The IASB Conceptual Framework for Financial Reporting sets forth the basic principles underlying the preparation and presentation of financial statements for external users, mainly the providers of capital. It is used by standard-setters in developing new standards and by practitioners (accountants and auditors) in applying standards or accounting for issues not addressed by any standard.
Qualitative characteristics of financial reports
Fundamental qualitative characteristics
There are two qualitative characteristics that make financial information useful: relevance and faithful representation. Information is relevant if it would potentially affect users’ decisions. Information is material if its omission or misstatement could influence users’ decisions. It depends on both nature and/or magnitude. Information represents an underlying transaction/phenomenon faithfully if it is complete (it includes all the information necessary for understanding), neutral (free from bias), and free from error.
Enhancing qualitative characteristics
There are four enhancing qualitative characteristics: comparability, verifiability, timeliness, and understandability.
Comparability allows users to identify similarities and differences. Consistency (over time and across companies) improves comparability.
Verifiability means that different people would agree that the information faithfully represents the underlying economic phenomena.
Timeliness improves usefulness of information.
Understandability means that the presentation is clear and concise such that a person with reasonable knowledge can understand the information if he studies it with care. It does not mean that useful information should be excluded just because it is difficult to understand.
Financial reports are constrained by the cost of obtaining and presenting information. It makes sense to present information only if the benefit of presentation would exceed its costs. Another constraint relates to the fact that non-quantifiable information cannot be presented in financial reports.
The elements of financial statements
In preparing financial statements, transactions and other effects are clubbed together into broad elements. Three elements, assets, liabilities, and equity are relevant to a company’s financial position. Two elements, income and expenses, are relevant for financial performance.
Assets are present economic resources (because they can produce economic benefits) controlled by the entity as a result of past events.
Liabilities are present obligations of the entity to transfer an economic resource as a result of past events.
Equity equals assets minus liabilities. It represents the residual interest.
Income refers to an increase in assets or decreases in liabilities, that cause an increase in equity, other than those relating to contributions from owners. It includes both revenues (income from ordinary activities) and gains.
Expenses are decreases in assets, or increases in liabilities, that decrease equity, other than those resulting from distributions to equity. These also include losses.
Underlying assumptions in financial statements
Financial statements are based on ‘accrual accounting’, and ‘going concern’.
Accrual accounting assumes that financial statements should reflect transactions in the period in which they incurred regardless of when the cash flow occurs.
Going concern refers to the assumption that the company will continue the business for the foreseeable future.
Recognition and measurement of financial statement elements
An item is recognized in financial statements if it meets the definition of the relevant element of financial statements. Elements are measured for this purpose using either the historical cost, amortized cost, current cost, realizable (settlement) value, present value or fair value.
- Historical cost is the amount of cash or cash equivalents (or fair value of consideration) paid to purchase the asset.
- Amortized cost is the historical cost adjusted for depreciation, amortization and/or impairment.
- Current cost is the amount of cash or cash equivalents that would be paid to acquire the asset today. Regarding liabilities, it means that an undiscounted amount of cash that would settle the obligation today.
- Realizable value is the amount of cash that could be obtained by selling the asset. For liabilities, it means the undiscounted amount of cash that would settle the liabilities (hence, also called settlement value).
- The present value is the discounted value of future cash flows.
- Fair value (also an exit price) is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.