ACCA F7 (INT) Financial Reporting - Study text - 2010

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Chapter 1: The conceptual framework

The International Accounting Standards Board (IASB) has developed a conceptual

framework document called the Framework for the Preparation and Presentation

of Financial Statements.

The IASB Framework covers the following topics:

 The objective of financial statements

 Underlying assumptions

 Qualitative characteristics of financial statements

 The elements of financial statements

 Recognition of the elements of financial statements

 Measurement of the elements of financial statements

 Concepts of capital and capital maintenance.

1.3 The purpose of a conceptual framework

Most preparers and users of financial statements recognise that there is a need for a

formal conceptual framework and that this can be useful in a number of ways. The

IASB has stated that the purpose of its Framework for the Preparation and

Presentation of Financial Statements is to:

 assist the IASB with the development of new international accounting standards

 assist national standard-setting bodies to develop accounting standards for their

own country

 provide guidance for the preparation of financial statements, both in applying

accounting standards and in dealing with items that are not the subject of any

accounting standard

 help auditors to form an opinion on whether a set of financial statements

complies with international accounting standards

 assist users in understanding financial statements that have been prepared in

accordance with international accounting standards

 provide those who are interested in the work of the IASB with information about

its approach to creating accounting standards.

Where there is a formal conceptual framework for accounting, accounting practice

and accounting standards are based on this framework.

Lack of a formal framework often means that accounting standards are developed

randomly or only to deal with particular problems. The result is that standards

might be inconsistent with each other or with legislation.

Lack of a conceptual framework may also mean that accounting standards fail to

address important issues. For example, until the IASB developed its Framework,

there was no proper definition of terms such as ‘asset’, ‘liability’, ‘income’ and

‘expenses’.

The business environment is becoming increasingly complex. It is unlikely that

accounting standards can cover all possible transactions. Where an entity enters into

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an unusual transaction and there is no relevant accounting standard, it can refer to

the Framework and apply the principles in it.

It can also be argued that a conceptual framework strengthens the credibility of

financial reporting and the accounting profession in general.

1.4 The alternative to a conceptual framework

The alternative to a system based on a conceptual framework (a ‘principles-based’

system) is a system based on detailed rules.

Accounting standards based on detailed rules are open to abuse. ‘Creative

accounting’ is the name given to techniques which enable management to give a

biased impression (usually favourable) of the company’s performance while still

complying with accounting standards and other regulations. During the 1980s there

were a number of scandals in which investors were misled by the financial

statements of apparently healthy companies which then collapsed. This was one of

the original reasons why the IASB and other standard setters developed their

conceptual frameworks. Principles are normally much harder to evade than rules.

Another disadvantage of a rule-based system is that standard setters are more likely

to be influenced by ‘vested interests’ such as large companies or a particular

business sector. The existence of a conceptual framework is an important safeguard

against this kind of political pressure.

Despite these problems, some preparers and regulators still appear to favour rule-

based standards. Standards based on principles may require management to use

their judgement (and to risk making a mistake), while rules simply need to be

followed. This can be important where management might face legal action if an

investor makes a poor decision based on information provided in the financial

statements.

The use of a conceptual framework can lead to standards that are theoretical and

complex. They may give the ‘right answer’ but be very difficult for the ordinary

preparer to understand and apply. However, a system of extremely detailed rules

can also be very difficult to apply.

1.5 The current situation

In theory, international accounting standards and international financial reporting

standards (IASs and IFRSs) are based on the IASB Framework. In practice, the

standards are a mixture of principles and rules.

Many standards (for example, the main accounting standards dealing with non-

current assets) reflect the fundamental principles in the Framework and are

consistent with each other. However, many of the more recent standards (for

example, the standards on financial instruments) have been heavily influenced by

US accounting practice. These standards are complex and tend to contain many

detailed rules and definitions.

Chapter 1: The conceptual framework

Financial statements: objectives and assumptions

 Users and their information needs

 Objectives of financial statements

 Predictive and confirmatory roles of financial information

 Underlying assumptions in the Framework

2 Financial statements: objectives and assumptions

2.1 Users and their information needs

The users of financial statements include present and future investors, employees,

lenders, suppliers, customers, government and government agencies and the

general public.

 Investors and their advisers need information to help them determine whether

they should buy, hold or sell investments. They are interested in the risk

attaching to their investments and the return provided by them, including the

ability of the entity to pay dividends.

 Employees need information which helps them to assess the ability of their

employers to provide remuneration, retirement benefits and employment

opportunities. They are also interested in information about the stability and

profitability of their employers.

 Lenders need information that enables them to determine whether their loans

and the related interest will be paid when due.

 Suppliers and other trade creditors need information that enables them to

determine whether amounts owing to them will be paid when due.

 Customers are interested in information about the ability of an entity to continue

to trade especially when their own business depends on trade with the entity.

 Governments and their agencies are need information that helps them to

regulate the activities of entities, to allocate resources and to determine taxation

policies.

 Members of the public may be interested in an entity for a number of reasons.

An entity may be a major employer in the locality or a major customer of local

suppliers. Financial statements may provide information about the entity’s

activities and recent developments in its prosperity.

The Framework states that: ‘While all of the information needs of these users cannot

be met by financial statements, there are needs which are common to all users. As

investors are providers of risk capital to the entity, the provision of financial

statements that meet their needs will also meet most of the needs of other users that

financial statements can satisfy’.

Investors and potential investors are assumed to be the most important users of the

financial statements and therefore accounting standards are developed to meet their

information needs.

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2.2 Objectives of financial statements

The IASB Framework states that the objectives of financial statements are to provide

users with information about:

 the financial position of the entity

 the financial performance of the entity

 changes in its financial position.

Users need this information to evaluate the ability of the entity to generate cash, and

the timing and certainty of this cash generation. This ability to generate cash

determines whether the entity will be able, for example, to pay its employees and

suppliers, pay interest and repay loans and pay dividends to its shareholders.

Financial reporting is a means by which the directors are made accountable to the

shareholders for:

 the way they have managed the company, and

 the financial results they have achieved.

Financial statements show the results of the stewardship of the assets and resources

of the entity.

Clearly, it is therefore essential that financial statements should be meaningful and

accurate, so that the shareholders can make a proper assessment.

Financial position

The financial position of an entity is affected by:

 the economic resources that it owns or controls

 its financial structure

 its liquidity and solvency

 its capacity to adapt to the changing environment in which it operates.

Information about the economic resources an entity controls, and its ability in the

past to modify these resources, is useful in predicting the ability of the entity to

generate cash in the future.

Information about financial structure (the ‘mix’ of debt and equity capital) is useful

for predicting the future borrowing needs of an entity, and the way in which its

future income will be distributed between lenders and shareholders.

Information about liquidity and solvency is useful in predicting the ability of an entity

to meet all its financial commitments in the future when they fall due for payment.

Financial performance

Information about financial performance, and in particular profitability, is useful for:

 assessing future profitability

Chapter 1: The conceptual framework

 assessing potential changes in the resources that an entity might have (‘control’)

in the future

 making a judgement about how effectively an entity would make use of any

additional resources that it obtains.

Changes in financial position

Information about changes in financial position is useful for assessing:

 the investing, financing and operating activities of an entity during the reporting

period

 its ability to generate cash and

 its need for cash.

Objectives of financial statements: summary

The objectives of financial statements are met by:

 the main financial statements (statement of financial position, income statement,

statement of comprehensive income, statement of cash flows, statement of

changes in equity) and

 supporting notes to the financial statements, which provide additional details.

2.3 Predictive and confirmatory roles of financial information

Financial information can serve two different roles for its users.

 A predictive role. Financial information can be used to predict what might

happen in the future, based on what has happened in the past.

 A confirmatory role. Financial information can be used to confirm whether past

predictions made by the user were correct.

2.4 Underlying assumptions in the Framework

There are two underlying assumptions on which the IASB Framework is based:

 accrual basis

 going concern basis.

Financial statements are prepared on the ‘accrual basis’ of accounting. This means

that the effect of transactions and other events are recognised in the financial

statements in the period when they occur and not in the period when the cash flows

relating to those transactions occur.

The accrual basis of accounting should be familiar to you from your earlier studies.

Accruals, prepayments and depreciation charges, for example, are all examples of

the application of the ‘accruals concept’.

The going concern basis of accounting is the assumption in preparing the financial

statements that the entity will continue to operate for the foreseeable future, and

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does not intend to go into liquidation and will not be forced into liquidation. The

going concern assumption is particularly relevant for the valuation of assets.

Chapter 1: The conceptual framework

Qualitative characteristics of financial statements

 Understandability

 Relevance

 Reliability

 Comparability

 Constraints on relevant and reliable information

3 Qualitative characteristics of financial statements

The IASB Framework states that qualitative characteristics of information in the

financial statements are the attributes that make the information useful to users.

There are four main qualitative characteristics of financial information:

 understandability

 relevance

 reliability

 comparability.

3.1 Understandability

Information in financial statements must be readily understandable to users.

Users are assumed to have a reasonable knowledge of business activities and

accounting. It is also assumed that they are willing to study information with

‘reasonable diligence’.

3.2 Relevance

Information must be relevant to the decision-making needs of users. Information is

relevant if it can be used for predictive or confirmatory purposes.

 It has predictive value if it helps users to predict what might happen in the

future.

 It has confirmatory value if it helps users to confirm the assessments and

predictions they have made in the past.

Relevant information should not be excluded from the financial statements simply

because it is too complex or may be too difficult for some users to understand.

The relevance of information is affected by:

 its nature and

 its materiality.

Materiality provides a threshold or cut-off point, and information is not relevant if it is

immaterial (= not material). Information for financial statements is material if its omission

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or misstatement could influence the economic decisions of users of the financial

statements.

3.3 Reliability

Information must be reliable. Information is reliable when:

 it is free from material error or bias, and

 the information provides a faithful representation of what it is supposed to

represent.

To be reliable, information must have the following qualities:

 faithful representation

 substance over form

 neutrality

 prudence

 completeness.

Faithful representation

Information should represent faithfully the transactions and other events that it is

intended to represent. The IASB Framework identifies internal goodwill as an item

that is difficult to identify or measure reliably. Internal goodwill is goodwill that a

business entity has created from its own efforts and activities. Internal goodwill has

a value. However with any estimated valuation of internal goodwill, there would be

a strong risk that the estimate would not be a faithful representation of its true

value.

This is why internal goodwill is excluded from the statement of financial position. In

other cases, it may be relevant to recognise an item in the financial statements, but

with a note provided to explain the risk of error in its recognition or measurement.

Substance over form

To provide a faithful representation, financial information must account for

transactions and other events in a way that reflects their substance and economic

reality (in other words, their true commercial impact) rather than their legal form.

If there is a difference between economic substance and legal form, the financial

information should represent the economic substance. An example of presenting

substance over form is the method used to account for finance leases, described in a

later chapter.

Neutrality

To be reliable, financial information should be neutral. Neutral means ‘free from

bias’.

Chapter 1: The conceptual framework

Prudence

Prudence is the inclusion of a degree of caution in exercising judgements in

conditions of uncertainty. In other words, prudence means using caution when

putting a value to an asset, liability or an item of income or expense. The purpose of

prudence is to:

 avoid overstating the value of assets or the amount of income, or

 avoid under-stating the amount of a liability or the amount of an expense.

Exercising prudence does not mean that the entity should create ‘hidden reserves’

by deliberately under-stating asset values or income.

An example of exercising prudence is making a reasonable allowance for doubtful

debts when giving a valuation to trade receivables in the statement of financial

position.

Completeness

To be reliable, financial information should also be complete. However, there are

some limitations on the need for completeness.

 Materiality – There is no need to obtain complete information if the missing

information is immaterial.

 Cost – Information should not be 100% complete if the extra cost of making it

complete exceeds the benefits obtained by having it complete. In other words,

the benefits from having complete information should not exceed the costs of

obtaining it.

3.4 Comparability

Financial information must be comparable. It should be comparable over time, so

that the information in the financial statements for one year can be compared with

previous years. The financial information for one business entity should also be

comparable with the information in the financial statements of other business

entities.

 Users must be able to compare the financial statements of an entity over time in

order to identify trends in its financial position or financial performance.

 Users must be able to compare the financial statements of different business

entities, in order to assess their relative financial position and financial

performance.

Consistency

To be comparable, financial statements should be prepared in a consistent way from

one year to the next.

Financial statements for any year should also show corresponding figures for the

previous financial year, to help users in making comparisons. This is a specific

requirement of IAS1 Presentation of Financial Statements.

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3.5 Constraints on relevant and reliable information

The IASB Framework identifies two constraints on the provision of relevant and

reliable information.

 Timeliness. If there is undue delay in reporting financial information, it might

lose its relevance. However, information produced quickly might be inaccurate

and so unreliable. There has to be a balance between timeliness (in order to

provide relevant information) and the need for reliability.

 Cost and benefits. The benefits obtained from financial information should

exceed the cost of obtaining and providing it. Information should not be

provided if the cost is not worth the benefit.

Since it is difficult to measure the benefits of financial information, the setters of

accounting standards must use their judgement in deciding whether certain items of

information should be provided in the financial statements (and if so, in how much

detail).

ACCA F7 (INT) Financial Reporting - Study text - 2010 - Emile Woolf Publishing

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