The Conceptual Framework for Financial Reporting (March 2018)
The Conceptual Framework for Financial Reporting is a document created by the International Accounting Standards Board (the “IASB”), the same body that writes the International Financial Reporting Standards used by many companies when they prepare their financial statements.
The current version of the Conceptual Framework was issued in 2018 and it, and its predecessors, is an attempt to provide the accountancy profession with a theoretical basis for preparing accounts or financial statements. It exists to help:
- The IASB in developing future financial reporting standards and in reviewing existing standards
- Promote the harmonization of financial reporting standards across the world and assist national accounting regulators
- Those accountants who are preparing financial statements and may be facing a situation that is not covered in the current financial reporting standards.
- The accountancy profession across the world
The Conceptual Framework is therefore concerned with the preparation of an organization’s financial statements (also referred to as General Purpose Financial Reporting).
The Purpose of General Purpose Financial Reporting
General purpose financial reporting refers to the financial statements prepared by a business. The objective of financial statements is to provide useful financial information about an entity (such as a company) to help its prime users make decisions.
Prime users of financial statements
The prime users of financial statements are existing or potential
- Investors (e.g. shareholders)
- Lenders (e.g. banks, debenture holders); and
- Other creditors (e.g. suppliers who provide credit, HMRC)
These users are the individuals and/or organizations that provide funding to the entity and will therefore have a significant interest in its finances.
Information needs of the users of financial statements
Users need information to help them make decisions and are interested in the future net cash flows that the business will generate as well as the effectiveness of the entity’s plans and the efficiency with which they are likely to be implemented.
Decisions that users make – investors
Investors want information to help them decide whether to buy, sell or hold onto shares and/or debentures in a company. In making their decision, they will take into account such matters as:
- Expected dividends and changes in the value of the shares or debentures
- The company’s ability to pay interest and debt repayment
- Business risk
- Company strategy
Decisions that users make – lenders and other creditors
Lenders and other creditors want information to help them decide whether or not they should provide loans or goods and services on credit to a company. They will therefore take into account such matters as:
- The company’s ability to pay interest on time
- The company’s ability repay loan capital on time
- The company’s ability to pay their liabilities when they fall due
Imagine that you are the accountant of a medium-sized manufacturing business that sells to customers on credit terms. What sort of financial information would you want to see before you would be willing to offer credit to a potential customer?
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- Whilst different businesses will require different information from potential customers, there will be many items of information that will be required by most if not all businesses, such as information on:-
- The business’ profitability, as highly profitable businesses are less likely to go out of business owing money
- The business’ assets and liabilities. It is usually harder to recover amounts owed by a customer that has few assets
- The business’ liquidity (i.e. its ability to pay its debts in the short-term), as a business with low liquidity is more likely to pay late or not pay at all
- The business’ payment policies, by examining a business’ cost of sales and levels of trade payables we are able to estimate how long the business takes to pay its suppliers
- Information over several periods
- Businesses will typically want more than a single year’s financial statements as this will enable them to identify trends (e.g. if profits are slowly declining over time)
Financial statements provide a large amount of financial information for users. Whilst they cannot provide all the information that an investor, lender or other creditor wants (since they really want to know what will happen in the future) the financial statements do go some way to providing the required information.
Financial statements provide information about a business’ resources (i.e. its assets) and its obligations (i.e. its liabilities) and how they have changed over time (i.e. how the business has performed). Users are therefore able to use this information to make judgements as to the business’ past risk and performance which can then be used to assess likely future risk and performance.