chapter | Conceptual and regulatory framework Contents Introduction Examination context Topic List | Financial stacemenes Purpose and use of financial statemencs Bases of accounting The IASB Framework International Accounting Standards Committee Foundation (IASCF) 6 International Financial Reporting Standards (IFRS) Inherene limitations of financial statements 8 Not-for-profit entities Summary and Self-cese Technieal reference Answers to Self-test Answers to Interactive questions The nstrrure OF CHARTERED NUNTSFinancial accounting Learning objectives Teco > Explain the nature of financial reporting > Explain the objectives of financial statements > Discuss the concepeual and regulatory framework affecting the preparation of financial statements > Discuss the importance of the IASB Framewerk > Apply the principles of the IASB Framework, including the qualitative characteristics of financial information, the elements of financial statements, recognition and measurement of the elements > Explain and demonstrate the differences between financial statements produced using: = The accrual basis = Cash accounting = The break-up basis > Explain and illustrate the differene definitions of capital and capital maintenance > Explain the regulatory framework affecting not-for-profit entities Specific sylabus references for this chapter are: Ia, b, ¢, 6, ef, 2e. Practical significance ‘The way that items and transactions are treated and presented in the financial statements may affect an investor's perception of the position and performance of an entity. Whilst individual accounting standards «can be developed to deal with specific issues itis also important that there is a framework that sats out the wider purposes that accounting standards are ineended to achieve. This helps to ensure that standards are consistent and not overly affected by politcal influence or self-interest groups. The International Accounting. ‘Standards Board's Framework for the Preparation and Presentation of Financiel Statements (IASB Framework) atcempts to provide this framework in the context of International Accounting Standards and International Financial Reporting Seandards (jointly referred to from this poine as IFRS). le does so by setting out consistent principles which form the basis for the development of detailed requirements in IFRS. Stop and think What do you think are the advantages of 2 principles based approach to the setting of accounting standards? Working context In the working environment you are unlikely co be consciously aware of the effect of the issues covered by this chapter. They are important nevertheless as these principles underpin all the financial statements which you will prepare or audit ‘cissrirure OP CHARTERED DecounTANSSyllabus links ‘The issues covered by this chapter and particularly the principles introduced by the IASB Framework are a fundamental part of the Financial Accounting syllabus. Throughout the rest of the text we will make reference to the way that the Framework affects the way that specific transactions are accounted for and presented. These principles will be further developed in Financial Reporting and at the Advanced Stage. tHe mistmure FY Srnec 3 1) necounisFinancial accounting Exam requirements Accounting and reporting concepts constitute 10% of the syllabus. This area of the syllabus is likely to be ‘examined in the written test section of the paper in conjunction with another topic, rather than in its own right. For example, in question on cangible non-currant assets you could be asked to consider how the definition of an asset affects the recognition of certain expenses as capital or revenue items. Part (a) of {question 4 in the sample paper required an explanation and discussion of the concept of substance over form in the context of che topic of leasing. ‘You could also be asked to discuss the objectives of financial information and the qualitative characteristics ‘which make information useful. Again this would typically be part (®) or (c) of a longer question rather than the main focus of the question Alearnatively, or in addition, this topic could be examined in the OT saction of the paper. In the tample paper two OT questions tested knowledge of the IASB Framework. In the examination, candidates may be required to: > Discuss the purpose of accounting regulations and standards for both profitemaking and not-for-profit Explain, with examples, the objectives of financial statements Explain the qualitative characteristics of financial information and the constraints on such information Describe the financial effects of the application of the definitions of the IASB Fremework Perform simple calculations to demonstrate the difference between the accrual basis, cash accounting and the breakcup basis > Explain the differene concepts of capital maineenance ‘cissrirure OP CHARTERED DecounTANS| Financial statements Section overview > Inthe UK companies financial statements must be prepared in accordance with the Companies Act. > In che UK financial statemenes must: = Be prepared in accordance with = Either UK GAAP Or IFRS = Givea true and fair view 1.1 What is financial accounting? Financial accounting isthe process of identifying. measuring and communicating economic information to ‘others so that they may make decisions on the basis of that information and assess the stawardship ofthe entity's management. Financial accounting involves > Recording transactions undertaken by a business entity > Grouping similar transactions together which are appropriate to the business > Presenting periodic results ‘The Financial Accounting syllabus focuses on the preparation of published financial information. Typically, this information is made available annually or hal-yearly (sometimes quarterly) and is presented in formats laid down or approved by governments in each national jurisdiction. (The Financial Reporting syllabus deals with more complex reporting issues and analysis and interpretation.) By contrast, management accounting or reporting is internal reporting for the use of the management of a business itself Incarnal management information can be tailored to management's own needs and provided in whatever detail and at whatever fraquency (eg continuous realetime information) management decides. ‘General principles relating to financial accounting are set out in che IASB Fromework forthe Preparation end Presentation of Financial Statements (Framework), which is explained further below. 1.2. Entity Most accounting requirements are written with a view to use by any type of accounting entity, including. ‘companies and other forms of organisation. such as partnership. In this text, the term ‘company’ is often used, because the main focus of the Financial Accounting syllabus is on the accounts of companies and groups of companies. 1.3 ‘The principal means of providing financial information to external users is the annual financial statements Financial statements are the accountant's summary of the performance of an entity over a particular period and ofits position at the end of that period. ‘A complete set of financial statements comprises: > The balance sheet (a statement of financial position) The income statement (a statement of financial performance) ‘The statement of changes in equity (another seatement of financial performance) ‘The statement of changes in financial position (usually in the form of a cash flow statement) Notas to the financial seatemente ene SFinancial accounting 1.4 1.5 The notes to the financial statements include: > Accounting policies, ie the specific principles, conventions, rules and practices applied in order to reflect the effects of transactions and other events in the financial statements, > Detaled financial and narrative information supporting the information in the primary financial stacements > Other information not reflected in the financial statements, but which is important to users in making their assessments, ‘The individual elements chat are included in the financial statements are covered in detail later in this chapter. Requirement to produce financial statements Limieed liability companies are required by law to prapare and publish financial statements annually. The form and content may be regulated primarily by national legislation, and in most cases must also comply ‘with Financial Reporting Standards. In the UK, all companies must comply with the provisions of the Companies Act 1985 (CA 1985) ‘Over the next year the provisions of the Companies Act 1985 will be gradually replaced by the Companies ‘Ace 2006. The provisions of both Acts are the same for the purpose of the Financial Accounting exam and therefore this Study Manual refers to che Companies Act 1985 chroughout, The key impact of this is as follows: > Every UK registered company is required to prepare a balance sheet and profit and loss account for each financial year which gives a true and fair view. > The financial statements must comply with Schedule 4 to CA 1985 as regards format and additional information provided by way of notes. The Companies Act 2006 makes provisions for: the Secretary of State to make Accounts Regulations that will replace schedule 4 but these are not yet finalised. Therefore the only disclosures covered by this text in Chapter 2 are those currencly contained in schedule 4. Financial reporting standards In most cases company financial statements must also comply with relevant Financial Reporting Standards and other professional guidance. In the UK these are 2: follows, > Accounting Standards ‘These include Financial Reporting Standards (FRSs) which are issued by the UK Accounting Standards Board (ASB) and Statements of Standard Accounting Practice (SSAPs) which have been adopted by the ASB, (SSAPs were originally issued by the Accounting Standards Committee (ASC), which was replaced by the ASB in 1990, IFRSs and SSAPs will apply to the majerity of individual company financial statements in the UK. > Financial Reporting Standard for Smaller Entities (FRSSE) This brings together all the accounting guidance which UK small companies are required to follow in drawing up their financial scatements. > International Financial Reporting Standards (IFRS) ‘These are issued by the International Accounting Standards Board (|ASB). UK companies whose securities are traded in a regulated public market, eg the London Stock Exchange, must prepare consolidated accounts in accordance with IFRS. These learning materials assume the preparation of financial statements in accordance with IFRS but also test differences between IFRS and UK GAAP (see below). Unincorporated entities are exempt from the above requirements but may need to follow other regulation, ‘eg charities must comply with the Charities Act ‘acmsnirure By orcharreeeo1.6 1.7 Point to note The term UK Generally Accepted Accounting Practice (GAAP) refers to all the rules, from whatever souree, which govern UK accounting. In the UK this is seen primarily as a combination of > Company law (mainly CA 1985 ~ see section 1.4) > Accounting Standards > Stock Exchange requirements (These are not examinable in the Financial Accounting syllabus) In the UK, GAAP has no statutory or regulatory authority or definition (unlike some other countries such as the United States) although the use of the term is increasingly common in practice. True and fair view In the UK there is an overriding Companies Act requirement that financial statements should present ‘a true and fair view! This term is not defined in the Companies Act or Accounting Standards. Truth is usually seen a8 an objective concept reflecting factual accuraey within the bounds of materiality Fairness is usually seen as meaning that the view given ie objective and unbiaeed True and fair ie usually defined in terme of GAAP. This means: > Compliance with Accounting Standards (which can be overridden on true and fair grounds only very rarely) > Adherence to the requirements of the Companies Act 1985, including ts true and fair override (see below) > In the absence of more specific requirements, application of general accounting principles and fundamental concepts and, where appropriate, adherence to accepted industry practices. Points to note > CA1985 uses the term'a true and fair view’ rather than ‘the true and fair view’ because itis possible for there to be more than one true and fair view. For example, financial statements based on historical cost can be true and fair, as can financial statements which incorporate revaluations. > What constitutes a true and fair view can then be restricted by stating that where a choice of ‘treatments or methods is permitted, che one selected should be the most appropriate to the company’s circumstances. This restriction i likely to ensure compliance with the spirit and underlying intentions of requirements, not just with the letter of them. > A further restriction is that financial statements should reflect the economic position of the company. thereby reflecting the substance of transactions (ie commercial reality), not meraly their legal form. In most cases this will be achieved by adhering to GAAP. (We will ook at substance in more detail in section 4 below). > The equivalene international term to a true and fair view is fair presentation.’ We will look 3¢ this in detail in Chapter 2 The statutory ‘true and fair override’ ‘The Companies Act 1985 requires that where compliance with its accounting rules would not lead to a true and fair view, those rules should be departed from co the extent necessary co give a true and fair view. Where the override of the statutory accounting requirements is invoked. eg co comply with an accounting standard, the Act requires disclosure of the particulars of the departure, che reason for it, and the financial effect. ‘The Companies Act 1985 also states that where compliance with its disclosure requirements is insufficient ‘to give a true and fair view, additional information should be disclosed such that a true and fair view is provided. BecharaFinancial accounting Point to note > Some UK accounting standards invoke the true and fair override of the Companies Act 1985. The Companies Act 1985 includes a specific statutory requirement to amortize (ie depreciate) purchased goodwill (ie the excess of the consideration over the net assets acquired when one company buys another) over its estimated useful economic life. FRS 10 Goodwill and Intangible Assets permits goodwill to be carried as an asset in the balance sheet without amortisation, provided that specific conditions are met, and invokes the true and fair override to justify this 2 Purpose and use of financial statements 2.1 Section overview > Financial statements are used to make economic decisions by a wide range of users > All users require information regarding: = Financial position = Financial performance, and = Changes in financial position. Users and their information needs The form and content of financial statements must be influenced by the use to which they are put. Nearly ‘everybody using them does so whan making economic decisions such at those to: > Decide when to buy, hold or sell shar: > Assess the stewardship or accountability of management. > Assess an entity's ability to provide benefits to employees. > Assess security for amounts lent to the entity. Much of the information needed for these different decisions is in fret common to them all. Financial statements aimed at meeting these common needs of a wide range of users are known as ‘general purpose’ financial statements. The IASB Framework identifies the following users of financial statements and their specific information needs. (We will look at the IASB Framework in more detail in Section 4 of this chapter). Present and potential > Make investment decisions, therefore need information on: investors = Risk and return on investment = Ability of entity to pay dividends Employees > Assess their employer's stability and profitabiliey > Assess their employer's ability co provide remuneration, ‘employment opportunities and retirement and other benefies Lenders > Assess whether loans will be repaid, and relaced interest will be paid, when due Suppliers and other trade > Assess the likelihood of being paid when due payables Customers > Assos whether entity will continua in existance ~ important where customers have a long-term involvement with, or are dependent on, the entity, eg where there are product warranties ‘or where specialist parts may be needed ‘cissrirure By orcharreeeoGovernments and their Assess allocation of resources and, therefore, activities of entities agencies > Assist in regulating activities > Assess exation > Provide a basis for national staisict The public > Assess trends and recent developments in the entity's prosperity and its activities — important where the entity makes a substancial contribution to a local economy. eg by providing employment and using leeal suppliers In most cases the users will need to analyse the financial statements in order to obtain the information they need. This might include the calculation of accounting ratios. (The calculation of accounting ratios and the analysis of those ratio is covered in che Financial Reporting syllabus ) 2.2 Objective of financial statements The objective of financial statements is to provide information about the reporting entity's financial position and financial performance that is useful to a wide range of users in making economic decisions. This objective can usually be met by focusing exclusively on the information needs of present and potential investors, This is because much of the financial information that is relevant to investors will also be relevant to other users In the UK equivalent of the IASB Framework — she ASB’s Statement of Principles, investors and potential investors are described as ‘the defining class of user’ 2.3 Accountability of management Management also has a stewardship role, in that it is accountable for the safe-keeping of the entity's resources and for their proper, efficient and profitable use. Providers of risk capital are interested in information that helps them co assess how effectively management has fulfilled this role, but again this assessment is made only as the basis for economic decisions, such as those about investments and the reappointment/ replacement of management. Financial reporting helps management to meet its need to be accountable to shareholders, and also co other stakeholders (eg employees or lenders), by providing information that is useful to the users in making ‘economic decisions. However, financial statements cannot provide the complete set of information required for assessing the stewardship of management (see section 7 ‘Inherent Limitations of Financial Statements’ Incer in this chapter) 2.4 Financial position, performance and changes in financial posi All economic decisions are based on an evaluation of an entity's ability to generate cash and of the timing and certainty of its generation. Information about the entity's financial position, performance and changes in financial position provides the foundation on which to base such decisions. ion 24.1 Financial position ‘An entitys financial position covers: > The economic resources it controls > Its financial structure (ie debt and share finance) > Iss liquidity and solvency and > Its capacity to adapt to changes in the environment in which it operates gone 9Financial accounting 242 243 244 Investors require information on financial position because it helps in assessing: > The entity's ability to generate cash in the future > How future cash flows will be distributed among those with an interest in, or claims on, the entity > Requirements for future finance and ability to raise that finance > The ability to meet financial commitments as they fall due Information about financial position is primarily provided in a balance sheet. Financial performance ‘The profit earned in a period is used as the measure of financial performance, where profc is calculated as income less expenses. Information about performance and variablity of performance is useful in > Assessing potential changes in the entity's economic resources in the future > Predicting the entity's capacity to generate cash from its existing resource base, and > Forming judgements about the effectiveness with which additional resources might be employed. Information on financial performance is provided by. > The income statement, and > The statement of changes in equity. Changes in financial position ‘Changes in financial position can be analysed under the headings of investing, financing and operating activities and are usually shown in a cash flow statement. ‘Cath flow information is largely free from the more judgemental allocation and measurement issues {ie in which period to include things and at what amount) that arise when items are included in the balance sheet or performance statements. For example, depreciation of non-current assets involves judgement and ‘estimation as to the period over which to charge depreciation. Cash flow information excludes non-cash items such as depreciation. Cash flow information is therefore seen as being factual in nature, and hence more reliable than other sources of information Information on the generation and use of cath is useful in evaluating the entiy’s ability co generate cash and its needs to use what i generated Notes and supplementary schedules Notes and schedules areached to financial statements can provide additional information relevant to users, for example the non-current assets note (see Chapter 2) Bases of accounting Section overview > There are four bases of accounting which you need to be familiar with: = Acerual basis = Going concern basis = Cash basis = Break-up basis > The accrual basis of accounting and going concern are referred to by the IASB Framework 3s “underlying assumptions: ‘cissrirure By orcharreeeo3.1 3.2 3.3 Accrual basis Under this basis of accounting, transactions are recognised when they occur, not when the related cath flows into or out of the entity. You will be familiar with this basis from your Accounting studies. Examples of the importance of this basis are as follows: > Sales are recorded in the period in which the risks and rewards of ownership pass from seller to buyer, not when the seller receives full payment. While this basis has no effect on the timing of the recognition of cash sales, ic does mean that eredit sales are recorded earlier than ifthe cash basis of accounting was used. When credit sales are recognised, a receivable is set up in the entity's books. > Expenses are recognised in the period when the goods or services are consumed, not when they are paid for. An amount payable will be set up in the entity's books for credit purchases, again leading to earlier recognition than if the cash basis was used. > The consumption of non-current assets, such as plant and machinery is recognised over the period during which they are used by the entity (ie the asset is depreciated). not in the year of purchase 25 they would be under the eash basis of accounting. Financial statements prepared on this basis provide information both about past transactions involving cash and about future resources flowing into the entity (when customers pay up) and flowing out of it (when suppliers are paid). They are therefore more useful for the making of economic decisions than those produced on the cash basis. Going concern basis The accrual basis of accounting assumes that an entity isa going concern. Under this basis, financial sseacements are prepared on the assumption that the entity will continue in operation for the foreseeable future, in that management has neither the intention nor the need to liquidate the entity by selling al its assets, paying offal ts liabilities and distributing any surplus to the owners. Examples of the importance of this basis are as follows: > The measurement of receivables from trade customers is made on the basis that there is no time limit over which management will chase slow payers. If the entity were to cease operation in, say, three months, a number of balances might have co be regarded as bad debts > The measurement of non-current assets is made on the basis that they can be utilised throughout their planned life. Otherwise, they would have to be valued at what they could immediately be sold for, which might not be very much, in the case of assets used in markets where there is excess capacity ‘The accrual basis and going concern are referred co by the IASB Framework as ‘underlying assumptions’. Cash basis ‘The cath batis of accounting is not used in the preparation of a company balanca sheet and income statement as iti not allowed by IFRS or UK GAAP, alhough the cash effect of transactions is presented in the form of a eash flow statement. (We will look atthe cash flow statement in Chapter 3.) The eash basis, may be used however, for small unincorporated entities, for example clubs and societies. In many ways the cash basis of accounting is very simple. Only the cash impact of a transaction is recorded. Examples of the impact of this are as follows: > Sales are recorded in the period in which the seller receives full payment. For credit sales chis will delay the recognition of the transaction. > Purchases are recorded in the peried in which goods are paid for rather than the period in which the ‘goods are purchased. For credit purchases this will delay the recognition of the purchase. > The purchase of a capital asset is treated as a cash outflow at the point that the cash consideration is paid. No subsequent adjustment is made for depreciation as this has ne impact on the cash balance of the business, goneFinancial accounting Worked example: Comparison of accrual basis and cash basis Joe Co buys 100 T-shires in January at £3.50 each. The purchase is made for cash. During January 30 T-shirts are sold for cash at £7.00 each Using accrual based accounting the results for January would be as follows: é é Revenue (30 * £7) 2i0 Cost of sales Purchases (00 * £3.50) 350 Closing invencory (70 * £3.50) 245) (105) Profi 108 Using cash accounting the results for January would be 2s follows: é Revenue (30 * £7) 210 Cost of sales (00 * £3.50) 350) Loss (140) Notice that there is an overall loss of £140 using cash accounting even though there is @ profit for the month of £105 using the accrual basis. The difference of £245 is the value of the closing inventories which is carried forward as an asset under accrual based accounting. 3.4 Break-up basis ‘As we saw in section 3.2 one of the key assumptions made in accrual based accounting is that the business will continue as a going concern. However, chs will not necessarily always be the case. There may be an ineantion or need to sell off the assets of the business. Such a sale eypically arises where the business isin financial difficulties and needs the cash to pay its creditors. Where this is the case an akernative method ‘of accounting must be used (in accordance with IAS | Presentation of Financial Statements). In these circumstances the financial statements will be prepared on a break-up basis, The effect of this is seen primarily in the balance sheet as follows: > Classification of assets All assets and labilties would be classified as current rather than non-current. > Valuation of assets Assets would be valued on the basis of the recoverable amount on sale. This is likely to be substantially lower than the carrying amount of assets held under historical cost accounting. 4 The IASB Framework Section overview > The IASB Framework for the Preparation and Presentation of Financial Statements (Framework) is the ‘conceptual framework upon which all JASs and IFRSs are based, It determines = How financial statements are prepared, and = The information they contain. ‘cissrirure By orcharreeeo4.1 42 43 Conceptual Framework “The Framework consists of a Preface and an Introduction followed by number of chapters: The objective of financial statements Underlying assumptions Qualitative characteristics of financial statements The elements of financial statements Recognition of the elements of financial sestements Measurement of the elements of financial statements Concepts of capital and capital maintenance In this chapter we have already introduced some of the concepts dealt with by the Framework. ‘We will now look specifically at each section in turn, Preface ‘The Preface to the Framework points out the fundamental reason why financial statements are produced worldwide, ie to satisfy the requirements of external users, but that practice varies due to the individual pressures in each country. These pressures may be social, political, economic or legal, bur they result in variations in practice from counery to country including > The form of the statements > The definition of their component parts (assets, liabilities, etc) > The criteria for recognition of itoms > Scope and disclosure of financial seatements. Ie is these difforences which the IASB wishes to narrow by harmonising all aspects of financial statements, including the regulations governing accounting standards and their preparation and presentation, The Preface also emphasises the way the financial statements are used to make economic decisions. We looked at thete decisions previously in Section 2.1 Introduction The Introduction provides alist of the purposes of the Framework: > Provide those who are interested in the work of the IASB with information about its approach to the formulation of IASs (now IFRSs) Assist the Board of the IASB in the development of future IASs and in its review of existing IAS Assist the Board of the IASB in promoting harmonisation of regulations, accounting standards and procedures relating to the presentation of financial scatements by providing a basis for reducing the umber of alternative accounting treatments permitted by IASs. > Assist national standard-setting bodies in developing national standards. > Assist preparers of financial statements in applying IASs and in dealing with topics that have yet to form the subject of an IAS. > Assist auditors in forming an opinion as to whether financial statements conform with IASs > Assist users of financial statements in inte-preting the information contained in financial statements prepared in conformity with IASS. ‘The Framework is net an IFRS and so does not overrule any individual IFRS. In the (rare) ease of conflict between an IFRS and the Framework, che IFRS will prevail. These cases will diminish over time as the Framewrk wil be used a8 a guide in the production of future IFRSe. The Framework itself will be revised ‘occasionally depending on the experience of the IASB in using it ‘The Introduction also considers users and their information needs. We have already looked 2¢ thie in section 2.1 of this chapter. goa 13Financial accounting 4.4 Qualitative characteristics of financial statements 44.1 Overview ‘The Framework states that qualitative characteristics are the attributes that make the information provided in financial seatements useful to users. “The four principal qualitative characteristics are understandabi ‘comparability. The key issues ean be summarised as follows Qualitative characteristics Undersandbley Relevance Relat Comparability —— Nacwe Macey | corsisceney Disclose Faithful Substance over Prudence Completeness represenation form Consesines Timeliness Corev banat Balnce beowesn Results ine presentation 44.2 Understandability Users must be able to understand financial statements. They are assumed to have some business, economic and accounting knowledge and to be able to apply themselves to study the information properly. Complex matters should not be left out of financial statements simply due to its difficulty ii is relevant information 443 Relevance Relevant information is both predictive and confirmatory. These roles are interrelated suemsrrure 14 OrcHARTEREDDefinition Relevance: Information has the quality of relevance when it influences the economic decisions of users by helping them evaluate past, present or future events or confirming, or correcting, their past evaluations. Information on financial position and performance is often used to predict future position and performance and other things of interest to the user, eg likely dividend, wage rises. The manner of presentation will ‘enhance the ability to make predictions, og by highlighting unusual itams. Materiality The relevance of information is affected by its nature and its materiality Definition Materiality: Information is material if ts omission or misstatement could influence the economic decisions cof users taken on the basis of the financial statements. Information may be judged relevant simply because ofits nature (eg remuneration of management). In other ceases, both the nature and materiality of the information are imporeane. Materialiy is not a primary ‘qualitative characteristic itsolf (lke reliability or relevance). because itis merely a threshold or cut-off point 444 Reliability Information must also be reliable to be useful. The user must be able to depend on it being 2 faithful representation. Definition Reliability: Information has the quality of reliability when it is free from material error and bias and can be depended upon by users to represent faithfully that which it either purports to represent or could reasonably be expected to represent. Even if information is relevant. ifit is very unreliable it may be misleading to recognise it. eg a disputed claim for damages in a legal action. Faithful representation Information must represent faithfully the transactions it purports to represent in order to be reliable, There is a risk that this may not be the case, not due co bias, but due to inherent difficulties in identifying the transactions or finding an appropriate method of measurement or presentation. Where measurement of the financial effects ofan item is so uncertain, entities should not recognise such an item. For example, although there is usually no daube as to the existence of internally generated goodwill here is considerable doubt as to its true value, ie it cannot be measured reliably. Therefore IAS 38 Intangible Assets prohibits the recognition of such goodwill (see Chapter 6). ‘Substance over form Faithful representation of a transaction is only possible if it is accounted for according to its substance and ‘economic reality, not with its legal form, goauue 1sFinancial accounting (a (Aj Definition ‘Substance over form: The principle that transactions and other events are accounted for and presenced in accordance with their substance and economic reality and not merely thelr legal form. Mose transactions are reasonably straightforward and their substance, ie commercial effect. is the same as their strict legal form. However, in some instances chis is not the case as can be seen in the following worked example. Worked example: Sale and repurchase agreement A Led sells goods to B Led for £10,000, but undertakes to repurchase the goods from B Led in 12 months time for £1 1,000. The legal form of the transaction is that A has sold goods co B as it has transferred legal title, To reflect the legal form, A Led would record a sale and show the resulting profit, any, in its income scatement. In 12 months’ time when logal title is regained, A Ltd would record a purchase. There would be no liability to B Lied in A Lea's balance sheet until the goods are repurchased. ‘The above treatment does not provide a faithful representation because it does not reflect the economic substance of the transaction. Afterall, A Ltd is under an obligation from the outset to repurchase the goods and A Led bears the risk that those goods will be obsolece and unsaleable in a year’s time. ‘The substance is that B Led has made a secured loan to A Led of £10,000 plus interest of £1,000, To reflect substance, A Led should continue to show the goods as an asset in inventories (at cost or net realisable value, if lower) and should include a liability co 8 Led of £10,000 in payables. A Led should accrue for the interest over the duration of the lean, ‘When A Led pays £11,000 to regain legal title, this should be treated as a repayment of the loan plus accrued interest. (Other examples of accounting for substance > Leases ‘Accounting for finanee leases under IAS 17 Leases (which is covered in Chapter 8) is an example of the application of substance as the lessee includes the asset on ies balance sheet even though the legal form of a lease is that of renting the asset, not buying it > Group financial statements Group financial sertements are covered in detail in Chapters 10 to 16, The central principle underlying ‘group accounts is that a group of companies is treated as though it were a single entity, even though each company within the group is itself a separate legal entity Neutrality Information must be free from bias to be reliable, Neutrality is lost ifthe financial statements are prepared so as to influence the user to make a judgement or decision in order to achieve a predetermined Prudence Uncertainties exist in the preparation of financial information, eg the collectability of doubtful receivables. ‘These uncertainties are recognised through disclosure and through the application of prudence. Prudence involves exercising a degree of caution when making judgements in conditions of uncertainty. Prudence does not, however, allow the creation of hidden reserves or excessive provisions, understatement of assets or income or overstatement of liabilities or expenses. ‘cissrirure By orcharreeeo‘Completeness Financial information must be complete, within the restrictions of materiality and cost, to be reliable ‘Omission may cause information to be misleading. 445 Comparability Users must be able to compare an entity's financial statements {@)_ Through time to identify trends. (b) With other entities’ statements, o evaluate their relative financial postion, performance and changes in financial postion ‘The consistency of treatment is therefore important across like items over time, within the entity and across all entities. ‘The disclosure of accounting policies is particularly imporcant here. Users must be able to distinguish between different accounting policies in order to be able to make a valid comparison of similar ieems in the accounts of different entices. ‘Comparability is not the same as uniformity. Entities should change accounting policies if those policies become inappropriate Corresponding information for preceding periods should be shown to enable comparison ever time, 44.6 Constraints on useful information (2) Timeliness Information may become irrelevant if there is a delay in reporting it. There is 2 balance between timeliness and the provision of reliable information. Information may be reported on a timely basis when not all aspects ofthe transaction are known, chus compromising reliability, every detail of transaction is known, it may be too late to publish the information because it has become invelevane. The overriding consideration is how best to satisfy the economic decision-making needs of che (b) Balance between benefits and cost This is a pervasive constraint, not a qualitative characteristic. When information is provided, its benefits must exceed che costs of obtaining and presenting it. Ths is a subjective area and there are other difficulties: others, not the intended users, may gain a benefit; also the cost may be paid by someone other than the users. It is therefore difficult to apply a cost-benefit analysis, but preparers and users should be aware of the constraint. (c) Balance between qualitative characteristics A trade-off between qualitative characteristics is often necessary, the aim being to achieve an appropriate balance co meet the objective of financial statements. It is a matter for professional judgement as to the relative importance of these characteristics in each individual case. Relevance v reliability ‘The most relevanc information may not always be the most reliable. For example, an entity may be facing a potential liability as a result of a legal claim, The outcome of the claim may not be sufficiently reliable to recognise a provision in the financial statements. However, information about the claim ‘would be relevant to the users of the financial statemenes as it would provide information about future liablicies. The conflice between relevance and reliability here is normally resolved through disclosure of the facts involved. Understandability v relevance Relevant information may not always be the most understandable. This is particularly true where the information involves complex issuas. In this situation relevance would take priority. It would not be: appropriate to omit information simply because it was dificult to understandFinancial accounting Faithful recognition v completeness In some cases faithful recognition may override the characteristic of completeness. For example, as discussed in section 44.4, internally generated goodwill is not recognised as its measurement is uncertain 44.7 True and fair view/fair presentation ‘The Framework does not atcempt to define these concepts directly. It does state, however, that the application of the principal ‘qualitative’ characteristics and of appropriate accounting standards ‘ill usually result in financial statements which show a true and fair view, or are presented fairly. (We will look at these terms in more detail in Chapter 2) 4.5 The elements of financial statements 45.1 Overview ‘Transactions and other events are grouped together in broad classes and in this way their financial effects are shown in the financial statements, These broad classes are the elements of financial statements. ‘The Framework lays out these elements as follows. Elements of finar statements a Performance in the Financial position in the income statement balance sheet > Assets > Income > Liabili > Expenses > Equiey ‘Contributions from equity participants and distributions to them are alse shown in the statement of changes in equity. 45.2 Definitions of elements a sitios Asset A resource controlled by an entity as aresult of Technically, che asset isthe access to past events and from which fucure economic ‘future economic benefits (eg cash benefis are expected to flow to the entity generation) not the underlying item of property itself (eg a machine), ‘A present obligation of the entity arising from An obligation implies that the entity is past events, the settlement of which is expected not free to avoid the outflow of to lead to the outflow from the entity of resources resources embodying economic benefits. Equity The residual amount found by deducting all of the Equity = ownership interest = net centty’s liabilities fromm all of the entity's assets. assets. For a company. this usually comprises shareholders’ funds (ie capieal and reserves), ‘cissrirure By orcharreeeo DecounTANSIncreases in economic benefits in the form of Income comprises revenue and gains, asset increasesilabilty decreases not resulting including all recognised gains on non- from contributions from equity participants, revenue items (eg revaluations of non- currene assees), Expenses Decreases in economic benefits in che form of Expenses includes losses, including all asset decreasesliability increases not resulting from diseributions to equity parvicipants recognised losses on non-revenue ieams (such as write-downs of non- current assets) Note the way that che changes in economic benefits resulting from asset and liability increases and decreases are used to define: > Income, and > Expenses. This arises from the ‘balance sheet approach’ adopted by the IASB Framework which treats performance statements, such as the income statement, as a means of reconciling changes in the financial position lamounes shown in the balance sheet. ‘These key definitions of ‘asset’ and ‘liability’ will be referred to again and again in these learning materials, because they form the foundation on which so many accounting standards are based, [eis very important that you ean reproduce these definitions accurately and quickly. 45.3 Assets ‘We can look in more detail at the components of the definitions given above. Assets must give rise €o future economic benefits, either alone or in conjunction with other items. Definition Future economic benefit: The potential to contribute, directly or indirectly, to the flow of eash and ash ‘equivalents to the entity. The potential may be a productive one that is part of the operating activities of the entity. It may also take the form of convertibility into cash or cash equivalents or a capability to reduce ‘cash outflows, such as when an alternative manufacturing process lowers the cost of production, In simple terms, an item is an asset if > [cis cash or the right to cash in future, eg a receivable, or a right to services that may be used to -generace cash, eg a prepayment. > [scan be used to generate cash or meet liabilities, eg a tangible or intangible non-current asset The existence of an asset, particularly in terms of control, is not reliant on: > Physical form (hence intangible assets such as pacents and copyrights may meet the definition of an asset and appear on the balance sheet ~ even though they have no physical substance), > Legal ownership (hence some leased assess. even though not legally owned by the company. may be included as assets on the balance sheet. (See Chapter 8)) ‘Transactions or events in the past give rise to assess. Those expected to occur in fucure do nec in themselves give rise to assets goaiue 19Financial accounting 45.4 Liabilities Again we look more closely at some aspects of the definition, ‘An essential feature of a liability is chat che entity has a present obligation. enfor Definition LY) on sation: A duty or responsibility to act or perform in a certain way. Obligations may be legally reaable at a consequence of a binding contract or statutory requirement. Obligations also arise, however, from normal business practice, custom and a desire to maintain good business relations or act in an equitable manner. Asse » A management deci een above, obligations may be: Legally enforceable as a consequence of a binding contract or statutory requirement. This is normally the case with amounts payable for goods and services received ‘The result of business practice. For example, even though a company has no legal obligation to do 0, it may have a policy of rectifying faults in ies products even after the warranty period has expired. ion (to acquire an asset, for example) does net in itself create an obligation, because ic can be reversed, But a management decision implemented in a way which creates expectations in the minds of customers, suppliers or employees, such as the warranty example above, becomes an ‘obligation. This is sometimes described as a constructive obligation. This issue is covered more fully in ‘Chapter 9 in the context of the recognition of provisions. Liabilities must arise from past transactions or events. For example, the sale of goods is the past ‘transaction which allows the recognition of repair warranty provisions. ‘Settlement of a present obligation will involve the entity giving up resources embodying economic benefits in order to satisfy the claim of the other party. In practice, most liabilities will be met in cash but this (Sj Interactive question |: Asset or liability? [Difficulty level: Easy] 20 @) (b) © See (ak plc has purchased a patent for £40,000. The patent gives the company sole use of a particular manufacturing process which will save £6,000 a yeat for the next five years. Elm ple paid John Brown £20,000 co set up a car repair shop, on condition that prioriey treatment is ‘given to cars from the company's fleet. Sycamore ple provides a warranty with every ‘washing machine sold, Answer at the end of this chapter ‘cissrirure OP CHARTERED455 Equity Equity is the residual of assets less liabilities, so the amount at which itis shown is dependent on the measurement of assets and liabilities. It has nothing to do with the market value of the entity's shares. Equity may be sub-classified in the balance sheet providing information which is relevant to the decision- raking needs of the users. This will indicate legal or other restrictions on the ability of the entity to discribute or otherwise apply its equity. In practical terms, the important distinction between liabilities and equity is that creditors have the right to insist that the transfer of economic resources is made to them regardless of the entity’ financial position, but owners do not. All decisions about payments to owners (such as dividends or share capieal buy-back) are at the discretion of management 45.6 Performance Profit is used as a measure of performance, or as a basis for other measures (2g £PS). It depends directly on the measurement of income and expenses, which in turn depend (in part) on the concepts of capital and capital maineenance adopted. Income and expenses can be presented in different ways in the income statement, to provide information relevant for economic decision-making. For example, an income statement could distinguish between income and expenses which relate to continuing operations and those which do not. Ikems of income and expense can be distinguished from each other or combined with each other. Income Both revenue and gains are included in the definition of income. Revenue arises in the course of ‘ordinary actives of an entity. (We will look at revenue in more detail in Chapter 7.) Definition Gains: Increases in economic benefits. As such they are no different in nature from revenue. Gains include those arising on the disposal of non-current assets. The definition of income also includes unrealised gains, eg on revaluation of non-current assets, A revaluation gives rise to an increase or decrease in equity Although these increases and decreases meet the definitions of income and expenses they are not included in the income scatement under certain concepts of capital maintenance, however, but are included in equity. (ln your Accounting studies you will have seen that a gain on revaluation is recognised in a revaluation reserve.) Expenses ‘As with income, the definition of expenses includes losses as wall as those expenses that arise in the course of ordinary activites of an entity Definition Losses: Decreases in economic benefits. As such they are no different in nature from other expenses. Losses will include chose arising on the disposal of non-current assets. The definition of expenses will also include unrealised losses. You will come across examples of these in your Financial Reporting and Advanced Stage studies. The wstrrure DechaRrERED 21 ECOUNTANTS22 Financial accounting 4.6 461 46.2 4.63 464 Recognition of elements in financial statements Meaning of recognised ‘An item is recognised when itis included in the balance sheet or income statement. Definition Recognition: The process of Incorporating in the balance sheet or income statement an item that meets the definiven ef an elemant and satisfies the fellowing eriteria for retegnition: > [eis probable that any future economic benefit associated with the item will low te er fram the encey, and >} The item has a cost or value that can be measured wich reliably Points ta note: (1) Regard must be given to materiality (see section 4.4.3 above. (2) An item which falco meee chese criteria ac one tlme may meet it subsequendly. (2) An item which fils:to meet the criteria may meric disclosure in the noces to the financial zaternencs {This is deale with in more decal by IAS 37 Provisions, Contingent Liabilities and Contingent seats which ig severed in Chaptor 9). Probability of future economic benefits Probability here refers ta the degree of uncertalnty that the future econonile benefits associated with an icem will Fow ta or from the envy. This must be judged on che basis of the characteristics of the ‘entity's envirenment and the evidence available whon che financial scaremenes are propared. ‘The Framework does not give a definition of ‘probable’, A working dafinition i ‘more likaly than not’ Reliability of measurement ‘The cost or value of an item in many cases must be estimated. Ths use of reasonable estimates is an essential part of the preparation of financial statements and does not undermine their reliability ‘Whore no reatonable estimate can be mada, tha ica shauld not be racognised (although its existence should be diselosed in the notes.) Recognition of items ‘We Current cose, Assets are carried at the amount ef eash or cash equivalence that would have to be paid ifthe same or an equivalene asset was acquired current. Lisbitios are carried ac che undiscounted amount of cash or cash equivalanes that would be required to-secle the obligation currently. sable (settlement) value — — Realisable value, The amoune of cash or cash equivalents that could currently be obusined by selling an 25sec in an orderly disposal, = Settlement value. The undiscounted amaunts of cash or cath equivalents expected to be paid co s20ely she fnbiliogs in che normal course of business > Present value, A current estimate of the prevenc discounted value of the future net cash flows in the normal course of business. Historical cost is the most commonly adopted measurement basis, buc this is usually combined with other bases, og an historical cost basis may be modified by the ravaluation of land and buildings 4.8 Capital and capital maintenance “The final section of the IASB Fromewark is devated to a brief discussion of the differene concepts of capital and capieal maincenance, pointing out chat: > The choice benween chem should be made on the basis of the needs of users of finan > The IASB has na presant intention of prescribing a particular modal 4.8.1 Financial capital and capital maintenance Definition Financial capital maintenance; Under a financial concept of capital such as invested mengy or invested purchasing powor enpital iz synonymous with che nat arsets or equity of the antity fi cecum 234.8.2 Physical capi 24 Financial accounting ‘The financial eoncepe of capital it adopted by most entities, ‘This concepe measures capital as the equity in the balance sheet, Profic is only earned in an accounting period if the equity at the end of the period is greater than it was at the start, having excluded the efacts of distributions to or coneributions érom the owners during che period, Monetary measure of capital Financial expital is urually maazured in menetary torms, is the € seerling or tho cure. This isthe concept applied in historieal cose accounting. This measure can be quite stable over shart periods of years, but is ebased by even quite low rates of general inflaion over longer periods, such as 20years. So comparisons ‘between capital now and eapiesl 20 years age are invalid Because the measurement instrument is het ‘Constant purchasing power Avariancon the monecary measure of financial eapital is dhe constane purchasing power measure, On this basis, the opening capital (ie equity) is uprated by the change in a broadly based price index, often a retail prices index. over the year. Also, che transactions during the year are uprated by che change in ‘tho samo index, A profit is only aarnad if the capital at tho end of tho year excoods these uprated values. (Tha value of the uprating is taken to equity, but is not regarded as a profit, mersly 2 ‘capital maintenance’ adjustment.) So this capital maintenance adjustmene can be chaughc of as an additional ‘expance in the income statement Comparisons over a 20-year period will be more valid ifthe eapieal 20 yetes ago is upeated for general inflation ever that 20-year peried. Bur there is no reason why inflation measured by a retall prices index should be at all clase to-the inflation ‘exparianced by an individual company. | and capital maintenance Definition Physical capital maintenance: Under 3 physical concept of capital, auch as operating capability, capital it regarded as the productive capacity of the entity based on. fer example, units of output per day. ‘This coneege lacks bchind menstary values. to the underlying physical productive capacity of the centity, Icis based on che approach that an entity is nothing other chan a maans of producing saleable ‘ouRputs, 50 a profi is earned only aor that productive capacity has boon maintained by a “capital siaintenance’ adjustment. (Again, che eapital maintenance adjustmene is eaken to equity and is treated as an addtional expense in the income staxement} Comparisons over 20 years should be more valid than under a monetary approach to capital ‘The difculsies in this approach lic in making the capical maintanance adjustment, Ieis basicaly « current cost approach, normal practice being to use industry-spectfic indices of movements in nonscurrent 25s0¢s, rathor than go to the expense of annual rovaluations by professional waluars. The dificuias lie in finding Indices appropriate to the produetive capacity of a particular entey i Seancommamorcusronsancvor [I (Al Worked example: Capital maintenance concepts Mecrcat plc purchased 20,060 eleccrical components on | January 20X7 for £10 each. They were all sold on 31 December 20X7 for £250,000. On that date che replacement cost of an electrical component was E11 SO. The general race of inflation as measured by the general price index was 12% during the year Profic could be calculated as follows: Cee ene eee eerie eee perenne (monetary terms) (constant purchasing, Poy Revenue 230,000 250,000 250.000 Cost of sales 20,000 = 10 (200,000) 20.000 > 11.2 (224000) 20,000 > 11.5 (230.000) Prosi 50.000 26,000 20.000 4.9 Statement of Principles for Financial Reporting ‘The UR equivalent to the IASB Framework is the ASB's Stacement of Principles for Financial Reporting, Overall, ‘cs wary similar to cho Framework, the key differences being the following: > The Statement of ribet includes the following chapters for which there is ne direct equivalent in the Fremenark: = The Reporting Enity (which decalls which encities should prepare and publish financial statements} = Presentation of Financial informotion {which deals with clansification and good presentxtion} = Accounting for Interest in Gther Endves (which deals with consolidation issues ~ sea Chapcers ID» 16) > The teceurement chapter is more detailed with an emphasis on che deprival value model — see Chapeer 5. 5 International Accounting Standards Committee Foundation (IASCF) 5.1 The IASCF TASCE was formed in March 2001 as a necfor-profie corporacion and is the parent entity af the IASB. ‘The IASCF is an independene organisation and ics crustees exercise oversight and raise necessary funding for che L438 te carry our its role as standard secter, Ik also oversees the work of che GfcurreD = 8Financial accounting International Financial Reporting, Interpretations Committee (IFRIC) and che Standards ‘Advisory Council (SAC). These are organised a3 follows: IASCF is responsible for: » Funding > Appointment of mambers of IASB, SAC and IFRIC TASB is respensibie for ‘SAC is responsibie for: 26 5.2 53 5.4 All echnical matters in general In parecula. che preparation and issue of invarnational accounting scandards put on LASE's agands > Inpue on LASB's project merable and prorices > Advice on standard-setting projects > Supporzing IASB in promotion!adoption of IFRS chroughour the world TFRIC is responsibie Far: > Interpretation and application of internavional accounting seandards Membership Membership ofthe SCF has been designed so cha it represencs an incerational group of preparers and ‘sera, who scare IASCF trustees, The selection process of the 19 trustogs takes into account gcogr=phieal factors and professional background, IASCF truscecs appoint the IASB members The IASB ‘The IASB is responsible for setting accounting standards. It i made up of 14 members (12 full-ime and ewe partcime members) coming fram nine countries, They have a variety of backgrounds and include: Auditors > Proparore of nancial sratomense + Users offinancal sintements, and } Academics Objectives of the IASB “The Prafoce to Intersil Financial Reporting Stonderds states thatthe objectives of the IASB are as follows: > To develop in the public interost. a single set of high-quality, understandable and enfarceable global accounting standards chat require high qualey, exraparont and comparable information in financial stcements and other fmanesal raporsing to help parvcipancs inthe various expial markess of the world and other users of the information ro make economie decisions > To promete the use and rigorous application of those standards. and > To work actively with national standard-seteers to bring about convergence of national accounting standards and IFRS to high quality solutions. ‘The issue of convargunce is vary topical A number of axorcizos are being undertaken ax the moment aiming ‘0 bring national and international ascounting standards into lin. OF enaRTEAEDconcerunaonecurenreancocne [IE 6 International Financial Reporting Standards (IFRS) Section overview > The influence of IFRS is grovring. » They aim to ensure that like transactions and evans are treated consistently. |a number of differences batwesn international and UK > In spite of some convergence thers are 3 srandards 6.1 The purpose of accounting standards ‘The everall purpose of acceunting standards ie to idenciy proper accounting praetices for the preparation of financial statements. ‘Accounting standards create a common understanding between users and preparers on how particular icams, for oxamplo the valuation of proporty, are treated. Financial statements should tharafare comply ‘with all applicable accounting standards. 6.2 Application of IFRS ‘Within each individual country local regulations govern, to a greater or lesser degrees, the issue of financial seatements. These local regulations include aecouneing standards issued by the nacional regulatory ‘bodies or professional accountancy bodies in the country conzerned, ‘Over she fst 28-yenrs however. che influence of IFRS on n: practices has boen growing, For example: nal accounting requirements and > For accounting periods commencing on or after | January 2005, all EU companies whose securities are weaded en a regulated publie marke such 1s dhe Landon Stock Exchange, must prepare their consolidated accounts in accordance with IFRS, (Noto thas although group financial statements muse follow IFRS che individual financial sacemencs do not need to} > In che UK unquoted companies are permitted (but not required) co adopt IFRS (s00 section | 5) 6.3 Setting of IFRS ‘The overall agends of the [ASS will inital be set by discussion with the SAC. The process for developing an individual standard weuld inveive the fllowing steps. Step | During the early stages of a project, IASB may establish an Advisory Committee to give advice on issues arising in the project. Consultation with the Advisory Committee and the SAC occurs throughout the project Step 2 IASB may develop and publish 2 Discussion Document for public comment. Step 3 Following che receipe and review of comments, IASB would develop and publish an Exposure Draft for public commence. cep 4 Following che receipe and review af comments. the IASB would issue 2 final International Financial Reporting Standard. ‘The period of exposure for public comment is normally 90 days, However. in exceptional circumstances, [proposals may be issued with a comment periad of 601days. Draft IFRIC Interpretations are exposed fora b-day comment period fi cecum 2728 Financial accounting 6.4 6.5 7 Scope and authority of IFRS ‘The Preface to IFRS makes the follawing points: > IFRS apply o all general purpose financial statements ie those directed towards the common information necds of a wide range of usors traneactions and ovonts to be accountod for ina likko > Tho IAS8's objecrva ie to requi way. > Te recognises that the IASC (he predecessor to the IASB) permitted different treatments {benchmark trexemene and allowed alternative treatment) for lke transactions and evence. Where thet geil exit ether sresement wuld eenetnute complianes with IFRS, » Standards inchade paragraphs in bold and plin ype. Bold type paragraphs indicate the main principles. but bath types have equal authority. } Any limitation of che applicabilty ofa specific IFRS is made clear in that standard. IFRS are not intended to be 1pplied to immaterial items, ner are they retrospective, Each individual IFRS lays ut ts seape at the beginning of the seandsrd. Differences between international and UK standards roncas betweon UK and incarnatianalstandarés remain imporcant because UK standards must ba complied with by all those UK companies whieh neither are required nor chose to adept international seandards (as we saw in section 6.2) ‘As che ASB has amended ies own seandards to fi international ones more clasely the number of dferences ‘between it standards and their incgrnational equivalent is much reduce and it likely to-redues further in the future, There ars, however a number af key differences which do still exist and which are ‘examinable. Those will be desle with throughout the ramaindar of the text. Inherent limitations of financial statements Section overview > There are limiescions inherent in financial staremments, including the fuce chat they are: = Accenventionalised representation, involving classifieation, aggregation and the allocation af items to particular accounting periods = Historical backward-looking). and = Based almost exclusively on financial data. Conventionalised representation Financial statements are highly standardised in verms ef chele overall format and presentation although businesses are very diverse in their nature, This may limit che usefulness of che information Financial sacemencs are highly aggregated in tha information on a grent many eransactions and balances is combined inco a fow figures in che accounes, which can often make it difficult for tho render co evaluate the components of the business. Allocation issues include for example, te application of the accrual concepe and depreciation of non currenc-asets. where management's judgements and estimates affect che period in which expenses or income are recognised. i Sean7.2 7.3 7.4 concmunacecumcrsarvore IIE Backward-looking Finanelal seatements are backward-laoking whereas mose users af financial information base thelr decisions on expeceations about the future, Financial statemencs contribute toward: this by helping to identify trends and by confirming the accuracy of previous expectations, but cannot realistically provide the complete information set required for all economic decisions by all users Omission of non-financial information By their nature, financial seacermencs coneain financial information, They de noe generally include nen- financial data such as } Narrative description of the major operations > Discussion of business risks and opportunitios » Narrative analysis of tho antity’s performance and prospects. > Management policies and how che business is governed and controlled. Financial seatements include the elemencs as defined in che IASB Framework. This means that items which do not mete those definitions are not included. For exampla, the value of the entiy’sinsermally generated goodwill ie through its reputation. loyalty and expertise ofits management and employees. or its chant pportiolio. While some companias de axperimonc with differont types of diselosure for such items, these disclosures are considered unsuitable for inclusion inthe financial statements (precisely because wuch items do not fall within ies definition of assecs) Other sources of information Sems of the limitations of financial statements are addressed in ths other information which is often Provided along with the financial statements, especially by large companies. such az operating and financial reviews and the Chairman's stacemiant Note that other information provided with financial statamonts is ‘uttide the scape of the Financial Accounting syllabus, ‘There are also many other sources of information available co at lease some users of financial statements, for example! > In ownor-managad businosses, cha owners have access to intornal management information becausa ‘they are the managament, This information is, potentially, available on 3 continucus real-time Basis and may include: = Future plans for the business = Budgets or forecasts = Management accounts, including. for example. divisional analysis > Banks will often obtain additional access to entity information under the terms of loan agreements > Potential investors (eg if they are planning to take a major stake or even a controlling interest) will ‘often negoriate additional access co corporate information. > Publicly available information, such as encity brochures and publicity macerial (eg press releases) > Brokers’ reperts on major companies, and > Pross reports and other media coverage (eg television er internss), fi cecum 2930 Financial accounting 8.1 8.2 8.3 Not-for-profit entities Section overview > Netfor-profic entities include eharites, elubs, and public sector organisations, > Reporting requirements will vary depending on the nature of the entity. Not-for-profit entities ‘The objective of moss company direcvors is xo manage the shargholders' investmant. In a majority of casoe ‘this will mean creating 3 profit. Hovraver, shis is not alvays the caso, For same encities their primary purpose i co provide a service rather than to make a profi Interactive question 2: Not-for-profit entities [Difficulty level: Easy] List as many eypes of notslorsprofie organizations at you ean. See Answer at che end of this chapter. ‘As this exercise has demenserated not-for-profit entities include a broad range of arganisations invalved in very different activities. Not-for-profit entities also vary considerably in size from che local rugby club co an internationally renowned charity. Reporting requirements Many of the organisations mentioned above may be companios. In this c1s0 they will naod to propars financial sestements and have chem audited in accordance with local legislation and accounting regulation. In che UK chis would include compliance with the Companies Ace and UK accounting standards For unincorporated ansitis the reporting reguirsments ars normally les oncrsus,ahough bess practice wauld be te follow local GAAP (se0 section 1.5). In addition. many not-for-profit organisations will need to comply wich regulations specifi to their sector, For example in the UK, charities are required to comply with the Charities Act 1993 and Statement of Recommended Practice: Accounting and Reporting by Charities, International public sector accounting standards Incornational Public Soesor Accounting Standards (IPSAS) aro issued by the Incernational Public Soczor ‘Accounting Standards Beard (IPSASB). The objective of IPSASE isto: > Develop high qu public sector financial reporting standards > Facilitate convergence of international and nacional standards. > Enhance the quality and uniformity of nancial reporting. (Currently there ieme requiroment for IPSAS to be adopted and in jurisdictions where national standards already exist since it is th local regulation which will be appiod. Tho IPSASB hamaver. envisage an inereasing rele for IPSAS in fusurs, purcieularty in the following areas: > Assisting national standard-serters in the davelopment of new standards and the revision of existing seandards > Being applied in jurisdictions where there ix no national legislation. i Seancommamorcusronsancvor [I Summary Financial Acounting Self-test ‘Answer the following questions | Which of the follaveing isthe best description of why the IASB Framework: roquires financial statements tobe prepared on the basis of accrual accounting? ‘As 2 result of che ‘substance over form! requirement So as wo be prudent Beeause itis the mose objective basis Because ic presencs both past transactions and future obligations oam> | Fy coe32 Financial accounting ‘The following relate ts the going concern assumption, (0) The entigy has no need co liquidate 2) The entigr has na intention to liquidate 1) The entity has no need ce cursail maserialy iss seale of operations 4) The entity has ne intention to curtail materially is scale of operations ‘Which of the above are the best description af the conditions which the IASB Framework identifies as necessary ifthe going concern basis isto be uted for the preparacion of financial scaremencs? A (I), (Bp and (3) only B (1). By and (4) only © (1). Bhand (4) only © (1). (2. @) and (4) ‘According to the IASB Fromewark which of the following s ene of the qualative characteristes which make information in financial statements useful2 A True and fair view B Comparatility Timeliness BD Hiscorieal cox ‘Which ofthe follawing isthe closest approximation to the JAS Frameworks definiion of an asset? A. Avesource controlled by the entity from which furure economic benefis are expected which can bbe measured reliably B Arresource controlled by the entity as a result of past events from which future economic benefits are expected which can be measured reliably C Arresource controlled by the entity from which future economic benefits are expectad DA resource controlled by che encity as a pesulc of pase evencs from which future economic benefits are expected ‘Which af the following is the closest approximation to the 458 Fremewerk’s definition ofa labiliy? ‘A. A\lsgal obligation arising from past events, the saetlemant of which is expected to result in an outfaw of resources embodying economic benefics Bn obligation arising from past events, che settlement of which is expected to result in an ourlaw of resources embodying economic benefits which can be measured reliably An obligasion arising from pase events, che setsiement of which is expected to result in an euefaw of resources embodying economic benefits DA legal obligation arising from past events, the sattlement of which is expected to resuit in an ourfiaw of rosourcas embodying ccanomic boncfis which can be maasured reliably Fucure sacelement is an essential part of che JSB Fremewark's definision of a labilicy. Which ef the following best describes the way chat setdament may occur? A. Payment of cash B Payment of cath or transfer of ether assets Payment of cash or transfer of other assets er raplacement of the cbligaticn with another obligation D_ Paymene of each or transfer of echer assets or raplacemant of the ebligatien with another obligation or conversion of the obligation co equity OF enaRTEAEDconcmunacecumcrsarvore IIE Which of the following it the closest approximation to the JASB Fronework's definition of income! A Inerense in assets B Ineresse in assets or decrease in lbilities © Increase in assets or decrease in liabilities. other than those relating ta transactions with equity parcicipants BD _Increase in assets, other than those relating co transactions with equity participants Which of the following is the closest approximation to che JASB Framework’ requirement a8 to when an asset or lability should be recognised? ‘A Its probable chat future economie banafits will low to er from the entiey and the item's coat or value can be estimated B__ [tis probable chat furure economic benefts will flow to or from the enticy and the ivem’s cose or value ean be measured reliably The ieem’s cose or value ean be measured reliably D The ieem’s cost or value ean be estimased Which of the following statements is true in respoet of International Public Soetar Accounting Seandards (|PSAS)? ‘A Currently there is no requirement for IPSAS to be adopted by public sector entities B IPSAS must be adopted by public sector entities where there are no national standards C Both IPSAS and nasienal standards must Be adopeed by publie séetor entitles None of the above seatemencs is correct TRADITIONAL FRUITS LTO ‘Traditional Fruits Led, a Harofordshire based fruit bowling and canning company, is looking to expand ies operations. The dircetors are haping to increase the rango of preserved fruit preduets and in ding £0 will need to invest in new equipment. They are alsa hoping co open a new facility in che South Ease hear co the fruit farms ef Kene and Surrey, ‘The finance directer has been asked co prepare a résumé of che financial performance of the company in order that possible providers of finanes can assess the future potential of the company. ‘The finance director wants to address all issues in hor résumé and has asked for your assistance, Requirements Prepare brief noces for the finance director. addressing each of the following and using the ASB Framework as a source of reference. {s) _[dentify potential providers of finance for Traditional Fruits Led and their information requirements in respect of financial statements, (b) Explain the terms ‘performance’ and ‘position’ and identify which of the financial statements will assiot che user in evaluating performance and position {c)_Indieace why, far decision-making purposes, the financial stacemencs alone are insufficient fi crowmte = 33Financial accounting I DAVIES AND SAYERS LTD Davies and Sayers Led (DBS Led) is a well-known publisher of children’s educational books. The finance direetor, Carol Roberts. is knawn for her commercial acumen rather than her technical ability Sha is therefore sesking your advice on twe partievlar accounting issues, (1) Vales of head of publishing (D&S Led have recency appointed a naw head of publthing. Jane Lindsay. jane recently worked for a key competitor. Surridge and Hughes ple (S&H ple}. Jane Is extremely popular amongst the leading authors in dhe market and is sure co attract the services of certain authors currendy working for SRH ple. Caral believes that jane is therefore of great value te DBS Led and that such value should therefore be recognised inthe balance sheet in che form of an asset (2) Provision for alleged breach of copyright Carol is aware that Poppy Anderson, one of DBS Led's authors, ie being accused of including Ideas in her texts that have previeusly been published’. Carol it certain a legal case will ensue and therefore, being prudent, wishes to recognise a liability in che accounts now far any damages that ara likoly £9 arisa, Requirements Using tha LASB Fromewerk a) Define the corms “assed, “abiliy’ and ‘recognised’ (b) Prepare brief notes for Carol Roberts, discussing whether the above resule in an asset er liabilty and whether or nat they should be recognised in the finaneial statements, Note: You are nat required to refer to specific IFRSs that may be relevant. Now, go back to the Learning Objectives in the Introduction. Ifyou are satisfied you have achioved these ‘abjectivos, please tiek ham off i Seanconcmunacecumcrsarvore IIE Point to note: The whole of the IASB: Framework (Frame) and Preface to International Financial Repartng Stondords (Preface) is examinable. The paragraphs listed below are the key references you should be familar wih | Purpose and use of financial staremonts > Users’ cara need is for information for making economic decisions > Objective is te prowide informacion on financial position, financial parformance and shanges ia financial position > Financial postion: — Revourees controlled Financial seruccure Liquidiey and solvency = Capacity to adapt te changes > Financial performance, measured as profi income lass expanses: = Potential changes to resources in che future Capacity to gonerate cath fram existing resource base = Effectiveness with which additional resources might be employed > Changes in financial positon: = Abiligy to gencrate cath = Neads to use what is generated > Noces and schedules: = Risks and uncertaineies = Resources and obligations not recognised in financial statements 2 Underlying assumptions > Accrual Basis Going concern + Qualitative characteristics of financial statements > Te be useful, information needs co have the actribures of, = Understandabilicy = Relevance, te include > Macorialcy = Reliability, to include: } Faithful ropresantation } Subseance over form Nowtralicy » Prudence > Realised/unrealised = Compnrabilcy > Application of chese should result in a crue and fair view/hir presencacion Frame (Preface) Frame (12) Frame (16) Frame (17) Frame (18) Frame (24) Frame (22) Frame (23) Frame (25) Frame (26) Frame (28) Frame (34) Frame (33) rame (35) Frame (36) Frame (37) rame (38) Frame (46) oF chanreatD 3536 Financial accounting 4 Elements of financial statements > Assot: a resource controlled by tho oncity at a rosule of pase events and from whieh future econemie benefies are expected to flow te the entity > Liability: a presont obligation of the conti arising from past events, the settlement of which is expected to lead te the eutflaw fram the entity of resources embodying economic benefits > Equity: the vesidual interest in assets less liabilities. ie net assets > Income (comprising revenue and gains): increase: in economic benefits in the form of aszor incroasosliabilicy docreases, othor than contributions from equity > Expenses (Including lotses): decreases in economic benefit in the form of anser docreasesilability increases, other than distributions to equity 5 Recognition > Assets and liabilities are recognised in financlal sestermencs — lit probable thar any future economic benefit asseciated with the fem will flaw to oF from the entity, and = Ike cost oF value can be measured with reliability 6 Measurement > Historical cose > Current cost > Realisable value > Present value 7 Capital maintenance > Financial capital: = Monssary = Conscant purchasing power > Physical expiea! BIASB > Objectives > Scope and autharicy > Process i Sean Frame (49) Frame (49) ne (49) Frame (70, 74- 78) Frame (70, 78- 78) Frame (83) Frame (100) Frame (104) Preface (6) Preface (7-17) Preface (18)re concmunacecumcrsarvore IIE B B B B © B c B A TRADITIONAL FRUITS LTD: (2) Potential providers of finance Information requirements > Tho axisting sharcholders.oftho Tha pratit before interest of Traditional Fruits company and potential new Ld (TF Led). to determine risk shareholders ~ through a new issue ‘of share capa, > Tho trond of profitability of TF Led together with a history of dividand payments. This wil enable them te assess necurn and risk of cheie investment. > The finanelal structure of TF Led. to determine che lavel of dabe finance a5 a moasure of risk. > TE Lea's liquidity or ability to pay our dividonds and rodeom share capital > TF Lea's ability to generace cash and the timing and certaingy of ies generation, > Existing and future lenders and The liquidity of TF Led and its ability co repay crodiors to the company. incgrest and capital instalments » The existing level of debe and any security over shat debt, {b) Performance and position and the financial statements which assist in evaluation Performance Ths financial performance ofa company comprises the return it ebtnins on the resources ie controls, Performance ein be measured in tarms ofthe profs of che company and is abliey © generacs exth dows, Management will be assessed on thelr skill In achieving the highest leva! of performance, given the resources available to them. Information an performance ean be found in The income seatement > Tho statement of changes in oquity » The cash flow statement, oe chante a738 Financial accounting Position ‘The financial position of the company is evaluated by reference to > The economic resources (assets and liabilities} it controls, > es capical soructure, ie ics level of debtfinance and shareholders’ funds. > es liquidity and selvaney, ‘The user of che financial statements A dizcussion of busines risks and epporcunitis > An evaluation of che qualey of management > A.narrative-analysi of position and performance DAVIES AND SAYERS LTD (a) Terms Assot ‘An asset is > A resoures controlled by the enticy > Asa result of past events, and > From which future ecenomie benefits are expected to flow ince the entity Legal ownership is notan essential part of the definition of an asset, even though such ownership ig indicative that the control criterion has been met. But the key is whather the entity controls a reroures, 0 having che continued use of an corn will oon bo suffciant evidence of contr. > Apresane obligation of the entity » Arising from pare evenee > The setement of which i expected eo renule nan cudlew from the entity of rezourees ‘embodying economic benefits ‘An obligacion arises from a legally-enforceable contract, but ic may also result from an encity’s ermal business practices OF enaRTEAEDconcmunacecumcrsarvore IIE Recognised Recognition means that an itent is recarded in dhe financial statements, An astet or lability it recognised if > Ieis probable chat any future economic benefic associated with the item will ow to ar from she ancy, and > The cost or value can be measured with reliability, (b) Notes for Carel Roberts (I) Value of head of publishing Existence of an asset I you apply the definition af an asset from the (ASB Framework to the head ef publishing, Jane Lindsay, i iz possible to argue that she has the characteristics of an asset ‘As a fulltime employee, Jane is likely ea have a contract which was signed prior to che balance sheet dace, The legal centract will prevent Jane werking fer any ether company, iving DAS Led unrescriceed access to any benefits she may provide I Jane i able to persuade new authors co join che D&S team, she fs creating a flaw offucure economic banafits = on tha assumption thac the authors’ naw work will prove salasworthy. However, cherg is uncarsaincy over > The enforceability of jane’s contract: she may recruit new authors to DBS Led, but Within shore period of time might leave and join a new eomnpany: her authors are then likely to follow her. » The revenue stream to rosul fromthe now authars: they have not as yor bean recruited and it i only possible that thoy will b; thers are alse no guarantees as to the quality of their fueure work and therefore the level of revenue-they are likely to generate, ‘Therefore, at cis stage we cannot conclude that an asses exists. Recognition of the asset ‘An item is paengnised whan itis included in the financial sentemencs at 2 monetary valu, (Carol Roberts i proposing to include Jane Lindsay as an asset in the balance shect Howaver, cerin eriteria should be applied prior te recognis > Is-there sufficient evidence of che existence of the assee? Can the asset be measured ats monetary amoune with sufficlene reliabiley? (2) Provision for breach of copyright Existence of a liability ‘At this stage Poppy Anderson has been accused of breach ef copyright. From the information given, thare is no opinion fram lawyers as to-the strength of the ease or estimate of the possible value of any eluim, Therefore, whilst a past trangaction has allegedly occurred. chere is insufficient evidence of, and uncertainty over, whacher an obligation sites Recognition of the liability Te recognise the labiliey in the francial seaeemente there must be suficient evidenes of che ‘existence of the liabilicy and ie should be probable that economic benefie will flow from the enciy In this.ease, chara is ineuciane evidence ofa liability and we are unable to reliably measure any portend ability ‘The ease isnt far soo carly a stage te astimate the possible loss, Ie wauld tharsfors ke aver: prudent and inappropriate to recagnise the liability in the financial sestemencs fi crow 39Financial accounting Answer to Interactive question | (2) Oak ple has purchased a pacene for £40,000. The patent gives che company sole use of a particular rmanufseturing process which will sxve £6,000 year for the next five years, (6) Elm ple paid John Brown £20,000 to sec up a car repair shop, on condivion thas priorisy crentmene. is given to cars from the company's fleet (@) Syeamore plc provides a warranty with vary sold, washing machi Answer to Interactive question 2 Charivies Friendly societies Public sector hospitals Public sector sehools Clubs Associations Local counsils Public services Trade unions Societies Housing associacions OF enaRTEAED ‘Thi is an asset albeit an intangible one, There: lia past event concrol and future economic benefic (through eose saving). This cannot be classed as an asset. Elm ple has ne conerol ever the ear repair shop and itis difficult to argue that there are future: economic benefits ‘This isa liabilicy, The business has an obligacion to fulfil the terms of the warranty. Ths lability ‘would be recognised when the warranty is Issued rather than when a elaim is made,