Lecture 3B: Introduction and Overview of the Conceptual Framework
Let's now get on to the next section. Here we're going to start now with the conceptual framework. I'm going to give you a brief overview of what the conceptual framework is all about.
Let's take a step back. Before we even look at the conceptual framework, we have all these kinds of world events, right? In the world, we have transaction circumstances - all that affect our company/our business. Now, all that will go into an accounting system. So that's all the data that comes in, and you'll have Pastel. So this will be your accounting business system such as Pastel. You capture all of it, your debits and credits, all your trial balances, and out will come two sets of information. There will be information for decision-making, which is for internal decision-making, and there will be information that goes to external users for external decision-making.
Now, what are we going to be focusing on? This is financial reporting; we will, therefore, focus on external decision-making. So that is where I put out the set of financial statements of the business. I give it to my bank and my investors because they do not have access on a day-to-day basis to my internal cash flows and management profits etc. The management accounting - I'm not going to worry about. That is going to be part of a second-year and third-year module called MAC. So, we are going to focus on external reporting, which is financial reporting.
We just covered what does general purpose financial reporting require for us - IFRS. IFRS then puts down a basis with a theory underlining all these accounting rules, and that is going to be called the framework. The framework is not an accounting standard. All it does is it provides the basis on which the other standards are going to be built, and it has to give guidance on the bigger principles that have to pervade all aspects of financial reporting.
So it first goes and says, “What is the objective of financial reporting?” The objective of any financial reporting is to communicate information to the users.
We're going to go and define this a little bit more, but that is step number one. But now, information must be useful, and the framework then defines what makes it useful. So the framework will list two types of characteristics that make information useful to the end-users - your investors and lenders.
From there it also starts to dictate what must be in those financial statements or financial reports. So the question of what must they contain gets addressed by something, which the framework calls “elements”. And elements will consist of assets, liabilities, equity and income and expenses. I'm going to go through and define all of those and spend a lot of time on the “what” in a separate video.
It also tells us when we can go and put these things into the financial report. So the when is addressed with certain recognition criteria and those recognition criteria for assets and liabilities, that tells you when you can put those in, requires some type of estimate of an amount, and it requires that future benefits or future outflows - assets and liabilities - are probable. Again, we're going to deal with that in more detail later on.
Last up; then one should address how to measure those elements. Here the framework falls horribly short. The framework does list four types of measurements, but it's actually never really addressing - this is how we account for things. Here it's going to say - Rather go and look at the individual accounting standards for property plant and equipment or inventory. How do you measure those separate things? Well, let me give you a little write-up or a little set of rules for each of those.
That's what the accounting standards are all about. So the framework puts out the basis for these first ones that tell us the objective is - to provide information, what makes the information useful, and what must that information contain.
Now all of this is going to require two assumptions. It requires that financial reporting is done for companies that we expect to keep going for longer than twelve months. That is what we'll call a “going concern”, and we have to assume that we don't use cash basis. We don't record the movements to income and expenses when cash is received or paid. No, we put it into these statements of profit and loss when it accrues to us, or it accrues to someone else. So we'll put revenue and expenses into the period in which it is earned or spent.
Basic overview, let's get into some of the theory now. Important that we're going to look at objectives; qualitative characteristics, i.e. what makes information useful. We will discuss the accrual basis and going concern, and these last two elements and recognition criteria are going to be done in a separate video.
Briefly, we've said - An overview what an objective should be in a framework; the IFRS framework is very specific and defines us down in quite a honed manner. So let's have a look at this now. The objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors (people who are providing money to us).
What is that information going to be used for? It's used for those investors and lenders to make decisions for themselves about whether or not to provide resources to the company. So whether they should lend or invest in their company.
So that’s the objective. It's a lot narrower than it used to be. We used to have a separate framework, also called the conceptual framework, which was done in 1989. And from 2010 we are replacing that old framework with a more up-to-date framework. This objective is part of the new framework called in 2010. It's been a lot more specific than the old objective was.
The qualitative characteristics that will make information useful to the users
Here we split between fundamental characteristics and enhancing characteristics.
Fundamental means it has to be there, so you cannot not have these. Here the standard lists, or the framework lists, relevance and faithful representation. We will discuss what those are in a second.
Enhancing - here are we talking about:
So let’s look at these:
Information must be appropriate for users to base their decisions on. What's very important within relevance, is something we call materiality. Materiality means that if something is left out; if we leave a bit of information out of the financial report; will it affect the users’ decisions? If it's yes, then its material, if not, then no.
Faithful representation means that the information should represent really what happened. The economic substance or the reality of the benefit or losses for the company.
The enhancing characteristics:
Comparability we've discussed, but our financial reports must make information comparable over time for our same company and amongst different entities, so two different companies in the same year.
If different external people looked at that same information, but tracks it all the way back to the source documents or really understood the underlying transaction, we must be able to be verifiable. If they look at it just from a financial report, if they did more digging, would they come to the same conclusion and report it in the same way that we did? We must be able to look at sales and track it down to the underlying sales invoices. Did those sales invoices really have actual deliveries from us to a client? What's very important under verifiability is the concept of neutrality, please.
The older the information gets, the less useful it is. We are making decisions or providing information for external parties like investors and lenders to make decisions. If the information is really old and out-of-date, it’s not going to be useful.
This is a bit of a difficult one because financial statements, especially for larger listed companies, are not understandable for the layman or the person who has not been trained in accounting. But, they must look at the definition. When they say financial statements should be drawn up in such a way that the average user can get value from the information. Here I mean the average user with some accounting training. Usually, I look at someone with say, a third-year accounting knowledge at a university. Just because information may not be understandable, doesn't mean you get to leave it out though.
Assumptions underlying IFRS:
Now, all of that is great. What we have to understand is we are doing financial statements for general purpose financial reports, with two very important underlying basis or assumptions:
your accrual basis
and the going concern assumption
We’ll quickly discuss those and we can move on to the next topic.
So, the accrual basis means that we don't just record revenue when we receive money. We record it when the transaction actually occurs, not when the cash flow happens. So I could sell something on credit today. I could sell you this pen and deliver it today; all the risks and rewards are transferred. I no longer own the pen, you do, but you didn't pay me cash. You said you would pay me cash in twelve months. When do I record the revenue? When the pen leaves and I transfer all the rewards, or when I receive the cash one year later? Well accounting and the IFRS says, when the risks and rewards are transferred, that is when I earned the revenue. I’ll record a debtor at the same time - a receivable - and when I get the cash in, I'll settle the receivable.
Just take note:
Always note the reporting date (year-end). It’s going to be a constant issue, all the way through your accounting studies. Where do the revenue and expenses go? Which year do they get recorded? The same for assets and liabilities.
Compare transaction date (when recognition criteria etc. are met) with reporting date – don’t recognise in the wrong period.
Going concern is going to affect accounting all the way through, and later on also auditing. Now, the framework says that General Purpose Financial Reports are based on the assumption that the company or entity will continue operating in the foreseeable future. It will continue buying and selling stock, manufacturing goods, paying staff, getting money in, and making profits.
What do they mean by foreseeable future? For your purposes, assume 12 months. So we will continue trading, our doors will be open, and people will have jobs for at least the next 12 months. So, if it doesn't, or if we can't continue trading for the next 12 months, we're not going to use IFRS at all.
If we can't do going concern, then what will we do? We will do liquidation basis, and we have no accounting standards for that, then we're going to go just do a set of records for the taxman. What would the accounting records be if we solve all the assets and settle all the debt today?
Okay but that's not IFRS, that's liquidation basis for tax purposes. If we are going to continue as a going concern, you will use IFRS.
Great guys, thanks. The next video is highly vital - you need to know the elements, definitions and recognition criteria, so please watch the next video with pen in hand and get ready. Thank you.