Conceptual Framework – Chapter 1

Chapter 1: The objective of general purpose financial reporting

Chapter 1 of the Framework discusses the objective of general purpose financial reporting, which forms the foundation of the Framework. Other aspects of the Framework (a reporting entity concept, the qualitative characteristics of, and the constraint on, useful financial information, elements of financial statements, recognition and derecognition, measurement, presentation and disclosure) flow logically from the objective.

The Chapter is divided into three main sections dealing with:
– the objective, usefulness and limitations of general purpose financial reporting;
– information about a reporting entity’s economic resources, claims, and changes in resources and claims; and
– information about an entity’s use of such resources.

Objective and usefulness

The Framework defines the objective of general purpose financial reporting as being:‘ to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions relating to providing resources to the entity. Those decisions involve decisions about: buying, selling or holding equity and debt instruments; providing or settling loans and other forms of credit; or exercising rights to vote on, or otherwise influence, management’s actions that affect the use of the entity’s economic resources.’

Existing and potential investors, lenders and other creditors (collectively, ‘users’ or ‘primary users’) cannot generally require reporting entities to provide information directly to them and must rely on general purpose financial reports for much of the financial information they need. Consequently, they are the primary users to whom general purpose financial reports are directed. Moreover, financial reports are prepared for users with a reasonable knowledge of business and economic activities who can review and analyse the information diligently.

Other parties, such as regulators and members of the public, may also find general purpose financial reports useful. However, those reports are not primarily directed to these other groups. This draws out an interesting facet of the Board’s objective for financial reporting being restricted to the information needs of those providing resources to a reporting entity. It excludes other common uses of financial information, notably the levying of corporation taxes and restrictions on distribution to members. These two very important areas of corporate activity will typically take as a starting point a measure of profit as reported in the entity’s financial reports. Self-evidently, if these uses are not considered in the development of accounting requirements, there is a risk that financial statements will be less suitable for these purposes.
The decisions described in the objective depend on the returns that existing and potential investors, lenders and other creditors expect, for example, dividends, principal and interest payments or market price increases. Investors’, lenders’ and other creditors’ expectations about returns depend on their assessment of the amount, timing and uncertainty of (the prospects for) future net cash inflows to the entity and on their assessment of management’s stewardship of the entity’s economic resources. Existing and potential investors, lenders and other creditors need information to help them make those assessments.

In doing so, users need information about:
– the economic resources of the entity, claims against the entity and changes in those resources and claims; and
– how efficiently and effectively the entity’s management and governing board have discharged their responsibilities to use the entity’s economic resources.

Limitations

The Framework acknowledges that general purpose financial reports do not, and cannot, provide all of the information needed by providers of capital. Users of financial reports need to consider other pertinent information, such as general economic and political conditions, and industry and company outlooks. Moreover, general purpose financial reports are not designed to show the value of a reporting entity, but to provide information to allow users to estimate it for themselves.
General purpose financial reports are focused on meeting the needs of the maximum number of primary users, who may have different, and possibly conflicting, needs for information. However, this does not preclude a reporting entity from including additional information that is most useful to a particular subset of primary users. It should be noted, however, that Presentation of Financial Statements contains the requirement that the understandability of financial statements should not be reduced by obscuring material information with immaterial information. Management of an entity need not rely on general purpose financial reports, since the relevant information can be obtained internally.

The Board notes that, to a large extent, financial reports are based on estimates, judgements and models rather than exact depictions. The Framework establishes the concepts that underlie those estimates, judgements and models. The concepts should be seen as a goal which the IASB and preparers should strive towards, but are unlikely to achieve in full, at least in the short term, because it takes time to understand, accept and implement new ways of analysing transactions and other events. Nevertheless, setting such a goal is essential if financial reporting is to evolve so as to improve its usefulness.

Information about the economic resources of an entity and the use made of them, claims against the entity, and changes in resources and claims

General purpose financial reports provide information about:
– the financial position of a reporting entity (the economic resources of, and claims against, the entity); and
– the effects of transactions and other events that change the economic resources of, and claims against, the entity.
Both types of information provide useful input for decisions about providing resources to an entity.

Economic resources and claims

Information about the nature and amounts of a reporting entity’s economic resources and claimscan help users to:
– identify the entity’s financial strengths and weaknesses;
– assess the entity’s liquidity and solvency, its needs for additional financing and how successful it is likely to be in obtaining that financing; and
– assess management’s stewardship of the entity’s economic resources.

Information about the priorities and payment requirements of existing claims helps users to predict how future cash flows will be distributed among lenders and creditors.
Different types of economic resources affect a user’s assessment of the entity’s prospects for future cash flows in different ways. Some future cash flows result directly from existing economic resources, such as accounts receivable. Other cash flows result from the entity using several resources in combination to produce and market goods or services to customers. Although those cash flows cannot be identified with individual economic resources (or claims), users need to know the nature and amount of the resources available for use in an entity’s operations.

Changes in economic resources and claims

Changes in a reporting entity’s economic resources and claims result from that entity’s financial performance and from other events or transactions such as issuing debt or equity instruments. In order to assess properly the prospects for future cash flows of the entity and management’s stewardship of resources, users need to know the extent to which the reporting entity has increased its available economic resources, and thus its capacity for generating net cash inflows through its operations rather than by obtaining additional resources directly from providers of capital.

Information about a reporting entity’s financial performance helps users to understand the return that the entity has produced on its economic resources. Information about the return can help users to assess management’s stewardship of the entity’s economic resources. Information about the variability and components of that return is also important, especially in assessing the uncertainty of future cash flows.
Information about a reporting entity’s past financial performance and how its management discharged its stewardship responsibilities is usually helpful in predicting the entity’s future returns on its economic resources.

Financial performance is reflected by changes in the entity’s economic resources and claims other than by obtaining additional resources directly from providers of capital. This is sometimes described as a ‘balance sheet approach’ to recording financial performance, whereby financial performance for a period is essentially derived as part of the overall movement in the entity’s financial position during that period. This is discussed more explicitly in the section of the Framework dealing with the elements of financial statements.

Consistent with this ‘balance sheet approach’, financial performance is based on accrual accounting, which depicts the effects of transactions and other events and circumstances on a reporting entity’s economic resources and claims in the periods in which those effects occur, even if the resulting cash receipts and payments occur in a different period. This provides a better basis for assessing the entity’s past and future performance than information based solely on cash flows.

Information about an entity’s financial performance may also indicate the extent to which events such as changes in market prices or interest rates have changed the entity’s economic resources and claims, thereby affecting the entity’s ability to generate net cash inflows. Nevertheless, information about an entity’s cash flows during a period also helps users to assess the entity’s ability to generate future net cash inflows, understand the entity’s operations, evaluate its financing and investing activities, assess its liquidity or solvency, assess management stewardship and interpret other information about financial performance.

Information about the use of economic resources (stewardship)

Management is responsible for the use of an entity’s economic resources – for example, by protecting those resources from unfavourable effects of economic factors, such as price and technological changes, and ensuring that the entity complies with applicable laws, regulations and contractual provisions.

Information about how efficiently and effectively the reporting entity’s management has discharged its responsibilities to use the entity’s economic resources helps users to assess management’s stewardship of those resources. Such information is also useful for predicting how efficiently and effectively management will use the entity’s economic resources in future periods. Hence, it can be useful for assessing the entity’s prospects for future net cash inflows.

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