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FOUNDATION EXAM FINANCIAL ACCOUNTING AND REPORTING  STUDY GUIDE Foundation exam Financial Accounting and Reporting  FINANCIAL ACCOUNTING AND REPORTING | iii...

FOUNDATION EXAM FINANCIAL ACCOUNTING AND REPORTING  STUDY GUIDE Foundation exam Financial Accounting and Reporting  FINANCIAL ACCOUNTING AND REPORTING | iii Ninth edition 2019 First edition 2010 The publishers are grateful to the IASB for permission to reproduce extracts from the ISBN 9781 5097 2714 8 International Financial Reporting Standards including all International Accounting Previous ISBN 9781 5097 1531 2 Standards, SIC and IFRIC Interpretations (the Standards). The Standards together with their accompanying documents are issued by: Published by BPP Learning Media Ltd The International Accounting Standards Board (IASB) All rights reserved. No part of this publication may 30 Cannon Street, London, EC4M 6XH, be reproduced or transmitted in any form or by any United Kingdom. means or stored in any retrieval system, electronic, Email: [email protected] Web: www.ifrs.org mechanical, photocopying, recording or otherwise without the prior permission of the publisher. Disclaimer: The IASB, the International Financial Reporting Standards (IFRS) Foundation, the authors and the publishers The contents of this book are intended as a guide do not accept responsibility for any loss caused by acting or refraining from acting in and not professional advice. Although every effort reliance on the material in this publication, has been made to ensure that the contents of this whether such loss is caused by negligence or book are correct at the time of going to press, BPP otherwise to the maximum extent permitted Learning Media, the Editor and the Author make no by law. warranty that the information in this book is accurate or complete and accept no liability for any loss or Copyright © IFRS Foundation damage suffered by any person acting or refraining All rights reserved. Reproduction and use from acting as a result of the material in this book. rights are strictly limited. No part of this publication may be translated, reprinted or reproduced or utilised in any form either in Every effort has been made to contact the copyright whole or in part or by any electronic, holders of any material reproduced within this mechanical or other means, now known or publication. If any have been inadvertently hereafter invented, including photocopying overlooked, BPP Learning Media will be pleased to and recording, or in any information storage make the appropriate credits in any subsequent and retrieval system, without prior permission reprints or editions. in writing from the IFRS Foundation. Contact the IFRS Foundation for further details. We are grateful to CPA Australia for permission to The IFRS Foundation logo, the IASB logo, the IFRS for SMEs logo, the "Hexagon Device", reproduce the Learning Objectives, the copyright "IFRS Foundation", "eIFRS", "IAS", "IASB", of which is owned by CPA Australia. "IFRS for SMEs", "IASs", "IFRS", "IFRSs", "International Accounting Standards" and "International Financial Reporting Printed in Australia Standards", "IFRIC" "SIC" and "IFRS Taxonomy" are Trade Marks of the IFRS This is printed on FSC accredited stock by an Foundation. FSC accredited printer. Further details of the Trade Marks including details of countries where the Trade Marks © are registered or applied for are available from the Licensor on BPP Learning Media Ltd 2019 request. iv | INTRODUCTION CONTENTS Page INTRODUCTION Foundation exams v Module features vi Preparing for your foundation exam viii Module summary x Learning objectives xii MODULES 1 The financial reporting environment 1 2 The accounting theory 99 3 Financial statements 149 4 Application of specific accounting standards 195 5 Business combinations 279 6 Analysis of financial statements 363 Revision questions 407 Answers to revision questions 433 Before you begin questions: Answers and commentary 447 Glossary of terms 465 Formulae 475 Index 479  FINANCIAL ACCOUNTING AND REPORTING | v FOUNDATION EXAMS International Education Standards CPA Australia is a member of the International Federation of Accountants (IFAC). All foundation exam education materials are developed in line with IFAC's International Education Standards. These standards provide guidance in establishing the content of professional accounting education programs together with the associated assessment. The standards also assist in developing the required passing standard for accounting education and competence of a professional accountant. The foundation exams provide you with the opportunity to demonstrate your competence in areas required for Associate membership of CPA Australia. By demonstrating this entry level knowledge you will be well positioned to succeed at the CPA Program and ultimately attaining the CPA designation. YOU AND YOUR STUDY PLAN This Study guide is designed to give you an understanding of what to expect in your exam as well as covering the fundamentals that you need to know. Exams will be based on the contents of the current Study guide. You will need to check My Online Learning to confirm which version you should use based on your exam date. There are no specifically recommended hours of study. Each candidate brings their own level of experience and knowledge to the foundation exams. The number of study hours required is entirely dependent on your prior knowledge of the subject. You will need to develop your own study plan. Refer to Preparing for your foundation exam on page vii. ADDITIONAL LEARNING SUPPORT If you feel you have gaps in your knowledge after reviewing the Study guide, there is a range of optional additional support to assist in your exam preparation. Additional learning support caters for different learning styles and budgets. Please check the CPA Australia website for more information www.cpaaustralia.com.au/cpa- program/cpa-program-candidates/your-in-semester-support/learning-resources/foundation STANDARDS AND LEGISLATION The material in this Study guide has been prepared based upon selected standards from the IASB. Candidates are advised that they should use this Study guide as the primary resource for their studies as the standards are frequently updated. Exams are based on the learning objectives outlined within this Study guide. vi | INTRODUCTION MODULE FEATURES Each module contains a number of helpful features to guide you through each topic. Learning Show the referenced CPA Australia learning objectives. objectives Topic list Tells you what you will be studying in this module. Module outline Presents a general idea of what is covered in this module. Module summary Summarises the content of the module, helping to set the scene so that you diagram can understand the bigger picture. Before you begin A small bank of questions to test any pre-existing knowledge that you may have of the module content. If you get them all correct then you may be able to reduce the time you need to spend on the particular module. There is a commentary section at the end of the Study guide called Before you begin questions: Answers and commentary. Section overview Summarises the key content of the particular section that you are about to start. Learning objective Indicates the learning objective covered by the section or paragraph to reference which it relates. LO 1.2 Definition Definitions of important concepts. You really need to know and understand these before the exam. Exam comments Highlight points that are likely to be particularly important or relevant to the exam. (Please note that this feature does not apply in every foundation exam exam Study guide.) Worked Example An illustration of a particular technique or concept with a solution or explanation provided. Question A question that enables you to practise a technique or test your understanding. You will find the solution at the end of the module. Key module points Reviews the key areas covered in the module.  FINANCIAL ACCOUNTING AND REPORTING | vii Quick revision A quick test of your knowledge of the main topics in this module. questions The quick revision questions are not a representation of the difficulty or style of questions which will be in the exam. They provide you with an opportunity to revise and assess your knowledge of the key concepts covered in the materials so far. They are not a practice exam, but rather a means to reflect on key concepts and not as the sole revision for the exam. Revision questions The revision questions are not a representation of the difficulty or style of questions which will be in the exam. They provide you with an opportunity to revise and assess your knowledge of the key concepts covered in the materials so far. They are not a practice exam, but rather a means to reflect on key concepts and not as the sole revision for the exam. Case study A practical example or illustration, usually involving a real world scenario. Formula to learn Formulae or equations that you need to learn as you may need to apply them in the exam. Bold text Throughout the Study guide you will see that some of the text is in bold type. This is to add emphasis and to help you to grasp the key elements within a sentence and paragraph. viii | INTRODUCTION PREPARING FOR YOUR FOUNDATION EXAM STUDY PLAN  Review all the learning objectives thoroughly. Use the weightings provided in the learning objectives table (see Learning Objectives section) to develop a study plan to ensure you provide yourself with enough time to revise each learning objective.  Don't leave your study to the last minute. You may need more time to explore learning objectives in greater detail than initially expected.  Be confident that you understand each learning objective. If you find that you are still unsure after reading the Study guide, seek additional information from other resources such as text books, supplementary learning materials or tuition providers. STUDY TECHNIQUES  In addition to being able to complete the revision and self-assessment questions in the Study guide, ensure you can apply the concepts of the learning objectives rather than just memorising responses.  Some exams have formulae and discount tables available to candidates throughout the exams. My Online Learning lists the tools available for each exam. Also see Computer-based exam navigation section.  Check My Online Learning on a weekly basis to keep track of announcements or updates to the Study guide. TIPS FOR EXAMS  Plan to arrive at the exam centre at least 15 minutes before your exam. Allow for possible delays with public transport or traffic.  You have three hours and fifteen minutes to complete the exam. As soon as you commence the exam your exam clock in the top right hand corner of the screen begins to count down. Watch your time carefully. ANSWERING MULTIPLE CHOICE QUESTIONS Foundation exams are a series of 100 multiple choice questions. Each question will contain four possible options. Step 1 Attempt every question. Read the question thoroughly. You may prefer to work out the answer before looking at the options, or you may prefer to look at the options at the beginning. Adopt the method that works best for you. Step 2 Read the four options and see if one matches your own answer. Be careful with numerical questions, as some options are designed to match answers that incorporate common errors. Check that your calculation is correct. Have you followed the requirement exactly? Have you included every step of the calculation? Step 3 You may find that none of the options matches your answer.  Re-read the question to ensure that you understand it and are answering the requirement.  Eliminate any obviously wrong answers.  Consider which of the remaining answers is the most likely to be correct and select the option.  FINANCIAL ACCOUNTING AND REPORTING | ix Step 4 If you are still unsure, you can flag the question and continue to the next question. Some questions will take you longer to answer than others. Try to reduce the average time per question, to allow yourself to revisit problem questions at the end of the exam. Revisit unanswered questions. A review tool is available at the end of the exam, which allows you to Review Incomplete or Review Flagged questions. When you come back to a question after a break you often find you are able to answer it correctly straight away. You are not penalised for incorrect answers, so never leave a question unanswered! COMPUTER-BASED EXAM NAVIGATION Your computer-based exam has the following functions:  Navigation – You can select your answer by: clicking on the circle to the left of the option, or typing the letter corresponding to the option. – To move through the exam, you use the 'Next' or 'Previous' buttons on the bottom of the screen. The function of each button is selected by your mouse, or with a combination of keyboard keys. For example, you can select the 'Next' button by clicking it with the mouse, or by typing ALT + N. – The 'Next' button moves you from one screen to the next screen. If you wish to go back and view the screen you just viewed, click the 'Previous' button or type ALT + P. – There is also a 'Navigator' button on the bottom of the screen which allows you to click ahead to any question in the exam. This button can be accessed using your mouse or ALT + V. 'Navigator' allows you to see a list of all questions and their status including 'Incomplete'/'Complete' and 'Unseen'. Any questions you have flagged for review will also be shown in this view.  Formulae – A 'Formulae' button is included in the computer-based exam for this subject. – The 'Formulae' button allows you to view the formulae provided in this Study guide (see Formulae section). – The 'Formulae' button is located at the bottom of the screen, to the left of the 'Navigator' button.  Select for review – There is a flag in the upper right corner of your exam screen labelled 'Flag for Review'. Alternatively you can use ALT + F to flag a question. You mark an exam question to review at a later time by clicking on this flag. The flag will appear filled-in once it is selected. You may mark any exam question for later review, whether you select an answer or not.  Review screen – After finishing the last exam question, you will see a review screen. This lists every exam question. If you clicked the 'Flag for Review' flag on a question screen, that question appears on the Review screen marked with the flag filled in. – If you skipped any exam questions, these will be labelled as 'Incomplete' even if you did not select them for review. – From the Review screen you can choose to: 1. review all of the questions in the exam by clicking 'Review All'; 2. individually select questions for review (click on the question number) or choose more questions for review (click on the flags corresponding to the questions); 3. review all questions marked as incomplete by clicking 'Review Incomplete'; 4. begin reviewing the selected review questions by clicking 'Review Flagged'; or 5. exit by clicking 'End Review' – this will also end your exam. x | INTRODUCTION MODULE SUMMARY This summary provides a snapshot of each of the modules, to help you to put the syllabus as a whole and the Study guide itself into perspective. Modules 1 and 2 mainly focus on the accounting concepts and principles and theories that are relevant to financial accounting and reporting. Modules 3, 4 and 5 then cover the actual preparation and presentation of financial statements for limited liability companies, both single companies and groups of companies, with Module 4 focusing particularly on the application of specific accounting standards. Finally, Module 6 covers the analysis and interpretation of financial statements. MODULE 1 – THE FINANCIAL REPORTING ENVIRONMENT In this module we will begin by considering the purpose of financial reporting and in particular who the financial statements are prepared for – the users of financial statements – and their information needs. We will also consider the regulatory framework within which international accounting standards are prepared and how this contributes to international GAAP. The IASB's Conceptual Framework for Financial Reporting sets out and explains the concepts and principles on which, in theory, IFRSs are based. We look at the advantages and disadvantages of using a conceptual framework and also at the objectives of general purpose financial reports: financial statements prepared for users external to a business. We also consider accounting policies: the specific principles and conventions that an entity adopts in preparing and presenting financial statements. This module also explains the concepts that underlie the preparation of financial statements and the qualities that financial information must have if it is to be useful to the users of financial statements. This module ends with a consideration of the elements of financial statements as set out in the IASB's Conceptual Framework – these are assets, liabilities, equity, income and expenses. You will learn the recognition criteria for each of these elements. MODULE 2 – THE ACCOUNTING THEORY The most common measure of asset/liability valuation is historical cost. However, in this module you will learn how to identify, explain and calculate other methods of measurement bases. You will also consider alternative methods of measuring capital and how this ties in with asset/liability valuation. In a company the shareholders are the owners, but the company is managed by the directors. The directors are agents of the shareholders, therefore you will consider what is meant by agency theory. You will also look at the various types of information within a company's annual report and financial statements that are available to shareholders and other users. Some of this information helps the shareholders to assess the performance of the company and of its directors. MODULE 3 – FINANCIAL STATEMENTS In this module we begin by looking at the overall format and content of company financial statements as set out in IAS 1 (revised) Presentation of Financial Statements. The module covers the statement of profit or loss and other comprehensive income, the statement of financial position and the statement of cash flows (IAS 7 Statement of Cash Flows). MODULE 4 – APPLICATION OF SPECIFIC ACCOUNTING STANDARDS In this module, we consider in detail the application of specific accounting standards, in particular the accounting treatment of intangible non-current assets in general and research and development costs, as well as the accounting treatment in situations where assets (tangible or intangible), fall in value. The module moves on to the topical areas of revenue recognition and accounting for current  FINANCIAL ACCOUNTING AND REPORTING | xi tax and deferred tax. The module then covers foreign currency accounting. There are two main aspects to dealing with foreign exchange – firstly, many companies will buy or sell goods from or to another country and in a foreign currency. These transactions in the foreign currency must be translated before they can be included in the financial records. The second aspect is that groups may include a foreign subsidiary and before the subsidiary's results can be included in the group financial statements the subsidiary's own financial statements must be translated. The module ends with the accounting of leases under IFRS 16. MODULE 5 – BUSINESS COMBINATIONS This detailed module will be looking at the techniques for preparing group financial statements or consolidated financial statements. It begins with a consideration of the major definitions and principles of consolidation which are vital to your understanding of the subject. Next we will study the basic procedures for producing a consolidated statement of financial position. Plenty of question practice is required but if you understand the basic steps and workings at this stage then your further studies of consolidated financial statements will become much easier. We move on to covering the preparation of the consolidated statement of profit or loss. This module ends with an examination of the accounting treatment of associated companies – the equity method of accounting. MODULE 6 – ANALYSIS OF FINANCIAL STATEMENTS In this module we consider the interpretation of financial statements by looking at the calculation of a number of different ratios and more importantly how these ratios can be used to analyse and interpret the financial statements. We shall also consider the limitations of financial analysis. xii | INTRODUCTION LEARNING OBJECTIVES CPA Australia's learning objectives for this Study guide are set out below. They are cross-referenced to the module in the Study guide where they are covered. GENERAL OVERVIEW This exam covers an understanding of the format and function of financial statements, including analysis and interpretation of financial statements. It also includes the production of financial statements for consolidated company groups, and foreign currency translation. This exam covers a critical awareness of accounting issues in an international context. It requires an understanding of the theoretical concepts within the regulatory and conceptual framework of corporate reporting. This includes recognition criteria, methods of valuation, and reporting and disclosure of the financial performance of companies. These are the Learning Objectives that will be covered in the exam. Module Learning Objectives (LO) Weighting Module 1 The LO1.1 Describe the regulatory environment for financial 25% financial reporting in Australia and the reasons for accounting and reporting reporting requirements. environment LO1.2 Discuss the main types of business entity and explain the reasons for selecting each structure. LO1.3 Identify different types of accounting regulation, including laws, Generally Accepted Accounting Principles and International Financial Reporting Standards. LO1.4 Explain how the requirements from users, together with social and environmental developments, impact the underlying principles and requirements of financial reporting and the desire to establish a single set of international accounting standards. LO1.5 Describe the role of the International Accounting Standards Board in developing a regulatory framework and explain how new policies and standards are established. LO1.6 Identify the purpose of a conceptual framework and the key characteristics in the Generally Accepted Accounting Principles (GAAP) and apply this knowledge to define and recognise the different elements of the financial statements. LO1.7 Describe and demonstrate the role of accounting standards and accounting policies in fairly presenting the financial performance and financial position of an entity.  FINANCIAL ACCOUNTING AND REPORTING | xiii Module Learning Objectives (LO) Weighting Module 2 The LO2.1 Compare historical cost accounting with other methods of 15% accounting valuation and explain the differences. theory LO2.2 Explain agency and contracting theories and how they relate to accounting policy choice (positive accounting theory). LO2.3 Apply the recognition criteria for the elements of the financial statements according to the conceptual framework (normative theory). Module 3 LO3.1 Prepare and present the statement of profit or loss and 15% Financial other comprehensive income with appropriate disclosure statements in accordance with relevant accounting standards and policies. LO3.2 Prepare and present the statement of financial position with appropriate disclosure in accordance with relevant accounting standards and policies. LO3.3 Prepare and present the statement of cash flows in accordance with relevant accounting standards and policies. LO3.4 Demonstrate the ability to detect, investigate and correct discrepancies or particular items/events while matching the financial statements to supporting documentation. Module 4 LO4.1 Calculate the carrying amounts of different classes of 22% Application intangible assets and prepare the relevant journal entries. of specific LO4.2 Interpret contracts to determine the amount and timing of accounting revenue to be recognised in the financial statements and standards reconcile the differences between ledgers if necessary. LO4.3 Calculate current and deferred income tax and prepare the relevant journal entries to record the tax effect in the financial statements. LO4.4 Calculate and account for foreign currency transactions at transaction date and subsequent dates. LO4.5 Translate financial statements from a functional currency to a presentation currency. xiv | INTRODUCTION Module Learning Objectives (LO) Weighting Module 5 LO5.1 Discuss the accounting issues for various forms of business 13% Business combinations. combinations LO5.2 Explain how goodwill is measured and disclosed at the date of acquisition and prepare the relevant journal entries. LO5.3 Explain how goodwill is measured and impaired subsequent to acquisition and prepare the relevant journal entries. LO5.4 Discuss the concept of control and calculate the non- controlling interest share of equity. LO5.5 Prepare consolidated statements of financial position, including the entries for goodwill and non-controlling interests. LO5.6 Prepare consolidated statements of profit or loss and other comprehensive income, including the entries for non-controlling interests and intra-group transactions. Module 6 LO6.1 Calculate, analyse and interpret financial ratios and their 10% Analysis of interrelationship in the financial statements. financial LO6.2 Explain the limitations of financial statement analysis. statements  1 MODULE 1 THE FINANCIAL REPORTING ENVIRONMENT Learning objectives Reference Describe the regulatory environment for financial reporting in Australia and the reasons LO1.1 for accounting and reporting requirements Discuss the main types of business entity and explain the reasons for selecting each LO1.2 structure Identify different types of accounting regulation, including laws, Generally Accepted LO1.3 Accounting Principles and International Financial Reporting Standards Explain how the requirements from users, together with social and environmental LO1.4 developments, impact the underlying principles and requirements of financial reporting and the desire to establish a single set of international accounting standards Describe the role of the International Accounting Standards Board in developing a LO1.5 regulatory framework and explain how new policies and standards are established Identify the purpose of a conceptual framework and the key characteristics in the LO1.6 Generally Accepted Accounting Principles (GAAP) and apply this knowledge to define and recognise the different elements of the financial statements Describe and demonstrate the role of accounting standards and accounting policies in LO1.7 fairly presenting the financial performance and financial position of an entity Topic list 1 The purpose of accounting 2 Nature, principles and scope of financial reporting 3 Users' and shareholders' needs 4 The need for a regulatory framework 5 The IFRS Foundation and the IASB 6 Generally accepted accounting principles (GAAP) 7 Conceptual Framework 8 Accounting regulation 9 Accounting policies 10 IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors 2 | THE FINANCIAL REPORTING ENVIRONMENT Topic list 11 The role of accounting standards 12 Accounting standards and choice 13 Accounting concepts 14 Qualitative characteristics of financial information 15 Materiality in the context of financial reporting 16 International Financial Reporting Standards 17 Developments in international harmonisation 18 The elements of financial statements 19 Recognition and derecognition of the elements of financial statements 20 Applying the recognition criteria 21 The main financial statements  FINANCIAL ACCOUNTING AND REPORTING | 3 MODULE OUTLINE This module introduces some basic ideas about the need for financial information and the users of financial information. It also covers the definition of financial reporting. MODULE 1 We then move on to look at the different sources of accounting regulation. Accounting is regulated by local statute (such as company law), by stock exchange requirements and by accounting standards. We will focus in particular on the activities of the International Accounting Standards Board (IASB) which is responsible for setting International Financial Reporting Standards (IFRS). We will discuss the importance of IFRS in the global regulation of accounting and the process the IASB undertakes in issuing a new accounting standard. We move on to look at the IASB's Conceptual Framework for Financial Reporting (Conceptual Framework) which represents the theoretical framework upon which all IFRS are based. We also consider accounting policies: the specific principles and conventions that an entity adopts in preparing and presenting financial statements. IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors explains how an entity should select and apply accounting policies. We examine the role and purpose of accounting standards in the regulation of financial reporting. We will look at this in the context of accounting policies and achieving the aim of preparing useful financial information. We will also review some of the key accounting concepts that have to be considered when preparing financial statements and discuss the process of harmonisation of accounting standards on a global basis. We will examine the main elements of financial statements: assets, liabilities, equity, income and expenses. Finally, we will look at the financial statements where these items are recognised and examine the recognition criteria for each of the elements of the financial statements. 4 | THE FINANCIAL REPORTING ENVIRONMENT The module content is summarised in the diagrams below. The financial reporting environment Financial reporting involves Need for regulation: Accounting: process of producing financial statements recording, analysing and for users GAAP is a combination of: summarising transactions company law of a business and accounting standards communicating that stock exchange rules information to decision IFRSs makers Users have different needs: Management Shareholders Suppliers Regulation varies Customers amongst countries Reporting entity: depending on local context Lenders entity whose general and level of development purpose financial Authorities of the nation statements are relied Employees upon by users of Financial analysts and accounts advisers Public Benefits of regulation: Information prepared consistently Companies disclose A regulatory framework and more information than accounting standards help make they would if there was financial statements more useful no regulation to users IASB issues standards IASB objectives: To develop high quality, understandable and enforceable global accounting standards To bring about convergence of national standards and IFRS  FINANCIAL ACCOUNTING AND REPORTING | 5 The Conceptual Framework and accounting policies The IASB’s Conceptual The IASB's Conceptual Framework The use of judgment in Framework and GAAP are is the international conceptual accounting decisions: MODULE 1 theoretical principles that form framework. Accounting standards provide the frame of reference for Its purpose is to: guidance on dealing with financial reporting assist the IASB to develop IFRS that transactions are based on consistent concepts; If no standard exists, the assist preparers to develop accountant must use consistent accounting policies when judgement Benefits of framework: no IFRS applies to a particular Conceptual Framework is a Used as a basis for transaction or event or when an useful reference point in development of accounting IFRS allows a choice of accounting these situations standards policy; and Financial reporting based on assist all parties to understand and standardised principles interpret IFRS. Preparers apply the spirit and reasoning behind standards; Accounting policies: therefore harder to avoid Principles, bases, rules, compliance conventions and practices used in preparing financial Objective of general purpose statements financial reporting: Provide information that is Provide useful information to relevant and faithfully existing and potential investors, represents the underlying lenders and other creditors transactions IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors Accounting standards and concepts Role of accounting standards: Accounting concepts: International harmonisation: Set out accounting rules Going concern (underlying Aim to have one set of global companies must follow assumption) accounting standards Applying accounting standards Accruals Number of barriers, but many should give a fair presentation Substance over form advantages EU adopted IFRS from 2005 IASB and US FASB have carried out important joint Accounting standards and choice: projects to harmonise Standards reduce variations in Fundamental qualitative accounting standards methods of accounting characteristics of financial information: relevance and But may be faithful representation inflexible/inappropriate in some circumstances Enhancing qualitative characteristics of financial information: comparability; verifiability; timeliness; and understandability 6 | THE FINANCIAL REPORTING ENVIRONMENT Elements of financial statements and their recognition criteria Elements of financial Recognition criteria The main elements of financial statements The Conceptual Framework states reports The Conceptual Framework that an item of the financial The statement of financial defines: statements is recognised if it: position includes: assets – meets the definition of an – assets liabilities element; – liabilities equity – is relevant and will provide – equity income users of the financial The statement of profit or expenses statements with a faithful loss and other representation of the comprehensive income transactions of the entity includes: – income – expenses The financial reporting environment: Module summary diagrams  FINANCIAL ACCOUNTING AND REPORTING | 7 BEFORE YOU BEGIN If you have studied these topics before, you may wonder whether you need to study this module in full. If this is the case, please attempt the questions below, which cover some of the key subjects in the area. MODULE 1 If you answer all these questions successfully, you probably have a reasonably detailed knowledge of the subject matter, but you should still skim through the module to ensure that you are familiar with everything covered. Please note, the Conceptual Framework was revised in March 2018, therefore if you studied this topic previously it is likely that your knowledge may be based on the previous Conceptual Framework, if this is the case please review this section of the module carefully. There are references in brackets indicating where in the module you can find the information, and you will also find a commentary at the back of the Study guide. 1 Identify three differences between financial and management accounts. (Sections 1.2 and 1.3) 2 What is the purpose of financial reporting? (Section 2.1) 3 Who are the main user groups of financial statements, and why are they interested in financial information? (Section 3.2) 4 What is GAAP? (Section 4.2) 5 Which of the following is not an advantages of accounting regulation? A Increased public confidence in financial statements B Enhanced comparability between financial statements C The development of rules which are applicable to all entities D The disclosure of more useful information than if there were no regulations (Section 4.3) 6 What is the IASB and what are its objectives? (Sections 5.1 to 5.3) 7 What is the IFRS Advisory Council and what is its purpose? (Section 5.4) 8 What is the IFRS Interpretations Committee and what is its purpose? (Section 5.4) 9 What is a conceptual framework? (Section 7) 10 What are the problems associated with not having a conceptual framework? (Section 7.1.2) 11 Which of the following is not an objective of the IASB's Conceptual Framework? A To assist in the understanding and interpretation of the Standards B To assist in the development of new IFRS on a consistent basis C To assist auditors in forming their opinion D To assist preparers to develop consistent accounting policies when a standard allows a choice of policy (Section 7.1.2) 12 What is the objective of general purpose financial reporting according to the IASB's Conceptual Framework? (Section 7.3) 13 What is a reporting entity? (Section 7.4) 14 What are accounting policies? (Section 9) 15 How is a change in accounting policy accounted for? (Section 10.3) 16 How is a change in accounting estimate accounted for? (Section 10.4) 17 What is the underlying assumption in preparing financial statements according to the Conceptual Framework? (Section 13.1) 18 Explain the concept of 'substance over form' and provide an example of its application. (Section 13.3) 19 What are the two fundamental qualitative characteristics and the four enhancing qualitative characteristics of financial statements identified by the Conceptual Framework? (Section 14) 20 What makes financial information relevant? (Section 14.1) 8 | THE FINANCIAL REPORTING ENVIRONMENT 21 Identify three barriers to the global harmonisation of accounting standards. (Section 17.2) 22 Define an asset. (Section 18.3) 23 Define a liability. (Section 18.4) 24 Define equity. (Section 18.5) 25 What criteria must be met in order for an item to be recognised in the financial statements? (Section 19) 26 Which of the following statements is correct? A All assets and liabilities must always be presented in order of liquidity. B A liability is always classified as non-current where the amount due is to be settled in more than 12 months. C A liability only occurs if there is a probability of a future cash outflow. D An asset occurs when an economic resource has the potential to produce economic benefits even if those benefits are not likely. (Section 21.1)  FINANCIAL ACCOUNTING AND REPORTING | 9 1 THE PURPOSE OF ACCOUNTING LO 1.2 Section overview  Accounting is the process of recording, analysing and summarising transactions of an entity MODULE 1 and communicating that information to decision makers.  A business is an entity which exists to make a profit.  There are three main types of business entity: sole traders, partnerships and limited liability companies.  Not-for-profit entities such as charities, clubs and government entities may also prepare accounts. 1.1 WHAT IS ACCOUNTING? You may have a wide understanding of what accounting and financial reporting is. Your job may be in one area or type of accounting, but you must understand the breadth of work which an accountant undertakes. In particular, you need to understand the distinction between financial accounting and management accounting. Definition Accounting is the process of recording, analysing and summarising transactions of a business and communicating that information to decision makers. Renaissance scholar Luca Pacioli wrote the first printed explanation of double-entry bookkeeping in 1494. Double-entry bookkeeping involves entering every transaction as a debit in one account and a corresponding credit in another account, and ensuring that they balance. Pacioli's description of the method was widely influential. The first English book on the subject was written in 1543 by John Gouge. The practice of double-entry bookkeeping has barely changed since then and is standard across the world, based upon the concept that every transaction has a dual effect expressed as debits equals credits. The original role of the accounting function was to record financial information and this is still its main focus. Why do businesses need to produce accounts? If a business is being run efficiently, why should it have to go through all the bother of accounting procedures in order to produce financial information? A business needs to produce information about its activities because there are various groups of people who want or need to know that information. Later in this module we will consider the different groups of users and the type of information that is of interest to the members of each group. 1.2 FINANCIAL ACCOUNTING Definition Financial accounting is a method of reporting the results and financial position of a business. It is not primarily concerned with providing information towards the more efficient running of the business. Although financial accounts are of interest to management, their principal function is to satisfy the information needs of persons not involved in running the business, in particular shareholders. Financial accounts provide historical information.  10 | THE FINANCIAL REPORTING ENVIRONMENT 1.3 MANAGEMENT ACCOUNTING The information needs of management go far beyond those of other account users. Managers have the responsibility of planning and controlling the resources of the business and for making decisions about the direction of the business both in the longer term and on a day to day basis. Therefore they need much more detailed information. They also need to plan for the future, for example, budgets, which predict future revenue and expenditure. Definition Management accounting, sometimes known as cost accounting, is a management information system which analyses data to provide information as a basis for managerial action. The concern of a management accountant is to present accounting information in the form most helpful to management. 1.4 WHAT IS A BUSINESS? Definition A business is an integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing a return in the form of dividends, lower costs or other economic benefits directly to investors or other owners, members or participants. Businesses of whatever size or nature exist to make a profit. There are a number of different ways of looking at a business. Some ideas are listed below.  A business is a commercial or industrial concern which exists to deal in the manufacture, re-sale or supply of goods and services.  A business is an organisation that uses economic resources to create goods or services which customers will buy.  A business is an organisation providing jobs for people.  A business invests money in resources for example, buildings, machinery, employees, in order to make even more money for its owners. This last definition introduces the important idea of profit. Businesses vary from very small businesses for example, the local shopkeeper or plumber, to very large ones for example, IKEA, Nestlé, Unilever. However all of them want to earn profits. Definition Profit is the excess of revenue (income) over expenses. When expenses exceed revenue, the business is running at a loss. One of the jobs of an accountant is to measure revenue and expenditure, and so profit. 1.5 TYPES OF BUSINESS ENTITY There are three main types of business entity:  Sole traders;  Partnerships; and  Limited liability companies. Sole traders are people who work for themselves. Examples may include the local shopkeeper, a plumber and a hairdresser. The term sole trader refers to the ownership of the business – sole traders can have employees.  FINANCIAL ACCOUNTING AND REPORTING | 11 Partnerships occur when two or more people decide to run a business together. Examples may include an accountancy practice, a medical practice and a legal practice. Limited liability companies are incorporated to take advantage of 'limited liability' for their owners (shareholders). This means that, unlike sole traders and partners, who are personally responsible for the amounts owed by their business, the shareholders of a limited liability company are only responsible for the amount unpaid on their shares. This means that if the shareholders have MODULE 1 purchased shares costing $100 but have only paid $40 to date, they would have to contribute the remaining $60 towards paying the company's debts. Generally, in law sole traders and partnerships are not separate entities from their owners. This is true in many jurisdictions, for example, Australia, the UK, India, New Zealand, China, Japan and Germany. In the US, however, partnerships do have separate legal personality but the partners are wholly liable for debts of the partnership. In all cases, however, a limited liability company is legally a separate entity from its owners and it can issue contracts in the company's name. For accounting purposes, all three entities are treated as separate from their owners. This is called the business entity concept. The methods of accounting used in all three types of business entities will be very similar, although will tend to become more complex the larger the entity. 1.5.1 NOT-FOR-PROFIT ENTITIES It is not only businesses that need to prepare financial statements. Charities and clubs, for example, may need to prepare financial statements every year. Financial statements also need to be prepared for government organisations (public sector organisations such as hospitals and local councils). 2 NATURE, PRINCIPLES AND SCOPE OF FINANCIAL REPORTING LO 1.1 Section overview  Financial reporting is the process of classifying, recording and presenting financial data in accordance with generally established concepts and principles. 2.1 WHAT IS FINANCIAL REPORTING? Financial data is the name given to the record of actual transactions carried out by a business for example, sales of goods, purchases of goods, payment of expenses. These transactions are analysed according to type, recorded in ledger accounts and summarised in the financial statements. Financial reporting is the process of reporting the results and financial position of an entity. Although financial accounts are of interest to management, their principal function is to provide historical information in order to satisfy the information needs of external users such as shareholders. Financial accounting is not primarily concerned with providing information towards the more efficient running of the business – this is the function of a separate branch of accounting, known as 'management accounting'. 2.2 GENERAL PURPOSE FINANCIAL REPORTING The Conceptual Framework (and company law in some countries) prescribe that a company should produce financial information about the reporting entity's assets, liabilities, equity, income and expenses that is useful to users of financial statements in assessing the prospects for future net cash inflows to the reporting entity and in assessing management's stewardship of the entity's economic resources (Conceptual Framework para.3.2). Accounts must normally be presented at least annually, and there are usually detailed regulations on what they must contain and the form they must take. For example, in Australia, the form and content of company financial statements is regulated by the Corporations Act 2001 and by Australian  12 | THE FINANCIAL REPORTING ENVIRONMENT Accounting Standards. The Australian Accounting Standards Board adopted the IFRSs for Australian entities required to report under the Corporations Act 2001 (Cwlth) (Corporations Act) for annual reporting periods beginning on or after 1 January 2005. Large listed companies (sometimes known as public companies) are required to publish their annual financial statements. A listed company is a company whose shares or debt instruments are publicly traded on a stock exchange. Published financial statements may be printed or made available on the company's website. In some countries, for example, the UK, all limited companies must 'publish' their annual accounts by filing them with the Registrar of Companies. They are then available to members of the public. These 'published' annual financial statements are general purpose financial statements or general purpose financial reports. In this module, the terms 'financial reports' and 'financial reporting' refer to general purpose financial reports and general purpose financial reporting unless otherwise noted. General purpose financial statements such as the statement of profit or loss and other comprehensive income, statement of financial position, statement of changes in equity, and the statement of cash flows and the notes make up the body of general purpose financial reports that are prepared for external users. They contain information which may be useful to a wide range of users external to the company. They are distinct from non-general purpose financial statements, commonly known as special purpose financial reports which are prepared for a particular group of users and for a particular purpose. Financial report prepared for the use of tax computations, bank reporting and for fulfilment of members reporting responsibilities are some examples of special purpose financial reports. Some users of financial statements are able to obtain additional information. For example, owners or lenders may be able to request forecasts and budgets and members of the public have access to information in the financial press or on the internet. However, generally, most external users have to rely on the annual financial statements as their major source of financial information. Financial statements do not include directors' reports, statements by the chairman, management commentaries or environmental and social reports, although these may be included in the published annual report of a large listed company (see Module 2). 2.3 LIMITATIONS OF FINANCIAL REPORTING General purpose financial statements cannot possibly provide all the information that external users might need about a company or business. Users may also need to consider information from other sources, such as general economic conditions, the political situation and conditions in the industry in which the business operates. There are other inherent limitations of the financial accounting and reporting process.  Financial statements are based on estimates and judgments. For example, management must estimate the useful lives of assets and the likelihood that amounts receivable will actually be received. Preparing financial statements and reports involves classifying and aggregating (adding together) information about transactions and other events. It also involves allocating the effects of continuous business transactions over separate accounting periods.  Financial statements are based on historical information. They do not reflect future events or transactions that may affect the business and the way that it operates. Users of the financial statements normally need to predict how well a business will perform in future and to understand the factors which may affect its future performance.  Financial statements largely record only the financial effects of transactions and events. For example, intangible assets such as the technical expertise of the workforce may have a very significant effect on a company's performance. However, these 'assets' are not recognised because they cannot be reliably valued at a monetary amount. Financial statements do not include non-financial information such as discussion of the risks and uncertainties that a business faces, or a description of its effect on the natural environment.  FINANCIAL ACCOUNTING AND REPORTING | 13 Question 1: Financial reporting Financial reporting means the financial statements produced only by a large listed company. Is this statement correct? A Yes B No MODULE 1 (The answer is at the end of the module.) 3 USERS' AND SHAREHOLDERS' NEEDS LO 1.4 Section overview  There are various groups of people who need information about the activities of a business. 3.1 THE NEED FOR FINANCIAL STATEMENTS The purpose of financial statements is to provide useful information about the financial position, performance and changes in financial position of an entity to a wide range of users. Users need this information for two reasons: 1. To make economic decisions; and 2. To assess the stewardship of management. 3.1.1 MAKING ECONOMIC DECISIONS The types of economic decisions for which financial statements are likely to be used include the following:  Decisions to buy, hold or sell equity investments;  Assessment of management stewardship and accountability;  Assessment of the entity's ability to pay employees;  Assessment of the security of amounts lent to the entity;  Determination of taxation policies;  Determination of distributable profits and dividends;  Inclusion in national income statistics; and  Regulation of the activities of entities. 3.1.2 STEWARDSHIP Stewardship is relevant where an organisation is managed by people other than its owners. For example, the owners of a listed company appoint directors to run the company on their behalf, who are then accountable for the company's resources. They must use these resources efficiently and effectively to produce profits or other benefits for the owners. Owners need to be able to assess the performance of the directors so that they can decide whether to reappoint them or remove them and how much they should be paid. 3.2 USERS OF FINANCIAL STATEMENTS AND ACCOUNTING INFORMATION A business should produce information about its activities because there are various groups of people who want or need to know that information. Large businesses are of interest to a greater variety of people and so we will consider the case of a listed company, whose shares can be purchased and sold on a stock exchange.  14 | THE FINANCIAL REPORTING ENVIRONMENT The following people are likely to be interested in financial information about a company with listed shares.  Managers of the company appointed by the company's owners to supervise the day-to-day activities of the company. They need information about the company's financial situation as it is currently and as it is expected to be in the future. This is to enable them to manage the business efficiently and to make effective decisions.  Shareholders of the company, that is, the company's owners, want to assess how well the management is performing. They want to know how profitable the company's operations are and how much profit they can afford to withdraw from the business for their own use.  Trade contacts include suppliers who provide goods to the company on credit and customers who purchase the goods or services provided by the company. Suppliers want to know about the company's ability to pay its debts; customers need to know that the company is a secure source of supply and is in no danger of having to close down.  Providers of finance to the company might include a bank which allows the company to operate an overdraft, or provides longer-term finance by granting a loan. The bank wants to ensure that the company is able to keep up interest payments, and eventually to repay the amounts advanced.  The taxation authorities want to know about business profits in order to assess the tax payable by the company, including sales taxes, for example, Goods and Services Tax or Value Added Tax.  Employees of the company should have a right to information about the company's financial situation, because their future careers and the size of their wages and salaries depend on it.  Financial analysts and advisers need information for their clients or audience. As examples, stockbrokers need information to advise investors; credit agencies want information to advise potential suppliers of goods to the company; and journalists need information for their reading public.  Government and their agencies are interested in the allocation of resources and therefore in the activities of business entities. They also require information in order to provide a basis for national statistics.  The public. Companies affect members of the public in a variety of ways. They may make a substantial contribution to a local economy by providing employment and using local suppliers. Another important factor is the effect of an entity on the environment as an example in relation to pollution. Accounting information is summarised in financial statements to satisfy the information needs of these different groups. These information needs will differ between each user group and not all will be equally satisfied. 3.3 NEEDS OF DIFFERENT USERS Managers of a business need the most information, to help them make their planning and control decisions. They clearly have 'special' access to information about the business, because they are able to demand whatever internally produced statements they require. When managers want a large amount of information about the costs and profitability of individual products, or different parts of their business, they can obtain it through a system of cost and management accounting rather than rely on the financial accounts. Shareholders, providers of finance and financial analysts and advisers need information that helps them to make decisions: whether to buy, hold or sell their investment in a business or whether to lend money to it. Unlike managers, these users are external to the business. Therefore they normally have to rely on the published financial statements to provide them with the information that they need. For this reason, in most developed countries, including Australia, published financial statements are primarily prepared to meet the information needs of existing and potential investors and lenders and their advisors.  FINANCIAL ACCOUNTING AND REPORTING | 15 Question 2: Information needs Which of the following items in the financial statements of a company would be of particular interest to a customer? A Operating profit B Retained earnings C Dividend payments MODULE 1 D Directors' remuneration (The answer is at the end of the module.) 4 THE NEED FOR A REGULATORY FRAMEWORK LOs 1.1, 1.3 Section overview  The regulatory framework ensures that general purpose financial reporting produces relevant and reliable information and therefore meets the needs of shareholders, lenders and other users.  Generally accepted accounting principles (GAAP) signifies all the rules, from whatever source, that govern accounting. GAAP includes accounting standards (IFRS and national standards), national company law, and local stock exchange requirements.  Regulation of companies and their published financial information can vary significantly in different countries throughout the world. 4.1 SUBJECT OUTLINE The regulatory framework consists of accounting rules and company law. These ensure that general purpose financial reporting provides useful information that meets the needs of shareholders, lenders and other users. The International Accounting Standards Board (IASB) develops and issues International Financial Reporting Standards (IFRS). As IFRS have no jurisdiction, and the IASB has no authority to impose accounting standards, individual countries draw up their own accounting regulations. In practice, national governments often adopt IFRS and then adapt them to operate together with local laws and regulations as necessary. 4.2 GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP) Generally accepted accounting principles (GAAP) signifies all the rules, from whatever source, which govern accounting. The concept is applicable globally. In individual countries GAAP is seen primarily as a combination of:  national company law;  national accounting standards; and  local stock exchange requirements. Although these sources are the basis for the GAAP of individual countries, the concept also includes sources such as:  IFRS; and  accounting requirements of other countries. In many countries, GAAP does not have any statutory or regulatory authority or definition. There are different views of GAAP in different countries. The IASB convergence program seeks to reduce these differences.  16 | THE FINANCIAL REPORTING ENVIRONMENT GAAP can be based on legislation and accounting standards that are either:  prescriptive/rules-based; or  principles-based. The US operates a prescriptive system, where standards are very detailed, attempting to cover all eventualities. Accounts which do not comply in all details are presumed to be misleading. This has the advantage of clear requirements which can be generally understood and it removes any element of judgment. In general, international financial reporting standards (IFRS) are principles-based. They do not specify all the details but seek to obtain adherence to the 'spirit' of the regulations. This leaves room for some element of professional judgment. It also makes it harder for entities to avoid applying a standard as the terms of reference are broader. (We will be discussing the differences between rules-based standards and principles-based standards in more detail later in this module.) 4.2.1 INDIVIDUAL JUDGMENT Financial statements are prepared on the basis of a number of fundamental accounting assumptions and conventions. Many figures in financial statements are derived from the application of judgment in putting these assumptions into practice. It is clear that different people exercising their judgment on the same facts can arrive at very different conclusions. Question 3: Judgment An accountancy training firm has an excellent reputation amongst students and employers. How would you value this? The firm may have relatively little in the form of tangible assets that you can touch, perhaps a building, desks and chairs. If you simply drew up a statement of financial position showing the cost of the assets owned, then the business would not seem to be worth much, yet its income earning potential might be high. This is true of many service organisations where the people are among the most valuable assets. Here judgment must be used in order to reach a valuation for the business, although one person's judgment may lead to a very different valuation from another person's. Required Can you think of any other areas where judgment would have to be used in preparing financial statements? (The answer is at the end of the module.) 4.3 ADVANTAGES AND DISADVANTAGES OF REGULATION The key benefit of accounting regulation is that it requires organisations to prepare financial statements on a consistent basis. This is useful for the users of financial statements that were identified earlier in this module. For example, an investor wishing to purchase shares in a company is able to compare that company's performance with another, as their financial statements should have been prepared on the same basis. Other advantages of regulation include the following:  The existence of accounting rules reduces variations in the way financial statements are prepared. Without regulation it would be possible for preparers to adopt whatever accounting treatments they choose and to vary these from year to year in order to present the company's profit figure and net assets in as favourable a light as possible. In addition, transactions and businesses have become increasingly complex. There are many legitimate ways to present, measure and disclose items such as complex financial instruments, but the accounting treatment of these items needs to be comparable between different entities and over time.  FINANCIAL ACCOUNTING AND REPORTING | 17  Regulation means there will be rules as to what should be disclosed which improves the quality of information produced. For example, IAS 1 Presentation of Financial Statements requires companies to disclose the accounting policies that they have followed, so that users can understand the judgments that preparers have made in arriving at the amounts in the financial statements. Financial statements must also include supporting notes which analyse and explain the main line items in the financial statements. Specific information that must be disclosed is set out in MODULE 1 accounting standards and (in some cases) companies legislation.  The existence of regulation is likely to ensure that companies disclose more information about their business activities and financial results than they may have done in the absence of such regulation. There is an argument that companies resist disclosing information unless they are required to do so. There are costs associated with providing financial information. Without regulation, management is likely to be unwilling to deliver 'bad news' to investors, or to provide information that could be used by competitors.  Regulation of companies listed on stock exchanges means there are strict requirements in terms of reporting and disclosure and this is likely to protect investors. In many countries, such as Australia, the US and the UK, systems of accounting regulation were originally developed as a response to high-profile company failures and frauds in which many investors lost their savings.  A strong system of regulation will increase public confidence in the published financial statements of companies. This is particularly important since there have recently been a number of high profile corporate failures contributed to by inappropriate accounting.  Some users of financial statements (for example, major corporate investors and lenders) have the power to demand the information that they need. Other users (for example, small investors and individual members of the public) have not. Regulation protects those less powerful individuals and organisations and can therefore be seen as a social good. Disadvantages of regulation include the following:  Strict regulation could mean a lack of flexibility for some businesses. Sometimes companies have differing business environments. These companies may have to adopt accounting treatments that do not properly reflect their financial performance and position and actually lessen the quality of the information that they provide. In this situation, it may be impossible for users to make meaningful comparisons between companies.  Companies may incur high costs in complying with the regulatory rules. The cost of providing the information required may outweigh the benefits of that information. This is particularly relevant where small companies have to comply with either US regulations or the full set of International Accounting Standards (known as 'full IFRS'). Both the US and 'full IFRS' systems were designed primarily to meet the accounting needs of multinational organisations and to protect large institutional investors in those organisations. They therefore include standards on topics such as financial instruments, earnings per share, operating segment disclosure and share-based payment transactions, which are, in most cases, not relevant to smaller entities. The IASB has now developed a special standard for small and medium entities (the IFRS for SMEs) as an alternative to 'full IFRS'. This standard omits certain topics and simplifies others in order to lessen the regulatory burden on smaller entities.  Detailed rules and regulations may mean that companies spend a great deal of time 'box-ticking' without considering the spirit of the regulation they are complying with. Information is provided because it is required, even though it is of little value. The problem can be particularly acute where preparers are required to make specific narrative disclosures, for example, about corporate governance or future prospects for the business. Users frequently complain about 'boiler plate' disclosures: general statements that could apply to any company and tell the reader nothing.  Regulation leads to financial statements that contain too much information and this can obscure the overall picture that they present. The length and volume of company annual reports is steadily growing as the result of new accounting requirements. Many commentators believe that published financial statements have become too complex for anybody other than a financial reporting expert to understand.  18 | THE FINANCIAL REPORTING ENVIRONMENT Question 4: Creative accounting Creative accounting is the name given to accounting treatments which comply with all applicable accounting regulations but which have been deliberately manipulated to give a biased impression of a company's performance or financial position. From the 1990s onwards, new or improved accounting standards were developed to prevent most of these practices. Required Briefly describe two possible methods of 'creative accounting'. (The answer is at the end of the module.) 4.4 VARIATIONS IN REGULATORY REGIMES Regulation of companies and their published financial information can vary significantly in different countries throughout the world. There are many reasons for these differences. In some cases it is due to differences in company structures, local culture and ownership patterns of companies. 4.4.1 COMPANY STRUCTURE AND OWNERSHIP A country where the majority of companies are family owned with few, if any, external shareholders outside the family will need far less regulation than a country which is dominated by large multinational corporations with large numbers of shareholders, who have no connection to the business. Much of the regulation in the latter case would be to ensure that companies are acting in the best interests of shareholders. In many family companies, the shareholders and directors are the same family members, so they will already be acting in the best interests of the shareholders and will be concerned about the long-term future of the business. 4.4.2 LEVEL OF DEVELOPMENT The level of development of a nation also has an impact on its level of regulation. Developing countries are further behind in the process of setting standards and establishing regulatory regimes than industrialised nations. East Timor, a tiny nation in both territory and population, was officially accepted into the United Nations as a sovereign state in 2002 after a long-running battle for independence from Indonesia. A poor nation, it is establishing systems for long-term political and economic stability but is still struggling with the problems facing many developing nations. It is party to international conventions and standards (including IFRS), but lags behind in implementation. Cambodia is another example of a Southeast Asian developing nation where conflict and resulting economic instability means it is still 'catching up' with more industrialised nations in terms of regulation adoption and implementation. Fiji, one of the largest and economically strongest Pacific island nations, was suspended from both the Pacific Island Forum and the Commonwealth of Nations during 2009, with both suspensions currently remaining in force. Fiji's political upheaval means standard-setting and regulation is of low importance. 4.4.3 DIFFERENT PURPOSES OF FINANCIAL REPORTING In some countries the purpose of preparing financial statements is solely for tax assessment, and therefore the accounting rules are often the same as the tax rules. In other countries, financial statements exist to provide information for investor decision-making. This will have an impact on the type of regulatory system in place. 4.4.4 DIFFERENT USER GROUPS Countries have different ideas about who the relevant user groups are and their respective importance. User groups may include financiers, management, investors, creditors, customers, employees, the government and the general public. In some countries investor and creditor groups are given prominence, while in others employees enjoy a higher profile.  FINANCIAL ACCOUNTING AND REPORTING | 19 5 THE IFRS FOUNDATION AND THE IASB LOs 1.1, 1.4, Section overview 1.5  The International regulatory framework consists of the following: MODULE 1 – The International Financial Reporting Standards Foundation (IFRS Foundation); – The International Accounting Standards Board (IASB); – The International Financial Reporting Standards Advisory Council; and – The International Financial Reporting Standards Interpretations Committee.  IFRS are developed through a formal system of due process and broad international consultation involving accountants, financial analysts and other users and regulatory bodies from around the world. 5.1 SUBJECT OUTLINE The IFRS Foundation is an independent, not-for-profit private sector organisation working in the public interest. It was founded in March 2001 as the International Accounting Standards Committee (IASC) Foundation and is the parent entity of the IASB. The IFRS Foundation publishes and promotes IFRS. Its mission statement is 'to develop IFRS Standards that bring transparency, accountability and efficiency to financial markets around the world'. The governance and oversight of the IFRS Foundation and its standard-setting bodies rests with the Trustees. They are also responsible for promoting IFRS and securing the organisation's funding. The Trustees are appointed for a renewable term of three years and must have an understanding of the issues relevant to the setting and development of IFRS but are not involved in a technical capacity. Six of the Trustees must be selected from the Asia/Oceania region, six from Europe, six from North America, one from Africa, one from South America and two from the rest of the world. A Monitoring Board (established in 2009) provides a formal link between the Trustees and public capital market authorities. The Monitoring Board participates in the process for appointing Trustees and approves their appointment. It also advises the Trustees, who are required to report to it annually, and review their work. The Monitoring Board has six members drawn from the European Commission (EC), the International Organization of Securities Commissions (IOSCO), the US Securities and Exchange Commission (SEC) and other regulatory bodies. The International Accounting Standards Board is the standard-setting body and is an independent, privately-funded accounting standard setter based in London. It is a part of the International regulatory framework, reporting to the IFRS Foundation. From April 2001 the IASB assumed accounting standard setting responsibilities from its predecessor body, the International Accounting Standards Committee (IASC). The IASB has an important role to play in the regulation of financial information as it is responsible for issuing IFRS, which are then adopted for use in many different jurisdictions. Since 2001, almost 120 countries have required or permitted the use of IFRS in preparing financial information which makes the IASB the most important accounting body worldwide. Most of the remaining major economies, other than the US, have timelines in place for the move from national accounting standards to convergence with IFRS in the near future. 5.2 THE COMPOSITION OF THE IASB The IASB is an independent group of experts with recent relevant practical experience. Its members are selected so that there is a mix of auditors, preparers, users and academics. The 12 members of the IASB come from many different countries and have a diverse range of backgrounds. There are currently three members from the Asia/Oceania region; three members from Europe; two members from North America; one member from Africa; one member from South America; and two members appointed from any area, subject to maintaining overall geographical balance.  20 | THE FINANCIAL REPORTING ENVIRONMENT The IASB aims to be collaborative in its development of standards by engaging with the worldwide standard setting community as well as investors, regulators, business leaders and the global accountancy profession. 5.3 OBJECTIVES OF THE IFRS FOUNDATION AND THE IASB The formal objectives of the IFRS Foundation and IASB are as follows:  To develop, in the public interest, a single set of high quality, understandable, enforceable and globally accepted financial reporting standards based upon clearly articulated principles. These standards should require high quality, transparent and comparable information in financial statements and other financial reporting to help investors, other participants in the world's capital markets and other users of financial information to make economic decisions.  To promote the use and rigorous application of those standards.  To take account of the needs of a range of sizes and types of entities in diverse economic settings.  To promote and facilitate adoption of International Financial Reporting Standards (IFRS), being the standards and interpretations issued through the IASB, through the convergence of national accounting standards and IFRSs. 5.4 STRUCTURE OF THE IFRS FOUNDATION The structure of the IFRS Foundation has the following main features:  The IFRS Foundation oversees two main areas – the standard-setting process and the IFRS Advisory Council (previously known as the Standards Advisory Council).  The standard-setting process consists of two bodies, the IASB (as discussed above) and the IFRS Interpretations Committee. The IASB has the sole responsibility for setting international financial reporting standards.  The IFRS Interpretations Committee (previously known as the International Financial Reporting Interpretations Committee or IFRIC) comprises 14 voting members drawn from a variety of countries and professional backgrounds. The IFRS Interpretations Committee provides timely guidance on the application and interpretation of IFRS. It deals with newly identified financial reporting issues not specifically addressed in IFRS, or issues where unsatisfactory or conflicting interpretations have developed, or seem likely to develop.  The IFRS Advisory Council (previously the Standards Advisory Council) is the formal advisory body to the IASB and Trustees of the IFRS Foundation. It is comprised of a wide range of representatives from user groups, preparers, financial analysts, academics, auditors, regulators, professional accounting bodies and investor groups that are affected by and interested in the IASB's work. Members of the Advisory Council are appointed by the Trustees. It meets three times a year to advise the IASB on a range of issues including the IASB's agenda and work program.  FINANCIAL ACCOUNTING AND REPORTING | 21 The structure of the IFRS Foundation can be illustrated as follows: Monitoring Board of public capital market authorities appoints, monitors reports to MODULE 1 IFRS Foundation Trustees (Governance) oversee, review effectiveness, appoint inform informs appoint and finance IFRS Advisory Council Standard setting International Accounting Standards Board (IASB) (IFRS/IFRS for SMEs) provides strategic advice IFRS Interpretations Committee IFRS Foundation support operations Education Initiative, IFRS Taxonomy (XBRL), Content Services 5.5 THE STANDARD SETTING PROCESS IFRS are developed through a formal system of due process and broad international consultation involving accountants, financial analysts and other users and regulatory bodies from around the world. The process of developing an accounting standard has six stages as follows: Step 1 Setting the agenda. The IASB evaluates the merits of adding a potential item to its agenda mainly by reference to the needs of investors. The IASB considers:  the relevance to users of the information and the reliability of information that could be provided;  whether existing guidance is available;  the possibility of increasing convergence;  the quality of the standard to be developed; and  resource constraints. The IFRS Advisory Council and the IFRS Interpretations Committee, other standard-setters and other interested parties may have made comments on accounting issues that could become potential agenda items. Step 2 Planning the project. When adding an item to its work agenda, the IASB considers whether to conduct the project alone or jointly with another standard setter. A working group is usually formed at this stage and the project plan is developed. 22 | THE FINANCIAL REPORTING ENVIRONMENT Step 3 Developing and publishing the discussion paper. It is not mandatory for the IASB to issue a discussion paper in the development of a standard, but it is usual practice where there is a major new topic being developed and the IASB wish to set out their position and invite comments at an early stage in the process. Typically, a discussion paper includes:  a comprehensive overview of the issue;  possible approaches in addressing the issue;  the preliminary views of its authors or the IASB; and  an invitation to comment. Step 4 Developing and publishing the exposure draft. This is a mandatory step in the due process. Regardless of whether a discussion paper has been published, the exposure draft is the IASB's main means of consulting the public on the proposed standard. The exposure draft sets out the proposed standard in detail. The development of the exposure draft begins with the IASB considering the following:  issues on the basis of staff research and recommendations;  comments received on the discussion paper (if one was published); and  suggestions made by the IFRS Advisory Council, working groups, other standard-setters and public meetings where the proposed standard was discussed. Once the exposure draft has been published the IASB again invites comments. Step 5 Developing and publishing the standard. The development occurs at IASB meetings when the IASB considers the comments received on the exposure draft. The IASB must then conside