TECHNICAL ARTICLES

Following are some important technical articles provided by the examining team of SBR. These are very important from exam point of view.

MEASUREMENT
GIVING INVESTORS WHAT THEY NEED
THE DEFINITION AND DISCLOSURE OF CAPITAL
CONCEPTS OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME
WHAT DIFFERENTIATES PROFIT OR LOSS FROM OTHER COMPREHENSIVE INCOME?
WHEN DOES DEBT SEEM TO BE EQUITY?

MEASUREMENT

The relevance of information provided by a particular measurement method depends on how it affects the financial statements. The cost should be justified by the benefits of reporting that information to existing and potential users. The different measures used should be the minimum necessary to provide relevant information and there should be infrequent changes with any necessary changes clearly explained. Further it makes sense for comparability and consistency purposes, to use the same method for initial and subsequent measurement unless there is a good reason from not doing so.

The existing Conceptual Framework provides very little guidance on measurement, which constitutes a serious gap in the Framework. A single measurement basis may not provide the most relevant information to users and therefore IFRSs adopt a mixed measurement basis, which includes fair value, historical cost, and net realisable value. Different information from different measurement bases may be relevant in different circumstances. A particular measurement bases may be easier to understand, more verifiable and less costly to implement. However, if different measurement bases are used, it can be argued that the totals in financial statements have little meaning. Those that prefer a single measurement method favour the use of current values to provide the most relevant information.

A business that is profit orientated has processes to transform market input values (inventory for example) into market output values.(sales of finished products).Thus it makes sense that current values should play a key role in measurement. Current market value would appear to be the most relevant measure of assets and liabilities for financial reporting purposes.

The IASB favour a mixed measurement approach whereby the most relevant measurement method is selected. It appears that investors feel that this approach is consistent with how they analyse financial statements and that the problems of mixed measurement are outweighed by the greater relevance achieved. In recent standards, it seems that the IASB felt that fair value would not provide the most relevant information in all circumstances. For example, IFRS 9 requires the use of cost in some cases and fair value in other cases, while IFRS 15 essentially applies cost allocation.

A factor to be considered when selecting a measurement basis is the degree of measurement uncertainty. The Exposure Draft on the Conceptual Framework states that for some estimates, a high level of measurement uncertainty may outweigh other factors to such an extent that the resulting information may have little relevance. Most measurement is uncertain and requires estimation. For example, recoverable value for impairment, depreciation estimates and fair value measures at level 2 and 3 under IFRS 13.Consequently, the IASB believes that the level of uncertainty associated with the measurement of an item should be considered when assessing whether a particular measurement basis provides relevant information.

Measurement uncertainty could be considered too great with the result that the entity may not recognise the asset or liability. An example of this would be research activities. However, sometimes a measure with a high degree of uncertainty provides the most relevant information about an item. For example, financial instruments for which prices are not observable. The IASB thinks that the level of measurement uncertainty that makes information lack relevance depends on the circumstances and can only be decided when developing particular standards.

It would be easier if measurement bases were categorised as either historical cost or current value. The Exposure Draft on the Conceptual Framework describes these two categories but also states that cashflow-based measurement techniques are generally used to estimate the measure of an asset or a liability as part of a prescribed measurement basis. Cash-flow-based measurement can be used to customise measurement bases, which can result in more relevant information but it may also be more difficult for users to understand. As a result the Exposure Draft does not identify those techniques as a separate category.

There are several areas of debate about measurement. For example, should any discussion of measurement bases include the use of entry and exit values, entity-specific values and the role of deprival value. Again should an entity‘s business model affect the measurement of its assets and liabilities. Many would advocate that different measurement methods should be applied that are dependent both on the nature of assets and liabilities and also, importantly, on how these are used in the business. For example, property can be measured at historical cost or fair value depending upon the business model.

In order to meet the objective of financial reporting, information provided by a particular measurement basis must be useful to users of financial statements. A measurement basis achieves this if the information is relevant and faithfully represents what it essentially is supposed to represent. In addition, the measurement basis needs to provide information that is comparable, verifiable, timely and understandable. The IASB believes that when selecting a measurement basis, the amount is more relevant if the way in which an asset or a liability contributes to future cash flows is considered. The IASB considers that the way in which an asset or a liability contributes to future cash flows depends, in part, on the nature of the business activities.

There are many different ways in which an asset or liability can be measured. Historical cost seems to be the easiest of these measures but even here, complexity can arise where there is a deferred payment or a payment, which involves an asset exchange. Subsequent accounting after initial recognition is not necessarily straightforward with historical cost as such matters as impairment of assets have to be taken into account and the latter is dependent upon rules, which can be sometimes subjective.

Current values have a variety of alternative valuation methods. These include market value, value-in-use and fulfilment value. Of these various methods, there is less ambiguity around current market prices as with any other measure of current value, there is likely to be specific rules in place to avoid inconsistency. In the main, the details of how these different measurement methods are applied, are set out in each accounting standard.

GIVING INVESTORS WHAT THEY NEED

Often the advice to investors is to focus upon cash and cash flow when analysing corporate reports. However insufficient financial capital can cause liquidity problems and sufficiency of financial capital is essential for growth. Discussion of the management of financial capital is normally linked with entities that are subject to external capital requirements but it is equally important to those entities which do not have regulatory obligations.

WHAT IS IT?

Financial capital is defined in various ways. The term has no accepted definition having been interpreted as equity held by shareholders or equity plus debt capital including finance leases. This can obviously affect the way in which ‗capital‘ is measured which has an impact on return on capital employed (ROCE).

An understanding of what an entity views as capital and its strategy for capital management is important to all companies and not just banks and insurance companies. Users have diverse views of what is important in their analysis of capital. Some focus on historical invested capital, others on accounting capital and others on market capitalisation.

INVESTOR NEEDS

Investors have specific but different needs for information about capital depending upon their approach to the valuation of a business. If the valuation approach is based upon a dividend model, then shortage of capital may have an impact upon future dividends. If ROCE is used for comparing the performance of entities, then investors need to know the nature and quantity of the historical capital employed in the business. There is diversity in practice as to what different companies see as capital and how it is managed.

There are various requirements for entities to disclose information about ‗capital‘. In drafting IFRS 7, Financial Instruments: Disclosures, the IASB considered whether it should require disclosures about capital. In assessing the risk profile of an entity, the management and level of an entity‘s capital is an important consideration.

The IASB believes that disclosures about capital are useful for all entities, but they are not intended to replace disclosures required by regulators as their reasons for disclosure may differ from those of the IASB. As an entity‘s capital does not relate solely to financial instruments, the IASB has included these disclosures in IAS V1, Presentation of Financial Statements rather than IFRS 7. IFRS 7 requires some specific disclosures about financial liabilities, it does not have similar requirements for equity instruments.

The IASB considered whether the definition of ‗capital‘ is different from the definition of equity in IAS 32, Financial Instruments; Presentation. In most cases disclosure capital would be the same as equity but it might also include or exclude some elements. The disclosure of capital is intended to give entities the ability to describe their view of the elements of capital if this is different from equity.

IAS 1 DISCLOSURES

As a result, IAS 1 requires an entity to disclose information that enables users to evaluate the entity‘s objectives, policies and processes for managing capital. This objective is obtained by disclosing qualitative and quantitative data. The former should include narrative information such as what the company manages as capital, whether there are any external capital requirements and how those requirements are incorporated into the management of capital.

Some entities regard some financial liabilities as part of capital whilst other entities regard capital as excluding some components of equity for example those arising from cash flow hedges. The IASB decided not to require quantitative disclosure of externally imposed capital requirements but rather decided that there should be disclosure of whether the entity has complied with any external capital requirements and, if not, the consequences of non-compliance. Further there is no requirement to disclose the capital targets set by management and whether the entity has complied with those targets, or the consequences of any non-compliance.

EXAMPLES

If the entity operates in several jurisdictions with different external capital requirements such that an aggregate disclosure of capital would not provide useful information, the entity may disclose separate information for each separate capital requirement.

Besides the requirements of IAS 1, the IFRS Practice Statement Management Commentary suggests that management should include forward-looking information in the commentary when it is aware of trends, uncertainties or other factors that could affect the entity‘s capital resources.

COMPANIES ACT

Additionally, some jurisdictions refer to capital disclosures as part of their legal requirements. In the UK,

Section 414 of the Companies Act 2006 deals with the contents of the Strategic Report and requires a ‗balanced and comprehensive analysis‘ of the development and performance of the business during the period and the position of the company at the end of the period.

The section further requires that to the extent necessary for an understanding of the development, performance or position of the business, the strategic report should include an analysis using key performance indicators. It makes sense that any analysis of a company‘s financial position should include consideration of how much capital it has and its sufficiency for the company‘s needs.

The Financial Reporting Council Guidance on the Strategic Report suggests that comments should appear in the report on the entity‘s financing arrangements such as changes in net debt or the financing of longterm liabilities.

CAPITALISATION TABLE

In addition to the annual report, an investor may find details of the entity‘s capital structure where the entity is involved in a transaction, such as a sale of bonds or equities.

It is normal for an entity to produce a capitalisation table in a prospectus showing the effects of the transactions on the capital structure. The table shows the ownership and debt interests in the entity but may show potential funding sources, and the effect of any public offerings.

The capitalisation table may present the pro forma impact of events that will occur as a result of an offering such as the automatic conversion of preferred stock, the issuance of common stock, or the use of the offering proceeds for the repayment of debt or other purposes. The IASB does not require such a table to be disclosed but it is often required by securities regulators.

For example, in the US, the table is used to calculate key operational metrics. Amedica Corporation announced in February 2016 that it had ‗made significant advancements in its ongoing initiative toward improving its capitalisation table, capitalisation, and operational structure‘.

It can be seen that information regarding an entity‘s capital structure is spread across several documents including the management commentary, the notes to financial statements, interim accounts and any document required by securities regulators.

DEBT AND EQUITY

Essentially there are two classes of capital reported in financial statements, namely debt and equity. However, debt and equity instruments can have different levels of right, benefit and risks.

When an entity issues a financial instrument, it has to determine its classification either as debt or as equity. The result of the classification can have a significant effect on the entity‘s reported results and financial position. Liability classification impacts upon an entity‘s gearing ratios and results in any payments being treated as interest and charged to earnings. Equity classification may be seen as diluting existing equity interests.

IAS 32 sets out the nature of the classification process but the standard is principle based and sometimes the outcomes are surprising to users. IAS 32 does not look to the legal form of an instrument but focuses on the contractual obligations of the instrument.

IAS 32 considers the substance of the financial instrument, applying the definitions to the instrument‘s contractual rights and obligations. The variety of instruments issued by entities makes this classification difficult with the application of the principles occasionally resulting in instruments that seem like equity being accounted for as liabilities. Recent developments in the types of financial instruments issued have added more complexity to capital structures with the resultant difficulties in interpretation and understanding.

The IASB has undertaken a research project with the aim of improving accounting for financial instruments that have characteristics of both liabilities and equity. The IASB has a major challenge in determining the best way to report the effects of recent innovations in capital structure.

DIVERSITY AND DIFFICULTY

There is a diversity of thinking about capital, which is not surprising given the issues with defining equity, the difficulty in locating sources of information about capital and the diversity of business models in an economy.

Capital needs are very specific to the business and are influenced by many factors such as debt covenants, and preservation of debt ratings. The variety and inconsistency of capital disclosures does not help the decision making process of investors. Therefore the details underlying a company‘s capital structure are essential to the assessment of any potential change in an entity‘s financial flexibility and value.

THE DEFINITION AND DISCLOSURE OF CAPITAL

Why does it matter anyway?

This article is useful to those candidates studying for SBR, Strategic Business Reporting. It is structured in two parts: first, it considers what might be included as the capital of a company and, second, why this distinction is important for the analysis of financial information.

Essentially, there are two classes of capital reported in financial statements: debt and equity. However, debt and equity instruments can have different levels of right, benefit and risks. When an entity issues a financial instrument, it has to determine its classification either as debt or as equity. The result of the classification can have a significant effect on the entity‘s reported results and financial position. Liability classification impacts upon an entity‘s gearing ratios and results in any payments being treated as interest and charged to earnings. Equity classification may be seen as diluting existing equity interests.

IAS 32, Financial Instruments: Presentation sets out the nature of the classification process but the standard is principle-based and sometimes the outcomes that result from its application are surprising to users. IAS 32 does not look to the legal form of an instrument but focuses on the contractual obligations of the instrument. IAS 32 considers the substance of the financial instrument, applying the definitions to the instrument‘s contractual rights and obligations.

MORE COMPLEXITY

The variety of instruments issued by entities makes this classification difficult with the application of the principles occasionally resulting in instruments that seem like equity being accounted for as liabilities. Recent developments in the types of financial instruments issued have added more complexity to capital structures with the resultant difficulties in interpretation and understanding. Consequently, the classification of capital is subjective which has implications for the analysis of financial statements.

To avoid this subjectivity, investors are often advised to focus upon cash and cash flow when analysing corporate reports. However, insufficient financial capital can cause liquidity problems and sufficiency of financial capital is essential for growth. Discussion of the management of financial capital is normally linked with entities that are subject to external capital requirements, but it is equally important to those entities that do not have regulatory obligations.

Financial capital is defined in various ways but has no widely accepted definition having been interpreted as equity held by shareholders or equity plus debt capital including finance leases. This can obviously affect the way in which capital is measured, which has an impact on return on capital employed (ROCE). An understanding of what an entity views as capital and its strategy for capital management is important to all companies and not just banks and insurance companies. Users have diverse views of what is important in their analysis of capital. Some focus on historical invested capital, others on accounting capital and others on market capitalisation.

There are various requirements for entities to disclose information about ‗capital‘. In drafting IFRS 7, Financial Instruments: Disclosures, the IASB considered whether it should require disclosures about capital. In assessing the risk profile of an entity, the management and level of an entity‘s capital is an important consideration. The IASB believes that disclosures about capital are useful for all entities, but they are not intended to replace disclosures required by regulators as their reasons for disclosure may differ from those of the IASB. As an entity‘s capital does not relate solely to financial instruments, the IASB has included these disclosures in IAS 1, Presentation of Financial Statements rather than IFRS 7. IFRS 7 requires some specific disclosures about financial liabilities; it does not have similar requirements for equity instruments.

The IASB considered whether the definition of capital is different from the definition of equity in IAS 32. In most cases, capital would be the same as equity but it might also include or exclude some other elements. The disclosure of capital is intended to give entities the ability to describe their view of the elements of capital if this is different from equity.

The IASB decided not to require quantitative disclosure of externally imposed capital requirements but rather decided that there should be disclosure of whether the entity has complied with any external capital requirements and, if not, the consequences of non-compliance. Further, there is no requirement to disclose the capital targets set by management and whether the entity has complied with those targets, or the consequences of any non-compliance.

Examples of some of the disclosures made by entities include information as to how gearing is managed, how capital is managed to sustain future product development and how ratios are used to evaluate the appropriateness of its capital structure. An entity bases these disclosures on the information provided internally to key management personnel. If the entity operates in several jurisdictions with different external capital requirements, such that an aggregate disclosure of capital would not provide useful information, the entity may disclose separate information for each separate capital requirement.

TRENDS

In the UK, Section 414 of the Companies Act 2006 deals with the contents of the Strategic Report and requires a ‗balanced and comprehensive analysis‘ of the development and performance of the business during the period and the position of the company at the end of the period. The section further requires that to the extent necessary for an understanding of the development, performance or position of the business, the strategic report should include an analysis using key performance indicators. It makes sense that any analysis of a company‘s financial position should include consideration of how much capital it has and its sufficiency for the company‘s needs. The Financial Reporting Council Guidance on the Strategic Report suggests that comments should appear in the report on the entity‘s financing arrangements such as changes in net debt or the financing of long-term liabilities.

In addition to the annual report, an investor may find details of the entity‘s capital structure where the entity is involved in a transaction, such as a sale of bonds or equities. It is normal for an entity to produce a capitalisation table in a prospectus showing the effects of the transactions on the capital structure. The table shows the ownership and debt interests in the entity but may show potential funding sources and the effect of any public offerings. The capitalisation table may present the pro forma impact of events that will occur as a result of an offering such as the automatic conversion of preferred stock, the issuance of common stock, or the use of the offering proceeds for the repayment of debt or other purposes.

The IASB does not require such a table to be disclosed but it is often required by securities regulators. For example, in the USA, the table is used to calculate key operational metrics. Amedica Corporation announced in February 2016 that it had ‗made significant advancements in its ongoing initiative toward improving its capitalization table, capitalization, and operational structure‘.

The IASB has undertaken a research project with the aim of improving the accounting for financial instruments that have characteristics of both liabilities and equity. This is likely to be a major challenge in determining the best way to report the effects of recent innovations in capital structure.

There is a diversity of thinking about capital that is not surprising given the issues with defining equity, the difficulty in locating sources of information about capital and the diversity of business models in an economy. Capital needs are very specific to the business and are influenced by many factors, such as debt covenants and preservation of debt ratings. The variety and inconsistency of capital disclosures does not help the decision making process of investors.

Therefore, the details underlying a company‘s capital structure are essential to the assessment of any potential change in an entity‘s financial flexibility and value. An appreciation of these issues and their significance is important to candidates studying for SBR.

CONCEPTS OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME

This article explains the current rules and the conceptual debate as to where in the statement of comprehensive income, profits and losses should be recognised – ie when should they be recognised in profit or loss and when in the other comprehensive income. Further, it explores the debate as to whether it is appropriate to recognise profits or losses twice!

The performance of a company is reported in the statement of profit or loss and other comprehensive income. IAS 1, Presentation of Financial Statements, defines profit or loss as ‗the total of income less expenses, excluding the components of other comprehensive income‘. Other comprehensive income (OCI) is defined as comprising ‗items of income and expense (including reclassification adjustments) that are not recognised in profit or loss as required or permitted by other IFRSs‘. Total comprehensive income is defined as ‗the change in equity during a period resulting from transactions and other events, other than those changes resulting from transactions with owners in their capacity as owners‘.

It is a myth, and simply incorrect, to state that only realised gains are included in profit or loss (P/L) and that only unrealised gains and losses are included in the OCI. For example, gains on the revaluation of land and buildings accounted for in accordance with IAS 16, Property Plant and Equipment (IAS 16 PPE), are recognised in OCI and accumulate in equity in Other Components of Equity (OCE). On the other hand, gains on the revaluation of land and buildings accounted for in accordance with IAS 40, Investment Properties, are recognised in P/L and are part of the Retained Earnings (RE). Both such gains are unrealised. The same point could be made with regard to the gains and losses on the financial asset of equity investments. If such financial assets are designated in accordance with IFRS 9, Financial Instruments

(IFRS 9), at inception as Fair Value Through Other Comprehensive Income (FVTOCI) then the gains and losses are recognised in OCI and accumulated in equity in OCE. Whereas if management decides not to make this election, then the investment will by default be designated and accounted for as Fair Value Through Profit or Loss (FVTP&L) and the gains and losses are recognised in P/L and become part of RE.

There is at present no overarching accounting theory that justifies or explains in which part of the statement gains and losses should be reported. The IASB‘s Conceptual Framework for Financial Reporting is silent on the matter. So rather than have a clear principles based approach what we currently have is a rules based approach to this issue. It is down to individual accounting standards to direct when gains and losses are to be reported in OCI. This is clearly an unsatisfactory approach. It is confusing for users.

In July 2013 the International Accounting Standards Board (IASB) published a discussion paper on its Conceptual Framework for Financial Reporting. This addressed the issue of where to recognise gains and losses. It suggests that the P/L should provide the primary source of information about the return an entity has made on its economic resources in a period. Accordingly the P/L should recognise the results of transactions, consumption and impairments of assets and fulfilment of liabilities in the period in which they occur. In addition the P/L would also recognise changes in the cost of assets and liabilities as well as any gains or losses resulting from their initial recognition. The role of the OCI would then be to support the P/L. Gains and losses would only be recognised in OCI if it made the P&L more relevant. In my view whilst this may be an improvement on the current absence of any guidance it does not provide the clarity and certainty users crave.

Recycling (the reclassification from equity to P&L)

Now let us consider the issue of recycling. This is where gains or losses are reclassified from equity to P/L as a reclassification adjustment. In other words gains or losses are first recognised in the OCI and then in a later accounting period also recognised in the P/L. In this way the gain or loss is reported in the total comprehensive income of two accounting periods and in colloquial terms is said to be recycled as it is recognised twice. At present it is down to individual accounting standards to direct when gains and losses are to be reclassified from equity to P/L as a reclassification adjustment. So rather than have a clear principles based approach on recycling what we currently have is a rules based approach to this issue.

This is clearly, again, an unsatisfactory approach but also as we shall see one addressed by the July 2013 IASB discussion paper on its Conceptual Framework for Financial Reporting

IAS 21, The Effects of Changes in Foreign Exchange Rates (IAS 21), is one example of a standard that requires gains and losses to be reclassified from equity to P/L as a reclassification adjustment. When a group has an overseas subsidiary a group exchange difference will arise on the re-translation of the subsidiary‘s goodwill and net assets. In accordance with IAS 21 such exchange differences are recognised in OCI and so accumulate in OCE. On the disposal of the subsidiary, IAS 21 requires that the net cumulative balance of group exchange differences be reclassified from equity to P&L as a reclassification adjustment – ie the balance of the group exchange differences in OCE is transferred to P/L to form part of the profit on disposal.

IAS 16 PPE is one example of a standard that prohibits gains and losses to be reclassified from equity to P/L as a reclassification adjustment. If we consider land that cost $10m which is treated in accordance with IAS 16 PPE. If the land is subsequently revalued to $12m, then the gain of $2m is recognised in OCI and will be taken to OCE. When in a later period the asset is sold for $13m, IAS 16 PPE specifically requires that the profit on disposal recognised in the P/L is $1m – ie the difference between the sale proceeds of $13m and the carrying value of $12m. The previously recognised gain of $2m is not recycled/reclassified back to P/L as part of the gain on disposal. However the $2m balance in the OCE reserve is now redundant as the asset has been sold and the profit is realised. Accordingly, there will be a transfer in the Statement of Changes in Equity, from the OCE of $2m into RE.

Double entry

For those who love the double entry let me show you the purchase, the revaluation, the disposal and the transfer to RE in this way.

On purchase $m $m

Dr Land PPE 10

Cr Cash 10

On revaluation

Dr Land PPE 2

Cr OCE and recognised in OCI 2


On disposal
Dr Cash		13
Cr Land PPE			12
Cr P/L			1
On transfer
Dr OCE	2

Cr Retained Earnings 2

If IAS 16 PPE allowed the reclassification from equity to P&L as a reclassification adjustment, the profit on disposal recognised in P&L would be $3m including the $2m reclassified from equity to P&L and the last two double entries above replaced with the following.

On reclassification from equity to P/L $m $m

Dr Cash 13

Cr Land PPE 12

Cr P/L 3

Dr OCE 2

IFRS 9 also prohibits the recycling of the gains and losses on FVTOCI investments to P/L on disposal. The no reclassification rule in both IAS 16 PPE and IFRS 9 means that such gains on those assets are only ever reported once in the statement of profit or loss and other comprehensive income – ie are only included once in total comprehensive income. However many users, it appears, rather ignore the total comprehensive income and the OCI and just base their evaluation of a company‘s performance on the P/L. These users then find it strange that gains that have become realised from transactions in the accounting period are not fully reported in the P/L of the accounting period. As such we can see the argument in favour of reclassification. With no reclassification the earnings per share will never fully include the gains on the sale of PPE and FVTOCI investments.

The following extract from the statement of comprehensive income summarises the current accounting treatment for which gains and losses are required to be included in OCI and, as required, discloses which gains and losses can and cannot be reclassified back to profit and loss.

Extract from the statement of profit or loss and other comprehensive income

	$m
Profit for the year	XX

Other comprehensive income

Gains and losses that cannot be reclassified back to profit or loss

Changes in revaluation surplus where the revaluation method is used in accordance with IAS 16	XX / (XX)
Remeasurements of a net defined benefit liability or asset recognised in accordance with IAS 19	XX / (XX)
Gains and losses on remeasuring FVTOCI financial assets in accordance with IFRS 9	XX / (XX)

Gains and losses that can be reclassified back to profit or loss

Group exchange differences from translating functional currencies into presentation currency in accordance with IAS 21	XX / (XX)

The effective portion of gains and losses on hedging instruments in a cash flow hedge under IFRS 9	XX / (XX)

Total comprehensive income	XX / (XX)

The future of reclassification

In the July 2013 discussion paper on the Conceptual Framework for Financial Reporting the role of the OCI and the reclassification from equity to P/L is debated.

No OCI and no reclassification

It can be argued that reclassification should simply be prohibited. This would free the statement of profit or loss and other comprehensive income from the need to formally to classify gains and losses between P/L and OCI. This would reduce complexity and gains and losses could only ever be recognised once. There would still remain the issue of how to define the earnings in earnings per share, a ratio loved by investors, as clearly total comprehensive income would contain too many gains and losses that were nonoperational, unrealised, outside the control of management and not relating to the accounting period.

Narrow approach to the OCI

Another suggestion is that the OCI should be restricted, should adopt a narrow approach. On this basis only bridging and mismatch gains and losses should be included in OCI and be reclassified from equity to P/L.

A revaluation surplus on a financial asset classified as FVTOCI is a good example of a bridging gain. The asset is accounted for at fair value on the statement of financial position but effectively at cost in P/L. As such, by recognising the revaluation surplus in OCI, the OCI is acting as a bridge between the statement of financial position and the P/L. On disposal reclassification ensures that the amount recognised in P/L will be consistent with the amounts that would be recognised in P/L if the financial asset had been measured at amortised cost.

The effective gain or loss on a cash flow hedge of a future transaction is an example of a mismatch gain or loss as it relates to a transaction in a future accounting period so needs to be carried forward so that it can be matched in the P/L of a future accounting period. Only by recognising the effective gain or loss in OCI and allowing it to be reclassified from equity to P/L can users to see the results of the hedging relationship.

Broad approach to the OCI

A third proposition is for the OCI to adopt a broad approach, by also including transitory gains and losses. The IASB would decide in each IFRS whether a transitory remeasurement should be subsequently recycled.

Examples of transitory gains and losses are those that arise on the remeasurement of defined benefit pension funds and revaluation surpluses on PPE.

Conclusion

Whilst the IASB has not yet determined which approach will be adopted, its chairman Hans Hoogervorst has gone on the record as saying ‗It is absolutely vital that the P/L contains all information that can be relevant to investors and that nothing of importance gets left out… and… the IASB should be very disciplined in its use of OCI as resorting to OCI too easily would undermine the credibility of net income so the OCI should only be used as an instrument of last resort‘.

WHAT DIFFERENTIATES PROFIT OR LOSS FROM OTHER COMPREHENSIVE INCOME?

The purpose of the statement of profit or loss and other comprehensive income (OCI) is to show an entity‘s financial performance in a way that is useful to a wide range of users so that they may attempt to assess the future net cash inflows of an entity. The statement should be classified and aggregated in a manner that makes it understandable and comparable. IFRS currently requires that the statement be presented as either one statement, being a combined statement of profit or loss and other comprehensive income or two statements, being the statement of profit or loss and the statement of profit or loss and other comprehensive income. An entity has to show separately in OCI, those items which would be reclassified (recycled) to profit or loss and those items which would never be reclassified (recycled) to profit or loss. The related tax effects have to be allocated to these sections.

Profit or loss includes all items of income or expense (including reclassification adjustments) except those items of income or expense that are recognised in OCI as required or permitted by IFRS. Reclassification adjustments are amounts recycled to profit or loss in the current period that were recognised in OCI in the current or previous periods. An example of items recognised in OCI that may be reclassified to profit or loss are foreign currency gains on the disposal of a foreign operation and realised gains or losses on cash flow hedges. Those items that may not be reclassified are changes in a revaluation surplus under IAS 16, Property, Plant and Equipment, and actuarial gains and losses on a defined benefit plan under IAS 19, Employee Benefits.

However, there is a general lack of agreement about which items should be presented in profit or loss and in OCI. The interaction between profit or loss and OCI is unclear, especially the notion of reclassification and when or which OCI items should be reclassified. A common misunderstanding is that the distinction is based upon realised versus unrealised gains. This lack of a consistent basis for determining how items should be presented has led to an inconsistent use of OCI in IFRS. It may be difficult to deal with OCI on a conceptual level since the IASB are finding it difficult to find a sound conceptual basis. However, there is urgent need for some guidance around this issue.

Opinions vary but there is a feeling that OCI has become a ‗dumping ground‘ for anything controversial because of a lack of clear definition of what should be included in the statement. Many users are thought to ignore OCI as the changes reported are not caused by the operating flows used for predictive purposes. Financial performance is not defined in the Conceptual Framework but could be viewed as reflecting the value the entity has generated in the period and this can be assessed from other elements of the financial statements and not just the statement of profit or loss and other comprehensive income. Examples would be the statement of cash flows and disclosures relating to operating segments. The presentation in profit or loss and OCI should allow a user to depict financial performance including the amount, timing and uncertainty of the entity‘s future net cash inflows and how efficiently and effectively the entity‘s management have discharged their duties regarding the resources of the entity.

Reclassification: for and against

There are several arguments for and against reclassification. If reclassification ceased, then there would be no need to define profit or loss, or any other total or subtotal in profit or loss, and any presentation decisions can be left to specific IFRSs. It is argued that reclassification protects the integrity of profit or loss and provides users with relevant information about a transaction that occurred in the period. Additionally, it can improve comparability where IFRS permits similar items to be recognised in either profit or loss or OCI.

Those against reclassification argue that the recycled amounts add to the complexity of financial reporting, may lead to earnings management and the reclassification adjustments may not meet the definitions of income or expense in the period as the change in the asset or liability may have occurred in a previous period.

The original logic for OCI was that it kept income-relevant items that possessed low reliability from contaminating the earnings number. Markets rely on profit or loss and it is widely used. The OCI figure is crucial because it can distort common valuation techniques used by investors, such as the price/earnings ratio. Thus, profit or loss needs to contain all information relevant to investors. Misuse of OCI would undermine the credibility of net income. The use of OCI as a temporary holding for cash flow hedging instruments and foreign currency translation is non-controversial.

However, other treatments such the policy of IFRS 9 to allow value changes in equity investments to go through OCI, are not accepted universally.

US GAAP will require value changes in all equity investments to go through profit or loss. Accounting for actuarial gains and losses on defined benefit schemes are presented through OCI and certain large US corporations have been hit hard with the losses incurred on these schemes. The presentation of these items in OCI would have made no difference to the ultimate settled liability but if they had been presented in profit or loss, the problem may have been dealt with earlier. An assumption that an unrealised loss has little effect on the business is an incorrect one.

The Discussion Paper on the Conceptual Framework considers three approaches to profit or loss and reclassification. The first approach prohibits reclassification. The other approaches, the narrow and broad approaches, require or permit reclassification. The narrow approach allows recognition in OCI for bridging items or mismatched remeasurements. While the broad approach has an additional category of ‗transitory measurements‘ (for example, remeasurement of a defined benefit obligation) which would allow the IASB greater flexibility. The narrow approach significantly restricts the types of items that would be eligible to be presented in OCI and gives the IASB little discretion when developing or amending IFRSs.

A bridging item arises where the IASB determines that the statement of comprehensive income would communicate more relevant information about financial performance if profit or loss reflected a different measurement basis from that reflected in the statement of financial position For example, if a debt instrument is measured at fair value in the statement of financial position, but is recognised in profit or loss using amortised cost, then amounts previously reported in OCI should be reclassified into profit or loss on impairment or disposal of the debt instrument. The IASB argues that this is consistent with the amounts that would be recognised in profit or loss if the debt instrument were to be measured at amortised cost.

A mismatched remeasurement arises where an item of income or expense represents an economic phenomenon so incompletely that, in the opinion of the IASB, presenting that item in profit or loss would provide information that has little relevance in assessing the entity‘s financial performance. An example of this is when a derivative is used to hedge a forecast transaction; changes in the fair value of the derivative may arise before the income or expense resulting from the forecast transaction. The argument is that before the results of the derivative and the hedged item can be matched together, any gains or losses resulting from the remeasurement of the derivative, to the extent that the hedge is effective and qualifies for hedge accounting, should be reported in OCI. Subsequently, those gains or losses are reclassified into profit or loss when the forecast transaction affects profit or loss. This allows users to see the results of the hedging relationship.

The IASB‘s preliminary view is that any requirement to present a profit or loss total or subtotal could also result in some items being reclassified. The commonly suggested attributes for differentiation between profit or loss and OCI (realised/unrealised, frequency of occurrence, operating/non-operating, measurement certainty/uncertainty, realisation in the short/long-term or outside management control) are difficult to distil into a set of principles.

Therefore, the IASB is suggesting two broad principles, namely:

Profit or loss provides the primary source of information about the return an entity has made on its economic resources in a period.
To support profit or loss, OCI should only be used if it makes profit or loss more relevant.

The IASB feels that changes in cost-based measures and gains or losses resulting from initial recognition should not be presented in OCI and that the results of transactions, consumption and impairments of assets and fulfilment of liabilities should be recognised in profit or loss in the period in which they occur. As a performance measure, profit or loss is more used although there are a number of other performance measures derived from the statement of profit or loss and OCI.

WHEN DOES DEBT SEEM TO BE EQUITY?

The difference between debt and equity in an entity‘s statement of financial position is not easy to distinguish for preparers of financial statements. Many financial instruments have both features with the result that this can lead to inconsistency of reporting.

The International Accounting Standards Board (IASB) agreed with respondents from its public consultation on its agenda (December 2012 report) that it needs greater clarity in its definitions of assets and liabilities for debt instruments. This should therefore help eliminate some uncertainty when accounting for assets and financial liabilities or non-financial liabilities. The respondents felt that defining the nature of liabilities would advance the IASB‘s thinking on distinguishing between financial instruments that should be classified as equity and those instruments that should be classified as liabilities.

The objective of IAS 32, Presentation is to establish principles for presenting financial instruments as liabilities or equity and for offsetting financial assets and liabilities. The classification of a financial instrument by the issuer as either debt or equity can have a significant impact on the entity‘s gearing ratio, reported earnings, and debt covenants. Equity classification can avoid such impact but may be perceived negatively if it is seen as diluting existing equity interests. The distinction between debt and equity is also relevant where an entity issues financial instruments to raise funds to settle a business combination using cash or as part consideration in a business combination.

Understanding the nature of the classification rules and potential effects is critical for management and must be borne in mind when evaluating alternative financing options. Liability classification normally results in any payments being treated as interest and charged to earnings, which may affect the entity’s ability to pay dividends on its equity shares.

The key feature of debt is that the issuer is obliged to deliver either cash or another financial asset to the holder. The contractual obligation may arise from a requirement to repay principal or interest or dividends. Such a contractual obligation may be established explicitly or indirectly but through the terms of the agreement. For example, a bond that requires the issuer to make interest payments and redeem the bond for cash is classified as debt. In contrast, equity is any contract that evidences a residual interest in the entity‘s assets after deducting all of its liabilities. A financial instrument is an equity instrument only if the instrument includes no contractual obligation to deliver cash or another financial asset to another entity, and if the instrument will or may be settled in the issuer’s own equity instruments.

For instance, ordinary shares, where all the payments are at the discretion of the issuer, are classified as equity of the issuer. The classification is not quite as simple as it seems. For example, preference shares required to be converted into a fixed number of ordinary shares on a fixed date, or on the occurrence of an event that is certain to occur, should be classified as equity.

A contract is not an equity instrument solely because it may result in the receipt or delivery of the entity‘s own equity instruments. The classification of this type of contract is dependent on whether there is variability in either the number of equity shares delivered or variability in the amount of cash or financial assets received. A contract that will be settled by the entity receiving or delivering a fixed number of its own equity instruments in exchange for a fixed amount of cash, or another financial asset, is an equity instrument. This has been called the ‗fixed for fixed‘ requirement. However, if there is any variability in the amount of cash or own equity instruments that will be delivered or received, then such a contract is a financial asset or liability as applicable.

For example, where a contract requires the entity to deliver as many of the entity‘s own equity instruments as are equal in value to a certain amount, the holder of the contract would be indifferent whether it received cash or shares to the value of that amount. Thus, this contract would be treated as debt.

Other factors that may result in an instrument being classified as debt are:

Is redemption at the option of the instrument holder?
Is there a limited life to the instrument?
Is redemption triggered by a future uncertain event that is beyond the control of both the holder and issuer of the instrument?
Are dividends non-discretionary?

Similarly, other factors that may result in the instrument being classified as equity are whether the shares are non-redeemable, whether there is no liquidation date or where the dividends are discretionary.

The classification of the financial instrument as either a liability or as equity is based on the principle of substance over form. Two exceptions from this principle are certain puttable instruments meeting specific criteria and certain obligations arising on liquidation. Some instruments have been structured with the intention of achieving particular tax, accounting or regulatory outcomes, with the effect that their substance can be difficult to evaluate.

The entity must make the decision as to the classification of the instrument at the time that the instrument is initially recognised. The classification is not subsequently changed based on changed circumstances. For example, this means that a redeemable preference share, where the holder can request redemption, is accounted for as debt even though legally it may be a share of the issuer.

In determining whether a mandatorily redeemable preference share is a financial liability or an equity instrument, it is necessary to examine the particular contractual rights attached to the instrument’s principal and return elements. The critical feature that distinguishes a liability from an equity instrument is the fact that the issuer does not have an unconditional right to avoid delivering cash or another financial asset to settle a contractual obligation. Such a contractual obligation could be established explicitly or indirectly. However, the obligation must be established through the terms and conditions of the financial instrument. Economic necessity does not result in a financial liability being classified as a liability. Similarly, a restriction on the ability of an entity to satisfy a contractual obligation, such as the company not having sufficient distributable profits or reserves, does not negate the entity’s contractual obligation.

Some instruments are structured to contain elements of both a liability and equity in a single instrument. Such instruments – for example, bonds that are convertible into a fixed number of equity shares and carry interest – are accounted for as separate liability and equity components. ‘Split accounting’ is used to measure the liability and the equity components upon initial recognition of the instrument. This method allocates the fair value of the consideration for the compound instrument into its liability and equity components. The fair value of the consideration in respect of the liability component is measured at the fair value of a similar liability that does not have any associated equity conversion option. The equity component is assigned the residual amount.

IAS 32 requires an entity to offset a financial asset and financial liability in the statement of financial position only when the entity currently has a legally enforceable right of set-off and intends either to settle the asset and liability on a net basis or to realise the asset and settle the liability simultaneously. An amendment to IAS 32 has clarified that the right of set-off must not be contingent on a future event and must be immediately available. It also must be legally enforceable for all the parties in the normal course of business, as well as in the event of default, insolvency or bankruptcy. Netting agreements, where the legal right of offset is only enforceable on the occurrence of some future event – such as default of a party – do not meet the offsetting requirements.

Rights issues can still be classified as equity when the price is denominated in a currency other than the entity‘s functional currency. The price of the right is denominated in currencies other than the issuer‘s functional currency, when the entity is listed in more than one jurisdiction or is required to do so by law or regulation. A fixed price in a non-functional currency would normally fail the fixed number of shares for a fixed amount of cash requirement in IAS 32 to be treated as an equity instrument. As a result, it is treated as an exception in IAS 32 and therefore treated as equity.

Two measurement categories exist for financial liabilities: fair value through profit or loss (FVTPL) and amortised cost. Financial liabilities held for trading are measured at FVTPL, and all other financial liabilities are measured at amortised cost unless the fair value option is applied.

The IASB and FASB have been working on a project to replace IAS 32 and converge IFRS and US GAAP for a number of years. The ‗Financial instruments with characteristics of equity‘ project (‗FICE‘) resulted in a discussion paper in 2008, but has been put on hold.

INTEGRATED REPORTING <IR>

Introduction

In 2013, the International Integrated Reporting Council (IIRC) released a framework for integrated reporting. This followed a three-month global consultation and trials in 25 countries.

The framework establishes principles and concepts that govern the overall content of an integrated report. An integrated report sets out how the organisation‘s strategy, governance, performance and prospects, which lead to the creation of value. There is no benchmarking for the above matters and the report is aimed primarily at the private sector but it could be adapted for public sector and not-for-profit organisations.

The aim is to give investors and shareholders a broader picture of how companies make their money and their prospects in the short, medium and long term.

Designed to be an approach to reporting which accurately conveys an organisation’s business model and its sources of value creation over time, the IR model recognises six types of capital, with these being consumed by a business and also created as part of its business processes. It is the way that capitals are consumed, transformed and created which is at the heart of the IR model.

Purpose of integrated report

The primary purpose of an integrated report is to explain to providers of financial capital how an organisation creates value over time. An integrated report benefits all stakeholders interested in a company‘s ability to create value, including employees, customers, suppliers, business partners, local communities, legislators, regulators and policymakers, although it is not directly aimed at all stakeholders. Providers of financial capital can have a significant effect on the capital allocation and attempting to aim the report at all stakeholders would be an impossible task and would reduce the focus and increase the length of the report. This would be contrary to the objectives of the report, which is value creation.

Historical financial statements are essential in corporate reporting, particularly for compliance purposes, but do not provide meaningful information regarding business value. Users need a more forward-looking focus without the necessity of companies providing their own forecasts and projections. Companies have recognised the benefits of showing a fuller picture of company value and a more holistic view of the organisation.

The International Integrated Reporting Framework will encourage the preparation of a report that shows their performance against strategy, explains the various capitals used and affected, and gives a longerterm view of the organisation. The integrated report is creating the next generation of the annual report as it enables stakeholders to make a more informed assessment of the organisation and its prospects.

EXPLANATION

Definition: <IR> demonstrates how organisations really create value:

It is a concise communication of an organisation‘s strategy, governance and performance
It demonstrates the links between its financial performance and its wider social, environmental and economic context
It shows how organisations create value over the short, medium and long term

Integrated reporting is about integrating material financial and non-financial information to enable investors and other stakeholders to understand how an organisation is really performing. An integrated report looks beyond the traditional time frame and scope of the current financial report by addressing the wider as well as longer-term consequences of decisions and action and by making clear the link between financial and non-financial value. It is important that an integrated report demonstrates the link between an organisation’s strategy, governance and business model

An Integrated Report should be a single report which is the organization‘s primary report – in most jurisdictions the Annual Report or equivalent.

PRINCIPLE-BASED FRAMEWORK

The IIRC has set out a principle-based framework rather than specifying a detailed disclosure and measurement standard. This enables each company to set out its own report rather than adopting a checklist approach. The culture change should enable companies to communicate their value creation better than the often boilerplate disclosures under IFRS. The report acts as a platform to explain what creates the underlying value in the business and how management protects this value. This gives the report more business relevance rather than the compliance led approach currently used.

Integrated reporting will not replace other forms of reporting but the vision is that preparers will pull together relevant information already produced to explain the key drivers of their business‘s value. Information will only be included in the report where it is material to the stakeholder‘s assessment of the business. There were concerns that the term ‘materiality’ had a certain legal connotation, with the result that some entities may feel that they should include regulatory information in the integrated report. However, the IIRC concluded that the term should continue to be used in this context as it is well understood.

The integrated report aims to provide an insight into the company‘s resources and relationships that are known as the capitals and how the company interacts with the external environment and the capitals to create value. These capitals can be financial, manufactured, intellectual, human, social and relationship, and natural capital, but companies need not adopt these classifications.

Following are the capitals (resources and relationships) on which the organisation depends, how the organisation uses them and its impact upon them!

Financial capital: This comprises the pool of funds available to the business, which includes both debt and equity finance. This description of financial capital focuses on the source of funds.

Manufactured capital. This is the human-created, production-oriented equipment and tools used in production or service provision, such as buildings, equipment and infrastructure. Manufactured capital draws a distinction is between inventory (as a short-term asset) and plant and equipment (tangible capital).

Human capital: Is understood to consist of the knowledge, skills and experience of the company‘s employees and managers, as they are relevant to improving operational performance.

Intellectual capital. This is a key element in an organisation‘s future earning potential, with a close link between investment in R&D, innovation, human resources and external relationships, as these can determine the organisation‘s competitive advantage.

Natural capital. This is any stock of natural resources or environmental assets which provide a flow of useful goods or services, now and in the future.

Social and relationships capital. Comprises the relationships within an organisation, as well as those between an organisation and its external stakeholders, depending on where social boundaries are drawn. These relationships should enhance both social and collective well-being.

The purpose of this framework is to establish principles and content that governs the report, and to explain the fundamental concepts that underpin them. The report should be concise, reliable and complete, including all material matters, both positive and negative in a balanced way and without material error.

Key components

Integrated reporting is built around the following key components:

Organisational overview and the external environment under which it operates
Governance structure and how this supports its ability to create value
Business model
Risks and opportunities and how they are dealing with them and how they affect the company‘s ability to create value
Strategy and resource allocation
Performance and achievement of strategic objectives for the period and outcomes
Outlook and challenges facing the company and their implications
The basis of presentation needs to be determined, including what matters are to be included in the integrated report and how the elements are quantified or evaluated.

The framework does not require discrete sections to be compiled in the report but there should be a high level review to ensure that all relevant aspects are included. The linkage across the above content can create a key storyline and can determine the major elements of the report such that the information relevant to each company would be different.

RELATIONSHIP WITH STAKEHOLDERS

An integrated report should provide insight into the nature and quality of the organisation‘s relationships with its key stakeholders, including how and to what extent the organisation understands, takes into account and responds to their needs and interests. Further, the report should be consistent over time to enable comparison with other entities.

South African organisations have been acknowledged as among the leaders in this area of corporate reporting with many listed companies and large state-owned companies having issued integrated reports. An integrated report may be prepared in response to existing compliance requirements – for example, a management commentary. Where that report is also prepared according to the framework, or even beyond the framework, it can be considered an integrated report. An integrated report may be either a standalone report or be included as a distinguishable part of another report or communication. For example, it can be included in the company‘s financial statements.

The IIRC considered the nature of value and value creation. These terms can include the total of all the capitals, the benefit captured by the company, the market value or cash flows of the organisation and the successful achievement of the company‘s objectives. However, the conclusion reached was that the framework should not define value from any one particular perspective because value depends upon the individual company‘s own perspective. It can be shown through movement of capital and can be defined as value created for the company or for others. An integrated report should not attempt to quantify value as assessments of value are left to those using the report.

Many respondents felt that there should be a requirement for a statement from those ‗charged with governance‘ acknowledging their responsibility for the integrated report in order to ensure the reliability and credibility of the integrated report. Additionally, it would increase the accountability for the content of the report.

The IIRC feels the inclusion of such a statement may result in additional liability concerns, such as inconsistency with regulatory requirements in certain jurisdictions, and could lead to a higher level of legal liability. The IIRC also felt that the above issues might result in a slower take-up of the report and decided that those ‗charged with governance‘ should, in time, be required to acknowledge their responsibility for the integrated report while, at the same time, recognising that reports in which they were not involved would lack credibility.

There has been discussion about whether the framework constitutes suitable criteria for report preparation and for assurance. The questions asked concerned measurement standards to be used for the information reported and how a preparer can ascertain the completeness of the report.

There were concerns over the ability to assess future disclosures, and recommendations were made that specific criteria should be used for measurement, the range of outcomes and the need for any confidence intervals be disclosed. The preparation of an integrated report requires judgment but there is a requirement for the report to describe its basis of preparation and presentation, including the significant frameworks and methods used to quantify or evaluate material matters. Also included is the disclosure of a summary of how the company determined the materiality limits and a description of the reporting boundaries.

The IIRC has stated that the prescription of specific KPIs and measurement methods is beyond the scope of a principles-based framework. The framework contains information on the principle-based approach and indicates that there is a need to include quantitative indicators whenever practicable and possible.

Additionally, consistency of measurement methods across different reports is of paramount importance. There is outline guidance on the selection of suitable quantitative indicators.

A company should consider how to describe the disclosures without causing a significant loss of competitive advantage. The entity will consider what advantage a competitor could actually gain from information in the integrated report, and will balance this against the need for disclosure.

Companies struggle to communicate value through traditional reporting. The framework can prove an effective tool for businesses looking to shift their reporting focus from annual financial performance to long-term shareholder value creation. The framework will be attractive to companies who wish to develop their narrative reporting around the business model to explain how the business has been developed.

SUMMARY – BENEFITS AND CHALLENGES

Benefits of <IR>

Integrated reporting gives a ‗dashboard‘ view of an organisation‘s activities and performance in this broader context.

Systems and Accountability. The need to report on each type of capital would create and enhance a system of internal measurement which would record and monitor each type for the purposes of reporting.
Decision-making. The connections made through <IR> enable investors to better evaluate the combined impact of the diverse factors, or ‗capitals‘, affecting the business.
The greater transparency and disclosure of <IR> should result in a decrease in reputation risk, which in turn should result in a lower cost of, and easier access to, sources of finance.
<IR> provides a platform for standard-setters and decision-makers to develop and harmonise business reporting. This in turn should reduce the need for costly bureaucracy imposed by central authorities.
The information disclosed, once audited and published, would create a fuller and more detailed account of the sources of added value, and threats to value (i.e. risks), for shareholders and others.
The information will lead to a higher level of trust from, and engagement with, a wide range of stakeholders.

Challenges in IR

Progress towards IR will happen at different speeds in different countries as regulations and directors duties vary across the globe
Directors liability will increase as they will be reporting on the future and on evolving issues
A balance will need to be created between benefits of reporting and the desire to avoid disclosing competitive information
It will take time to convince management to overcome focus on short term rewards.

Use of concepts of materiality in applying the IR Framework

Integrated reporting (IR) takes a broader view of business reporting, emphasising the need for entities to provide

Information to help investors assess the sustainability of their business model. IR is a process which results in

Communication, through the integrated report, about value creation over time. An integrated report is a concise

Communication about how an organisation‘s strategy, governance, performance and prospects lead to the creation of

Value over the short, medium and long term. The materiality definition for IR purposes would consider that material

Matters are those which are of such relevance and importance that they could substantively influence the assessments of the intended report users. In the case of IR, relevant matters are those which affect or have the potential to affect the organisation‘s ability to create value over time. For financial reporting purposes, the nature or extent of an omission or misstatement in the organisation‘s financial statements determines relevance. Matters which are considered material for financial reporting purposes, or for other forms of reporting, may also be material for IR purposes if they are of such relevance and importance that they could change the assessments of providers of financial capital with regard to the organisation‘s ability to create value. Another feature of materiality for IR purposes is that the definition emphasises the involvement of senior management and those charged with governance in the materiality determination process in order for the organisation to determine how best to disclose its value creation development in a meaningful and transparent way.

THE PROFESSIONAL AND ETHICAL DUTIES OF THE ACCOUNTANT

Code of Ethics

(a) Integrity – to be straightforward and honest in all professional and business relationships.

A professional accountant shall not knowingly be associated with reports, returns, communications or other information where the professional accountant believes that the information: (a) Contains a materially false or misleading statement;

(b) Contains statements or information furnished recklessly; or

(c) Omits or obscures information required to be included where such omission or obscurity would be misleading.

(b) Objectivity – to not allow bias, conflict of interest or undue influence of others to override professional or business judgments

A professional accountant may be exposed to situations that may impair objectivity. It is impracticable to define and prescribe all such situations. A professional accountant shall not perform a professional service if a circumstance or relationship biases or unduly influences the accountant‘s professional judgment with respect to that service.

(c) Professional

Competence and Due Care – to maintain professional knowledge and skill at the level required to ensure that a client or employer receives competent professional services based on current developments in practice, legislation and techniques and act diligently and in accordance with applicable technical and professional standards.

The principle of professional competence and due care imposes the following obligations on all professional accountants:

(a) To maintain professional knowledge and skill at the level required to ensure that clients or employers receive competent professional service;

and

(b) To act diligently in accordance with applicable technical and professional standards when providing professional services. Competent professional service requires the exercise of sound judgment in applying professional knowledge and skill in the performance of such service. Professional competence may be divided into two separate phases:

(a) Attainment of professional competence; and (b) Maintenance of professional competence.

(d) Confidentiality – to respect the confidentiality of information acquired as a result of professional and business relationships and, therefore, not disclose any such information to third parties without proper and specific authority, unless there is a legal or professional right or duty to disclose, nor use the information for the personal advantage of the professional accountant or third parties.

The principle of confidentiality imposes an obligation on all professional accountants to refrain from:

(a) Disclosing outside the firm or employing organization confidential information acquired as a result of professional and business relationships without proper and specific authority or unless there is a legal or professional right or duty to disclose; and

(b) Using confidential information acquired as a result of professional and business relationships

The following are circumstances where professional accountants are or may be required to disclose confidential information or when such disclosure may be appropriate:

(a) Disclosure is permitted by law and is authorized by the client or the employer;

(b) Disclosure is required by law, for example:

(i) Production of documents or other provision of evidence in the course of legal proceedings; or

(ii) Disclosure to the appropriate public authorities of infringements of the law that come to light; and by law:

(i) To comply with the quality review of a member body or professional body;

(ii) To respond to an inquiry or investigation by a member body or regulatory body;

(iii) To protect the professional interests of a professional accountant in legal proceedings; or

(iv) To comply with technical standards and ethics requirements.

In deciding whether to disclose confidential information, relevant factors to consider include:

• Whether the interests of all parties, including third parties whose interests may be affected, could be harmed if the client or employer consents to the disclosure of information by the professional accountant.

• Whether all the relevant information is known and substantiated, to the extent it is practicable; when the situation involves unsubstantiated facts, incomplete information or unsubstantiated conclusions, professional judgment shall be used in determining the type of disclosure to be made, if any.

• The type of communication that is expected and to whom it is addressed.

• Whether the parties to whom the communication is addressed are appropriate recipients.

(e) Professional Behavior – to comply with relevant laws and regulations and avoid any action that discredits the profession.

The principle of professional behavior imposes an obligation on all professional accountants to comply with relevant laws and regulations and avoid any action that the professional accountant knows or should know may discredit the profession. This includes actions that a reasonable and informed third party, weighing all the specific facts and circumstances available to the professional accountant at that time, would be likely to conclude adversely affects the good reputation of the profession.

In marketing and promoting themselves and their work, professional accountants shall not bring the profession into disrepute. Professional accountants shall be honest and truthful and not:

(a) Make exaggerated claims for the services they are able to offer, the

qualifications they possess, or experience they have gained; or

(b) Make disparaging references or unsubstantiated comparisons to the work of others.

Self-interest threat – the threat that a financial or other interest will inappropriately influence the professional accountant‘s judgment or behavior;
Self-review threat – the threat that a professional accountant will not appropriately evaluate the results of a previous judgment made or service performed by the professional accountant, or by another individual within the professional accountant‘s firm or employing organization, on which the accountant will rely when forming a judgment as part of providing a current service;
Advocacy threat – the threat that a professional accountant will promote a client‘s or employer‘s position to the point that the professional accountant‘s objectivity is compromised;
Familiarity threat – the threat that due to a long or close relationship with a client or employer, a professional accountant will be too sympathetic to their interests or too accepting of their work; and
Intimidation threat – the threat that a professional accountant will be deterred from acting objectively because of actual or perceived pressures, including attempts to exercise undue influence over the professional accountant.

Ethical theories

‘Absolutism’ /Dogmatic/non-consequentialist

Ethical absolutism is concerned with whether an action or conduct is right or wrong. Therefore, from the standpoint of ethical absolutes, some things are always right and some things are always wrong, no matter how one tries to rationalise them.

Ethical absolutism requires that individuals always defer to a set of rules to guide them in the ethical decision-making process. It holds that whether an action is ethical does not depend on the view of the person facing the dilemma; instead it depends on whether the action conforms to the given set of ethical rules and standards.

Absolutism takes no account of who is making the ethical judgement, but defers to universal principles which should guide anyone‘s behaviour in the situation, regardless of their background.

‘Relativism’ /pragmatic/consequentialist

Ethical relativism is the broad acceptance that nothing is objectively right or wrong, but depends on the circumstances of the situation and the individuality of the person facing the situation or dilemma.

It suggests that an ethical position held by one person may be viewed as right for them, but may be wholly unacceptable to another person in the same situation. Relativism therefore insists that what is considered true by an individual replaces the search for an absolute truth by denying the existence of objective moral standards. Rather, according to ethical relativism, individuals must evaluate actions on the basis of what they feel is best for themselves.

Ethical relativism takes account of who is making the ethical decision and what their psychological, cultural and moral background is and accepts that different people will form different moral opinions of the most ethical approach to be taken in any given situation.

Kohlberg’s Levels of Moral Development

Laurence Kohlberg devised a theory which explained the rationale behind human moral reasoning, where he was less concerned about the actual decision taken but rather the cognitive process which arrived at each judgement. Kohlberg described the development of individual moral and ethical reasoning through three discrete levels: pre-conventional, conventional and post-conventional.

At the pre-

conventional level of moral reasoning, morality is conceived of in terms of

rewards,

punishments and instrumental motivations. Those demonstrating intolerance of norms and regulations in preference for selfserving motives are

typically preconventional.

1.1 Pre conventional– Obedience and punishment

At the most basic level, individuals make decisions based on punishment and reward and at this stage have not developed any particular ethical beliefs.

How can I avoid punishment?

1.2 Pre conventional– Instrumental purpose and Exchange

At a slightly higher level, individuals learn to do something for the promise of future benefits. What’s in it for me?

At the conventional level, morality is understood in terms of compliance with either or both of peer pressure/social expectations or regulations, laws and guidelines. A high degree of compliance is assumed to be a highly moral position. A person who is ethically engaged at the conventional level will consider it important to learn the rules and expectations which apply to them and then comply in detail. These can concern legal rules, social norms and accepted standards of behaviour.

2.1

Conventional– Interpersonal accord and conformity

At this stage, individuals start to develop behaviour patterns that are based on their family, friends, work colleagues and peers. Good behavior is that which pleases others in the immediate group

Sometimes referred to as the ‗good boy–good girl‘ orientation, this stage focuses on living up to social expectations and accepted roles in society. Due consideration is given to the expectations of peers with an emphasis on conformity when arriving at an appropriate decision.

2.2

Conventional– Social accord and

system maintenance

The previous level expands from following the norms of a peer group into following the norms for society as a whole. Laws and social norms

As individuals progress towards this more advanced stage of moral development, focus shifts towards a sense of duty and responsibility by observing law and order, adhering to rules and respecting authority.

At the post-

conventional level, morality is understood in terms of conformance with ‗higher‘ or ‗universal‘ ethical principles as perceived by the person being considered.

Post-conventional assumptions often challenge existing regulatory regimes and

social norms, and so post-conventional behaviour is often costly in personal terms. The nature of the ‗higher‘ ethical principles

is subjective and specific to the person.

3.1 Post conventional– Social contract and individual rights

The post conventional level recognises that individuals are separate from society and that the individual‘s perception may take precedence over society‘s view.

Individuals start to challenge social norms. In this stage, the individual believes that laws that do not promote general welfare should be changed where necessary to meet the greater good for the greatest number.Laws are open to question but are still being upheld for the good of the community and in the name of democratic values.

3.2 Post conventional– Universal ethical

Principles

At the highest level, individuals will reject social norms by behaving in the way they believe to be right, and will campaign to change the views of others so that their norms become society‘s norms.

Kohlberg believed that stage six existed but that very few individuals operated consistently at this level. self-chosen ethical principals- high value is placed on justice, dignity, and equality of all persons.

Corporate Citizenship

Corporate citizenship is an approach which can be adopted by any business with the aim of shaping its core values so that they more closely align the decisions made each day by its directors, managers and employees with the needs of the society in which the business operates.

There are three principles which take into account successful corporate citizenship:

Minimising any harm caused to society by the decisions and actions of a business, which could include avoiding harm to the natural environment as well as the social infrastructure.
Maximising any benefit created for society as a consequence of normal business activity. Any successful business will stimulate local economic activity and increase employment, but a good corporate citizen will do this with greater sensitivity to its environmental and social impacts.
Remaining clearly accountable and responsive to a wide range of its stakeholders, thereby combining business self-interest with a greater sense of responsibility towards society at large.

By embracing the corporate citizenship agenda, an organisation is able to recognise its fundamental rights and acknowledge that it has responsibilities towards the wider community.

Responsibilities of the business as a corporate citizen

Just as an individual has the responsibility to obey the law, fit in with the social and ethical norms of society, and behave in an appropriate way, so does a business.

Its responsibility is to always comply with the laws and social norms which apply in each country it deals with. This extends to being a good employer, maintaining prompt payment of payables accounts, encouraging good working conditions at supplier companies and similar areas of good business practice.

The 3 perspectives are:

limited view: stakeholders considered when in business‘ interest (main groups considered are employees and local community)
Equivalent view: self interest is not primary motivation. Organization is focused on legal requirements and ethical fulfillment.
Extended view: Combination of self interest promoting the power that organizations have and wider responsibility towards society.

Ethical decision making model

THE AMERICAN ACCOUNTING ASSOCIATION (AAA) MODEL

The American Accounting Association (AAA) model comes from a report for the AAA written by Langenderfer and Rockness in 1990. In the report, they suggest a logical, seven-step process for decision making, which takes ethical issues into account.

The model begins, at Step 1, by establishing the facts of the case. While perhaps obvious, this step means that when the decision-making process starts, there is no ambiguity about what is under consideration.

Step 2 is to identify the ethical issues in the case. This involves examining the facts of the case and asking what ethical issues are at stake.

The third step is an identification of the norms, principles, and values related to the case. This involves placing the decision in its social, ethical, and, in some cases, professional behaviour context. In this last context, professional codes of ethics or the social expectations of the profession are taken to be the norms, principles, and values. For example, if stock market rules are involved in the decision, then these will be a relevant factor to consider in this step.

In the fourth step, each alternative course of action is identified. This involves stating each one, without consideration of the norms, principles, and values identified in Step 3, in order to ensure that each outcome is considered, however appropriate or inappropriate that outcome might be.

Then, in Step 5, the norms, principles, and values identified in Step 3 are overlaid on to the options identified in Step 4. When this is done, it should be possible to see which options accord with the norms and which do not.

In Step 6, the consequences of the outcomes are considered. Again, the purpose of the model is to make the implications of each outcome unambiguous so that the final decision is made in full knowledge and recognition of each one.

Finally, in Step 7, the decision is taken.

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IAS31: TECHNICAL ARTICLES