Frameworks

Conceptual Framework for Financial Reporting

 

Introduction: the need for a conceptual framework

 

A conceptual framework is a set of theoretical principles and concepts that underlie the preparation and presentation of financial statements.

 

If no conceptual framework existed, then it is more likely that accounting standards would be produced on a haphazard basis as particular issues and circumstances arose. These accounting standards might be inconsistent with one another, or perhaps even contradictory.

 

A strong conceptual framework therefore means that there is a set of principles in place from which all future accounting standards draw. It also acts as a reference point for the preparers of financial statements if there is no adequate accounting standard governing the types of transactions that an entity enters into (this will be extremely rare).

 

This section of the text considers the contents of the Conceptual Framework for Financial Reporting (‘the Framework’) in more detail.

 

The purpose of the Framework

 

The purpose of the Framework is:

 

• to assist the International Accounting Standards Board (the Board) when developing new standards

 

• to help national standard setters develop new standards

 

• to provide guidance on issues not covered by IFRS Standards

 

• to assist auditors.

The objective of financial reporting

 

The Framework says that the objective of financial reporting is to provide information to existing and potential investors, lenders and other creditors which helps them when making decisions about providing resources to the reporting entity.

 

Underlying assumption

 

The Framework identifies going concern as the underlying assumption governing the preparation of financial statements.

 

The going concern basis assumes that the entity will not liquidate or curtail the scale of its operations.

 

Qualitative characteristics of useful financial information

 

The Framework identifies types of information that are useful to the users of financial statements.

 

It identifies two fundamental qualitative characteristics of useful financial information:

 

• Relevance

 

Information is relevant if it will impact decisions made by its users.

 

– Relevant information has predictive value or confirmatory value to a user

 

–   Relevance is supported by materiality considerations:

 

– Information is regarded as material if its omission or misstatement could influence the decisions made by users of that information

 

– An omission or mis-statement could be material due to its size or nature

 

– Materiality is an entity-specific consideration and so the Framework does not specify a minimum threshold.

 

• Faithful representation

 

For financial information to be faithfully presented, it must be:

 

–   complete

 

–   neutral

 

–   free from error.

 

Therefore, it must comprise information necessary for a proper understanding, it must be without bias or manipulation and clearly described.

 

In addition to the two fundamental qualitative characteristics, there are four enhancing qualitative characteristics of useful financial information. These should be maximised when possible:

 

• Comparability

 

Information is more useful if it can be compared with similar information about other entities, or even the same entity over different time periods.

 

Consistency of presentation helps to achieve comparability of financial information. Permitting different accounting treatments for similar items is likely to reduce comparability.

 

• Verifiability

 

The Framework explains that verifiability means ‘that different, knowledgeable and independent observers could reach consensus, although not necessarily complete agreement, that a particular presentation of an item or items is a faithful representation‘ (Framework, para QC26).

 

Verifiability of financial information provides assurance to users regarding its credibility and reliability.

 

• Timeliness

 

Information should be made available to users within a timescale which is likely to influence their decisions. Older information is less useful.

 

• Understandability

 

Information should be presented clearly and concisely.

 

Prudence

 

Older versions of the Framework referred to the importance of the concept of prudence.

 

Being prudent means exercising caution. In corporate reporting, this is often interpreted as meaning that entities should not overstate their assets or understate their liabilities.

 

The Board removed prudence from the Framework because they thought it was inconsistent with neutrality. This is because reducing assets in one period is likely to lead to the over-statement of financial performance in the next period.

 

However, as discussed later in this chapter, the Board are considering reintroducing into the Framework an explicit reference to prudence.

 

 

 

The cost constraint

 

It is important that the costs incurred in reporting financial information are justified by the benefits that the information brings to its users.

 

The elements of financial statements

 

The financial effects of a transaction can be grouped into broad classes, known as the elements.

 

According to the Framework, there are five elements of financial statements:



 

Assets – resources controlled by an entity from a past event that will lead to a probable inflow of economic benefits.

 

Liabilities – obligations of an entity arising from a past event that will lead to a probable outflow of economic resources.

 

Equity – the residual net assets of an entity after deducting its liabilities.

 

Incomes – increases in economic benefits during the accounting period.

 

Expenses – decreases in economic benefits during the accounting period.

 

 

Recognition of the elements of financial statements

 

The Framework says that an item should be recognised in the financial statements if:

 

• it meets the definition of an element

 

• it is probable that future economic benefits will flow to or from the entity

 

• the item can be measured reliably.

 

Measurement of the elements of financial statements

 

Measurement is the process of determining the amount at which the elements should be recognised and carried at in the statement of financial position and the statement of profit or loss and other comprehensive income.

 

The Framework identifies four possible measurement bases:

 

Historical cost

 

Assets are recorded at the amount paid to acquire them.

 

Liabilities are recorded at the value of the proceeds received, or at the amount expected to be paid to satisfy the liability.

 

Current cost

 

Assets are carried at their current purchase price.

 

Liabilities are carried at the amount currently required to settle them.

 

Realisable value

 

Assets are carried at the amount that would be received in an orderly disposal.

 

Liabilities are carried at the amount to be paid to satisfy them in the normal course of business.

 

Present value

 

Assets are carried at the present value of the future cash flows that the item will generate.

 

Liabilities are carried at the present value of the future cash outflows required to settle them.

 

Current issues: Materiality

 

The following Practice Statement is an examinable document for P2.

 

ED 2015/8: IFRS Practice Statement – Application of Materiality in Financial Statements

 

Materiality as a concept is used widely in financial reporting. The purpose of this Practice Statement is to help management when applying the concept of materiality to the production of financial statements. The key contents are summarised below.

 

Defining materiality and the users

 

Something is material if its omission or mis-statement would influence the economic decisions of users.

 

Deciding on whether an item is material is judgemental. Management must therefore consider the users of the financial statements.

 

The primary users, according to the Framework, are investors, lenders and other creditors. It can be assumed that the users have reasonable business knowledge. The purpose of financial reporting is to enable these users to make decisions about providing resources to the reporting entity.

 

Quantitative and qualitative thresholds

 

Materiality is often determined quantitatively (e.g. as a percentage of assets). However, materiality should also be considered qualitatively. For example, misleading or incomplete disclosure notes may omit or obscure information and therefore affect the users’ interpretation of the financial statements.

 

Some items can be material for other reasons, such as:

 

• Items that trigger non-compliance with laws and regulations, or loan covenants

 

• Transactions that might be key to future operations (even if immaterial in the current year).

 

Presentation and disclosure

 

Management should consider not just whether an item is included in the financial statements but also how it is presented. Management should use judgement to determine the appropriate level of aggregation, as well as the level of prominence it attains. Examples include:

 

• Deciding what line items to present separately on the face of the primary financial statements

 

• Deciding on the level of detail to be provided in both current year and prior year disclosure notes.

 

Materiality and practicality

 

Entities are able to adopt certain procedures that reduce the time and cost of preparing financial statements without causing material errors. Examples include:

 

• Capitalising capital expenditure only if it exceeds a certain threshold

 

• Selecting a monetary unit, such as $1,000, and rounding to this unit when producing financial statements.

 

These choices should be regularly reviewed to ensure that they are not leading to a material error, or a material loss of detail.

 

Errors

 

It is best practice to correct all errors identified, whether material or not. However, the correction of immaterial errors may involve undue cost or create delays in publishing the financial statements. In such instances, management should consider how pervasive an error is – e.g. an error recording purchases would potentially also impact cost of sales, payables, and inventory.

 

Material mis-statements identified before the authorisation of the financial statements must be corrected no matter how costly.

 

If a material error relates to a prior period then it is adjusted retrospectively (in accordance with IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors).

 

Intentional errors

 

Sometimes management may choose not to comply with a requirement within an IFRS Standard because the impact is immaterial. For example, management may choose not to discount a liability to present value because the discounted and un-discounted values are so similar.

 

The Practice Statement notes that this is different from management using an inappropriate discount rate so as to minimise the value of the liability. In this case, management is clearly trying to achieve a particular presentation in the financial statements, and so this must therefore be material.

 

 

 

Current issues: The Framework

 

The following exposure draft is an examinable document for P2.

 

ED/2015/3: Conceptual Framework for Financial Reporting

 

The Board has identified weaknesses in the existing Framework:

 

• Important areas are not covered. For example, the existing Framework provides very little guidance on the presentation and disclosure of financial information.

 

• Some aspects of the existing Framework are out of date and fail to reflect the current thinking of the Board, such as the guidance on the recognition of assets and liabilities.

 

• Some guidance is unclear, such as how to deal with measurement uncertainties.

 

The exposure draft proposes amendments to the Framework that will address these weaknesses as well as a number of other areas.

 

Objectives and qualitative characteristics

 

In the exposure draft, the Board proposes to amend the Framework in order to:

 

• emphasise the importance of being able to assess management’s stewardship of an entity’s resources

 

• reintroduce the concept of prudence (the exercise of caution when making judgements) and to stress its importance in relation to the faithful representation of financial information

 

• make an explicit statement that a faithful representation reports the economic substance of a transaction rather than its legal form.

 

The reporting entity

 

The exposure draft proposes a definition of the reporting entity as one that produces financial statements.

 

The exposure draft states that consolidated financial statements are those where the boundary of the reporting entity is based on both direct and indirect control. The Board believes that consolidated financial statements are more useful than individual financial statements.

 

Definitions of assets and liabilities

 

The exposure draft proposes the following definitions:

 

• An asset is ‘a present economic resource controlled by the entity as a result of past events‘ (ED/2015/3, para 4.5).

 

• A liability is ‘a present obligation of the entity to transfer an economic resource as a result of past events’ (ED/2015/3, para 24).

 

• An ‘economic resource’ is ‘a right that has the potential of producing economic benefits’ (ED/2015/3, para 4.4).

 

These differ from current definitions of assets and liabilities, which state that inflows or outflows of economic benefits should be probable.

 

Recognition

 

The exposure draft proposes recognition criteria for the elements that are centred on the qualitative characteristics of useful financial information. It is proposed that an element would be recognised if recognition provides:

 

• relevant information about the element

 

• a faithful representation of the element

 

• benefits to the users of the financial information that outweighs the cost of preparation.

 

Derecognition

 

The existing Framework does not address derecognition.

 

The exposure draft addresses this. It provides guidance to ensure an entity provides a faithful representation of assets or liabilities retained after the transaction and the changes in an entity’s net assets that result from the transaction.

 

Measurement

 

The exposure draft outlines two broad ways of measuring the elements:

 

• Historical cost

 

• Current value

 

The exposure draft proposes guidance on the factors to consider when selecting a measurement basis.

 

Presentation and disclosure

 

The existing Framework does not provide enough guidance on presentation and disclosure.

 

The exposure draft states the importance of effective communication. It notes that financial information should be well structured and not obscured by unnecessary detail.

 

In terms of the presentation of financial performance, the exposure draft states that profit or loss is the primary source of information. As such, there is a rebuttable presumption that incomes and expenses will be recorded in profit or loss. The exposure draft proposes that incomes and expenses should only be recognised outside of profit or loss in other comprehensive income if:

 

• the entity holds assets or liabilities at current value and components of the value change would not arise if the asset or liability was held at historical cost, and

 

• excluding the item from profit or loss enhances the relevance of financial information.

 

The exposure draft also proposes a rebuttable presumption that incomes and expenses included in other comprehensive income will be recycled to profit or loss in the future.

 

Test your understanding 1 – Framework

 

In September 2010, the Board issued the Conceptual Framework for Financial Reporting 2010 (‘the Framework’). Nonetheless, proposals to restart work on the Framework quickly achieved a lot of support. This led to the release of a discussion paper in 2013 and an exposure draft in 2015 that outlined further potential changes to the Framework. These discussions clearly highlight the importance of the Framework to the users and producers of International Financial Reporting Standards.

 

Required:

 

How does the Framework define the elements relating to financial position, and why might these definitions be criticised?

 

 

 

2 IFRS 13 Fair Value Measurement

 

Introduction

 

The objective of IFRS 13 is to provide a single source of guidance for fair value measurement where it is required by a reporting standard, rather than it being spread throughout several reporting standards.

 

Many accounting standards require or allow items to be measured at fair value. Some examples from your prior studies include:

 

• IAS 16 Property, Plant and Equipment, which allows entities to measure property, plant and equipment at fair value

 

• IFRS 3 Business Combinations, which requires the identifiable net assets of a subsidiary to be measured at fair value at the acquisition date.

 

Scope

 

IFRS 13 does not apply to:

 

• share-based payment transactions (IFRS 2 Share-based Payments)

 

• leases (IFRS 16 Leases).

 

The definition of fair value

 

Fair value is defined as ‘the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date’ (IFRS 13, para 9).

 

Market participants are knowledgeable, third parties. When pricing an asset or a liability, they would take into account:

 

• Condition

 

• Location

 

• Restrictions on use.

 

It should be assumed that market participants are not forced into transactions (i.e. they are not suffering from cash flow shortages).

 

IFRS 13 notes that there are various approaches to determining the fair value of an asset or liability:

 

• Market approaches (valuations based on recent sales prices)

 

• Cost approaches (valuations based on replacement cost)

 

• Income approaches (valuations based on financial forecasts).

 

Whatever approach is taken, the aim is always the same – to estimate the price that would be transferred in a transaction with a market participant.

 

The price

 

Fair value is a market-based measurement, not one that is entity specific. As such, when determining the price at which an asset would be sold (or the price paid to transfer a liability), observable data from active markets should be used where possible.

 

An active market is a market where transactions for the asset or liability occur frequently.

 

IFRS 13 classifies inputs into valuation techniques into three levels.

 

• Level 1 inputs are quoted prices for identical assets in active markets.

 

• Level 2 inputs are observable prices that are not level 1 inputs. This may include:

 

–   Quoted prices for similar assets in active markets

 

–   Quoted prices for identical assets in less active markets

 

–   Observable inputs that are not prices (such as interest rates).

 

 

• Level 3 inputs are unobservable. This could include cash or profit forecasts using an entity’s own data.

 

A significant adjustment to a level 2 input would lead to it being categorised as a level 3 input.

 

Priority is given to level 1 inputs. The lowest priority is given to level 3 inputs.

 

Inputs to determine fair value

 

IFRS 13 gives the following examples of inputs used to determine fair value:

 

			Asset		Example
	Level 1		Equity shares in a listed		Unadjusted quoted prices in an
			entity		active market.
	Level 2		Building held and used		Price per square metre for the
					building from observable
					market data, such as observed
					transactions for similar
					buildings in similar locations.
	Level 3		Cash-generating unit		Profit or cash flow forecast
					using own data.

 

 

 

Test you understanding 2 – Baklava

 

Baklava has an investment property that is measured at fair value. This property is rented out on short-term leases.

 

The directors wish to fair value the property by estimating the present value of the net cash flows that the property will generate for Baklava. They argue that this best reflects the way in which the building will generate economic benefits for Baklava.

 

The building is unique, although there have been many sales of similar buildings in the local area.

 

Required:

 

Discuss whether the valuation technique suggested by the directors complies with International Financial Reporting Standards.

 

Markets

 

The price received when an asset is sold (or paid when a liability is transferred) may differ depending on the specific market where the transaction occurs.

 

Principal market

 

IFRS 13 says that fair value should be measured by reference to the principal market.

 

The principal market is the market with the greatest activity for the asset or liability being measured.

 

The entity must be able to access the principal market at the measurement date. This means that the principal market for the same asset can differ between entities.

 

Most advantageous market

 

If there is no principal market, then fair value is measured by reference to prices in the most advantageous market.

 

The most advantageous market is the one that maximises the net amount received from selling an asset (or minimises the amount paid to transfer a liability).

 

Transaction costs (such as legal and broker fees) will play a role in deciding which market is most advantageous. However, fair value is not adjusted for transaction costs because they are a characteristic of the market, rather than the asset.

 

Test your understanding 3 – Markets

 

An asset is sold in two different active markets at different prices. An entity enters into transactions in both markets and can access the price in those markets for the asset at the measurement date as follows:

 

	Market 1	Market 2
	$	$
Price	26	25
Transaction costs	(3)	(1)
Transport costs	(2)	(2)
	–––––	–––––
Net price received	21	22
	–––––	–––––

 

What is the fair value of the asset if:

 

• market 1 is the principal market for the asset?

 

• no principal market can be determined?

 

 

 

Non-financial assets

 

What is a non-financial asset?

 

The difference between financial and non-financial assets is covered in detail in 1. Financial assets include:

 

• Contractual rights to receive cash (such as receivables)

 

• Investments in equity shares.

 

Non-financial assets include:

 

• Property, plant and equipment

 

• Intangible assets.

 

The fair value of a non-financial asset

 

IFRS 13 says that the fair value of a non-financial asset should be based on its highest and best use.

 

The highest and best use of an asset is the use that a market participant would adopt in order to maximise its value.

 

The current use of a non-financial asset can be assumed to be the highest and best use, unless evidence exists to the contrary.

 

The highest and best use should take into account uses that are:

 

• Physically possible

 

• Legally permissible

 

• Financially feasible.

 

IFRS 13 says a use can be legally permissible even if it is not legally approved.

 

Test you understanding 4 – Five Quarters

 

Five Quarters has purchased 100% of the ordinary shares of Three Halves and is trying to determine the fair value of the net assets at the acquisition date.

 

Three Halves owns land that is currently developed for industrial use. The fair value of the land if used in a manufacturing operation is $5 million.

 

Many nearby plots of land have been developed for residential use (as high-rise apartment buildings). The land owned by Three Halves does not have planning permission for residential use, although permission has been granted for similar plots of land. The fair value of Three Halves’ land as a vacant site for residential development is $6 million. However, transformation costs of $0.3 million would need to be incurred to get the land into this condition.

 

Required:

 

How should the fair value of the land be determined?

 

 

 

Disclosures

 

Disclosures should provide information that enables users of financial statements to evaluate the inputs and methods used to determine how fair value measurements have been arrived at.

 

The level in the three-tier valuation hierarchy should be disclosed, together with supporting details of valuation methods and inputs used where appropriate. As would be expected, more detailed information is required where there is significant use of level-three inputs to arrive at a fair value measurement to enable users of financial statements to understand how such fair values have been arrived at.

 

Disclosure should also be made when there is a change of valuation technique to measure an asset or liability. This will include any change in the level of inputs used to determine fair value of particular assets and/or liabilities.

 

Chapter summary

Test your understanding 1 – Framework

 

The Framework (para 4.4) provides the following definitions:

 

• ‘An asset is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity.

 

• A liability is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits.

 

• Equity is the residual interest in the assets of the entity after deducting all its liabilities.’

 

The following criticisms could be made of these definitions:

 

• The definitions are inconsistently applied across the range of IFRS and IAS Standards

 

• The concept of ‘control’ is not clearly defined and can prove difficult to apply

 

• There is a lack of guidance about the meaning of an ‘economic resource’

 

• The notion of ‘expectation’ is vague. Does it refer to the probability of an inflow/outflow or to a mathematical ‘expected value’?

 

• The definitions do not offer enough guidance as to the difference between liabilities and equity. Further guidance here would benefit users, particularly when applying these concepts to financial instruments.

 

 

 

 

Test you understanding 2 – Baklava

 

The directors’ estimate of the future net cash flows that the building will generate is a level 3 input. IFRS 13 gives lowest priority to level 3 inputs. These should not be used if a level 1 or level 2 input exists.

 

Observable data about the recent sales prices of similar properties is a level 2 input. The fair value of the building should therefore be based on these prices, with adjustments made as necessary to reflect the specific location and condition of Baklava’s building.

 

Test your understanding 3 – Markets

 

• If Market 1 is the principal market then the fair value would be measured using the price that would be received in that market less transport costs. The fair value would therefore be $24 ($26 – $2). Transaction costs are ignored as they are not a characteristic of the asset.

 

• If neither market is the principal market for the asset then the fair value would be measured in the most advantageous market. The most advantageous market is the market that maximises the net amount received from the sale.

 

The net amount received in Market 2 ($22) is higher than the net amount received in Market 1 ($21). Market 2 is therefore the most advantageous market. This results in a fair value measurement of $23 ($25 – $2). IFRS 13 specifies that transaction costs play a role when determining which market is most advantageous but that they are not factored into the fair value measurement itself.

 

Test you understanding 4 – Five Quarters

 

Land is a non-financial asset. IFRS 13 says that the fair value of a non-financial asset should be based on its highest and best use. This is presumed to be its current use, unless evidence exists to the contrary.

 

The current use of the asset would suggest a fair value of $5 million.

 

However, there is evidence that market participants would be interested in developing the land for residential use.

 

Residential use of the land is not legally prohibited. Similar plots of land have been granted planning permission, so it is likely that this particular plot of land will also be granted planning permission.

 

If used for residential purposes, the fair value of the land would be $5.7 million ($6m – $0.3m).

 

It would seem that the land’s highest and best use is for residential development. Its fair value is therefore $5.7 million.