Financial Reporting Book

Financial reporting
J. Haslam and D. Chow

AC3091
2016
Undergraduate study in
Economics, Management,
Finance and the Social Sciences
This is an extract from a subject guide for an undergraduate course offered as part of the
University of London International Programmes in Economics, Management, Finance and
the Social Sciences. Materials for these programmes are developed by academics at the
London School of Economics and Political Science (LSE).
For more information, see: www.londoninternational.ac.uk
The 2016 edition of this guide was prepared for the University of London International
Programmes by:
Professor J. Haslam, Heriot-Watt University
and
Dr D.Chow, Durham University
It draws on previous editions of the guide prepared by J. Horton and S. Miles
Professor J. Horton, BSc, M Phil, PhD, Department of Accounting, University of Exeter Business
School.
It was revised and updated in 2007 by:
S. Miles, PhD. Department of Accounting, The Business School, Oxford Brookes University.
This is one of a series of subject guides published by the University. We regret that due
to pressure of work the authors are unable to enter into any correspondence relating to,
or arising from, the guide. If you have any comments on this subject guide, favourable or
unfavourable, please use the form at the back of this guide.
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Published by: University of London

© University of London 2012
Reprinted with minor revisions 2016
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Contents
Contents
Introduction............................................................................................................. 1
Aims and objectives of this course.................................................................................. 1
Learning outcomes......................................................................................................... 1
Syllabus.......................................................................................................................... 2
How to use this guide..................................................................................................... 2
Essential reading............................................................................................................ 3
Further reading............................................................................................................... 4
Online study resources.................................................................................................... 6
Preparation for the examination...................................................................................... 7
Overview of the guide.................................................................................................... 8
Index of abbreviations used in this guide......................................................................... 9
Chapter 1: Rationale for financial reporting and its regulation........................... 11
Aims of the chapter...................................................................................................... 11
Learning outcomes....................................................................................................... 11
Essential reading.......................................................................................................... 11
Further reading............................................................................................................. 11
Financial accounting theory.......................................................................................... 12
Financial accounting and its role................................................................................... 13
Financial accounting regulation.................................................................................... 15
Accounting standards: what form should they take?...................................................... 17
Descriptions of accounting and its regulation................................................................ 19
UK accounting regulation and the influence of international accounting standards........ 20
Institutional setting for accounting regulation: the UK................................................... 20
Statutory regulation: IASs/IFRSs gained force of law...................................................... 22
Mandatory regulation: standard-setting and the case of the UK..................................... 23
Stock Exchange............................................................................................................ 25
Reminder of learning outcomes.................................................................................... 26
Sample examination questions...................................................................................... 27
Chapter 2: Conceptual framework........................................................................ 29
Further reading............................................................................................................. 29
Definition of a conceptual framework............................................................................ 30
Rationale for a conceptual framework........................................................................... 31
Advantages claimed for a conceptual framework........................................................... 31
The US, IASC and UK initiatives compared..................................................................... 32
Objectives of financial reporting.................................................................................... 33
Qualitative characteristics of accounting information..................................................... 35
Elements of financial statements................................................................................... 38
Recognition and measurement in financial statements SFAC 5, SOP............................... 41
Presentation of financial information............................................................................. 44
Review of the conceptual framework ........................................................................... 45
Conclusions.................................................................................................................. 46
i
AC3091 Financial reporting

Sample examination questions...................................................................................... 47
Chapter 3: Income measurement and capital maintenance.................................. 49
Further reading............................................................................................................. 49
A view of income and capital often characterised as the accountant’s view.................... 50
A view of income and capital often characterised as the economist’s view..................... 50
Hicks’s version of the economist’s concept of income..................................................... 51
Hicks’s income number 1.............................................................................................. 51
Income ex ante and income ex post.............................................................................. 55
What if interest rates are expected to change?.............................................................. 58
Implications of Hicks’s measures of income................................................................... 64
Implications for accountants......................................................................................... 65
Chapter 4: Historical cost accounting (HCA) and accounting for changing
prices/values.......................................................................................................... 67
Further reading............................................................................................................. 68
Introduction................................................................................................................. 68
Revising HCA............................................................................................................... 69
Characteristics of HCA.................................................................................................. 70
Advantages of HCA...................................................................................................... 70
Disadvantages of HCA.................................................................................................. 71
Alternatives to HCA...................................................................................................... 73
Introducing CPP accounting.......................................................................................... 73
General and specific changes in price............................................................................ 74
Profit recognition and capital maintenance................................................................... 74
Assessing CPP accounting ........................................................................................... 75
Converting from HCA to CPP: a step-by-step guide....................................................... 76
Worked example and explanation of CPP...................................................................... 78
Advantages of CPP....................................................................................................... 82
Disadvantages of CPP................................................................................................... 82
Introduction to current value accounting (CVA)............................................................. 83
Replacement cost accounting (RCA).............................................................................. 83
Net realisable value (NRV)............................................................................................ 83
Present value (PV)........................................................................................................ 84
Deprival value (DV)....................................................................................................... 84
Holding gains and current operating profit.................................................................... 87
Capital maintenance concepts ..................................................................................... 88
Current value accounting using replacement cost ......................................................... 91
Worked example and explanation of CVA...................................................................... 91
More on deprival value................................................................................................. 96
Advantages and disadvantages of replacement cost.................................................... 100
Advantages and disadvantages of deprival value......................................................... 101
ii
Contents
Combined CPP/CVA system........................................................................................ 101

Reminder of learning outcomes.................................................................................. 107
Sample examination question..................................................................................... 108
Chapter 5: Accounting for groups....................................................................... 111
Aims of the chapter.................................................................................................... 111
Learning outcomes..................................................................................................... 111
Essential reading........................................................................................................ 111
Further reading........................................................................................................... 111
Introduction............................................................................................................... 112
Key principles and rationales....................................................................................... 113
Requirement for consolidated accounts....................................................................... 116
Different models of group accounting ........................................................................ 117
Different types of relationships within a group .......................................................... 118
Accounting for subsidiaries......................................................................................... 119
Merger accounting..................................................................................................... 138
Accounting for associates........................................................................................... 138
Accounting for joint ventures...................................................................................... 142
Discussion.................................................................................................................. 145
Sample examination questions.................................................................................... 148
Chapter 6: Accounting for foreign currencies..................................................... 151
Further reading........................................................................................................... 151
Introduction............................................................................................................... 151
Foreign currency conversion: business transactions...................................................... 152
Foreign currency translation: business transactions...................................................... 153
Which exchange rate should be used to record foreign currency translations? ............. 155
Accounting for the closing rate method and the temporal method............................... 157
Final thoughts............................................................................................................ 162
Chapter 7: Accounting for tangible non-current assets...................................... 165
Further reading........................................................................................................... 165
Tangible non-current assets (owned)........................................................................... 166
Measurement of tangible non-current assets............................................................... 166
Borrowing costs.......................................................................................................... 167
Measurement after recognition: revaluation................................................................ 168
Depreciation............................................................................................................... 170
Tangible non-current assets (not owned): leases.......................................................... 179
Chapter 8: Intangible assets: goodwill and R&D................................................. 187
Further reading........................................................................................................... 187
iii
Introduction............................................................................................................... 188
Goodwill: the debate.................................................................................................. 188
Intangible assets (other than goodwill)....................................................................... 194
Impairment: IAS 36..................................................................................................... 197
Research and development......................................................................................... 198
International differences............................................................................................. 200
Chapter 9: Accounting for inventories and construction contracts.................... 203
Further reading........................................................................................................... 203
Components of inventory............................................................................................ 203
Implications of inventory for the accounts................................................................... 204
Inventory valuation: definitions .................................................................................. 206
Implications of fair value accounting........................................................................... 208
Construction contracts................................................................................................ 208
Profit recognition methods.......................................................................................... 208
Sample examination question .................................................................................... 213
Chapter 10: Accounting for equity and liabilities............................................... 215
Further reading........................................................................................................... 215
Share capital and reserves.......................................................................................... 216
Ordinary shares.......................................................................................................... 216
Preference shares....................................................................................................... 216
Accounting issues: equity or liability?.......................................................................... 217
Off-balance sheet financing........................................................................................ 225
Chapter 11: Accounting for taxation................................................................... 229
Further reading........................................................................................................... 229
An introduction to corporation tax systems................................................................. 230
UK: corporation tax.................................................................................................... 230
Deferred taxation: taxable profit versus accounting profit............................................ 233
Three approaches to the accounting treatment of deferred tax.................................... 235
Value-added tax (VAT)................................................................................................ 238
Chapter 12: Analysis and interpretation of financial reports.............................. 241
Further reading........................................................................................................... 241
iv
Contents
Introduction to the interpretation of financial statements............................................ 241

Ratio analysis – introduction....................................................................................... 242
Cash flow statement................................................................................................... 246
Trend analysis............................................................................................................. 246
International differences............................................................................................. 247
Appendix 1: Solutions to activities and Sample examination questions............ 251
Chapter 3................................................................................................................... 251
Chapter 4................................................................................................................... 251
Chapter 5................................................................................................................... 256
Chapter 6................................................................................................................... 260
Chapter 7................................................................................................................... 262
Chapter 8................................................................................................................... 268
Chapter 9................................................................................................................... 269
Chapter 10................................................................................................................. 275
Chapter 12................................................................................................................. 276
Appendix 2: Example of eight-column accounting paper................................... 277
v
Notes
vi
Introduction
Introduction
What is or should be the role of accounting in society? How important

is or might be accounting in this respect? In what sense is and should
accounting be regulated?
You may have encountered the financial accounting statements of
companies, a major focus here, as part of your work or as a shareholder
or other user. These statements will probably have been prepared
by accountants and audited by an independent firm of auditors. The
statements would still require some analysis by the user, for instance:
Which figures are subject to management discretion? Which figures
depend on accounting choice? How can you distinguish between two
companies with identical earnings? How should accounting be regulated?
Who should regulate or organise the production of accounting?
This subject guide is concerned with helping you to develop an
understanding of financial accounting consistent with the aims and
objectives of the course specified below.
Aims and objectives of this course

The Financial reporting syllabus is concerned with the theory and
practice of financial accounting. This involves a sound understanding of
the concepts and choices that underlie measurement and disclosure in
financial statements. The aims and objectives of the course are to:
• stimulate theoretical enquiry into financial accounting issues
• develop your knowledge and understanding of financial accounting
• prepare you for further academic study in accounting and related areas
• enable you to pursue a professional accountancy qualification
• equip you for employment in areas where an understanding of
accounting issues and tools is helpful.
Learning outcomes
At the end of this course and having completed the Essential readings and
activities, you should be able to:
• explain and apply a number of theoretical approaches to financial
accounting
• record and analyse data
• prepare financial statements under alternative accounting conventions
• describe a number of regulatory issues relating to financial accounting
• critically evaluate theories and practices of, and other matters relating
to, financial accounting.
The learning outcomes that you are expected to achieve for the various
topics are listed at the end of each chapter.
1
Syllabus
The rationale for financial reporting. Arguments for and against regulation
of financial reporting. Methods of regulation, including standardisation of
accounting practices. The nature and purposes of a conceptual framework
for financial reporting: the objectives of financial reporting; the qualitative
characteristics of accounting information; the definitions of an asset
and a liability; recognition and measurement in financial statements;
international framework. Narrative reporting and issues of corporate social
responsibility. Economic and accounting concepts of income, capital and
value with particular reference to Hicks’s income concepts.
Strengths and weaknesses of historical cost accounting. Bases of
asset valuation. Capital maintenance concepts and various associated
techniques: current value accounting systems, current purchasing power
accounting, replacement cost accounting; in addition to entry (historical
cost) and exit value accounting.
Accounting for investments and groups of companies. The merger and
acquisition methods. Associated companies and joint ventures. Accounting
for foreign currency transactions, foreign subsidiaries and branches: the
temporal and closing rate/net investment methods of foreign currency
translation.
Accounting for tangible and intangible assets: fixed assets and
depreciation; stocks and long-term contracts; research and development;
goodwill. Accounting for leases. Accounting for liabilities. Accounting for
taxation, including deferred taxation.
Analysis and interpretation of corporate financial reports; introduction to
international differences in financial reporting.
Accounting standards in this subject guide

This subject guide is written for International Programmes students,
who will be studying in many different countries subject to different
accounting rules and regulations. The International Accounting Standards
Board (IASB) is quickly becoming the generally accepted accounting
regulator at the international level. In the EU and Australia, for example,
all listed companies are required to produce group financial statements
in accordance with current International Accounting Standards (IASs)
and International Financial Reporting Standards (IFRSs) – the latter
are gradually replacing the former as the IASs come to be updated and
revised. Many other countries such as the USA and China are working
towards closing the convergence gap between IASs/IFRSs and national
regulations. This subject guide has been written with this in mind. The
subject guide has an international focus but within that we give some
particular consideration to the UK (e.g. in the context of accounting for
changing prices) because it serves to illustrate some key developments.
All worked examples use £ sterling as the currency. A list of abbreviations
reflecting the emphases of the guide is given at the end of the Introduction.
How to use this guide

This subject guide is intended to supplement the Essential reading, not to
replace it. It should be read in conjunction with the Essential reading and
supported by Further reading. The list of Further reading is a selection
from many possible sources. Please seek additional reading on any topics
that you find difficult to grasp. Please note that, given the rapid
2
Introduction
pace of change in financial accounting, you should use the

latest editions of texts, particularly the Essential reading text
for the course.
In addition to the Essential reading listed at the beginning of each chapter,
you should read the appropriate available accounting practitioner journal
(e.g. Accountancy and Certified Accountant in the UK). Journals of other
professional accountancy bodies in other countries are just as relevant.
It may also be useful for you to obtain a copy of the Annual Reports and
Accounts of a large company in your country. This will provide you with a
good reference aid for some of the main issues addressed in this guide. You
can generally obtain these reports on the company’s website. Alternatively
you could write to the company asking for a copy of their report.
Websites
It is also recommended that you use the internet and investigate the
different professional bodies and government organisations’ websites
which are a useful source of information on current developments in
financial reporting and regulation. Examples include:
• www.frc.org.uk for the UK Accounting Standards Board (ASB)
• www.fasb.org for the US Financial Accounting Standards Board (FASB)
• www.iasb.org.uk for the International Accounting Standards Board
(IASB).
Unless otherwise stated, all websites in this subject guide were accessed in
April 2012. We cannot guarantee, however, that they will stay current and
you may need to perform an internet search to find the relevant pages.
Activities
This subject guide is divided into 12 chapters, the majority of which are
self-contained. Most chapters contain worked numerical examples, where
appropriate, and activities appear throughout the guide. It is strongly
recommended that you attempt to answer, or consider the implications of,
all activities. Many of them require you to do additional reading. Solutions
to some of the activities and sample examination questions are available in
Appendix 1 at the back of the guide.
Sample examination questions

There are sample examination questions at the end of each chapter, aimed
to test your knowledge and prepare you for the examination. However,
the Sample examination paper, found on the virtual learning environment
(VLE), is a more accurate reflection of the type of questions that are likely
to come up in the examination.
Reading advice
There is no single wholly satisfactory textbook covering all the topics
discussed in this course. References are given to one of the main advanced
financial accounting textbooks. References for specific Further reading will
also be given where appropriate. You are advised to check if new editions
of these textbooks are available.
Essential reading
Alexander, D., A. Britton and A. Jorissen International Financial Reporting
and Analysis. (Andover: Cengange Learning EMEA, 2011) fifth edition
[ISBN 9781408032282]. Hereafter, we will refer to this book simply as
International Financial Reporting.
3
Detailed reading references in this subject guide refer to the editions of the
set textbooks listed below. New editions of one or more of these textbooks
may have been published by the time you study this course. You can use
a more recent edition of any of the books; use the detailed chapter and
section headings and the index to identify relevant readings. Also check
the VLE regularly for updated guidance on readings.
Further reading
Please note that as long as you read the Essential reading you are then free
to read around the subject area in any text, paper or online resource. You
will need to support your learning by reading as widely as possible and by
thinking about how these principles apply in the real world. To help you
read extensively, you have free access to the VLE and University of London
Online Library (see below).
Other useful texts for this course include:
Collins, B. and J. McKeith Financial Accounting and Reporting. (London:
McGraw-Hill, 2010)[ISBN 9780077114527].
You might find it helpful to refer to a dictionary of accounting when you
encounter a new term. Two such dictionaries are:
Nobes, C. The Penguin Dictionary of Accounting. (London: Penguin Books Ltd,
2006) second edition [ISBN 9780141025254].
Owen, G. Dictionary of Accounting. (Oxford: Oxford University Press, 2005)
third edition [ISBN 9780192806277].
It is also recommended that you purchase or have access to the following
reference texts:
Deegan, C. and J. Unerman Financial Accounting Theory. (London: McGraw-
Hill, 2011) second European edition [ISBN 9780077126735].
Glautier, M.W.E., B. Underdown and D. Morris Accounting Theory and Practice.
(Harlow: Financial Times Prentice Hall, 2011) eighth edition [ISBN
9780273693857]. Please note that this is the Essential reading for 25
Principles of accounting so you may already own a copy.
Lewis, R. and D. Pendrill Advanced Financial Accounting. (Harlow: Financial
Times Prentice Hall, 2004) seventh edition [ISBN 9780273658498].
Palepu, K.G., and P.M. Healy Business Analysis and Valuation: Using Financial
Statements. (Mason, OH: Thomson South-Western, 2008) fourth edition
[ISBN 9780324302929].
Suitable international texts for reference include:
Nobes, C. and R. Parker Comparative International Accounting.
(Harlow: Financial Times Prentice Hall, 2012) twelfth edition
[ISBN 9780273763796].
Choi, F.D. and G.K. Meek International Accounting. (Harlow: Pearson, 2012)
seventh edition [ISBN 9780132311496].
Those of you who have studied 25 Principles of accounting may find
it useful to keep your subject guide to hand as you study this course.
The following is a list of all other reading listed in the Further reading
category in the subject guide:
Baxter, W.T. Depreciation. (London: Sweet & Maxwell, 1971)
[ISBN 042114470X].
Baxter, W.T. Inflation Accounting. (Oxford: Philip Allan, 1984)
[ISBN 9780860036234] Chapters 3, 8 (pp.103–15) and 12 (pp.182–201).
Beaver, W.H. and J.S. Demski ‘The Nature of Income Measurement’, Accounting
Review 54(1) 1979.
4
Introduction
Baxter, W.T. ‘Accounting Standards – Boon or Curse’, Accounting and Business

Review, Winter 1981, pp.3–10.
Beaver, W.H. Financial Reporting: An Accounting Revolution. (Harlow: Prentice-
Hall, 1981) [ISBN 9780133161335]. Chapter 7.
Bromwich, M. Financial Reporting, Information and Capital Markets. (London:
Pitman Publishing, 1992) [ISBN 9780273034643] Chapters 3, 4, 10–12.
(Although this focuses specifically on the FASB’s Conceptual Framework,
it also discusses a number of issues about the conceptual framework
approach that can be considered in relation to the IASB’s Framework for
the Preparation and Presentation of Financial Statements and the ASB’s
Statement of Principles.)
Cadbury report (1992). Available at www.iia.org.uk – search for ‘Cadbury report’.
Company Law Review Steering Group, Company Law Reform. Modern Company
Law for a Competitive Economy: Developing the Framework. Available at
www.berr.gov.uk/files/file23245.pdf
Draper, P.R., W.M. McInnes, A.P. Marshall and P.F. Pope ‘An Assessment of the
Effective Annual Rate Method as a Basis for Making Accounting Allocations’,
Journal of Business Finance & Accounting 20(1) 1993, pp.56–63.
Ernst and Young, International GAAP 2012: Generally Accepted Accounting
Practices under International Reporting Standards. (Chichester: John Wiley &
Sons, 2012) [ISBN 9781119962458].
Gallhofer, S. and J. Haslam, ‘Exploring social, political and economic
dimensions of accounting in the global context: the IASB and accounting
disaggregation’, Socio-Economic Review 8(4) 2007, pp. 633–64.
Hicks, J.R. ‘Income’ in Parker, R.H., G.C. Harcourt and G. Whittington (eds)
Readings in the Concepts and Measurements of Income. (Oxford: Philip Allan,
Hicks, J.R. Value and Capital. (Oxford: Clarendon, 1946) second edition
[ISBN 9780198282693] Chapter 14.
Holmes, G., A. Sugden and P. Gee Interpreting Company Reports and Accounts.
(Harlow: Prentice-Hall, 2008) tenth edition [ISBN 9780273711414]
Chapters 4, 10 and 11.
Ijiri, Y. ‘A Defence for Historical Cost Accounting’ in R. Sterling (ed.) Asset
Valuation and Income Determination. (Lawrance, KA: Scholars Book Co.,
1971) [ISBN 9780914348115].
Macve, R. ‘Accounting for Long-Term Loans’, in B. Carsberg and S. Dev (eds)
External Financial Reporting. (Harlow: Prentice Hall, 1984).
Macve, R. A Conceptual Framework For Financial Accounting and Reporting:
the Possibilities for an Agreed Structure. (London: Institute of Chartered
Accountants in England and Wales, 1981) [ISBN 9780852913116].
Paish, F.W. ‘Capital and Income’, Economica 7(28) 1940.
Peerless, S. ‘Accounting for Business Marriages’, Accountancy Magazine, October
1994, p.100.
Prakesh, P. and S. Sunder ‘The Case Against Separation of Current Operating
Profit and Holding Gains’, American Accounting Review, January 1979 (pp.1–22).
Sandilands Report, Inflation Accounting: Report of the Inflation Accounting
Committee, Cmnd. 6225 (London: HMSO, 1975). Chapters 10 and 12
(pp.159–65).
Scott, W. Financial Accounting Theory. (London: Prentice-Hall, 2011)
[ISBN 9780135119150].
Smith, T. Accounting for Growth. (London: Century, 1996) second edition
[ISBN 9780712675949]. Chapter 16.
Solomons, D. ‘Economic and Accounting Concepts of Income’, Accounting
Review 36(3) 1961 (reprinted in Parker, R.H., G.C. Harcourt and G.
Whittington (eds) Readings in the Concepts and Measurements of Income.
(Oxford: Philip Allan, 1986) second edition [ISBN 9780860035367].
5
Weetman, P. (ed.) SSAP 15 Accounting for Deferred Taxation. (Edinburgh:

The Institute of Chartered Accountants of Scotland, 1992)
[ISBN 9781871250237].
Whittington, G. Inflation Accounting: An Introduction to the Debate. (Cambridge:
Cambridge University Press, 1983) [ISBN 9780521270557].
Online study resources

In addition to the subject guide and the Essential reading, it is crucial that
you take advantage of the study resources that are available online for this
course, including the VLE and the Online Library.
You can access the VLE, the Online Library and your
University of London email account via the Student Portal at:
http://my.londoninternational.ac.uk
You should have received your login details for the Student Portal with
your official offer, which was emailed to the address that you gave
on your application form. You have probably already logged in to the
Student Portal in order to register! As soon as you registered, you will
automatically have been granted access to the VLE, Online Library and
your fully functional University of London email account.
If you have forgotten these login details, please click on the ‘Forgotten
your password’ link on the login page.
The VLE
The VLE, which complements this subject guide, has been designed to
enhance your learning experience, providing additional support and a
sense of community. It forms an important part of your study experience
with the University of London and you should access it regularly.
The VLE provides a range of resources for EMFSS courses:
• Electronic study materials: All of the printed materials which you
receive from the University of London are available to download, to
give you flexibility in how and where you study.
• Discussion forums: An open space for you to discuss interests
and seek support from your peers, working collaboratively to solve
problems and discuss subject material. Some forums are moderated by
an LSE academic.
• Videos: Recorded academic introductions to many subjects;
interviews and debates with academics who have designed the courses
and teach similar ones at LSE.
• Recorded lectures: For a few subjects, where appropriate, various
teaching sessions of the course have been recorded and made available
online via the VLE.
• Audiovisual tutorials and solutions: For some of the first year
and larger later courses such as Introduction to Economics, Statistics,
Mathematics and Principles of Banking and Accounting, audio-visual
tutorials are available to help you work through key concepts and to
show the standard expected in exams.
• Self-testing activities: Allowing you to test your own
understanding of subject material.
• Study skills: Expert advice on getting started with your studies,
preparing for examinations and developing your digital literacy skills.
6
Introduction
Note: Students registered for Laws courses also receive access to the
dedicated Laws VLE.
Some of these resources are available for certain courses only, but we
are expanding our provision all the time and you should check the VLE
regularly for updates.
Making use of the Online Library

The Online Library (http://onlinelibrary.london.ac.uk) contains a huge
array of journal articles and other resources to help you read widely and
extensively.
To access the majority of resources via the Online Library you will either
need to use your University of London Student Portal login details, or you
will be required to register and use an Athens login.
The easiest way to locate relevant content and journal articles in the
Online Library is to use the Summon search engine.
If you are having trouble finding an article listed in a reading list, try
removing any punctuation from the title, such as single quotation marks,
question marks and colons.
For further advice, please use the online help pages (http://onlinelibrary.
london.ac.uk/resources/summon) or contact the Online Library team:
onlinelibrary@shl.london.ac.uk
Changes to the syllabus

The material contained in this subject guide reflects the syllabus for the
year 2016–17.
The field of accounting changes regularly, and there may be updates to
the syllabus for this course that are not included in this subject guide. Any
such updates will be posted on the VLE. It is essential that you check the
VLE at the beginning of each academic year (September) for new material
and changes to the syllabus. Any additional material posted on the
VLE will be examinable.
Preparation for the examination

Important: the information and advice given here are based on the
examination structure used at the time this guide was written. Please
note that subject guides may be used for several years. Because of this
we strongly advise you to always check both the current Programme
regulations for relevant information about the examination, and the VLE
where you should be advised of any forthcoming changes. You should also
carefully check the rubric/instructions on the paper you actually sit and
follow those instructions.
With regard to this subject guide, you should:
• refer to the Essential reading and any Further reading you might
require to fully understand the topics in the syllabus
• attempt all the activities in each chapter
• complete all the sample examination questions.
We also recommend that you read through the section on examinations in
Strategies for success. It contains some useful guidelines on preparing for
examinations.
7
Remember, it is important to check the VLE for:

• up-to-date information on examination and assessment arrangements
for this course
• where available, past examination papers and Examiners’ commentaries
for the course which give advice on how each question might best be
answered.
Format of the examination

The examination could cover any of the subjects that are addressed in
this syllabus. The examination is three hours long, and you are normally
required to answer four questions from a choice of seven. These will
be a mixture of essay-style questions and computation with discussion
questions. You therefore need to concentrate on both the qualitative and
quantitative characteristics of the topics. You cannot rely purely upon, for
example, the computation aspects to pass the examination. The entire
syllabus is examinable. Appendix 1 contains solutions to activities and to
Sample examination questions. Note that solutions are available only for
selected activities and questions. Sample examination papers can be found
on the VLE.
The examination also has an additional 15 minutes which is given as
reading time. You may begin writing at any point after the start of the
examination (which remains three hours in length). The total time available
to you in the examination hall will therefore be 3 hours and 15 minutes.
Overview of the guide

As emphasised throughout this subject guide, accounting is a
communication tool. The business entity communicates financial
information to interested parties (e.g. potential and existing shareholders,
creditors, managers, employees, NGOs, suppliers, the government, etc.)
in the form of financial statements. These financial statements will in
themselves impart information about the economic resources of the
entity which are under the control of management.
Policy-makers (e.g. standard-setters) and others helping to shape
accounting (including practising accountants) have to ask themselves a
number of basic questions before they can even begin to construct the
financial statements. For example:
• Which disclosures and figures should be included in these Financial
accounting statements? How much detail should be given?
• How should these figures be calculated?
• Who are the users of this information?
• Will they find the figures useful for their decisions and purposes? What
is accounting’s role?
T. Smith quotes an old joke which summarises some criticisms of accounting:
An old man was lost in a hot air balloon. Fortunately he
saw someone walking in a field below him so he lost height
and when he was within range shouted ‘Can you tell me
where I am?’ The walker stopped, paused for thought and
shouted back ‘You’re in a hot air balloon.’ ‘You must be an
accountant’ retorted the balloonist. ‘Amazing’, said the walker.
‘How did you know that?’ ‘Because the information you just
gave me was both totally accurate and completely useless!’
(Smith, T. Accounting for Growth, 1996, p.73)
8
Introduction
Chapter 2 of this subject guide addresses some key accounting issues:

• What is and should be accounting’s role in society?
• Who are the users?
• What information would they benefit from?
• What should the underlying criteria be: relevant information, reliable
information, or both (if possible)?
• In what sense is or should accounting be regulated?
The remaining chapters consider a number of basic questions and issues
that have been debated over the years when deciding upon which
disclosures and figures should be reported in the accounts, for instance:
• What alternative measurement methods are available?
• Will they capture the underlying economic reality of the business?
• Will they be useful and understandable to users?
• Will the figures enable users to make optimal decisions concerning the
allocation of their own scarce economic resources?
• What do the standard-setters believe firms should be measuring and
reporting, and why?
• Are the standards theoretically and conceptually correct in requiring
companies to report and measure certain figures?
• Are the methods appropriate given the environment in which
companies now operate?
• What issues still need to be addressed and why?
Chapters 3–4 deal with income measurement and capital maintenance
(and also consider economic approaches, such as those proposed by
Hicks), historical cost accounting, current purchasing power accounting
and current value accounting. Chapters 5–12 are firmly based upon the
modified historical cost/mixed measurement systems relating possibilities
to the Hicks income concepts. We discuss the implications of Hicksian
theory and would also recommend Biekpe, N., M. Tippett and R. Willett
‘Accounting Earnings, Permanent Cash Flow And The Distribution Of
The Earnings To Price Ratio’, The British Accounting Review 30(2) 1998,
pp.105–40. We are concerned to point to the relevance of context and seek
to broaden horizons on financial accounting. We consider possible futures
for accounting.
Index of abbreviations used in this guide

AEC Annual equivalent costs
ASB Accounting Standards Board
CBS Consolidated Balance Sheet
CIS Consolidated Income Statement
CPP current purchasing power
CVA current value accounting
DV deprival value, also known as ‘value to the business’ or ‘value to the
owner’.
EPS earnings per share
EC European Community
9
EU European Union
FASB Financial Accounting Standards Board
FIFO first-in, first-out
FPPFS Framework for the Preparation and Presentation of Financial Statements
FRS Financial Reporting Standard
GPP General Purchasing Power
HCA Historical Cost Accounting
IAS International Accounting Standard
IASB International Accounting Standards Board
IASC International Accounting Standards Committee
IFRS International Financial Reporting Standard
IOSCO International Organization of Securities Commissions
LIFO last-in, first-out
NBV net book value
NPV net present value
NRV net realisable value, also known as ‘current exit value’
P/E price/earnings ratio
PV present value, also known as ‘economic value’
RC replacement cost, also known as ‘current entry cost’
ROCE return on capital employed
RPI Retail Price Index
SEC Securities and Exchange Commission
SOP Statement of Principles
SSAP Statement of Standard Accounting Practice
10
Chapter 1: Rationale for financial reporting and its regulation
Chapter 1: Rationale for financial

reporting and its regulation
Aims of the chapter

This chapter introduces:
• the role of accounting in society
• the regulatory framework (discussion focused upon the international
framework)
• arguments for and against forms of accounting regulation, including
voluntary disclosure.
Learning outcomes
By the end of this chapter, and having completed the Essential reading and
• delineate the basic character of financial accounting theory
• discuss the role of accounting in society
• explain the different levels of authority in the UK regulatory
framework
• explain and discuss the implications of the International Accounting
Standards Board (IASB)
• discuss the arguments for and against accounting standards
• discuss the theory of regulation.
Essential reading
International Financial Reporting, Chapter 1.
Further reading
Baxter, W.T. ‘Accounting Standards – Boon or Curse’, Accounting and Business
Review, Winter 1981, pp.3–10.
Beaver, W.H. Financial Reporting: An Accounting Revolution. (Harlow: Prentice-
Hall, 1981) [ISBN 9780133161335]. Chapter 7.
Pitman Publishing, 1992) [ISBN 9780273034643]. Chapters 10 and 11.
Cadbury report (1992); this can be viewed on the internet. See the website for
the Institute of Internal Auditors: www.iia.org.uk followed by a search for
‘Cadbury report’.
Deegan, C. and J. Unerman Financial Accounting Theory. (London: McGraw-
Hill, 2011) second European edition [ISBN 9780077126735] Chapters 1–4.
Gallhofer, S. and J. Haslam, ‘Exploring social, political and economic
dimensions of accounting in the global context: the IASB and accounting
disaggregation’, Socio-Economic Review 8(4) 2007, pp. 633–64.
Times Prentice Hall, 2004) seventh edition [ISBN 9780273658498]
Chapters 1–3.
Scott, W. Financial Accounting Theory. (London: Prentice-Hall, 2011)
[ISBN 9780135119150].
11
Financial accounting theory

What is financial accounting? There are different understandings of it.
Some would equate it to ‘external accounting’, which indicates an
accounting that, in the case of the business firm, goes outside the
organisation to owners not closely involved in internal business
management or into the broader public realm. This is potentially a quite
broad understanding of financial accounting. Interestingly, it could
actually go beyond the financial, if including it, and may reflect very old
notions of rendering an account more generally.
A common, narrower usage understands financial accounting to be
external and financial. In most university courses on financial accounting
there is a further narrowing with the typical focus being on the commercial
business organisation that is owned by shareholders who are understood
to be other than the company’s management. Financial accounting, where
it is seen as external, which is usually the case, is often distinguished from
internal ‘management accounting’.
In broad terms, all accounting can be understood in terms of decision
making and control roles (where these encompass dimensions of
accountability and stewardship).
The relation between financial accounting and financial reporting is also
not a settled one. In some usages they are taken to be the same or at least
substantively so. In others, the accounting implies a broader activity (e.g.
recording) and reporting is understood as a branch of it. In yet other
usages, financial reporting equates to a broader external reporting that
need not be restricted to the financial whereas financial accounting (or
simply accounting) is understood to be so restricted. In trying to introduce
the subject matter, it is appropriate to give insight into these nuances
that are found in what is a quite diverse literature on accounting. Both
financial reporting and financial accounting may be distinguished from
financial statements in perhaps including narrative reports.
In this subject guide, we shall typically equate financial accounting and
financial reporting and where we intend a different connotation we shall
make that explicit. Often, reflecting much of the literature and practice,
we shall use the term financial accounting where we mean the external
and financial accounting of organisations (typically commercial business
organisations) but we shall give some recognition to broader definitions
(e.g. in referring to some notions of corporate social responsibility
accounting) and in those cases make clear that we are departing
from the narrower view. We shall adopt the broad understanding of
accounting’s role. But here we need to introduce a further framework
for understanding. Controversies do not end with issues of definition or
delineation.
The study of financial accounting (whether understood broadly or
narrowly) is the study of a social phenomenon. Accounting is constructed
by people in a context and impacts upon them and the context.
Presumably its justification is in terms of social well-being.
The study of accounting may clearly be seen, and is typically understood,
as a social science. One common way of classifying theories in the
social sciences (e.g. in economics) is to distinguish between normative
and positive approaches, or (as is preferred here) between prescriptive
and descriptive approaches. Prescriptive approaches are concerned
with developing a theory of accounting ‘as it should be’ and descriptive
approaches with developing a theory of accounting ‘as it is’.
12
In this subject guide we give insights into the more prescriptive and the
more descriptive approaches. Again, there are different approaches within
this broad categorisation. For instance, there are those who draw primarily
from economics in formulating either prescriptive or descriptive theories of
accounting. And one should note here that there are different views within
economics! Others draw from sociology or adopt a more interdisciplinary
perspective. The latter approach overlaps with concerns to understand
financial accounting more broadly and especially in terms of its scope, the
variety of influences upon it and its diverse consequences. Many academics
and policy-makers consider mainstream economic theory to be a good
basis for theorising financial accounting prescriptively and descriptively
while for others it is a narrow approach that does not take into account
the actual and potential repercussions of financial accounting. We shall try
to give insights into major instances of the more economistic approaches
and other approaches and also here try to build bridges between them.
We shall thus begin to explore how accounting’s role has been variously
theorised prescriptively, e.g. as improving economic decisions so as to
enhance social welfare or as contributing to a better democracy and shall
consider descriptive studies of accounting so as to also reflect the diverse
approaches of the literature.
In this chapter we consider prescriptive views that have emerged in
relation to issues of accounting’s regulation. We shall see that many views
here reflect mainstream economistic thinking. We offer descriptions of
financial accounting practice and its context in the UK and internationally,
with again an emphasis on how financial accounting is regulated. It
becomes clear here that a mainstream economistic thinking has been
influential in the construction of a regulatory framework with linked
institutions in this area. We also give some attention to ways of seeing
beyond the economistic.
Financial accounting and its role

Mainstream economistic views see financial accounting as information that
guides economic decisions. Actually, in many abstract models that are not
uncommon in economic reasoning, perfect information is simply taken to
exist.
To the extent that information in general and financial accounting in
particular are considered more realistically, the approaching of perfect
information is often taken as desired. As the information increases
in quality (a notion encompassing increased transparency) economic
decisions are understood to improve. Perhaps more detailed, disaggregated
information could be given. Perhaps companies could be valued better
or report better their value. The view is that scarce resources are better
allocated in the economy and social welfare increased.
A modification of this position again in the direction of greater realism
appreciates that information is costly. Its benefits should exceed its costs.
Substantively, the latter are ostensibly the dominant views of the
influential accounting policy-makers. The IASB, for instance, emphasises
the role of financial accounting information in guiding economic
decisions and thus enhancing social welfare. Less frequently in official
pronouncements but often used to justify actual policy decisions, explicit
reference is made to the costliness of this or that possible provision
(although the UK’s ASB does make reference to it in its stated aims – as
well as pointing out that it is not in favour of revolutionary changes to
financial reporting!).
13
Those giving thought to further dimensions of the imperfect character

of real world economies have added further layers of complexity in
their prescriptions. The assumption that more transparency is better
than less is brought into question beyond simple cost-benefit analysis.
Lipsey and Lancaster (1957) argue that in imperfect market contexts,
improving information without improving other aspects of the economic
system might even reduce social welfare. Possible reasons include that
in a competitive economy businesses need to have incentives to innovate
that might be countered if too much is made transparent. Thus, even
shareholders have an interest in keeping some information within the firm.
If more information is publicly available it may be easier for monopolistic
firms to strengthen monopolistic positions, to the detriment of social
welfare (Gallhofer and Haslam, 2007).
Such considerations may help us with descriptive theory. Factors such
as the above, together with information’s costliness, as well as lack of
shareholder control over corporate management, may explain why many
commentators believe that financial accounting information falls short of
the information that one might assume, from a more mainstream position,
capital providers would want (Tinker, 1985, even refers to shareholder
alienation). This is in spite of the apparent shareholder and investor
orientation of the influential policy-makers. Perhaps it is the case that
financial accounting does reflect the conventionally assumed interests of
shareholders – but in an imperfect market – or perhaps those interests are
only partially or imperfectly satisfied.
Returning to prescription, another view from someone well versed in an
information economics perspective takes further the notion of imperfect
markets (towards an appreciation of the imperfect character of the socio-
economic and political context) and fuses with a more interdisciplinary
perspective, indicating that financial accounting cannot be understood to
have only narrowly conceived economic consequences. Joseph Stiglitz,
a Nobel prize winner in economics, notes that when information like
financial accounting enters the public realm it enters a complex context
of conflicting forces. One cannot assume that information produced for
purpose X will not be used for purpose Y. Purpose Y may include the desire
to impose stricter regulations on business and/or enhance the general
democratic control over business. The prescriptive implication may not be
so clear but the suggestion is that some kind of trade off may be necessary
in an imperfect context.
Drawing from such an insight, some researchers point to financial
accounting’s role in potentially changing (for the better) the character of
the socio-political and economic system as well as serving it (Gallhofer
and Haslam, 2007). Similar prescriptive thinking is behind other socio-
economic and socio-political theorising, in which forms of corporate
social responsibility accounting are envisioned that transform the
narrower economistic financial accounting towards a more holistic form
of accounting that reflects (from their perspectives) all things of relevance
to social well-being (in relation to corporate operations). More generally,
the concern for a more holistic external accounting involves going beyond
mainstream perceptions and includes prescriptions of non-financial
information (see Gallhofer and Haslam, 2007).
These prescriptive suggestions have had little influence on accounting
policy-makers, although The Corporate Report (1975), a draft policy
statement of the UK Accounting Standards Steering Committee (a
forerunner of today’s UK ASB), did put forward a stakeholder-orientated
form of external accounting that included non-financial as well as financial
information. It never became a standard (Gallhofer and Haslam, 2007).
14
Financial accounting regulation

Mainstream economistic reasoning has also been influential in respect of
the issue of how best to regulate financial accounting. Some of the above
perspectives have implications for how accounting should be regulated.
Perspectives that assume the existence of perfect information clearly would
not see the need for further regulation. Under the scenario of perfect and
complete markets, a company that accepted all projects with non-negative
present values would simply have to announce these present values or
cash flows to the market, if we take a slightly less abstract view (although
strictly in such reasoning this would automatically happen for markets to
be perfect and complete). The value of the company would then equal the
present value of these cash flows, which in turn would equal the market
price. Under these circumstances one may even question whether annual
reports are necessary. Within mainstream economic thinking (that assumes
‘perfect and complete markets’ to maximise well-being and the role of
‘accounting information’ to be confined to serving markets), the answer
to this question would be in the negative as it would be to the question
‘is the regulation of accounting necessary in this context?’ The market
here provides what is deemed an unambiguous and value free measure of
wealth. Even in a broader, more holistic view, the argument might weigh
against state and/or quasi-state regulation in this economic sphere where
markets were more perfect and complete.
In any case, the scenario of perfect and complete markets does not reflect
the real world. Markets are not complete and perfect and thus the market
does not provide an unambiguous measure. So we can consider the case
for state and/or quasi-state regulation within a mainstream economics
perspective.
Other perspectives hold that the functioning of markets (within an
institutional, regulatory framework) is enough to regulate financial
accounting adequately. Businesses have an incentive to provide accounting
information to the market to raise capital and an interest in being honest
and providing good quality information due to the negative impacts
of loss of reputation (organisations failing to inform or misleading the
capital market will be regarded as ‘lemons’ – and punished). Another way
of seeing this is that there are strong incentives for managers to disclose
information, e.g. they may need to raise finance in the competitive market
and will thus provide relevant information to aid them in this (and
reputation has a value here so honesty may pay). In addition there is a
market for managers, in so far as the managers themselves would want to
inform the market as to how well they are doing and hence enable them
to seek other jobs elsewhere. The ‘free market’ camp would thus argue
that, even in the real world, we should leave it to the market or what some
call ‘market regulation’ (noting that markets themselves always appear to
require some form of state regulation in practice). Some argue the market
for information is good enough to produce an optimal supply.
There are also contracting arguments that have been put forward.
Companies could simply have a contract with their suppliers of capital to
disclose certain information to them, including having the information
audited. Any undisclosed information could then be obtained by private
searches and/or payment for additional information that may be required.
One point that may be made here too is that regulation beyond the
market may displace some of the positives of market functioning. It may
problematically, for instance, restrict the accounting methods that may
be used (although that may also reflect a poor form of interventionist
15
regulation). Further, users will tend to overstate their desire for disclosure
if they do not have to pay for it (although indirectly they may bear costs).
The costs will be borne by those supplying the information.
History does indicate that companies will voluntarily disclose at least
some information (at least they will disclose some information under
other pressures). While those observing practice historically admit to
some evidence of this type of market-induced effect, substantively they
point to weak financial accounting here and the case for regulating
financial accounting in terms of state and/or state-backed or quasi-state
professional regulation, beyond the more liberal approach. The view here
is that the market for information is such that without interventionist
regulation a sub-optimal amount of information will be produced. And the
comparability it facilitates may be less than desirable. The case for likewise
regulating notions of broader corporate social responsibility accounting is
similar. This said, contexts vary and a great deal of pressure may be placed
on business (e.g. by competitive forces, a strong civil society) without
legislation or quasi-law.
Under the contracting arguments, the actual cost of enforcing the
individual contracts or ‘group contracts’ would be higher than those
costs associated with state and/or state-like regulation. Even with these
contracts there would be a need for comparability of accounting practices.
A number of related arguments for regulation have been suggested,
reflecting the assumption of an imperfect markets context, including the
following:
• Left unregulated as envisaged, market forces would ‘lead to an
uneven possession of information among investors’. Consequently the
regulation would provide an equitable solution. ‘It is only fair that the
less informed be protected from the more informed.’ Some have more
power than others (over others) in terms of accessing information.
• Accounting information shares the characteristics of a public good, and
therefore suffers the same problems of externalities and free riders.
Under these conditions the absence of the regulation envisaged could
result in the under provision of information.
• Managers have incentives not to disclose unfavourable information.
Consequently investors would be unable to distinguish good
companies from bad ones, resulting in ‘adverse selection’. Further,
investors need protection from the fraudulent, which would actually
produce misleading information. Due to information asymmetries, the
disclosures may not obviously be seen as fraudulent.
Others argue markets are not so speedy in re-adjusting to changes. If
they may keep returning to reasonable positions or an equilibrium (a
contestable view for some), people may get hurt in the process, given its
slow speed. Indeed this may be in ways they can scarcely be compensated
for.
The ‘balanced’ view on financial accounting discussed above may be
taken as implying that regulation to improve transparency should not
be universally overly strict, or it might imply the need for a regulation
that has limits and that might be set so as to prevent firms competing
in the market place in terms of information disclosure, which may drive
disclosure towards too much transparency. In an imperfect markets
context, a particular level of disclosure or transparency would be optimal
for social welfare. A degree of secrecy or confidentiality is required
16
to allow the system to function for the best (e.g. create incentives for
research and development, discourage monopolistic practice that might
be encouraged through information sharing). A degree of transparency
is required to facilitate financing and the better allocation of resources.
The regulation envisaged may bring this balanced disclosure about better.
Markets functioning without that may lead to ‘beggar-my-neighbour’
disruptive forms of competition in respect of disclosure.
Some analysts of the issues have used game theory as a framework and
tried to model (appreciating the possibility of audit) external financial
accounting disclosures in relation to the incentives of regulators and
corporate managers (e.g. incentives to disclose or hide, to be honest or
dishonest). From this quasi-descriptive modelling (to which dimensions of
uncertainty and the costliness of information can be built in) an attempt
is made to see if answers can be found to questions such as: Is rigid
regulation better than flexible regulation? Is mandatory disclosure better
than a looser more voluntary approach? This framework can enhance
appreciation of the character and feasibility of actual and potential
regulatory forms, although it is not straightforward to translate this into
social welfare implications in an imperfect markets and imperfect societal
context.
Activity 1.1
Read Beaver (1981) Chapter 7 and Gallhofer and Haslam (2007), taking notes.
Critically appraise the main arguments that Beaver puts forward for increased regulation.
How do Gallhofer and Haslam (2007) see accounting regulation?
Accounting standards: what form should they take?

One way of regulating accounting, suggesting intervention beyond the
more liberal approach, is through accounting standards. These could be
prescribed by law or by ostensibly independent professional bodies (and
the latter’s prescriptions may then in some way be backed by law).
If we believe in regulating accounting through the use of accounting
standards, what form should the standards take? We could consider Edey
(1977)’s discussion. Edey (1977) discussed and illustrated four possible
types of accounting standards, all with different levels of detailed rules,
with the lowest level (Type 1) being less prescriptive than the highest level
(Type 4).
Type 1: ‘Tell people what you have done.’ This type of standard in the first place
restricts accounting to information about what has happened but Edey
emphasises that the restriction is to basic disclosure rules.
Type 2: Uniformity of presentation. This type of standard would only concern rules
on how you should present your financial results and hence create some
form of uniformity and consistency.
Type 3: Disclosure of specific matters. This type of standard would require

disclosure of specific matters in certain cases.
Type 4: How to value assets/liabilities, what is regarded as income, how income
is allocated to periods, and so on. Edey here characterises this type of
standard as specifying considerable detail.
In terms of the earlier argumentation, the more detailed and the less
flexible the requirements then the stronger the regulation.
17
Comparing arguments for and against standards is clearly related,

then, to arguments for and against forms of regulation. We extend or
refine the earlier argumentation by considering Baxter. These reflect an
understanding of the nature of company law in the UK context, whereby
that law is assumed not to prescribe very detailed inflexible accounting
standards.
Arguments for accounting standards

Baxter outlines the arguments for the imposition of accounting standards,
suggesting that:
• standards provide handy rules for the daily work of accountants.
Types 1–3 in Edey’s typology would:
• help improve published reports
• supplement company law with fuller, clearer and more consistent
figures
• foster comparability which in turn would help analysts and potential
investors compare and evaluate firms
• force weaker accountants to improve their work
• provide a defence for accountants in court, and strengthen resistance
‘if a tycoon tries to bully his accountants into producing biased figures’.
Other arguments put forward include the following:
• They would provide credibility to the accounting profession which
might otherwise be undermined if there are continued scandals over
the extreme subjectivity of some companies’ financial statements.
• They provide discipline – although some believe that if companies
were left to their own devices they would ultimately be disciplined by
the financial markets.
• In the short term, the use of standards attempts to alleviate the risk to
investors.
Arguments against accounting standards

The following arguments have been made:
• Accounting standards are costly and bureaucratic.
• Accounting figures (due to their very nature) do not lend themselves
to standardisation; industries differ, so do firms; the needs of users
vary. Thus standards may be suitable for the average but may not suit
the fringes.
• Standards can lead to a kind of rule following, where two similar
situations might be treated differently becuase they fall either side of a
rule.
• Standard-setters may bow to political pressures and thus the
development of accounting standards may be merely consensus-
seeking (e.g. accounting standards could be over-influenced by those
parties with easiest access to the standard-setters or the most vocal
lobbyist).
• Standards in themselves could actually reduce professional judgement
and be bad for the academic education of accountants (e.g. they might
be more interested in what is required to comply with the standard
than in investigating the ideal accounting system).
• Standards may lull users into a false sense of security (i.e. investors
may believe that the accounts are all based on the same specific rules,
18
when in fact a standard principle may still leave room for different
estimates). Consequently investors and other users need to be
educated about this.
• If they do not take account of possible economic consequences,
standards may result in adverse allocation effects. Accounting
standards might result in sub-optimal behaviour purely to ensure that
accounting earnings are not reduced.
• Standards could result in overload, e.g. if there are too many
standards; if standards are too detailed; if standards are not specific
enough; if there are too many standard-setters.
Activity 1.2
What criteria are relevant in deciding upon accounting standards? Should standards
specify the detail or be more in the nature of general guidelines?
Descriptions of accounting and its regulation

There are various types of descriptive theory. They may be more or less
subjective or subjectivist in their orientation. They may be developed from
a quite precise theoretical proposition or hypothesis or from a much looser,
open stance. All theories may be considered mixtures of the deductive and
inductive (i.e. they are developed through a process of logical deduction
from underlying premises and from reflection on observed reality) but
they may have a deductive or an inductive emphasis. They can draw upon
different understandings of context and have different themes. They may
be more or less critical (i.e. their prescriptive dimension may imply a more
or less radical position).
Deegan and Unerman (2011) provided an overview of different descriptive
theories of financial accounting. Financial accounting may be understood
in practice to equate to what it should be in a prescriptive theory or it
could be understood as failing against its prescriptive benchmark. Deegan
and Unerman (2011) point to theorists who suggest it is biased to serve
the relatively rich and powerful in society. Others suggest that financial
accounting may promote a materialist or narrow culture. For instance,
they suggest that accounting portrays that a materialist profit making is
the only thing important about a business organisation, which accounting
constructs as a financial machine, and it encourages a simplistic
dichotomous debit-credit kind of thinking in areas beyond technical
accounting. In terms of accounting regulation, again this may be seen in
a descriptive theory to equate with a prescriptive theory of accounting
regulation as it should be. Other theories include capture theory – where
those who are meant to be regulated control the regulations – and theories
that, for example, suggest that accounting regulation is largely controlled
by the relatively rich and powerful.
Many descriptive theories begin with an attempt to understand what
accounting and accounting regulation are like in terms of basic content
and form, e.g. what are the requirements of a law or standard? This
is an emphasis in what follows. Many theories see actual regulatory
developments as appropriately responding to regulatory failures (although
these developments may be found wanting as things change – giving
rise to new regulations also deemed appropriate). Such theories are very
similar to those that equate actual practice to some variant of prescriptive
theory. They may also be considered official theories as they are theories
that official regulatory bodies would use to describe themselves.
19
We focus here initially on accounting regulation in ways that substantively

reflect such basic description and mainstream interpretation. We focus on
accounting regulation in the UK but in the global context, reflecting the
significant influence of international accounting standards in the UK (and
beyond).
UK accounting regulation and the influence of

international accounting standards
The regulatory framework relating to financial reporting varies from
country to country. For Cooke and Parker (1994), the nature of the
regulatory framework will depend upon (among other things):
• the influence of tax rules
• the type of legal system
• the history and influence of the accounting profession.
In the UK, the regulatory framework has developed over many years
and consists of a mass of rules and regulations – some statutory, some
mandatory, others customary. We shall consider the variety of rules and
regulations that exist in the UK. Note that the UK regulatory framework
has been influential in many other countries. For instance, Cooke and
Parker (1994) state that:
Malaysia’s colonial past is reflected in many ways in the current
reporting environment, which is very similar, though not
identical to the UK environment.
Impetus for regulation

Often, regulations are implemented after well-publicised scandals. This
was the case with the establishment of the UK’s Accounting Standards
Steering Committee (ASSC) in 1970. Two scandals in the late 1960s
were understood to highlight the extent of subjectivity in financial
reporting: the General Electric Corporation (GEC) takeover of AEI
Ltd and Pergamon Press’s profit figure both led to questions about the
correctness of published financial statements of UK companies. Even today,
with the existence of standards that have over time tended to become
more extensive and detailed, similar questions are asked, e.g. in the US
following the scandal of Enron.
Institutional setting for accounting regulation: the UK

The rules applicable to large UK companies (rather than small or medium-
sized ones) come in three main forms:
• Statutory legislation: primarily the Companies Act 1985 and the
Companies Act 1989 (revised). The European Union (EU) instigated
a harmonisation programme that involved the issuing of a number
of directives in order to harmonise the accounting practices of
companies within the EU. In November 1995 the EU announced:
‘Rather than amend existing Directives, the proposal is to improve the
present situation by associating the EU with the efforts undertaken
by IASC and IOSCO towards a broader international harmonisation
of accounting standards.’ The EU adopted regulations with effect
from 1 January 2005 that required listed companies in Europe to use
generally accepted international accounting principles (IASs/IFRSs)
when preparing their group accounts.
20
• Mandatory regulation: the Statements of Standard Accounting

Practice (SSAP) developed originally by the Accounting Standards
Committee (ASC) and adopted by the Accounting Standards Board
(ASB), and Financial Reporting Standards (FRSs) issued by the ASB
since 1990.
• The Stock Exchange Listing Rules: these impose rules on
companies listed on the London Stock Exchange, including compliance
with the Combined Code of Corporate Governance (2003).
Statutory legislation: Companies Act
The Companies Acts prior to the early 1980s contained only general
requirements for companies and groups relating to the need to prepare,
distribute and file financial statements. There was very little detail in the
Acts – this was left to the practices adopted by accountants.
In 1981 requirements about the form and content of published accounts
underwent a radical change when the UK implemented the EC (now EU)
Fourth Directive in the Companies Act 1981. The Fourth Directive imposed
standardised formats for the income statement and balance sheet, and
required a ‘true and fair view’1 (see below). This was achieved by 1
The ‘true and fair view’
making rules about: was required in the
UK prior to the Fourth
• the format of accounts Directive. Indeed, it
was as a result of the
• certain accounting principles
UK’s pressure upon the
• valuation rules EU that the true and
fair requirement was
• disclosure of information.
included in the Directive.
The Companies Act 1985 (CA 1985) consolidated the previous Acts
(1947, 1948, 1967, 1980 and 1981) and set out general rules and formats
governing the content and form of published company accounts.
CA 1985 was then amended and supplemented by the Companies Act
1989, which enacted the Seventh EU Directive. This Directive had a similar
role to the Fourth, but in connection with consolidated accounts. Its
objective again was to harmonise practice within the EU, but its effect in
the UK was less dramatic than had been the case with the Fourth Directive,
because the basis of the Seventh Directive was to a large extent the Anglo-
Saxon model of consolidation, whereas the Fourth Directive had been
based more on continental practices.
The ‘true and fair’ requirement

In addition to preparing accounts, s.226 of the 1985 requires that:
(2) The balance sheet shall give a true and fair view of the state
of affairs of the company as at the end of the financial year; and
the [income statement] shall give a true and fair view of the
profit and loss of the company for the financial year.
(3) A company’s individual accounts shall comply with
the provisions of Schedule 4 as to the form and content of
the balance sheet and [income statement] and additional
information to be provided by way of notes to the accounts.
In the above respect, the Act makes it clear that the true and fair
requirement is overriding.
If in special circumstances compliance with any of those
provisions is inconsistent with the requirement to give a true and
fair view, the directors shall depart from that provision to the
extent necessary to give a true and fair view. Particulars of any
21
such departure, the reasons for it and its effect shall be given in
the note to the accounts.
(Section 226(5))
What is the definition of ‘true and fair’?

The Companies Act does not define ‘true and fair’. However, within the
Financial accounting literature, Lewis and Pendrill (2004, p.27) quote a
definition by G.A. Lee (1981, p.270):
Today ‘true and fair’ has become a term of art. It is generally
understood to mean a presentation of accounts, drawn up
according to accepted accounting principles, using accurate
figures as far as possible, and reasonable estimates otherwise;
and arranging them so as to show, within the limits of current
accounting practice, as objective a picture as possible, free from
wilful bias, distortion, manipulation or concealment of material
facts.
Statutory regulation: IASs/IFRSs gained force of law

The International Accounting Standards Board (IASB) was preceded by
the Board of the International Accounting Standards Committee (IASC),
which operated from 1973 until 2001. The IASC gained the acceptance
of the International Federation of Accountants, a worldwide association
of accountancy bodies with the aim of harmonising accounting standards
at an international level. The IASC was (as the IASB is) a private sector
body ostensibly independent of government influence. The level of
harmonisation achieved was understood to be reduced by (a) weak
standards that permitted too many accounting choices in order to satisfy
diverse member requirements and (b) a lack of enforcement power.
Enforcement was eventually achieved via the International Organization
of Securities Commissions (IOSCO) (see stock exchange regulation
below) and the EU. In 1995 the EU agreed to require all listed European
companies to conform to IASs/IFRSs, following a review of the standards.
The following year the EU Contact Committee reported that IASs/IFRSs
were compatible with EU directives, with minor exceptions, leading to
legislation in 2001 that required all EU listed companies to follow IASs/
IFRSs from 2005. Hence, IASs/IFRSs constituted statutory regulation for
the listed companies. The IASB superseded the IASC in 2001, inheriting
34 standards, 14 of which were criticised by the IOSCO as unacceptable
by regulators worldwide. The IASB was set up initially recognising the
IASs but gradually replacing them and adding to them with IFRSs. The
IASB decided to improve the standards before the EU adoption in 2005,
and thereby embarked on the improvements project. This project was
completed by 2003, resulting in 15 revised IASs (IFRSs). From 2005
Australian-listed groups and from 2007 New Zealand-listed groups had to
comply with IASs/IFRSs. More recently South Korea, China, Brazil, Israel,
Malaysia and Mexico have made similar moves or committed to the same.
Several countries have domestic GAAP identical to the IASs/IFRSs and
some have abandoned developing their own standards. FASB and IASB are
committed to a convergence process and progress on this has been made.
22
Mandatory regulation: standard-setting and the case of

the UK
In the UK, prior to the establishment of the Accounting Standards
Committee (ASC), legislated accounting regulation was limited to a few
statutory rules governing the presentation of financial statements within
the Companies Act. These were very basic and accounting practices were
varied and inconsistent. Consequently the ASC was set up in 1976. Its
objectives were to:
define accounting concepts, to narrow differences of financial
accounting and reporting treatment, and to codify generally
accepted best practice in the public interest.
The ASC’s membership consisted of representatives from the various UK

accounting bodies. They were part-time and unpaid. Following major
criticism of the ASC that it was unable to respond quickly to changing
needs or to deal with fundamental issues, a Review Committee was
established in 1987 under the chairmanship of Sir Ronald Dearing.
Following the Dearing Report on the creation of accounting standards, the
following bodies were established:
FRC Ltd Board Council
Accountancy
Accounting Auditing Board for Professional Financial
Investigation
Standards Practices Actuarial Oversight Reporting
and Discipline
Board Board Standards Board Review Panel
Board
Committee on
Urgent Corporate
Issues Governance
Task Force
Executive
Figure 1.1 Organisational chart for the accounting standard-setting body in the
UK. Source: www.frc.org.uk/about/chart.cfm
• Financial Reporting Council (FRC)

Established in 1990, this is made up of representatives of users,
preparers and accountants in practice. It provides guidance to the
Accounting Standards Board (ASB) on work programmes, priorities
and issues of concern, and is responsible for financing arrangements.
The chairman is appointed by the Secretary of State for Business,
Enterprise and Regulatory Reform with the Governor of the Bank of
England, the accountancy profession and the financial community. The
FRC is financed by the government, the accountancy profession and
financial institutions (the government contributing about one-third
against the two-thirds from the accountancy profession and financial
institutions respectively). The FRC aims ‘to promote confidence in
corporate reporting and governance’.
• Financial Reporting Review Panel (FRRP)
Established in 1990 with a QC as its Chair, the FRRP examines
material departures from standards by large companies. The
Introduction to Accounting Standards requires it to:
enquire into annual accounts where it appears that
Companies Act requirements, including the
23
requirement that annual accounts shall show a true and fair

view, might have been breached.
It has been authorised under the Companies Act to make application to the
court for a declaration that a company’s annual accounts do not comply
with the requirements of the Companies Act and for an order that the
directors prepare revised accounts. (See below.)
• Accounting Standards Board (ASB)
Established in August 1990, this replaced the ASC. It is an expert body
to develop, issue and withdraw accounting standards, with a full-time
chairman and technical director and 10 members in total (originally
nine). It also has a large full-time secretariat. It issues Financial
Reporting Standards (FRS) on its own authority, on a
two-thirds majority. A committee of the FRC appoints its members.
The ASB has stated its aims as follows:
to establish and improve standards of financial accounting and
reporting, for the benefit of users, preparers and auditors of
financial information.
One of the ways in which it intends to achieve its aims is by

‘developing principles to guide it in establishing standards and to
provide a framework within which others can exercise judgement in
resolving accounting issues.’
It has listed a number of ‘fundamental guidelines’ which include
‘to be objective and to ensure that the information resulting from
the application of accounting standards faithfully represents the
underlying commercial activity’; such information should be ‘neutral
in the sense that it is free from any form of bias intended to influence
users in a particular direction and should not be designed to favour
any group of users or preparers.’
Other fundamental guidelines include issuing standards only when
the expected benefits exceed the perceived costs, and ‘taking account
of the desire of the financial community for evolutionary rather than
revolutionary change in the reporting process where this is consistent
with the objectives.’
• Urgent Issues Task Force (UITF)
This is concerned with serious differences in current practice. Its main
role is to assist the ASB in areas where an accounting standard or
Companies Act provision exists but where unsatisfactory or conflicting
interpretations have arisen or seem likely to develop. It reaches a
consensus about issues and its pronouncements are published in
Abstracts, available on the FRC website.
Accounting standards and company law

Following the Dearing Committee’s review of standard-setting, changes
were also made to company law:
• Section 19 of the Companies Act 1989 inserted a new section (s.256)
into CA 1985. This includes a definition of accounting standards and,
among other things, gives the Secretary of State power to make grants
to bodies (or for the purpose of):
issuing accounting standards overseeing and directing their issue
investigating departures from standards or from the accounting
requirements of the Act and taking steps to secure compliance with
them.
24
• The Companies Act 1989 inserted a new paragraph 36A into Schedule
4 of CA 1985. This requires it to be stated whether the accounts have
been prepared in accordance with applicable accounting standards,
with particulars of any material departure from those standards and
reasons for these to be given.
• Section 12 of the Companies Act 1989 inserted a new section (s.254B)
into CA 1985 giving the Secretary of State power to apply to the court
for a declaration that a company’s annual accounts do not comply
with the requirements of the Act and for an order that the directors
prepare revised accounts. The Secretary of State may also authorise
a person for this purpose and, as noted above, has authorised the
Financial Reporting Review Panel (FRRP) to make such applications.
If the court finds against the company, it may order that application
costs and reasonable expenses of the company in connection with (or
in consequence of) preparing revised accounts shall be borne by the
directors who were party to approving the defective accounts.
Note that the power to apply to the courts relates to non-compliance with
the Act’s requirements rather than specifically with standards. This then
raises the question of the relationship between accounting standards and
the requirement for accounts to show a true and fair view. Below is the
professional opinion of Mary Arden QC:
Compliance with accounting standards will normally be
necessary for Financial Statements to give a true and fair view…
The requirement to give a true and fair view may in special
circumstances require a departure from accounting standards…
If in exceptional circumstances compliance with an accounting
standard is inconsistent with the requirement to give a true and
fair view, the requirement of the accounting standard should be
departed from to the extent necessary to give a true and fair view.
(Appendix to Foreword to Accounting Standards, ASB, 1993)
Mary Arden QC stated that whether accounts satisfy true and fair
requirements is for the courts to decide, but they will look to the practices
and views of accountants; the more authoritative these are, the more the
courts will be ready to follow them.
Just as a custom which is upheld by the courts may properly
be regarded as a source of law, so too, in my view, does an
accounting standard which the court holds must be complied
with to meet the true and fair requirement become, in cases
where it is applicable, a source of law in itself in the widest
sense of that term.
(Mary Arden QC, ‘The True and Fair requirement’.)
The Companies Act 2006 implemented some of the proposals of the
Company Law Review (see Activity 1.4).
Stock Exchange
The London Stock Exchange also lays down regulations concerning listed
companies’ published accounts. The regulations require the provision of
more information, and more frequently, than either the law or the UK
ASB or the IASB requires. For example, companies are required to publish
interim accounts and provide more detail regarding certain liabilities (e.g.
bank loans).
In 1995 the International Organization of Securities Commissions (IOSCO)
agreed to a review of IASs, with a view to endorsing IASs for cross-border
25
offerings. Fourteen standards were rejected by IOSCO but later revised

by the IASB. The IOSCO’s technical committee now ‘recommends that
its members allow multinational issuers to use IFRSs in cross-border
offerings and listings, as supplemented by reconciliation, disclosure and
interpretation where necessary to address outstanding substantive issues
at a national or regional level’ (Technical Committee of IOSCO, Statement
on the development and use of International Financial Reporting
Standards in 2005, February 2005, p.4).
UK listed companies must also comply with the Combined Code of
Corporate governance (Higgs, 2003). The Combined Code provides
general guidance on governance and internal control for organisations.
Corporate Governance has come under great scrutiny following a string of
high-profile corporate collapses such as Enron and WorldCom, associated
with fraud, abuse of managerial power and social irresponsibility. This
triggered a number of accelerated reviews of governance frameworks
and resulted in an increased number of practical pronouncements. In
the USA the Sarbanes-Oxley Act on corporate governance is the most
comprehensive law to affect accounting and the audit profession since the
Securities and Exchange Act 1934. By changing guidelines into formal law,
this represents a divergence from the UK model on corporate governance
(Friedman and Miles, 2006, p.258)
Activity 1.3
In the UK, the Stock Exchange was one of the earliest sources of rules and regulations
relating to financial statements. In many other countries, the rules and regulations of the
relevant stock exchange are important.
a. Why do stock exchanges take such an interest in rules and regulations relating to
financial statements?
b. What are the main requirements of the stock exchange in your country?
Activity 1.4
The Company Law Review was set up to examine the whole framework of company
law. Study its recommendations: Company Law Reform. Modern Company Law for a
Competitive Economy: Developing the Framework, which can be found at:
www.berr.gov.uk/files/file23245.pdf.
A Companies Act was introduced in 2006. To what extent did it implement the
recommendations?
Reminder of learning outcomes

Having completed this chapter, and the Essential reading and activities,
you should be able to:
• delineate the basic character of financial accounting theory
• discuss the role of accounting in society
• explain the different levels of authority in the UK regulatory
framework
• explain and discuss the implications of the International Accounting
Standards Board on the role of the Accounting Standards Board
• discuss the arguments for and against accounting standards
• discuss the theory of regulation
26

Question 1.1
To what extent should accounting standards take economic consequences
into account? Discuss.
Question 1.2
What factors should be considered in deciding upon the form of
accounting regulation?
27
Notes
28
Chapter 2: Conceptual framework
Aims of the chapter

The aim of this chapter is to consider what a conceptual framework
is and then to address some of the key principles related to setting
up a conceptual framework. These principles have been examined by
many different groups of standard-setters around the world (including
in Australia, Canada, the UK and the USA). We will look at the UK’s
Statement of Principles (SOP) and the US Concept Statements. The
ASB modelled the SOP on the IASB Framework for the Preparation and
Presentation of Financial Statements (FPPFS), which in turn was based on
the US conceptual framework. It is strongly recommended that you review
the FPPFS.1 1
To find this, consult the
IASB website:
www.iasb.org.uk/
Learning outcomes
By the end of this chapter, and having completed the Essential readings
and activities, you should be able to:
• define a conceptual framework
• identify the main efforts by the US, the IASC and the UK to introduce a
conceptual framework
• describe the objectives of financial reporting as per the conceptual
frameworks produced
• explain the ‘ideal’ qualitative characteristics of accounting information
as suggested by these frameworks
• define assets and liabilities as suggested by these frameworks
• explain and describe recognition and measurement
• apply the conceptual frameworks to particular transactions; for
instance, would they help in deciding how to account for research and
development?
Essential reading
Accounting Standards Board, 1999, Statement of Principles for Financial
Reporting. (Reproduced in Accountancy, March 2000, pp.109–38). See
below for the ASB website.
Websites
See also the following websites:
www.frc.org.uk/asb/technical/principles.cfm
www.iasb.org.uk/ then follow links to summaries of international financial
reporting standards
Further reading
Pitman Publishing, 1992) [ISBN 9780273034643]. Chapter 12 (Although
this focuses specifically on the FASB’s conceptual framework, it also
discusses a number of issues about the conceptual framework approach that
can be considered in relation to the IASB’s FPPFS and the ASB’s Statement
of Principles.)
29
Ernst and Young, International GAAP 2012: Generally Accepted Accounting

Practices under International Reporting Standards. (Chichester: John Wiley &
Sons, 2012) [ISBN 9781119962458]. Chapter 2.
Chapter 1.
Macve, R. A Conceptual Framework For Financial Accounting and Reporting:
the Possibilities for an Agreed Structure. (London: Institute of Chartered
Accountants in England and Wales, 1981) [ISBN 9780852913116].
Relevant IASB publication

Framework for the Preparation and Presentation of Financial Statements.
Relevant UK standards
The Statement of Principles.
FRS 18 Accounting Policies (replaced SSAP 2 Disclosure of Accounting Policies).
Definition of a conceptual framework

The quest for a conceptual framework for financial reporting has been
undertaken (with varying degrees of success in terms of securing
agreement) in many different countries. But what is a conceptual
framework?
In the USA, one definition by the Financial Accounting Standards Board
(FASB) is:
A Conceptual framework is a constitution, a coherent system
of interrelated objectives and fundamentals that can lead to
consistent standards and that prescribes the nature, function
and limits of financial accounting and financial statements.
The ASB in the UK states that their Statement of Principles (SOP)

(equivalent to the US conceptual framework):
sets out the principles that the Accounting Standards Board
believes should underlie the preparation and presentation of
general purpose financial statements… A coherent frame of
reference to be used by the Board in the development and
review of accounting standards.
Macve (1981) stated that a conceptual framework would:

provide a consistent approach for making decisions about
choices of accounting practice and for setting standards.
However, he also recognised that it would be difficult to implement such a

conceptual framework.
All three definitions suggest that a conceptual framework provides an
explicit description of how accounting rules should be formulated and
the environment in which they apply. More specifically, a conceptual
framework is supposed to address some fairly fundamental questions
about financial statements themselves. For instance:
• What are the objectives of financial statements?
• For whom and by whom are these financial statements required?
• What information do the users of these financial statements require?
• What types of financial statement would best satisfy these users’ needs?
• Do current financial statements meet these requirements?
• How could current financial statements be improved?
30
Although these questions are fundamental, the extent to which they have
been addressed varies among countries. However, in general:
the various standard-setting bodies around the world have too

often attempted to resolve practical accounting and reporting
through the development of accounting standards, without such
an accepted theoretical frame of reference.
(Ernst and Young, 2001)
In other words, too often standard-setting is reactive (to particular

problems) rather than proactive.
Rationale for a conceptual framework

The FASB states that the rationale for a conceptual framework is:
1. To facilitate decisions on controversial accounting issues –
providing a clear basis for reaching conclusions that those with vested
interests would find it hard to resist.
2. To provide a common framework of reference on theoretical
issues, so as to avoid both waste of effort in addressing such issues
from first principles for each specific standard and the dangers of
inconsistency.
3. To reduce the need for many detailed standards on specific issues
– by enabling accountants to resolve issues by reference to general
principles rather than detailed rules.
Advantages claimed for a conceptual framework

According to the UK Statement of Principles, a conceptual framework
should:
• clarify the conceptual underpinnings of proposed accounting standards
• enable standards to be developed on a consistent basis
• reduce the need to debate fundamental issues each time a standard is
developed or revised
• enable preparers and users of financial statements to understand the
Board’s approach to setting standards and the nature and function of
information in general purpose financial statements
• help preparers and auditors with new issues to carry out an initial
analysis of the issues in the absence of applicable accounting
standards.
Other advantages claimed for a conceptual framework are that it:
• facilitates decisions on controversial items, by reducing the scope for
personal bias and political pressure
• may reduce the need for many detailed standards if accountants can
resolve issues by general principles
• limits the bounds of judgement and hence increases comparability
• may protect accounting from intervention by governments
• helps justify accounting practices when they are under attack in the
courts, if they can be shown to be derived from, and consistent with, a
conceptual framework.
31
The US, IASC and UK initiatives compared

In this section we consider briefly some of the important milestones in the
quest for a conceptual framework in the US, IASB and the UK. You need
not know the exact detail as such, but you should be aware of the main
considerations of each initiative and the main similarities and differences
between each approach.
US initiative: FASB conceptual framework

The FASB issued six concept statements in the late 1970s/early 1980s, of
which five are listed here:
• Statement of Financial Accounting Concepts (SFAC) No. 1 Objectives of
Financial Reporting by Business Enterprises.
• SFAC No. 2 Qualitative Characteristics of Accounting Information.
• SFAC No. 4 Objectives of Financial Reporting by Non Business
Organisations.
• SFAC No. 5 Recognition and Measurement in Financial Statements of
Business Enterprises.
• SFAC No. 6 Elements of Financial Statements (replacing SFAC No. 3).
• SFAC No. 7 Using Cash Flow Information and Present Value in
Accounting Measurements.
This chapter will discuss four of these concept statements – 1, 2, 5 and 6 –
which address some of the key conceptual issues.
IASC Framework for the presentation and preparation of financial

statements
The IASC conceptual framework was introduced as an exposure draft in
May 1988, and a final statement in September 1989, in an attempt to
‘explain the conceptual framework that underlies the preparation and
presentation of financial statements.’ Apparently modelled on the FASB
framework, it exhibits many of the strengths and weaknesses of that
earlier framework (see discussions below).
UK: ASB’s Statement of Principles (SOP)

In the UK the ASB issued a Draft Statement of Principles, initially chapter
by chapter but then as a whole, for general comment. In 1996, some
aspects of the Draft Statement of Principles attracted adverse comment and
as a result this framework was modified. The final version of the SOP was
agreed in October 1999. Appendix II notes that the SOP was based on the
IASC’s Framework. Appendix III points out that the Board does not regard
the SOP as the final word on the principles underlying financial reporting
and that, as accounting thought is continually evolving, it may need to be
revised from time to time. Currently the SOP consists of eight chapters:
Chapter 1: The Objective of Financial Statements
Chapter 2: The Reporting Entity
Chapter 3: The Qualitative Characteristics of Financial Information
Chapter 4: The Elements of Financial Statements
Chapter 5: Recognition in Financial Statements
Chapter 6: Measurement in Financial Statements
Chapter 7: Presentation of Financial Information
Chapter 8: Accounting for Interests in Other Entities.
32
Although the main purpose of the SOP is to help set accounting standards,
the Introduction to it notes that, due to other factors to be considered
when setting standards (including legal requirements and cost/benefit
considerations), a standard may still adopt an approach different from
that suggested by the principles. The SOP has not been developed within
the constraints imposed by company law so it may contribute to the future
development of law.
Objectives of financial reporting

The underlying objective of all the conceptual frameworks discussed above
in relation to financial reporting is to provide useful information so users
can make business and economic decisions. This is sometimes contrasted
with an alternative objective – to provide information on how the business
has carried out its stewardship responsibilities.
There is an overlap, however, between these objectives. One may argue
that information about historical stewardship, or accountability for
past actions, is relevant for decision making and control and indeed the
rationale for it may be expressed in these terms. Nevertheless the objective
promoted in the conceptual frameworks is not as restricted. In principle,
it goes beyond history, stewardship and accountability without limit.
This freedom results in threats as well as opportunities for and through
accounting.
Decision usefulness appears to be a reasonable objective, although we
have seen that it should be subject to our discussion in the last chapter of
context and the imperfect nature thereof. To satisfy it two questions should
be considered:
1. Who are the users?
2. What type of information do they need?
In the case of the FASB, the statement identifies many potential users of
accounts and their interests, but argues that those most directly concerned
with a business share a common interest in the company’s ability to
generate favourable cash flows. In developing objectives for general-
purpose external financial reports, the statement focuses on the needs of
investors and creditors (though it suggests that information prepared to
meet these needs is likely to be generally useful to other groups which
have essentially the same interest) and argues that:
Financial reporting should provide information that is useful
to present and potential investors, creditors and other users in
making rational investment, credit and similar decisions.
Its principal conclusion is:
Financial reporting should provide information to help
investors, creditors and others assess the amounts, timing
and uncertainty of prospective net cash flows to the related
enterprise.
The SOP requires that financial reports provide information about:
• the economic resources of an enterprise, its obligations and owners’
equity
• enterprise performance and earnings
• liquidity, solvency and funds flow
• management stewardship and performance.
33
It notes in relation to its requirement for information about enterprise

performance that:
…interest in an enterprise’s cash flows and its ability to
generate favourable cash flows leads primarily to an interest in
information about its earnings rather than information directly
about its cash flows… Information about enterprise earnings
and its components measured by accrual accounting generally
provides a better indication of enterprise performance than
information about current cash receipts and payments.
The FASB then asserts that what investors want are balance sheets
and income statements: inductively from the fact that this is what they
currently actually get and politically because the FASB has no intention of
undermining the very basis of present practice and thus has rationalised
accrual accounting.
However, the FASB has actually steered away from trying to identify the
kind of information that may assist users (e.g. current value information,
management forecasts, etc.)
In the UK, the ASB’s SOP states that the objective is to provide information
about the financial performance and financial position of an entity which
would be useful to a wide range of users in assessing the stewardship of
managers.
The ASB has selected the investor’s perspective as the one most likely to
help in the preparation of general-purpose financial statements. It states
that, whilst recognising a large number of potential users of financial
statements, who usually require different information for the different
decisions they must make, a statement based on such a perspective focuses
on the common interest of all users – the entity’s cash-generating
ability and financial adaptability. It therefore focuses on present
and potential investors as the defining class of user, arguing that in
meeting their needs financial statements will meet the common needs of
other users. It notes that information that is not needed by investors need
not be given in the financial statements.
The SOP details the information required by investors, which is very
similar to the FASB, and is said to comprise the following:
• In relation to financial performance: the return obtained on its
resources, the components of that return and the characteristics of
those components.
• In relation to financial position: the economic resources controlled by
the entity, its financial structure, liquidity and solvency, risk profile and
risk management approach, and capacity to adapt to changes in the
environment.
• Information about the generation and use of cash, which provides a
further perspective on financial performance.
Outside commentators on the objectives of reporting delineated

in conceptual frameworks:
Many practitioners and academics have commented on the above
approaches. For example, Bromwich (1992) pointed out that in the FASB’s
Conceptual Framework the emphasis was strongly on information for
decision-making. The same is true of the ASB Statement of Principles.
Depending on how information for decision making is understood and
how stewardship is understood, it is possible that information useful for
decision-making purposes may not be useful for assessing stewardship.
34
The ASB defines stewardship broadly so as to include accountability not

only for the safekeeping of the resources, but also for their proper, efficient
and profitable use. It therefore involves an economic decision on whether
(for example) to hold or sell shares and to reappoint or dismiss the
management. Some would take a narrower view of stewardship and the
information deemed useful by the ASB may not stretch to this specific.
Similarly, by focusing on the assumed common need, does the FASB ignore
the possibility of differing (and possibly conflicting) needs of different
users? In focusing in particular on investors and creditors, many other
groups could be harmed by standards promulgated to meet the needs of
these particular groups. This is the ‘social choice’ problem.
As Macve (1981) stated:
[R]ecognition of the variety of users’ needs and of conflicts
between different rights leads to the view that reaching
agreement on the form and content of financial statements is
as much a ‘political’ process, a search for compromise between
different parties, as it is a search for the methods which are
‘technically’ best.
Activity 2.1
Do you think that the investor’s perspective is the most appropriate?
With reference to a selected ‘conceptual framework’, satisfy yourself that you are aware
of the range of stated objectives of financial reporting.
Qualitative characteristics of accounting information

Although most conceptual frameworks identify many of the same
qualitative characteristics of accounting information, the hierarchy of these
characteristics might vary. The overriding concern is that the information
that is provided to users should be useful in relation to their decision-
making process. To ensure that it is useful, this information should have
certain characteristics. The characteristics considered here are:
• relevance
• reliability
• comparability
• understandability.
The FASB, in SFAC 2 Qualitative Characteristics of Accounting Infornation,
examines the characteristics that make accounting information useful. It
establishes a ‘hierarchy of accounting qualities’ (see Figure 2.1).
35
Users of accounting Decision makers

information and their characteristics
Pervasive Benefit > Cost

constraint
User-specific Understandability
qualities
Decision usefulness
Primary
decision-specific Relevance Reliability
qualities
Ingredients
of primary Predictive Feedback Timeliness Verifiability Representational
qualities value value faithfulness
Secondary and
interactive Comparability Neutrality
qualities (including consistency)
Threshold for
recognition Materiality
Figure 2.1 FASB’s hierarchy of accounting qualities

Similarly the ASB, in Chapter 3 of the SOP, sets out the qualitative
characteristics of useful financial information in a diagram which is more
detailed than the FASB’s but based on the same characteristics discussed
above (see Figure 2.2).
What makes financial information useful?
Giving information that is not
Threshold quality MATERIALITY material may impair the usefulness
of the other information given
RELEVANCE RELIABILITY COMPARABILITY UNDERSTANDABILITY
Information that Information that is a Similarities and The significance of the

has the ability to complete and faithful differences can be information can be
influence decisions representation discerned and evaluated perceived
Predictive Confirmatory Faithful Neutral Free Complete Prudence Consistency Disclosure User’s Aggregation
value value representation from abilities and
material error classification
Figure 2.2 ASB’s qualitative characteristics of useful financial information

The various terms used in the two figures are discussed below.
Materiality
To begin with there must be some assessment of whether the information
is material (i.e. could this information influence users’ decisions?).
Materiality is viewed as a threshold characteristic because if any
information is immaterial then users are not interested in it whatever
other characteristics it has. Immaterial information should not be given
as this may impair understanding of the financial statements. But what is
material? Does the assessment of materiality vary between users?
36
Relevance
The FASB defines relevance as the capacity of information to make a
difference in a decision by helping users to form predictions about the
outcomes of past, present and future events to confirm or correct prior
expectations. Similarly the ASB defines relevant information as that which
is able to ‘influence the economic decisions of users and is provided in
time to influence those decisions.’
Reliability
The ASB states that reliable information is:
• faithful representation (i.e. it can be depended upon to represent
what it purports to represent or could reasonably be expected to
represent – reflects the substance of a transaction or event)
• free from deliberate or systematic bias (i.e. is neutral)
• complete and free from material error
• prepared on a prudent basis (i.e. under conditions of uncertainty,
a degree of caution has been exercised in making the necessary
judgements or estimates).
The FASB states:
To be reliable, financial statements must portray the important
relationships of the firm itself. Information is reliable if it is
verifiable and neutral and if users can depend on it to represent
that which it is intended to represent.
Comparability
The ASB states that comparability enables users to discern similarities in
and differences between the effect and nature of transactions and events
between entities, and over time for the same entity (very similar to the
FASB definition). It requires consistency and disclosure of accounting
policies. The SOP notes, however, that consistency should not prevent the
introduction of improved accounting policies.
Understandability
To be useful, information must be understandable. This depends on the
way in which it is aggregated, classified and presented, and on the ability
of users (who are presumed to have reasonable knowledge of business
and accounting and are prepared to study the information with reasonable
diligence).
Conservatism/prudence
In the FASB hierarchy of accounting qualities, conservatism does not
appear within the diagram, unlike prudence for the ASB. The FASB
statement notes that there is a place for conservatism in financial
reporting, but that if it is not applied with care it may conflict with
qualitative characteristics such as neutrality and representational
faithfulness by introducing bias. Conservatism should not imply deliberate,
consistent understatement of profit and net assets; rather it requires that
adequate consideration be given to the risks and uncertainty attached
to business situations. Similarly the ASB states that prudence is only
necessary in conditions of uncertainty and should not be used for
deliberate overstatement of liabilities/losses or deliberate understatement
of assets/gains, nor to create excessive provisions or hidden reserves.
37
Trade-off between relevance and reliability

Both statements highlight the trade-offs that have to be made between
relevance and reliability. The ASB states that where there is conflict ‘it will
usually be appropriate to use the information that is the most relevant of
whichever information is reliable’. However, financial information should
not be provided until it is reliable. But how is one to assess which is ‘most
relevant’? What if, for example, one method has greater predictive value
but another greater confirmatory value? Neither statement helps the
reader to determine how to make these trade-offs. What if different users
have different preferences? Bromwich (1992) points to the problem of
identifying characteristics for accounting information which are utility- or
value-free.
Further comments
Does spelling out what is meant by ‘useful’ get us very far? For Macve
(1981): ‘many other studies have identified desirable attributes but have
not led to greater agreement in practice about particular problems and it
shifts the area of disagreement from ‘is this information useful?’ to ‘is this
reliable?’ or ‘is this relevant?’ and may merely lead to ‘wordshuffling’. But
the analysis may help us identify some reasons for disagreement (e.g. ‘this
proposed treatment does not have predictive value/confirmatory value/
faithful representation’).
It has been suggested that the definition of ‘reliable’ is circular:
information is reliable if it can be depended upon to represent what it
purports to represent (i.e. it is reliable if it is reliable).
Bromwich (1992) points to two problems with the use of predictive value
in the FASB conceptual framework projects:
It has not made explicit the decision model it sees investors using.
It has not shown how accounting information can obtain predictive value.
Activity 2.2
1. Often an accounting standard will have to make a trade-off between reliability and
relevance:
a. What is the difference between reliability and relevance?
b. How should accounting standards rank these two qualitative characteristics?
c. Which user groups need to be considered when determining the relative
importance of reliability and relevance?
2. Other qualitative characteristics might be important. Discuss how timeliness,
objectivity, verifiability and neutrality might fit in with characteristics we have
described already.
3. The benefits from reporting accounting information should exceed the costs. How
easy (or difficult) do you think it is to quantify the costs and benefits of an accounting
item?
Elements of financial statements

Both the ASB and the FASB identify and define elements of financial
statements which comprise the building blocks with which financial
statements are constructed. The FASB defines 10 interrelated elements
whereas the ASB defines only seven.
38
Definition FASB ASB

Assets √ √
Liabilities √ √
Ownership interest (equity) √ √
Gains √ √
Losses √ √
Contributions (investment) from owners √ √
Distributions from owners √ √
Comprehensive income √
Expenses √
Revenues √
Central to these definitions are the definitions of assets and liabilities.
The ASB defines:
• assets as ‘rights or other access to future economic benefits controlled
by an entity as a result of past transactions or events’, and
• liabilities as ‘obligations of an entity to transfer economic benefits as
a result of past transactions or events.’
Although the definition of an asset covers most non-monetary assets found
in the balance sheet, it does not necessarily cover all assets, such as certain
intangible assets such as client lists. The use of the word ‘rights’ does not
restrict the definition to an ownership criterion (consider finance leases).2 2
See Chapter 7.
In particular, the statements point out that just because a transaction
or event affects an element (e.g. results in the creation of a new asset),
this does not mean that the effect will be recognised in the financial
statements; that depends on the recognition and measurement criteria
(discussed below).
In addition, ownership interest is defined as ‘the residual amount found
by deducting all of the entity’s liabilities from all of the entity’s assets.’
The ASB definitions are practically identical to the FASB’s definitions.
The FASB statement points out the essential characteristics of assets and
liabilities:
An asset has three essential characteristics:
a. it embodies a probable future benefit that involves a
capacity, singly or in combination with other assets, to
contribute directly or indirectly to future net cash flows,
b. a particular entity can obtain the benefit and control others’
access to it, and
c. the transaction or other event giving rise to the entity’s right
to or control of the benefit has already occurred.
A liability has three essential characteristics:
a. it embodies a present duty or responsibility to one or more
other entities that entails settlement by probable future
transfer or use of assets at a specified or determinable date,
on occurrence of a specified event, or on demand
b. the duty or responsibility obligates a particular entity,
leaving it little or no discretion to avoid the future sacrifice,
and
c. the transaction or other event obligating the entity has
already happened.
39
The ASB makes further points in relation to assets and liabilities:

In relation to assets it notes that:
• An asset is not the item of property itself but the rights or other access
to some or all of the future economic benefits derived from it.
• There need not be legal ownership of the property from which the
future benefits are derived.
• There need not be legal rights to future benefits.
• The future economic benefits need not be certain (though uncertainty
may affect recognition).
• Entity control involves power to obtain for itself any economic benefits
that arise and to prevent or limit others’ access to those benefits; the
SOP notes that ‘it is generally not possible for an entity to choose if
and when to realise the economic benefits derivable from factors such
as its market share, superior management or good labour relations
because the rights or other access to such benefits cannot be controlled
independently of the business as a whole.’
• Control need not be legally enforceable.
In relation to liabilities the ASB notes that:
• ‘Obligations’ implies that the entity cannot avoid the outflow of
resources.
• Legal obligation is not necessary (for example an obligation may be
created by a pattern of past practice).
• It need not be certain that there will be a transfer of future economic
benefits, only that there might be such a transfer; obligations that may
not result in such a transfer will still be obligations, but may not be
recognised in the financial statements.
• The obligation need not be to transfer known amounts of cash, it could
involve, for example, the provision of services.
Further comments
Are the definitions useful, given that they are sufficient but not necessary
conditions for the inclusion of an item in the financial statements?
Macve (1981) points out that the definitions are so general that they are
unlikely to exclude anything that one might reasonably want to include.
Indeed, the FASB statement itself points out that it expects most assets
and liabilities in the present practice to continue to qualify as assets or
liabilities under the definitions, and that the definitions neither require nor
presage upheavals in present practice.
Note that these definitions do not depend on legal enforceability. But how
far removed from a legal one might a right or claim be? Is it a question of
the probability of future benefits or sacrifice of future benefits? But how
probable is probable? (The FASB statement notes that probable is used
with its ‘usual general meaning’, referring to ‘that which can reasonably
be expected or believed on the basis of available evidence or logic but is
neither certain nor proved.’) What is a past transaction? What gives rise to
the existence of an asset or liability?
These are some of the recognition problems that the statements do
not help with, but which are particularly important for executory
contracts3 – that is, a promise for a promise, for example an agreement 3
See below for further
to sell goods at a future date in return for payment at a future date. The discussion.
‘Elements’ chapter in the ASB statement says that rights and obligations
40
under such unperformed contracts represent a single asset or liability

(‘a net position comprising a combined right and obligation either to
participate in the exchange or alternatively to be compensated (or to
compensate) for the consequences of the exchange not taking place’),
and initially the rights and obligations are likely to be exactly offsetting,
though often that will not remain the case. In the chapter on ‘Recognition’,
the ASB notes that changing circumstances may cause an imbalance to
arise, in which case the net position will either be an asset or a liability
and will be recognised if the recognition criteria are met. It states,
however, that where such an asset or liability exists, if the historical cost
basis of measurement is being used, the carrying value will be the cost of
entering into the agreement, which is usually nil. In effect the contract is
recognised at nil.
Macve concludes that it is difficult to understand why the FASB should
think these definitions helpful in analysing and resolving new accounting
issues as they arise.
Activity 2.3
What do the definitions of assets and liabilities above actually mean? Explain in your own
words.
Recognition and measurement in financial statements

SFAC 5, SOP4 4
Chapter 4.
Recognition
Recognition deals with those items that should appear in the financial
statements. The ASB states:
The objective of financial statements is achieved to a large
extent through depicting in the primary financial statements, in
words and by a monetary amount, the effects that transactions
and other events have on the elements. This process is known as
recognition.
The criteria for initial recognition of an element5 in the SOP are that: 5
The elements of
financial statements are
1. There is sufficient evidence that the change in assets or liabilities those discussed above
inherent in the element has occurred (including, as appropriate, such as assets, liabilities,
evidence that a future beneficial inflow or outflow will occur). ownership interest, gain
and so on.
2. The element can be measured as a monetary amount with sufficient
reliability.
Similarly the FASB sets out four fundamental recognition criteria:
1. meeting the definition of an element
2. measurability – having a relevant attribute which is measurable with
sufficient reliability
3. relevance
4. reliability.
The ASB’s SOP points out that although the starting point for the
recognition process may be the effect on assets and liabilities, the notions
of ‘matching’ and the ‘critical event’ may help in identifying the effects.
However, the SOP emphasises that ‘matching’ is not used to drive the
recognition process. It seeks to prevent unrestricted use of the matching
concept, otherwise it would be possible to delay recognition in the
performance statement of most items of expenditure whose hoped-for
benefits lay in the future. It restricts this by allowing only items that meet
41
the definition of assets, liabilities and ownership interest to appear in the

balance sheet. Thus expenditure or losses not associated with control of
rights or other access to future economic benefits will be recognised as a
loss in the period in which they are incurred; and expenditure incurred
with a view to future economic benefits where the relationship is too
uncertain will be recognised as a loss immediately. However, it recognises
that, for example, if future economic benefits are eliminated over several
accounting periods, the cost of the asset that comprises those benefits will
be recognised as a loss over the same accounting periods.
The SOP suggests that focusing on the critical event in the operating cycle
may make it easier to identify gains arising from the provision of goods
and services; this will be the point at which there is sufficient evidence
that the gain exists and it can be measured reliably. This need not be at
the time of full performance. The statement suggests that a contract to,
for example, build large buildings might involve performing a series of
stages for each of which there is a critical event. It suggests that ‘in such
circumstances the gain that is expected to be earned on the contract as a
whole will need to be allocated among the critical events.’6 6
See Chapter 9.
The concept of realisation does not appear amongst the criteria for
recognition in the SOP. In Appendix III the Board points out that, over
time, even wider notions of ‘realisation’ have become irrelevant and, rather
than choosing to ‘bend a term so that it has meaning other than its natural
meaning’, the Board has chosen to focus on the underlying objective of
recognising a gain only if there is reasonable certainty that it exists and
can be measured reliably. ‘Although the realisation notion is one means of
determining whether the existence of a gain is reasonably certain… in the
Board’s view it is not necessarily the best way.’ In Appendix I the Board
points out that although this appears to conflict with the Companies Act
(which states that only profits realised at the balance sheet date may be
included in the income statement), ‘the way in which the Act defines a
realised profit means that the exact effect of this difference is not clear.’
However, the FASB states that to recognise revenues and gains the items
should be (a) realised or realisable and (b) earned.
Activity 2.4
What typically gives rise to ‘change’ needing to be considered for recognition?
If there is a change in an asset which is not offset by a change in a liability then where
should the gain or loss be recognised? What are the conditions under which gains can be
recognised in the income statement either in the UK or internationally?
Measurement
Assuming that financial items satisfy the recognition criteria, at what
amount should they be recorded in the financial statements? Should
they be at cost, at market value or at some other amount? There are a
number of different theoretical approaches to measurement, for example
replacement cost or deprival value. Many of the different approaches
are reviewed in this subject guide. The underlying argument regarding
measurement is that there is no single valuation method that can
meet all financial reporting purposes in all circumstances.
In the US, SFAC No. 5 dealt more with current practices than actual
recommendations (and it received much criticism). For instance, it did
not prescribe a particular measurement attribute to be used in given
circumstances. Instead it listed five measurement attributes used in
practice:
42
• historical cost
• current cost
• current market value
• net realisable value
• present value of future cash flows.
It concluded that ‘rather than attempt to select a single attribute and
force changes in practice… this statement suggests that use of different
attributes will continue.’ It notes that an ideal measuring unit would be
stable over time but suggests that at times of low inflation nominal units
of money are relatively stable; ‘the Board expects that nominal units of
money will continue to be used to measure items recognised in financial
statements’ but suggests that this might change if increased inflation
led to ‘intolerable’ distortions. This is similar to the ASB who note that
although most financial statements are prepared using the financial capital
maintenance concept and measured in nominal units, adjustments will
be needed if the problem of general price change is acute, and if the
problem of specific changes is acute ‘it will be necessary to adopt a
system of accounting that informs the user of the significance of specific
price changes for the entity’s financial performance and financial position.’
Little in the FASB statement is likely to lead to a change from existing
US practice. Indeed, it largely reaffirms it. Paragraph 2 notes that ‘the
recognition criteria and guidance in the Statement are generally consistent
with current practice and do not imply radical change’ (though it notes the
possibility of future change is not foreclosed – see also paragraph 91).
However, the ASB states, in Chapter 6 of the SOP, that the measurement is
based on the assumption that a ‘mixed measurement’ approach (often
referred to as ‘modified historical cost’)7 will be adopted, whereby 7
The ASB (1999)
some items will be measured at historical cost and others at current states that although
the measurement
value. It suggests that ‘the basis selected will be the one that best meets
basis noted above is
the objective of financial statements and the demands of the qualitative often referred to as
characteristics of financial information, bearing in mind the nature of the the ‘modified historical
assets or liabilities concerned and the circumstances involved.’ cost basis’, it is more
accurately referred to as
Following initial recognition, items will be remeasured, as necessary, to
the ‘mixed measurement
ensure that items measured at historical cost are carried at the lower of system’.
cost and recoverable amount, and items shown at current value are kept
up-to-date.
The statement asserts that ‘current value is at its most relevant when it
reflects the loss that the entity would suffer if it were deprived of the asset
involved’ and therefore advocates a measurement basis known as ‘value to
the business’ or ‘deprival value’, depicted diagrammatically in Figure 2.3.
(The concept of deprival value will be discussed in more detail later in the
subject guide.)
Value to the business
= lower of:
Replacement cost and Recoverable amount

= higher of:
Value in use and Net realisable value

Figure 2.3 ‘Value to the business’ or ‘deprival value’
43
The SOP notes that the ‘relief value’ of a liability may be selected in a
similar manner.
It stops short of advocating a move towards current value accounting:
[I]t says nothing about the desirability or otherwise of adopting
an approach that involves all balance sheet items being
measured at current value, just as it says nothing about the
desirability or otherwise of adopting an approach that involves
all balance sheet items being measured at historical cost. All it
does say is that both these approaches would involve a radical
change to existing practice.
(ASB, 1999)
However, in discussing the choice of a measurement basis it makes the
following points:
• As markets develop, measurement bases once thought unreliable may
become more reliable.
• The need for relevant information means that the measurement basis
should be one that provides information useful for assessing the
entity’s ability to generate cash flows and its financial adaptability.
• If both historical cost and current value measures are available, the
better one to use will be the one that is more relevant.
• Current value measures are not necessarily less reliable than historical
cost measures; for example provisions for bad and doubtful debts
under historical cost accounting involve estimates similar to (and of
similar reliability to) those involved in ascertaining current values not
derived from an active market.
• ‘Assessment of relevance and reliability needs to take into account
what the asset or liability represents.’ It suggests that an investment
which represents a ‘store’ of spare cash will best be measured at
current value since its relevance to the entity will be the future cash
flows that it represents right to.
An earlier exposure draft of the SOP was criticised by many as being an
attempt to introduce a current cost accounting system. The SOP
appears to play down the importance of fully blown, current-cost systems
by suggesting that a mixed measurement system will continue
to be used, though it refers to many advantages of current value. The
statement refers to choosing the most relevant basis when both historical
cost and current value are available and reliable, and the need to choose
a measurement basis according to the nature of the assets, the particular
circumstances, the objectives of financial statements and the qualitative
characteristics of financial information. But can the mixed measurement
system be justified in terms of ‘principles’? It also raises questions of
comparability. Baxter comments that ‘such muddled figures hardly add to
accounting dignity’.8 8
Accountancy, October
1999.
Presentation of financial information

Chapter 7 of the SOP discusses the financial statements and the
presentation of financial information. It identifies what constitutes good
presentation in:
1. the statement of financial performance (the components of
performance and their characteristics – ‘their nature, cause, function,
relative continuity or re-occurrence, stability, risk, predictability and
reliability’)
44
2. the statement of financial position (the types and functions of assets

and liabilities and the relationships between them)
3. the cash flow statement (distinguishing in particular cash flows from
operating activities, and those from other activities).
The statement notes the importance of aggregation, interpretation
and simplification in portraying items in financial statements, to avoid
excessive detail obscuring the message; the notes to the accounts should
be used to amplify and explain the statements.
Accounting for interests in other entities

Chapter 8 of the SOP discusses how different investments in other entities
should be reflected in a single entity’s accounts and in consolidated
accounts. This involves issues, such as accounting for business
combinations and entities over which there is significant influence, which
are considered later, in Chapter 5 of this guide.
Review of the conceptual framework

The IASB produced a Discussion Paper in 2006 – Preliminary views on an
improved conceptual framework for financial reporting. Subsequently an
Exposure Draft (with the same name) was issued in 2008. It was part of a
series of initiatives developed jointly by the FASB and the IASB to provide
a foundation for principles-based and converged standards. The focus
is on information for providers of capital and substantively it is wedded
to the conventions of previous influential frameworks. Let us review its
qualitative characteristics.
Relevance and faithful representation are classified as fundamental
qualitative characteristics. Faithful representation is meant to replace
reliability – and hence is controversial, depending upon how it is
interpreted. Comparability, verifiability, timeliness and understandability
are classified as enhancing qualitative characteristics.
Specific attention is directed to ‘constraints of financial reporting’:
• Materiality: the report should not be cluttered with immaterial
information: information is understood as material if its omission or
misstatement would influence user decisions.
• Costs: Benefits of financial reporting should be greater than costs.
The emphasis on decision-usefulness is controversial for those who
recognise the need to constrain disclosure in an imperfect markets context
or who fear that the stewardship dimension might be overlooked. Some
believe stewardship should be specifically referred to, perhaps even as a
separate objective.
A further exposure draft in relation to this project was issued in 2010.
This focused on the development of a reporting entity concept. This is
again from the perspective of providers of capital seeking information they
do not have about a ‘circumscribed area of business activity’. We shall
consider the reporting entity concept further later in relation to group
accounts.
Discussion on other areas, including elements and recognition, and,
measurement, continue.
45
Conclusions
The ASB’s Statement of Principles in many respects resembles much of
the existing practice. However, the SOP has played a significant role in
the development of new Financial Reporting Standards (FRSs). As the
ASB states ‘…all the standards that have been issued since then [i.e.
after the SOP] are therefore based on those principles. Indeed, some
of the principles play very significant roles in those standards [i.e. new
standards]. For example:
• FRS 2 Accounting for Subsidiary Undertakings uses the reporting entity
concept described in Chapter 2 of the statement
• FRS 4 Capital Instruments, FRS 5 Reporting the Substance of
Transactions, FRS 7 Fair Values in Acquisition Accounting, FRS 12
Provisions, Contingent Liabilities and Contingent Assets, FRS 19 Deferred
Tax, FRS 26 Financial Instruments: Recognition and Measurement all
use the definition of assets and liabilities (where applicable) set out in
Chapter 4;
• FRS 11 Impairment of Non-Current Assets and Goodwill uses the
recoverable amount notion described in Chapter 6; and
• FRS 3 Reporting Financial Performance draws on the principles of good
presentation described in Chapter 7.
• FRS 18 Accounting Policies and FRS 28 Corresponding Amounts draws
on the qualitative characteristics of accounting information set out in
Chapter 3.’
However the one major difference with existing practice revolves around
the notion of ‘matching’. An earlier draft was also criticised for appearing
to downgrade the importance of ‘matching’ in the accounting process.
Many commentators saw the SOP’s focus on assets and liabilities as
emphasising the balance sheet at the expense of the matching concept.
They saw this as meaning that certain items which presently appear in
the balance sheet as a result of the matching process (certain deferred
debits/credits) would be excluded. They agreed that accounting should
continue to be based on the recognition of transactions. The SOP retains
the emphasis on assets and liabilities, but points out that transactions will
continue to be the most common form of event affecting the elements and
therefore the most common reason for recognising and de-recognising
items in financial statements. However, it does not accord primacy to
matching; the matching process will be restricted in that expenditure and
losses will be carried forward only if there are economic benefits still to
be derived from them. Baxter, in supporting this approach, points out that
‘matching’ is a misnomer:
[O]ften income rises or falls without a linked match. Thus

overheads have no cause-and-effect links with particular
revenues; neither have storm damage nor stores’ obsolescence;
interest is earned without a cost and so on… If matching is
unnecessary for such ‘unlinked’ assets changes, it cannot be
essential to the income concept.
What matters are the changes in the assets…
(Accountancy, October 1999)
46
Activity 2.5
How might a conceptual framework be used to counter lobbying by pressure groups
whenever a new (contentious) accounting standard is proposed?
Contrast the UK approach to standard-setting (often allowing choices of accounting
method) with the US approach (more detailed, specific).

Having completed this chapter, and the Essential readings and activities,
• define a conceptual framework
• identify the main efforts by the US, the IASC and the UK to introduce a
conceptual framework
• describe the objectives of financial reporting
• explain the ‘ideal’ qualitative characteristics of accounting information
• define assets and liabilities
• explain and describe recognition and measurement
• apply the conceptual frameworks to particular transactions; for
instance, would they help in deciding how to account for research and
development?

Question 2.1
Select a ‘conceptual framework’ that is most relevant to your country or
the country in which you are studying (e.g. FASB, IASC, ASB). Discuss
the main arguments in favour of and against a conceptual framework in
general and the strengths and weaknesses of the particular framework that
you have selected.
Question 2.2
The FASB’s conceptual framework was expected to:
a. guide the body responsible for establishing standards
b. provide a frame of reference for resolving accounting questions in the
absence of a specific promulgated standard
c. determine bounds of judgement in preparing financial statements
d. increase users’ understanding of, and confidence in, financial
statements
e. enhance comparability.
How feasible do you think are all of these expectations? What difficulties
can you identify that the FASB might have in its attempt to satisfy all five
expectations?
Question 2.3
Evaluate efforts to date to re-orientate the conceptual framework for
financial reporting that are part of the IASB and FASB convergence project.
47
Notes
48
Chapter 3: Income measurement and capital maintenance
Chapter 3: Income measurement and

capital maintenance
Aims of the chapter

This chapter introduces different views of income and capital. One is often
characterised as the view of accountants, the other is often characterised
as the view of economists. The economist’s view is then considered further
in terms of its possible implications for accounting.
Learning outcomes
By the end of this chapter, and having completed the Essential reading and
• contrast the accountant’s and the economist’s approach to income and
asset value measurement
• explain Hicks’s definition of ‘well-offness’ and measures of income
numbers 1 and 2
• discuss ex ante income and both ex post incomes for Hicks’s income 1
and 2
• calculate income ex ante and ex post for both Hicks’s income measures
• discuss the implications of Hicks’s income measures for both
economists and accountants.
Essential reading
Further reading
Beaver, W.H. and J.S. Demski ‘The Nature of Income Measurement’, Accounting
Review 54(1) 1979.
Pitman Publishing, 1992) [ISBN 9780273034643]. Chapters 3 and 4.
Hicks, J.R. Value and Capital. (Oxford: Clarendon, 1946) second edition.
Chapter 14.
Hicks, J.R. ‘Incomes’ in Parker, R.H., G.C. Harcourt and G. Whittington (eds)
Readings in the Concepts and Measurements of Income. (Oxford: Philip Allan,
Chapter 4.
Paish, F.W. ‘Capital and Income’, Economica 7(28) 1940.
Solomons, D. ‘Economic and Accounting Concepts of Income’, Accounting
Review 36(3) 1961 (reprinted in Parker, R.H., G.C. Harcourt and G.
Whittington (eds) Readings in the Concepts and Measurements of Income.
(Oxford: Philip Allan, 1986) second edition [ISBN 9780860035367]).
Whittington, G. Inflation Accounting: An Introduction to the Debate. (Cambridge:
Cambridge University Press, 1983) [ISBN 9780521270557]. Chapter 2.
49
A view of income and capital often characterised as the

accountant’s view
The accountant is here understood as computing the income for a period
by one or both of two approaches that logically give the same financial
number:
1. Take revenues less the cost of sales and other expenses for a period to
compute profit Y0→1 directly
2. Compute profit for a period by comparing opening and closing net
assets, adjusting for new capital injections or withdrawals, thus
(assuming no capital injections) calculating the value of
NA1 – NA0 + D0–1
Y0→1 = NA1 – NA0 + D0–1
Where:
Y0→1 = profit for the period
NA1 = net assets at the end of the period
NA0 = net assets at the beginning of the period
D0–1 = distribution for the period.
Net profit here is the difference between opening and closing net assets
before distributions: consistent here with seeing the balancing figure in the
balance sheet as profit for the year. By this logic, beyond constraints of a
particular view, income depends on valuation of net assets. The approach
associated with the economist values net assets using net present values
(NPVs).
A view of income and capital often characterised as the

economist’s view
The relationship between income and capital can be expressed as:
Y0→1 = V1 – V0 + D1
Here V0 is the opening capital value, V1 is the closing capital value and D1
represents consumption (or expected cash flow to be received at the end
of year 1). The value of the business is calculated using the present value
of expected cash flows.
Activity 3.1
Compare and contrast the views of income and capital discussed above.
Activity 3.2
A business is set up by Zillah Corporations with an expected four-year life. At the start of
2010, the cash flows expected to occur at the end of the years to which they relate are:
£
2010 10,000
2011 8,000
2012 6,000
2013 4,000
Assume the interest rate is 10% and is expected to remain constant.
What would be the economic value of the business at the start of 2010 (i.e. V2010)?
The solution to this activity is given in Appendix 1.
50
Hicks’s version of the economist’s concept of income

Many accounting theorists have appealed to the notions of Economic
Income developed by Sir John Hicks in his book Value and Capital.1 This 1
See Further reading
is perhaps strange, as Hicks notes that income is a ‘rough approximation’, above.
a ‘guide for prudent conduct’, whose purpose in practical affairs is ‘to
give people an indication of the amount which they can consume without
impoverishing themselves’. This leads to Hicks’s central concept of
income:
the maximum value a person can consume during a week and
still expect to be as well off at the end of the week as at the
beginning.
(Note that Hicks uses ‘week’ to denote a period during which variations
in price might be neglected in analysis; extreme inflatory conditions, for
example, may problematise this.)
Although Hicks’s analysis relates to the individual, it has also been applied
to measuring corporate income. The Sandilands Committee on inflation
accounting based its proposals on Hicks’s central concept, defined for a
company as:
the maximum value the company can distribute during the year
and still expect to be as well off at the end of the year as it was
at the beginning.
The corporate equivalent of ability to consume is thus related to the

dividend the company could pay.
What, then, does it mean ‘to be as well off’? Hicks spells out a number of
practical ‘approximations’ to his central concept (see below).
Hicks’s income number 1

Hicks’s first approximation (income number 1) is:
the maximum amount that can be spent during a period if there
is to be an expectation of maintaining intact the capital value of
prospective receipts (in money terms).
Actually, all Hicks’s constructs refer to the individual’s spending in

a period, if in principle the key to each construct is the individual’s
consumption during the period. Hicks notes that the measure of durable
goods consumption could be difficult without satisfactory secondhand
markets for the goods (if such markets exist, consumption can be
measured by change in the goods’ value over the specified period).
Under Hicks’s number 1, ‘well-offness’ to be maintained is thus the NPV of
future cash flows. Hicks sees this as the definition most people implicitly
use in their private affairs, but as leading to ambiguities when interest
rates change (see Hicks’s number 2 below). Let us assume all future cash
flows occur at the end of each relevant period with certainty, and that
there is one constant interest rate for borrowing and lending. Taking time
0 as the present time and time 1 as the end of the first period (say a year),
we initially use the following notation:
D1 = the cash flow arising at time 1
V1 = the capital value at time 1 (= PV of future cash flows from time 1
onwards)
V0 = the capital value at time 0 (= PV of future cash flows from time 0
onwards).
51
The capital values are measured excluding dividends, i.e. V1 does not
include the cash flow receivable at time 1 (D1). Income number 1 for the
period from time 0 to time 1 (Y0→1) is thus measured as:
Y0→1 = D1 + V1 – V0
If the individual actually consumes this amount of income (assuming
consumption in the period from t0 to t1 is all paid for at the time t1), then
remaining wealth at t1 is V0, so the individual is as well-off at the end of
the period as at the beginning. The above expression can be interpreted in
two ways. First, we can write the expression as:
Y0→1 = (D1 + V1) – V0
The term in parentheses represents the total expected wealth, made up of
net cash received plus the present value of expected future net receipts, at
the end of the first period. So Y0→1 is the amount by which total wealth is
expected to increase during the period.
The second way of splitting the expression above is:
Y0→1 = D1 + (V1 – V0)
This can be interpreted as dividing economic income into two components:
the expected cash flow for the period and the expected change in the value
of the individual’s wealth (excluding end-of-period cash D1). We might
refer to the component in parentheses as an expected holding gain or
loss. This should be distinguished from a windfall gain or loss (discussed
below), which is unexpected.
Example 1: perpetuity
A government bond pays £150 a year for ever. If the interest rate is 10%,
then the capital value of the bond at time 0 (ex interest) is:
£150 = £1,500 = V0
0.1
At t1 the value of the bond (cum, or with, interest) is:
£150 = £1,650 = V1
£150 +
0.1
Therefore the income from the bond is:

Y0→1 = £1,500 – £1,650 = £150
This is the same each year, and the capital value remains at £1,500 (ex
interest).
Example 2: an annuity
An annuity pays £150 p.a. at the end of each of the three years and
costs £373.00. The interest rate is 10%. Analyse each year’s receipts into
‘income’ and repayment of ‘capital’. Assume that all the ‘income’ is spent
and the ‘capital’ receipts are reinvested in a bank account which pays
interest at 10%:
52
£ 1 2 3 4 5 6 7 8 9
Opening Income ‘Capital’ Total Interest Total Capital Bank Total
value from receipt receipts on bank income value of balance capital
annuity from from deposit (2+5) annuity (7+8)
(10%×1) annuity annuity @ 10% after
(10% × 8) payment
Time
t0 – – – – – – 373.00 – 373.00
t1 373.00 37.30 112.70 150.00 – 37.30 260.30 112.70 373.00
t2 260.30 26.03 123.97 150.00 11.27 37.30 136.33 236.67 373.00
t3 136.33 13.63 136.37 150.00 23.67 37.30 – 373.00 373.00
Thereafter the bank pays £37.30 interest each year on the balance of
£373.00.
Applying the formulae above, we find:
V0 = £373.00
V1 = £260.30
D1 = £150
Y0→1 = £150 + £260.30 – £373 = £37.30
Note: The actual financing and consumption policy adopted will not alter
the calculation of the income from the annuity in column 1.
Example 3: a ‘capital budgeting project’

An investment project is expected to have the following cash outlays and
receipts.
Time Cash Flows Discount Factor @ 10%
t0 – 4,000 1.0000
t1 +2,000 0.9091
t2 +1,500 0.8264
t3 +2,000 0.7513
Activity 3.3
If the cost of capital is 10%, what is the NPV of the project to the nearest £1?
The solution to this activity is given in Appendix 1.
Analyse the cash flows into ‘income’ and ‘capital’, on similar assumptions
to the previous example above and assuming the initial outlay of £4,000
was borrowed via a bank overdraft.
53
£ 1 2 3 4 5 6 7 8 9
Opening Income Capital Total Interest Total Capital Bank Total
value from receipt or project received/ income value of balance capital
project shortfall receipts (paid) to (2+5) project (overdraft) (7+8)
(10% × 1) (4 – 1) (payments) bank
(10% × 8)
Time
t0 – – (4,000) (4,000) – – 4,560 (4,000) 560
t1 4,560 456 1,544 2,000 (400) 56 3,016 (2,456) 560
t2 3,016 302 1,198 1,500 (246) 56 1,818 (1,258) 560
t3 1,818 182 1,818 2,000 (126) 56 – 560 560
Therefore the bank account will pay £56 p.a. interest on the £560 balance.
Applying the valuation and income formulae above:
Project value at time 1 = £1,500 × (0.9091) + £2,000 × (0.8264) = £3,016
Project value at time 2 = £2,000 × (0.9091) = £1,818
Example 4: Cash flows

Your friend expects to get cash of £1,000 at time 1 and £2,000 p.a.
thereafter (all cash flows arise at year end) in perpetuity. The rate of interest
is expected to remain at 10% p.a. He wishes to consume all income, but no
more, and can borrow from and lend to the bank at 10% p.a.
What is his income in year 1? Relevant variables are as follows:

D1 = £1,000
(= cash flow at time 1)
£2,000
V1 = = £20,000
0.1
(= PV of future cash flows from t1 onwards)
(
V0 =
£1,000
+
£2,000
×
1 (
= £909.09 + £18,181.82 = £19,090.91
1.1 0.1 1.1
(= PV of future cash flows from t0 onwards)
Therefore income number 1 equals £1909.09:
£1,000 + £20,000 – £19,090.91 = £1,909.09
How can he consume £1,909.09 when the year’s cash flow is only £1,000?
He only has cash of £1,000, but could borrow £909.09 from the bank at the
prevailing rate of interest; this would reduce his capital at time 1 (V1) from
£20,000 to £19,090.91 thus maintaining his original capital (V0).
Interest of £90.91 p.a. on the loan would reduce net future cash flows to
(£2,000 – £90.91) = £1909.09 p.a. (Rather than borrow, he could realise
£909.09 of the capital value at time 1 by sale, leaving capital value at
£19,090.91, on which future receipts at 10% p.a. would be £1,909.09.)
Future income will remain at £1909.09 p.a. provided he exactly maintains
his opening capital.
In this example income equals the rate of interest (r) applied to the opening
capital value (i.e. rV0). This is because V0 equals (D1 + V1) discounted back
one period by r, which in turns means that (D1 + V1) equals (1 + r)V0 ;
income may thus be expressed as (1 + r)V0 – V0, or rV0.
It should also be noted that, on the assumptions made so far, if the opening
capital is exactly maintained and all the income (including the accretion to
54
capital value) consumed, then in future years the income figure would be
constant (and equal to rV0).
Summary of formulae:
Y0→1 = D1 + V1 +V0
D1 + V1
V0 =
1+r
(1 + r)V0 = D1 + V1
Y0→1 = (1 + r)V0–V0
Y0→1 = rV0
Income ex ante and income ex post

If we relax the assumption of certainty, problems arise. In addition
to different people having different expectations about the future, in
conditions of uncertainty actual cash flows will tend to differ from forecast
cash flows. Moreover, new information or changing conditions will revise
expectations about all future cash flows. Given these differences, we will
have different amounts for the capital values at time 1 and time 0, and for
the cash flow at time 1, depending on whether these were calculated at
the beginning or end of the year.
We may call our calculations made at the beginning of the year, at t0, ex
ante or ‘forward-looking’ and add the symbol ‘t0’ to show they were
computed at time 0 in the light of the knowledge and expectations we had
at that time. We may call our calculations made at the end of the year, at
time 1, ex post, or ‘backward-looking’ and add the symbol ‘t1’ to show
they were computed at time 1 in the light of our revised knowledge and
expectations. We use the following notation:
Ex ante variables
D 1t 0 = the cash flow we expect to receive at time 1, given our
knowledge and expectations at time 0
V 1t 0 = the expected capital value at time 1, given our knowledge and
expectations at time 0
V 0t 0 = the opening capital value at time 0, given our knowledge and
expectations at time 0 (This will equal (D1t0 + V1t0) discounted back
one period at the rate of interest for that period.)
Ex post variables
D 1t 1 = the actual cash flow occurring at time 1
V 1t 1 = the capital value at time 1, given our revised knowledge and
V 0t 1 = the revised calculation of our opening capital value given the
actual cash flow for the year and our revised expectations at the end
of the year. (This will equal (D1t1 + V1t1) discounted back one period
at the rate of interest prevailing for that period.)
Given these differences between ex ante and ex post calculations, we now
have different measures of income number 1 depending on the time the
income number is calculated.
Income number 1 ex ante

First of all, we may calculate income ex ante, or ‘forecast’ income based
entirely on our expectations at the beginning of the period, time
0. For Hicks, this is the figure relevant to decisions. This makes sense if
55
income is regarded as a guide to consumption. Income number 1 ex ante

may be expressed as:
Number 1 Y0→1 ex ante = D1t0 + V1t0 – V0t0
As noted earlier, this equals rV0t0. For the reason given above, income
number 1 ex ante will always equal interest on the capital value at the start
of the period.
Income number 1 ex post version A and version B

We may alternatively (or in addition) calculate income number 1 ex post,
income for the period calculated at the end of the period. There are,
however, two possible versions of income number 1 ex post, which we will
call ‘version A’ and ‘version B’.
They differ in their treatment of windfall (unexpected) gains and losses.
Windfalls (unexpected) arise from differences between:
• forecast and actual cash flows for the period
• original expectations of future cash flows from the end of the period
onwards and our revised expectations of future cash flows.
(They may also arise from differences between expected and actual
interest rates, or changes in expected interest rates, but we are as yet
assuming constant interest rates.)
Version A
Version A may be expressed as:
Income number 1 Y0→1 ex post version A = D1t1 + V1t1 – V0t0
This is actual cash flow for the period plus capital accumulated including
windfalls. Hicks describes income ex post as income ex ante plus windfalls.
Thus the definition of ex post income incorporates all windfalls measured
as:
(D1t1 + V1t1) – (D1t0 + V1t0)
Here, income is no longer equal to rV0t0 (because windfalls are not
reflected in the opening capital value).
It could be argued that the definition of Hicks’s income 1 ex post version
A set out above is meaningless as it compares two numbers calculated
using information available at time t1 with a number calculated using only
information available at time t0. If the individual had the information at t0
that the individual has at t1, the individual’s calculation of NPV would not
have been the originally calculated V0t0 but rather:
1
V0t1 = (D1t1 + V1t1)
1+r
This gives an alternative version of ex post income: version B.
Version B
Version B may be expressed as:
Income number 1 Y0→1ex post version B = D1t1 + V1t1 – V0t1
This is actual cash flow for the period, plus capital accumulation
excluding windfalls.
Windfalls are excluded because we have restated our opening capital with
the benefit of hindsight to what it would have been had we had perfect
foresight at t0. This measure would therefore have been our ex ante income
number 1 if we had had perfect knowledge at t0; it follows that income
under this version is equal to rV0t1.
56
The treatment adopted for these ex post windfalls determines our ex ante
income for future periods (assuming we consume all income). Including
them in income under version A maintains our originally foreseen capital
value as the basis for measuring future income ex ante and (assuming
constant interest rates) our ex ante income for the next period would equal
ex ante income for this period (rV0t0). Excluding them from income as per
version B maintains revised opening capital value as the basis for future
ex ante income and (assuming constant interest rates) ex ante income for
the next period would equal ex post (version B) income for this period (=
rV0t1). Thus this second version of ex post income is closer to Hicks’s own
intentions than version A.
Example 5
A project is expected to generate cash flows of £10,000 p.a. in perpetuity.
The interest rate is expected to remain at 10% p.a. Cash flows arise at year
end. At the end of the first year the actual cash receipts are £5,000. At that
time, expectations of future cash receipts are changed to £12,000 p.a. The
interest rate for the first year is 10% and is expected to remain unchanged.
1. What is the income for the first period (i) ex ante and (ii) ex post?
2. Reconcile the ex ante income with both versions of ex post income.
At time 0 and time 1 we have the following information:
ex ante Beginning of the year

currently here
→
t0 t1 t2 t3 t4 →
8
Cash flows 10,000 10,000 10,000 10,000
D1 0 ………….… → V 1t0 →………
V 0t0 →……………………………………………………………………… →
ex post End of the year

currently here
→
t0 t1 t2 t3 t4 →
8
Cash flows 5,000 12,000 12,000 12,000
D1t1 …………. … V 1t1 →……………………

→
V 0t1→ ……………………………………………………………………… →
Ex ante variables Ex post variables
D1t0 = £10,000 D1t1 = £5,000

£10,000 £12,000
V1t0 = = £100,000 V1t1 = = £120,000
0.1 0.1
£10,000 £5,000
V0t0 = = £100,000 V0t1 = = £113,636
0.1 1.1
57
Income 1 ex ante,
Y0→1 ex ante= D1t0 + V1t0 – V0t0
= £10,000 + £100,000 – £100,000 = £10,000
(= 10% × £100,000 = rV0t0)
Income 1 ex post,
Y0→1 ex post version A = D1t1 + V1t1 – V0t0
= £5,000 + £120,000 – £100,000
= £25,000
(no longer equal to interest on the opening capital value).
Y0→1 ex post version B = D1t1 + V1t1 – V0t1
= £5,000 + £120,000 – £113,636
= £11,364
(= 10% × £113,636 = rV0t1)
Note that even if ex post income is based upon knowledge of the actual
cash flow that we know at time 1, it is still based upon expectations of the
future from time 1 onwards; V1t1 still measures expected future cash flows
discounted at the expected rate of interest. Thus, income ex post is still a
very subjective measure.
Reconciliation £
1. Budgeted income for year (ex ante) £10,000
Revision of current cash flow (D0t1 – D1t0) <5,000>
Revision of forecast cash flows +2,000 £20,000
0.1
Income for the year (ex post) version A £25,000
2. Budgeted income for year (ex ante) £10,000

Revision to capital value at beginning of the year due to:
Decrease in actual cash flow – 5,000 = <4.545>

1.1
2,000 1
Revision to forecasts after t1: + × = £18,182
0.1 1.1
Net change £13,637
Add interest on net change 13,637 @ 10% £1,364

Income for the year (ex post) version B £11,364
What if interest rates are expected to change?

So far interest rates have been assumed to remain constant. What happens
if interest rates are expected to change, or change unexpectedly? How
does this affect our concept of income? We have already noted with
income number 1 that unexpected changes in interest rates would give
rise to windfalls through the effect on capital values (see also example
7 below). But Hicks goes further and suggests that once we allow for
changes in the rate of interest we must change our ideas about what
constitutes ‘well-offness’ and hence our ideas about income measurement.
Now that interest rates are allowed to change, the following additional
notation will be used:
58
Ex ante variables
r 0t 0 = the interest rate from time 0 to time 1, given our knowledge and
r nt 0 = the interest rate from time n to time n + 1, given our knowledge and
Ex post variables
r 0t 1 = the interest rate that actually prevailed from time 0 to time 1
r nt 1 = the interest rate from time n to time n + 1, given our knowledge and
Example 6
A security pays £200 a year forever. At time 0 the interest rate is expected
to be 10% p.a. for the first two years and 20% p.a. thereafter. All cash
flows arise at year end. At the end of each year the difference between
income (calculated on a number 1 basis) and cash received is invested in a
bank account at the prevailing interest rate so as to maintain the opening
capital value. What is income number 1 ex ante for each of the first three
years?
Ex ante variables
D1t0 = £200 (= Dtn0 for all n from 2 to infinity)
£200
V2t0 = = £1,000 (Vnt0 for all n from 3 to infinity)
0.2
(
V1t0 =
£200
+
£200
×
1
(
= £1,090.91
1.1 0.2 1.1
(
V0t0 =
£200
+
£200
+
£200
×
1
= £1,173.55
(
1.1 (1.1) 2
0.2 (1.1)2
r0t0 = r1t0 = 10%
r2t0 = 20% = rnt0 for all n from 3 to infinity
Y0→1 = £200 + £1,090.91 – £1,173.55 = £117.36
(=10% × £1,173.55)
£82.64 will be invested in the bank, so that total capital at time 1 is now
£1,173.55 (i.e. the security valued at £1,090.91 plus the bank balance of
£82.64). The expected capital value at time 2 is now the security valued
at £1,000 plus £82.64 in the bank, a total of £1,082.64. The bank pays
interest of £8.27 (rounded) at t2 so that cash receipts at time 2 total
£208.26.
Y1→2 = £208.27 + £1,082.64 – £1,173.55 = £117.36
£90.91 will be invested in the bank at t2, so that total capital (security plus
bank balance) is once more maintained at £1,173.55; the total amount
now in the bank is £173.55 (i.e. £82.64 plus £90.91), on which interest at
20% will be £34.71 p.a. Future cash receipts will therefore total £234.71.
Capital value at time 3 will consist of the security valued at £1,000 and the
bank deposit of £173.55 = £1,173.55.
Y2→3 (and each year thereafter) = £234.71 + £1,173.55 –
£1,173.55 = £234.71
59
Since the capital value is henceforth expected to be constant, and the

interest rate to remain constant at 20%, ex ante income for period 3
onwards will be £234.71 p.a. for ever. Thus, according to Hicks’s income
number 1 ex ante, the income stream here will be £117.36, £117.36,
£234.71, £234.71,…,£234.71.
But in these circumstances Hicks suggests that someone who could
consume that pattern of income appears to be getting better off over time
as the prospect of spending £234.71 a year draws nearer; one may be
thought better off if one can consume £234.71 a year rather than £117.36
a year. Yet in his central concept Hicks has defined income as the amount
one can consume during the year while remaining as well-off at the end as
at the start; thus, there would be no change in one’s well-offness.
Hence Hicks suggests that maintenance of the capitalised value of
prospective money receipts does not correspond with our ideas of well-
offness when interest rates change.

The possibility that individuals could exploit changes in interest rates
to change their consumption pattern leads Hicks to develop his second
approximation of income:
the maximum amount the individual can spend this week and
still expect to be able to spend the same amount in each ensuing
week.
For a company we may define it as:

the maximum dividend the company can pay in a period and
still expect to be able to pay the same dividend in all future
periods.
When interest rates are not expected to change (and do not change), this
will be the same as income number 1; if interest rates are expected to
change (or do unexpectedly), the two income measures differ and Hicks
regards number 2 as a better measure of income and closer to his central
concept. In example 6 above, income number 2 would be £200 every year
– the amount the security pays every year regardless of the interest rate.
Note also the effect of an unexpected change in the interest rate on income
number 1, ex post, compared with income 2, even when cash flows are
regular perpetuities.
Example 7
A bond pays £100 at the end of each year forever. The rate of interest is
expected to be 20% p.a. forever (i.e. r0t0 = rnt0 for all n from 1 to infinity),
so the bond’s value is £500 (i.e. 100/0.2). At time 1 the interest rate (r1t1)
unexpectedly changes to 10% and is expected to remain at 10% forever
thereafter (i.e. r1t1 for all n from 2 to infinity); the bond’s value therefore
rises to £1,000 (i.e. 100/0.1). The revised opening capital value is:
(D1t1 + V1t1) 100 + (100/0.1)
V0t1 = = = £916.66
1.2 1.2
Income ex ante, both number 1 and 2, is £100 (= 20% × £500, i.e.
r0t0(V0t0)) since the interest rate is not expected to change.
Income number 1 ex post version A is: 100 + 1,000 – 500 = 600
Income number 1 ex post version B is: 100 + 1,000 – 916.66 = 183.34.
60
Although this is 20% on the revised opening capital value (i.e. r0t1(V0t1))
note that future income ex ante will no longer be this amount, but
(assuming that all of the income is consumed so that the capital is
maintained at V0t1) will be 10% × £916.66 = £91.66 (i.e. r1t1(V0t1)).
But here income number 2 still measures ex post income as £100. The
constant annual cash flow is unaffected by the change in the interest
rate; it is therefore the amount that can be spent this period with the
expectation of being able to spend the same amount in all future periods.
(As noted below, however, if cash flows are not regular perpetuities, an
unexpected change in the rate of interest will affect income number 2 ex
post.)
Number 2 ex ante
When the net cash flows are regular perpetuities, income number 2 ex
ante will equal the amount of the net cash flows. If they are not regular
perpetuities but interest rates are assumed constant, it will (as noted
above) equal income number 1 ex ante. If the cash flows are not regular
perpetuities and there are expected changes in the interest rate, calculation
of income number 2 ex ante is more difficult. Assuming, however, that just
one change is expected, at time 1, after which rates are expected to remain
constant (i.e. r1t0 = rnt0 for all n from 2 to infinity), then income number 2
ex ante may be calculated by solving for Y in the following:
(
V0t0 =
Y
+
Y
×
1
(
1 + r0t0 r1t0 1 + r0t0
where Y equals the amount of the annual income. This reflects the fact
that the constant annual stream of consumption when discounted at the
prevailing interest rates must have a present value equal to the opening
‘well-offness’ or capital value. In the case considered here, it may be solved
also by finding income (Y) such that:
(V0t0)(r1t0)(1 + r0t0)
Y=
(1 + r1t0)
Number 2 ex post
Income number 2 will be affected if there are differences between
expected and actual cash flows or differences between originally expected
cash flows and our revised expectations of those cash flows. Once again
we will have ex post measures. Moreover, there will again be two different
measures of ex post income, depending upon how we treat windfalls.
Income number 2 ex post version A may be defined as:
the maximum amount an individual can consume in a period
and still expect to be able to consume the originally foreseen
number 2 ex ante income in all future periods.
This version treats as windfall gains or losses all end-of-year period wealth
that is not needed to generate in future periods the initially determined
Hicks’s number 2 income ex ante. The second version of ex post Hicks’s
number 2 aims to calculate the amount that, if consumed in the first
period, will leave enough wealth to permit the individual to consume the
same amount in all subsequent periods. Income number 2 ex post version
B may be defined as:
the maximum amount an individual can consume in a period and still
expect to be able to consume the same amount in all future periods.
61
It therefore follows the basic definition of number 2, but calculates as

income what would have been the ex ante income had one, at time 0,
had the knowledge and expectations that one has at time 1. It therefore
excludes windfalls from income.
When the cash flows are not regular perpetuities, an unexpected change
in the interest rate will also affect income number 2 ex post, because of
the additional borrowing and lending necessary to achieve the equalised
stream of consumption.
Example 8
A project is expected to generate cash flows of £2,000 per annum in
perpetuity. The rate of interest is expected to remain constant at 10%.
£2,000 is actually received at time 1, but at that time the rate of interest
suddenly changes to 20% and is expected to remain at that level forever.
Also at that time, expectations of future cash flows are changed to £4,000
per annum forever. All cash flows arise at the end of the year.
What is the income for the first period?
Ex ante Beginning of
the year
currently
here ↓
t0 t1 t2 t3 t4 →
8
Cash flows 2,000 2,000 2,000 2,000
V 0t0 D1t0 ……….… V 1t0 →………

→
r0t0 = 10%
(= rnt0 for all n from 1 to infinity)
Ex post End of the year

currently here↓
t0 t1 t2 t3 t4 →
8
Cash flows 2,000 4,000 4,000 4,000

V 0t1 D1t1 ……….… V 1t1→………
→
r1t1 = 20%
(=rn t1 for all n from 2
to infinity)
At time 0 and time 1 we have the following information:

Ex ante variables Ex post variables
D1t0 = £2,000 D1t1 = £2,000
£2,000 £4,000
V1t0 = = £20,000 V1t1 = = £20,000
0.1 0.2
£2,000 £2,000 £20,000
V0t0 = = £20,000 V0t1 = + = £20,000
0.1 1.1 1.1
Income number 1 ex ante and income number 2 ex ante

These both equal £2,000 per annum since the interest rate was not
expected to change.
62
Income number 1 ex post

This would also equal £2,000 as capital values at time 1 and time 0 are
unchanged at £20,000.
Income number 2 ex post version A

Given that there is only one change in the interest rate and it is expected
to be constant from time 1 onwards, income number 2 ex post version
A may be calculated as follows. The original number 2 ex ante income
was £2,000. To maintain it in the future at 20% p.a. requires capital of
only £10,000 (i.e. 2,000/0.2). Since the capital value at time 1 (v1t1) is
£20,000, £10,000 of that may be consumed as income this year, which,
added to the actual cash flow for the period, gives total income for the
year of £12,000. This may be expressed as:
Original number 2 ex ante income
Y = D1t1 + V1t1 –
r1t1
To consume this income it would be necessary to sell £10,000 of the

capital value at time 1, or to borrow £10,000 at 20%.
Reconciliation £
Budgeted income for year ex ante 2,000
+2,000
Change in forecasted cash flows + = 20,000
0.1
2,000 2,000
Change in interest rate – = <10,000>
0.2 0.1
Income for the year ex post version A 12,000
Income number 2 ex post version B

Income number 2 ex post version B may be calculated by making use of the
fact that the revised standard stream of consumption from time 0 onwards
must have a present value, when discounted at the prevailing interest
rates, equal to the revised opening capital value (v0t1). Thus,
(
V0t1 =
Y
+
Y
×
1
(
1 + r0t1 r1t1 1 + r0t1
where Y equals the amount of the annual income.

Thus:
(
2,000 =
Y
+
Y
×
1
(
1.1 0.2 1.1
which, when solved for Y, gives income of £3,666.67. In order to consume

this, capital of £1,666.67 must be realised by sale (or borrowed at 20%),
leaving £18,333.33, on which income at 20% p.a. will be £3,666.67.
Here, this may alternatively be calculated by solving for:
Y = r1t1(D1t1 + V1t1 – Y )
which eventually resolves to:

r1 t1(D1t1 + V1t1)
Y=
(1 + r1t1)
63
Reconciliation £
Budgeted income for year ex ante 2,000.00
+2,000 1
Change in forecasted cash flows × = 8,333.33
0.2 1.2
Interest on revision capital @ 20% (8,333.33 × 0.2) = 1,666.67
Income for the year ex post version B 3,666.67
Note that this is the only ex post income measure that involves no looking
backwards. The other figures are based on information at time t0 or use
the interest rate that has just passed. Hicks’s income number 2 ex post
version B uses only end-of-year realisations of cash flows and capital
values and prospective interest rates.

Hicks’s recognises that even income number 2 is not the end of the story,
because if prices are changing we want to be able to consume the same
amount in real terms each week: we need a standard stream of real
consumption. He therefore defines approximation number 3 as:
the maximum amount of money which the individual can spend
this week and still expect to be able to spend the same amount
in real terms in each ensuing week.
Hicks sees that the problem with calculating this lies in finding an
appropriate index number of prices – a problem we return to in our
discussions of current purchasing power accounting in Chapter 4.
Implications of Hicks’s measures of income

Hicks’s price-level income is not uniquely defined. Even ignoring
contrasting changes, and calculation to income numbers 1 and 2, the
result is six different measures of income.
Does this matter?
Hicks observes that all definitions are based on an individual’s
expectations. Income has been defined as a forward-looking, ex ante
concept. This makes sense if income is a guide to consumption. But what
happens if expectations are not achieved? Hicks notes that the value of
an individual’s prospective receipts at the end of the period can be more
or less than the same value determined at the beginning of the period. In
other words, the information available to the individual at the end of the
period may lead to revision of the original calculation of the capital value
of prospective receipts. Basing his discussion on income number 1, Hicks
calls increases or decreases in the capital value of prospective receipts at
the end of the period windfall gains or losses, and describes income ex post
as income ex ante plus windfall gains less windfall losses.
Although Hicks acknowledges that ex post measures of income might have
usefulness as historical measures of activity, he sees no role for them in
economic analysis, as ex post measures (by definition) come too late to
affect individual decision making. This leads him to argue that windfall
gains and losses will come into future income calculations.
Thus Hicks concludes that income is a ‘very dangerous term’, that ‘the
concept is one that a positive theoretical economist only employs in his
argument at his peril’ and that income is ‘a bad tool which breaks in our
hands’.
64
Implications for accountants

Using income as a basis for sharing out rewards from past performance
(‘ex post settling up’) depends in part on an updated view of likely future
performance.
One version of income ex post (A above) would be objective if the capital
values at the beginning and end of the period were fully represented
by assets whose values were established in perfect markets. The assets
of many manufacturing and trading businesses illustrate that this is
not reality. Such assets are specific and not regularly traded, and the
businesses’ prospects of future earnings depend largely on the skills of
the company’s employees, established trading relationships, reputation
for product quality, market power and so on; in other words the value of
these businesses comprises a large element of ‘goodwill’ whose value is
essentially subjective.
The other version of income ex post (B above) is subjective, relying on
estimates of what the opening capitalised value of the prospects would
have been at the beginning of the period if information available now
had been available then.
From a decision-making perspective, calculation of income ex post has value
primarily in terms of budgetary control (i.e. monitoring of outturn and
revision of plans in order to learn from mistakes in the hope of improving
future decisions). The ex post incomes have little significance on their own
for future decisions – these must be based on the new calculation of income
ex ante for future periods (which version B also provides). As calculation
of the new income ex ante includes the capital value now, this does suggest
that information on the present market values of assets (i.e. current wealth
endowment) may be helpful, to both management and shareholders, in
forming their estimates of a company’s likely future prospects. Although
such estimates must be subjective, it could be helpful for shareholders to be
given the management’s estimates, since these are the basis on which the
management are reinvesting the shareholders’ money.
So what is the value in studying these theoretical concepts of

income?
The value lies not so much in deriving prescriptions for accounting, as
in the appreciation of the following limitations of any practical income
measurement:
1. There can be no objective income measurement (including historical
cost); actual cash flows may be seen as objective financial results. Any
attempt at income measurement requires valuations which in most
cases are subjective and cannot be ‘correct’.
2. Income measurements based on changes in the value of the recorded
‘net assets’ of a business can give only a partial picture of the changes
in the value of the business as a whole.
3. Income measurements ‘ex post’ are not in themselves useful for
management’s or shareholders’ investment decisions. They may help
to improve decision-making (through comparisons with previous
plans), but are only helpful for current and future decisions in so far
as they can assist the formation of expectations about the future. Some
would argue that ex post measures are useful as ‘control’ information
(i.e. providing feedback for assigning responsibility and for corrective
action). But Solomons (1961) argues that two coupled factors also
severely limit the potential of ex post income measurement for control:
65
the general impossibility of identifying how much of any variance

from, or revision to, a plan is ‘controllable’ and therefore the
responsibility of the relevant manager
the inherent subjectivity in making revised expectations about the
future.

Having completed this chapter, and the Essential reading and activities,
• contrast the accountant’s and the economist’s approach to income and
asset value measurement
• explain Hicks’s definition of ‘well-offness’ and measures of income
numbers 1 and 2
• discuss ex ante income and both ex post incomes for Hicks’s income 1
and 2
• calculate income ex ante and ex post for both Hicks’s income measures
• discuss the implications of Hicks’s income measures for both
economists and accountants.
66

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J. Haslam and D. Chow

University of London International Programmes

Published by: University of London

Reminder of learning outcomes.................................................................................... 47

Combined CPP/CVA system........................................................................................ 101

Introduction to the interpretation of financial statements............................................ 241

What is or should be the role of accounting in society? How important

Aims and objectives of this course

Accounting standards in this subject guide

How to use this guide

pace of change in financial accounting, you should use the

Sample examination questions

Baxter, W.T. ‘Accounting Standards – Boon or Curse’, Accounting and Business

Weetman, P. (ed.) SSAP 15 Accounting for Deferred Taxation. (Edinburgh:

Online study resources

Making use of the Online Library

Changes to the syllabus

Preparation for the examination

Remember, it is important to check the VLE for:

Format of the examination

Overview of the guide

Chapter 2 of this subject guide addresses some key accounting issues:

Index of abbreviations used in this guide

Chapter 1: Rationale for financial

Aims of the chapter

Financial accounting theory

Financial accounting and its role

Those giving thought to further dimensions of the imperfect character

Financial accounting regulation

Accounting standards: what form should they take?

Type 3: Disclosure of specific matters. This type of standard would require

Comparing arguments for and against standards is clearly related,

Arguments for accounting standards

Arguments against accounting standards

Descriptions of accounting and its regulation

We focus here initially on accounting regulation in ways that substantively

UK accounting regulation and the influence of

Impetus for regulation

Institutional setting for accounting regulation: the UK

• Mandatory regulation: the Statements of Standard Accounting

The ‘true and fair’ requirement

What is the definition of ‘true and fair’?

Statutory regulation: IASs/IFRSs gained force of law

Mandatory regulation: standard-setting and the case of

The ASC’s membership consisted of representatives from the various UK

FRC Ltd Board Council

• Financial Reporting Council (FRC)

requirement that annual accounts shall show a true and fair

One of the ways in which it intends to achieve its aims is by

Accounting standards and company law

offerings. Fourteen standards were rejected by IOSCO but later revised

Reminder of learning outcomes

Sample examination questions

Chapter 2: Conceptual framework

Aims of the chapter

Ernst and Young, International GAAP 2012: Generally Accepted Accounting

Relevant IASB publication

Definition of a conceptual framework

The ASB in the UK states that their Statement of Principles (SOP)

Macve (1981) stated that a conceptual framework would:

However, he also recognised that it would be difficult to implement such a

the various standard-setting bodies around the world have too