Chapter 1 A conceptual framework

Qualification ACCA
Paper F7 INT
Chapter 1 Fill in these boxes
Template ID CD1
Source

Fill in this box with where the

information came from

Chapter Learning Objectives Common to this chapter

Upon completion of this chapter you will be able to: Common to this chapter

 Describe what is meant by a conceptual framework

 Discuss whether a conceptual framework is necessary
Bullet point text
 Discuss what an alternative system to a conceptual framework No limit to number of
might be bullets here as the
number of bullets
 Explain what is meant by understandability in relation to the depends purely on
provision of financial information the number of
content objectives
 Define the qualitative characteristics of relevance and reliability covered in this
chapter
 Describe the qualities that enhance these two characteristics
 Define the characteristic of comparability
 Discuss the importance of comparability to users of financial
statements
 Define recognition in financial statements
Draw diagram here
 Explain the recognition criteria in financial statements Either draw in word
or insert a picture
 Apply the recognition criteria to assets
 Apply the recognition criteria to liabilities
 Apply the recognition criteria to income and expenses
 Discuss what is meant by the balance sheet approach to
recognition
 Indicate when income and expense recognition should occur
under the balance sheet approach

REPORTINGCH1ACCAF7INTJCV1 -1-
 A CONCEPTUAL
FRAMEWORK

THE
FRAMEWORK

OBJECTIVES USERS

QUALITATIVE
CHARACTERISTICS

RELEVANCE RELIABILITY COMPARABILITY UNDERSTANTABILITY

RECOGNITION

ASSETS LIABILITIES INCOME EXPENSES

REPORTINGCH1ACCAF7INTJCV1 -2-
1 THE MEANING OF A CONCEPTUAL FRAMEWORK

Qualification ACCA
Paper F7 INT
Chapter 1 Fill in these boxes
Content Objective Describe what is meant by a
conceptual framework of accounting
Content, illustration and
TYU included? Fill in this box with where the
Source (esp. vital) Text 2.5 GBR Ch 1 information came from

1.1 What is a conceptual framework?

A conceptual framework is:

. a coherent system of interrelated objectives and fundamental principles
. a framework which prescribes the nature, function and limits of financial accounting and
financial statements.

1.2 Generally Accepted Accounting Practice (GAAP)

GAAP is:
. accounting practice which has substantial authoritative support amongst users of financial
Information.
. accounting standards generally representing GAAP but there may be a point in GAAP
which is not reflected in an accounting standard.
. including the requirements of: national laws and other acceptable accounting treatments
not incorporated in legislation or quasi-legislation.

Qualification ACCA
Paper F7 INT
Chapter 1
Content Objective Discuss whether a conceptual
framework is necessary
Content, illustration and
TYU included?
Source (esp. vital) Text 2.5 GBR Ch 1

REPORTINGCH1ACCAF7INTJCV1 -3-
1.3 Reasons for having a conceptual framework

There are a variety of arguments for having a conceptual framework:

. enables accounting standards and GAAP to be developed in accordance with agreed

principles
 avoids ‘fire fighting’, whereby accounting standards are developed in a piecemeal way in
response to specific problems or abuses
. ‘fire fighting’ can lead to inconsistencies between different accounting standards, and
between accounting standards and legislation.
 lack of a conceptual framework may mean that certain critical issues are not addressed.
For example, until recently there was no definition of basic terms such as ‘asset’ or ‘liability’ in
any accounting standard.
 as transactions become more complex and businesses become more sophisticated it
helps preparers and auditors of accounts to deal with transactions which are not the
subject of an accounting standard.
 accounting standards based on principles are thought to be harder to circumvent.
 it strengthens the credibility of UK financial reporting and the accounting profession
 it becomes less likely that the standard setting process can be influenced by ‘vested
interests’ (e.g. large companies/business sectors)

Qualification ACCA
Paper F7 INT
Chapter 1
Content Objective Discuss what an alternative system to
a conceptual framework might be
Content, illustration and
TYU included?
Source (esp. vital) Text 2.5 GBR Ch 1 and expandable text
from 2.5 Int Ch 2

1.4 Alternative system

A possible alternative to a conceptual framework is:

. a prescriptive ‘cookbook’ approach
. this would be based on rules rather than principles.
. in the 1980s, ‘creative accounting’ practices were developed which manipulated the picture
presented by the financial statements without actually breaching any regulations
. principles are harder to circumvent.

REPORTINGCH1ACCAF7INTJCV1 -4-
 Expandable text
The search for a conceptual framework
A conceptual framework is defined by the US Financial Accounting Standards Board
(FASB) as ‘a constitution, a coherent system of interrelated objectives and fundamentals that
can lead to consistent standards and that prescribes the nature, function and limits of financial
accounting and financial statements’.
Much of the early international work on developing a conceptual framework was carried out in
the US, where a series of Statements of Financial Accounting Concepts (SFACs) were
developed. The IASC largely used these SFACs to develop its own Framework, and the UK
‘Statement of Principles’ was largely based on the IASC Framework. Since there is so much
common agreement on the concepts underpinning financial accounting, it is hoped that
standards based on these concepts can be agreed throughout the world.

Generally Accepted Accounting Principles

You may see references to Generally Accepted Accounting Principles (GAAP), which
refers to the whole corpus of financial accounting methods in use in a particular regime. For
example, US GAAP is followed in the US, while UK GAAP is followed in the UK.

Your examination is based on international accounting principles, which some

commentators may refer to as ‘international GAAP’. However, GAAP is wider than
simply referring to accounting standards; it encompasses relevant statute and
conceptual statements. For example, UK GAAP comprises the Companies Act,
accounting standards in force in the UK, as well as any other accounting practices
consistent with the UK conceptual framework laid down in the Statement of Principles.
For this reason it can be argued that ‘international GAAP’ as a concept does not exist
since, by definition, statute only applies to specific countries. There is no international
statute, so there can be no all-encompassing international GAAP. The use of the term
‘international GAAP’ is therefore not recommended.

1.5 The Framework for the Preparation and Presentation of Financial

Statements
The Framework for the Preparation and Presentation of Financial Statements (the
Framework) was originally developed by the IASC:
. its sets out concepts underlying the preparation and presentation of financial
statements.
. it is not an accounting standard
. nothing in the Framework overrides a specific International Accounting Standard.

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 1.6 Purpose of the Framework

The purpose of the Framework is to:

 assist the IASB in the development of future accounting standards and in its review of
existing International Accounting Standards
. assist the IASB by providing a basis for reducing the number of alternative accounting
treatments permitted by International Accounting Standards
 assist national standard-setting bodies in developing national standards
. assist preparers of financial statements in applying International Accounting Standards
and in dealing with topics that do not form the subject of an International Accounting
Standard
. assist auditors in forming an opinion about whether financial statements conform with
International Accounting Standards
 . assist users of financial statements in interpreting the information contained in financial
statements prepared in conformity with International Accounting Standards
. provide those who are interested in the work of the IASB with information about its
approach to the formulation of International Accounting Standards.

1.7 Topics covered in the framework

The following topics are covered in the Framework:

1 The objective of financial statements
2 Underlying assumptions
3 Qualitative characteristics of financial statements
4 The elements of financial statements
5 Recognition of the elements of financial statements
6 Measurement of the elements of financial statements
7 Concepts of capital and capital maintenance.

1.8 The objective of financial statements

The objective of financial statements is:

. to provide information about the financial position, performance and changes in financial
position of an enterprise
. that is useful to a wide range of users in making economic decisions.

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1.9 Users of financial statements

The Statement of Principles recognises the following users of financial statements:

.current and potential investors
.lenders
.suppliers and trade creditors
. employees
.customers
.,government
. the public

Expandable text
Objective of financial statements
Financial statements meet the common needs of most users. However, financial statements
do not provide all the information that users may need to make economic decisions, since
they largely portray the financial effects of past events and do not necessarily provide non-
financial information.

Financial statements also show the results of the stewardship of management, that is the
accountability of management for the resources entrusted to it. Those users who wish to
assess the stewardship of management do so in order that they may make economic
decisions, for example whether to hold or sell their investment in the enterprise or whether to
re-appoint or replace the management. The economic decisions that are taken by users of
financial statements require an evaluation of the ability of an enterprise to generate cash, and
of the timing and certainty of its generation. Users are better able to evaluate this ability to
generate cash if they are provided with information that focuses on the:
 financial position of an enterprise – this is affected by:
– the economic resources it controls
– its financial structure
– its liquidity and solvency
– its capacity to adapt to changes in the environment in which it operates
 performance of the enterprise – this comprises the return obtained by the enterprise on
the resources it controls
 cash flow of an enterprise – this is useful in providing the user with an additional
perspective on the performance of an enterprise by indicating the amounts and principal
sources of its cash inflows and outflows.

Information about financial position is primarily provided in a balance sheet. Information

about performance is primarily provided in an income statement and a statement of
changes in equity. Information on cash flows is provided by a cash flow statement.
All the primary financial statements provide information that is useful in evaluating the
financial adaptability of an enterprise.

The component parts of the financial statements interrelate because they reflect different
aspects of the same transactions or other events. Although each statement provides
information that is different from the others, none is likely to serve only a single purpose or
provide all the information necessary for particular needs of users.

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The financial statements also contain notes and supplementary schedules and other
information.

Users of financial statements

Investors (providers of risk capital) are interested in information that:

 helps them to assess how effectively management has fulfilled its stewardship role (the
safekeeping of the entity’s resources and their proper, efficient and profitable use)

 is useful in taking decisions about their investment or potential investment in

the entity.

They are, as a result, concerned with the risk inherent in, and return provided by, their
investments. They need information on the entity’s financial performance and financial
position that helps them to assess its cash generation abilities and its financial adaptability.

Other users of financial statements, and their information needs, include the following:
 Lenders – interested in information that enables them to determine whether their loans
will be repaid, and whether the interest attaching to them will be paid, when due. Potential
lenders are interested in information that helps them to decide whether to lend to the entity
and on what terms.
Suppliers and other trade payables – interested in information that enables them to decide
whether to sell to the entity and to assess the likelihood that amounts owing to them will be
paid when due.
 Employees – interested in information about the stability and profitability of their employer.
They are also interested in information that helps them to assess the ability of their employer
to provide remuneration, employment opportunities and retirement benefits.
 Customers – interested in information about the entity’s continued existence. This is
especially so when they are dependent on the entity (e.g. if product warranties are involved or
if specialised replacement parts may be needed).
 Governments and their agencies – interested in the allocation of resources and,
therefore, the activities of entities. They also require information in order to regulate the
activities of entities, assess taxation and provide a basis for national statistics.
 The public – interested in information about the trends and recent developments in the
entity’s prosperity and the range of its activities. For example, an entity may make a
substantial contribution to a local economy by providing employment and using local
suppliers.

2 Qualitative characteristics of financial information

2.1 Introduction

Qualitative characteristics are the attributes that make information provided in financial
statements useful to others.
The Framework identifies four qualitative characteristics (relevance, reliability, comparability
and understandability), subject to a threshold quality of materiality, as shown in the diagram
below:

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2.2 Threshold quality – materiality

A threshold quality is:

. one that needs to be considered before considering the other qualities of that information .
. a cut off point - if any information does not pass the test of the threshold quality, it does
not need to be considered further.

Information is material:
. if its omission or misstatement could influence the economic decisions of users taken on
the basis of the financial statements.
. depends on the size of the item or error judged in the particular circumstances of its
omission or misstatement

REPORTINGCH1ACCAF7INTJCV1 -9-
 Qualification ACCA
Paper F7 INT
Chapter 1
Content Objective Explain what is meant by
understandability in relation to the
provision of financial information
Content, illustration and TYU 1 – new
TYU included?
Source (esp. vital) Text 2.5 GBR Ch 1

2.3 Understandability

Understandability depends on:

 the way in which information is presented
 the capabilities of users.

It is assumed that users:

. have a reasonable knowledge of business and economic activities
. are willing to study the information provided with reasonable diligence.

For Information to be understandable:

. users need to be able to perceive its significance
. information that is relevant and reliable should not be excluded from the financial statements
simply because it is difficult for some users to understand.

Test your understanding 1

What is meant by understandability?

Solution
Financial information is understandable is the users of that information can perceive its
significance.

REPORTINGCH1ACCAF7INTJCV1 - 10 -
 Qualification ACCA
Paper F7 INT
Chapter 1
Content Objective Define the qualitative characteristics of
relevance and reliability
Content, illustration and TYU 2 and 3 - new
TYU included?
Source (esp. vital) Text 2.5 GBR Ch 1

Qualification ACCA
Paper F7 INT
Chapter 1
Content Objective Describe the characteristics that
enhance these two characteristics
Content, illustration and
TYU included?
Source (esp. vital) Text 2.5 GBR Ch 1 and 2.5 Int Ch 2

2.4 Relevance

Information is relevant if:

. it has the ability to influence the economic decisions of users, and
. is provided in time to influence those decisions.

2.5 Qualities of relevance

Information provided by financial statements:

. needs to be relevant
. where choices have to be made between mutually exclusive options, the option
selected should be the one that results in the relevance of the information being
maximised – in other words, the one that would be of most use in taking economic
decisions.

Information that is relevant has predictive value or confirmatory value:

. predictive value enables users to evaluate or assess past, present or future events.
. confirmatory value helps users to confirm or correct past evaluations and
assessments

REPORTINGCH1ACCAF7INTJCV1 - 11 -
 Expandable text
Information has the quality of relevance when it influences the economic decisions of users
by helping them evaluate past, present or future events or by confirming, or correcting, their
past evaluations.

Information about financial position and past performance is frequently used as the basis for
predicting future financial position and performance and other matters in which users are
directly interested, such as dividend and wage payments. To have predictive value,
information need not be in the form of an explicit forecast.

The ability to make predictions from financial statements is enhanced, however, by the
manner in which information concerning past transactions and events is displayed.
For example, the predictive value of the income statement is enhanced if unusual,
abnormal and infrequent items of income or expense are separately disclosed.

The predictive and confirmatory roles of information are interrelated. For example, information
about the current level and structure of asset holdings has value to users when they
endeavour to predict the ability of the enterprise to take advantage of opportunities and its
ability to react to adverse situations.

There are several monetary attributes that could be used in financial statements, e.g.
historical cost, current cost or net realisable value. The choice of attribute to be reported
should be based on its relevance to the economic decisions of users.

Test your understanding 2

What is relevant financial information?

Solution
Financial information is relevant if it has the ability to influence the economic decisions of
users and it is provided in time to influence those decisions.

2.6 Reliability

Reliable information can be depended upon to present a faithful representation and is

neutral, error free, complete and prudent.

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2.7 Qualities of reliability
Information is reliable when:
 it can be depended upon by users to represent faithfully what it either purports to
represent or could reasonably be expected to represent
 it is free from deliberate or systematic bias (i.e. it is neutral)
 it is free from material error
 it is complete within the bounds of materiality
 in conditions of uncertainty, a degree of caution (i.e. prudence) has been applied in
exercising judgement and making the necessary estimates.

Expandable text

Faithful representation
If information is to represent faithfully the transactions and other events that it purports to
represent, they must be accounted for and presented in accordance with their substance and
economic reality and not merely their legal form.
Neutrality
Information must be neutral, that is, free from bias. Financial statements are not neutral if, by
the selection or presentation of information, they influence the making of a decision or
judgement in order to achieve a predetermined result or outcome.
Completeness
Information must be complete and free from error within the bounds of materiality. A material
error or an omission can cause the financial statements to be false or misleading and thus
unreliable and deficient in terms of their relevance.
Prudence
Uncertainty surrounds many of the events and circumstances that are reported on in financial
statements. It is dealt with in those statements by disclosing the nature and extent of the
uncertainty involved and by exercising prudence.

Prudence means exercising a degree of caution in making judgements about estimates

required under conditions of uncertainty, such that gains and assets are not
overstated and losses and liabilities are not understated. The existence of assets and
gains requires more confirmatory evidence and greater reliability of measurement than
are required for liabilities and losses.

It is not necessary to exercise prudence where there is no uncertainty. Nor is it appropriate to

use prudence as a reason for, for example, creating hidden reserves or excessive provisions,
deliberately understating assets or gains, or deliberately overstating liabilities or losses. That
would mean that the financial statements are not neutral and, therefore, are not reliable.

REPORTINGCH1ACCAF7INTJCV1 - 13 -
 Test your understanding 3
What is reliable financial information?

Solution
Reliable financial information is information which presents a faithful representation and is
neutral, error free, complete and prudent.

Qualification ACCA
Paper F7 INT
Chapter 1
Content Objective Define the characteristic of
comparability
Content, illustration and
TYU included?
Source (esp. vital) Text 2.5 GBR Ch 1

Qualification ACCA
Paper F7 INT
Chapter 1
Content Objective Discuss the importance of
comparability to users of financial
statements
Content, illustration and TYU 4 – new
TYU included?
Source (esp. vital) Text 2.5 GBR Ch 1 and 2.5 Int Ch 2

2.8 Comparability

Users must be able to:

. compare the financial statements of an entity over time to identify trends in its financial
position and performance
. compare the financial statements of different entities to evaluate their relative financial
performance and financial position.

For this to be the case there must be:

. consistency
. disclosure

REPORTINGCH1ACCAF7INTJCV1 - 14 -
 Expandable text

An important implication of comparability is that users are informed of the accounting policies
employed in preparation of the financial statements, any changes in those policies and the
effects of such changes. Compliance with accounting standards, including the disclosure of
the accounting policies used by the enterprise, helps to achieve comparability.

Because users wish to compare the financial position, performance and changes in financial
position of an enterprise over time, it is important that the financial statements show
corresponding information for the preceding periods.

Test your understanding 4

What is meant by comparability?

Solution
Comparability is the ability to compare financial statements from one accounting period to the
next and to compare the financial statements of different entities.

Expandable text
The following three items outline situations where more of one quality can only be achieved at
a cost. This cost may be an actual cost or may be a reduction in the level of another quality.
Balance between qualitative characteristics

In practice, a balancing, or trade-off, between qualitative characteristics is often

necessary. Generally the aim is to achieve an appropriate balance among the
characteristics in order to meet the objective of financial statements.

Timeliness
If there is undue delay in the reporting of information, it may lose its relevance.

Benefit and cost

The balance between benefit and cost is a pervasive constraint rather than a qualitative
characteristic. The benefits derived from information should exceed the cost of providing it.

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True and fair view/fair presentation
Financial statements are frequently described as giving a true and fair view of, or presenting
fairly, the financial position and performance of an enterprise. Although the Framework does
not deal directly with this concept, the application of the principal qualitative characteristics
and of appropriate accounting standards should in all normal circumstances result in financial
statements that convey what is generally understood as a true and fair view of, or as
presenting fairly, such information.

3 Recognition in the financial statements

Qualification ACCA
Paper F7 INT
Chapter 1
Content Objective Define recognition
Content, illustration and
TYU included?
Source (esp. vital) Text 2.5 INT Ch 2

3.1 Recognition

Recognition is the depiction of an element of the financial statements in words and by a

monetary amount and the inclusion of that amount in the financial statement totals.

3.2 Elements of financial statements

The Framework identifies five elements of financial statements are identified, all of which are
seen to be interrelated:

. assets
. liabilities
. equity interest
. income
. expenses

These elements will be discussed in more detail later in the chapter.

REPORTINGCH1ACCAF7INTJCV1 - 16 -
 Qualification ACCA
Paper F7 INT
Chapter 1
Content Objective Explain the recognition criteria in
financial statements
Content, illustration and
TYU included?
Source (esp. vital) Text 2.5 int Ch 2

3.3 Recognition process

The recognition process has the following stages:

 initial recognition
 subsequent remeasurement,
 derecognition

3.4 Recognition criteria

An item should be recognised in the financial statements if:

 It meets one of the definitions of an element of the financial statements (see below).
 There is sufficient evidence that the change in assets/liabilities inherent in the item has
occurred
 The item can be measured at a monetary amount with sufficient reliability.

Expandable text

General recognition criteria

An item should be recognised in the financial statements if:
 It meets one of the definitions of an element of the financial statements (see above).
 There is sufficient evidence that the change in assets/liabilities inherent in the item has
occurred (including, where appropriate, evidence that a future inflow or outflow of benefit
will occur).
For example, a contract is an enforceable, but as yet unperformed, promise given to or by
an external party to transfer assets and/or liabilities in the future.
These only provide sufficient evidence where there is a ‘firm commitment’, i.e. the contract
can be enforced (either commercially or legally and practically) by an external party
(usually another party to the contract).
 The item can be measured at a monetary amount with sufficient reliability.

For many items an estimate will be necessary. The use of reasonable estimates is a normal
part of the preparation of financial statements. Provided the estimate is reasonably reliable
and prudent it should be recognised.

REPORTINGCH1ACCAF7INTJCV1 - 17 -
A good example of the above is in the recognition of attributable profit on long-term contracts.
Provided a reasonable estimate can be made of the degree of completion and the gain, and
the gain is prudently estimated, then profit is recognised.

The recognition process

Recognition is triggered where a past event indicates that there has been a measurable
change in the assets or liabilities of the entity.

The effect of uncertainty

Remember the trade-off between relevance and reliability described above. Here uncertainty
is countered by evidence. The more and the better the evidence, the less uncertainty over an
item’s existence, nature and measurement and the more reliable the item will be. What
constitutes sufficient evidence is a matter of judgement.

Derecognition
Derecognition is appropriate where a past event has eliminated a previously recognised asset
or liability or where evidence is no longer sufficiently strong to support continued recognition.

4 Elements of the financial statements

4.1 Importance of the elements

Recognition takes place of the elements in the financial statements:

. assets
. liabilities
. equity interest
. income
. expenses

4.2 Assets

Assets are:
. resources controlled by the enterprise
. as a result of past events.
. from which future economic benefits are expected to flow to the enterprise

4.3 Liabilities

REPORTINGCH1ACCAF7INTJCV1 - 18 -
Liabilities are:
. an entity’s obligations
. to transfer economic benefits
. as a result of past transactions or events.

4.4 Equity interest

Equity interest is
. the residual amount found by deducting all liabilities of the entity from all of the entity’s
assets

4.5 Income

Income is:
. increases in economic benefits during the accounting period in the form of inflows or
enhancements of assets or decreases in liabilities:
. that result in increases in equity,
. other than those relating to contributions from equity participants.

4.6 Expenses

Expenses are:
. decreases in economic benefits during the accounting period in the form of outflows or
depletions of assets or incurrences of liabilities,
. that result in decreases in equity,
. other than those relating to distributions to equity participants.

Expandable text
An asset is a resource controlled by the enterprise as a result of past events and from which
future economic benefits are expected to flow to the enterprise.
To explain further the parts of the definition of an asset:
 ‘Controlled by the enterprise’ – Control is the ability to obtain the economic benefits and to
restrict the access of others (e.g. by a company being the sole user of its plant and
machinery, or by selling surplus plant and machinery).

REPORTINGCH1ACCAF7INTJCV1 - 19 -
  ‘
Past events’ – The event must be ‘past’ before an asset can arise. For example, equipment
will only become an asset when there is the right to demand delivery or access to the asset’s
potential. Dependent on the terms of the contract, this may be on acceptance of the order or
on delivery.

‘Future economic benefits’ – These are evidenced by the prospective receipt of cash. This
could be cash itself, a debt receivable or any item which may be sold. Although, for example,
a factory may not be sold (on a going concern basis) it houses the manufacture of goods.
When these goods are sold the economic benefit resulting from the use of the factory is
realised as cash.

Liabilities
Liabilities are an entity’s obligations to transfer economic benefits as a result of past
transactions or events.
To explain further the parts of the definition of a liability:
 ‘Obligations’ – These may be legal or not. For example, the year end tax liability relates to
the year’s (i.e. past) events but in law this liability does not arise until it is assessed some
time later.
 ‘Transfer economic benefits’ – This could be a transfer of cash, or other
property, the provision of a service, or the refraining from activities which
would otherwise be profitable.

 ‘Past transactions or events’ – Similar points are made here to those under assets.
 Complementary nature of assets and liabilities – As should be evident from the above, assets and liabilities are
seen as mirror images of each other. Sometimes they are offset, e.g. a credit
note issued to a customer will be set against his debt rather than being recorded
as a separate liability.

Equity interest
Equity interest is the residual amount found by deducting all liabilities of the entity from all of
the entity’s assets.

The definition describes the residual nature of equity interest. Owners’ wealth can be
increased whether or not a distribution is made. The sharing may be in different proportions.
Equity interest is usually analysed in financial statements to distinguish that arising from
owners’ contributions to that resulting from other events. The latter is split into different
reserves which may have different applications or legal status.

REPORTINGCH1ACCAF7INTJCV1 - 20 -
5 Recognition of assets, liabilities, income and expenses

Qualification ACCA
Paper F7 INT
Chapter 1
Content Objective Apply the recognition criteria to assets
Content, illustration and Illustration – Act 1 GBR test Ch 1
TYU included? TYU 5 and 6– new
Source (esp. vital) Text 2.5 GBR Ch 1

Qualification ACCA
Paper F7 INT
Chapter 1
Content Objective Apply the recognition criteria to
liabilities
Content, illustration and As above
TYU included?
Source (esp. vital) Text 2.5 GBR Ch 1

5.1 Recognition of assets

An asset will only be recognised if:

. it gives rights or other access to future economic benefits controlled by an entity as a
result of past transactions or events, and
. it can be measured with sufficient reliability

5.2 Recognition of liabilities

A liability will only be recognised if:

. there is an obligation to transfer economic benefits as a result of past transactions or
events, and
. it can be measured with sufficient reliability

REPORTINGCH1ACCAF7INTJCV1 - 21 -
 Illustration 1

Below are listed four situations.

1 M has paid $3 million towards the cost of a new hospital in the nearby town, on condition
that the hospital agrees to give priority treatment to its employees if they are injured at
work.
2 N is the freehold legal owner of a waste disposal tip. It has charged customers for the
right to dispose of their waste for many years. The tip is now full, and heavily polluted
with chemicals. If cleaned up, which would cost $8 million, the site of the tip could be
sold for housing purposes for $6 million.
3 P has signed a contract to pay its finance director $300,000 per year for the next five
years. He has agreed to work full time for the firm over that period.
4 Q has paid $25,000 to buy a patent right, giving it the right to sole use, for 8 years, of a
manufacturing method which saves costs.
For each situation, state whether an asset or a liability is created.

Solution

1 The Framework defines an asset as resources controlled by the enterprise as a result of

past events and from which future economic benefits are expected to flow to the
enterprise. M cannot control the actions of the hospital, nor is it certain that there is
access to future economic benefits. Therefore M does not have an asset.
2 N controls the tip as the result of a past transaction, but there does not appear to be any
access to future economic benefits, as the tip cannot be sold in its present state and no
further income can be obtained from it. Therefore the site of the tip is not an asset.
It is possible that N has a liability for the cost of cleaning up the tip. A liability is an
obligation to transfer economic benefits as a result of past transactions or events. In
practice, N may be legally obliged to clean up the tip so that it is no longer in a
dangerous condition. If this were the case, there would be a liability of $8 million and a
corresponding asset for $6 million.
3 At first sight, the contract between P and its finance director may appear to give P a
liability. However, the salary is paid as a result of the director’s work during the next five
years. There is no past event and therefore P cannot have a liability.
4 It is clear that Q has acquired rights to future economic benefits (through cost savings)
through a past transaction (the purchase) and that it controls the benefits (it has sole use
of the method for 8 years). The patent rights are an asset of Q .

Test your understanding 5

Company A has leased and asset from Company B which Company A is to use for the
asset’s entire useful life. The asset would have a cash value of $100,000 is purchased
outright.

Is this an asset of Company A or Company B and why?

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Solution
Company A has access to the future economic benefits from the asset, and has control of the
asset as a result of a past event, the lease transaction. The asset can be measured reliably
therefore the asset should be recorded by Company A.

Test your understanding 6

A company intends to carry out expenditure in the following year of $100,000 in order to
manufacture its products in a different way.

Is this a liability of the company and why?

Solution
The company may have intentions to pay $100,000 but, from the evidence, there is no
obligation to carry out the expenditure and therefore there is no liability.

Qualification ACCA
Paper F7 INT
Chapter 1
Content Objective Apply the recognition criteria income
and expenses
Content, illustration and Illustration – new
TYU included? TYU – new
Source (esp. vital) Text 2.5 INt Ch 2

Qualification ACCA
Paper F7 INT
Chapter 1
Content Objective Discuss what is meant by the balance
sheet approach to recognition
Content, illustration and Illustration – new
TYU included? TYU – new
Source (esp. vital) Text 2.5 INT Ch 2

REPORTINGCH1ACCAF7INTJCV1 - 23 -
 Qualification ACCA
Paper F7 INT
Chapter 1
Content Objective Indicate when income and expense
recognition should occur under the
balance sheet approach
Content, illustration and Illustration – new
TYU included? TYU – new
Source (esp. vital) Text 2.5 INt Ch 2

5.3 Recognition of income

Income is recognised in the income statement when:
. an increase in future economic benefits arises from an increase in an asset (or a
reduction in a liability), and
. can be measured reliably.

5.4 Recognition of expenses

Expenses are recognised in the income statement when:
a decrease in future economic benefits arises from a decrease in an asset or an
increase in a liability, and
. can be measured reliably.

5.5 Balance sheet approach

It can be seen therefore that:

. income is an increase in an asset/decrease in a liability
. expenses are an increase in a liability/decrease in an asset

As income and expenses are therefore recognised on the basis of changes in assets and
liabilities this is known as a balance sheet approach to recognition.

Expandable text

Recognition of gains
Evidence is needed to ascertain whether the gain has been ‘earned’, i.e. an increase in equity
interest/net assets had occurred before the end of the reporting period.
Gains reflected in the income statement are seen as particularly important since the income
statement is used as a primary measure of performance. Hence a gain included here must be
earned and realised.

Realisation is concerned with restricting recognition to those items whose existence

and amount is particularly well evidenced. This will usually mean that conversion into
cash or cash equivalents has occurred or is reasonably assured.

REPORTINGCH1ACCAF7INTJCV1 - 24 -
If a gain fails to meet the tests of being earned and realised, it may still meet the general
recognition criteria. In this case, such a gain should be included in the statement of changes
in equity, e.g. unrealised holding gain on the revaluation of a property held for consumption in
the business (rather than for its investment potential).

The recognition of losses

Evidence is needed to ascertain whether a decrease in equity interest/net assets had
occurred before the end of the reporting period.
Where a loss is not to be recognised, i.e. the expenditure is carried forward to the next period
as an asset under the matching concept, sufficient evidence must exist.

Balance sheet approach

The IASB in its Framework document has adopted a ‘balance sheet approach’ to revenue
recognition, stating that it is the observed movement in net assets that identifies whether a
gain should be recognised. This is somewhat at odds with the transactional approach of IAS
18 (see later) which states that a gain should be recognised when certain stated conditions
are met for the transaction in hand.

Illustration 2

a) A company makes sales on credit of $10,000. What is the justification for treating this
as income?

b) A company makes cash purchases. What is the justification for treating this as an
expense?

Solution

a) There has been an increase in an asset – receivables – therefore treated as

income.
b) There has been a decrease in an asset – cash – therefore treat as an expense

Test your understanding 7

What is meant by the balance sheet approach to recognition of income and expenses?

Solution
Income should be recognised when there is an increase in an asset or decrease in a liability,
Expenses should be recognised when there is an increase in a liability or a decrease in an
asset.

REPORTINGCH1ACCAF7INTJCV1 - 25 -
Chapter Summary
Qualification ACCA
Paper F7 INT
Chapter 1 Fill in these boxes
Template ID CS1
Source

Fill in this box with where the

information came from

CONCEPTUAL
FRAMEWORK Draw graphic here
i.e. diagram,
flowchart picture, etc

THE
FRAMEWORK

OBJECTIVES USERS

QUALITATIVE
CHARACTERISTICS

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 RECOGNITION

ASSETS
INCOME
LIABILITIES EXPENSES

REPORTINGCH1ACCAF7INTJCV1 - 27 -
Checklist – submit with each
chapter
NGLM CHECKLIST Tick
1 Table completed per content objective Done
2 Icons Done
3 Followed blueprint Done
4 Read and followed the house style document Done
5 Content, illustrations, TYUs included Done
6 Legacy material used and referenced, although text Done
must be up to date with current standards.
7 Activities etc. taken from legacy material (please list):
Illustration 1 – GBR text 2.5 Ch 1 Act 1

8 No bullet after heading – begin with some explanatory Done

text
9 Bullets used, max. 9 bullets per heading, 70 words per Done
bullet
10 Any exceptions to rule 9 as per the syllabus Done
11 Expandable text, 500 words max per paragraph Done
12 Main content Arial 10, headings bold 14, subheadings Done
bold 12, correctly numbered with 1, 1.1, 1.2, etc.
13 Diagrams/tables used Done

14 Tables are 15 cm across and rules on text followed

(more info on balance sheets etc., layout in the house
style guide)
15 Varied style for illustrations Done
16 Reviewed pilot Done
17 Chapter overview, summary and checklist completed Done
18 Saved correctly Done

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