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

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Chapter 1: The conceptual framework

Accounting policies

 Definition

 The selection and application of accounting policies

 Consistency of accounting policies

 Changes in accounting policies

4 Accounting policies

4.1 Definition

Accounting policies are defined (in IAS8) as the ‘specific principles, bases,

conventions, rules and practices applied by an entity in preparing and presenting

financial statements’.

4.2 The selection and application of accounting policies

The selection and application of accounting policies is covered by IAS8: Accounting

policies, changes in accounting estimates and errors. IAS8 includes requirements

for the selection and application of accounting policies:

 When an item (for example, a transaction) is covered by an accounting standard,

or by an Interpretation of a standard, the accounting policy applied to the item

should comply with the requirements of the Standard or Interpretation.

 When an item is not covered by an accounting standard, or by an Interpretation

of a Standard, management should use judgement in selecting the accounting

policy to apply.

The IASB Framework is not itself an accounting standard. If there is a conflict

between an accounting standard (or an Interpretation) and the Framework,

management must follow the accounting standard.

When judgement is used to select an accounting policy, the financial information

resulting from the application of the accounting policy must be:

 relevant to the economic decision-making needs of the users of the financial

statements, and

 reliable.

In making a judgement about the selection of an accounting policy, management

should refer to the following, in descending order of priority, and consider whether

they are applicable:

 the requirements of accounting standards or guidance from Interpretations that

deal with similar and related issues

 definitions, recognition criteria and measurement concepts for assets, liabilities,

income and expenses in the IASB Framework.

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4.3 Consistency of accounting policies

An entity should select and apply its accounting policies consistently for similar

transactions, events or conditions, unless an accounting standard requires or

permits:

 some items to be categorised separately, and

 a different accounting policy to be applied to this category.

4.4 Changes in accounting policies

A change in accounting policy is permitted only under either of two circumstances

(IAS8):

 if a change in policy is required by an accounting standard or Interpretation, or

 if a change in accounting policy will result in reliable and more relevant financial

information.

Accounting policies and comparability

In order to be able to compare the financial statements of different entities and the

financial statements of the same entity over time, users need information about the

accounting policies used by an entity. They also need information about any

changes to accounting policies and the effects of those changes.

Frequent changes of accounting policies do not improve the information provided

to users (and are effectively prohibited by IAS8). However, an entity should not

continue to use the same accounting policy for the sake of comparability if there is

an alternative that would produce more relevant or more reliable information.

Chapter 1: The conceptual framework

The elements of financial statements

 Assets

 Liabilities

 Equity

 Income

 Expenses

5 The elements of financial statements

The IASB Framework discusses the five elements of financial statements:

 for reporting financial position: assets, liabilities and equity

 for reporting financial performance: income and expenses.

5.1 Assets

An asset is defined as:

 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.

Resource controlled by the entity

Control is the ability to obtain economic benefits from the asset, and to restrict the

ability of others to obtain the same benefits from the same item.

An entity usually uses assets to produce goods or services to meet the needs of its

customers, and because customers are willing to pay for the goods and services, this

contributes to the cash flow of the entity. Cash itself is an asset because of its

command over other resources.

Many assets have a physical form, but this is not an essential requirement for the

existence of an asset.

The result of past events

Assets result from past transactions or other past events. An asset is not created by

any transaction that is expected to occur in the future but has not yet happened. For

example, an intention to buy inventory does not create an asset.

Expected future economic benefits

An asset should be expected to provide future economic benefits to the entity.

Providing future economic benefits can be defined as contributing, directly or

indirectly, to the flow of cash (and cash equivalents) into the entity.

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5.2 Liabilities

A liability is defined as:

 a present obligation of an entity

 arising from past events

 the settlement of which is expected to result in an outflow of resources that

embody economic benefits.

Present obligation

A liability is an obligation that already exists. An obligation may be legally

enforceable as a result of a binding contract or a statutory requirement, such as a

legal obligation to pay a supplier for goods purchased.

Obligations may also arise from normal business practice, or a desire to maintain

good customer relations or the desire to act in a fair way. For example, an entity

might undertake to rectify faulty goods for customers, even if these are now outside

their warranty period. This undertaking creates an obligation, even though it is not

legally enforceable by the customers of the entity.

Past transactions or events

A liability arises out of a past transaction or event. For example, a trade payable

arises out of the past purchase of goods or services, and an obligation to repay a

bank loan arises out of past borrowing.

Future outflow of economic resources

The settlement of a liability should result in an outflow of resources that embody

economic benefits. This usually involves the payment of cash or transfer of other

assets. A liability is measured by the value of these resources that will be paid or

transferred.

Some liabilities can be measured only with a substantial amount of estimation.

These may be called provisions.

5.3 Equity

Equity is the residual interest in an entity after the value of all its liabilities has been

deducted from the value of all its assets. It is a ‘balance sheet value’ of the entity’s

net assets. It does not represent in any way the market value of the equity.

Equity may be sub-classified in the balance sheet, for example, into share capital,

retained profits and other reserves that represent capital maintenance adjustments.

5.4 Income

Financial performance is measured by profit or loss. Profit is measured as income

less expenses.

Chapter 1: The conceptual framework

Income includes both revenue and gains.

 Revenue is income arising in the course of the ordinary activities of the entity. It

includes sales revenue, fee income, royalties income, rental income and income

from investments (interest and dividends).

 Gains include gains on the disposal of non-current assets. Realised gains are

often reported in the financial statements net of related expenses. They might

arise in the normal course of business activities. Gains might also be unrealised.

Unrealised gains occur whenever an asset is revalued upwards, but is not

disposed of. For example, an unrealised gain occurs when marketable securities

owned by the entity are revalued upwards.

5.5 Expenses

Expenses include:

 Expenses arising in the normal course of activities, such as the cost of sales and

other operating costs, including depreciation of non-current assets. Expenses

result in the outflow of assets (such as cash or finished goods inventory) or the

depletion of assets (for example, the depreciation of non-current assets).

 Losses include for example, the loss on disposal of a non-current asset, and

losses arising from damage due to fire or flooding. Losses are usually reported

as net of related income.

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Fair presentation

 What is meant by fair presentation (or a true and fair view)

 Fair presentation and compliance with IFRSs

 Where fair presentation conflicts with an accounting standard

6 Fair presentation

6.1 What is meant by fair presentation (or a true and fair view)

Financial statements are often described as showing a ‘true and fair view’ or

‘presenting fairly’ the financial position and performance of an entity, and changes

in its financial position. In some countries (for example, the UK) this is the central

requirement of financial reporting.

Under ‘international GAAP’ (specifically IAS1) financial statements are required to

present fairly the financial position, financial performance and cash flows of the

entity.

The IASB Framework does not deal directly with this issue. However, it does state

that if an entity complies with international accounting standards, and if its financial

information has the desirable qualitative characteristics of information, then its

financial statements ‘should convey what is generally understood as a true and fair

view of such information’.

IAS1 states that: ‘Fair presentation requires the faithful representation of the effects

of transactions, other events and conditions in accordance with the definitions and

recognition criteria for assets, liabilities, income and expenses set out in the

Framework.’

The use of the term ‘faithful representation’ means more than that the amounts in

the financial statements should be materially correct. It implies that information

should present clearly the transactions and other events that it is intended to

represent. 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.

Faithful representation also implies that the amounts in the financial statements

should be classified and presented and disclosures made in such a way that

important information is not obscured and users are not misled.

6.2 Fair presentation and compliance with IFRSs

The application of IFRSs, with additional disclosure when necessary, is presumed to

result in financial statements that achieve a fair presentation. IAS1 states that:

Chapter 1: The conceptual framework

 When the financial statements of an entity comply fully with International

Financial Reporting Standards, this fact should be disclosed.

 An entity should not claim to comply with IFRSs unless it complies with all the

requirements of every applicable Standard.

IAS1 appears to equate fair presentation with compliance with accounting

standards.

In some situations fair presentation may require more than this. It is important to

apply the spirit (or general intention) behind an accounting standard as well as the

strict letter (what the standard actually says).

The requirement to ‘present fairly’ also applies to transactions which are not

covered by any specific accounting standard. It is worth noting that there is no IFRS

that covers complex transactions and arrangements which have been deliberately

structured so that their economic substance is different from their legal form.

IAS 1 states that a fair presentation requires an entity:

 to select and apply accounting policies in accordance with IAS8 Accounting

policies, changes in accounting estimates and errors. IAS8 explains how an

entity should develop an appropriate accounting policy where there is no

standard.

 to present information in a manner that provides relevant, reliable, comparable

and understandable information

 to provide additional disclosures where these are necessary to enable users to

understand the impact of particular transactions and other events on the entity’s

financial performance and financial position (even where these are not required

by IFRSs).

6.3 Where fair presentation conflicts with an accounting standard

IAS1 acknowledges that in extremely rare circumstances compliance with a

standard or an Interpretation may produce financial statements that are so

misleading that they do not provide useful information and no longer give a fair

presentation.

An entity can then depart from the requirements of the standard or interpretation. It

must disclose:

 that management has concluded that the financial statements present fairly the

entity’s financial position, financial performance and cash flows;

 that it has complied with applicable standards and interpretations, except that it

has departed from a particular requirement to achieve a fair presentation;

 the title of the standard or interpretation from which the entity has departed, the

nature of the departure, including the treatment that the standard or

interpretation would require, the reason why that treatment would be

misleading, and the treatment adopted; and

Paper F7: Financial reporting (International)

 for each period presented, the financial impact of the departure on each item in

the financial statements that would have been reported in complying with the

requirement.

Paper F7 (INT)

Financial reporting

CHAPTER

Recognition and

measurement

Contents

1 Accounting concepts

2 Recognition in the financial statements: IASB

Framework

3 IAS18: Revenue

4 Alternatives to historical cost accounting

Paper F7: Financial reporting (International)

Accounting concepts

 Consistency of presentation

 Materiality and aggregation

 Offsetting

1 Accounting concepts

In addition to the accounting concepts in the IASB Framework, some other

accounting concepts are used in financial reporting. These concepts, together with

the underlying assumptions of going concern and accruals, are explained in IAS 1:

Presentation of financial statements.

1.1 Consistency of presentation

Consistency of presentation is needed if financial information is to be comparable.

IAS1 states that there should be consistency in the presentation and classification of

items in the financial statements from one year to the next. There are just two

exceptions to the requirement for consistency:

 Consistency is not required when it is apparent, following a significant change in

the entity’s operations or a review of its financial statements, that a different

presentation or classification would be more appropriate.

 Consistency is not appropriate if a new accounting standard (or the issue of an

Interpretation of a standard by IFRIC) requires a change in the presentation of

information.

1.2 Materiality and aggregation

IAS1 also states that each material class of similar items should be presented

separately in the financial statements.

In addition, items of a dissimilar nature should not be aggregated together in the

financial statements (combined as a single item and in a single total), unless their

value is immaterial.

1.3 Offsetting

IAS1 states that:

 Assets and liabilities should not be offset against each other.

 Similarly income and expenses should not be offset against each other.

Instead they should be reported separately.

The exceptions to this rule are when:

 offsetting is required or permitted by an accounting standard or the

Interpretation of a standard

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

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