Conceptual Framework for Financial Reporting

FOREWORD AND INTRODUCTION

Foreword

The Hong Kong Institute of Certified Public Accountants (HKICPA) is updating its conceptual framework in phases. As each chapter is finalised, relevant paragraphs from the 1997 Framework for the Preparation and Presentation of Financial Statements are replaced. When complete, HKFRSs will have a single comprehensive document called the Conceptual Framework for Financial Reporting.

This version includes:

• Chapter 1: The objective of financial reporting
• Chapter 3: Qualitative characteristics of useful financial information
• Chapter 2: (To be added - reporting entity concept)
• Chapter 4: Remaining text from the Framework (1997)

Introduction (Carried forward from Framework 1997)

Financial statements are prepared for external users worldwide. Differences exist between countries due to:

• Social, economic and legal circumstances
• Different user needs when setting national requirements
• Varying definitions of elements (assets, liabilities, equity, income, expenses)
• Different recognition criteria and measurement bases

Economic decisions users make include:

(a) When to buy, hold or sell equity investments

(b) Assessing management stewardship/accountability

(c) Assessing entity's ability to pay employees

(d) Assessing security for amounts lent

(e) Determining taxation policies

(f) Determining distributable profits and dividends

(g) Preparing national income statistics

(h) Regulating entity activities

Accounting model: Most commonly based on recoverable historical cost and nominal financial capital maintenance concept. The Framework applies to a range of accounting models.

Purpose and Status of the Conceptual Framework

The Conceptual Framework sets out concepts underlying preparation and presentation of financial statements for external users.

Purposes:

(a) Assist HKICPA Council in developing future HKFRSs and Accounting Guidelines

(b) [Not used]

(c) [Not used]

(d) Assist preparers in applying HKFRSs and dealing with unregulated topics

(e) Assist auditors in forming opinions on HKFRS compliance

(f) Assist users in interpreting financial statements

(g) Inform interested parties about the Council's approach

Important status notes:

• The Framework is NOT a HKFRS or Accounting Guideline
• It does NOT define standards for any particular measurement or disclosure issue
• Nothing in the Framework overrides any specific HKFRS or Accounting Guideline
• In case of conflict, HKFRS/Accounting Guideline requirements prevail
• The Framework will be revised periodically

Scope of the Conceptual Framework

The Framework deals with:

(a) Objective of financial reporting

(b) Qualitative characteristics of useful financial information

(c) Definition, recognition and measurement of elements

(d) Concepts of capital and capital maintenance

CHAPTER 1: THE OBJECTIVE OF GENERAL PURPOSE FINANCIAL REPORTING

Introduction (OB1)

The objective of general purpose financial reporting forms the foundation of the Conceptual Framework. All other aspects flow logically from this objective:

• Reporting entity concept
• Qualitative characteristics and constraints
• Elements of financial statements
• Recognition, measurement, presentation and disclosure

Objective, Usefulness and Limitations (OB2-OB11)

OB2 - Primary Objective:

The objective of general purpose financial reporting 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 to the entity.

Decisions include:

• Buying, selling or holding equity and debt instruments
• Providing or settling loans and other forms of credit

OB3 - Dependence on Returns:

• Investors expect dividends, principal, interest payments or market price increases
• Lenders/creditors expect principal and interest payments
• All depend on assessment of amount, timing and uncertainty of future net cash inflows

OB4 - Information Needed:

To assess future net cash inflow prospects, users need information about:

• Resources of the entity
• Claims against the entity
• How efficiently/effectively management discharged responsibilities
• Management's discharge of responsibilities (protecting resources, ensuring compliance)

OB5 - Primary Users:

Many existing and potential investors, lenders and other creditors cannot require reporting entities to provide information directly to them and must rely on general purpose financial reports. Consequently, they are the primary users to whom general purpose financial reports are directed.

OB6 - Limitations:

General purpose financial reports do NOT and CANNOT provide all information needed. Users must consider:

• General economic conditions and expectations
• Political events and climate
• Industry and company outlooks

OB7 - Value Estimation:

General purpose financial reports are not designed to show the value of a reporting entity; but they provide information to help users estimate the value.

OB8 - Conflicting Needs:

Individual primary users have different, possibly conflicting information needs. The HKICPA seeks to provide the information set meeting the maximum number of primary users' needs.

OB9 - Management's Position:

Management is interested but does NOT need to rely on general purpose financial reports because it can obtain information internally.

OB10 - Other Users:

Regulators and the public may find reports useful, but reports are NOT primarily directed to these groups.

OB11 - Estimates and Judgements:

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.

Information About Economic Resources, Claims, and Changes (OB12-OB21)

OB12 - Two Types of Information:

1. Financial position (economic resources and claims)
2. Effects of transactions/events changing resources and claims

Both provide useful input for decisions about providing resources.

Economic Resources and Claims (OB13-OB14)

OB13 - Usefulness:

Information about nature and amounts helps users identify:

• Financial strengths and weaknesses
• Liquidity and solvency
• Needs for additional financing
• Likelihood of obtaining financing
• How future cash flows will be distributed among claimants

OB14 - Different Types:

• Some future cash flows result directly from existing resources (e.g., accounts receivable)
• Other cash flows result from using several resources in combination
• Users need to know nature and amount of resources available for operations

Changes in Economic Resources and Claims (OB15-OB16)

OB15 - Two Sources of Changes:

1. Financial performance (OB17-OB20)
2. Other events/transactions (e.g., issuing debt/equity instruments - OB21)

Users need to distinguish between both types.

OB16 - Financial Performance Information:

• Helps understand return produced on economic resources
• Indicates how well management discharged responsibilities
• Information about variability and components is important
• Past performance is usually helpful in predicting future returns

Financial Performance Reflected by Accrual Accounting (OB17-OB19)

OB17 - Accrual Accounting:

Accrual accounting 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 past and future performance than cash information alone.

OB18 - Financial Performance Information:

Reflected by changes in economic resources and claims (other than obtaining resources directly from investors/creditors). Indicates:

• Extent entity has increased available economic resources
• Capacity for generating net cash inflows through operations

OB19 - External Events:

Information may indicate how events like changes in market prices or interest rates have affected economic resources and claims.

Financial Performance Reflected by Past Cash Flows (OB20)

OB20 - Cash Flow Information:

Helps users assess ability to generate future net cash inflows. Indicates:

• How entity obtains and spends cash
• Borrowing and repayment of debt
• Cash dividends or other distributions
• Factors affecting liquidity or solvency
• Helps understand operations, evaluate financing/investing activities

Changes Not Resulting from Financial Performance (OB21)

OB21 - Other Changes:

Economic resources and claims may change for reasons other than financial performance, such as issuing additional ownership shares. This information is necessary for a complete understanding of why resources and claims changed and implications for future financial performance.

CHAPTER 2: THE REPORTING ENTITY

[To be added]

CHAPTER 3: QUALITATIVE CHARACTERISTICS OF USEFUL FINANCIAL INFORMATION

Introduction (QC1-QC3)

QC1 - Purpose:

The qualitative characteristics identify the types of information most likely to be useful to existing and potential investors, lenders and other creditors for making decisions about the reporting entity.

QC2 - Information Provided:

Financial reports provide information about:

• Economic resources
• Claims against the reporting entity
• Effects of transactions and other events/conditions that change resources and claims
• Some include explanatory material about management's expectations and strategies

QC3 - Application:

Qualitative characteristics apply to financial information in financial statements and information provided in other ways. Cost is a pervasive constraint. Application may differ for different types of information (e.g., forward-looking vs. historical).

Qualitative Characteristics Overview (QC4)

QC4 - Core Principle:

If financial information is to be useful, it must be relevant and faithfully represents what it purports to represent. The usefulness of financial information is enhanced if it is comparable, verifiable, timely and understandable.

Fundamental Qualitative Characteristics (QC5-QC18)

QC5 - Two Fundamentals:

1. Relevance
2. Faithful representation

Relevance (QC6-QC11)

QC6 - Definition:

Relevant financial information is capable of making a difference in the decisions made by users.

Information may be capable of making a difference even if:

• Some users choose not to take advantage of it
• Users are already aware of it from other sources

QC7 - Components:

Financial information is capable of making a difference if it has:

• Predictive value
• Confirmatory value
• Or both

QC8 - Predictive Value:

Financial information has predictive value if it can be used as an input to processes employed by users to predict future outcomes.

Information need NOT be a prediction or forecast to have predictive value.

QC9 - Confirmatory Value:

Financial information has confirmatory value if it provides feedback about (confirms or changes) previous evaluations.

QC10 - Interrelationship:

Predictive value and confirmatory value are interrelated. Information with predictive value often also has confirmatory value.

Example: Current year revenue information can be used to predict future revenues AND can be compared with previous predictions to improve prediction processes.

QC11 - Materiality:

Information is material if omitting it or misstating it could influence decisions that users make on the basis of financial information about a specific reporting entity.

Key points about materiality:

• It is an entity-specific aspect of relevance
• Based on nature or magnitude (or both) of items
• In the context of an individual entity's financial report
• The Board CANNOT specify a uniform quantitative threshold
• Cannot predetermine what could be material in a particular situation

Faithful Representation (QC12-QC16)

QC12 - Definition:

Financial reports represent economic phenomena in words and numbers. To be useful, financial information must not only represent relevant phenomena, but it must also faithfully represent the phenomena that it purports to represent.

Three characteristics of a perfectly faithful representation:

1. Complete
2. Neutral
3. Free from error

Perfection is seldom, if ever, achievable. The objective is to maximise these qualities to the extent possible.

QC13 - Complete Depiction:

Includes all information necessary for a user to understand the phenomenon being depicted:

• Description of the nature of items
• Numerical depiction
• Description of what the numerical depiction represents (e.g., original cost, adjusted cost, fair value)
• For some items: explanations of significant facts, factors and circumstances, and the process used

QC14 - Neutral Depiction:

A neutral depiction is without bias in the selection or presentation of financial information.

• Not slanted, weighted, emphasised, de-emphasised or manipulated
• Does NOT mean information with no purpose or no influence on behaviour
• Relevant financial information is, by definition, capable of making a difference in users' decisions

QC15 - Free from Error:

Faithful representation does not mean accurate in all respects.

Free from error means:

• No errors or omissions in the description of the phenomenon
• The process used has been selected and applied with no errors

Example: An estimate of an unobservable price or value cannot be determined to be accurate or inaccurate. However, a representation can be faithful if:

• The amount is described clearly and accurately as an estimate
• The nature and limitations of the estimating process are explained
• No errors have been made in selecting and applying an appropriate process

QC16 - Faithful Representation Alone is Not Enough:

A faithful representation by itself does not necessarily result in useful information.

Example 1: Reporting an asset acquired through a government grant at no cost would faithfully represent its cost, but that information would probably not be very useful.

Example 2: An estimate of impairment can be a faithful representation if properly applied, described and explained. However, if uncertainty is sufficiently large, the estimate will not be particularly useful.

Applying the Fundamental Qualitative Characteristics (QC17-QC18)

QC17 - Both Required:

Information must be both relevant and faithfully represented if it is to be useful.

Neither a faithful representation of an irrelevant phenomenon nor an unfaithful representation of a relevant phenomenon helps users make good decisions.

QC18 - Efficient Process:

1. Identify an economic phenomenon with potential to be useful
2. Identify the most relevant type of information about that phenomenon (if available and faithfully representable)
3. Determine whether that information is available and can be faithfully represented
4. If not, repeat with the next most relevant type of information

Enhancing Qualitative Characteristics (QC19-QC34)

QC19 - Four Enhancing Characteristics:

1. Comparability
2. Verifiability
3. Timeliness
4. Understandability

These enhance the usefulness of information that is relevant and faithfully represented. They may also help determine which of two ways should be used to depict a phenomenon if both are equally relevant and faithfully represented.

Comparability (QC20-QC25)

QC20 - Purpose:

Users' decisions involve choosing between alternatives. Information is more useful if it can be compared with:

• Similar information about other entities
• Similar information about the same entity for another period or date

QC21 - Definition:

Comparability is the qualitative characteristic that enables users to identify and understand similarities in, and differences among, items.

Unlike other qualitative characteristics, comparability does NOT relate to a single item. A comparison requires at least two items.

QC22 - Consistency vs. Comparability:

• Consistency: Use of the same methods for the same items (period to period or across entities)
• Comparability: The goal
• Consistency helps achieve comparability

QC23 - Comparability is NOT Uniformity:

For information to be comparable, like things must look alike and different things must look different.

Comparability is NOT enhanced by:

• Making unlike things look alike
• Making like things look different

QC24 - Natural Comparability:

Some degree of comparability is likely to be attained by satisfying the fundamental qualitative characteristics.

QC25 - Alternative Methods:

Although a single economic phenomenon can be faithfully represented in multiple ways, permitting alternative accounting methods for the same economic phenomenon diminishes comparability.

Verifiability (QC26-QC28)

QC26 - Definition:

Verifiability helps assure users that information faithfully represents the economic phenomena it purports to represent.

Verifiability means that different knowledgeable and independent observers could reach consensus (not necessarily complete agreement) that a particular depiction is a faithful representation.

Quantified information need not be a single point estimate to be verifiable. A range of possible amounts and related probabilities can also be verified.

QC27 - Direct vs. Indirect Verification:

QC28 - Forward-looking Information:

It may not be possible to verify some explanations and forward-looking financial information until a future period, if at all. To help users decide whether to use that information, it would normally be necessary to disclose:

• Underlying assumptions
• Methods of compiling the information
• Other factors and circumstances that support the information

Timeliness (QC29)

QC29 - Definition:

Timeliness means having information available to decision-makers in time to be capable of influencing their decisions.

• Generally, the older the information, the less useful it is
• However, some information may continue to be timely long after the end of a reporting period (e.g., for identifying and assessing trends)

Understandability (QC30-QC32)

QC30 - Making Information Understandable:

Classifying, characterising and presenting information clearly and concisely makes it understandable.

QC31 - Complex Phenomena:

Some phenomena are inherently complex and cannot be made easy to understand. Excluding information about those phenomena from financial reports might make the information in those financial reports easier to understand. However, those reports would be incomplete and therefore potentially misleading.

QC32 - User Assumptions:

Financial reports are prepared for users who have a reasonable knowledge of business and economic activities and who review and analyse the information diligently.

Even well-informed and diligent users may sometimes need to seek the aid of an adviser to understand complex economic phenomena.

Applying the Enhancing Characteristics (QC33-QC34)

QC33 - Cannot Override Fundamentals:

The enhancing qualitative characteristics, either individually or as a group, cannot make information useful if that information is irrelevant or not faithfully represented.

QC34 - Iterative Process:

• Applying enhancing characteristics is an iterative process without a prescribed order
• Sometimes one enhancing characteristic may need to be diminished to maximise another
• Example: A temporary reduction in comparability from prospectively applying a new standard may be worthwhile to improve relevance or faithful representation in the longer term
• Appropriate disclosures may partially compensate for non-comparability

The Cost Constraint on Useful Financial Reporting (QC35-QC39)

QC35 - Pervasive Constraint:

Cost is a pervasive constraint on the information that can be provided by financial reporting.

Reporting financial information imposes costs, and it is important that those costs are justified by the benefits.

QC36 - Who Bears Costs:

• Providers expend most of the effort (collecting, processing, verifying, disseminating)
• Users ultimately bear costs in the form of reduced returns
• Users also incur costs of analysing and interpreting information
• If needed information is not provided, users incur additional costs to obtain it elsewhere or estimate it

QC37 - Benefits:

Reporting relevant and faithfully represented information:

• Helps users make decisions with more confidence
• Results in more efficient functioning of capital markets
• Results in lower cost of capital for the economy as a whole
• Individual users receive benefits from more informed decisions

However, general purpose financial reports cannot provide all information every user finds relevant.

QC38 - HKICPA's Application:

In applying the cost constraint, the HKICPA assesses whether the benefits of reporting particular information are likely to justify the costs incurred to provide and use that information.

The HKICPA seeks information from:

• Providers of financial information
• Users
• Auditors
• Academics
• Others

Assessments are based on a combination of quantitative and qualitative information.

QC39 - Subjectivity:

Because of inherent subjectivity, different individuals' assessments of costs and benefits will vary. The HKICPA seeks to consider costs and benefits in relation to financial reporting generally, not just individual reporting entities.

Differences may be appropriate because of:

• Different sizes of entities
• Different ways of raising capital (publicly or privately)
• Different users' needs
• Other factors

CHAPTER 4: THE FRAMEWORK (1997): THE REMAINING TEXT

Underlying Assumption

4.1 - Going Concern:

The financial statements are normally prepared on the assumption that an entity is a going concern and will continue in operation for the foreseeable future.

• Assumes entity has neither the intention nor need to liquidate or curtail materially the scale of operations
• If such intention or need exists, financial statements may need to be prepared on a different basis
• If so, the basis used is disclosed

The Elements of Financial Statements (4.2-4.36)

4.2 - Broad Classes:

Financial statements portray financial effects by grouping transactions and events into broad classes according to their economic characteristics.

Elements directly related to financial position (balance sheet):

• Assets
• Liabilities
• Equity

Elements directly related to performance (income statement):

• Income
• Expenses

4.3 - Sub-classification:

The presentation of elements involves sub-classification (e.g., by nature or function) to display information most useful for economic decisions.

Financial Position (4.4-4.7)

4.4 - Definitions:

(a) An asset is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity.

(b) A liability is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits.

(c) Equity is the residual interest in the assets of the entity after deducting all its liabilities.

4.5 - Definitions vs. Recognition:

The definitions identify essential features but do NOT specify recognition criteria. Items may meet definitions but not be recognised if they fail recognition criteria (probability and reliability - see 4.37-4.53).

4.6 - Substance over Form:

In assessing whether an item meets the definition of an asset, liability or equity, attention needs to be given to its underlying substance and economic reality and not merely its legal form.

Example - Finance Leases:

The substance and economic reality are that the lessee acquires the economic benefits of using the leased asset for most of its useful life in return for an obligation to pay approximately the fair value plus finance charge. Thus, finance leases give rise to items satisfying asset and liability definitions.

4.7 - Current Practice:

Balance sheets drawn up under current HKFRSs may include items that do NOT satisfy the definitions of an asset or liability and are not shown as part of equity. The definitions will underlie future reviews and formulation of further standards.

Assets (4.8-4.14)

4.8 - Future Economic Benefit:

The future economic benefit embodied in an asset is the potential to contribute, directly or indirectly, to the flow of cash and cash equivalents to the entity.

• May be productive (part of operating activities)
• May take the form of convertibility into cash/cash equivalents
• May be a capability to reduce cash outflows

4.9 - Production of Goods/Services:

Entities usually employ assets to produce goods or services that satisfy customer wants/needs, for which customers pay, contributing to cash flow.

4.10 - Ways Benefits May Flow:

An asset may be:

(a) Used singly or in combination with other assets in production

(b) Exchanged for other assets

(c) Used to settle a liability

(d) Distributed to owners

4.11 - Physical Form Not Essential:

Many assets have physical form, but physical form is NOT essential. Patents and copyrights are assets if future economic benefits are expected and controlled.

4.12 - Legal Rights Not Essential:

In determining the existence of an asset, the right of ownership is not essential.

Example: Property held on a lease is an asset if the entity controls the expected benefits. Know-how obtained from development activity may meet the definition of an asset when, by keeping it secret, the entity controls the expected benefits.

4.13 - Past Transactions/Events:

Assets result from past transactions or other past events. Transactions or events expected to occur in the future do NOT in themselves give rise to assets.

Example: An intention to purchase inventory does not, of itself, meet the definition of an asset.

4.14 - Expenditure vs. Assets:

There is a close association between incurring expenditure and generating assets, but they do NOT necessarily coincide.

• Expenditure may provide evidence that future economic benefits were sought but is NOT conclusive proof
• Absence of related expenditure does NOT preclude an item from satisfying the definition of an asset (e.g., donated items)

Liabilities (4.15-4.19)

4.15 - Present Obligation:

An essential characteristic of a liability is that the entity has a present obligation.

An obligation is a duty or responsibility to act or perform in a certain way.

Sources of obligations:

• Legally enforceable (binding contract or statutory requirement) - e.g., amounts payable for goods/services received
• Normal business practice, custom, desire to maintain good business relations or act equitably - e.g., rectifying faults after warranty period

4.16 - Present Obligation vs. Future Commitment:

A distinction needs to be drawn between a present obligation and a future commitment.

• A decision to acquire assets in the future does NOT, of itself, give rise to a present obligation
• An obligation normally arises only when the asset is delivered or the entity enters into an irrevocable agreement

4.17 - Settlement of Present Obligation:

Settlement may occur by:

(a) Payment of cash

(b) Transfer of other assets

(c) Provision of services

(d) Replacement with another obligation

(e) Conversion of the obligation to equity

An obligation may also be extinguished by a creditor waiving or forfeiting its rights.

4.18 - Past Transactions/Events:

Liabilities result from past transactions or other past events.

Examples:

• Acquisition of goods/services gives rise to trade payables
• Receipt of a bank loan results in an obligation to repay
• Future rebates based on annual purchases may be recognised as liabilities (past sales give rise to the liability)

4.19 - Provisions:

Some liabilities can be measured only by using a substantial degree of estimation. Some entities describe these liabilities as provisions.

The definition in 4.4 follows a broader approach. When a provision involves a present obligation and satisfies the rest of the definition, it is a liability even if the amount has to be estimated.

Examples: Provisions for payments under existing warranties, provisions to cover pension obligations.

Equity (4.20-4.23)

4.20 - Sub-classification:

Equity may be sub-classified in the balance sheet. For a corporate entity:

• Funds contributed by shareholders
• Retained earnings
• Reserves representing appropriations of retained earnings
• Reserves representing capital maintenance adjustments

Such classifications are relevant when they indicate legal or other restrictions on the entity's ability to distribute or apply its equity.

4.21 - Creation of Reserves:

• Sometimes required by statute or law to provide added protection from losses
• May be established if tax law grants exemptions/reductions when transfers are made
• Transfers to such reserves are appropriations of retained earnings, NOT expenses

4.22 - Equity Amount:

The amount at which equity is shown depends on the measurement of assets and liabilities. Normally, the aggregate amount of equity only by coincidence corresponds with:

• Aggregate market value of shares
• Sum that could be raised by disposing of net assets piecemeal
• Sum that could be raised by disposing of the entity as a whole on a going concern basis

4.23 - Other Entity Types:

The definition of equity and other aspects dealing with equity are appropriate for sole proprietorships, partnerships, trusts and government business undertakings.

Performance (4.24-4.28)

4.24 - Profit as Measure:

Profit is frequently used as a measure of performance or as the basis for other measures (return on investment, earnings per share). The recognition and measurement of income and expenses depends in part on the concepts of capital and capital maintenance used.

4.25 - Definitions:

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

(b) 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.

4.26 - Definitions vs. Recognition:

The definitions identify essential features but do NOT specify recognition criteria.

4.27 - Presentation:

Income and expenses may be presented in different ways. It is common practice to distinguish between items arising from ordinary activities and those that do not.

Example: Disposal of a long-term investment is unlikely to recur on a regular basis.

4.28 - Different Measures:

Distinguishing and combining items in different ways permits several measures of entity performance:

• Gross margin
• Profit or loss from ordinary activities before taxation
• Profit or loss from ordinary activities after taxation
• Profit or loss

Income (4.29-4.32)

4.29 - Revenue and Gains:

The definition of income encompasses both revenue and gains.

Revenue arises in the course of ordinary activities and includes: sales, fees, interest, dividends, royalties and rent.

4.30 - Gains:

Gains represent other items that meet the definition of income and may or may not arise in the course of ordinary activities. They are no different in nature from revenue and are NOT regarded as a separate element.

4.31 - Types of Gains:

• Gains on disposal of non-current assets
• Unrealised gains (e.g., on revaluation of marketable securities, increases in carrying amount of long-term assets)
• Gains are usually displayed separately and often reported net of related expenses

4.32 - How Income is Received:

Various kinds of assets may be received or enhanced by income: cash, receivables, goods and services received in exchange. Income may also result from the settlement of liabilities.

Expenses (4.33-4.35)

4.33 - Expenses and Losses:

The definition of expenses encompasses losses as well as expenses arising in the course of ordinary activities.

Examples of ordinary expenses: Cost of sales, wages, depreciation. Usually take the form of outflow or depletion of assets.

4.34 - Losses:

Losses represent other items that meet the definition of expenses and may or may not arise in the course of ordinary activities. They are no different in nature from other expenses and are NOT regarded as a separate element.

4.35 - Types of Losses:

• Resulting from disasters (fire, flood)
• Arising on disposal of non-current assets
• Unrealised losses (e.g., from effects of increases in foreign exchange rates on borrowings)
• Usually displayed separately and often reported net of related income

Capital Maintenance Adjustments (4.36)

4.36 - Revaluation/Restatement:

The revaluation or restatement of assets and liabilities gives rise to increases or decreases in equity. While these meet the definition of income and expenses, they are NOT included in the income statement under certain concepts of capital maintenance. Instead, they are included in equity as capital maintenance adjustments or revaluation reserves.

Recognition of the Elements of Financial Statements (4.37-4.53)

4.37 - Definition of Recognition:

Recognition is the process of incorporating in the balance sheet or income statement an item that meets the definition of an element and satisfies the criteria for recognition.

It involves:

• Depiction of the item in words and by a monetary amount
• Inclusion of that amount in the balance sheet or income statement totals

Items that satisfy the recognition criteria SHOULD be recognised. Failure to recognise such items is NOT rectified by disclosure of accounting policies, notes or explanatory material.

4.38 - Recognition Criteria:

An item that meets the definition of an element should be recognised if:

(a) it is probable that any future economic benefit associated with the item will flow to or from the entity; and

(b) the item has a cost or value that can be measured with reliability.

4.39 - Materiality and Interrelationship:

• Regard needs to be given to materiality considerations
• The interrelationship between elements means that recognising one element (e.g., an asset) automatically requires recognition of another element (e.g., income or a liability)

The Probability of Future Economic Benefit (4.40)

4.40 - Probability Concept:

The concept of probability refers to the degree of uncertainty that future economic benefits will flow to or from the entity. Assessments are made on the basis of evidence available when financial statements are prepared.

Example: When it is probable that a receivable will be paid, it is justifiable to recognise it as an asset. For a large population of receivables, some degree of non-payment is normally considered probable, so an expense representing the expected reduction is recognised.

Reliability of Measurement (4.41-4.43)

4.41 - Measurement Reliability:

The second criterion is that the item possesses a cost or value that can be measured with reliability.

• In many cases, cost or value must be estimated
• The use of reasonable estimates is an essential part of preparation and does NOT undermine reliability
• When a reasonable estimate cannot be made, the item is NOT recognised

Example: Expected proceeds from a lawsuit may meet the definitions of an asset and income and the probability criterion, but if it cannot be measured reliably, it should NOT be recognised. The existence of the claim would be disclosed in the notes.

4.42 - Later Recognition:

An item that fails to meet recognition criteria at a particular point in time may qualify for recognition at a later date as a result of subsequent circumstances or events.

4.43 - Disclosure:

An item that possesses the essential characteristics of an element but fails to meet recognition criteria may nonetheless warrant disclosure in the notes, explanatory material or supplementary schedules when knowledge of the item is relevant.

Recognition of Assets (4.44-4.45)

4.44 - Asset Recognition:

An asset is recognised in the balance sheet when it is probable that the future economic benefits will flow to the entity and the asset has a cost or value that can be measured reliably.

4.45 - When NOT to Recognise:

An asset is NOT recognised when expenditure has been incurred for which it is considered improbable that economic benefits will flow beyond the current accounting period. Such a transaction results in recognition of an expense.

Recognition of Liabilities (4.46)

4.46 - Liability Recognition:

A liability is recognised in the balance sheet when it is probable that an outflow of resources embodying economic benefits will result from the settlement of a present obligation and the amount at which the settlement will take place can be measured reliably.

Note: Obligations under contracts that are equally proportionately unperformed (e.g., inventory ordered but not yet received) are generally NOT recognised as liabilities. However, such obligations may meet the definition and recognition criteria in particular circumstances.

Recognition of Income (4.47-4.48)

4.47 - Income Recognition:

Income is recognised in the income statement when an increase in future economic benefits related to an increase in an asset or a decrease of a liability has arisen that can be measured reliably.

Recognition of income occurs simultaneously with recognition of increases in assets or decreases in liabilities.

4.48 - Practical Procedures:

Procedures normally adopted for recognising income (e.g., requirement that revenue should be earned) are applications of the recognition criteria. Such procedures restrict recognition to items that can be measured reliably and have a sufficient degree of certainty.

Recognition of Expenses (4.49-4.53)

4.49 - Expense Recognition:

Expenses are recognised in the income statement when a decrease in future economic benefits related to a decrease in an asset or an increase of a liability has arisen that can be measured reliably.

Recognition of expenses occurs simultaneously with recognition of increases in liabilities or decreases in assets.

4.50 - Matching Concept:

Expenses are recognised on the basis of a direct association between costs incurred and the earning of specific items of income. This is commonly referred to as matching of costs with revenues.

Example: Various components of expense making up cost of goods sold are recognised at the same time as income from the sale of goods.

Important: The application of matching does NOT allow recognition of items in the balance sheet which do NOT meet the definition of assets or liabilities.

4.51 - Systematic Allocation:

When economic benefits are expected to arise over several accounting periods and association with income can only be broadly or indirectly determined, expenses are recognised on the basis of systematic and rational allocation procedures.

Examples: Depreciation of property, plant and equipment; amortisation of goodwill, patents and trademarks.

4.52 - Immediate Recognition:

An expense is recognised immediately in the income statement when an expenditure produces no future economic benefits or when, and to the extent that, future economic benefits do not qualify, or cease to qualify, for recognition in the balance sheet as an asset.

4.53 - Liability Without Asset:

An expense is also recognised when a liability is incurred without the recognition of an asset (e.g., a liability under a product warranty).

Measurement of the Elements of Financial Statements (4.54-4.56)

4.54 - Definition of Measurement:

Measurement is the process of determining the monetary amounts at which the elements of the financial statements are to be recognised and carried in the balance sheet and income statement.

This involves the selection of the particular basis of measurement.

4.55 - Measurement Bases:

4.56 - Most Common Basis:

The measurement basis most commonly adopted by entities in preparing their financial statements is historical cost.

Historical cost is usually combined with other measurement bases:

• Inventories: lower of cost and net realisable value
• Marketable securities: may be carried at market value
• Pension liabilities: carried at present value

Concepts of Capital and Capital Maintenance (4.57-4.65)

Concepts of Capital (4.57-4.58)

4.57 - Two Concepts:

4.58 - Selection:

The selection of the appropriate concept should be based on the needs of users:

• Financial concept: If users are primarily concerned with maintenance of nominal invested capital or purchasing power of invested capital
• Physical concept: If users' main concern is with the operating capability of the entity

Concepts of Capital Maintenance and Determination of Profit (4.59-4.65)

4.59 - Two Concepts of Capital Maintenance:

(a) Financial capital maintenance: A profit is earned only if the financial (or money) amount of net assets at the end of the period exceeds the financial amount of net assets at the beginning of the period, after excluding distributions to and contributions from owners.

Can be measured in:

• Nominal monetary units
• Units of constant purchasing power

(b) Physical capital maintenance: A profit is earned only if the physical productive capacity (or operating capability) at the end of the period exceeds the physical productive capacity at the beginning of the period, after excluding distributions to and contributions from owners.

4.60 - Linkage:

The concept of capital maintenance provides the linkage between concepts of capital and concepts of profit. It is a prerequisite for distinguishing between:

• Return on capital (profit)
• Return of capital

Only inflows of assets in excess of amounts needed to maintain capital may be regarded as profit.

4.61 - Measurement Basis Requirements:

• Physical capital maintenance: Requires the current cost basis of measurement
• Financial capital maintenance: Does NOT require a particular basis; selection depends on the type of financial capital being maintained

4.62 - Principal Difference:

The principal difference between the two concepts of capital maintenance is the treatment of the effects of changes in the prices of assets and liabilities of the entity.

4.63 - Financial Capital Maintenance - Nominal Monetary Units:

• Profit represents the increase in nominal money capital over the period
• Holding gains (increases in prices of assets held) are conceptually profits
• They may NOT be recognised until assets are disposed of in an exchange transaction

Financial Capital Maintenance - Constant Purchasing Power Units:

• Profit represents the increase in invested purchasing power over the period
• Only the part of price increases that exceeds the increase in the general level of prices is regarded as profit
• The rest is treated as a capital maintenance adjustment (part of equity)

4.64 - Physical Capital Maintenance:

• Profit represents the increase in physical productive capacity over the period
• All price changes affecting assets and liabilities are viewed as changes in the measurement of physical productive capacity
• They are treated as capital maintenance adjustments (part of equity), NOT as profit

4.65 - Selection of Accounting Model:

The selection of the measurement bases and concept of capital maintenance will determine the accounting model used in the preparation of the financial statements.

Different accounting models exhibit different degrees of relevance and reliability. Management must seek a balance between relevance and reliability.

The Framework is applicable to a range of accounting models. At present, the HKICPA does NOT intend to prescribe a particular model except in exceptional circumstances (e.g., entities reporting in the currency of a hyperinflationary economy).

APPENDIX: COMPARISON OF HK CONCEPTUAL FRAMEWORK WITH IASB CONCEPTUAL FRAMEWORK

Significant Differences

BASIS FOR CONCLUSIONS ON CHAPTER 1

Key Points from Basis for Conclusions

BC1.3-BC1.7 - General Purpose Financial Reporting:

• The Framework establishes an objective of financial reporting (not just financial statements)
• Financial statements are a central part of financial reporting
• General purpose financial reports are still the most efficient and effective way to meet information needs of a variety of users

BC1.8 - Reporting Entity:

• Financial reports should reflect separation between the entity and its owners
• Account for the entity (and its economic resources and claims) rather than primary users and their interests

BC1.9-BC1.23 - Primary Users:

• Primary users are existing and potential investors, lenders and other creditors who cannot require reporting entities to provide information directly
• Regulators and the public are NOT primary users
• Reasons for focusing on this group:

1. They have the most critical and immediate need for information
2. The Board's responsibilities require focus on capital market participants
3. Information meeting their needs is likely to meet needs of users in different governance models

BC1.19 - Management's Needs:

• Some information directed to primary users may meet some of management's needs
• But management has access to additional financial information
• General purpose financial reporting need NOT be explicitly directed to management

BC1.20-BC1.23 - Regulators' Needs:

• The Board acknowledged that interests of investors, lenders and creditors often overlap with regulators
• However, expanding the objective to include maintaining financial stability could create conflicts
• The Board concluded that eliminating the existing objective would be inconsistent with its basic mission

BC1.24-BC1.30 - Usefulness for Making Decisions:

• The objective focuses on providing information useful in making economic decisions
• Also helpful in assessing management's stewardship
• The Board decided NOT to use the term "stewardship" due to translation difficulties
• The objective is the same for all entities, though cost constraints and differences in activities may lead to different reporting requirements

BC1.31-BC1.35 - Financial Performance and Position:

• The Board concluded it would be inappropriate to designate one type of information as the primary focus
• Financial reports must provide information about economic resources and claims AND changes during a period
• The Board rejected directing the statement of financial position towards the needs of a particular subset of users

BASIS FOR CONCLUSIONS ON CHAPTER 3

Key Points from Basis for Conclusions

BC3.4-BC3.7 - Objective and Qualitative Characteristics:

• Alternatives exist for all aspects of financial reporting
• The Board will choose the alternative that goes furthest towards achieving the objective
• Chapter 3 describes the first step in making judgements needed to apply the objective

BC3.8-BC3.10 - Fundamental vs. Enhancing:

• The distinction is NOT arbitrary
• Information without the two fundamental characteristics (relevance and faithful representation) is NOT useful
• It cannot be made useful by being more comparable, verifiable, timely or understandable

BC3.11-BC3.18 - Relevance:

• The definition focuses on capability of making a difference (not whether it actually makes a difference)
• Predictive value and confirmatory value are interrelated
• Materiality is an entity-specific aspect of relevance
• The Board CANNOT specify a uniform quantitative threshold for materiality

BC3.19-BC3.31 - Faithful Representation:

• The term "reliability" was replaced because it did not clearly convey the intended meaning
• Different people understood reliability differently (some focused on verifiability, others on faithful representation, others on precision)
• "Faithful representation" more clearly conveys the intended meaning
• Substance over form is NOT a separate component (it would be redundant)
• Prudence/conservatism is NOT included because including either would be inconsistent with neutrality

BC3.32-BC3.43 - Enhancing Characteristics:

• Comparability: enables users to identify and understand similarities and differences
• Verifiability: different knowledgeable and independent observers could reach consensus
• Timeliness: information available in time to influence decisions
• Understandability: prepared for users with reasonable knowledge who analyse diligently

BC3.44-BC3.46 - Characteristics Not Included:

• Certain characteristics considered but not included as separate qualitative characteristics

BC3.47-BC3.48 - Cost Constraint:

• Cost is a pervasive constraint
• The Board assesses whether benefits justify costs
• Assessments are based on quantitative and qualitative information

BASIS FOR CONCLUSIONS ON CHAPTER 4

Background

Chapter 4 contains the remaining text from the 1997 *Framework for the Preparation and Presentation of Financial Statements* that has not yet been replaced by the IASB's revised Conceptual Framework chapters. The HKICPA retained this text to ensure continuity while the IASB completes its phased revision. The following summarises the conceptual reasoning underlying the key provisions of Chapter 4.

Underlying Assumption — Going Concern (4.1)

The going concern assumption is fundamental because financial statements prepared on a liquidation basis would use entirely different measurement bases and presentation. The assumption that an entity will continue in operation for the foreseeable future allows assets to be measured at recoverable historical cost rather than forced-sale values, and allows liabilities to be classified as current/non-current based on expected settlement rather than immediate demand. The HKICPA retained this assumption unchanged because it aligns with the IASB's view and is universally accepted in financial reporting.

Elements of Financial Statements (4.2-4.36)

The 1997 Framework defined five elements — assets, liabilities, equity, income, and expenses — using definitions based on *expected future economic benefits*. These definitions served as the foundation for HKFRS development for over two decades. The IASB subsequently revised the asset and liability definitions in its 2018 Conceptual Framework to focus on *rights* and *obligations* rather than expected flows. However, the HKICPA retained the 1997 definitions in Chapter 4 because:

• The revised IASB definitions apply prospectively to new standards developed under the revised Framework
• Existing HKFRS standards (HKAS 16, HKAS 37, HKAS 38, HKFRS 3, etc.) were built on the 1997 definitions
• Changing element definitions retroactively would create inconsistency between the Framework and existing standards until those standards are revised
• The 1997 definitions remain conceptually sound for understanding the principles underlying current HKFRS

Recognition Criteria (4.37-4.53)

The 1997 Framework established two recognition criteria: (a) probability of future economic benefit, and (b) reliable measurement. These criteria are deliberately conservative — they ensure that only items with sufficient certainty enter the financial statements. The IASB's 2018 Framework removed probability as a standalone criterion and integrated it into the definitions themselves. The HKICPA retained the 1997 criteria because:

• The probability threshold provides a practical filter that prevents recognition of highly uncertain items
• Reliable measurement remains essential — if an item cannot be measured with sufficient reliability, it should be disclosed in notes rather than recognised
• The two-criterion approach is well-understood by preparers and auditors in Hong Kong
• Current HKFRS standards were designed with these criteria in mind

Measurement Bases (4.54-4.56)

The 1997 Framework acknowledged multiple measurement bases — historical cost, current cost, realisable value, and present value — without prescribing a single basis. This reflects the reality that different measurement bases serve different purposes:

• Historical cost provides verifiability and is the most commonly used basis
• Current cost and realisable value provide more relevant information when prices change significantly
• Present value captures the time value of money for long-term items

The HKICPA retained this discussion because HKFRS already employs a mixed measurement model (e.g., historical cost for PP&E under HKAS 16, fair value for investment property under HKAS 40, present value for provisions under HKAS 37). The Framework's role is to explain *why* different bases are used, not to mandate a single approach.

Concepts of Capital and Capital Maintenance (4.57-4.65)

The distinction between financial capital maintenance and physical capital maintenance addresses a fundamental question: what does "profit" mean? Under financial capital maintenance, profit is the increase in nominal (or constant purchasing power) financial capital after excluding distributions to and contributions from owners. Under physical capital maintenance, profit is the increase in physical productive capacity.

Most entities adopt the financial capital maintenance concept because:

• It aligns with the proprietary view of the entity (focus on owners' wealth)
• It is simpler to apply — nominal dollars are used
• It is the basis for current HKFRS

Physical capital maintenance is conceptually relevant for entities whose value lies in operating capability (e.g., manufacturing, extractive industries), but measurement difficulties (how to quantify "physical productive capacity") have limited its adoption in practice. The HKICPA retained both concepts because some jurisdictions and industries continue to explore physical capital maintenance, and the Framework should accommodate different accounting models.

Retention Status

The HKICPA expects to replace Chapter 4 when the IASB completes its review of the remaining Framework topics, or when the Council determines that the revised definitions should be adopted for HKFRS purposes. Until then, Chapter 4 continues to provide useful guidance for: (a) understanding the conceptual basis of existing HKFRS, (b) developing accounting policies when no specific standard applies (HKAS 8 hierarchy), and (c) informing the Council's deliberations on future standards.

KEY TAKEAWAYS SUMMARY TABLE

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