IASB Conceptual Framework and Qualitative Characteristics of Financial Information

Accounting standards are many and detailed, and no standard can cover every transaction a business may enter. The International Accounting Standards Board (IASB) Conceptual Framework fills that gap. It sets out the ideas that every standard rests on: why financial statements exist, what makes the information in them useful, and how the building blocks of the statements are defined.

This topic covers the purpose and structure of the framework, the objective of financial reporting, and the qualitative characteristics of useful information.

In past papers a multiple-choice item on the framework appears in about two diets in five, and Section B has asked a full question on it twice in the 20 diets reviewed. Questions ask you to list the characteristics, to say which is fundamental and which enhancing, or to explain the objective.

Read the earlier topic on FRC Nigeria, bases of accounting and elements of financial statements first, because this topic uses its statements and terms. The next topic covers the recognition and measurement chapters of the framework and the other accounting concepts.

Why a conceptual framework exists

The concepts, principles, conventions, laws and rules used to prepare statements are together called generally accepted accounting principles (GAAP), as the previous topic explained. Some are in law and in standards. Many of the most basic ones are in neither and are simply accepted practice. A conceptual framework is a system of concepts and principles, consistent with one another, that underpins the preparation of financial statements.

The IASB’s predecessor issued the first one in 1989. The IASB worked with the United States (US) standard setter Financial Accounting Standards Board (FASB) on a common framework, and the complete revised document was published in March 2018 as The Conceptual Framework for Financial Reporting. The changes did not alter IFRS in any fundamental way.

A formal framework helps in several ways.

• Standards and practice are then based on one set of ideas. Without a framework, standards are written one problem at a time and can contradict each other or the law.
• Important issues are less likely to be missed. Before the IASB had a framework there was no proper definition of an asset, a liability, income or an expense.
• Business grows more complex and no standard can cover every transaction. An entity with an unusual transaction and no relevant standard can apply the principles in the framework.
• It strengthens the credibility of financial reporting and of the profession.

The alternative is a system of detailed rules. Rules can be abused through Creative accounting, which means techniques that give a biased, usually favourable, picture of performance while still complying with the rules. Scandals in the 1980s, when apparently healthy companies collapsed, were one reason standard setters adopted frameworks. Rules are also open to pressure from large companies and sectors with vested interests.

Against that, principles ask management to use judgement and risk being wrong, and a framework can lead to standards that are theoretical and complex. Very detailed rules are also hard to apply.

Structure and status of the framework

The framework has eight chapters:

1. The objective of general purpose financial reporting.
2. Qualitative characteristics of useful financial information.
3. Financial statements and the reporting entity.
4. The elements of financial statements.
5. Recognition and derecognition.
6. Measurement.
7. Presentation and disclosure.
8. Concepts of capital and capital maintenance.

It has three purposes. It helps the IASB develop standards that rest on consistent concepts. It helps preparers develop consistent accounting policies when no standard applies to a transaction, or when a standard allows a choice. It helps everyone understand and interpret IFRS. The framework is Not itself an IFRS, and nothing in it overrides any specific IFRS (Conceptual Framework, paragraph SP1.2). In the rare case of a conflict, the IFRS prevails.

Users and the objective of financial reporting

Many investors, lenders and other creditors cannot demand information from an entity and must rely on its general purpose financial reports (Conceptual Framework, Chapter 1). They are the primary users. The reports cannot give them everything they need, they do not show what the entity is worth. Users have different needs, so the standards aim to serve the greatest number.

Regulators and the public may also use the reports, but the reports are not mainly directed at them. Management does not need to rely on them.

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 deciding whether to provide resources to it (Conceptual Framework, paragraph 1.2). Their decisions concern buying, selling or holding shares and debt, and granting or settling loans and credit.

To make them, users assess the prospects for future net cash inflows to the entity. For that they need information about three things:

• the Resources of the entity;
• the Claims against it; and
• how efficiently and effectively management has used the resources, which is the stewardship question.

The financial statements supply that information in two main ways. The Financial position shows economic resources and the claims on them. Changes in financial position come from Financial performance and from other events such as share issues.

• Resources and claims. Knowing their nature and amounts helps users see financial strengths and weaknesses, judge liquidity and solvency, and judge whether more finance will be needed. Information on the priority of claims helps users predict how future cash flows will be shared.
• Financial performance. Accrual accounting records the effects of transactions in the periods they occur, even if the cash moves in another period. That gives a better basis for judging past and future performance than the cash movements alone. Performance information shows how well management has used the resources, how far the entity generates cash from operations and not from fresh capital, how outside factors such as prices and interest rates may affect it, and how variable returns are.
• Cash flows. Information on how the entity obtains and uses cash, including borrowing and repayment and dividends, shows liquidity and financial flexibility.
• Other changes. Changes that come from events beyond daily trading must also be reported so that users understand the reason for changes in position.

Financial statements and the reporting entity

The objective of the financial statements themselves is to give information about the entity’s assets, liabilities, equity, income and expenses that helps users assess the prospects for future net cash inflows and the stewardship of resources. The information is given in:

• the Statement of financial position, by recognising assets, liabilities and equity;
• the Statement of financial performance, by recognising income and expenses; and
• the Other statements and notes, which present and disclose recognised and unrecognised items, cash flows, contributions from and distributions to holders of equity, and the methods, assumptions and judgements used.

The statements cover a specified Reporting period. They give information on assets, liabilities and equity at the end of the period, or during it, and on income and expenses for the period. They are prepared on the going concern assumption (Conceptual Framework, paragraph 3.9; International Accounting Standard (IAS) 1, paragraphs 25 and 26), which means that the entity will continue in operation for the foreseeable future.

If the entity intends or must cease operations, a different basis may be needed and it must be disclosed.

Qualitative characteristics of useful information

For information to help decisions it needs certain qualities (Conceptual Framework, paragraph 2.4). The framework divides them into two groups. The Fundamental characteristics are relevance and faithful representation. The Enhancing characteristics are comparability, verifiability, timeliness and understandability (paragraphs 2.5 and 2.23). Information must first be relevant and faithfully represent what it claims to represent. Enhancing characteristics make it more useful and cannot make up for a lack of either fundamental one.

Relevance

Information is relevant when it is capable of making a difference to users’ decisions. It is relevant if it has Predictive value, which helps users forecast future outcomes, or Confirmatory value, which helps them confirm or correct earlier assessments, or both. Materiality is part of relevance. Information is material if leaving it out or misstating it could influence decisions that users make from the report of a specific entity.

Materiality depends on the nature or size of an item, or both, in the context of that entity’s report. The IASB does not set a uniform numerical threshold.

Faithful representation

Reports describe economic resources, claims and the effects of transactions in words and numbers. To be useful, the description must be a faithful representation of what it claims to depict. A perfectly faithful representation has three qualities.

• Complete. It includes everything users need to understand the item, with the descriptions and explanations that go with it.
• Neutral. It is selected and presented without bias.
• Free from error. There are no errors or omissions in describing the item, and the process used to produce it has been applied without error.

Enhancing characteristics

• Comparability lets users see similarities and differences between items. Information is more useful when it can be compared with other entities or with the same entity in another period. Consistency, which is the use of the same methods for the same items, supports comparability but is not the same thing.
• Verifiability assures users that the information is a faithful representation. Different knowledgeable and independent observers could reach agreement that it is. A range of possible amounts with probabilities can be verified as well as a single figure.
• Timeliness means having information available to decision makers while it can still influence their decisions.
• Understandability means classifying, characterising and presenting the information clearly and concisely so that users with reasonable knowledge can follow it.

Cost is a pervasive limit (Conceptual Framework, paragraph 2.39). The benefit of reporting a piece of information must justify the cost of providing it.

The elements of financial statements

Background. Chapter 4 of the framework defines the five elements (Conceptual Framework, paragraph 4.3 for assets, 4.26 for liabilities, 4.63 for equity and 4.68 for income and expenses), and examiners have asked for them (May 2021, Question 6). The definitions are given here from the framework.

An item is recognised in the statements only when it meets one of these definitions and recognising it gives users useful information. The next topic covers recognition, derecognition and measurement.

The ideas in more depth

Relevance and faithful representation work together

A perfectly accurate figure about something that does not matter to users is useless, and a relevant figure that is biased or wrong misleads. That is why the two fundamental characteristics are both required. The enhancing characteristics improve information that already has both, for example by making it easier to compare with last year.

Consistency and comparability

Consistency is a means. Comparability is the result. A business that changes its depreciation method every year is inconsistent, and users cannot compare its profits between years. Applying the same method to similar assets within one year is also consistent, and so is the same treatment across different entities.

Materiality in practice

An error of a given size can be material in one place and not in another. The same ₦200,000 error is small against total assets of ₦100,000,000 and large against a profit of ₦1,000,000. The nature of an item can also make it material, for example an amount the law requires to be disclosed. Whether an item is material is a matter of judgement about the entity in front of you.

Why the framework matters when there is no standard

If a company enters a new type of contract that no standard covers, the preparer asks: does the item meet the definition of an asset, liability, income or expense, is it relevant, and does it represent faithfully what happened. The answers lead to a policy that is consistent with the rest of IFRS.

Prudence and neutrality

The 2018 framework restored the idea that prudence supports neutrality, because caution in the face of uncertainty helps avoid overstating assets and income. The next topic explains how prudence works in practice.

Sources and references

• IASB, Conceptual Framework for Financial Reporting (March 2018): paragraph SP1.2 (status), paragraph 1.2 (objective), paragraphs 2.4, 2.5, 2.23 and 2.39 (qualitative characteristics and the cost constraint), paragraph 3.9 (going concern), and paragraphs 4.3, 4.26, 4.63 and 4.68 (definitions of the elements).
• IAS 1 Presentation of Financial Statements: paragraphs 25 and 26 (going concern).

Worked example: applying the framework at Mubarak Textiles

1. Elements. Equipment, inventory, receivables and cash are Assets. The bank loan and payables are Liabilities. Sales are Income. Rent paid is an Expense.
2. Total assets.
   ₦1,500,000 + ₦700,000 + ₦480,000 + ₦420,000 = ₦3,100,000.
3. Total liabilities.
   ₦900,000 + ₦400,000 = ₦1,300,000.
4. Equity.
   ₦3,100,000 − ₦1,300,000 = ₦1,800,000.
   Check: liabilities ₦1,300,000 + equity ₦1,800,000 = ₦3,100,000, which equals total assets.
5. Materiality.
   ₦30,000 ÷ ₦1,500,000 = 2% of equipment, which is Not material for most users.
   ₦30,000 ÷ ₦150,000 = 20% of profit, which is Material.
   The same error is judged differently in each context.
6. Measurement. Historical cost is ₦2,000,000. Current cost is ₦2,600,000, the amount to buy a similar machine now. Realisable value is ₦1,400,000, what a sale would bring, and it applies only if the business is not a going concern.
7. Characteristic. Users cannot compare this year with last year, so Comparability is breached, and so is consistency of method.

Common mistakes in the exam

• Calling relevance and faithful representation enhancing, or timeliness fundamental. Fundamental: relevance and faithful representation. Enhancing: comparability, verifiability, timeliness, understandability.
• Writing “reliability”, “stability” or “predictability” as characteristics. They are not in the framework list.
• Treating materiality as a fixed percentage. The IASB does not set one.
• Mixing up predictive value, which looks forward, with confirmatory value, which checks the past.
• Naming the elements without defining them, when the question asks you to explain them.
• Saying that management is a primary user, or that regulators are the main audience.
• Stating that the framework overrides an IFRS when it does not.

Quick revision

• Framework: eight chapters, published March 2018. Not an IFRS. An IFRS prevails.
• Objective: useful to existing and potential investors, lenders and other creditors deciding whether to provide resources.
• Users need information on resources, claims and management’s use of the resources.
• Fundamental: relevance (predictive, confirmatory, material) and faithful representation (complete, neutral, free from error).
• Enhancing: comparability, verifiability, timeliness, understandability. Cost limits all of it.
• Elements: asset, liability, equity in the statement of financial position. Income and expenses in financial performance.
• Statements cover a reporting period and assume going concern.

Practice questions

These are original questions written in the style of the Institute of Chartered Accountants of Nigeria (ICAN) exam. Try each one before you open the answer.

Section A style: multiple choice

Section B style: written questions

A further written question

Model answers

Spotted a mistake? Tell us and we will check it.