ACCA strategic business reporting study text

Kaplan Publishing Limited, all other Kaplan group companies, the International Accounting Standards Board, and the IFRS Foundation expressly disclaim all liability to any person in resp

ACCA

Strategic Business

Reporting

Study Text

ii

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ISBN: 978-1-78415-823-1

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Chapter 7 Foreign currency in individual financial

Chapter 11 Events after the reporting period, provisions and

Chapter 23 Current issues 589

iv KAPLAN PUBLISHING

Frameworks

Chapter learning objectives

Upon completion of this chapter you will be able to:

• Discuss the importance of a conceptual framework in underpinning the production of accounting standards

• Discuss the objectives of financial reporting including disclosure

of information that can be used to help assess management’s stewardship of the entity’s resources and the limitations of financial reporting

• Discuss the nature of the qualitative characteristics of useful financial information

• Explain the roles of prudence and substance over form in financial reporting

• Discuss the high level measurement uncertainty that can make financial information less relevant

• Evaluate the decisions made by management on recognition, derecognition and measurement

• Critically discuss and apply the definitions of the elements of financial statements

• Discuss and apply the definitions of ‘fair value’ measurement and ‘active market'

• Discuss and apply the ‘fair value hierarchy’

• Discuss and apply the principles of highest and best use, most advantageous and principal market

• Explain the circumstances where an entity may use a valuation technique

1

1 Conceptual Framework for Financial Reporting

Introduction: the need for a conceptual framework

A conceptual framework is a set of theoretical principles and concepts that underlie the preparation and presentation of financial statements

If no conceptual framework existed, then it is more likely that accounting standards would be produced on a haphazard basis as particular issues and circumstances arose These accounting standards might be

inconsistent with one another, or perhaps even contradictory

A strong conceptual framework therefore means that there is a set of principles in place from which all future accounting standards draw It also acts as a reference point for the preparers of financial statements if there is

no adequate accounting standard governing the types of transactions that

an entity enters into (this will be extremely rare)

This section of the text considers the contents of the Conceptual Framework for Financial Reporting ('the Framework') in more detail

Background

In 1989 the Board issued the Framework for the Preparation and Presentation of Financial Statements

In 2004 a decision was made to work with the US FASB in order to develop

a common framework The first phase concentrated on two areas:

The Board issued the Conceptual Framework for Financial Reporting in

2010 This was the original 1989 version updated for the two areas above The joint project with the FASB was then suspended

• The objectives of financial reporting

• The qualitative characteristics of useful financial information

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In 2012 the Board decided to revisit the Framework, although this time

without the US FASB It decided to focus on the following areas:

A Discussion Paper outlining the Board’s thinking on these areas was

published in 2013 The Board received extensive feedback, highlighting the

importance of the Framework to the users and preparers of financial

statements However, this feedback was varied Some suggested that the

discussion paper was under-developed; others suggested that it was too

detailed Devising a Framework that satisfies all parties will most likely

prove impossible

In response to feedback the Board published an Exposure Draft in 2015

This is discussed in the ‘Current Issues’ chapter of this Study Text

The purpose of the Framework

The purpose of the Framework is:

The Board believes that consistency within IFRS Standards, and

comparability between different sets of accounting standards, will help

investors to make informed decisions about whether to buy, sell or hold an

entity's equity and debt instruments

• elements of financial statements

• reporting entity

• presentation and disclosure

(a) to assist the International Accounting Standards Board (the Board)

when developing new standards

(b) to help national standard setters develop new standards

(c) to provide guidance on issues not covered by IFRS Standards

(d) to assist auditors

The objective of financial reporting

The Framework says that the objective of financial reporting is to provide information to existing and potential investors, lenders and other creditors which helps them when making decisions about providing resources to the reporting entity

Qualitative characteristics of useful financial information

The Framework identifies types of information that are useful to the users of financial statements

It identifies two fundamental qualitative characteristics of useful financial information:

Information is relevant if it will impact decisions made by its users

– Relevant information has predictive value or confirmatory value to

a user– Relevance is supported by materiality considerations:

– Information is regarded as material if its omission or misstatement could influence the decisions made by users of that information

– An omission or mis-statement could be material due to its size or nature

– Materiality is an entity-specific consideration and so the Framework does not specify a minimum threshold

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For financial information to be faithfully presented, it must be:

Therefore, it must comprise information necessary for a proper

understanding, it must be without bias or manipulation and clearly

described

In addition to the two fundamental qualitative characteristics, there are four

enhancing qualitative characteristics of useful financial information These

should be maximised when possible:

Information is more useful if it can be compared with similar information

about other entities, or even the same entity over different time periods

Consistency of presentation helps to achieve comparability of financial

information Permitting different accounting treatments for similar items

is likely to reduce comparability

The Framework explains that verifiability means 'that different,

knowledgeable and independent observers could reach

consensus, although not necessarily complete agreement, that a

particular presentation of an item or items is a faithful

representation' (Framework, para QC26)

Verifiability of financial information provides assurance to users

regarding its credibility and reliability

Information should be made available to users within a timescale which

is likely to influence their decisions Older information is less useful

Information should be presented clearly and concisely

The cost constraint

It is important that the costs incurred in reporting financial information are justified by the benefits that the information brings to its users

The elements of financial statements

The financial effects of a transaction can be grouped into broad classes, known as the elements

According to the Framework, there are five elements of financial statements: Assets – resources controlled by an entity from a past event that will lead to

a probable inflow of economic benefits

Liabilities – obligations of an entity arising from a past event that will lead to

a probable outflow of economic resources

Equity – the residual net assets of an entity after deducting its liabilities Incomes – increases in economic benefits during the accounting period Expenses – decreases in economic benefits during the accounting period

Criticisms of the definitions of the elements

The following criticisms could be made of these definitions:

• The definitions are inconsistently applied across the range of IFRS and IAS Standards

• The concept of ‘control’ is not clearly defined and proves difficult to apply

• There is a lack of guidance about the meaning of an ‘economic resource’

• The notion of ‘expectation’ is vague Does it refer to the probability of

an inflow/outflow or to a mathematical ‘expected value’?

• The definitions offer insufficient guidance on the difference between liabilities and equity Further guidance here would benefit users, particularly when applying these concepts to financial instruments

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Recognition of the elements of financial statements

The Framework says that an item should be recognised in the financial

statements if:

Measurement of the elements of financial statements

Measurement is the process of determining the amount at which the

elements should be recognised and carried at in the statement of financial

position and the statement of profit or loss and other comprehensive

income

The Framework identifies four possible measurement bases:

Historical cost

Assets are recorded at the amount paid to acquire them

Liabilities are recorded at the value of the proceeds received, or at the

amount expected to be paid to satisfy the liability

Current cost

Assets are carried at their current purchase price

Liabilities are carried at the amount currently required to settle them

Liabilities are carried at the present value of the future cash outflows

required to settle them

• it meets the definition of an element

• it is probable that future economic benefits will flow to or from the entity

• the item can be measured reliably

The Board removed prudence from the Framework because they thought it was inconsistent with neutrality This is because reducing assets in one period is likely to lead to the over-statement of financial performance in the next period

The Board are considering reintroducing an explicit reference to prudence into the Framework

Criticisms of financial reporting

The Framework relates to financial reporting However, the very nature of financial reporting has become increasingly criticised in recent years This has led to the emergence of forms of non-financial reporting, which are discussed later in this text

Some of the criticisms of financial reporting are discussed below

Historical information The statement of profit or loss shows the performance of the entity over the past reporting period This offers little insight into the future Moreover by the time financial statements are published, the information presented will be several months out of date

Unrecognised assets and liabilities Some assets and liabilities are not recognised in financial statements prepared using IFRS Standards, such as internally generated goodwill This means that no asset is recognised in respect of the company’s reputation or employee skills even though these may play a pivotal role in its success Clutter

Financial reports have been criticised in recent years for becoming increasingly cluttered as a result of extensive disclosure requirements

These disclosures can be very generic and they make harder for the users

to find relevant information

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Financial/non-financial information

Current and past profits and cash flows are not the only determinate of future

success Long-term success is also dependent on how an entity is

governed, the risks to which it is exposed and how well these are managed,

and whether its business activities are sustainable into the medium and

long-term Financial statements prepared in accordance with IFRS

Standards say little about these areas

Estimates

Financial reporting uses many estimates (e.g depreciation rates)

Estimates are subjective and could be manipulated in order to achieve

particular profit targets The subjective nature of estimates reduces

comparability between companies

The statement of cash flows somewhat compensates for the impact of

accounting estimates However, the cash position of an entity can also be

window-dressed (such as by delaying payments to suppliers)

Professional judgement

Financial reporting requires judgement For example, judgement is required

by lessors when classifying a lease as a finance lease or an operating

lease Subjective decisions reduce comparability and increase the risk of

bias

Use of historical cost

Some accounting standards, such as IAS 16 Property, Plant and

Equipment, permit assets to be measured at historical cost In times of

rising prices, the statement of profit or loss will not show a sustainable level

of profit

Policy choices

Some standards, such as IAS 16 Property, Plant and Equipment and IAS 40

Investment Properties, allow entities to choose between cost and fair value

models This makes it harder to investors to compare financial statements

on a like-for-like basis