Concepts – Evolution of a Global Conceptual Framework Chapter 10 Concepts – Evolution of a Global Conceptual Framework

Objectives By the end of the chapter, you should be able to: discuss how financial accounting standards have evolved discuss the accounting principles set out in the International Framework the UK Statement of Principles FASB Statements of Financial Accounting Concepts comment critically on rule-based and principles-based approaches.

Development of standards Numerous accounting standards produced by: International – IASB European – EU Directives National standard setters – FASB in USA; ASB in UK. Early standards aimed at consistency to protect the auditors Aim to achieve consistency in the treatment of major items eg. IAS 2 Inventories), and were seen as a mechanism to avoid conflicting rules and practices. Developed in answer to existing problems Later standards aimed at transparency for investors Emphasis on provision of information useful for making economic decisions Reliability of information only apparent if management changes.

The evolution of financial accounting standards Financial accounting practices are dynamic responses to changing political, fiscal, economic and commercial conditions. There are a variety of accounting treatments for similar transactions. If annual financial reports are to be useful for making economic decisions, there is a need for uniformity and consistency. The growth in global commerce has lead to a need for uniform global standards

Conceptual framework The framework does not create standards. It aims to assist: standard setters to develop standards on a rational basis preparers with a principles basis for decisions where there are no standards auditors who can refer to the Framework principles, and stakeholders when interpreting the financial statements.

Framework content Objectives of General Purpose Financial Reports (GPFRs) Qualitative characteristics of information Assumptions underlying preparation of financial statements Influences on preparation of statements Definition, recognition and measurement of accounting elements

Concepts of Accounting

Concepts Statements The FASB was the first to create a conceptual framework with the issue of a series of Concepts Statements as a basis for financial accounting and reporting standards. Other countries followed this lead with Concepts Statements of their own. With the advent of the global economy the IASB Conceptual Framework has become the accepted framework by those countries that have adopted IFRSs and IASs and is similar in many respects to the FASB Concepts Statements

FASB concepts statements The FASB series of Concepts Statements include: Statement No. 1 : Objectives of Financial Reporting by Business Enterprises Statement No. 2 : Qualitative Characteristics of Accounting Information Statement No. 6 : Elements of Financial Statements Statement No. 5 : Recognition and Measurement in Financial Statements of Business Enterprises.

Concepts statement no. 1 : Objectives of financial reporting by business enterprises Financial reporting should provide information to present and potential investors and creditors that is: understandable by a user who has a reasonable knowledge of business activities; and useful in making rational investment and credit decisions based on an assessment of the amounts, timing and uncertainty of prospective net cash inflows, that is, is there enough cash to pay creditors on time, cover capital expenditure and pay dividends?

Concepts statement no. 1 : Objectives of financial reporting by business enterprises (Continued) Financial reporting should provide information about resources and claims A statement of financial position Financial reporting should provide information about and reason for changes A cash flow statement and a statement of financial performance These statements allow users to check movements in operating capital and financing, see how cash has been spent and assess solvency, liquidity and profitability.

Concepts statement no. 6 : Elements of financial statements The IASB Framework defines 5 elements: Assets Liabilities Equity Revenue Expenses The FASB elements: Investments by owners Distributions to owners Comprehensive income are part of the IASB’s Equity element Gains Losses are parts of the IASB’s Revenue and Expense elements

Concepts statement no. 6 : Elements of financial statements This statement defines ten elements, including seven that appear in the Statement of Principles: Assets – probable future economic benefits obtained or controlled as a result of past transactions or events. Liabilities – probable future sacrifices of economic benefits arising from present obligations to transfer assets or provide services to other entities in the future as a result of past transactions or events. Equity – the residual interest in the assets of an entity that remains after deducting its liabilities. In a business enterprise, the equity is the ownership interest. Investments by owners – increases in equity. Assets are most commonly received as investments by owners but it might also include services or taking on liabilities of the enterprise.

Concepts statement no. 6 : Elements of financial statements (Continued) Distributions to owners – decreases in equity resulting from transferring assets, rendering services or incurring liabilities by the enterprise to owners. Gains – increases in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity except those that result from revenues or investments by owners. Losses – decreases in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and events and circumstances affecting the entity, except those that result from expenses or distributions to owners.

Concepts statement no. 6 : Elements of financial statements (Continued) The Statement also defines three additional elements: Comprehensive income – includes all changes in equity during a period except those resulting from investments by owners and distributions to owners. Revenues – inflows or other enhancements of assets of an entity or settlements of its liabilities (or a combination of both) from delivering or producing goods, rendering services or other activities that constitute the entity’s ongoing major or central operations. Expenses – outflows or other using up of assets or incurring liabilities (or a combination of both) from delivering or producing goods, rendering services or carrying out other activities that constitute the entity’s ongoing major or central operations.

Concepts statement no. 5 : Recognition and measurement in financial statements of business enterprises This statement defines financial statements sets out recognition criteria for inclusion in the statements and comments on measurement.

Concepts statement no. 5 : Recognition and measurement in financial statements of business enterprises (Continued) A full set of financial statements for a period should show: financial position at the end of the period; earnings for the period; comprehensive income for the period; cash flows during the period; investments by and distributions to owners during the period. Financial reporting also includes useful information that is better provided by other means (e.g. notes to the financial statements and supplementary information).

Concepts statement no. 5 : Recognition and measurement in financial statements of business enterprises (Continued) There are four fundamental recognition criteria: Definitions – The item meets the definition of an element of financial statements Measurability – It has a relevant attribute measurable with sufficient reliability Relevance – The information about it is capable of making a difference in user decisions Reliability – The information is representationally faithful, verifiable and neutral. Recognition is subject to a cost–benefit constraint and a materiality threshold.

Concepts statement no. 5: Recognition and measurement in financial statements of business enterprises (Continued) Measurement Attributes Items currently reported in the financial statements are measured by different attributes, for example, historical cost, current (replacement) cost, current market value, net realisable value and present value of future cash flows, depending on the nature of the item and the relevance and reliability of the attribute measured. Monetary unit The monetary unit or measurement scale in current practice in financial statements is nominal units of money, that is, unadjusted for changes in purchasing power of money over time.

IASB framework for presentation and preparation of financial statements The objective: is to provide information about the financial position, performance and changes in financial position of an enterprise that is useful to a wide range of users in making economic decisions The qualitative characteristics: are the attributes that make the information in financial statements useful to investors, creditors, and others. The Framework identifies four principal qualitative characteristics: Understandability Relevance Reliability Comparability

Qualitative Characteristics

Qualitative characteristics Relevance timely - users have the information when it is needed and useful Feedback - on the way in which past events have affected the entity during the period being reported on, and the outcome of earlier predictions on which the entity’s management based its decisions predictive - allow users to either make their own prediction about the economic viability of the entity or assess predictions and assurances given by management as to the future success or otherwise of the entity

Qualitative characteristics Understandability presented in such a way that it can be recognised for what it is and be understood by users who have a reasonable knowledge of business and economic activities and accounting, and a willingness to study the information with reasonable diligence. Reliability representationally faithful, verifiable, unbiased Comparability between accounting periods and entities in similar businesses

Influences on Qualities Need to balance between characteristics Relevance – timely Reliable – verifiable an accurate Benefits must exceed costs Materiality is subjective judgement call IAS 1 says this is relevant to all financial reporting Prudence Caution with estimates Not overly conservative No secret reserves

Assumptions in Preparation Accrual basis accounting transactions accounted for in the period in which they occur, not necessarily when cash is exchanged. Going concern basis that the business will continue operating as normal for the foreseeable future (at least the next accounting year) discontinued activities reported separately Period reporting Common time periods (normally a year) Allows for performance comparison Interim financial reports

IASB framework for presentation and preparation of financial statements Definition of elements: Assets - resources controlled by the enterprise as a result of past events and from which future economic benefits are expected to flow to the enterprise Liabilities - present obligations of the enterprise arising from past events, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits Equity - the residual interest in the assets of the enterprise after deducting all its liabilities

IASB framework for presentation and preparation of financial statements Income - increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants Expenses - decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants

IASB framework for presentation and preparation of financial statements Recognition and Measurement: Elements are recognised in the financial statements when the following criteria are satisfied: It is probable that any future economic benefit associated with the item will flow to or from the enterprise; and The item's cost or value can be measured with reliability. Measurement involves assigning monetary amounts at which the elements are to be recognised and reported. A variety of measurement bases are used today to different degrees and in varying combinations, including: Historical cost Current cost Net realisable (settlement) value Present value (discounted)

The concepts of capital and capital maintenance Two types of capital and capital maintenance provides the link between capital and profit, thereby allowing a distinction between the return on capital and the return of capital financial concept is concerned with the maintenance of the money amount of the entity’s net assets. A profit is achieved when the monetary value of the net assets at the end of the reporting period exceeds the monetary value of the net assets at the start of the period – after allowing for contributions from, and distributions to, the owners during the period. Any measurement basis may be used when this concept of capital maintenance is adopted

The concepts of capital and capital maintenance physical concept is concerned with the productive or operating capability of the entity. A profit is achieved when the physical productive capability (or the funds or resources needed to achieve the capability) at the end of the reporting period exceeds the capability at the start of the period – after allowing for contributions from, and distributions to, the owners during the period. This concept requires the current cost basis of measurement to be used.

ASB statement of principles Another forerunner of the IASB Framework. Objectives Users The reporting entity Central control.

ASB statement of principles (Continued) The qualitative characteristics Relevance Reliability Comparability Understandability.

ASB statement of principles (Continued) Equity investors Objective information for stewardship Fair information for investment decision making Reliance on external information.

ASB statement of principles (Continued) Loan creditors Banks principal lenders and shareholders Access to internal information Published disclosures less relevant.

ASB statement of principles (Continued) Measurement Cash-generation abilities Carrying values reliable Gradualist approach to current values.

ASB statement of principles (Continued) Presentation of financial information Income statement Recognise only gains and losses Classify by function Separate out amounts affected in different ways Separate unusual items.

ASB statement of principles (Continued) Accounting for interest in other entities Aggregate where control.

Conceptual framework – convergence project Framework to be developed over eight phases Phase A: Objective and qualitative characteristics (Final chapter published) Phase B: Elements and recognition Phase C: Measurement Phase D: Reporting entity (ED Q2 2010) Phase E: Presentation and disclosure Phase F: Purpose and status of framework Phase G: Applicability to not-for-profit entities Phase H: Other issues, if necessary.

Phase A – the objective of financial reporting The fundamental objective is to provide financial information that is useful to present and potential equity investors when making investment decisions and assessing stewardship. Stewardship not specifically mentioned. BUT reviewing past performance has an implication for assessing future cash flows. Presumption that general purpose financial statements will satisfy the information needs of other stakeholders.

Phase A – qualitative characteristics Two fundamental qualitative characteristics Relevance and faithful representation Other characteristics that may make the information more useful are: Comparability Consistency, verifiability Timeliness and understandability.

Discussion points Do you agree or disagree with the following statements: Accountability and decision-usefulness are not compatible The present balance sheet almost defies comprehension.

Discussion points (Continued) Do you agree or disagree with the following statements: Insufficient attention is paid to an enterprise’s cash or liquidity position Current values may be more relevant than HCA, but may be too unreliable.

Review questions Name the user groups and information needs of the user groups identified by the ASB in its Statement of Principles. R. MacVe in A Conceptual Framework for Financial Accounting and Reporting: The Possibilities for an Agreed Structure suggested that the search for a conceptual framework was a political process. Discuss the effect that this thinking has had and will have on standard setting.

Review questions (Continued) ‘The replacement of accrual accounting with cash flow accounting would avoid the need for a conceptual framework.’ Discuss. 9. Key qualitative characteristics in the IASB Framework are relevance and reliability. Preparers of financial statements may face a dilemma in satisfying both criteria at once. Discuss. 10 An asset is defined in the IASB Framework as a resource which an entity controls as a result of past events and from which future economic benefits are expected to flow to the entity. Discuss whether property, plant and equipment automatically qualify as assets.