ACCA P2 (INT) Corporate Reporting - Study text

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Chapter 1: The financial reporting framework

Interpretation would require, the reason why that treatment would be

misleading, and the treatment adopted; and

 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.

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IFRSs and measurement

 Cost bases

 Fair value

11 IFRSs and measurement

11.1 Cost bases

There used to be an international accounting standard IAS 15 Information reflecting

the effects of changing prices. This was withdrawn with effect from 1 January 2005.

Inflation accounting requires the use of a system such as current cost accounting

(CCA) or current purchasing power accounting (CPP). Attempts to introduce full

inflation accounting have been unpopular. Each system has some advantages but

neither is ideal and neither has been widely accepted. It is extremely unlikely that

the IASB or any other major standard setter will require either of CCA or CPP in the

foreseeable future.

However, most people accept that information based on historical cost is not

particularly relevant to users. Many entities attempt to overcome this problem by

using modified historical cost accounting. Some or all non-current assets are

measured at a valuation, instead of at historical cost. For example, properties are

often included in the statement of financial position at market value.

The issue here is how assets and liabilities should be measured. This is the subject of

an important debate within the accounting profession. Some, including the UK

Accounting Standards Board favour current value (that is value to the business or

deprival value). This has the advantage that it reflects economic reality and the

intentions of management. For example, a business will not sell an asset if it can

obtain a greater inflow of cash by continuing to use it and vice versa. However,

current value can be complex to apply in practice and may not be easily understood

by users.

Others, including the US Financial Accounting Standards Board favour fair value.

The IASB is also moving towards greater use of fair value.

11.2 Fair value

Fair value is a possible basis for the valuation of assets in the financial statements.

Although it is not described in the IASB Framework, many IASs and IFRSs require it

to be used instead of historical cost or as an alternative to historical cost. For

example, IAS 39 requires many types of investment to be measured at fair value.

Fair value is defined as ‘the amount for which an asset could be exchanged between

knowledgeable, willing parties in an arm’s length transaction’ (IAS 16).

Chapter 1: The financial reporting framework

Fair value is normally open market value. If an item does not have a reliable market

value (for example, because it is unusual or specialised), it may be possible to

estimate its fair value in other ways.

Fair value may be used in financial statements in the following circumstances:

 After its initial recognition at acquisition, a non-current asset may be re-valued

to its fair value.

 Inventory is measured in the statement of financial position at the lower of cost

or net realisable value. Net realisable value (NRV) is the selling price of the

inventory item in the ordinary course of business, less the estimated further

costs to completion and the expected selling costs. NRV may or may not be the

same as fair value.

 Revenue should be measured in the income statement at the fair value of the

consideration received or receivable (IAS 18).

Fair value is often approximately the same as current value, but sometimes fair

value and current value can be very different.

Examples

An entity has a portfolio of investments that are traded in an active market. The fair

value of these investments is their market value. The value to the business (current

value) of the investments is their replacement cost or their net realisable value. In

this case both are the same amount: open market value. (Economic value is not

relevant because the investments are held to be sold at a profit, not to be used in the

business).

Here, fair value and current value are the same.

An entity has a machine. The machine has been specially adapted for use in this

entity’s particular business. The fair value of the machine is its open market value:

$20,000. This is quite low, because few other businesses could make use of the

machine without having to spend a considerable amount of money adapting it and

renovating it. The economic value of the machine is $30,000 and its depreciated

replacement cost is $25,000 (the amount that the entity would have to pay to acquire

an equivalent machine which has been used for the same length of time). Therefore

the current value of the machine is $25,000 (lower of replacement cost and

recoverable amount).

Here, fair value and current value are different.

Problems with the use of fair value

Fair value is easy to understand and less complicated to apply than value to the

business/current value. Arguably, it is also more reliable than value to the business,

because market value is more easily verified than (for example) economic value.

However, it has some serious disadvantages:

 There may not be an active market for some kinds of asset. Where there is no

active market, estimates have to be used and these may not be reliable.

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 It anticipates sales and profits which may never happen (the entity may have no

plans to sell the asset).

 Market values can move up and down quite rapidly. This may distort trends in

the financial statements and make it difficult for users to assess an entity’s

performance over time.

A notable example of this problem occurred during 2007 and 2008 with the collapse

of the market for certain types of asset-backed securities (mortgage-related

securities known as CDOs). Many banks, particularly in the US and Europe,

announced huge losses, due largely to the requirement to write down their

investments in these financial instruments to fair value, even though fair value was

difficult to assess.

Despite these problems, it looks increasingly likely that the IASB will require greater

use of fair value in future.

Chapter 1: The financial reporting framework

Recent developments

 Improved Conceptual Framework

 Conceptual framework discussion paper

 ED 2009/5: Fair value measurement

 ED 2009/2: Credit risk in liability measurement

12 Recent developments

12.1 Improved Conceptual Framework

The IASB and the US Financial Accounting Standards Board (FASB) are developing

a common conceptual framework that improves on the existing conceptual

frameworks of both boards. The IASB has stated that the improved framework

“would provide a sound foundation for developing future accounting standards

and is essential to fulfilling the boards’ goal of developing standards that are

principles-based, internally consistent, internationally converged, and that lead to

financial reporting that provides the information needed for investment, credit, and

similar decisions”.

There are eight phases to the project:

Phase Topic

A Objectives and qualitative characteristics

B Elements and recognition

C Measurement

D Reporting entity

E Presentation and disclosure

F Purpose and status

G Application to not-for-profit entities

H Remaining issues, if any

In May 2008, they issued an exposure draft: Preliminary Views on an Improved

Conceptual Framework for Financial Reporting: The Objective of Financial Reporting and

Qualitative Characteristics of Decision-useful Financial Reporting Information. This deals

with phase A of the project.

The boards are still discussing other phases of the project.

12.2 Conceptual framework exposure draft

The exposure draft: Preliminary Views on an improved Conceptual Framework for

Financial Reporting: The Objective of Financial Reporting and Qualitative Characteristics

of Decision-useful Financial Reporting Information is summarised below. It discusses

the first two chapters of the proposed framework, chapter 1 dealing with the

objective of financial reporting and chapter 2 dealing with the qualitative

characteristics of useful financial information.

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It is useful to compare this ED with the comparable sections of the IASB

Framework.

Objectives of financial reporting

The exposure draft puts forward the following views.

 Financial statements should be prepared from the perspective of the entity itself

(an entity perspective) rather than from the perspective of its owners (a

proprietary perspective).

 Present and potential capital providers are the main primary user group for

financial statements. Capital providers include investors in share capital and

lenders of capital. However the ED also states that employees might provide

human capital (and some of their remuneration, in the form of a pension, might

not be received for many years), suppliers provide capital when they extend

credit and customers may provide capital by pre-paying for goods or services.

‘To the extent that employees, suppliers, customers or other groups make

decisions relating to providing capital to the entity in the form of credit, they are

capital providers.’

 The objective of financial reporting should be broad enough so that information

is provided to equity investors, lenders and other providers of capital to enable

them or help them to make decisions in their capacity as capital providers. For

example, financial reports should enable investors to make decisions about

allocating their investment resources, and protecting or enhancing their

investments.

Qualitative characteristics of financial information

The exposure draft suggests qualitative characteristics of ‘decision-useful financial

reporting information’ that differs in some ways from the IASB Framework.

The desirable qualitative characteristics of financial information are divided into:

 fundamental qualitative characteristics: these are essential characteristics that

financial information must have to be useful to decision-makers

 enhancing qualitative characteristics: these are characteristics that enhance or

improve the quality of financial information, but which have no value unless the

information also possesses the fundamental qualitative characteristics.

According to the ED, there are two fundamental qualitative characteristics of

financial information:

 Relevance: financial information must be relevant to the needs of tits users. This

means that the information must have a predictive value or a confirmatory value

(as defined in the IASB Framework). Relevant information should be capable of

making a difference to decisions made by providers of capital to the entity, in

their role as capital providers.

 Faithful representation: financial information must represent faithfully the

economic reality, and represent reliably what it is intended to represent. To

provide faithful representation, information must be complete, free from

material error and neutral (free from bias). The ED comments that freedom from

Chapter 1: The financial reporting framework

material error does not mean total freedom from error but that for accounting

estimates a minimum level of accuracy is needed for the estimate to provide

faithful representation.

Enhancing qualitative characteristics of financial information improve the quality

of financial information, but only if the information possess the two fundamental

qualitative characteristics. The ED identifies four enhancing characteristics:

 Comparability

 Understandability: however users of financial statements should be assumed to

possess a reasonable knowledge of economic and business affairs

 Timeliness: information should be provided in time t influence the decisions of

users of the financial statements. However, ‘timeliness’ does not necessarily

mean that information should be current or recent. Some users of financial

statements make decisions on the basis of a study of trends over a long period of

time.

 Verifiability. Information is verifiable when different knowledgeable and

independent observers (for example auditors) could reach a general consensus

about the financial information being free from bias and material error.

The ED also recognises two ‘pervasive’ constraints on the quality of financial

information:

 Materiality –A financial report should include all material information and non-

material items should probably be excluded. However if there are material

omissions or misstatements in financial information, the information will not

provide faithful representation, because it will not be complete or free from

material error.

 Benefits and costs – Costs are a constraint on the amount or detail of

information obtained and provided. The benefits of financial information should

justify the costs of providing it and using it, although an assessment of ‘benefits’

is a qualitative judgement.

Paper P2: Corporate Reporting (International)

12.3 ED 2009/5: Fair value measurements

Certain IFRSs require various assets, liabilities and equity instruments to be

measured at fair value. The guidance on measuring these items at fair value is

detailed within the individual IFRSs rather than in one place within a conceptual

framework. This adds unnecessary complexity to IFRSs. Additionally, existing

guidance in IFRSs about fair value is not always consistent.

The IASB’s objectives in issuing this ED are to:

 establish a single source of guidance for all fair value measurements required by

IFRSs, in order to reduce comlexity and improve consistency in the application

of fair value measurements

 clarify the definition of fair value, and

 enhance disclosures about fair value, so that users of financial statements can

assess the extent to which fair values are used to measure an entity’s assets and

liabilities.

Main features of the ED

Fair value is defined as the price that would be received to sell an asset or paid to

transfer a liability in an orderly transaction between market participants at the

measurement date (an exit price).

In the absence of an actual transaction at the measurement date, a fair value

measurement assumes a hypothetical transaction in the most advantageous market

for the asset or liability.

Fair value measurement is based on the assumption that the transaction takes place

in the most advantageous market to which the entity has access.

Fair value is determined using the assumptions that market participants would use

in pricing the asset or liability.

There is further specific guidance on the measurement of the fair value of liabilities,

specific transactions and valuation techniques (including specific guidance on

markets that are no longer active).

12.4 DP 2009/2: Credit risk in liability measurement

If the credit risk of a borrower deteriorated then the fair value of the lender’s asset

would fall. For example if two people each borrowed £200,000 and one was in

financial difficulty such that he might breach the terms of the loan, the lender would

put less value on the loan to the person in difficulty.

The above illustration looks at things from the viewpoint of the lender but if credit

worthiness can affect the value of an asset then it must also affect the value of the

liability (there can only be one fair value).

This DP explores the fundamental question of whether credit risk should be

considered when measuring liabilities.

Arguments for incorporating credit risk

Consistency at initial recognition

Chapter 1: The financial reporting framework

 The initial measurement of a liability incurred in an exchange of cash includes

the effects of the borrower's credit risk so there is no reason why subsequent

current measurements should exclude changes in factors that were included in

the initial measurement.

Accounting mismatch

 Changes in creditworthiness of a borrower affect the fair vale of the receivable.

 Failure to include own credit risk in the measurement of liabilities leads to an

accounting mismatch.

Arguments against incorporating credit risk

Counter-intuitive results

 Where the credit worthiness of a borrower falls then the fair value of the liability

will also fall. If the liability is being measured at fair value in the financial

statements this would lead to the recognition of a gain!

Realisation

 An asset can be sold at any time to realise gains and losses. It is not always as

easy to settle a liability so any gain is hypothetical and is unlikely to be realised.

Paper P2: Corporate Reporting (International)

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

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