Welcome again, today we will discuss about the conceptual framework of accounting. We will cover definition, need and conceptual framework for financial reporting. Hope you will enjoy it. Let’s start

What is conceptual framework?

what is conceptual frameworkConceptual framework of accounting is like a structured theory of accounting. Which is defined as a coherent system of interrelated objectives and fundamentals that can lead to consistent standards and that prescribes nature, function and limits of financial accounting.

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Need of conceptual framework

The reason behind developing conceptual framework is to provide accounting standards, a basis to resolve accounting disagreement and fundamental principles. With the existence of conceptual framework an organization can solve partial problems quickly and users understand and get confident in financial reporting.

Conceptual framework for financial reporting

Below figure will provide you an overview of the conceptual framework. The first level of conceptual framework identifies the goals and purpose of accounting. The second level is the bridge between the first level and third level. And the third level explains the implementation of conceptual framework.
what is conceptual framework for financial reporting

First level: Basic objective

Financial reporting should provide information:
  • That is useful to present and future investors, creditors who are making decision about investment, credit or similar.
  • That is useful to present and future investors, creditors in assessing the future cash flows.
  • About the economic resources of the organization, claims on those resources and changes in them.

Second level: Fundamental concepts

Second level of conceptual framework forms a bridge between why of accounting which is the first level and how of accounting which is third level of accounting. Second level of conceptual framework is consist of:

Qualitative characteristics of accounting information: 

Qualitative characteristics of accounting information are identified as a way to distinguish more useful information from the less useful information for decision-making purpose. Qualitative characteristics divided into two types:

Primary qualities: Relevance and reliability are two types of primary qualities which makes accounting information more useful for decision-making purpose. 
  • Relevance of information means that the information must be capable of making a difference in decision making. If the information does not make any difference in the decision, then it will be irrelevant. For information to be relevant, it must have a predictive or feedback value and must be presented in a timely basis. The Predictive value of information means an information that help user to make a prediction about past, present and future events. An information which helps a user to confirm prior expectations is called the feedback value of that information. Timeliness means information must be available to the user before it loses its capability to influence.
  • An information is reliable when it is verifiable, faithfully represented and free from error and bias. Verifiability helps user assure that information is faithfully represented. An Information is faithful when it represents what really existed or happened and an information is neutral, when it is free from error or bias. 
Secondary qualities: Comparability and consistency are two types of secondary qualities which influence the decision-making
  • An information that has been measured and reported in a similar manner for different enterprises is considered as comparable. Comparability lets a user identify the real similarities and differences in economic phenomena.
  • Consistency means a company should follow a particular method for similar events from period to period. For example, if a company follows the straight line method to charging depreciation, then it should always follow it.

Elements of financial statement: 

  • Asset: Asset is a resource which can obtain the probable future economic benefit.
  • Liability: Liability is a present obligation arising from past events. In other words, liability is the claim against the asset. 
  • Expenses: Expense is an expenditure whose benefit is not fulfilled or enjoyed immediately.
  • Revenues: Revenue is the inflow of assets which results an increase of owners’ equity.
  • Equity: Equity is the right to claim ownership when the company dissolves.
  • Gain: Gain is an increase in the company asset which is not related to sales.
  • Loss:  Loss is a decrease in the company asset which is not related to sales.

Third level: Recognition and measurement concept

Third level consists of:

Basic assumption
  • Economic entity: Economic entity means that the activity of a business enterprise can be kept separate from its owner and any other business unit. The entity concept does not necessarily refer to a legal entity.
  • Going concern: The going concern assumption means that the organization will have a long life. It will last long enough to fulfill its objectives and commitments.
  • Monetary Unit: The monetary unit assumption explains money is the common denominator of an economic activity. The monetary unit is relevant, simple, universally available, understandable and useful.
  • Periodicity: Periodicity assumption explains that the economic activity of an organization can be divided into artificial time periods. These artificial time periods can vary depending on the organization but most commonly used time periods are monthly, quarterly and yearly.
Basic principles
  • Historical cost: Historical cost principle explains that an asset should be recorded at its cost price (purchase price). It also includes all the cost that was necessary to get the asset ready for use. Historical cost helps an organization distinguish an asset’s original cost from its current cost.
  • Revenue recognition: Revenue recognition principle states that revenue is recognized when it is earned. For example, ABC Company got an order to produce three hundred shirts. ABC Company will recognize the revenue when they will actually deliver the order and receive the payment.
  •  Matching principle: Matching principle means expense is recognized at the time revenue is recognized. For example, ABC Company will recognize the cost of producing three hundred shirts when produced shirts will make a contribution to revenue.
  • Full disclosure: Full disclosure principle holds that organization should provide all the information that is important enough to make a change in judgment or decision of the user.
  • Cost Benefit Relationship: The costs of providing the information must be weighed against the benefits that can be derived from using the information.
  • Materiality: Sound and acceptable standards should be followed if the amount involved is significant when compared with the other revenues and expenses, assets and liabilities, or net income of the entity.
  • Industry Practices: Follow the general practices in the firm's industry, which sometimes requires departure from basic theory.
  • Conservatism: Conservatism means when in doubt, choose the solution that will be least likely to overstate assets and income. 
Conceptual framework for financial reporting - Explanation
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