Accounting Regulation and the Conceptual Framework PDF

Accounting Regulation and the conceptual framework Alice Li Key sources of regulation of financial reporting in Australia The major sources of financial reporting regulation in Australia are: ­ The Corporations Act 2001 ­ International Accounting Standards Board (IASB) ­ Australian A...

Accounting Regulation and the conceptual framework Alice Li Key sources of regulation of financial reporting in Australia The major sources of financial reporting regulation in Australia are: ­ The Corporations Act 2001 ­ International Accounting Standards Board (IASB) ­ Australian Accounting Standards Board (AASB) ­ Conceptual Framework ­ ASX Listing Rules ­ ASIC ­ APRA ­ Royal Commission Is that all? Sources of regulation continued The Corporations Act 2001 ­ Particularly Part 2M3 of Chapter 2 ­ https://www.legislation.gov.au/Details/C2017C00328/Html/ Volume_2#_Toc494872419 In this unit we are only concerned with so-called ‘reporting entities’. We do not deal with sole traders etc. These were covered in earlier units. Reporting entities Reporting entities generally have to prepare financial reports using Australian accounting standards. ­ Generally, these are entities listed on the Australian Stock Exchange.  Some companies are traded on the ASX, but prepare their reports using non- Australian rules  News Corporation (NWS) uses US accounting rules.  https://newscorp.com/wp-content/uploads/2023/10/News-Corp-Annual-Report-20 23.pdf The Corporations Act 2001 refers to reporting entities as ‘disclosing entities’ in section 292. Disclosing entities are defined in para 111AC ­ Basically – any entity if its debt and/or equity instruments are traded in a stock exchange. Other entities The Corporations Act 2001 deals with and defines a range of other types of entities, such as large proprietary and small proprietary companies. ­ Don’t worry about these distinctions in this unit. Reporting entities - requirements Stock exchanges demand continuous disclosure of information which may be relevant to investors https://www.asx.com.au/asx/share-price-research/company/AGL The Corporations Act requires financial reports annual and half yearly reports (both have audit reports). In addition, companies have to prepare directors’ reports half yearly. Financial reports These have to be prepared according to accounting standards. They must also give a true and fair view. (s296 of the Corporations Act 2001) What happens when following an accounting standard does not give a true and fair view? Bad luck! You still have to follow the accounting standards (s 297 of the Corporations Act 2001) Some accounting standards facilitate off balance sheet Financing (OBF) and earnings management (EM) Standard setting - Australia Background – Prior to 1991 there were no mandatory accounting standards in Australia. ­ Some rules were developed, but often ignored. On the first of January 2005, Australia adopted financial accounting standards developed by the International Accounting Standards Board (IASB). ­ https://www.ifrs.org/ The International Accounting Standards Board (IASB) International Accounting Standards Board (IASB) produces International Financial Reporting Standards (IFRS), and before that, International Accounting Standards (IAS). The IASB is based in London, sets international accounting rules (standards and interpretations) Heavy influence of UK, USA, Western Europe actors and Board members. Generally engages in a vigorous due process when developing rules The classification system between the AASB rules and IFRS More recent standards are called International Financial Reporting Standards (IFRS)  E.g. IFRS 8 Operating Segments = AASB 8 Operating Segments Previously, they were called International Accounting Standards (IAS)  E.g. IAS 8 Accounting Policies = AASB 108 Accounting Policies Institutions continued  Australian Stock Exchange (ASX)  Australian Securities and Investment Commission (ASIC) ◦ Investor protection  Financial Reporting Council (FRC) ◦ Supervises the AASB Why Whyare arethere thereso somany manyinstitutions? institutions?IsIsthis thisoverkill? overkill? How Howcan canwewehave havefinancial financialcrises crisessuch suchas asthe theGFC, GFC,ififthere thereare areso somany manyinstitutions institutionsinvolved? involved? Standard setting – Australia continued  “The Financial Reporting Council (FRC) is responsible for overseeing the effectiveness of the financial reporting framework in Australia”.  https://frc.gov.au/index.php/about-f rc  “The AASB is committed to developing, in the public interest, a single set of high-quality, understandable accounting standards that require transparent and comparable information in general purpose financial statements”. (link forward) ◦ https://www.aasb.gov.au/AASB-Bo ard.aspx Standard setting in Australia continued  The Minister ◦ The FRC reports to the Assistant Treasurer. ◦ https://frc.gov.au/sites/frc.gov.au/files/2023-10/frc-annual-r eport-2022-23.pdf (page 3 in the pdf counter)  Focus groups are designed to help the AASB understand the needs of users of General Purpose Financial Reports (GPFR). Standard setting – Australia continued  As mentioned above, Australia adopted IASB standards from 1/1/2005.  The role of the AASB has changed from developing its own standards to working with the IASB in the development and modification of accounting rules. ◦ Rules = standards and interpretations. Accounting rules – naming and types  Australian Accounting Standards Board (AASB) ◦ Click on the link below and go to the tab called Pronouncements http://www.aasb.gov.au/ ◦ The AASB formally approves and adopts rules developed by the IASB. The Australian versions are usually identical to the International rules But there may be differences, e.g. AASB 107 Cash Flows v International Accounting Standard 7 Cash Flows (IAS 7) Naming of standards continued The four-digit standards are unique to Australia and do not have any relationship to IASB rules. The three-digit standards (101, 102 etc.) are based on a previous set of rules (IAS) issued by the IASB. These rules still exist and have force of law. The one and two-digit standards (1, 10, 15, etc.) are based on a new set of rules (IFRS) issued by the IASB. These also have the force of law. Naming of standards continued  Click on AASB 8 Operating Segments and scroll to page 3. You will notice reference to a comparison with IFRS 8. ◦ IFRS is the name given by the IASB to the most recent set of its accounting standards (International Financial Reporting Standard).  Go back to the pronouncements page on the AASB website and click on AASB 108 Accounting Policies, Changes in Accounting Estimates and Errors, and scroll to page 3, you will notice reference to IAS 8. ◦ IAS is the name given to the previous set of rules produced by the IASB.  So what? ◦ Be careful if you wish to use the IASB/IFRS rules. It is easy to grab the wrong rule. IAS 8 v IFRS 8. Australian Accounting Rules  The AASB website distinguishes between standards, interpretations, and the conceptual framework. https://www.aasb.gov.au/Pronouncements.aspx Common characteristics of standards: ◦ The objective of the specific rule and sent out the scope of that rule. ◦ Key terms are defined. These may be near the start of the standard (AASB 116), or in an appendix at the back of the standard (AASB 9). ◦ The standards often have an appendix that provides application guidance. ◦ If you click on Extra (to the right of the standard’s name), you will find other resources, such as the basis for conclusion, and often implementation guidance (IG),illustrative examples (IE), or introduction (IN).  Interpretations have a much sharper focus and are only concerned with very specific issues. ◦ Interpretations and standards have the force of law.  The conceptual framework does not have the force of law. It is designed to guide standard setters (see below). The Conceptual Framework  Introduction to the Conceptual Framework ◦ The Australian Accounting Standards Board (AASB) seeks to improve the ‘quality’ of the rules it authorizes. (Link back to AASB statement) Similar to the UK and US standard setters, the AASB attempted to develop a conceptual framework (CF) to assist standard setters when developing or modifying standards. The CF could also be useful for preparers, in those cases where there was not an accounting rule in place. This has proven to be an incredibly difficult process for standard setters. The IASB released an updated conceptual framework in 2018. https://www.ifrs.org/projects/2018/conceptual-framework/ The current version is available here. https://www.aasb.gov.au/Pronouncements/Conceptual-framework.aspx ◦ What does ‘quality’ mean in relation to accounting rules?  Introduction to the 2018 CF ◦ Chapter 1. The objective of general purpose financial reporting ◦ Chapter 2. Qualitative characteristics of useful financial information ◦ Chapter 3. Financial statements and the reporting entity ◦ Chapter 4. The elements of financial statements ◦ Chapter 5. Recognition and derecognition ◦ Chapter 6. Measurement ◦ Chapter 7. Presentation and disclosure ◦ Chapter 8. Concepts of capital and capital maintenance  The status and purpose of the CF  “ The purpose of the Conceptual Framework is to: ◦ (a) assist the Australian Accounting Standards Board (Board) to develop Australian Accounting Standards (Standards) that are based on consistent concepts; ◦ (b) assist preparers to develop consistent accounting policies when no Standard applies to a particular transaction or other event, or when a Standard allows a choice of accounting policy; and ◦ (c) assist all parties to understand and interpret the Standards.” SP1.1  In SP1.5 the AASB states that the CF is designed to ‘foster trust, growth, and long-term financial stability in the Australian economy”. The objective of GPFR  “1.2 The objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions relating to providing resources to the entity.  Those decisions involve decisions about: ◦ (a) buying, selling or holding equity and debt instruments; ◦ (b) providing or settling loans and other forms of credit; or ◦ (c) exercising rights to vote on, or otherwise influence, management’s actions that affect the use of the entity’s Please note notethis thisisisaacritical criticalslide. slide.Note Notealso alsoparagraph paragraph3.2 3.2ofofthe theCF. economicPlease resources.” CF. We Wewill willexamine examineand andapply applythis thisissue issuemany manytimes timesininthe theunit. unit. Chapter 2 of the CF – qualitative characteristics ◦ “ 2.1 The qualitative characteristics of useful financial information discussed in this chapter identify the types of information that are likely to be most useful to the existing and potential investors, …. for making decisions about the reporting entity on the basis of information in its financial report (financial information).” (Underline added) ◦ The CF classifies qualitative characteristics into two groups, fundamental and enhancing as shown below: Enhancing Fundamental qualitative qualitative characteristics characteristics Comparability Relevance Verifiability Faithful representation Timeliness Understandabilit Fundamental - qualitative characteristics Relevance: ­ Relevant financial information is capable of making a difference in the decisions made by users.  Materiality: Information is material if omitting, misstating or obscuring it could reasonably be expected to influence decisions Faithful representation: ­ Financial information must not only represent relevant phenomena, but it must also faithfully represent the substance of the phenomena that it purports to represent. ­ Paragraph 2.13 states that perfectly faithful representations require the information to be complete, neutral, and free from error. The standard setters explicitly recognize this is seldom, if ever, achievable. Source: AASB (2019) Faithful representation continued  Complete depiction – users can Accounting judgements and estimates understand the phenomenon Preparation of the financial statements requires management to make judgements, estimates being described (assets, and assumptions about future events. Information on material judgements and liabilities, revenues etc.) estimates considered when applying the accounting policies can be found in the following notes:  Neutral – no bias - not slanted one way or the other. ◦ Many figures in the GPFR require estimates and judgement of things that will happen in the future – see image on the right. ◦ https://www.boral.com.au/sites/d efault/files/media/field_document /Boral-Annual-Report-2023_0.pdf (p 102 pdf counter) Estimation and judgement in financial accounting  Some people are surprised to hear that figures in financial accounting reports are produced using estimates and professional judgement.  There is an ‘urban myth’ that financial accounting numbers are ‘solid’ or ‘real’. This is just wrong.  The events and transactions we record may have happened in the past, but accountants need to look to the future in order to classify and measure these events and transactions. ◦ Remember, the objective of financial accounting is to provide reports which help users make investment decisions. Therefore, future-based information may be more relevant than historic information.  The gross A/R balance is based on transactions in the past. The net A/R shows how much the entity expects to collect in the future. ◦ Which number would be more relevant to users? Estimation and judgement - basic example How Howcould couldthe thePDD PDD(Provision (Provisionfor forDoubtful Doubtful Receivables - gross v net Debts) be different? It depends on the Debts) be different? It depends on the estimates estimatesand andprofessional professionaljudgement judgementofof The balance sheet the theamount amountthe theentity entitywill willnot notcollect. collect. AR $1,000 $1,000 Less PDD $10 $50 Which Whichfigure figureisisthe the‘correct’ ‘correct’one? one? Net A/R $990 $950 The Thecash cashbelongs belongstotothe theentity entityatatthis thispoint. point. How Howmuch muchrevenue revenueshould shouldwewerecord? record? Revenue Do we have to complete tasks in the future, before Do we have to complete tasks in the future, before Dr Cash $100 we wecan cansaysaywewehave haveearned earnedthis thisrevenue? revenue? Cr Revenue (and or) $x Cr Unearned revenue (L) $100 -$x (extended returns period, new products with returns, some warranties, subscription services, travel agents, airlines, etc) Changes in accounting estimates (AASB 108) ◦ This standard explains the need to use estimates and judgement in financial accounting reports. It goes on to describe how accountants should deal with changes in estimates. “32 As a result of the uncertainties inherent in business activities, many items in financial statements cannot be measured with precision but can only be estimated. Estimation involves judgements based on the latest available, reliable information. For example, estimates may be required of: (a) bad debts; (b) inventory obsolescence; (c) the fair value of financial assets or financial liabilities; (d) the useful lives of, or expected pattern of consumption of the future economic benefits embodied in, depreciable assets; and (e)warranty obligations.” https://www.aasb.gov.au/admin/file/content105/c9/AASB108_08-15_COMPmar21_01-2 3.pdf Faithful representation continued - neutrality  If many figures are subject to estimates, how should preparers approach this issue? ◦ Should they be ‘conservative’? Understate their assets and revenues, recognize their expenses and liabilities quickly? ◦ Under the 2018 version of the CF, the standard setters want to eliminate conservatism. It might sound silly, but conservatism gave rise to a lot of dirty accounting games which can mislead users. The next slide gives an example. There are hundreds of other examples. We will look at some in this unit. Note how conservatism can be used to promote profits in future years. Link this to bonuses paid to managers. Conservatism – income smoothing example Conservative approach Non-conservative approach ­ Recognize $700 expense and provision in each year. ­ In this case, the profit will be reduced by $700 in each year.  Dr Warranty expense Managers Managers may maywant wanttotoreduce reducethethefirst firstyear’s year’s profit, $700 profit, if they were concerned it was likelytotobe if they were concerned it was likely be ‘too  Cr high’ andWarranty could not payable be achieved again in ‘too high’ and could not be achieved again in the thesecond second year. $700year.The Themanagers managers‘massage’ ‘massage’thethe users’ users’perceptions perceptionsthrough throughincome incomesmoothing. smoothing. Faithful representations continued- prudence ◦ “2.16 Neutrality is supported by the exercise of prudence. ◦ Prudence is the exercise of caution when making judgements under conditions of uncertainty. ◦ The exercise of prudence means that assets and income are not overstated and liabilities and expenses are not understated. ◦ Equally, the exercise of prudence does not allow for the understatement of assets or income or the overstatement of liabilities or expenses. ◦ Such misstatements can lead to the overstatement or understatement of income or expenses in future periods.”  Prudence ◦ “2.17 The exercise of prudence does not imply a need for asymmetry, for example, a systematic need for more persuasive evidence to support the recognition of assets or income than the recognition of liabilities or expenses. ◦ Such asymmetry is not a qualitative characteristic of useful financial information. ◦ Nevertheless, particular Standards may contain asymmetric requirements if this is a consequence of decisions intended to select the most relevant information that faithfully represents what it purports to represent.” For example, AASB 138 Intangibles requires asymmetric treatment of research costs. Research costs to develop an intangible asset must be expensed and cannot ever be included in the cost base of the intangible asset. Development costs may be included in the cost base. Applying the fundamental qualitative characteristics ◦ “2.20 Information must both be relevant and provide a faithful representation of what it purports to represent if it is to be useful. ◦ Neither a faithful representation of an irrelevant phenomenon nor an unfaithful representation of a relevant phenomenon helps users make good decisions.” ◦ Paragraph 2.22 notes that there will be times preparers will need to consider a trade-off between the fundamental characteristics. The most relevant information could be a highly uncertain estimate. However, a highly uncertain estimate may not be a faithful representation of the phenomenon.  Enhancing Qualitative Characteristics Comparability: ­ Comparability is the qualitative characteristic that enables users to identify and understand similarities in, and differences among, items. Verifiability: ­ Quality of information that helps assure users that information faithfully represents the economic phenomena. Timeliness ­ Timeliness means having information available to decision- makers in time to be capable of influencing their decisions Understandability ­ Classifying, characterising and presenting information clearly and concisely makes it understandable. Source: AASB (2019) Definitions of the elements - assets ◦ “ 4.3 An asset is a present economic resource controlled by the entity as a result of past events. ◦ 4.4 An economic resource is a right that has the potential to produce economic benefits. ◦ 4.5 This section discusses three aspects of those definitions: (a) right (see paragraphs 4.6–4.13); (b) potential to produce economic benefits (see paragraphs 4.14–4.18); and (c) control (see paragraphs 4.19–4.25).” This Thisdefinition definitionmay maybe bedifferent differenttotowhat whatyou youhave haveseen seenpreviously. previously. This Thiscan canbebesummarized summarizedas asfollows. follows. An Anasset assetisisaapresent presentright rightthat thathas hasthe thepotential potentialtotoproduce produceeconomic economic benefits. benefits. This right is controlled by the entity, as a result of pastevents. This right is controlled by the entity, as a result of past events. Liabilities  “ 4.26 A liability is a present obligation of the entity to transfer an economic resource as a result of past events.  4.27 For a liability to exist, three criteria must all be satisfied: ◦ (a) the entity has an obligation (see paragraphs 4.28–4.35); ◦ (b) the obligation is to transfer an economic resource (see paragraphs 4.36–4.41); and ◦ (c) the obligation is a present obligation that exists as a result of past events (see paragraphs 4.42–4.47).” Income and expenses ◦ “4.68 Income is increases in assets, or decreases in liabilities, that result in increases in equity, other than those relating to contributions from holders of equity claims. ◦ 4.69 Expenses are decreases in assets, or increases in liabilities, that result in decreases in equity, other than those relating to distributions to holders of equity claims.” ◦ Paragraph 4.70 reinforces the idea that contributions of equity by the owners are not income and distributions of equity to owners (drawings and dividends) are not expenses. ◦ Equity is the residual interest in the assets of the entity after deducting all its liabilities. Central relationship in accounting  An asset is a present right that has the potential to produce economic benefits. This right is controlled by the entity, as a result of past events.  An expense is often caused by the using up, wasting or consuming of an asset. Sometimes it is caused by the recognition of certain liabilities (e.g. wages payable – wages expense)  Expenses have nothing to do with spending money. ◦ Spend money to buy a truck = asset increases pay off a loan = reduce a liability pay a dividend = not an expense – a reduction in equity pay wages = sometimes an expense – sometimes part of the cost base of an asset Recognition criteria Only items that meet the definition criteria should be recognised, however, some items might fail, because: Judgments on useful information (CF 5.7) Relevance to users (CF 5.12) Existence of uncertainty (CF 5.14) Low probability of an inflow or outflow of economic benefits (CF 5.15) Measurement uncertainty (CF 5.19) Other factors (CF 5.24) Recognition - in the statements ◦ “5.7 Not recognising an item that meets the definition of one of the elements makes the statement of financial position and the statement(s) of financial performance less complete and can exclude useful information from financial statements. ◦ On the other hand, in some circumstances, recognising some items that meet the definition of one of the elements would not provide useful information. ◦ An asset or liability is recognised only if recognition of that asset or liability and of any resulting income, expenses or changes in equity provides users of financial statements with information that is useful, ie” ….. is relevant and a faithful representation. ◦ “5.8 …. An asset or liability is recognised if the benefits of the information provided to users of financial statements by recognition are likely to justify the costs of providing and using that information. In some cases, the costs of recognition may outweigh its benefits.” Recognition - relevance ◦ “5.12 Information about assets, liabilities, equity, income and expenses is relevant to users of financial statements. ◦ However, recognition of a particular asset or liability and any resulting income, expenses or changes in equity may not always provide relevant information. ◦ That may be the case if, for example: (a) it is uncertain whether an asset or liability exists….; or (b) an asset or liability exists, but the probability of an inflow or outflow of economic benefits is low…” Recognition – existence uncertainty  Contingent assets and contingent liabilities are examples of situations where it is unclear if an asset or liability exists.  Paragraph 5.14 indicates that in these cases, if there is a low probability of inflows or outflows of economic benefits, and if there is ‘an exceptionally wide range’ of possible outcomes, then it may not be appropriate to report an asset or liability, as this would not provide relevant information. ◦ Whether or not it is recognized on the balance sheet, note disclosures would be expected. Recognition – low probability ◦ “5.15 An asset or liability can exist even if the probability of an inflow or outflow of economic benefits is low …. ◦ 5.16 If the probability of an inflow or outflow of economic benefits is low, the most relevant information about the asset or liability may be information about the magnitude of the possible inflows or outflows, their possible timing and the factors affecting the probability of their occurrence. The typical location for such information is in the notes.” ◦ 5.17 states that even if the probability of an outflow or inflow of economic benefits is low, it may be appropriate to recognize these on the balance sheet, if this gives a faithful representation and if it provides relevant information”. Recognition– measurement uncertainty ◦ “5.18 Recognition of a particular asset or liability is appropriate if it provides not only relevant information, but also a faithful representation of that asset or liability and of any resulting income, expenses or changes in equity. ◦ Whether a faithful representation can be provided may be affected by the level of measurement uncertainty associated with the asset or liability or by other factors. ◦ 5.19 For an asset or liability to be recognised, it must be measured. In many cases, such measures must be estimated and are therefore subject to measurement uncertainty….. the use of reasonable estimates is an essential part of the preparation of financial information and does not undermine the usefulness of the information if the estimates are clearly and accurately described and explained. ◦ Even a high level of measurement uncertainty does not necessarily prevent such an estimate from providing useful information.” Measurement uncertainty continued  Paragraph 5.20 gives examples of where you can have high levels of measurement uncertainty. ◦ If using cash-flow-based measurement techniques, and one or more of the following applies: The range of possible outcomes is ‘exceptionally wide’ and the probability of each outcome is ‘exceptionally difficult to estimate’. The measure is ‘exceptionally’ sensitive to small changes in estimates of the probability of future cash inflows or outflows. Measuring the asset or liability requires ‘exceptionally difficult or exceptionally subjective allocations of cash flows that do not relate solely to the item being measured’. Measurement uncertainty continued ◦ Paragraph 5.21 requires accountants to exercise professional discretion when dealing with figures subject to considerable measurement uncertainty. ◦ Ideally, accountants will include the most relevant estimate and use note disclosures to describe the key variables impacting this estimate. However, if the most relevant estimate is subject to excessive measurement uncertainty, the accountant may report another figure, even if it is less relevant. ◦ Paragraph 5.22 suggests that the standard setters recognize there are only limited circumstances where an asset or liability would not be reported on the balance sheet, due to measurement uncertainty being so high that it would be impossible to provide useful information.  Measurement ◦ The CF recognizes that assets and liabilities, and related income and expenses, will be measured using a variety of measurement bases. ◦ Historical cost - not an issue ◦ Current value Fair value Value in use (for assets) and fulfilment value (for liabilities) Current cost – don’t worry about this in this unit. Example of how the CF could be applied  Information can be presented 2 ways in financial reports. ◦ 1) Recognised on the face of the financial statements. ◦ 2) Disclosed in the notes to the financial statements  Examine the next two slides. ◦ Note the total liabilities recognised in the balance sheet  Then look at the notes to the accounts. ◦ Any thoughts? Consider the commitments. ◦ Why are they not recognised? ◦ Consider the CF. Note Notethese these 22figures figures Reference Australian Accounting Standards Board (AASB). (2024). Conceptual Framework for Financial Reporting (issue date: Dec 2021). Retrieved from Melbourne: Commonwealth of Australia. Available at: https://www.aasb.gov.au/admin/file/content105/c9/Conceptual_Framework_05-19_COMPdec21_01-22.pdf Loftus, J., et al. (2023). Financial Reporting (4th ed.). Milton, QLD: John Wiley and Sons Australia, Ltd. Available at: https://www.wileydirect.com.au/buy/financial-reporting/