The IASB bases its financial reporting standards on the conceptual framework that it adopted in 2010. The conceptual framework was developed by IASB and it lays down the basic concepts and principles that act as the foundation for preparation and presentation of the financial statements. The framework is also used as guide to develop / improve standards and to resolve any accounting conflicts. Note that the conceptual framework is not an accounting standard in itself and cannot be used as an alternative to the financial reporting standards applicable in your country.
The IFRS framework addresses the following:
- Objectives of financial statements
- Underlying assumptions of the financial statements
- Qualitative characteristics of financial statements
- Elements of financial statements
- Recognition of the elements of financial statements
- Measurement of the elements of financial statements
Objectives of the Financial Statements
In very simple words, the objective of Financial Statements is:
“To provide useful information to the users.”
Let’s look at this statement more closely. There are three keywords here:
Useful: The useful here refers to the need for financial statements to be able to provide high quality information to the users. The usefulness is described in the form of the qualitative characteristics of the financial statements.
Information: This refers to what information should the financial statements provide. This includes financial position, financial performance, and changes in financial position. These three tips of information are provided in the three financial statements, namely, balance sheet, income statement, and statement of cash flow.
Users: This refers to the end users of financial statements such as investors, lenders, employees, government, customers, vendors, etc.
Underlying Assumptions of IFRS
There are two fundamental assumptions underlying the financial statements: Going Concern, and Accruals.
Going Concern: Here the idea is that the business will continue to operate for the forceable future. This is a really important assumption because if it was so that the business will close by the end of the year, then all the assets will have to be sold and their sale value would have to be recorded in the books. However, this is not the case and businesses use their assets and resources for many years.
Accruals: The second important assumption is the accrual principal according to which we match any income and expenses to the period in which they were earned or incurred not in the period in which the payment was received or made.
Qualitative Characteristics of Financial Statements
The conceptual framework sets out four qualitative characteristics of financial statements:
- Understandable: The users should be able to understand and appreciate the information.
- Relevant: The information should be relevant to the users so that they can make their decisions effectively.
- Reliable: The information should be factually accurate.
- Comparable: The users should be able to compare the information with the peers or with previous years’ information.
So, to be useful, the information on financial position, financial performance, and changes in financial position should be understandable, relevant, reliable, and comparable.
Elements of Financial Statements
The framework lists five elements of financial statements:
- Assets: An asset is 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.
- Liabilities: A liability is 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.
- Equity: Equity is the residual interest in the assets of the entity after deducting all its liabilities.
- Income: Income is 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.
- Expense: Expenses are 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.
We see the assets, liabilities, and equity in the statement of financial position (Balance Sheet), and we see the income and expenses in the statement of financial performance (Income Statement).
Recognition of the Elements of Financial Statement
Along with the five elements, the framework also provides guidelines about when these elements are recognized in the financial reports.
To be recognized, an item must meet the definition of an element, and satisfy the following criteria:
- It is probable that any future economic benefit associated with the item will flow to or from the entity; and
- The item’s cost or value can be measured with reliability.
Measurement of the Elements of Financial Statement
The final part of the framework describes how we should measure an item once it has been recognized. It suggests the following conceptual models:
- Historical Cost
- Current Cost
- Realizable (Settlement) Value
- Present Value
Among these, historical cost is the most commonly used measure. Note that the IFRS framework does not provide which measurement model should be used for a particular element. Such details are provided in the reporting standards.