ACCA P2 (INT) Corporate Reporting - Study text

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Chapter 1: The financial reporting framework

The IASB Framework

 Introduction

 Users and their information needs

 Objectives of financial statements

 Predictive and confirmatory roles of financial information

 Underlying assumptions in the Framework

4 The IASB Framework

4.1 Introduction

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.

The Framework should already be familiar to you from previous studies. This

chapter contains revision material about the Framework, but you should think

about the concepts and principles in the Framework, and be prepared to discuss any

of them in your exam..

4.2 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.

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 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.

4.3 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.

Chapter 1: The financial reporting framework

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.

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

 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, statement of

comprehensive income (or income statement and statement of comprehensive

income), statement of cash flows, and statement of changes in equity), and

 supporting notes to the accounts, which provide additional details.

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4.4 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.

It is expected that when an entity adopts a particular accounting policy in respect of

an item, that policy is applied consistently. If this is the case then financial

information should be comparable with prior periods as the accounts have been

prepared on the same basis.

Investors use financial information from the annual report in making investment

decisions, such as whether to buy or sell shares in an operating entity. Financial

information is not the only information used. Up to date share price and company

information can be found on the internet. Additional information provided in the

annual report such as the chairman’s report and management commentary is very

useful as a commentary on the current results and a review of the objectives of the

entity going forward. By the time the financial statements are published they are

already out of date so financial information in the accounts can be criticised for

being too ‘backward looking.’

Overall, a combination of financial and additional information should improve the

use of the annual report in attempting to explain and evaluate the entity’s financial

and operational risks.

4.5 Underlying assumptions in the Framework

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

 accruals basis

 going concern basis.

Financial statements are prepared on the accruals 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 accruals basis of accounting should be familiar to you from your earlier studies.

Accruals, prepayments and depreciation charges 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

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 financial reporting framework

Qualitative characteristics of financial statements

 Understandability

 Relevance

 Reliability

 Comparability

 Constraints on relevant and reliable information

5 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.

5.1 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’.

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.

5.2 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.

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

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

statements.

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5.3 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’.

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

Chapter 1: The financial reporting framework

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 bad or

irrecoverable 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.

5.4 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 IAS 1.

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5.5 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).

Chapter 1: The financial reporting framework

The elements of financial statements

 Assets

 Liabilities

 Equity

 Income

 Expenses

6 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.

6.1 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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6.2 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.

6.3 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 statement of financial position, into share

capital, retained profits and other reserves that represent capital maintenance

adjustments.

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

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