IASB'S CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING

Relevant to ACCA Qualification Papers F7 and P2

I am from England, and here in the UK, unlike most countries, our system of government has
no comprehensive written constitution. Many countries do have such constitutions and in
these circumstances the laws of the land are shaped and influenced by the constitution. Now
while the International Accounting Standards Board (IASB) is not a country it does have a
sort of constitution, in the form of the Conceptual Framework for Financial Reporting (the
Framework), that proves the definitive reference document for the development of
accounting standards. The Framework can also be described as a theoretical base, a
statement of principles, a philosophy and a map. By setting out the very basic theory of
accounting the Framework points the way for the development of new accounting standards.
It should be noted that the Framework is not an accounting standard, and where there is
perceived to be a conflict between the Framework and the specific provisions of an
accounting standard then the accounting standard prevails.
Before we look at the contents of the Framework, let us continue to put the Framework into
context. It is true to say that the Framework:
seeks to ensure that accounting standards have a consistent approach to problem
solving and do not represent a series of ad hoc responses that address accounting
problems on a piece meal basis
assists the IASB in the development of coherent and consistent accounting
standards
is not a standard, but rather acts as a guide to the preparers of financial statements
to enable them to resolve accounting issues that are not addressed directly in a
standard
is an incredibly important and influential document that helps users understand the
purpose of, and limitations of, financial reporting
used to be called the Framework for the Preparation and Presentation of Financial
Statements
is a current issue as it is being revised as a joint project with the IASB's American
counterparts the Financial Accounting Standards Board.
OVERVIEW OF THE CONTENTS OF THE FRAMEWORK
The starting point of the Framework is to address the fundamental question of why financial
statements are actually prepared. The basic answer to that is they are prepared to provide
financial information about the reporting entity that is useful to existing and potential
investors, lenders, and other creditors in making decisions about providing resources to the
entity.
In turn this means the Framework has to consider what is meant by useful information. In
essence for information to be useful it must be considered both relevant, ie capable of
making a difference in the decisions made by users and be faithful in its presentation, ie be
complete, neutral and free from error. The usefulness of information is enhanced if it is also
comparable, verifiable, timely, and understandable.
The Framework also considers the nature of the reporting entity and, in what reminds me of
my school chemistry lessons, the basic elements from which financial statements are
constructed. The Framework identifies three elements relating to the statement of financial
position, being assets, liabilities and equity, and two relating to the statement of profit or loss,
being income and expenses. The definitions and recognition criteria of these elements are
very important and these are considered in detail below.

THE FIVE ELEMENTS

An asset is defined as 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.
Assets are presented on the statement of financial position as being noncurrent or current.
They can be intangible, that is, without physical presence for example, goodwill. Examples
of assets include property plant and equipment, financial assets and inventory.
While most assets will be both controlled and legally owned by the entity it should be noted
that legal ownership is not a prerequisite for recognition, rather it is control that is the key
issue. For example IAS 17, Leases, with regard to a lessee with a finance lease, is
consistent with the Framework's definition of an asset. IAS 17 requires that where
substantially all the risks and rewards of ownership have passed to the lessee it is regarded
as a finance lease and the lessee should recognise an asset on the statement of financial
position in respect of the benefits that it controls, even though the asset subject to the lease
is not the legally owned by the lessee. So this reflects that the economic reality of a finance
lease is a loan to buy an asset, and so the accounting is a faithful presentation.
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.
Liabilities are also presented on the statement of financial position as being noncurrent or
current. Examples of liabilities include trade payables, tax creditors and loans.
It should be noted that in order to recognise a liability there does not have to be an obligation
that is due on demand but rather there has to be a present obligation. Thus for example IAS
37, Provisions, Contingent Liabilities and Contingent Assets is consistent with the
Framework's approach when considering whether there is a liability for the future costs to
decommission oil rigs. As soon as a company has erected an oil rig that it is required to
dismantle at the end of the oil rig's life, it will have a present obligation in respect of the
decommissioning costs. This liability will be recognised in full, as a non-current liability and
measured at present value to reflect the time value of money. The past event that creates
the present obligation is the original erection of the oil rig as once it is erected the company
is responsible to incur the costs of decommissioning.
Equity is defined as the residual interest in the assets of the entity after deducting all its
liabilities.
The effect of this definition is to acknowledge the supreme conceptual importance of
identifying, recognising and measuring assets and liabilities, as equity is conceptually
regarded as a function of assets and liabilities, ie a balancing figure.
Equity includes the original capital introduced by the owners, ie share capital and share
premium, the accumulated retained profits of the entity, ie retained earnings, unrealised
asset gains in the form of revaluation reserves and, in group accounts, the equity interest in
the subsidiaries not enjoyed by the parent company, ie the non-controlling interest (NCI).
Slightly more exotically, equity can also include the equity element of convertible loan stock,
equity settled share based payments, differences arising when there are increases or
decreases in the NCI, group foreign exchange differences and contingently issuable shares.
These would probably all be included in equity under the umbrella term of Other
Components of Equity.

Income is defined as the increases in economic benefits during the accounting period in the
form of inflows or enhancements of assets or decreases of liabilities that result in increases
in equity, other than those relating to contributions from equity participants.
Most income is revenue generated from the normal activities of the business in selling goods
and services, and as such is recognised in the Income section of the statement of profit or
loss and other comprehensive income, however certain types of income are required by
specific standards to be recognised directly to equity, ie reserves, for example certain
revaluation gains on assets. In these circumstances the income (gain) is then also reported
in the Other Comprehensive Income section of the statement of profit or loss and other
comprehensive income.
The reference to other than those relating to contributions from equity participants means
that when the entity issues shares to equity shareholders, while this clearly increases the
asset of cash, it is a transaction with equity participants and so does not represent income
for the entity.
Again note how the definition of income is linked into assets and liabilities. This is often
referred to as the balance sheet approach (the former name for the statement of financial
position).
Expenses are defined as decreases in economic benefits during the accounting period in the
form of outflows or depletions of assets or incurrences of liabilities that result in decreases in
equity, other than those relating to distributions to equity participants.
The reference to other than those relating to distributions to equity participants refers to the
payment of dividends to equity shareholders. Such dividends are not an expense and so are
not recognised anywhere in the statement of profit or loss and other comprehensive income.
Rather they represent an appropriation of profit that is as reported as a deduction from
Retained Earnings in the Statement of Changes in Equity.
Examples of expenses include depreciation, impairment of assets and purchases. As with
income most expenses are recognised in the Income Statement section of the statement of
profit or loss and other comprehensive income, but in certain circumstances expenses
(losses) are required by specific standards to be recognised directly in equity and reported in
the Other Comprehensive Income Section of the statement of profit or loss and other
comprehensive income. An example of this is an impairment loss, on a previously revalued
asset, that does not exceed the balance of its Revaluation Reserve.
THE RECOGNITION CRITERIA FOR ELEMENTS
The Framework also lays out the formal recognition criteria that have to be met to enable
elements to be recognised in the financial statements. The recognition criteria that have to
be met are that
that an item that meets the definition of an element and
it is probable that any future economic benefit associated with the item will flow to or
from the entity and
the items cost or value can be measured with reliability.
MEASUREMENT ISSUES FOR ELEMENTS
Finally the issue of whether assets and liabilities should be measured at cost or value is
considered by the Framework. To use cost should be reliable as the cost is generally known,
though cost is not necessary very relevant for the users as it is past orientated. To use a
valuation method is generally regarded as relevant to the users as it up to date, but value
does have the drawback of not always being reliable. This conflict creates a dilemma that is
not satisfactorily resolved as the Framework is indecisive and acknowledges that there are
various measurement methods that can be used. The failure to be prescriptive at this basic

level results in many accounting standards sitting on the fence how they wish to measure
assets. For example, IAS 40, Investment Properties and IAS 16, Property, Plant and
Equipment both allow the preparer the choice to formulate their own accounting policy on
measurement.
APPLYING THE FRAMEWORK
A company is about to enter into a three-year lease to rent a building. The lease cannot be
cancelled and there is no certainty of renewal. The landlord retains responsibility for
maintaining the premises in good repair. The directors are aware that in accordance with IAS
17 that technically the lease is classified as an operating lease, and that accordingly the
correct accounting treatment is to simply expense the statement of profit or loss with the
rentals payable.
Required
Explain how such a lease can be regarded as creating an asset and liability per the
Framework.
Solution lease
Given that it is reasonable to assume that the expected life of the premises will vastly
exceed three years and that the landlord (lessor) is responsible for the maintenance, on the
basis of the information given, the risks and rewards of ownership have not passed. As such
IAS 17 prescribes that the lessee charges the rentals payable to the statement of profit or
loss. No asset or liability is recognised, although the notes to the financial statements will
disclose the existence of the future rental payments.
However, instead of considering IAS 17 let us consider how the Framework could approach
the issue. To recognise a liability per the Framework requires that there is a past event that
gives rise to a present obligation. It can be argued that the signing of the lease is a sufficient
past event as to create a present obligation to pay the rentals for the whole period of the
lease. On the same basis, while substantially all the risks and rewards of ownership have not
passed, the lessee does control the use of the building for three years and has the benefits
that brings.
Accordingly, when considering the Framework, a radically different potential treatment arises
for this lease. On entering the lease a liability is recognised, measured at the present value
of the future cash flow obligations to reflect the time value of money. In turn an asset would
also be accounted for. After the initial recognition of the liability, a finance cost is charged
against profit in respect of unwinding the discount on the liability. The annual cash rental
payments are accounted for as a reduction in the liability. The asset is systematically written
off against profit over the three years of the agreement (depreciation).
There is, at present, a conflict between IAS 17 and the Framework. The IASB is currently
reviewing IAS 17 because the current accounting treatment of lessees not recognising the
future operating lease rentals as liabilities arguably amounts to off balance sheet financing.
The Frameworks definition of a liability is at the heart of proposals to revise IAS 17 to
ensure that the statement of financial position faithfully and completely represents all an
entitys liabilities. Accordingly this conflict should soon be resolved.
Tom Clendon FCCA is a subject expert at Kaplan
Last updated: 10 Aug 2015