IASB Conceptual Framework (Detailed)

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 in making decisions about providing resources to the entity.

These decisions involve buying, selling, or holding equity and debt instruments, and providing or settling loans and other forms of credit. To make these decisions, users need information about:

• The entity's economic resources (assets) and claims against the entity (liabilities and equity) — i.e., its financial position
• Changes in economic resources and claims — resulting from the entity's financial performance (income and expenses) and other events (contributions from and distributions to owners)
• How efficiently and effectively management has used the entity's resources — stewardship/accountability

Key points:

• The primary users are existing and potential investors, lenders, and other creditors — not management (who have access to internal information) or regulators or the general public
• Financial statements provide information about the reporting entity — not about its industry or the economy generally
• Financial statements are based on estimates, judgements, and models, not exact depictions of economic reality
• General purpose financial statements cannot provide all the information users need — users are expected to use other sources as well

For financial information to be useful, it must possess two fundamental qualitative characteristics:

1. Relevance:

• Information is relevant if it is capable of making a difference in the decisions made by users
• Information can make a difference by having predictive value (helps users predict future outcomes), confirmatory value (confirms or changes previous evaluations), or both
• Materiality is an entity-specific aspect of relevance. Information is material if omitting, misstating, or obscuring it could reasonably be expected to influence users' decisions. Materiality depends on the nature and/or magnitude of the item in the context of the entity's financial report

2. Faithful representation:

• Financial information must faithfully represent the economic phenomena it purports to represent
• A perfectly faithful representation would be complete (includes all information necessary for a user to understand the phenomenon), neutral (without bias in selection or presentation — does not mean "without purpose" but does mean not slanted to achieve a desired outcome), and free from error (no errors or omissions in description, and the process used to produce the information was applied without errors — does not mean "perfectly accurate" for estimates, but that the nature and limitations are explained)
• The Framework notes that substance over form is inherent in faithful representation — financial information should reflect the economic substance of transactions, not merely their legal form

Applying the fundamental characteristics: The most useful information is both relevant AND faithfully represented. Information that is relevant but not faithfully represented (or vice versa) is not useful. If information is neither relevant nor faithfully represented, the enhancing characteristics cannot make it useful.

Four enhancing characteristics increase the usefulness of information that is already relevant and faithfully represented:

Cost constraint: Reporting financial information imposes costs. The benefits of information should justify the costs of providing it. This is a pervasive constraint, not a qualitative characteristic.

The 2018 Conceptual Framework revised the definitions of the five elements:

Recognition is the process of including an item that meets the definition of an element in the statement of financial position or the statement of financial performance.

Recognition criteria (2018 Framework): An item that meets the definition of an element should be recognised if doing so provides users with:

• Relevant information about the asset, liability, income, or expense — including information about future cash flows
• A faithful representation of the item — the item can be measured with sufficient reliability

When recognition may NOT be appropriate (even if the definition is met):

• It is uncertain whether an asset or liability exists (existence uncertainty — e.g., a contingent asset where it is unclear whether the entity has a right)
• An asset or liability exists but there is a low probability of an inflow or outflow of economic benefits (relevance may be low)
• No measurement basis provides a faithful representation at an acceptable cost (measurement uncertainty is too high)

Derecognition:

• Assets: Derecognise when the entity loses control of all or part of the recognised asset (e.g., sells, transfers, rights expire)
• Liabilities: Derecognise when the entity no longer has a present obligation for all or part of the recognised liability (e.g., pays, is released, obligation expires)
• The accounting for derecognition should faithfully represent: the assets and liabilities retained (if any), and the change in assets and liabilities resulting from the transaction

The Framework discusses several measurement bases. The choice depends on which basis provides the most useful information (relevant and faithfully represented) in the specific circumstances.

Factors affecting the choice of measurement basis:

• Relevance: Which basis best captures the characteristics of the asset/liability and how it contributes to future cash flows? For traded financial instruments, fair value is most relevant. For owner-occupied property, historical cost (with depreciation) may be more relevant than fair value.
• Faithful representation: Which basis can be measured most reliably? Historical cost is generally more verifiable. Fair value may involve significant estimation uncertainty for illiquid assets.
• Enhancing characteristics: Which basis provides the most comparable, verifiable, timely, and understandable information?
• Cost constraint: Some measurement bases (fair value for illiquid assets) are costly to determine. The benefit must justify the cost.

The Framework discusses two concepts of capital and capital maintenance:

1. Financial capital maintenance:

• Profit is earned only if the financial (monetary) amount of net assets at the end of the period exceeds the financial amount at the beginning (after excluding distributions to and contributions from owners)
• Capital is defined in terms of nominal monetary units (or units of constant purchasing power, if adjusted for inflation)
• This is the concept used by most entities under IFRS in practice
• Under this concept, holding gains on assets (e.g., revaluation of property) are treated as income (they increase financial capital)

2. Physical capital maintenance:

• Profit is earned only if the physical productive capacity (or operating capability) at the end of the period exceeds that at the beginning (after excluding transactions with owners)
• Capital is defined in terms of the entity's operating capacity — the ability to produce goods or services
• Under this concept, holding gains on assets are NOT income — they represent the cost of maintaining physical capacity and are treated as capital maintenance adjustments (equity reserves)
• Requires current cost measurement
• Rarely used in practice but conceptually important — it explains why revaluation surpluses are credited to OCI/equity (not profit) under IAS 16's revaluation model

Practical significance: The choice of capital maintenance concept affects the determination of profit. Most entities use financial capital maintenance (nominal monetary units). The distinction becomes important in periods of significant inflation — financial capital maintenance may overstate real profit because it does not account for the need to replace assets at higher prices.