The Conceptual Framework and Accounting Standards WACE Year 12 Accounting and Finance
“Explain the purpose of the Conceptual Framework, the objective of general purpose financial reports, the qualitative characteristics of useful information, and the definitions and recognition criteria for the five elements”
The Conceptual Framework is the set of concepts that underpins general purpose financial reports. Its objective is to give existing and potential investors, lenders and other creditors information useful for decisions. Useful information must be relevant and faithfully represented, and is enhanced by comparability, verifiability, timeliness and understandability. The five elements are assets, liabilities, equity, income and expenses.
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What this dot point is asking
SCSA wants you to explain why the Conceptual Framework exists, state the objective of financial reporting, list and apply the qualitative characteristics, and define and recognise the five elements. You should also know that companies must comply with Australian Accounting Standards Board (AASB) standards and the Corporations Act 2001.
The purpose of the Conceptual Framework
The Conceptual Framework for Financial Reporting is a set of agreed concepts, issued by the AASB, that describes the objective of, and the ideas behind, general purpose financial reports. It guides the AASB in setting standards and helps preparers when no standard applies.
A reporting entity is one where users depend on general purpose financial reports for information because they cannot command reports tailored to their own needs. Public companies listed on the ASX are clear examples.
The objective of general purpose financial reports
The objective is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources. Those decisions include buying or selling shares, providing loans, and voting at meetings.
Qualitative characteristics
The framework splits these into two groups.
Fundamental characteristics (information must have both):
- Relevance: information is capable of making a difference to a decision. It has predictive value, confirmatory value, or both. Materiality is the entity-specific aspect of relevance.
- Faithful representation: information depicts the substance of what it claims to. Ideally it is complete, neutral and free from error.
Enhancing characteristics (these improve usefulness):
- Comparability: users can identify similarities and differences across periods and between entities.
- Verifiability: independent observers could reach consensus that a depiction is faithful.
- Timeliness: information is available in time to influence decisions.
- Understandability: information is classified, characterised and presented clearly.
The benefit of reporting information must justify the cost of providing it. This pervasive cost constraint limits how much detail standards can require.
The five elements
An asset is a present economic resource controlled by the entity as a result of past events. A liability is a present obligation to transfer an economic resource as a result of past events. Equity is the residual interest in the assets after deducting liabilities. Income is increases in assets, or decreases in liabilities, that increase equity (other than contributions from owners). Expenses are decreases in assets, or increases in liabilities, that decrease equity (other than distributions to owners).
Equity is captured by the accounting equation:
An item is recognised in the statements when it meets the definition of an element and recognition provides relevant information and a faithful representation, with benefits exceeding cost.
Standards and the Corporations Act
Companies in Australia must prepare reports that comply with the AASB Accounting Standards and the Corporations Act 2001. Standards translate the broad concepts into specific rules, for example AASB 116 on property, plant and equipment. Note that in WACE Units 3 and 4 you are not required to apply GST.
A business pays $12 000 on 1 July for a 12-month insurance policy. The Conceptual Framework guides how this payment is classified at the date of purchase and then as time passes.
Step 1: Recognise the asset at the date of payment
On 1 July the business controls unused insurance cover for the next 12 months. This satisfies the asset definition: it is a present economic resource (the right to receive insurance services) controlled by the entity as a result of a past event (the payment). The full $12 000 is therefore recognised as the asset Prepaid Insurance, not as an expense, because the economic resource has not yet been consumed.
Step 2: Expense the cover as it is consumed each month
As each month passes, $1 000 of insurance service is used up. The portion of the resource that no longer exists must be derecognised as an asset and recognised instead as Insurance Expense, matching the cost to the period in which the protection is received. This is the accrual basis in action: the expense is recorded when the service is consumed, not when the cash was paid.
Step 3: Verify the reconciliation after three months
After three months, $3 000 of cover has been consumed and recognised as Insurance Expense, leaving $9 000 of prepaid cover still controlled by the business. The two amounts must add back to the original payment as a check:
Final answer: After three months, the asset Prepaid Insurance is $9 000 and Insurance Expense recognised to date is $3 000.
Students often write that information must be relevant or faithfully represented, as if either alone is enough. Both fundamental characteristics are required together. Highly relevant information that cannot be faithfully represented, or a perfectly faithful figure that is irrelevant to decisions, fails the test of usefulness.
Exam-style questions
Questions in the style of SCSA exam questions on this dot point, each with a worked answer. They are written by ExamExplained unless tagged "Past paper"; the year shows the paper a question is modelled on.
WACE 2022-style6 marksExplain the objective of general purpose financial reports and identify the two fundamental qualitative characteristics that information must have to meet that objective. Use an example to show how the two characteristics work together.Show worked answer →
A 6 mark response needs the objective, both fundamental characteristics, and a worked example linking them.
Objective. General purpose financial reports aim to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in deciding whether to provide resources, for example buying shares or extending a loan.
Fundamental characteristics. Information must be both relevant (capable of making a difference to a decision, through predictive or confirmatory value) and faithfully represented (depicting the economic substance completely, neutrally and free from error).
Example. A reported provision for a likely $200,000 legal settlement is relevant because it could change an investor's decision, and it is faithfully represented only if the company recognises a neutral best estimate and discloses the uncertainty rather than ignoring or overstating it. Both are needed: a relevant figure that cannot be faithfully measured, or a faithful figure no one needs, fails the objective. Markers reward the decision-usefulness objective and both characteristics applied together.
WACE 2023-style6 marksDefine an asset and a liability under the Conceptual Framework, and explain the recognition test the Framework now applies to decide whether an item is included in the financial statements.Show worked answer →
A 6 mark response needs both definitions and the usefulness-based recognition test.
Asset. A present economic resource controlled by the entity as a result of past events, where an economic resource is a right with the potential to produce economic benefits.
Liability. A present obligation of the entity to transfer an economic resource as a result of past events.
Recognition. Meeting a definition is necessary but not sufficient. The Framework recognises an item only if recognition provides users with information that is both relevant and a faithful representation. Recognition may be inappropriate where existence is highly uncertain or where any measurement would be so uncertain that the resulting information would not be useful. The older "probable inflow and reliable measurement" thresholds have been replaced by this usefulness test. Markers reward precise definitions resting on control or obligation and a past event, plus the relevance-and-faithful-representation recognition test.