ACCA paper f 7 financial reoirting F7FR session02 d08

SESSION 02 – CONCEPTUAL FRAMEWORK OVERVIEW Objective To set out the concepts that underlie the preparation and presentation of financial statements for external users PURPOSE AND STATUS Financial position and performance THE OBJECTIVE OF FINANCIAL STATEMENTS Purpose Principles vs rules Scope Financial statements Application Users and their needs Users and their information needs The future UNDERLYING ASSUMPTIONS CONCEPTS OF CAPITAL AND CAPITAL MAINTENANCE Accrual basis Going concern QUALITATIVE CHARACTERISTICS OF FINANCIAL STATEMENTS Principal qualitative characteristics Understandability Relevance Reliability Comparability ELEMENTS OF FINANCIAL STATEMENTS Definitions Recognition Measurement bases Historical cost Concepts of capital Concepts of capital maintenance Fair value Analysing accounts 0201 SESSION 02 – CONCEPTUAL FRAMEWORK PURPOSE AND STATUS 1.1 Purpose To assist the Board of IASB in developing future IFRSs and reviewing existing IASs promoting harmonisation of regulations etc by providing a basis for reducing the number of alternative accounting treatments permitted by IFRSs To assist national standard setting bodies in developing national standards To assist preparers of financial statements in applying IFRSs and in dealing with topics that have yet to form the subject of an IFRS To assist auditors in forming an opinion as to whether financial statements conform with IFRSs To assist users of financial statements in interpreting information contained in financial statements prepared in conformity with IFRSs To provide those who are interested in the work of IASB with information about its approach to the formulation of IFRSs Commentary In short to provide a conceptual framework as a foundation for the preparation and appraisal of accounting standards 1.2 Principles vs rules A conceptual framework lays down the building blocks upon which accounting standards are laid The IASBs framework sets out the principles of how to account for transactions and events without being too prescriptive in giving rules Commentary Most other GAAPS have some similar form of conceptual framework, even US GAAP has a conceptual framework even though it is rules based UK GAAP calls their framework a “Statement of Principles” Those following US GAAP follow a rules based set of regulations, there being a rule for every transaction and if there is no rule for a particular transaction then a new rule is made up Under a principle based conceptual framework there are no strict rules but a set of guidelines to assist in the preparation and understanding of financial statements 0202 SESSION 02 – CONCEPTUAL FRAMEWORK A conceptual framework is a relatively new concept in accounting Before we had a conceptual framework there was basically nothing binding together the accounting system This led to a lot of inconsistencies in accounting and made it extremely difficult to make comparisons between entities or even within a single entity over more than one accounting period 1.3 Scope Objective of financial statements Underlying assumptions Qualitative characteristics that determine the usefulness of information in financial statements Definition, recognition and measurement of elements Concepts of capital and capital maintenance 1.4 Financial statements Included Statement of financial position Statement of comprehensive income, this will include the profit or loss and other comprehensive income Statement of changes in financial position (e.g a statement of cash flows) Integral notes, other statements and explanatory material Not included reports by directors statements by chairman discussion and analysis by management and similar items included in a financial or annual report 1.5 Application Financial statements of all commercial, industrial and business reporting entities, whether public or private 0203 SESSION 02 – CONCEPTUAL FRAMEWORK 1.6 Users and their information needs Users Information needs Investors and their advisers Risk and return of investment Need information Employees and their representatives Stability and profitability of employers Lenders Whether loans and interest will be paid when due Suppliers and other trade creditors Whether amounts owing will be paid when due Customers Continuance – important for long-term involvement with, or dependence on, the entity Governments and their agencies Allocation of resources and, therefore, activities of entities Public Contribution to local economy including number of employees and patronage of local suppliers for decision-making (buy, hold or sell?) to assess ability to pay dividends Ability to provide remuneration, retirement benefits and employment opportunities Information to regulate activities, determine taxation policies and as the basis for national income and similar statistics Trends and recent developments in prosperity and range of activities 1.7 The future The framework is now quite a dated document, and there are a number of areas where the framework is in conflict with accounting standards, IAS 17 Leases is an example of conflict The standard will always take precedence over the framework document The IASB, in a convergence project with FASB, are in the process of producing a new framework document The project has been broken down into phases and the IASB has recently issued an exposure draft on the first two phases The draft deals with; The objectives of financial reporting, and The qualitative characteristics of information used in financial reporting Commentary These exposure drafts are not an examinable document in the F7 syllabus 0204 SESSION 02 – CONCEPTUAL FRAMEWORK THE OBJECTIVE OF FINANCIAL STATEMENTS To provide information about the financial position, the financial performance, and cash flows of an entity that is useful to a wide range of users in making economic decisions Also, to show the results of management’s stewardship (i.e accountability for resources entrusted to it) 2.1 Financial position, performance and cash flows Information that enables users to evaluate ability of entity to generate cash and cash equivalents timing and certainty of their generation FINANCIAL POSITION Affected by economic resources controlled financial structure liquidity and solvency capacity to adapt to changes ⇒ STATEMENT OF FINANCIAL POSITION FINANCIAL PERFORMANCE In particular profitability To predict capacity to generate cash flows from existing resource base To form judgements about effectiveness with which additional resources might be employed ⇒ STATEMENT OF COMPREHENSIVE INCOME CASH FLOWS To assess investing, financing and operating activities To assess ability to generate cash and cash equivalents and needs to utilise those cash flows Framework does not define funds ⇒ SEPARATE STATEMENT 0205 SESSION 02 – CONCEPTUAL FRAMEWORK UNDERLYING ASSUMPTIONS 3.1 Accrual basis Effects of transactions and other events are recognised when they occur, and recorded in the accounting records and reported in the financial statements of the periods to which they relate 3.2 Going concern Assumption that an entity will continue in operation for the foreseeable future Therefore there is neither the intention nor need to liquidate or curtail materially the scale of operations QUALITATIVE CHARACTERISTICS OF FINANCIAL STATEMENTS Attributes that make information provided in financial statements useful to users 4.1 Principal qualitative characteristics Relate to Presentation 4.2 Content Understandability Relevance Comparability Reliability Understandability Users are assumed to have a reasonable knowledge of business and economic activities and accounting and a willingness to study information with reasonable diligence Information about complex matters should not be excluded on the grounds that it may be too difficult for certain users to understand 4.3 Relevance Quality helps users evaluate past, present or future events; confirm or correct their past evaluations 0206 SESSION 02 – CONCEPTUAL FRAMEWORK Relevance of information is affected by Its nature Nature alone may be sufficient to determine relevance Materiality Information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements Depends on size of item or error judged in the particular circumstances of its omission or misstatement 4.4 Reliability a threshold or cut-off point rather than being a primary qualitative characteristic Free from material error and bias Can be depended upon by users to represent faithfully that which it either purports to represent or could reasonably be expected to represent Reliability encompasses: faithful representation – e.g meeting recognition criteria substance over form – substance and economic reality, not merely legal form – see session neutrality – free from bias prudence – including a degree of caution in making estimates under conditions of uncertainty, such that assets or income are not overstated and liabilities or expenses are not understated completeness (within bounds of materiality and cost) – an omission can cause information to be false or misleading and thus unreliable 4.5 Comparability Users need to be able to compare financial statements of an entity through time – to identify trends in financial position and performance financial statements of different entities – to evaluate relative financial position, performance and cash flows 0207 SESSION 02 – CONCEPTUAL FRAMEWORK Therefore we need consistent measurement and display of financial effect of like transactions and other events Users must be informed of accounting policies employed, any changes in those policies and the effects of such changes Financial statements must show corresponding information for preceding periods ELEMENTS OF FINANCIAL STATEMENTS 5.1 Definitions “Elements” are broad classes of the financial effects of transactions grouped according to their economic characteristics An asset is a resource controlled by the entity as a result of past events from which future economic benefits are expected to flow A liability is a present obligation of the entity arising from past events settlement of which is expected to result in an outflow of resources embodying economic benefits Equity is the residual interest in the assets of the entity after deducting all its liabilities Income is increases in economic benefits during the accounting period in the form of inflows (or enhancements) of assets or decreases of liabilities that result in increases in equity other than those relating to contributions from equity participants Expenses are decreases in economic benefits during the accounting period in the form of outflows (or depletions) of assets or incurrences of liabilities that result in decreases in equity other than those relating to distributions to equity participants The Framework defines assets, liabilities and equity, and the definitions for income and expenses follow on from those Therefore it is said that the Framework takes a statement of financial position approach 0208 SESSION 02 – CONCEPTUAL FRAMEWORK 5.2 Recognition 5.2.1 Meaning The process of incorporating in the statement of financial position or statement of comprehensive income an item that meets the definition of an element and satisfies the criteria for recognition - noted below It involves the depiction of the item in words and by a monetary amount and the inclusion of that amount in the statement of financial positions or statement of comprehensive income totals Items that satisfy the recognition criteria shall be recognised The failure to recognise such items is not rectified by disclosure of the accounting policies used nor by notes or explanatory material 5.2.2 Recognition criteria It is probable that any future economic benefit associated with the item will flow to or from the entity and The item has a cost or value that can be measured with reliability 5.3 Measurement bases Assets Historical cost Current cost Realisable (settlement) value Present value Liabilities The amount paid (or the fair value of the consideration given) to acquire them at the time of their acquisition The amount received in exchange for the obligation The amount that would have to be paid if the same or an equivalent asset was acquired currently The undiscounted amount that would be required to settle the obligation currently The amount that could currently be obtained by selling the asset in an orderly disposal At settlement values (i.e the undiscounted amounts expected to be paid to satisfy the liabilities in the normal course of business) Present discounted value of the future net cash inflows that the item is expected to generate in the normal course of business Present discounted value of the future net cash outflows that are expected to be required to settle the liabilities in the normal course of business 0209 SESSION 02 – CONCEPTUAL FRAMEWORK CONCEPTS OF CAPITAL AND CAPITAL MAINTENANCE 6.1 Historic cost accounting Accounting has historically been based upon what an item had cost, its historic cost, but as economies have advanced so there has been concern that historic cost accounting does not reflect the modern economics of today’s transactions 6.1.1 Advantages of historic cost Easy to understand and follow Objective evidence of transactions Used throughout the world 6.1.2 Disadvantages of historic cost Current revenues are matched with historic costs Value of the assets in the statement of financial position not equate to the economic benefits to be earned from their use Holding gains are not separated from operating gains Holding gains are gains made merely by holding onto an asset If inventory was bought a year ago for $10, and sold today for $18, but to replace that inventory would cost $15, then the profit of $8 is made up of two components, a holding gain of $5 (15 – 10) and an operating gain of $3 (18 – 15) Historic cost accounting does not reflect the general rise in prices, inflation, that affects an economy 6.2 Concepts of capital 6.2.1 Financial concept Capital is synonymous with the net assets or equity of the entity 6.2.2 Physical concept Capital is regarded as the productive capacity of the entity based on, e.g units of output per day 6.3 Concepts of capital maintenance and the determination of profit The wealth of a company is measured by its ability to maintain a level of capital A number of capital maintenance theories have been used by accountants over the past 40 years 0210 SESSION 02 – CONCEPTUAL FRAMEWORK 6.3.1 Financial capital maintenance Profit is earned only if the financial (or money) amount of the net assets at the end of the period exceeds the financial (or money) amount of net assets at the beginning of the period (after excluding any distributions to/contributions from owners during the period) There are two theories based upon financial capital maintenance; Money concept, which is historic cost accounting Real term concept, which considers the impact of a general level of inflation This method is called Current Purchasing Power (CPP) accounting and in its simplest form would uplift asset, liability, revenue and cost figures to reflect levels of inflation in the economy 6.3.2 Physical capital maintenance Profit is earned only if the physical productive capacity (or operating capability) of the entity at the end of the period exceeds the physical productive capacity at the beginning of the period (after excluding any distributions to/contributions from, owners during the period) Current Cost Accounting (CCA) is an accounting model that has been used in the past to reflect changes in the operating capabilities of an entity This method applies specific changes in value to each component of the operations of an entity The impact of both real term and physical capital maintenance concepts would be to reduce the level of distributable profits of an entity, taking account of either inflation or specific price level changes By reducing profit levels it insured that the capital of an entity was at least as much at the end of the year as it was at the beginning of the year 6.4 Fair value The IASB define fair value as ‘the amount for which an asset could be exchanged, or a liability settled, between knowledgeable and willing parties in an arm’s length agreement’ It is the latest attempt by the profession to introduce some form of current accounting into the conceptual framework Fair value could be arrived at from a number of methods, the ideal fair value would be to take a price from an active market place But not all transactions have active market places, therefore other methods of arriving at a fair value have to be found, one of the most common being that of present value Many accounting standards now require assets or liabilities to be measured at fair value, IAS 39 on financial instruments and IFRS on business combinations being two examples 6.5 Analysing accounts When analysing accounts care must be taken in respect of the base information that is being used Accounts based on historic costs will give totally different results that those based on current costs 0211 SESSION 02 – CONCEPTUAL FRAMEWORK It is highly likely that in times of rising prices profitability will be much higher using historic cost accounting than under current cost accounting, current cost would attempt to strip out any holding gains The use of CPP accounting takes out the impact of inflation from the base figures, and uses a common time based unit of currency Inventory holding days is going to be affected by how inventory is measured, is it measured on historic or current costs FOCUS You should now be able to: discuss what is meant by a conceptual framework of accounting; discuss whether a conceptual framework is necessary and what an alternative system might be; discuss what is meant by understandability in relation to the provision of financial information; discuss what is meant by relevance and reliability and describe the qualities that enhance these characteristics; discuss the importance of comparability to users of financial statements; define what is meant by ’recognition’ in financial statements and discuss the recognition criteria; apply the recognition criteria to: assets and liabilities; income and expenses discuss what is meant by the statement of financial position approach to recognition; indicate when income and expense recognition should occur; explain the following measures and compute amounts using; historical cost; fair value/current cost; net realisable value; present value of future cash flows describe the advantages and disadvantages of the use of historical cost accounting; discuss whether the use of current value accounting overcomes the problems of historic cost accounting; describe the concept of financial and physical capital maintenance and how this affects the determination of profits; discuss how the interpretation of current value based financial statements would differ from those using historical cost based accounts 0212 ... position and performance financial statements of different entities – to evaluate relative financial position, performance and cash flows 02 07 SESSION 02 – CONCEPTUAL FRAMEWORK Therefore we need... display of financial effect of like transactions and other events Users must be informed of accounting policies employed, any changes in those policies and the effects of such changes Financial. .. concept of financial and physical capital maintenance and how this affects the determination of profits; discuss how the interpretation of current value based financial statements would differ from