The IFRS Conceptual Framework: The Foundation the Standards Rest On

Why a document that sets no rules is needed

Standards cannot describe every possible situation. Businesses invent new forms of transactions faster than the rules are updated, and in that gap professional judgement needs something to rest on.

The Conceptual Framework plays three roles: it helps the standard-setter develop consistent standards, helps preparers resolve issues not covered by standards, and helps users understand why financial statements look the way they do.

The objective of financial reporting

General purpose financial statements are prepared for users who cannot demand the information they need directly from the company: investors, lenders and other providers of capital. They need data to decide whether to provide resources.

This objective implies an important practical limitation: financial statements are not prepared for the tax authority and are not the owner's management report. They answer the question of the company's prospects for future cash flows, and every requirement is tuned to that question.

Qualitative characteristics of useful information

Information is useful if it is relevant and faithfully represented. Relevance means it can make a difference to a user's decision; faithful representation means completeness, neutrality and freedom from error in depicting the economic phenomenon.

These two are the fundamental characteristics: without them the rest are meaningless. The enhancing characteristics — comparability, verifiability, timeliness and understandability — increase the usefulness of information but do not replace the fundamental requirements.

A cost constraint is stated separately: the benefits of information must exceed the cost of preparing it. In practice, this constraint explains why the extent of disclosures is driven by materiality rather than by a desire to disclose everything.

• relevance — the information affects the user's decision
• faithful representation — complete, neutral, free from error
• comparability across periods and companies
• verifiability — independent experts would reach a similar conclusion
• timeliness — data is available while it is still relevant
• understandability for a reasonably informed user

Elements of financial statements and their definitions

The Conceptual Framework defines an asset, a liability, equity, income and expenses. The definitions are based not on the form of documents but on economic rights and obligations: an asset is a resource controlled by the company that is capable of producing economic benefits.

This definition makes it possible to resolve non-obvious situations. If equipment legally belongs to someone else but the company controls its use and obtains the benefits, the question of recognising an asset is decided on the substance of the relationship, not on the title certificate.

Recognition, derecognition and measurement

An element is recognised in the financial statements if recognition provides users with relevant and faithfully represented information, taking into account the cost of preparing it. Derecognition occurs when the company loses control of an asset or is released from an obligation.

Measurement can use different bases: historical cost shows the actual cost of the transaction, current value reflects current conditions. The basis is chosen according to which information will be more useful to the user in the particular case, and the choice is disclosed.

Alongside sit the assumptions on which the whole structure rests: the going concern basis and the accrual basis, under which transactions are recorded in the period they occur rather than when cash moves.

• recognise an element when it is relevant and faithfully represented
• derecognise on loss of control or release from the obligation
• measure at historical cost or at current value
• the going concern assumption
• accrual basis rather than cash basis

How the Conceptual Framework is used in practice

It is most often consulted in three situations: a transaction is not covered by a specific standard, a standard allows several interpretations, or a mechanical application of the rules clearly distorts the picture.

The second practical use is developing the accounting policy. When a company chooses between permitted options, the argument rests on the qualitative characteristics of information: which option gives the user a more relevant and faithful picture.

The third is defending a position before the auditor. A reasoned judgement that refers to principles is far more convincing than a reference to established practice or to the previous accountant's decision.

Where the principles diverge from familiar local accounting

The national accounting tradition is largely oriented towards documents and tax consequences. The international approach puts economic substance first, and this regularly leads to different answers for the same transaction.

Classic points of divergence are the timing of revenue recognition, measurement of assets after initial recognition, lease accounting and provisions. In each case the difference is explained not by technique but by a different objective of financial reporting.

Leader Audit helps companies build IFRS accounting thoughtfully: starting from principles rather than copying someone else's journal entries. We are an audit firm with 13 years of experience and more than 220 audits completed.