Chapter 1: Accounting regulation and the conceptual framework Comprehension questions

7. Specify the objectives of general purpose financial reporting, the nature of users and the
information to be provided to users to achieve the objectives as provided in the Conceptual
Framework.
1. Objective of Financial Reporting:
 The main goal of general-purpose financial reporting is to offer helpful financial
information to investors, lenders, and creditors.
 This information assists them in making decisions about investing or lending money
to a company.
2. Nature of Information Provided:
 The provided information focuses strictly on the financial aspects of the company.
 It must be relevant and useful, sticking within the financial realm and not venturing
into other areas like politics or environmental issues.
3. Users and Focus:
 The primary users targeted are investors, lenders, and creditors, both current and
potential.
 While other stakeholders like government, customers, and employees may have an
interest in broader issues, they're not the main focus.
 Despite growing interest in non-financial matters like environmental and social
issues, the framework prioritizes the needs of investors who are assumed to care
about such issues.
9. Outline the fundamental qualitative characteristics of information that is useful to users
of financial statements.
1. Relevance:
 Financial information is relevant if it can influence decisions made by those using it.
 It has predictive value if it helps users predict future outcomes or confirmatory value
if it confirms or changes past expectations.
 Even if users don't end up using the information, its potential to impact decisions
matters.
2. Faithful Representation:
 Information is faithfully represented if it meets three criteria:
 Completeness: It includes all necessary information for users to understand
the topic, with no crucial details left out.
 Neutrality: It is presented without bias, meaning it's not skewed to favor any
particular viewpoint.
 Freedom from error: The information is accurate and free from mistakes or
omissions.
These characteristics ensure that financial information is not only useful but also trustworthy and
reliable for decision-making purposes.

10. Discuss the importance of the going concern assumptions to the practice of accounting.
The going concern assumption means that when financial statements are prepared, it's assumed that
the company will continue operating into the foreseeable future. This is crucial because it allows
accountants to use historical costs for assets and liabilities. For noncurrent assets, like buildings or
machinery, it lets accountants spread their costs over time through depreciation.
This assumption helps in two ways:
1. It emphasizes the use of historical costs over current market values, which may not always be
reliable.
2. It ensures that financial statements aren't based on the idea of the company being liquidated or
forced to sell its assets quickly.
In essence, the going concern assumption helps in presenting a more realistic picture of a company's
financial health by assuming it will continue its operations as usual.

11. Discuss the essential characteristics of an asset as described in the Conceptual

Framework.
An asset is something valuable that a company controls and can use to generate economic benefits.
1. It is a right: This means the company has the right to use the asset and gain benefits from it.
2. It has the potential to produce economic benefits: This doesn't mean the benefits are
guaranteed or even likely. It just means that there's a possibility for the asset to generate
economic gains for the company.
3. It is controlled by the entity: The company has the power to use the asset and receive the
economic benefits it produces.
In summary, an asset is something valuable that a company owns or controls, which has the potential
to generate economic benefits.

12. Discuss the essential characteristics of a liability as described in the Conceptual

Framework.
A liability is something that a company owes or has a duty to fulfill in the future because of a past
event.
1. The entity has an obligation: This means the company has a duty or responsibility to do
something in the future. The company usually can't avoid this obligation.
2. The obligation is to transfer an economic resource: This means the company must give up
something of value in the future, like money or goods.
3. The obligation is a present obligation resulting from past events: This means the
obligation exists now because of something that happened in the past. For example, if a
 company owes wages to employees for work already done, that's a liability because of past
events.
In summary, a liability is a duty or responsibility for a company to give up something of value in the
future, resulting from past events.

13. Discuss the difference, if any, between income, revenue and gains.
1. Income: Income is when a company's assets increase or liabilities decrease, making the
company's equity go up. It can come from various sources like selling goods, receiving
grants, or forgiving debts.
2. Revenue: Revenue is a type of income that comes from the company's regular activities, like
selling products or services. It's the money the company earns from its main business.
3. Gains: Gains are also a type of income, but they come from events outside the company's
regular operations. For example, making money from selling assets like property or stocks.
In short, income is the overall increase in a company's wealth, revenue is money earned from the
company's main business, and gains are extra money made from things like selling assets.
14. Describe the qualitative characteristics of financial information according to the
Conceptual Framework, distinguishing between fundamental and enhancing characteristics.
Fundamental Qualitative Characteristics:
 Relevance: Financial information is relevant if it helps users (like investors) make decisions
and has predictive or confirmatory value, meaning it helps predict future outcomes or
confirms past expectations.
 Faithful Representation: Financial information is faithfully represented if it's complete
(includes all necessary details), neutral (free from bias), and free from errors or omissions.
Enhancing Characteristics:
 Comparability: Financial information is comparable if it can be compared with similar
information from other entities or across different periods, helping users identify similarities
and differences.
 Verifiability: Financial information is verifiable if different independent observers can agree
it's a faithful representation, and it can be verified either directly (by observation) or indirectly
(by checking inputs and recalculating).
 Timeliness: Timely information means it's available when needed, influencing decisions
effectively.
 Understandability: Financial information is understandable if it's presented clearly, making
it easy for users to comprehend.
In summary, fundamental characteristics ensure financial information is relevant and faithfully
represented, while enhancing characteristics make it more useful by enhancing comparability,
verifiability, timeliness, and understandability.
15. Define ‘equity’, and explain why the Conceptual Framework does not prescribe any
recognition criteria for equity.
Definition of Equity:
  Equity is defined as the leftover interest in a company's assets after deducting all its liabilities.
In simple terms, it's what remains when you subtract what the company owes from what it
owns.
Reason for No Recognition Criteria:
 Equity is considered a residual, meaning it's determined after recognizing assets and
liabilities. Since equity is calculated as a result of this subtraction (Equity = Assets -
Liabilities), there's no need for specific criteria for recognizing equity. It's simply what's left
over after all other financial elements are accounted for.

Application and analysis exercises Exercise

1.6 Financial statements

An entity purchases a rental property for $5 000 000 as an investment. The building is fully rented and
is in a good area. At the end of the current year, the entity hires an appraiser who reports that the fair
value of the building is $7 500 000 plus or minus 15%. Depreciating the building over 40 years would
reduce the carrying amount to $4 875 000. 1. What are the relevance and faithful representation
accounting considerations in deciding how to measure the building in the entity’s financial
statements? 2. Does the Conceptual Framework lead to measuring the building at $7 500 000? Or at
$4 875 000? Or at some other amount? (LO5 and LO9)

1. Accounting Considerations: 1.1 Relevance:

 Financial info should be useful for decision-making.
 Important info shouldn't be left out or wrongly stated.
 Info should be given on time when it matters. 1.2 Faithful Representation:
  Financial info should be complete, fair, and mostly error-free.
 Balancing usefulness and accuracy is important.
 Honest addressing of estimations and uncertainties.
2. Application of the Conceptual Framework:
 The property's value affects the company's worth to investors.
 Trusting the appraiser's report while understanding its limitations.
 There's no set rule for measurement, but it should be useful and true to represent the
property's value.

Exercise 1.11
Assessing probabilities in accounting recognition The Conceptual Framework defines an asset as a
present economic resource controlled by the entity as a result of past events. At the same time the
Conceptual Framework establishes that an asset is to be recognised only if it provides information to
the users of the financial statements that is relevant and has faithful representation. Discuss the
recognition criteria of ‘relevance’ and ‘faithful representation’ and provide examples, if any, when an
asset may not be recognised in the financial statements. (LO7 and LO8)

Relevance Criteria:
 Financial info is relevant if it helps users make decisions, either by evaluating past, present, or
future events or by confirming or correcting past evaluations.
 Materiality is a part of relevance, meaning info is important if leaving it out or stating it
incorrectly could affect users' decisions.
 Timeliness is also important for relevance, as info must be provided when it's most likely to
affect decisions.
Faithful Representation Criteria:
 Financial info is accurately represented if it's complete, unbiased, and free from significant
errors, allowing users to trust it.
 Sometimes, there's a balance to be struck between relevance and accuracy, requiring
judgment.
 Estimates and uncertainties can affect accuracy, but these are addressed through disclosure
and cautious decision-making.
Example of Non-Recognition of Assets:
 Internally generated intangible assets may not be recognized as they often lack reliable
valuation methods and may not meet the criteria of relevance and accuracy.
In short, financial info must be relevant and accurately represented. Some assets may not be
recognized if they don't meet these criteria.

Exercise 1.12
Definition of elements Explain how Beachside Ltd should account for the following items/situations,
justifying your answer by reference to the Conceptual Framework’s definitions and recognition
criteria. 1. Receipt of artwork of sentimental value only. 2. Beachside Ltd receives 5 000 shares in
Monty Ltd, trading at $6 each, as a gift from a grateful client. 3. The panoramic view of the coast
from Beachside Ltd’s café windows, which you are convinced attracts customers to the café. 4. The
court has ordered Beachside Ltd to repair the environmental damage it caused to the local river
system. You have no idea how much this repair work will cost. (LO7 and LO8)

1. Receipt of artwork of sentimental value only:

 Not considered an asset as it doesn't meet the definition of an economic resource
controlled by the entity.
 No need to recognize anything since it's not an asset.
2. Receipt of 5,000 shares in Monty Ltd:
 Meets asset definition: economic resource controlled by Beachside Ltd due to future
sales or dividend potential.
 Counts as an asset because it can bring in money through dividends or selling.
 Recognize it because it's relevant and accurately represented.
 3. Café's panoramic view:
 Not an asset as Beachside Ltd doesn't control access to the view.
 Doesn't count as an asset since Beachside Ltd can't control who sees it.
 No need to recognize it since it's not an asset.
 No recognition criteria apply as there's no asset to recognize.
4. Court order to repair environmental damage:
 Meets liability definition: legal obligation to transfer economic resources due to past
event.
 Fails reliable measurement criterion as repair cost is unknown.
 Counts as a liability because it's a legal obligation to pay for repairs.
 Can't recognize it without knowing the repair cost, but if a minimum cost is known,
recognize that amount and disclose potential higher costs.
 If a minimum cost is known, recognition criteria are met for that amount, with
disclosure of potential higher costs.

Exercise 1.13
Definition and recognition criteria Explain how Simpkins Ltd should account for the following items,
justifying your answer by reference to the definitions and recognition criteria in the Conceptual
Framework. Also. state, where appropriate, which ledger accounts should be debited and credited.
Required 1. Photographs of the company’s founders, which are of great sentimental and historical
value. 2. (a) Simpkins Ltd has been sued for negligence — likely it will lose the case. (b) Simpkins
Ltd has been sued for negligence — likely it will win the case. 3. Obsolete machinery now retired
from use. 4. Simpkins Ltd receives a donation of $5 000. (LO7 and LO8)

1. Photographs of the company’s founders:

 Not considered an asset because it doesn't provide future economic benefits.
 No need to recognize anything since it's not an asset.
2. Sued for negligence: a. Likely to lose the case:
 Recognize a liability for at least $20,000. Debit Liability, Credit Expense. b. Likely
to win the case:
 Don't recognize a liability since it's unlikely to pay damages. Disclosure may be
needed.
3. Obsolete machinery:
 No longer an asset as it doesn't provide future economic benefits.
 Write off the machinery from the accounts.
4. Donation received:
  Recognize an asset of $5,000 as it's a cash inflow controlled by the entity. Debit
Cash, Credit Donation Received.
 Also, recognize income of $5,000 since it increases equity. Debit Income, Credit
Equity.

Exercise 1.18
Asset definition and recognition A retail store of Savemart Ltd was broke in and $21 000 was stolen
from night safe. Explain how Savemart should account for this event, justifying your answer by
reference to relevant Conceptual Framework definitions and recognition criteria. (LO7 and LO8)
The theft of $21,000 cash from Savemart Ltd's retail store should be accounted for as follows:
 Expense Definition: The theft qualifies as an expense because it results in a decrease in
assets (cash) during the period, leading to a decrease in equity.
 Recognition Criteria: An expense must be recognized when the decrease in economic
resources (cash) is relevant and can be faithfully represented.
 Satisfaction of Recognition Criteria: The theft meets both recognition criteria as it
represents a decrease in economic benefits related to an asset decrease (cash) and the amount
lost ($21,000) is known.
 Accounting Entry: Recognize an expense (debit) and asset decrease (credit) of $21,000.
Exercise 1.19 Recognition and derecognition The following events occurred in relation to assets and
liabilities recognised by Watson Ltd. (a) Watson Ltd settled (paid) an account payable. (b) Watson
Ltd sold an item of inventory to a customer. (c) Watson Ltd had been using the fair value
measurement base for its plant but estimates of fair value have become unreliable due to changes in
market conditions. (d) A debtor, Holmes Pty Ltd, is facing financial difficulties and has advised that it
might be unable to pay the amount owing to Watson Ltd. Required For each event, state whether it
would be likely to result in derecognition of an asset or liability in accordance with the Conceptual
Framework. Give reasons for your answer. (LO8)
 Event (a): Watson Ltd settled an account payable. This means they paid off a debt. When a
liability (in this case, the accounts payable) is settled, it's removed from the financial
statements. The cash used to settle the liability is also removed from the assets. So, both the
liability and the asset (cash) are derecognized from the financial statements.
 Event (b): Watson Ltd sold an item of inventory to a customer. When inventory is sold, it's
no longer held by the company, so it's removed from the assets. Therefore, the asset
(inventory) is derecognized from the financial statements.
 Event (c): Watson Ltd had been using fair value for its plant, but estimates of fair value have
become unreliable. This event doesn't necessarily lead to derecognition of the asset (plant).
However, if the new fair value of the plant is determined to be $0 due to changes in market
conditions, then the asset would be derecognized. Otherwise, the asset (plant) remains on the
balance sheet, possibly with a different valuation.
 Event (d): A debtor, Holmes Pty Ltd, is facing financial difficulties and may be unable to
pay. In this case, Watson Ltd would likely recognize an allowance for doubtful debts for the
amount owed by Holmes Pty Ltd. However, this doesn't lead to derecognition of the asset
(accounts receivable) unless Watson Ltd determines that it will not be able to collect the
amount owed. If they determine it's unlikely to collect, they would remove the accounts
receivable from the financial statements. Otherwise, the asset remains on the balance sheet,
possibly with an allowance for doubtful debts.