CHAPTER 7: CONCEPTUAL FRAMEWORK – Presentation and Disclosure
Concepts of capital
Presentation and disclosure
A reporting entity communicates information about its assets, liabilities, equity, income and expenses by
presenting and disclosing information in the financial statements.
Effective communication of information in financial statements:
a) makes the information more relevant and contributes to a faithful representation of an entity’s
assets, liabilities, income and expenses.
b) enhances the understandability and comparability of information in the financial statements.
c) supported by not duplicating information in different parts of the financial statements.
Classification
Classification is the sorting of assets, liabilities, equity, income and expenses on the basis of shared or
similar characteristics.
Classification of income and expenses
Income and expenses are classified as components of profit and loss and components of other
comprehensive income.
The Revised Conceptual Framework has introduced the term statement of financial performance to refer
to the statement of profit or loss together with the statement presenting other comprehensive income.
The components of other comprehensive income are subsequently recycled or reclassified to profit or
loss or retained earnings.
Aggregation
Aggregation is the adding together of assets, liabilities, equity, income and expenses that have similar or
shared characteristics and are included in the same classification.
Aggregation makes information more useful by summarizing a large volume of detail. However,
aggregation may conceal some of the detail.
Typically, the statement of financial position and the statement of financial position and the statement
of financial performance provide summarized or condensed information. More detailed information is
provided in the notes to financial statements.
Capital Maintenance
The financial performance of an entity is determined using two approaches, namely transaction
approach and capital maintenance approach.
The transaction approach is the traditional preparation of an income statement.
The capital maintenance approach means that net income occurs only after the capital used from the
beginning of the period is maintained.
The distinction between return of capital and return on capital is important to the understanding of net
income.
Shareholders invest in equity to earn a return on capital or an amount in excess of their original
investment. Return of capital is an erosion of the capital invested in the entity.
The Conceptual Framework considered two concepts of capital maintenance or well-offness, namely
financial capital and physical capital.
Financial capital
Under a financial capital concept, such invested money or invested purchasing power, capital is
synonymous with net assets or equity of the entity.
Financial capital is the monetary amount of the net assets contributed by shareholders and the amount
of the increase in net assets resulting from earnings retained by the entity.
Net income under financial capital
Under the financial capital concept, net income occurs “when the nominal amount of the net assets at
the end of the year exceeds the nominal amount of the net assets at the beginning of the period, after
excluding distributions to and contributions by owners during the period.”
Illustration
The following assets, liabilities and other financial data pertain to the current year:
January 1 December 31
Total assets 1,500,000 2,500,000
Total liabilities 1,000,000 1,200,000
Additional investments during the year 400,000
Dividends paid during the year 300,000
Computation of net income
Net assets – December 31 1,300,000
Add: Dividends paid 300,000
Total 1,600,000
Less: Net assets – January 11, 2020 500,000
Additional investments 400,000 900,000
Net income 700,000
Note that the amount of net assets is “the excess of total assets over the total liabilities”.
This is the reason this approach is also known as the net assets approach.
Physical capital
Physical capital is the quantitative measure of the physical productive capacity to produce goods and
services.
The physical productive capacity may be based on, for example, units of output per day or physical
capacity of productive assets to produce goods and services.
This concept requires that productive assets be measured at current cost, rather than historical cost.
Productive assets include inventories and property, plant and equipment. The current cost for these
productive assets must be maintained in order that physical capital is also maintained.
Under this concept, net income occurs “when the physical productive capital of the entity at the end of
the year exceeds the physical productive capital at the beginning of the period, also after excluding
distributions to and contributions from owners during the period.”
Illustration
Assume in the previously given illustration, the net assets of P500,000 on January 1 had a current cost of
P800,000 by reason of inflationary condition.
Net assets – December 31 1,300,000
Add: Dividends paid 300,000
Total 1,600,000
Less: Net assets at current cost, January 11, 2020 800,000
Additional investments 400,000 1,200,000
Net income 400,000
MULTIPLE CHOICE THEORIES
1. The financial capital concept requires that net assets shall be measured at
a. Current cost
b. Historical cost
c. Historical cost adjusted for changes in purchasing power
d. Current cost adjusted for changes in purchasing power
2. The physical capital concept requires the adoption of which measurement basis?
a. Historical cost c. Realizable value
b. Current cost d. Present value
3. Which capital maintenance concept is applied respectively to net income and comprehensive income?
a. Financial capital and Financial capital
b. Physical capital and Physical capital
c. Financial capital and Physical capital
d. Physical capital and Financial capital
4. Which statement regarding the term “profit” is true?
a. Profit is any amount over and above that required to maintain the capital at the beginning of
the period.
b. Profit is the residual amount that remains after expenses have been deducted from income.
c. Profit is the equivalent of net income under IFRS.
d. All of these statements are true about the term profit.
