ACCA P2 (INT) Corporate Reporting - Study text

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Chapter 1: The financial reporting framework

1.2 The need for regulation

There are several reasons why financial reporting practice should be regulated. The

most obvious one is that without it, an entity would be free to adopt any accounting

treatment that it chose. There are other reasons.

 Persons external to the business are normally dependent on the published

financial statements for information about an entity’s activities. Regulation

ensures that external users of financial statements are provided with information

that is relevant to their decisions and reliable.

 Accounting standards and other forms of regulation help to ensure that entities

adopt similar accounting treatments for similar items and account for similar

transactions in the same way over time. This makes it possible to compare the

financial statements of different entities and to compare an entity’s performance

for the current year with its performance in previous years.

 Without regulation, management would adopt whichever accounting treatment

presented its results and position in the best possible light. Sometimes

management might deliberately mislead users of the financial statements.

1.3 Sources of regulation

The main sources of regulation are:

 accounting standards

 company law

 for listed companies, the listing rules of the relevant Stock Exchange.

Accounting standards are authoritative statements of how particular types of

transactions and events are reflected in the financial statements. In some countries

(for example in the UK) they have legal authority, but in most countries they do not

have the force of law.

Company law varies from country to country, but typically it sets out rules for

determining profits available for distribution, issuing and redeeming share capital,

the reserves that a company must have and the uses to which they can be put. These

matters are not covered in accounting standards.

Listing rules set out the information which entities must supply when their shares

are traded on a major stock market. They must comply with these rules in order to

maintain their listing. These rules include requirements relating to information,

including financial reports, that entities must prepare and provide to the stock

market while they are listed.

1.4 Principles and rules

Company law consists of detailed rules. Accounting standards may be rules-based

or principles-based. IASs and IFRSs are mainly principles based, though some

would argue that in practice they are a mixture of rules and principles.

It is possible for rules and principles to complement each other. Many countries

(including the UK, Canada and Australia) have a regulatory system in which

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company law deals only with a few specific matters. Detailed financial reporting

practice is developed by the accounting profession through accounting standards.

Accounting standards are generally (though not always) principles-based. This

allows reporting practice to develop over time in response to the needs of users and

changes in the business environment. Accounting standards usually allow preparers

to exercise judgement in developing accounting policies that are appropriate to the

circumstances of a particular entity.

In other countries (including most European countries, the USA and Japan), the

content of financial statements and accounting practice are prescribed in great detail

by company law. There is very little scope for individual judgement. Until fairly

recently, accounting standards were almost non-existent. Because the existing

framework is based on detailed rules, users of the financial statements tend to view

principles-based accounting as insufficiently rigorous.

Chapter 1: The financial reporting framework

Constitution and objectives of the IASC Foundation and the IASB

 The IASC Foundation

 Structure of the IASC Foundation

 The International Accounting Standards Board (IASB)

 The International Financial Reporting Interpretations Committee (IFRIC)

 Standards Advisory Council (SAC)

 The influence of IOSCO

 IFRSs and IASs

 National standard setters and the IASB

2 Constitution and objectives of the IASC Foundation

and IASB

2.1 The IASC Foundation

The original International Accounting Standards Committee (IASC) was established

in 1973 to develop international accounting standards. The aim of international

standards is to harmonise accounting procedures throughout the world. The first

International Accounting Standards (IASs) were issued in 1975.

However, international accounting standards cannot be applied in any country

without the approval of the national regulators in that country. Many countries,

including the US and the UK, have continued to develop their own national

accounting standards.

In 2001, the constitution of the IASC was altered, and the Trustees formed the

International Accounting Standards Committee Foundation or IASC Foundation.

The 19 Trustees of the IASC Foundation are responsible for:

 governance of the Foundation and the bodies within it

 fund-raising.

The International Accounting Standards Board (IASB) is the standard-setting body

of the IASC Foundation.

The chairman of the IASB is also the Chief Executive of the IASC Foundation, and is

accountable to the Trustees.

The objectives of the IASC Foundation

The objectives of the IASC Foundation are to:

 develop, in the public interest, a single set of high-quality global accounting

standards

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 promote the use and rigorous application of those standards

 to take account of the special needs of small and medium sized entities and

emerging economies

 to bring about the convergence of national accounting standards and the

international accounting standards.

2.2 Structure of the IASC Foundation

The current structure of the IASC Foundation is as follows:

2.3 The International Accounting Standards Board (IASB)

The IASB is responsible for developing international accounting standards.

The IASB consists of 14 members, all with technical expertise in accounting, who are

appointed by the Trustees. Each IASB member is appointed for a five-year term,

which might be renewed once for a further five years.

Each IASB member has one vote, and approval of eight members is required for the

publication of:

 an exposure draft

 a revised International Accounting Standard (IAS)

 an International Financial Reporting Standard (IFRS)

 a final Interpretation of the International Financial Reporting Interpretations

Committee (IFRIC).

The IASB has full responsibility for all IASB technical matters, including the issue of

IFRSs and revised IASs, and has full discretion over the technical agenda of the

IASB.

Chapter 1: The financial reporting framework

2.4 The International Financial Reporting Interpretations Committee (IFRIC)

The role of IFRIC is to issue rapid guidance where there are differing possible

interpretations of an international accounting standard. Its role is therefore to:

 interpret international accounting standards (IASs and IFRSs)

 issue timely guidance on issues not covered by an IAS or IFRS, within the

context of the IASB Framework

 publish draft Interpretations for public comment. After studying responses to

the draft Interpretation, it will obtain IASB approval for a final (published)

Interpretation.

2.5 Standards Advisory Council (SAC)

The Standards Advisory Council (SAC) provides a forum through which the IASB is

able to gather opinions and advice from different countries and industries. The SAC

consists of experts from different countries and different business sectors, who offer

advice to the IASB.

2.6 The influence of IOSCO

IOSCO is the International Organisation of Securities Commissions. Securities

Commissions are the regulators of the stock markets in their country. The US

Securities and Exchange Commission (SEC) is a key IOSCO member. (The Securities

Commission in the UK is the Financial Services Authority.)

Within each country, the Securities Commission is responsible for the listing rules

that companies must follow if they wish to obtain a listing for their shares. (A listing

is needed before the shares can be traded on a major stock market.) An aim of

IOSCO is to develop international investment, and a view of IOSCO is that

international investment will be encouraged if all major companies use the same

accounting standards for reporting their financial position and performance.

IOSCO has therefore been an influential supporter of the development of

international accounting standards. An IOSCO representative is a non-voting

observer at meetings of the IASB.

In 1995 the IASC agreed with IOSCO to develop a set of core standards. IOSCO also

agreed that if it approved these core standards, it would endorse them as an

acceptable basis of accounting for companies seeking to raise capital and list their

shares in all global stock markets (including the US).

The IASC completed its core standards with the issue of IAS 39 in December 1998.

They were endorsed by IOSCO in 2000. IOSCO has now recommended that its

members (including the SEC) should permit multinational issuers of shares to use

financial statements based on IASs and IFRSs for cross-border share offerings and

listings. (The SEC is one of the few authorities that still does not accept IFRS

financial statements for listing purposes. However, the US Financial Accounting

Standards Board and the IASB are now engaged in a convergence project to create a

single set of accounting standards.)

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In 2004, the European Union (EU) agreed that all listed European companies should

prepare their group financial statements in accordance with IASs and IFRSs, for

periods beginning on or after 1st January 2005.

Companies listed on any stock exchange in the EU must therefore publish accounts

that comply with international accounting standards.

2.7 IFRSs and IASs

When the new Constitution of the IASC Foundation was set up in 2001, the IASB

became the body responsible for:

 developing and publishing accounting standards as IFRSs and

 approving and publishing Interpretations of IFRSs.

Before the new Constitution was established, standards had been published as

International Accounting Standards (IASs) and Interpretations were published as

SIC Interpretations.

The IASB decided that all IASs and SICs that had been issued previously would

continue to be applicable, unless they are subsequently amended or withdrawn.

This means that IASs still in issue have the same status as IFRSs. It is convenient to

refer to IASs and IFRSs as ‘international accounting standards’.

2.8 National standard setters and the IASB

The IASB has no power to enforce its standards. Without the support of at least the

major national standard setters, IFRSs are unlikely to be adopted.

However, there are strong arguments for international convergence. (International

convergence means that the accounting standards of different countries move

towards each other, so that they are increasingly similar.) Most national standard

setters are committed to the principle of international convergence. Over 100

countries have now adopted IFRSs, at least for major companies.

All the major national standard setting bodies are represented on the IASB, so that

they can influence the development of new standards and their views are taken into

account.

All the major national standard setters issue Discussion Papers and Exposure Drafts

in their own countries so that preparers and users in each country can comment on

them. Several national standard setters (including the UK ASB) allow entities to

adopt IFRSs rather than local standards if they choose. Many standard setters are

carrying out short term convergence projects in which domestic standards are

moved closer to IFRSs and IASs.

In addition, the IASB has been working with national standard setters on specific

projects. For example:

Chapter 1: The financial reporting framework

 the IASB and the UK ASB worked together to develop IAS 36 Impairment of assets

and IAS 37 Provisions, contingent liabilities and contingent assets (and the

equivalent UK standards)

 some other recent standards have been developed by a group of national

standard setters and the IASB working together

 the IASB Framework was originally based on work carried out by the US FASB;

the Framework has in turn influenced the UK ASB in developing its own

conceptual framework

 national standard setters sometimes carry out the research for IASB projects. For

example, the Canadian ASB has carried out work on measurement objectives

and have issued a discussion paper on this topic.

The role of the FASB: the USA and IFRSs

The US Financial Accounting Standards Board (FASB) has a special role in

developing new international standards.

The IASB and the FASB are currently working together in the following ways:

 A short-term convergence project aims to reduce differences between certain

IASs and IFRSs and certain US standards. The IASB has issued IFRS 5 Non-

current assets held for sale and discontinued operations as a result of this project.

 Several joint projects are in progress to develop new standards on business

combinations, revenue recognition and performance reporting.

 The two standard setters are jointly developing a new conceptual framework.

This will eventually replace the current IASB Framework.

Even so, US GAAP is much more rules-based than IFRSs, and it has taken time for

US companies to accept a principles-based regulatory system. Many preparers and

users of financial statements outside the USA are concerned about the influence of

the FASB. Their main concern is that future international standards will be suitable

for large listed companies only and will be too rigid and detailed for small and

medium sized entities and those in developing countries.

In August 2008, the Securities and Exchange Commission (the regulator of the US

stock markets) announced a provisional ‘road map’ for the switch by US companies

from US reporting standards to international financial reporting standards. This is

expected to occur in 2014, possibly earlier for some US companies, provided that

certain conditions are met by 2011.

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A conceptual framework for financial reporting

 The meaning of GAAP

 The meaning of a conceptual framework

 The purpose of a conceptual framework

 The alternative to a conceptual framework

3 A conceptual framework for financial reporting

3.1 The meaning of GAAP

The preparation and presentation of financial statements is based on a large number

of concepts, principles and detailed rules. Some of these are contained in law, and

others are in financial reporting standards. Many of the most fundamental concepts

are not contained in any law or regulation or standard, but are simply accepted

accounting principles and conventions.

All the concepts, principles, conventions, laws, rules and regulations that are used

to prepare and present financial statements are known as Generally Accepted

Accounting Principles or GAAP.

‘Generally accepted accounting principles’ vary from country to country, because

each country has its own legal and regulatory system. The way in which businesses

operate also differs from country to country. For example, there is US GAAP and

UK GAAP.

Many countries have now adopted International Financial Reporting Standards or

IFRSs, sometimes called international accounting standards. Although there are no

international laws on financial reporting it is now fairly common to refer to

‘international GAAP’. International GAAP includes the IASB’s conceptual

framework, plus all the international accounting standards, and all the associated

interpretations and guidelines.

3.2 The meaning of a conceptual framework

A conceptual framework is a system of concepts and principles that underpin the

preparation of financial statements. These concepts and principles should be

consistent with one another.

More recently, the term ‘conceptual framework’ has come to mean not only the

principles themselves, but a document or statement that sets out and explains the

concepts and principles that support the preparation of financial statements. A

conceptual framework is developed for a particular regulatory system or a

particular set of ‘generally accepted accounting principles’ or GAAP.

Chapter 1: The financial reporting 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 of financial statements

 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.

3.3 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.

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 standards are developed randomly or

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

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.

3.4 The alternative to a conceptual framework

The alternative to a system based on a conceptual framework 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

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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 its

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

This can be important where management can face legal action if an investor makes

a poor decision based on 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.

ACCA P2 (INT) Corporate Reporting - Study text - 2010 (Emile Woolf)

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