Financial Reporting and Accounting Standards PDF

CHAPTER ONE =========== Financial Reporting and Accounting Standards ============================================ **Introduction** Fair presentation of financial affairs is the essence of accounting theory and practice. With the increasing size and complexity of business enterprises and the incre...

CHAPTER ONE =========== Financial Reporting and Accounting Standards ============================================ **Introduction** Fair presentation of financial affairs is the essence of accounting theory and practice. With the increasing size and complexity of business enterprises and the increasing economic role of government, the responsibility placed on accountants is greater today than ever before. If accountants are to meet this challenge, they must have a logical and consistent body of accounting theory to guide them. This theoretical structure must be realistic in terms of the economic environment and must be designed to meet the needs of users of financial statements. Financial statements and reports prepared by accountants are vital to the successful working of society. Economists, investors, business executives, labor leaders, bankers, and government officials all rely on these financial statements and reports as fair and meaningful summaries of day-to-day business transactions In addition, these groups are making increased use of accounting as a base for forecasting future economic trends. **NATURE and environment of financial accounting** For purposes of study and practice, the discipline of accounting is commonly divided into the following areas or subsets: financial accounting, managerial (cost) accounting, tax accounting, and not- for- profit (public sector) accounting. This chapter concentrates on financial accounting. Financial accounting has been characterized as *"that branch of accounting concerned with the classification, recording, analysis, and interpretation of the overall financial position and operating results of an organization*." Financial accounting encompasses the process and decisions that culminate in the preparation of financial statements relative to the enterprise as a whole for use by parties both internal and external to the enterprise. **Organizations and Laws affecting Financial Accounting** Certain professional organizations, governmental agencies, and legislature acts have been extremely influential in shaping the development of the existing body of financial accounting theory. Among the most important of these have been the International Accounting standards, the financial Accounting standards in U.K., the American Institute of certified public Accountants, the Association of chartered certified Accountants (ACCA) in U.K., the American Accounting Association etc. Awareness of the roles of these institutional forces is helpful in gaining an understanding of current accounting principles and practices. **The International Accounting Standards Board (IASB)** The International Accounting Standards Board (Board) is the standard-setting body of the IFRS Foundation. Selected, overseen and funded by the IFRS Foundation, the Board has complete responsibility for technical matters, including the preparation and issuing of IFRS Standards. The Trustees of the IFRS Foundation are responsible for governance and oversight. A Monitoring Board provides a formal accountability link between the Trustees and public authorities. - **IFRS is developed by the International Accounting Standards Board (IASB), which operates under the oversight of the IFRS Foundation.** - **IASB was formerly called International Accounting Standards Committee (IASC)** - **IASB is based in London** **What is IFRS?** IFRS is a globally recognized set of Standards for the preparation of financial statements by business entities. IFRS is a set of globally accepted standards for financial reporting applied primarily by listed entities in over 160 countries. The overriding requirement of IFRS is for the financial statements to give a fair presentation (or a true and fair view). Individual standards and interpretations are developed and maintained by the IASB and the IFRS interpretations committee. - IFRS is designed for use by profit-oriented entities - Those Standards gives guideline about: - - - How to present them in a set of financial statements; and related disclosures about those items. ***Principles-Based vs. Rules-Based Standards*** IFRS are referred to as being **principles**-**based standards** - Provide core principles (objectives) with minimum guidance. - They are more loosely framed, allowing for professional judgment to be applied - The judgments are expected to be consistent with clear conceptual framework - Results in accounting that is more flexible to deal with unique economic and business circumstances US GAAP are referred to as being **rules-based standards:** - They are more prescriptive - Provide a rule for every situation - Body of knowledge too large and complicated - Although more guidance is a comfort to some, it becomes difficult to ensure that the standards are all consistent. **Difference between IFRS and US GAAP** - **Inventory costing method** - **US GAAP allows LIFO method** - **IFRS doesn't allow LIFO method** - **Valuation of property, plant, and equipment** - **U.S.GAAP: Cost less accumulated depreciation** - **IFRS: Cost less accumulated depreciation (or) fair value(revaluation)** - **Valuation of intangible assets** - **U.S GAAP: Cost less accumulated amortization. Revaluation prohibited** - **IFRS: Cost less accumulated amortization (or) fair value(revaluation)** **Why IFRS?** - Investors are acting on a global market !! - National standards don't work on a global market - Cross boarder business is hindered by national standards **Benefits of IFRS are:** - Credibility of local market to foreign investors - More cross-border investment - Efficient capital allocation - Comparability across political boundaries - Facilitates global education and training **Benefit of IFRS to companies!** - Facilitates raising capital abroad - Integrated IT systems - One set of books + easier consolidation **IFRS Adoption** - More than 160 countries - International support to have global accounting standards - G20 , WB , IMF , International Organization of Securities Commissions and International Federation of Accountants The application of IFRS in Ethiopia =================================== - There was no accounting standard in Ethiopia (ROSC, 2007) - The absence of one set of accounting standard in the country, financial statements depict limited information for users which indicates the existence of urgent need for Ethiopia to have a uniform standard. - Since most of the countries in the world are following IFRS, Ethiopia should not isolate itself. - Consequently, very recently, the government of Ethiopia issued a proclamation called "Financial Report Proclamation of Ethiopia: 847/2014" and Council of Ministers Regulation 332/2014. **The proclamation requires:** - Commercial (business) organizations to follow: - International Financial Reporting Standards (IFRS), or - International Financial Reporting Standards for Small and Medium Enterprises (IFRS for SME) - Charities and societies to follow International Public Sector Accounting Standards (IPSAS) - Public auditors to follow International Standards for Auditing (ISA). Accounting and Audit Board of Ethiopia (AABE) established and took responsibility to guide and dictate the implementation of IFRS. - **Adoption**: Complete adherence to the IFRS. (Highly encouraged by IASB) - **Adaptation**: Customizing the standard to specific need of the country. (Highly discouraged by IASB) Even though IFRS is required for a certain type of institutions, the companies are not applying the standards properly. The required companies are also facing many challenges such as lack of proper instruction, lack of availability of specialists and need for training, etc In Ethiopia for the reporting purpose Business enterprise are classified in to three: **1.** Significant Public interest entity (PIE) **2.** Other Public interest entity **3.** Small and Medium Enterprise (SME) **1. Significant Public interest entity (PIE) (based on nature)** - - Banks - Insurance company and other financial institutions - Government Enterprises - Corporations - Pension funds - Cooperatives and unions - Consumer association - ECX members - Any company which issued equity/debt security or ready to issue those securities (They have to applied until 2015 E.C/ 2023 GC ) **2. Other Public interest entity (based on their size )** - If one company fulfill **two of four** a\. Annual sales turnover \>= 300,000,000 Birr b\. Total Assets \>= 200,000,000 Birr c\. Total Liability \>= 200,000,000 Birr d\. Number of employees \>= 200 (They have to applied until 2015 E.C/ 2023 GC ) **3. Small and Medium Enterprise (SME)** - If one company fulfill two of four a\. Annual sales turnover \>=20,000,000 But \< 300,000,000 Birr b\. Total Assets \>=20,000,000 But \< 200,000,000 Birr c\. Total Liability \>=20,000,000 But \< 200,000,000 Birr d\. Number of employees \>= 20 But \< 200 (They have to applied until 2016 E.C/ 2024 GC ) **IRFS for SMEs** - Final standard issued 9 July 2009 - 130 - 230 pages Disclosure - Simplified IFRSs, but built on an IFRS foundation - Divided into **39** **Sections** - Designed specifically for SMEs - Internationally recognized **Who are SMEs?** - Small or medium enterprise is: - A reporting entity, and - is not a public interest entity - *IFRS for SMEs* is intended for entities that do not have public accountability. Conceptual Frame work for Financial Reporting ============================================= ***Conceptual Framework*** is a statement of generally accepted theoretical principles which form the frame of reference for financial reporting. It sets out the concepts that underlie the preparation and presentation of financial statements. The *Conceptual Framework* distinguishes between **fundamental** and **enhancing** qualitative characteristics, for analysis purposes. Fundamental qualitative characteristics distinguish useful financial reporting information from information that is not useful or that is misleading. Enhancing qualitative characteristics distinguish more useful information from less useful information. **Why conceptual framework is necessary?** - To increase FS users understanding & confidence eon the reports - To enhance comparability among FS of different companies - To solve new or existing practical problems more quickly - **To assist IASB in setting new standards and reviewing existing ones.** - **enhances consistency across standards** - **enhances consistency over time as Board members change** - **To assist national standard-setters** - **To assist preparers, auditors and users** - **Preparers use Conceptual Framework to develop accounting policies in the absence of specific standard or interpretation** **Development of Conceptual framework** There are three levels in **Development of C**onceptual framework: a. **FIRST LEVEL** **OBJECTIVES OF FINANCIAL STATEMENTS** The **objective** of financial statements is to provide information about the **financial position** (balance sheet), **performance** (income statement), and **changes in financial position** (cash flow statement) of an entity; this information should be useful to a wide range of users for the purpose of making economic decisions, focusing on users who cannot dictate the information they should be getting. 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 about providing resources to the entity. b. **SECOND LEVEL** **QUALITATIVE CHARACTERISTICS OF FINANCIAL REPORTING** 1. **The fundamental qualitative characteristics** **If financial information is to be useful, it must be relevant and faithfully represent what it purports to represent (i.e. fundamental qualities). Financial information without both relevance and faithful representation is not useful, and it cannot be made useful by being more comparable, verifiable, timely or understandable.** - **Relevance:** Relevant information is capable of making a difference in the decisions made by users. It is capable of making a difference in decisions if it has **predictive value**, **confirmatory value** or both. - **Predictive value (input to predict future cash flows):** Accounting information should be helpful to external decision makers by increasing their ability to make predictions about the outcome of future events. Decision makers working from accounting information that has little or no predictive value are merely speculating. - **confirmatory value (confirm/disconfirm prior cash flow expectations):** Accounting information should be helpful to external decision makers who are confirming past predictions or making updates, adjustments, or corrections to predictions. - **Materiality:** Materiality is an entity specific aspect of relevance based on the [nature] or [magnitude], or both, of the items to which the information relates in the context of an individual entity's financial report. Consequently, an entity [need not] apply its accounting policies to immaterial items; and disclose immaterial information. - **Faithful representation**: Financial reports represent **economic phenomena** in words and numbers. To be useful, financial information must not only represent relevant phenomena but must **faithfully represent** the phenomena that it purports to represent. - **Completeness:** A **complete** depiction includes all information necessary for a user to understand the phenomenon being depicted, including all necessary descriptions and explanations. - **Neutrality:** Accounting information must be free from bias regarding a particular view point, predetermined result, or particular party. Preparers of financial reports must not attempt to induce a predetermined outcome or a particular mode of behavior (such as to purchase a company's stock). Accounting information cannot be selected to favor one set of interested parties over another. It should be factual and truthful this means that information must not be manipulated in any way in order to influence the decisions of users. - **Free from error: Free from error** means there are no errors or omissions in the description of the phenomenon and no errors made in the process by which the financial information was produced. It does not mean that no inaccuracies can arise, particularly where estimates have to be made 2. **Enhancing qualitative characteristics** - **Timeliness**: means available to decision makers before it loses its capacity to influence their decisions. Accounting information should be timely if it is to influence decisions, like the news of the world; state financial information has less impact than fresh information. - **Understandability:** Classifying, characterizing and presenting information clearly and concisely make it *understandable*. Some phenomena are inherently complex and cannot be made easy to understand. Excluding information about those phenomena from financial reports might make the information in those financial reports easier to understand. However, those reports would be incomplete and therefore potentially misleading. Financial reports are prepared for users who have a reasonable knowledge of business and economic activities and who review and analyses the information diligently. At times, even well-informed and diligent users may need to seek the aid of an adviser to understand information about complex economic phenomena. - **Verifiability:** - Verifiability pertains to maintenance of audit trials to information source documents that can be checked for accuracy. It also pertains to the existence of alternative information sources as backing. Verification implies a consensus and implies that independent measures using the same measurement methods would reach substantially the same conclusions. - **Comparability:** Information should be presented in a consistent manner over time and in a consistent manner between entities to enable users to make significant comparisons. Information about a reporting entity is more useful if it can be compared with similar information about other entities and with similar information about the same entity for another period or another date. Users' decisions involve choosing between alternatives, for example, selling or holding an investment, or investing in one reporting entity or another. **ELEMENTS OF FINANCIAL STATEMENTS** An important aspect of the theoretical structure is the establishment and definition of the basic categories of items to be included in financial statements. At present, accounting uses many terms that have peculiar and specific meaning in the language of business. One such term is asset. Is it something we own? If the answer is yes, can we assume that any asset leased would never be shown on the balance sheet? Is it any thing of value used (or for which there is a right to use) by the enterprise? If the answer is yes, then why the management of the enterprise should not be reported as an asset? It seems necessary, therefore, to develop a basic definitional framework for the elements of accounting. Such definitions provide guidance for identifying what to include and what to exclude from the financial statements. SFAC No.6 defines 10 elements of financial statements as follows: 1. **Assets** Assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. They have three essential characteristics: a. They embody a future benefit that involves a capacity, singly or in combination with other assets to contribute directly or indirectly to future net cash flows. b. The entity can control access to the benefit c. The transaction or event-giving rise to the entity's right to, or control of, the benefit has already occurred (result of past transactions). Liabilities =========== Liabilities are probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as result of past transactions or events. They have three essential characteristics. a. They embody a duty or responsibility to others that entails settlement by future transfer or use of assets, provision of services or other yielding of economic benefits, at a specified or determinable date, on occurrence of a specified event, or on demand. b. The duty or responsibility obligates the entity, leaving it little or no discretion to avoid it. c. The transaction or event obligating the entity has already occurred. Equity ====== Equity is the residual (ownership) interest in the assets of an entity that remains after deducting its liabilities. While equity in total is a residual, it includes specific categories of items, for example, types of share capital, contributed surplus and retained earnings Income ====== **Income:** Increase in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities those results in increases in equity, other than those relating to contribution from equity participants. 5. **Expenses** **Expenses:** decrease in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities those results in decreases in equity, other than those relating to distribution to equity participants. **THIRDLEVEL: recognition, measurement and disclosure concepts** **Recognition**: The process of incorporating in the statement of financial position or statement of profit or loss and other comprehensive income an item that meets the definition of an element and satisfies the following Criteria for recognition: - it is probable that any future economic benefit associated with the item will flow to or from the entity; and - the item has a cost or value that can be measured with reliability **Measurement**: The process of determining the monetary amounts at which the elements of the financial statements are to be recognized and carried in the statement of financial position and statement of profit or loss and other comprehensive income. **Disclosure to compliance with IFRS:** Most importantly, financial statements should **present fairly** the financial position, financial performance and cash flows of an entity. **Compliance with IFRS** is presumed to result in financial statements that achieve a fair presentation. IAS 1 stipulates that financial statements shall present fairly the financial position, financial performance and cash flows of an entity. Fair presentation requires the faithful representation of the effects of transactions, other events and conditions in accordance with the definitions and recognition criteria for assets, liabilities, income and expenses set out in the *Conceptual Framework*. The following points made by IAS 1 expand on this principle. \(a) **Compliance with IFRS** should be disclosed \(b) **All relevant IFRS** must be followed if compliance with IFRS is disclosed \(c) Use of an **inappropriate accounting treatment** cannot be rectified either by disclosure of accounting policies or notes/explanatory material IAS 1 states what is required for a fair presentation. - Selection and application of **accounting policies** - **Presentation of information** in a manner which provides relevant, reliable, comparable and understandable information - **Additional disclosures** where required **Summary of conceptual frame work for financial reporting** ***Fair value Measurement & Impairment*** ***What is fair value?*** ***Fair value*** is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. This definition of fair value is sometimes referred to as an 'exit price'. As per the definition, the fair value of an asset is: - the price that would be received to sell an asset (exit price) - in an orderly transaction (not a forced sale/liquidation) - between market participants (market-based view, independent buyers & sellers-not related parties) - at the measurement date (current price) **Characteristics of fair value** - a market value (not entity-specific value) - an exit value - requires judgement to measure (especially Level 3 measurements) **What the IASB says about fair value** - Has predictive value and confirmatory value (provides relevant information) - fair value reflects expectations about the amount, timing and uncertainties of the cash flows (reflecting market participants' expectations). - Provides comparable information (between entities and within an entity) - market participant perspective, identical assets (absent estimation error) measured at the same amount irrespective of when and for what purpose they are acquired **Fair value hierarchy** - **Level 1** -- highest priority is given to **quoted prices** in active markets for **identical assets** or **liabilities** - **Level 2** -- **observable inputs** not included in level 1 (e.g. quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active) - **Level 3** -- **unobservable inputs** developed using best information available (e.g. entity's own data) ***Level 2 inputs:*** - Quoted prices for *similar assets or liabilities in active markets.* - Quoted prices for identical or similar assets or liabilities in markets that are *not active.* - Inputs other than quoted prices those are observable for the asset or liability. Examples:- - interest rates and yield curves observable at commonly quoted intervals; Implied volatilities; loss severities; credit risks; a default rates - Inputs that are derived principally from or corroborated by observable market data that, through correlation or other means, are determined to be relevant to the asset or liability being measured (market-corroborated inputs). There are factors to consider in determining the fair value of an asset. These factors include: - Condition - Location - Age - Restriction, etc **Fair value measurement techniques** - When transactions are directly observable in a market, the determination of fair value can be relatively straightforward. In other circumstances, a valuation technique is used. - IFRS 13 describes three valuation techniques: 1. **Market approach** -- uses price information generated by market transactions 2. **Income approach** -- converts future amounts (e.g. cash flows or income and expenses) to a single (present value) amount 3. **Cost approach** -- determines the value that reflects current replacement cost - Valuation techniques used to measure fair value should maximise the use of relevant observable inputs and minimise the use of unobservable inputs. **Observable inputs** -- developed using market data such as publicly available information about actual events or transactions. **Unobservable inputs** -- market data not available and developed using best information available about assumptions that market participants would use. - Characteristics of market participants (ie buyers and sellers in principal market (or most advantageous market): - independent - knowledgeable - willing to transact for the asset or liability - able to transact for the asset or liability - **Assumption**: market participants act in their economic best interest **Selecting the appropriate market: Which market?** The principal & the most advantageous market **Principal market:** This has the greatest volume, frequency and level of activity for the asset or liability**.** When the principal market is not identified, most advantageous market is used. The Most advantageous market - maximises the amount that would be received to sell an asset - minimises the amount that would be paid to transfer the liability - It is where the holder's value is maximized - Other considerations: - reporting entity must have access to the market at the measurement date **Impairment of assets** Impairment is sudden reduction in value of non-current assets. Impairment ***'concept':*** an asset should not be measured at an amount greater than the entity expects to recover from its sale or use. An impairment loss is the amount by which the carrying amount (BV) of an asset exceeds its recoverable amount. - Recoverable amount is the *higher* of fair value less costs of disposal (FVLCD) and value in use (VIU) - **External sources** - decline in assets' market value - adverse changes in technological, market, economic or legal environment - market interest rates - carrying amount of the net assets is more than market capitalisation - **Internal sources** - Obsolescence or physical damage of an asset - Plans for a significant reorganisation/discontinuation or sale of an asset - evidence that an asset's performance is worse than expected **Example 1:** Assume that Cruz Company performs an impairment test for its equipment. The carrying amount of Cruz's equipment is €200,000, its fair value less costs to sell is €180,000, and its value-in-use is €205,000. As a result, there is no impairment because carrying amount \< recoverable amount. **Example 2:** Assume the same information for Cruz Company except that the value-in-use of Cruz's equipment is €175,000 rather than €205,000. Cruz makes the following entry to record the impairment loss. Loss on Impairment 20,000 Accumulated Depreciation---Equipment 20,000 **Reversal of Impairment Loss** After recording the impairment loss, the recoverable amount becomes the basis of the impaired asset. What happens if a review in a future year indicates that the asset is no longer impaired because the recoverable amount of the asset is higher than the carrying amount? In that case, the impairment loss may be reversed. To illustrate, assume that Tan Group purchases equipment on January 1, 2019, for \$300,000, with a useful life of three years and no residual value. Its depreciation and related carrying amount over the three years is as follows. **Year Depreciation Expense Carrying Amount** 2019 \$100,000 (\$300,000/3) \$200,000 2020 \$100,000 (\$300,000/3) \$100,000 2021 \$100,000 (\$300,000/3) 0 At December 31, 2019, Tan determines it has an impairment loss of \$20,000 and therefore makes the following entry. Loss on Impairment 20,000 Accumulated Depreciation---Equipment 20,000 Tan\'s depreciation expense and related carrying amount after the impairment is as indicated below: **Year Depreciation Expense Carrying Amount** 2020 \$90,000 (\$180,000/2) \$90,000 2021 \$90,000 (\$180,000/2) 0 At the end of 2020, Tan determines that the recoverable amount of the equipment is \$96,000, which is greater than its carrying amount of \$90,000. In this case, Tan reverses the previously recognized impairment loss with the following entry. Accumulated Depreciation---Equipment 6,000 Recovery of Impairment Loss 6,000 The recovery of the impairment loss is reported in the "Other income and expense" section of the income statement. The carrying amount of Tan\'s equipment is now \$96,000 (\$90,000 + \$6,000) at December 31, 2020. The general rule related to reversals of impairments is as follows. The amount of the recovery of the loss is limited to the carrying amount that would result if the impairment had not occurred. For example, the carrying amount of Tan\'s equipment at the end of 2020 would be \$100,000, assuming no impairment. The \$6,000 recovery is therefore permitted because Tan\'s carrying amount on the equipment is now only \$96,000. However, any recovery above \$10,000 is not permitted. The reason is that any recovery above \$10,000 results in Tan carrying the asset at a value above its historical cost.