In the last two episodes I have explained some of the different sections of the Conceptual framework. I started from the objectives of financial reporting which is basically to help with informed decision making by the various stakeholders that use it. It was then expanded to the going concern concept, the qualitative characteristics of financial information and definition of the different elements of financial statement.
In this series we would start with the recognition and de-recognition principles as described in the framework. Items are recognized in the financial statements only when they meet the definition as described in the definition of the elements in the financial statement. This serves as the basic criteria for recognition, however items are further subjected to reliability and relevance test. This implies that not all items that meet the definition are recognized because the reliability of how the cost is measured is very important. This buttresses the concept of fundamental characteristics discussed earlier which covered Relevance and Faithful representation. Regardless of an item meeting the definition of the elements, its relevance, reliability of cost estimate and completeness are key considerations for recognition in the financial statements. It is also noteworthy to state that recognition might not provide relevant information if there is uncertainty over the existence of the element or if there is a low probability of an inflow or outflow of economic resources.
De-recognition on the other hand, is the removal of an asset or liability from the statement of financial position which could either be partial or full. De-recognition usually occurs where an entity has lost control of an asset or a liability or an obligation has been extinguished.
There are instances where an entity might have appeared to transfer an asset or liability. However, de-recognition would not be appropriate if exposure to variations in the element’s economic benefits is retained. An example is where an asset is sold for an amount higher than its fair value and the seller has the first right to buy at an amount different from the projected fair value. This implies that control over the asset has not been released to the buyer and the entity still determines the basis of the asset. The asset should not be de-recognized, and any exchange of funds should be treated as a loan.
The next chapter of the Conceptual framework is about the listed Measurement bases, namely 1) Historical cost basis; and 2) Current value (which includes fair value, value in use and current cost). Historical cost is the cost at the time of acquiring and asset of incurring a liability while fair value is the price determined by knowledgeable parties without any encumbrance or constraints. Value in use is the present value of expected cash-flows accruable to an entity or on an asset while the current cost is the replacement cost of an item in the same state.
The Framework opines that when selecting the measurement basis to be adopted, an entity must consider the characteristics of the asset or liability and how the assets contribute to future cash flow patterns. The example below explains this, XYZ purchases a building in Lekki, a prime location. This is an area of Lagos where property prices are increasing steadily. As such, the value of the building is susceptible to market factors, and could substantially differ from the initial purchase price paid by XYZ. If the intention is to hold the building for use then the Historical cost can be adopted although the amount it would be carried at would differ significantly to its market value. However, if the intention is to sell the building in the future, then the fair value can be used as a measurement basis. It must also be noted that using the historical cost in this scenario is not wrong, but we do not think it will allow the financial information to be faithfully represented.
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