Introduction

This article is part two in the series on the Conceptual Framework, as promulgated by the International Accounting Standards Board (IASB). Going forward, the IASB will be referred to as “the Board”. Also, if you haven’t already read it, part one of the series can be found here.

In this article – second in the series – attention will be focussed on the first Chapter of the Framework. The official title of that Chapter is Chapter 1 – The Objective of General-Purpose Financial Reporting (IASB, 2018, p. A14).

The Framework itself is divided into Chapters, sections and paragraphs. Consequently, it seemed logical to approach the breakdown of the whole Framework in like fashion.

Chapter 1 has four (4) main sections. The sections are further divided up by numbered paragraphs. The four (4) main sections are made up of the following:

1. Introduction – starting from para. 1.1
2. Objective, usefulness and limitations of General-Purpose Financial Reporting – starting from para. 1.2
3. Information about a reporting entity’s economic resources, claims against the entity and changes in resources and claims – starting from para. 1.12
4. Information about use of the entity’s economic resources – starting from para. 1.22

Aside the Chapters of the Framework, there is a little preliminary section (if you like) which addresses the question of why the Framework was needed in the first place. Even though that was touched on in the preceding article, a brief refresher follows.

Status and purpose of the Conceptual Framework

The first question which naturally comes to mind when one picks the Framework is this: what is the use of the Framework; and what is its position in the grand scheme of things?  The answer is buried deep in the bowels of para. SP1.1 to SP1.5.  

To be clear, the Framework is not a standard; and furthermore, no single provision in the Framework overrides anything in any standard (IASB, 2018, p. A13)

As for its purpose, three (3) of them are listed by the IASB:

1. Assisting the Board develop standards based on consistent concepts
2. Assisting financial statement preparers develop (or select, if you like) consistent accounting policies, when there are no standards specifying how transactions carried out by the “Reporting Entity” are to be treated, or when a standard allows the “Reporting Entity” to choose the accounting policy to be adopted
3. Assisting all parties understand and interpret the Standards

From time to time, the Framework might undergo some revisions. The Board says this does not lead to automatic changes in already promulgated standards. Standard amendments will require the Board to follow the regular due process it employs in the drafting and revision of standards (IASB, 2018, p. A13).

The effect of these paragraphs is clear: Standards are the superior pronouncements of the Board. The Framework just acts as a conceptual guide for all parties involved; and “consistency” in Financial Reporting is why the Framework exists.

What at all is the point of General-Purpose Financial Reporting?

This question needs to be answered. This is because, in the very first section of Chapter 1– which is the introduction— the Board makes it clear in para. 1.1 that the objective forms the foundation of the Framework. Everything else which follows in the Framework flows logically from the objective.

The answer to the question is to be found in para. 1.2. The objective of general-purpose Financial Reporting is to provide financial information to various users. Users need this information to make decisions. And the decisions border on whether or not to provide resources (think money) to the “Reporting Entity” (the “Reporting Entity” shall simply be referred to as the “entity” going forward).      

The Board describes these users as primary users. The reason, as per para. 1.5, is because they cannot directly demand specific information from the managers of the entity, and must rely on the general-purpose financial reports (IASB, 2018, p. A16). Primary users include: current and prospective future investors, lenders to the entity, as well as other creditors of the entity. We will refer to these primary users, in this article, generically as “users”.

A closer look at the decisions we’re talking about

The Board makes mention of three main types of decisions users make in para. 1.2. These are:

1. Deciding to buy, sell, or hold the entity’s equity instruments (think shares/ stock) as well as debt instruments (think bonds and debentures);
2. Providing loans to the entity, or settling loans provided by the entity; and
3. Exercising the right vote on the actions of the managers of the entity. That is, the decision to influence the actions taken by the managers, which will naturally affect how the entity’s resources are to be used

Decisions need to be made. However, what is more important to note is that, the decisions to be made (and usually made) by users mainly depend on how they expect to benefit from the decision in question. A couple of possible benefits are laid out in para. 1.3: dividends, principal and interest payments, as well as price increases in the securities issued by the entity. These are benefits users expect to receive and these benefits are usually collectively referred to as the “return(s)” to the users.

Given that the return is what users are going to get, they need to understand it. The return any investor will get from an investment depends on a couple of things. The first thing is: what the expected amount is. The second has to do with the timing of the receipt of that amount. That is, when one can expect to receive the money. The more it tarries, the lower the return. Hence the saying, a dollar today, is worth more than a dollar tomorrow.

The third thing about return has to do with its uncertainty. We shall define uncertainty of return as how likely or how unlikely it is that a certain return will be made on an investment. When it comes to return, the likelier the better, as unpredictability is hardly desired by any investor. In order for people to decide to give an entity their money, there needs to be a demonstration by the entity that this investor can expect the entity to be awash with cash in the future. Only this will allow for cash to flow to the investor, lender or other creditor of the entity. Given such a demonstration, uncertainty is reduced to the barest minimum.

A wildcard

One would think, these three factors, once satisfied, clears the way for an investor to part with their money. One would not be far off, except that there is a wildcard—almost an afterthought in most cases but very crucial! This factor is the assessment of how the managers of the entity are faring in the role given to them to play. The Board describes this as “management’s stewardship of the of the entity’s economic resources” in para. 1.3. This assessment is very important because, even with good economics, a viable investment becomes a bad one because the managers are horrendous at their job.

What kind of information are users looking out for?

There is a lot of information users want, in order to make their assessments. In the Framework, the Board lists two main items in para. 1.4. We will further split them up for the purposes of understanding. They are:

1. Firstly:
   1. What the economic resources currently at the disposal of the entity are;
   2. Claims other people have against the entity which the entity has to settle;
   3. How those economic resources have changed over time; and
   4. How those claims have changed over time
2. And then secondly, the effectiveness and efficiency with which the entity’s managers (management and the governing board are considered one for the purposes of management) have performed their responsibility to use the entity’s economic resources at their disposal.

Limitations of Financial Reporting

Even though Financial Reporting provides useful financial information, it has its own limitations. These are things that a user should not expect to get directly from general-purpose financial reports. The Board notes in para. 1.7 that general purpose financial reports are not designed to show what the value of an entity is (IASB, 2018, p. A16). Nevertheless, the financial reports provide information which can be used to make that assessment of the entity’s value.

As mentioned in the earlier paragraph, users have different, and possibly conflicting, information needs. The Board however, offers some reassurance in para. 1.8, to the effect that the development of Standards will be done in a way which seeks to provide an information set, meeting the needs of the maximum number of primary users. Nevertheless, this limitation does not in any way preclude the entity from including additional information in the general-purpose financial reports, which are most useful to a particular subset of users.

In para. 1.10 the Board introduces “other parties”, who may be viewed as secondary users. The Board says general-purpose financial reports are not primarily directed at these other groups. Examples in these other groups include: regulators, members of the general public (who are not investors) such as community advocacy groups, among others.

A key concept concerning the nature of financial reports which needs to be understood is that they are not exact depictions of what are. Para. 1.11 makes this clear. To a large extent, they are based on estimates, judgements and models. The Conceptual Framework will establish the concepts which underlie those estimated judgements and models. One can view these concepts as goals which need to be strived towards.

Economic resources, claims, and changes in resources and claims

General-purpose financial reports will provide information about an entity’s economic resources, as well as the claims against the entity. These two, taken together, is what is referred to as the Financial Position of the entity.

Aside the Financial Position, financial reports will also show how various transactions, as well as other events (even outside the control of the entity) have affected its economic resources and the claims against the entity. By this, we are talking about how the Financial Position has changed over time.

Why is information about Financial Position necessary?

The answer to this question is in para. 1.13 and 1.14. The Board makes mention of financial strengths and weaknesses. The information on Financial Position helps users identify financial strengths and weaknesses (IASB, 2018, p. A17). This has to do with factors such as liquidity and solvency. It also has to do with whether or not the entity needs additional financing, and if so the likelihood that it actually obtains the financing it needs.

Information on Financial Position also helps make an assessment of the wildcard we mentioned earlier. Users will now be able assess management’s stewardship of the resources at their disposal. Badly used resources can easily be spotted.

Furthermore, information on Financial Position can help identify who the entity owes—these are the claims on the entity. The information will also enable an ascertainment of what the amounts owing are, as well as what the priorities of payments are. It helps determine which claims are more pressing and what the magnitude of those claims are. This allows a prediction to be made of future cash outflow to such claimants and what might be left on after such claims have been settled.

The cause of changes in economic resources and claims

Changes in economic resources and claims are caused by two main categories of items listed in para. 15. The first of them is the Financial Performance of the entity. Financial Performance is basically whether the entity has made a profit or a loss. The point here is that, Financial Performance (whether a profit or loss) directly leads to a change in the resources and/or claims of the entity.

Information on Financial Performance is directly linked to the return the entity has produced on the economic resources at its disposal. Thus, Financial Performance information can help users to understand the return the entity has made on its resources. Users will use this information on Financial Performance to identify things such as the components of the returns, and what the variability of that return is.

The analysis, by users, of the Financial Performance of the entity, and hence the return on the resources at the disposal of the entity (and by implication, at the disposal of its management) is primarily how management’s stewardship is assessed. The catch is that, a comparison of past Financial Performance to current Financial Performance, helps predict future performance and hence future return on the economic resources of the entity. With a bad management, the future can only portend gloom.

The second category of items which can cause changes in the resources and claims of the entity, which the Board makes mention of, is other events or transactions. Examples of such an issue by the entity of equity or debt instruments. When this is done, resources change; claims also change. For instance, assuming the company issues debt by borrowing in the bond markets, resources (cash or money) increase (because the entity would have received money from those who buy the bonds), but claims (how much the entity owes) increase as well (because more people would now be owed money by the entity). In the future, the entity has to pay back.

Financial Performance in the context of Accrual Accounting

In the discussion about Financial Performance, the Board makes sure to indicate the clear distinction between that which is based on accrual accounting on one hand, and that which is based on cash accounting on the other.

Accrual accounting may be the defined as accounting for transactions, and other events and circumstances in the period in which the effects of these transactions, and other events and circumstances are felt, even if the cash receipts or payments from those transactions occur in another period (IASB, 2018, p. A18). The key point to note, is the part about the movement of cash. Whether that cash moves or not, accrual accounting makes sure to take note of the effects of the transactions, when they occur, and then report them specifically in those periods where their effect is felt.

Accruals forms the bedrock of modern-day Financial Reporting. This means that, the periods in question need to be clearly delineated periods (usually referred to as financial/fiscal years). The Board notes in para. 1.17 that, information about changes in resources and/or claims of an entity in specific periods, provides a better basis of assessing the entity’s past and future Financial Performance. This is as compared to information solely about cash payments and receipts for the period (cash accounting).

The benefits of accrual accounting over cash accounting have been advanced by many. First, the information on Financial Performance based on accruals (alias for accrual accounting), stated clearly in para. 1.18, shows how much the entity has been able increase its resources for the financial year in question, and by implication the entity’s capacity for generating cash inflows solely from its operations. This information is directly tied to the assessment of management’s stewardship of the entity’s economic resources.

What all this means, is that, it is possible for an entity to be bleeding cash from its operations (that is, the core business it has decided to do), because the entity’s Financial Performance (based on accruals) is horrible. Yet, this entity still survives because of its capacity to raise cash (additional resources) directly from investors and creditors. The company Uber is a prime example of this. Without accruals, and with a sole focus on cash accounting, this nuance may not be spotted by users of the financial information.

Another advantage also of accruals is that it indicates how much changes in external factors, such as interest rates, market prices et cetera, have affected Financial Performance (which in affect causes changes in the resources and/or claims of the entity). This then consequently helps make an assessment of the entity’s ability to generate net cash inflows over that period, and how the changes in these external factors have affected that ability.

Financial Performance in the context of Cash Accounting

Cash accounting has already been briefly introduced. Now, cash accounting is not useless. In fact, many have noted that it provides the most useful information, because cash is the blood which runs in the veins of an entity. No cash means the entity dies.

The Board notes in para. 1.20 that Financial Performance reflected by past cash flows during a period also helps users assess the entity’s ability to generate future net cash inflows and to assess management’s stewardship of the entity’s economic resources.

The information will basically be a detailing of (1) how cash is obtained by the entity; and (2) how that cash is spent by the entity. This, mainly, will cover transactions such as the entity’s borrowing and repayment of debt, cash dividends and other cash distributions to investors. These are usually things which affect the entity’s liquidity and/or solvency. Once again, as noted above, the entity’s ability to generate cash basically determines if the entity lives or dies—this is what liquidity and solvency are about. No cash; no entity.

The information about cash flows reveals much about the reporting entity’s operations, its investing activities, and its financing activities. These are what helps assess the entity’s liquidity situation and solvency situation.

Economic resources’ and claims’ changes not resulting from Financial Performance

As has already been alluded to, an entity’s economic resources and claims can change due to the effect of other factors not related to the entity’s Financial Performance. An example being if and when the reporting entity issues debt or equity instruments and these have no relation whatsoever to its daily business activities. This will cause claims and resources to change, but is not the result of Financial Performance.

This information is needed by users to help them obtain a complete picture of the entity and its activities. The relevant question on users’ minds include: why claims and resources have changed, and what the implications of those changes are for the entity’s future Financial Performance.

How has the entity’s resources been used?

This question is also a critical one which needs answering. It has been alluded to throughout this article. The Board notes in para. 1.22 that the effectiveness and efficiency with which management has discharged is responsibilities to use the entity’s economic resources helps users to assess management’s stewardship of those resources (IASB, 2018, p. A19).

As can be inferred, this information is useful in predicting how effectively and efficiently management will use the entity’s economic resources in future periods; the direct effect of this being a prediction of what future net cash inflows to the entity might be.

As far as management’s responsibilities go, examples listed in para. 1.23 include: protecting the entity’s economic resources from unfavourable effects of economic factors, such as price and technological changes, ensuring that the entity complies with applicable laws and regulations; and also ensuring that the entity complies with contractual provision to which it is a party.

Compliance by the entity, ensures that the entity does not suffer penalties in the future, thereby helping to safeguard precious resources.

Conclusion

In this article, part two of the series, an attempt has been made to cover Chapter 1 of the Conceptual Framework for financial report as promulgated by the IASB in March 2018. The four main sections of Chapter 1 were taken one after the other and broken down. These include:

1. The introduction to Chapter 1;
2. What the:
   1. objective of General-Purpose Financial Reporting is,
   2. uses and limitations of General-Purpose Financial Reporting are;
3. Information about:
   1. a reporting entity’s economic resources
   2. claims against the entity; and
   3. changes in resources and claims
4. Information about use of the entity’s economic resources

If the reader has noticed, the trend has been that Financial Reporting aims to help users (1) to make a good assessment of what has happened in the past, in order (2) to be able to predict what could happen in the future. This determination then helps users (3) make informed decisions on whether or not to give their resources to the reporting entity going forward.

Also, in this article, it has been made clear that primary users want to judge three main things: Financial Performance of the entity, Financial Position of the entity, and net cash inflows to the entity.

In future parts of this article, the other Chapters of the Conceptual Framework as promulgated by the International Accounting Standards Board will be discussed in detail.

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References

IASB. (2018). Conceptual Framework for Financial Reporting. London: IFRS Foundation. Retrieved from http://eifrs.ifrs.org/eifrs/PdfAlone?id=24380&sidebarOption=UnaccompaniedConceptual