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MODULE 1 THE ROLE AND IMPORTANCE OF FINANCIAL REPORTING LEARNING OBJECTIVES After completing this module, you should be able to: 1.1 explain the role and importance of financial reporting 1.2 explain the role of the IASB Conceptual Framework in financial reporting and accounting standards...

MODULE 1 THE ROLE AND IMPORTANCE OF FINANCIAL REPORTING LEARNING OBJECTIVES After completing this module, you should be able to: 1.1 explain the role and importance of financial reporting 1.2 explain the role of the IASB Conceptual Framework in financial reporting and accounting standards 1.3 describe the objective and limitations of general purpose financial reporting as identified in the Conceptual Framework 1.4 explain the definitions of the elements of financial statements and recognition criteria adopted by the Conceptual Framework 1.5 explain the application of the standards to the financial reporting process and apply specific standards 1.6 discuss and demonstrate the importance of professional judgement in the financial reporting process 1.7 explain the implications of using cost and fair value accounting 1.8 explain how materiality is assessed and determine the materiality of transactions. ASSUMED KNOWLEDGE It is assumed that, before commencing your study in this module, you are able to: « explain the four primary financial statements, including their purpose and interrelationship « prepare each of the four primary financial statements using the accrual method of accounting « read and interpret International Financial Reporting Standards (IFRSs). LEARNING RESOURCES International Financial Reporting Standards (IFRSs), with a particular focus on the IASB Conceptual Framework for Financial Reporting: * |ASB Conceptual Framework for Financial Reporting (2018) * |FRS 2 Share-based Payment « IFRS 5 Non-current Assets Held for Sale and Discontinued Operations * IFRS 9 Financial Instruments * IFRS 13 Fair Value Measurement * IFRS 16 Leases = IAS 1 Presentation of Financial Statements * IAS 2 Inventories * |AS 8 Accounting Policies, Changes in Accounting Estimates and Errors * |AS 16 Property, Plant and Equipment * |AS 19 Employee Benefits * |AS 36 Impairment of Assets * |AS 37 Provisions, Contingent Liabilities and Contingent Assets * |AS 40 Investment Property. PREVIEW Financial reporting is the process of documenting an entity’s financial status in the form of financial reports/statements. The entity uses the prepared financial reports as a communication tool to assist users with their decision making. There is a broad range of users, including shareholders, banks and other creditors, competitors, employees and financial analysts — and they may have different information needs. Therefore, to assist users in their decision making, it is critical that financial statements are prepared in accordance with a financial reporting framework that recognises and endeavours to satisfy the needs of these users. This module considers the role and importance of financial reporting, particularly the need for general purpose financial statements (GPFSs). and discusses the application of financial reporting in an international context. It then discusses the role that the IASB Conceptual Framework for Financial Reporting (Conceptual Framework) plays in financial reporting, including a discussion on the objective and limitations of GPFSs as identified in the Conceptual Framework. The module discusses the qualitative characteristics of financial information and the definitions, recog- nition criteria and measurement of financial reporting items as outlined in the Conceptual Framework. The concept of materiality and how it is applied to financial reporting is also addressed. This module also examines the application of the measurement principles in International Financial Reporting Standards (IFRSs) in the context of selected issues. IFRSs are developed based on the Conceptual Framework as a consistent language for reporting that ensures that financial statements are understandable and can be compared among entities. IFRSs are the global language of accounting standards. Measurement is a complex and controversial aspect of accounting. In this module, alternative measurement bases are studied, and the application of the mixed measurement model (based on cost and fair value) is examined. Measurement issues are considered in the context of leases, employee benefits, share-based payments and investment properties. The module also explores the importance of professional judgement in the reporting process. 1.1 THE ROLE AND IMPORTANCE OF FINANCIAL REPORTING Financial reporting is a process that provides entities with an important communication tool to reach out to external stakeholders (users) interested in their financial information for decision making. That communication tool is represented by the GPFSs prepared in accordance with the Conceptual Framework and the accounting standards developed based on the framework. These financial statements provide users with financial information about the entity, including its financial position, financial performance and cash flows. THE ROLE OF FINANCIAL REPORTING The role of financial reporting is to provide users with information to enable them to achieve effective decision making. It also provides a stewardship or accountability role by requiring managers to give an account of how they have used the resources provided by those users. The stewardship role is particularly important when there is a separation between ownership and management in an entity. Effective financial reporting communicates the ‘story” of the entity during the period so that the users can understand what the entity has achieved and how it has achieved it. Improving the communication effectiveness of financial statements is one of the central themes of the IASB’s standard-setting work (IFRS Foundation 2016). The objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to its primary users for making decisions about providing resources to the entity. These decisions include: « buying, selling or holding equity and debt instruments; « providing or settling loans and other forms ofcredit; or « exercising rights to vote on, or otherwise influence, management’s actions that affect the use of the entity’s resources (Conceptual Framework, para. 1.2). Identification of the primary users of financial reports is crucial in determining the information that should be disseminated through the financial reports to effectively satisfy their decision-making needs. The IASB identifies primary users as those that provide equity or debt finance to the entity. Specifically, 2 Financial Reporting the primary users of an entity’s financial information are existing and potential investors, lenders and other creditors that must rely on general purpose financial reports for much of the information they need as they may be unable to command information from an entity directly (Conceptual Framework, paras 1.2 and 1.5). General purpose financial reports are directed to those primary users to provide information about the economic resources of the entity, claims against the entity, and changes in those resources and claims, which is necessary for these users to assess the entity for their decision making (Conceptual Framework. para. 1.4). Financial reports provide information about an entity’s financial position at a point in time. They also provide information about an entity’s financial performance as a result of transactions and other events that change the financial position during a reporting period (Conceptual Framework, paras 1.12-1.16). More specifically, the statement of financial position (or balance sheet) provides information about the financial position (i.e. the assets, liabilities and equity) of the entity at a point in time. The statement of profit or loss and other comprehensive income (the statement of P/L and OCI) (also referred to as the ‘statement of financial performance’ or just ‘profit or loss statement’) reports on the financial performance (i.e. the income, expenses and profitability) for a reporting period on an accrual basis. The statement of cash flows reports on the cash inflows and outflows of the entity for a reporting period on a cash basis. Changes in the net assets, or equity, are reported in the statement of changes in equity. All individual financial reports are prepared by an entity as at a particular point in time or for a particular reporting period, but the presentation of financial reports is prescribed to ensure that they are comparable with the entity’s previous financial statements and with the financial statements of other entities (IAS I, para. 1). Financial reporting via general purpose financial statements should not be seen as the only way for an entity to communicate to external users. Other types of reporting, including investor updates, sustainability reporting, corporate governance reporting and other prospective, or forward-looking, information, should be considered as well. For example, when an entity is intending to list on a stock exchange, it would normally be required to provide some forward-looking information to potential investors to help them make their investment decision. Technology advancements provide opportunities for various other methods of information dissemination that, together with financial reporting via GPFSs, can be incorporated into a whole suite of reporting tools to properly and efficiently address the information needs of users. THE IMPORTANCE OF FINANCIAL REPORTING Financial reporting is important because of the often significant level of resources under the responsibility of managers and the financial impact of the decisions that users make from relying on the information pro- vided in financial reports. This importance is reflected in company regulators and stock exchanges around the world requiring financial statements to be prepared by entities as part of their reporting obligations. The types of decisions that financial statements might be used for are highlighted in figure 1.1. Should | invest money How has the company in the company? performed in comparison to its competitors? Should | sell goods Should 1 lend money to the company? to the company? Source: CPA Australia 2022. MODULE 1 The Role and Importance of Financial Reporting 3 Information Needs of the User As previously mentioned, the primary users of financial information are existing and potential investors, lenders and other creditors (Conceptual Framework, para. 1.5). Management of an entity also require financial information for decision making. but they can obtain whatever information they need internally and do not need to rely on general purpose financial reports (Conceptual Framework, para. 1.9). Other users of financial information include regulators and members of the public, such as community groups and potential employees; however, general purpose financial reports are not primarily directed to these users (Conceptual Framework, para. 1.10). In the Conceptual Framework, it is the primary users that are the focus of general purposes financial reports. Entities are required to prepare general purpose financial reports specifically to assist their primary users in their decision making. However, the decisions facing the primary users may give rise to varying or even conflicting information needs. Consider, for example, lenders as users of financial statements. Lenders are interested in making an assessment of an entity’s capacity to meet its interest and principal repayment obligations and the level of risk associated with a loan. As investors invest equity, they are also interested in the assessment of risk and the ability of the entity to service its debt, so that the entity can continue its operations and provide a return to investors. These varying information needs and the resulting information demands may give rise to different preferences for the measurement of assets or the timing of the recognition of revenue. For example, lenders may prefer a measure of the net realisable value of certain assets provided as security to assess whether the security is sufficient in the event that the entity defaults on repayment. However, investors may prefer measurement of those assets based on their value in use, which provides a better indication of the expected benefits to be derived from the continued use of the assets. The TASB’s approach to resolving conflicting user information needs is to provide the information that will meet “the needs of the maximum number of primary users’ (Conceptual Framework, para. 1.8). However. according to the IASB, focusing on common information needs does not prevent an entity from providing additional information that may be useful to another sub-group of primary users (Conceptual Framework, para. 1.8). It should also be noted that trying to meet the needs of the maximum number of primary users may have different implications depending on the context. For example, for some entities, investors may be the largest group of primary users, but for other entities, the largest group of primary users may be lenders. Conflicting information needs are shown in figure 1.2. The grey shaded area represents the common information needs of the primary user groups. Conflict arises where the information needs do not overlap (the navy shaded areas) or where the information needs of only two user groups are shared (the gold shaded areas). The navy and gold shaded areas depict differing information needs, where choices made by standard setters and preparers may result in the needs of some primary users being met at the expense of the needs of other primary users. m Maximising the number of primary users whose information needs are met Investors Source: Adapted from IFRS Foundation 2022, Conceptual Framework for Financial Reporting, paras 1.5-1.8, IFRS Foundation, London, p. Al8. © CPA Australia 2022. 4 Financial Reporting  According to the Conceptual Framework, who are the primary users of general purpose financial reports, and why do you think they are regarded as the primary users? Consider the following statement. By focusing on the information needs of investors, lenders and other creditors, financial reporting will not be useful for other users. Do you agree or disagree? Give reasons for your answer. UNDERSTANDING THE INTERNATIONAL FINANCIAL REPORTING STANDARDS In this module, the terms ‘financial reports’ and ‘financial reporting’ refer to general purpose financial reports and general purpose financial reporting unless otherwise noted. GPFSs such as the statement of P/L and OCI, 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. The information included in GPFSs must comply with the International Financial Reporting Standards (IFRSs) and achieve fair presentation in accordance with the definition and recognition criteria in the Conceptual Framework. The Conceptual Framework is not a standard itself; therefore, it will not override any IFRSs. If a conflict is identified between provisions of an IFRS and the Conceptual Framework, the IFRS will take precedence. If any new provisions in the IFRSs depart from the Conceptual Framework. the TASB will explain the departure in the Basis for Conclusions of the relevant standard. The IFRSs are an internationally recognised set of accounting standards ‘that bring transparency, accountability and efficiency to financial markets around the world” (IFRS Foundation 2022a). IFRSs are used by most publicly listed companies in over 140 jurisdictions. 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. There are two series of international accounting standards. The first series, the International Accounting Standards (IASs), are those standards issued from 1973 to 2001, before the new International Accounting Standards Board (IASB) was formed. The second series. the International Financial Reporting Standards (IFRSs), are those standards issued under the IASB since 2001 and reflect the changes in accounting and business practices since that date. Some IASs are still relevant today and have therefore remained under their original IAS heading. An example is IAS 1 Presentation of Financial Statements. AASB standards are the accounting standards developed by the Australian Accounting Standards Board for all economic sectors in Australia. A specific numbering system has been used for the AASBs to identify their connection to the international accounting standards. AASB standards numbered by using one or two digits (from 1 to 99) are the equivalent of IFRSs. AASB standards numbered by using three digits (from 101 to 999) are the equivalent of IASs; and AASB standards numbered with four digits (from 1001 onwards) have no international equivalent (AASB 2021). The AASBs, whilst complying with the IFRSs, sometimes include additional paragraphs where reporting requirements differ for specific entities such as Australian not-for-profit entities. These paragraphs have the prefix ‘AUS’ and generally begin with words that highlight their limited applicability. For example: ‘Notwithstanding paragraphs xx, in respect of not- for-profit entities...". Each standard includes a statement at the beginning referring to its structure, main principles and terms, and the context in which the standard should be read. Example 1.1 shows this statement as is included at the beginning of IFRS 16 Leases. MODULE 1 The Role and Importance of Financial Reporting 5  Statement from IFRS 16 Leases International Financial Reporting Standard 16 Leases (IFRS 16) is set out in paragraphs 1-106 and Appendices A-D. All the paragraphs have equal authority. Paragraphs in bold type state the main principles. Terms defined in Appendix A are in italics the first time that they appear in the Standard. Definitions of other terms are given in the Glossary for International Financial Reporting Standards. The Standard should be read in the context of its objective and the Basis for Conclusions, the Preface to IFRS Standards and the Conceptual Framework for Financial Reporting. IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors provides a basis for selecting and applying accounting policies in the absence of explicit guidance. Source: IFRS Foundation 2022, IFRS 16 Leases, IFRS Foundation, London. p. AS21. Each standard begins with statements on its Objective and Scope and includes a section for its Effective Date (ED) and whether earlier adoption is permitted. Additional sections such as the Basis for Conclusions (BC) and the Illustrative Examples (IE) accompany the standard but are not considered to be a part of the standard. The BC section provides detailed explanations of the IASB’s considerations when developing and/or updating the standard. The IE section is included for those standards requiring practical explanations and may provide examples to demonstrate the application of the main principles of the standard. The IEs are not meant to represent the only application of a particular aspect and are not intended to be industry- specific. Example 1.2 is taken from the Illustrative Examples section of IFRS 16 Leases — it is Example 5 from that standard which works through identifying whether or not a lease exists for a truck rental contract. ‘When a member (or members) of the IASB does not approve the publication of a standard, that standard will include a section called Dissenting Opinion (DO) which states the reasons for any member objections. EXAMPLE 1.2 IFRS 16 Leases, lllustrative Example 5 — Truck Rental Customer enters into a contract with Supplier for the use of a truck for one week to transport cargo from New York to San Francisco. Supplier does not have substitution rights. Only cargo specified in the contract is permitted to be transported on this truck for the period of the contract. The contract specifies a maximum distance that the truck can be driven. Customer is able to choose the details of the journey (speed, route, rest stops, etc.) within the parameters of the contract. Customer does not have the right to continue using the truck after the specified trip is complete. The cargo to be transported, and the timing and location of pick-up in New York and delivery in San Francisco, are specified in the contract. Customer is responsible for driving the truck from New York to San Francisco. The contract contains a lease of a truck. Customer has the right to use the truck for the duration of the specified trip. There is an identified asset. The truck is explicitly specified in the contract, and Supplier does not have the right to substitute the truck. Customer has the right to control the use of the truck throughout the period of use because: (a) Customer has the right to obtain substantially all of the economic benefits from use of the truck over the period of use. Customer has exclusive use of the truck throughout the period of use. (b) Customer has the right to direct the use of the truck because the conditions in B24(b(i) exist. How and for what purpose the truck will be used (i.e. the transportation of specified cargo from New York to San Francisco within a specified timeframe) is predetermined in the contract. Customer directs the use of the truck because it has the right to operate the truck (for example, speed, route, rest stops) throughout the period of use. Customer makes all of the decisions about the use of the truck that can be made during the period of use through its control of the operations of the truck. Because the duration of the contract is one week, this lease meets the definition of a short-term lease. Source: TFRS Foundation 2022, IFRS 16 Leases, IFRS Foundation, London, part B, illustrative examples. EXPLORE FURTHER If you wish to explore this topic further, you should refer to IFRS 16 Leases, reading from the fitle page up to and including paragraphs 14 of the standard. Also refer to IFRS 16 IE section for further illustrative examples on the application of the standard. 6 Financial Reporting INTERACTION BETWEEN FINANCIAL REPORTING AND THE REGULATORY ENVIRONMENT — WHO MUST PREPARE GENERAL PURPOSE FINANCIAL REPORTS? International Accounting Standards Board General purpose financial reporting applies to reporting entities. The question of who must prepare general purpose financial reports is a matter for governments and regulatory agencies of each jurisdiction that adopts IFRS to decide. The Conceptual Framework therefore sets out a general definition of a reporting entity at paragraph 3.10 as follows. A reporting entity s an entity that is required, or chooses, to prepare financial statements. A reporting entity can be a single entity or a portion of an entity or can comprise more than one entity. A reporting entity is not necessarily a legal entity. The IFRSs do not further clarify who must prepare general purpose financial reports. In jurisdictions adopting IFRSs, legislation and other regulatory requirements usually require general purpose financial reports from entities that have issued debt or equity securities traded in a public market. The IASB does not, however, limit general purpose financial reporting to these entities. In this regard, the Conceptual Framework indicates that a reporting entity can be any entity that has existing and potential investors, lenders and other creditors who must rely on general purpose financial reports for much of the information they need to make decisions about providing resources to the entity. A reporting entity can be a for-profit entity or a not-for-profit entity. A reporting entity can operate in the private sector or the public sector. Examples of for-profit private sector entities include companies, partnership and trading trusts. Examples of not-for-profit entities include registered clubs, associations, charities and government departments. A reporting entity can be one entity ora group of entities comprising a parent and its subsidiaries (Conceptual Framework, para. 3.11). ‘Whilst the IFRSs and the Conceptual Framework are also applied in the not-for-profit sector in some jurisdictions, emphasis throughout this subject is generally on for-profit private sector entities whose equity and/or debt securities are publicly listed in financial markets. Australian Accounting Standards Board In Australia, for-profit private sector entities are subject to the Conceptual Framework and must prepare financial statements that comply with Australian Accounting Standards (i.e. prepare general purpose financial statements) when required to do so by either: 1. legislation that requires the entity to prepare financial statements in accordance with Australian accounting standards or ‘accounting standards” 2. their constituting or other document requires the entity to prepare financial statements in accordance with Australian Accounting Standards, provided that the relevant document was created or amended on or after 1 July 2021. Other for-profit private sector entities may nonetheless elect to apply the Conceptual Framework and prepare general purpose financial reports (AASB Conceptual Framework, para. Aus1.1). The predecessor of the Conceptual Framework, titled the Framework for the Preparation and Presentation of Financial Statements. continues to apply to not-for-profit entities. Legislation Part 2M.3 (Financial Reporting) of the Corporations Act requires an entity that is a disclosing entity, public company, large proprietary company or registered scheme to prepare an annual financial report (s. 292). The financial report must comply with Australian Accounting Standards when they are applicable (s. 296). A disclosing entity is an entity with enhanced disclosure securities on issue, which is similar to the notion of public accountability (s. 11TAC). A proprietary company is usually limited by shares and can have no more than 50 shareholders. A large proprietary company is based on qualifying for two out of three size thresholds for revenue, gross assets and number of employees (s. 45A). The thresholds are revenue of $50 million or more, gross assets of $25 million or more, and employees of 100 or more. A public company is a company other than a proprietary company (s. 9). The financial reporting obligations of other types of entities are included in other federal or state- based legislation. For example, for associations, the appropriate legislation is the relevant state-based Incorporated Associations Act. MODULE 1 The Role and Importance of Financial Reporting 7 Constituting or Other Document A for-profit private sector entity may be founded on a constituting or other document. such as a partnership agreement, trust deed or joint arrangement (AASB 2020). If that document was created or amended after 1 July 2021 and requires the entity to prepare financial statements in accordance with Australian Accounting Standards, the entity must prepare general purpose financial reports. If the document was created before, and has not been amended since, 1 July 2021, and requires the entity to prepare financial statements in accordance with Australian Accounting Standards, presuming the entity does not have a legislative requirement to prepare general purpose financial reports, it may prepare special purpose financial reports instead. As part of its special purpose financial reports, the entity will be required to provide additional disclosures, including the following: + why the entity is preparing special purpose financial reports + the material accounting policies applied in the special purpose financial reports and details on any changes in these policies, including the nature and reasons for the change and its financial statement impact whether the special purpose financial reports comply with the consolidation and/or equity accounting requirements in Australian Accounting Standards where the entity has interest in other entities + where a material accounting policy applied in the special purpose financial reports does not comply with all recognition and measurement requirements in Australian Accounting Standards, an indication of how it does not comply, and + astatement as to whether the special purpose financial reports, overall. comply with all recognition and measurement requirements in Australian Accounting Standards (AASB 1054, para. 9A). Two Tiers of General Purpose Financial Reporting The Australian Accounting Standards Board has a two-tier model of general purpose financial reporting. The two tiers are as follows (refer AASB 1053, para. 7). (a) Tier 1: Australian Accounting Standards: and (b) Tier 2: Australian Accounting Standards — Simplified Disclosures. Tier 1 general purpose financial reporting means an entity must satisfy all the recognition, measurement and disclosure requirements in Australian Accounting Standards, which incorporates IFRSs (AASB 1053, para. 8). Tier 1 applies to for-profit private sector entities with public accountability that are required by legislation to prepare financial statements that comply with Australian Accounting Standards. and Australian Governments either at the federal, state, territory or local level (AASB 1053, para. 11). A for-profit private sector entity has public accountability if: it has debt or equity instruments (i.. securities) that are traded in a public market or it is in the process of issuing securities for such trading: or + ‘it holds assets in a fiduciary capacity for a broad group of outsiders as one of its primary businesses’, for example banks, insurance companies, securities brokers/dealers and mutual funds (AASB 1053, Appendix A). Tier 2 general purpose financial reporting means an entity must satisfy all the recognition and measurement requirements in Australian Accounting Standards but has substantially simplified disclosures relative to Tier 1 (AASB 1053, para. 9). The disclosure requirements for Tier 2 entities are set out in a separate standard, AASB 1060 General Purpose Financial Statements — Simplified Disclosures for For- Profit and Not-for-Profit Tier2 Entities. As such, Tier 2 entities complying with the simplified disclosure requirements of AASB 1060 are exempt from the disclosure requirements specified within other Australian Accounting Standards. AASB 1060 is available to a wide range of entities that are required to prepare general purpose financial statements in both the private and public sectors (refer AASB 1053, para. 13): (a) for-profit private sector entities that do not have public accountability; (b) not-for-profit private sector entities; and (c) public sector entities... other than the Australian Government and State, Territory and Local Governments. Notwithstanding that Tier 2 is available to an entity required to prepare a general purpose financial report, it may still elect to apply Tier 1 and the full requirements of Australian Accounting Standards. Refer to Note 1 ‘Summary of significant accounting policies’ in the notes to financial statements of Techworks Ltd (see appendix). What type offinancial statements have been prepared by Techworks Ltd? What factors might explain the type offinancial statements that have been prepared? 8 Financial Reporting External Reporting Board of New Zealand The External Reporting Board (XRB) of New Zealand also has a multi-tiered accounting standards frame- work in which the nature of the entity determines the level of disclosure and compliance requirements. Entities are categorised as either ‘for-profit’ entities or ‘public-benefit’ (not-for-profit) entities. Then entities are subclassified based on whether they are publicly accountable for their financial reports, and/or their size. This multi-tiered approach is summarised in table 1.1. TABLE 1.1 External Reporting Board Accounting Standards Framework - tiered approach For-profit entities Public benefit entities (PBEs) Accounting Accounting Standards Standards Tier1 Publicly accountable (as NZIFRS Publicly accountable (as ~ PBE Standards defined below); or public defined below); or PBEs sector entities with total with total expenses > expenses > $30 million $30 million (termed large’) (termed ‘large’) Tier2 Non-publicly accountable NZ IFRS Non-publicly accountable, ~ PBE Standards and non-large for-profit Reduced not large, have total Reduced Disclosure public sector entities which Disclosure expenses < $30 million Regime (PBE elect to be in Tier2 Regime but > $2 million, which Standards RDR) (NZIFRSRDR) elect to be in Tier 2 Tier 3 Non-publicly accountable PBE Simple Format with total expenses < Reporting Standard — $2 million which electto Accrual (SFR-A) bein Tier 3 Tier 4 Entities allowed by law PBE Simple Format to use cash accounting Reporting Standard — which elect to be in Tier 4 Cash (SFR-C) Source: External Reporting Board (New Zealand) 2019, ‘Accounting Standards Framework’, accessed July 2022, htps://www.xrb.govt.nz/standards/accounting-standards/accounting-standards-framework. The definition of public accountability is similar to that provided above, except it also includes an entity deemed to have public accountability by the Financial Markets Authority under s. 461K and s. 461L(1)(a) of the Financial Markets Conduct Act 2013. Other Jurisdictions In other jurisdictions, the appropriate legislation includes the Singapore Companies Act (Chapter 50) 2006 (Singapore) and the Companies Act 2016 (Malaysia). This legislation will specify the content of the financial statements, the regularity of reporting and the basis on which the financial statements are prepared. Not all entities from jurisdictions that adopted IFRSs are required to prepare financial reports in accordance with the IFRSs. An entity may use alternative bases for accounting if this is required or permitted. For example, in Malaysia, eligible private entities comply with the Malaysian Private Entities Reporting Standard (MPERS) rather than with the IFRSs. Alternatively, an entity that is not required to report separately in accordance with the IFRSs may still need to provide information that must comply with the IFRSs to a parent entity for inclusion in a set of consolidated financial statements. This module and this subject will only address an entity’s obligations under the IFRSs. INTERNATIONAL INITIATIVES TO DECREASE FINANCIAL REPORTING COMPLEXITY An ongoing criticism of financial reporting is the complexity of financial reports. Improving the commu- nication effectiveness of disclosures in financial statements is a current focus of many accounting setters, including the TASB, and there are a growing number of initiatives to help combat the issue, including: « reducing differences in reporting standards among countries « reducing reporting requirements of small and medium-sized entities MODULE 1 The Role and Importance of Financial Reporting 9 + catering to the information needs of multiple stakeholders improving the content and structure of the primary financial statements clarifying disclosure requirements and improving the usefulness of disclosures + improving understanding of the existing requirements and helping entities make better materiality judgements considering how management commentary outside the financial statements could better complement and support the financial statements improving communication between preparers and users by enabling information to be delivered in an electronic format. TASB and other standard setters across the world made significant progress on the first three initiatives listed — the following section provides further details. Reducing Differences in Reporting Standards Among Countries Overall, the complexity in financial reporting has decreased due to increased acceptance of the IFRSs in many parts of the world. More than 140 jurisdictions worldwide require the use of the IFRSs for their publicly listed companies. The global acceptance of the IFRSs led to the commitment of the US Financial Accounting Standards Board (FASB) to work with the IASB to explore the possibilities of the convergence of US Generally Accepted Accounting Principles (GAAP) with the TFRSs. In 2007, the US Securities and Exchange Commission (SEC) eliminated the requirement for foreign companies registered with the US SEC to reconcile their IFRS-based financial statements to US GAAP. However. the US SEC does not permit domestic issuers to adopt the IFRSs (SEC 2007). Reducing Reporting Requirements of Small and Medium-sized Entities The complexity of the full IFRSs led the IASB and accounting standards-setting bodies to specify less complex standards for some entities. Examples of such reductions are as follows. International Accounting Standards Board To reduce the complexity of following the full IFRSs for small and medium-sized entities (SMEs). the TASB has introduced the IFRS for SMEs. The IFRS for SMEs is described as being less complex than the “full’ IFRSs because: * topics not relevant to SMEs, such as earnings per share, interim financial reporting and segment reporting, are omitted + many principles for recognising and measuring assets, liabilities, income and expenses in the full IFRSs are simplified — for example, amortising goodwill; expensing all borrowings and development costs; allowing the cost model for associates and jointly controlled entities; and providing undue cost or effort exemptions for specific requirements + significantly fewer disclosures are required (about a 90 per cent reduction) + the standards are written in clear, easily understandable language (IFRS Foundation 2022c). The IFRS for SMEs was first issued in 2009 and amended in 2015 following a comprehensive review. At the time of writing, the IASB was undertaking its second comprehensive review to determine how the IFRS for SMEs should be amended to take account of new IFRSs and amendments to existing IFRSs. The TASB is preparing an exposure draft outlining the proposed amendments to the IFRS for SMEs which may be released after publication (IFRS Foundation 2022d). Australian Accounting Standards Board The AASB has not adopted /FRS for SMEs to date, but AASB 1060 is based on the disclosure requirements of IFRS for SMEs. In Australia, for-profit private sector entities may prepare special purpose financial reports rather than GPFSs if legislation or their constituting or other document does not require them to prepare GPFSs. Special purpose financial statements (SPFSs) are prepared and presented in accordance with the specific information needs of the entity’s financial statement users. A few selected entities can lodge SPFSs with ASIC. An entity that lodges SPFSs with the Australian Securities and Investments Commission (ASIC) must ensure that they comply with a minimum set of Australian Accounting Standards as follows. * AASB 101 Presentation of Financial Statements * AASB 107 Statement of Cash Flows * AASB 108 Accounting Policies, Changes in Accounting Estimates and Errors * AASB 1048 Interpretation of Standards 10 Financial Reporting * AASB 1053 Application of Tiers of Australian Accounting Standards * AASB 1054 Australian Additional Disclosures Entities that lodge SPFSs with ASIC are also required to ensure that the financial statements give ‘a true and fair’ view (s. 297 of the Corporations Act). In ASIC’s opinion, SPFSs can only present a true and fair view if they apply all recognition and measurement requirements in Australian Accounting Standards (e.g. depreciation, tax-effect accounting, leases, inventories, employee benefits) (ASIC Regulatory Guide 85). ASIC’s Regulatory Guide does not have any legal status. Whilst some entities that lodge SPFESs follow ASIC’s advice, others do not. In practice, there are many large proprietary companies that choose to lodge SPFSs with ASIC based on the minimum standards approach listed in this section. Catering to the Information Needs of Multiple Stakeholders One aspect of the current complexity in financial reporting, which has attracted the attention of accounting standards-setting bodies worldwide, has resulted from the need to measure ‘performance’ from multiple perspectives. This requirement cannot be met simply by the reporting of financial statements. A company’s performance is a multifaceted measure. Therefore, there is a need for information such as the progress of the company — in terms of strategy and plan — rather than financial measures such as profit, assets and liabilities. Although the reporting of the strategy and plan is material to investors, lenders and other stakeholders, there is no requirement to report this information in the IFRSs. The increase in the reporting of non-mandatory information in annual reports (relative to the mandated financial information) makes financial reporting seem like a mere compliance exercise rather than an exercise that communicates the information needs of multiple stakeholders. To address this concern, some of the present research projects in progress across the world are as follows. International Accounting Standards Board To assist entities to communicate their disclosures more effectively, the IASB engaged in a research project around a so-called *Disclosure Initiative’ to develop better disclosure requirements in accounting standards, around accounting policies and in general. Following feedback from stakeholders used to inform the TASB’s research, in March 2021 the IASB published an Exposure Draft Disclosure Requirements in IFRS Standards — A Pilot Approach, which sets out a proposed new approach to developing and drafting disclosure requirements in all standards starting with IAS 19 Employee Benefits and IFRS 13 Fair Value Measurement (IFRS Foundation 2022e). This project is part of the Board’s wider series of initiatives under the theme ‘Better Communication in Financial Reporting” (IFRS Foundation 2022b). Technology Advancements Technology advancements provide opportunities for other sources and methods for information to be provided to the primary users of general purpose financial statements. The rapid pace of technological advancements can be, at the same time, a source of challenges and opportunities for entities preparing financial information, users consuming information and standard setters prescribing how the information should be prepared and disseminated. As technology progresses, new items need to be recognised in the financial statements (e.g. crypto-assets), new avenues become available to disseminate and consume information (e.g. electronically instead of paper-based reports) and new techniques are used to analyse the information (e.g. big data analytics with the use of artificial intelligence). IASB recognises these broad implications of technology for financial reporting as part of the IFRS Foundation’s Technology Incentive announced in November 2018. This initiative seeks to develop a strategic plan to address the impact of technological advancements on financial reporting and standard setting. Summary Accounting standard-setters have had a renewed focus on reducing complexity in financial reporting. However, challenges still exist regarding the development of an overarching disclosure model to measure performance without increasing the complexity of financial reporting. INTERNATIONAL INITIATIVES TOWARD SUSTAINABILITY-RELATED FINANCIAL REPORTING In response to growing global demand for high quality and comparable disclosures by entities on matters of sustainability, on November 3, 2021, at the 26th United Nations Climate Change Conference of the Parties (COP26), the United Nations global summit to address climate change, the IFRS Foundation announced the establishment of the International Sustainability Standards Board (ISSB). MODULE 1 The Role and Importance of Financial Reporting 11 International Sustainability Standards Board The purpose of the ISSB is to develop a ‘comprehensive global baseline of sustainability-related disclosure standards that provide investors and other capital market participants with information about companies’ sustainability-related risks and opportunities to help them make informed decisions’ (IFRS Foundation 2022f). Overseen by the IFRS Foundation Trustees, the disclosure standards issued by the ISSB will be referred to as IFRS Sustainability Disclosure Standards, while the accounting standards issued by the IASB will now be referred to as IFRS Accounting Standards. In March 2022, the ISSB published Exposure Drafts seeking comments on its first two proposed IFRS Sustainability Disclosure Standards: [Draft] IFRS S1 General Requirements for Disclosure of Sustainability-related Financial Information and [Draft] IFRS S2 Climate-related Disclosures (IFRS Foundation 2022g). Australian Accounting Standards Board In light of international developments, the AASB announced its intention to be responsible for developing a reporting framework and requirements for sustainability-related matters in Australia. In particular, the AASB’s objectives are to: « develop reporting requirements for sustainability-related financial information in general purpose financial reporting to meet the evolving information needs of primary users; and « improve the consistency, completeness, comparability and verifiability of sustainability-related financial disclosures (AASB 2022). To meet these objectives, the AASB aims to: « develop a separate, or independent, suite of standards that specifically address sustainability-related financial disclosures made as part of general purpose financial reporting; and « prioritise international alignment by using the work of the... ISSB as a baseline, with modifications for Australian matters and requirements when necessary (AASB 2022). The AASB will use the IFRS Sustainability Disclosure Standards as a baseline in developing its own domestic standards, making modifications when deemed necessary to meet the information needs of Australian stakeholders. When issued, these standards will require entities to provide additional disclosures in their general purpose financial reports on sustainability-related financial matters. 1.2 THE CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING In this section we examine the IASB Conceptual Framework for Financial Reporting (Conceptual Framework). The Conceptual Framework sets out the concepts that underlie the preparation and presentation of financial statements for external users (Conceptual Framework, *Status and Purpose’). The Conceptual Framework is structured as shown in table 1.2. TABLE 1.2 Structure of the Conceptual Framework for Financial Reporting Chapter Conte Status and Purpose « Provides a detailed description of the status and purpose of the Conceptual Framework 1. Objective * Sets out the objective of general purpose financial reporting 2. Qualitative « Provides guidance on the qualitative characteristics of useful financial information characteristics 3. Financial statements « Describes the objective and scope of general purpose financial statements as and the reporting entity well as the reporting entity concept 4. Elements of financial « Provides the definitions of the elements of financial statements statements 5. Recognition and « Sets out the recognition and derecognition criteria derecognition 12 Financial Reporting  6. Measurement * Provides guidance on the measurement bases including historical cost and current value 7. Presentation and * Provides guidance on classification, presentation and disclosure disclosure 8. Concepts of capitaland » Provides guidance on the concepts of capital and capital maintenance. capital maintenance Source: CPA Australia 2022. The purpose and application of the Conceptual Framework will now be discussed. and its components will be examined in detail. THE PURPOSE AND APPLICATION OF THE CONCEPTUAL FRAMEWORK Having a common framework is an important foundation in guiding the development of accounting standards and accounting practice. Moreover. accounting standards do not address all possible transactions an entity may enter into. In these instances when the standards do not provide guidance, or sufficiently specific guidance, it is the role of the Conceptual Framework to provide guidance to facilitate consistency in the reporting of transactions and events. The Conceptual Framework provides a formal frame of reference for: « what types of transactions and events should be accounted for « when the effects of transactions and events should be recognised how the effects of transactions and events should be measured + how the effects of transactions and events should be summarised and presented in financial statements. For example, IAS 36 Impairment of Assets applies the principle that the carrying amount of an asset should not exceed its recoverable amount. This principle is consistent with the concept of an asset adopted in the Conceptual Framework: a present economic resource controlled by the entity as a result of past events. An economic resource is a right that has the potential to produce economic benefits (paras 4.3-4.4). As an asset represents a resource that has the potential to produce future benefits, the amount at which it is reported in the statement of financial position (i.e. its carrying amount) should not exceed the expected benefits to be derived from the asset (i.e. the recoverable amount). The Conceptual Framework can be applied in several ways, as shown in table 1.3. TABLE 1.3 Applying the Conceptual Framework for Financial Reporting Who is applying the Conceptual Framework? How the Conceptual Framework is applied Standard setters To develop accounting standards Preparers To obtain guidance when issues that are not directly covered by a standard or interpretation arise (specifically, IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors requires the Conceptual Framework to be considered when there is an absence of a specific accounting standard or interpretation (IAS 8, paras 10-11)) Auditors To help form an opinion on compliance with an IFRS Users. To better understand and interpret the financial reports they are reviewing Source: CPA Australia 2022. ‘Where there is a conflict between an IFRS and the Conceptual Framework, the requirements of the particular standard override those of the Conceptual Framework (para. SP1.2). MODULE 1 The Role and Importance of Financial Reporting 13 OBJECTIVES AND LIMITATIONS OF GENERAL PURPOSE FINANCIAL REPORTING The objective of general purpose financial reporting is to provide financial information to the primary users to support their decision-making needs. In addition. general purpose financial reporting performs a stewardship function. which involves reporting on how efficiently and effectively management has used the resources entrusted to it (Conceptual Framework, paras 1.22—1.23). This emphasis on user decision making in order to ascertain the information the entity should provide follows a decision-usefulness approach. The decision-usefulness objective of financial reporting is probably the most important objective. However, it is not possible for entities to provide all information about the financial position, performance and changes in financial position to all users. Preparers of GPFSs are required to exercise some judgement in deciding which information is required for the decision-usefulness objective to be met. Consider the following problems. * Lack offamiliarity with new types of information. If users of financial statements are not familiar with an item of information, it is difficult to assess its usefulness to their decision-making processes. Preparers will then be faced with difficulties in trying to assess if the new item of information should be recognised under an existing category in the financial reports or disclosed separately. Furthermore. some users may not have the technical expertise to understand complex information; for example, information that is based on finance principles such as present value calculations. This problem is especially relevant during times of rapid technological advancement, where technologies may generate new items for which there may not be sufficient guidance provided by accounting standard setters. * Decision-usefulness may vary among users. The personal beliefs and values of users may determine the information that they tend to use in their decision making. For example. some investors may consider information about environmental performance to be relevant for their decision making, whereas others might exclude it from their decision-making models. The differences in what users find relevant are also likely to depend on the decision being made. For example, the information needs of customers deciding whether to enter into a long-term purchase contract will differ from the needs of employee representative groups negotiating remuneration and working conditions for employees. * Capable of multiple interpretations. Preparers may have a different perception of what is useful information to users than the users themselves. For example, using fair value as the measurement basis for assets may be useful for investors to assess the entity’s future economic benefits likely to be generated versus other entities; however, value in use may be considered by preparers as better capturing the management’s plans and expectations regarding particular assets. These competing views are difficult to reconcile under the currently specified decision-usefulness objective of general purpose financial reporting. * Time and cost constraints in preparing GPFSs. Due to time and cost constraints in preparing general purpose financial reports, it is not possible for entities to provide all the useful information that will meet all the varying needs of users. When a user requires specific information that has not been disclosed in an entity’s financial reports. the IASB recommends the use of other sources such as ‘general economic conditions and expectations, political events and political climate, and industry and company outlooks” (Conceptual Framework, para. 1.6) to help gain a clearer understanding. The IASB also explains that the financial reports are ‘not designed to show the value’ of the organisation but to help decision makers make their own estimates as to its value (Conceptual Framework, para. 1.7). Nevertheless. the time and cost constraints in preparing GPFSs can be reduced with the help of new technologies that are capable of capturing. managing, processing and reporting on vast amounts of data. Consider the following statement. The decision-usefulness objective provides unambiguous guidance in resolving financial reporting problems. Do you agree? Give reasons for your answer. 14 Financial Reporting EXPLORE FURTHER If you wish to explore this topic further, you should read paragraphs 1.6-1.11 of the Conceptual Framework (in the IFRS Compilation Handbook). PRINCIPLES ESTABLISHED IN THE CONCEPTUAL FRAMEWORK There are two important assumptions established in the Conceptual Framework that form the foundation of general purpose financial reporting. These are the assumption of the accrual basis of accounting and the assumption that the entity is a going concern. Accrual Basis The accrual basis of accounting recognises the effects of transactions and other events when they occur (which may not correspond to the time that cash is exchanged in response to a transaction) and reports them in the financial statements in the periods to which they relate. The accrual basis of accounting requires an entity to recognise revenues when they are earned rather than when cash is received. Also, under the accrual basis of accounting, expenses are recognised when they are incurred rather than when cash is paid. For example, an entity selling goods or services on credit recognises the revenue and related expenses (cost of sales) incurred in earning that revenue when the sale takes place, regardless of the timing of the cash inflow and cash outflow relating to that revenue and those expenses. Also, the accrual basis requires an entity to recognise the depreciation of a non-current asset (with a limited useful life) as the economic benefits of that asset are consumed or expire; an entity does not account for the asset as an expense in the period in which it is acquired. The Conceptual Framework advocates for accrual basis of accounting as it considers that it provides a better basis for assessing the entity’s past performance and predicting future performance than relying only on financial statements prepared on a cash basis (Conceptual Framework, para. 1.17). EXPLORE FURTHER If you wish to explore this topic further, you should read paragraphs 1.17-1.19 of the Conceptual Framework. QUESTION 1.4 Inits first year of operations, Tower Ltd purchased and paid for widgets costing $50 000. During that year, Tower Ltd sold 60 per cent of the widgets. The widgets on hand at the end of the year cost $20000. The sales were on credit terms. Tower Ltd received $37 000 in cash from customers, and $3000 remained uncollected at the end of the year. During the last quarter of the first year of operations, Tower Ltd entered into a property insurance contract for losses arising from fire or theft. The annual premium of $4000 was paid in cash and the insurance expired nine months after the end of the reporting period. Calculate Tower Ltd's profit for the first year of operations on an accrual basis and on a cash basis. Explain the difference between the two measures. Which of the two profit measures is more useful for assessing Tower Ltd’s performance during its first year of operations? Give reasons for your answer. Going Concern Financial statements prepared in accordance with the going concern assumption presume that the entity will continue to operate for the foreseeable future. The carrying amounts of assets and liabilities in the statement of financial position are normally based on the going concern assumption. For example, the carrying amount of property. plant and equipment — whether measured on a cost or fair value basis — assumes that the carrying amount will be recoverable through the entity’s continuing operations. Some assets, such as property and plant, may be stated at amounts that exceed their disposal value because the entity expects to obtain greater economic benefits through the continued use of such an asset. ‘Where the going concern assumption is not appropriate (e.g. because of the entity’s intention or need to wind up operations), the financial statements should be prepared on some other basis. The Conceptual Framework does not specify an alternative basis. However, one approach may be to state assets at their net realisable value — which in the case of certain intangible assets may be negligible — and liabilities at the amount required for their immediate settlement. MODULE 1 The Role and Importance of Financial Reporting 15 EXPLORE FURTHER If you wish to explore this topic further, you should read paragraph 3.9 of the Conceptual Framework. 1.3 QUALITATIVE CHARACTERISTICS OF USEFUL FINANCIAL INFORMATION Chapter 2 of the Conceptual Framework focuses on the qualitative characteristics of financial information, and it provides that in order to be useful, financial information must: be relevant and faithfully represent what it purports to represent. The usefulness of financial information is enhanced if it is comparable, verifiable, timely and understandable (Conceptual Framework, para. 2.4). These qualitative characteristics are illustrated in figure 1.3. FIGURE 1.3 Qualitative characteristics of financial information Fundamental qualitative characteristics Enhancing qualitative characteristics Source: CPA Australia 2022. FUNDAMENTAL QUALITATIVE CHARACTERISTICS Relevance Information is relevant when it is capable of influencing the decisions of users (Conceptual Framework, para. 2.6). This influence can occur through the predictive value or the confirmatory value of financial information, or both. Table 1.4 shows how relevant information helps users. TABLE 1.4 How relevant information helps users The Conceptual Framework requires relevant information | How this relates to that helps users... financial reporting.. In forming expectations This relates to the Financial information can be used to predict about the outcomes of past, predictive value of the future cash flows of an entity and the present and future events. financial information. timing and uncertainty of those cash flows. in confirming o correcting This is referred to Expectations of future cash flows can be their past evaluations. as feedback, or the compared with actual cash flows when confirmatory value of financial statements relating to those future financial information. periods are issued and the reasons for any differences between expected cash flows and actual cash flows are investigated. Source: CPA Australia 2022. 16 Financial Reporting Materiality Relevance also encompasses materiality. A subjective approach to materiality is adopted in the Conceptual Framework: Information is material if omitting, misstating or obscuring it could reasonably be expected to influence decisions that the primary users of general purpose financial reports... make on the basis of those reports, which provide financial information about a specific reporting entity (para. 2.11). Materiality is an aspect of relevance that can be affected by the nature or the size of an item of financial information, or both. Some information will be considered material if it refers to amounts that are considered large enough to influence the decision making of primary users. However, deciding what is large enough to be material is a matter of professional judgement by preparers, as the Conceptual Framework does not prescribe quantitative thresholds for materiality because the application of the concept of materiality is considered to be entity-specific (Conceptual Framework, para. 2.11). Some other information may be material regardless of the amounts it refers to. Consider the following examples. * An entity may engage in transactions with its directors that involve amounts that are not material to the entity. However, the disclosure of these related party transactions may be relevant to users’ needs, irrespective of the amounts involved, because of the nature of the relationship between the directors and the entity and their accountability to shareholders. * An entity may engage in new activities, the results of which have little impact on profit at present. However, the results may be relevant to the decision-making needs of users because they may affect the users’ assessment of the entity’s future growth and risk profile. In summary. whether information is material is a matter of judgement that depends on the facts and circumstances of an entity. IASB Practice Statement 2 Making Materiality Judgements highlights ways in which management can identify whether financial information is useful to the primary users (and therefore material), and this is outlined in table 1.5. TABLE 1.5 Identifying financial information useful to users of financial reports Cor n Example User expectations How users think the entity should be managed (.e. stewardship) gathered through discussions with users or from information that is publicly available Management perspective Changing management perspective to think about decisions from the perspective of the user (i.e. s if they were external users themselves and did not have the internal knowledge held by management, for example, about key risks or key value drivers) Observing user or market ~ For example, on particular transactions or disclosures issued by the entity or on responses to information responses by external parties such as analysts Source: Adapted from IFRS Foundation 2022, IFRS Practice Statement 2: Making Materiality Judgements, paras 21-23, IFRS Foundation, London, part B. The Practice Statement is non-mandatory guidance developed by the IASB, and its application is not required to state compliance with IFRS Standards. EXPLORE FURTHER If you wish to explore this topic further, you should read paragraphs 2.4-2.11 of the Conceptual Framework. Faithful Representation Together with relevance, faithful representation is a fundamental qualitative characteristic of useful financial information according to the Conceptual Framework. Faithful representation requires that financial information faithfully represent the effects of transactions and events that they purport to represent (Conceptual Framework, para. 2.12). For example, the statement of financial position should faithfully represent the effects of the events that give rise to assets, liabilities and equity at a point in time, normally the end of the reporting period. Ideally, faithful representation means that financial information is complete, neutral and free from error. However, it is usually impractical to maximise these three characteristics simultaneously. MODULE 1 The Role and Importance of Financial Reporting 17 Faithful representation implies that there should be a fair representation of the economic outcomes of all transactions and events that involve the entity. However, this assumes that there are accounting solutions to all of the problems and financial reporting issues encountered by preparers of the financial reports. In practice, difficulties in identifying the transactions and other events that must be accounted for, as well as in applying or developing appropriate measurement and presentation techniques. can impede the achievement of faithful representation. EXPLORE FURTHER If you wish to explore this topic further, you should read paragraphs 2.12-2.19 of the Conceptual Framework. Application of Fundamental Qualitative Characteristics For information to be useful. it must be both relevant and faithfully represented. This may involve professional judgement in making a trade-off between relevance and faithful representation. For example, information about future cash flows expected to be derived from an asset may be highly relevant, but it may be difficult to faithfully represent this aspect ofthe asset because of the inherent uncertainty of future events. Paragraph 2.21 of the Conceptual Framework suggests a process for making such judgements as follows. 1. Identify an economic phenomenon, information about which may be useful to decision makers. 2. Identify the information that would be most relevant about this phenomenon. 3. Determine if the information is available and can provide a faithful representation of the economic phenomenon. EXPLORE FURTHER If you wish to explore this topic further, you should read paragraphs 2.20-2.22 of the Conceptual Framework. 'QUESTION 1. Coalite Ltd participates in an emissions trading scheme. It holds emission trading allowances, which provide a permit for a specified amount of carbon emissions for the year. If its operating processes result in carbon emissions, Coalite Ltd must deliver sufficient emission trading allowances to the government to ‘pay’ for the amount of carbon emitted during the year. If it does not hold enough emission trading allowances, Coalite Ltd will need to buy more to settle its obligation to the government. If the company’s holding of trading allowances is surplus to its needs, the allowances may be sold. Assume that in determining how to apply the fundamental qualitative characteristics, the chief financial officer (CFO) of Coalite Ltd has completed the first step by identifying the emission trading allowances held as being potentially useful to the users of the company’s financial statements. (a) Identify the type of information about emission trading allowances that would be most relevant if it were available and could be faithfully represented. (b) Do you think the information that you suggested is likely to be available and able to be represented faithfully? If not, what might be the next most relevant type of information about the emission trading allowances? ENHANCING QUALITATIVE CHARACTERISTICS Comparability Comparability is one ofthe four enhancing qualitative characteristics of financial information prescribed in the Conceptual Framework. Financial information is more useful if it can be compared with similar information about the same entity for another reporting period and with similar information about other entities. The ability to compare financial statements over time is important to enable users to identify trends in the entity’s financial position and performance. The ability to compare the financial statements of different entities is important in assessing their relative financial position and performance. Comparability also enables users to recognise similarities or differences between two sets of economic phenomena. For example, an entity with an existing investment in Company A is deciding whether to continue to invest in Company A or to move its investment to Company B. Comparable financial information will help the investor in making the decision. 18 Financial Reporting  Consistency is seen as contributing to the goal of comparability. The Conceptual Framework refers to the concept of consistency as ‘the use of the same methods for the same items’ (para. 2.26). This may be in reference to the use of consistent methods either by different entities for the same period or by the same entity over different periods. Comparability is not satisfied by mere uniformity of accounting policies and methods. In fact, the Conceptual Framework (para. 2.27) cautions against this view because it may result in dissimilar items being treated or presented similarly. For example, assets that form part of continuing operations differ from assets that form part of discontinued operations. Future economic benefits of assets that form part of continuing operations are expected to be recovered mainly by the continued use in the ordinary course of business. On the other hand, the future economic benefits of assets forming part of discontinued operations are expected to be recovered through disposal rather than continued use. The adoption of uniform accounting methods to represent economic information about assets that form part of continuing operations and those that form part of discontinued operations would not enhance comparability. Such methods would fail to reflect the differences in the way that economic benefits are expected to be derived from the two types of assets. Comparability of financial statements is enhanced by the disclosure of the accounting policies adopted in preparing the financial statements and of any changes in those policies and their effects. Disclosure of accounting policies and material accounting policies are considered further in module 2. Verifiability Verifiability exists if knowledgeable and independent observers can reach a consensus that the information is falthfully represented. As shownin table 1.6, verification may be direct or indirect. TABLE 1.6 Form of verification Direct Confirming the market price used to measure the fair value of an asset that is traded in an active market Indirect Checking the inputs and processes used to determine the reported information. For example, verifying fair value with a model that checks inputs such as the contractual cash flows and the choice of an appropriate interest rate, and the methodology or rationale used to estimate fair value. Consensus might refer to a range (e.g. an estimate of the fair value of a corporate bond that is not traded in an active market as being between $940 and $970) but not necessarily to a point estimate (e.g. the historical cost being $990). Verifiability can help to assure users that financial information is faithfully represented. Source: Adapted from IFRS Foundation 2022, Conceptual Framework for Financial Reporting, para. 2.31, FRS Foundation, London, p. A27. Timeliness Timeliness enhances the relevance of information in GPFSs. Undue delays in reporting information may reduce the relevance of that information to users’ decision making. Timeliness suggests that there is a need for financial information at regular intervals, for example, half-year and annual financial reports. The timeliness of financial information is critical for investment decisions. Unexpected events and delayed news that impact negatively on the financial statements will normally result in a loss of confidence and plummeting share prices within the investment market. To maintain the timeliness of information reported in financial statements, it may be necessary to report on the effects of a transaction or other event before all of the required information is available. Accordingly, it may be necessary to use estimates instead of waiting until more directly observable information becomes available, in which case the benefits from ensuring timeliness should be weighed against the costs of the decrease in the reliability of the information. Technological advancements have improved the timeliness of information disclosed because new technologies capture and disseminate information more quickly than in the past. Understandability Understandability requires the informationin financial statements to be clearly and concisely classified, characterised and presemed (Conceptual Framework, para. 2.34). MODULE 1 The Role and Importance of Financial Reporting 19  Understandability cannot be interpreted independently of the inherent capability of users of the financial statements. Users are presumed to have reasonable knowledge of business and economic activities (Conceptual Framework, para. 2.36). This implies that. for example. the informed user should readily understand the measurement basis adopted for a particular financial statement item. Information is not excluded from a financial report merely because it is difficult for users to understand (Conceptual Framework, para. 2.35). This would be inconsistent with the characteristic of completeness incorporated in faithful representation. Technological advancements may mean that information that was previously difficult to understand can now be analysed with the help of artificial intelligence using applications such as machine learning. thereby making more information suitable to be disclosed. EXPLORE FURTHER If you wish to explore this topic further, you should read paragraphs 2.34-2.36 of the Conceptual Framework. The objectives of IFRS 13 Fair Value Measurement include establishing a common definition of fair value and common guidance for fair value measurement. The standard prescribes the following fair value measurement hierarchy (in descending order). Level 1 Quoted price for an identical asset or liability Level 2 Observable prices other than those included within Level 1 Level 3 Unobservable inputs for the asset or liability. Explain how the enhancing qualitative characteristics, comparability and ver ity, are applied in the requirements of IFRS 13. Application of Enhancing Qualitative Characteristics Although enhancing characteristics improve the relevance or faithful representation of information, they do not make irrelevant or unfaithfully represented information useful. If information were omitted from financial statements, rendering them incomplete (not representing faithfully the effects of all transactions and effects affecting the entity), the consistent omission of that information over multiple periods may provide comparability, but it would not make the information useful. For example, if an entity omitted several material subsidiaries from its consolidated financial statements, repeating this omission in each reporting period may provide comparability. However, financial statements that do not faithfully represent the financial position and financial performance of the group that they report on are not useful for user decision making. Preparers need to exercise professional judgement in balancing the qualitative characteristics and in assessing the relative importance of enhancing characteristics in different contexts. In selecting an appropriate accounting policy, such as a measurement attribute, preparers may need to make a trade- off between an enhancing qualitative characteristic and another qualitative characteristic. For instance, the preparer may need to forego the enhancing qualitative characteristic of comparability to change an accounting policy in the interests of providing more relevant or more faithfully represented information. For example, an entity may adopt fair value measurement in order to provide more relevant information at the expense of comparability with previous periods. Additional disclosures, such as the reason for and effects of the change of accounting policy, and the restatement of reported comparative amounts may improve comparability to assist users in making decisions about the particular entity. Module 2 considers the application of comparability in IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors in the context of disclosure requirements for changes in accounting policies. THE COST CONSTRAINT ON USEFUL FINANCIAL REPORTING While the cost constraint of preparing general purpose financial statements was identified as a limitation of GPFSs in general, the Conceptual Framework addresses this concern at the end of Chapter 2, after describing the qualitative characteristics of financial information. More specifically, paragraph 2.39 of the Conceptual Framework notes that a pervasive constraint on financial reporting is the balance between the costs of providing financial information (that include the costs of collecting, processing, verifying and disseminating information) versus the benefits derived from providing such information. 20 Financial Reporting  Providing useful financial information facilitates the efficient functioning of capital markets and lowers the cost of capital (Conceptual Framework, para. 2.41). The provision of relevant and faithfully represented financial information enables users to make more informed decisions and to make their decisions more confidently, which should generally benefit the entity providing that information. However. the cost of meeting all information needs of all users is normally prohibitive, and therefore some information may need to be left out from the statements. Materiality plays an important role in helping preparers and users of financial reports decide what information needs to be provided. In addition, the IASB provides specific exemptions within standards. For example. a lessee may elect to not apply lease recognition, measurement and presentation requirements to leases of less than 12 months and where the asset being leased is of low value (IFRS 16, paras 5-8). This exemption is allowed because the cost of obtaining the required information may exceed the benefit of providing the information to users. As technology progresses, the cost of financial reporting has the potential to decrease, while the benefits of providing the information to users may increase as users may find new ways to analyse it. However, the benefits of providing information via the traditional means of GPFSs may also decrease as users have access to additional sources of relevant information. For example, new technologies may allow users to analyse the tone of voice and facial expressions of executives at analyst or shareholders meetings to make decisions instead of relying on potentially outdated financial information from GPFSs. EXPLORE FURTHER If you wish to explore this topic further, you should read paragraphs 2.39-2.43 of the Conceptual Framework. APPLICATION OF QUALITATIVE CHARACTERISTICS IN THE INTERNATIONAL FINANCIAL REPORTING STANDARDS The qualitative characteristics are reflected in the underlying principles of the IFRSs. IAS 1 Presentation of Financial Statements, paragraphs 15-24, refers to the Conceptual Framework definitions and recognition criteria, objectives and qualitative characteristics. Specifically. IAS 1, paragraph 15, states: 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 application of IFRSs, with additional disclosure when necessary, is presumed to result in financial statements that achieve a fair presentation. 1.4 THE ELEMENTS OF FINANCIAL STATEMENTS Now that the fundamentals of financial reporting have been discussed, how the Conceptual Framework addresses the elements that make up financial statements will be considered. The elements of financial statements are assets, liabilities, equity, income and expenses. Figure 1.4 presents the key decisions relating to the elements of the financial statements. The first two decisions (definition and recognition) will be discussed in this section, while measurement and disclosure will be considered later in the module. DEFINING THE ELEMENTS OF FINANCIAL STATEMENTS Assets Note that the definitions of assets and liabilities are fundamental because the definitions of the other elements flow from them. The Conceptual Framework defines an asset as: a present economic resource controlled by the entity as a result of past events. An economic resource is a right that has the potential to produce economic benefits (paras 4.3-4.4). The three key components of the asset definition are: 1. itis a right 2. it has the potential to produce future economic benefits 3. the asset is controlled by the entity. MODULE 1 The Role and Importance of Financial Reporting 21  FIGURE 1.4 Key decision areas in accounting for transactions and other events * Did a past event, or events, give rise to an item that satisfies [ D=tRuich) the definition of an element of financial statements? * Does an item that meets the definition of an element need to be incorporated in financial statements? * How to measure the items that are recognised in financial statements? i * How should items be disclosed or presented in financial statements or notes to the accounts? Source: CPA Australia 2022. For an asset to exist, an entity must have the right to it, established by contract, legislation or other means. The most common type of rights are the rights arising from legal ownership. While in principle, each of an entity’s right is a separate asset, related rights are treated as a single asset (Conceptual Framework, para. 4.11). Sometimes. it may be difficult to establish whether a right exists. In those cases. until the existence uncertainty is clarified, it is uncertain whether an asset exists. Only the rights that have the potential to produce future economic benefits for an entity beyond the economic benefits available to other parties are to be treated as assets by that entity. Rights that everyone can access and use to generate economic benefits (e.g. rights of access to public goods) cannot be considered assets by entities that use them. For an entity to have control, it does not necessarily follow that the entity has ownership of the asset. For example, IFRS 16 Leases requires a right-of-use asset to be recognised for a leased asset, even though the entity does not own the underlying asset (e.g. a building). This is because the entity controls the benefits arising from using the asset during the lease term. Consider the following example. A mining company has responsibility for maintaining a private road on land over which it holds a lease. The road provides access to the mine. Recently. the company paid for the road to be resealed (resurfaced) at a cost of $3 million. The economic benefits from the resealed road are expected to be obtained over several accounting periods, even though the association with income can only be broadly or indirectly determined. In accordance with IAS 16 Property, Plant and Equipment, the expenditure on resealing the road should be capitalised as part of the road. The new road surface enhances the economic benefits that the company expects to obtain from the use of the road. Control has been established because the resealed road is on land over which the company has obtained control by entering into a lease. The costs of resealing the road should then be progressively recognised over the useful life of the road as expenses (i.e. depreciation). Assets are considered to result from past events. A past event normally occurs when the asset is purchased or produced. However, assets may also arise in other circumstances. For example, an asset may be gifted to the entity as part of a government grant program. It is important to draw the distinction between past events and transactions or events that are expected to occur in the future. Future transactions do not give rise to assets until such time as they occur. For instance, if an entity develops an operational plan that requires the purchase of an item of machinery in six months, the definition of an asset is not met until such time as the machinery is purchased. 22 Financial Reporting  It is important to note that the definition does not require the t to be a physical asset. Many assets, such as patents and copyrights, are intangible in nature. These assets give rise to future economic benefits (in the form of royalties or sales) but do not have a physical form. Liabilities A liabi y is defined as: a present obligation of the entity to transfer an economic resource as a result of past events (Conceptual Framework, para. 4.26). The key components of the liability definition are: 1. the requirement for the entity to have a present obligation 2. the obligation is to transfer an economic resource 3. that the present obligation exists as a result of past events. A present obligation may be legally enforceable, or it may arise from normal business practice, custom and a desire to maintain good business relationships or to act in an equitable manner. For example, an entity selling goods may have a long time practice to accept the return of faulty goods for a full exchange, even after the contractual warranty period has expired, to maintain favourable relationships with its customers. Nevertheless, the present obligation should be strictly related to a transaction or other event that took place in the past — in the previous example, that transaction is the sale of goods. The transfer of economic resources is often referred to as the ‘settlement’ of a liability. Paragraphs 4.39—4.40 of the Conceptual Framework provide examples of how a liability might be settled, as shown in figure 1.5. Examples of how a liability might be settled Transfer of other assets Payment Liability Provision of cash settiement of services Conversion of Replacement the obligation of the obligation to equity with another obligation Source: Adapted from IFRS Foundation 2022, Conceptual Framework for Financial Reporting, paras 4.39-4.40, IFRS Foundation, London, pp. A42-A43. © CPA Australia 2022. The conversion of an obligation to equity and the replacement of an obligation with another obligation do not directly involve a transfer of economic resources. Consider, for example, the issue of shares to debt-holders in settlement of a liability. The issue of shares would normally involve consideration passing to the entity. If debt is settled by conversion to shares, the consideration ‘paid’ by the debt-holders is the surrender of their debt claim against the entity. From the perspective of the entity issuing the shares, the consideration is the discharge of the obligation for the debt. Instead of receiving an inflow of economic resources in consideration for the issue of shares, it has avoided an outflow of resources. The economic MODULE 1 The Role and Importance of Financial Reporting 23 substance is the same as if the new shareholders had contributed cash or other economic resources for the shares and those resources were used to settle the liability. Liabilities only arise from a past event or transaction. For example, if an entity purchases an item of equipment for $1 million and agrees to pay for the equipment in 90 days, the past event is purchasing the asset (the equipment), and the entity has an obligation to pay for the equipment. It is important to note that a decision by management to undertake a particular transaction in the future (e.g. to acquire a new item of plant and equipment) does not, of itself, give rise to a liability. Equity Equity is defined as ‘the residual interest in the assets of the entity after deducting all its liabilities’ (Conceptual Framework, para. 4.63). The definition of equity flows from the definitions of assets and liabilities. Equity is simply the difference between assets and liabilities. Furthermore, the amount at which equity is shown in the statement of financial position is derived from the recognition and measurement of assets and liabilities. Figure 1.6 illustrates how equity changes during the reporting period because of an entity’s financial performance and its contributions from, and distributions to, holders of equity claims. How recognition links the elements of financial statements Statement of financial position at beginning of reporting period Assets minus liabilities equal equity |+ Statement(s) of financial performance Income minus expenses - Changes in equity Contributions from holders of equity claims minus distributions to holders of equity claims Statement of financial position at end of reporting period Assets minus liabilities equal equity Source: IFRS Foundation 2022, Conceptual Framework for Financial Reporting, IFRS Foundation, London, diagram 5.1, p. AS1. EXPLORE FURTHER If you wish to explore this topic further, you should read paragraphs 4.63-4.67 of the Conceptual Framework. Income Income is defined as: increases in assets, o decreases of liabilities, that result in increases in equity, other than those relating to contributions from holders of equity claims (Conceptual Framework, para. 4.68). The two essential characteristics of income are: 1. an increase in assets or a reduction in liabilities 2. an increase in equity, other than as a result of a contribution from owners. Income does not arise from an increase in assets if there is a corresponding increase in liabilities because there would not be an increase in equity. For example, if an entity receives revenue in advance of services being provided. it would recognise an increase in assets (i.e. cash) and an equivalent increase in liabilities (i.e. unearned revenue or revenue received in advance) representing the obligation to deliver services yet to be rendered. Income does not arise until the liability is reduced. As the services are rendered, the entity recognises income and a corresponding reduction in the liability. 24 Financial Reporting  Income refers to both revenue and gains. Revenue arises in the course of the ordinary activities of an entity (e.g. through sales). Revenue from contracts with customers, a subset of revenue, is discussed in module 3. Gains are those items that meet the definition of income that may or may not arise in the course of ordinary activities of an entity (e.g. sale of a non-current asset). They are not a separate element in the Conceptual Framework as they are not considered different in nature to revenue (Conceptual Framework, para. 4.72). Expenses Expenses are defined as: decreases in assets, or increases of liabilities, that result in decreases in equity, other than those relating to distributions to holders of equity claims (Conceptual Framework, para. 4.69). The two essential characteristics of an expense are: 1. a decrease in assets or an increase in liabilities 2. adecrease in equity, other than those arising from distributions to holders of equity claims. An expense is the opposite of income. An example of an expense is wages, which involve outflows of cash and cash equivalents to employees for the provision of services. Depreciation is an example of an expense involving the depletion of assets. The accrual of electricity charges gives rise to an expense involving the incurrence of a liability. The measurement of profit or loss is determined as the difference between income and expenses. However, under the IFRSs, not all items that meet the definitions of income and expenses are recognised as income or expenses used in the calculation of profit. For example, revaluation gains on property, plant and equipment under the valuation model are required to be recognised in OCI and accumulated in equity, unless a prior downward revaluation is being reversed (IAS 16 Property, Plant and Equipment). Gains and losses that are recognised in other comprehensive income are reported in the statement of P/L and OCI in accordance with IAS 1 Presentation of Financial Statements (refer to module 2). EXPLORE FURTHER If you wish to explore this topic further, you should read paragraphs 4.68-4.72 of the Conceptual Framework. CRITERIA FOR RECOGNISING ELEMENTS OF FINANCIAL STATEMENTS Recognising elements of financial statements involves capturing, in words and with a monetary amount, the items that meet the definition of an asset, a liability, equity, income or expenses, either alone or in combination with other items that meet the same definition. The items recognised as assets, liabilities and equity will then be depicted in the statement of financial position, while the recognised income and expenses will be included in the statement of f