual accounting that reflects the financial performance of an entity. Information about changes in economic resources and claims enables users to assess the past and future ability of an entity to generate cash flows. The information can also enable users to assess how general economic events affect the ability of an entity to generate cash flows. According to the Conceptual Framework 2010, entities are required to provide information on its cash flow so as to enable users to assess the ability of an entity to generate future cash flows. In addition, such information provides facts and materials about how an entity obtains and spends cash. Information about changes in an entity’s economic resources and claims from events and transactions is crucial when users want to get a clear picture of the total change in an entity’s economic resources and claims (Ernst & Young, 2010). 

Characteristics of useful financial information

The qualitative features of useful financial information are necessary when identifying information that is useful to users while making decisions about an entity. The qualitative characteristics apply to financial information in general purpose financial statements and financial information that is provided through other ways. Entities should ensure that the financial information that they provide through financial reports are relevant and faithfully represent what they are supposed to represent. The fundamental qualitative characteristics of useful financial information are relevance and faithful representation. Relevant financial information contains predictive and confirmatory value that is necessary in influencing decisions made by users. In order for the information to be relevant, it also has to have materiality which is an entity-specific aspect that is based on the items that provide relevant information. Financial information that is represented by financial reports are also expected to faithfully represent the aspects it is supposed to represent. This means that the information should be complete, neutral, and error free. 

In order to enhance the usefulness of information that is represented in financial reports, entities should ensure comparability, verifiability, timeliness, and understandability of the reports. The information in the financial report should be comparable with similar information from other entities. Comparability will enable users of financial records to assess and understand the difference between different items. In order for the information to be verifiable, knowledgeable and independent observers should be able to agree that a particular item is a faithful representation. Timeliness of financial information ensures that the information is available in time so that users are able to use this information to make decisions. Understandability means that the information is clearly and concisely classified and presented so that users are able to understand the information (Ernst & Young, 2010). 

Elements from which financial statements are made

Financial statements show the financial effects of transactions and events by grouping them into different classes based on their economic characteristics. These classes are what are known as elements of financial statements. The elements that are used to measure the financial position of an entity in the balance sheet include assets, liability and equity. Elements that measure financial performance in income statements are income and expenses. The presentation of the elements in the balance sheet and income statement require some form of sub-classification. For instance, assets and liabilities are classified according to their nature and function in the business so that users are able to use this information to make decisions. 

Elements that are used to measure the financial position of an entity are assets, liabilities, and equities. According to the Conceptual Framework 2010, assets are resources that arise from past events and an entity can control and which can bring future economic benefits to an entity. Liabilities refer to present obligations of an entity that arise from past events and will result in a future outflow. Equity refers to the interest in the assets that result after subtracting all liabilities. 

Concepts of capital and capital maintenance 

The concept of capital is used by most entities while preparing financial statements. In the financial concept of capital, it is synonymous to net assets or equity in an entity. In the physical concept of capital, it refers to as the productive capacity of an entity and could be represented as units of output per day. In order to select the proper concept of capital, an entity should assess the needs of the users in the financial statements of the entity. This means that the entity can adopt the financial concept if the users want to assess the maintenance of invested capital. The physical concept of capital can be used if users want to assess the operating capability of an entity. 

Capital maintenance can either be financial capital maintenance of physical capital maintenance. Financial capital maintenance can be measured as nominal monetary units or constant purchasing power units. In financial capital maintenance, an entity is able to earn profits if the net assets of an entity at the end of the period exceed the net assets at the beginning of the period after subtracting contributions from and distributions to owners during the period. In physical capital maintenance, profits are earned when the operating capability of an entity at the end of a period exceed the operating capability at the beginning of the period after deducting contributions from and distributions to owners (IFRS Foundation, 2011). 

How the Conceptual Framework 2010 differs from the existing framework

The Conceptual Framework 2010 is different from the previous framework used by the IASB in that it limits the number of recipients of the general purpose financial reporting. In the 2010 framework, entities will be required to address existing or potential investors, lenders, and other creditors as the primary users of financial statements. This is different from the existing framework that includes existing or potential investors, lenders, creditors, employees, suppliers, governments, customers and the general public as the primary users of financial statements (Johnson, 2005). A new assumption that the information needs of investors meet the information needs of other stakeholders was included. According to the Conceptual Framework 2010, regulators are removed from the list of primary users because they can demand the financial information they need from entities. 

There are also other limitations of general-purpose financial statements that have been included in the Conceptual Framework 2010, including those statements that may not meet all the users’ needs. In addition, entities will not be required to provide information regarding their value. Entities will not be required to report their financial stability as an objective of general purpose financial reporting. According to the board, the objectives in the 2010 conceptual framework are not inconsistent with financial stability. This is because financial information that is relevant and presented faithfully can improve the users’ confidence hence improves financial stability.

In the current Conceptual Framework, liability and equity are some of the elements that relate to the financial position of an entity. In the IASB’s current Framework, a liability is defined as, “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.” (IFRS Foundation, 2011). However, Conceptual Framework 2010 defines liability as “A liability is a present economic burden for which the entity has a present economic obligation.”

The definition of equity and the difference between equity and liability have also been changed in the Conceptual Framework 2010. In the new framework, equity is defined as “the residual interest in the assets of the entity after deducting all its liabilities.” The current framework however has no distinction between liabilities and equity. The new Conceptual Framework has therefore provided a clear distinction between liabilities and equity (Johnson, 2005). 

One of the issues that arise from the Conceptual Framework 2010 regarding the preparation of financial reports regarding the financial position and performance of an entity is cost constraints. In order to prepare financial statements in accordance to the Conceptual Framework 2010, entities will incur costs needs to prepare financial statement that meet all the qualitative characteristics. However, the costs incurred while meeting the standards will be justified in the overall benefits of the prepared financial information. Another contemporary issue that results from the Conceptual framework 2010 is materiality constraint which involves how different items will impact the financial operations of an entity. Entities must therefore consider qualitative and quantitative factors while determining whether an item is material (Ohlson et al., 2010). 

 

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